MCQ Test Bank

Corporate(Finance!(Berk/DeMarzo)!
Chapter!1!-!The!Corporation!
!
!
1.1!The!Four!Types!of!Firms!
1)!!A!sole!proprietorship!is!owned!by:!
A)!!One!person!
B)!!Two!of!more!persons!
C)!!Shareholders!
D)!!Bankers!
Answer:!!!A!
Explanation:!!! A)!!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!1.1!The!Four!Types!of!Firms!
Skill:!Definition!
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2)!!Which!of!the!following!organization!forms!for!a!business!does!not!avoid!double!taxation?!
A)!!Limited!Partnership!
B)!!LCL!Corporation!
C)!!LSL!Corporation!
D)!!Limited!Liability!Company!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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3)!!Which!of!the!following!organization!forms!has!the!most!revenue?!
A)!!LSL!Corporation!
B)!!Limited!Partnership!
C)!!LCL!Corporation!
D)!!Limited!Liability!Company!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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4)!!Which!of!the!following!organization!forms!accounts!for!the!greatest!number!of!firms?!
A)!!LSL!Corporation!
B)!!Limited!Partnership!
C)!!Sole!Proprietorship!
D)!!LCL!Corporation!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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5)!!Which!of!the!following!is!NOT!an!advantage!of!a!sole!proprietorship?!
A)!!Single!taxation!
B)!!Ease!of!setup!
C)!!Limited!liability!
D)!!No!separation!of!ownership!and!control!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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6)!!Which!of!the!following!statements!regarding!limited!partnerships!is!true?!
A)!!There!is!no!limit!on!a!limited!partnerRs!liability.!
B)!!A!limited!partnerRs!liability!is!limited!by!the!amount!of!their!investment.!
C)!!A!limited!partner!is!not!liable!until!all!the!assets!of!the!general!partners!have!been!exhausted.!
D)!!A!general!partnerRs!liability!is!limited!by!the!amount!of!their!investment.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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7)!!Which!of!the!following!is!/!are!an!advantage!of!incorporation?!
A)!!Access!to!capital!markets!
B)!!Limited!liability!
C)!!Unlimited!life!
D)!!All!of!the!above!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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8)!!Which!of!the!following!statements!is!most!correct?!
A)!!An!advantage!to!incorporation!is!that!it!allows!for!less!regulation!of!the!business.!
B)!!An!advantage!of!a!corporation!is!that!it!is!subject!to!double!taxation.!
C)!!Unlike!a!partnership,!a!disadvantage!of!a!corporation!is!that!has!limited!liability.!
D)!!Corporations!face!more!regulations!when!compared!to!partnerships.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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9)!!A!limited!liability!company!is!essentially!
A)!!a!limited!partnership!without!limited!partners.!
B)!!a!limited!partnership!without!a!general!partner.!
C)!!just!another!name!for!a!limited!partnership.!
D)!!just!another!name!for!a!corporation.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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10)!!The!distinguishing!feature!of!a!corporation!is!that!
A)!!their!is!no!legal!difference!between!the!corporation!and!its!owners.!
B)!!it!is!a!legally!defined,!artificial!being,!separate!from!its!owners.!
C)!!it!spreads!liability!for!its!corporate!obligations!to!all!shareholders.!
D)!!provides!limited!liability!only!to!small!shareholders.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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11)!!Which!of!the!following!are!subject!to!double!taxation?!
A)!!Corporation!
B)!!Partnership!
C)!!Sole!proprietorship!
D)!!A!and!B!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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12)!!You!own!100!shares!of!a!LCL!Corporation.!!The!corporation!earns!$5.00!per!share!before!taxes.!!Once!the!
corporation!has!paid!any!corporate!taxes!that!are!due,!it!will!distribute!the!rest!of!its!earnings!to!its!
shareholders!in!the!form!of!a!dividend.!!If!the!corporate!tax!rate!is!40%!and!your!personal!tax!rate!on!(both!
dividend!and!non-dividend)!income!is!30%,!then!how!much!money!is!left!for!you!after!all!taxes!have!been!
paid?!
A)!!$210!
B)!!$300!
C)!!$350!
D)!!$500!
Answer:!!!A!
Explanation:!!! A)!!EPS!×!number!of!shares!×!(1!-!Corporate!Tax!Rate)!×!(1!-!Individual!Tax!Rate)!
$5.00!per!share!×!100!shares!×!(1!-!.40)!x!(1!-!.30)!=!$210!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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13)!!You!own!100!shares!of!a!Sub!Chapter!LSL!Corporation.!!The!corporation!earns!$5.00!per!share!before!taxes.!!
Once!the!corporation!has!paid!any!corporate!taxes!that!are!due,!it!will!distribute!the!rest!of!its!earnings!to!its!
shareholders!in!the!form!of!a!dividend.!!If!the!corporate!tax!rate!is!40%!and!your!personal!tax!rate!on!(both!
dividend!and!non-dividend)!income!is!30%,!then!how!much!money!is!left!for!you!after!all!taxes!have!been!
paid?!
A)!!$210!
B)!!$300!
C)!!$350!
D)!!$500!
Answer:!!!C!
B)!!
C)!!EPS!×!number!of!shares!×!(1!-!Individual!Tax!Rate)!
$5.00!per!share!×!100!shares!×!(1!-!.30)!=!$350!
D)!!
Diff:!2!
Skill:!Analytical!
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14)!!You!are!a!shareholder!in!a!LCL!corporation.!!This!corporation!earns!$4!per!share!before!taxes.!!After!it!has!paid!
taxes,!it!will!distribute!the!remainder!of!its!earnings!to!you!as!a!dividend.!!The!dividend!is!income!to!you,!so!
you!will!then!pay!taxes!on!these!earnings.!!The!corporate!tax!rate!is!35%!and!your!tax!rate!on!dividend!income!
is!15%.!!The!effective!tax!rate!on!your!share!of!the!corporations!earnings!is!closest!to:!
A)!!15%!
B)!!35%!
C)!!45%!
D)!!50%!
Answer:!!!C!
B)!!
C)!!Fist!the!corporation!pays!taxes.!!It!earned!$4!per!share,!but!must!pay!$4!×!.35!=!$1.40!to!the!
government!in!corporate!taxes.!!That!leaves!$4.00!-!$1.40!=!$2.60!to!distribute!to!the!
shareholders.!!However,!the!shareholder!must!pay!$2.60!×!.15!=!$0.39!in!income!taxes!on!this!
amount,!leaving!only!$2.21!to!the!shareholder!after!all!taxes!are!paid.!!The!total!amount!paid!
in!taxes!is!$1.40!+!0.39!=!$1.79.!!The!effective!tax!rate!is!then!$1.79!÷!$4!=!.4475!or!44.75%!which!
is!closest!to!45%.!
D)!!
Diff:!3!
Skill:!Analytical!
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15)!!Explain!the!benefits!of!incorporation.!
Answer:!!!1.! Limited!liability!
2.! Unlimited!life!
3.! Access!to!capital!markets!/!availability!of!outside!funding!
Diff:!2!
Skill:!Conceptual!
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16)!!Explain!the!difference!between!a!sub-chapter!LSL!corporation!and!a!sub-chapter!LCL!corporation.!
!
Answer:!!!=C=!Corporation! =S=!Corporation!
Publicly!traded!stock! Privately!traded!stock!
Unlimited!shareholders! No!more!than!75!shareholders!
Double!taxation! Taxed!like!a!partnership!
Diff:!2!
Skill:!Conceptual!
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1.2!Ownership!Versus!Control!of!Corporations!
1)!!In!a!corporation,!the!ultimate!decisions!regarding!business!matters!are!made!by!
A)!!the!Board!of!Directors.!
B)!!debt!holders.!
C)!!shareholders.!
D)!!investors.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!1.2!Ownership!Versus!Control!of!Corporations!
Skill:!Conceptual!
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2)!!The!person!charged!with!running!the!corporation!by!instituting!the!rules!and!policies!set!by!the!board!of!
directors!is!called!
A)!!the!Chief!Operating!Officer.!
B)!!the!Company!President.!
C)!!the!Chief!Executive!Officer.!
D)!!the!Chief!Financial!Officer.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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3)!!The!Principal-Agent!Problem!arises!!
A)!!because!managers!have!little!incentive!to!work!in!the!interest!of!shareholders!when!this!means!working!
against!their!own!self-interest.!
B)!!because!of!the!separation!of!ownership!and!control!in!a!corporation.!
C)!!Both!A!and!B!
D)!!None!of!the!above!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
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4)!!If!shareholders!are!unhappy!with!a!CEORs!performance,!they!are!most!likely!to!
A)!!buy!more!shares!in!an!effort!to!gain!control!of!the!firm.!
B)!!file!a!shareholder!resolution.!
C)!!replace!the!CEO!through!a!grassroots!shareholder!uprising.!
D)!!sell!their!shares.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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5)!!A!________,!is!when!a!rich!individual!or!organization!purchases!a!large!fraction!of!the!stock!of!a!poorly!
performing!firm!and!in!doing!so!gets!enough!votes!to!replace!the!board!of!directors!and!the!CEO.!
A)!!shareholder!proposal!
B)!!leveraged!buyout!
C)!!shareholder!action!
D)!!hostile!takeover!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
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6)!!Which!of!the!following!statements!is!false?!
A)!!In!bankruptcy,!management!is!given!the!opportunity!to!reorganize!the!firm!and!renegotiate!with!debt!
holders.!
B)!!Because!a!corporation!is!a!separate!legal!entity,!when!it!fails!to!repay!its!debts,!the!people!who!lent!to!the!
firm,!the!debt!holders!are!entitled!to!seize!the!assets!of!the!corporation!in!compensation!for!the!default.!
C)!!As!long!as!the!corporation!can!satisfy!the!claims!of!the!debt!holders,!ownership!remains!in!the!hands!of!
the!equity!holders.!
D)!!If!the!corporation!fails!to!satisfy!debt!holdersR!claims,!debt!holders!may!lose!control!of!the!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!corporation!fails!to!satisfy!debt!holdersR!claims,!debt!holders!may!take!control!of!the!
firm.!
Diff:!2!
Skill:!Conceptual!
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7)!!What!strategies!are!available!to!shareholders!to!help!ensure!that!managers!are!motivated!to!act!in!the!interest!
of!the!shareholders!rather!than!their!own!interest?!
Answer:!!!1.! The!threat!of!a!hostile!takeover!
2.! Shareholder!initiatives!
3.! Performance!based!compensation!
Diff:!3!
Skill:!Conceptual!
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1.3!The!Stock!Market!
Use$the$table$for$the$question(s)$below.
!
Consider!the!following!two!quotes!for!XYZ!stock:!
!
November!11th! November!18th!
Ask:! 25.25! Ask:! 26.00!
Bid:! 25.20! Bid:! 25.93!
1)!!How!much!would!you!have!to!pay!to!purchase!100!shares!of!XYZ!stock!on!November!18th?!
A)!!$2520!
B)!!$2525!
C)!!$2593!
D)!!$2600!
Answer:!!!D!
B)!!
C)!!
D)!!100!shares!×!$26.00!(ask!price)!=!$2600!
Diff:!1!
Topic:!1.3!The!Stock!Market!
Skill:!Analytical!
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2)!!How!much!would!you!receive!if!you!sold!200!shares!of!XYZ!stock!on!November!11th?!
A)!!$5050!
B)!!$5040!
C)!!$5186!
D)!!$5200!
Answer:!!!B!
B)!!200!shares!×!$25.20!(bid!price)!=!$5040!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
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3)!!The!largest!stock!market!in!the!world!is!
A)!!the!London!Stock!Exchange.!
B)!!NASDAQ.!
C)!!the!American!Stock!Exchange.!
D)!!the!New!York!Stock!Exchange.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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4)!!An!investment!is!said!to!be!liquid!if!the!investment!
A)!!has!large!day!to!day!fluctuations!in!price.!
B)!!has!a!large!bid-ask!spread.!
C)!!can!easily!be!converted!into!cash.!
D)!!is!traded!on!a!stock!exchange.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
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5)!!What!type!of!company!trades!on!an!organized!stock!exchange?!
A)!!a!limited!liability!company.!
B)!!a!private!company.!
C)!!an!LSL!corporation.!
D)!!a!public!company.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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A)!!On!Nasdaq,!stocks!can!and!do!have!multiple!market!makers!who!compete!with!each!other.!Each!market!
maker!must!post!bid!and!ask!prices!in!the!Nasdaq!network!where!they!can!be!viewed!by!all!participants.!
B)!!Bid!prices!exceed!ask!prices.!
C)!!Because!customers!always!buy!at!the!ask!and!sell!at!the!bid,!the!bid-ask!spread!is!a!transaction!cost!
investors!have!to!pay!in!order!to!trade.!
D)!!On!the!floor!of!the!NYSE,!market!makers!(known!on!the!NYSE!as!specialists)!match!buyers!and!sellers.!
Answer:!!!B!
B)!!Ask!prices!exceed!bid!prices.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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!
Consider!the!following!two!quotes!for!XYZ!stock:!
!
November!11th! November!18th!
Ask:! 25.25! Ask:! 26.00!
Bid:! 25.20! Bid:! 25.93!
!
7)!!What!are!your!net!proceeds!if!you!purchased!2500!shares!of!XYZ!stock!on!November!11th!and!then!sold!them!
a!week!later!on!November!18th?!
Answer:!!!sell!at!bid!price!11/18!=!2500!×!$25.93!=!$64,825!
now!subtract!the!price!paid!for!the!shares!
buy!at!ask!price!11/11!=!2500!×!$25.25!=!$63,125!
so!net!proceeds!=!64,825!-!63,125!=!$1700!
Diff:!2!
Skill:!Analytical!
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8)!!Explain!the!main!differences!between!the!NYSE!and!NASDAQ!stock!markets.!
Answer:!!!Key!points:!
NYSE!has!physical!location—NASDAQ!is!an!electronic!market.!
NYSE!has!one!specialist!!in!each!stock!and!his!role!is!to!match!buyers!and!sellers.!
NASDAQ!has!multiple!market!makers!(dealers)!in!each!stock!who!stand!ready!to!trade!on!their!own!
accounts.!
Diff:!2!
Skill:!Conceptual!
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Chapter!2!-!Introduction!to!Financial!Statement!Analysis!
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2.1!The!Disclosure!of!Financial!Information!
1)!!U.S.!public!companies!are!required!to!file!their!annual!financial!statements!with!the!U.S.!Securities!and!
Exchange!Commission!on!which!form?!
A)!!10-A!
B)!!10-K!
C)!!10-Q!
D)!!10-SEC!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!2.1!The!Disclosure!of!Financial!Information!
Skill:!Definition!
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2)!!Which!of!the!following!is!not!a!financial!statement!that!every!public!company!is!required!to!produce?!
A)!!Income!Statement!
B)!!Statement!of!Sources!and!Uses!of!Cash!
C)!!Balance!Sheet!
D)!!Statement!of!StockholdersN!Equity!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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3)!!The!third!party!who!checks!!annual!financial!statements!to!ensure!that!they!are!prepared!according!to!GAAP!
and!verifies!that!the!information!reported!is!reliable!is!the!
A)!!NYSE!Enforcement!Board.!
B)!!Accounting!Standards!Board.!
C)!!Securities!and!Exchange!Commission!(SEC).!
D)!!auditor.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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4)!!What!is!the!role!of!an!auditor!in!financial!statement!analysis?!
Answer:!!!Key!points:!
1.! To!ensure!that!the!annual!financial!statements!are!prepared!accurately.!
2.! To!ensure!that!the!annual!financial!statements!are!prepared!according!to!GAAP.!
3.! To!verify!that!the!information!used!in!preparing!the!annual!financial!statements!is!reliable.!
Diff:!2!
Skill:!Conceptual!
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5)!!What!are!the!four!financial!statements!that!all!public!companies!must!produce?!
Answer:!!!1.! Balance!Sheet!
2.! Income!Statement!
3.! Statement!of!Cash!Flows!
4.! Statement!of!StockholderNs!Equity!
Diff:!2!
Skill:!Conceptual!
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2.2!The!Balance!Sheet!
1)!!Which!of!the!following!balance!sheet!equations!is!incorrect?!
A)!!Assets!-!Liabilities!=!ShareholdersN!!Equity!
B)!!Assets!=!Liabilities!+!ShareholdersN!Equity!
C)!!Assets!-!Current!Liabilities!=!Long!Term!Liabilities!
D)!!Assets!-!Current!Liabilities!=!Long!Term!Liabilities!+!ShareholdersN!Equity!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!2.2!The!Balance!Sheet!
Skill:!Conceptual!
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2)!!Cash!is!a!
A)!!Long-term!asset.!
B)!!Current!Asset.!
C)!!Current!Liability.!
D)!!Long-term!liability.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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3)!!Accounts!payable!is!a!
A)!!Long-term!liability.!
B)!!Current!Asset.!
C)!!Long-term!asset.!
D)!!Current!Liability.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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4)!!A!30!year!mortgage!loan!is!a!
A)!!Long-term!liability.!
B)!!Current!Liability.!
C)!!Current!Asset.!
D)!!Long-term!asset.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
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5)!!Which!of!the!following!statements!regarding!the!balance!sheet!is!incorrect?!
A)!!The!balance!sheet!provides!a!snapshots!of!the!firmNs!financial!position!at!a!given!point!in!time.!
B)!!The!balance!sheet!lists!the!firmNs!assets!and!liabilities.!
C)!!The!balance!sheet!reports!stockholdersN!equity!on!the!right!hand!side.!
D)!!The!balance!sheet!reports!liabilities!on!the!left!hand!side.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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Consider!the!following!balance!sheet:!
!
Luther!Corporation!
Consolidated!Balance!Sheet!
December!31,!2006!and!2005!(in!$!millions)!
!
Liabilities!and!
Assets! 2006! 2005!! StockholdersL!Equity! 2006! 2005!
Current$Assets$ $ $ $ Current$Liabilities! ! !
Cash! 63.6! 58.5!! Accounts!payable! 87.6! 73.5!
Notes!payable!/!!
Accounts!receivable! 55.5! 39.6!! short-term!debt! 10.5! 9.6!
Current!maturities!of!
Inventories! 45.9! 42.9!! long-term!debt! 39.9! 36.9!
Other!current!assets! 6.0! 3.0!! Other!current!liabilities! 6.0! 12.0!
!!!!!Total!current!assets! 171.0! 144.0!! !!!!!Total!current!liabilities! 144.0! 132.0!
! ! ! ! !
Long-Term$Assets$ $ $ Long-Term$Liabilities! ! !
!!Land! 66.6! 62.1! !!Long-term!debt! 239.7! 168.9!
!!Buildings! 109.5! 91.5!! !!Capital!lease!obligationss ---! ---
!!Equipment! 119.1! 99.6!! Total!Debt! 239.7! 168.9!
!!Less!accumulated!
!!depreciation! (56.1)! (52.5)!! Deferred!taxes! 22.8! 22.2!
Net!property,!plant,!and!
equipment! 239.1! 200.7!! Other!long-term!liabilities ---! ---
Goodwill 60.0! --!! Total!long-term!liabilities! 262.5! 191.1!
Other!long-term!assets! 63.0! 42.0!! Total!liabilities! 406.5! 323.1!
!!!!!Total!long-term!assets! 362.1! 242.7!! StockholdersN!Equity! 126.6! 63.6!
! ! ! ! ! ! !
Total!liabilities!and!
Total!Assets! 533.1! 386.7!! StockholdersL!Equity! 533.1! 386.7!
!
6)!!What!is!LutherNs!net!working!capital!in!2005?!
A)!!$12!million!
B)!!$27!million!
C)!!$39!million!
D)!!$63.6!million!
Answer:!!!A!
Explanation:!!! A)!!NWC!=!current!assets!-!current!liabilities!=!144!-!132!=!$12!million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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7)!!If!in!2006!Luther!has!10.2!million!shares!outstanding!and!these!shares!are!trading!at!$16!per!share,!then!
LutherNs!Market-to-book!ratio!would!be!closest!to:!
A)!!0.39!
B)!!0.76!
C)!!1.29!
D)!!2.57!
Answer:!!!C!
B)!!
C)!!MTB!=!market!cap!/!book!value!of!equity!=!(10.2!million!×!16)!/!126.6!=!163.2!/!126.6!=!1.289!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!When!using!the!book!value!of!equity,!the!debt!to!equity!ratio!for!Luther!in!2006!is!closest!to:!
A)!!2.21!
B)!!2.29!
C)!!2.98!
D)!!3.03!
Answer:!!!B!
B)!!D/E!=!Total!Debt!/!Total!Equity!
Total!Debt!=!(notes!payable!(10.5)!+!current!maturities!of!long-term!debt!(39.9)!+!long-term!
debt!(239.7)!=!290.1!million!
Total!Equity!=!126.6,!so!D/E!=!290.1!/!126.6!=!2.29!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!If!in!2006!Luther!has!10.2!million!shares!outstanding!and!these!shares!are!trading!at!$16!per!share,!then!using!
the!market!value!of!equity,!the!debt!to!equity!ratio!for!Luther!in!2006!is!closest!to:!
A)!!1.71!
B)!!1.78!
C)!!2.31!
D)!!2.35!
Answer:!!!B!
B)!!D/E!=!Total!Debt!/!Total!Equity!
Total!Debt!=!(notes!payable!(10.5)!+!current!maturities!of!long-term!debt!(39.9)!+!long-term!
debt!(239.7)!=!290.1!million!
Total!Equity!=!10.2!×!$16!=!163.2,!so!D/E!=!290.1!/!163.2!=!1.78!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!If!in!2006!Luther!has!10.2!million!shares!outstanding!and!these!shares!are!trading!at!$16!per!share,!then!what!
is!LutherNs!Enterprise!Value?!
A)!!-$63.3!million!
B)!!$353.1!million!
C)!!$389.7!million!
D)!!$516.9!million!
Answer:!!!C!
B)!!
C)!!Enterprise!value!=!MVE!+!Debt!-!Cash!=!10.2!×!$16!+!290.1!-!63.6!=!389.7!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!LutherNs!current!ratio!for!2006!is!closest!to:!
A)!!0.84!
B)!!0.87!
C)!!1.15!
D)!!1.19!
Answer:!!!D!
B)!!
C)!!
D)!!c urrent!ratio!=!current!assets!/!current!liabilities!=!171!/!144!=!1.19!
Diff:!2!
Skill:!Analytical!
!
12)!!LutherNs!quick!ratio!for!2005!is!closest!to:!
A)!!0.77!
B)!!1.31!
C)!!1.09!
D)!!0.92!
Answer:!!!A!
Explanation:!!! A)!!quick!ratio!=!(current!assets!-!inventory)!/!current!liabilities!
quick!ratio!=!(144.0!-!42.9)!/!132!=!0.77!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!The!change!in!LutherNs!quick!ratio!from!2005!to!2006!is!closest!to:!
A)!!a!decrease!of!.10!
B)!!an!increase!of!.10!
C)!!a!decrease!of!.15!
D)!!an!increase!of!.15!
Answer:!!!B!
B)!!quick!ratio!in!2006!=!(171.0!-!45.9)/144!=!.87!
quick!rat!io!2005!=!(144.0!-!42.9)!/!132!=!.77!
so!the!quick!ratio!increased!by!.87!-!.77!=!.10!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
14)!!If!on!December!31,!2005!!Luther!has!8!million!shares!outstanding!trading!at!$15!per!share.,!then!what!is!
LutherNs!market-to-book!ratio?!
Answer:!!!market-to-book!=!market!value!of!equity!/!book!value!of!equity!
market-to-book!=!8!million!×!$15!/!$63.6!=!1.89!
Diff:!2!
Skill:!Analytical!
!
15)!!If!on!December!31,!2005!!Luther!has!8!million!shares!outstanding!trading!at!$15!per!share.,!then!what!is!
LutherNs!enterprise!value?!
Answer:!!!Enterprise!value!=!Market!value!of!equity!+!Debt!-!Cash!
market!value!of!equity!=!8!million!×!$15!=!$120!million!
Debt!=!notes!payable!+!current!maturities!of!long-term!debt!+!long-term!debt!
Debt!=!9.6!+!!36.9!+!!168.9!=!!215.4!
Cash!=!58.5!
So,!enterprise!value!=!$120!+!215.4!-!58.5!=!$276.90!
Diff:!2!
Skill:!Analytical!
!
2.3!The!Income!Statement!
1)!!Which!of!the!following!statements!regarding!the!income!statement!is!incorrect?!
A)!!The!income!statement!shows!the!earnings!and!expenses!at!a!given!point!in!time.!
B)!!The!income!statement!shows!the!flow!of!earnings!and!expenses!generated!by!the!firm!between!two!
dates.!
C)!!The!last!or!bbottomb!line!of!the!income!statement!shows!the!firmNs!net!income.!
D)!!The!first!line!of!an!income!statement!lists!the!revenues!from!the!sales!of!products!or!services.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!2.3!The!Income!Statement!
Skill:!Conceptual!
!
2)!!Gross!profit!is!calculated!as!
A)!!Total!sales!-!cost!of!sales!-!selling,!general!and!administrative!expenses!-!depreciation!and!amortization!
B)!!Total!sales!-!cost!of!sales!-!selling,!general!and!administrative!expenses!
C)!!Total!sales!-!cost!of!sales!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Which!of!the!following!is!not!an!operating!expense?!
A)!!Interest!expense!
B)!!Depreciation!and!amortization!
C)!!Selling,!general!and!administrative!expenses!
D)!!Research!and!development!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Consider!the!following!income!statement!and!other!information:
!
Luther!Corporation!
Consolidated!Income!Statement!
Year!ended!December!31!(in!$!millions)!
2006 2005!
Total!sales 610.1 578.3!
Cost!of!sales (500.2) (481.9)!
Gross!profit 109.9 96.4!
Selling,!general,!and!!
administrative!expenses (40.5) (39.0)!
Research!and!development (24.6) (22.8)!
Depreciation!and!amortization (3.6) (3.3)!
Operating!income 41.2 31.3!
Other!income --- ---
Earnings!before!interest!and!taxes!(EBIT) 41.2 31.3!
Interest!income!(expense) (25.1) (15.8)!
Pretax!income 16.1 15.5!
Taxes (5.5) (5.3)!
Net!income 10.6 10.2!
Price!per!share $16 $15!

Shares!outstanding!(millions) 10.2 8.0!
Stock!options!outstanding!(millions) 0.3 0.2!
StockholdersN!Equity 126.6 63.6!

Total!Liabilities!and!StockholdersN!Equity 533.1 386.7!
!
4)!!For!the!year!ending!December!31,!2006!LutherNs!earnings!per!share!are!closest!to:!
A)!!$1.01!
B)!!$1.04!
C)!!$1.58!
D)!!$4.04!
Answer:!!!B!
B)!!EPS!=!Net!Income!/!Shares!Outstanding!=!$10.6!/!!10.2!=!$1.04!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Assuming!that!Luther!has!no!convertible!bonds!outstanding,!then!for!the!year!ending!December!31,!2006!
LutherNs!diluted!earnings!per!share!are!closest!to:!
A)!!$1.01!
B)!!$1.04!
C)!!$1.53!
D)!!$3.92!
Answer:!!!A!
Explanation:!!! A)!!Diluted!EPS!=!Net!Income!/!(shares!outstanding!+!options!contracts!outstanding!+!shares!
possible!from!convertible!bonds!outstanding)!=!10.6!/!(10.2!+!0.3!+!0.0)!=!$1.01!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!LutherNs!Operating!Margin!for!the!year!ending!December!31,!2005!is!closest!to:!
A)!!1.8%!
B)!!2.7%!
C)!!5.4%!
D)!!16.7%!
Answer:!!!C!
B)!!
C)!!Operating!Margin!=!Operating!Income!/!Sales!
OM!=!31.3!/!578.3!=!.054!or!5.4%!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!LutherNs!Net!Profit!Margin!for!the!year!ending!December!31,!2005!is!closest!to:!
A)!!1.8%!
B)!!2.7%!
C)!!5.4%!
D)!!16.7%!
Answer:!!!A!
Explanation:!!! A)!!Net!Profit!Margin!=!Net!Income!/!Total!Sales!=!10.2!/!578.3!=!.018!or!1.8%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!LutherNs!earnings!before!interest,!taxes,!depreciation,!and!amortization!(EBITDA)!for!the!year!ending!
December!31,!2006!is!closest!to:!
A)!!19.7!million!
B)!!37.6!million!
C)!!41.2!million!
D)!!44.8!million!
Answer:!!!D!
B)!!
C)!!
D)!!EBITDA!=!EBIT!+!Depreciation!&!Amortization!=!41.2!+!3.6!=!$!44.8!million!
Diff:!1!
Skill:!Analytical!
!
9)!!LutherNs!return!on!equity!(ROE)!for!the!year!ending!December!31,!2006!is!closest!to:!
A)!!2.0%!
B)!!6.5%!
C)!!8.4%!
D)!!12.7%!
Answer:!!!C!
B)!!
C)!!ROE!=!Net!income!/!shareholdersN!equity!=!10.6!/!126.6!=!.084!or!8.4%!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!LutherNs!return!on!assets!(ROA)!for!the!year!ending!December!31,!2006!is!closest!to:!
A)!!2.0%!
B)!!6.5%!
C)!!8.4%!
D)!!12.7%!
Answer:!!!A!
Explanation:!!! A)!!ROA!=!Net!income!/!total!assets.!
This!is!a!little!tricky!in!that!total!assets!arenNt!given!in!the!problem.!!The!student!must!
remember!the!basic!balance!sheet!equation!A!=!L!+!SE.!!Total!Liabilities!and!ShareholdersN!
Equity!is!given!and!this!is!the!same!as!total!assets.!!So!ROA!=!10.6!/!533.1!=!!.020!or!2.0%!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
11)!!LutherNs!price!-!earnings!ration!(P/E)!for!the!year!ending!December!31,!2006!is!closest!to:!
A)!!7.9!
B)!!10.1!
C)!!15.4!
D)!!16.0!
Answer:!!!C!
B)!!
C)!!P/E!=!Price!/!EPS!or!Market!Cap!/!Earnings!!=!(10.2!×!$16)!/!$10.6!=!15.4!
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!Calculate!LutherNs!return!of!equity!(ROE),!return!of!assets!(ROA),!and!price-to-earnings!ratio!(P/E)!for!the!year!
ending!December!31,!2005.!
Answer:!!!ROE!=!NI!/!shareholder!equity!=!10.2!/!63.6!=!.160!or!16.0%!
ROA!=!NI/!total!assets!
Here!total!assets!are!not!given,!but!we!know!that!Total!Assets!=!Total!Liabilities!+!Shareholder!Equity,!
so!ROA!=!10.2!/!386.7!=!.026!or!2.6%!
P/E!=!price!/!EPS!or!Market!Cap!/!NI!=!(8.0!×!$15)!/!$10.2!=!11.8!
Diff:!2!
Skill:!Analytical!
!
13)!!If!LutherNs!accounts!receivable!were!$55.5!million!in!2006,!then!calculate!LutherNs!accounts!receivable!days!for!
2006.!
Answer:!!! accounts receivable 55.5
Accounts!receivable!days!= !!= !=!33.2!days!
sales/365 610.1/ 365
Diff:!2!
Skill:!Analytical!
!
2.4!The!Statement!of!Cash!Flows!
1)!!Which!of!the!following!is!not!a!section!on!the!cash!flow!statement?!
A)!!Income!generating!activities!
B)!!Investing!activities!
C)!!Operating!activities!
D)!!Financing!activities!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!2.4!The!Statement!of!Cash!Flows!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!net!income!transferred!to!retained!earnings!is!correct?!
A)!!Net!income!=!net!income!transferred!to!retained!earnings!-!dividends!
B)!!Net!income!transferred!to!retain!earnings!=!net!income!+!dividends!
C)!!Net!income!=!net!income!transferred!to!retain!earnings!+!dividends!
D)!!Net!income!transferred!to!retain!earnings!-!net!income!=!!dividends!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Which!of!the!following!is!not!a!reason!why!cash!flow!may!not!equal!net!income?!
A)!!Amortization!is!added!in!when!calculating!net!income.!
B)!!Changes!in!inventory!will!change!cash!flows!but!not!income.!
C)!!Capital!expenditures!are!not!recorded!on!the!income!statement.!
D)!!Depreciation!is!deducted!when!calculating!net!income.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!Which!of!the!following!adjustments!to!net!income!is!not!correct!if!you!are!trying!to!calculate!cash!flow!from!
operating!activities?!
A)!!Add!increases!in!accounts!payable!
B)!!Add!back!depreciation!
C)!!Add!increases!in!accounts!receivable!
D)!!Deduct!increases!in!inventory!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Which!of!the!following!adjustments!is!not!correct!if!you!are!trying!to!calculate!cash!flow!from!financing!
activities?!
A)!!Add!dividends!paid!
B)!!Add!any!increase!in!long!term!borrowing!
C)!!Add!any!increase!in!short-term!borrowing!
D)!!Add!proceeds!from!the!sale!of!stock!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Use$the$tables$for$the$question(s)$below.
!
Consider!the!following!financial!information:!
!
Luther!Corporation!
Consolidated!Balance!Sheet!
December!31,!2006!and!2005!(in!$!millions)!
Liabilities!and!StockholdersL!
Assets! 2006! 2005!! Equity! 2006! 2005!
Current$Assets$ $ $ $ Current$Liabilities! ! !
Cash! 63.6! 58.5!! Accounts!payable! 87.6! 73.5!
Notes!payable!/!!
Accounts!receivable! 55.5! 39.6!! short-term!debt! 10.5! 9.6!
Current!maturities!of!long-term!
Inventories! 45.9! 42.9!! debt! 39.9! 36.9!
Other!current!assets! 6.0! 3.0!! Other!current!liabilities! 6.0! 12.0!
!!!!!Total!current!assets! 171.0! 144.0!! !!!!!Total!current!liabilities! 144.0! 132.0!
! ! ! ! !
Long-Term$Assets$ $ $ Long-Term$Liabilities! ! !
!!Land! 66.6! 62.1! !!Long-term!debt! 239.7! 168.9!
!!Buildings! 109.5! 91.5!! !!Capital!lease!obligationss ---! ---
!!Equipment! 119.1! 99.6!! Total!Debt! 239.7! 168.9!
!!Less!accumulated!
!!depreciation! (56.1)! (52.5)!! Deferred!taxes! 22.8! 22.2!
Net!property,!plant,!and!
equipment! 239.1! 200.7!! Other!long-term!liabilities ---! ---
Goodwill 60.0! --!! Total!long-term!liabilities! 262.5! !
Other!long-term!assets! 63.0! 42.0!! Total!liabilities! 406.5! 323.1!
!!!!!Total!long-term!assets! 362.1! 242.7!! StockholdersN!Equity! 126.6! 63.6!
! ! ! ! ! ! !
Total!liabilities!and!
Total!Assets! 533.1! 386.7!! StockholdersL!Equity! 533.1! 386.7!
!
!
Luther!Corporation!
Consolidated!Income!Statement!
Year!ended!December!31!(in!$!millions)!
2006 2005!
Total!sales 610.1 578.3!
Cost!of!sales (500.2) (481.9)!
Gross!profit 109.9 96.4!
Selling,!general,!and!!
administrative!expenses (40.5) (39.0)!
Research!and!development (24.6) (22.8)!
Depreciation!and!amortization (3.6) (3.3)!
Operating!income 41.2 31.3!
Other!income --- ---
Earnings!before!interest!and!taxes!(EBIT) 41.2 31.3!
Interest!income!(expense) (25.1) (15.8)!
Pretax!income 16.1 15.5!
Taxes (5.5) (5.3)!
Net!income 10.6 10.2!
Dividends!Paid !!!!!!!!!!!!!!!!!5.1 5.0!
Price!per!Share $16 $15!
Shares!outstanding!(millions) 10.2 8.0!
Stock!options!outstanding!(millions) 0.3 0.2!
Stockholders’!Equity 126.6 63.6!

