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FIN 540 Final Exam

FIN 540 Week 11 Final Exam – Strayer

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Chapters 24 Through 30

CHAPTER 24—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION

TRUE/FALSE

1. A central question that must be addressed in bankruptcy proceedings is whether the firm’s inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values.

2. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm’s income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants.

3. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority.

4. The primary test of feasibility in a reorganization is whether the firm’s fixed charges after reorganization can be covered by its projected cash flows.

5. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes.

6. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating.

7. Even if a firm’s cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment.

8. One of the actions that can be taken in bankruptcy under the standard of feasibility is to replace existing management with a new team if the quality of management is judged to have been substandard.

MULTIPLE CHOICE

9. Chapter 7 of the Bankruptcy Act is designed to do which of the following?
a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.
b. Ensure that the firm is viable after emerging from bankruptcy.
c. Allow the firm to negotiate with each creditor individually.
d. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt.
e. Protect shareholders against creditors.

10. Which of the following statements is most CORRECT?
a. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws.
b. All bankruptcy petitions are filed by creditors seeking to protect their claims against firms in financial distress. Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm’s management.
c. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act.
d. “Restructuring” a firm’s debt can involve forgiving a certain portion of the debt, but it cannot call for changing the debt’s maturity or its contractual interest rate.
e. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.

11. Which of the following statements is most CORRECT?
a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
b. The basic doctrine of fairness states that all debtholders must be treated equally.
c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely.
e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its assets if they are sold off individually.

12. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) Trustees’ costs to administer and operate the firm.
(2) Common stockholders.
(3) General, or unsecured, creditors.
(4) Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan.
(5) Taxes due to federal and state governments.

a. 5, 4, 1, 3, 2
b. 4, 1, 5, 3, 2
c. 5, 1, 4, 2, 3
d. 1, 5, 4, 3, 2
e. 1, 4, 3, 5, 2

CHAPTER 25—PORTFOLIO THEORY AND ASSET PRICING MODELS

TRUE/FALSE

1. The slope of the SML is determined by the value of beta.

2. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck’s stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

3. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

4. A stock with a beta equal to −1.0 has zero systematic (or market) risk.

5. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

6. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

7. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

8. The CAPM is a multi-period model which takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

9. The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

10. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

11. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

MULTIPLE CHOICE

13. You have the following data on three stocks:

Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

As a risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
a. A; B.
b. B; C.
c. C; A.
d. C; B.
e. A; A.

14. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.

15. Which of the following is NOT a potential problem with beta and its estimation?
a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta.
b. The beta of “the market,” can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
d. There is a wide confidence interval around a typical stock’s estimated beta.
e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

16. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.

17. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),
a. The past realized rate of return must be equal to the expected rate of return; that is, .
b. The required rate of return must equal the realized rate of return; that is, r = .
c. All companies must pay dividends.
d. No companies can be in danger of declaring bankruptcy.
e. The expected rate of return must be equal to the required rate of return; that is, = r.

18. Which of the following statements is CORRECT?
a. The slope of the CML is (M − rRF)/bM.
b. All portfolios that lie on the CML to the right of M are inefficient.
c. All portfolios that lie on the CML to the left of M are inefficient.
d. The slope of the CML is (M − rRF)/M.
e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

19. In a portfolio of three different stocks, which of the following could NOT be true?
a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is less than the betas of each of the individual stocks.
c. The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.
d. The beta of the portfolio cannot be equal to 1.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

20. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B
1 0.03 0.16 0.05
2 −0.05 0.20 0.05
3 0.01 0.18 0.05
4 −0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > +1; bB = 0.
b. bA = 0; bB = −1.
c. bA < 0; bB = 0.
d. bA < −1; bB = 1. e. bA > 0; bB = 1.

21. Which of the following statements is CORRECT?
a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.
e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

22. Which of the following statements is CORRECT?
a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The slope of the characteristic line is the stock’s standard deviation.
c. The distance of the plot points from the characteristic line is a measure of the stock’s market risk.
d. The distance of the plot points from the characteristic line is a measure of the stock’s diversifiable risk.
e. “Characteristic line” is another name for the Security Market Line.

23. Which of the following statements is CORRECT?
a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.
b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM.
c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.
d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.
e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

24. Assume an economy in which there are three securities: Stock A with rA = 10% and A = 10%; Stock B with rB = 15% and B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT?
a. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
b. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
c. The investor’s risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.
e. The expected return on the investor’s portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

25. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio?
a. 1.1139
b. 1.1700
c. 1.2311
d. 1.2927
e. 1.3573

26. Your mother’s well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock?

rp bp
a. 11.69%; 1.22
b. 12.30%; 1.28
c. 12.92%; 1.34
d. 13.56%; 1.41
e. 14.24%; 1.48

27. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.’s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc.
a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%

28. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?
a. 36.10%
b. 38.00%
c. 40.00%
d. 42.00%
e. 44.10%

29. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market’s required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund’s assets are as follows:

Stock Investment Beta
A $ 200,000 1.50
B 300,000 −0.50
C 500,000 1.25
D 1,000,000 0.75

a. 10.67%
b. 11.23%
c. 11.82%
d. 12.45%
e. 13.10%

30. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the indicated percentage. What is the firm’s new required rate of return?

Beta: 1.50
Required return (rs) 10.20%
RPM: 6.00%
Percentage increase in beta: 20%

a. 14.00%
b. 14.70%
c. 15.44%
d. 16.21%
e. 17.02%

31. Assume that the market is in equilibrium and that stock betas can be estimated with historical data. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required return on the United Fund are shown below. Based on this information, what is the required return on the market, rM?

Year Market UF
2008 −9% −14%
2009 11% 16%
2010 15% 22%
2011 5% 7%
2012 −1% −2%

rRF: 7.00%; rUnited: 15.00%

a. 10.57%
b. 11.13%
c. 11.72%
d. 12.33%
e. 12.95%

32. You are given the following returns on “the market” and Stock F during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what’s the value of beta 2 − beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator’s regression function.)

Year Market Stock F
1 6.10% 6.50%
2 12.90% −3.70%
3 16.20% 21.71%

a. 7.89
b. 8.30
c. 8.74
d. 9.20
e. 9.66

PROBLEM

33. Security A has an expected return of 12.4% with a standard deviation of 15%, and a correlation with the market of 0.85. Security B has an expected return of −0.73% with a standard deviation of 20%, and a correlation with the market of −0.67. The standard deviation of rM is 12%.
a. To someone who acts in accordance with the CAPM, which security is more risky, A or B? Why? (Hint: No calculations are necessary to answer this question; it is easy.)
b. What are the beta coefficients of A and B? Calculations are necessary.
c. If the risk-free rate is 6%, what is the value of rM?

34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and X = 5%. The expected return for Y is 12% and Y = 6%. The correlation coefficient, rXY, is 0.75.
a. Calculate rp and p for 100%, 75%, 50%, 25%, and 0% in Stock X.
b. Use the values you calculated for rp and p to graph the attainable set of portfolios. Which part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves to show how an investor might select a portfolio comprised of Stocks X and Y. Let an indifference curve be tangent to the efficient set at the point where rp = 11%.
c. Now suppose we add a riskless asset to the investment possibilities. What effects will this have on the construction of portfolios?
d. Suppose rM = 12%, M = 4%, and rRF = 6%. What would be the required and expected return on a portfolio with P = 10%?
e. Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this information, along with data given previously, to determine Stock X’s and Stock Y’s beta coefficients.
f. What is the required rate of return on Stocks X and Y? Do these stocks appear to be in equilibrium? If not, what would happen to bring about an equilibrium?

35. Stock A has an expected return rA = 10% and A = 10%. Stock B has rB = 14% and B = 15%. rAB = 0. The rate of return on riskless assets is 6%.
a. Construct a graph that shows the feasible and efficient sets, giving consideration to the existence of the riskless asset.
b. Explain what would happen to the CML if the two stocks had (a) a positive correlation coefficient or (b) a negative correlation coefficient.
c. Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone’s indifference curves were such that they were tangent to the CML to the right of the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

CHAPTER 26—REAL OPTIONS

TRUE/FALSE

1. Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows.

2. Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds.

3. The option to abandon a project is a real option, but a call option on a stock is not a real option.

4. Real options are most valuable when the underlying source of risk is very low.

5. Real options affect the size, but not the risk, of a project’s expected cash flows.

MULTIPLE CHOICE

6. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option?
a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today.
b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year.
c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
d. Waiting would probably reduce the project’s risk.
e. The investment timing option does not affect the cash flows and will therefore have no impact on the project’s risk.

7. Which one of the following is an example of a “flexibility” option?
a. A company has an option to close down an operation if it turns out to be unprofitable.
b. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial.
e. A company has an option to invest in a project today or to wait a year.

8. Which of the following is NOT a real option?
a. The option to buy shares of stock if its price goes up.
b. The option to expand into a new geographic region.
c. The option to abandon a project.
d. The option to switch the type of fuel used in an industrial furnace.
e. The option to expand production if the product is successful.

9. Which of the following will NOT increase the value of a real option?
a. An increase in the volatility of the underlying source of risk.
b. An increase in the risk-free rate.
c. An increase in the cost of obtaining the real option.
d. A decrease in the probability that a competitor will enter the market of the project in question.
e. Lengthening the time in which a real option must be exercised.

10. Which of the following is most CORRECT?
a. Real options change the risk, but not the size, of projects’ expected cash flows.
b. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash flows.
c. Very few projects actually have real options.
d. Real options are less valuable when there is a lot of uncertainty about the true values future sales and costs.
e. Real options change the size, but not the risk, of projects’ expected cash flows.

11. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation?
a. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.
b. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.
d. Real options should not have any effect on the size of the optimal capital budget.
e. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.

12. Refer to Exhibit 26.1. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project’s expected NPV, in thousands of dollars?
a. $336.15
b. $373.50
c. $415.00
d. $461.11
e. $507.22

13. Refer to Exhibit 26.1. Calculate the project’s coefficient of variation. (Hint: Use the expected NPV.)
a. 5.87
b. 6.52
c. 7.25
d. 7.97
e. 8.77

14. Refer to Exhibit 26.2. Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project’s expected NPV in today’s dollars (i.e., at t = 0), relative to the NPV if it proceeds today?
a. $77.23
b. $85.81
c. $95.34
d. $105.94
e. $116.53

15. Refer to Exhibit 26.2. Calculate the effect of waiting on the project’s risk, using the same data. By how much will delaying reduce the project’s coefficient of variation? (Hint: Use the expected NPV.)
a. 2.23
b. 2.46
c. 2.70
d. 2.97
e. 3.27

16. Refer to Exhibit 26.3. Based on the above data, what is the project’s net present value?
a. −$1,312,456
b. −$1,104,607
c. −$875,203
d. $105,999
e. $321,788

17. Refer to Exhibit 26.3. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
a. −$1,104,607
b. −$875,203
c. $199,328
d. $561,947
e. $898,205

18. Refer to Exhibit 26.4. Based on the above information, what is the Z−90’s expected net present value?
a. −$6,678
b. −$3,251
c. $15,303
d. $20,004
e. $45,965

19. Refer to Exhibit 26.4. Now assume that one year from now SI will know if the Z−45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?
a. $0
b. $2,075
c. $4,067
d. $8,945
e. $10,745

CHAPTER 27—PROVIDING AND OBTAINING CREDIT

TRUE/FALSE

1. The credit period is the amount of time it takes to do a credit search on a potential customer.

2. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit.

3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business.

4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses.

5. Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms.

6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount.

7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly.

8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged.

10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month’s sales.

MULTIPLE CHOICE

1. A firm’s credit policy consists of which of the following items?
a. Credit period, cash discounts, credit standards, collection policy.
b. Credit period, cash discounts, receivables monitoring, collection policy.
c. Cash discounts, credit standards, receivables monitoring, collection policy.
d. Credit period, receivables monitoring, credit standards, collection policy.
e. Credit period, cash discounts, credit standards, receivables monitoring.

2. Which of the following is not correct?
a. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales.
b. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased.
c. Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account.
d. A lax collection policy will frequently lead to an increase in accounts receivable.
e. Collection policy is how a firm goes about collecting past-due accounts.

3. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days?
a. The quarterly uncollected balances schedule will be the same in each quarter.
b. The level of accounts receivable will be constant from month to month.
c. The ratio of accounts receivable to sales will vary from month to month.
d. The level of accounts receivable at the end of each quarter will be the same.
e. DSO will vary from month to month.

4. Which of the following statements is most correct?
a. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially “weak” firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts.
b. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity.
c. Firms use seasonal dating primarily to decrease their DSO.
d. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st.
e. If credit sales as a percentage of a firm’s total sales increases, and the volume of credit sales also increases, then the firm’s accounts receivable will automatically increase.

5. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank?
a. Competitive cost of services provided.
b. Size of the bank’s deposits.
c. Experience of personnel.
d. Loyalty and willingness to assume lending risks.
e. Convenience of location.

6. Refer to Exhibit 27.1. How large are your brother’s monthly payments?
a. $6,250
b. $7,000
c. $7,500
d. $5,250
e. $6,875

7. Refer to Exhibit 27.1. What is the nominal annual add-on interest rate on this loan?
a. 10.00%
b. 16.47%
c. 18.83%
d. 20.00%
e. 24.00%

8. Suppose that you’re planning a vacation and borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged?
a. 14.00%
b. 8.57%
c. 16.28%
d. 21.21%
e. 28.00%

9. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans?
a. 11.00%
b. 15.94%
c. 11.46%
d. 13.75%
e. 12.72%

10. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent “add-on”, one-year installment loan, payable in four equal quarterly payments. What is the effective annual rate of interest?
a. 9.50%
b. 10.19%
c. 15.99%
d. 16.98%
e. 20.38%

11. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan?
a. 16.22%
b. 17.97%
c. 17.48%
d. 18.67%
e. 18.00%

12. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request for a $75,000, 1-year loan.

Alternative 1: 7 percent discount interest, with a 10 percent compensating balance.
Alternative 2: 8 percent simple interest, with interest paid monthly.

What is the effective annual rate on the cheaper loan?
a. 8.00%
b. 7.23%
c. 7.67%
d. 8.43%
e. 8.30%

13. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discounted loan?
a. 10.7%
b. 12.0%
c. 12.5%
d. 13.6%
e. 14.1%

14. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11 percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note?
a. $111,000
b. $100,000
c. $112,360
d. $89,000
e. $108,840

15. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note?
a. $61,856
b. $67,531
c. $60,000
d. $68,182
e. $67,423

16. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan?
a. 5.10%
b. 10.19%
c. 12.00%
d. 20.38%
e. 30.57%

17. Refer to Exhibit 27.2. What would be the incremental bad losses if the change were made?
a. $315,000
b. $260,500
c. −$260,500 (bad debt losses would decline)
d. −$315,000 (Bad debt losses would decline)
e. $0 (no change would occur)

18. Refer to Exhibit 27.2. What would be the incremental cost of carrying receivables if this change were made?
a. $108,750
b. −$116,250 (carrying costs would decline)
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,500

19. Refer to Exhibit 27.2. What are the incremental pre-tax profits from this proposal?
a. $181,250
b. $271,750
c. $256,250
d. $206,500
e. $231,250

20. Refer to Exhibit 272.3. What would be the cost to Van Doren of the discounts taken?
a. $116,750
b. −$108,750
c. $155,000
d. $225,000
e. $260,500

21. Refer to Exhibit 27.3. What would be the incremental bad debt losses if the change were made?
a. $130,000
b. $250,000
c. −$250,000 (bad debt losses would decline)
d. −$130,000 (bad debt losses would decline)
e. $620,000

22. Refer to Exhibit 27.3. What would be the incremental cost of carrying receivables if the change were made?
a. −$108,750 (carrying costs would decline)
b. $116,250
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,000

23. Refer to Exhibit 27.3. What are the incremental pre-tax profits from this proposal?
a. $283,750
b. $250,500
c. $303,250
d. $493,750
e. $288,250

24. Darren’s Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Darren already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Darren would otherwise keep in the account. Which of the following statements is most correct?
a. The cost of using additional trade credit is approximately 36 percent.
b. Considering only the explicit costs, Darren should finance the expansion with the bank loan.
c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan.
d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Darren would hold a cash balance of one-half the compensating balance amount even if the loan were not taken.
e. If Darren had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

25. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates?
a. 1.12%
b. 2.48%
c. 3.60%
d. 4.25%
e. 5.00%

26. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its credit period?
a. −$20,000
b. −$10,000
c. $0
d. $10,000
e. $20,000

27. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan?
a. 9.50%
b. 10.19%
c. 15.22%
d. 16.99%
e. 22.05%

CHAPTER 28—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

TRUE/FALSE

1. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together.

2. The easier a firm’s access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates.

3. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash.

4. A just-in-time system is designed to stretch accounts payable as long as possible.

5. If a company increases its safety stock, then its EOQ will go up.

6. If a company increases its safety stock, then its average inventory will go up.

MULTIPLE CHOICE

7. Which of the following would cause average inventory holdings to decrease, other things held constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.

8. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn’t matter which you use since cash flow is unaffected by the choice of inventory identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

9. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*.
a. If the total amount of cash needed during the year increases by 20%, then C* will increase by 20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

10. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

11. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748

12. Humphrey’s Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now?
a. $200
b. $333
c. $414
d. $500
e. $666

13. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180, and the total cash needed for transactions annually is $960,000. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

14. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180. In addition, the total estimated cash costs (transfers and carrying cost) for the firm, based on 16 transactions per year, are $5,760. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

15. Suppose Stanley’s Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.)
a. $1,000 loss
b. $1,000 benefit
c. $500 loss
d. $500 benefit
e. $0 (The change would not affect profits.)

16. Each year, Holly’s Best Salad Dressing, Inc. (HBSD) purchases 50,000 gallons of extra virgin olive oil. Ordering costs are $100 per order, and the carrying cost, as a percentage of inventory value, is 80 percent. The purchase price to HBSD is $0.50 per gallon. Management currently orders the EOQ each time an order is placed. No safety stock is carried. The supplier is now offering a quantity discount of $0.03 per gallon if HBSD orders 10,000 gallons at a time. Should HBSD take the discount?
a. From a cost standpoint, HBSD is indifferent.
b. No, the cost exceeds the benefit by $500.
c. No, the cost exceeds the benefit by $1,000.
d. Yes, the benefit exceeds the cost by $500.
e. Yes, the benefit exceeds the cost by $1,120.

17. New England Charm, Inc. specializes in selling scented candles. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered New England’s inventory problem from the EOQ model viewpoint. If the following constitute the relevant data, how does the current policy compare with the optimal policy?

Ordering cost = $10 per order
Carrying cost = 20% of purchase price
Purchase price = $10 per unit
Total sales for year = 1,000 units
Safety stock = 0

a. Total costs will be the same, since the current policy is optimal.
b. Total costs under the current policy will be less than total costs under the EOQ by $10.
c. Total costs under the current policy exceed those under the EOQ by $3.
d. Total costs under the current policy exceed those under the EOQ by $10.
e. Cannot be determined due to insufficient information.

18. Refer to Exhibit 28.1. According to the Baumol model, what is the optimal transaction size for transfers from marketable securities to cash?
a. $7,071
b. $38,357
c. $70,711
d. $102,956
e. $87,000

19. Refer to Exhibit 28.1. According to the Baumol model, what should be Duckett’s average cash balance?
a. $35,356
b. $3,536
c. $22,157
d. $70,711
e. $42,918

20. Refer to Exhibit 28.1. What will be the total cost to Duckett of maintaining the optimal average cash balance, as determined by the Baumol model?
a. $35,356
b. $7,071
c. $18,493
d. $70,711
e. $53,190

21. Refer to Exhibit 28.2. What is the economic ordering quantity for chips?
a. 12,088
b. 3,175
c. 6,243
d. 13,675
e. 8,124

22. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is its average inventory level?
a. 12,088
b. 3,175
c. 15,750
d. 13,675
e. 8,124

23. Refer to Exhibit 28.2. Assume that Cartwright holds a safety stock equal to a 30-day supply of chips. What is the maximum amount of inventory that will have on hand at any time, that is, what will be the inventory level right after a delivery is made?
a. 9,216
b. 3,175
c. 6,243
d. 13,675
e. 8,124

24. Refer to Exhibit 28.2. How many orders should Cartwright place during the year?
a. 12
b. 25
c. 30
d. 40
e. 60

25. Refer to Exhibit 28.2. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30-day supply of chips, then at what inventory level should an order be placed?
a. 15,570
b. 3,175
c. 12,250
d. 13,675
e. 8,124

26. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is Cartwright’s minimum cost of ordering and carrying inventory?
a. $28,500
b. $15,950
c. $68,440
d. $34,220
e. $47,693

27. Refer to Exhibit 28.3. What is the firm’s EOQ?
a. 26,833
b. 30,040
c. 43,987
d. 13,563
e. 21,456

28. Refer to Exhibit 28.3. What is Palmer’s minimum costs of ordering and holding inventory?
a. $6,254
b. $10,733
c. $11,560
d. $13,563
e. $19,825

29. Refer to Exhibit 28.3. Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a least 40,000 gallons. Should Palmer increase its ordering quantity to take the discount?
a. Yes; it will save $827 if it takes the discount.
b. No; it will lose $827 if it takes the discount.
c. Yes; it will save $14,400 if it takes the discount.
d. Yes; it will save $13,573 if it takes the discount.
e. No; it will lose $13,573 if it takes the discount.

