Financial Management (Chapter 8: Risk and Return-Capital A) 2.

24 9) The expected return from investing in the asset is

Market Theory) B) 2.56 A) 9.00%.
8.1 Portfolio Returns and Portfolio Risk C) 2.83 B) 9.35%.
D) 2.98 C) 10.00%.
1) Which of the following portfolios is clearly preferred to the others? D) 10.55%.
6) You are considering investing in a portfolio consisting of 40%
Expected Standard Electric General and 60% Buckstar. If the expected rate of return on 10) The standard deviation of returns is
Return Deviation Electric General is 16% and the expected return on Buckstar is 9%, A) 8.00%.
A 14% 12% what is the expected return on the portfolio? B) 7.63%.
B 22% 20% A) 12.50% C) 4.68%.
C 18% 16% B) 13.20% D) 2.76%.
C) 11.80%
A) Investment A D) 10.00%
B) Investment B 11) What is the expected rate of return on a portfolio 18% of which is
C) Investment C 7) The expected return on MSFT next year is 12% with a standard invested in an S&P 500 Index fund, 65% in a technology fund, and
D) Cannot be determined deviation of 20%. The expected return on AAPL next year is 24% with 17% in Treasury Bills. The expected rate of return is 11% on the S&P
a standard deviation of 30%. If James makes equal investments in Index fund, 14% on the technology fund and 2% on the Treasury Bills.
2) You are considering investing in U.S. Steel. Which of the following MSFT and AAPL, what is the expected return on his portfolio. A) 10.25%
is an example of nondiversifiable risk? A) 20% B) 8.33%
A) Risk resulting from foreign expropriation of U.S. Steel property B) 16% C) 11.42%
B) Risk resulting from oil exploration by Marathon Oil (a U.S. Steel C) 18% D) 9.00%
subsidy) D) 25%
C) Risk resulting from a strike against U.S. Steel 12) What is the expected rate of return on a portfolio Which consists of
D) None of the above 8) The expected return on MSFT next year is 12% with a standard $9,000 invested in an S&P 500 Index fund, $32,500 in a technology
deviation of 20%. The expected return on AAPL next year is 24% with fund, and $8,500 in Treasury Bills. The expected rate of return is 11%
a standard deviation of 30%. The correlation between the two stocks is on the S&P Index fund, 14% on the technology fund and 2% on the
3) You are considering buying some stock in Continental Grain. Which .6. If James makes equal investments in MSFT and AAPL, what is the Treasury Bills.
of the following is an example of nondiversifiable risk? expected return on his portfolio. A) $154.00
A) Risk resulting from a general decline in the stock market A) 21.45% B) $142.80
B) Risk resulting from a news release that several of Continental's grain B) 25.00% C) $65.00
silos were tainted C) 4.60% D) $15.12
C) Risk resulting from an explosion in a grain elevator owned by D) 15.00%
Continental
D) Risk resulting from an impending lawsuit against Continental Use the following information, which describes the possible outcomes Use the following information, which describes the expected return and
from investing in a particular asset, to answer the following standard deviation for three different assets, to answer the following
4) If there is a 20% chance we will get a 16% return, a 30% chance of question(s). question(s).
getting a 14% return, a 40% chance of getting a 12% return, and a 10%
chance of getting an 8% return, what is the expected rate of return? State of the Economy Probability of the States Percentage Portfolio X Portfolio
A) 12% Returns Y Portfolio Z
B) 13% Economic Expected
C) 14% recession 25% 5% return 9.5% 8.8% 9.5%
D) 15% Moderate economic Standard
growth 55% 10% deviation 4.9% 5.5% 5.5%
5) If there is a 20% chance we will get a 16% return, a 30% chance of Strong economic
getting a 14% return, a 40% chance of getting a 12% return, and a 10% growth 20% 13% 13) If an investor must choose between investing in either portfolio X
chance of getting an 8% return, what would be the standard deviation? or portfolio Y, then
A) she will always choose Asset X over Asset Y. 22) The standard deviation of returns on Warchester stock is 20% and 32) You are considering a portfolio consisting of equal investments in
B) she will always choose Asset Y over Asset X. on Shoesbury stock it is 16%. The coefficient of correlation between the stocks Northbank Inc. and Tropical Escapes Inc. Returns on the 2
C) she will be indifferent between investing in Asset X and Asset Y. the stocks is .75. The standard deviation of any portfolio combining the stocks under various conditions are shown below.
D) none of the above. two stocks will be less than 20%.
Answer: TRUE Scenario Return (%) Return % Return %
14) An investor will get maximum risk reduction by combining assets Probability Northbank Tropical Portfolio
that are 23) Most financial assets have correlation coefficients between 0 and 1. 0.20 4% 16%
A) negatively correlated. Answer: TRUE 0.50 10% 10%
B) positively correlated. 0.30 20% -10%
C) uncorrelated.
D) perfectly, positively correlated. 24) Portfolio returns can be calculated as the geometric mean of the Calculate the expected rate of and the standard deviation return of the
returns on the individual assets in the portfolio. portfolio.
15) A negative coefficient of correlation implies that Answer: FALSE Answer: In every scenario, the return on the portfolio is 10% so the
A) on average, returns to such assets are negative. expected return must also be 10% and the standard deviation is 0%.
B) asset returns tend to move in opposite directions. 25) When constructing a portfolio, it is a good idea to put all your eggs
C) asset return tend to move in opposite directions. in one basket, then watch the basket closely. 8.2 Systematic Risk and the Market Portfolio
D) None of the above because the coefficient of correlation cannot be Answer: FALSE
negative. 1) The capital asset pricing model
26) A portfolio containing a mix of stocks, bonds, and real estate is A) provides a risk-return trade-off in which risk is measured in terms of
likely to be more diversified than a portfolio made up of only one asset the market returns.
16) The portfolio standard deviation will always be less than the class. B) provides a risk-return trade-off in which risk is measured in terms of
standard deviation of any asset in the portfolio. Answer: TRUE beta.
Answer: FALSE C) measures risk as the correlation coefficient between a security and
27) An asset with a large standard deviation of returns can lower market rates of return.
17) When assets are positively correlated, they tend to rise or fall portfolio risk if its returns are uncorrelated with the returns on the other D) depicts the total risk of a security.
together. assets in the portfolio.
Answer: TRUE Answer: TRUE 2) The appropriate measure for risk according to the capital asset
pricing model is
18) The standard deviation of a portfolio is always just the weighted A) the standard deviation of a firm's cash flows.
average of the standard deviations of assets in the portfolio. 28) The greater the dispersion of possible returns, the riskier is the B) alpha.
Answer: FALSE investment. C) beta.
Answer: TRUE D) probability of correlation.
19) A correlation coefficient of +1 indicates that returns on one asset
can be exactly predicted from the returns on another asset. 29) For the most part, there has been a positive relation between risk 3) You are considering investing in Ford Motor Company. Which of
Answer: TRUE and return historically. the following is an example of diversifiable risk?
Answer: TRUE A) Risk resulting from the possibility of a stock market crash
B) Risk resulting from uncertainty regarding a possible strike against
20) Adequate portfolio diversification can be achieved by investing in 30) The benefit from diversification is far greater when the Ford
several companies in the same industry. diversification occurs across asset types. C) Risk resulting from an expected recession
Answer: FALSE Answer: TRUE D) Risk resulting from interest rates decreasing

21) A portfolio will always have less risk than the riskiest asset in it if 31) Investing in foreign stocks is one way to improve diversification of 4) On average, when the overall market changes by 10%, the stock of
the correlation of assets is less than perfectly positive. a portfolio. Veracity Communications changes 12%. What is Veracity's beta?
Answer: TRUE Answer: TRUE A) 1.2
B) 8.33%
C) 12%
D) Insufficient information is provided exhibits returns which are ________ volatile than those of the market 14) The market (systematic) risk associated with an individual stock is
portfolio. most closely identified with the
5) Which of the following has a beta of zero? A) more, more A) variance of the returns of the stock.
A) A risk-free asset B) more, less B) variance of the returns of the market.
B) The market C) less, more C) beta of the stock.
C) A high-risk asset D) less, less D) standard deviation of the stock.
D) Both A and B
15) Which of the following is NOT an example of systematic risk?
11) You hold a portfolio with the following securities: A) Inflation
6) Beta is a statistical measure of B) Recession
A) hyperbolic. Percent C) Management risk
B) total risk. Security of Portfolio Beta Return D) Interest rate risk
C) the standard deviation. X Corporation 20% 1.35 14%
D) the relationship between an investment's returns and the market Y Corporation 35% .95 10%
return. Z Corporation 45% .75 8% 16) What type of risk can investors reduce through diversification?
A) All risk
7) A stock's beta is a measure of its Compute the expected return and beta for the portfolio. B) Systematic risk only
A) systematic risk. A) 10.67%, 1.02 C) Unsystematic risk only
B) unsystematic risk. B) 9.9%, 1.02 D) Uncertainty
C) company-specific risk. C) 34.4%, .94
D) diversifiable risk. D) 9.9%, .94 17) Which of the following statements is true?
A) A stock with a beta less than zero has no exposure to systematic
8) If you hold a portfolio made up of the following stocks: 12) The beta of ABC Co. stock is the slope of risk.
A) the security market line. B) A stock with a beta greater than 1.0 has lower nondiversifiable risk
Investment Value Beta B) the characteristic line for a plot of returns on the S&P 500 versus than a stock with a beta of 1.0.
Stock A $2,000 1.5 returns on short-term Treasury bills. C) A stock with a beta less than 1.0 has lower nondiversifiable risk than
Stock B $5,000 1.2 C) the arbitrage pricing line. a stock with a beta of 1.0.
Stock C $3,000 .8 D) the line of best fit for a plot of ABC Co. returns against the returns D) A stock with a beta less than 1.0 has higher nondiversifiable risk
of the market portfolio for the same period. than a stock with a beta of 1.0.
What is the beta of the portfolio?
A) 1.17 18) Currently, the expected return on the market is 12.5% and the
B) 1.14 13) You are thinking of adding one of two investments to an already required rate of return for Alpha, Inc. is 12.5%. Therefore, Alpha's beta
C) 1.32 well diversified portfolio. must be
D) Can't be determined from information given A) less than 1.0.
Security A Security B B) greater than 1.0.
Expected return = 12% Expected return = 12% C) equal to 1.0.
9) Changes in the general economy, such as changes in interest rates or Standard deviation of returns = 20.9% Standard deviation of returns D) unknown based on the information provided.
tax laws, represent what type of risk? = 10.1%
A) Firm-specific risk Beta = .8 Beta = 2
B) Market risk 19) Investment risk is
C) Unsystematic risk If you are a risk-averse investor A) the probability of achieving a return that is greater than what was
D) Diversifiable risk A) security A is the better choice. expected.
B) security B is the better choice. B) the probability of achieving a beta coefficient that is less than what
10) A stock with a beta greater than 1.0 has returns that are ________ C) either security would be acceptable. was expected.
volatile than the market, and a stock with a beta of less than 1.0 D) cannot be determined with information given. C) the probability of achieving a return that is less than what was
expected.
D) the probability of achieving a standard deviation that is less than 37) Briefly discuss why there is no reason to believe that the market
what was expected. will reward investors with additional returns for assuming unsystematic
25) Beta is a measurement of the relationship between a security's risk.
20) Which of the following statements is true? returns and the general market's returns. Answer: Through diversification, risk can be lowered without
A) Systematic, or market, risk can be reduced through diversification. Answer: TRUE sacrificing returns. The market rewards investors for the systematic risk
B) Both systematic and unsystematic risk can be reduced through that cannot be eliminated through proper asset allocation in a
diversification. 26) Total risk equals unique security risk times systematic risk. diversified portfolio.
C) Unsystematic, or company, risk can be reduced through Answer: FALSE
diversification. 38) Provide an intuitive discussion of beta and its importance for
D) Neither systematic nor unsystematic risk can be reduced through 27) The CAPM designates the risk-return tradeoff existing in the measuring risk.
diversification. market, where risk is defined in terms of beta. Answer: Beta is an important measure that indicates the systematic risk
Answer: TRUE of a given investment. Since systematic risk cannot be diversified
21) Which of the following is a good measure of the relationship away, investors are compensated for taking this risk. Beta compares the
between an investment's returns and the market's returns? 28) It is impossible to eliminate all risk through diversification. market risk of a particular investment with the market risk of the
A) The beta coefficient Answer: TRUE market, and the risk premium necessary for a stock is directly
B) The standard variation proportional to the risk premium for the market as a whole. When the
C) The CPI 29) Stocks with higher betas are usually more stable than stocks with risk premium is added to the risk free rate, this results in the required
D) The S&P 500 Index lower betas. return for the stock.
Answer: FALSE

22) Which of the following is generally used to measure the market 30) A stock with a beta of 1.0 would on average earn the risk-free rate. 8.3 The Security Market Line and the CAPM
when calculating betas? Answer: FALSE
A) The Dow Jones Industrial Average 1) The risk-return relationship for each financial asset is shown on
B) The Standard & Poors 500 Index 31) Unsystematic risk can be eliminated through diversification. A) the capital market line.
C) The Value Line Quantam Index Answer: TRUE B) the New York Stock Exchange market line.
D) The Case Schiller Housing Index C) the security market line.
32) Increasing a portfolio from 2 stocks to 4 stocks will reduce risk D) none of the above.
23) Your broker mailed you your year-end statement. You have more than increasing a portfolio from 10 stocks to 12 stocks.
$25,000 invested in Dow Chemical, $18,000 tied up in GM, $36,000 in Answer: FALSE 2) Siebling Manufacturing Company's common stock has a beta of .8.
Microsoft stock, and $11,000 in Nike. The betas for each of your stocks If the expected risk-free return is 2% and the market offers a premium
are 1.55 for Dow, 1.12 for GM, 2.39 for Microsoft, and .76 for Nike. 33) The market rewards assuming additional unsystematic risk with of 8% over the risk-free rate, what is the expected return on Siebling's
What is the beta of your portfolio? additional returns. common stock?
A) 1.46 Answer: FALSE A) 7.8%
B) 1.70 B) 13.4%
C) 2.60 34) On average, the market rewards assuming additional systematic C) 14.4%
D) 0.41 risk with additional returns. D) 8.4%
Answer: TRUE
24) You are considering a portfolio of three stocks with 30% of your 3) Huit Industries' common stock has an expected return of 11.4% and
money invested in company X, 45% of your money invested in a beta of 1.2. If the expected risk-free return is 3%, what is the expected
company Y, and 25% of your money invested in company Z. If the 35) Betas for individual stocks tend to be stable. return for the market (round your answer to the nearest .1%)?
betas for each stock are 1.22 for company X, 1.46 for company Y, and Answer: FALSE A) 7.7%
1.03 for company Z, what is the portfolio beta? B) 9.6%
A) 1.24 36) A stock with a beta greater than 1.0 has lower nondiversifiable risk C) 10.0%
B) 1.00 than a stock with a beta of 1.0. D) 11.4%
C) 1.28 Answer: FALSE
D) 1.33
 9) Bell Weather, Inc. has a beta of 1.25. The return on the market C) 3.0%
portfolio is 12.5%, and the risk-free rate is 5%. According to CAPM, D) 9.2%
4) Tanzlin Manufacturing's common stock has a beta of 1.5. If the what is the required return on this stock?
expected risk-free return is 2% and the expected return on the market is A) 20.62% 13) Hefty stock has a beta of 1.2. If the risk-free rate is 7% and the
14%, what is the expected return on the stock? B) 9.37% market risk premium is 6.5%, what is the required rate of return on
A) 13.5% C) 14.37% Hefty?
B) 21.0% D) 15.62% A) 14.8%
C) 16.8% B) 14.4%
D) 20.0% C) 12.4%
10) The rate on six-month T-bills is currently 5%. Andvark Company D) 13.5%
5) Given the capital asset pricing model, a security with a beta of 1.5 stock has a beta of 1.69 and a required rate of return of 15.4%.
should return ________, if the risk-free rate is 3% and the market According to CAPM, determine the return on the market portfolio. 14) The market risk premium is measured by
return is 11%. A) 11.15% A) beta.
A) 16.5% B) 6.15% B) market return less risk-free rate.
B) 14.0% C) 17.07% C) T-bill rate.
C) 14.5% D) 14.11% D) standard deviation.
D) 15.0%
11) You are going to invest all of your funds in one of three projects
6) The security market line (SML) relates risk to return, for a given set with the following distribution of possible returns: 15) Marjen stock has a required return of 20%. The expected market
of market conditions. If expected inflation increases, which of the return is 15%, and the beta of Marjen's stock is 1.5. Calculate the risk-
following would most likely occur? Project 1 Project 2 free rate.
A) The market risk premium would increase. Standard Deviation 12% Standard Deviation 19.5% A) 4%
B) Beta would increase. Probability Return Probability Return B) 5%
C) The slope of the SML would increase. 50% Chance 20% 30% Chance 30% C) 6%
D) The SML line would shift up. 50% Chance -4% 40% Chance 10% D) 7%
30% Chance -20%
Project 3 16) You are thinking about purchasing 1,000 shares of stock in the
7) The security market line (SML) relates risk to return, for a given set Standard Deviation 12% following firms:
of market conditions. If risk aversion increases, which of the following Probability Return
would most likely occur? 10% Chance 30% Number of Shares Firm's Beta
A) The market risk premium would increase. 40% Chance 15% Firm A 100 0.75
B) Beta would increase. 40% Chance 10% Firm B 200 1.47
C) The slope of the SML would increase. 10% Chance -21% Firm C 200 0.82
D) The SML line would shift up. Firm D 600 1.60
If you are a risk-averse investor, which one should you choose?
8) The Elvis Alive Corporation, makers of Elvis memorabilia, has a A) Project 1 If you purchase the number of shares specified, then the beta of your
beta of 2.35. The return on the market portfolio is 12%, and the risk- B) Project 2 portfolio will be:
free rate is 2.5%. According to CAPM, what is the risk premium on a C) Project 3 A) 1.16.
stock with a beta of 1.0? B) 1.35.
A) 12.00% C) 1.00.
B) 22.33% 12) The expected return on the market portfolio is currently 11%. D) Cannot be determined without knowing the stock prices.
C) 9.5% Battmobile Corporation stockholders require a rate of return of 23.0%,
D) 14.5% and the stock has a beta of 2.5. According to CAPM, determine the
risk-free rate. Use the following information to answer the following question(s).
A) 17.5%
B) 2.75% Beta
 Market 1 25) The security market line (SML) intercepts the Y axis at the risk- RB = Rf + BB(Rm - Rf)
Firm A 1.25 free rate. RB = .02 + 1.20(.10 - .02)
Firm B 0.6 Answer: FALSE RB = .116 or 11.6%