Total!Liabilities!and!Stockholders’!Equity 533.1 386.7!
!
6)!!For!the!year!ending!December!31,!2006!LutherNs!cash!flow!from!operating!activities!is!?!!
Answer:!!!Operating!cash!flow!=!NI!+!Depreciation!-!chg!in!AR!+!chg!in!AP!-!chg!in!INV!
Operating!cash!flow!=!10.6!+!3.6!-!(55.5!-!39.6)!+!(87.6!-!73.5)!-!(45.9!-!42.9)!=!9.4!
Diff:!3!
Skill:!Analytical!
!
7)!!For!the!year!ending!December!31,!2006!LutherNs!cash!flow!from!financing!activities!is?!
Answer:!!!Cash!flow!from!financing:!
-!dividends!paid! (5.1)!
+!sale!or!(purchase)!of!stock! 57.5*!
+!increase!in!ST!borrowing! 3.9!
+!increase!in!LT!borrowing! 70.8!
!
Cash!flow!from!financing! 127.1!
!
NI!transferred!to!RE(2006)!=!NI!-!Dividends!paid!=!10.6!-!5.1!=!5.6!
!
sale!of!stock!=!Equity(2006)!-!NI!transferred!to!RE(2006)!-!Equity(2005)!!
! =!126.6!-!5.5!-!63.6!=!57.5!
!
increase!in!ST!borrowing!=!chg!in!notes!payable!+!chg!in!current!portion!of!LT!debt!
! =!!(10.5!-!9.6)!+!(39.9!-!36.9)!=!3.9!
!
increase!in!LT!borrowing!=!239.7!-!168.9!=!70.8!
Diff:!3!
Skill:!Analytical!
!
2.5!Other!Financial!Statement!Information!
1)!!In!addition!to!the!balance!sheet,!income!statement,!and!the!statement!of!cash!flows,!a!firmNs!complete!financial!
statements!will!include!all!of!the!following!except:!
A)!!Management!discussion!and!Analysis!
B)!!Notes!to!the!financial!statements!
C)!!Securities!and!Exchange!CommissionNs!(SEC)!commentary!
D)!!Statement!of!stockholdersN!equity!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!2.5!Other!Financial!Statement!Information!
Skill:!Conceptual!
!
2)!!Off-balance!sheet!transactions!are!required!to!be!disclosed!
A)!!in!the!management!discussion!and!analysis.!
B)!!in!the!auditorNs!report.!
C)!!in!the!Securities!and!Exchange!CommissionNs!commentary.!
D)!!in!the!statement!of!stockholdersN!equity.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Details!of!acquisitions,!spin-offs,!leases,!taxes,!and!risk!management!activities!are!given!
A)!!in!the!management!discussion!and!analysis.!
B)!!in!the!Securities!and!Exchange!CommissionNs!commentary.!
C)!!in!the!auditorNs!report.!
D)!!in!the!notes!to!the!financial!statements.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
2.6!Accounting!Manipulation!
1)!!In!response!to!corporate!scandals!such!as!Enron!and!WorldCom,!in!2002!congress!passed!a!law!that!requires,!
among!other!things,!that!CEOs!and!CFOs!certify!the!accuracy!and!appropriateness!of!their!firmNs!financial!
statements!and!increases!he!penalties!against!them!if!the!financial!statements!later!prove!to!be!fraudulent.!!
The!name!of!this!act!is?!
A)!!The!Glass-Steagall!Act!
B)!!The!Sarbanes-Oxley!Act!
C)!!The!Accuracy!in!Accounting!Act!
D)!!The!McCain-Feingold!Act!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!2.6!Accounting!Manipulation!
Skill:!Definition
!
Chapter!3!-!Arbitrage!and!Financial!Decision!Making!
!
!
3.1!Valuing!Costs!and!Benefits!
1)!!Which!of!the!following!statements!regarding!the!valuing!of!costs!and!benefits!is!not!correct?!
A)!!The!first!step!in!evaluating!a!project!is!to!identify!its!costs!and!benefits.!
B)!!In!the!absence!of!competitive!markets,!we!can!use!one-sided!prices!to!determine!exact!cash!values.!
C)!!Competitive!market!prices!allow!us!to!calculate!the!value!of!a!decision!without!worrying!about!the!
tastes!or!opinions!of!the!decision!maker.!
D)!!Because!competitive!markets!exist!for!most!commodities!and!financial!assets,!we!can!use!them!to!
determine!cash!values!and!evaluate!decisions!in!most!situations.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!3.1!Valuing!Costs!and!Benefits!
Skill:!Conceptual!
!
Use$the$information$for$the$question(s)$below.
!
Alaska!North!Slope!Crude!Oil!(ANS)! $71.75/Bbl!
West!Texas!Intermediate!Crude!Oil!(WTI)! $73.06/Bbl!
!
As!an!oil!refiner,!you!are!able!to!produce!$76!worth!of!unleaded!gasoline!from!one!barrel!of!Alaska!North!Slope!(ANS)!
crude!oil.!!Because!of!its!lower!sulfur!content,!you!can!produce!$77!worth!of!unleaded!gasoline!from!one!barrel!of!West!
Texas!Intermediate!(WTI)!crude.!
!
2)!!Another!oil!refiner!is!offering!to!trade!you!10,150!Bbls!of!Alaska!North!Slope!(ANS)!crude!oil!for!10,000!Bbls!of!
West!Texas!Intermediate!(WTI)!crude!oil.!!Assuming!you!currently!have!10,000!Bbls!of!WTI!crude,!the!added!
benefit!(cost)!to!you!if!you!take!the!trade!is!closest!to:!
A)!!($1,400)!
B)!!$1,400!
C)!!($3,908)!
D)!!$3,908!
Answer:!!!B!
B)!!Total!Benefits!
!
No!trade!and!refine!WTI!crude!(base!case)!
10,000!Bbls!×!$77!of!gasoline/Bbl!=!$770,000!
!
Trade!WTI!for!ANS!crude!
!
!
Added!Benefits!=!Total!Benefits!-!Base!Case!
!
=!$771,400!-!$770,000!=!$1,400!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
3)!!Assuming!you!currently!have!10,000!Bbls!of!WTI!crude,!the!added!benefit!(cost)!to!you!if!you!were!to!sell!the!
10,000!Bbls!of!WTI!crude!and!use!the!proceeds!to!purchase!and!refine!ANS!crude!is!closest!to:!
A)!!($1,400)!
B)!!$1,400!
C)!!($3,908)!
D)!!$3,908!
Answer:!!!D!
B)!!
C)!!
D)!!Total!Benefits!
!
!
Sell!WTI!and!use!proceeds!to!buy!ANS!
10,000!Bbls!WTI!×!$73.06/Bbl!=!$730,600!
Buy!ANS!crude!
$730,600!/!$71.75/Bbl!ANS!=!10,182.57!or!approx!10,183!Bbls!ANS!
10,183Bbls!×!$76!of!gasoline/Bbl!=!$773,908!
!
!
=!$773,908!-!$770,000!=!$3,908!
Diff:!2!
Skill:!Analytical!
!
4)!!Assuming!you!just!purchased!10,000!Bbls!of!WTI!crude!at!the!current!market!price,!the!net!benefit!(cost)!to!
you!if!you!were!to!refine!this!crude!oil!and!sell!the!unleaded!gasoline!is!closest!to:!
A)!!$730,600!
B)!!$770,000!
C)!!$771,400!
D)!!$773,908!
Answer:!!!B!
B)!!Total!Benefits!
!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
West!Texas!Intermediate!(WTI)!crude!oil.!!Assuming!you!just!purchased!10,000!Bbls!of!WTI!crude!at!the!
current!market!price,!the!net!benefit!(cost)!to!you!if!you!take!the!trade!is!closest!to:!
A)!!$730,600!
B)!!$770,000!
C)!!$771,400!
D)!!$773,908!
Answer:!!!C!
B)!!
C)!!Total!Benefits!
!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Assuming!you!currently!have!10,000!Bbls!of!WTI!crude,!the!total!benefits!to!you!if!you!were!to!sell!the!10,000!
Bbls!of!WTI!crude!and!use!the!proceeds!to!purchase!and!refine!ANS!crude!is!closest!to:!
A)!!$730,600!
B)!!$770,000!
C)!!$771,400!
D)!!$773,908!
Answer:!!!D!
B)!!
C)!!
D)!!Total!Benefits!
!
10,000!Bbls!WTI!×!$73.06/Bbl!=!$730,600!
Buy!ANS!crude!
$730,600!/!$71.75/Bbl!ANS!=!10,182.57!or!approx!10,183!Bbls!ANS!
10,183Bbls!×!$76!of!gasoline/Bbl!=!$773,908!
Diff:!2!
Skill:!Analytical!
!
West!Texas!Intermediate!(WTI)!crude!oil.!!Assuming!you!currently!have!10,000!Bbls!of!WTI!crude,!what!
should!you!do?!
A)!!Sell!10,00!Bbls!WTI!crude!on!the!market!and!use!the!proceeds!to!purchase!and!refine!ANS!crude.!
B)!!Do!nothing,!refine!the!10,000!Bbls!of!WTI!crude.!
C)!!Trade!the!10,000!Bbls!WTI!crude!with!the!other!refiner!and!refine!the!10,150!Bbls!of!ANS!crude.!
D)!!Trade!the!10,000!Bbls!WTI!crude!with!the!other!refiner!and!then!sell!the!10,150!Bbls!of!ANS!crude.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Low-Grade!Copper!Ore! $571!per!Ton!
High-Grade!Copper!Ore! $843!!per!Ton!
!
Coloma!Cooper!Incorporated!is!able!to!produce!$640!worth!of!copper!from!one!ton!of!low-grade!copper!ore.!!Because!of!its!
higher!copper!content,!Coloma!can!produce!$940!worth!of!copper!from!one!ton!of!high-grade!copper!ore.!
!
8)!!A!mining!company!is!offering!to!trade!you!7,250!tons!of!low-grade!copper!ore!for!5,000!tons!of!high-grade!
copper!ore.!!Assuming!you!currently!have!5,000!tons!of!high-grade!ore,!what!should!you!do?!
Answer:!!!Don[t!trade.!!Coloma!should!keep!the!high!grade!ore!and!refine!it.!
!
See!below:!
!
Total!Benefits!
!
No!trade!and!refine!high-grade!ore!(base!case)!
5,000!tons!!×!$940!of!copper/ton!=!$4,700,000!
!
Trade!high-grade!for!low-grade!
7,250!tons!×!$640!of!copper/ton!=!$4,640,000!
Diff:!2!
Skill:!Analytical!
!
9)!!A!company!that!manufactures!copper!piping!is!offering!to!trade!you!5,925!tons!of!low-grade!copper!ore!for!
4,000!tons!of!high-grade!copper!ore.!!Assuming!you!currently!have!4,000!tons!of!high-grade!ore,!what!are!the!
total!benefits!and!added!benefits!of!taking!the!trade?!
Answer:!!!Total!Benefits!
!
No!trade!and!refine!high-grade!ore!(base!case)!
4,000!tons!!×!$940!of!copper/ton!=!$3,760,000!
!
Trade!high-grade!for!low-grade!
5,925!tons!×!$640!of!copper/ton!=!$3,792,000!(total!benefits)!
!
=!$3,792,000!-!$3,760,000!=!$32,000!(added!benefit)!
Diff:!2!
Skill:!Analytical!
!
3.2!Interest!Rates!and!the!Time!Value!of!Money!
1)!!Which!of!the!following!statements!is!incorrect?!
A)!!In!general,!money!toady!is!worth!more!than!money!in!one!year.!
B)!!We!define!the!risk-free!interest!rate,!rf!for!a!given!period!as!the!interest!rate!at!which!money!can!be!
borrowed!or!lent!without!risk!over!that!period.!
C)!!We!refer!to!(1!-!rf)!as!the!interest!rate!factor!for!risk-free!cash!flows.!
D)!!For!most!financial!decisions,!costs!and!benefits!occur!at!different!points!in!time.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!3.2!Interest!Rates!and!the!Time!Value!of!Money!
Skill:!Conceptual!
!
2)!!If!the!risk-free!rate!of!interest!(rf)!is!6%,!then!you!should!be!indifferent!between!receiving!$250!in!one!year!or:!
A)!!$235.85!today!
B)!!$250.00!today!
C)!!$265.00!today!
Answer:!!!A!
Explanation:!!! A)!!Benefit!=!$250.00!/!($1.06!in!one!year!/!$1.00!today)!=!$235.85!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
3)!!If!the!risk-free!rate!of!interest!(rf)!is!6%,!then!you!should!be!indifferent!between!receiving!$250!today!or:!
A)!!$235.85!in!one!year!
B)!!$250.00!in!one!year!
C)!!$265.00!in!one!year!
Answer:!!!C!
B)!!
C)!!$250.00!×!(1.06)!=!$265.00!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!A!project!you!are!considering!is!expected!to!provide!benefits!worth!$225,000!in!one!year.!!If!the!risk-free!rate!
of!interest!(rf)!is!8%,!then!the!value!of!the!benefits!of!this!project!today!are!closest!to:!
A)!!$190,333!
B)!!$208,333!
C)!!$225,000!
D)!!$243,000!
Answer:!!!B!
B)!!$225,000!/!(1.08)!=!$208,333!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Suppose!you!have!$500!today!and!the!risk-free!interest!rate!(rf)!is!5%.!!The!equivalent!value!in!one!year!is!
closest!to:!
A)!!$475!
B)!!$476!
C)!!$500!
D)!!$525!
Answer:!!!D!
B)!!
C)!!
D)!!$500!×!(1.05)!=!$525!
Diff:!1!
Skill:!Analytical!
!
6)!!Suppose!you!will!receive!$500!in!one!year!and!the!risk-free!interest!rate!(rf)!is!5%.!!The!equivalent!value!today!
is!closest!to:!
A)!!$475!
B)!!$476!
C)!!$500!
D)!!$525!
Answer:!!!B!
B)!!$500!/!(1.05)!=!$476!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
3.3!Present!Value!and!the!NPV!Decision!Rule!
1)!!Which!of!the!following!formulas!regarding!NPV!is!incorrect?!
A)!!NPV!+!PV(benefits)!=!PV(Cost)!
B)!!NPV!+!PV(costs)!=!PV(benefits)!
C)!!NPV!=!PV(All!project!cash!flows)!
D)!!NPV$=!PV(benefits)!-!PV(costs)!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!3.3!Present!Value!and!the!NPV!Decision!Rule!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!Net!Present!Value!(NPV)!is!incorrect?!
A)!!The!NPV!represents!the!value!of!the!project!in!terms!of!cash!today.!
B)!!Good!projects!will!have!a!positive!NPV.!
C)!!The!NPV!of!a!project!is!the!difference!between!the!present!value!of!its!benefits!and!the!present!value!of!
its!costs.!
D)!!When!faced!with!a!set!of!alternatives,!choose!the!one!with!the!lowest!NPV!in!order!to!minimize!the!
preset!value!of!costs.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Which!of!the!following!statements!regarding!the!NPV!decision!rule!is!false?!
A)!!Reject!projects!with!a!NPV!of!zero,!as!accepting!them!is!equivalent!to!loosing!the!present!value!of!the!
projects!costs.!
B)!!When!faced!with!a!set!of!alternatives,!choose!the!one!with!the!highest!NPV.!
C)!!Accept!those!projects!with!a!positive!NPV,!as!accepting!them!is!equivalent!to!receiving!their!NPV!in!
cash!today.!
D)!!Reject!those!projects!with!a!negative!NPV,!as!not!doing!them!has!NPV!=!0.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!You!are!offered!an!investment!opportunity!in!which!you!will!receive!$23,750!today!in!exchange!for!paying!
$25,000!in!one!year.!!Suppose!the!risk-free!interest!rate!is!6%!per!year.!!Should!you!take!this!project?!!The!NPV!
for!this!project!is!closest!to:!
A)!!Yes;!NPV!=!$165! !
B)!!No;!NPV!=!$165!
C)!!Yes;!NPV!=!-$165!
D)!!No;!NPV!=!-$165!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!23,750!-!25,000/(1.06)!=!165,!since!NPV!>!0!accept!the!project!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!You!are!offered!an!investment!opportunity!in!which!you!will!receive!$25,000!in!one!year!in!exchange!for!
paying!$23,750!today.!!Suppose!the!risk-free!interest!rate!is!6%!per!year.!!Should!you!take!this!project?!!The!
NPV!for!this!project!is!closest!to:!
A)!!Yes;!NPV!=!$165! !
B)!!No;!NPV!=!$165!
C)!!Yes;!NPV!=!-$165!
D)!!No;!NPV!=!-$165!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!=!-23,750!+!25,000!/!1.06!=!-165,!since!NPV!<!0!you!should!reject!project!
Diff:!2!
Skill:!Analytical!
!
6)!!You!have!an!investment!opportunity!in!Germany!that!requires!an!investment!of!$250,000!today!and!will!
produce!a!cash!flow!of!€208,650!in!one!year!with!no!risk.!!Suppose!the!risk-free!rate!of!interest!in!Germany!is!
7%!and!the!current!competitive!exchange!rate!is!€0.78!to!$1.00.!!What!is!the!NPV!of!this!project?!!Would!you!
take!the!project?!
A)!!NPV!=!0;!No!
B)!!NPV!=!2,358;!No!
C)!!NPV!=!2,358;!Yes!
D)!!NPV!=!13,650;!Yes!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!-250,000!+!(€208,650!/!1.07)!×!$1.00!/!€0.78!=!0,!so!since!NPV!is!not!>!0,!reject!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
7)!!You!have!an!investment!opportunity!in!Germany!that!requires!an!investment!of!$250,000!today!and!will!
produce!a!cash!flow!of!€208,650!in!one!year!with!no!risk.!!Suppose!the!risk-free!rate!of!interest!in!Germany!is!
6%!and!the!current!competitive!exchange!rate!is!€0.78!to!$1.00.!!What!is!the!NPV!of!this!project?!!Would!you!
take!the!project?!
A)!!NPV!=!0;!No!
B)!!NPV!=!2,358;!No!
C)!!NPV!=!2,358;!Yes!
D)!!NPV!=!13,650;!Yes!
Answer:!!!C!
B)!!
C)!!NPV!=!-250,000!+!(€208,650!/!1.06)!×!$1.00!/!€0.78!=!2358,!so!since!NPV!!>!0,!accept!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Cash!flow! Cash!flow!
Project! today! !in!one!year!
feenief! -10! 15!
fmeenief! 10! -8!
fminief! -15! 20!
fmoef! 10! -15!
!
8)!!If!the!risk-free!interest!rate!is!10%,!then!the!NPV!for!feenief!is!closest!to:!
A)!!-3.64!
B)!!2.73!
C)!!3.18!
D)!!3.64!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!=!-10!+!15!/!1.10!=!3.64!
Diff:!1!
Skill:!Analytical!
!
9)!!If!the!risk-free!interest!rate!is!10%,!then!the!NPV!for!fmoef!is!closest!to:!
A)!!-3.64!
B)!!2.73!
C)!!3.18!
D)!!3.64!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!10!-!15!/!1.1!=!-3.64!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!If!the!risk-free!interest!rate!is!10%,!then!of!the!four!projects!listed,!if!you!could!only!invest!in!one!project,!
which!on!e!would!you!select?!
A)!!Eenie!
B)!!Meenie!
C)!!Minie!
D)!!Moe!
Answer:!!!A!
Explanation:!!! A)!!Eenie!has!highest!NPV!
NPV!Eenie!=!-10!+!15!/!1.1!=!3.64!
NPV!Meenie!=!10!-!8!/!1.1!=!2.73!
NPV!Minie!=!-15!+!20!/!1.1!=!3.18!
NPV!moe!=!10!-!15!/!1.1!=!-3.64!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!If!the!risk-free!interest!rate!is!10%,!then!of!the!four!projects!listed,!which!project!would!you!never!want!to!
invest!in?!
A)!!Eenie!
B)!!Meenie!
C)!!Minie!
D)!!Moe!
Answer:!!!D!
B)!!
C)!!
D)!!Moe!has!negative!NPV!
NPV!Eenie!=!-10!+!15!/!1.1!=!3.64!
NPV!Meenie!=!10!-!!8/1.1!=!2.73!
NPV!Minie!=!-15!+!20!/!1.1!=!3.18!
NPV!moe!=!10!-!15!/!1.1!=!-3.64!
Diff:!2!
Skill:!Analytical!
!
12)!!If!the!risk-free!interest!rate!is!10%,!then!of!the!four!projects!listed,!if!could!only!invest!in!two!of!these!projects,!
which!two!projects!would!you!select?!
A)!!Minie!&!Eenie!
B)!!Minie!&!Meenie!
C)!!Eenie!&!Moe!
D)!!Eenie!&!Meenie!
Answer:!!!A!
Explanation:!!! A)!!Eenie!&!Minie!have!the!highest!NPVs!
NPV!Eenie!=!-10!+!15!/!1.1!=!3.64!
NPV!Meenie!=!10!-!8!/!1.1!=!2.73!
NPV!Minie!=!-15!+!20!/!1.1!=!3.18!
NPV!moe!=!10!-!15!/!1.1!=!-3.64!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
13)!!You!have!an!investment!opportunity!in!the!United!Kingdom!that!requires!an!investment!of!$500,000!today!
and!will!produce!a!cash!flow!of!£320,000!in!one!year!with!no!risk.!!Suppose!the!risk-free!rate!of!interest!in!the!
U.K!is!6%!and!the!current!competitive!exchange!rate!is!$1.70/£.!What!is!the!NPV!of!this!project?!!Would!you!
take!the!project?!
Answer:!!!NPV!=!-500,000!+!(£320,000!/!1.06)!×!$1.70/£!=!$15,208!so!since!NPV!!>!0,!accept!
Diff:!2!
Skill:!Analytical!
!
!
Project! today! !in!one!year!
falphaf! -18! 23!
fbetaf! 15! -12!
fgammaf! 15! -20!
fdeltaf! -16! 21!
!
14)!!Assume!that!the!risk-free!interest!rate!is!10%.!!Rank!each!of!the!four!projects!from!most!desirable!to!least!
desirable!based!upon!NPV.!!Which!project!would!you!invest!in!first?!!Are!there!any!projects!that!you!wouldn[t!
invest!in?!
Answer:!!!Ranking!
1.! NPV!beta!=!15!- 12!/!1.1!=!4.09!
2.! NPV!delta!=!-16!!+!21!/!1.1!=!3.09!
3.! NPV!alpha!=!-18!+!23!/!1.1!=!2.91!
!
Would!never!invest!in!gamma.!!NPV!gamma!=!15!-!20!/!1.1!=!-3.18!
Diff:!3!
Skill:!Analytical!
3.4!Arbitrage!and!the!Law!of!One!Price!
1)!!Which!of!the!following!statements!regarding!arbitrage!is!the!most!correct?!
A)!!Any!situation!in!which!it!is!possible!to!make!a!profit!without!taking!any!risk!is!known!as!an!arbitrage!
opportunity.!
B)!!Any!situation!in!which!it!is!possible!to!make!a!profit!without!making!any!investment!is!known!as!an!
arbitrage!opportunity.!
C)!!We!call!a!competitive!market!in!which!there!are!no!arbitrage!opportunities!an!arbitrage!market.!
D)!!The!practice!of!buying!and!selling!equivalent!goods!in!different!markets!to!take!advantage!of!a!price!
difference!is!known!as!arbitrage.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!3.4!Arbitrage!and!the!Law!of!One!Price!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!the!Law!of!One!Price!is!incorrect?!
A)!!At!any!point!in!time,!the!price!of!two!equivalent!goods!trading!in!different!competitive!markets!will!be!
the!same.!
B)!!One!useful!consequence!of!the!Law!of!One!Price!is!that!when!evaluating!costs!and!benefits!to!compute!a!
net!present!value,!we!can!use!any!competitive!price!to!determine!a!cash!value,!without!checking!the!
price!in!all!possible!markets.!
C)!!If!equivalent!goods!or!securities!trade!simultaneously!in!different!competitive!markets,!then!they!will!
trade!for!the!same!price!in!both!markets.!
D)!!An!important!property!of!the!Law!of!One!Price!is!that!it!holds!even!in!markets!where!arbitrage!is!not!
possible.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Consider!the!following!prices!from!a!McDonald[s!Restaurant:!
!
Big!Mac!Sandwich! $2.99!
Large!Coke! $1.39!
Large!Fry! $1.09!
!
3)!!A!McDonald[s!Big!Mac!value!meal!consists!of!a!Big!Mac!Sandwich,!Large!Coke,!and!a!Large!Fry.!!Assuming!
that!there!is!a!competitive!market!for!McDonald[s!food!items,!at!what!price!must!a!Big!Mac!value!meal!sell!to!
insure!the!absence!of!an!arbitrage!opportunity!and!uphold!the!law!of!one!price?!
A)!!$4.08!
B)!!$4.38!
C)!!$5.47!
D)!!$5.77!
Answer:!!!C!
B)!!
C)!!2.99!+!1.39!+!1.09!=!5.47!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!A!McDonald[s!Big!Mac!value!meal!consists!of!a!Big!Mac!Sandwich,!Large!Coke,!and!a!Large!Fry.!!Assume!that!
there!is!a!competitive!market!for!McDonald[s!food!items!and!that!McDonalds!sells!the!Big!Mac!value!meal!for!
$4.79.!!Does!an!arbitrage!opportunity!exists!and!if!so!how!would!you!exploit!!it!and!how!much!would!you!
make!on!one!extra!value!meal?!
A)!!Yes,!buy!extra!value!meal!and!then!sell!Big!Mac,!Coke,!and!Fries!to!make!arbitrage!profit!of!$0.68!
B)!!No,!no!arbitrage!opportunity!exists!
C)!!Yes,!buy!Big!Mac,!Coke,!and!Fries!then!sell!value!meal!to!make!arbitrage!profit!of!$1.09!
D)!!Yes,!buy!Big!Mac,!Coke,!and!Fries!then!sell!value!meal!to!make!arbitrage!profit!of!$0.68!
Answer:!!!A!
Explanation:!!! A)!!Buy!value!meal!and!sell!Big!Mac,!Coke!and!Fries!
-4.79!+!2.99!+!1.39!+!1.09!=!0.68!(so!arbitrage!exists)!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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5)!!Walgreen!Company!(NYSE:!WAG)!is!currently!trading!at!$48.75!on!the!NYSE.!!Walgreen!Company!is!also!
listed!on!NASDAQ!and!assume!it!is!currently!trading!on!NASDAQ!at!$48.50.!!Does!an!arbitrage!opportunity!
exists!and!if!so!how!would!you!exploit!!it!and!how!much!would!you!make!on!a!block!trade!of!100!shares?!
A)!!No,!no!arbitrage!opportunity!exists!
B)!!Yes,!!buy!on!NASDAQ!and!sell!on!NYSE,!make!$25!
C)!!Yes,!!buy!on!NYSE!and!sell!on!NASDAQ,!make!$25!
D)!!Yes,!!buy!on!NASDAQ!and!sell!on!NYSE,!make!$250!
Answer:!!!B!
B)!!Yes,!buy!100!shares!×!48.50!and!sell!100!shares!×!48.75!=!$25.00!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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6)!!You!are!up!late!watching!TV!one!night!and!see!an!ad!from!Ronco!for!the!Dial-o-matic!food!slicer.!!You!learn!
that!the!Dial-o-matic!sells!for!$29.95.!!But!wait,!theres!more.!!Ronco!is!also!including!in!this!deal!a!set!of!Ginsu!
steak!knives!worth!$10.95!and!another!free!gift!worth!$7.95.!!Assuming!that!there!is!a!competitive!market!for!
Ronco!items,!at!what!price!must!Ronco!be!selling!this!three!item!Dial-o-matic!deal!to!insure!the!absence!of!an!
arbitrage!opportunity!and!uphold!the!law!of!one!price?!
Answer:!!!29.95!+!10.95!+!7.95!=!$48.85!
Diff:!1!
Skill:!Analytical!
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7)!!Advanced!Micro!Devices!(NYSE:!AMD)!is!currently!trading!at!$20.75!on!the!NYSE.!!Advanced!Micro!Devices!
is!also!listed!on!NASDAQ!and!assume!it!is!currently!trading!on!NASDAQ!at!$20.50.!!Does!an!arbitrage!
opportunity!exists!and!if!so!how!would!you!exploit!!it!and!how!much!would!you!make!on!a!block!trade!of!
1000!shares?!
Answer:!!!Yes,!buy!1000!shares!×!20.50!and!sell!1000!shares!×!20.75!=!$250.00!
Diff:!1!
Skill:!Analytical!
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3.5!No-Arbitrage!and!Security!Prices!
1)!!Which!of!the!following!statements!regarding!arbitrage!and!security!prices!is!incorrect?!
A)!!We!call!the!price!of!a!security!in!a!normal!market!the!no-arbitrage!price!for!the!security.!
B)!!In!financial!markets!it!is!possible!to!sell!a!security!you!do!not!own!by!doing!a!short!sale.!
C)!!When!a!bond!is!underpriced,!the!arbitrage!strategy!involves!selling!the!bond!and!investing!some!of!the!
proceeds.!
D)!!The!general!formula!for!the!no-arbitrage!price!of!a!security!is!Price(security)!=!PV(All!cash!flows!paid!by!
the!security).!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!3.5!No-Arbitrage!and!Security!Prices!
Skill:!Conceptual!
!
2)!!Consider!two!securities,!A!&!B.!!Suppose!a!third!security,!C,!has!the!same!cash!flows!as!A!and!B!combined.!!
Given!this!information!about!securities!A,B,!&!C,!which!of!the!following!statements!is!incorrect?!
A)!!If!the!total!price!of!A!and!B!is!cheaper!than!the!price!of!C,!then!we!could!make!a!profit!selling!A!and!B!
and!buying!C.!
B)!!Price(C)!=!Price(A)!+!Price(B)!
C)!!Because!security!C!is!equivalent!to!the!portfolio!of!A!and!B,!by!the!law!of!one!price!they!must!have!the!
same!price.!
D)!!The!relationship!known!as!value!additivity!says!that!the!value!of!a!portfolio!is!equal!to!the!sum!of!the!
values!of!its!parts.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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3)!!Which!of!the!following!statements!regarding!value!additivity!is!false?!
A)!!The!value!of!a!portfolio!is!equal!to!the!sum!of!the!values!of!its!parts.!!
B)!!The!price!or!value!of!the!entire!firm!is!equal!to!the!sum!of!the!values!of!all!projects!and!investments!
within!the!firm.!
C)!!To!maximize!the!value!of!the!entire!firm,!managers!should!make!decisions!that!maximize!NPV.!
D)!!Value!additivity!does!not!have!important!consequences!for!the!value!of!the!entire!firm,!only!on!
portfolios!of!firms.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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A)!!Financial!transactions!are!not!sources!of!value,!but!merely!serve!to!adjust!the!timing!and!risk!of!the!cash!
flows!to!best!suit!the!needs!of!the!firm!or!its!investors.!
B)!!The!NPV!of!trading!a!security!in!a!normal!market!is!zero.!
C)!!We!cannot!separate!a!firm[s!investment!decision!from!the!decision!of!how!to!finance!the!investment.!
D)!!In!normal!markets,!trading!securities!neither!creates!nor!destroys!value.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Suppose!that!Bondi!Inc.!is!a!holding!company!that!owns!both!Pizza!Hut!and!Kentucky!Fried!Chicken!
Franchised!Restaurants.!!If!the!value!of!Bondi!is!$130!million,!and!the!Pizza!Hut!Franchises!are!worth!$70!
million,!then!what!is!the!value!of!the!Kentucky!Fried!Chicken!Franchises?!
A)!!$60!million!
B)!!$70!million!
C)!!$130!million!
D)!!Unable!to!determine!with!the!information!provided!
Answer:!!!A!
Explanation:!!! A)!!value!KFC!=!value!of!Bondi!-!value!of!Pizza!Hut!=!130!-!70!=!$60!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
An!independent!film!maker!is!considering!producing!a!new!movie.!!The!initial!cost!for!making!this!movie!will!be!$20!
million!today.!!!Once!the!movie!is!completed,!in!one!year,!the!movie!will!be!sold!to!a!major!studio!for!$25!million.!!Rather!
than!paying!for!the!$20!million!investment!entirely!using!its!own!cash,!the!film!maker!is!considering!raising!additional!
funds!by!issuing!a!security!that!will!pay!investors!$11!million!in!one!year.!!Suppose!the!risk-free!rate!of!interest!is!10%.!
!
6)!!Without!issuing!the!new!security,!the!npv!for!this!project!is!closest!to!what!amount?!!Should!the!film!maker!
make!the!investment?!
A)!!$1.7!million;!Yes!
B)!!$1.7!million;!No!
C)!!$2.7!million;!Yes!
D)!!$2.7!million;!No!
Answer:!!!C!
B)!!
C)!!NPV!=!-20!+!25!/!1.10!=!$2.7!million,!since!NPV!>!0!take!the!investment!
D)!!
Diff:!2!
Skill:!Analytical!
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7)!!Assuming!that!the!film!maker!issues!the!new!security,!the!npv!for!this!project!is!closest!to!what!amount?!!
Should!the!film!maker!make!the!investment?!
A)!!$1.7!million;!Yes!
B)!!$1.7!million;!No!
C)!!$2.7!million;!Yes!
D)!!$2.7!million;!No!
Answer:!!!C!
B)!!
C)!!NPV!=!-10!+!(25!-!11)!/!1.10!=!2.7!million,!since!NPV!>!0!then!invest!
D)!!
Diff:!2!
Skill:!Analytical!
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8)!!What!is!the!NPV!of!this!project!if!the!film!maker!does!not!issue!the!new!security?!!What!is!the!NPV!if!the!film!
maker!issues!the!new!security?!
A)!!$1.7!million;!$1.7!million!
B)!!$1.7!million;!$2.7!million!
C)!!$2.7!million;!$1.7!million!
D)!!$2.7!million;!$2.7!million!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!(no!security)!=!-20!+!25!/!1.1!=!$2.7!
NPV(w/!security)!=!!-10!+!(25!-!11)!/!1.10!=!$2.7!million!
Diff:!2!
Skill:!Analytical!
!
!
Security! today! in!one!year!
A! 0! 100!
B! 100! 0!
C! 100! 100!
!
9)!!If!the!risk-free!rate!of!interest!is!7.5%,!then!the!value!of!security!fAf!is!closest!to:!
A)!!$91.00!
B)!!$92.50!
C)!!$93.00!
D)!!$100.00!
Answer:!!!C!
B)!!
C)!!=!100!/!1.075!=!93.02!which!is!approximately!$93.00!
D)!!
Diff:!2!
Skill:!Analytical!
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10)!!If!the!risk-free!rate!of!interest!is!7.5%,!then!the!value!of!security!fBf!is!closest!to:!
A)!!$91.00!
B)!!$92.50!
C)!!$93.00!
D)!!$100.00!
Answer:!!!D!
B)!!
C)!!
D)!!Since!the!cash!flow!is!already!stated!in!today[s!dollars,!!no!discounting!is!needed.!!The!PV!is!
$100.!
Diff:!2!
Skill:!Analytical!
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11)!!If!the!value!of!security!fCf!is!$180,!then!what!must!be!the!value!of!security!fAf?!
A)!!$80!
B)!!$90!
C)!!$100!
D)!!Unable!to!determine!without!the!risk-free!rate.!
Answer:!!!A!
Explanation:!!! A)!!The!cash!flows!from!C!are!simply!a!combination!of!A!&!B,!so!price(C)!=!price(A)!+!price(B)!!
Since!B!is!already!in!todays!dollars,!price(B)!must!=!100,!so!price!A!=!180!-!100!=!$80.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
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!
An!exchange!traded!fund!(ETF)!is!a!security!that!represents!a!portfolio!of!individual!stocks.!!Consider!an!ETF!for!which!
each!share!represents!a!portfolio!of!two!shares!of!International!Business!Machines!(IBM),!three!shares!of!Merck!(MRK),!and!
three!shares!of!Citigroup!Inc.!(C).!!Suppose!the!current!market!price!of!each!individual!stock!are!shown!below:!
!
Stock! Current!Price!
IBM! $79.50!
MRK! $40.00!
C! $48.50!
!
12)!!The!price!per!share!of!the!ETF!in!a!normal!market!is!closest!to:!
A)!!$168.00!
B)!!$336.00!
C)!!$424.50!
D)!!$504.00!
Answer:!!!C!
B)!!
C)!!=!2!×!79.50!+!3!×!40.00!+!3!×!48.50!=!$424.50!
D)!!
Diff:!2!
Skill:!Analytical!
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13)!!Suppose!that!the!ETF!is!trading!for!$424.50;!you!should!
A)!!sell!the!EFT!and!buy!2!shares!of!IBM,!3!shares!of!MRK,!and!3!shares!of!C.!
B)!!sell!the!EFT!and!buy!3!shares!of!IBM,!2!shares!of!MRK,!and!3!shares!of!C.!
C)!!buy!the!EFT!and!sell!2!shares!of!IBM,!3!shares!of!MRK,!and!3!shares!of!C.!
D)!!do!nothing,!no!arbitrage!opportunity!exists.!
Answer:!!!D!
B)!!
C)!!
D)!!Value!of!ETF!=!2!×!79.50!+!3!×!40.00!+!3!×!48.50!=!$424.50,!so!no!arbitrage!opportunity!exists!
Diff:!3!
Skill:!Analytical!
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14)!!Suppose!a!security!with!a!risk-free!cash!flow!of!$1000!in!one!year!trades!for!$909!today.!!If!there!are!no!
arbitrage!opportunities,!!then!the!current!risk-free!interest!rate!is!closest!to:!
A)!!8%!
B)!!10%!
C)!!11%!
D)!!12%!
Answer:!!!B!
B)!!PV!=!FV$/!(1!+!i)!==>>>!(1!+!i)!=!FV$/!PV!=!$1000!/!$909!=!1.10!so!i!=!10%!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
An!exchange!traded!fund!(ETF)!is!a!security!that!represents!a!portfolio!of!individual!stocks.!!Consider!an!ETF!for!which!
each!share!represents!a!portfolio!of!two!shares!of!International!Business!Machines!(IBM),!three!shares!of!Merck!(MRK),!and!
three!shares!of!Citigroup!Inc.!(C).!!Suppose!the!current!market!price!of!each!individual!stock!are!shown!below:!
!
Stock! Current!Price!
IBM! $79.50!
MRK! $40.00!
C! $48.50!
!
15)!!Assume!that!the!ETF!is!trading!for!$426.00,!what!(if!any)!arbitrage!opportunity!exists?!!What!(if!any)!trades!
would!you!make?!
Answer:!!!Value!of!ETF!=!2!×!79.50!+!3!×!40.00!+!3!×!48.50!=!$424.50,!so!an!arbitrage!opportunity!exists.!!You!should!
sell!the!EFT!for!$426.00!and!buy!2!shares!of!IBM,!3!shares!of!MRK,!and!3!shares!of!C.!
Diff:!3!
Skill:!Analytical!
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16)!!The!price!per!share!of!the!ETF!in!a!normal!market!is:!
Answer:!!!Value!of!ETF!=!2!×!79.50!+!3!×!40.00!+!3!×!48.50!=!$424.50!
Diff:!2!
Skill:!Analytical!
3.6!The!Price!of!Risk!
1)!!Which!one!of!the!following!statements!is!false?!
A)!!When!we!compute!the!return!of!a!security!based!on!the!average!payoff!we!expect!to!receive,!we!call!it!
the!expected!return.!
B)!!The!notion!that!investors!prefer!to!have!a!safe!income!rather!than!a!risky!one!of!the!same!average!
amount!is!call!risk!aversion.!
C)!!Because!investors!are!risk!averse,!the!risk-free!interest!rate!is!not!the!right!rate!to!use!when!converting!
risky!cash!flows!across!time.!
D)!!The!more!risk!averse!investors!are,!the!higher!the!current!price!of!a!risky!asset!will!be!compared!to!a!
risk-free!bond.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!3.6!The!Price!of!Risk!
Skill:!Conceptual!
!
!
! Market!Price! Cash!Flow!in!One!Year!
Security! Today! Poor!Economy! Good!Economy!
A! 200! 840! 0!
B! 600! 0! 840!
C! ???! 840! 4200!
!
2)!!Based!upon!the!information!provided!about!securities!A,!B,!and!C,!the!risk-free!rate!of!interest!is!closest!to:!
A)!!4%!
B)!!5%!
C)!!8%!
D)!!10%!
Answer:!!!B!
B)!!We!can!construct!the!risk-free!asset!by!forming!a!portfolio!of!A!and!B.!!This!portfolio!has!a!
certain!payoff!of!$840.!!The!price!for!this!portfolio!is!$800.!!We!know!that!$800!=!$840!/!!(1!+!i)!!
==>!!(1!+!i)!=!840!/!800!=!1.05!==>!i!=!.05!or!5%.!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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3)!!What!is!the!no-arbitrage!price!for!security!C?!
A)!!$800!
B)!!$1600!
C)!!$3200!
D)!!$4000!
Answer:!!!C!
B)!!
C)!!Security!C!has!the!same!payoffs!as!a!portfolio!consisting!of!1!unit!of!security!A!and!5!units!of!
security!B.!!Therefore,!under!the!law!of!one!price,!the!value!must!be!1!×!$200!+!5!×!$600!=!
$3200.!
D)!!
Diff:!2!
Skill:!Analytical!
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4)!!Suppose!a!risky!security!pays!an!average!cash!flow!of!$100!in!one!year.!!The!risk-free!rate!is!5%,!and!the!
expected!return!on!the!market!index!is!13%.!!If!the!returns!on!this!security!are!high!when!the!economy!is!
strong!and!low!when!the!economy!is!weak,!but!the!returns!vary!by!only!half!as!much!as!the!market!index,!
what!risk!premium!is!appropriate!for!this!security?!
A)!!4%!
B)!!6.5%!
C)!!9%!
D)!!11%!
Answer:!!!A!
Explanation:!!! A)!!Since!the!security!is!half!as!risky!as!the!market,!then!the!risk-premium!for!the!security!should!
be!half!of!the!market!risk!premium.!!The!market!risk!premium!is!13%!-!5%!=!8%,!so!the!risk!
premium!on!this!security!should!be!half!of!this!or!4%.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
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5)!!Suppose!a!risky!security!pays!an!average!cash!flow!of!$100!in!one!year.!!The!risk-free!rate!is!5%,!and!the!
expected!return!on!the!market!index!is!13%.!!If!the!returns!on!this!security!are!high!when!the!economy!is!
strong!and!low!when!the!economy!is!weak,!but!the!returns!vary!by!only!half!as!much!as!the!market!index,!
then!the!price!for!this!risky!security!is!closest!to:!
A)!!$88!
B)!!$92!
C)!!$93!
D)!!$95!
Answer:!!!B!
B)!!Since!the!security!is!half!as!risky!as!the!market,!then!the!risk-premium!for!the!security!should!
be!half!of!the!market!risk!premium.!!The!market!risk!premium!is!13%!-!5%!=!8%,!so!the!risk!
premium!on!this!security!should!be!half!of!this!or!4%.!!So!the!expected!return!should!be!equal!
to!the!risk-free!rate!+!the!risk!premium!=!5%!+!4%!=!9%.!!Therefore!the!price!=!$100!/!1.09!=!$92.!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
! Market!Price! Cash!Flow!in!One!Year!
Security! Today! Poor!Economy! Good!Economy!
A! 200! 840! 0!
B! 600! 0! 840!
C! ???! 840! 4200!
!
6)!!Suppose!that!security!C!had!a!risk!premium!of!30%,!describe!what!arbitrage!opportunity!exists!and!how!you!
would!exploit!it.!
Answer:!!!Step!#1!-!Determine!the!risk-free!rate!
!
We!can!construct!the!risk-free!asset!by!forming!a!portfolio!of!A!and!B.!!This!portfolio!has!a!certain!
payoff!of!$840.!!The!price!for!this!portfolio!is!$800.!!We!know!that!$800!=!$840!/!(1!+!i)!==>!(1!+!i)!=!840!/!
800!=!1.05!==>!!i!=!.05!or!5%.!
!
Step!#2!-!Determine!the!price!using!the!expected!return.!
!
Since!the!risk!premium!is!30%!and!the!risk-free!rate!is!5%,!then!the!expected!return!is!35%.!
!
The!average!payoff!of!security!C!is!(840!+!4200)!/!2!=!2520!!so!the!price!of!C!=!2520!/!(1.35)!=!$1,867.!
!
However,!Security!C!has!the!same!payoffs!as!a!portfolio!consisting!of!1!unit!of!security!A!and!5!units!of!
security!B.!!Therefore,!under!the!law!of!one!price,!the!value!must!be!1!×!$200!+!5!×!$600!=!$3200.!
!
Since!these!two!prices!are!not!the!same,!there!must!be!an!arbitrage!opportunity.!!Here!we!can!buy!
security!C!for!$1,867!and!sell!the!portfolio!of!A!&!B!for!$3,200!yielding!an!arbitrage!profit!of!$1,333.!
Diff:!3!
Skill:!Analytical!
3.7!Arbitrage!with!Transaction!Costs!
A)!!No!arbitrage!opportunities!will!exist!until!the!underlying!prices!diverge!by!more!than!the!amount!of!the!
transaction!costs.!
B)!!Because!you!will!generally!pay!a!slightly!lower!price!when!you!buy!a!security!(the!ask!price)!than!you!
receive!when!you!sell!(the!bid!price)!you!will!pay!the!bid-ask!spread.!
C)!!The!price!of!a!security!should!equal!the!present!value!of!its!cash!flows,!up!to!the!transaction!costs!of!
trading!the!security!and!the!cash!flows.!
D)!!In!most!markets,!you!must!pay!transactions!costs!to!trade!securities.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!3!
Topic:!3.7!Arbitrage!with!Transactions!Costs!
Skill:!Conceptual!
!
2)!!Consider!a!bond!that!pays!$1000!in!one!year.!!Suppose!that!the!market!interest!rate!for!savings!is!8%,!but!the!
interest!rate!for!borrowing!is!10%.!!The!price!range!that!this!bond!must!trade!in!a!normal!market!if!no!
arbitrage!opportunities!exist!is!closest!to:!
A)!!$909!to!$917!
B)!!$909!to!$926!
C)!!$917!to!$926!
D)!!$909!to!$1000!
Answer:!!!B!
B)!!VB!@!8%!=!1000!/!1.08!=!$926!!VB!@!10%!=!1000!/!1.10!=!$909!so!range!is!909!to!926!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Security! Bid! Ask!
IBM! 79.45! 79.50!
MRK! 39.95! 40.05!
C! 48.50! 48.55!
!
3)!!Consider!an!ETF!that!is!made!up!of!one!share!each!of!IBM,!MRK,!and!C.!!The!minimum!ask!price!for!this!ETF!
in!a!normal!market!is!closest!to:!
A)!!$167.80!
B)!!$167.90!
C)!!$168.00!
D)!!$168.10!
Answer:!!!B!
B)!!Here!we!use!the!Bid!prices!Value!=!79.45!+!39.95!+!48.50!=!$167.90!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!Consider!an!ETF!that!is!made!up!of!one!share!each!of!IBM,!MRK,!and!C.!!The!minimum!bid!price!for!this!ETF!
in!a!normal!market!is!closest!to:!
A)!!$167.80!
B)!!$167.90!
C)!!$168.00!
D)!!$168.10!
Answer:!!!D!
B)!!
C)!!
D)!!Here!we!use!the!ask!prices!Value!=!79.50!+!40.05!+!48.55!=!$168.10!
Diff:!2!
Skill:!Analytical!
!
5)!!In!a!normal!market!with!transactions!costs,!is!it!possible!for!different!investors!to!place!different!values!on!an!
investment!opportunity?!!Are!there!any!limits!on!the!amount!that!their!values!can!differ?!
Answer:!!!Values!can!differ,!but!only!up!to!the!total!amount!of!transactions!costs.!
Diff:!2!
Skill:!Conceptual!
!
!
Security! Bid! Ask!
IBM! 79.45! 79.50!
MRK! 39.95! 40.05!
C! 48.50! 48.55!
!
6)!!Consider!an!ETF!that!is!made!up!of!one!share!each!of!IBM,!MRK,!and!C.!!!The!current!quote!for!this!ETF!
currently!is!$167.75!(bid)!$167.85!(ask).!!What!should!you!do?!
Answer:!!!There!is!an!arbitrage!opportunity.!!Buy!the!ETF!at!the!ask!of!$167.85!and!sell!the!underlying!securities!at!
the!bid!prices.!!So!we!have!+79.45!+!39.95!+!48.50!-!167.85!=!.05!arbitrage!profit!per!share!
Diff:!2!
Skill:!Analytical!
!
Answer:!!!Nothing,!there!is!no!arbitrage!opportunity!here.!!The!ask!price!must!fall!below!$167.90!or!the!bid!price!
must!be!above!$168.10!for!there!to!be!an!arbitrage.!
Diff:!2!
Skill:!Analytical!
!
Answer:!!!There!is!an!arbitrage!opportunity.!!Sell!the!ETF!at!the!bid!of!$168.15!and!buy!the!underlying!securities!
at!the!ask!prices.!!So!we!have!+!168.15!-!79.50!-!40.05!-!48.55!=!.05!arbitrage!profit!per!share!
Diff:!2!
Skill:!Analytical!
!
Chapter!4!-!The!Time!Value!of!Money!
!
!
4.1!The!Timeline!
Use$the$figure$for$the$question(s)$below.
1)!!Which!of!the!following!statements!regarding!timelines!is!false?!
A)!!Timelines!are!an!important!first!step!in!organizing!and!then!solving!a!financial!problem.!
B)!!We!refer!to!a!series!of!cash!flows!lasting!several!periods!as!a!stream!of!cash!flows.!
C)!!Not!every!stream!of!cash!flows!can!be!represented!on!a!timeline.!
D)!!A!timeline!is!a!linear!representation!of!the!timing!of!the!(expected)!cash!flows.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!4.1!The!Timeline!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!the!timeline!is!false?!
A)!!Date!1!is!one!year!from!now.!
B)!!The!$5000!below!date!1!is!the!payment!you!will!receive!at!the!end!of!the!first!year.!
C)!!The!$5000!below!date!2!is!the!payment!you!will!receive!at!the!beginning!of!the!second!year.!
D)!!Date!0!represents!today.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
3)!!Which!of!the!following!statements!regarding!the!timeline!is!false?!
A)!!Date!1!is!the!end!of!the!first!year.!
B)!!Date!0!is!the!beginning!of!the!first!year.!
C)!!The!space!between!date!0!and!date!1!represents!the!time!period!between!two!specific!dates.!
D)!!You!will!find!the!timeline!most!useful!in!tracking!cash!flows!if!you!interpret!each!point!on!the!timeline!
as!a!period!or!interval!of!time.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
Joe!just!inherited!the!family!business,!and!having!no!desire!to!run!the!family!business,!he!has!decided!to!sell!it!to!an!
entrepreneur.!!In!exchange!for!the!family!business,!Joe!has!been!offered!an!immediate!payment!of!$100,000.!!Joe!will!also!
receive!payments!of!$50,000!in!one!year,!$50,000!in!two!years,!and!$75,000!in!three!years.!!The!current!market!rate!of!
interest!for!Joe!is!6%.
4)!!Draw!a!timeline!detailing!JoeWs!cash!flows!from!the!sale!of!the!family!business.!
Answer:!!!!
!
Diff:!2!
Skill:!Conceptual!
!
5)!!You!have!been!offered!the!following!investment!opportunity,!if!you!pay!$2500!today,!you!will!receive!$1000!
at!the!end!of!each!of!the!next!three!years.!!Draw!a!timeline!detailing!this!investment!opportunity.!
Answer:!!!!
!
Diff:!1!
Skill:!Conceptual!
!
Year A B!
0 -$150 -$225!
1 40 175!
2 80 125!
3 100 -50!
!
6)!!Draw!a!timeline!detailing!the!cash!flows!from!investment!YA.Y!
Answer:!!!!
!
Diff:!1!
Skill:!Conceptual!
!
7)!!Draw!a!timeline!detailing!the!cash!flows!from!investment!YB.Y!
Answer:!!!!
!
Diff:!1!
Skill:!Conceptual!
!
Suppose!that!a!young!couple!has!just!had!their!first!baby!and!they!wish!to!ensure!that!enough!money!will!be!available!to!
pay!for!their!childWs!college!education.!!Currently,!college!tuition,!books,!fees,!and!other!costs,!average!$12,500!per!year.!!On!
average,!tuition!and!other!costs!have!historically!increased!at!a!rate!of!4%!per!year.!!
8)!!Assume!that!college!costs!continue!to!increase!an!average!of!4%!per!year!and!that!all!her!college!savings!are!
invested!in!an!account!paying!7%!interest.!!Draw!a!timeline!that!details!the!amount!of!money!she!will!need!to!
have!in!the!future!four!each!of!her!four!years!of!her!undergraduate!education.!!
!!
Answer:!!!$25,322.71! $25,322.71(1.04)1! $25,322.71(1.04)2! $25,322.71(1.04)3!
18! 19! 20! 21!
Note!that!the!tuition!for!the!first!year!is!calculated!as:!!$12,5000(1.04)18!=!$25,322.71!
Diff:!2!
Skill:!Conceptual!
!
9)!!Suppose!that!a!young!couple!has!just!had!their!first!baby!and!they!wish!to!insure!that!enough!money!will!be!
available!to!pay!for!their!childWs!college!education.!!They!decide!to!make!deposits!into!an!educational!savings!
account!on!each!of!their!daughterWs!birthdays,!starting!with!her!first!birthday.!!Assume!that!the!educational!
savings!account!will!return!a!constant!7%.!!The!parents!deposit!$2000!on!their!daughterWs!first!birthday!and!
plan!to!increase!the!size!of!their!deposits!by!5%!each!year.!!Draw!a!timeline!that!details!the!amount!that!would!
be!available!for!the!daughterWs!college!expenses!on!her!18th!birthday.!
Answer:!!!!
!
Diff:!2!
Skill:!Analytical!
4.2!The!Three!Rules!of!Time!Travel!
A)!!The!process!of!moving!a!value!or!cash!flow!forward!in!time!is!known!as!compounding.!
B)!!The!effect!of!earning!interest!on!interest!is!known!as!compound!interest.!
C)!!It!is!only!possible!to!compare!or!combine!values!at!the!same!point!in!time.!
D)!!A!dollar!in!the!future!is!worth!more!than!a!dollar!today.!
Answer:!!!D!
B)!!
C)!!
D)!!A!dollar!in!the!future!is!worth!less!than!a!dollar!today.!
Diff:!1!
Topic:!4.2!The!Three!Rules!of!Time!Travel!
Skill:!Conceptual!
!
A)!!Finding!the!present!value!and!compounding!are!the!same.!
B)!!A!dollar!today!and!a!dollar!in!one!year!are!not!equivalent.!
C)!!If!you!want!to!compare!or!combine!cash!flows!that!occur!at!different!points!in!time,!you!first!need!to!
convert!the!cash!flows!into!the!same!units!or!move!them!to!the!same!point!in!time.!
D)!!The!equivalent!value!of!two!cash!flows!at!two!different!points!in!time!is!sometimes!referred!to!as!the!
time!value!of!money.!
Answer:!!!A!
Explanation:!!! A)!!Finding!the!present!value!and!discounting!are!the!same.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!process!of!moving!a!value!or!cash!flow!backward!in!time!is!known!as!discounting.!
B)!! C
FV!=!
(1 r )n
C)!!The!process!of!moving!a!value!or!cash!flow!forward!in!time!is!known!as!compounding.!
D)!!The!value!of!a!cash!flow!that!is!moved!forward!in!time!is!known!as!its!future!value.!
Answer:!!!B!
B)!!FV!=!C(1!+!r)n$
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!Consider!the!following!time!line:!
If!the!current!market!rate!of!interest!is!8%,!then!the!present!value!of!this!timeline!is!closest!to:!
A)!!$1000!
B)!!$857!
C)!!$860!
D)!!$926!
Answer:!!!B!
B)!!PV!=!FV$/!(1!+!r)n!=!1000!/!(1.08)2!=!857.34!or!approximately!$857!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Consider!the!following!timeline:!
If!the!current!market!rate!of!interest!is!10%,!then!the!future!value!of!this!timeline!is!closest!to:!
A)!!$666!
B)!!$500!
C)!!$605!
D)!!$650!
Answer:!!!A!
Explanation:!!! A)!!FV!=!PV(1!+!r)n!=!500(1.10)3!=!665.50!which!is!approximately!$666!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Consider!the!following!timeline:
!
If!the!current!market!rate!of!interest!is!12%,!then!the!value!of!the!cash!flows!in!year!0!and!year!2!as!of!year!1!is!
closest!to:!
A)!!$2120!
B)!!$2013!
C)!!$2000!
D)!!$1893!
Answer:!!!B!
B)!!This!is!a!two!part!problem!involving!both!present!and!future!values.
FV!of!year!0!c/f!=!FV!=!PV(1!+!r)n!=!1000(1.12)1!=!$1120
PV!of!year!2!c/f!=!PV!=!FV/(1!+!r)n!=!1000/(1.12)1!=!$893
So!the!answer!is!$1120!+!$893!=!$2013!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
If!the!current!market!rate!of!interest!is!7%,!then!the!future!value!of!this!timeline!as!of!year!3!is!closest!to:!
A)!!$1720!
B)!!$1500!
C)!!$1404!
D)!!$1717!
Answer:!!!A!
Explanation:!!! A)!!FV!=!PV(1!+!r)n
FV!=!500(1.07)3!+!500(1.07)2!+!500(1.07)1!=!$1719.97!or!approximately!$1720!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
If!the!current!market!rate!of!interest!is!9%,!then!the!present!value!of!this!timeline!as!of!year!0!is!closest!to:!
A)!!$492!
B)!!$637!
C)!!$600!
D)!!$400!
Answer:!!!A!
Explanation:!!! A)!!PV$=$FV(1!+!r)n
100!/!(1.09)1!=!91.74
200!/!(1.09)2!=!168.34
300!/!(1.09)3!=!231.66
Sum!=!491.74!which!is!approximately!$492!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
If!the!current!market!rate!of!interest!is!8%,!then!the!value!as!of!year!1!is!closest!to:!
A)!!$0!
B)!!$1003!
C)!!$540!
D)!!$77!
Answer:!!!D!
B)!!
C)!!
D)!!Two!part!problem:
FV!=!PV(1!+!r)n!=!500(1.08)1!=!$540
PV!=!FV/(1!+!r)n!=!-500!/!(1.08)1!=!-$463
So!the!answer!is!$540!+!-$463!=!$77!
Diff:!2!
Skill:!Analytical!
!
4.3!The!Power!of!Compounding:!An!Application!
1)!!Suppose!you!invest!$1000!into!a!mutual!fund!that!is!expected!to!earn!a!rate!of!return!of!10%.!!The!amount!of!
money!will!you!have!in!10!years!is!closest!to!which!of!the!following?!!The!amount!you!will!have!in!50!years!is!
closest!to!which!of!the!following?!
A)!!$386;!$9!
B)!!$2,594;!$45,259!
C)!!$2,594;!$117,391!
D)!!$3,138;!$!1,311,892!
Answer:!!!C!
B)!!
C)!!FV!=!1000(1.10)10!=!2,594;!FV!=!1000(1.10)50!=!$117,391!
D)!!
Diff:!1!
Topic:!4.3!The!Power!of!Compounding:!An!Application!
Skill:!Analytical!
!
2)!!It!has!long!been!told!that!the!Dutch!purchased!Manhattan!island!in!1626!for!the!value!of!60!guilders!($24).!!
Assuming!that!the!Dutch!invested!this!money!into!an!account!earning!5%,!approximately!how!much!would!
their!investment!be!worth!380!years!later!in!2006?!
A)!!$2.7!billion!
B)!!$3.1!billion!
C)!!$4.5!billion!
D)!!$1.9!trillion!
Answer:!!!A!
Explanation:!!! A)!!FV!=!24(1.05)380!=!2,704,860,602!or!2.7!billion!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!4.3!The!Power!of!Compounding:!An!Application!
Skill:!Analytical!
!
4.4!Valuing!a!Stream!of!Cash!Flows!
1)!!Consider!the!following!timeline!detailing!a!stream!of!cash!flows:!
!
If!the!current!market!rate!of!interest!is!8%,!then!the!present!value!of!this!stream!of!cash!flows!is!closest!to:!
A)!!$22,871!
B)!!$21,211!
C)!!$24,074!
D)!!$26,000!
Answer:!!!B!
B)!!PV!=!5000!/!(1.07)1!+!6000!/!(1.07)2!+!7000!/!(1.07)3!+!8000!/!(1.07)4!=!$21,210.72!
C)!!
D)!!
Diff:!2!
Topic:!4.4!Valuing!a!Stream!of!Cash!Flows!
Skill:!Analytical!
!
A)!! PV
FV!=
(1 r )n
B)!! N
Cn
PV!=!
n 0 (1 r )n
C)!! N
FV!=! Cn!×!(1!+!r)n!!
n 0
D)!!Most!investment!opportunities!have!multiple!cash!flows!that!occur!at!different!points!in!time.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
If!the!current!market!rate!of!interest!is!8%,!then!the!future!value!of!this!stream!of!cash!flows!is!closest!to:!
A)!!$11,699!
B)!!$10,832!
C)!!$12,635!
D)!!$10,339!
Answer:!!!A!
Explanation:!!! A)!!FV!=!1000(1.08)4!+!2000(1.08)3!+!3000(1.08)2!+!4000(1.08)1!=!$11,699!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
If!the!current!market!rate!of!interest!is!10%,!then!the!present!value!of!this!stream!of!cash!flows!is!closest!to:!
A)!!$674!
B)!!$600!
C)!!$460!
D)!!$287!
Answer:!!!C!
B)!!
C)!!PV!=!100!/!(1.10)1!+!100!/!(1.10)2!+!200!/!(1.10)3!+!200!/!(1.10)4!=!$460!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
If!the!current!market!rate!of!interest!is!6%,!then!the!future!value!of!this!stream!of!cash!flows!is!closest!to:!
A)!!$1,723!
B)!!$1,500!
C)!!$1,626!
D)!!$1,288!
Answer:!!!A!
Explanation:!!! A)!!FV!=!100(1.06)5!+!200(1.06)4!+!300(1.06)3!+!400(1.06)2!+!500(1.06)1!=!$1723!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!In!terms!of!present!value,!how!much!will!Joe!receive!for!selling!the!family!business?!
Answer:!!!PV!=!$100,000!+!$50,000!/!(1.06)1!+!$50,000!/!(1.06)2!+!$75,000!/!(1.06)3!=!$254,641!
Diff:!2!
Skill:!Analytical!
!
4.5!The!Net!Present!Value!of!a!Stream!of!Cash!Flows!
1)!!You!have!been!offered!the!following!investment!opportunity,!if!you!pay!$2500!today,!you!will!receive!$1000!
at!the!end!of!each!of!the!next!three!years.!!Assuming!that!you!could!otherwise!earn!10%!per!year!on!your!
money,!!the!NPV!for!this!opportunity!is!closest!to:!
A)!!$12!
B)!!$18!
C)!!-$13!
D)!!$500!
Answer:!!!C!
B)!!
C)!!NPV!=!-2500!+!1000!/!(1.10)1!+!1000!/!(1.10)2!+!1000!/!(1.10)3!=!-13.15!which!is!approximately!
-$13!
D)!!
Diff:!2!
Topic:!4.5!The!Net!Present!Value!of!a!Stream!of!Cash!Flows!
Skill:!Analytical!
!
Year A B!
0 -$150 -$225!
1 40 175!
2 80 125!
3 100 -50!
!
2)!!If!the!interest!rate!is!6%,!then!the!NPV!of!investment!YAY!is!closest!to:!
A)!!$70!
B)!!$43!
C)!!-$32!
D)!!$9!
Answer:!!!B!
B)!!NPV!=!-150!+!40!/!(1.06)1!+!80!/!(1.06)2!+!100!/!(1.06)3!=!$42.90!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
3)!!If!the!interest!rate!is!6%,!then!the!NPV!of!investment!YBY!is!closest!to:!
A)!!$84!
B)!!-$32!
C)!!$43!
D)!!$9!
Answer:!!!D!
Explanation:!!! A)!!NPV!=!-225!+!175!/!(1.06)1!+!125!/!(1.06)2!+!-50!/!(1.06)3!=!$9.36!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!Suppose!a!second!entrepreneur!approaches!Joe!and!offers!him!$250,000!today!for!the!business.!!Should!Joe!
accept!the!new!entrepreneurWs!offer!or!stick!with!the!original!offer!of!$100,000!and!the!series!of!payments!over!
three!years?!!Why?!
Answer:!!!Joe!should!take!the!original!offer!of!$100,000!+!payments.
PV!of!the!original!offer!=!$100,000!+!$50,000!/!(1.06)1!+!$50,000!/!(1.06)2!+!$75,000!/!(1.06)3!=!$254,641!!
So,!the!NPV!of!taking!the!second!offer!is!$250,000!-!$254,641!=!-$4,641!!Since!the!NPV!is!negative!we!
would!not!take!the!second!offer.!
Diff:!2!
Skill:!Analytical!
!
Year A B!
0 -$150 -$225!
1 40 175!
2 80 125!
3 100 -50!
!
5)!!If!the!interest!rate!is!10%,!then!which!investment(s),!if!any,!would!you!take!and!why?!
Answer:!!!NPVA!=!!-150!+!40!/!(1.10)1!+!80!/!(1.10)2!+!100!/!(1.10)3!=!$27.61
NPVB!=!-225!+!175!/!(1.10)1!+!125!/!(1.10)2!+!-50!/!(1.10)3!=!-$0.17
Therefore,!you!should!take!A!since!NPVA!>!0!and!reject!B!since!NPVB!<!0.!
Diff:!3!
Skill:!Analytical!
4.6!Perpetuities,!Annuities,!and!Other!Special!Cases!
1)!!Which!of!the!following!statements!regarding!perpetuities!is!false?!
A)!!To!find!the!value!of!a!perpetuity!one!cash!flow!at!a!time!would!take!forever.!
B)!!A!perpetuity!is!a!stream!of!equal!cash!flows!that!occurs!at!regular!intervals!and!lasts!forever.!
C)!! r
PV!of!a!perpetuity!=!
C
D)!!One!example!of!a!perpetuity!is!the!British!government!bond!called!a!consol.!
Answer:!!!C!
B)!!
C)!! C
r
D)!!
Diff:!1!
Topic:!4.6!Perpetuities,!Annuities,!and!Other!Special!Cases!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!annuities!is!false?!
A)!! 1 1
PV!of!an!annuity!=!C!×! 1
r (1 r ) N
B)!!The!difference!between!an!annuity!and!a!perpetuity!is!that!a!perpetuity!ends!after!some!fixed!number!of!
payments.!
C)!!An!annuity!is!a!stream!of!N!equal!cash!flows!paid!at!regular!intervals.!
D)!!Most!car!loans,!mortgages,!and!some!bonds!are!annuities.!
Answer:!!!B!
B)!!A!perpetuity!never!ends.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!of!the!following!statements!regarding!growing!perpetuities!is!false?!
A)!!We!assume!that!r$<$g!for!a!growing!perpetuity.!
B)!! C
PV!of!a!growing!perpetuity!=!
r g
C)!!To!find!the!value!of!a!growing!perpetuity!one!cash!flow!at!a!time!would!take!forever.!
D)!!A!growing!perpetuity!is!a!cash!flow!stream!that!occurs!at!regular!intervals!and!grows!at!a!constant!rate!
forever.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!Which!of!the!following!statements!regarding!growing!annuities!is!false?!
A)!!A!growing!annuity!is!a!stream!of!N!growing!cash!flows,!paid!at!regular!intervals.!
B)!!We!assume!that!g!<!r!when!using!the!growing!annuity!formula.!
C)!! 1 1 g
PV!of!a!growing!annuity!=!C!×! 1
r g 1 r
D)!!A!growing!annuity!is!like!a!growing!perpetuity!that!never!comes!to!an!end.!
Answer:!!!D!
B)!!
C)!!
D)!!An!annuity!does!end.!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!difference!between!an!annuity!and!a!perpetuity!is!that!an!annuity!ends!after!some!fixed!number!of!
payments.!
B)!!Most!car!loans,!mortgages,!and!some!bonds!are!annuities.!
C)!!A!growing!perpetuity!is!a!cash!flow!stream!that!occurs!at!regular!intervals!and!grows!at!a!constant!rate!
forever.!
D)!!An!annuity!is!a!stream!of!N!equal!cash!flows!paid!at!irregular!intervals.!
Answer:!!!D!
B)!!
C)!!
D)!!annuities!are!paid!at!regular!intervals.!
Diff:!2!
Skill:!Conceptual!
!
6)!!Which!of!the!following!formulas!is!incorrect?!
A)!!PV!of!a!growing!annuity!=!C!×! 1 1 g
1
r g 1 r
B)!!PV!of!an!annuity!=!C!×! 1 1
1
r (1 r ) N
C)!! C
PV!of!a!growing!perpetuity!=!
r g
D)!! C
r
Answer:!!!A!
Explanation:!!! A)!!PV!of!a!growing!annuity!=!C!×! 1 1 g
1
r g 1 r
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
7)!!Assuming!that!costs!continue!to!increase!an!average!of!4%!per!year,!tuition!and!other!costs!for!one!year!for!
this!student!in!18!years!when!she!enters!college!will!be!closest!to:!
A)!!$12,500!
B)!!$21,500!
C)!!$320,568!
D)!!$25,323!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!PV(1!+!i)N!!=!$12,500(1.04)18!=!$25,322.71!
Diff:!2!
Skill:!Analytical!
!
8)!!Assuming!that!college!costs!continue!to!increase!an!average!of!4%!per!year!and!that!all!her!college!savings!are!
invested!in!an!account!paying!7%!interest,!then!the!amount!of!money!she!will!need!to!have!available!at!age!18!
to!pay!for!all!four!years!of!her!undergraduate!education!is!closest!to:!!!
A)!!$97,110!
B)!!$107,532!
C)!!$101,291!
D)!!$50,000!
Answer:!!!A!
Explanation:!!! A)!!This!is!a!two!step!problem.
Step!#1!determine!the!cost!of!the!first!year!of!college.
FV!=!PV(1!+!i)N!!=!$12,500(1.04)18!=!$25,322.71
Step!#2!figure!out!the!value!for!four!years!of!college.
PV!of!a!growing!annuity!due!=!C!x! 1 1
1 g !(1!+!r)!
r g 1 r
4
1 1 .04
=!!$25,322.71!×! 1 (1!+!.07)!=!$97,110.01!
.07 .04 1 .07
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
9)!!The!British!government!has!a!consol!bond!outstanding!that!pays!
the!current!interest!rate!in!Great!Britain!is!5%!and!that!you!will!receive!your!first!interest!payment!one!year!
from!now,!then!the!value!of!the!consol!bond!is!closest!to:!
A)!! 1000!
B)!! 1100!
C)!! 2100!
D)!! 2000!
Answer:!!!D!
B)!!
C)!!
D)!!PVP!=!C$/!r!=!100!/!.05!=!2000!
Diff:!1!
Skill:!Analytical!
!
10)!!The!British!government!has!a!consol!bond!outstanding!that!pays!
the!current!interest!rate!in!Great!Britain!is!5%!and!that!you!will!receive!your!first!interest!payment!
immediately!upon!purchasing!the!consol!bond,!then!the!value!of!the!consol!bond!is!closest!to:!
A)!! 2000!
B)!! 2100!
C)!! 1000!
D)!! 1100!
Answer:!!!B!
B)!!PVP!=!C$/!r!=!100!/!.05!=!2000!+!100!immediate!interest!payment!=! 2100!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!If!the!current!rate!of!interest!is!8%,!then!the!present!value!of!an!investment!that!pays!$1000!per!year!and!lasts!
20!years!is!closest!to:!
A)!!$18,519!
B)!!$45,761!
C)!!$9,818!
D)!!$20,000!
Answer:!!!C!
B)!!
C)!!N!=!20
I!=!8
PMT!=!1000
FV!=!0
Compute!PV!=!$9,818!
D)!!
Diff:!1!
Skill:!Analytical!
!
12)!!If!the!current!rate!of!interest!is!8%,!then!the!future!value!20!years!from!now!of!an!investment!that!pays!$1000!
per!year!and!lasts!20!years!is!closest!to:!
A)!!$45,761!
B)!!$36,725!
C)!!$9,818!
D)!!$93,219!
Answer:!!!A!
Explanation:!!! A)!!N!=!20
I!=!8
PMT!=!1000
PV!=!0
Compute!FV!=!$45,761!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!Suppose!that!a!young!couple!has!just!had!their!first!baby!and!they!wish!to!insure!that!enough!money!will!be!
available!to!pay!for!their!childWs!college!education.!!They!decide!to!make!deposits!into!an!educational!savings!
account!on!each!of!their!daughterWs!birthdays,!starting!with!her!first!birthday.!!Assume!that!the!educational!
savings!account!will!return!a!constant!7%.!!The!parents!deposit!$2000!on!their!daughterWs!first!birthday!and!
plan!to!increase!the!size!of!their!deposits!by!5%!each!year.!!Assuming!that!the!parents!have!already!made!the!
deposit!for!their!daughterWs!18th!birthday,!then!the!amount!available!for!the!daughterWs!college!expenses!on!
her!18th!birthday!is!closest!to:!
A)!!$42,825!
B)!!$97,331!
C)!!$67,998!
D)!!$103,063!
Answer:!!!B!
B)!!FV!of!a!growing!annuity!
!
18
1 1 .05
$2,000!×!!! 1 !(1.07)18=!$97,331!
.07 .05 1 .07
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!Since!your!first!birthday,!your!grandparents!have!been!depositing!$1000!into!a!savings!account!on!everyone!
of!your!birthdays.!!The!account!pays!4%!interest!annually.!!Immediately!after!your!grandparents!make!the!
deposit!on!your!18th!birthday,!the!amount!of!money!in!your!savings!account!will!be!closest!to:!
A)!!$25,645!
B)!!$36,465!
C)!!$12,659!
D)!!$18,000!
Answer:!!!A!
Explanation:!!! A)!!N!=!18
PMT!=!1000
I!=!4
PV!=!0
Compute!FV!=!$25,645!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!Consider!a!growing!perpetuity!that!will!pay!$100!in!one!year.!!Each!year!after!that,!you!will!receive!a!payment!
on!the!anniversary!of!the!last!payment!that!is!6%!larger!than!the!last!payment.!!This!pattern!of!payments!will!
continue!forever.!!If!the!interest!rate!is!11%,!then!the!value!of!this!perpetuity!is!closest!to:!
A)!!$1,667!
B)!!$588!
C)!!$2,000!
D)!!$909!
Answer:!!!C!
B)!!
C)!!PV!growing!Perpetuity!=!C$/!r$-$g!=!100!/!(.11!-!.06)!=!$2000!
D)!!
Diff:!1!
Skill:!Analytical!
!
16)!!You!are!thinking!about!investing!in!a!mine!that!will!produce!$10,000!worth!of!ore!in!the!first!year.!!As!the!ore!
closest!to!the!surface!is!removed!it!will!become!more!difficult!to!extract!the!ore.!!Therefore,!the!value!of!the!ore!
that!you!mine!will!decline!at!a!rate!of!8%!per!year!forever.!!If!the!appropriate!interest!rate!is!6%,!then!the!value!
of!this!mining!operation!is!closest!to:!
A)!!$71,429!
B)!!$500,000!
C)!!$166,667!
D)!!This!problem!cannot!be!solved.!
Answer:!!!A!
Explanation:!!! A)!!PVP!=!C$/!r$-$g$=!10,000!/!(.06!-!-.08)!=!10,000!/!.14!=!$71,429!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
Assume!that!you!are!30!years!old!today,!and!that!you!are!planning!on!retirement!at!age!65.!!Your!current!salary!is!$45,000!
and!you!expect!your!salary!to!increase!at!a!rate!of!5%!per!year!as!long!as!you!work.!!To!save!for!your!retirement,!you!plan!
on!making!annual!contributions!to!a!retirement!account.!!Your!first!contribution!will!be!made!on!your!31st!birthday!and!
will!be!8%!of!this!yearWs!salary.!!Likewise,!you!expect!to!deposit!8%!of!your!salary!each!year!until!you!reach!age!65.!!
Assume!that!the!rate!of!interest!is!7%.
17)!!The!present!value!(at!age!30)!of!your!retirement!savings!is!closest!to:!
A)!!$87,000!
B)!!$108,000!
C)!!$46,600!
D)!!$75,230!
Answer:!!!A!
Explanation:!!! A)!!First!deposit!=!.08!×!$45,000!=!$3,600
35
1 1 .05
$3,600!×!! 1 !=!$87,003!
.07 .05 1 .07
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!The!future!value!at!retirement!(age!65)!of!your!savings!is!closest!to:!
A)!!$497,530!
B)!!$928,895!
C)!!$1,263,236!
D)!!$108,000!
Answer:!!!B!
B)!!First!deposit!=!.08!x!$45,000!=!$3,600
35
1 1 .05
$3,600!×! 1 !(1.07)35=!$928,895!!or
.07 .05 1 .07
35
1 1 .05
PVA!(growing)!=!!$3,600!×! 1 !=!$87,003
.07 .05 1 .07
FV!=!PV(1!+!i)N!=!$87,003(1.07)35!=!$928,895!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
19)!!You!work!for!a!pharmaceutical!company!that!has!developed!a!new!drug.!!The!patent!on!the!drug!will!last!for!
17!years.!!You!expect!that!the!drug!will!produce!cash!flows!of!$10!million!in!its!first!year!and!that!this!amount!
will!grow!at!a!rate!of!4%!per!year!for!the!next!17!years.!!Once!the!patent!expires,!other!pharmaceutical!
companies!will!be!able!to!produce!generic!equivalents!of!your!drug!and!competition!will!drive!any!future!
profits!to!zero.!!If!the!interest!rate!is!12%!per!year,!then!the!present!value!of!producing!this!drug!is!closest!to:!
A)!!$71!million!
B)!!$90!million!
C)!!$170!million!
D)!!$105!million!
Answer:!!!B!
B)!! 17
1 1 .04
$10!×!!! 1 =!$89.53!million!!
.12 .04 1 .12
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!Your!son!is!about!to!start!kindergarten!in!a!private!school.!!Currently,!the!tuition!is!$12,000!per!year,!payable!
at!the!start!of!the!school!year.!!You!expect!annual!tuition!increases!to!average!6%!per!year!over!the!next!13!
years.!!Assuming!that!you!son!remains!in!this!private!school!through!high!school!and!that!your!current!
interest!rate!is!7%,!then!the!present!value!of!your!sonWs!private!school!education!is!closest!to:!
A)!!$332,300!
B)!!$137,900!
C)!!$155,800!
D)!!$156,000!
Answer:!!!B!
B)!! 13
1 1 .06
$12,000!×!! 1 !=!$137,893!!
.07 .06 1 .07
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
21)!!Your!son!is!about!to!start!kindergarten!in!a!private!school.!!Currently,!the!tuition!is!$12,000!per!year,!payable!
at!the!start!of!the!school!year.!!You!expect!annual!tuition!increases!to!average!6%!per!year!over!the!next!13!
years.!!Assuming!that!you!son!remains!in!this!private!school!through!high!school!and!that!your!current!
interest!rate!is!6%,!then!the!present!value!of!your!sonWs!private!school!education!is!closest!to:!
A)!!$106,230!
B)!!$156,000!
C)!!$137,900!
D)!!This!problem!cannot!be!solved!
Answer:!!!B!
B)!!This!is!a!bit!of!a!trick!question.!!The!PV!of!a!growing!annuity!formula!is!undefined!since!r$=$g.!!
But!since$r$=$g,!the!growth!in!the!payments!is!exactly!offset!by!the!current!interest!rate.!!
Therefore!the!answer!is!12,000!×!13!=!$156,000.!!You!could!also!individually!discount!each!of!
the!13!payments!and!arrive!at!the!same!answer.!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
22)!!Define!the!following!terms:
(a)! perpetuity
(b)! annuity
(c)! growing!perpetuity
(d)! growing!annuity!
Answer:!!!(a)! A!perpetuity!is!a!stream!of!equal!cash!flows!that!occur!at!regular!intervals!and!lasts!forever.
(b)! An!annuity!is!a!stream!of!N!equal!cash!flows!paid!at!regular!intervals.
(c)! A!growing!perpetuity!is!a!cash!flow!stream!that!occurs!at!regular!intervals!and!grows!at!a!constant!
rate!forever.
(d)! A!growing!annuity!is!a!stream!of!N!growing!cash!flows,!paid!at!regular!intervals.!
Diff:!2!
Skill:!Definition!
!
23)!!How!do!you!calculate!(mathematically)!the!present!value!of!a(n):
(a)! perpetuity
(b)! annuity
(c)! growing!perpetuity
(d)! growing!annuity!
Answer:!!!(a)! PV!of!a!perpetuity!=$ C
r
1 1
(b)! PV!of!an!annuity!=!C!×! 1
r (1 r ) N
(c)! PV!of!a!growing!perpetuity!=! C
r g
(d)! PV!of!a!growing!annuity!=!C!× 1 1 g
1
r g 1 r
Diff:!2!
Skill:!Conceptual!
!
24)!!Assuming!that!college!costs!continue!to!increase!an!average!of!4%!per!year!and!that!all!her!college!savings!are!
invested!in!an!account!paying!7%!interest,!then!the!amount!of!money!she!will!need!to!have!available!at!age!18!
to!pay!for!all!four!years!of!her!undergraduate!education!is!closest!to:!!!
Answer:!!!This!is!a!two!step!problem.
Step!#1!determine!the!cost!of!the!first!year!of!college.
FV!=!PV(1!+!i)N!!=!$12,500(1.04)18!=!$25,322.71
Step!#2!figure!out!the!value!for!four!years!of!college.
PV!of!a!growing!annuity!due!=!C!× 1 1 g (1!+!r)!
1
r g 1 r
4
1 1 .04
=!!$25,322.71!×! 1 (1!+!.07)!=!$97.110.01!
.07 .04 1 .07
Diff:!3!
Skill:!Analytical!
!
Assume!that!you!are!30!years!old!today,!and!that!you!are!planning!on!retirement!at!age!65.!!Your!current!salary!is!$45,000!
and!you!expect!your!salary!to!increase!at!a!rate!of!5%!per!year!as!long!as!you!work.!!To!save!for!your!retirement,!you!plan!
on!making!annual!contributions!to!a!retirement!account.!!Your!first!contribution!will!be!made!on!your!31st!birthday!and!
will!be!8%!of!this!yearWs!salary.!!Likewise,!you!expect!to!deposit!8%!of!your!salary!each!year!until!you!reach!age!65.!!
Assume!that!the!rate!of!interest!is!7%.
25)!!The!future!value!at!retirement!(age!65)!of!your!savings!is:!
Answer:!!!First!deposit!=!.08!×!$45,000!=!$3,600
35
1 1 .05
$3,600!× 1 !(1.07)35=!$928,895!
.07 .05 1 .07
Diff:!3!
Skill:!Analytical!
!
26)!!Assume!that!you!are!30!years!old!today,!and!that!you!are!planning!on!retiring!at!age!65.!!Your!current!salary!is!
$45,000!and!you!expect!your!salary!to!increase!at!a!rate!of!5%!per!year!as!long!as!you!work.!!To!save!for!your!
retirement,!you!plan!on!making!annual!contributions!to!a!retirement!account.!!Your!first!contribution!will!be!
made!on!your!31st!birthday!and!will!be!8%!of!this!yearWs!salary.!!Likewise,!you!expect!to!deposit!8%!of!your!
salary!each!year!until!you!reach!age!65.!!At!retirement!(age!65)!you!will!begin!withdrawing!equal!annual!
payments!to!pay!for!your!living!expenses!during!retirement!(on!your!65th!birthday).!!If!you!expect!to!die!one!
day!before!your!101st!birthday!(Your!last!withdraw!will!be!on!your!100th!birthday)!and!if!the!annual!rate!of!
return!is!7%,!then!how!much!money!will!you!have!to!spend!in!each!of!your!golden!years!of!retirement?!
Answer:!!!$71,260
First!deposit!=!.08!×!$45,000!=!$3,600
35
1 1 .05
$3,600!×! 1 !(1.07)35=!$928,895
.07 .05 1 .07
so,
N!=!36
I!=!7
PV!=!928,895
FV!=!0
Compute!PMT!=!71260!
Diff:!3!
Skill:!Analytical!
4.7!Solving!Problems!with!a!Spreadsheet!Program!
1)!!Which!of!the!following!is!not!a!valid!time!value!of!money!function!in!Excel?!
A)!!PMT!
B)!!NPER!
C)!!I!
D)!!FV!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!4.7!Solving!Problems!with!a!Spreadsheet!Program!
Skill:!Conceptual!
!
2)!!Suppose!that!you!deposit!$10,000!in!an!account!that!pays!6%!interest!and!you!want!to!know!how!much!will!be!
in!your!account!at!the!end!of!10!years.!!To!solve!this!problem!in!Microsoft!Excel,!you!would!use!which!of!the!
following!Excel!formulas?!
A)!!=FV(.06,10000,0,10)!
B)!!=PV(.06,10000,0,10)!
C)!!=FV(.06,10,0,10000)!
D)!!=PV(.06,10,0,10000)!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Suppose!that!you!are!considering!an!investment!that!will!pay!you!$4000!per!year!for!the!next!five!years.!!The!
appropriate!rate!of!interest!is!5%.!!You!want!to!know!the!present!value!of!the!cash!flows!from!this!investment.!!
To!solve!this!problem!in!Microsoft!Excel,!you!would!use!which!of!the!following!excel!formulas?!
A)!!=PV(.05,5,4000,0,0)!
B)!!=PV(.05,5,4000,0,1)!
C)!!=PV(5,.05,4000,0)!
D)!!=PV(5,5,4000,0)!
Answer:!!!A!
Explanation:!!! A)!!=PV(.05,5,4000,0,0)!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
4.8!Solving!for!Variables!Other!Than!Present!Value!or!Future!Value!
1)!!You!are!interested!in!purchasing!a!new!automobile!that!costs!$35,000.!!The!dealership!offers!you!a!special!
financing!rate!of!6%!APR!(0.5%)!per!month!for!48!months.!!Assuming!that!you!do!not!make!a!down!payment!
on!the!auto!and!you!take!the!dealerWs!financing!deal,!then!your!monthly!car!payments!would!be!closest!to:!
A)!!$729!
B)!!$822!
C)!!$842!
D)!!$647!
Answer:!!!B!
B)!!PV!=!35000
I!=!.5
N!=!48
FV!=!0
Compute!Payment!=!$821.98!
C)!!
D)!!
Diff:!2!
Topic:!4.8!Solving!for!Variables!Other!Than!Present!Value!or!Future!Value!
Skill:!Analytical!
!
2)!!You!are!considering!purchasing!a!new!home.!!You!will!need!to!borrow!$250,000!to!purchase!the!home.!!A!
mortgage!company!offers!you!a!15!year!fixed!rate!mortgage!(180!months)!at!9%!APR!(0.75%!month).!!If!you!
borrow!the!money!from!this!mortgage!company,!your!monthly!mortgage!payment!will!be!closest!to:!
A)!!$2,585!
B)!!$660!
C)!!$2,535!
D)!!$1,390!
Answer:!!!C!
B)!!
C)!!PV!=!250000
I!=!0.75
N!=!180
FV!=!0
Compute!PMT!=!$2535.67!
D)!!
Diff:!2!
Skill:!Analytical!
!
3)!!The!British!government!has!just!issued!a!new!consol!bond!that!sells!for!£1000!and!pays!interest!of!8%.!!The!
annual!interest!payment!on!this!bond!must!be:!
A)!!£80!
B)!!£8!
C)!!£1000!
D)!!£12,500!
Answer:!!!A!
Explanation:!!! A)!!£1000!×!.08!=!£80!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!You!are!saving!for!retirement.!!To!live!comfortably,!you!decide!that!you!will!need!$2.5!million!dollars!by!the!
time!you!are!65.!!If!today!is!your!30th!birthday,!and!you!decide,!starting!today,!and!on!every!birthday!up!to!
and!including!your!65th!birthday,!that!you!will!deposit!the!same!amount!into!your!savings!account.!!
Assuming!the!interest!rate!is!5%,!the!amount!that!you!must!set!aside!each!and!every!year!on!your!birthday!is!
closest!to:!
A)!!$71,430!
B)!!$27,680!
C)!!$26,100!
D)!!$26,260!
Answer:!!!C!
B)!!
C)!!PV!(age!29)!=!2500000!/!(1.05)36!=!431643.54
PV!=!431,643.54
FV!=!0
I!=!5
N!=!36
Compute!PMT!=!$26,086!
D)!!
Diff:!3!
Skill:!Analytical!
!
5)!!You!have!an!investment!opportunity!that!will!cost!you!$10,000!today,!but!return!$12,500!to!you!in!one!year.!!
The!IRR!of!this!investment!opportunity!is!closest!to:!
A)!!80%!
B)!!125%!
C)!!20%!
D)!!25%!
Answer:!!!D!
B)!!
C)!!
D)!! $12,500
IRR!=! !-!1!=!0.25!or!25%!
$10, 000
Diff:!1!
Skill:!Analytical!
!
6)!!After!your!grandmother!retired,!she!purchased!an!annuity!contract!for!$250,000!that!will!pay!her!$25,000!at!
the!end!of!every!year!until!she!dies.!!The!appropriate!interest!rate!for!this!annuity!is!8%.!!The!number!of!years!
that!your!grandmother!must!live!in!order!to!get!more!value!out!of!the!annuity!than!what!she!paid!for!it!is!
closest!to:!
A)!!21!
B)!!16!
C)!!8!
D)!!10!
Answer:!!!A!
Explanation:!!! A)!!PV!=!250000
FV!=!0
I!=!8
PMT!=!-!25000
Compute!N!=!21!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!You!are!offered!an!investment!opportunity!that!costs!you!$28,000,has!an!NPV!of!$2278,!lasts!for!three!years,!
has!interest!rate!of!10%,!and!produces!the!following!cash!flows:!
!
The!missing!cash!flow!from!year!2!is!closest!to:!
A)!!$12,500!
B)!!$12,000!
C)!!$13,000!
D)!!$10,000!
Answer:!!!B!
B)!!NPV!=!PV!benefits!-!PV!of!costs
2278!=!10000!/!(1.10)1!+!X$/!(1.10)2!+!15000!/!(1.10)3!-!28000
30278!=!10000!/!(1.10)1!+!X$/!(1.10)2!+!15000!/!(1.10)3
30278!=!9091!+!X$/!(1.10)2!+!11270
9917!=!X$/!(1.10)2
X!=!11,999.57!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!You!are!looking!for!a!new!truck!and!see!the!following!advertisement.!!YOwn!a!new!truck!!!No!money!down.!!
Just!five!easy!annual!payments!of!$8000.Y!!You!know!that!you!can!get!the!same!truck!from!the!dealer!across!
town!for!only!$31,120.!!The!interest!rate!for!the!deal!advertised!is!closest!to:!
A)!!9%!
B)!!8%!
C)!!8.5%!
D)!!10%!
Answer:!!!A!
Explanation:!!! A)!!PV!=!31120
FV!=!0
N!=!5
PMT!=!-8000
Compute!I!=!8.9965%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!You!are!considering!investing!in!a!zero!coupon!bond!that!will!pay!you!its!face!value!of!$1000!in!ten!years.!!If!
the!bond!is!currently!selling!for!$485.20,!then!the!IRR!for!investing!in!this!bond!is!closest!to:!
A)!!12%!
B)!!8.0%!
C)!!7.5%!
D)!!10%!
Answer:!!!C!
B)!!
C)!!PV!=!-485.20
FV!=!1000
PMT!=!0
N!=!10
Compute!I!=!7.5%!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!You!are!considering!investing!in!a!security!that!will!pay!you!$80!in!interest!at!the!end!of!each!of!the!next!10!
years.!If!this!security!is!currently!selling!for!$588.81,!then!the!IRR!for!investing!in!this!security!is!closest!to:!
A)!!6.0%!
B)!!7.0%!
C)!!6.5%!
D)!!5.0%!
Answer:!!!A!
Explanation:!!! A)!!PV!=!-588.81
PMT!=!80
N!=!10
FV!=!0
Compute!I!=!5.99989!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical
!
Chapter!5!-!Interest!Rates!
!
!
5.1!Interest!Rate!Quotes!and!Adjustments!
A)!!Because!interest!rates!may!be!quoted!for!different!time!intervals,!it!is!often!necessary!to!adjust!the!
interest!rate!to!a!time!period!that!matches!that!of!our!cash!flows.!
B)!!The!effective!annual!rate!indicates!the!amount!of!interest!that!will!be!earned!at!the!end!of!one!year.!
C)!!The!annual!percentage!rate!indicates!the!amount!of!simple!interest!earned!in!one!year.!
D)!!The!annual!percentage!rate!indicates!the!amount!of!interest!including!the!effect!of!compounding.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!5.1!Interest!Rate!Quotes!and!Adjustments!
Skill:!Conceptual!
!
2)!!Which!of!the!following!equations!is!incorrect?!
A)!!!! k 1 EAR !-!1=!APR$
B)!!Equivalent!n-Period!Discount!Rate!=!(1!+!r)n!-!1!
C)!! k
APR
1!+!EAR!=! 1
k
D)!! APR
Interest!Rate!per!Compounding!Period!=!
k periods / year
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!The!effective!annual!rate!(EAR)!for!a!loan!with!a!stated!APR!of!8%!compounded!monthly!is!closest!to:!
A)!!8.30%!
B)!!8.33%!
C)!!8.00%!
D)!!8.24%!
Answer:!!!A!
Explanation:!!! A)!!EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.08!/!12)12!-!1!=!.083!or!8.3%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!The!effective!annual!rate!(EAR)!for!a!loan!with!a!stated!APR!of!10%!compounded!quarterly!is!closest!to:!
A)!!10.52%!
B)!!10.25%!
C)!!10.38%!
D)!!10.00%!
Answer:!!!C!
B)!!
C)!!EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.10!/!4)4!-!1!=!.1038!or!10.38%!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!The!effective!annual!rate!(EAR)!for!a!savings!account!with!a!stated!APR!of!4%!compounded!daily!is!closest!to:!
A)!!4.00%!
B)!!4.10%!
C)!!4.08%!
D)!!4.06%!
Answer:!!!C!
B)!!
C)!!EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.04!/!365)365!-!1!=!.04088!or!4!.08%!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Consider!the!following!investment!alternatives:
Investment Rate Compounding!