WEB CHAPTER 29—PENSION PLAN MANAGEMENT

TRUE/FALSE

1. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm’s pension fund.

2. If employees have a right to receive pension benefits even if they leave the company prior to retirement, their pension rights are said to be vested.

3. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan.

4. The performance measurement of stock portfolio managers must recognize the risk inherent in the investment portfolio. One way to incorporate risk into performance measurement is to examine the portfolio’s alpha, which measures the vertical distance of the portfolio’s return above or below the Security Market Line.

MULTIPLE CHOICE

5. Which of the following statements about pension plans if any, is incorrect?
a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee’s final salary.
b. A portable pension plan is one that an employee can carry from one employer to another.
c. An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.
d. If assets exceed the present value of benefits, the pension plan is fully funded.
e. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

6. Which of the following statements about defined contribution plans is incorrect?
a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.
b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.
c. Defined benefit plans are used more often by large corporations than by small companies.
d. The PBGC insures a portion of pension benefits.
e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

7. Which of the following statements about pension plan portfolio performance is incorrect?
a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.
b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives.
c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.
d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.
e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

8. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd’s current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years. Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year’s wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd’s expected annual retirement benefit, rounded to the nearest thousands of dollars?
a. $35,000
b. $57,000
c. $89,000
d. $116,000
e. $132,000

9. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio’s alpha?
a. −0.75%
b. −0.15%
c. 0%
d. 0.15%
e. 0.75%

10. Arnold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20,000 at the end of each year following retirement until death. The firm’s pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington’s annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows.)
a. $2,756
b. $3,642
c. $4,443
d. $4,967
e. $5,491

WEB CHAPTER 30—FINANCIAL MANAGEMENT IN NOT-FOR-PROFIT BUSINESSES

TRUE/FALSE

1. The primary goal of investor-owned firms is shareholder wealth maximization, while the primary goal of not-for-profit firms is typically stated in terms of some mission; for example, to provide health care services to the communities served.

2. Not-for-profit firms have fund capital in place of equity capital. Since fund capital does not have to provide a return to stockholders, the appropriate cost of fund capital in a cost of capital estimate is zero.

3. Since not-for-profit firms do not pay taxes, they receive no tax benefits whatsoever from using debt financing.

4. The net present social value model formally recognizes that not-for-profit firms must consider the social value along with the financial value of proposed new projects.

MULTIPLE CHOICE

5. Which of the following statements about project risk analysis in not-for-profit firms is incorrect?
a. A project’s corporate beta measures the contribution of the project to the overall corporate risk of the firm.
b. A project’s corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio.
c. A project’s corporate beta is defined as (P/F)rPF, where P is the standard deviation of the project’s returns, F is the standard deviation of the firm’s returns, and rPF is the correlation among the two sets of returns.
d. In practice, it is usually difficult, if not impossible, to directly measure a project’s corporate risk, so project risk analysis typically focuses on stand-alone risk.
e. The market risk of a project is not relevant to not-for-profit firms.

6. Which of the following statements about municipal bond financing is most correct?
a. Whereas the vast majority of Treasury and corporate bonds are held by institutions, no municipal bonds are held by individual investors.
b. The primary attraction of municipal bonds to individual investors is their high before-tax yields.
c. Municipal bonds usually pay higher coupon rates than corporate bonds with similar ratings.
d. Municipal bonds are risk-free.
e. In contrast to corporate bonds, municipal bond issues are not required to be registered with the Securities and Exchange Commission.

7. Which of the following statements about a not-for-profit firm’s ownership is most correct?
a. The residual earnings (profits) of not-for-profit firms can be distributed to the firm’s top managers.
b. Not-for-profit firms are exempt from federal taxes, but they must pay state and local taxes, including property taxes.
c. Upon liquidation of a not-for-profit firm, the proceeds from the sale of its assets are distributed, on a pro rata basis, to the firm’s employees.
d. None of the profits are used for private inurement.
e. Not-for-profit firms are governed by a board of trustees whose members are elected by the community at large.

8. Which of the following statements about a not-for-profit firm’s cost of capital estimate is most correct?
a. The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings.
b. The cost of tax-exempt debt issued by not-for-profit firms is increased (“grossed up”) by 1 − T in the WACC estimate to reflect the fact that such firms do not pay taxes.
c. Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investor-owned companies.
d. Not-for-profit firms have a zero cost of capital.
e. Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.

9. Which of the following statements about a not-for-profit firm’s fund capital is most correct?
a. The sole source of fund capital is the excess of revenues over expenses.
b. Fund capital has a zero opportunity cost.
c. Fund capital can only come from donations.
d. Fund capital does not change over time.
e. Fund capital is equivalent to equity capital in investor-owned firms.

10. Which of the following statements about a not-for-profit firm’s sources of capital is most correct?
a. Fund capital is obtained by retaining earnings⎯if all earnings are paid out as dividends, no fund capital is created.
b. Preferred stock is never used by not-for-profit firms.
c. Not-for-profit firms are not allowed to raise capital by borrowing.
d. Not-for-profit firms usually have high dividend payouts.
e. Since not-for-profit firms are tax exempt, there is no tax advantage to debt capital.

FIN 540 Week 11 Final Exam – Strayer University NEW

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Chapters 24 Through 30

CHAPTER 24—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION

TRUE/FALSE

1. A central question that must be addressed in bankruptcy proceedings is whether the firm’s inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values.

2. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm’s income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants.

3. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority.

4. The primary test of feasibility in a reorganization is whether the firm’s fixed charges after reorganization can be covered by its projected cash flows.

5. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes.

6. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating.

7. Even if a firm’s cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment.

8. One of the actions that can be taken in bankruptcy under the standard of feasibility is to replace existing management with a new team if the quality of management is judged to have been substandard.

MULTIPLE CHOICE

9. Chapter 7 of the Bankruptcy Act is designed to do which of the following?
a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.
b. Ensure that the firm is viable after emerging from bankruptcy.
c. Allow the firm to negotiate with each creditor individually.
d. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt.
e. Protect shareholders against creditors.

10. Which of the following statements is most CORRECT?
a. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws.
b. All bankruptcy petitions are filed by creditors seeking to protect their claims against firms in financial distress. Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm’s management.
c. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act.
d. “Restructuring” a firm’s debt can involve forgiving a certain portion of the debt, but it cannot call for changing the debt’s maturity or its contractual interest rate.
e. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.

11. Which of the following statements is most CORRECT?
a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
b. The basic doctrine of fairness states that all debtholders must be treated equally.
c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely.
e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its assets if they are sold off individually.

12. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) Trustees’ costs to administer and operate the firm.
(2) Common stockholders.
(3) General, or unsecured, creditors.
(4) Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan.
(5) Taxes due to federal and state governments.

a. 5, 4, 1, 3, 2
b. 4, 1, 5, 3, 2
c. 5, 1, 4, 2, 3
d. 1, 5, 4, 3, 2
e. 1, 4, 3, 5, 2

CHAPTER 25—PORTFOLIO THEORY AND ASSET PRICING MODELS

TRUE/FALSE

1. The slope of the SML is determined by the value of beta.

2. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck’s stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

3. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

4. A stock with a beta equal to −1.0 has zero systematic (or market) risk.

5. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

6. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

7. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

8. The CAPM is a multi-period model which takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

9. The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

10. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

11. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

MULTIPLE CHOICE

13. You have the following data on three stocks:

Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

As a risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
a. A; B.
b. B; C.
c. C; A.
d. C; B.
e. A; A.

14. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.

15. Which of the following is NOT a potential problem with beta and its estimation?
a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta.
b. The beta of “the market,” can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
d. There is a wide confidence interval around a typical stock’s estimated beta.
e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

16. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.

17. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),
a. The past realized rate of return must be equal to the expected rate of return; that is, .
b. The required rate of return must equal the realized rate of return; that is, r = .
c. All companies must pay dividends.
d. No companies can be in danger of declaring bankruptcy.
e. The expected rate of return must be equal to the required rate of return; that is, = r.

18. Which of the following statements is CORRECT?
a. The slope of the CML is (M − rRF)/bM.
b. All portfolios that lie on the CML to the right of M are inefficient.
c. All portfolios that lie on the CML to the left of M are inefficient.
d. The slope of the CML is (M − rRF)/M.
e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

19. In a portfolio of three different stocks, which of the following could NOT be true?
a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is less than the betas of each of the individual stocks.
c. The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.
d. The beta of the portfolio cannot be equal to 1.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

20. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B
1 0.03 0.16 0.05
2 −0.05 0.20 0.05
3 0.01 0.18 0.05
4 −0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > +1; bB = 0.
b. bA = 0; bB = −1.
c. bA < 0; bB = 0.
d. bA < −1; bB = 1. e. bA > 0; bB = 1.

21. Which of the following statements is CORRECT?
a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.
e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

22. Which of the following statements is CORRECT?
a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The slope of the characteristic line is the stock’s standard deviation.
c. The distance of the plot points from the characteristic line is a measure of the stock’s market risk.
d. The distance of the plot points from the characteristic line is a measure of the stock’s diversifiable risk.
e. “Characteristic line” is another name for the Security Market Line.

23. Which of the following statements is CORRECT?
a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.
b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM.
c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.
d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.
e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

24. Assume an economy in which there are three securities: Stock A with rA = 10% and A = 10%; Stock B with rB = 15% and B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT?
a. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
b. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
c. The investor’s risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.
e. The expected return on the investor’s portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

25. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio?
a. 1.1139
b. 1.1700
c. 1.2311
d. 1.2927
e. 1.3573

26. Your mother’s well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock?

rp bp
a. 11.69%; 1.22
b. 12.30%; 1.28
c. 12.92%; 1.34
d. 13.56%; 1.41
e. 14.24%; 1.48

27. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.’s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc.
a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%

28. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?
a. 36.10%
b. 38.00%
c. 40.00%
d. 42.00%
e. 44.10%

29. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market’s required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund’s assets are as follows:

Stock Investment Beta
A $ 200,000 1.50
B 300,000 −0.50
C 500,000 1.25
D 1,000,000 0.75

a. 10.67%
b. 11.23%
c. 11.82%
d. 12.45%
e. 13.10%

30. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the indicated percentage. What is the firm’s new required rate of return?

Beta: 1.50
Required return (rs) 10.20%
RPM: 6.00%
Percentage increase in beta: 20%

a. 14.00%
b. 14.70%
c. 15.44%
d. 16.21%
e. 17.02%

31. Assume that the market is in equilibrium and that stock betas can be estimated with historical data. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required return on the United Fund are shown below. Based on this information, what is the required return on the market, rM?

Year Market UF
2008 −9% −14%
2009 11% 16%
2010 15% 22%
2011 5% 7%
2012 −1% −2%

rRF: 7.00%; rUnited: 15.00%

a. 10.57%
b. 11.13%
c. 11.72%
d. 12.33%
e. 12.95%

32. You are given the following returns on “the market” and Stock F during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what’s the value of beta 2 − beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator’s regression function.)

Year Market Stock F
1 6.10% 6.50%
2 12.90% −3.70%
3 16.20% 21.71%

a. 7.89
b. 8.30
c. 8.74
d. 9.20
e. 9.66

PROBLEM

33. Security A has an expected return of 12.4% with a standard deviation of 15%, and a correlation with the market of 0.85. Security B has an expected return of −0.73% with a standard deviation of 20%, and a correlation with the market of −0.67. The standard deviation of rM is 12%.
a. To someone who acts in accordance with the CAPM, which security is more risky, A or B? Why? (Hint: No calculations are necessary to answer this question; it is easy.)
b. What are the beta coefficients of A and B? Calculations are necessary.
c. If the risk-free rate is 6%, what is the value of rM?

34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and X = 5%. The expected return for Y is 12% and Y = 6%. The correlation coefficient, rXY, is 0.75.
a. Calculate rp and p for 100%, 75%, 50%, 25%, and 0% in Stock X.
b. Use the values you calculated for rp and p to graph the attainable set of portfolios. Which part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves to show how an investor might select a portfolio comprised of Stocks X and Y. Let an indifference curve be tangent to the efficient set at the point where rp = 11%.
c. Now suppose we add a riskless asset to the investment possibilities. What effects will this have on the construction of portfolios?
d. Suppose rM = 12%, M = 4%, and rRF = 6%. What would be the required and expected return on a portfolio with P = 10%?
e. Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this information, along with data given previously, to determine Stock X’s and Stock Y’s beta coefficients.
f. What is the required rate of return on Stocks X and Y? Do these stocks appear to be in equilibrium? If not, what would happen to bring about an equilibrium?

35. Stock A has an expected return rA = 10% and A = 10%. Stock B has rB = 14% and B = 15%. rAB = 0. The rate of return on riskless assets is 6%.
a. Construct a graph that shows the feasible and efficient sets, giving consideration to the existence of the riskless asset.
b. Explain what would happen to the CML if the two stocks had (a) a positive correlation coefficient or (b) a negative correlation coefficient.
c. Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone’s indifference curves were such that they were tangent to the CML to the right of the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

CHAPTER 26—REAL OPTIONS

TRUE/FALSE

1. Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows.

2. Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds.

3. The option to abandon a project is a real option, but a call option on a stock is not a real option.

4. Real options are most valuable when the underlying source of risk is very low.

5. Real options affect the size, but not the risk, of a project’s expected cash flows.

MULTIPLE CHOICE

6. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option?
a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today.
b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year.
c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
d. Waiting would probably reduce the project’s risk.
e. The investment timing option does not affect the cash flows and will therefore have no impact on the project’s risk.

7. Which one of the following is an example of a “flexibility” option?
a. A company has an option to close down an operation if it turns out to be unprofitable.
b. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial.
e. A company has an option to invest in a project today or to wait a year.

8. Which of the following is NOT a real option?
a. The option to buy shares of stock if its price goes up.
b. The option to expand into a new geographic region.
c. The option to abandon a project.
d. The option to switch the type of fuel used in an industrial furnace.
e. The option to expand production if the product is successful.

9. Which of the following will NOT increase the value of a real option?
a. An increase in the volatility of the underlying source of risk.
b. An increase in the risk-free rate.
c. An increase in the cost of obtaining the real option.
d. A decrease in the probability that a competitor will enter the market of the project in question.
e. Lengthening the time in which a real option must be exercised.

10. Which of the following is most CORRECT?
a. Real options change the risk, but not the size, of projects’ expected cash flows.
b. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash flows.
c. Very few projects actually have real options.
d. Real options are less valuable when there is a lot of uncertainty about the true values future sales and costs.
e. Real options change the size, but not the risk, of projects’ expected cash flows.

11. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation?
a. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.
b. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.
d. Real options should not have any effect on the size of the optimal capital budget.
e. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.

12. Refer to Exhibit 26.1. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project’s expected NPV, in thousands of dollars?
a. $336.15
b. $373.50
c. $415.00
d. $461.11
e. $507.22

13. Refer to Exhibit 26.1. Calculate the project’s coefficient of variation. (Hint: Use the expected NPV.)
a. 5.87
b. 6.52
c. 7.25
d. 7.97
e. 8.77

14. Refer to Exhibit 26.2. Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project’s expected NPV in today’s dollars (i.e., at t = 0), relative to the NPV if it proceeds today?
a. $77.23
b. $85.81
c. $95.34
d. $105.94
e. $116.53

15. Refer to Exhibit 26.2. Calculate the effect of waiting on the project’s risk, using the same data. By how much will delaying reduce the project’s coefficient of variation? (Hint: Use the expected NPV.)
a. 2.23
b. 2.46
c. 2.70
d. 2.97
e. 3.27

16. Refer to Exhibit 26.3. Based on the above data, what is the project’s net present value?
a. −$1,312,456
b. −$1,104,607
c. −$875,203
d. $105,999
e. $321,788

17. Refer to Exhibit 26.3. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
a. −$1,104,607
b. −$875,203
c. $199,328
d. $561,947
e. $898,205

18. Refer to Exhibit 26.4. Based on the above information, what is the Z−90’s expected net present value?
a. −$6,678
b. −$3,251
c. $15,303
d. $20,004
e. $45,965

19. Refer to Exhibit 26.4. Now assume that one year from now SI will know if the Z−45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?
a. $0
b. $2,075
c. $4,067
d. $8,945
e. $10,745

CHAPTER 27—PROVIDING AND OBTAINING CREDIT

TRUE/FALSE

1. The credit period is the amount of time it takes to do a credit search on a potential customer.

2. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit.

3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business.

4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses.

5. Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms.

6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount.

7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly.

8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged.

10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month’s sales.

MULTIPLE CHOICE

1. A firm’s credit policy consists of which of the following items?
a. Credit period, cash discounts, credit standards, collection policy.
b. Credit period, cash discounts, receivables monitoring, collection policy.
c. Cash discounts, credit standards, receivables monitoring, collection policy.
d. Credit period, receivables monitoring, credit standards, collection policy.
e. Credit period, cash discounts, credit standards, receivables monitoring.

2. Which of the following is not correct?
a. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales.
b. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased.
c. Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account.
d. A lax collection policy will frequently lead to an increase in accounts receivable.
e. Collection policy is how a firm goes about collecting past-due accounts.

3. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days?
a. The quarterly uncollected balances schedule will be the same in each quarter.
b. The level of accounts receivable will be constant from month to month.
c. The ratio of accounts receivable to sales will vary from month to month.
d. The level of accounts receivable at the end of each quarter will be the same.
e. DSO will vary from month to month.

4. Which of the following statements is most correct?
a. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially “weak” firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts.
b. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity.
c. Firms use seasonal dating primarily to decrease their DSO.
d. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st.
e. If credit sales as a percentage of a firm’s total sales increases, and the volume of credit sales also increases, then the firm’s accounts receivable will automatically increase.

5. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank?
a. Competitive cost of services provided.
b. Size of the bank’s deposits.
c. Experience of personnel.
d. Loyalty and willingness to assume lending risks.
e. Convenience of location.

6. Refer to Exhibit 27.1. How large are your brother’s monthly payments?
a. $6,250
b. $7,000
c. $7,500
d. $5,250
e. $6,875

7. Refer to Exhibit 27.1. What is the nominal annual add-on interest rate on this loan?
a. 10.00%
b. 16.47%
c. 18.83%
d. 20.00%
e. 24.00%

8. Suppose that you’re planning a vacation and borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged?
a. 14.00%
b. 8.57%
c. 16.28%
d. 21.21%
e. 28.00%

9. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans?
a. 11.00%
b. 15.94%
c. 11.46%
d. 13.75%
e. 12.72%

10. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent “add-on”, one-year installment loan, payable in four equal quarterly payments. What is the effective annual rate of interest?
a. 9.50%
b. 10.19%
c. 15.99%
d. 16.98%
e. 20.38%

11. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan?
a. 16.22%
b. 17.97%
c. 17.48%
d. 18.67%
e. 18.00%

12. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request for a $75,000, 1-year loan.

Alternative 1: 7 percent discount interest, with a 10 percent compensating balance.
Alternative 2: 8 percent simple interest, with interest paid monthly.