Market Return 10% Risk Free Rate 2% 26) The security market line can drawn by connecting the risk-free rate
and the expected return on the market portfolio. 33) AA & Co. has a beta of .656. If the expected market return is
17) The market risk premium is Answer: TRUE 13.2% and the risk-free rate is 5.7%, what is the appropriate required
A) 2%. return of AA & Co. using the CAPM model?
B) 4%. 27) If investors expected inflation to increase in the future, the SML Answer: Required Rate of Return = Risk-Free Rate + (Market Return -
C) 6%. would shift up, but the slope would remain the same. Risk-Free Rate) × Beta = 5.7% + (13.2% - 5.7%) × 0.656 = 10.62%
D) 8%. Answer: TRUE

18) Firm A's risk premium is 28) If investors became more risk averse The SML would shift Financial Management (Chapter 9: Debt Valuation and Interest Rates)
A) 4%. downward and the slope of the SML would fall. 9.1 Overview of Corporate Debt
B) 6%. Answer: FALSE
C) 8%. 1) The par value of a bond
D) 10%. 29) A security with a beta of zero has a required rate of return equal to A) never equals its market value.
the overall market rate of return. B) is determined by the investor.
19) Firm B's risk premium is Answer: FALSE C) generally is $1,000.
A) 2.66%. D) is never returned to the bondholder.
B) 4.8%.
C) 6.3%. 30) The return for the market during the next period is expected to be 2) The interest on corporate bonds is typically paid
D) 8.1%. 11.5%; the risk-free rate is 2.5%. Calculate the required rate of return A) semiannually.
for a stock with a beta of 1.5. B) annually.
Answer: C) quarterly.
20) The required rate of return for Firm A is K = 2.5% + 1.5(11.5% - 2.5%) = 16% D) monthly.
A) 8%.
B) 12%. 31) Asset A has a required return of 18% and a beta of 1.4. The 3) On any given day, a bond can be issued at
C) 16%. expected market return is 14%. What is the risk-free rate? Plot the A) a discount.
D) Cannot be determined with information given. security market line. B) a premium.
Answer: C) par.
21) U. S. Treasury bills can be used to approximate the risk-free rate. K = Krf + (Km - Krf)b D) all of the above.
Answer: TRUE 18% = X + (14% - X)1.4
18% - X =19.6% - 1.4X
22) Long-term bonds issued by large, established corporations are .4X = 1.6% 4) Advantages to borrowing in the private market include
commonly used to estimate the risk-free rate. X = 4% = Risk - free Rate = Krf A) less restrictive covenants.
Answer: FALSE B) reduced initial costs.
32) Security A has an expected rate of return of 22% and a beta of 2.5. C) lower interest costs.
23) The market beta changes frequently with economic conditions. Security B has a beta of 1.20. If the Treasury bill rate is 2.0%, what is D) avoiding future SEC registration.
Answer: FALSE the expected rate of return for security B?
Answer: 5) Advantages of privately placing debt include all of the
24) The S&P 500 Index is commonly used to estimate the market rate RA = RF + BA(Rm - Rf) following EXCEPT
of return. .22 = .02 + 2.5 (Rm - .02) A) speed.
Answer: TRUE .20 = 2.5 (Rm - .02) = 2.5 Rm - .05 B) reduced placement costs.
.25 = 2.5 Rm C) restrictive covenants.
.10 = Rm D) flexibility.
 C) Floating rate C) is less than 10%.
6) Corporate debt can be privately placed with D) The priority of claims D) cannot be determined.
A) union pension funds.
B) life insurance companies. 4) Sterling Corp. bonds pay 10% annual interest and are selling at 97.
C) state pension funds. 13) The par value of a corporate bond indicates the level of interest The market rate of interest
D) all of the above payments that will be paid to investors. A) is less than 10%.
Answer: FALSE B) is greater than 10%.
C) equals 10%.
7) Which of the following is generally NOT a characteristic of a bond? 14) Any unsecured long-term debt instrument is a debenture. D) cannot be determined.
A) Voting rights Answer: TRUE
B) Par value 5) The Blackburn Group has recently issued 20-year, unsecured bonds
C) Claims on assets and income 15) A conversion feature confers the option of redeeming a bond for rated BB by Moody's. These bonds yield 443 basis points above the
D) Indenture the company's stock rather than cash. U.S. Treasury yield of 2.76%. The yield to maturity on these bonds is
Answer: TRUE A) 4.43%.
8) The detailed legal agreement between a bond's issuer and its trustees B) 7.19%.
is known as the 16) The debenture is the legal agreement between the firm issuing a C) 12.23%.
A) collateral agreement. bond and the bond trustee who represents the bondholders. D) mortgage bonds.
B) call provision. Answer: FALSE
C) indenture.
D) covenant. 17) The current yield is the average rate of interest a bond will from the 6) Colby & Company bonds pay semiannual interest of $50. They
time of purchase until it matures. mature in 15 years and have a par value of $1,000. The market rate of
9) The issuance of bonds to raise capital for a corporation Answer: FALSE interest is 8%. The market value of Colby bonds is (round to the nearest
A) magnifies the returns to the stockholders. dollar)
B) increases risk to the stockholders. 18) If the issuing company becomes insolvent, the claims of the A) $1,173.
C) is a cheaper form of capital than the issuance of common stock. bondholders are honored before those of preferred stockholders. B) $743.
D) all of the above. Answer: TRUE C) $1,000.
D) $827.
9.2 Valuing Corporate Debt
10) A(n)________ is used to outline the issuing company's contractual 7) Caldwell, Inc. sold an issue of 30-year, $1,000 par value bonds to the
obligations to bondholders. 1) The yield to maturity on a bond public. The bonds carry a 10.85% coupon rate and pay interest
A) mortgage A) is fixed in the indenture. semiannually. It is now 12 years later. The current market rate of
B) debenture B) is lower for higher-risk bonds. interest on the Caldwell bonds is 8.45%. What is the current market
C) bond rating C) is the required return on the bond. price (intrinsic value) of the bonds? Round off to the nearest $1.
D) indenture D) is generally equal to the coupon interest rate. A) $751
B) $1,177
11) Bonds with ratings lower than Standard & Poor's BBB or Moody's 2) All of the following affect the value of a bond EXCEPT C) $1,220
Baa are classified as A) investors' required rate of return. D) $976
A) in default. B) the recorded value of the firm's assets.
B) investment grade. C) the coupon rate of interest. 8) MI has a $1,000 par value, 30-year bond outstanding that was issued
C) not investment grade. D) the maturity date of the bond. 20 years ago at an annual coupon rate of 10%, paid semiannually.
D) medium quality. Market interest rates on similar bonds are 7%. Calculate the bond's
price.
12) Which of the following features allows a borrower to redeem or 3) A $1,000 par value 10-year bond with a 10% coupon rate recently A) $956.42
repurchase a bond issue before its maturity date? sold for $900. The yield to maturity B) $1,000.00
A) The call provision A) is 10%. C) $1,168.31
B) Convertibility B) is greater than 10%. D) $1,213.19
 required rate of return of 11%, and round your answer to the nearest
$10. 20) Brookline, Inc. just sold an issue of 30-year bonds for $1,107.20.
9) Davis & Davis issued $1,000 par value bonds at 102. The bonds pay A) $970 Investors require a rate of return on these bonds of 7.75%. The bonds
12% interest annually and mature in 30 years. The market rate of B) $1,330 pay interest semiannually. What is the coupon rate of the bonds?
interest is (round to the nearest hundredth of a percent) C) $330 A) 7.750%
A) 12.00%. D) $1,000 B) 11.072%
B) 11.71%. C) 9.375%
C) 10.12%. D) 8.675%
D) 11.29%. 15) Bond ratings directly affect a bond's
A) spread over the Treasury yield.
10) What is the yield to maturity of a nine-year bond that pays a B) coupon rate. 21) Applebee sold an issue of 30-year, $1,000 par value bonds to the
coupon rate of 20% per year, has a $1,000 par value, and is currently C) maturity date. public. The coupon rate of 8.75% is payable annually. It is now five
priced at $1,407? Assume annual coupon payments. D) call provisions. years later, and the current market rate of interest is 7.25%. What is the
A) 21.81% current market price (intrinsic value) of the bonds? Round off to the
B) 6.14% 16) The discount rate used to value a bond is nearest $1.
C) 12.28% A) the coupon interest rate. A) $715
D) 11.43% B) determined by the issuing company. B) $1,171
C) fixed for the life of the bond. C) $1,225
11) What is the expected rate of return on a bond that matures in seven D) the market rate of interest. D) $697
years, has a par value of $1,000, a coupon rate of 14%, and is currently
selling for $911? Assume annual coupon payments. 17) As interest rates, and consequently investors' required rates of 22) Six years ago, Colt, Inc. sold an issue of 30-year, $1,000 par value
A) 7.81% return, change over time, the ________ of outstanding bonds will also bonds. The coupon rate of 5.25% is payable annually. Investors
B) 15.36% change. presently require a rate of return of 8.375%. What is the current market
C) 15.61% A) maturity date price (intrinsic value) of the bonds? Round off to the nearest $1.
D) 16.22% B) coupon interest payment A) $1,050
C) par value B) $932
D) price C) $681
12) What is the expected rate of return on a bond that pays a coupon D) $1,111
rate of 9% paid semi-annually, has a par value of $1,000, matures in
five years, and is currently selling for $1071? 18) Mango Company bonds pay a semiannual coupon rate of 6.4%. 23) Blue's Chips Inc. has a $1,000 par value bond that is currently
A) 7.28% They have eight years to maturity and face value, or par, of $1,000. selling for $1,300. It has an annual coupon rate of 7%, paid
B) 8.40% Compute the value of Mango bonds if investors' required rate of return semiannually, and has nine years remaining until maturity. What is
C) 3.64% is 5%. the annual yield to maturity on the bond? (Round to the nearest whole
D) 4.21% A) $1,090.48 percentage.)
B) $883.66 A) 3.15%
13) What is the value of a bond that has a par value of $1,000, a coupon C) $1,006.83 B) 1.57%
rate of $80 (annually), and matures in 11 years? Assume a required rate D) $950.00 C) 3.12%
of return of 11%, and round your answer to the nearest $10. D) 6.24%
A) $320.66 19) Terminator Bug Company bonds have a 14% coupon rate. Interest
B) $1,011.00 is paid semiannually. The bonds have a par value of $1,000 and will
C) $813.80 mature 10 years from now. Compute the value of Terminator bonds if 24) You are considering the purchase of Hytec bonds that were issued
D) $790.79 investors' required rate of return is 12%. 14 years ago. When the bonds were originally sold, they had a 30-year
A) $1,114.70 maturity and a 14.375% coupon interest rate that is payable
14) What is the value of a bond that matures in three years, has an B) $1,149.39 semiannually. The bond is currently selling for $1,508.72. What is the
annual coupon payment of $110, and a par value of $1,000? Assume a C) $894.06 yield to maturity on the bonds?
D) $1,000.00 A) 8.50%
B) 14.38% 30) When a bond's coupon rate is higher than the required rate of 38) You purchased Photon, Inc. bonds exactly one year ago today for
C) 11.11% return, the bond $875. During the latest year, you received $65 in interest on the bonds.
D) 7.67% A) will sell at a discount from par. The current yield on these bonds is 6.5%.
B) will sell at a premium over par. Answer: FALSE
25) Aurand, Inc. has outstanding bonds with an 8% annual coupon rate C) may sell at either a discount or a premium.
paid semiannually. The bonds have a par value of $1,000, a current D) will sell at par value. 39) A AAA rated bond's yield to maturity will be very close to it's
price of $904, and will mature in 14 years. What is the annual yield to expected yield.
maturity on the bond? 31) Miller Motorworks has a $1,000 par value, 8% annual coupon bond Answer: TRUE
A) 15.80% with interest payable semiannually with a remaining term of 15 years.
B) 10.47% The annual market yield on similar bonds is 6%. This bond will at a 40) The longer the time to maturity, the more sensitive a bond's price to
C) 9.24% discount from par. changes in market interest rates.
D) 7.90% Answer: FALSE Answer: TRUE
E) 4.62%
32) Lambda Co. has bonds outstanding that mature in 10 years. The
26) Marshall Manufacturing has a bond outstanding that was issued 20 bonds have $1,000 par value, pay interest annually at a rate of 9%, and 41) A bond's value equals the present value of interest and principal the
years ago at a coupon rate of 9%. The $1,000 par value bond pays have a current selling price of $1,125. The yield to maturity on the owner will receive.
interest semiannually and was originally issued with a term of 30 years. bonds is less than 9%. Answer: TRUE
If today's interest rate is 14%, what is the value of the bond today? Answer: TRUE
A) $654.98 42) The higher the bond rating, the more default risk associated with
B) $735.15 33) Generic, Inc. has bonds outstanding that mature in 20 years. The the bond.
C) $814.42 bonds have $1,000 par value, pay interest annually at a rate of 10%, Answer: FALSE
D) $941.87 and have a current selling price of $875.25. The current yield on the
bonds is 11.63%. 43) Bond ratings measure the interest rate risk of a given bond issue.
Answer: FALSE Answer: FALSE
27) A $1,000 par value bond is currently listed as selling at 92 1/8. This
means 34) A basis point is equal to one hundredth of a percentage point. 44) When referring to bonds, expected rate of return and yield to
A) that you can buy the bond for $92.125. Answer: TRUE maturity are often used interchangeably.
B) that you can buy the bond for $921.25. Answer: TRUE
C) that if you purchase the bond today, you will receive $921.25 when 35) A bond's "spread" refers to the difference between it's Moody's
the bond matures. rating and its Standard & Poors rating. 45) Investment grade bonds are rated BB or lower.
D) none of the above. Answer: FALSE Answer: FALSE