A 6.25% Annual!
B 6.10% Daily!
C 6.125 Quarterly!
D 6.120 Monthly!
!
6)!!Which!alternative!offers!you!the!highest!effective!rate!of!return?!
A)!!Investment!A!
B)!!Investment!B!
C)!!Investment!C!
D)!!Investment!D!
Answer:!!!D!
B)!!
C)!!
D)!!EAR!(A)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0625!/!1)1!-!1!=!.0625!or!6.250%
EAR!(B)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0610!/!365)365!-!1!=!.06289!or!6.289%
EAR!(C)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06125!/!4)4!-!1!=!.06267!or!6.267%
EAR!(D)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0612!/!12)12!-!1!=!.06295!or!6.300%!
Diff:!2!
Skill:!Analytical!
!
7)!!Which!alternative!offers!you!the!lowest!effective!rate!of!return?!
A)!!Investment!A!
B)!!Investment!B!
C)!!Investment!C!
D)!!Investment!D!
Answer:!!!A!
Explanation:!!! A)!!EAR!(A)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0625!/!1)1!-!1!=!.0625!or!6.250%
EAR!(B)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0610!/!365)365!-!1!=!.06289!or!6.289%
EAR!(C)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06125!/!4)4!-!1!=!.06267!or!6.267%
EAR!(D)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0612!/!12)12!-!1!=!.06295!or!6.300%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!The!highest!effective!rate!of!return!you!could!earn!on!any!of!these!investments!is!closest!to:!
A)!!6.250%!
B)!!6.267%!
C)!!6.300%!
D)!!6.310%!
Answer:!!!C!
B)!!
C)!!EAR!(A)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0625!/!1)1!-!1!=!.0625!or!6.250%
EAR!(B)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0610!/!365)365!-!1!=!.06289!or!6.289%
EAR!(C)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06125!/!4)4!-!1!=!.06267!or!6.267%
EAR!(D)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0612!/!12)12!-!1!=!.06295!or!6.300%!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!The!lowest!effective!rate!of!return!you!could!earn!on!any!of!these!investments!is!closest!to:!
A)!!6.250%!
B)!!6.267%!
C)!!6.100%!
D)!!6.300%!
Answer:!!!A!
Explanation:!!! A)!!EAR!(A)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0625!/!1)1!-!1!=!.0625!or!6.250%
EAR!(B)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0610!/!365)365!-!1!=!.06289!or!6.289%
EAR!(C)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06125!/!4)4!-!1!=!.06267!or!6.267%
EAR!(D)!=!(1!+!APR$/!k)k!-!1!=!(1!+!.0612!/!12)12!-!1!=!.06295!or!6.300%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
Use$the$information$for$the$question(s)$below.!
!
Your!firm!needs!to!invest!in!a!new!delivery!truck.!!The!life!expectancy!of!the!delivery!truck!is!five!years.!!You!can!purchase!
a!new!delivery!truck!for!an!upfront!cost!of!$200,000,!or!you!can!lease!a!truck!from!the!manufacturer!for!five!years!for!a!
monthly!lease!payment!of!$4000!(paid!at!the!end!of!each!month).!!Your!firm!can!borrow!at!6%!APR!with!quarterly!
compounding.!
!
10)!!The!effective!annual!rate!on!your!firm\s!borrowings!is!closest!to:!
A)!!6.00%!
B)!!6.24%!
C)!!6.17%!
D)!!6.14%!
Answer:!!!D!
B)!!
C)!!
D)!!EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06!/!4)4!-!1!=!.06136!or!6.14%!
Diff:!1!
Skill:!Analytical!
!
11)!!The!monthly!discount!rate!that!you!should!use!to!evaluate!the!truck!lease!is!closest!to:!
A)!!0.487%!
B)!!0.512%!
C)!!0.498%!
D)!!0.500%!
Answer:!!!C!
B)!!
C)!!EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06!/!4)4!-!1!=!.06136!or!6.14%
Monthly!rate!=!(1!+!EAR)(1/12)!-!1=!(1.06136)(1/12)!-!1!=!.004975!=!0.498%!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!The!present!value!of!the!lease!payments!for!the!delivery!truck!is!closest!to:!
A)!!$206,900!
B)!!$207,050!
C)!!$207,680!
D)!!$198,420!
Answer:!!!B!
B)!!First!we!need!to!calculate!the!monthly!discount!rate!for!the!lease!arrangement.
EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06!/!4)4!-!1!=!.06136!or!6!.14%
Monthly!rate!=!(1!+!EAR)(1/12)!-!1=!(1.06136)(1/12)!-!1!=!.004975!=!0.4975%
!
Now!we!can!apply!the!PVA!formula!to!calculate!the!PV!of!the!lease!or!by!calculator:
I!=!.4975
N!=!60!!(5!years!×!12!months/yr)
FV!=!0
PMT!=!$4000
Compute!PV!=!207,051.61!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
13)!!You!are!considering!purchasing!a!new!automobile!that!will!cost!you!$28,000.!!The!dealer!offers!you!4.9%!APR!
financing!for!60!months!(with!payments!made!at!the!end!of!the!month).!!Assuming!you!finance!the!entire!
$28,000!and!finance!through!the!dealer,!your!monthly!payments!will!be!closest!to:!
A)!!$1,454!
B)!!$527!
C)!!$467!
D)!!$478!
Answer:!!!B!
B)!!First!we!need!the!monthly!interest!rate!=!APR$/!k!=!.049!/!12!=!.004083!or!.4083%.!
Now:
PV!=!28000
I!=!.4083
FV!=!0
N!=!60
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!You!are!considering!purchasing!a!new!truck!that!will!cost!you!$34,000.!!The!dealer!offers!you!1.9%!APR!
financing!for!48!months!(with!payments!made!at!the!end!of!the!month).!!Assuming!you!finance!the!entire!
$34,000!and!finance!through!the!dealer,!your!monthly!payments!will!be!closest!to:!
A)!!$708!
B)!!$594!
C)!!$736!
D)!!$1,086!
Answer:!!!C!
B)!!
C)!!First!we!need!the!monthly!interest!rate!=!APR$/!k!=!.019!/!12!=!.001583!or!.1583%.
!
Now:
PV!=!34000
I!=!.1583
FV!=!0
N!=!48
D)!!
Diff:!2!
Skill:!Analytical!
!
!
You!are!in!the!process!of!purchasing!a!new!automobile!that!will!cost!you!$27,500.!!The!dealership!is!offering!you!either!a!
$2,500!rebate!(applied!toward!the!purchase!price)!or!1.9%!financing!for!48!months!(with!payments!made!at!the!end!of!the!
month).!!You!have!been!pre-approved!for!an!auto!loan!through!your!local!credit!union!at!an!interest!rate!of!6.5%!for!48!
months.!
!
15)!!If!you!take!the!$2,500!rebate!and!finance!your!new!car!through!your!credit!union!your!monthly!payments!will!
be!closest!to:!
A)!!$595!
B)!!$652!
C)!!$593!
D)!!$541!
Answer:!!!C!
B)!!
Now:
PV!=!25000!(27,500!-!2,500!rebate)
I!=!.5417
FV!=!0
N!=!48
Compute!PMT!=!$592.87
D)!!
Diff:!2!
Skill:!Analytical!
!
16)!!If!you!forgo!the!$2,500!rebate!and!finance!your!new!car!through!the!dealership!your!monthly!payments!(with!
payments!made!at!the!end!of!the!month)!will!be!closest!to:!
A)!!$593!
B)!!$652!
C)!!$595!
D)!!$541!
Answer:!!!C!
B)!!
!
Now:
PV!=!27500!(no!rebate)
I!=!.1583
FV!=!0
N!=!48
D)!!
Diff:!2!
Skill:!Analytical!
!
!
You!are!purchasing!a!new!home!and!need!to!borrow!$250,000!from!a!mortgage!lender.!!The!mortgage!lender!quotes!you!a!
rate!of!6.25%!APR!for!a!30-year!fixed!rate!mortgage.!!The!mortgage!lender!also!tells!you!that!if!you!are!willing!to!pay!2!
points,!they!can!offer!you!a!lower!rate!of!6.0%!APR!for!a!30-year!fixed!rate!mortgage.!!One!point!is!equal!to!1%!of!the!loan!
value.!!So!if!you!take!the!lower!rate!and!pay!the!points!you!will!need!to!borrow!an!additional!$5000!to!cover!points!you!are!
paying!the!lender.!
!
17)!!Assuming!you!don\t!pay!the!points!and!borrow!from!the!mortgage!lender!at!6.25%,!then!your!monthly!
mortgage!payment!(with!payments!made!at!the!end!of!the!month)!will!be!closest!to:!
A)!!$1570!
B)!!$1530!
C)!!$1540!
D)!!$1500!
Answer:!!!C!
B)!!
!
Now:
PV!=!250000!(no!points)
I!=!.5208
FV!=!0
N!=!360!(30!years!×!12!months)
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Assuming!you!pay!the!points!and!borrow!from!the!mortgage!lender!at!6.00%,!then!your!monthly!mortgage!
payment!(with!payments!made!at!the!end!of!the!month)!will!be!closest!to:!
A)!!$1540!
B)!!$1530!
C)!!$1570!
D)!!$1500!
Answer:!!!B!
B)!!First!we!need!the!monthly!interest!rate!=!APR$/!k!=!.0600!/!12!=!.005000!or!0.50%.
!
Now:
PV!=!255000!(2!points)
I!=!.50
FV!=!0
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Two!years!ago!you!purchased!a!new!SUV.!!You!financed!your!SUV!for!60!months!(with!payments!made!at!the!end!of!the!
month)!with!a!loan!at!5.9%!APR.!!You!monthly!payments!are!$617.16!and!you!have!just!made!your!24th!monthly!payment!
on!your!SUV.!
!
19)!!The!amount!of!your!original!loan!is!closest!to:!
A)!!$37,000!
B)!!$32,000!
C)!!$20,300!
D)!!$31,250!
Answer:!!!B!
!
Now:
I!=!.4917
FV!=!0
N!=!60
PMT!=!617.16!
Compute!PV!=!$31,999.86!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!Assuming!that!you!have!made!all!of!the!first!24!payments!on!time,!then!the!outstanding!principal!balance!on!
your!SUV!loan!is!closest!to:!
A)!!$31,250!
B)!!20,300!
C)!!$19,200!
D)!!$32,000!
Answer:!!!B!
!
Now:
I!=!.4917
FV!=!0
N!=!36!(remaining!payments!60!-!24!=!36)
PMT!=!617.16!
Compute!PV!=!$20,316.92!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Your!firm!needs!to!invest!in!a!new!delivery!truck.!!The!life!expectancy!of!the!delivery!truck!is!five!years.!!You!can!purchase!
a!new!delivery!truck!for!an!upfront!cost!of!$200,000,!or!you!can!lease!a!truck!from!the!manufacturer!for!five!years!for!a!
monthly!lease!payment!of!$4000!(paid!at!the!end!of!each!month).!!Your!firm!can!borrow!at!6%!APR!with!quarterly!
compounding.!
!
21)!!Should!you!purchase!the!delivery!truck!or!lease!it?!!Why?!
Answer:!!!First!we!need!to!calculate!the!monthly!discount!rate!for!the!lease!arrangement.
EAR!=!(1!+!APR$/!k)k!-!1!=!(1!+!.06!/!4)4!-!1!=!.06136!or!6!.14%
Monthly!rate!=!(1!+!EAR)(1/12)!-!1=!(1.06136)(1/12)!-!1!=!.004975!=!0.4975%
!
Now!we!can!apply!the!PVA!formula!to!calculate!the!PV!of!the!lease!or!by!calculator:
I!=!.4975
N!=!60!!(5!years!×!12!months/yr)
FV!=!0
PMT!=!$4000
Compute!PV!=!207,051.61
!
So!leasing!the!truck!will!cost!us!207051.61!-!200000!=!7051.61!more!than!purchasing.!!Therefore!we!are!
better!off!purchasing!the!truck.!
Diff:!3!
Skill:!Analytical!
!
22)!!You!are!in!the!process!of!purchasing!a!new!automobile!that!will!cost!you!$25,000.!!The!dealership!is!offering!
you!either!a!$1,000!rebate!(applied!toward!the!purchase!price)!or!3.9%!financing!for!60!months!(with!
payments!made!at!the!end!of!the!month).!!You!have!been!pre-approved!for!an!auto!loan!through!your!local!
credit!union!at!an!interest!rate!of!7.5%!for!60!months.!!Should!you!take!the!$2000!rebate!and!finance!through!
your!credit!union!or!forgo!the!rebate!and!finance!through!the!dealership!at!the!lower!3.9%!APR?!
Answer:!!!Take!the!rebate!
Credit!Union:
First!we!need!the!monthly!interest!rate!=!APR$/!k!=!.075!/!12!=!.00625!or!.625%.
Now:
PV!=!24000!(rebate!25,000!-!1,000)
I!=!.625
FV!=!0
N!=!60
Dealership:
Now:
PV!=!25000!(no!rebate)
I!=!.325
FV!=!0
N!=!60
Since!459.29!<!480.91,!go!with!the!dealership!and!forgo!the!rebate.!
Diff:!3!
Skill:!Analytical!
!
23)!!You!are!purchasing!a!new!home!and!need!to!borrow!$325,000!from!a!mortgage!lender.!!The!mortgage!lender!
quotes!you!a!rate!of!6.!5%!APR!for!a!30-year!fixed!rate!mortgage!(with!payments!made!at!the!end!of!each!
month).!!The!mortgage!lender!also!tells!you!that!if!you!are!willing!to!pay!1!point,!they!can!offer!you!a!lower!
rate!of!6.25%!APR!for!a!30-year!fixed!rate!mortgage.!!One!point!is!equal!to!1%!of!the!loan!value.!!So!if!you!take!
the!lower!rate!and!pay!the!points!you!will!need!to!borrow!an!additional!$3250!to!cover!points!you!are!paying!
the!lender.!Assuming!that!you!do!not!intend!to!prepay!your!mortgage!(pay!off!your!mortgage!early),!are!you!
better!off!paying!the!1!point!and!borrowing!at!6.25%!APR!or!just!taking!out!the!loan!at!6.5%!without!any!
points?!
Answer:!!!Pay!the!points!
Points!(6.25%!APR)
Now:
PV!=!328250!(!325,000!+!1!point)
I!=!.5208
FV!=!0
Compute!PMT!=!$2,021.01
No!Points
Now:
PV!=!325000!(no!points)
I!=!.5417
FV!=!0
Compute!PMT!=!$2,054.22
Since!$2,021.01!<!$2,054.22,!pay!the!points!!
Diff:!3!
Skill:!Analytical!
!
!
Two!years!ago!you!purchased!a!new!SUV.!!You!financed!your!SUV!for!60!months!(with!payments!made!at!the!end!of!the!
month)!with!a!loan!at!5.9%!APR.!!You!monthly!payments!are!$617.16!and!you!have!just!made!your!24th!monthly!payment!
on!your!SUV.!
!
24)!!Assuming!that!you!have!made!all!of!the!first!24!payments!on!time,!then!how!much!interest!have!you!paid!
over!the!first!two!years!of!your!loan?!
Answer:!!!$3,128.78
First!figure!out!the!outstanding!balance:
We!need!the!monthly!interest!rate!=!APR$/!k!=!.059!/!12!=!.004917!or!0.4917%.
Now
I!=!.4917
FV!=!0
N!=!36!(remaining!payments!=!60!-!24!=!36)
PMT!=!617.16!
Compute!PV!=!$20,316,80
Next!figure!out!the!original!loan!amount:
First!we!need!the!monthly!interest!rate!=!APR$/!k!=!.059!/!12!=!.004917!or!0.4917%.
Now
I!=!.4917
FV!=!0
N!=!60!(original!number!of!payments)
PMT!=!617.16!
Compute!PV!=!$31,999.55
So!the!amount!of!principal!paid!=!31,999.55!-!20,316.80!=!11,682.75.
You!have!paid!a!total!of!24!×!617.16!=!$14,811.84.
So!amount!of!Interest!=!14,811.84!-!11,682.75!=!3,129.09.!
Diff:!3!
Skill:!Analytica
5.2!The!Determinants!of!Interest!Rates!
A)!!The!interest!rates!that!banks!offer!on!investments!or!charge!on!loans!depends!on!the!horizon!of!the!
investment!or!loan.!
B)!!The!Federal!Reserve!determines!very!short-term!interest!rates!through!its!influence!on!the!federal!funds!
rate.!
C)!!The!interest!rates!that!are!quoted!by!banks!and!other!financial!institutions!are!nominal!interest!rates.!
D)!!Fundamentally,!interest!rates!are!determined!by!the!Federal!Reserve.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!5.2!The!Determinants!of!Interest!Rates!
Skill:!Conceptual!
!
A)!!The!relationship!between!the!investment!term!and!the!interest!rate!is!called!the!term!structure!of!interest!
rates.!
B)!!Real!interest!rates!indicate!the!rate!at!which!your!money!will!grow!if!invested!for!a!certain!period.!!
C)!!The!yield!curve!is!a!potential!leading!indicator!of!future!economic!growth.!
D)!!The!shape!of!the!yield!curve!will!be!strongly!influenced!by!interest!rate!expectations.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!yield!curve!changes!over!time.!
B)!!The!formulas!for!computing!present!values!of!annuities!and!perpetuities!cannot!be!used!in!situations!in!
which!cash!flows!need!to!be!discounted!at!different!rates.!
C)!!We!can!use!the!term!structure!to!compute!the!present!and!future!values!of!a!risk-free!cash!flow!over!
different!investment!horizons.!
D)!!The!yield!curve!tends!to!be!inverted!as!the!economy!comes!out!of!a!recession.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!plot!of!the!relationship!between!the!investment!risk!and!the!interest!rate!is!call!the!yield!curve.!
B)!!Each!of!the!last!six!recessions!in!the!United!States!was!preceded!by!a!period!with!an!inverted!yield!curve.!
C)!!The!nominal!interest!rate!does!not!represent!the!increase!in!purchasing!power!that!will!result!from!
investing!
D)!!A!risk-free!cash!flow!received!in!two!years!should!be!discounted!at!the!two-year!interest!rate.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!An!inverted!yield!curve!generally!signals!an!expected!decline!in!future!interest!rates.!
B)!!An!inverted!yield!curve!is!often!interpreted!as!a!positive!forecast!for!economic!growth.!
C)!!All!the!formulas!for!computing!present!values!of!annuities!and!perpetuities!are!based!upon!discounting!
all!of!the!cash!flows!at!the!same!rate.!
D)!!The!rate!of!growth!of!your!purchasing!power!is!determined!by!the!real!interest!rate.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! 1 r
i!= !-!1!
1 rr
B)!! 1 r
1!+!rr!=
1 i
C)!!rr! !i!-!r$
D)!! r i
rr!=
1 i
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!If!the!current!inflation!rate!is!5%,!then!the!nominal!rate!necessary!for!you!to!earn!an!8%!real!interest!rate!on!
your!investment!is!closest!to:!
A)!!13.0%!
B)!!13.4%!
C)!!4.9%!
D)!!3.0%!
Answer:!!!B!
B)!!!nominal!=!(1!+!inflation)(1!+!real)!-!1!=!(1.05)(1.08)!-!1!=!.134!or!13.4%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!If!the!current!inflation!rate!is!4%!and!you!have!an!investment!opportunity!that!pays!10%,!then!the!real!rate!of!
interest!on!your!investment!is!closest!to:!
A)!!10.0%!
B)!!14.0%!
C)!!6.0%!
D)!!5.8%!
Answer:!!!D!
Explanation:!!! A)!!1!+!!nominal!=!(1!+!inflation)(1!+!real)!!
real!interest!rate!=!! 1 + nominal !-!1!=!.057692!or!5.77%!
1 + inflation
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
Suppose!the!term!structure!of!interest!rates!is!shown!below:!
Term 1!year 2!years 3!years 5!years 10!years 20!years!
Rate!
(EAR%) 5.00% 4.80% 4.60% 4.50% 4.25% 4.15%!
!
9)!!What!is!the!shape!of!the!yield!curve!and!what!expectations!are!investors!likely!to!have!about!future!interest!
rates?!
A)!!Inverted;!Higher!
B)!!Normal;!Higher!
C)!!Inverted;!Lower!
D)!!Normal;!Lower!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
10)!!The!present!value!of!receiving!$1000!per!year!with!certainty!at!the!end!of!the!next!three!years!is!closest!to:!
A)!!$2,737!
B)!!$2,723!
C)!!$2,733!
D)!!$2,744!
Answer:!!!A!
Explanation:!!! A)!!=!1000!/!(1.05)!+!1000!/!(1.048)2!+!1000!/!(1.046)3!=!2737!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!Consider!an!investment!that!pays!$1000!certain!at!the!end!of!each!of!the!next!four!years.!!If!the!investment!
costs!$3,500!and!has!an!NPV!of!$74.26,!then!the!four!year!risk-free!interest!rate!is!closest!to:!
A)!!4.5%!
B)!!4.58%!
C)!!4.55%!
D)!!4.53%!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!=!74.26!=!-3500!+!1000!/!(1.05)1!+!1000!/!(1.048)2!+!1000!/!(1.046)3!+!1000!/!(1!+!x)4
3574.26!-!1000!/!(1.05)1!+!1000!/!(1.048)2!+!1000!/!(1.046)3!=!1000!/!(1!+!x)4
837.60!=!1000!/!(1!+!X)4!!==>>!!(1!+!X)4!=!1000!/!837.60!!==>>!X!=!.0453!or!4.53%!
Diff:!3!
Skill:!Analytical!
!
12)!!The!NPV!of!an!investment!that!costs!$2700!and!pays!$1000!certain!at!the!end!of!one,!three,!and!five!years!is!
closest!to:!
A)!!21.47!
B)!!$1665.62!
C)!!-100.26!
D)!!-71.38!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!=!-2700!+!1000!/!(1.05)1!+!1000!/!(1.046)3!+!1000!/!(1.045)5!=!-71.38!
Diff:!2!
Skill:!Analytical!
!
13)!!Can!the!nominal!interest!rate!ever!be!negative?!!Can!the!real!interest!rate!ever!be!negative?!!Explain.!
Answer:!!!The!nominal!interest!rate!can!never!be!negative!since!by!just!holding!your!money!you!are!earning!a!0%!
return!(no!negative)!on!your!money.!!The!real!rate,!however,!can!be!negative!anytime!that!the!inflation!
rate!exceeds!the!nominal!rate.!
Diff:!1!
Skill:!Conceptual!
!
Suppose!the!term!structure!of!interest!rates!is!shown!below:!
Term 1!year 2!years 3!years 5!years 10!years 20!years!