What is the effective annual rate on the cheaper loan?
a. 8.00%
b. 7.23%
c. 7.67%
d. 8.43%
e. 8.30%

13. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discounted loan?
a. 10.7%
b. 12.0%
c. 12.5%
d. 13.6%
e. 14.1%

14. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11 percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note?
a. $111,000
b. $100,000
c. $112,360
d. $89,000
e. $108,840

15. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note?
a. $61,856
b. $67,531
c. $60,000
d. $68,182
e. $67,423

16. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan?
a. 5.10%
b. 10.19%
c. 12.00%
d. 20.38%
e. 30.57%

17. Refer to Exhibit 27.2. What would be the incremental bad losses if the change were made?
a. $315,000
b. $260,500
c. −$260,500 (bad debt losses would decline)
d. −$315,000 (Bad debt losses would decline)
e. $0 (no change would occur)

18. Refer to Exhibit 27.2. What would be the incremental cost of carrying receivables if this change were made?
a. $108,750
b. −$116,250 (carrying costs would decline)
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,500

19. Refer to Exhibit 27.2. What are the incremental pre-tax profits from this proposal?
a. $181,250
b. $271,750
c. $256,250
d. $206,500
e. $231,250

20. Refer to Exhibit 272.3. What would be the cost to Van Doren of the discounts taken?
a. $116,750
b. −$108,750
c. $155,000
d. $225,000
e. $260,500

21. Refer to Exhibit 27.3. What would be the incremental bad debt losses if the change were made?
a. $130,000
b. $250,000
c. −$250,000 (bad debt losses would decline)
d. −$130,000 (bad debt losses would decline)
e. $620,000

22. Refer to Exhibit 27.3. What would be the incremental cost of carrying receivables if the change were made?
a. −$108,750 (carrying costs would decline)
b. $116,250
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,000

23. Refer to Exhibit 27.3. What are the incremental pre-tax profits from this proposal?
a. $283,750
b. $250,500
c. $303,250
d. $493,750
e. $288,250

24. Darren’s Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Darren already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Darren would otherwise keep in the account. Which of the following statements is most correct?
a. The cost of using additional trade credit is approximately 36 percent.
b. Considering only the explicit costs, Darren should finance the expansion with the bank loan.
c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan.
d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Darren would hold a cash balance of one-half the compensating balance amount even if the loan were not taken.
e. If Darren had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

25. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates?
a. 1.12%
b. 2.48%
c. 3.60%
d. 4.25%
e. 5.00%

26. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its credit period?
a. −$20,000
b. −$10,000
c. $0
d. $10,000
e. $20,000

27. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan?
a. 9.50%
b. 10.19%
c. 15.22%
d. 16.99%
e. 22.05%

CHAPTER 28—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

TRUE/FALSE

1. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together.

2. The easier a firm’s access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates.

3. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash.

4. A just-in-time system is designed to stretch accounts payable as long as possible.

5. If a company increases its safety stock, then its EOQ will go up.

6. If a company increases its safety stock, then its average inventory will go up.

MULTIPLE CHOICE

7. Which of the following would cause average inventory holdings to decrease, other things held constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.

8. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn’t matter which you use since cash flow is unaffected by the choice of inventory identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

9. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*.
a. If the total amount of cash needed during the year increases by 20%, then C* will increase by 20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

10. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

11. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748

12. Humphrey’s Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now?
a. $200
b. $333
c. $414
d. $500
e. $666

13. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180, and the total cash needed for transactions annually is $960,000. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

14. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180. In addition, the total estimated cash costs (transfers and carrying cost) for the firm, based on 16 transactions per year, are $5,760. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

15. Suppose Stanley’s Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.)
a. $1,000 loss
b. $1,000 benefit
c. $500 loss
d. $500 benefit
e. $0 (The change would not affect profits.)

16. Each year, Holly’s Best Salad Dressing, Inc. (HBSD) purchases 50,000 gallons of extra virgin olive oil. Ordering costs are $100 per order, and the carrying cost, as a percentage of inventory value, is 80 percent. The purchase price to HBSD is $0.50 per gallon. Management currently orders the EOQ each time an order is placed. No safety stock is carried. The supplier is now offering a quantity discount of $0.03 per gallon if HBSD orders 10,000 gallons at a time. Should HBSD take the discount?
a. From a cost standpoint, HBSD is indifferent.
b. No, the cost exceeds the benefit by $500.
c. No, the cost exceeds the benefit by $1,000.
d. Yes, the benefit exceeds the cost by $500.
e. Yes, the benefit exceeds the cost by $1,120.

17. New England Charm, Inc. specializes in selling scented candles. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered New England’s inventory problem from the EOQ model viewpoint. If the following constitute the relevant data, how does the current policy compare with the optimal policy?

Ordering cost = $10 per order
Carrying cost = 20% of purchase price
Purchase price = $10 per unit
Total sales for year = 1,000 units
Safety stock = 0

a. Total costs will be the same, since the current policy is optimal.
b. Total costs under the current policy will be less than total costs under the EOQ by $10.
c. Total costs under the current policy exceed those under the EOQ by $3.
d. Total costs under the current policy exceed those under the EOQ by $10.
e. Cannot be determined due to insufficient information.

18. Refer to Exhibit 28.1. According to the Baumol model, what is the optimal transaction size for transfers from marketable securities to cash?
a. $7,071
b. $38,357
c. $70,711
d. $102,956
e. $87,000

19. Refer to Exhibit 28.1. According to the Baumol model, what should be Duckett’s average cash balance?
a. $35,356
b. $3,536
c. $22,157
d. $70,711
e. $42,918

20. Refer to Exhibit 28.1. What will be the total cost to Duckett of maintaining the optimal average cash balance, as determined by the Baumol model?
a. $35,356
b. $7,071
c. $18,493
d. $70,711
e. $53,190

21. Refer to Exhibit 28.2. What is the economic ordering quantity for chips?
a. 12,088
b. 3,175
c. 6,243
d. 13,675
e. 8,124

22. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is its average inventory level?
a. 12,088
b. 3,175
c. 15,750
d. 13,675
e. 8,124

23. Refer to Exhibit 28.2. Assume that Cartwright holds a safety stock equal to a 30-day supply of chips. What is the maximum amount of inventory that will have on hand at any time, that is, what will be the inventory level right after a delivery is made?
a. 9,216
b. 3,175
c. 6,243
d. 13,675
e. 8,124

24. Refer to Exhibit 28.2. How many orders should Cartwright place during the year?
a. 12
b. 25
c. 30
d. 40
e. 60

25. Refer to Exhibit 28.2. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30-day supply of chips, then at what inventory level should an order be placed?
a. 15,570
b. 3,175
c. 12,250
d. 13,675
e. 8,124

26. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is Cartwright’s minimum cost of ordering and carrying inventory?
a. $28,500
b. $15,950
c. $68,440
d. $34,220
e. $47,693

27. Refer to Exhibit 28.3. What is the firm’s EOQ?
a. 26,833
b. 30,040
c. 43,987
d. 13,563
e. 21,456

28. Refer to Exhibit 28.3. What is Palmer’s minimum costs of ordering and holding inventory?
a. $6,254
b. $10,733
c. $11,560
d. $13,563
e. $19,825

29. Refer to Exhibit 28.3. Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a least 40,000 gallons. Should Palmer increase its ordering quantity to take the discount?
a. Yes; it will save $827 if it takes the discount.
b. No; it will lose $827 if it takes the discount.
c. Yes; it will save $14,400 if it takes the discount.
d. Yes; it will save $13,573 if it takes the discount.
e. No; it will lose $13,573 if it takes the discount.

WEB CHAPTER 29—PENSION PLAN MANAGEMENT

TRUE/FALSE

1. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm’s pension fund.

2. If employees have a right to receive pension benefits even if they leave the company prior to retirement, their pension rights are said to be vested.

3. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan.

4. The performance measurement of stock portfolio managers must recognize the risk inherent in the investment portfolio. One way to incorporate risk into performance measurement is to examine the portfolio’s alpha, which measures the vertical distance of the portfolio’s return above or below the Security Market Line.

MULTIPLE CHOICE

5. Which of the following statements about pension plans if any, is incorrect?
a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee’s final salary.
b. A portable pension plan is one that an employee can carry from one employer to another.
c. An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.
d. If assets exceed the present value of benefits, the pension plan is fully funded.
e. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

6. Which of the following statements about defined contribution plans is incorrect?
a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.
b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.
c. Defined benefit plans are used more often by large corporations than by small companies.
d. The PBGC insures a portion of pension benefits.
e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

7. Which of the following statements about pension plan portfolio performance is incorrect?
a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.
b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives.
c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.
d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.
e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

8. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd’s current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years. Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year’s wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd’s expected annual retirement benefit, rounded to the nearest thousands of dollars?
a. $35,000
b. $57,000
c. $89,000
d. $116,000
e. $132,000

9. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio’s alpha?
a. −0.75%
b. −0.15%
c. 0%
d. 0.15%
e. 0.75%

10. Arnold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20,000 at the end of each year following retirement until death. The firm’s pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington’s annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows.)
a. $2,756
b. $3,642
c. $4,443
d. $4,967
e. $5,491

WEB CHAPTER 30—FINANCIAL MANAGEMENT IN NOT-FOR-PROFIT BUSINESSES

TRUE/FALSE

1. The primary goal of investor-owned firms is shareholder wealth maximization, while the primary goal of not-for-profit firms is typically stated in terms of some mission; for example, to provide health care services to the communities served.

2. Not-for-profit firms have fund capital in place of equity capital. Since fund capital does not have to provide a return to stockholders, the appropriate cost of fund capital in a cost of capital estimate is zero.

3. Since not-for-profit firms do not pay taxes, they receive no tax benefits whatsoever from using debt financing.

4. The net present social value model formally recognizes that not-for-profit firms must consider the social value along with the financial value of proposed new projects.

MULTIPLE CHOICE

5. Which of the following statements about project risk analysis in not-for-profit firms is incorrect?
a. A project’s corporate beta measures the contribution of the project to the overall corporate risk of the firm.
b. A project’s corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio.
c. A project’s corporate beta is defined as (P/F)rPF, where P is the standard deviation of the project’s returns, F is the standard deviation of the firm’s returns, and rPF is the correlation among the two sets of returns.
d. In practice, it is usually difficult, if not impossible, to directly measure a project’s corporate risk, so project risk analysis typically focuses on stand-alone risk.
e. The market risk of a project is not relevant to not-for-profit firms.

6. Which of the following statements about municipal bond financing is most correct?
a. Whereas the vast majority of Treasury and corporate bonds are held by institutions, no municipal bonds are held by individual investors.
b. The primary attraction of municipal bonds to individual investors is their high before-tax yields.
c. Municipal bonds usually pay higher coupon rates than corporate bonds with similar ratings.
d. Municipal bonds are risk-free.
e. In contrast to corporate bonds, municipal bond issues are not required to be registered with the Securities and Exchange Commission.

7. Which of the following statements about a not-for-profit firm’s ownership is most correct?
a. The residual earnings (profits) of not-for-profit firms can be distributed to the firm’s top managers.
b. Not-for-profit firms are exempt from federal taxes, but they must pay state and local taxes, including property taxes.
c. Upon liquidation of a not-for-profit firm, the proceeds from the sale of its assets are distributed, on a pro rata basis, to the firm’s employees.
d. None of the profits are used for private inurement.
e. Not-for-profit firms are governed by a board of trustees whose members are elected by the community at large.

8. Which of the following statements about a not-for-profit firm’s cost of capital estimate is most correct?
a. The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings.
b. The cost of tax-exempt debt issued by not-for-profit firms is increased (“grossed up”) by 1 − T in the WACC estimate to reflect the fact that such firms do not pay taxes.
c. Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investor-owned companies.
d. Not-for-profit firms have a zero cost of capital.
e. Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.

9. Which of the following statements about a not-for-profit firm’s fund capital is most correct?
a. The sole source of fund capital is the excess of revenues over expenses.
b. Fund capital has a zero opportunity cost.
c. Fund capital can only come from donations.
d. Fund capital does not change over time.
e. Fund capital is equivalent to equity capital in investor-owned firms.

10. Which of the following statements about a not-for-profit firm’s sources of capital is most correct?
a. Fund capital is obtained by retaining earnings⎯if all earnings are paid out as dividends, no fund capital is created.
b. Preferred stock is never used by not-for-profit firms.
c. Not-for-profit firms are not allowed to raise capital by borrowing.
d. Not-for-profit firms usually have high dividend payouts.
e. Since not-for-profit firms are tax exempt, there is no tax advantage to debt capital.

FIN 540 Week 9 Homework Problems – Strayer University NEW

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Week 9
Homework Problems Chapter 29

1. Which of the following statements about pension plans if any, is incorrect?
a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit.
b. If assets exceed the present value of benefits, the pension plan is fully funded.
c. Such as $500 per month or 50 percent of the employee’s final salary.
d. A portable pension plan is one that an employee can carry from one employer to another
e. An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.
f. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

2. Which of the following statements about defined contribution plans is incorrect?
a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.
b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.
c. Defined benefit plans are used more often by large corporations than by small companies.
d. The PBGC insures a portion of pension benefits.
e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

3. Which of the following statements about pension plan portfolio performance is incorrect?
a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.
b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives.
c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.
d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.
e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

4. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd’s current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years. Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year’s wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd’s expected annual retirement benefit, rounded to the nearest thousands of dollars?
a. $35,000
b. $57,000
c. $89,000
d. $116,000
e. $132,000

5. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio’s alpha?
a. −0.75%
b. −0.15%
c. 0%
d. 0.15%
e. 0.75%

FIN 540 Week 8 Homework Problems – Strayer University NEW

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Week 8
Homework Problems Chapter 28

1. Which of the following would cause average inventory holdings to decrease, other things held constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.

2. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn’t matter which you use since cash flow is unaffected by the choice of inventory identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

3. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*.

a. If the total amount of cash needed during the year increases by 20%, then C will increase by 20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

4. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

5. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748

FIN 540 Week 5 Midterm Exam – Strayer University NEW

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Midterm Exam Chapter 18 Through 23

CHAPTER 18—PUBLIC AND PRIVATE FINANCING: INITIAL OFFERINGS, SEASONED OFFERINGS, AND INVESTMENT BANKS

TRUE/FALSE

1. If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement.

2. Going public establishes a market value for the firm’s stock, and it also ensures that a liquid market will continue to exist for the firm’s shares. This is especially true for small firms that are not widely followed by security analysts.

3. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public.

4. The term “leaving money on the table” refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm’s new stock offering. The banker is, in effect, “buying the job” with the low bid and thus not getting all the money his firm would normally earn on the job.

5. Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another.

6. The term “equity carve-out” refers to the situation where a firm’s managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it “carves out” some of their value.

7. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.

8. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings.

9. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate.

10. When a firm refunds a debt issue, the firm’s stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond.

MULTIPLE CHOICE

11. Which of the following is generally NOT true and an advantage of going public?
a. Increases the liquidity of the firm’s stock.
b. Makes it easier to obtain new equity capital.
c. Establishes a market value for the firm.
d. Makes it easier for owner-managers to engage in profitable self-dealings.
e. Facilitates stockholder diversification.

12. Which of the following statements about listing on a stock exchange is most CORRECT?
a. Any firm can be listed on the NYSE as long as it pays the listing fee.
b. Listing provides a company with some “free” advertising, and it may enhance the firm’s prestige and help it do more business.
c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.
e. Listing is a decision of more significance to a firm than going public.

13. Which of the following statements is most CORRECT?
a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
c. The SEC requires that all private placements be handled by a registered investment banker.
d. Private placements can generally bring in funds faster than is the case with public offerings.
e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

14. Which of the following statements is most CORRECT?
a. The key benefits associated with refunding debt are the reduction in the firm’s debt ratio and the creation of more reserve borrowing capacity.
b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.
c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen.
d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings.
e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.

15. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?
a. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.
b. The flotation costs associated with issuing new bonds rise.
c. The firm’s CFO believes that interest rates are likely to decline in the future.
d. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.
e. The yield to maturity on the company’s outstanding bonds increases due to a weakening of the firm’s financial situation.

16. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT?
a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market.
b. Listing a large firm’s stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm.
c. Stockholders have the right to elect the firm’s directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management’s performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer.
d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called “market pressure,” and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue.
e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

17. Which of the following statements is NOT CORRECT?
a. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will always exist for the firm’s shares.
b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC.
c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called “going public,” and the market for such stock is called the new issue market.
d. It is possible for a firm to go public and yet not raise any additional new capital.
e. When a corporation’s shares are owned by a few individuals who own most of the stock or are part of the firm’s management, we say that the firm is “closely, or privately, held.”

18. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker’s required return on such arrangements is 15%, and ignore taxes.
a. $1,235,925
b. $1,300,973
c. $1,369,446
d. $1,441,522
e. $1,517,391

19. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?
a. $79,425
b. $83,606
c. $88,006
d. $92,406
e. $97,027

20. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.
a. $453,443
b. $476,115
c. $499,921
d. $524,917
e. $551,163

21. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.
a. $278,606
b. $292,536
c. $307,163
d. $322,521
e. $338,647

22. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯assume that the firm’s tax rate is zero.

The company’s decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?
a. 9.57%
b. 10.07%
c. 10.60%
d. 11.16%
e. 11.72%

23. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual “breakeven rate”?
a. 9.29%
b. 9.78%
c. 10.29%
d. 10.81%
e. 11.35%

24. Refer to Exhibit 18.1. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding?
a. $5,049,939
b. $5,315,725
c. $5,595,500
d. $5,890,000
e. $6,200,000

25. Refer to Exhibit 18.1. What will the after-tax annual interest savings for NWW be if the refunding takes place?
a. $664,050
b. $699,000
c. $768,900
d. $845,790
e. $930,369

26. Refer to Exhibit 18.1. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?
a. $6,480
b. $7,200
c. $8,000
d. $8,800
e. $9,680

27. Refer to Exhibit 18.1. What is the NPV if NWW refunds its bonds today?
a. $1,746,987
b. $1,838,933
c. $1,935,719
d. $2,037,599
e. $2,241,359

CHAPTER 19—LEASE FINANCING

TRUE/FALSE

1. Many leases written today combine the features of operating and financial leases. Such leases are often called “combination leases.”

2. A sale and leaseback arrangement is a type of financial, or capital, lease.

3. Operating leases help to shift the risk of obsolescence from the user to the lessor.

4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.

5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines.

6. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm’s income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm’s balance sheet.

7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget.

8. A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease.

9. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

10. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company’s books.

11. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value.

12. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee’s viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

MULTIPLE CHOICE

13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee’s
a. capital budgeting project cash flows.
b. debt cash flows.
c. pension fund cash flows.
d. sales.
e. equity cash flows.

14. Operating leases often have terms that include
a. full amortization over the life of the lease.
b. very high penalties if the lease is canceled.
c. restrictions on how much the leased property can be used.
d. much longer lease periods than for most financial leases.
e. maintenance of the equipment by the lessor.

15. Which of the following statements is most CORRECT?
a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
c. Capital, or financial, leases generally provide for maintenance by the lessor.
d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.
e. Firms that use “off balance sheet” financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.

16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the
a. residual value as a liability.
b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability.
c. undiscounted sum of future lease payments as an asset and as an offsetting liability.
d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.
e. residual value as a fixed asset.

17. Heavy use of off-balance sheet lease financing will tend to
a. make a company appear less risky than it actually is because its stated debt ratio will appear lower.
b. affect a company’s cash flows but not its degree of risk.
c. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.
d. affect the lessee’s cash flows but only due to tax effects.
e. make a company appear more risky than it actually is because its stated debt ratio will be increased.

18. In the lease versus buy decision, leasing is often preferable
a. because, generally, no down payment is required, and there are no indirect interest costs.
b. because lease obligations do not affect the firm’s risk as seen by investors.
c. because the lessee owns the property at the end of the least term.
d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.
e. because it has no effect on the firm’s ability to borrow to make other investments.

19. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased
a. is financed with long-term debt.
b. is financed with debt whose maturity matches the term of the lease.
c. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at the WACC.
d. is financed with retained earnings.
e. is financed with short-term debt.

20. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.
a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455

21. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm’s tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
a. $96
b. $106
c. $112
d. $117
e. $123

22. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC’s tax rate is 40%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.)
a. $849
b. $896
c. $945
d. $999
e. $1,047

23. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
a. $5,734
b. $6,023
c. $6,324
d. $6,640
e. $6,972

CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES

TRUE/FALSE

1. The “preferred” feature of preferred stock means that it normally will provide a higher expected return than will common stock.

2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible.

3. A warrant is an option, and as such it cannot be used as a “sweetener.”

4. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

5. The problem of dilution of stockholders’ earnings never results from the sale of call options, but it can arise if warrants are used.

6. A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued. Most traded warrants are originally attached to bonds or preferred stocks.

7. The owner of a convertible bond owns, in effect, both a bond and a call option.

8. A convertible debenture can never sell for more than its conversion value or less than its bond value.

9. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder.

10. Firms generally do not call their convertibles unless the conversion value is greater than the call price.

11. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters.

12. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

13. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

14. Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

15. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax exemption on preferred dividends received.

MULTIPLE CHOICE

16. Which of the following statements is most CORRECT?
a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm’s common stock.
b. From the issuer’s point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.
e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.