28) You paid $865.50 for a corporate bond that has a 6.75% coupon
rate. What is the bond's current yield? 36) A bond issued by Pomme Computers has a coupon rate of #5 paid 46) The current yield of a bond will equal its coupon rate when the
A) 8.375% semi-annually. If the market's required rate of return on this bond is bond is selling at par value.
B) 7.800% also 3%, the bond will sell at par value. Answer: TRUE
C) 15.001% Answer: TRUE
D) 6.667% 47) The better the bond rating, the lower the rate of return demanded in
37) Dry Seal plans to issue bonds to expand operations. The bonds will the capital markets.
29) A $1,000 par value bond with a 12% coupon rate currently selling have a par value of $1,000, a 10-year maturity, and a coupon interest Answer: TRUE
for $825 has a current yield of rate of 9%, paid semiannually. Current market conditions are such that
A) 14.55%. the bonds will be sold to net $937.79. The yield-to-maturity of these 48) The sensitivity of a bond's value to changing interest rates depends
B) 12.44%. bonds is 10%. on both the bond's time to maturity and its pattern of cash flows.
C) 7.27%. Answer: FALSE Answer: TRUE
D) 5.61%.
49) Compare and contrast current yield and yield to maturity.
Answer: The current yield is a measure of the one-year return on a
bond if purchased today. The current yield is calculated by taking a
bond's annual coupon payment and dividing by its market price. Yield
to maturity measures the return on a bond if it is held to maturity. The
yield to maturity is that discount rate that would make the present value
of the expected future cash flows exactly equal to the market price at
time of calculation. In an efficient market, the yield to maturity will
reflect the market rate of interest and required return of bondholders.
50) BCD's $1,000 par value bonds currently sell for $798.50. The
coupon rate is 10%, paid semiannually. If the bonds have five years
before maturity, what is the yield to maturity or expected rate of return?
Answer: N=10, PV=-798.50, PMT=50, FV=1000, solve for i=8.00
semi-annual rate, 8.00% × 2 = 16%
51) If you are willing to pay $1,392.05 for a 15-year, $1,000 par value
bond that pays 10% interest semiannually, what is your expected rate of
return?
Answer: N=30, PV=-1,392.05, PMT=50, FV=1000, solve for i=2.99
semi-annual rate, 2.99 % × 2 = 6%
52) DAH, Inc. has issued a 12% bond that is to mature in nine years.
The bond had a $1,000 par value, and interest is due to be paid
semiannually. If your required rate of return is 10%, what price would
you be willing to pay for the bond?
Answer:
N=18, i=5, PMT=60, FV=1000, solve for PV=.-1116.90
Price = $1,116.90
53) The market price of a 20-year, $1,000 bond that pays 9% interest
semiannually is $774.31. What is the bond's yield to maturity?
Answer: N=40, PV=-774.31, PMT=45, FV=1000, solve for i=6.00
semi-annual rate, 6.00 × 2 = 6%
54) Calculate the value of a bond that is expected to mature in 13 years
with a $1,000 face value. The interest coupon rate is 8%, and the
required rate of return is 10%. Interest is paid annually.
Answer:
N=13, i=5, PMT=80, FV=1000, solve for PV=.-1116.90
Price = $1,116.90
55) Garvin, Inc.'s bonds have a par value of $1,000. The bonds pay
semiannual interest of $40 and mature in five years.
a. How much would you pay for Garvin bonds if your required rate
of return is 10%?
b. How much would you pay if your required rate of return is 8%? B) a premium to par value.
Answer: C) a discount to par value.
a. N=10, i=5, PMT=40, FV=1000, solve for PV=-922.78 D) cannot be determined from information given.
Price = $922.78
b. Price = $1,000 5) Which of the following statements is true?
A) A bond that has a rating of AA is considered to be a junk bond.
56) Given the following information, determine the market value of B) A bond will sell at a premium if the prevailing required rate of
EAO Company bonds. return is less than the bond's coupon rate.
Par value $1,000 C) A zero coupon is a bond that is secured by a lien on real property.
Coupon rate 10% D) The legal document that describes all of the terms and conditions of
Years to maturity 6 a bond issue is called a debenture agreement.
Market rate 8%
Interest paid semiannually 6) Quirk Drugs sold an issue of 30-year, $1,000 par value bonds to the
Answer: public that carry a 10.85% coupon rate, payable semiannually. It is now
N=12, i=4, PMT=50, FV=1000, solve for PV=-1093.85 10 years later, and the current market rate of interest is 9.00%. If
Price = $1,093.85 interest rates remain at 9.00% until Quirk's bonds mature, what will
happen to the value of the bonds over time?
A) The bonds will sell at a premium and decline in value until maturity.
9.3 Bond Valuation: Four Key Relationships B) The bonds will sell at a discount and rise in value until maturity.
C) The bonds will sell at a premium and rise in value until maturity.
1) If the market price of a bond increases, then D) The bonds will sell at a discount and fall in value until maturity.
A) the yield to maturity decreases.
B) the coupon rate increases.
C) the yield to maturity increases. 7) Which of the following statements is true?
D) none of the above. A) When investors' required rate of return equals the bond's coupon
rate, then the market value of the bond may be selling at par value.
2) If current market interest rates rise, what will happen to the value of B) When investors' required rate of return exceeds the bond's coupon
outstanding bonds? rate, then the market value of the bond will be greater than par value.
A) It will rise. C) When investors' required rate of return is less than the bond's
B) It will fall. coupon rate, then market value of the bond will be greater than par
C) It will remain unchanged. value.
D) There is no connection between current market interest rates and the D) When investors' required rate of return is less than the bond's
value of outstanding bonds. coupon rate, then the market value of the bond will be less than par
value.
3) If current market interest rates fall, what will happen to the value of
outstanding bonds? 8) A bond with a face value of $1,000 has annual coupon payments of
A) It will rise. $100 and was issued seven years ago. The bond currently sells for
B) It will fall. $1,085, has eight years left to maturity. This bond's ________ must be
C) It will remain unchanged. less than 10%.
D) There is no connection between current market interest rates and the A) current yield
value of outstanding bonds. B) coupon rate
C) current yield and coupon rate
D) yield to maturity and current yield
4) Cassel Corp. bonds pay an annual coupon rate of 10%. If investors' Answer: D
required rate of return is now 8% on these bonds, they will be priced at
A) par value.
9) A bond has a coupon rate of 6% paid semi-annually, a par value of
$1,000, and matures tomorrow. The bond will sell for
A) approximately $1,030 .
B) approximately $1,000.
C) approximately $1,060.
D) The price cannot be estimated without knowing the market rate of
interest.
10) Which of the following statements about bonds is true?
A) Bond prices move in the same direction as market interest rates.
B) If market interest rates change, long-term bonds will fluctuate more
in value than short-term bonds.
C) Long-term bonds are less risky than short-term bonds.
D) If market interest rates are higher than a bond's coupon interest rate,
then the bond will sell above its par value.
E) None of the above.
11) Which of the following statements about bonds is true?
A) As the maturity date of a bond approaches, the market value of a
bond will become more volatile.
B) Long-term bonds have less interest rate risk than do short-term
bonds.
C) Bond prices move in the same direction as market interest rates.
D) If market interest rates are above a bond's coupon interest rate, then
the bond will sell below its par value.
12) Which of the following statements about bonds is true?
A) The market value of a bond moves in the opposite direction of
market interest rates.
B) As the maturity date of a bond approaches, the market value of a
bond will become more volatile.
C) Long-term bonds are less risky than short-term bonds.
D) If market interest rates are higher than a bond's coupon interest rate,
then the bond will sell above its par value.
E) None of the above.
13) A bond investor seeking capital gains should purchase
A) bonds with short maturity dates when interest rates are expected to
rise.
B) bonds with distant maturity dates when interest rates are expected to
rise.
C) bonds with short maturity dates when interest rates are expected to
decline.
D) bonds with distant maturity dates when interest rates are expected to
decline.
14) Which of the following statements about bonds is true?
A) If market interest rates are below a bond's coupon interest rate, then
the bond will sell above its par value.
B) Long-term bonds have less interest rate risk than do short-term
bonds.
C) Bond prices move in the same direction as market interest rates.
D) As the maturity date of a bond approaches, the market value of a
bond will become more volatile.
15) Bonds cannot be worth less than their book value.
Answer: FALSE
16) So long as a bond sells for an amount above its par value, the
coupon interest rate and yield to maturity remain equal.
Answer: FALSE
17) As market interest rates increase, bond prices decrease.
Answer: TRUE
18) Bonds that sell at a discount have a coupon rate lower than the
market interest rate.
Answer: TRUE
19) Bonds with a longer time to maturity have less interest rate risk.
Answer: FALSE
20) As investors' required rate of return on a bond increases, the value
of the bond increases also.
Answer: FALSE
21) As the maturity date of a bond approaches, the bond's market value
approaches its par value.
Answer: TRUE
22) Shorter-term bonds have greater interest rate risk than do longer-
term bonds.
Answer: FALSE
23) Why are longer-term bonds more sensitive to changes in interest
rates than shorter-term bonds?
Answer: Longer-term bonds are more price-sensitive to changes in
interest rates because there are more cash flows remaining whose
values are affected by the change. Since shorter-term bonds have fewer
cash flows remaining, price sensitivity to change in interest rates will
be lower. In addition, as the bond gets closer to maturity, the present
value of the maturity payment gets less and less volatile. Duration is a
measure of how responsive a bond's price is to changing interest rates.
Duration is higher for long-term bonds than for short-term bonds.
9.4 Types of Bonds
1) Eurobonds are
A) issued in a country different from the one in whose currency the
bond is denominated.
B) issued only in Europe.
C) the European equivalent of a junk bond.
D) none of the above.
2) Which of the following statements about zero coupon bonds is
FALSE?
A) When the bonds mature, the issuing firm is faced with a small cash
outflow relative to the cash inflow the firm receives when the bonds are
initially issued.
B) Zero coupon bonds have lower interest rate risk than bonds with
high coupons.
C) Zero coupon bonds are an extremely popular way for corporations to
borrow money.
D) Most zero coupon bonds in the U.S. are government issues.
3) Which of the following bond types has the greatest risk for
investors?
A) Debentures
B) Mortgage bonds
C) Floating rate bonds
D) Subordinated debentures
4) The holder of a non-amortizing bonds
A) receives no periodic interest payments.
B) receives the full par value of the bond when it matures.
C) receives shares of common stock rather than cash interest payments.
D) receives periodic payments that consist of both interest and
principal.
5) Junk bonds
A) pay little or no interest.
B) are commonly used to finance municipal waste disposal facilities.
C) are issued by the U. S. Treasury Department.
D) have yields that are considerably higher than those of the highest
rated bonds.
6) Debentures are unsecured long-term debt.
Answer: TRUE
7) Zero coupon bonds are disadvantageous to the issuing firm if interest
rates fall.
Answer: TRUE
8) Eurobonds are bonds issued in a country different from the one in
whose currency the bond is denominated.
Answer: TRUE
9) Convertible bonds can be exchanged for the issuing firm's common
stock at a price specified at the time of issue.
Answer: TRUE
9.5 Determinants of Interest
1) The nominal interest rate
A) does not include inflation.
B) includes inflation and the real rate of interest.
C) ignores the Fisher effect.
D) is the rate at which banks lend money to other banks.
2) Government bonds have lower yield to maturity than do corporate
bonds of the same maturity because the ________ premium is lower for
government bonds.
A) interest rate risk
B) inflation
C) default
D) maturity
3) The Fisher effect can be expressed mathematically as
A) ( nominal rate)= (the real rate of interest) ( the inflation rate).
B) (1+ the nominal rate)= (1+the real rate of interest) (1 + the inflation
rate).
C) the nominal rate)= the real rate of interest + the inflation rate).
D) the real rate of interest= the nominal rate - the inflation rate).
4) The yield on a corporate bond with a 20 year maturity would include
A) only the real rate of interest and expected inflation.
B) the risk-free rate multiplied by 1+ default rate.
C) the risk-free rate plus a default risk premium, a liquidity risk
premium and a maturity risk premium.
D) the real rate of interest, the expected inflation rate and a default risk
premium.
5) Pursuant to the Fisher Effect, the real interest rate is exactly equal to
the nominal interest rate less the rate of inflation.
Answer: FALSE
6) When inflation rates go up, bond prices go up as well.
Answer: FALSE
7) As the time to maturity increases, the maturity premium increases.
Answer: TRUE
8) Maturity risk and liquidity risk are equivalent terms.
Answer: FALSE
9) Maturity risk and liquidity risk are equivalent terms.
Answer: FALSE
10) Long-term government bonds are not without maturity risk.
Answer: TRUE
11) Explain why an increase in the inflation rate will cause the yield to
maturity on a bond to increase.
Answer: When the inflation rate increases, it means that the risk free
rate of return will increase. This happens because investors need to
make some real return, even on a risk free investment. This means that
in order to keep the real rate of return constant, when the inflation rate
goes up, the nominal interest rate goes up as well. Consequently, to
maintain the same real rate of return, the nominal rate must go up,
which in turn raises the required return, or yield to maturity.
12) What elements determine what the yield to maturity will be for a
bond?
Answer: The starting point is the risk free rate, a rate for a bond with
no risks. A short term treasury bill reflects the risk free rate. The risk
free rate comprises the real rate of return plus an inflation premium, so
that the investor can earn the real return. If one knows the nominal risk
free rate and the inflation rate, one can determine the real rate through
the Fisher effect. When there is a possibility of default, the investor
must receive a default premium to reflect that risk. Finally, there is the
risk that the yield to maturity of the bond may change over the life of
the bond, possibly lowering its value. This risk is reflected by the
investor adding a maturity premium to the required return. In summary,
the yield to maturity will be the real return, plus premiums for inflation,
default, and maturity.
13) Given the anticipated rate of inflation (i) of 6.3% and the real rate
of interest (R) of 4.7%, find the nominal rate of interest (r).
Answer:
r = R + i + iR
r = .047 + 0.63 + (.063)(.047)
r = 11.3%
14) If provided the nominal rate of interest (r) of 14.2% and the
anticipated rate of inflation (i) of 5.5%, what is the real rate of interest
(R)?
Answer:
r = R + i + iR
.142 = R + .055 + (.055)(R)
.142 - .055 = 1.055R + .055 - .055
.087 = 1.055R
R = 8.2%
15) Given the anticipated rate of inflation (i) of 6.13% and the real rate
of interest (R) of 7.56%, what is the true inflation premium?
Answer: We know the inflation premium to equal i + iR or = 0.0613 +
(.0613)(.0756) = 6.59%
Financial Management (Chapter 10: Stock Valuation)
10.1 Common Stock
1) The XYZ Company, whose common stock is currently selling for
$40 per share, is expected to pay a $2.00 dividend in the coming year.
If investors believe that the expected rate of return on XYZ is 14%,
what growth rate in dividends must be expected?
A) 5%
B) 14%
C) 9%
D) 6%
2) The expected rate of return on a share of common stock whose
dividends are growing at a constant rate (g) is which of the following?
A) (D1 + g)/Vc
B) D1/Vc + g
C) D1/g years and then sell it. You estimate that a required rate of return of 13) Marble Corporation's ROE is 17%. Their dividend payout ratio is
D) D1/Vc 17.5% will be adequate compensation for this investment. Calculate the 20%. The last dividend, just paid, was $2.58. If dividends are expected
present value of the expected dividends. to grow by the company's sustainable growth rate indefinitely, what is
A) $4.91 the current value of Marble common stock if its required return is 18%?
3) Green Company's common stock is currently selling at $24.00 per B) $5.40 A) $14.33
share. The company recently paid dividends of $1.92 per share and C) $9.80 B) $18.27
projects growth at a rate of 4%. At this rate, what is the stock's D) $6.80 C) $47.67
expected rate of return? D) $66.61
A) 4.08%
B) 8.00% 9) You are evaluating the purchase of Charbridge, Inc. common stock 14) Fris B. Corporation stock is currently selling for $42.86. It is
C) 12.00% which currently pays no dividend and is not expected to do so for many expected to pay a dividend of $3.00 at the end of the year. Dividends
D) 8.80% years. Because of rapidly growing sales and profits, you believe the are expected to grow at a constant rate of 3% indefinitely. Compute the
stock will be worth $51.50 in 3 years. If your required rate of return is required rate of return on FBC stock.
4) Common stockholders are essentially 16%, what is the stock worth today? A) 10%
A) creditors of the firm. A) $59.74 B) 33%
B) managers of the firm. B) $51.25 C) 7%
C) owners of the firm. C) $32.99 D) 4.3%
D) all of the above. D) $0.00 because stocks that do not pay dividends have no value.
Answer: C
10) CEOs naming friends to the board of directors and paying them 15) You are evaluating the purchase of Cool Toys, Inc. common stock
5) Butler, Inc.'s return on equity is 17% and management retains 75% more than the norm is an example of the that just paid a dividend of $1.80. You expect the dividend to grow at a
of earnings for investment purposes. Based on this information, what A) agency problem. rate of 12%, indefinitely. You estimate that a required rate of return of
will be the firm's growth rate? B) preemptive right. 17.5% will be adequate compensation for this investment. Assuming
A) 4.25% C) majority voting feature. that your analysis is correct, what is the most that you would be willing
B) 22.67% D) proxy fights. to pay for the common stock if you were to purchase it today? Round to
C) 44.12% the nearest $.01.
D) 12.75% 11) Little Feet Shoe Co. just paid a dividend of $1.65 on its common A) $36.65
stock. This company's dividends are expected to grow at a constant rate B) $91.23
of 3% indefinitely. If the required rate of return on this stock is 11%, C) $51.55
6) If a company has a return on equity of 25% and wants a growth rate compute the current value of per share of LFS stock. D) $74.82
of 10%, how much of ROE should be retained? A) $20.63
A) 40% B) $21.24 16) A stock currently sells for $63 per share, and the required return on
B) 50% C) $15.00 the stock is 10%. Assuming a growth rate of 5%, calculate the
C) 60% D) $55.00 stock's lastdividend paid.
D) 70% A) $1
B) $3
7) ________ gives minority shareholders more power to elect board of 12) Marshall Manufacturing has common stock which paid a dividend C) $5
directors. of $1.00 a share last year. You expect the stock to grow at 5% per year. D) $7
A) Preemptive right If the appropriate rate of return on this stock is 12%, how much are you
B) Majority voting willing to pay for the stock today? 17) A decrease in the ________ will cause an increase in common
C) Proxy fights A) $13.00 stock value.
D) Cumulative voting B) $15.00 A) growth rate
C) $17.00 B) required rate of return
8) You are evaluating the purchase of Cellars, Inc. common stock that D) $19.00 C) last paid dividend
just paid a dividend of $1.80. You expect the dividend to grow at a rate D) both B and C
of 12% for the next three years. You plan to hold the stock for three
 D) never. Common shareholders have no claim on the company's 27) Marjen, Inc. just paid a dividend of $5. Marjen stock currently sells
assets. for $73.57. The return on stocks like Marjen, Inc. is around 10%. What
18) Acme Consolidated has a return on equity of 12%. If Acme is the implied growth rate of dividends.
distributes 60% of earnings as dividends, its expected growth rate will 23) KDP's most recent dividend was $2.00 per share and is selling A) 1%
be today in the market for $70. The dividend is expected to grow at a rate B) 3%
A) new 4.80%. of 7% per year for the foreseeable future. If the market return is 10% on C) 5%
B) 7.20%. investments with comparable risk, should you purchase the stock? D) 7%
C) 12%. A) No, because the stock is overpriced $1.33.
D) 6%. B) No, because the stock is overpriced $3.33. 28) Which investor incurs the greatest risk?
C) Yes, because the stock is underpriced $1.33. A) Mortgage bondholder
19) An investor is contemplating the purchase of common stock at the D) Yes, because the stock is underpriced $3.33. B) Preferred stockholder
beginning of this year and to hold the stock for one year. The investor C) Common stockholder
expects the year-end dividend to be $2.00 and expects a year-end price D) Debenture bondholder
for the stock of $40. If this investor's required rate of return is 10%, 24) An issue of common stock currently sells for $50.00 per share, has
then the value of the stock to this investor is an expected dividend to be paid at the end of the year of $2.50 per 29) What allows common stockholders the right to cast a number of
A) $36.36. share, and has an expected growth rate to infinity of 5% per year. If votes equal to the number of directors being elected?
B) $38.18. investors' required rate of return for this particular security is 12% per A) The majority voting provision
C) $33.06. year, then this security is B) The casting feature
D) $34.88. A) overvalued and offering an expected return higher than the required C) The cumulative voting provision
return. D) The proxy method
20) A firm just paid $2.00 on its common stock and expects to continue B) undervalued and offering an expected return higher than the
paying dividends, which are expected to grow 5% each year, from now required return.
to infinity. If the required rate of return for this stock is 9%, then the C) overvalued and offering an expected return lower than the required 30) The shareholder can cast all votes for a single candidate or split
value of the stock is return. them among various candidates through
A) $50.00. D) undervalued and offering an expected return lower than the required A) proxy fights.
B) $40.00. return. B) cumulative voting.
C) $54.50. C) call provisions.
D) $52.50. 25) You are considering the purchase of Miller Manufacturing, Inc.'s D) majority voting.
common stock. The stock is selling for $21.00 per share. The next
dividend is expected to be $2.10, and you expect the dividend to keep 31) You are considering the purchase of common stock that just paid a
21) An issue of common stock currently sells for $40.00 per share, has growing at a constant rate. If the stock is returning 15%, calculate the dividend of $6.50 per share. Security analysts agree with top
an expected dividend to be paid at the end of the year of $2.00 per growth rate of dividends. management in projecting steady growth of 12% in dividends and
share, and has an expected growth rate to infinity of 5% per year. The A) 3% earnings over the foreseeable future. Your required rate of return for
expected rate of return on this security is B) 5% stocks of this type is 18%. How much should you expect to pay for this
A) 5%. C) 8% stock?
B) 10.25%. D) 10% A) $86
C) 13.11%. B) $94
D) 10%. 26) ABC, Inc. just paid a dividend of $2. ABC expects dividends to C) $108
grow at 10%. The return on stocks like ABC, Inc. is typically around D) $121
22) Common shareholders have a claim on the company's assets 12%. What is the most you would pay for a share of ABC stock? E) $242
A) at any time, equal to the value of their shares. A) $100
B) only after the claims of debtholders and preferred shareholders have B) $110
been satisfied. C) $120 32) You are considering the purchase of Wahoo, Inc. The firm just paid
C) after the claims of the preferred shareholders have been satisfied, D) $130 a dividend of $4.20 per share. The stock is selling for $115 per share.
but before the debt holders. Security analysts agree with top management in projecting steady
growth of 12% in dividends and earnings over the foreseeable future.
Your required rate of return for stocks of this type is 17.5%. If you R = (D/V) + g
were to purchase and hold the stock for three years, what would the R = ($3.68/$26.75) + .055
expected dividends be worth today? 39) The stockholder's expected rate of return consists of a dividend R = 19.26%
A) $12.60 yield and interest.
B) $9.21 Answer: FALSE
C) $17.12 47) Tannerly Worldwide's common stock is currently selling for $48 a
D) $15.55 40) When bankruptcy occurs, the claims of the common shareholders share. If the expected dividend at the end of the year is $2.40 and last
E) $11.46 may go unsatisfied. year's dividend was $2.00, what is the rate of return implicit in the
Answer: TRUE current stock price?
33) A share of common stock just paid a dividend of $3.25 per share. Answer:
The expected long-run growth rate for this stock is 18%. If investors 41) Cumulative voting gives each share of stock a number of votes Rc = 2.40/48 + (2.40 - 2.00)/2.00
require a rate of return of 24%, what should the price of the stock be? equal to the number of directors being elected to the board. = .05 + .20
A) $57.51 Answer: TRUE = 25%
B) $62.25
C) $71.86 42) The expected rate of return implied by a given market price equals 48) Draper Company's common stock paid a dividend last year of
D) $63.92 the required rate of return for investors at the margin. $3.70. You believe that the long-term growth in the dividends of the
Answer: TRUE firm will be 8% per year. If your required return for Draper is 14%,
34) Common stockholders expect greater returns than bondholders how much are you willing to pay for the stock?
because 43) Stock valuation is more precise than bond valuation as stock cash
A) they have no legal right to receive dividends. flows are more certain.
B) they bear greater risk. Answer: FALSE Answer: P0 = = = $66.60
C) in the event of liquidation, they are only entitled to receive any cash
that is left after all creditors are paid. 44) The stock valuation model D1/(Rc - g) requires Rc > G.
D) all of the above. Answer: TRUE
49) Determine the rate of return on a $25 common stock that pays a
45) Is the following common stock priced correctly? If no, what is the dividend of $2.50 in year 1 and grows at a rate of 5%.
35) WSU Inc. is a young company that does not yet pay a dividend. correct price?
You believe that the company will begin to pay dividends 5 years from Answer: Kcs = + 5% = 10% + 5% = 15%
now, and that the company will then be worth $50 per share. If your Price = $26.25
required rate of return on this risky stock is 20%, what is the stock Required rate of return = 13%
worth today? Dividend year 0 = $2.00
A) $40 Dividend year 1 = $2.10 50) You are considering the purchase of AMDEX Company stock. You
B) $10 anticipate that the company will pay dividends of $2.00 per share next
C) $20.09 Answer: year and $2.25 per share the following year. You believe that you can
D) $0.00 sell the stock for $17.50 per share two years from now. If your required
Growth rate = = 5% rate of return is 12%, what is the maximum price that you would pay
36) Common stockholders are essentially creditors of the firm. for a share of AMDEX Company stock?
Answer: FALSE Answer:
Vcs = 2.10 /(.13 - .05)= $26.25
The stock is priced correctly. Vc = $2.00 PVIF12%,1 + $19.75 PVIF12%,2
37) Common stock represents a claim on residual income. = ($2.00)(.893) + ($19.75)(.797)
Answer: TRUE = $17.53
46) The common stock of Cranberry, Inc. is selling for $26.75 on the
38) The growth rate of future earnings is determined by return on open market. A dividend of $3.68 is expected to be distributed, and the
equity and the profit-retention rate. growth rate of this company is estimated to be 5.5%. If Richard Dean,
an average investor, is considering purchasing this stock at the market 51) You can purchase one share of Sumter Company common stock for
Answer: TRUE $80 today. You expect the price of the common stock to increase to $85
price, what is his expected rate of return?
Answer:
per share in one year. The company pays an annual dividend of $3.00 5) The retail analyst at Morgan-Sachs values stock of the GAP at 10) Apple stock is now selling for $460 per share. The P/E ratio based
per share. What is your expected rate of return for Sumter stock? $38.00 per share. They are using the average industry "forward" P/E on current earnings is 10.98 and the P/E ratio based on expected
Answer: ratio of 17. Their forecasted earnings per share for next year is earnings is 10.16. The expected growth rate in Apples earnings must be
A) $0.54. A) 2.39%.
B) $1.50. B) 8.07%.
$80.00 = + C) $2.24. C) -7.5%.
D) There is not enough information calculate earnings per share. D) 5.5%.
$80.00 (1 + R) = $88.00 6) Home Depot stock is currently selling for $75 per share. Next year's 11) The P/E ratio is the market price of a share of stock divided by
dividend is expected to be $1.56; next year's earnings per share are book equity per share.
(1 + R) = = $1.10 expected to be $4.16. Home Depot's P/E ratio is Answer: FALSE
A) .055.
R = .10 B) 18. 12) The higher a firm's P/E ratio, the more optimistic investors feel
C) 2.14. about the firm's growth prospects.
D) 48. Answer: TRUE

