Business Finance Final Exam
A. Multiple Choice Questions -
Q1. Assume that interest rates on 20-year Treasury and corporate bonds with different ratings, all of which are non-callable, are as follows:
T-bond = 7.72%
A = 9.64%
AAA = 8.72%
BBB = 10.18%
What most probably caused the differences in rates among these issues?
a. real risk-free rate differences
b. default risk differences
c. maturity risk differences
d. inflation differences
Q2. If the yield to maturity is 5.5%, what is the price of a 15-year, zero-coupon bond with a par value of $1,000?
a. $413.35
b. $429.48
c.447.93
d. $469.72
Q3. If 10-year T-bonds have a yield of 6.2%, 10-year corporate bonds yield 8.5%, the maturity risk premium on all 10-year bonds is 1.3%, and corporate bonds have a 0.4% liquidity premium versus a zero liquidity premium for T-bonds, what is the default risk premium on the corporate bond?
a. 1. 90%
b. 2.09%
c. 2.30%
d. 2.53%
Q4. Five-year Treasury bonds yield 5.5%. The inflation premium (IP) is 1.9%, and the maturity risk premium (MRP) on 5- year bonds is 0.4%. What is the real risk-free rate, r*?
a. 2.59%
b. 2.88%
c. 3.20%
d. 3.52%
Q5. What is one of the advantages of going private?
a. reduced managerial flexibility
b. lower shareholder participation
c. higher cost in security registration
d. increased managerial efficiency
Q6. What is an example of a seasoned equity offering?
a. Shares are sold by founding members from their holdings in the primary market.
b. Unsubscribed new shares from the previous IPO are sold in the secondary market.
c. New shares are sold to the general public by companies in the primary market.
d. Used shares are sold to existing shareholders in the secondary market.
Q7. Which of the following statements best describes private placements?
a. In a private placement, securities are sold to private (individual) investors rather than to institutions.
b. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement.
c. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs.
d. Private placements can generally bring in funds faster than is the case with public offerings.
Q8. Which statement regarding market efficiency is true?
a. Semi-strong-form market efficiency implies that as soon as any public or private information comes into being it is incorporated into stock prices.
b. Weak-form market efficiency implies that recent trends in stock prices are of no use in predicting future stock prices.
c. Market efficiency implies that all stocks should have the same expected return.
d. According to strong-form market efficiency, insiders would find it possible to consistently earn abnormal returns in the stock market even if they have superior knowledge about the company.
Q9. Stock X is expected to pay a dividend of $3.00 at the end of the year, i.e., D1 = $3.00, and that dividend is expected to grow at a constant rate of 6% a year. The stock currently trades at a price of $50 a share. Assume that the stock is in equilibrium, i.e., the stock's price equals its intrinsic value.
Which of the following statements is correct?
a. The stock's required return is 10%.
v. The stock's expected dividend yield and growth rate are equal.
c. The stock's expected dividend yield is 5%.
d. The stock's expected capital gains yield is 5%.
Q10. Which statement regarding preferred stocks is true?
a. Preferred stockholders have a priority to income but not to liquidation proceeds over bondholders in the event of bankruptcy.
b. The preferred stock of a given firm is generally less risky to investors than the same firm's common stock.
c. Preferred dividends are not generally cumulative.
d. A big advantage of preferred stock is that dividends on preferred stocks are tax deductible by the issuing corporation.
Q11. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 12.5%, and the expected constant growth rate is g = 8.5%. What is its current price?
a. $17.82
b. $18.28
c. $18.75
d. $19.22
Q12. Ewert Enterprises' stock currently sells for $30.50 per share. The stock's dividend is projected to increase at a constant rate of 4.50% per year. The required rate of return on the stock, rs, is 10.00%. What is Ewert's expected price 3 years from today?
a. $31.61
b. $32.43
c. $33.26
d. $34.81
Q13. Alberta Inc. (Al) pays an annual dividend of $4 per share. If Al's stock is currently trading at $75 per share, and Al's expected growth rate is 4%, what is Al's expected return?
a. 9.33%
b. 10.70%
c. 15.00%
d. 28.00%
Q14. Which statement regarding the IRR method is correct?
a. One defect of the IRR method is that it does not take account of cash flows over a project's full life.
b. One defect of the IRR method is that it does not take account of the time value of money.
c. One defect of the IRR method is that it does not take account of the cost of capital.
d. One defect of the IRR method is that it does not assume that the cash flows to be received from a project can be reinvested at a rate other than the IRR itself.
Q15. Which statement regarding payback is true?
a. The regular payback method recognizes all cash flows over a project's life.
b. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money.
c. The regular payback method was widely used years ago, but virtually no companies even calculate the payback today.
d. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how -tang it will take to recover the funds invested in a project.
Q16. Which of the following statements is correct?
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method -assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
Q17. Which of the following statements best describes a situation involving sunk costs?
a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
c. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed those funds for tax purposes, and now is deciding whether to go forward with the project.
d. If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.
Q18. Which of the following statements best describes externalities?
a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favourable effect on other operations, then this is not an externality.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.
c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favour the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
Q19. As a member of Midwest Corporation's financial staff, you must estimate the Year 1 operating cash flow for a proposed project with the following data. What is the Year 1 net operating cash flow?