17. Which of the following statements about convertibles is most CORRECT?
a. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
b. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertible’s conversion (or exercise) price is generally set equal to or below the underlying stock’s price.
d. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm’s otherwise similar straight debt and the expected return on its common stock.
e. The coupon interest rate on a firm’s convertibles is generally set higher than the market yield on its otherwise similar straight debt.

18. Which of the following statements concerning warrants is correct?
a. Warrants are long-term put options that have value because holders can sell the firm’s common stock at the exercise price regardless of how low the market price drops.
b. Warrants are long-term call options that have value because holders can buy the firm’s common stock at the exercise price regardless of how high the stock’s price has risen.
c. A firm’s investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock’s price increases. However, if the option is exercised, the issuing company’s debt declines if warrants were used but remains the same if it used convertibles.

19. Which of the following statements is most CORRECT?
a. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
b. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
d. Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
e. Warrants have an option feature but convertibles do not.

20. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
e. $866.25

21. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62

22. Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?
a. 6.66%
b. 6.99%
c. 7.34%
d. 7.71%
e. 8.09%

23. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm’s straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?
a. 7.83%
b. 8.24%
c. 8.65%
d. 9.08%
e. 9.54%

24. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?
a. 6.75%
b. 7.11%
c. 7.48%
d. 7.88%
e. 8.27%

25. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
e. $4.56

26. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of the convertible at the end of Year 3?
a. $794.01
b. $835.81
c. $879.80
d. $926.10
e. $972.41

27. Refer to Exhibit 20.1. What is the bond’s conversion ratio?
a. 27.14
b. 28.57
c. 30.00
d. 31.50
e. 33.08

28. Refer to Exhibit 20.1. What is the bond’s conversion value?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

29. Refer to Exhibit 20.1. What is the bond’s straight-debt value?
a. $684.78
b. $720.82
c. $758.76
d. $798.70
e. $838.63

30. Refer to Exhibit 20.1. What is the minimum price (or “floor” price) at which the Neuman’s bonds should sell?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

CHAPTER 21—DYNAMIC CAPITAL STRUCTURES

TRUE/FALSE

1. In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

2. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

3. MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.

4. MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.

5. The Miller model begins with the MM model with taxes and then adds personal taxes.

6. The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

7. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient.

8. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

9. The MM model is the same as the Miller model, but with zero corporate taxes.

10. In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

11. In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

12. In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

13. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

14. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

MULTIPLE CHOICE

15. The major contribution of the Miller model is that it demonstrates that
a. personal taxes decrease the value of using corporate debt.
b. financial distress and agency costs reduce the value of using corporate debt.
c. equity costs increase with financial leverage.
d. debt costs increase with financial leverage.
e. personal taxes increase the value of using corporate debt.

16. Which of the following statements concerning capital structure theory is NOT CORRECT?
a. Under MM with zero taxes, financial leverage has no effect on a firm’s value.
b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
e. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

17. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is less than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the unlevered cost of equity.

18. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the cost of debt.

19. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm is independent of the amount of debt it uses.
e. The tax shields should be discounted at the unlevered cost of equity.

20. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L’s cost of equity?
a. 11.4%
b. 12.0%
c. 12.6%
d. 13.3%
e. 14.0%

21. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what would Firm L’s total value be if it had no debt?
a. $358,421
b. $377,286
c. $397,143
d. $417,000
e. $437,850

22. A local firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is the value of your firm’s tax shield, i.e., how much value does the use of debt add?
a. $92,571
b. $102,857
c. $113,143
d. $124,457
e. $136,903

23. Refer to Exhibit 21.1. What is the value of the firm according to MM with corporate taxes?
a. $475,875
b. $528,750
c. $587,500
d. $646,250
e. $710,875

24. Refer to Exhibit 21.1. What is the firm’s cost of equity?
a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%

25. Refer to Exhibit 21.1. Assume that the firm’s gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
a. 16.4%
b. 18.2%
c. 20.2%
d. 22.5%
e. 25.0%

26. Refer to Exhibit 21.2. According to the MM extension with growth, what is the value of Kitto’s tax shield?
a. $156,385
b. $164,616
c. $173,280
d. $182,400
e. $192,000

27. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s unlevered value?
a. $1,296,000
b. $1,440,000
c. $1,600,000
d. $1,760,000
e. $1,936,000

28. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s value of equity?
a. $1,492,000
b. $1,529,300
c. $1,567,533
d. $1,606,721
e. $1,646,889

29. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s equity if it is viewed as an option?
a. $228.77
b. $254.19
c. $282.43
d. $313.81
e. $345.19

30. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s debt if its equity is viewed as an option?
a. $167.57
b. $186.19
c. $204.81
d. $225.29
e. $247.82

31. Refer to Exhibit 21.3. What is the yield on Wilson Dover’s debt?
a. 6.04%
b. 6.36%
c. 6.70%
d. 7.05%
e. 7.42%

CHAPTER 22—MERGERS AND CORPORATE CONTROL

TRUE/FALSE

1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies’ pre-merger values.

3. A spin-off is a type of divestiture in which the assets of a division are sold to another firm.

4. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

5. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price.

6. Most defensive mergers occur as a result of managers’ actions to maximize shareholders’ wealth.

7. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in agreeing on the terms of a merger.

8. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy.

9. Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action.

10. Currently (2012), mergers can be accounted for using either the purchase method or the pooling method.

11. Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge “golden parachutes” that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as “poison pills.”

12. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.

13. The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary’s stock.

14. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers.

15. The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share.

16. Since managers’ central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm’s stockholders.

17. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive.

18. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

19. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship.

20. Since a manager’s central goal is to maximize the firm’s stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

21. Only if a target firm’s value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

22. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

23. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently.

24. Coca-Cola’s acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

25. A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

26. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger.

27. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

28. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

29. Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

30. The three main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

31. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

32. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm’s operations if it had no debt.

MULTIPLE CHOICE

33. Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s?
a. A profitable firm acquires a firm with large accumulated tax losses that may be carried forward.
b. Attempts to stabilize earnings by diversifying.
c. Purchase of assets below their replacement costs.
d. Reduction in competition resulting from mergers.
e. Synergistic benefits arising from mergers.

34. Firms use defensive tactics to fight off undesired mergers. These tactics do not include
a. getting a white squire to purchase stock in the firm.
b. getting white knights to bid for the firm.
c. repurchasing their own stock.
d. changing the bylaws to eliminate supermajority voting requirements.
e. raising antitrust issues.

35. Which of the following statements is most CORRECT?
a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
b. Defensive mergers are designed to make a company less vulnerable to a takeover.
c. Hostile mergers always create value for the acquiring firm.
d. In a tender offer, the target firm’s management always remain after the merger is completed.
e. A conglomerate merger is one where a firm combines with another firm in the same industry.

36. Which of the following statements is most CORRECT?
a. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
b. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
c. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what’s probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
d. Operating economies are never a motive for mergers.
e. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

37. Which of the following statements is most CORRECT?
a. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm’s capital structure, it will not affect its overall required rate of return.
b. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis.
c. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms.
d. The primary rationale for most operating mergers is synergy.
e. The acquiring firm’s required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

38. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
b. The horizon value is calculated by discounting the expected earnings at the WACC.
c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
d. The horizon value must always be more than 20 years in the future.
e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

39. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
d. The APV approach stands for the accounting pre-valuation approach.
e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

40. Which of the following statements is most CORRECT?
a. A defensive merger is one where the firm’s managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover.
b. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition.
c. Cash payments are used in takeovers but never in mergers.
d. Managers often are fired in takeovers, but never in mergers.
e. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

41. A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can’t be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent’s marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?
a. 10.2%; $2,245,000
b. 10.2%; $2,135,000
c. 23.8%; $1,905,000
d. 10.2%; $1,750,000
e. 34.0%; $1,650,000

42. A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally’s Sandwiches, which is currently financed using 20% debt at a cost of 8%. Club Café’s analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Sally’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?
a. 12.0%
b. 13.9%
c. 14.4%
d. 16.0%
e. 16.9%

43. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller chain. Arthouse’s analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Craftworks is 16%. Craftworks has 4 million shares outstanding and no debt. Craftworks’ current price is $16.25. What is the maximum price per share that Arthouse should offer?
a. $16.25
b. $16.97
c. $17.42
d. $18.13
e. $19.00

44. Holland Auto Parts is considering a merger with Workman Car Parts. Workman’s market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Workman’s required rate of return on equity be after it is acquired?
a. 7.4%
b. 8.9%
c. 9.3%
d. 9.6%
e. 9.7%

45. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP). Raymond’s analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Raymond?
a. $53.40 million
b. $61.96 million
c. $64.64 million
d. $76.96 million
e. $79.64 million

46. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers expects Fast Fruit’s NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Fast Fruit is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Fast Fruit will need $10 million of net new investment in operating capital. Fast Fruit’s marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Fast Fruit to Juicers will both grow at a constant rate of 4%. Juicers has determined that Fast Fruit’s cost of equity is 17.5%, and Fast Fruit currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Juicers must pay $45 million to acquire Fast Fruit. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Juicers of Fast Fruit’s equity.
a. $45.0 million
b. $68.2 million
c. $86.5 million
d. $113.2 million
e. $133.0 million

47. Refer to Exhibit 22.1. What is Glassmakers’ pre-merger WACC?
a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

48. Refer to Exhibit 22.1. What discount rate should you use to discount Glassmakers’ free cash flows and interest tax savings?
a. 10.01%
b. 10.06%
c. 11.29%
d. 11.44%
e. 13.49%

49. Refer to Exhibit 22.1. What is the value of Glassmakers’ equity to Best? (Round your answer to the closest thousand dollars.)
a. $16,019,000
b. $17,111,000
c. $18,916,000
d. $22,111,000
e. $22,916,000

CHAPTER 23—ENTERPRISE RISK MANAGEMENT

TRUE/FALSE

1. One objective of risk management can be to reduce the volatility of a firm’s cash flows.

2. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

3. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses.

4. In theory, reducing the volatility of its cash flows will always increase a company’s value.

5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words “long” and “short” refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

MULTIPLE CHOICE

6. Which of the following are NOT ways risk management can be used to increase the value of a firm?
a. Risk management can help a firm maintain its optimal capital budget.
b. Risk management can reduce the expected costs of financial distress.
c. Risk management can help firms minimize taxes.
d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.
e. Risk management can increase debt capacity.

7. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?
a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
b. Interest rate price risk can be eliminated by holding zero coupon bonds.
c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.
d. Interest rate risk can never be reduced.
e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.

8. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?
a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
d. A company can swap fixed interest payments for floating interest payments.
e. A swap involves the exchange of cash payment obligations.

9. Which of the following statements is most CORRECT?
a. Futures contracts generally trade on an organized exchange and are marked to market daily.
b. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
c. There are futures contracts for currencies but no forward contracts for currencies.
d. Futures contracts don’t have any margin requirements but forward contracts do.
e. One advantage of forward contracts is that they are default free.

10. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?
a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
b. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
c. Enter into a short hedge where the bank agrees to sell interest rate futures.
d. Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.
e. Buying inverse floaters.

11. Company A can issue floating-rate debt at LIBOR + 1% and can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5% and can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B?
a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%.
b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%.
c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%.
d. A pays a fixed rate of 7.95%, B pays LIBOR.
e. None of the above answers is correct.

12. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89’09. What is the implied annual interest rate inherent in this futures contract?
a. 6.32%
b. 6.65%
c. 7.00%
d. 7.35%
e. 7.72%

13. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. What is the implied annual interest rate inherent in the futures contract?
a. 6.86%
b. 7.22%
c. 7.60%
d. 8.00%
e. 8.40%

14. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the nearest whole dollar.)
a. −$78.00
b. −$82.00
c. −$86.00
d. −$90.00
e. −$95.00

FIN 540 Week 10 Assignment 1 – Strayer University NEW

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Assignment 1: Galaxy Skis
Due Week 10 and worth 400 points
Galaxy International is a small privately held company in the Northeast U.S. which manufactures high- tech carbon composite skis for the U.S. market. The company has been in business for 20 years, has 125 employees, and has $50 million in annual sales. Its owner, Jeremy Riven, is an ex-Olympic skier who developed the proprietary technology and bonding polymers that give Galaxy skis their unique flexibility, durability, and propensity to need low maintenance—all of which serious skiers in the U.S. have come to prize. Major costs involved in the manufacturing of skis are oil polymers, carbon fiber, and labor. Ski technicians are highly skilled machinists, and manufacturing the finished product is as much an art form as it is a science.
Jeremy has recently considered an initial public offering (IPO) to allow the firm to raise the funds it needs to go international. The underwriting group from Morgan Stanley believes they could easily raise sixty (60) million in the equity markets, and fifty (50) million in the bond market. Jeremy is trying to determine the cost of debt, the cost of equity (four [4] million shares at $15/share), and the firm’s weighted average cost of capital if he goes public and issues corporate bonds with a coupon rate of 8%. Last year, the firm resided in a 28% tax bracket. The risk-free rate in the U.S. is 2%, and the expected return on the market is 14%. Morgan Stanley estimates Galaxy’s beta, if traded publicly, would be approximately 1.8%. Galaxy has been growing at 15% a year since its inception.
Jeremy would like to expand his current U.S. facility from 40,000 square feet to 100,000 square feet, automate certain processes which heretofore have been done manually, and outsource work to China, where he plans to either build or lease a plant to extend his ski line worldwide. He could build a 50,000- square-foot facility in Canton for fifty (50) million dollars, or lease a similar facility for ten (10) million a year. Annual operating costs would be twenty (20) million dollars, and projected free cash flow, based on past experience, would be twelve (12) million a year (whether he leases or buys). The life of the plant would be fifteen (15) years, and inflation in China is currently running at 6% annually. Galaxy would repatriate profits from the Chinese operation and consolidate them with those of the U.S. operations. All expenses of operating the plant in China would be in Yuan.
Use the Internet to locate information about current events in China related to its economic state.
Write a six to eight (6-8) page paper in which you:
1. Examine the pros and cons of an IPO for Galaxy International. Recommend whether the company should or should not proceed with an IPO.
2. Evaluate the appropriateness of the financing alternatives and strategies that are available to Jeremy, and select the one (1) you believe best suits the company. Provide support for your rationale.
3. Determine the advantages of debt over equity, and what each would cost after taxes. Determine Galaxy’s weighted average cost of capital (WACC) if it uses both alternatives to raise capital (i.e., debt and equity).
4. Recommend one (1) financial instrument that Jeremy could use in order to ensure a stable supply of oil for his operations and to protect his firm from currency translation losses.
5. Suggest one (1) approach that Jeremy can use to hedge his currency translation and transaction exposure to the Yuan. Provide support for your suggestion.
6. Determine whether Jeremy should lease or buy the plant in China. Justify your position using information regarding the current economic state in China.
7. Imagine that you are a portfolio manager. Determine whether or not you would want to participate in the IPO if Galaxy International goes public. Provide a rationale for your decision. Determine the expected return on the stock using Capital Asset Pricing Model (CAPM).
8. Determine if the Galaxy International’s expected returns would exceed its WACC. Provide a rationale.
9. Use at least five (5) quality academic resources in this assignment. Note: Wikipedia and other Websites to not qualify as academic resources.
Your assignment must follow these formatting requirements:
• • Be typed, double spaced, using Times New Roman font (size 12), with one-inch margins on all sides; citations and references must follow APA or school-specific format. Check with your professor for any additional instructions.
• • Include a cover page containing the title of the assignment, the student’s name, the professor’s name, the course title, and the date. The cover page and the reference page are not included in the required assignment page length.

FIN 540 Week 11 Final Exam – Strayer University NEW

FIN/540 Week 11 Final Exam – Strayer NEW

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Chapters 24 Through 30

CHAPTER 24—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION

TRUE/FALSE

1. A central question that must be addressed in bankruptcy proceedings is whether the firm’s inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values.

2. In the event of bankruptcy under the federal bankruptcy laws, debtholders have a prior claim to a firm’s income and assets before both common and preferred stockholders. Moreover, in a bankruptcy all debtholders are treated equally as a single class of claimants.

3. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority.

4. The primary test of feasibility in a reorganization is whether the firm’s fixed charges after reorganization can be covered by its projected cash flows.

5. Bankruptcy plays no role in settling labor disputes and product liability suits. Such issues are outside the bounds of bankruptcy law and are covered by other statutes.

6. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating.

7. Even if a firm’s cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment.

8. One of the actions that can be taken in bankruptcy under the standard of feasibility is to replace existing management with a new team if the quality of management is judged to have been substandard.

MULTIPLE CHOICE

9. Chapter 7 of the Bankruptcy Act is designed to do which of the following?
a. Establish the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.
b. Ensure that the firm is viable after emerging from bankruptcy.
c. Allow the firm to negotiate with each creditor individually.
d. Provide safeguards against the withdrawal of assets by the owners of the bankrupt firm and allow insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt.
e. Protect shareholders against creditors.

10. Which of the following statements is most CORRECT?
a. Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws.
b. All bankruptcy petitions are filed by creditors seeking to protect their claims against firms in financial distress. Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm’s management.
c. Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act.
d. “Restructuring” a firm’s debt can involve forgiving a certain portion of the debt, but it cannot call for changing the debt’s maturity or its contractual interest rate.
e. Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.

11. Which of the following statements is most CORRECT?
a. The primary test of feasibility in a reorganization is whether every claimant agrees with the reorganization plan.
b. The basic doctrine of fairness states that all debtholders must be treated equally.
c. Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the “public interest” is not a relevant concern.
d. While a firm is in bankruptcy, the existing management is always allowed to retain control, though the court will monitor its actions closely.
e. To a large extent, the decision to dissolve a firm through liquidation versus keeping it alive through reorganization depends on a determination of the value of the firm if it is rehabilitated versus the value of its assets if they are sold off individually.

12. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest.

(1) Trustees’ costs to administer and operate the firm.
(2) Common stockholders.
(3) General, or unsecured, creditors.
(4) Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan.
(5) Taxes due to federal and state governments.

a. 5, 4, 1, 3, 2
b. 4, 1, 5, 3, 2
c. 5, 1, 4, 2, 3
d. 1, 5, 4, 3, 2
e. 1, 4, 3, 5, 2

CHAPTER 25—PORTFOLIO THEORY AND ASSET PRICING MODELS

TRUE/FALSE

1. The slope of the SML is determined by the value of beta.

2. If you plotted the returns of Selleck & Company against those of the market and found that the slope of your line was negative, the CAPM would indicate that the required rate of return on Selleck’s stock should be less than the risk-free rate for a well-diversified investor, assuming that the observed relationship is expected to continue in the future.

3. If the returns of two firms are negatively correlated, then one of them must have a negative beta.

4. A stock with a beta equal to −1.0 has zero systematic (or market) risk.

5. It is possible for a firm to have a positive beta, even if the correlation between its returns and those of another firm are negative.

6. In portfolio analysis, we often use ex post (historical) returns and standard deviations, despite the fact that we are interested in ex ante (future) data.

7. If investors are risk averse and hold only one stock, we can conclude that the required rate of return on a stock whose standard deviation is 0.21 will be greater than the required return on a stock whose standard deviation is 0.10. However, if stocks are held in portfolios, it is possible that the required return could be higher on the low standard deviation stock.

8. The CAPM is a multi-period model which takes account of differences in securities’ maturities, and it can be used to determine the required rate of return for any given level of systematic risk.

9. The SML relates required returns to firms’ systematic (or market) risk. The slope and intercept of this line can be influenced by managerial actions.

10. The Y-axis intercept of the SML indicates the return on an individual asset when the realized return on an average (b = 1) stock is zero.

11. We will almost always find that the beta of a diversified portfolio is less stable over time than the beta of a single security.

12. Arbitrage pricing theory is based on the premise that more than one factor affects stock returns, and the factors are specified to be (1) market returns, (2) dividend yields, and (3) changes in inflation.

MULTIPLE CHOICE

13. You have the following data on three stocks:

Stock Standard Deviation Beta
A 0.15 0.79
B 0.25 0.61
C 0.20 1.29

As a risk minimizer, you would choose Stock ____ if it is to be held in isolation and Stock ____ if it is to be held as part of a well-diversified portfolio.
a. A; B.
b. B; C.
c. C; A.
d. C; B.
e. A; A.

14. Which is the best measure of risk for an asset held in isolation, and which is the best measure for an asset held in a diversified portfolio?
a. Standard deviation; correlation coefficient.
b. Beta; variance.
c. Coefficient of variation; beta.
d. Beta; beta.
e. Variance; correlation coefficient.