10.2 The Comparables Approach to Valuing Common Stock 13) P/E ratios found in published sources or on the internet are always
7) McDonald's stock currently sells for $103. It's expected earnings per computed by dividing the next period's expected earnings into the
1) If a stock has a much higher than normal P/E ratio, investors share are $5.50. The average P/E ratio for the industry is 24. If current price of the stock.
probably expect investors expected the same growth rate and risk for McDonald's as for Answer: FALSE
A) slow growth in earnings. an average firm in the same industry, it's stock price would
B) rapid growth in earnings. A) stay about the same. 14) The higher the investor's required rate of return, the higher the P/E
C) large increases in the price of the stock. B) rise. ratio will be.
D) a declining stock price. C) fall. Answer: FALSE
D) there is not enough information.
2) Which of the following factors will influence a firm's P/E ratio?
A) The investors' required rate of return 8) If the ROE on a new investment is less than the firm's required rate 15) Walmart's current earnings per share of $5.02 are expected to grow
B) Firm investment opportunities of return at a rate of 17% per year for the next few years. Using a P/E ratio of
C) General market conditions A) the investment increases the firm's value. 13.46, what is a reasonable value for a share of Walmart Stock.
D) All of the above B) the investment leaves the firm's value unchanged. Answer: A reasonable value for Walmart would be
C) the effect on the firm's value is unpredictable. $5.02(1.17)(13.46)=$79.06 per share.
3) The P/E ratio is calculated by dividing D) the investment reduces the firm's value.
A) the current stock price by stockholders' equity. 16) RAH Inc. is not publicly traded, but the P/E ratios of it's 4 closest
B) total assets by net income. 9) Zorba's is a small chain of restaurants whose stock is not publicly competitors are 15, 15.3, 15.7, and 16.5. RAH's current earnings per
C) the current stock price by earnings per share. traded. The average P/E ratio for similar restaurant chains is 16.5; the share are $1.50. They are expected to grow at 6% for the next few
D) the current stock price by operating cash flow per share. P/E ratio for the S&P 500 Index is 15.2. This year's earnings were years. What is a reasonable price for a share of RAH stock?
$1.21 per share and next year's earnings are forecasted at $1.46 per Answer: An appropriate P/E ratio would be an average of the 4
share. A reasonable price for a share of Zorba's stock is competitors:
4) The GAP's most recent earnings per share were $1.75. Analysts A) $24.09. (15 + 15.3 + 15.7 + 16.5)/4 = 15.625. A reasonable price would be
forecast next year's earnings per share at $1.88. If the appropriate P/E B) $19.96. $1.50(1.06)(15.625) = $24.84.
ratio is 15, a share of GAP stock should be valued at C) $20.23.
A) $28.20. D) $16.50.
B) $26.25. 10.3 Preferred Stock
C) $27.23.
D) $8.57.
1) UVP preferred stock pays $5.00 in annual dividends. If your
required rate of return is 13%, how much will you be willing to pay for
one share?
A) $38.46
B) $26.26
C) $65.46
D) $46.38
2) Green Corp.'s preferred stock is selling for $20.83. If the company
pays $2.50 annual dividends, what is the expected rate of return on its
stock?
A) 8.33%
B) 12.00%
C) 2.50%
D) 20.00%
3) Sacramento Light & Power issued preferred stock in 1998 that had a
par value of $85. The preferred stock pays a dividend of 5.75%.
Investors require a rate of return of 6.50% today on this stock. What is
the value of the preferred stock today? Round to the nearest $1.
A) $100
B) $85
C) $75
D) $16
4) Which of the following statements is true?
A) Preferred stockholders are entitled to dividends before common
stockholders can receive dividends.
B) Preferred stock, like common stock, usually has no maturity; i.e., the
corporation does not pay back the investment.
C) The market value of preferred stock, like bonds, will usually
fluctuate in value primarily as the result of market rates of interest.
D) All of the above.
5) Which of the following statements concerning preferred stock is
correct?
A) Preferred stock generally is more costly to the firm than common
stock.
B) Most issues of preferred stock have a cumulative feature.
C) Preferred dividend payments are tax-deductible.
D) Preferred stock is a riskier form of capital to the firm than bonds.
6) World Wide Interlink Corp. has decided to undertake a large project.
Consequently, there is a need for additional funds. The financial
manager plans to issue preferred stock with an annual dividend of $5
per share. The stock will have a par value of $30. If investors' required
rate of return on this investment is currently 20%, what should the
preferred stock's market value be?
A) $10
B) $15
C) $20
D) $25
7) Davis Gas & Electric issued preferred stock in 1985 that had a par
value of $50. The stock pays a dividend of 7.875%. Assume that shares
are currently selling for $62.50. What is the preferred stockholder's
expected rate of return? Round to the nearest 0.01%.
A) 6.30%
B) 7.88%
C) 10.25%
D) 5.02%
8) Murky Pharmaceuticals has issued preferred stock with a par value
of $100 and a 5% dividend. The investors' required yield is 10%. What
is the value of a share of Murky preferred?
A) $100
B) $75
C) $50
D) $25
9) Edison Power and Light has an outstanding issue of cumulative
preferred stock with an annual fixed dividend of $2.00 per share. It has
not paid the preferred dividend for the last 3 years, but intends to pay a
dividend on the common stock in the coming year. Before Edison can
pay a dividend on the common stock
A) preferred shareholders may cast all their votes for a single director.
B) preferred shareholders must receive dividends totaling $8.00 per
share.
C) preferred shareholders must receive $2.00 per share.
D) will not necessarily receive any dividend.
10) Which of the following provisions is unique to preferred
stockholders and usually NOT available to common stockholders?
A) Cumulative dividends feature
B) Voting rights
C) Fixed dividend
D) Both A and C
11) Piercing Publishers recently issued preferred stock with a fixed
annual dividend of $3.00 per share. Investors require a 5% return on
similar preferred stock issues. The stock is currently selling for $65. Is
the stock a good buy?
A) Yes, as it is undervalued $5.
B) Yes, as it is undervalued $10.
C) No, as it is overvalued $5.
D) No, as it is overvalued $10.
12) Tri State Pickle Company preferred stock pays a perpetual annual
dividend of 2 1/2% of its par value. Par value of TSP preferred stock is
$100 per share. If investors' required rate of return on this stock is 15%,
what is the value of per share?
A) $37.50
B) $15.00
C) $16.67
D) $6.00
13) Petrified Forest Skin Care, Inc. pays an annual perpetual dividend
of $1.70 per share. If the stock is currently selling for $21.25 per share,
what is the expected rate of return on this stock.
A) 36.13%
B) 12.5%
C) 8.0%
D) 13.6%
14) Horizon Communications stock pays a fixed annual dividend of
$3.00. Because of lower inflation, the market's required yield on this
preferred stock has gone from 12% to 10%. As a result
A) Horizon's dividend decreased by 6 cents.
B) The value of Horizon's preferred increased by $3.00.
C) The value of Horizon's preferred decreased by $5.00.
D) The value of Horizon's preferred increased by $5.00.
15) The required rate of return on TKF preferred has fallen from 5.75%
at the time of issue to the present rate of 5%. The stock now sells for
$115. What was the original price?
A) $75.61
B) $132.25
C) $114
D) $100
16) Preferred stock is similar to a bond in which of the following ways?
A) Preferred stock always contains a maturity date.
B) Both investments provide a fixed income. Answer: FALSE
C) Both contain a growth factor similar to common stock.
D) None of the above. 22) An issue of preferred stock currently sells for $52.50 per share and 30) To determine the value of a share of preferred stock, the discount
pays a constant annual expected dividend of $2.25 per share. The rate used is the annual dividend percent.
17) Solitron Manufacturing Company preferred stock is selling for $14. expected return on this security is Answer: FALSE
If it has a yearly dividend of $1, what is your expected rate of return if A) 4.29%.
you purchase the stock at its market price (round your answer to the B) 0.04%. 31) The value of preferred shares is affected by changes in interest
nearest .1%). C) 8.33%. rates.
A) 25.0% D) 13.33%. Answer: TRUE
B) 14.2%
C) 7.1% 23) Expected cash flow for a preferred stock primarily consists of 32) Miller/Hershey's preferred stock is selling at $54 on the market and
D) 9.3% A) dividend payments. pays an annual dividend of $4.20 per share.
B) changes in the price of the stock. a. What is the expected rate of return on the stock?
18) An decrease in the ________ will increase the value of preferred C) interest payments. b. If an investor's required rate of return is 9%, what is the value of
stock. D) both A and B. the stock for that investor?
A) expected rate of return c. Considering the investor's required rate of return, does this stock
B) life of the investment 24) Preferred stock is similar to common stock in that seem to be a desirable investment?
C) dividend paid A) it has no fixed maturity date. Answer:
D) both A and C B) the nonpayment of dividends can bring on bankruptcy. a. R = D/V
C) dividends are limited in amount. R = $4.20/54
D) both carry voting rights. R = 7.78%
19) Texon's preferred stock sells for $85 and pays $11 each year in b. V = D/R
dividends. What is the required rate of return? V = $4.20/.09
25) Profitable companies often prefer to issue debt rather than preferred V = $46.66
stock because c. No, it is not a desirable investment.
Answer: Required rate of return = = 0.129 A) debt creates less risk for the company.
B) interest payments are fixed but preferred shareholders expect 33) Discuss two reasons why preferred stock would be viewed as less
dividends to grow. risky than common stock to investors.
20) What is the value of a preferred stock that pays a $2.10 dividend to C) preferred shares dilute the voting rights of common shareholders but Answer: Preferred stockholders are paid before common stockholders
an investor with a required rate of return of 6% (round your answer to bonds do not. in the event of bankruptcy. Common stockholders, as the residual
the nearest $1)? D) interest on debt is deductible for tax purposes, but preferred owners of a corporation, would receive any monies remaining after
A) $35 dividends are not. bondholder and preferred stock claims are satisfied. Preferred dividends
B) $23 are paid before common stock dividends in the normal course of
C) $17 26) In the event of bankruptcy, preferred stockholders and common business. In the event that a preferred dividend is not paid, it
D) $21 stockholders have the same claim on the firm's assets. accumulates and dividends in arrears must be paid before any common
Answer: FALSE stock dividends can be declared. Common shareholders take the risk
21) Which of the following formulas is appropriate to find the value of that they will not receive dividends. The magnitude of the cash flows
preferred stock with a fixed dividend? 27) A company may issue multiple classes of preferred stock. from preferred is also known where it is not known for common stock.
A) Value of preferred stock = Annual Preferred Stock Dividend (1 + Answer: TRUE Because cash flows are more certain, preferred stock would be
growth rate)/Market's Required Yield on Preferred Stock considered less risky to the investor.
B) Value of preferred stock = Annual Preferred Stock Dividend (1 + 28) The cumulative dividend feature is necessary to protect the rights of
growth rate)/Market's Required Yield on Preferred Stock - growth rate preferred stockholders. 34) Determine the rate of return on a preferred stock that costs $50 and
C) Value of preferred stock = Annual Preferred Stock Answer: TRUE pays a $6 per share dividend.
Dividend/Market's Required Yield on Preferred Stock Answer:
D) Value of preferred stock = Annual Preferred Stock K = Div = 6 = 12%
Dividend/Investor's Required Yield on Preferred Stock 29) Preferred stock cannot be retired. Vg 50
 7) A block trade is a trade involving 10,000 or more shares by a single
holder. 1) In order to maximize firm value, management should invest in new
Answer: TRUE assets when cash flows from the assets are discounted at the firm's
10.4 The Stock Market ________ and result in a positive NPV.
A) cost of capital
1) An example of a primary market transaction is 8) The NASDAQ trading floors are located in New York City. B) cost of debt used to finance the project
A) a new issue of stock by Evergreen Solar. Answer: FALSE C) rate of return on equity
B) a purchase of Microsoft stock on Nasdaq. D) internal rate of return
C) Target repurchasing some its own stock from an investor. 9) Large, established technology companies such as Apple, Dell, Intel
D) a sale of IBM stock on the NYSE. and Microsoft all trade on the NYSE. 2) The investor's required rate of return differs from the firm's cost of
Answer: FALSE capital due to the
2) The largest market stock exchange in the U.S. is A) firm's beta.
A) NYSE. 10) Trading on the Nasdaq is done electronically and does not require a B) tax deductible of interest.
B) Nasdaq. physical location. C) CAPM.
C) AMEX. Answer: TRUE D) time value of money.
D) the CBOT.
11) In addition to stocks in individual companies, the AMEX conducts 3) The weights used to determine the relative importance of the firm's
3) Which of the following companies is most likely to trade on the New trading in such securities as ETFs and options. sources of capital should reflect
York Stock Exchange? Answer: TRUE A) book values in accord with generally accepted accounting
A) Dell principles.
B) Genzyme Transgenics B) current market values for bonds, common stock, and preferred stock
C) Coca Cola 12) Describe the major differences between the organized exchanges and book values for retained earnings.
D) Tata Motors such as the NYSE and electronic networks such as Nasdaq. C) current market values.
Answer: The organized exchanges such as the New York Stock D) subjective adjustments for firm risk.
Exchange have a physical location and a trading floor where buyers and
4) Which of the following exchanges has the strictest listing sellers of securities can meet face to face. An increasing percentage of 4) Which of the following best describes a firm's cost of capital?
requirements? NYSE and AMEX trades is, however, executed electronically. Nasdaq A) The average yield to maturity on debt
A) AMEX is an electronically linked network of traders that post bid and ask B) The average cost of the firm's assets
B) Nasdaq prices (the prices they are willing to pay or accept for securities) and C) The rate of return that must be earned on its investments in order to
C) NYSE the quantities they are willing to purchase or sell. There is no physical satisfy the firm's investors
D) OTC trading floor. Although companies trading on Nasdaq tend to be smaller D) The coupon rate on preferred stock
and younger than those traded on the NYSE, Nasdaq listings do include
5) A small, newly listed technology company is most likely to be listed some very large companies such as Microsoft and Apple. 5) A firm's capital structure consists of which of the following?
on A) Common stock
A) AMEX. 13) Distinguish between primary stock market transactions and B) Preferred stock
B) NYSE. secondary stock market transaction. C) Bonds
C) Nasdaq National Markets. Answer: When a company issues stock to the public for the first time, D) All of the above
D) Nasdaq Capital Markets. the event is known as an IPO or Initial Public Offering. Subsequent to
the IPO, trading in the company's stock takes place on one of the major 6) Which of the following must be adjusted for the firm's tax rate when
6) Listing requirements for the New York Stock Exchange include exchanges such as the NYSE or Nasdaq. In the great majority of these estimating the weighted average cost of capital WACC?
A) profitability. transactions, investors buy stock from other investors who wish to sell A) Cost of common equity
B) market value. it, rather than directly from the company that issued it B) Cost of preferred stock
C) breadth of ownership. C) Cost of debt
D) all of the above. D) All of the above
Financial Management (Chapter 14: The Cost of Capital)
14.1 The Cost of Capital: An Overview
7) For tax purposes, interest on corporate debt is 13) The weighted average cost of capital is computed using before-tax Short-term notes $150 $150
A) deductible for the investor, but not for the borrower. costs of each of the sources of financing that a firm uses to finance a Long-term debt $450 $600
B) deductible for the borrower, but not for the investor. project. Preferred Stock $75 $150
C) fully taxable for both the borrower and the investor. Answer: FALSE Common Stock $600 $1500
D) fully deductible for both the borrower and the investor.
Total $1575 $2400
14) When investors increase their required rate of return, the cost of
8) Which of the following reasons causes bonds to be a less expensive capital increases simultaneously.
1) The percentage of common stock in Spencer's weighted average cost
form of capital for a public firm than the issuance of common stock? Answer: TRUE
of capital is
Bondholders
A) 62.5%.
A) bear less risk than common stockholders bear. 15) The firm should continue to invest in new projects up to the point
B) 66.7%.
B) have prior voting rights over common stockholders. where the marginal rate of return earned on a new investment equals
C) 6.25%.
C) receive greater returns than common stockholders. the marginal cost of new capital.
D) 38.1%.
D) investors pay a lower tax rate on bond interest Answer: TRUE
2) The percentage of debt in Spencer's weighted average cost of capital
9) The cost of capital is 16) Business risk reflects the added variability in earnings available to a
is
A) the opportunity cost of using funds to invest in new projects. firm's shareholders.
A) 38.1%.
B) the rate of return the firm must earn on its investments in order to Answer: FALSE
B) 31.25.
satisfy the required rate of return of the firm's investors.
C) 25%.
C) the required rate of return for new capital investments which have 17) The after-tax cost of capital is computed by multiplying the before-
D) 57.14%.
typical or average risk. tax cost of capital by 1 minus the tax rate.
D) all of the above. Answer: FALSE
3) The percentage of preferred stock in Spencer's weighted average cost
of capital is
10) Cost of capital is 18) Briefly identify and describe some important uses of a firm's
A) 5.9%.
A) the coupon rate of debt. weighted average cost of capital.
B) 62.5%.
B) a minimum rate of return set by the board of directors.
C) 4.76%.
C) the rate of return that must be earned on additional investment if Answer: The WACC is used to establish the value of a firm. If a
D) 6.25%.
firm value is to remain unchanged. private equity firm wanted to purchase BJ's Wholesale Club, it would
Answer: D
D) the average cost of the firm's assets. discount BJ's expected cash flows by its estimated cost of capital. The
WACC is the starting point for determining the required rate of return
4) The total capital that should be used in computing the weights for
11) Which of the following is a correct formula for calculating the cost on capital expenditures. The WACC is also used in evaluating a firm's
Spencer's WACC is
of capital? performance and determining whether or not it is creating value for its
A) $1,275.
A) WACC = weighted after-tax cost of debt + weighted cost of shareholders.
B) $2,400.
preferred stock + weighted cost of common stock
C) $2,250.
B) WACC = weighted after-tax cost of debt + weighted after-tax cost
D) $1,575.
of preferred stock + weighted after-tax cost of common stock 14.2 Determining the Firm's Capital Structure Weights
C) WACC = (after-tax cost of debt + cost of preferred stock + cost of
5) Which of the following statements is true?
common stock )/3 Use the following information to answer the following question(s).
A) The level of general economic conditions will determine whether a
D) WACC = weighted cost of debt + weighted cost of preferred stock +
firm should utilize an arithmetic average cost of capital or a weighted
weighted cost of common stock The following data concerning
average cost of capital.
Spencer Transgenics' capital structure is available.
B) A firm should utilize a weighted average cost of capital for
12) The minimum rate of return necessary to attract an investor to
evaluating investment decisions rather than an arithmetic average cost
purchase or hold a security is called the cost of capital. $ millions Book Values Market Values
of capital.
Answer: FALSE Accounts C) For an average firm that is capitalized with 65% equity, usage of an
Payable & arithmetic average cost of capital will usually overstate the true cost of
Accruals $300 capital.
D) All of the above are true. A) 10.76% B) Retained earnings
E) None of the above is true. B) 5.85% C) Debt
C) 4.55% D) Preferred stock
D) 5.4%
6) A firm's weighted marginal cost of capital increases when internal 8) Which of the following is NOT used to calculate the cost of debt?
equity financing is exhausted but is unaffected by an increase in the 2) The expected dividend is $2.50 for a share of stock priced at $25. A) Face value of the debt
cost of other financing sources. What is the cost of common equity if the long-term growth in dividends B) Market price of the debt
Answer: FALSE is projected to be 4%? C) Number of years to maturity
A) 10% D) Risk-free rate
7) Capital structure represents the mix of equity and interest-bearing B) 8%
debt used by a firm. C) 14% 9) Which of the following is a valid issue in implementing the dividend
Answer: TRUE D) 18% growth model? The model
A) is too complex to be used to estimate value.
8) When computing a firm's cost of capital, book values should be used 3) Sonderson Corporation is undertaking a capital budgeting analysis. B) does not require an accurate estimate of the rate of growth in future
be used because they are more objective. The firm's beta is 1.5. The rate on six-month T-bills is 5%, and the dividends.
Answer: FALSE return on the S&P 500 index is 12%. What is the appropriate cost of C) is based upon the assumption that dividends are expected to grow at
common equity in determining the firm's cost of capital? a constant rate forever.
9) The percentage of debt in the firm's capital structure should be A) 13.1% D) both A and C.
adjusted by multiplying by 1 minus the firm's marginal tax rate. B) 15.5%
Answer: FALSE C) 17.7% 10) An increase in ________ will increase the cost of common equity.
D) 19.9% A) the expected growth rate of dividends
B) the risk-free rate
10) The amount of debt in the firm's capital structure should include all C) the dividend
interest-bearing debt, both long-term and short-term. 4) Most firms use Treasury securities with maturities of ________ to D) both A and B
Answer: TRUE determine the appropriate risk-free rate to use in the CAPM.
A) 90 days 11) Bender and Co. is issuing a $1,000 par value bond that pays 9%
11) Why are market values preferred to book (balance sheet) values B) 180 days interest annually. Investors are expected to pay $918 for the 10-year
when computing a firm's weighted average cost of capital. C) 10 years bond. What is the after-tax cost of debt if the firm is in the 34% tax
D) 30 years bracket?
Answer: The balance sheet shows the values of bonds, preferred stock, A) 6.83%
and common stock when they were issued, which might have been 5) The cost of preferred stock is equal to B) 9.00%
years ago under very different market conditions or when the company A) the preferred stock dividend divided by market price. C) 10.35%
was at a different stage in its development. B) the preferred stock dividend divided by its par value. D) 15.68%
C) (1 - tax rate) times the preferred stock dividend divided by net price.
The current market values of bonds and stocks allows the company to D) the preferred stock dividend divided by the net market price. 12) MTD Inc. has a new bond issue that will net the firm $1,603,500.
compute an accurate estimate of investors' required rates of return in The bonds have a $1,500,000 par value, pay interest annually at a 6%
the present or near future. In practice, however, book values may be 6) The most expensive source of capital is usually coupon rate, and mature in 10 years. The firm has a marginal tax rate of
used for debt if the debt is not frequently traded and accurate estimates A) preferred stock. 34%. The after-tax cost of the debt issue is
of market value are hard to obtain. B) new common stock. A) 5.1%.
C) debt. B) 3.37%.
D) retained earnings. C) 5.6%.
14.3 Estimating the Cost of Individual Sources of Capital D) 6.58%.