Rate!
(EAR%) 5.00% 4.80% 4.60% 4.50% 4.25% 4.15%!
!
14)!!After!examining!the!yield!curve,!what!predictions!do!you!have!about!interest!rates!in!the!future?!!About!
future!economic!growth!and!the!overall!state!of!the!economy?!
Answer:!!!This!is!an!inverted!yield!curve,!which!implies!that!interest!rates!should!be!falling!in!the!future.!!An!
inverted!yield!curve!is!often!interpreted!as!a!negative!forecast!for!economic!growth.!!Since!each!of!the!
last!six!recessions!in!the!U.S.!were!proceeded!by!a!period!with!an!inverted!yield!curve!it!could!be!a!
leading!indicator!of!a!future!recession.!
Diff:!2!
Skill:!Conceptual!
!
15)!!What!is!the!NPV!of!an!investment!that!costs!$2500!and!pays!$1000!certain!at!the!end!of!one,!three,!and!five!
years!?!
Answer:!!!NPV!=!-2500!+!1000!/!(1.05)1!+!1000!/!(1.046)3!+!1000!/!(1.045)5!=!128.62!
Diff:!2!
Skill:!Analytical
5.3!Risk!and!Taxes!
A)!!When!we!refer!to!the!grisk-free!interest!rate,g!we!mean!the!rate!on!U.S.!Treasuries.!
B)!!Interest!rates!vary!with!the!investment!horizon.!
C)!!All!borrowers,!besides!the!U.S.!Treasury,!have!some!risk!of!default.!
D)!!When!interest!on!a!loan!is!tax!deductible,!the!effective!after-tax!interest!rate!is! !×!(1!-!r).!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!5.3!Risk!and!Taxes!
Skill:!Conceptual!
!
A)!!The!equivalent!after-tax!interest!rate!is!r!-!( !×!r).!
B)!!Interest!rates!vary!based!on!the!identity!of!the!borrower.!
C)!!The!ability!to!deduct!the!interest!expense!increases!the!effective!after-tax!interest!rate!paid!on!the!loan.!
D)!!For!loans!to!borrowers!other!than!the!U.S.!Treasury,!the!stated!interest!rate!is!the!maximum!amount!that!
investors!will!receive.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!U.S.!Treasury!securities!are!widely!regarded!to!be!risk-free!because!there!is!virtually!no!chance!the!
government!will!default!on!these!bonds.!
B)!!In!general,!if!the!interest!rate!is!r!and!the!tax!rate!is! ,!then!for!each!$1!invested!you!will!earn!interest!
equal!to!r!and!owe!taxes!of! !×!r!on!the!interest.!
C)!!Investors!may!receive!less!than!the!stated!interest!rate!if!the!borrowing!company!has!financial!
difficulties!and!is!unable!to!fully!repay!the!loan.!
D)!!Taxes!reduce!the!amount!of!interest!the!investor!can!keep,!and!we!refer!to!this!reduced!amount!as!the!
tax!effective!interest!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!actual!cash!flow!that!the!investor!will!get!to!keep!will!be!reduced!by!the!amount!of!any!tax!
payments.!
B)!!The!equivalent!after-tax!interest!rate!is!r(1!-! ).!
C)!!The!right!discount!rate!for!a!cash!flow!is!the!rate!of!return!available!in!the!market!on!other!investments!
of!comparable!risk!and!term.!
D)!!To!compensate!for!the!risk!that!they!will!receive!less!if!the!firm!defaults,!investors!demand!a!lower!
interest!rate!than!the!rate!on!U.S.!Treasuries.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
5)!!Assume!that!you!presently!have!a!monthly!home!mortgage!with!a!stated!interest!rate!of!7%!APR.!!If!your!
income!tax!rate!is!20%,!then!the!after!tax!EAR!for!your!home!mortgage!is!closest!to:!
A)!!5.6%!
B)!!7.2%!
C)!!5.8%!
D)!!7.0%!
Answer:!!!C!
B)!!
C)!!Step!#1!find!the!EAR
EAR!=!(1!+!.07!/!12)12!!-!1!=!7.2%
Step!#2!find!the!after!tax!cost
aftertax!=!before$tax$(1!-!T)!=!.072!(1!-!.2)!=!.0578!or!approximately!5.8%!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Suppose!you!have!the!following!Loans!/!Investments
!
Credit!Card! 14.90%!APR!(Monthly!Compounding)!
Automobile!Loan! 5.90%!APR!(Monthly!Compounding)!
Home!Equity!Loan! 8.25%!APR!(Monthly!Compounding)!
Money!Market!Fund! 5.10%!EAR!
!
6)!!If!your!income!tax!rate!is!30%,!then!the!after-tax!EAR!for!your!home!equity!loan!is!closest!to:!
A)!!6.0%!
B)!!5.9%!
C)!!8.6%!
D)!!5.8%!
Answer:!!!A!
Explanation:!!! A)!!Step!#1!find!the!EAR
EAR!=!(1!+!.0825!/!12)12!!-!1!=!8.569%
aftertax!=!before$tax$(1!-!T)!=!.08569!(1!-!.3)!=!.0599!or!approximately!6.0%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!If!your!income!tax!rate!is!30%,!then!the!after-tax!return!you!receive!on!your!money!market!fund!is!closest!to:!
A)!!3.7%!
B)!!5.1%!
C)!!3.6%!
D)!!4.2%!
Answer:!!!C!
B)!!
C)!!This!is!already!stated!as!an!EAR,!so!aftertax!=!before$tax!(1!-!T)!=!.051!(1!-!.3)!=!.0357!or!
approximately!3.6%!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!What!is!the!effective!after-tax!rate!of!each!instrument,!expressed!as!an!EAR?!
Answer:!!!Credit!Card
Interest!is!not!deductible!so,
EAR!=!(1!+!.149!/!12)12!!-!1!=!15.96%
Car!Loan
Interest!is!not!deductible!so,
EAR!=!(1!+!.059!/!12)12!!-!1!=!6.06%
Home!Equity!Loan
Step!#1!find!the!EAR
EAR!=!(1!+!.0825!/!12)12!!-!1!=!8.569%
aftertax!=!before$tax!(1!-!T)!=!.08569!(1!-!.3)!=!.0599!or!approximately!6.0%
Money!Market!Fund
This!is!already!stated!as!an!EAR,!so!aftertax!=$before$tax$(1!-!T)!=!.051!(1!-!.3)!=!.0357!or!approximately!
3.6%!
Diff:!2!
Skill:!Analytical
5.4!The!Opportunity!Cost!of!Capital!
A)!!The!investor’s!opportunity!cost!of!capital!is!the!best!available!expected!return!offered!in!the!market!on!
an!investment!of!comparable!risk!and!term!of!the!cash!flows!being!discounted.!
B)!!Interest!rates!we!observe!in!the!market!will!vary!based!on!quoting!conventions,!the!term!of!investment,!
and!risk.!
C)!!The!opportunity!cost!of!capital!is!the!return!the!investor!forgoes!when!the!investor!takes!on!a!new!
investment.!
D)!!For!a!risk-free!project,!the!opportunity!cost!of!capital!will!typically!be!greater!than!the!interest!rate!of!U.S.!
Treasury!securities!with!a!similar!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!5.4!The!Opportunity!Cost!of!Capital!!
Skill:!Conceptual!
!
A)!!The!actual!return!kept!by!an!investor!will!depend!on!how!the!interest!is!taxed.!
B)!!The!equivalent!after-tax!interest!rate!is!r(1!-! )!
C)!!The!highest!interest!rate,!for!a!given!horizon,!is!the!rate!paid!on!U.S.!Treasury!securities.!
D)!!It!is!important!to!use!a!discount!rate!that!matches!both!the!horizon!and!the!risk!of!the!cash!flows.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!5.4!The!Opportunity!Cost!of!Capital!!
Skill:!Conceptual!
!
Chapter!6!-!Investment!Decision!Rules!
!
!
6.1!NPV!and!Stand-Alone!Projects!
A)!!About!75%!of!firms!surveyed!used!the!NPV!rule!for!making!investment!decisions.!
B)!!If!you!are!unsure!of!your!cost!of!capital!estimate,!it!is!important!to!determine!how!sensitive!your!
analysis!is!to!errors!in!this!estimate.!
C)!!To!decide!whether!to!invest!using!the!NPV!rule,!we!need!to!know!the!cost!of!capital.!
D)!!NPV!is!positive!only!for!discount!rates!greater!than!the!internal!rate!of!return.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!6.1!NPV!and!Stand-Alone!Projects!
Skill:!Conceptual!
!
A)!!In!general,!the!difference!between!the!cost!of!capital!and!the!IRR!is!the!maximum!amount!of!estimation!
error!in!the!cost!of!capital!estimate!that!can!exist!without!altering!the!original!decision.!
B)!!The!IRR!can!provide!information!on!how!sensitive!your!analysis!is!to!errors!in!the!estimate!of!your!cost!
of!capital.!
C)!!If!you!are!unsure!of!your!cost!of!capital!estimate,!it!is!important!to!determine!how!sensitive!your!
D)!!If!the!cost!of!capital!estimate!is!more!than!the!IRR,!the!NPV!will!be!positive.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!cost!of!capital!estimate!is!more!than!the!IRR,!the!NPV!will!be!negative.!
Diff:!1!
Skill:!Conceptual!
!
!
Consider!a!project!with!the!following!cash!flows:
Year Cash!Flow!
0 -10,000!
1 4,000!
2 4,000!
3 4,000!
4 4,000!
!
3)!!If!the!appropriate!discount!rate!for!this!project!is!15%,!then!the!NPV!is!closest!to:!
A)!!$6,000!
B)!!-$867!
C)!!$1,420!
D)!!$867!
Answer:!!!C!
B)!!
C)!!NPV!=!-10,000!+!4000!/!(1.15)1!+!4000!/!(1.15)2!+!4000!/!(1.15)3!+!4000!/!(1.15)4!=!1419.91!
D)!!
Diff:!1!
Skill:!Analytical!
!
Consider!the!following!two!projects:
Year!0 Year!1 Year!2 Year!3 Year!4 Discount!