15. Which of the following is NOT a potential problem with beta and its estimation?
a. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta.
b. The beta of “the market,” can change over time, sometimes drastically.
c. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed.
d. There is a wide confidence interval around a typical stock’s estimated beta.
e. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta.

16. Stock A’s beta is 1.5 and Stock B’s beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.)
a. Stock B must be a more desirable addition to a portfolio than Stock A.
b. Stock A must be a more desirable addition to a portfolio than Stock B.
c. The expected return on Stock A should be greater than that on Stock B.
d. The expected return on Stock B should be greater than that on Stock A.
e. When held in isolation, Stock A has greater risk than Stock B.

17. For markets to be in equilibrium (that is, for there to be no strong pressure for prices to depart from their current levels),
a. The past realized rate of return must be equal to the expected rate of return; that is, .
b. The required rate of return must equal the realized rate of return; that is, r = .
c. All companies must pay dividends.
d. No companies can be in danger of declaring bankruptcy.
e. The expected rate of return must be equal to the required rate of return; that is, = r.

18. Which of the following statements is CORRECT?
a. The slope of the CML is (M − rRF)/bM.
b. All portfolios that lie on the CML to the right of M are inefficient.
c. All portfolios that lie on the CML to the left of M are inefficient.
d. The slope of the CML is (M − rRF)/M.
e. The Capital Market Line (CML) is a curved line that connects the risk-free rate and the market portfolio.

19. In a portfolio of three different stocks, which of the following could NOT be true?
a. The riskiness of the portfolio is greater than the riskiness of one or two of the stocks.
b. The beta of the portfolio is less than the betas of each of the individual stocks.
c. The beta of the portfolio is greater than the beta of one or two of the individual stocks’ betas.
d. The beta of the portfolio cannot be equal to 1.
e. The riskiness of the portfolio is less than the riskiness of each of the stocks if they were held in isolation.

20. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

Years Market Stock A Stock B
1 0.03 0.16 0.05
2 −0.05 0.20 0.05
3 0.01 0.18 0.05
4 −0.10 0.25 0.05
5 0.06 0.14 0.05

a. bA > +1; bB = 0.
b. bA = 0; bB = −1.
c. bA < 0; bB = 0.
d. bA < −1; bB = 1. e. bA > 0; bB = 1.

21. Which of the following statements is CORRECT?
a. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is about 0.6.
b. The typical R2 for a stock is about 0.3 and the typical R2 for a large portfolio is about 0.94.
c. The typical R2 for a stock is about 0.94 and the typical R2 for a portfolio is also about 0.94.
d. The typical R2 for a stock is about 0.6 and the typical R2 for a portfolio is also about 0.6.
e. The typical R2 for a stock is about 0.3 and the typical R2 for a portfolio is also about 0.3.

22. Which of the following statements is CORRECT?
a. The characteristic line is the regression line that results from plotting the returns on a particular stock versus the returns on a stock from a different industry.
b. The slope of the characteristic line is the stock’s standard deviation.
c. The distance of the plot points from the characteristic line is a measure of the stock’s market risk.
d. The distance of the plot points from the characteristic line is a measure of the stock’s diversifiable risk.
e. “Characteristic line” is another name for the Security Market Line.

23. Which of the following statements is CORRECT?
a. Richard Roll has argued that it is possible to test the CAPM to see if it is correct.
b. Tests have shown that the risk/return relationship appears to be linear, but the slope of the relationship is greater than that predicted by the CAPM.
c. Tests have shown that the betas of individual stocks are stable over time, but that the betas of large portfolios are much less stable.
d. The most widely cited study of the validity of the CAPM is one performed by Modigliani and Miller.
e. Tests have shown that the betas of individual stocks are unstable over time, but that the betas of large portfolios are reasonably stable over time.

24. Assume an economy in which there are three securities: Stock A with rA = 10% and A = 10%; Stock B with rB = 15% and B = 20%; and a riskless asset with rRF = 7%. Stocks A and B are uncorrelated (rAB = 0). Which of the following statements is most CORRECT?
a. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 10% and a standard deviation (SD) of approximately 10%.
b. The expected return on the investor’s portfolio will probably have an expected return that is somewhat below 15% and a standard deviation (SD) that is between 10% and 20%.
c. The investor’s risk/return indifference curve will be tangent to the CML at a point where the expected return is in the range of 7% to 10%.
d. Since the two stocks have a zero correlation coefficient, the investor can form a riskless portfolio whose expected return is in the range of 10% to 15%.
e. The expected return on the investor’s portfolio will probably have an expected return that is somewhat above 15% and a standard deviation (SD) of approximately 20%.

25. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio?
a. 1.1139
b. 1.1700
c. 1.2311
d. 1.2927
e. 1.3573

26. Your mother’s well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock?

rp bp
a. 11.69%; 1.22
b. 12.30%; 1.28
c. 12.92%; 1.34
d. 13.56%; 1.41
e. 14.24%; 1.48

27. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.’s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc.
a. 10.29%
b. 10.83%
c. 11.40%
d. 12.00%
e. 12.60%

28. A stock you are holding has a beta of 2.0 and the stock is currently in equilibrium. The required rate of return on the stock is 15% versus a required return on an average stock of 10%. Now the required return on an average stock increases by 30.0% (not percentage points). The risk-free rate is unchanged. By what percentage (not percentage points) would the required return on your stock increase as a result of this event?
a. 36.10%
b. 38.00%
c. 40.00%
d. 42.00%
e. 44.10%

29. Calculate the required rate of return for the Wagner Assets Management Group, which holds 4 stocks. The market’s required rate of return is 15.0%, the risk-free rate is 7.0%, and the Fund’s assets are as follows:

Stock Investment Beta
A $ 200,000 1.50
B 300,000 −0.50
C 500,000 1.25
D 1,000,000 0.75

a. 10.67%
b. 11.23%
c. 11.82%
d. 12.45%
e. 13.10%

30. Consider the information below for Postman Builders Inc. Suppose that the expected inflation rate and thus the inflation premium increase by 2.0 percentage points, and Postman acquires risky assets that increase its beta by the indicated percentage. What is the firm’s new required rate of return?

Beta: 1.50
Required return (rs) 10.20%
RPM: 6.00%
Percentage increase in beta: 20%

a. 14.00%
b. 14.70%
c. 15.44%
d. 16.21%
e. 17.02%

31. Assume that the market is in equilibrium and that stock betas can be estimated with historical data. The returns on the market, the returns on United Fund (UF), the risk-free rate, and the required return on the United Fund are shown below. Based on this information, what is the required return on the market, rM?

Year Market UF
2008 −9% −14%
2009 11% 16%
2010 15% 22%
2011 5% 7%
2012 −1% −2%

rRF: 7.00%; rUnited: 15.00%

a. 10.57%
b. 11.13%
c. 11.72%
d. 12.33%
e. 12.95%

32. You are given the following returns on “the market” and Stock F during the last three years. We could calculate beta using data for Years 1 and 2 and then, after Year 3, calculate a new beta for Years 2 and 3. How different are those two betas, i.e., what’s the value of beta 2 − beta 1? (Hint: You can find betas using the Rise-Over-Run method, or using your calculator’s regression function.)

Year Market Stock F
1 6.10% 6.50%
2 12.90% −3.70%
3 16.20% 21.71%

a. 7.89
b. 8.30
c. 8.74
d. 9.20
e. 9.66

PROBLEM

33. Security A has an expected return of 12.4% with a standard deviation of 15%, and a correlation with the market of 0.85. Security B has an expected return of −0.73% with a standard deviation of 20%, and a correlation with the market of −0.67. The standard deviation of rM is 12%.
a. To someone who acts in accordance with the CAPM, which security is more risky, A or B? Why? (Hint: No calculations are necessary to answer this question; it is easy.)
b. What are the beta coefficients of A and B? Calculations are necessary.
c. If the risk-free rate is 6%, what is the value of rM?

34. You plan to invest in Stock X, Stock Y, or some combination of the two. The expected return for X is 10% and X = 5%. The expected return for Y is 12% and Y = 6%. The correlation coefficient, rXY, is 0.75.
a. Calculate rp and p for 100%, 75%, 50%, 25%, and 0% in Stock X.
b. Use the values you calculated for rp and p to graph the attainable set of portfolios. Which part of the attainable set is efficient? Also, draw in a set of hypothetical indifference curves to show how an investor might select a portfolio comprised of Stocks X and Y. Let an indifference curve be tangent to the efficient set at the point where rp = 11%.
c. Now suppose we add a riskless asset to the investment possibilities. What effects will this have on the construction of portfolios?
d. Suppose rM = 12%, M = 4%, and rRF = 6%. What would be the required and expected return on a portfolio with P = 10%?
e. Suppose the correlation of Stock X with the market, rXM, is 0.8, while rYM = 0.9. Use this information, along with data given previously, to determine Stock X’s and Stock Y’s beta coefficients.
f. What is the required rate of return on Stocks X and Y? Do these stocks appear to be in equilibrium? If not, what would happen to bring about an equilibrium?

35. Stock A has an expected return rA = 10% and A = 10%. Stock B has rB = 14% and B = 15%. rAB = 0. The rate of return on riskless assets is 6%.
a. Construct a graph that shows the feasible and efficient sets, giving consideration to the existence of the riskless asset.
b. Explain what would happen to the CML if the two stocks had (a) a positive correlation coefficient or (b) a negative correlation coefficient.
c. Suppose these were the only three securities (A, B, and riskless) in the economy, and everyone’s indifference curves were such that they were tangent to the CML to the right of the point where the CML was tangent to the efficient set of risky assets. Would this represent a stable equilibrium? If not, how would an equilibrium be produced?

CHAPTER 26—REAL OPTIONS

TRUE/FALSE

1. Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows.

2. Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds.

3. The option to abandon a project is a real option, but a call option on a stock is not a real option.

4. Real options are most valuable when the underlying source of risk is very low.

5. Real options affect the size, but not the risk, of a project’s expected cash flows.

MULTIPLE CHOICE

6. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option?
a. The more uncertainty about the future cash flows, the more logical it is for Aaron to go ahead with this project today.
b. Since the project has a positive expected NPV today, this means that its expected NPV will be even higher if it chooses to wait a year.
c. Since the project has a positive expected NPV today, this means that it should be accepted in order to lock in that NPV.
d. Waiting would probably reduce the project’s risk.
e. The investment timing option does not affect the cash flows and will therefore have no impact on the project’s risk.

7. Which one of the following is an example of a “flexibility” option?
a. A company has an option to close down an operation if it turns out to be unprofitable.
b. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
c. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
d. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly commercial.
e. A company has an option to invest in a project today or to wait a year.

8. Which of the following is NOT a real option?
a. The option to buy shares of stock if its price goes up.
b. The option to expand into a new geographic region.
c. The option to abandon a project.
d. The option to switch the type of fuel used in an industrial furnace.
e. The option to expand production if the product is successful.

9. Which of the following will NOT increase the value of a real option?
a. An increase in the volatility of the underlying source of risk.
b. An increase in the risk-free rate.
c. An increase in the cost of obtaining the real option.
d. A decrease in the probability that a competitor will enter the market of the project in question.
e. Lengthening the time in which a real option must be exercised.

10. Which of the following is most CORRECT?
a. Real options change the risk, but not the size, of projects’ expected cash flows.
b. Real options are likely to reduce the cost of capital that should be used to discount a project’s expected cash flows.
c. Very few projects actually have real options.
d. Real options are less valuable when there is a lot of uncertainty about the true values future sales and costs.
e. Real options change the size, but not the risk, of projects’ expected cash flows.

11. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation?
a. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.
b. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget.
c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.
d. Real options should not have any effect on the size of the optimal capital budget.
e. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.

12. Refer to Exhibit 26.1. Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project’s expected NPV, in thousands of dollars?
a. $336.15
b. $373.50
c. $415.00
d. $461.11
e. $507.22

13. Refer to Exhibit 26.1. Calculate the project’s coefficient of variation. (Hint: Use the expected NPV.)
a. 5.87
b. 6.52
c. 7.25
d. 7.97
e. 8.77

14. Refer to Exhibit 26.2. Assuming that all cash flows are discounted at 10%, if NPC chooses to wait a year before proceeding, how much will this increase or decrease the project’s expected NPV in today’s dollars (i.e., at t = 0), relative to the NPV if it proceeds today?
a. $77.23
b. $85.81
c. $95.34
d. $105.94
e. $116.53

15. Refer to Exhibit 26.2. Calculate the effect of waiting on the project’s risk, using the same data. By how much will delaying reduce the project’s coefficient of variation? (Hint: Use the expected NPV.)
a. 2.23
b. 2.46
c. 2.70
d. 2.97
e. 3.27

16. Refer to Exhibit 26.3. Based on the above data, what is the project’s net present value?
a. −$1,312,456
b. −$1,104,607
c. −$875,203
d. $105,999
e. $321,788

17. Refer to Exhibit 26.3. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of −$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
a. −$1,104,607
b. −$875,203
c. $199,328
d. $561,947
e. $898,205

18. Refer to Exhibit 26.4. Based on the above information, what is the Z−90’s expected net present value?
a. −$6,678
b. −$3,251
c. $15,303
d. $20,004
e. $45,965

19. Refer to Exhibit 26.4. Now assume that one year from now SI will know if the Z−45 has become the industry standard. Also assume that after receiving the cash flows at t = 1, SI has the option to abandon the project, in which case it will receive an additional $100,000 at t = 1 but no cash flows after t = 1. Assuming that the cost of capital remains at 12%, what is the estimated value of the abandonment option?
a. $0
b. $2,075
c. $4,067
d. $8,945
e. $10,745

CHAPTER 27—PROVIDING AND OBTAINING CREDIT

TRUE/FALSE

1. The credit period is the amount of time it takes to do a credit search on a potential customer.

2. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit.

3. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business.

4. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses.

5. Cash discounts are mostly used to get new customers in the door since existing customers almost always use the delayed payment terms.

6. When deciding whether to offer a discount for cash payment, a firm must balance the profits from additional sales with the lost revenues from the discount.

7. The primary reason to monitor aggregate accounts receivable is to see if customers, on average, are paying more slowly.

8. DSO analysis of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

9. If sales are seasonal, the days sales outstanding will fluctuate from month to month, even if the amount of time customers take to pay remains unchanged.

10. The percentage aging schedule of accounts receivable is the most robust way to see if customers are, on average, paying more slowly, because it is unaffected by seasonal changes in sales.

11. The uncollected balances schedule is constructed at the end of a quarter by dividing the dollar amount of remaining receivables from each month in that quarter by that month’s sales.

MULTIPLE CHOICE

1. A firm’s credit policy consists of which of the following items?
a. Credit period, cash discounts, credit standards, collection policy.
b. Credit period, cash discounts, receivables monitoring, collection policy.
c. Cash discounts, credit standards, receivables monitoring, collection policy.
d. Credit period, receivables monitoring, credit standards, collection policy.
e. Credit period, cash discounts, credit standards, receivables monitoring.

2. Which of the following is not correct?
a. A more aggressive collection policy will reduce bad debt expenses, but may also decrease sales.
b. Collection policy usually has little impact on sales since collecting past-due accounts occurs only after the customer has already purchased.
c. Typically a firm will turn over an account to a collection agency only after it has tried several times on its own to collect the account.
d. A lax collection policy will frequently lead to an increase in accounts receivable.
e. Collection policy is how a firm goes about collecting past-due accounts.

3. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days?
a. The quarterly uncollected balances schedule will be the same in each quarter.
b. The level of accounts receivable will be constant from month to month.
c. The ratio of accounts receivable to sales will vary from month to month.
d. The level of accounts receivable at the end of each quarter will be the same.
e. DSO will vary from month to month.

4. Which of the following statements is most correct?
a. It is possible for a firm to overstate profits by offering very lenient credit terms which encourage additional sales to financially “weak” firms. A major disadvantage of such a policy is that it is likely to increase uncollectible accounts.
b. A firm with excess production capacity and relatively low variable costs would not be inclined to extend more liberal credit terms to its customers than a firm with similar costs that is operating close to capacity.
c. Firms use seasonal dating primarily to decrease their DSO.
d. Seasonal dating with terms 2/15, net 30 days, with April 1 dating, means that if the original sale took place on February 1st, the customer can take the discount up until March 15th, but must pay the net invoice amount by April 1st.
e. If credit sales as a percentage of a firm’s total sales increases, and the volume of credit sales also increases, then the firm’s accounts receivable will automatically increase.

5. Which one of the following aspects of banks is considered most relevant to businesses when choosing a bank?
a. Competitive cost of services provided.
b. Size of the bank’s deposits.
c. Experience of personnel.
d. Loyalty and willingness to assume lending risks.
e. Convenience of location.

6. Refer to Exhibit 27.1. How large are your brother’s monthly payments?
a. $6,250
b. $7,000
c. $7,500
d. $5,250
e. $6,875

7. Refer to Exhibit 27.1. What is the nominal annual add-on interest rate on this loan?
a. 10.00%
b. 16.47%
c. 18.83%
d. 20.00%
e. 24.00%

8. Suppose that you’re planning a vacation and borrow $2,000 from a bank for one year at a stated annual interest rate of 14 percent, with interest prepaid (a discounted loan). Also, assume that the bank requires you to maintain a compensating balance equal to 20 percent of the initial loan value. What effective annual interest rate are you being charged?
a. 14.00%
b. 8.57%
c. 16.28%
d. 21.21%
e. 28.00%

9. Faircross Farms harvests its crops four times annually and receives payment for its crop 90 days after it is picked and shipped. However, planting, irrigating, and harvesting must be done on a nearly continual schedule. The firm uses 90-day bank notes to finance its operations. The firm arranges an 11 percent discount interest loan with a 20 percent compensating balance four times annually. What is the effective annual interest rate of these discount loans?
a. 11.00%
b. 15.94%
c. 11.46%
d. 13.75%
e. 12.72%

10. Gladys Turner borrowed $12,000 from the bank using a 10.19 percent “add-on”, one-year installment loan, payable in four equal quarterly payments. What is the effective annual rate of interest?
a. 9.50%
b. 10.19%
c. 15.99%
d. 16.98%
e. 20.38%

11. The Arthos Group needs to borrow $200,000 from its bank. The bank has offered the company a 12-month installment loan (monthly payments) with 9 percent add-on interest. What is the effective annual rate (EAR) of this loan?
a. 16.22%
b. 17.97%
c. 17.48%
d. 18.67%
e. 18.00%

12. The Somerset Bank offered Blakemore Inc. the following loan alternatives in response to its request for a $75,000, 1-year loan.

Alternative 1: 7 percent discount interest, with a 10 percent compensating balance.
Alternative 2: 8 percent simple interest, with interest paid monthly.

What is the effective annual rate on the cheaper loan?
a. 8.00%
b. 7.23%
c. 7.67%
d. 8.43%
e. 8.30%

13. Harris Flooring Inc. is planning to borrow $12,000 from the bank for new sanding machines. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 12 percent discounted loan?
a. 10.7%
b. 12.0%
c. 12.5%
d. 13.6%
e. 14.1%

14. Maxwell Gardens requires a $100,000 annual loan in order to pay laborers to tend and harvest its organic vegetable crop. Maxwell borrows on a discount interest basis at a nominal annual rate of 11 percent. If Maxwell must actually receive $100,000 net proceeds to finance its crop, then what must be the face value of the note?
a. $111,000
b. $100,000
c. $112,360
d. $89,000
e. $108,840

15. Sunnydale Organics, Inc. harvests crops in roughly 90-day cycles based on a 360-day year. The firm receives payment from its harvests sometime after shipment. Due in part to the firm’s rapid growth, it has been borrowing to finance its harvests using 90-day bank notes on which the firm pays 12 percent discount interest. If the firm requires $60,000 in proceeds from each note, what must be the face value of each note?
a. $61,856
b. $67,531
c. $60,000
d. $68,182
e. $67,423

16. Danby Design Inc. has approached the bank with its plan to borrow $12,000. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the approximate (nominal) rate of interest on the 10.19 percent add-on loan?
a. 5.10%
b. 10.19%
c. 12.00%
d. 20.38%
e. 30.57%

17. Refer to Exhibit 27.2. What would be the incremental bad losses if the change were made?
a. $315,000
b. $260,500
c. −$260,500 (bad debt losses would decline)
d. −$315,000 (Bad debt losses would decline)
e. $0 (no change would occur)

18. Refer to Exhibit 27.2. What would be the incremental cost of carrying receivables if this change were made?
a. $108,750
b. −$116,250 (carrying costs would decline)
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,500

19. Refer to Exhibit 27.2. What are the incremental pre-tax profits from this proposal?
a. $181,250
b. $271,750
c. $256,250
d. $206,500
e. $231,250

20. Refer to Exhibit 272.3. What would be the cost to Van Doren of the discounts taken?
a. $116,750
b. −$108,750
c. $155,000
d. $225,000
e. $260,500

21. Refer to Exhibit 27.3. What would be the incremental bad debt losses if the change were made?
a. $130,000
b. $250,000
c. −$250,000 (bad debt losses would decline)
d. −$130,000 (bad debt losses would decline)
e. $620,000

22. Refer to Exhibit 27.3. What would be the incremental cost of carrying receivables if the change were made?
a. −$108,750 (carrying costs would decline)
b. $116,250
c. $157,900
d. −$225,000 (carrying costs would decline)
e. $260,000

23. Refer to Exhibit 27.3. What are the incremental pre-tax profits from this proposal?
a. $283,750
b. $250,500
c. $303,250
d. $493,750
e. $288,250

24. Darren’s Hair Products, Inc. purchases supplies from a single supplier on terms of 1/10, net 20. Currently, Darren takes the discount, but she believes she could extend the payment to 40 days without any adverse effects if she decided not to take the discount. Darren needs an additional $50,000 to support an expansion of fixed assets. This amount could be raised by making greater use of trade credit or by arranging a bank loan. The banker has offered to loan the money at 12 percent discount interest. Additionally, the bank requires an average compensating balance of 20 percent of the loan amount. Darren already has a commercial checking account at this bank that could be counted toward the compensating balance, but the required compensating balance amount is twice the amount that Darren would otherwise keep in the account. Which of the following statements is most correct?
a. The cost of using additional trade credit is approximately 36 percent.
b. Considering only the explicit costs, Darren should finance the expansion with the bank loan.
c. The cost of expanding trade credit using the approximation formula is less than the cost of the bank loan. However, the true cost of the trade credit when compounding is considered is greater than the cost of the bank loan.
d. The effective cost of the bank loan is decreased from 17.65 percent to 15.38 percent because Darren would hold a cash balance of one-half the compensating balance amount even if the loan were not taken.
e. If Darren had transaction balances that exceeded the compensating balance requirement, the effective cost of the bank loan would be 12.00 percent.