1) PVE, Inc. has $15 million of debt outstanding with a coupon rate of 7) When calculating the weighted average cost of capital, which of the
9%. Currently, the yield to maturity on these bonds is 7%. If the firm's following has to be adjusted for taxes? 13) Alpha has an outstanding bond issue that has a 7.75% semiannual
tax rate is 35%, what is the after-tax cost of debt to J & B? A) Common stock coupon, a current maturity of 20 years, and sells for $967.97. The firm's
income tax rate is 40%. What should Alpha use as an after-tax cost of 18) Hill Town Motels has $5 million of debt outstanding with a coupon D) 16.8%
debt for cost of capital purposes? rate of 12%. Currently, the yield to maturity on these bonds is 14%. If E) 18.8%
A) 2.42% the firm's tax rate is 40%, what is the after-tax cost of debt to Hill Town
B) 4.04% Motels? Use the following information to answer the following question(s).
C) 4.85% A) 5.43%
D) 8.08% B) 11.2% Berlioz Inc. is trying to estimate its cost of common equity, and it has
C) 8.4% the following information. The firm has a beta of 0.90, the before-tax
Use the following information to answer the following question(s). D) 5.6% cost of the firm's debt is 7.75%, and the firm estimates that the risk-free
rate is 4% while the current market return is 12%.
The current market price of an existing debt issue is $1,125. The bonds
have a $1,000 par value, pay interest annually at a 12% coupon rate, 19) Verigreen Lawn Care products just paid a dividend of $1.85. This Berlioz stock currently sells for $35.00 per share. The firm pays
and mature in 10 years. The firm has a marginal tax rate of 34%. dividend is expected to grow at a constant rate of 3% per year, so the dividends annually and expects dividends to grow at a constant rate of
next expected dividend is $1.90. The stock price is currently $12.50. 5% indefinitely. The most recent dividend per share, paid yesterday, is
14) The before-tax cost of this debt issue is New stock can be sold at this price subject to flotation costs of 15%. $2.00. Finally, the firm has a marginal tax rate of 34%.
A) 12%. The company's marginal tax rate is 40%. Compute the cost of common
B) 7.92%. equity. 23) The cost of common equity using the dividend-growth model is
C) 9.97%. A) 18.0% A) 11.00%.
D) 13%. B) 17.8% B) 11.32%.
C) 18.2% C) 11.50%.
15) The after-tax cost of this debt issue is D) 15.2% D) 11.72%.
A) 7.92%.
B) 6.58%. 20) Sola Cola Corporation is undertaking a capital budgeting analysis. 24) The cost of common equity using the CAPM is
C) 12%. The rate on 10-year U.S. Treasury bonds is 3.60%, and the return on A) 11.00%.
D) 3.39%. the S & P 500 index is 11.6%. If the cost of Sola Cola's common equity B) 11.20%.
is 19.6%, calculate their beta. C) 11.50%.
A) 1.69 D) 11.72%.
16) Walker & Son is issuing a 10-year, $1,000 par value bond that pays B) 5.4
9% interest annually. The bond is expected to sell for $885. What is C) 2.0
Walker & Son's after-tax cost of debt if the firm is in the 34% tax D) 1.38 25) The best estimate of the cost of new common equity is
bracket? A) 11.00%.
A) 7.23% 21) Pony Corporation is undertaking a capital budgeting analysis. The B) between 11.0% and 11.2%.
B) 8.01% firm's beta is 1.5. The rate on 10-year U.S. Treasury bonds is 5%, and C) 11.50%.
C) 9.15% the return on the S & P 500 index is 12%. What is the cost of Pony's D) between 10% and 12%.
D) 10.35% common equity?
A) 13.3% 26) XYZ Corporation is trying to determine the appropriate cost of
17) Dublin International Corporation's marginal tax rate is 40%. It can B) 15.5% preferred stock to use in determining the firm's cost of capital. This
issue three-year bonds with a coupon rate of 8.5% and par value of C) 17.7% firm's preferred stock is currently selling for $29.89 and pays a
$1,000. The bonds can be sold now at a price of $938.90 each. D) 19.9% perpetual annual dividend of $2.60 per share. Compute the cost of
Determine the appropriate after-tax cost of debt for Dublin preferred stock for XYZ.
International to use in a capital budgeting analysis. A) 7.2%
A) 11.0% 22) The last paid dividend is $2 for a share of common stock that is B) 6.2%
B) 5.2% currently selling for $20. What is the cost of common equity if the C) 8.7%
C) 6.6% long-term growth rate in dividends for the firm is expected to be 8%? D) 16.7%
D) 7.2% A) 10.8%
B) 12.8%
C) 14.8%
27) Many corporate finance professionals favor the CAPM for D) 6.5% 35) The current total value of the firm is
determining the cost of equity. Which of the following is a reason for A) $6,450,000.
this preference? 32) Alpha's beta is 1.06, the present T-bond rate is 6%, and the return B) $5,750,000.
A) The data is less expensive. on the S & P 500 is 15.25%. What is Alpha's cost of common equity C) $4,950,000.
B) The variables in the model that apply to public corporations are using the CAPM approach? D) $3,250,000.
readily available from public sources. A) 21.25%
C) Because the CAPM gives better treatment to flotation costs. B) 15.81%
D) The CAPM uses data from the firm's financial statements. C) 9.25% 36) The proportion of debt in this firm's capital structure is
D) 6.32% A) 40%.
B) 50%.
28) In calculating the cost of capital for an average firm, which of the 33) Paramount, Inc. just paid a dividend of $2.05 per share, and the C) 60%.
following statements is true? firm is expected to experience constant growth of 12.50% over the D) 70%.
A) The cost of a firm's bonds is greater than the cost of its common foreseeable future. The common stock is currently selling for $65.90
stock. per share. What is Paramount's cost of retained earnings using the 37) The after-tax cost of debt is
B) The cost of a firm's preferred stock is greater than the cost of its Dividend Growth Model approach? A) 6.20%.
common stock. A) 12.50% B) 5.40%.
C) The cost of a firm's retained earnings is less than the cost of its B) 17.90% C) 4.60%.
bonds. C) 16.00% D) 3.80%.
D) The cost of a firm's common stock is greater than the cost of its D) 14.55%
bonds. 38) The after-tax cost of common stock is
A) 14.67%.
29) A firm has an issue of preferred stock that pays an annual dividend 34) The George Company, Inc., has two issues of debt. Issue A has a B) 13.23%.
of $2.00 per share and currently is selling for $18.50 per share. Finally, maturity value of 8 million dollars, a coupon rate of 8%, paid annually, C) 12.41%.
the firm's marginal tax rate is 34%. This firm's cost of financing with and is selling at par. Issue B was issued as a 15 year bond 5 years ago. D) 11.65%.
new preferred stock is Its coupon rate is 9%, paid annually. Investors demand a pre-tax return
A) 10%. of 9.3% on this bond. The maturity value of Issue B is 6 million 39) The firm's weighted average cost of capital is
B) 7.13%. dollars. The George company has a marginal tax rate of 35%. What is A) 10.47%.
C) 10.81%. the company's after tax cost of debt? B) 9.29%.
D) 6.6%. A) 4.73% C) 8.63%.
B) 5.56% D) 7.71%.
30) The CAPM approach is used to determine the cost of C) 7.36%
A) debt. D) 8.47% 40) The firm financed completely with equity capital has a cost of
B) preferred stock. capital equal to the required return on common stock.
C) common equity. Use the following information to answer the following question(s). Answer: TRUE
D) long term funds.
A firm currently has the following capital structure which it intends to 41) A bond with a Moody's rating of Aaa and an S&P rating of AAA
maintain. Debt: $3,000,000 par value of 9% bonds outstanding with an will have a higher required return than a bond with a Moody's rating of
31) Given the following information, determine the risk-free rate. annual before-tax yield to maturity of 7.67% on a new issue. The bonds Aa1 and an S&P rating of AA+.
currently sell for $115 per $100 par value. Answer: FALSE
Cost of equity = 12%
Beta = 1.50 Common stock: 46,000 shares outstanding currently selling for $50 per 42) If the before-tax cost of debt is 9% and the firm has a 34% marginal
Market risk premium = 6% share. The firm expects to pay a $5.50 dividend per share one year from tax rate, the after-tax cost of debt is 5.94%.
now and is experiencing a 3.67% growth rate in dividends, which it Answer: TRUE
A) 6.0% expects to continue indefinitely. The firm's marginal tax rate is 40%.
B) 3.0% The company has no plans to issue new securities. 43) No adjustment is made in the cost of preferred stock for taxes since
C) 9.0% preferred stock dividends are not tax-deductible.
Answer: TRUE
44) A firm can estimate its cost of debt by finding the yield on bonds
issued by other firms with similar ratings and maturities.
Answer: TRUE
45) The cost of debt is equal to one minus the marginal tax rate times
the coupon rate of interest on the firm's outstanding debt.
Answer: FALSE
46) Assuming an after-tax cost of preferred stock of 12% and a
corporate tax rate of 40%, a firm must earn at least $20 before tax on
every $100 invested.
Answer: TRUE
47) The cost of common equity is already on an after-tax basis since
dividends paid to common stockholders are not tax-deductible.
Answer: TRUE
48) Because issuing common equity entails less risk to the firm, it is
always less expensive than borrowing.
Answer: FALSE
49) It is not possible for a firm's after-tax cost of common equity to be
lower than its after-tax cost of debt.
Answer: TRUE
50) Explain why the investor's required return on debt is not equal to
the corporation's cost of debt, and explain why the investor's required
return on equity is not equal to the corporation's cost of equity.
Answer: Interest expense is a deduction from the firm's taxable
income. The firm can deduct interest expense before taxes, thus
reducing the firm's tax burden. If a business is in the 34% tax bracket,
taxes are reduced by 34 cents for every dollar of interest expense. A
10% interest rate thus become (10% × (1-.34)) or 6.6% after taxes. This
causes the after-tax component of debt in the cost of capital to be less
than the required return of the firm's creditors.
51) Discuss the primary advantages of the CAPM approach in
determining the cost of common equity.
Answer: There are two primary advantages of using the CAPM
approach to determine the cost of common equity. First, the model is
simple to understand and implement. The variables for the model are
readily available from public sources. Second, the model can be applied
to companies that do not pay dividends.
52) Vipsu Corporation plans to issue 10-year bonds with a par value of
$1,000 that will pay $55 every six months. The net amount of capital to
the firm from the sale of each bond is $840.68. If Vipsu is in the 25%
tax bracket, what is the after-tax cost of debt?
Answer: Find the present value factors that equate
$840.67 = $55(PVIFA, 20, r/2) + $1,000(PVIF, 20, r/2)
r = 0.14
kd = 14(1 - 0.25) = .105 = 10.5%
In this answer the six month rate has been doubled to get 14%. If the
investor demands a 6 month rate of 7%, the investor will demand (l.07
squared) - 1 or 14.5%.
53) Moore Financing Corporation has preferred stock in its capital
structure paying a dividend of $3.75 and selling for $25.00. If the
marginal tax rate for Moore is 34%, what is the after-tax cost of
preferred financing?
Answer: After-tax cost of preferred = $3.75/$25.00 = .15
54) Hoak Company's common stock is currently selling for $50. Last
year's dividend was $1.83 per share. Investors expect dividends to grow
at an annual rate of 9% into the future.
a. What is Hoak's cost of common equity?
b. Selling new common stock is expected to decrease the price of the
stock by $5.00. What is the cost of new common stock? Dividends will
remain the same.
Answer:
a. Kr = [$1.83(1.09)/$50] + 0.09 = 0.13
b. Ks = [$1.83(1.09)/$50 - $5] + 0.09 = 0.134
55) Toto and Associates' preferred stock is selling for $18.40. The
stock pays an annual dividend of $2.21 per share. What is the cost of
preferred stock to the company?
Answer: Kp = $2.21/$18.40 = 12%
56) Sutter Corporation's common stock is selling for $16.80 a share.
Last year, Sutter paid a dividend of $.80. Investors are expecting
Sutter's dividends to grow at a rate of 5% per year. What is the cost of
common equity?
Answer: Kc = (D1/Po) + 6 = [$80(1.05)/16.80] + .05 = 10%
Alternatively, 16.80 = (.80 × 1.05)/r - .05), so 16.80r - .84 = .84, after
we multiply each side of the equation by (r - .05). Adding .84 to each
side, we see that 16.80r = 1.68, so r = .10
57) Gibson Industries is issuing a $1,000 par value bond with an 8%
semi-annual interest coupon rate and that matures in 11 years. Investors
are willing to pay $972 for these bonds. Gibson is in the 34% tax
bracket. What will be the after-tax cost of debt of the bond?
Answer: Using a financial calculator, N = 11 × 2, PV = -972, PMT =
80/2, FV = 1000. Solving for i, we get 4.197% or an annual yield of
8.39%.
After-tax cost of debt = 8.39(1 - .34)
After-tax cost of debt = 5.54%
58) The preferred stock of Wells Co. sells for $15.30 and pays a $1.75
dividend. What is the cost of capital for preferred stock?
Answer:
Cost of preferred stock = 1.75/15.30
Cost of preferred stock = 11.44%
59) Caribe's common stock sells for $41, and dividends paid last year
were $1.18. The dividends and earnings per share are predicted to have
a 5% growth rate. What is the cost of common equity for Caribe?
Answer:
Cost of internal equity = ((1.18(1 .05)/41) + .05
Cost of internal equity = 8.02%
14.4 Summing Up: Calculating the Firm's WACC
1) Based on current market values, Shawhan Supply 's capital structure
is 30% debt, 20% preferred stock, and 50% common stock. When using
book values, capital structure is 25% debt, 10% preferred stock, and
65% common stock. The required return on each component is: debt—
10%; preferred stock—11%; and common stock—18%. The marginal
tax rate is 40%. What rate of return must Shawhan Supply earn on its
investments if the value of the firm is to remain unchanged?
A) 18.0%
B) 13.0%
C) 10.0%
D) 14.3%
2) Which of the following is the preferred method in estimating a firm's
cost of capital?
A) Consider the cost of a specific source of financing that will be used
for a firm's new projects; i.e., the marginal cost of capital.
B) Calculate the weighted average cost of new capital to be utilized in
financing a firm's projects.
C) Calculate the firm's weighted average CAPM to be utilized in
financing a firm's projects.
D) Calculate the firm's cost of capital using the historical cost of
components.
3) Capital budgeting analyses typically assume a constant cost of
capital, even though the analysts know it will change. One reason for
this practice is that
A) the changes are too small to affect the decision.
B) a constant cost of capital is the most conservative assumption.
C) the changes are unpredictable.
D) NPV calculations do not allow more than one discount rate.
4) Reliable Metals plans to issue bonds that will mature in 20 years,
will have a semi-annual coupon rate of 7%, and will have a Moody's
rating of Aa2. Bonds of other metals companies with similar maturities
and ratings currently yield an average of 6.3%.
A) Reliable's bonds will sell at a price to yield about 6.3% because that
is the investors' opportunity cost.
B) Reliable's bonds should be priced to yield a rate close to the coupon
rate.
C) Reliable's bonds should yield more than 6.3% because they are new.
D) Reliable's bonds should yield less than 6.3% because they are new.
5) Tropical Fruit Drinks issued $10,000,000 in bonds to expand its
production facilities. After issuing the bonds, the company was 60%
debt financed and 40% common equity financed. Tropical intends to
retire 20% of the bonds each year for the next 5 years and not to issue
any new debt.
A) All things equal, we would expect Tropical Fruit Drinks cost of
capital to decrease gradually over the next 5 years.
B) All things equal, we would expect Tropical Fruit Drinks cost of
capital to increase gradually over the next 5 years.
C) All things equal, we would expect Tropical Fruit Drinks cost of
capital to stay the same for the next 5 years, then decrease rapidly.
D) All things equal, we would expect Tropical Fruit Drinks cost of
capital to stay the same for the next five years, then increase rapidly.
6) Metals Corp. has $2,575,000 of debt, $550,000 of preferred stock,
and $18,125,000 of common equity. Metals Corp.'s after-tax cost of
debt is 5.25%, preferred stock has a cost of 6.35%, and newly issued
common stock has a cost of 14.05%. What is Metals Corp.'s weighted
average cost of capital?
A) 12.78%
B) 10.84%
C) 8.32%
D) 6.56%
7) How frequently do most firms update their cost of capital?
A) Rarely, if ever
B) At least once a year
C) Daily
D) Only when there are major changes in the firm's capital structure
8) The highest cost of capital at which a project can reach break-even
NPV is the project's
A) component cost of capital.
B) cost of common equity.
C) project-specific cost of capital.
D) internal rate of return.
9) The WACC should be computed using
A) balance sheet weights and target yields.
B) weights based on the firm's ideal capital structure and target yields
on debt and equity.
C) market weights and opportunity costs to the firm.
D) market weights and opportunity costs to investors.
10) The opportunity cost of securities issued by a firm is determined by
A) the rate of return investors could earn on riskless securities.
B) the rate of return on the firm's next best investment opportunity.
C) the rate of return investors could obtain on similar securities.
D) the weighted average rate of return on all securities issued by the
firm.
11) Which of the following statements regarding calculating a firm's
cost of capital is correct?
A) The after-tax cost of debt is generally more expensive than the after-
tax cost of preferred stock.
B) Since retained earnings are readily available, the cost of retained
earnings is generally lower than the cost of debt.
C) If a company's beta increases, this will increase the cost of capital.
D) The level of general economic conditions will determine whether a
firm should utilize an arithmetic average cost of capital or a weighted
average cost of capital.
12) A company has a capital structure that consists of 50% debt and
50% equity. Which of the following is generally true?
A) The weighted average cost of capital is less than the cost of equity
financing.
B) The cost of equity financing is greater than the cost of debt
financing.
C) The weighted average cost of capital is calculated on a before-tax
basis.
D) Both A and B.
13) Which of the following circumstances would invalidate the
constant cost of capital assumption?
A) the project will be financed entirely with debt.
B) The firm know that it's marginal tax rate will change from 25% to
34% next year.
C) the project will be financed entirely from retained earnings.
D) the price of the company's stock is extremely volatile.
14) A strong stock market and reasonably good earnings have caused
the price of the firm's common stock to increase by 25%.
A) This will have no effect on the firm's cost of capital.
B) All thing's equal, this will increase the firm's cost of capital.
C) All thing's equal, this will lower the firm's cost of capital.
D) This will only affect the cost of capital if the firm uses CAPM to
compute the cost of equity.
15) The weighted cost of capital assumes that the company maintains a
constant debt to equity ratio.
Answer: TRUE
16) In most instances, as the amount of debt rises, the common
stockholders will decrease their required rate of return.
Answer: FALSE
17) All things equal, as the tax rate increases, the incentive to use more
debt financing increases.
Answer: TRUE
18) As long as the firm issues no new debt, changes in interest rates
will have no effect on the cost of capital.
Answer: FALSE
19) National Gridlock's capital structure consisted of $125 million of
debt and $250 million of equity before it issued bonds to borrow an
additional $125 million. The new funds will be used to finance
infrastructure improvements and expansion. The company believes that
the project will generate enough cash to retire 1/5 of the bonds each
year. How do the borrowing and the repayment plan affect the discount
rate(s) that should be used to evaluate this project?
Answer: Such a large borrowing will definitely impact National
Gridlock's WACC and the discount rate it will use. Increasing the
amount of debt from 33% to 50% should, all things equal, lower the
company's WACC because of the tax shelter provided by the additional
interest expense. Because the company plans to retire the debt over
such a short period of time, the WACC should gradually return to about
its previous level.
National Gridlock could discount cash flows from the project at
different rates, reflecting its changing cost of capital, or it could use the
higher rate based on a capital structure of 1/3 debt and 2/3 equity.
Using the higher rate would be conservative and somewhat understate
the project's NPV.
20) Why is it important to use market-based weights rather than
balance sheet weights when estimating a company's weighted average
cost of capital
Answer: The WACC is supposed to represent the opportunity cost of
funds to the investors. A company may have issued bonds years ago
when interest rates were either higher or lower. Common stocks also
may have been first issued when the company was new and risky and
market conditions were very different. These "embedded" costs are
irrelevant to the investor who decides to buy or keep the company's
bonds and stocks. These investors will be looking only at the rate of
return that could be earned on investments of similar risk available
today.
14.5 Estimating Project Costs of Capital
1) Pilgrim's WACC is 12%. It has one opportunity to invest in a high
risk project with an expected rate of return of 25%. It has another
opportunity to lease a building to a government agency. The expected
rate of return on the lease is 10%.
A) Pilgrim should definitely accept the high risk project and reject the
leasing arrangement.
B) Ideally, Pilgrim would discount the cash flows from each project at
a rate appropriate to its risk.
C) Pilgrim should definitely accept both projects.
D) Pilgrim should finance the lease with all debt and the high risk
project with all equity.
2) Plimoth Plantation's overall WACC is 11%. It has an opportunity to
accept a project that involves nearly riskless cash flows, but will earn
only 7%. This project will require a significant portion of the firm's
capital. If Plimoth accepts this project
A) the value of the company will fall because it's WACC will fall.
B) the value of the company will fall because it's average rate of return
on investments will fall.
C) the value of the company will rise because its WACC will fall.
D) both it's average rate of return and its WACC should fall.
Answer: D
3) Alio e Olio has restaurants throughout the United States, Canada,
and Western Europe. It is considering a proposal to open several
restaurants in major cities of India and China.
A) Alio e Olio should use the company's overall WACC to evaluate all
proposals.
B) Alio e Olio should use a lower discount rate for new ventures to be
sure it does not miss out on opportunities.
C) Alio e Olio should evaluate projects in different regions at discount
rates that reflect the risk inherent in those projects.
D) Alio e Olio should adjust the discount rate for specific regions to
reflect the specific sources of funding used.
4) In theory using the same discount rate to evaluate all projects can
lead to
A) rejection of low risk projects that should be accepted.
B) acceptance of high risk projects that should be rejected.
C) control of efforts by employees with a vested interested in a project
to manipulate the discount rate.
D) all of the above.
5) Lott Bros Developers evaluates a great many small to medium size
projects each year. Some are riskier than others. Lott Bros should
probably
A) allow individual project managers to estimate their own discount
rates.
B) try to identify the specific funding sources for each project.
C) use the company's overall WACC for all projects.
D) spend a great deal of time and money to estimate discount rates for
each project.
6) Survey literature indicates that separate project costs of capital
A) are used by less than half of major companies.
B) are used by more than 75% of major companies.
C) are used by nearly all major companies.
D) are almost never used by major companies.
7) Estimating a divisional cost of capital by comparing the division to a
similar free-standing company is known as
A) Divisional Average Cost of Capital approach (DACC).
B) Segmental Capital Structure approach. (SCS).
C) the "pure play" approach.
D) Project Specific Approach (PSA).
8) The "pure play" approach to estimating a divisions WACC involves
A) computing the value of the division if it were to be spun off as a
separate company.
B) comparisons to free standing firms with businesses similar to the
division.
C) "deleveraging" the division so that only the cost of equity is
considered.
D) using the company's WACC to estimate the value added by the
division.
9) Which of the following is a good reason to use divisional costs of
capital?
A) Division managers have no vested interest in underestimating the
capital costs associated with their division.
B) Divisional costs of capital reduce are relatively easy to estimate.
C) Comparison firms are often engaged in various lines of business.
D) The divisions of a company represent well-defined lines of business
with different risk characteristics, for example oil and gas exploration
and distribution through pipelines.
10) Large firms are most likely to adjust for differences in the risk
levels of investments taken on by different parts of the firm
A) by subjectively adjusting the company's WACC up or down.
B) by estimating individual costs of capital for each individual project.
C) by estimating individual costs of capital for each division or unit of
the company.
D) by identifying the specific sources of funding used by each division
or unit.
11) The average cost of capital is the appropriate rate to use when
evaluating new investments, even though the new investments might be
in a higher risk class.
Answer: FALSE
12) The weighted average cost of capital is the minimum required
return that must be earned on additional investment if firm value is to
remain unchanged.
Answer: TRUE
13) Using separate cost of capital estimates for individual projects is
not appropriate when the projects are relatively few in number and
large in scale.
Answer: FALSE
14) Using a firm's overall cost of capital to evaluate individual projects
creates an incentive for managers to avoid high risk projects with
potentially high returns.
Answer: FALSE
15) Most large firms use individual costs of capital to evaluate all
projects.
Answer: FALSE
16) Tantasqua Paper Products is composed of 3 divisions: industrial
paper products, commercial paper products, and a forestry division
which grows trees for wood pulp used in the paper-making process.
Each of these divisions takes on a large number of projects with
differing risk characteristics. Tantasqua now uses a single discount rate
based on the company's WACC to evaluate all capital budgeting
proposals. Discuss the advantages and disadvantages of this approach.
Answer: The single discount rate approach minimizes time and effort
spent in estimating the required rate of return for projects and divisions.
The single rate may be perceived as fair by the division managers and
project managers. This approach minimizes the problem of managers
attempting to manipulate the discount rate to have their projects
accepted.
The biggest disadvantage to this approach is that it may cause
Tantasqua to accept projects whose returns are not high enough to
justify their risk or on the contrary, reject attractive low risk projects
whose returns are below the WACC.
17) Tantasqua Paper Products is composed of 3 divisions: industrial
paper products, commercial paper products, and a forestry division
which grows trees for wood pulp used in the paper-making process.
Each of these divisions takes on a large number of projects with
differing risk characteristics. Tantasqua now uses a single discount rate
based on the company's WACC to evaluate all capital budgeting
proposals. Discuss the advantages and disadvantages of switching to an
approach based on separate discount rates for each division or even the
risk level of each project.
Answer: Switching to multiple discount rates may lead to better capital
budgeting decisions because it matches the discount rate used to the
unique risk characteristics of each project or division. Tantasqua would