Project Cash!Flow Cash!Flow Cash!Flow Cash!Flow Cash!Flow Rate!
A -100 40 50 60 N/A .15!
B -73 30 30 30 30 .15!
!
4)!!The!NPV!of!project!A!is!closest!to:!
A)!!12.0!
B)!!12.6!
C)!!15.0!
D)!!42.9!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!-100!+!40!/!(1.15)1!+!50!/!(1.15)2!+!60!/!(1.15)3!=!12.04!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!The!NPV!of!project!B!is!closest!to:!
A)!!12.6!
B)!!23.3!
C)!!12.0!
D)!!15.0!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!-73+!30!/!(1.15)1!+!30!/!(1.15)2!+!30!/!(1.15)3!+!30!/!(1.15)4!=!12.6494!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
The!Sisyphean!Company!is!planning!on!investing!in!a!new!project.!!This!will!involve!the!purchase!of!some!
new!machinery!costing!$450,000.!!The!Sisyphean!Company!expects!cash!inflows!from!this!project!as!
detailed!below:
Year One Year!Two Year!Three Year!Four!

$200,000 $225,000 $275,000 $200,000!
The!appropriate!discount!rate!for!this!project!is!16%.
6)!!The!NPV!for!this!project!is!closest!to:!
A)!!$176,270!
B)!!$123,420!
C)!!$450,000!
D)!!$179,590!
Answer:!!!A!
Explanation:!!! A)!!NPV!=!-450000+!200,000!/!(1.16)1!+225000!/!(1.15)2!+!275000!/!(1.15)3!+200,000!/!(1.15)4!=!176,265!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
Use$the$table$for$the$question(s)$below.!
!
Year!0 Year!1 Year!2 Year!3 Year!4 Year!5 Year!6 Year!7 Discount

Project C/F C/F C/F C/F C/F C/F C/F C/F Rate!
Alpha -79 20 25 30 35 40 N/A N/A 15%!
Beta -80 25 25 25 25 25 25 25 16%!
!
7)!!The!NPV!for!project!alpha!is!closest!to:!
A)!!$20.96!
B)!!$16.92!
C)!!$24.01!
D)!!$14.41!
Answer:!!!B!
B)!!NPV!=!-79+!20!/!(1.15)1!+!25!/!(1.15)2!+!30!/!(1.15)3!+!35!/!(1.15)4!!+!40!/!(1.15)5=!16.92!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!The!NPV!for!project!beta!is!closest!to:!
A)!!$24.01!
B)!!$16.92!
C)!!$20.96!
D)!!$14.41!
Answer:!!!C!
B)!!
C)!!NPV!=!-80+!25!/!(1.16)1!+!25!/!(1.16)2!+!25!/!(1.16)3!+!25!/!(1.16)4!!+!25!/!(1.16)5!+!!50!/!(1.16)6!+!!25!
/!(1.16)7=!20.96!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Larry!the!Cucumber!has!been!offered!$14!million!to!star!in!the!lead!role!of!the!next!three!Larry!Boy!adventure!movies.!!If!
Larry!takes!this!offer,!he!will!have!to!forgo!acting!in!other!Veggie!movies!that!would!pay!him!$5!million!at!the!end!of!each!
of!the!next!three!years.!!Assume!Larry[s!personal!cost!of!capital!is!10%!per!year.
9)!!The!NPV!of!Larry[s!three!movie!Larry!Boy!offer!is!closest!to:!
A)!!3.5!million!
B)!!-1.6!million!
C)!!1.6!million!
D)!!-1.0!million!
Answer:!!!C!
B)!!
C)!!NPV!=!14!+!-5!/!(1.10)1!+!-5!/!(1.10)2!+!-5!/!(1.10)3!=!1.57!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Boulderado!has!come!up!with!a!new!composite!snowboard.!!Development!will!take!Boulderado!four!years!and!cost!
$250,000!per!year,!with!the!first!of!the!four!equal!investments!payable!today!upon!acceptance!of!the!project.!!Once!in!
production!the!snowboard!is!expected!to!produce!annual!cash!flows!of!$200,000!each!year!for!10!years.!!Boulderado[s!
discount!rate!is!10%.!
!
10)!!The!NPV!for!Boulderado[s!snowboard!project!is!closest!to:!
A)!!$228,900!
B)!!$46,900!
C)!!$51,600!
D)!!$23,800!
Answer:!!!C!
B)!!
C)!!CF0!=!-250,000
CF1!=!-250,000
CF2!=!-250,000
CF3!=!-250,000
CF4!=!+200,000
CF5!=!+200,000
CF6!=!+200,000
CF7!=!+200,000
CF8!=!+200,000
CF9!=!+200,000
CF10!=!+200,000
CF11!=!+200,000
CF12!=!+200,000
CF13!=!+200,000
I!=!10
Compute!NPV!=!51,588!
D)!!
Diff:!2!
Skill:!Analytical!
6.2!Alternative!Decision!Rules!
A)!!The!IRR!investment!rule!will!identify!the!correct!decision!in!many,!but!not!all,!situations.!
B)!!By!setting!the!NPV!equal!to!zero!and!solving!for!r,!we!find!the!IRR.!
C)!!If!you!are!unsure!of!your!cost!of!capital!estimate,!it!is!important!to!determine!how!sensitive!your!
D)!!The!simplest!investment!rule!is!the!NPV!investment!rule.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!6.2!Alternative!Decision!Rules!
Skill:!Conceptual!
!
A)!!It!is!possible!that!an!IRR!does!not!exist!for!an!investment!opportunity.!
B)!!If!the!payback!period!is!less!than!a!pre-specified!length!of!time!you!accept!the!project!!
C)!!The!internal!rate!of!return!(IRR)!investment!rule!is!based!upon!the!notion!that!if!the!return!on!other!
alternatives!!is!greater!than!the!return!on!the!investment!opportunity!you!should!undertake!the!
investment!opportunity.!
D)!!It!is!possible!that!there!is!no!discount!rate!that!will!set!the!NPV!equal!to!zero.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!payback!investment!rule!is!based!on!the!notion!that!an!opportunity!that!pays!back!its!initial!
investments!quickly!is!a!good!idea.!
B)!!An!IRR!will!always!exist!for!an!investment!opportunity.!
C)!!A!NPV!will!always!exist!for!an!investment!opportunity.!
D)!!In!general,!there!can!be!as!many!IRRs!as!the!number!of!times!the!project[s!cash!flows!change!sign!over!
time.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!IRR!investment!rule!states!you!should!turn!down!any!investment!opportunity!where!the!IRR!is!less!
than!the!opportunity!cost!of!capital.!
B)!!The!IRR!investment!rule!states!that!you!should!take!any!investment!opportunity!where!the!IRR!exceeds!
the!opportunity!cost!of!capital.!
C)!!Since!the!IRR!rule!is!based!upon!the!rate!at!which!the!NPV!equals!zero,!like!the!NPV!decision!rule,!the!
IRR!decision!rule!will!always!identify!the!correct!investment!decisions.!
D)!!There!are!situations!in!which!multiple!IRRs!exist.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!In!general,!the!IRR!rule!works!for!a!stand-alone!project!if!all!of!the!project[s!positive!cash!flows!precede!
its!negative!cash!flows.!
B)!!There!is!no!easy!fix!for!the!IRR!rule!when!there!are!multiple!IRRs.!
C)!!The!payback!rule!is!primarily!used!because!of!its!simplicity.!
D)!!No!investment!rule!that!ignores!the!set!of!alternative!investment!alternatives!can!be!optimal.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!payback!rule!is!useful!in!cases!where!the!cost!of!making!an!incorrect!decision!might!not!be!large!
enough!to!justify!the!time!required!for!calculating!the!NPV.!
B)!!The!payback!rule!is!reliable!because!it!considers!the!time!value!of!money!and!depends!on!the!cost!of!
capital.!
C)!!For!most!investment!opportunities!expenses!occur!initially!and!cash!is!received!later.!
D)!!Fifty!percent!of!firms!surveyed!reported!using!the!payback!rule!for!making!decisions.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!distinction!between!simply!making!money!and!creating!value!is!the!essence!of!the!NPV!calculation.!
B)!!The!concept!of!economic!profit!has!been!popularized!recently!under!the!name!Economic!Value!Added!
(EVA).!
C)!!EVA!is!a!measure!of!value!created!over!the!life!of!a!project.!
D)!!The!EVA!investment!rule!can!be!stated!as!accept!any!investment!opportunity!in!which!the!present!value!
of!all!future!EVAs!is!positive.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Year Cash!Flow!
0 -10,000!
1 4,000!
2 4,000!
3 4,000!
4 4,000!
!
8)!!Assume!the!appropriate!discount!rate!for!this!project!is!15%.!!The!payback!period!for!this!project!is!closest!to:!
A)!!3!
B)!!2.5!
C)!!2!
D)!!4!
Answer:!!!B!
B)!!Payback$=!10000!/!4000!=!2.5!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!Assume!the!appropriate!discount!rate!for!this!project!is!15%.!!The!IRR!for!this!project!is!closest!to:!
A)!!21%!
B)!!22%!
C)!!15%!
D)!!60%!
Answer:!!!B!
B)!!CF0!=!-10000
CF1!=!4000
CF2!=!4000
CF3!=!4000
CF4!=!4000
Compute!IRR!=!21.86%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!

A -100 40 50 60 N/A .15!
B -73 30 30 30 30 .15!
!
10)!!The!payback!period!for!project!A!is!closest!to:!
A)!!2.0!years!
B)!!2.4!years!
C)!!2.5!years!
D)!!2.2!years!
Answer:!!!D!
B)!!
C)!!
D)!!Payback!period.!!It!is!clear!that!the!project!is!not!paid!off!after!two!years!since!we!have!only!
received!90!toward!the!100!investment.!!To!calculate!the!fraction!of!the!third!year,!we!take!the!
$10!yet!to!be!repaid!($100!investment!-!$40!(year!1)!-!$50!(year!2))!/!$60!(cashflow!in!year!3)!
=!.166667!so!the!payback!is!2.166667!years.!
Diff:!2!
Skill:!Analytical!
!
11)!!The!payback!period!for!project!B!is!closest!to:!
A)!!2.5!years!
B)!!2.0!years!
C)!!2.2!years!
D)!!2.4!years!
Answer:!!!D!
B)!!
C)!!
D)!!Payback$=!73!/!30!=!2.43!years!
Diff:!1!
Skill:!Analytical!
!
12)!!The!internal!rate!of!return!(IRR)!for!project!A!is!closest!to:!
A)!!7.7%!
B)!!21.6%!
C)!!23.3%!
D)!!42.9%!
Answer:!!!B!
B)!!CF0!=!-100
CF1!=!40
CF2!=!50
CF3!=!60
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!The!internal!rate!of!return!(IRR)!for!project!B!is!closest!to:!
A)!!21.6%!
B)!!23.3%!
C)!!42.9%!
D)!!7.7%!
Answer:!!!B!
B)!!CF0!=!-73
CF1!=!30
CF2!=!30
CF3!=!30
CF4!=!30
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!Which!of!the!following!statements!is!correct?!
A)!!You!should!accept!project!A!since!its!IRR!>!15%!
B)!!You!should!reject!project!B!since!its!NPV!>!0!
C)!!Your!should!accept!project!A!since!its!NPV!<!0!
D)!!You!should!accept!project!B!since!its!IRR!<!15%!
Answer:!!!A!
Explanation:!!! A)!!NPVA!=!-100!+!40/(1.15)1!+!50/(1.15)2!+!60/(1.15)3!=!12.04
NPVB!=!-73+!30/(1.15)1!+!30/(1.15)2!+!30/(1.15)3!+!30/(1.15)4!=!12.65
IRR!A
CF0!=!-100
CF1!=!40
CF2!=!50
CF3!=!60
Compute!IRR!=!21.64%
IRR!B
CF0!=!-73
CF1!=!30
CF2!=!30
CF3!=!30
CF4!=!30
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
15)!!The!maximum!number!of!!IRRs!that!could!exist!for!project!B!is:!
A)!!3!
B)!!1!
C)!!2!
D)!!0!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!

Alpha -79 20 25 30 35 40 N/A N/A 15%!
Beta -80 25 25 25 25 25 25 25 16%!
!
16)!!The!payback!period!for!project!Alpha!is!closest!to:!
A)!!3.2!years!
B)!!2.9!years!
C)!!3.1!years!
D)!!2.6!years!
Answer:!!!C!
B)!!
C)!!It!is!clear!that!the!project!will!not!be!paid!off!until!sometime!after!year!3.!!After!the!cashflow!in!
year!three!there!will!still!be!$4!remaining!to!be!paid!back!in!year!four!!
(79!-!20!-!25!-!30)!=!4
To!find!the!fractional!year!take!4!/!35!=!.1143!so!payback!is!3.11!years!
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!The!payback!period!for!project!beta!is!closest!to:!
A)!!2.9!years!
B)!!3.1!years!
C)!!2.6!years!
D)!!3.2!years!
Answer:!!!D!
B)!!
C)!!
D)!!Payback$=!80!/!25!=!3.2!
Diff:!1!
Skill:!Analytical!
!
18)!!The!internal!rate!of!return!(IRR)!for!project!Alpha!is!closest!to:!
A)!!25.0%!
B)!!22.2%!
C)!!24.5%!
D)!!22.7%!
Answer:!!!D!
B)!!
C)!!
D)!!CF0!=!-79
CF1!=!20
CF2!=!25
CF3!=!30
CF4!=!35
CF5!=!40
Compute!IRR!=!22.68!
Diff:!2!
Skill:!Analytical!
!
19)!!The!internal!rate!of!return!(IRR)!for!project!Beta!is!closest!to:!
A)!!25.0%!
B)!!22.7%!
C)!!24.5%!
D)!!22.2%!
Answer:!!!C!
B)!!
C)!!PV!=!-80
PMT!=!25
FV!=!0
N!=!7
Compute!I!=!24.52!
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!Which!of!the!following!statements!is!correct?!
A)!!You!should!invest!in!project!Beta!since!NPVBeta!>!0!
B)!!You!should!invest!in!project!Alpha!since!IRRAlpha!>!IRRBeta!
C)!!Your!should!invest!i!project!Alpha!since!NPVAlpha!<!0!
D)!!You!should!invest!in!project!Beta!since!IRRBeta!>!0!
Answer:!!!A!
Explanation:!!! A)!!NPV!Alpha
NPV!=!-79!+!20!/!(1.15)1!+!25!/!(1.15)2!+!30!/!(1.15)3!+!35!/!(1.15)4!!+!40!/!(1.15)5=!16.92
NPV!Beta
NPV!=!-80!+!25!/!(1.16)1!+!25!/!(1.16)2!+!25!/!(1.16)3!+!25!/!(1.16)4!!+!25!/!(1.16)5!+!25!/!(1.16)6!+!!25!
/!(1.16)7=!20.96
IRR!Alpha
CF0!=!-79
CF1!=!20
CF2!=!25
CF3!=!30
CF4!=!35
CF5!=!40
Compute!IRR!=!22.68
IRR!Beta
PV!=!-80
PMT!=!25
FV!=!0
N$=!7
Compute!I!=!24.52!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
detailed!below:

$200,000 $225,000 $275,000 $200,000!
21)!!The!payback!period!for!this!project!is!closest!to:!
A)!!2.1!years!
B)!!3.0!years!
C)!!2!years!
D)!!2.2!years!
Answer:!!!A!
Explanation:!!! A)!!It!is!clear!that!the!project!will!not!be!paid!off!after!2!years.!!The!balance!due!after!the!second!
year!is!equal!to!450000!-!200000!-!225000!=!$25,000,!so!to!find!the!fractional!year!we!take!
25000/275000!=!.0909!so!the!payback!period!=!2.09!years!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
22)!!The!IRR!for!this!project!is!closest!to:!
A)!!18.9%!
B)!!22.7%!
C)!!34.1%!
D)!!39.1%!
Answer:!!!C!
B)!!
C)!!CF0!=!-450000
CF1!=!200000
CF2!=!225000
CF3!=!275000
CF4!=!200000
D)!!
Diff:!1!
Skill:!Analytical!
!
!
23)!!The!IRR!for!Larry[s!three!movie!deal!offer!is!closest!to:!
A)!!3.5%!
B)!!1.6%!
C)!!-3.5%!
D)!!-1.6%!
Answer:!!!A!
Explanation:!!! A)!!CF0!=!+14
CF1!=!-5
CF2!=!-5
CF3!=!-5
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
24)!!Larry!should:!
A)!!Reject!the!offer!because!the!NPV!<!0!
B)!!Accept!the!offer!even!though!the!IRR!<!10%,!because!the!NPV!>!0!
C)!!Reject!the!offer!because!the!IRR!<!10%!
D)!!Accept!the!offer!because!the!IRR!>!0%!
Answer:!!!B!
B)!!NPV!=!14!+!-5!/!(1.10)1!+!-5!/!(1.10)2!+!-5!/!(1.10)3!=!1.57
CF0!=!+14
CF1!=!-5
CF2!=!-5
CF3!=!-5
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Boulderado!has!come!up!with!a!new!composite!snowboard.!!Development!will!take!Boulderado!four!years!and!cost!
$250,000!per!year,!with!the!first!of!the!four!equal!investments!payable!today!upon!acceptance!of!the!project.!!Once!in!
production!the!snowboard!is!expected!to!produce!annual!cash!flows!of!$200,000!each!year!for!10!years.!!Boulderado[s!
discount!rate!is!10%.!
!
25)!!The!IRR!for!Boulderado[s!snowboard!project!is!closest!to:!
A)!!10.4%!
B)!!10.0%!
C)!!11.0%!
D)!!15.1%!
Answer:!!!C!
B)!!
C)!!CF0!=!-250,000
CF1!=!-250,000
CF2!=!-250,000
CF3!=!-250,000
CF4!=!+200,000
CF5!=!+200,000
CF6!=!+200,000
CF7!=!+200,000
CF8!=!+200,000
CF9!=!+200,000
CF10!=!+200,000
CF11!=!+200,000
CF12!=!+200,000
CF13!=!+200,000
D)!!
Diff:!2!
Skill:!Analytical!
!
26)!!Calculate!the!IRR!for!the!snow!board!project!and!use!it!to!determine!he!maximum!deviation!allowable!in!the!
cost!of!capital!estimate!that!leaves!the!investment!decision!unchanged.!!The!maximum!deviation!allowable!is!
closest!to:!
A)!!11.0%!
B)!!0.0%!
C)!!2.5%!
D)!!1.0%!
Answer:!!!D!
B)!!
C)!!
D)!!CF0!=!-250,000
CF1!=!-250,000
CF2!=!-250,000
CF3!=!-250,000
CF4!=!+200,000
CF5!=!+200,000
CF6!=!+200,000
CF7!=!+200,000
CF8!=!+200,000
CF9!=!+200,000
CF10!=!+200,000
CF11!=!+200,000
CF12!=!+200,000
CF13!=!+200,000
Maximum$deviation!=!IRR!-!Cost$of$Capital!=!11.0%!-!10.0%!=!1.0%!
Diff:!3!
Skill:!Analytical!
!
!
27)!!Explain!why!the!NPV!decision!rule!might!provide!Larry!with!a!different!!decision!outcome!than!the!IRR!rule!
when!evaluating!Larry[s!three!movie!deal!offer.!
Answer:!!!The!NPV!rule!will!always!give!the!right!decision.!!In!this!problem,!Larry!starts!with!the!cash!up!front,!a!
positive!cash!flow,!then!followed!by!three!negative!cash!flows.!!This!is!the!exact!opposite!as!what!we!
want!with!the!IRR.!!The!IRR!assumes!that!we!start!with!a!negative!outflow!followed!by!Inflow(s).!!Since!
we!start!with!a!positive!cash!inflow,!the!IRR!rule!cannot!be!trusted!to!give!the!correct!answer.!
Diff:!3!
Skill:!Conceptual!
!
28)!!You!are!considering!an!investment!in!an!everlasting!gobstopper!machine.!!This!machine!will!cost!$10!million!
and!will!produce!cash!flows!of!$1!million!and!the!end!of!every!year!forever.!!The!appropriate!cost!of!capital!is!
8%.!!Compute!the!economic!value!added!(EVA)!for!this!project.!!Calculate!the!PV!of!the!EVAs!for!this!project.!
Answer:!!!The!EVA!in!every!year!is:!
Cn!-!10r!=!1!-!10r!
!
Using!the!perpetuity!formula,!the!present!value!of!these!EVAs!is!
1 10r 1 10(.08) 1
PV(EVA)!=! !=! !=!! -!10!=!$2.5!million!
n .08 .08
(1 .08)
Diff:!2!
Skill:!Analytical!
!
29)!!You!are!considering!purchasing!a!new!automated!forklift!system!for!your!firm[s!warehouse.!!The!automated!
forklift!will!cost!$500,000!and!generate!cash!flows!of!$125,000!per!year.!!The!forklift!will!depreciate!evenly!
over!the!five!years,!at!which!point!it!must!be!replaced.!!The!cost!of!capital!is!8%!per!year.!!Based!upon!the!EVA!
investment!rule,!should!you!invest!in!the!automated!forklift?!
!
Answer:!!!The!EVA!is!calculated!as!follows!(all!values!in!thousands):!
Year 0 1 2 3 4 5!
Capital 500 400 300 200 100 0!
Cash!Flow 125 125 125 125 125!
Capital!Charge -40 -32 -24 -16 -8!
Depreciation -100 -100 -100 -100 -100!
EVA -15 -7 1 9 17!
PV!of!EVA -13.89 -6.00 0.79 6.62 11.57!
Sum!of!PV(EVA) -0.91
!
For!example,!EVA1!=!$125!-!8%($500)!-!$100!=!-15
Since!the!PV(EVA)!=!-91,000!<!0!you!should!not!invest.!
Diff:!3!
Skill:!Analytical!
6.3!Mutually!Exclusive!Investment!Opportunities!
A)!!Problems!can!arise!using!the!IRR!method!when!the!mutually!exclusive!investments!have!different!cash!
flow!patterns.!
B)!!The!IRR!is!affected!by!the!scale!of!the!investment!opportunity.!
C)!!Multiple!incremental!IRRs!might!exist.!
D)!!The!incremental!IRR!rule!assumes!that!the!riskiness!of!the!two!projects!is!the!same.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!6.3!Mutually!Exclusive!Investment!Opportunities!
Skill:!Conceptual!
!
A)!!The!incremental!IRR!investment!rule!applies!the!IRR!rule!to!the!difference!between!the!cash!flows!of!the!
two!mutually!exclusive!alternatives.!
B)!!When!a!manager!must!choose!among!mutually!exclusive!investments,!the!NPV!rule!provides!a!
straightforward!answer.!
C)!!The!likelihood!of!multiple!IRRs!is!greater!with!the!regular!IRR!rule!than!with!the!incremental!IRR!rule.!
D)!!Problems!can!arise!using!the!IRR!method!when!the!mutually!exclusive!investments!have!differences!in!
scale.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!using!the!incremental!IRR!rule,!you!must!keep!track!of!which!project!is!the!incremental!project!
and!ensure!that!the!incremental!cash!flows!are!initially!positive!and!then!become!negative.!
B)!!Picking!one!project!over!another!simply!because!it!has!a!larger!IRR!can!lead!to!mistakes.!
C)!!Problems!arise!using!the!IRR!method!when!the!mutually!exclusive!investments!have!differences!in!scale.!
D)!!When!the!risks!of!two!projects!are!different,!only!the!NPV!rule!will!give!a!reliable!answer.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!incremental!IRR!need!not!exist.!
B)!!If!a!change!in!the!timing!of!the!cash!flows!does!not!affect!the!NPV,!then!the!change!in!timing!will!not!
impact!the!IRR.!
C)!!Although!the!incremental!IRR!rule!can!provide!a!reliable!method!for!choosing!among!projects,!it!can!be!
difficult!to!apply!correctly.!
D)!!When!projects!are!mutually!exclusive,!it!is!not!enough!to!determine!which!projects!have!positive!NPVs.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Consider!two!mutually!exclusive!projects!A!&!B.!!If!you!subtract!the!cash!flows!of!opportunity!B!from!the!cash!
flows!of!opportunity!A,!then!you!should!!
A)!!take!opportunity!A!if!the!regular!IRR!exceeds!the!cost!of!capital.!
B)!!take!opportunity!A!if!the!incremental!IRR!exceeds!the!cost!of!capital.!
C)!!take!opportunity!B!if!the!regular!IRR!exceeds!the!cost!of!capital.!
D)!!take!opportunity!B!if!the!incremental!IRR!exceeds!the!cost!of!capital.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
6)!!You!are!trying!to!decide!between!three!mutually!exclusive!investment!opportunities.!!The!most!appropriate!
tool!for!identifying!the!correct!decision!is:!
A)!!NPV!
B)!!Profitability!index!
C)!!IRR!
D)!!Incremental!IRR!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!

A -100 40 50 60 N/A .15!
B -73 30 30 30 30 .15!
!
7)!!Assume!that!projects!A!and!B!are!mutually!exclusive.!!The!correct!investment!decision!and!the!best!rational!
for!that!decision!is!to?!
A)!!Invest!in!project!A!since!NPVB!<!NPVA!!
B)!!Invest!in!project!B!since!IRRB!>!IRRA!!
C)!!Invest!in!project!B!since!NPVB!>!NPVA!!
D)!!Invest!in!project!A!since!NPVA!>!0!
Answer:!!!C!
B)!!
C)!!NPVA!=!-100!+!40!/!(1.15)1!+!50!/!(1.15)2!+!60!/!(1.15)3!=!12.04
NPVB!=!-73+!30!/!(1.15)1!+!30!/!(1.15)2!+!30!/!(1.15)3!+!30!/!(1.15)4!=!12.64
IRR!A
CF0!=!-100
CF1!=!40
CF2!=!50
CF3!=!60
Compute!IRR!=!21.65%
IRR!B
CF0!=!-73
CF1!=!30
CF2!=!30
CF3!=!30
CF4!=!30
D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!The!incremental!IRR!of!Project!B!over!Project!A!is!closest!to:!
A)!!12.6%!
B)!!23.3%!
C)!!1.7%!
D)!!17.3%!
Answer:!!!A!
Explanation:!!! A)!!First!we!need!to!find!the!incremental!cash!flows!by!taking!cashflows!of!A!-!cashflows!of!B.
IRR!A!-!B
CF0!=!(-100!-!!-73)!=!-27
CF1!=!(40!-!30)!=!10
CF2!=!(50!-!30)!=!20
CF3!=!(60!-!30)!=!30
CF4!=!(0!-!30)!=!-30
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
9)!!The!maximum!number!of!incremental!IRRs!that!!could!exist!for!project!B!over!project!A!is?!
A)!!1!
B)!!2!
C)!!0!
D)!!3!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!

Alpha -79 20 25 30 35 40 N/A N/A 15%!
Beta -80 25 25 25 25 25 25 25 16%!
!
10)!!Assume!that!projects!Alpha!and!Beta!are!mutually!exclusive.!!The!correct!investment!decision!and!the!best!
rational!for!that!decision!is!to?!
A)!!Invest!in!project!Beta!since!NPVBeta!>!0!
B)!!Invest!in!project!Alpha!since!NPVBeta!<!NPVAlpha!
C)!!Invest!in!project!Beta!since!IRRB!>!IRRA!
D)!!Invest!in!project!Beta!since!NPVBeta!>!NPVAlpha!>!0!
Answer:!!!D!
B)!!
C)!!
D)!!NPV!Alpha
NPV!=!-79!+!20!/!(1.15)1!+!25!/!(1.15)2!+!30!/!(1.15)3!+!35!/!(1.15)4!!+!40!/!(1.15)5=!16.92
NPV!Beta
NPV!=!-80!+!25!/!(1.16)1!+!25!/!(1.16)2!+!25!/!(1.16)3!+!25!/!(1.16)4!!+!25!/!(1.16)5!+!!!
50!/!(1.16)6!+!!25!/!(1.16)7=!20.96
IRR!Alpha
CF0!=!-79
CF1!=!20
CF2!=!25
CF3!=!30
CF4!=!35
CF5!=!40
Compute!IRR!=!22.68
IRR!Beta
PV!=!-80
PMT!=!25
FV!=!0
N$=!7
Compute!I!=!24.52
Diff:!3!
Skill:!Analytical!
!
11)!!Assume!that!projects!Alpha!and!Beta!are!mutually!exclusive.!!Which!of!the!following!statements!is!true!
regarding!the!investment!decision!tools[!suitability!for!deciding!between!projects!Alpha!&!Beta.!
A)!!The!incremental!IRR!should!not!be!used!since!the!projects!have!different!lives.!
B)!!The!incremental!IRR!should!not!be!used!since!the!projects!have!different!discount!rates!
C)!!The!incremental!IRR!should!not!be!used!since!the!projects!have!different!cash!flow!patterns.!
D)!!Both!the!NPV!and!incremental!IRR!approaches!are!appropriate!to!solve!this!problem.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Consider!two!mutually!exclusive!projects!with!the!following!cash!flows:
Project C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6!

A $(41,215) $12,500 $14,000 $16,500 $18,000 20,000 N/A!
B $(46,775) $15,000 $15,000 $15,000 $15,000 $15,000 $15,000!
!
12)!!You!are!considering!using!the!incremental!IRR!approach!to!decide!between!the!two!mutually!exclusive!
projects!A!&!B.!!How!many!potential!incremental!IRRs!could!there!be?!
A)!!3!
B)!!0!
C)!!2!
D)!!1!
Answer:!!!A!
Explanation:!!! A)!!Project C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6!
A ($41,215) $12,500! $14,000! $16,500! $18,000! 20,000 0!
B ($46,775) $15,000! $15,000! $15,000! $15,000! $15,000! $15,000!!
B!-!A ($5,560) $2,500! $1,000! ($1,500) ($3,000) ($5,000) $15,000!!