25. Tillyard Inc. requires a $25,000 1-year loan. The bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent nominal interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rates?
a. 1.12%
b. 2.48%
c. 3.60%
d. 4.25%
e. 5.00%

26. Campbell Computing Inc. currently has sales of $1,000,000, and its days sales outstanding is 30 days. The financial manager estimates that offering longer credit terms would (1) increase the days sales outstanding to 50 days and (2) increase sales to $1,200,000. However, bad debt losses, which were 2 percent on the old sales, would amount to 5 percent on the incremental sales only (bad debts on the old sales would stay at 2 percent). Variable costs are 80 percent of sales, and Campbell has a 15 percent receivables financing cost. What would the annual incremental pre-tax profit be if Bass extended its credit period?
a. −$20,000
b. −$10,000
c. $0
d. $10,000
e. $20,000

27. No Tree Too Tall, Inc. is planning to borrow $12,000 from the bank. The bank offers the choice of a 12 percent discount interest loan or a 10.19 percent add-on, one-year installment loan, payable in 4 equal quarterly payments. What is the effective rate of interest on the 10.19 percent add-on loan?
a. 9.50%
b. 10.19%
c. 15.22%
d. 16.99%
e. 22.05%

CHAPTER 28—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL

TRUE/FALSE

1. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together.

2. The easier a firm’s access to borrowed funds the higher its precautionary balances will be, in order to protect against sudden increases in interest rates.

3. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash.

4. A just-in-time system is designed to stretch accounts payable as long as possible.

5. If a company increases its safety stock, then its EOQ will go up.

6. If a company increases its safety stock, then its average inventory will go up.

MULTIPLE CHOICE

7. Which of the following would cause average inventory holdings to decrease, other things held constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.

8. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn’t matter which you use since cash flow is unaffected by the choice of inventory identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

9. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*.
a. If the total amount of cash needed during the year increases by 20%, then C* will increase by 20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

10. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

11. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748

12. Humphrey’s Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now?
a. $200
b. $333
c. $414
d. $500
e. $666

13. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180, and the total cash needed for transactions annually is $960,000. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

14. Gemini Inc.’s optimal cash transfer amount, using the Baumol model, is $60,000. The firm’s fixed cost per cash transfer of marketable securities to cash is $180. In addition, the total estimated cash costs (transfers and carrying cost) for the firm, based on 16 transactions per year, are $5,760. On what opportunity cost of holding cash was this analysis based?
a. 19.2%
b. 10.4%
c. 6.3%
d. 12.1%
e. 9.6%

15. Suppose Stanley’s Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.)
a. $1,000 loss
b. $1,000 benefit
c. $500 loss
d. $500 benefit
e. $0 (The change would not affect profits.)

16. Each year, Holly’s Best Salad Dressing, Inc. (HBSD) purchases 50,000 gallons of extra virgin olive oil. Ordering costs are $100 per order, and the carrying cost, as a percentage of inventory value, is 80 percent. The purchase price to HBSD is $0.50 per gallon. Management currently orders the EOQ each time an order is placed. No safety stock is carried. The supplier is now offering a quantity discount of $0.03 per gallon if HBSD orders 10,000 gallons at a time. Should HBSD take the discount?
a. From a cost standpoint, HBSD is indifferent.
b. No, the cost exceeds the benefit by $500.
c. No, the cost exceeds the benefit by $1,000.
d. Yes, the benefit exceeds the cost by $500.
e. Yes, the benefit exceeds the cost by $1,120.

17. New England Charm, Inc. specializes in selling scented candles. The company has established a policy of reordering inventory every 30 days. A recently employed MBA has considered New England’s inventory problem from the EOQ model viewpoint. If the following constitute the relevant data, how does the current policy compare with the optimal policy?

Ordering cost = $10 per order
Carrying cost = 20% of purchase price
Purchase price = $10 per unit
Total sales for year = 1,000 units
Safety stock = 0

a. Total costs will be the same, since the current policy is optimal.
b. Total costs under the current policy will be less than total costs under the EOQ by $10.
c. Total costs under the current policy exceed those under the EOQ by $3.
d. Total costs under the current policy exceed those under the EOQ by $10.
e. Cannot be determined due to insufficient information.

18. Refer to Exhibit 28.1. According to the Baumol model, what is the optimal transaction size for transfers from marketable securities to cash?
a. $7,071
b. $38,357
c. $70,711
d. $102,956
e. $87,000

19. Refer to Exhibit 28.1. According to the Baumol model, what should be Duckett’s average cash balance?
a. $35,356
b. $3,536
c. $22,157
d. $70,711
e. $42,918

20. Refer to Exhibit 28.1. What will be the total cost to Duckett of maintaining the optimal average cash balance, as determined by the Baumol model?
a. $35,356
b. $7,071
c. $18,493
d. $70,711
e. $53,190

21. Refer to Exhibit 28.2. What is the economic ordering quantity for chips?
a. 12,088
b. 3,175
c. 6,243
d. 13,675
e. 8,124

22. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is its average inventory level?
a. 12,088
b. 3,175
c. 15,750
d. 13,675
e. 8,124

23. Refer to Exhibit 28.2. Assume that Cartwright holds a safety stock equal to a 30-day supply of chips. What is the maximum amount of inventory that will have on hand at any time, that is, what will be the inventory level right after a delivery is made?
a. 9,216
b. 3,175
c. 6,243
d. 13,675
e. 8,124

24. Refer to Exhibit 28.2. How many orders should Cartwright place during the year?
a. 12
b. 25
c. 30
d. 40
e. 60

25. Refer to Exhibit 28.2. If the lead time for placing an order is 5 days, and Cartwright holds a safety stock equal to a 30-day supply of chips, then at what inventory level should an order be placed?
a. 15,570
b. 3,175
c. 12,250
d. 13,675
e. 8,124

26. Refer to Exhibit 28.2. If Cartwright holds a safety stock equal to a 30-day supply of chips, what is Cartwright’s minimum cost of ordering and carrying inventory?
a. $28,500
b. $15,950
c. $68,440
d. $34,220
e. $47,693

27. Refer to Exhibit 28.3. What is the firm’s EOQ?
a. 26,833
b. 30,040
c. 43,987
d. 13,563
e. 21,456

28. Refer to Exhibit 28.3. What is Palmer’s minimum costs of ordering and holding inventory?
a. $6,254
b. $10,733
c. $11,560
d. $13,563
e. $19,825

29. Refer to Exhibit 28.3. Now, suppose the manufacturer offers a discount of 0.5 percent for orders of a least 40,000 gallons. Should Palmer increase its ordering quantity to take the discount?
a. Yes; it will save $827 if it takes the discount.
b. No; it will lose $827 if it takes the discount.
c. Yes; it will save $14,400 if it takes the discount.
d. Yes; it will save $13,573 if it takes the discount.
e. No; it will lose $13,573 if it takes the discount.

WEB CHAPTER 29—PENSION PLAN MANAGEMENT

TRUE/FALSE

1. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm’s pension fund.

2. If employees have a right to receive pension benefits even if they leave the company prior to retirement, their pension rights are said to be vested.

3. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan.

4. The performance measurement of stock portfolio managers must recognize the risk inherent in the investment portfolio. One way to incorporate risk into performance measurement is to examine the portfolio’s alpha, which measures the vertical distance of the portfolio’s return above or below the Security Market Line.

MULTIPLE CHOICE

5. Which of the following statements about pension plans if any, is incorrect?
a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit, such as $500 per month or 50 percent of the employee’s final salary.
b. A portable pension plan is one that an employee can carry from one employer to another.
c. An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.
d. If assets exceed the present value of benefits, the pension plan is fully funded.
e. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

6. Which of the following statements about defined contribution plans is incorrect?
a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.
b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.
c. Defined benefit plans are used more often by large corporations than by small companies.
d. The PBGC insures a portion of pension benefits.
e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

7. Which of the following statements about pension plan portfolio performance is incorrect?
a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.
b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives.
c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.
d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.
e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

8. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd’s current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years. Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year’s wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd’s expected annual retirement benefit, rounded to the nearest thousands of dollars?
a. $35,000
b. $57,000
c. $89,000
d. $116,000
e. $132,000

9. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio’s alpha?
a. −0.75%
b. −0.15%
c. 0%
d. 0.15%
e. 0.75%

10. Arnold Rossiter is a 40-year-old employee of the Barrington Company who will retire at age 60 and expects to live to age 75. The firm has promised a retirement income of $20,000 at the end of each year following retirement until death. The firm’s pension fund is expected to earn 7 percent annually on its assets and the firm uses 7% to discount pension benefits. What is Barrington’s annual pension contribution to the nearest dollar for Mr. Rossiter? (Assume certainty and end-of-year cash flows.)
a. $2,756
b. $3,642
c. $4,443
d. $4,967
e. $5,491

WEB CHAPTER 30—FINANCIAL MANAGEMENT IN NOT-FOR-PROFIT BUSINESSES

TRUE/FALSE

1. The primary goal of investor-owned firms is shareholder wealth maximization, while the primary goal of not-for-profit firms is typically stated in terms of some mission; for example, to provide health care services to the communities served.

2. Not-for-profit firms have fund capital in place of equity capital. Since fund capital does not have to provide a return to stockholders, the appropriate cost of fund capital in a cost of capital estimate is zero.

3. Since not-for-profit firms do not pay taxes, they receive no tax benefits whatsoever from using debt financing.

4. The net present social value model formally recognizes that not-for-profit firms must consider the social value along with the financial value of proposed new projects.

MULTIPLE CHOICE

5. Which of the following statements about project risk analysis in not-for-profit firms is incorrect?
a. A project’s corporate beta measures the contribution of the project to the overall corporate risk of the firm.
b. A project’s corporate beta is found (at least conceptually) by regressing returns on the project against returns on the market portfolio.
c. A project’s corporate beta is defined as (P/F)rPF, where P is the standard deviation of the project’s returns, F is the standard deviation of the firm’s returns, and rPF is the correlation among the two sets of returns.
d. In practice, it is usually difficult, if not impossible, to directly measure a project’s corporate risk, so project risk analysis typically focuses on stand-alone risk.
e. The market risk of a project is not relevant to not-for-profit firms.

6. Which of the following statements about municipal bond financing is most correct?
a. Whereas the vast majority of Treasury and corporate bonds are held by institutions, no municipal bonds are held by individual investors.
b. The primary attraction of municipal bonds to individual investors is their high before-tax yields.
c. Municipal bonds usually pay higher coupon rates than corporate bonds with similar ratings.
d. Municipal bonds are risk-free.
e. In contrast to corporate bonds, municipal bond issues are not required to be registered with the Securities and Exchange Commission.

7. Which of the following statements about a not-for-profit firm’s ownership is most correct?
a. The residual earnings (profits) of not-for-profit firms can be distributed to the firm’s top managers.
b. Not-for-profit firms are exempt from federal taxes, but they must pay state and local taxes, including property taxes.
c. Upon liquidation of a not-for-profit firm, the proceeds from the sale of its assets are distributed, on a pro rata basis, to the firm’s employees.
d. None of the profits are used for private inurement.
e. Not-for-profit firms are governed by a board of trustees whose members are elected by the community at large.

8. Which of the following statements about a not-for-profit firm’s cost of capital estimate is most correct?
a. The capital structure weights for a not-for-profit firm are set at 50/50, because such firms can raise $1 of debt financing for each dollar of retained earnings.
b. The cost of tax-exempt debt issued by not-for-profit firms is increased (“grossed up”) by 1 − T in the WACC estimate to reflect the fact that such firms do not pay taxes.
c. Equity (fund) capital has a cost that is roughly equivalent to the cost of retained earnings to similar investor-owned companies.
d. Not-for-profit firms have a zero cost of capital.
e. Since a not-for-profit firm has no shareholders, its WACC estimate does not include a cost of equity (fund capital) estimate.

9. Which of the following statements about a not-for-profit firm’s fund capital is most correct?
a. The sole source of fund capital is the excess of revenues over expenses.
b. Fund capital has a zero opportunity cost.
c. Fund capital can only come from donations.
d. Fund capital does not change over time.
e. Fund capital is equivalent to equity capital in investor-owned firms.

10. Which of the following statements about a not-for-profit firm’s sources of capital is most correct?
a. Fund capital is obtained by retaining earnings⎯if all earnings are paid out as dividends, no fund capital is created.
b. Preferred stock is never used by not-for-profit firms.
c. Not-for-profit firms are not allowed to raise capital by borrowing.
d. Not-for-profit firms usually have high dividend payouts.
e. Since not-for-profit firms are tax exempt, there is no tax advantage to debt capital.

FIN 540 Week 5 Midterm Exam – Strayer University NEW

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Midterm Exam Chapter 18 Through 23

CHAPTER 18—PUBLIC AND PRIVATE FINANCING: INITIAL OFFERINGS, SEASONED OFFERINGS, AND INVESTMENT BANKS

TRUE/FALSE

1. If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement.

2. Going public establishes a market value for the firm’s stock, and it also ensures that a liquid market will continue to exist for the firm’s shares. This is especially true for small firms that are not widely followed by security analysts.

3. The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public.

4. The term “leaving money on the table” refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm’s new stock offering. The banker is, in effect, “buying the job” with the low bid and thus not getting all the money his firm would normally earn on the job.

5. Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another.

6. The term “equity carve-out” refers to the situation where a firm’s managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it “carves out” some of their value.

7. Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.

8. The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings.

9. If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate.

10. When a firm refunds a debt issue, the firm’s stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond.

MULTIPLE CHOICE

11. Which of the following is generally NOT true and an advantage of going public?
a. Increases the liquidity of the firm’s stock.
b. Makes it easier to obtain new equity capital.
c. Establishes a market value for the firm.
d. Makes it easier for owner-managers to engage in profitable self-dealings.
e. Facilitates stockholder diversification.

12. Which of the following statements about listing on a stock exchange is most CORRECT?
a. Any firm can be listed on the NYSE as long as it pays the listing fee.
b. Listing provides a company with some “free” advertising, and it may enhance the firm’s prestige and help it do more business.
c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.
e. Listing is a decision of more significance to a firm than going public.

13. Which of the following statements is most CORRECT?
a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
c. The SEC requires that all private placements be handled by a registered investment banker.
d. Private placements can generally bring in funds faster than is the case with public offerings.
e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

14. Which of the following statements is most CORRECT?
a. The key benefits associated with refunding debt are the reduction in the firm’s debt ratio and the creation of more reserve borrowing capacity.
b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.
c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen.
d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings.
e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.

15. Which of the following factors would increase the likelihood that a company would call its outstanding bonds at this time?
a. A provision in the bond indenture lowers the call price on specific dates, and yesterday was one of those dates.
b. The flotation costs associated with issuing new bonds rise.
c. The firm’s CFO believes that interest rates are likely to decline in the future.
d. The firm’s CFO believes that corporate tax rates are likely to be increased in the future.
e. The yield to maturity on the company’s outstanding bonds increases due to a weakening of the firm’s financial situation.

16. Which of the following statements concerning common stock and the investment banking process is NOT CORRECT?
a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market.
b. Listing a large firm’s stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm.
c. Stockholders have the right to elect the firm’s directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management’s performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer.
d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called “market pressure,” and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue.
e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

17. Which of the following statements is NOT CORRECT?
a. “Going public” establishes a firm’s true intrinsic value and ensures that a liquid market will always exist for the firm’s shares.
b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC.
c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called “going public,” and the market for such stock is called the new issue market.
d. It is possible for a firm to go public and yet not raise any additional new capital.
e. When a corporation’s shares are owned by a few individuals who own most of the stock or are part of the firm’s management, we say that the firm is “closely, or privately, held.”

18. In its negotiations with its investment bankers, Patton Electronics has reached an agreement whereby the investment bankers receive a smaller fee now (6% of gross proceeds versus their normal 10%) but also receive a 1-year option to purchase an additional 200,000 shares at $5.00 per share. Patton will go public by selling $5,000,000 of new common stock. The investment bankers expect to exercise the option and purchase the 200,000 shares in exactly one year, when the stock price is forecasted to be $6.50 per share. However, there is a chance that the stock price will actually be $12.00 per share one year from now. If the $12 price occurs, what would the present value of the entire underwriting compensation be? Assume that the investment banker’s required return on such arrangements is 15%, and ignore taxes.
a. $1,235,925
b. $1,300,973
c. $1,369,446
d. $1,441,522
e. $1,517,391

19. To finance its ongoing construction project, Bowen-Roth Inc. will need $5,000,000 of new capital during each of the next 3 years. The firm has a choice of issuing new debt or equity each year as the funds are needed, or issue only debt now and equity later. Its target capital structure is 40% debt and 60% equity, and it wants to be at that structure in 3 years, when the project has been completed. Debt flotation costs for a single debt issue would be 1.6% of the gross debt proceeds. Yearly flotation costs for 3 separate issues of debt would be 3.0% of the gross amount. Ignoring time value effects, how much would the firm save by raising all of the debt now, in a single issue, rather than in 3 separate issues?
a. $79,425
b. $83,606
c. $88,006
d. $92,406
e. $97,027

20. 10 years ago, the City of Melrose issued $3,000,000 of 8% coupon, 30-year, semiannual payment, tax-exempt muni bonds. The bonds had 10 years of call protection, but now the bonds can be called if the city chooses to do so. The call premium would be 6% of the face amount. New 20-year, 6%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2% of the amount of bonds sold. What is the net present value of the refunding? Note that cities pay no income taxes, hence taxes are not relevant.
a. $453,443
b. $476,115
c. $499,921
d. $524,917
e. $551,163

21. Five years ago, the State of Oklahoma issued $2,000,000 of 7% coupon, 20-year semiannual payment, tax-exempt bonds. The bonds had 5 years of call protection, but now the state can call the bonds if it chooses to do so. The call premium would be 5% of the face amount. Today 15-year, 5%, semiannual payment bonds can be sold at par, but flotation costs on this issue would be 2%. What is the net present value of the refunding? Because these are tax-exempt bonds, taxes are not relevant.
a. $278,606
b. $292,536
c. $307,163
d. $322,521
e. $338,647

22. Palmer Company has $5,000,000 of 15-year maturity bonds outstanding. Each bond has a maturity value of $1,000, an annual coupon of 12.0%. The bonds can be called at any time with a premium of $50 per bond. If the bonds are called, the company must pay flotation costs of $10 per new refunding bond. Ignore tax considerations⎯assume that the firm’s tax rate is zero.