then be less likely to reject good projects that offered relatively low
rates of return but with very little risk or to accept projects with too
much risk for the rate of return implied by the discount rate.
On the other hand, trying to match discount rates to each individual
project might be time consuming and often somewhat subjective. The
benefits of such an attempt might not be commensurate with the costs.
Using a WACC tailored to each of the three divisions is a more
practical approach, but also not without its problems. In particular, it
might be difficult to find good free-standing comparable companies
needed to implement the "pure play" approach.
14.6 Flotation Costs and Project NPV
1) Jen and Barry's Ice Cream needs $20 million in new capital to
expand its production facilities. It will use 40% debt and 60% equity.
The company's after-tax cost of debt is 5% and the cost of equity is
12.5%. Flotation costs will be 3% for debt and 9% for equity. Compute
Jen and Barry's weighted average flotation cost.
A) 6.6%
B) 6.0%
C) 9.5%
D) 16.1%
2) Jen and Barry's Ice Cream needs $20 million in new capital to
expand its production facilities. It will use 40% debt and 60% equity.
The company's after-tax cost of debt is 5% and the cost of equity is
12.5%. Flotation costs will be 3% for debt and 9% for equity. What rate
should be used to discount the cash flows from the expansion project?
A) 6.6%
B) 6.0%
C) 9.5%
D) 16.1%
3) Jen and Barry's Ice Cream needs $20 million in new capital to
expand its production facilities. It will use 40% debt and 60% equity.
The company's after-tax cost of debt is 5% and the cost of equity is
12.5%. Flotation costs will be 3% for debt and 9% for equity. What is
the total amount of capital that will need to be raised to finance the
expansion project?
A) $22,386,000
B) $20,000,000
C) $21,200.000
D) $21,413,276
4) Stonehedge Dairy will expand its organic yogurt production capacity
at a cost of $10,000,000. The expansion will increase after-tax
operating cash by $1.4 million dollars per year for the next 20 years.
Stonehedge's WACC is 10%. To raise the $10,000,000 Stonehedge will
need to issue new securities at a weighted average flotation cost of
10%. What is the NPV of the expansion?
A) $918,989
B) $807,878
C) $11,918,989
D) $1,918,989
5) When new capital must be raised for an expansion project, flotation
costs should
A) be deducted from the operating cash flows.
B) increase the initial investment outlay.
C) be considered in recomputing the firm's overall WACC.
D) be ignored.
6) Larger issues of new common stock can cause ________ to increase.
A) flotation costs
B) the investor's required rate of return
C) the stock price
D) the tax rate
7) As the size of a financing issue increases, the ________ usually
decreases on a percentage basis.
A) cost of equity Answer: In order to raise $15 million after flotation costs, Sprite will 5) Which of the following is NOT a component of a firm's capital
B) flotation cost of the issue need to raise $15,000,000/(1-.12) = $17,045,455. Using a financial structure?
C) effective tax rate calculator, the PV of the incremental cash flows is N=20, i=12, A) Preferred stock
D) both A and B PMT=2,300,000 and PV=17,179,720. The project's NPV is B) Bonds
$17,179,720 - $17,045,455 = $134,265. C) Common stock
8) The cost of newly issued common stock is greater than the current D) Accounts payable
cost common equity because of E) Retained earnings
A) capital gains taxes on retained earnings. Financial Management (Chapter 15: Capital Structure Policy)
B) flotation costs on newly issued common stock. 15.1 A Glance at Capital Structure Choices in Practice 6) Merrimac Brewing company's total assets equal $18 million. The
C) capital gains taxes on newly issued common stock. book value of Merrimac's equity is $6 million. Excess cash is
D) all of the above 1) The firm's optimal capital structure is the mix of financing sources $200,000. The market value of Merrimac's equity is $10 million. Its
that Debt to Enterprise Value ratio is .5. What is the book value of
9) Flotation costs A) minimizes the risk of financial distress. Merrimac's interest- bearing debt?
A) have no effect on the project's NPV. B) maximizes after-tax earnings. A) $5.25 million
B) increase the firm's cost of capital, but only for the life of the project. C) maximizes the total value of the firm's debt and equity. B) $10.2 million
C) increase the initial investment in a project. D) maximizes favorable leverage. C) $15 million
D) permanently increase the firm's cost of capital. D) $20.4 million
2) Suppose we calculate a times interest earned ratio of 29 for Colgate-
10) Flotation costs increase the amount of funds that must be raised to Palmolive. We can conclude
finance an investment. A) Colgate-Palmolive may experience some difficulty meeting its 7) Merrimac Brewing company's total assets equal $18 million. The
Answer: TRUE interest payments. book value of Merrimac's equity is $6 million. Excess cash is
B) Colgate-Palmolive is very unlikely to have difficulty meeting its $200,000. The market value of Merrimac's equity is $10 million. Its
interest payments. Debt to Enterprise Value ratio is .5. What is Merrimac's Debt Ratio?
11) Flotation costs are usually ignored when computing the NPV of C) Colgate-Palmolive has $29 of operating cash flow for every dollar A) .75
projects financed with newly issued securities. of interest expense. B) .67
Answer: FALSE D) Colgate-Palmolive's EBITDA is 29 times larger than its interest C) .33
expense. D) .25
12) All capital projects incur flotation costs, no matter how they are
financed. 3) A firm's capital structure consists of which of the following? 8) Cornucopia's liabilities and equity are shown below:
Answer: FALSE A) The amount of debt that a firm uses
B) The amount of debt and preferred stock that a firm uses Accounts
13) Flotation costs are higher for debt than for equity because debt C) The amount of debt, preferred stock, and common stock that a firm Payable $500,000
creates more risk to the issuer. uses Accrued
Answer: FALSE D) The mix of long and short-term debt used by the firm Expenses 250,000
Short-term Note
14) A project with a positive NPV may have a negative NPV when at 5% 300,000
flotation costs are considered. 4) The enterprise value of the firm is defined as Long-Term Debt 1,250,000
Answer: TRUE A) (Market Value of Interest Bearing Debt-Excess Cash) + Market Common Equity,
Value of Equity Book Value 2,500,000
15) Sprite Communications will erect 20 new transmission towers at a B) (Book Value of Interest Bearing Debt-Excess Cash) + Market Value
Common Equity,
total cost of $15,000,000. The expansion will increase after-tax of Equity
Market Value 6,000,000
operating cash flows by $2.3 million dollars per year for the next 20 C) (Book Value of Interest Bearing Debt-Excess Cash) + Book Value
years. Sprite's WACC is 12%. To raise the $15,000,000, Sprite will of Equity
need to issue new securities at a weighted average flotation cost of D) Market Value of Interest Bearing Debt + Market Value of Equity What is Cornucopia's debt ratio?
12%. What is the NPV of the expansion? A) .48
B) .32
C) .21
D) .30 retained earnings total $10 million. There is no preferred stock. What is 19) The Times Interest Earned Ratio measures a firm's ability to meet
the book value of interest bearing debt? both interest payments and scheduled principal repayments.
A) $15 million Answer: FALSE
9) Cornucopia's liabilities and equity are shown below: B) $7 million
C) $18 million 20) The debt ratio is usually computed using book values for both debt
Accounts D) $8 million and equity.
Payable $500,000 Answer: TRUE
Accrued 13) Which of the following should be excluded from a firm's capital
Expenses 250,000 structure? 21) Debt ratios and debt to enterprise value ratios differ widely from
Short-term Note A) Common equity one industry to another.
at 5% 300,000 B) Non-interest bearing debt Answer: TRUE
Long-Term Debt 1,250,000 C) Long-term debt
D) Short-term bank notes
Common Equity,
Book Value 2,500,000 22) What is meant by the terms "favorable" and "unfavorable"
leverage?
Common Equity,
14) A company that earns a rate of return on its investments lower than
Market Value 6,000,000
the interest rate on its debt is said to have Answer: If a firm can earn a higher rate of return on its investments
A) unfavorable financial leverage. than it pays in interest on borrowed funds, the difference goes to the
What is Cornucopia's debt to value ratio? B) a sub-optimal capital structure. firm's owners, its shareholders. The additional money earned will cause
A) .48 C) favorable financial leverage. Return on Equity to be higher than Return on Assets. In essence, the
B) .32 D) negative financial leverage. firm is using "other people's money" to make money for its owners.
C) .21
D) .30 15) A company whose rate of return on investments is higher than the Leverage can also work in reverse. Interest is a fixed cost. It must be
interest rate on its debt is said to have paid whether or not the firm has sufficient earnings. When the rate of
10) Fibonacci Property Management's balance sheet shows total A) unfavorable financial leverage. return on investments is lower that the interest rate on borrowed,
liabilities of $5 million and total assets of $13 million. Interest bearing B) a sub-optimal capital structure. leverage is said to be "unfavorable" and return on owner's equity will
liabilities total $3 million (book value). The market value of C) favorable financial leverage. be reduced by the difference.
Fibonnacci's equity is $21 million. What is Fibonacci's debt ratio? D) negative financial leverage.
A) .38 23) Why is the Debt to Assets Ratio always higher than the Debt to
B) .23 16) How does the text distinguish between firm's financial Value ratio?
C) .125 structure and its capital structure?
D) .24 A) Financial structure includes only interest bearing debt. Answer: First, the debt to assets ratio uses book values. Book values
B) Capital structure includes only non-interest bearing debt. for debt in the numerator are usually close to market values, but the
C) Financial structure uses market values of equity. asset values used in the denominator are often distorted by inflation
11) Fibonacci Property Management's balance sheet shows total D) Capital structure includes only interest bearing debt. and, in any case, do not represent the true value of the firm. The Debt
liabilities of $5 million and total assets of $13 million. Interest bearing to Value ratio has a smaller numerator, because non-interest bearing
liabilities total $3 million (book value). Excess cash $500,000. The 17) Financial structure includes long-term and short-term sources of debt is excluded, and a larger denominator because for a healthy firm,
market value of Fibonnacci's equity is $21 million. What is Fibonacci's funds. the market value of the equity will be considerably greater than the
Debt to Enterprise Value ratio? Answer: TRUE book value.
A) .38
B) .23 24) Bipolar Beverages total assets equal $360 million. The book value
C) .125 18) A firm's financial structure is defined by the Debt Ratio, while of Bipolar's equity is $180 million. The market value of Bipolar's
D) .106 its capital structure is defined by the Debt to Value ratio. equity is $ 250 million. The book value of the company's interest
Answer: TRUE bearing debt is $120 million. Compute Bipolar's Debt Ratio and Debt to
12) Tremont Inc.'s Total Assets =$25 million. The balance sheet shows Value Ratio.
Accounts payable and accruals totaling $7 million, common stock and
Answer:
Debt Ratio = 180,000,000/360,000,000 = .50
Debt to value ratio = $120,000,000/($120,000,000 + 250,000,000) =
.324
15.2 Capital Structure Theory
1) In its original form, the Modigliani and Miller Capital Structure
Theorem
A) uses unrealistic assumptions.
B) provided important insights into capital structure policy.
C) concludes that how a firm is financed is not important.
D) all of the above.
2) The inclusion of bankruptcy risk in firm valuation
A) acknowledges that a firm has an upper limit to debt financing.
B) causes cost of capital curve to be linear.
C) causes the cost of capital curve to be downward sloping regardless
of capital structure.
D) has no consequences for practical management of capital structure
policy.
3) Which of the following is the most important factor that affects a
firm's financing mix?
A) The amount of EPS
B) The amount of operating income
C) The number of shares that are outstanding
D) The predictability of cash flows
4) When the impact of taxes is considered, as the firm takes on more
debt
A) there will be no change in total cash flows.
B) both taxes and total cash flow to stockholders and bondholders will
decrease.
C) cash flows will increase because taxes will decrease.
D) the weighted average cost of capital will increase.
5) The original form of the Modigliani and Miller Capital Structure
Theorem
A) ignores the effect of taxes.
B) ignores the relationship between firm value and cost of capital.
C) ignores transaction costs.
D) both A and C are true.
6) Optimal capital structure is
A) the funding mix that will maximize the company's common stock
price.
B) the mix of all items that appear on the right-hand side of the
company's balance sheet.
C) the mix of funds that will minimize the firm's beta.
D) the mix of securities that will maximize EPS.
7) An optimal capital structure is achieved
A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's break-even point is achieved.
D) when a firm's weighted average cost of capital is minimized.
8) From the information below, select the optimal capital structure for
Mountain High Corp.
A) Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50
B) Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90
C) Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20
D) Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40
E) Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00
9) An optimal capital structure is achieved
A) when a firm's expected profits are maximized.
B) when a firm's expected EPS are maximized.
C) when a firm's expected stock price is maximized.
D) when a firm's break-even point is achieved.
10) Using the original Modigliani and Miller assumptions if a firm's
cost of capital is 12% when it is all equity financed and it's cost of debt
is 8%, the cost of equity will be ________% when the firm is financed
with equal amount of debt and equity.
A) 12%
B) 24%
C) 16%
D) cannot be determined with the information given.
11) The tradeoff theory of capital structure management assumes
A) no corporate income taxes.
B) cost of equity remains constant with an increase in financial
leverage.
C) firms might fail.
D) none of the above.
12) Which of the following is consistent with the Tradeoff theory of
capital structure?
A) The cost of capital continuously decreases as the firm's debt ratio
increases.
B) The cost of capital remains constant as the firm's debt ratio
increases.
C) There are no costs associated with bankruptcy.
D) There is an optimal level of debt financing.
13) Which of the following is a reasonable conclusion from the
Tradeoff theory of capital structure?
A) A high debt ratio will result in a maximum price of a firm's common
stock.
B) A firm's common stock price will not be affected by the amount of
debt a firm uses.
C) A low debt ratio will result in a maximum price for a firm's common
stock.
D) Modest levels of debt have a more favorable impact on a firm's
average cost of capital and stock price than no debt.
14) Which of the following is consistent with the original formulation
of the Modigliani and Miller Capital Structure Theorem?
A) A firm's composite cost of capital decreases as financial leverage is
used.
B) A firm's common stock price falls as financial leverage is used.
C) A firm's composite cost of capital and common stock price are
unaffected by the amount of financial leverage used by the firm.
D) A firm's composite cost of capital increases as operating leverage is
used.
15) Which of the following will happen if the original Modigliani and
Miller Theorem is relaxed to include taxes, but not bankruptcy costs?
A) Increased usage of financial leverage will increase a firm's
composite cost of capital indefinitely.
B) Increased usage of financial leverage will lower a firm's composite
cost of capital indefinitely.
C) Increased usage of financial leverage will not affect a firm's
composite cost of capital.
D) Increased usage of operating leverage will increase a firm's
composite cost of capital indefinitely.
16) The Tradeoff theory of capital structure suggests that if a firm
moves from zero debt in its capital structure to moderate usage of debt,
the result is an increase in a firm's
A) stock price.
B) cost of equity.
C) dividend payout.
D) both A and C.
17) If interest expense lowers taxes, why does the WACC not decrease
indefinitely with the addition of more debt?
A) The tax shield effect of debt will result in a lower cost of equity.
B) Increasing debt too much can result in a greater likelihood of firm
failure (financial distress).
C) A firm's common stock price will not be affected by the amount of
debt a firm uses.
D) Too much common equity increases the probability of bankruptcy.
18) Capital structure theory suggests that companies may put the
interests of ________ ahead of the interests of ________.
A) Potential stockholders, existing stockholders
B) Stockholders, bondholders
C) Existing shareholders, IRS
D) There are no potential conflicts arising from the way a firm manages
its capital structure.
19) The inclusion of bankruptcy costs and taxes in firm valuation
A) causes the cost of capital curve to be umbrella shaped.
B) is consistent with a saucer-shaped cost of capital curve.
C) is consistent with a cost of capital curve that slopes downward.
D) causes the cost of capital to rise in a linear fashion as more debt is
added to the capital structure.
20) The theory that managers may prefer internal sources of funds to
the lowest cost source of funds is known as
A) the Modigliani and Miller Proposition.
B) tradeoff theory.
C) financial stress avoidance theory.
D) pecking order theory.
21) The Tradeoff Theory of capital structure theory indicates that
A) the tax shield on debt positively affects firm value, indicating that
there is some benefit to financial leverage as opposed to an all-equity
capitalization.
B) the higher the firm's financial leverage, the higher the probability the
firm will be unable to meet the financial obligations included in its debt
contracts, which could ultimately lead to firm failure.
C) there is a range of capital structures, rather than a single capital
structure, that is optimal.
D) all of the above. $2 million in debt at a before-tax rate of 8%. The tax rate is 40%. How
much cash does each firm return to its investors.
A) Lowell $2,400,000, Lawrence $2,144,000
22) The Tradeoff Theory view of capital structure management says B) Lowell $2,400,000, Lawrence $2,240,000
that the cost of capital curve is C) Lowell $2,400,000, Lawrence $2,464,000
A) a straight line. D) Lowell $2,400,000, Lawrence $2,304,000
B) v-shaped.
C) s-shaped.
D) saucer-shaped. 28) The most acceptable view of capital structure, according to the text,
is that the weighted average cost of capital
23) Assume that the tax rate is 40% and bankruptcy costs are negligible A) first falls with moderate levels of leverage and then increases as a
until a firm's debt to equity ratio is greater than one. If Madison Co. firm's leverage becomes high.
increases debt from 10% of its capital structure to 40%, cash flows to B) does not change with leverage.
investors will C) increases proportionately with increases in leverage.
A) decrease. D) increases with moderate amounts of leverage and then falls.
B) remain the same.
C) increase. 29) Newbury Inc. has retained $2 million in earnings this year. It can
D) A firm's cash flows are independent of its capital structure. borrow up to $1.5 million at a rate of 8% and sell the same amount of
new stock at a cost of 17%. Newbury's cost of common equity without
24) The pecking order theory of capital structure is derived from selling any new stock is 16%. If Newbury's capital budget is $2.5
A) expectations theory. million, pecking order theory says management will use
B) the Modigliani-Miller theory. A) $1.5 million in debt and $1 million in retained earnings.
C) liquidity preference theory. B) $2 million in retained earnings and $0.5 million in debt.
D) agency theory. C) $833,333 each from retained earnings, new debt and new stock.
D) $1.5 million in debt and $1 million in new stock.
25) With taxes, but in the absence of financial distress costs, the 30) Which of the following is part of a firm's financial structure but
optimal capital structure would be NOT a component of its capital structure?
A) 100% equity. A) Retained earnings
B) 50% debt, 50% equity. B) Mortgage bonds
C) 100% debt. C) Accounts payable
D) completely insensitive to the mix of debt and equity. D) Both A and C
26) Chelsea Corporation's cost of equity is 16% and it is 100% equity
financed. If it can borrow enough money at 10% to buy back half of its 31) Investors require a higher return on common stock investments if a
stock, what would would happen to the cost of equity be under the firm uses less leverage.
original assumptions of the Modigliani and Miller Capital Structure Answer: FALSE
Theorem.
A) It would remain at 16%. 32) Other things the same, the use of debt financing reduces the firm's
B) It would rise to 22%. total tax bill, resulting in a higher total market value.
C) It would fall to 11%. Answer: TRUE
D) It would fall to 13%.
33) Given the existence of taxes and bankruptcy costs, the optimal
27) Lowell Corporation and Lawrence Corporation each have EBIT of capital structure is 100% debt.
$4 million. Lowell has no debt and no interest expense; Lawrence has Answer: FALSE
34) The Modigliani and Miller Capital Structure Theorem suggests that Answer: Adams Inc. EBIT $50 million - Interest $0 = Earnings before
the cost of equity decreases as financial leverage increases. tax $50 million.
Answer: FALSE
Adams Bellingham
35) The objective of capital structure management is to maximize the EBIT $50 million $50 million
market value of the firm's equity. Interest Exp 0.00 10 million
Answer: TRUE EBT 50 million 40 million
Taxes @.30 15 million 12 million
36) Agency costs occur when managers choose the easiest form of
Net Income $35 million $28 million
financing over the value maximizing capital structure.
Answer: TRUE Dividends $35 million $28 million
$28 million +$10
37) The pecking order theory of capital structure indicates that firms Total million = $38
prefer to finance investment opportunities with least expensive forms of distributions $35 million million
financing first and the most expensive last.
Answer: FALSE
42) Cheshire Corporation is now financed 100% with equity. The cost
38) The trade-off theory of capital structure recognizes the tax-shield of equity is 15%. Cheshire is considering a proposal to borrow enough
benefit of debt financing, but also recognizes that the benefit is offset money at 7% to buy back half of its common stock. It would then be
by costs associated with debt financing. financed 50% with debt and 50% with equity.
Answer: TRUE
Assume that this does not affect the cost of equity. Cheshire's tax rate is
39) The tax shield on interest is calculated by multiplying the interest 40%. What is Cheshire's cost of capital without and with the stock
rate paid on debt by the principal amount of the debt and the firm's repurchase?
marginal tax rate.
Answer: TRUE Answer: Cheshire's cost of capital is now 15%. After the stock
repurchase, it would be
7%(1 - .4)(.5) + 15%(.5) = 9.6%
40) In the original version of the Modigliani and Miller capital structure
theorem, as a firm increases the amount of debt in its capital structure, 43) Under what conditions are shareholders likely to incur agency costs
the cost of equity will rise but the cost of capital will remain the same. when managers make capital budgeting decisions?
Answer: TRUE
Answer: When managers are not major shareholders of the company,
41) Adams Inc. expects EBIT of $50 million if there is a recession, their self-interest may not coincide with the interests of shareholders.
$100 million if the economy is normal, and $150 million if the Managers may avoid risky but potentially rewarding proposals and the
economy expands. Bellingham Inc. also expects EBIT of $50 million if additional effort and scrutiny that come with raising outside capital.
there is a recession, $100 million if the economy is normal, and $150
million if the economy expands. 44) Briefly explain what the empirical evidence suggests about
financial managers' actions as they relate to the capital structure theory.
Adams is financed entirely with equity while Bellingham is financed
50% with debt at 10%. Adams has $200 million in equity; Bellingham Answer: Capital structure theory predicts that managers will add debt
is financed with $100 million of debt and $100 million of equity. The to the capital structure when current leverage is below the firm's
tax rate is 30%. Both firms pay out all available earnings as dividends. optimal range of leverage use at the base of the overall cost of capital
If there is a recession, compare dividends and total distributions to curve. Survey research indicates that in practice managers only go to
investors for each company. the debt markets after after internal funds have been exhausted. This is
surprising as the cost of internal equity is greater than that of the cost of
debt.
There are two reasons why this is happening. The most obvious reason
for this behavior is that using internal funds minimizes the
inconvenience to managers and constraints on their behavior that might
come with issuing debt. The other possibility is that managers do not
actually try to minimize the WACC.
15.3 Why Do Capital Structures Differ across Industries?
1) Which of the following factors favors the use of more debt in a
company's financial structure?
A) High levels of taxable income
B) Low levels of taxable income
C) The business is basically risky with unpredictable cash flows.
D) Risk of bankruptcy would make customers reluctant to buy the
company's products.
2) Which industry would you expect to have the highest Debt to Asset
ratios?
A) Business oriented software
B) Electric utilities
C) Communications equipment
D) Retail clothing
3) In which countries would you expect companies to have the lowest
leverage ratios?
A) Countries with very high tax rates
B) Countries that tend to subsidize key industries and protect them
from failure
C) Countries where creditors have very strong legal protection
D) Countries where the market value of companies is high compared to
their book values
4) Which of the following is a good reason for a company to have
higher than average debt ratios.
A) The company's cash flows are difficult to predict.
B) The company generates little taxable income.
C) Customer support is an important aspect of the company's business.
D) The company faces high marginal tax rates.
5) At the beginning of the financial crisis of 2008, excessive debt
caused serious problems in the ________ industry.
A) computer
B) pharmaceuticals
C) utilities From the table above we can conclude A) corporate tax rate
D) financial A) Waltham has a conservative capital structure policies. B) personal tax rate
B) Waltham has too much debt. C) company's degree of operating leverage
6) U. S. companies differ very little in their capital structures. C) Waltham uses more leverage than the typical firm in its industry. D) expected cost of bankruptcy
Answer: FALSE D) Waltham's EPS would be more sensitive than a typical firm's to
changes in EBIT. 8) The EBIT-EPS indifference point
7) Companies faced with higher tax burdens are likely to use more A) identifies the EBIT level at which the EPS will be the same
debt. 2) Which two ratios would be most helpful in managing a firm's capital regardless of the financing plan.
Answer: TRUE structure? B) identifies the point at which the analysis can use EBIT and EPS
A) Book Debt to Equity, Current Ratio interchangeably.
B) Debt to Value Ratio and Times Interest Earned C) identifies the level of earnings at which the management is
8) Conservative balance sheets may be advantageous for companies C) Debt to Assets, Profit Margin indifferent about the payments of dividends.
that have long-term relationships with their customers. D) Payables Turnover, Return on Assets D) none of the above.
Answer: TRUE