!
Note!that!there!are!three!sign!changes!hence!there!potential!IRRs.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!If!the!discount!rate!for!project!A!is!16%,!then!what!is!the!NPV!for!project!A?!
Answer:!!!NPV!A
CF0!=!-41,215
CF1!=!12,500
CF2!=!14,000
CF3!=!16,500
CF4!=!18,000
CF5!=!20,000
I$=!16
Compute!NPV!=!$9,999.50!
Diff:!2!
Skill:!Analytical!
!
14)!!If!the!discount!rate!for!project!B!is!15%,!then!what!is!the!NPV!for!project!B?!
Answer:!!!NPV!B
CF0!=!-46,775
CF1!=!15,000
CF2!=!15,000
CF3!=!15,000
CF4!=!15,000
CF5!=!15,000
CF6!=!15,000
Compute!NPV!=!$9,9992.24!
Diff:!2!
Skill:!Analytical!
!
15)!!What!is!the!incremental!IRR!for!project!B!over!project!A?!!Would!you!feel!comfortable!basing!your!decision!on!
the!incremental!IRR?!
!
Answer:!!!Project C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6!
A ($41,215) $12,500! $14,000! $16,500! $18,000! 20,000 0!
B ($46,775) $15,000! $15,000! $15,000! $15,000! $15,000! $15,000!!
B!-!A ($5,560) $2,500! $1,000! ($1,500) ($3,000) ($5,000) $15,000!!
Compute!IRR!=!8.95%,!no!since!there!are!multiple!sign!changes!in!the!incremental!cash!flows.!
Diff:!2!
Skill:!Analytical!
!
16)!!Assuming!that!the!discount!rate!for!project!A!is!16%!and!the!discount!rate!for!B!is!15%,!then!given!that!these!
are!mutually!exclusive!projects,!which!project!would!you!take!and!why?!
Answer:!!!NPV!A
CF0!=!-41,215
CF1!=!12,500
CF2!=!14,000
CF3!=!16,500
CF4!=!18,000
CF5!=!20,000
I$=!16
Compute!NPV!=!$9,999.50
NPV!B
CF0!=!-46,775
CF1!=!15,000
CF2!=!15,000
CF3!=!15,000
CF4!=!15,000
CF5!=!15,000
CF6!=!15,000
Compute!NPV!=!$9,9992.24
Take!A,!since!NPV!of!A!>!NPV!!of!B!and!both!are!positive.!
Diff:!3!
Skill:!Analytical!
!
6.4!Project!Selection!with!Resource!Restraints!
A)!!If!there!is!a!fixed!supply!of!resource!available,!you!should!rank!projects!by!the!profitability!index,!
selecting!the!project!with!the!lowest!profitability!index!first!and!working!your!way!down!the!list!until!
the!resource!is!consumed.!
B)!!Practitioners!often!use!the!profitability!index!to!identify!the!optimal!combination!of!projects!when!there!
is!a!fixed!supply!of!resources.!
C)!!If!there!is!a!fixed!supply!of!resources!available,!so!that!you!cannot!undertake!all!possible!opportunities,!
then!simply!picking!the!highest!NPV!opportunity!might!not!lead!to!the!best!decision.!
D)!!The!profitability!index!is!calculated!as!the!NPV!divided!by!the!resources!consumed!by!the!project.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!6.4!Project!Selection!with!Resource!Constraints!
Skill:!Conceptual!
!
A)!!The!profitability!index!measures!the!value!created!in!terms!of!NPV!per!unit!of!resource!consumed.!
B)!!The!profitability!index!is!the!ratio!of!value!created!to!resources!consumed.!
C)!!The!profitability!index!can!can!be!easily!adapted!for!determining!the!correct!investment!decisions!when!
multiple!resource!constraints!exist.!
D)!!The!profitability!index!measures!the!ebang!for!your!buck.e!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!You!are!opening!up!a!brand!new!retail!strip!mall.!!You!presently!have!more!potential!retail!outlets!wanting!to!
locate!in!your!mall!than!you!have!space!available.!!What!is!the!most!appropriate!tool!to!use!if!you!are!trying!to!
determine!the!optimal!allocation!of!your!retail!space?!
A)!!IRR!
B)!!Payback!period!
C)!!NPV!
D)!!Profitability!!index!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
Year Cash!Flow!
0 -10,000!
1 4,000!
2 4,000!
3 4,000!
4 4,000!
!
4)!!Assume!the!appropriate!discount!rate!for!this!project!is!15%.!!The!profitability!index!for!this!project!is!closest!
to:!
A)!!.14!
B)!!.22!
C)!!.60!
D)!!.15!
Answer:!!!A!
Explanation:!!! A)!! 4, 000 4, 000 4, 000 4, 000
NPV$=$-10,000!+! + + + !=!$1420
1
(1.15) (1.15)2 (1.15)3 (1.15) 4
PI!=!NPV$/!investment!=!1420!/!10000!=!.1420!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!

A -100 40 50 60 N/A .15!
B -73 30 30 30 30 .15!
!
5)!!The!profitability!index!for!project!A!is!closest!to:!
A)!!0.12!
B)!!21.65!
C)!!0.17!
D)!!12.04!
Answer:!!!A!
Explanation:!!! A)!!PI!=!NPV!/!Investment!(or!resources!consumed)
NPV!=!-100!+!40!/!(1.15)1!+!50!/!(1.15)2!+!60!/!(1.15)3!=!12.04
So,!PI!=!12.04!/!100!=!.1204!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!The!profitability!index!for!project!B!is!closest!to:!
A)!!23.34!
B)!!12.64!
C)!!0.17!
D)!!0.12!
Answer:!!!C!
B)!!
C)!!PI!=!NPV!/!Investment!(or!resources!consumed)
NPV!=!-73!+!30!/!(1.15)1!+!30!/!(1.15)2!+!30!/!(1.15)3!+!30!/!(1.15)4!=!12.64
So,!PI!=!12.64!/!73!=!.1732!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!list!of!projects:
Project Investment NPV!

A 135,000 6,000!
B 200,000 30,000!
C 125,000 20,000!
D 150,000 2,000!
E 175,000 10,000!
F 75,000 10,000!
G 80,000 9,000!
H 200,000 20,000!
I 50,000 4,000!
!
7)!!Assuming!that!your!capital!is!constrained,!which!investment!tool!should!you!use!to!determine!the!correct!
investment!decisions?!
A)!!Profitability!Index!
B)!!Incremental!IRR!
C)!!NPV!
D)!!IRR!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
8)!!Assuming!that!your!capital!is!constrained,!which!project!should!you!invest!in!first?!
A)!!Project!C!
B)!!Project!G!
C)!!Project!B!
D)!!Project!F!
Answer:!!!A!
Explanation:!!! A)!!!
! ! Profitability! !
Project Investment NPV! Index! Rank!
A 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Assuming!that!your!capital!is!constrained,!what!is!the!fifth!project!that!you!should!invest!in?!
A)!!Project!H!
B)!!Project!I!
C)!!Project!B!
D)!!Project!A!
Answer:!!!A!
A 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Assuming!that!your!capital!is!constrained,!which!project!should!you!invest!in!last?!
A)!!Project!A!
B)!!Project!I!
C)!!Project!D!
D)!!Project!C!
Answer:!!!C!
B)!!
C)!!!
AA 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!Assuming!that!your!capital!is!constrained,!so!that!you!only!have!$600,000!available!to!invest!in!projects,!
which!project!should!you!invest!in!and!in!what!order?!
A)!!CBFH!
B)!!CBGF!
C)!!BCFG!
D)!!CBFG!
Answer:!!!A!
A 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
This!is!a!tricky!problem!in!that!by!the!rankings!CBFG!seem!optimal,!but!this!combination!
leaves!$120,000!on!the!table!uninvested.!!By!replacing!G!with!H!the!full!$600,000!is!invested!
and!the!NPV!of!the!combination!of!projects!is!increased!by!$11,000.!!Therefore!you!should!
invest!in!projects!CBFH.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!Assume!that!your!capital!is!constrained,!so!that!you!only!have!$600,000!available!to!invest!in!projects.!!If!you!
invest!in!the!optimal!combination!of!projects!given!your!capital!constraint,!then!the!total!NPV!for!all!the!
projects!you!invest!in!will!be!closest!to:!
A)!!$65,000!
B)!!$80,000!
C)!!$69,000!
D)!!$111,000!
Answer:!!!B!
B)!!!
A 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
!
This!is!a!tricky!problem!in!that!by!the!rankings!CBFG!seem!optimal,!but!this!combination!
leaves!$120,000!on!the!table!uninvested.!!By!replacing!G!with!H!the!full!$600,000!is!invested!
and!the!NPV!of!the!combination!of!projects!is!increased!by!$11,000.!Therefore!you!should!
invest!in!projects!CBFH.
The!NPV!=!NPVC!+!NPVB!+!NPVF!+!NPVH!=!20000!+!30000!+!10000!+!20000!=!$80,000.!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
13)!!Assume!that!your!capital!is!constrained,!so!that!you!only!have!$500,000!available!to!invest!in!projects.!!If!you!
invest!in!the!optimal!combination!of!projects!given!your!capital!constraint,!then!the!total!NPV!for!all!the!
projects!you!invest!in!will!be!closest!to:!
A)!!$111,000!
B)!!$69,000!
C)!!$80,000!
D)!!$58.000!
Answer:!!!B!
B)!!!
A 135,000 6,000! 0.0444! 8!
B 200,000 30,000! 0.1500! 2!
C 125,000 20,000! 0.1600! 1!
D 150,000 2,000! 0.0133! 9!
E 175,000 10,000! 0.0571! 7!
F 75,000 10,000! 0.1333! 3!
G 80,000 9,000! 0.1125! 4!
H 200,000 20,000! 0.1000! 5!
I 50,000 4,000! 0.8000! 6!
The!optimal!combination!based!upon!PI!rankings!is!CBFG,!so!the!total!NPV!=!20000!+!30000!+!
10000!+!9000!=!$69,000!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
detailed!below:

$200,000 $225,000 $275,000 $200,000!
14)!!The!profitability!index!for!this!project!is!closest!to:!
A)!!.44!
B)!!.26!
C)!!0.39!
D)!!.34!
Answer:!!!C!
B)!!
C)!!PI!=!NPV!/!Investment
NPV!=!-450000!+!200000/(1.16)1!+!225000/(1.16)2!+!275000/(1.16)3!+!2000000/(1.16)4!=!176,265
So,!PI!=!176265!/!450000!=!0.39!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Your!firm!is!preparing!to!open!a!new!retail!strip!mall!and!you!have!multiple!businesses!that!would!like!lease!space!in!it.!!
Each!business!will!pay!a!fixed!amount!of!rent!each!month!plus!a!percentage!of!the!gross!sales!generated!each!month.!!The!
cash!flows!from!each!of!the!businesses!has!approximately!the!same!amount!of!risk.!!The!business!names,!square!footage!
requirements,!and!monthly!expected!cash!flows!for!each!of!the!businesses!that!would!like!to!lease!space!in!your!strip!mall!
are!provided!below:
Square!Feet! Expected!Monthly!
Business!Name Required Cash!Flow!
Videos!Now 4,000 70,000!
Gords!Gym 3,500 52,500!
Pizza!Warehouse 2,500 52,500!
Super!Clips 1,500 25,500!
30!1/2!Flavors 1,500 28,500!
S-Mart 12,000 180,000!
WalVerde!Drugs 6,000 147,000!
Multigular!Wireless 1,000 22,250!
!
15)!!If!your!new!strip!mall!will!have!15,000!square!feet!of!retail!space!available!to!be!leased,!to!which!businesses!
should!you!lease!and!why?!
!
Answer:!!! Square!Feet! Expected!Monthly! C/F!per! Project!
Business!Name Required Cash!Flow S.F. Rank!
Videos!Now 4,000 70,000 17.5 5!
Gords!Gym 3,500 52,500 15 7!
Pizza!Warehouse 2,500 52,500 21 3!
Super!Clips 1,500 25,500 17 6!
30!1/2!Flavors 1,500 28,500 19 4!
S-Mart 12,000 180,000 15 8!
WalVerde!Drugs 6,000 147,000 24.5 1!
Multigular!Wireless 1,000 22,250 22.25 2!
So!we!select!projects!based!upon!their!ranking!until!we!run!out!of!space.!!The!optimal!combination!is!
shown!below:
WalVerde!Drugs 6,000 147,000 24.5 1!

30!1/2!Flavors 1,500 28,500 19 4!
Videos!Now 4,000 70,000 17.5 5!
Total 15,000 $320,250
Diff:!3!
Skill:!Analytical!
!
16)!!If!your!new!strip!mall!will!have!16,000!square!feet!of!retail!space!available!to!be!leased,!to!which!businesses!
should!you!lease!and!why?!
!
Answer:!!! Square!Feet! Expected!Monthly! C/F!per! Project!
Business!Name Required Cash!Flow S.F. Rank!
Videos!Now 4,000 70,000 17.5 5!
Gords!Gym 3,500 52,500 15 7!
Super!Clips 1,500 25,500 17 6!
30!1/2!Flavors 1,500 28,500 19 4!
S-Mart 12,000 180,000 15 8!
WalVerde!Drugs 6,000 147,000 24.5 1!
So!we!select!projects!based!upon!their!ranking!until!we!run!out!of!space.!!This!combination!is!shown!
below:
WalVerde!Drugs 6,000 147,000 24.5 1!

30!1/2!Flavors 1,500 28,500 19 4!
Videos!Now 4,000 70,000 17.5 5!
Total 15,000 $320,250
!
But!notice!that!this!combination!leaves!1,000!square!feet!unleased.!!We!therefore!should!look!to!see!if!
there!is!a!combination!that!leases!more!space!and!offers!a!higher!monthly!cash!flow.!!If!we!forgo!
renting!to!Videos!Now!and!instead!rent!to!both!Super!Clips!and!Gords!Gym!we!will!obtain!a!higher!
monthly!cash!flow.!!The!optimal!combination!is!shown!below:
WalVerde!Drugs 6,000 147,000 24.5 1!

30!1/2!Flavors 1,500 28,500 19 4!
Super!Clips 1,500 25,500 17 6!
Gords!Gym 3,500 52,500 15 7!
Total 16,000 $328,250
Diff:!3!
Skill:!Analytical!
!
17)!!Consider!the!following!list!of!projects:
Project Investment NPV!

A 405,000 18,000!
B 600,000 90,000!
C 375,000 60,000!
D 450,000 6,000!
E 525,000 30,000!
F 225,000 30,000!
G 240,000 27,000!
H 600,000 60,000!
I 150,000 12,000!
J 270,000 30,000!
You!are!given!a!budget!of!only!$1,800,000!to!invest!in!projects.!!Which!projects!will!you!select,!in!what!order!
will!you!select!them,!and!why?!
!
Answer:!!!Project Investment NPV! PI! Rank!
A 405,000 18,000! 0.0444! 9!
B 600,000 90,000! 0.1500! 2!
C 375,000 60,000! 0.1600! 1!
D 450,000 6,000! 0.0133! 10!
E 525,000 30,000! 0.0571! 8!
F 225,000 30,000! 0.1333! 3!
G 240,000 27,000! 0.1125! 4!
H 600,000 60,000! 0.1000! 6!
I 150,000 12,000! 0.0800! 7!
J 270,000 30,000! 0.1111! 5!
!
Beginning! Project Cost Ending!
1,800,000 C 375,000 1,425,000!
1,425,000 B 600,000 825,000!
825,000 F 525,000 300,000!
300,000 J 270,000 30,000!
Normally!we!would!want!to!take!projects!CBFG.!!However,!we!can!do!better!by!dumping!G!and!taking!
J!instead.!!Allow!it!has!a!lower!profitability!index,!it!has!a!higher!NPV!and!allows!more!capital!to!be!
invested.!
Diff:!3!
Skill:!Analytical!
!
Chapter!7!-!Fundamentals!of!Capital!Budgeting!
!
!
7.1!Forecasting!Earnings!
A)!!A!capital!budget!lists!the!projects!and!investments!that!c!company!plans!to!undertake!during!the!coming!
year.!
B)!!Income!Tax!=!EBIT!×!(1!-! c).!
C)!!When!sales!of!a!new!product!displace!sales!of!an!existing!product,!the!situation!is!often!referred!to!as!
cannibalization.!
D)!!Overhead!expenses!are!often!allocated!to!the!different!business!activities!for!accounting!purposes.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!7.1!Forecasting!Earnings!
Skill:!Conceptual!
!
A)!!Sales!will!ultimately!decline!as!the!product!nears!obsolescence!or!faces!increased!competition.!
B)!!Managers!sometimes!continue!to!invest!in!a!project!that!has!a!negative!NPV!because!they!have!already!
invested!a!large!amount!in!the!project!and!feel!that!by!not!continuing!it,!the!prior!investment!will!wasted.!
C)!!With!straight-line!depreciation!the!asset’s!cost!is!divided!equally!over!its!life.!
D)!!A!projects!unlevered!net!income!is!equal!to!its!incremental!revenues!less!costs!and!depreciation,!
evaluated!on!an!pre-tax!basis.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!begin!the!capital!budgeting!process!by!determining!the!incremental!earnings!of!a!project.!
B)!!The!marginal!corporate!tax!rate!is!the!tax!rate!the!firm!will!pay!on!an!incremental!dollar!of!pre-tax!
income.!
C)!!Investments!in!plant,!property,!and!equipment!are!directly!listed!as!expense!when!calculating!earnings.!
D)!!The!opportunity!cost!of!using!a!resource!is!the!value!it!could!have!provided!in!its!best!alternative!use.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!When!evaluating!a!capital!budgeting!decision,!the!correct!tax!rate!to!use!is!the!firm’s!average!corporate!
tax!rate.!
B)!!To!determine!the!capital!budget,!firms!analyze!alternative!projects!and!decide!which!ones!to!accept!
through!a!process!called!capital!budgeting.!
C)!!A!new!product!typically!has!lower!sales!initially,!as!customers!gradually!become!aware!of!the!product.!
D)!!Sunk!costs!have!been!or!will!be!paid!regardless!of!the!decision!whether!or!not!to!proceed!with!the!
project.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!value!is!lost!when!a!resource!is!used!by!another!project,!we!should!include!the!opportunity!cost!
as!an!incremental!cost!of!the!project.!
B)!!Sunk!costs!are!incremental!with!respect!to!the!current!decision!regarding!the!project!and!should!be!
included!in!its!analysis.!
C)!!Overhead!expenses!are!associated!with!activities!that!are!not!directly!attributable!to!a!single!business!
activity!but!instead!affect!many!different!areas!of!the!corporation.!
D)!!When!computing!the!incremental!earnings!of!an!investment!decision,!we!should!include!all!changes!
between!the!firm’s!earnings!with!the!project!versus!without!the!project.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!firm!deducts!a!fraction!of!the!investments!in!plant,!property,!and!equipment!each!year!as!
depreciation.!
B)!!If!securities!are!fairly!priced,!the!net!present!value!of!a!fixed!set!of!cash!flows!is!independent!of!how!
those!cash!flows!are!financed.!
C)!!Sunk!cost!fallacy!is!a!term!used!to!describe!the!tendency!of!people!to!ignore!sunk!costs!in!capital!
budgeting!analysis.!
D)!!A!good!rule!to!remember!is!that!if!our!decision!does!not!affect!a!cash!flow!then!the!cash!flow!should!not!
affect!our!decision.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!ultimate!goal!in!capital!budgeting!is!to!determine!the!effect!of!the!decision!to!take!a!particular!
project!on!the!firmYs!cash!flows.!
B)!!To!the!extent!that!overhead!costs!are!fixed!and!will!be!incurred!in!any!case,!they!are!incremental!to!the!
project!and!should!be!included!in!the!capital!budgeting!analysis.!
C)!!Unlevered!Net!Income!=!(Revenue!-!Costs!-!Depreciation)!×!(1!-! c).!
D)!!Earnings!are!not!cash!flows.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Project!externalities!are!direct!effects!of!the!project!that!may!increase!of!decrease!the!profits!of!other!
business!activities!of!the!firm.!
B)!!Incremental!earnings!are!the!amount!by!which!the!firmYs!earnings!are!expected!to!change!as!a!result!of!
the!investment!decision.!
C)!!The!average!selling!price!of!a!product!and!its!cost!of!production!will!generally!change!over!time.!
D)!!Any!money!that!has!already!been!spent!is!a!sunk!cost!and!therefore!irrelevant!in!the!capital!budgeting!
process.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!Many!projects!use!a!resource!that!the!company!already!owns.!
B)!!When!evaluating!a!capital!budgeting!decision,!we!generally!include!interest!expense.!
C)!!Only!include!as!incremental!expenses!in!your!capital!budgeting!analysis!the!additional!overhead!
expenses!that!arise!because!of!the!decision!to!take!on!the!project.!
D)!!As!a!practical!matter,!to!derive!the!forecasted!cash!flows!of!a!project,!financial!managers!often!begin!by!
forecasting!earnings.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!simplest!method!used!to!calculate!depreciation!is!the!straight-line!method.!
B)!!A!sunk!cost!is!any!unrecoverable!cost!for!which!the!firm!is!already!liable.!
C)!!Unlevered!Net!Income!=!EBIT!×! c.!
D)!!The!decision!to!continue!or!abandon!should!be!based!only!on!the!incremental!costs!and!benefits!of!the!
project!going!forward.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
11)!!Which!of!the!following!costs!would!you!consider!when!making!a!capital!budgeting!decision?!
A)!!Sunk!cost!
B)!!Opportunity!cost!
C)!!Interest!expense!
D)!!Fixed!overhead!cost!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
12)!!A!decrease!in!the!sales!of!a!current!project!because!of!the!launching!of!a!new!project!is!
A)!!cannibalization.!
B)!!a!sunk!cost.!
C)!!an!overhead!expense.!
D)!!irrelevant!to!the!investment!decision.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
13)!!Money!that!has!been!or!will!be!paid!regardless!of!the!decision!whether!or!not!to!proceed!with!the!project!is!
A)!!cannibalization.!
B)!!considered!as!part!of!the!initial!investment!in!the!project.!
C)!!an!opportunity!cost.!
D)!!a!sunk!cost.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
14)!!The!value!of!currently!unused!warehouse!space!that!will!be!used!as!part!of!a!new!capital!budgeting!project!is!
A)!!an!opportunity!cost.!
B)!!irrelevant!to!the!investment!decision.!
C)!!an!overhead!expense.!
D)!!a!sunk!cost.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
!
Ford!Motor!Company!is!considering!launching!a!new!line!of!hybrid!Diesel-Electric!SUVs.!!!The!heavy!advertising!expenses!
associated!with!the!new!SUV!launch!would!generate!operating!losses!of!$35!million!next!year.!!Without!the!new!SUV,!Ford!
expects!to!earn!pre-tax!income!of!$80!million!from!operations!next!year.!!Ford!pays!a!30%!tax!rate!on!its!pre-tax!income.!
!
15)!!The!amount!that!Ford!Motor!Company!owe!in!taxes!next!year!without!the!launch!of!the!new!SUV!is!closest!to:!
A)!!$24.0!million!
B)!!$56.0!million!
C)!!$31.5!million!
D)!!$13.5!million!
Answer:!!!A!
Explanation:!!! A)!!=!$80!×!.30!=!$24!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
16)!!The!amount!that!Ford!Motor!Company!owe!in!taxes!next!year!with!the!launch!of!the!new!SUV!is!closest!to:!
A)!!$13.5!million!
B)!!$31.5!million!
C)!!$56.0!million!
D)!!$24.0!million!
Answer:!!!A!
Explanation:!!! A)!!=!(80!-!35)!×!.30!=!13.5!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Food!For!Less!(FFL),!a!grocery!store,!is!considering!offering!one!hour!photo!developing!in!their!store.!!The!firm!expects!
that!sales!from!the!new!one!hour!machine!will!be!$150,000!per!year.!!FFL!currently!offers!overnight!film!processing!with!
annual!sales!of!$100,000.!!While!many!of!the!one!hour!photo!sales!will!be!to!new!customers,!FFL!estimates!that!60%!of!their!
current!overnight!photo!customers!will!switch!and!use!the!one!hour!service.!!
!
17)!!The!level!of!incremental!sales!associated!with!introducing!the!new!one!hour!photo!service!is!closest!to:!
A)!!$90,000!
B)!!$150,000!
C)!!$60,000!
D)!!$120,000!
Answer:!!!A!
Explanation:!!! A)!!=!$150,000!-!(cannibalized!sales)!=!150000!-!.60!×!100,000!=!$90,000!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Suppose!that!of!the!60%!of!FFLYs!current!overnight!photo!customers,!half!would!start!taking!their!film!to!a!
competitor!that!offers!one!hour!photo!processing!if!FFL!fails!to!offer!the!one!hour!service.!!The!level!of!
incremental!sales!in!this!case!is!closest!to:!
A)!!$60,000!
B)!!$150,000!
C)!!$90,000!
D)!!$120,000!
Answer:!!!D!
B)!!
C)!!
D)!!=!$150,000!-!(cannibalized!sales)!=!150000!-!(.60!×!.50)!×!100,000!=!$120,000
Note!that!the!rate!of!cannibalization!is!only!30%!(.60!×!.50)!since!the!other!30%!would!have!
taken!their!film!elsewhere.!
Diff:!2!
Skill:!Analytical!
!
!
Glucose!Scan!Incorporated!(GSI)!currently!sells!its!latest!glucose!monitor,!the!Glucoscan!3000,!to!diabetic!patients!for!$129.!!
GSI!plans!on!lowering!their!price!next!year!to!$99!per!unit.!!The!cost!of!goods!sold!for!each!Glucoscan!unit!is!$50,!and!GSI!
expects!to!sell!100,000!units!over!the!next!year.
19)!!Suppose!that!if!GSI!drops!the!price!on!the!Glucoscan!3000!immediately,!it!can!increase!sales!over!the!next!year!
by!30%!to!130,000!units.!!The!incremental!impact!of!this!price!drop!on!the!firms!EBIT!is!closest!to:!
A)!!a!decline!of!1.5!million!
B)!!an!increase!of!1.5!million!
C)!!a!decline!of!2.4!million!
D)!!an!increase!of!2.4!million!
Answer:!!!A!
Explanation:!!! A)!!Without!price!cut!=!100,000!units!×!($129!-!50)!=!$7,900,000
With!price!cut!=!130,000!units!×!($99!-!50)!=!$6,370,000
So,!incremental!=!6,370,000!-!7,900,000!=!-1,530,000!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!Suppose!that!if!GSI!drops!the!price!on!the!Glucoscan!3000!immediately,!it!can!increase!sales!over!the!next!year!
by!30%!to!130,000!units.!!Also!suppose!that!for!each!Glucoscan!monitor!sold,!GSI!expects!additional!sales!of!
$100!per!year!on!glucose!testing!strips!and!these!strips!have!a!gross!profit!margin!of!75%.!!Considering!the!
increase!in!the!sale!of!testing!strips,!the!incremental!impact!of!this!price!drop!on!the!firms!EBIT!is!closest!to:!
A)!!A!decline!of!1.5!million!
B)!!Adecline!of!0.7!million!
C)!!An!increase!of!0.7!million!
D)!!An!increase!of!1.5!million!
Answer:!!!C!
B)!!
C)!!Without!Price!Cut
Monitor!sales!=!100,000!×!($129!-!$50)!=!$7,900,000
Strip!sales!=!100,000!×!($100!-!$25)!=!$7,500,000
Total!EBIT!=!7,900,000!+!7,500,000!=!15,400,000
With!Price!Cut
Monitor!sales!=!130,000!×!($99!-!$50)!=!$6,370.000
Strip!sales!=!130,000!×!($100!-!$25)!=!$9,750,000
Total!EBIT!=!6,370,000!+!9,750,000!=!!16,120,000
Incremental!=!16,120,000!-!!15,400,000!!=!!720,000!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
The!Sisyphean!Corporation!is!considering!investing!in!a!new!cane!manufacturing!machine!that!has!an!estimated!life!of!
three!years.!!The!cost!of!the!machine!is!$30,000!and!the!machine!will!be!depreciated!straight!line!over!its!three-year!life!to!a!
residual!value!of!$0.!!
The!cane!manufacturing!machine!will!result!in!sales!of!2,000!canes!in!year!1.!!Sales!are!estimated!to!grow!by!10%!per!year!
each!year!through!year!three.!!The!price!per!cane!that!Sisyphean!will!charge!its!customers!is!$18!each!and!is!to!remain!
constant.!!The!canes!have!a!cost!per!unit!to!manufacture!of!$9!each.!
Installation!of!the!machine!and!the!resulting!increase!in!manufacturing!capacity!will!require!an!increase!in!various!net!
working!capital!accounts.!!It!is!estimated!that!the!Sisyphean!Corporation!needs!to!hold!2%!of!its!annual!sales!in!cash,!4%!of!
its!annual!sales!in!accounts!receivable,!9%!of!its!annual!sales!in!inventory,!and!6%!of!its!annual!sales!in!accounts!payable.!!
The!firm!is!in!the!35%!tax!bracket,!and!has!a!cost!of!capital!of!10%.
21)!!The!incremental!EBIT!in!the!first!year!for!the!Sisyphean!CorporationYs!project!!is!closest!to:!
A)!!$18,000!
B)!!$8,000!
C)!!$11,700!
D)!!$5,200!
Answer:!!!B!
B)!!Incremental!Earnings!Forecast!
Year! 1! 2! 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Cost!of!Good!Sold!(units!×!$9) 18,000 19,800 21,780!
Gross!Profit 18,000 19,800 21,780!
Depreciation!($30,000!/!3) 10,000 10,000 10,000!
EBIT 8,000 9,800 11,780!
Income!tax!at!35% 2,800 3,430 4,123!
Unlevered!net!income 5,200 6,370 7,657!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
22)!!The!incremental!unlevered!net!income!in!the!first!year!for!the!Sisyphean!CorporationYs!project!!is!closest!to:!
A)!!$8,000!
B)!!$18,000!
C)!!$5,200!
D)!!$11,700!
Answer:!!!C!
B)!!
C)!!Incremental!Earnings!Forecast!
Year! 1! 2! 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Gross!Profit 18,000 19,800 21,780!
Depreciation!($30,000!/!3) 10,000 10,000 10,000!
EBIT 8,000 9,800 11,780!
Income!tax!at!35% 2,800 3,430 4,123!
D)!!
Diff:!3!
Skill:!Analytical!
!
23)!!The!depreciation!tax!shield!for!the!Sisyphean!CorporationYs!project!!in!the!first!year!is!closest!to:!
A)!!$8,000!
B)!!$3,500!
C)!!$2,800!
D)!!$5,200!
Answer:!!!B!
B)!!Depreciation!tax!shield!=!depreciation!×! c!=!(30000/3)!×!.35!=!$3,500!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
24)!!The!amount!of!!incremental!income!taxes!that!the!Sisyphean!Company!will!pay!in!the!first!year!on!this!new!
project!is!closest!to:!
A)!!$6,300!
B)!!$5,200!
C)!!$3,500!
D)!!$2,800!
Answer:!!!D!
B)!!
C)!!
D)!!Incremental!Earnings!Forecast!
Year! 1! 2! 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Gross!Profit 18,000 19,800 21,780!
Depreciation!($30,000!/!3) 10,000 10,000 10,000!
EBIT 8,000 9,800 11,780!
Income!tax!at!35% 2,800 3,430 4,123!
Diff:!2!
Skill:!Analytical!
!
25)!!What!is!a!sunk!cost?!!Should!it!be!included!in!the!incremental!cash!flows!for!a!project?!!Why!or!why!not?!
Answer:!!!A!sunk!cost!is!any!unrecoverable!cost!for!which!the!firm!is!already!liable.!!Sunk!costs!will!have!to!be!
paid!regardless!of!the!decision!whether!or!not!to!proceed!with!the!project.!!Therefore,!sunk!costs!are!not!
incremental!with!respect!to!the!current!decision!regarding!the!project!and!should!not!be!included!in!its!
analysis.!
Diff:!2!
Skill:!Conceptual!
!
26)!!What!is!an!opportunity!cost?!!Should!it!be!included!in!the!incremental!cash!flows!for!a!project?!!Why!or!why!
not?!
Answer:!!!Many!projects!use!resources!that!the!company!already!owns.!!An!opportunity!cost!is!the!cost!of!using!a!
resource!that!otherwise!could!have!provided!value!to!the!firm.!!The!opportunity!cost!of!using!a!
resource!is!the!value!it!could!have!provided!in!its!best!alternative!use.!!Because!this!value!is!lost!when!a!
resource!is!used!by!another!project,!we!should!always!include!the!opportunity!cost!as!an!incremental!
cost!of!the!project.!
Diff:!2!
Skill:!Conceptual!
!
!
27)!!Construct!a!simple!income!statement!showing!the!incremental!EBIT!and!the!incremental!unlevered!net!
income!for!all!three!years!of!the!Sisyphean!Companies!project.!
!
Answer:!!!Incremental!Earnings!Forecast!
Year! 1! 2! 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Gross!Profit 18,000 19,800 21,780!
Depreciation!($30,000!/!3) 10,000 10,000 10,000!
EBIT 8,000 9,800 11,780!
Income!tax!at!35% 2,800 3,430 4,123!
Diff:!3!
Skill:!Analytical!
7.2!Determining!Free!Cash!Flow!and!NPV!
A)!!Depreciation!is!not!a!cash!expense!paid!by!the!firm.!
B)!!Net!Working!Capital!=!Cash!+!Inventory!+!Payables!-!Receivables.!
C)!!Since!1997,!companies!can!dcarry!backd!losses!for!two!years!and!dcarry!forwardd!losses!for!20!years.!
D)!!Earnings!do!not!represent!real!profits.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!7.2!Determining!Free!Cash!Flow!and!NPV!
Skill:!Conceptual!
!
2)!!Which!of!the!following!questions!is!false?!
A)!!Net!Working!Capital!=!Current!Assets!-!Current!Liabilities.!
B)!!Because!depreciation!is!not!a!cash!flow,!we!do!not!include!it!in!the!cash!flow!forecast.!
C)!!Tax!loss!carry!backs!allow!corporations!to!take!losses!during!the!current!year!and!use!them!to!offset!
income!in!future!years.!
D)!!Earnings!are!an!accounting!measure!of!firm!performance.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Depreciation!is!a!method!used!for!accounting!and!tax!purposes!to!allocate!the!original!purchase!cost!of!
the!asset!over!its!life.!
B)!!Sometimes!the!firm!explicitly!forecast!free!cash!flow!over!a!shorter!horizon!than!the!full!horizon!of!the!
project!or!investment.!
C)!!Earnings!include!the!cost!of!capital!investments,!but!do!not!include!non-cash!charges,!such!as!
depreciation.!
D)!!Firms!often!report!a!different!depreciation!expense!for!accounting!and!for!tax!purposes.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Most!projects!will!require!the!firm!to!invest!in!net!working!capital.!
B)!!The!main!components!of!net!working!capital!are!cash,!inventory,!receivables,!and!property,!plant!and!
equipment.!
C)!! NWCt!=!NWCt!-!NWCt!-!1.!
D)!!In!the!final!year!of!a!project,!the!firm!ultimately!recovers!the!investment!in!net!working!capital.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Depreciation!expenses!have!a!positive!impact!on!free!cash!flow.!
B)!!Free!Cash!Flow!=!(Revenues!-!Costs!-!Depreciation)!×!(1!-! c )!-!Capital!Expenditures!-! NWC!+! c!×!
Depreciation.!
C)!!The!firm!cannot!use!its!earnings!to!buy!goods,!pay!employees,!fund!new!investments,!or!pay!dividends!
to!shareholders.!
D)!!The!depreciation!tax!shield!is!the!tax!savings!that!results!from!the!ability!to!deduct!depreciation.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!only!the!tax!consequences!of!depreciation!are!relevant!for!free!cash!flow,!we!should!use!the!
depreciation!expense!that!the!firm!will!use!for!tax!purposed!in!our!free!cash!flow!forecasts.!
B)!!A!firm!generally!identifies!its!marginal!tax!rate!by!determining!the!tax!bracket!that!it!falls!into!based!on!
its!overall!level!of!pre-tax!income.!
C)!!Free!Cash!Flow!=!(Revenues!-!Costs)!×!(1!-! c)!-!Capital!Expenditures!-! NWC!+! c!×!Depreciation.!
D)!!Net!working!capital!is!the!difference!between!current!liabilities!and!current!assets.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!terminal!of!continuation!value!of!the!project!represents!the!market!value!(as!of!the!last!forecast!
period)!of!the!free!cash!flow!from!the!project!at!all!future!dates.!
B)!!The!incremental!effect!of!a!project!on!the!firm’s!available!cash!is!the!projectYs!free!cash!flow.!
C)!!!(1!-! c)!×!Depreciation!is!called!the!depreciation!tax!shield.!
D)!!To!evaluate!a!capital!budgeting!decision,!we!must!determine!its!consequences!for!the!firmYs!available!
cash.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!Which!of!the!following!cash!flows!are!relevant!incremental!cash!flows!for!a!project!that!you!are!currently!
considering!investing!in?!
A)!!The!tax!savings!brought!about!by!the!projects!depreciation!expense.!
B)!!The!cost!of!a!marketing!survey!you!conducted!to!determine!demand!for!the!proposed!project.!
C)!!Interest!payments!on!debt!used!to!finance!the!project.!
D)!!Research!and!Development!expenditures!you!have!made.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!Your!firm!is!considering!building!a!new!office!complex.!!Your!firm!already!owns!land!suitable!for!the!new!
complex.!!The!current!book!value!of!the!land!is!$100,000,!however!a!commercial!real!estate!again!has!
informed!you!that!an!outside!buyer!is!interested!in!purchasing!this!land!and!would!be!willing!to!pay!$650,000!
for!it.!!When!calculating!the!NPV!of!your!new!office!complex,!ignoring!taxes,!the!appropriate!incremental!
cash!flow!for!the!use!of!this!land!is:!
A)!!$650,000!
B)!!$0!
C)!!$100,000!
D)!!$750,000!
Answer:!!!A!
Explanation:!!! A)!!It!is!appropriate!to!use!the!market!value.!!If!taxes!are!include,!the!value!would!be!the!after-tax!
value!of!the!land.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
10)!!You!are!considering!adding!a!micro!brewery!on!to!one!of!your!firmYs!existing!restaurants.!!This!will!entail!an!
increase!in!inventory!of!$8,000,!an!increase!in!accounts!payables!of!$2,500,!and!an!increase!in!property,!plant,!
and!equipment!of!$40,000.!!All!other!accounts!will!remain!unchanged.!!The!change!in!net!working!capital!
resulting!from!the!addition!of!the!micro!brewery!is:!
A)!!$45,500!
B)!!$10,500!
C)!!$6,500!
D)!!$5,500!
Answer:!!!D!
B)!!
C)!!
D)!!NWC!=!CA!-!CL!!=!$8000!-!$2500!=!$5500!
Diff:!1!
Skill:!Analytical!
!
11)!!You!are!considering!adding!a!micro!brewery!on!to!one!of!your!firmYs!existing!restaurants.!!This!will!entail!an!
investment!of!$40,000!in!new!equipment.!!This!equipment!will!be!depreciated!straight!line!over!five!years.!!If!
your!firmYs!marginal!corporate!tax!rate!is!35%,!then!what!is!the!value!of!the!micro!breweryYs!depreciation!tax!
shield!in!the!first!year!of!operation?!
A)!!$2,800!
B)!!$14,000!
C)!!$5,200!
D)!!$26,000!
Answer:!!!A!
Explanation:!!! A)!!First!figure!out!the!straight!line!depreciation.
$40,000!/!5!years!=!$8000!depreciation!per!year.!
Then!!.35!×!$8000!=!$2,800!depreciation!tax!shield!per!year.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!The!Sisyphean!Company!is!considering!a!new!project!that!will!have!an!annual!depreciation!expense!of!$2.5!
million.!!If!SisypheanYs!marginal!corporate!tax!rate!is!40%!and!their!average!corporate!tax!rate!is!30%,!then!
what!is!the!value!of!the!depreciation!tax!shield!on!their!new!project?!
A)!!$750,000!
B)!!$1,000,000!
C)!!$1,500,000!
D)!!$1,750,000!
Answer:!!!B!
B)!!Here!we!need!to!use!the!marginal!tax!rate.
So!depreciation!tax!shield!=!$2,500,000!×!.40!=!$1!million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
13)!!The!required!net!working!capital!in!the!first!year!for!the!Sisyphean!CorporationYs!project!!is!closest!to:!
A)!!$3,600!
B)!!$3,960!
C)!!$2,880!
D)!!$5,400!
Answer:!!!A!
Explanation:!!! A)!!Networking!Capital!Forecast!
Year 1 2 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Cash!(2%!of!sales) 720 792 871.2!
Accounts!Receivable!(4%!of!sales) 1440 1584 1742.4!
Inventory!(9%!of!sales) 3240 3564 3920.4!
Accounts!Payable!(5%!of!sales) 1800 1980 2178!
NWC!(Cash!+!Inventory+!AR!-!AP) 3600 3960 4356!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
14)!!The!required!net!working!capital!in!the!second!year!for!the!Sisyphean!CorporationYs!project!!is!closest!to:!
A)!!$3,960!
B)!!$4,360!
C)!!$3.190!
D)!!$5,940!
Answer:!!!A!
Explanation:!!! A)!!Networking!Capital!Forecast!
Year 1 2 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Cash!(2%!of!sales) 720 792 871.2!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
15)!!The!change!in!Net!working!capital!from!year!one!to!year!two!is!closest!to:!
A)!!A!decrease!of!$360!
B)!!An!increase!of!$360!
C)!!An!increase!of!$396!
D)!!A!decrease!of!$396!
Answer:!!!B!
B)!!Networking!Capital!Forecast!
Year 1 2 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Cash!(2%!of!sales) 720 792 871.2!
!
Change!=!3960!-!3600!=!360!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
16)!!Bubba!Ho-Tep!Company!reported!net!income!of!$300!million!for!the!most!recent!fiscal!year.!!The!firm!had!
depreciation!expenses!of!$125!million!and!capital!expenditures!of!$150!million.!!Although!they!had!no!interest!
expense,!the!firm!did!have!an!increase!in!net!working!capital!of!$20!million.!!What!is!Bubba!Ho-TepYs!free!cash!
flow?!
A)!!$170!million!
B)!!$255!million!
C)!!$150!million!
D)!!$5!million!
Answer:!!!B!
B)!!FCF!=!NI!+!Dep!-!Capital!Ex!-!chg!NWC
! =!300!+!125!-!150!-!20!=!255!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Temporary!Housing!Services!Incorporated!(THSI)!is!considering!a!project!that!involves!setting!up!a!temporary!housing!
facility!in!an!area!recently!damaged!by!a!hurricane.!!THSI!will!lease!space!in!this!facility!to!various!agencies!and!groups!
providing!relief!services!to!the!area.!!THSI!estimates!that!this!project!will!initially!cost!$5!million!to!setup!and!will!generate!
$20!million!in!revenues!during!its!first!and!only!year!in!operation!(paid!in!one!year).!Operating!expenses!are!expected!to!
total!$12!million!during!this!year!and!depreciation!expense!will!be!another!$3!million.!!THSI!will!require!no!working!
capital!for!this!investment.!!THSIYs!marginal!tax!rate!is!35%.!!!
!
17)!!Ignoring!the!original!investment!of!$5!million,!what!is!THSIYs!free!cash!flow!for!the!first!and!only!year!of!
operation?!
A)!!$5.0!million!
B)!!$3.75!million!
C)!!$8.0!million!
D)!!$6.25!million!
Answer:!!!D!
B)!!
C)!!
D)!!FCF!=!(revenues!-!expenses!-!depreciation)!×!(1!-!tax!rate)!+!depreciation$
FCF!=!(20!-!12!-!3)!×!(1!-!.35)!+!3!=6.25!
Diff:!2!
Skill:!Analytical!
!
18)!!Assume!that!THSIYs!cost!of!capital!for!this!project!is!15%.!!The!NPV!of!this!temporary!housing!project!is!closest!
to:!
A)!!$435,000!
B)!!-$650,000!
C)!!$1,960,000!
D)!!-$435,000!
Answer:!!!A!
Explanation:!!! A)!!FCF!=!(20!-!12!-!3)!×!(1!-!.35)!+!3!=6.25
So,!NPV!=!-5.0!+!6.25!/!1.15!=!.434782!or!$434,782!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Shepard!Industries!is!evaluating!a!proposal!to!expand!its!current!distribution!facilities.!!Management!has!projected!the!
project!will!produce!the!following!cash!flows!for!the!first!two!years!(in!millions).
Year 1 2!
Revenues 1200 1400!
Operating!Expense 450 525!
Depreciation 240 280!
Increase!in!working!capital 60 70!
Capital!expenditures 300 350!
Marginal!corporate!tax!rate 30% 30%!
!
19)!!The!incremental!EBIT!for!Shepard!Industries!in!year!one!is!closest!to:!
A)!!$360!
B)!!$750!
C)!!$595!
D)!!$510!
Answer:!!!D!
B)!!
C)!!
D)!!Revenues 1200 1400!
-!Expenses 450 525!
-!Depreciation 240 280!
=!EBIT 510 595!
Diff:!2!
Skill:!Analytical!
!
20)!!The!incremental!EBIT!for!Shepard!Industries!in!year!two!is!closest!to:!
A)!!$415!
B)!!$875!
C)!!$595!
D)!!$510!
Answer:!!!C!
B)!!
C)!!Revenues 1200 1400!
-!Expenses 450 525!
=!EBIT 510 595!
D)!!
Diff:!2!
Skill:!Analytical!
!
21)!!The!incremental!unlevered!net!income!Shepard!Industries!in!year!one!is!closest!to:!
A)!!$510!
B)!!$415!
C)!!$600!
D)!!$355!
Answer:!!!D!
B)!!
C)!!
D)!!Revenues 1200 1400!
-!Expenses 450 525!
=!EBIT 510 595!
-!Taxes!(30%) 153 178.5!
Incremental Net Income 357 416.5!
Diff:!2!
Skill:!Analytical!
!
22)!!The!incremental!unlevered!net!income!Shepard!Industries!in!year!two!is!closest!to:!
A)!!$355!
B)!!$415!
C)!!$600!
D)!!$510!
Answer:!!!B!
B)!!Revenues 1200 1400!
-!Expenses 450 525!
=!EBIT 510 595!
-!Taxes!(30%) 153 178.5!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
23)!!The!depreciation!tax!shield!for!Shepard!Industries!project!in!year!one!is!closest!to:!
A)!!$84!
B)!!$168!
C)!!$96!
D)!!$72!
Answer:!!!D!
B)!!
C)!!
D)!!$240!×!.30!=!$72!
Diff:!1!
Skill:!Analytical!
!
24)!!The!depreciation!tax!shield!for!Shepard!Industries!project!in!year!two!is!closest!to:!
A)!!$84!
B)!!$196!
C)!!$72!
D)!!$96!
Answer:!!!A!
Explanation:!!! A)!!$280!×!.30!=!$84!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
25)!!The!free!cash!flow!from!Shepard!Industries!project!in!year!one!is!closest!to:!
A)!!$240!
B)!!$300!
C)!!-$5!
D)!!$390!
Answer:!!!A!
Explanation:!!! A)!!Free!Cash!Flow
Revenues 1200 1400!
-!Expenses 450 525!
=!EBIT 510 595!
-!Taxes!(30%) 153 178.5!
+!Depreciation 240 280!
-!Capital!expenditures 300 350!
-!Change!in!NWC 60 70!
Free Cash Flow 237 276.5!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
26)!!The!free!cash!flow!from!Shepard!Industries!project!in!year!two!is!closest!to:!
A)!!$345!
B)!!$455!
C)!!$275!
D)!!-$5!
Answer:!!!C!
B)!!
C)!!Free!Cash!Flow
Revenues 1200 1400!
-!Expenses 450 525!
=!EBIT 510 595!
-!Taxes!(30%) 153 178.5!
+!Depreciation 240 280!
-!Capital!expenditures 300 350!
-!Change!in!NWC 60 70!
Free Cash Flow 237 276.5!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Epiphany!Industries!is!considering!a!new!capital!budgeting!project!that!will!last!for!three!years.!!Epiphany!plans!on!using!
a!cost!of!capital!of!12%!to!evaluate!this!project.!!Based!on!extensive!research,!it!has!prepared!the!following!incremental!cash!
flow!projects:
Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Cost!of!Goods!Sold!(50%!of!Sales) 50,000 50,000 50,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
=!unlevered!net!income 13,000 13,000 13,000!
+!Depreciation 30,000 30,000 30,000!
+!changes!to!working!capital -5,000 -5,000 10,000!
-!capital!expenditures -90,000
27)!!The!free!cash!flow!for!the!first!year!of!EpiphanyYs!project!is!closest!to:!
A)!!$43,000!
B)!!$25,000!
C)!!$38,000!
D)!!$45,000!
Answer:!!!C!
B)!!
C)!!Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!=!11,946
IRR!=!19.14%
D)!!
Diff:!2!
Skill:!Analytical!
!
28)!!The!free!cash!flow!for!the!last!year!of!EpiphanyYs!project!is!closest!to:!
A)!!$53,000!
B)!!$38,000!
C)!!$35,000!
D)!!$43,000!
Answer:!!!A!
Explanation:!!! A)!!Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!=!11,946
IRR!=!19.14%
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
29)!!The!NPV!for!EpiphanyYs!Project!is!closest!to:!
A)!!$4,825!
B)!!$39,000!
C)!!$11,946!
D)!!$20,400!
Answer:!!!C!
B)!!
C)!!Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!=!11,946
IRR!=!19.14%
D)!!
Diff:!3!
Skill:!Analytical!
!
30)!!Luther!Industries!has!outstanding!tax!loss!carryforwards!of!$70!million!from!losses!over!the!past!four!years.!!
If!Luther!earns!$15!million!per!year!in!pre-tax!income!from!now!on,!Luther!first!pay!taxes!in?!
A)!!7!years.!
B)!!2!years.!
C)!!4!years.!
D)!!5!years.!
Answer:!!!D!
B)!!
C)!!
D)!!The!number!of!years!the!tax!loss!carryforwards!will!last!ban!be!calculated!as!the!tax!loss!carry!
forward!dividend!by!the!annual!pre-tax!income!or:!
$70 million
Years!with!no!tax!=!! !=!4.67!years,!so!Luther!wonYt!have!to!pay!taxes!for!the!next!
$15 million
four!years,!but!will!have!to!start!paying!some!taxes!5!years!from!now.!
Diff:!1!
Skill:!Analytical!
!
31)!!You!are!considering!investing!$600,000!in!a!new!automated!inventory!system!that!will!provide!and!after-tax!
cost!savings!of!$50,000!next!year.!!These!cost!savings!are!expected!to!grow!at!the!same!rate!as!sales.!!If!sales!are!
expected!to!grow!at!5%!per!year!and!your!cost!of!capital!is!10%,!then!what!is!the!NPV!of!the!automated!
inventory!system?!
A)!!$400,000!
B)!!$500,000!
C)!!-$100,000!
D)!!$1,000,000!
Answer:!!!A!
Explanation:!!! A)!! $50,000
NPV!=!! -!$600,000!=!$400,000!
.10 - .05
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
32)!!Calculate!the!total!Free!Cash!Flows!for!each!of!the!three!years!for!the!Sisyphean!CorporationYs!new!project.!
!
Answer:!!!Incremental!Earnings!Forecast!
Year 1 2 3!
Units 2,000 2,200 2,420!
Sales!(units!×!$18) 36,000 39,600 43,560!
Gross!Profit 18,000 19,800 21,780!
Depreciation!($30,000!/!3) 10,000 10,000 10,000!
EBIT 8,000 9,800 11,780!
Income!tax!at!35% 2,800 3,430 4,123!
Unlevered!net!income! 5,200! 6,370! 7,657!
Add!back!Depreciation 10,000 10,000 10,000!
Cash!Flows!from!Operations 15,200 16,370 17,657!
Networking!Capital!Forecast
Year 1 2 3!
Sales!(units!×!$18) 36,000 39,600 43,560!
Cash!(2%!of!sales) 720 792 871.2!
Change!(investment)!in!NWC -3600 -360 -396 4356!
Investment!in!machine -30,000
Total!Free!Cash!Flows -33,600 14,840 15,974 22,013!
!
Diff:!3!
Skill:!Analytical!
!
!
Kinston!Industries!is!considering!investing!in!a!machine!that!will!cost!$125,000!and!will!last!for!three!years.!!The!machine!
will!generate!revenues!of!$120,000!each!year!and!the!cost!of!goods!sold!will!be!50%!of!sales.!!At!the!end!of!year!three!the!
machine!will!be!sold!for!$15,000.!!The!appropriate!cost!of!capital!is!10%!and!Kinston!is!in!the!35%!tax!bracket.!
!
33)!!Assume!that!KinstonYs!new!machine!will!be!depreciated!straight!line!to!a!salvage!value!of!$5,000!at!the!end!of!
year!three.!!What!is!the!after-tax!salvage!value!of!this!project?!
Answer:!!!If!the!machine!is!depreciated!straight!line!to!a!book!value!of!$5,000.!So!$15,000!-!$5,000!=!$10,000!gain!on!
the!sale!which!is!taxable.!!So!the!after!tax!salvage!value!=!$15,000!-!$10,000!×!.35!(tax!rate)!=!$11,500.!
Diff:!2!
Skill:!Analytical!
!
34)!!Assume!that!KinstonYs!new!machine!will!be!depreciated!straight!line!to!a!salvage!value!of!$5,000!at!the!end!of!
year!three.!!What!is!the!NPV!for!this!project?!
!
Answer:!!!Year 0 1 2 3!
Sales!(revenues) 120,000 120,000 120,000!
Cost!of!Goods!Sold 60,000 60,000 60,000!
-!Depreciation 40,000 40,000 40,000!
EBIT 20,000 20,000 20,000!
-Taxes(35%) 7,000 7,000 7,000!
+!Depreciation 40,000 40,000 40,000!
+!capital!expenditures -125,000
+!Liquidation!cash!flows 11,500!
Free Cash Flow -125,000 53,000 53,000 64,500!
PV of FCF (I =!10%) -125,000 48,182 43,802 48,46!
NPV = 15,443
Liquidation/Salvage!Value!Calculation:
If!the!machine!is!depreciated!straight!line!to!a!book!value!of!$5,000.!So!$15,000!-!$5,000!=!$10,000!gain!on!
the!sale!which!is!taxable.!!So,!the!after!tax!salvage!value!=!$15,000!-!$10,000!×!.35!(tax!rate)!=!$11,500.!
Diff:!3!
Skill:!Analytical!
!
35)!!Assume!that!KinstonYs!new!machine!will!be!depreciated!using!MACRS!according!to!the!following!schedule:
Year 3!Years!
1 33.33%!
2 44.45%!
3 14.81%!
4 7.41%!
What!is!the!NPV!of!this!project?!
!
Sales!(revenues) 120,000 120,000 120,000!
Cost!of!Goods!Sold 60,000 60,000 60,000!
-!Depreciation 41,663 55,563 18,513!
EBIT 18,338 4,438 41,488!
-Taxes(35%) 6,418 1,553 14,521!
+!Depreciation 41,663 55,563 18,513!
+!capital!expenditures -125,000
+!Liquidation!cash!flows 12,992!
Free!Cash!Flow -125,000 53,582 58,447 58,471!