The company’s decision of whether to call the bonds depends critically on the current interest rate on newly issued bonds. What is the breakeven interest rate, the rate below which it would be profitable to call in the bonds?
a. 9.57%
b. 10.07%
c. 10.60%
d. 11.16%
e. 11.72%

23. Stanovich Enterprises has 10-year, 12.0% semiannual coupon bonds outstanding. Each bond is now eligible to be called at a call price of $1,060. If the bonds are called, the company must replace them with new 10-year bonds. The flotation cost of issuing new bonds is estimated to be $45 per bond. How low would the yield to maturity on the new bonds have to be in order for it to be profitable to call the bonds today, i.e., what is the nominal annual “breakeven rate”?
a. 9.29%
b. 9.78%
c. 10.29%
d. 10.81%
e. 11.35%

24. Refer to Exhibit 18.1. What is the required after-tax refunding investment outlay, i.e., the cash outlay at the time of the refunding?
a. $5,049,939
b. $5,315,725
c. $5,595,500
d. $5,890,000
e. $6,200,000

25. Refer to Exhibit 18.1. What will the after-tax annual interest savings for NWW be if the refunding takes place?
a. $664,050
b. $699,000
c. $768,900
d. $845,790
e. $930,369

26. Refer to Exhibit 18.1. The amortization of flotation costs reduces taxes and thus provides an annual cash flow. What will the net increase or decrease in the annual flotation cost tax savings be if refunding takes place?
a. $6,480
b. $7,200
c. $8,000
d. $8,800
e. $9,680

27. Refer to Exhibit 18.1. What is the NPV if NWW refunds its bonds today?
a. $1,746,987
b. $1,838,933
c. $1,935,719
d. $2,037,599
e. $2,241,359

CHAPTER 19—LEASE FINANCING

TRUE/FALSE

1. Many leases written today combine the features of operating and financial leases. Such leases are often called “combination leases.”

2. A sale and leaseback arrangement is a type of financial, or capital, lease.

3. Operating leases help to shift the risk of obsolescence from the user to the lessor.

4. Under a sale and leaseback arrangement, the seller of the leased property is the lessee and the buyer is the lessor.

5. The full amount of a lease payment is tax deductible provided the contract qualifies as a true lease under IRS guidelines.

6. Leasing is often referred to as off-balance sheet financing because lease payments are shown as operating expenses on a firm’s income statement and, under certain conditions, leased assets and associated liabilities do not appear on the firm’s balance sheet.

7. Leasing is typically a financing decision and not a capital budgeting decision. Thus, the availability of lease financing cannot affect the size of the capital budget.

8. A leveraged lease is more risky from the lessee’s standpoint than an unleveraged lease.

9. A synthetic lease is a combination of derivative securities and asset purchases that mimic the cash flows of an operating lease.

10. In a synthetic lease a special purpose entity (SPE) is set up by a corporation that wants to acquire the use of an asset. The SPE borrows up to 97% of its capital, uses its funds to buy the asset, and then leases it to the sponsoring corporation on a short-term basis. This keeps both the asset and the debt off the sponsoring company’s books.

11. If a leased asset has a negative residual value, for example, as a result of a statutory requirement to dispose of an asset in an environmentally sound manner, the lessee of the asset could reasonably expect to pay a lower lease rate because the asset does not have a positive residual value.

12. Assume that a piece of leased equipment has a relatively high rather than low expected residual value. From the lessee’s viewpoint, it might be better to own the asset rather than lease it because with a high residual value the lessee will likely face a higher lease rate.

MULTIPLE CHOICE

13. From the lessee viewpoint, the riskiness of the cash flows, with the possible exception of the residual value, is about the same as the riskiness of the lessee’s
a. capital budgeting project cash flows.
b. debt cash flows.
c. pension fund cash flows.
d. sales.
e. equity cash flows.

14. Operating leases often have terms that include
a. full amortization over the life of the lease.
b. very high penalties if the lease is canceled.
c. restrictions on how much the leased property can be used.
d. much longer lease periods than for most financial leases.
e. maintenance of the equipment by the lessor.

15. Which of the following statements is most CORRECT?
a. Capitalizing a lease means that the firm issues equity capital in proportion to its current capital structure, in an amount sufficient to support the lease payment obligation.
b. The fixed charges associated with a lease can be as high as, but never greater than, the fixed payments associated with a loan.
c. Capital, or financial, leases generally provide for maintenance by the lessor.
d. A key difference between a capital lease and an operating lease is that with a capital lease, the lease payments provide the lessor with a return of the funds invested in the asset plus a return on the invested funds, whereas with an operating lease the lessor depends on the residual value to realize a full return of and on the investment.
e. Firms that use “off balance sheet” financing, such as leasing, would show lower debt ratios if the effects of their leases were reflected in their financial statements.

16. Financial Accounting Standards Board (FASB) Statement #13 requires that for an unqualified audit report, financial (or capital) leases must be included in the balance sheet by reporting the
a. residual value as a liability.
b. present value of future lease payments as an asset and also showing this same amount as an offsetting liability.
c. undiscounted sum of future lease payments as an asset and as an offsetting liability.
d. undiscounted sum of future lease payments, less the residual value, as an asset and as an offsetting liability.
e. residual value as a fixed asset.

17. Heavy use of off-balance sheet lease financing will tend to
a. make a company appear less risky than it actually is because its stated debt ratio will appear lower.
b. affect a company’s cash flows but not its degree of risk.
c. have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.
d. affect the lessee’s cash flows but only due to tax effects.
e. make a company appear more risky than it actually is because its stated debt ratio will be increased.

18. In the lease versus buy decision, leasing is often preferable
a. because, generally, no down payment is required, and there are no indirect interest costs.
b. because lease obligations do not affect the firm’s risk as seen by investors.
c. because the lessee owns the property at the end of the least term.
d. because the lessee may have greater flexibility in abandoning the project in which the leased property is used than if the lessee bought and owned the asset.
e. because it has no effect on the firm’s ability to borrow to make other investments.

19. A lease versus purchase analysis should compare the cost of leasing to the cost of owning, assuming that the asset purchased
a. is financed with long-term debt.
b. is financed with debt whose maturity matches the term of the lease.
c. is financed with a mix of debt and equity based on the firm’s target capital structure, i.e., at the WACC.
d. is financed with retained earnings.
e. is financed with short-term debt.

20. Stanley Inc. must purchase $6,000,000 worth of service equipment and is weighing the merits of leasing the equipment or purchasing. The company has a zero tax rate due to tax loss carry-forwards, and is considering a 5-year, bank loan to finance the equipment. The loan has an interest rate of 10% and would be amortized over 5 years, with 5 end-of-year payments. Stanley can also lease the equipment for 5 end-of-year payments of $1,790,000 each. How much larger or smaller is the bank loan payment than the lease payment? Note: Subtract the loan payment from the lease payment.
a. $177,169
b. $196,854
c. $207,215
d. $217,576
e. $228,455

21. To finance some manufacturing tools it needs for the next 3 years, Waldrop Corporation is considering a leasing arrangement. The tools will be obsolete and worthless after 3 years. The firm will depreciate the cost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchase price, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 each and lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid at the end of the year. The firm’s tax rate is 40%. Annual maintenance costs associated with ownership are estimated at $240,000, but this cost would be borne by the lessor if it leases. What is the net advantage to leasing (NAL), in thousands? (Suggestion: Delete 3 zeros from dollars and work in thousands.)
a. $96
b. $106
c. $112
d. $117
e. $123

22. Delamont Transport Company (DTC) is evaluating the merits of leasing versus purchasing a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If DTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. DTC’s tax rate is 40%. What is the net advantage to leasing? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.15, and 0.07.)
a. $849
b. $896
c. $945
d. $999
e. $1,047

23. Carmichael Cleaners needs a new steam finishing machine that costs $100,000. The company is evaluating whether it should lease or purchase the machine. The equipment falls into the MACRS 3-year class, and it would be used for 3 years and then sold, because the firm plans to move to a new facility at that time. The estimated value of the equipment after 3 years is $30,000. A maintenance contract on the equipment would cost $3,000 per year, payable at the beginning of each year. Alternatively, the firm could lease the equipment for 3 years for a lease payment of $29,000 per year, payable at the beginning of each year. The lease would include maintenance. The firm is in the 20% tax bracket, and it could obtain a 3-year simple interest loan, interest payable at the end of the year, to purchase the equipment at a before-tax cost of 10%. If there is a positive Net Advantage to Leasing the firm will lease the equipment. Otherwise, it will buy it. What is the NAL? (Note: Assume MACRS rates for Years 1 to 4 are 0.3333, 0.4445, 0.1481, and 0.0741.)
a. $5,734
b. $6,023
c. $6,324
d. $6,640
e. $6,972

CHAPTER 20—HYBRID FINANCING: PREFERRED STOCK, WARRANTS, AND CONVERTIBLES

TRUE/FALSE

1. The “preferred” feature of preferred stock means that it normally will provide a higher expected return than will common stock.

2. Unlike bonds, the cost of preferred stock to the issuing firm is the same on a before-tax and after-tax basis. This is because dividends on preferred stock are not tax deductible, whereas interest on bonds is deductible.

3. A warrant is an option, and as such it cannot be used as a “sweetener.”

4. A warrant holder is not entitled to vote, but he or she does receive any cash dividends paid on the underlying stock.

5. The problem of dilution of stockholders’ earnings never results from the sale of call options, but it can arise if warrants are used.

6. A detachable warrant is a warrant that can be detached and traded separately from the bond with which it was issued. Most traded warrants are originally attached to bonds or preferred stocks.

7. The owner of a convertible bond owns, in effect, both a bond and a call option.

8. A convertible debenture can never sell for more than its conversion value or less than its bond value.

9. Most convertible securities are bonds or preferred stocks that, under specified terms and conditions, can be exchanged for common stock at the option of the holder.

10. Firms generally do not call their convertibles unless the conversion value is greater than the call price.

11. Many preferred stocks extend voting rights to preferred shareholders if the preferred dividend has been omitted for some specified period, for example, 4 quarters.

12. Preferred stockholders have priority over common stockholders with respect to dividends, because dividends must be paid on preferred stock before they can be paid on common stock. However, preferred and common stockholders normally have equal priority with respect to liquidating proceeds in the event of bankruptcy.

13. Preferred stock typically has a par value, and the dividend is often stated as a percentage of par. The par value is also important in the event of liquidation, as the preferred stockholders are generally entitled to receive the par value before anything is given to the common stockholders.

14. Preferred stock can provide a financing alternative for some firms when market conditions are such that they cannot issue either pure debt or common stock at any reasonable cost.

15. Corporations that invest surplus funds in floating-rate preferred stock benefit from getting a relatively stable price, which is desirable for liquidity portfolios, and they also benefit from the 70% tax exemption on preferred dividends received.

MULTIPLE CHOICE

16. Which of the following statements is most CORRECT?
a. By law in most states, all preferred stock must be cumulative, meaning that the compounded total of all unpaid preferred dividends must be paid before any dividends can be paid on the firm’s common stock.
b. From the issuer’s point of view, preferred stock is less risky than bonds.
c. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date, generally 25 years or less.
d. Unlike bonds, preferred stock cannot have a convertible feature.
e. Preferred stock generally has a higher component cost of capital to the firm than does common stock.

17. Which of the following statements about convertibles is most CORRECT?
a. One advantage of convertibles over warrants is that the issuer receives additional cash money when convertibles are converted.
b. Investors are willing to accept a lower interest rate on a convertible than on otherwise similar straight debt because convertibles are less risky than straight debt.
c. At the time it is issued, a convertible’s conversion (or exercise) price is generally set equal to or below the underlying stock’s price.
d. For equilibrium to exist, the expected return on a convertible bond must normally be between the expected return on the firm’s otherwise similar straight debt and the expected return on its common stock.
e. The coupon interest rate on a firm’s convertibles is generally set higher than the market yield on its otherwise similar straight debt.

18. Which of the following statements concerning warrants is correct?
a. Warrants are long-term put options that have value because holders can sell the firm’s common stock at the exercise price regardless of how low the market price drops.
b. Warrants are long-term call options that have value because holders can buy the firm’s common stock at the exercise price regardless of how high the stock’s price has risen.
c. A firm’s investors would generally prefer to see it issue bonds with warrants than straight bonds because the warrants dilute the value of new shareholders, and that value is transferred to existing shareholders.
d. A drawback to using warrants is that if the firm is very successful, investors will be less likely to exercise the warrants, and this will deprive the firm of receiving any new capital.
e. Bonds with warrants and convertible bonds both have option features that their holders can exercise if the underlying stock’s price increases. However, if the option is exercised, the issuing company’s debt declines if warrants were used but remains the same if it used convertibles.

19. Which of the following statements is most CORRECT?
a. One important difference between warrants and convertibles is that convertibles bring in additional funds when they are converted, but exercising warrants does not bring in any additional funds.
b. The coupon rate on convertible debt is normally set below the coupon rate that would be set on otherwise similar straight debt even though investing in convertibles is more risky than investing in straight debt.
c. The value of a warrant to buy a safe, stable stock should exceed the value of a warrant to buy a risky, volatile stock, other things held constant.
d. Warrants can sometimes be detached and traded separately from the debt with which they were issued, but this is unusual.
e. Warrants have an option feature but convertibles do not.

20. The common stock of Southern Airlines currently sells for $33, and its 8% convertible debentures (issued at par, or $1,000) sell for $850. Each debenture can be converted into 25 shares of common stock at any time before 2025. What is the conversion value of the bond?
a. $707.33
b. $744.56
c. $783.75
d. $825.00
e. $866.25

21. Convertible debentures for Kulik Corporation were issued at their $1,000 par value in 2012. At any time prior to maturity on February 1, 2032, a debenture holder can exchange a bond for 25 shares of common stock. What is the conversion price, Pc?
a. $40.00
b. $42.00
c. $44.10
d. $46.31
e. $48.62

22. Mariano Manufacturing can issue a 25-year, 8.1% annual payment bond at par. Its investment bankers also stated that the company can sell an issue of annual payment preferred stock to corporate investors who are in the 40% tax bracket. The corporate investors require an after-tax return on the preferred that exceeds their after-tax return on the bonds by 1.0%, which would represent an after-tax risk premium. What coupon rate must be set on the preferred in order to issue it at par?
a. 6.66%
b. 6.99%
c. 7.34%
d. 7.71%
e. 8.09%

23. Preissle Company, wants to sell some 20-year, annual interest, $1,000 par value bonds. Its stock sells for $42 per share, and each bond would have 75 warrants attached to it, each exercisable into one share of stock at an exercise price of $47. The firm’s straight bonds yield 10%. Each warrant is expected to have a market value of $2.00 given that the stock sells for $42. What coupon interest rate must the company set on the bonds in order to sell the bonds-with-warrants at par?
a. 7.83%
b. 8.24%
c. 8.65%
d. 9.08%
e. 9.54%

24. McGovern Enterprises is interested in issuing bonds with warrants attached. The bonds will have a 30-year maturity and annual interest payments. Each bond will come with 20 warrants that give the holder the right to purchase one share of stock per warrant. The investment bankers estimate that each warrant will have a value of $10.00. A similar straight-debt issue would require a 10% coupon. What coupon rate should be set on the bonds-with-warrants so that the package would sell for $1,000?
a. 6.75%
b. 7.11%
c. 7.48%
d. 7.88%
e. 8.27%

25. Potter & Lopez Inc. just sold a bond with 50 warrants attached. The bonds have a 20-year maturity and an annual coupon of 12%, and they were issued at their $1,000 par value. The current yield on similar straight bonds is 15%. What is the implied value of each warrant?
a. $3.76
b. $3.94
c. $4.14
d. $4.35
e. $4.56

26. Mikkleson Mining stock is selling for $40 per share and has an expected dividend in the coming year of $2.00, and has an expected constant growth rate of 5.00%. The company is considering issuing a 10-year convertible bond that would be priced at its $1,000 par value. The bonds would have an 8.00% annual coupon, and each bond could be converted into 20 shares of common stock. The required rate of return on an otherwise similar nonconvertible bond is 10.00%. What is the estimated floor price of the convertible at the end of Year 3?
a. $794.01
b. $835.81
c. $879.80
d. $926.10
e. $972.41

27. Refer to Exhibit 20.1. What is the bond’s conversion ratio?
a. 27.14
b. 28.57
c. 30.00
d. 31.50
e. 33.08

28. Refer to Exhibit 20.1. What is the bond’s conversion value?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

29. Refer to Exhibit 20.1. What is the bond’s straight-debt value?
a. $684.78
b. $720.82
c. $758.76
d. $798.70
e. $838.63

30. Refer to Exhibit 20.1. What is the minimum price (or “floor” price) at which the Neuman’s bonds should sell?
a. $698.15
b. $734.89
c. $773.57
d. $814.29
e. $857.14

CHAPTER 21—DYNAMIC CAPITAL STRUCTURES

TRUE/FALSE

1. In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.

2. According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.

3. MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.

4. MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.

5. The Miller model begins with the MM model with taxes and then adds personal taxes.

6. The Miller model begins with the MM model without corporate taxes and then adds personal taxes.

7. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient.

8. The MM model with corporate taxes is the same as the Miller model, but with zero personal taxes.

9. The MM model is the same as the Miller model, but with zero corporate taxes.

10. In the MM extension with growth, the appropriate discount rate for the tax shield is the unlevered cost of equity.

11. In the MM extension with growth, the appropriate discount rate for the tax shield is the WACC.

12. In the MM extension with growth, the appropriate discount rate for the tax shield is the after-tax cost of debt.

13. When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt.

14. When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity.

MULTIPLE CHOICE

15. The major contribution of the Miller model is that it demonstrates that
a. personal taxes decrease the value of using corporate debt.
b. financial distress and agency costs reduce the value of using corporate debt.
c. equity costs increase with financial leverage.
d. debt costs increase with financial leverage.
e. personal taxes increase the value of using corporate debt.

16. Which of the following statements concerning capital structure theory is NOT CORRECT?
a. Under MM with zero taxes, financial leverage has no effect on a firm’s value.
b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
e. The major contribution of Miller’s theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

17. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is less than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the unlevered cost of equity.

18. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm increases with the amount of debt.
e. The tax shields should be discounted at the cost of debt.

19. Which of the following statements concerning the MM extension with growth is NOT CORRECT?
a. The value of a growing tax shield is greater than the value of a constant tax shield.
b. For a given D/S, the levered cost of equity is greater than the levered cost of equity under MM’s original (with tax) assumptions.
c. For a given D/S, the WACC is greater than the WACC under MM’s original (with tax) assumptions.
d. The total value of the firm is independent of the amount of debt it uses.
e. The tax shields should be discounted at the unlevered cost of equity.

20. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a rate of 5%, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is Firm L’s cost of equity?
a. 11.4%
b. 12.0%
c. 12.6%
d. 13.3%
e. 14.0%

21. The market value of Firm L’s debt is $200,000 and its yield is 9%. The firm’s equity has a market value of $300,000, its earnings are growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what would Firm L’s total value be if it had no debt?
a. $358,421
b. $377,286
c. $397,143
d. $417,000
e. $437,850

22. A local firm has debt worth $200,000, with a yield of 9%, and equity worth $300,000. It is growing at a 5% rate, and its tax rate is 40%. A similar firm with no debt has a cost of equity of 12%. Under the MM extension with growth, what is the value of your firm’s tax shield, i.e., how much value does the use of debt add?
a. $92,571
b. $102,857
c. $113,143
d. $124,457
e. $136,903

23. Refer to Exhibit 21.1. What is the value of the firm according to MM with corporate taxes?
a. $475,875
b. $528,750
c. $587,500
d. $646,250
e. $710,875

24. Refer to Exhibit 21.1. What is the firm’s cost of equity?
a. 21.0%
b. 23.3%
c. 25.9%
d. 28.8%
e. 32.0%

25. Refer to Exhibit 21.1. Assume that the firm’s gain from leverage according to the Miller model is $126,667. If the effective personal tax rate on stock income is TS = 20%, what is the implied personal tax rate on debt income?
a. 16.4%
b. 18.2%
c. 20.2%
d. 22.5%
e. 25.0%

26. Refer to Exhibit 21.2. According to the MM extension with growth, what is the value of Kitto’s tax shield?
a. $156,385
b. $164,616
c. $173,280
d. $182,400
e. $192,000

27. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s unlevered value?
a. $1,296,000
b. $1,440,000
c. $1,600,000
d. $1,760,000
e. $1,936,000

28. Refer to Exhibit 21.2. According to the MM extension with growth, what is Kitto’s value of equity?
a. $1,492,000
b. $1,529,300
c. $1,567,533
d. $1,606,721
e. $1,646,889

29. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s equity if it is viewed as an option?
a. $228.77
b. $254.19
c. $282.43
d. $313.81
e. $345.19

30. Refer to Exhibit 21.3. What is the value (in millions) of Wilson Dover’s debt if its equity is viewed as an option?
a. $167.57
b. $186.19
c. $204.81
d. $225.29
e. $247.82

31. Refer to Exhibit 21.3. What is the yield on Wilson Dover’s debt?
a. 6.04%
b. 6.36%
c. 6.70%
d. 7.05%
e. 7.42%

CHAPTER 22—MERGERS AND CORPORATE CONTROL

TRUE/FALSE

1. In a merger with true synergies, the post-merger value exceeds the sum of the separate companies’ pre-merger values.

3. A spin-off is a type of divestiture in which the assets of a division are sold to another firm.

4. A conglomerate merger occurs when two firms with either a horizontal or a vertical business relationship combine.

5. Merger activity is likely to heat up when interest rates are high because target firms can expect to receive an especially high premium over the pre-announcement stock price.

