FIN 540 Week 11 Final Exam – Strayer
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Chapters 24 Through 30
CHAPTER 24—BANKRUPTCY, REORGANIZATION, AND LIQUIDATION
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.
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
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.
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?
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?
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.
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?
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
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?
Required return (rs) 10.20%
Percentage increase in beta: 20%
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%
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%
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
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.
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?
13. Refer to Exhibit 26.1. Calculate the project’s coefficient of variation. (Hint: Use the expected NPV.)
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?
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.)
16. Refer to Exhibit 26.3. Based on the above data, what is the project’s net present value?
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?
18. Refer to Exhibit 26.4. Based on the above information, what is the Z−90’s expected net present value?
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?
CHAPTER 27—PROVIDING AND OBTAINING CREDIT
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.
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?
7. Refer to Exhibit 27.1. What is the nominal annual add-on interest rate on this loan?
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?
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?
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?
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?
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?
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?
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?
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?
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?
17. Refer to Exhibit 27.2. What would be the incremental bad losses if the change were made?
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?
b. −$116,250 (carrying costs would decline)
d. −$225,000 (carrying costs would decline)
19. Refer to Exhibit 27.2. What are the incremental pre-tax profits from this proposal?
20. Refer to Exhibit 272.3. What would be the cost to Van Doren of the discounts taken?
21. Refer to Exhibit 27.3. What would be the incremental bad debt losses if the change were made?
c. −$250,000 (bad debt losses would decline)
d. −$130,000 (bad debt losses would decline)
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)
d. −$225,000 (carrying costs would decline)
23. Refer to Exhibit 27.3. What are the incremental pre-tax profits from this proposal?
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?
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?
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?
CHAPTER 28—ADVANCED ISSUES IN CASH MANAGEMENT AND INVENTORY CONTROL
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.
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?
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?
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?
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?
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?
19. Refer to Exhibit 28.1. According to the Baumol model, what should be Duckett’s average cash balance?
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?
21. Refer to Exhibit 28.2. What is the economic ordering quantity for chips?
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?
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?
24. Refer to Exhibit 28.2. How many orders should Cartwright place during the year?
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?
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?
27. Refer to Exhibit 28.3. What is the firm’s EOQ?
28. Refer to Exhibit 28.3. What is Palmer’s minimum costs of ordering and holding inventory?
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
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.
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?
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?
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.)
WEB CHAPTER 30—FINANCIAL MANAGEMENT IN NOT-FOR-PROFIT BUSINESSES
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.
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.