PV!of!FCF!(I!=!10%) -125,000 48,711 48,303 43,930!
NPV!= 15,944
!
Liquidation/Salvage!Value!Calculation:
If!the!machine!is!depreciated!straight!line!to!a!book!value!of!7.41%!×!125,000!=!$9,263.!So!$15,000!-!
$9,263!=!$5,737!gain!on!the!sale!which!is!taxable.!!So!the!after!tax!salvage!value!=!$15,000!-!$7,737!×!.35!
(tax!rate)!=!$12,992.!
Diff:!2!
Skill:!Analytical!
!
7.3!Analyzing!the!Project!
A)!!The!break-even!level!of!an!input!is!the!level!for!which!the!investment!has!an!IRR!of!zero.!
B)!!The!most!difficult!part!of!capital!budgeting!is!deciding!how!to!estimate!the!cash!flows!and!the!cost!of!
capital.!
C)!!When!evaluating!a!capital!budgeting!project,!financial!managers!should!make!the!decision!that!
maximizes!NPV.!
D)!!Sensitivity!analysis!reveals!which!aspects!of!the!project!are!most!critical!when!we!are!actually!managing!
the!project.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!7.3!Analyzing!the!Project!
Skill:!Conceptual!
!
A)!!Sensitivity!analysis!allows!us!to!explore!the!effects!of!errors!in!our!estimated!inputs!in!our!NPV!analysis!
for!the!project.!
B)!!To!compute!the!NPV!for!a!project,!you!need!to!estimate!the!incremental!cash!flows!and!choose!a!
discount!rate.!
C)!!Estimates!of!the!cash!flows!and!cost!of!capital!are!often!subject!to!significant!uncertainty.!
D)!!When!we!are!certain!regarding!the!input!to!a!capital!budgeting!decision,!it!is!often!useful!to!determine!
the!break-even!level!of!that!input.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!We!can!use!scenario!analysis!to!evaluate!alternative!pricing!strategies!for!our!project.!
B)!!Scenario!analysis!considers!the!effect!on!NPV!of!changing!multiple!project!parameters.!
C)!!The!difference!between!the!IRR!of!a!project!and!the!cost!of!capital!tells!you!how!much!error!in!the!cost!of!
capital!it!would!take!to!change!the!investment!decision.!
D)!!Scenario!analysis!breaks!the!NPV!calculation!into!its!component!assumptions!and!show!how!the!NPV!
varies!as!each!one!of!the!underlying!assumptions!change.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!The!difference!between!scenario!analysis!and!sensitivity!analysis!is:!
A)!!Scenario!analysis!is!based!upon!the!IRR!and!sensitivity!analysis!is!based!upon!NPV.!
B)!!Only!sensitivity!analysis!allows!us!to!change!our!estimated!inputs!of!our!NPV!analysis.!
C)!!Scenario!analysis!considers!the!effect!on!NPV!of!changing!multiple!project!parameters.!
D)!!Only!Scenaripo!analysis!breaks!the!NPV!calculation!into!its!component!assumptions.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
5)!!An!exploration!of!the!effect!on!NPV!of!changing!multiple!project!parameters!is!called!
A)!!scenario!analysis.!
B)!!IRR!analysis.!
C)!!accounting!break-even!analysis.!
D)!!sensitivity!analysis.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
6)!!An!analysis!that!breaks!the!NPV!calculation!into!its!component!assumptions!and!shows!how!the!NPV!varies!
as!one!of!the!underlying!assumptions!is!changed!is!called!
A)!!scenario!analysis.!
B)!!IRR!analysis.!
C)!!accounting!break-even!analysis.!
D)!!sensitivity!analysis.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
7)!!What!is!sensitivity!analysis?!
Answer:!!!Sensitivity!analysis!breaks!the!NPV!calculation!into!its!component!assumptions!and!shows!how!the!
NPV!varies!as!each!of!the!underlying!assumptions!change.!!Sensitivity!analysis!allows!us!to!explore!the!
effects!of!errors!in!your!estimated!inputs!to!our!NPV!calculations!and!reveals!which!aspects!of!the!
project!are!most!critical!when!we!are!actually!managing!the!project.!
Diff:!2!
Skill:!Conceptual!
!
8)!!How!does!scenario!analysis!differ!from!sensitivity!analysis?!
Answer:!!!Where!sensitivity!analysis!considers!the!change!in!NPV!for!individual!parameter!changes,!scenario!
analysis!considers!the!effect!on!NPV!of!change!multiple!project!parameters!simultaneously.!
Diff:!2!
Skill:!Conceptual!
!
!
Epiphany!Industries!is!considering!a!new!capital!budgeting!project!that!will!last!for!three!years.!!Epiphany!plans!on!using!
a!cost!of!capital!of!12%!to!evaluate!this!project.!!Based!on!extensive!research,!it!has!prepared!the!following!incremental!cash!
flow!projects:
Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
9)!!What!is!the!NPV!of!the!EpiphanyYs!project?!
!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!= 11,946
Diff:!2!
Skill:!Analytical!
!
10)!!Epiphany!would!like!to!know!how!sensitive!the!projectYs!NPV!is!to!changes!in!the!discount!rate.!!How!much!
can!the!discount!rate!vary!before!the!NPV!reaches!zero?!
!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!= 11,946
IRR!= 19.14%
!
So!the!discount!rate!can!vary!by!12%!-!19.14%!=!7.14%!
Diff:!3!
Skill:!Analytical!
!
11)!!Epiphany!is!worried!about!the!reliability!of!the!sales!forecast.!!How!sensitive!is!the!projectYs!NPV!to!a!10%!
change!!in!sales.!
!
Answer:!!!Base!Case!
Year 0 1 2 3!
Sales!(Revenues) 100,000 100,000 100,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 20,000 20,000 20,000!
-!Taxes!(35%) 7000 7000 7000!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 38,000 38,000 53,000!
PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

discount!rate 0.12
NPV!= 11,946
IRR!= 19
!
10%!Decrease!in!Sales!
Year 0 1 2 3!
Sales!(Revenues) 90,000 90,000 90,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 15,000 15,000 15,000!
-!Taxes!(35%) 5250 5250 5250!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 34,750 34,750 49,750!
PV!of!FCF!(FCF/(1!+!I)n) -90,000 31,027 27,702 35,411!

discount!rate 0.12
NPV!= 4,140
!
!
!
!
!
10%!Increase!in!Sales!
Year 0 1 2 3!
Sales!(Revenues) 110,000 110,000 110,000!
-!Depreciation 30,000 30,000 30,000!
=!EBIT 25,000 25,000 25,000!
-!Taxes!(35%) 8750 8750 8750!
+!Depreciation 30,000 30,000 30,000!
=!Free!Cash!Flow -90,000 41,250 41,250 56,250!
PV!of!FCF!(FCF/(1+I)n) -90,000 36,830 32,884 40,038!

discount!rate 0.12
NPV!= 19,752
!
So!a!+!or!-!10%!change!in!sales!will!cause!the!NPV!to!vary!between!4,140!and!19,752.!
!
Diff:!3!
Topic:!7.3!Analyzing!the!Project!!
Skill:!Analytical
!
Chapter!8!-!Valuing!Bonds!
!
!
8.1!The!Four!Types!of!Firms!
A)!!Bonds!are!a!securities!sold!by!governments!and!corporations!to!raise!money!from!investors!today!in!
exchange!for!promised!future!payments.!
B)!!By!convention!the!coupon!rate!is!expressed!as!an!effective!annual!rate.!
C)!!Bonds!typically!make!two!types!of!payments!to!their!holders.!
D)!!The!time!remaining!until!the!repayment!date!is!known!as!the!term!of!the!bond.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!8.1!Bond!Cash!Flows,!Prices,!and!Yields!
Skill:!Definition!
!
A)!!The!principal!or!face!value!of!a!bond!is!the!notional!amount!we!use!to!compute!the!interest!payments.!
B)!!Payments!are!made!on!bonds!until!a!final!repayment!date,!called!the!term!date!of!the!bond.!
C)!!The!coupon!rate!of!a!bond!is!set!by!the!issuer!and!stated!on!the!bond!certificate.!
D)!!The!promised!interest!payments!of!a!bond!are!called!coupons.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!The!bond!certificate!typically!specifies!that!the!coupons!will!be!paid!periodically!until!the!maturity!date!
of!the!bond.!
B)!!The!bond!certificate!indicates!the!amounts!and!dates!of!all!payments!to!be!made.!
C)!!The!only!cash!payments!the!investor!will!receive!from!a!zero!coupon!bond!are!the!interest!payments!
that!are!paid!up!until!the!maturity!date.!
D)!!Usually!the!face!value!of!a!bond!is!repaid!at!maturity.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!The!amount!of!each!coupon!payment!is!determined!by!the!coupon!rate!of!the!bond.!
B)!!Prior!to!its!maturity!date,!the!price!of!a!zero-coupon!bond!is!always!greater!than!its!face!value.!
C)!!The!simplest!type!of!bond!is!a!zero-coupon!bond.!
D)!!Treasury!bills!are!U.S.!government!bonds!with!a!maturity!of!up!to!one!year.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Bond!traders!typically!quote!bond!prices!rather!than!bond!yields!.!
B)!!Treasury!bills!are!zero-coupon!bonds.!
C)!!Zero-coupon!bonds!always!trade!at!a!discount.!
D)!!The!yield!to!maturity!is!typically!stated!as!an!annual!rate!by!multiplying!the!calculated!YTM!by!the!
number!of!coupon!payment!per!year,!thereby!converting!it!to!an!APR.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
A)!! 1/ n
face value
Yield!to!maturity!for!an!n-period!!zero-coupon!bond!= 1
price
B)!! Coupon Coupon Coupon + Face
Price!of!an!n-period!bond!=! !+!! !+!...!+!
1
(1 YTM ) (1 YTM )2 (1 YTM )n
C)!! 1 1 Face Value
Price!of!an!n-period!bond!=!Coupon!× 1 !+
YTM (1 YTM ) n
(1 YTM )n
D)!! Coupon rate x Face Value
Coupon!=
number of coupon payments per year
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!One!advantage!of!quoting!the!yield!to!maturity!rather!than!the!price!is!that!the!yield!is!independent!of!
the!face!value!of!the!bond.!
B)!!Unlike!the!case!of!bonds!that!pay!coupons,!for!zero-coupon!bonds,!there!is!no!simple!formula!to!solve!
for!the!yield!to!maturity!directly.!
C)!!Because!we!can!convert!any!bond!price!into!a!yield,!and!vice!versa,!bond!prices!and!yields!are!often!
used!interchangeably.!
D)!!The!IRR!of!an!investment!in!a!bond!is!given!a!special!name,!the!yield!to!maturity!(YTM).!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!IRR!of!an!investment!in!a!zero-coupon!bond!is!the!rate!of!return!that!investors!will!earn!on!their!
money!if!they!buy!a!default!free!bond!at!its!current!price!and!hold!it!to!maturity.!
B)!!The!yield!to!maturity!of!a!bond!is!the!discount!rate!that!sets!the!future!value!of!the!promised!bond!
payments!equal!to!the!current!market!price!of!the!bond.!
C)!!Financial!professionals!also!use!the!term!spot!interest!rates!to!refer!to!the!default-free!zero-coupon!yields.!
D)!!When!we!calculate!a!bondZs!yield!to!maturity!by!solving!the!formula,!Price!of!an!n-period!bond!=!
Coupon Coupon Coupon + Face
!+!! !+!...!+! ,!the!yield!we!compute!will!be!a!rate!per!coupon!interval.!
1
(1 YTM ) (1 YTM )2 (1 YTM )n
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Zero-coupon!bonds!are!also!called!pure!discount!bonds.!
B)!!The!IRR!of!an!investment!opportunity!is!the!discount!rate!at!which!the!NPV!of!the!investment!
opportunity!is!equal!to!zero.!
C)!!The!yield!to!maturity!for!a!zero-coupon!bond!is!the!return!you!will!earn!as!an!investor!from!holding!the!
bond!to!maturity!and!receiving!the!promised!face!value!payment.!
D)!!When!prices!are!quoted!in!the!bond!market,!they!are!conventionally!quoted!in!increments!of!$1000.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
10)!!Consider!a!zero!coupon!bond!with!20!years!to!maturity.!!The!price!will!this!bond!trade!if!the!YTM!is!6%!is!
closest!to:!
A)!!$215!
B)!!$312!
C)!!$335!
D)!!$306!
Answer:!!!B!
B)!!FV!=!1000
I!=!6
PMT!=!0
N!=20
Compute!PV!=!311.80!
FV 1000
or,!PV!=!! =! =!311.80!
N
(1 i ) (1 .06) 20
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!Consider!a!zero-coupon!bond!with!a!$1000!face!value!and!10!years!left!until!maturity.!!If!the!YTM!of!this!bond!
is!10.4%,!then!the!price!of!this!bond!is!closest!to:!
A)!!$1000!
B)!!$602!
C)!!$1040!
D)!!$372!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!1000
I!=!10.4
PMT!=!0
N!=10
FV 1000
or,!PV!=! !=! =!371.80!
N
(1 i ) (1 .104)10
Diff:!1!
Skill:!Analytical!
!
12)!!Consider!a!zero-coupon!bond!with!a!$1000!face!value!and!10!years!left!until!maturity.!!If!the!bond!is!currently!
trading!for!$459,!then!the!yield!to!maturity!on!this!bond!is!closest!to:!
A)!!7.5%!
B)!!10.4%!
C)!!9.7%!
D)!!8.1%!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!1000
PV!=!-459
PMT!=!0
N)=10
Compute!I!=!8.09!8!or!8.1%!
Diff:!2!
Skill:!Analytical!
!
Use)the)information)for)the)question(s))below.)
!
The!Sisyphean!Company!has!a!bond!outstanding!with!a!face!value!of!$1000!that!reaches!maturity!in!15!years.!!The!bond!
certificate!indicates!that!the!stated!coupon!rate!for!this!bond!is!8%!and!that!the!coupon!payments!are!to!be!made!
semi-annually.!!!
!
13)!!How!much!will!each!semi-annual!coupon!payment!be?!
A)!!$60!
B)!!$40!
C)!!$120!
D)!!$80!
Answer:!!!B!
B)!!Coupon!=!(coupon!rate!x!face!value)/number!of!coupons!per!year
=!(.08!×!1000)!/!2!=!$40!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
14)!!Assuming!the!appropriate!YTM!on!the!Sisyphean!bond!is!7.5%,!then!the!price!that!this!bond!trades!for!will!be!
closest!to:!
A)!!$1,045!
B)!!$691!
C)!!$1,000!
D)!!$957!
Answer:!!!A!
Explanation:!!! A)!!FV!=!1000
I!=!3.75!(7.5/2)
PMT!=!40!(80/2)
N!=!30!(15!×!2)
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!Assuming!the!appropriate!YTM!on!the!Sisyphean!bond!is!7.5%,!then!this!bond!will!trade!at!
A)!!par.!
B)!!a!discount.!
C)!!a!premium.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
16)!!Assuming!the!appropriate!YTM!on!the!Sisyphean!bond!is!9.0%,!then!the!price!that!this!bond!trades!for!will!be!
closest!to:!
A)!!$946!
B)!!$919!
C)!!$1,086!
D)!!$1,000!
Answer:!!!B!
B)!!FV!=!1000
I!=!4.5!(9/2)
PMT!=!40!(80/2)
N!=!30!(15!×!2)
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!Assuming!the!appropriate!YTM!on!the!Sisyphean!bond!is!9%,!then!this!bond!will!trade!at!
A)!!a!premium.!
B)!!a!discount.!
C)!!par.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Assuming!that!this!bond!trades!for!$1,112,!then!the!YTM!for!this!bond!is!closest!to:!
A)!!8.0%!
B)!!3.4%!
C)!!6.8%!
D)!!9.2%!
Answer:!!!C!
B)!!
C)!!FV!=!1000
PMT!=!40!(80/2)
N!=!30!(15!×!2)
PV!=!-1112
Compute!I!=!3.3987!×!2!=!6.7975!or!6.8%!
D)!!
Diff:!3!
Skill:!Analytical!
!
19)!!Assuming!that!this!bond!trades!for!$903,!then!the!YTM!for!this!bond!is!closest!to:!
A)!!8.0%!
B)!!6.8%!
C)!!9.9%!
D)!!9.2%!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!1000
PMT!=!40!(80/2)
N!=!30!(15!×!2)
PV!=!-903
Compute!I!=!4.6027!×!2!=!9.2054!or!9.2%!
Diff:!3!
Skill:!Analytical!
!
Use)the)table)for)the)question(s))below.
!
The!following!table!summarizes!prices!of!various!default-free!zero-coupon!bonds!(expressed!as!a!percentage!of!face!value):
Maturity!(years) 1 2 3 4 5!
Price!(per!$100!face!value) 94.52 89.68 85.40 81.65 78.35!
!
20)!!The!yield!to!maturity!for!the!two!year!zero-coupon!bond!is!closest!to:!
A)!!6.0%!
B)!!5.8%!
C)!!5.6%!
D)!!5.5%!
Answer:!!!C!
B)!!
C)!!yield!=!(100!/!price)(1/n)!-!1
=!(100!/!89.68).5!-!1!=!.056!or!5.6%!
D)!!
Diff:!2!
Skill:!Analytical!
!
21)!!The!yield!to!maturity!for!the!three!year!zero-coupon!bond!is!closest!to:!
A)!!5.4%!
B)!!5.8%!
C)!!5.6%!
D)!!6.0%!
Answer:!!!A!
Explanation:!!! A)!!yield!=!(100!/!price)(1/n)!-!1
=!(100!/!85.40)(1/3)!-!1!=!.054!or!5.4%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
22)!!Based!upon!the!information!provided!in!the!table!above,!you!can!conclude!
A)!!that!the!yield!curve!is!flat.!
B)!!nothing!about!the!shape!of!the!yield!curve.!
C)!!that!the!yield!curve!is!downward!sloping.!
D)!!that!the!yield!curve!is!upward!sloping.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
23)!!What!is!the!relationship!between!a!bondZs!price!and!its!yield!to!maturity?!
Answer:!!!There!is!an!inverse!relationship!between!a!bondZs!yield!to!maturity!and!its!price.!!As!YTM!increases,!the!
value!of!the!bond!declines.!!Likewise,!as!the!YTM!falls,!the!value!of!the!bond!will!increase.!
Diff:!2!
Skill:!Conceptual!
!
Use)the)information)for)the)question(s))below.)
!
The!Sisyphean!Company!has!a!bond!outstanding!with!a!face!value!of!$1000!that!reaches!maturity!in!15!years.!!The!bond!
certificate!indicates!that!the!stated!coupon!rate!for!this!bond!is!8%!and!that!the!coupon!payments!are!to!be!made!
semi-annually.!!!
!
24)!!How!much!are!each!of!the!semi-annual!coupon!payments?!!Assuming!the!appropriate!YTM!on!the!Sisyphean!
bond!is!8.8%,!then!at!what!price!should!this!bond!trade!for?!
Answer:!!!Coupon!=!(coupon!rate!×!face!value)/number!of!coupons!per!year
=!(.08!×!1000)!/!2!=!$40
FV!=!1000
I!=!4.4!(8.8/2)
PMT!=!40!(80/2)
N!=!30!(15!×!2)
Diff:!2!
Skill:!Analytical!
!
25)!!Assuming!that!this!bond!trades!for!$1,035.44,!then!the!YTM!for!this!bond!is!equal!to:!
Answer:!!!FV!=!1000
PMT!=!40!(80!/!2)
N!=!30!(15!×!2)
PV!=!-1035.44
Compute!I!=!3.8!×!2!=!7.6!or!7.6%!
Diff:!3!
Skill:!Analytical!
!
!
The!following!table!summarizes!prices!of!various!default-free!zero-coupon!bonds!(expressed!as!a!percentage!of!face!value):
!
26)!!Compute!the!yield!to!maturity!for!each!of!the!five!zero-coupon!bonds.!
!
Answer:!!!Maturity!(years) 1 2 3 4 5!
Yield!to!maturity 5.8% 5.6% 5.4% 5.2% 5.0%!
Each!yield!to!maturity!above!is!calculated!using!the!formula:!YTM!=!(100/price)(1/n)!-!1!
Diff:!3!
Skill:!Analytical!
!
27)!!Plot!the!zero-coupon!yield!curve!(for!the!first!five!years).!
Answer:!!!
!
Diff:!3!
Skill:!Graphing
8.2!Dynamic!Behavior!of!Bond!Prices!
A)!!If!the!bond!trades!at!a!discount,!and!investor!who!buys!the!bond!will!earn!a!return!both!from!receiving!
the!coupons!and!from!receiving!a!face!value!that!exceeds!the!price!paid!for!the!bond.!
B)!!Most!coupon!bond!issuers!choose!a!coupon!rate!so!that!the!bonds!will!initially!trade!at,!or!very!near!to,!
par.!
C)!!Coupon!bonds!always!trade!for!a!discount.!
D)!!At!any!point!in!time,!changes!in!market!interest!rates!affect!a!bondZs!yield!to!maturity!and!its!price.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!8.2!Dynamic!Behavior!of!Bond!Prices!
Skill:!Conceptual!
!
A)!!When!a!bond!is!trading!at!a!discount,!the!price!drop!when!a!coupon!is!paid!will!be!larger!than!the!price!
increase!between!coupons,!so!the!bondZs!discount!will!tend!to!decline!as!time!passes.!
B)!!When!a!bond!trades!at!a!price!equal!to!its!face!value,!it!is!said!to!trade!at!par.!
C)!!As!interest!rates!and!bond!yield!rise,!bond!prices!will!fall.!
D)!!Ultimately,!the!prices!of!all!bonds!approach!the!bondZs!face!value!when!the!bonds!mature!and!their!last!
coupon!are!paid.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!bond!trades!at!par!when!its!coupon!rate!is!equal!to!its!yield!to!maturity.!
B)!!The!clean!price!of!a!bond!is!adjusted!for!accrued!interest.!
C)!!The!price!of!the!bond!will!drop!by!the!amount!of!the!coupon!immediately!after!the!coupon!is!paid.!
D)!!If!a!coupon!bondZs!yield!to!maturity!exceeds!its!coupon!rate,!the!present!value!of!its!cash!flows!at!the!
yield!to!maturity!will!be!greater!than!its!face!value.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Bond!prices!converge!to!the!bondZs!face!value!due!to!the!time!effect,!but!simultaneously!move!up!and!
down!due!to!unpredictable!changes!in!bond!yields.!
B)!!As!interest!rates!and!bond!yields!fall,!bond!prices!will!rise.!
C)!!Bonds!with!higher!coupon!rates!are!more!sensitive!to!interest!rate!changes.!
D)!!Shorter!maturity!zero!coupon!bonds!are!less!sensitive!to!changes!in!interest!rates!than!are!longer-term!
zero!coupon!bonds.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!a!bond!trades!at!a!premium,!its!yield!to!maturity!will!exceed!its!coupon!rate.!
B)!!A!bond!that!trades!at!a!premium!is!said!to!trade!above!par.!
C)!!When!a!coupon-paying!bond!is!trading!at!a!premium,!an!investorZs!return!from!the!coupons!is!
diminished!by!receiving!a!face!value!less!than!the!price!paid!for!the!bond.!
D)!!Holding!fixed!the!bondZs!yield!to!maturity,!for!a!bond!not!trading!at!par,!the!present!value!of!the!bondZs!
remaining!cash!flows!changes!as!the!time!to!maturity!decreases.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Invoice!price!=!dirty!price!
B)!!Clean!price!=!dirty!price!-!accrued!interest!
C)!! days since last coupon payment
Accrued!interest!=!!coupon!amount!×
360
D)!!Cash!price!=!clean!price!+!accrued!interest!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Prices!of!bonds!with!lower!durations!are!more!sensitive!to!interest!rate!changes.!
B)!!When!a!bond!is!trading!at!a!discount,!the!price!increase!between!coupons!will!exceed!the!drop!when!a!
coupon!is!paid,!so!the!bond’s!price!will!rise!and!its!discount!will!decline!as!time!passes.!
C)!!Coupon!bonds!may!trade!at!a!discount,!at!a!premium,!or!at!par.!
D)!!The!sensitivity!of!a!bondZs!price!changes!in!interest!rates!is!the!bondZs!duration.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!If!a!bond!is!currently!trading!at!its!face!(par)!value,!then!it!must!be!the!case!that!
A)!!the!bondZs!yield!to!maturity!is!less!than!its!coupon!rate.!
B)!!the!bondZs!yield!to!maturity!is!equal!to!its!coupon!rate.!
C)!!the!bondZs!yield!to!maturity!is!greater!than!its!coupon!rate.!
D)!!the!bond!is!a!zero-coupon!bond.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!The!discount!rate!that!sets!the!present!value!of!the!promised!bond!payments!equal!to!the!current!market!price!
of!the!bond!is!called!
A)!!the!current!yield.!
B)!!the!yield!to!maturity.!
C)!!the!zero!coupon!yield.!
D)!!the!discount!yield.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
10)!!Consider!a!zero!coupon!bond!with!20!years!to!maturity.!!The!amount!that!the!price!of!the!bond!will!change!if!
its!yield!to!maturity!decreases!from!7%!to!5%!is!closest!to:!
A)!!$120!
B)!!-$53!
C)!!$53!
D)!!$673!
Answer:!!!A!
I!=!7
PMT!=!0
N!=!20
Compute!PV!=!258.42
FV!=!1000
I!=!5
PMT!=!0
N!=!20
Compute!PV!=!376.89
chg!=!(376.89!-!258.42)!=!118.47!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!Consider!a!zero!coupon!bond!with!20!years!to!maturity.!!The!percentage!change!in!the!price!of!the!bond!!if!its!
yield!to!maturity!decreases!from!7%!to!5%!is!closest!to:!
A)!!46%!
B)!!17%!
C)!!22%!
D)!!38%!
Answer:!!!A!
I!=!7
PMT!=!0
N!=!20
Compute!PV!=!258.42
FV!=!1000
I!=!5
PMT!=!0
N!=!20
Compute!PV!=!376.89
%chg!=!(376.89!-!258.42)!/!258.42!=!.4584!or!45.8%!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!Consider!a!bond!that!pays!annually!an!8%!coupon!with!20!years!to!maturity.!!The!amount!that!the!price!of!the!
bond!will!change!if!its!yield!to!maturity!increases!from!5%!to!7%!is!closest!to:!
A)!!-$270!
B)!!-$225!
C)!!-$310!
D)!!-$250!
Answer:!!!A!
I!=!7
PMT!=!80
N!=!20
Compute!PV!=!1105.94
FV!=!1000
I!=!5
PMT!=!80
N!=!20
chg!=!(1105.94!-!1373.87!)!=!-267.93!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!Consider!a!bond!that!pays!annually!an!8%!coupon!with!20!years!to!maturity.!!The!percentage!change!in!the!
price!of!the!bond!if!its!yield!to!maturity!increases!from!5%!to!7%!is!closest!to:!
A)!!22%!
B)!!24%!
C)!!-22%!
D)!!-24%!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!1000
I!=!7
PMT!=!80
N!=!20
FV!=!1000
I!=!5
PMT!=!80
N!=!20
chg!=!(1105.94!-!1373.87!)!=!-267.93
%chg!=!-267.93!/!1105.94!=!-0.2422!or!-24%!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!four!bonds!that!pay!annual!coupons:
Bond Years!to!maturity Coupon YTM!