9) Top management's desire to avoid the scrutiny that comes with 3) When benchmarking a firm's capital structure, management should 9) As a general rule, the optimal capital structure
higher levels of debt may influence the capital structures of some firms. compare it to A) maximizes expected EPS and also maximizes the price per share of
Answer: TRUE A) firms in S&P 500. common stock.
B) firms in the same geographic region. B) minimizes the interest rate on debt and also maximizes the expected
10) List and briefly explain at least two important reasons why capital C) firms recognized for the quality of their management. EPS.
structures tend to differ between industries and even companies within D) firms in similar lines of business. C) minimizes the required rate on equity and also maximizes the stock
the same industry. price.
4) If a firm chose to increase its debt ratio from 20% to 40%, what is D) maximizes the price per share of common stock and also minimizes
Answer: There are several reasons why firms use more or less debt in the potential risk? the weighted average cost of capital.
their capital structure. Firms facing high tax burdens may find the tax A) The average cost of capital would most likely rise.
shield from interest especially valuable. Firms with relatively safe B) The price of the firm's common stock would definitely decline. 10) The capital structure that minimizes the weighted average cost of
businesses (i.e. low bankruptcy costs) and a low rate of return on assets C) If economic forces cause a reduction of sales, the firm's EPS might capital will also
such as electric or gas utilities may use leverage to boost return on decline. A) maximize EPS for any given level of EBIT.
equity. Other businesses may have an especially strong need to reassure D) The firm's WACC might decline. B) minimize the value of the firm.
their customers that they will not go out of business (high bankruptcy C) minimize bankruptcy costs.
costs.) 5) When using an EPS-EBIT chart to evaluate a pure debt financing D) maximize the price per share of common stock.
and pure equity financing plan, the debt financing plan line will have
A) a steeper slope than the equity financing plan line. Use the following information to answer the following question(s).
15.4 Making Financing Decisions B) a slower rate of change as EBIT increases.
C) a downward slope. Your firm is trying to determine whether it should finance a project
1) D) the same slope as the equity plan, but a higher intercept. requiring $800,000 with new common stock or with debt. The firm is
Comparable faced with the following financing alternatives:
Waltham Watch Firms I: Issue new common stock. Sale price of the common stock is
Debt ratio 33% 42% 6) Basic tools of capital structure management include expected to be $40 per share.
Interest -bearing A) EBIT-EPS analysis. II: Issue new bonds with a coupon rate of 12%.
debt ratio 19% 23 B) comparative profitability ratios. The firm has a marginal tax rate of 34%, the company currently has
Times interest C) capital budgeting techniques. 40,000 shares of common stock outstanding, and $90,000 face value of
earned ratio 25 20 D) economic value added analysis. 10% debt outstanding.
EBITDA
7) An increase in the ________ is likely to encourage a corporation to 11) Total shares outstanding will be
coverage ratio 6 4
increase its debt ratio. A) 20,000 under alternative I and zero under alternative II.
B) 40,000 under alternative I and 60,000 under alternative II. of common stock which have a market value of $10 per share, no shareholders are $2,791,800, with 384,000 shares of common stock
C) 60,000 under alternative I and 40,000 under alternative II. preferred stock, and no debt. The firm is considering two alternatives to outstanding.
D) 60,000 under both alternative I and alternative II. finance a new product: (a) the issuance of $6 million of 10% bonds, or
(b) the issuance of 60,000 new shares of common stock at $10 per If the firm were to instead have a debt ratio of 80%, additional interest
share. If Zybeck issues common stock this year, what will the firm's expense would cause profits available to stockholders to decline to
12) The total interest obligation will be return on equity be next year? $2,732,400, but only 307,200 common shares would be outstanding.
A) $105,000 under alternative I and $9,000 under alternative II. A) 16.7% What is the difference in EPS at a debt ratio of 80% versus 60%?
B) $9,000 under alternative I and $105,000 under alternative II. B) 18.2% A) $$1.62
C) zero under alternative I and $96,000 under alternative II. C) 22.1% B) $1.33
D) $105,000 under both alternative I and alternative II. D) 26.4% C) $7.27
E) 29.6% D) $-0.15
13) Weaknesses of the EBIT-EPS analysis include
A) that it disregards the implicit costs of debt financing. Use the following information to answer the following question(s).
B) that it ignores the effect of the specific financing decision on the 17) Abbot Corp has a debt ratio (debt to assets) of 20%. Management is
firm's cost of common equity capital. wondering if its current capital structure is too conservative. Abbot Your firm is trying to determine whether it should finance a project
C) that it considers only the level of the earnings stream and ignores the Corp's present EBIT is $4.5 million, and profits available to common requiring $800,000 with new common stock or with debt. The firm is
variability inherent in it. shareholders are $2,910,600, with 600,000 shares of common stock faced with the following financing alternatives:
D) all of the above. outstanding. If the firm were to instead have a debt ratio of 40%, I: Issue new common stock. Sale price of the common stock is
additional interest expense would cause profits available to expected to be $40 per share.
14) Farar, Inc. projects operating income of $4 million next year. The stockholders to decline to $2,851,200, but only 480,000 common II: Issue new bonds with a coupon rate of 12%.
firm's income tax rate is 40%. Farar presently has 750,000 shares of shares would be outstanding. What is the difference in EPS at a debt The firm has a marginal tax rate of 34%, the company currently has
common stock, no preferred stock, and no debt. The firm is considering ratio of 40% versus 20%? 40,000 shares of common stock outstanding, and $90,000 face value of
the issuance of $6 million of 10% bonds to finance a new product that A) $4.85 10% debt outstanding.
is not expected to generate an increase in income for two years. If Farar B) $6.34
issues the bonds this year, what will projected EPS be next year? C) $1.09 20) The indifference level of EBIT is
A) $1.53 D) $-0.10 A) $99,000.
B) $1.98 B) $66,600.
C) $2.72 18) Babbit Corp has a debt ratio (debt to assets) of 40%. Management C) $333,000.
D) $4.53 is wondering if its current capital structure is too conservative. Babbit D) $297,000.
Corp's present EBIT is $4.5 million, and profits available to common
shareholders are $2,851,200, with 480,000 shares of common stock
15) Zybeck Corp. projects operating income of $4 million next year. outstanding. If the firm were to instead have a debt ratio of 60%, 21) EPS at the indifference level of EBIT is
The firm's income tax rate is 40%. Zybeck presently has 750,000 shares additional interest expense would cause profits available to A) $3.17.
of common stock which have a market value of $10 per share, no stockholders to decline to $2,791,800, but only 384,000 common B) $4.80.
preferred stock, and no debt. The firm is considering two alternatives to shares would be outstanding. What is the difference in EPS at a debt C) $5.27.
finance a new product: (a) the issuance of $6 million of 10% bonds, or ratio of 60% versus 40%? D) $5.90.
(b) the issuance of 60,000 new shares of common stock. There are no A) $5.94
issuance costs for either the bonds or the stock. If Zybeck issues B) $1.33 22) A firm is analyzing two different capital structures for financing a
common stock this year, what will projected EPS be next year? C) $1.09 new asset that will cost $100,000. The effects of the two structures on
A) $2.10 D) $-0.12 the firm's balance sheet are described below.
B) $2.96
C) $2.33 Plan A: finance with 50% debt
D) $1.67 19) Cabot Corp has a debt ratio (debt to assets) of 60%. Management is New asset $100,000 Debt $50,000
wondering if its current capital structure is too conservative. Cabot Common equity $50,000
16) Zybeck Corp. projects operating income of $4 million next year. Corp's present EBIT is $4.5 million, and profits available to common Total $100,000
The firm's income tax rate is 40%. Zybeck presently has 750,000 shares
Plan B: finance with 70% debt 27) Comparative leverage ratio analysis does not involve the use of b. Does the "indifference point" calculated in question (a) above truly
New asset $100,000 Debt $70,000 industry norms. represent a point where stockholders are indifferent between stock and
Common equity $30,000 Answer: FALSE debt financing? Explain your answer.
Total $100,000
28) High coverage ratios, compared with a standard, imply unused debt Answer:
Based on the information provided, we can conclude that capacity. a. (EBIT - 0)(1 - 0.4)/3,200,000 =
A) if the firm chooses Plan A, then any changes in the firm's EBIT will Answer: TRUE (EBIT - 520,000)(1 - 0.4)/3,000,000
lead to larger fluctuations in the firm's EPS than if the firm chooses EBIT = $8,320,000.
Plan B. 29) Benchmarking the company's capital structure is popular because it b. No. Financial risk is ignored.
B) if the firm chooses Plan B, then any changes in the firm's EBIT will is impossible to know exactly what the company's optimal capital
lead to larger fluctuations in the firm's EPS than if the firm chooses structure should be.
Plan A. Answer: TRUE 33) The MAX Corporation is planning a $4 million expansion this year.
C) if the firm chooses Plan A, then any changes in the firm's EBIT will The expansion can be financed by issuing either common stock or
lead to the same fluctuations in the firm's EPS as will occur if the firm 30) Rising bankruptcy costs should cause most firms to use less debt bonds. The new common stock can be sold for $60 per share. The
chooses Plan B. and more equity. bonds can be issued with a 12% coupon rate. The firm's existing shares
D) if the firm chooses Plan B, then any changes in the firm's EBIT will Answer: TRUE of preferred stock pay dividends of $2.00 per share. The company's
lead to smaller fluctuations in the firm's EPS than if the firm chooses combined state and federal corporate income tax rate is 46%. The
Plan A. company's balance sheet prior to expansion is as follows:
31) Roberts, Inc. is trying to decide how best to finance a proposed $10
million capital investment. Under Plan I, the project will be financed MAX Corporation
23) The level of EBIT that will equate EPS between two different entirely with long-term 9% bonds. The firm currently has no debt or Current assets $ 2,000,000
financing plans is called the preferred stock. Under Plan II, common stock will be sold to net the Fixed assets 8,000,000
A) indifference point. firm $20 a share; presently, 1 million shares are outstanding. The Total assets $10,000,000
B) optimal capital plan. corporate tax rate for Roberts is 40%. Current liabilities $ 1,500,000
C) pivot point. a. Calculate the indifference level of EBIT associated with the two Bonds:
D) tradeoff point financing plans. (8%, $1,000 par value) 1,000,000
b. Which financing plan would you expect to cause the greatest (10%, $1,000 par value) 4,000,000
24) Useful ratios for bench-marking a firm's capital structure include change in EPS relative to a change in EBIT? Why? Preferred stock:
A) the Debt ratio. c. If EBIT is expected to be $3.1 million, which plan will result in a ($100 par value) 500,000
B) Times Interest Earned ratio. higher EPS? Common stock:
C) EBITDA coverage ratio. ($2 par value) 700,000
D) all of the above. Answer: Retained earnings 2,300,000
a. (EBIT)(1 - 0.4)/1,500,000 = Total liabilities and equity $10,000,000
25) Which of the following factors was most often cited by CFOs as an (EBIT - $900,000)(1 - 0.4)/1,000,000
important influence on debt use? EBIT = $2,700,000 a. Calculate the indifference level of EBIT between the two plans.
A) Keeping the confidence of customers and suppliers b. The bond plan will magnify changes in EPS since adding debt b. If EBIT is expected to be $3 million, which plan will result in
B) Minimizing bankruptcy costs increases financial leverage. higher EPS?
C) Maintaining financial flexibility c. Since $3.1 million EBIT is above the indifference point of $2.7
D) Benchmarking against similar firms million, the bond plan will give a higher EPS. Answer:
a.
26) The EBIT-EPS indifference point, sometimes called the break-even 32) Young Enterprises is financed entirely with 3 million shares of EPS: Stock Plan [(EBIT - $480,000)(1 - .46) - $10,000]/[(350,000 +
point, identifies the optimal range of financial leverage regardless of common stock selling for $20 a share. Capital of $4 million is needed 66,667)]
the financing plan chosen by the financial manager. for this year's capital budget. Additional funds can be raised with new [(EBIT)(.54) - $259,200 - $10,000]/(416,667)
Answer: FALSE stock (ignore dilution) or with 13% 10-year bonds. Young's tax rate is EPS: Bond Plan
40%. [(EBIT - $960,000)(1 - .46) - $10,000]/(350,000)
a. Calculate the financing plan's EBIT indifference point. [(EBIT)(.54) - $518,400 - $10,000]/(350,000)
(350,000)[EBIT(.54) - $269,200] = Interest expense was $180,000. Earnings before interest and taxes were
(416,667)[EBIT(.54) - $528,400] $2.5 million. Depreciation was $1.5 million. Compute the following
(189,000)EBIT - $94,220,000,000 = ratios: Debt ratio, Interest-bearing debt ratio, Times interest earned
(225,000)EBIT - $220,000,000,000 ratio, and EBITDA coverage ratio.
(36,000)EBIT = $125,780,000,000
EBIT = $3,493,889 Answer:
b. Debt ratio = $4,000,000/$10,000,000 = .40.
EPS: Stock Plan Interest bearing debt ratio = (4,000,000 - 1,000,000)/10,000,000 = .30
[($3,000,000 - $480,000)(1 - .46) - $10,000]/(350,000 + 66,667) = Times Interest earned ratio = 2,500,000/180,000 = 13.89
$1,350,800/416,667 = $3.24 EBITDA coverage ratio = (2,500,000 + 1,500,000)/180,000 = 22.22
EPS: Bond Plan
[($3,000,000 - $960,000)(1 - .46) - $10,000]/350,000 =
$1,091,600/350,000 = $3.12
Stock plan has higher EPS.