6. Most defensive mergers occur as a result of managers’ actions to maximize shareholders’ wealth.

7. Post-merger control and the negotiated price paid by the acquirer are two of the most important issues in agreeing on the terms of a merger.

8. A company seeking to fight off a hostile takeover might employ the services of an investment banking firm to develop a defensive strategy.

9. Since the primary rationale for any operating merger is synergy, in planning such mergers, the development of accurate pro forma cash flows is the single most important action.

10. Currently (2012), mergers can be accounted for using either the purchase method or the pooling method.

11. Borrowing funds on terms that would require immediate repayment of all funds if the firm is acquired, selling off valuable assets, and granting huge “golden parachutes” that open if the firm is acquired are three procedures used to defend against hostile takeovers. These strategies are known as “poison pills.”

12. A joint venture is one in which two, or sometimes more, independent companies agree to combine resources in order to achieve a specific objective, usually limited in scope.

13. The two principal advantages of holding companies are (1) the holding company can control a great deal of assets with limited equity and (2) the dividends received by the parent from the subsidiary are not taxed if the parent holds at least 50% of the subsidiary’s stock.

14. The purchase of assets at below their replacement cost and tax considerations are two factors that motivate mergers.

15. The primary reason managers give for most mergers is to acquire more assets so as to increase sales and market share.

16. Since managers’ central goal is to maximize stock price, managerial control issues do not interfere with mergers that would benefit the target firm’s stockholders.

17. One of the main reasons why foreign firms are interested in buying U.S. companies is to gain entrance to the U.S. market. A decline in the value of the dollar relative to most foreign currencies makes this competitive strategy especially attractive.

18. If a petrochemical firm that used oil as feedstock merged with an oil producer that had large oil reserves and a drilling subsidiary, this would be a vertical merger.

19. A congeneric merger is one where the merging firms operate in related businesses but do not necessarily produce the same products or have a producer-supplier relationship.

20. Since a manager’s central goal is to maximize the firm’s stock price, any merger offer that provides stockholders with significant gains over the current stock price will be approved by the current management team.

21. Only if a target firm’s value is greater to the acquiring firm than its market value as a separate entity will a merger be financially justified.

22. Discounted cash flow methods are not appropriate for evaluating mergers because the cash flows are uncertain and the discount rate can only be determined after the merger is consummated.

23. In a financial merger, the relevant post-merger cash flows are simply the sum of the expected cash flows of the two companies, measured as if they were operated independently.

24. Coca-Cola’s acquisition of Columbia Pictures and its announcement that it would operate its new subsidiary separately could be described as primarily a financial merger.

25. A two-tier merger offer is one where the acquiring company offers to purchase the target company in a two-part transaction. Cash is paid to some stockholders, bonds are issued to others, but the total values of each part of the transaction are equal.

26. The distribution of synergistic gains between the stockholders of two merged firms is almost always based strictly on their respective market values before the announcement of the merger.

27. The rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm.

28. Any goodwill created in a merger must be amortized over its expected life, usually 40 years, for shareholder reporting purposes.

29. Although goodwill created in a merger may not be amortized for shareholder reporting purposes, it may be amortized for Federal tax purposes.

30. The three main advantages of holding companies are (1) control with fractional ownership, (2) taxation benefits, and (3) isolation of operating risks.

31. If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the horizon value is calculated by discounting the free cash flows plus the expected future tax shields at the weighted average cost of capital.

32. The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm’s operations if it had no debt.

MULTIPLE CHOICE

33. Which of the following are legal and acceptable reasons for the high level of merger activity in the U.S. during the 1980s?
a. A profitable firm acquires a firm with large accumulated tax losses that may be carried forward.
b. Attempts to stabilize earnings by diversifying.
c. Purchase of assets below their replacement costs.
d. Reduction in competition resulting from mergers.
e. Synergistic benefits arising from mergers.

34. Firms use defensive tactics to fight off undesired mergers. These tactics do not include
a. getting a white squire to purchase stock in the firm.
b. getting white knights to bid for the firm.
c. repurchasing their own stock.
d. changing the bylaws to eliminate supermajority voting requirements.
e. raising antitrust issues.

35. Which of the following statements is most CORRECT?
a. Regulations in the United States prohibit acquiring firms from using common stock to purchase another firm.
b. Defensive mergers are designed to make a company less vulnerable to a takeover.
c. Hostile mergers always create value for the acquiring firm.
d. In a tender offer, the target firm’s management always remain after the merger is completed.
e. A conglomerate merger is one where a firm combines with another firm in the same industry.

36. Which of the following statements is most CORRECT?
a. The smaller the synergistic benefits of a particular merger, the greater the scope for striking a bargain in negotiations, and the higher the probability that the merger will be completed.
b. Since mergers are frequently financed by debt rather than equity, a lower cost of debt or a greater debt capacity are rarely relevant considerations when considering a merger.
c. Managers who purchase other firms often assert that the new combined firm will enjoy benefits from diversification, including more stable earnings. However, since shareholders are free to diversify their own holdings, and at what’s probably a lower cost, diversification benefits is generally not a valid motive for a publicly held firm.
d. Operating economies are never a motive for mergers.
e. Tax considerations often play a part in mergers. If one firm has excess cash, purchasing another firm exposes the purchasing firm to additional taxes. Thus, firms with excess cash rarely undertake mergers.

37. Which of the following statements is most CORRECT?
a. Financial theory says that the choice of how to pay for a merger is really irrelevant because, although it may affect the firm’s capital structure, it will not affect its overall required rate of return.
b. The basic rationale for any financial merger is synergy and, thus, the estimation of pro forma cash flows is the single most important part of the analysis.
c. In most mergers, the benefits of synergy and the premium the acquirer pays over the market price are summed and then divided equally between the shareholders of the acquiring and target firms.
d. The primary rationale for most operating mergers is synergy.
e. The acquiring firm’s required rate of return in most horizontal mergers will not be affected, because the 2 firms will have similar betas.

38. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt.
b. The horizon value is calculated by discounting the expected earnings at the WACC.
c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.
d. The horizon value must always be more than 20 years in the future.
e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

39. Which of the following statements about valuing a firm using the APV approach is most CORRECT?
a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.
b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.
c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity.
d. The APV approach stands for the accounting pre-valuation approach.
e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

40. Which of the following statements is most CORRECT?
a. A defensive merger is one where the firm’s managers decide to merge with another firm to avoid or lessen the possibility of being acquired through a hostile takeover.
b. Acquiring firms send a signal that their stock is undervalued if they choose to use stock to pay for the acquisition.
c. Cash payments are used in takeovers but never in mergers.
d. Managers often are fired in takeovers, but never in mergers.
e. If a company that produces military equipment merges with a company that manages a chain of motels, this is an example of a horizontal merger.

41. A parent holding company sells shares in its subsidiary such that the parent now owns only 65% of the subsidiary and, thus, the tax returns of the parent and its subsidiary can’t be consolidated. The parent receives annual dividends from the subsidiary of $2,500,000. If the parent’s marginal tax rate is 34% and if the exclusion on intercompany dividends is 70%, what is the effective tax rate on the intercompany dividends, and how much net dividends are received?
a. 10.2%; $2,245,000
b. 10.2%; $2,135,000
c. 23.8%; $1,905,000
d. 10.2%; $1,750,000
e. 34.0%; $1,650,000

42. A regional restaurant chain, Club Café, is considering purchasing a smaller chain, Sally’s Sandwiches, which is currently financed using 20% debt at a cost of 8%. Club Café’s analysts project that the merger will result in incremental free cash flows and interest tax savings of $2 million in Year 1, $4 million in Year 2, $5 million in Year 3, and $117 million in Year 4. (The Year 4 cash flow includes a horizon value of $107 million.) The acquisition would be made immediately, if it is to be undertaken. Sally’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8%, and the market risk premium is 4%. What is the appropriate rate for use in discounting the free cash flows and the interest tax savings?
a. 12.0%
b. 13.9%
c. 14.4%
d. 16.0%
e. 16.9%

43. The owners of Arthouse Inc., a national artist supplies chain, are contemplating purchasing Craftworks Inc, a smaller chain. Arthouse’s analysts project that the merger will result in incremental free flows and interest tax savings with a combined present value of $72.52 million, and they have determined that the appropriate discount rate for valuing Craftworks is 16%. Craftworks has 4 million shares outstanding and no debt. Craftworks’ current price is $16.25. What is the maximum price per share that Arthouse should offer?
a. $16.25
b. $16.97
c. $17.42
d. $18.13
e. $19.00

44. Holland Auto Parts is considering a merger with Workman Car Parts. Workman’s market-determined beta is 0.9, and the firm currently is financed with 20% debt, at an interest rate of 8%, and its tax rate is 25%. If Holland acquires Workman, it will increase the debt to 60%, at an interest rate of 9%, and the tax rate will increase to 35%. The risk-free rate is 6% and the market risk premium is 4%. What will Workman’s required rate of return on equity be after it is acquired?
a. 7.4%
b. 8.9%
c. 9.3%
d. 9.6%
e. 9.7%

45. Raymond Supply, a national hardware chain, is considering purchasing a smaller chain, Strauss & Glazer Parts (SGP). Raymond’s analysts project that the merger will result in the following incremental free cash flows, tax shields, and horizon values:

Year 1 2 3 4
Free cash flow $1 $3 $3 $7
Unlevered horizon value 75
Tax shield 1 1 2 3
Horizon value of tax shield 32

Assume that all cash flows occur at the end of the year. SGP is currently financed with 30% debt at a rate of 10%. The acquisition would be made immediately, and if it is undertaken, SGP would retain its current $15 million of debt and issue enough new debt to continue at the 30% target level. The interest rate would remain the same. SGP’s pre-merger beta is 2.0, and its post-merger tax rate would be 34%. The risk-free rate is 8% and the market risk premium is 4%. What is the value of SGP to Raymond?
a. $53.40 million
b. $61.96 million
c. $64.64 million
d. $76.96 million
e. $79.64 million

46. Juicers Inc. is thinking of acquiring Fast Fruit Company. Juicers expects Fast Fruit’s NOPAT to be $9 million the first year, with no net new investment in operating capital and no interest expense. For the second year, Fast Fruit is expected to have NOPAT of $25 million and interest expense of $5 million. Also, in the second year only, Fast Fruit will need $10 million of net new investment in operating capital. Fast Fruit’s marginal tax rate is 40%. After the second year, the free cash flows and the tax shields from Fast Fruit to Juicers will both grow at a constant rate of 4%. Juicers has determined that Fast Fruit’s cost of equity is 17.5%, and Fast Fruit currently has no debt outstanding. Assume that all cash flows occur at the end of the year, Juicers must pay $45 million to acquire Fast Fruit. What it the NPV of the proposed acquisition? Note that you must first calculate the value to Juicers of Fast Fruit’s equity.
a. $45.0 million
b. $68.2 million
c. $86.5 million
d. $113.2 million
e. $133.0 million

47. Refer to Exhibit 22.1. What is Glassmakers’ pre-merger WACC?
a. 9.02%
b. 9.50%
c. 9.83%
d. 10.01%
e. 11.29%

48. Refer to Exhibit 22.1. What discount rate should you use to discount Glassmakers’ free cash flows and interest tax savings?
a. 10.01%
b. 10.06%
c. 11.29%
d. 11.44%
e. 13.49%

49. Refer to Exhibit 22.1. What is the value of Glassmakers’ equity to Best? (Round your answer to the closest thousand dollars.)
a. $16,019,000
b. $17,111,000
c. $18,916,000
d. $22,111,000
e. $22,916,000

CHAPTER 23—ENTERPRISE RISK MANAGEMENT

TRUE/FALSE

1. One objective of risk management can be to reduce the volatility of a firm’s cash flows.

2. Interest rate swaps allow a firm to exchange fixed for floating-rate payments, but a swap cannot reduce actual net interest expenses.

3. Speculative risks are symmetrical in the sense that they offer the chance of a gain as well as a loss, while pure risks are those that can only lead to losses.

4. In theory, reducing the volatility of its cash flows will always increase a company’s value.

5. The two basic types of hedges involving the futures market are long hedges and short hedges, where the words “long” and “short” refer to the maturity of the hedging instrument. For example, a long hedge might use Treasury bonds, while a short hedge might use 3-month T-bills.

MULTIPLE CHOICE

6. Which of the following are NOT ways risk management can be used to increase the value of a firm?
a. Risk management can help a firm maintain its optimal capital budget.
b. Risk management can reduce the expected costs of financial distress.
c. Risk management can help firms minimize taxes.
d. Risk management can allow managers to defer receipt of their bonuses and thus postpone tax payments.
e. Risk management can increase debt capacity.

7. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?
a. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.
b. Interest rate price risk can be eliminated by holding zero coupon bonds.
c. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.
d. Interest rate risk can never be reduced.
e. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.

8. A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?
a. The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.
b. Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.
c. A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.
d. A company can swap fixed interest payments for floating interest payments.
e. A swap involves the exchange of cash payment obligations.

9. Which of the following statements is most CORRECT?
a. Futures contracts generally trade on an organized exchange and are marked to market daily.
b. Goods are never delivered under forward contracts, but are almost always delivered under futures contracts.
c. There are futures contracts for currencies but no forward contracts for currencies.
d. Futures contracts don’t have any margin requirements but forward contracts do.
e. One advantage of forward contracts is that they are default free.

10. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of the following strategies would protect the bank against rising interest rates?
a. Entering into an interest rate swap where the bank receives a fixed payment stream, and in return agrees to make payments that float with market interest rates.
b. Purchase principal only (PO) strips that decline in value whenever interest rates rise.
c. Enter into a short hedge where the bank agrees to sell interest rate futures.
d. Sell some of the bank’s floating-rate loans and use the proceeds to make fixed-rate loans.
e. Buying inverse floaters.

11. Company A can issue floating-rate debt at LIBOR + 1% and can issue fixed rate debt at 9%. Company B can issue floating-rate debt at LIBOR + 1.5% and can issue fixed-rate debt at 9.4%. Suppose A issues floating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A will make a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. What are the resulting net payments of A and B?
a. A pays a fixed rate of 9%, B pays LIBOR + 1.5%.
b. A pays a fixed rate of 8.95%, B pays LIBOR + 1.45%.
c. A pays LIBOR plus 1%, B pays a fixed rate of 9.4%.
d. A pays a fixed rate of 7.95%, B pays LIBOR.
e. None of the above answers is correct.

12. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89’09. What is the implied annual interest rate inherent in this futures contract?
a. 6.32%
b. 6.65%
c. 7.00%
d. 7.35%
e. 7.72%

13. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. What is the implied annual interest rate inherent in the futures contract?
a. 6.86%
b. 7.22%
c. 7.60%
d. 8.00%
e. 8.40%

14. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80’07. If annual interest rates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a $1,000 par value, and round to the nearest whole dollar.)
a. −$78.00
b. −$82.00
c. −$86.00
d. −$90.00
e. −$95.00

FIN 540 Week 9 Homework Problems – Strayer University NEW

FIN/540 Week 9 Homework Problems – Strayer NEW

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Week 9
Homework Problems Chapter 29

1. Which of the following statements about pension plans if any, is incorrect?
a. Under a defined benefit plan, the employer agrees to give retirees a specifically defined benefit.
b. If assets exceed the present value of benefits, the pension plan is fully funded.
c. Such as $500 per month or 50 percent of the employee’s final salary.
d. A portable pension plan is one that an employee can carry from one employer to another
e. An employer’s obligation is satisfied under a defined contribution plan when it makes the required contributions to the plan. The risk of inadequate investment returns is borne by the employee.
f. A defined contribution plan is, in effect, a savings plan that is funded by employers, although many plans also permit additional contributions by employees.

2. Which of the following statements about defined contribution plans is incorrect?
a. In general, employees can choose the investment vehicle under a defined contribution plan. Thus, highly risk-averse employees can choose low-risk investments, while more risk-tolerant employees can choose high-risk investments.
b. In a defined contribution plan, the employer must make larger-than-average contributions to the pension plan when investment returns have been below expectations.
c. Defined benefit plans are used more often by large corporations than by small companies.
d. The PBGC insures a portion of pension benefits.
e. A defined contribution plan places the risk of poor pension portfolio performance on the employee.

3. Which of the following statements about pension plan portfolio performance is incorrect?
a. Alpha analysis, which relies on the Capital Asset Pricing Model, considers the risk of the portfolio when measuring performance.
b. Peer comparison examines the relative performance of portfolio managers with similar investment objectives.
c. A portfolio annual return of 12 percent from one investment advisor is not necessarily better than a return of 10 percent from another advisor.
d. In managing the retiree portfolio, fund managers often use immunization techniques such as alpha analysis to eliminate, or at least significantly reduce, the risk associated with changing interest rates.
e. Pension fund sponsors must evaluate the performance of their portfolio managers periodically as a basis for future asset allocations.

4. Ms. Lloyd, who is 25 and expects to retire at age 60, has just been hired by the Chambers Corporation. Ms. Lloyd’s current salary is $30,000 per year, but her wages are expected to increase by 5 percent annually over the next 35 years. Chambers has a defined benefit pension plan in which workers receive 2 percent of their final year’s wages for each year of employment. Assume a world of certainty. Further, assume that all payments occur at year-end. What is Ms. Lloyd’s expected annual retirement benefit, rounded to the nearest thousands of dollars?
a. $35,000
b. $57,000
c. $89,000
d. $116,000
e. $132,000

5. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio’s alpha?
a. −0.75%
b. −0.15%
c. 0%
d. 0.15%
e. 0.75%

FIN 540 Week 8 Homework Problems – Strayer University NEW

FIN/540 Week 8 Homework Problems – Strayer NEW

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Week 8
Homework Problems Chapter 28

1. Which of the following would cause average inventory holdings to decrease, other things held constant?
a. The purchase price of inventory items decreases by 50 percent.
b. The carrying price of an item decreases (as a percent of purchase price).
c. The sales forecast is revised downward by 10 percent.
d. Interest rates fall.
e. Fixed order costs double.

2. During times of inflation, which of these inventory accounting methods is best for cash flow?
a. LIFO, because the most expensive goods are recorded as being sold first, resulting in a higher cost of goods sold and a lower reported net income.
b. Specific identification, because it correctly identifies the actual item sold and so the actual cost is recorded on the income statement.
c. Weighted average, because it smoothes the reported cost of goods sold over time.
d. It doesn’t matter which you use since cash flow is unaffected by the choice of inventory identification method.
e. FIFO, because the cheapest goods are recorded as being sold first, resulting in lower cost of goods sold and higher reported net income.

3. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*.

a. If the total amount of cash needed during the year increases by 20%, then C will increase by 20%.
b. If the average cash balance increases by 20%, then the total holding costs will increase by 20%.
c. If the average cash balance increases by 20% the total transactions costs will increase by 20%.
d. The optimal transfer amount is the same for all companies.
e. If the fixed costs of selling securities or obtaining a loan (cost per transaction) increase by 20%, then C* will increase by 20%.

4. Which of the following is true of the EOQ model? Note that the optimal order quantity, Q, will be called EOQ.
a. If the annual sales, in units, increases by 20%, then EOQ will increase by 20%.
b. If the average inventory increases by 20%, then the total carrying costs will increase by 20%.
c. If the average inventory increases by 20% the total order costs will increase by 20%.
d. The EOC is the same for all companies.
e. If the fixed per order cost increases by 20%, then EOQ will increase by 20%.

5. Halliday Inc. receives a $2 million payment once a year. Of this amount, $700,000 is needed for cash payments made during the next year. Each time Halliday deposits money in its account, a charge of $2.00 is assessed to cover clerical costs. If Halliday can hold marketable securities that yield 5 percent, and then convert these securities to cash at a cost of only the $2 deposit charge, what is the total cost for one year of holding the minimum cost cash balance according to the Baumol model?
a. $7,483
b. $187
c. $3,741
d. $374
e. $748