Sales revenues, each year - $35,000
Capital cost allowance - $10,000
Cash operating costs - $17,000
Interest expense - $4,000
Tax rate - 35.0%
a. $12,380
b. $13,032
c. $14,440
d. $15,200
Q20. Canada Corp.'s management has determined that two mutually exclusive projects have the following NPV: Project A NPV $5,000 Project B NPV $6,000
Which best describes the correct managerial decision given the information above?
a. Decline both projects since both projects must have an NPV greater than $10,000.
b. Accept both projects since the NPV of A will offset any potential losses resulting from B.
c Accept A and decline B since they both have positive NPVs.
d. Accept B, and reject A, since project A has a lower NPV than project B.
Q21. What will heavy use of off-balance sheet lease financing tend to do?
a. make a company appear more risky than it actually is because its stated debt ratio will be increased
b. make a company appear less risky than it actually is because its stated debt ratio will appear lower
c. affect a company's cash flows but not its degree of risk
d. affect the lessee's cash flows but only due to tax effects
Q22. Which of the following explains the risk underlying an operating lease?
a. Operating leases help to shift the risk of obsolescence from the user to the lessor.
b. Operating leases help to shift the risk of obsolescence from the user to the lessee.
c. Operating leases help to balance the risk of obsolescence between the lessor and lessee.
d. Operating leases help to shift the risk of obsolescence from the lessor to the user (lessee).
Q23. You are considering buying a zero growth stock. If the firm pays a $10.00 annual dividend, and your required rate of return is 2%, what is the maximum price you would pay for this stock?
a. $500
b. $50
c. $15
d. $10
Q24. Which statement regarding normal cash flows is correct?
a. If a project has normal cash flows, then its IRR must be positive.
b. If a project has normal cash flows, then its MIRR must be positive.
c. If a project has normal cash flows, then it will have exactly two real IRRs.
d. If a project has normal cash flows, then it can have only one real IRR, whereas a project with non-normal cash flows might have more than one real IRR.
Q25. Which of the following is NOT a cash flow and thus should not be reflected in the analysis of a capital budgeting project?
a. changes in net operating working capital
b. shipping and installation costs
c. cannibalization effects
d. sunk costs that have been expensed for tax purposes
B. Problems
Q1. Bonds -
Company A's 10-year bond has a face value of $1,000 and pays 8% coupon rate, paid semiannually. The price of the bond is $1,125. The bond is callable in 3 years at $1,050.
a) What is the YTM?
b) What is the current yield?
c) What is the bond's capital gain or loss yield?
d) What is the YTC?
Q2. Risk and Return-
Stock A's return has the following distribution:
|
Scenario
|
Probability
|
Rate of Return
|
|
Weak
|
0.3
|
15%
|
|
Average
|
0.4
|
0%
|
|
Strong
|
0.3
|
10%
|
a) What is the expected return for Stock A?
b) What is Stock A's standard deviation?
c) What is the Coefficient of Variation for Stock A?
Q3. Costs of Going Public
Company A recently underwent an IPO. It was planning to sell 5 million shares. The deal was on a best efforts basis. The Investment bank was able to sell 3 million shares at $10 each. The bank charged 5% spread. The company incurred $300,000 in legal and consulting costs.
a) What are the net proceeds to the company?
b) What are the net proceeds to the investment bank?
c) How much money was left on the table if the closing price on day one was $13 per share?
d) What were the total costs of going public?
Q4. Determining stock price for a Non-constant dividend stock
Suppose a company's stock paid a dividend of $5 at the end of last year. You expect the dividend to grow at a rate of 10% for the next three years and then to grow at a constant rate of 2% thereafter. Assume the required rate of return is 10%.
a) What are the dividends for the next three years?
b) What is the expected price of the stock at time = 3?
c) What is the value of the stock today?
Q5. Evaluating Cash Flows
A project has an initial cost of $50,000 and expected cash inflows of $25,000 per year for 5 years, and a cost of capital of 10%.
a) Calculate the project's NPV.
b) Calculate its IRR.
c) Calculate its MIRR.
d) Calculate its Pl.
e) What is the project's payback period?
Q6. Evaluating projects with unequal lives
Company A is considering investing in either equipment A or B. Equipment A has an expected life 8 years, will cost $30,000 and will produce net cash flows of $10,000er year. Equipment B has an expected life of 5 years, will cost $40,000 and will produce net cash flows of $14,000 per year. The company's cost of capital 10%.
a) What is the NPV for each piece of equipment?
b) What is the equivalent annual annuity for each piece of equipment?
c) Which equipment should the firm invest in?
Q7. Leasing
Company A is considering to install a new piece of machinery costing $1 million in its plant. It will cost an additional $100,000 for machine installation. The company can borrow at 10% if it purchases the machine, or it can lease the machinery. The asset has a CCA rate of 20% and a life of 4 years. The company's tax rate is 30%. If it leases, it will have to pay $250,000 at the beginning of each year for the next 4 years. The machine has an estimated residual value of $100,000 at the end of 4 years.
a) Calculate the net advantage to leasing (NAL).
b) Should the company lease or purchase?