34) Sunshine Candy Company's capital structure for the past year of
operation is shown below.

First mortgage bonds at 12% $2,000,000

Debentures at 15% 1,500,000
Common stock (1 million shares) 5,000,000
Retained earnings 500,000
Total $9,000,000

The federal tax rate is 50%. Sunshine Candy Company, home-based in

Orlando, wants to raise an additional $1 million to open new facilities
in Tampa and Miami. The firm can accomplish this via two
alternatives: (1) it can sell a new issue of 20-year debentures with 16%
interest; or (2) 20,000 new shares of common stock can be sold to the
public to net the candy company $50 per share.

A recent study, performed by an outside consulting organization,

projected Sunshine Candy Company's long-term EBIT level at
approximately $6.8 million. Find the indifference level of EBIT (with
regard to EPS) between the suggested financing plans.

Answer:
[(EBIT - 465,000)(0.5)]/1,020,000 =
[(EBIT - 625,000)(0.5)]/1,000,000
(0.5 EBIT - 232,500)/102 =
<0 -="" .5="" 312="" ebit="">/100
50 EBIT - 23,250,000 = 51 EBIT - 31,875,000
EBIT = $8,625,000 indifference level

35) Allston-Brighton Corp. has total assets of $10 million, total

liabilities of $4 million, of which $1 million are non-interest bearing.