A 1 0% 5%!
B 5 6% 7%!
C 10 10% 9%!
D 20 0% 8%!
!
14)!!The!percentage!change!in!the!price!of!the!bond!gAg!if!its!yield!to!maturity!increases!from!5%!to!6%!is!closest!to:!
A)!!-4%!
B)!!-6%!
C)!!-1%!
D)!!4%!
Answer:!!!C!
B)!!
C)!!!
Years!to! ! ! ! ! ! !
Bond maturity Coupon YTM Price0 Price1 %!Chg $!Chg!
A 1 0% 5% $952.38! $943.40! -0.94% ($8.98)!
B 5 6% 7% $959.00! $920.15! -4.05% ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! -6.03% ($64.18)!
D 20 0% 8% $214.55! $178.43! -16.83% ($36.12)!
D)!!
Diff:!3!
Skill:!Analytical!
!
15)!!The!percentage!change!in!the!price!of!the!bond!gCg!!if!its!yield!to!maturity!increases!from!9%!to!10%!is!closest!
to:!
A)!!-17%!
B)!!-6%!
C)!!-4%!
D)!!4%!
Answer:!!!B!
B)!!!
Years!to! ! ! ! ! ! !
A 1 0% 5% $952.38! $943.40! -0.94% ($8.98)!
B 5 6% 7% $959.00! $920.15! -4.05% ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! -6.03% ($64.18)!
D 20 0% 8% $214.55! $178.43! -16.83% ($36.12)!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
16)!!The!amount!that!the!price!of!!bond!gBg!will!change!if!its!yield!to!maturity!increases!from!7%!to!8%!is!closest!to:!
A)!!-$36!
B)!!$9!
C)!!$36!
D)!!$39!
Answer:!!!D!
B)!!
C)!!
D)!!!
Years!to! ! ! ! ! !
Bond maturity Coupon YTM Price0 Price1 $!Chg!
1 0% 5% $952.38! $943.40! ($8.98)!
B 5 6% 7% $959.00! $920.15! ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! ($64.18)!
D 20 0% 8% $214.55! $178.43! ($36.12)!
Diff:!2!
Skill:!Analytical!
!
17)!!The!amount!that!the!price!of!!bond!gDg!will!change!if!its!yield!to!maturity!increases!from!8%!to!9%!is!closest!to:!
A)!!-$36!
B)!!-$39!
C)!!$36!
D)!!$9!
Answer:!!!A!
Years!to! ! ! ! ! !
Bond maturity Coupon YTM Price0 Price1 $!Chg!
A 1 0% 5% $952.38! $943.40! ($8.98)!
B 5 6% 7% $959.00! $920.15! ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! ($64.18)!
D 20 0% 8% $214.55! $178.43! ($36.12)!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Which!of!the!four!bonds!is!the!most!sensitive!to!a!one!percent!increase!in!the!YTM?!
A)!!Bond!A!
B)!!Bond!B!
C)!!Bond!C!
D)!!Bond!D!
Answer:!!!D!
B)!!
C)!!
D)!!!
Years!to! ! ! ! ! ! !
A 1 0% 5% $952.38! $943.40! -0.94% ($8.98)!
B 5 6% 7% $959.00! $920.15! -4.05% ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! -6.03% ($64.18)!
D 20 0% 8% $214.55! $178.43! -16.83% ($36.12)!
Diff:!3!
Skill:!Analytical!
!
19)!!Which!of!the!four!bonds!is!the!least!sensitive!to!a!one!percent!increase!in!the!YTM?!
A)!!Bond!A!
B)!!Bond!B!
C)!!Bond!C!
D)!!Bond!D!
Answer:!!!A!
Years!to! ! ! ! ! ! !
A 1 0% 5% $952.38! $943.40! -0.94% ($8.98)!
B 5 6% 7% $959.00! $920.15! -4.05% ($38.85)!
C 10 10% 9% $1,064.18! $1,000.00! -6.03% ($64.18)!
D 20 0% 8% $214.55! $178.43! -16.83% ($36.12)!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
20)!!Consider!a!corporate!bond!with!a!$1000!face!value,!8%!coupon!with!semiannual!coupon!payments,!7!years!
until!maturity,!and!a!YTM!of!9%.!!It!has!been!57!days!since!the!last!coupon!payment!was!made!and!there!are!
182!days!in!the!current!coupon!period.!!The!dirty!(cash)!price!for!this!bond!is!closest!to:!
A)!!$949.70!
B)!!$961.40!
C)!!$936.40!
D)!!$948.90!
Answer:!!!B!
B)!!Dirty!price!=!Clean!price!+!accrued!interest
Clean!Price:
FV!=!1000
PMT!=!40!(80!/!2)
I!=!4.5!(9!/!2)
N!=!14!(7!×!2)
Compute!PV!=!948.89
Accrued!Interest!=!coupon!×!(days!since!last!payment/days!in!current!coupon!period)
=!40!×!(57!/!182)!=!12.53
So,!dirty!price!=!948.89!+!12.53!=!961.42!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
21)!!Consider!a!corporate!bond!with!a!$1000!face!value,!10%!coupon!with!semiannual!coupon!payments,!5!years!
until!maturity,!and!currently!is!selling!for!(has!a!cash!price!of)!$1,113.80.!!The!next!coupon!payment!will!be!
made!in!63!days!and!there!are!182!days!in!the!current!coupon!period.!!The!clean!price!for!this!bond!is!closest!
to:!
A)!!$1146.50!
B)!!$1065.70!
C)!!$1113.80!
D)!!$1081.10!
Answer:!!!D!
B)!!
C)!!
D)!!Clean!price!=!Dirty!price!-!accrued!interest
Accrued!Interest!=!coupon!×!(days!since!last!payment/days!in!current!coupon!period)
=!50!×!((182!-!63)!/!182)!=!32.69
So,!clean!price!=!$1,113.80!-!32.69!=!1081.11!
Diff:!3!
Skill:!Analytical!
!
22)!!If!its!YTM!does!not!change,!how!does!a!bondZs!cash!price!change!between!coupon!payments?!
Answer:!!!Two!part!answer:
1.!! The!bondZs!cash!price!(dirty!price)!will!vary!with!the!amount!of!accrued!interest.
2.!! If!the!YTM!is!not!equal!to!the!coupon!rate,!then!as!time!goes!on!the!bond!price!will!approach!the!
face!value.!
Diff:!2!
Skill:!Conceptual!
!
!
Consider!the!following!four!bonds!that!pay!annual!coupons:
Bond Years!to!maturity Coupon YTM!

A 1 0% 5%!
B 5 6% 7%!
C 10 10% 9%!
D 20 0% 8%!
!
!
23)!!Assume!that!the!YTM!increases!by!1%!for!each!of!the!four!bonds!listed.!!Rank!the!bonds!based!upon!the!
sensitivity!of!their!prices!from!least!to!most!sensitive.!
Answer:!!! Years!to!
Bond maturity Coupon YTM Price0 Price1 $!Chg %!Chg Rank!
A 1 0% 5% $952.38! $943.40! ($8.98) -0.94% 1!!
B 5 6% 7% $959.00! $920.15! ($38.85) -4.05% 2!!
C 10 10% 9% $1,064.18! $1,000.00! ($64.18) -6.03% 3!!
D 20 0% 8% $214.55! $178.43! ($36.12) -16.83% 4!!
Diff:!3!
Skill:!Analytical
8.3!The!Yield!Curve!and!Bond!Arbitrage!
A)!!Given!the!spot!interest!rates,!we!can!determine!the!price!and!yield!of!any!other!default-free!bond.!
B)!!As!the!coupon!increases,!earlier!cash!flows!become!relatively!less!important!than!later!cash!flows!in!the!
calculation!of!the!present!value.!!
C)!!When!the!yield!curve!is!flat,!all!zero-coupon!and!coupon-paying!bonds!will!have!the!same!yield,!
independent!of!their!maturities!and!coupon!rates.!
D)!!When!U.S.!bond!traders!refer!to!“the!yield!curve,”!they!are!often!referring!to!the!coupon-paying!
Treasury!yield!curve.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!8.3!The!Yield!Curve!and!Bond!Arbitrage!
Skill:!Conceptual!
!
A)!!We!can!use!the!law!of!one!price!to!compute!the!price!of!a!coupon!bond!from!the!prices!of!zero-coupon!
bonds.!
B)!!The!plot!of!the!yields!of!coupon!bonds!of!different!maturities!is!called!the!coupon-paying!yield!curve.!
C)!!It!is!possible!to!replicate!the!cash!flows!of!a!coupon!bond!using!zero-coupon!bonds.!
D)!!Because!the!coupon!bond!provides!cash!flows!at!different!points!in!time,!the!yield!to!maturity!of!a!
coupon!bond!is!the!simple!average!of!the!yields!of!the!zero-coupon!bonds!of!equal!and!shorter!
maturities.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!By!convention,!practitioners!always!plot!the!yield!of!the!most!senior!issued!bonds,!termed!the!
on-the-run-bonds.!
B)!!We!can!determine!the!no-arbitrage!price!of!a!coupon!bond!by!discounting!its!cash!flows!using!the!
zero-coupon!yields.!!
C)!!If!the!zero!coupon!yield!curve!is!upward!sloping,!the!resulting!yield!to!maturity!decreases!with!the!
coupon!rate!of!the!bond.!
D)!!The!yield!to!maturity!of!a!coupon!bond!is!a!weighted!average!of!the!yields!on!the!zero-coupon!bonds.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!yield!to!maturity!of!a!coupon!bond!is!a!weighted!average!of!the!yields!on!the!zero-coupon!bonds.!
B)!!If!the!zero-coupon!yield!curve!is!downward!sloping,!the!yield!to!maturity!will!decrease!with!the!coupon!
rate.!!
C)!!The!information!in!the!zero-coupon!yield!curve!is!sufficient!to!price!all!other!risk-free!bonds.!
D)!!When!the!yield!curve!is!flat,!all!zero-coupon!and!coupon-paying!bonds!will!have!the!same!yield,!
independent!of!their!maturities!and!coupon!rates.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
Consider!the!following!zero-coupon!yields!on!default!free!securities:
Zero-Coupon!YTM 5.80% 5.50% 5.20% 5.00% 4.80%!
!
5)!!The!price!today!of!a!3!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!6%!is!
closest!to:!
A)!!$1000!
B)!!$1021!
C)!!$1013!
D)!!$1005!
Answer:!!!B!
B)!!P!=!60!/!1.058!+!60!/!1.0552!+!1060!/!1.0523!=!1021.07!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!A!3!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!6%!will!trade?!
A)!!at!a!discount!
B)!!at!a!premium!
C)!!at!par!
D)!!There!is!insufficient!information!to!provided!to!answer!this!question.!
Answer:!!!B!
B)!!P!=!60!/!1.058!+!60!/!1.0552!+!1060!/!1.0523!=!1021.07!which!is!greater!than!$1000,!so!it!trades!at!a!
premium.!!The!other!way!to!answer!this!question!is!to!simply!note!that!the!coupon!rate!is!
greater!than!any!of!the!zero!coupon!yields!during!the!first!three!years!so!its!must!trade!at!a!
premium.!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!YTM!of!a!3!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!6%!is!closest!
to:!
A)!!5.5%!
B)!!5.8%!
C)!!5.5%!
D)!!5.2%!
Answer:!!!D!
B)!!
C)!!
D)!!P!=!60!/!1.058!+!60!/!1.0552!+!1060!/!1.0523!=!1021.07
PV!=!-1021.07
PMT!=!60
FV!=!1000
N!=!3
Compute!I!=!5.223!or!5.2%!
Diff:!3!
Skill:!Analytical!
!
8)!!The!price!of!a!five-year,!zero-coupon,!default-free!security!with!a!face!value!of!$1000!is!closest!to:!
A)!!$754!
B)!!$772!
C)!!$776!
D)!!$791!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!1000
PMT!=!0
N!=!5
I!=!4.8
Diff:!2!
Skill:!Analytical!
!
9)!!The!price!today!of!a!4!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!5.25%!
is!closest!to:!
A)!!$1000!
B)!!$1003!
C)!!$1008!
D)!!$987!
Answer:!!!C!
B)!!
C)!!P!=!52.50!/!1.058!+!52.50!/!1.0552!+!!52.50!/!1.0523!+!1052.50!/!1.0504!=!1007.78!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!A!4!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!5.25%!will!trade!
A)!!at!a!premium.!
B)!!at!par.!
C)!!at!a!discount.!
D)!!There!is!insufficient!information!to!provided!to!answer!this!question.!
Answer:!!!A!
Explanation:!!! A)!!P!=!52.50!/!1.058!+!52.50!/!1.0552!+!!52.50!/!1.0523!+!1052.50!/!1.0504!=!1007.78!which!is!greater!
than!$1000,!so!it!trades!at!a!premium.!!!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!The!YTM!of!a!4!year!default!free!security!with!a!face!value!of!$1000!and!an!annual!coupon!rate!of!5.25%!is!
closest!to:!
A)!!5.2%!
B)!!5.0%!
C)!!4.9%!
D)!!5.25%!
Answer:!!!B!
B)!!P!=!52.50!/!1.058!+!52.50!/!1.0552!+!!52.50!/!1.0523!+!1052.50!/!1.0504!=!1007.78
PV!=!-1007.78
PMT!=!52.50
FV!=!1000
N!=!4
Compute!I!=!5.030!or!5.0%!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!What!is!the!price!today!of!a!two-year,!default-free!security!with!a!face!value!of!$1000!and!an!annual!coupon!
rate!of!5.75%?!!Does!this!bond!trade!at!a!discount,!premium,!or!at!par?!
Answer:!!!$1004.46
P!=!57.50!/!1.058!+!1057.50!/!1.0552!=!1004.46!and!since!this!is!>!$1000,!the!bond!sells!at!a!premium.!
Diff:!2!
Skill:!Analytical!
!
8.4!Corporate!Bonds!
1)!!A!corporate!bond!which!receives!a!BBB!rating!from!Standard!and!PoorZs!is!considered!
A)!!a!junk!bond.!
B)!!an!investment!grade!bond.!
C)!!a!defaulted!bond.!
D)!!a!high-yield!bond.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!8.4!Corporate!Bonds!
Skill:!Definition!
!
A)!!Investors!pay!less!for!bonds!with!credit!risk!than!they!would!for!an!otherwise!identical!default-free!
bond.!
B)!!The!yield!to!maturity!of!a!defaultable!bond!is!equal!to!the!expected!return!of!investing!in!the!bond.!
C)!!The!risk!of!default,!which!is!known!as!the!credit!risk!of!the!bond,!means!that!the!bond’s!cash!flows!are!
not!known!with!certainty.!
D)!!For!corporate!bonds,!the!issuer!may!default—that!is,!it!might!not!pay!back!the!full!amount!promised!in!
the!bond!certificate.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!the!cash!flows!promised!by!the!bond!are!the!most!that!bondholders!can!hope!to!receive,!the!
cash!flows!that!a!purchaser!of!a!bond!with!credit!risk!expects!to!receive!may!be!less!than!that!amount.!
B)!!By!consulting!bond!ratings,!investors!can!assess!the!credit-worthiness!of!a!particular!bond!issue.!
C)!!Because!the!yield!to!maturity!for!a!bond!is!calculated!using!the!promised!cash!flows,!the!yield!of!bond’s!
with!credit!risk!will!be!lower!than!that!of!otherwise!identical!default-free!bonds.!
D)!!A!higher!yield!to!maturity!does!not!necessarily!imply!that!a!bondZs!expected!return!is!higher.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!bondZs!expected!return,!which!is!equal!to!the!firmZs!debt!cost!of!capital,!is!less!than!the!yield!to!
maturity!if!there!is!a!risk!of!default.!
B)!!The!two!best-known!bond-rating!companies!are!Standard!&!PoorZs!and!Dow!Jones.!
C)!!Bonds!in!the!bottom!five!categories!are!often!call!speculative!bonds,!junk!bonds,!or!high-yield!bonds.!
D)!!Bond!ratings!encourage!widespread!investor!participation!and!relatively!liquid!markets.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Bond!ratings!encourage!widespread!investor!participation!and!relatively!liquid!markets.!
B)!!Bonds!in!the!top!four!categories!are!often!referred!to!as!investment!grade!bonds.!
C)!!A!bond’s!rating!depends!on!the!risk!of!bankruptcy!as!well!as!the!bondholderZs!ability!to!lay!claim!to!the!
firm’s!assets!in!the!event!of!a!bankruptcy.!
D)!!Debt!issues!with!a!low-priority!claim!in!bankruptcy!will!have!a!better!rating!than!issues!from!the!same!
company!that!have!a!higher!priority!in!bankruptcy.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Investors!pay!less!for!bonds!with!credit!risk!than!they!would!for!an!otherwise!identical!default-free!
bond.!
B)!!Credit!spreads!fluctuate!as!perceptions!regarding!the!probability!of!default!change.!
C)!!Credit!spreads!are!high!for!bonds!with!high!ratings.!
D)!!We!refer!to!the!difference!between!the!yields!of!the!corporate!bonds!and!the!Treasury!yields!as!the!
default!spread!or!credit!spread.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Consider!the!following!yields!to!maturity!on!various!one-year!zero-coupon!securities:
Security Yield!(%)!
Treasury 4.6!
AAA!corporate 4.8!
BBB!corporate 5.6!
B!Corporate 6.2!
!
7)!!The!price!(expressed!as!a!percentage!of!the!face!value)!of!a!one-year,!zero-coupon!corporate!bond!with!a!BBB!
rating!is!closest!to:!
A)!!95.60!
B)!!94.16!
C)!!95.42!
D)!!94.70!
Answer:!!!D!
B)!!
C)!!
D)!!P!=!100!/!(1.056)!=!94.70!
Diff:!1!
Skill:!Analytical!
!
8)!!The!price!(expressed!as!a!percentage!of!the!face!value)!of!a!one-year,!zero-coupon!corporate!bond!with!a!AAA!
rating!is!closest!to:!
A)!!94.70!
B)!!95.60!
C)!!94.16!
D)!!95.42!
Answer:!!!D!
B)!!
C)!!
D)!!P!=!100!/!(1.048)!=!95.42!
Diff:!1!
Skill:!Analytical!
!
9)!!The!credit!spread!of!the!BBB!corporate!bond!is!closest!to:!
A)!!1.0%!
B)!!5.6%!
C)!!1.6%!
D)!!0.8%!
Answer:!!!A!
Explanation:!!! A)!!=!5.6%!-!4.6%!(BBB!Yield!-!risk!free!yield)!=!1.0%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!The!credit!spread!of!the!B!corporate!bond!is!closest!to:!
A)!!1.6%!
B)!!0.8%!
C)!!1.0%!
D)!!1.4%!
Answer:!!!A!
Explanation:!!! A)!!=!6.2%!-!4.6%!(B!Yield!-!risk!free!yield)!=!1.6%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
Use)the)information)for)the)question(s))below.!
!
Luther!Industries!needs!to!raise!$25!million!to!fund!a!new!office!complex.!!The!company!plans!on!issuing!ten-year!bonds!
with!a!face!value!of!$1000!and!a!coupon!rate!of!7.0%!(annual!payments).!!The!following!table!summarizes!the!YTM!for!
similar!ten-year!corporate!bonds!of!various!credit!ratings:
Rating AAA AA A BBB BB!

YTM 6.70% 6.80% 7.00% 7.40% 8.00%!
!
11)!!Assuming!that!LutherZs!bonds!receive!a!AAA!rating,!the!price!of!the!bonds!will!be!closest!to:!
A)!!$1021!
B)!!$1014!
C)!!$1000!
D)!!$937!
Answer:!!!A!
PMT!=!70
N!=!10
I!=!6.7
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!Assuming!that!LutherZs!bonds!receive!a!AAA!rating,!the!number!of!bonds!that!Luther!must!issue!to!raise!the!
needed!$25!million!is!closest!to:!
A)!!24,655!
B)!!25,000!
C)!!24,477!
D)!!26,681!
Answer:!!!C!
B)!!
C)!!FV!=!1000
PMT!=!70
N!=!10
I!=!6.7
Total!number!of!bonds!=!$25,000,000!/!1021.37!=!24,476.93!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!What!rating!must!Luther!receive!on!these!bonds!if!they!want!the!bonds!to!be!issued!at!par?!
A)!!A!
B)!!B!
C)!!BBB!
D)!!AA!
Answer:!!!A!
PMT!=!70
N!=!10
I!=!7.0!(yield!for!A!rating)
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!Suppose!that!when!these!bonds!were!issued,!Luther!received!a!price!of!$972.42!for!each!bond.!!What!is!the!
likely!rating!that!LutherZs!bonds!received?!
A)!!AA!
B)!!BBB!
C)!!B!
D)!!A!
Answer:!!!B!
B)!!FV!=!1000
PMT!=!70
N!=!10
PV!=!-972.42
Compute!I!=!7.4!!which!is!the!BBB!rating!yield!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!Explain!why!the!expected!return!of!a!corporate!bind!does!not!equal!its!yield!to!maturity?!
Answer:!!!Because!we!calculate!the!yield!to!maturity!using!the!promised!cash!flows!rather!than!the!expected!cash!
flows.!!Since!there!is!some!non!zero!probability!of!default,!there!is!some!chance!that!we!will!receive!an!
amount!less!than!the!promised!amount,!thereby!driving!down!the!expected!return!below!the!YTM.!
Diff:!2!
Skill:!Conceptual!
!
8.5!Appendix:!Forward!Interest!Rate!
1)!!Forward!interest!rates!tend!
A)!!accurately!predict!future!spots!rates!because!of!the!law!of!one!price.!
B)!!not!to!be!good!predictors!of!future!spot!rates.!
C)!!tend!to!be!biased!downward!as!predictors!of!future!spot!rates!when!the!yield!curve!is!upward!sloping.!
D)!!tend!to!be!biased!upward!as!predictors!of!future!spot!rates!when!the!yield!curve!is!downward!sloping.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!8.5!Appendix:!Forward!Interest!Rates!
Skill:!Conceptual!
!
A)!!The!forward!rate!for!year!1!is!the!rate!on!an!investment!that!starts!today!and!is!repaid!in!one!year;!it!is!
equivalent!to!an!investment!in!a!one-year!zero-coupon!bond.!
B)!!The!forward!rate!is!only!a!good!predictor!of!spot!interest!rates!in!the!future!when!investors!are!risk!
adverse.!
C)!!We!can!use!the!law!of!one!price!to!calculate!the!forward!rate!from!the!zero-coupon!yield!curve.!
D)!!An!interest!rate!forward!contract!is!a!contract!today!that!fixes!the!interest!rate!for!a!loan!or!investment!in!
the!future.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!In!general,!the!expected!future!spot!interest!rate!will!reflect!investorZs!preferences!toward!the!risk!of!
future!interest!rate!fluctuations.!
B)!!If!investors!did!not!care!about!risk,!then!they!would!be!indifferent!between!investing!in!a!two-year!bond!
and!investing!in!a!one-year!bond!and!rolling!over!the!money!in!one-year.!
C)!!When!we!refer!to!the!one-year!forward!rate!for!year!5,!we!mean!the!rate!available!today!on!a!one-year!
investment!that!begins!four!years!from!today!and!is!repaid!five!years!from!today.!
D)!!In!general,!we!can!compute!the!forward!rate!for!year!n!by!comparing!an!investment!in!an!n-year,!
zero-coupon!bond!to!an!investment!in!an!(n)+!1)!year,!zero-coupon!bond,!with!the!interest!rate!earned!in!
the!nth!year!being!guaranteed!through!an!interest!rate!forward!contract.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Forward!rates!tend!not!to!be!good!predictors!of!future!spot!rates.!
B)!!Given!the!risk!associated!with!interest!rate!changes,!corporate!managers!require!tools!to!help!manage!
this!risk.!
C)!!One!of!the!most!important!tools!to!manage!the!risk!of!interest!rate!changes!are!interest!rate!forward!
contracts.!
D)!!A!spot!rate!is!an!interest!rate!that!we!can!guarantee!today!for!a!loan!or!investment!that!will!occur!in!the!
future.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Expected!future!spot!interest!rate!=!forward!interest!rate!+!risk!premium!
B)!!(1!+)f1)!×!(1!+)f2)!×!(1!+)f3)!×!...!×!(1!+!fn)!=!(1!+!YTMn)n)
C)!! (1 YTM n 1)n 1
fn!=! !-!1!
(1 YTM n )n
D)!!(1!+!YTMn)n!=!(1!+!YTMn)-!1)n)-!1(1!+!fn)!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
Consider!the!following!zero-coupon!yields!on!default!free!securities:
Zero-Coupon!YTM 5.80% 5.50% 5.20% 5.00% 4.80%!
!
6)!!The!forward!rate!for!year!2!(the!forward!rate!quoted!today!for!an!investment!that!begins!in!one!year!and!
matures!in!two!years)!is!closest!to:!
A)!!5.80%!
B)!!5.50%!
C)!!5.20%!
D)!!5.65%!
Answer:!!!C!
B)!!
C)!! (1 YTM n )n
f2!=! !-!1!=!(1.055)2!/!(1.058)!=!1.052!-!1!=!5.2%!
(1 YTM n 1)n 1
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!forward!rate!for!year!3!(the!forward!rate!quoted!today!for!an!investment!that!begins!in!two!years!and!
matures!in!three!years)!is!closest!to:!
A)!!4.5%!
B)!!5.0%!
C)!!5.2%!
D)!!4.6%!
Answer:!!!D!
B)!!
C)!!
D)!! (1 YTM n )n
f3!=! -!1!=!(1.0520)3!/!(1.055)2!=!1.046!-!1!=!4.6%!
(1 YTM n 1)n 1
Diff:!1!
Skill:!Analytical!
!
8)!!The!forward!rate!for!year!4!(the!forward!rate!quoted!today!for!an!investment!that!begins!in!three!years!and!
matures!in!four!years)!is!closest!to:!
A)!!4.5%!
B)!!4.6%!
C)!!4.4%!
D)!!5.0%!
Answer:!!!C!
B)!!
C)!! (1 YTM n )n
f4!=! !-!1!=!(1.050)4!/!(1.052)3!=!1.044!-!1!=!4.4%!
(1 YTM n 1)n 1
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!forward!rate!for!year!5!(the!forward!rate!quoted!today!for!an!investment!that!begins!in!four!years!and!
matures!in!five!years)!is!closest!to:!
A)!!4.0%!
B)!!3.8%!
C)!!4.8%!
D)!!4.2%!
Answer:!!!A!
Explanation:!!! A)!! (1 YTM n )n
f5!=! !-!1!=!(1.048)5!/!(1.050)4!=!1.040!-!1!=!4.0%!
(1 YTM n 1)n 1
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Chapter!9!-!Valuing!Stocks!
!
!
9.1!Stock!Prices,!Returns,!and!the!Investment!Horizon!
A)!!There!are!two!potential!sources!of!cash!flows!from!owning!a!stock.!
B)!!An!investor!will!be!willing!to!pay!a!price!today!for!a!share!of!stock!up!to!the!point!that!this!transaction!
has!a!zero!NPV.!
C)!!An!investor!might!generate!cash!by!choosing!to!sell!the!shares!at!some!future!date.!
D)!!Because!the!cash!flows!from!stock!are!known!with!certainty,!we!can!discount!them!using!the!risk-free!
interest!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!Because!these!cash!flows!are!risky,!we!cannot!discount!them!using!the!risk-free!interest!rate.!
Diff:!1!
Topic:!9.1!Stock!Prices,!Returns,!and!the!Investment!Horizon!
Skill:!Conceptual!
!
2)!!When!discounting!dividends!you!should!use?!
A)!!the!weighted!average!cost!of!capital.!
B)!!the!after!tax!weighted!average!cost!of!capital.!
C)!!the!equity!cost!of!capital.!
D)!!the!before!tax!cost!of!debt.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!equity!cost!of!capital!for!a!stock!is!the!expected!return!of!other!investments!available!in!the!market!
with!equivalent!risk!to!the!firm’s!shares.!
B)!!The!price!of!a!share!of!stock!is!equal!to!the!present!value!of!the!expected!future!dividends!it!will!pay.!
C)!! Div1 P1
If!the!current!stock!price!were!less!than!P0!=! ,!it!would!be!a!negative!NPV!investment,!and!we!
1 rE
would!expect!investors!to!rush!in!and!sell!it,!driving!down!the!stocks!price.
D)!!The!law!of!one!price!implies!that!to!value!any!security,!we!must!determine!the!expected!cash!flows!an!
investor!will!receive!from!owning!it.!
Answer:!!!C!
B)!!
C)!!In!this!case!the!stock!would!be!undervalued!and!we!would!expect!investors!to!buy!it.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!We!must!discount!the!cash!flows!from!stock!based!on!the!equity!cost!of!capital!for!the!stock.!
B)!!The!divided!yield!is!the!percentage!return!the!investor!expects!to!earn!from!the!dividend!paid!by!the!
stock.!
C)!!The!firm!might!pay!out!cash!to!its!shareholders!in!the!form!of!a!dividend.!
D)!!The!dividend!yield!is!the!expected!annual!dividend!of!a!stock,!divided!by!its!expected!future!sale!price.!
Answer:!!!D!
B)!!
C)!!
D)!!The!dividend!yield!is!the!annual!dividend!divided!by!the!current!price.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Future!dividend!payments!and!stock!prices!are!not!known!with!certainty;!rather!these!values!are!based!
on!the!investor’s!expectations!at!the!time!the!stock!is!purchased.!
B)!!The!capital!gain!is!the!difference!between!the!expected!sale!price!and!the!purchase!price!of!the!stock.!
C)!!The!sum!of!the!dividend!yield!and!the!capital!gain!rate!is!called!the!total!return!of!the!stock.!
D)!!We!divide!the!capital!gain!by!the!expected!future!stock!price!to!calculate!the!capital!gain!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!The!capital!gains!rate!is!the!capital!gain!divided!by!the!current!stock!price.!
Diff:!2!
Skill:!Conceptual!
!
A)!!An!investor!will!be!willing!to!pay!up!to!the!point!at!which!the!current!price!of!a!share!of!stock!equals!the!
present!value!of!the!expected!future!dividends!an!expected!future!sale!price.!
B)!!The!expected!total!return!of!a!stock!should!equal!the!expected!return!of!other!investments!available!in!
the!market!with!equivalent!risk.!
C)!!The!total!amount!received!in!dividends!and!from!selling!the!stock!will!depend!on!the!investor’s!
investment!horizon.!
D)!! Div1 P1
If!the!current!stock!price!were!greater!than!!P0!= ,!it!would!be!a!positive!NPV!investment,!and!
1 rE
we!would!expect!investors!to!rush!in!and!buy!it,!driving!up!the!stocks!price.
Answer:!!!D!
B)!!
C)!!
D)!!It!would!be!a!negative!NPV!investment.!
Diff:!2!
Skill:!Conceptual!
!
A)!! P P
Capital!Gains!Rate!= 0 1
P0
B)!! Div1
Dividend!Yield!=
P0
C)!! Div1 Div2 P2
P0!=!! +!
1 rE (1 rE )2
D)!!rE!=!Capital!Gains!Rate!+!Dividend!Yield!
Answer:!!!A!
Explanation:!!! A)!! P P
Capital!Gains!Rate!= 1 0
P0
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! Div1 Div2 P2 DivN
P0!=! !+! !+!...!+!
2
1 rE (1 rE ) (1 rE ) N
B)!! N
Divn
P0!=!
n 1 (1 rE ) n
C)!! Div1 P0
rE!=
P1
D)!! Div1 P1
P0!=!
1 rE
Answer:!!!C!
B)!!
C)!! Div1 P1
rE!=!
P0
D)!!
Diff:!2!
Skill:!Conceptual!
!
Use'the'information'for'the'question(s)'below.!
!
Von!Bora!Corporation!is!expected!pay!a!dividend!of!$1.40!per!share!at!the!end!of!this!year!and!a!$1.50!per!share!at!the!end!
of!the!second!year.!!You!expect!Von!Bora^s!stock!price!to!be!$25.00!at!the!end!of!two!years.!!Von!Bora^s!equity!cost!of!capital!
is!10%!
!
9)!!The!price!you!would!be!willing!to!pay!today!for!a!share!of!Von!Bora!stock,!if!you!plan!to!hold!the!stock!for!
two!years!is!closest!to:!
A)!!$23.15!
B)!!$20.65!
C)!!$21.95!
D)!!$21.90!
Answer:!!!A!
Explanation:!!! A)!! Div1 Div2 P2 1.40 1.50 25.00
P0!=! !+! !=!! !+!! !=!$23.17!
1 rE (1 rE ) 2 1 .10 (1 .10)2
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!Suppose!you!plan!to!hold!Von!Bora!stock!for!one!year.!!The!price!would!would!expect!to!be!able!to!sell!a!share!
of!Von!Bora!stock!in!one!year!is!closest!to:!
A)!!$26.50!
B)!!$22.70!
C)!!$23.15!
D)!!$24.10!
Answer:!!!D!
B)!!
C)!!
D)!! Div2 P2 1.50 25.00
P1!=! !=!!! =!$24.10!
(1 rE )1
(1 .10) 2
Diff:!2!
Skill:!Analytical!
!
11)!!Suppose!you!plan!to!hold!Von!Bora!stock!for!only!one!year.!!Your!capital!gain!from!holding!Von!Bora!stock!
for!the!first!year!is!closest!to:!
A)!!$0.95!
B)!!$1.40!
C)!!$1.85!
D)!!$1.25!
Answer:!!!A!
Explanation:!!! A)!! Div2 P2 1.50 25.00
P1!=! !=!!! !=!$24.10
1 (1 .10)
(1 rE )
Div1 Div2 P2 1.40 1.50 25.00

P0!=! !+! !=!! !+! !=!$23.17
1 rE (1 rE ) 2 1 .10 (1 .10) 2
Capital!Gain!='P1!-'P0!=!24.10!-!23.17!=!$0.93!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!Suppose!you!plan!to!hold!Von!Bora!stock!for!only!one!year.!!Your!capital!gain!rate!from!holding!Von!Bora!
stock!for!the!first!year!is!closest!to:!
A)!!3.5%!
B)!!4.0%!
C)!!6.0%!
D)!!4.5%!
Answer:!!!B!
B)!! Div2 P2 1.50 25.00
P1!=!! !=!!! =!$24.10
1 (1 .10)
(1 rE )
Div1 Div2 P2 1.40 1.50 25.00

P0!=!! !+! !=!! !+! !=!$23.17
1 rE (1 rE ) 2 1 .10 (1 .10) 2
Capital!Gain!=!P1!-!P0!=!24.10!-!23.17!=!$0.93
Capital!Gain!rate!=!capital!gain/!P0!=!0.93!/!23.17!=!.0401!or!4.0%!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!Suppose!you!plan!to!hold!Von!Bora!stock!for!only!one!year.!!Your!dividend!yield!from!holding!Von!Bora!
stock!for!the!first!year!is!closest!to:!
A)!!6.0%!
B)!!4.0%!
C)!!6.5%!
D)!!5.5%!
Answer:!!!A!
Explanation:!!! A)!! Div1 Div2 P2 1.40 1.50 25.00
P0!=!! !+! !=!! !+! =!$23.17
1 rE (1 rE ) 2 1 .10 (1 .10)2
Dividend!yield!='Div1!/!P0!=!$1.40!/!23.17!=!.0604!or!6.0%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!Suppose!you!plan!on!purchasing!Von!Bora!stock!in!one!year,!right!after!the!$1.40!dividend!is!paid.!!You!then!
plan!on!selling!your!stock!at!the!end!of!year!two,!right!after!the!$1.50!dividend!is!paid.!!The!capital!gain!rate!
that!you!will!receive!on!your!investment!is!closest!to:!
A)!!4.00%!
B)!!3.75%!
C)!!6.25%!
D)!!3.50%!
Answer:!!!B!
B)!! Div2 P2 1.50 25.00
P1!=!!=!! !=!!! =!$24.10
1 (1 .10)
(1 rE )
So!capital!gain!rate!=!(P2!-!P1)!/!P1!=!($25.00!-!$24.10)!/!$24.10!=!.03734!or!3.73%!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
plan!on!selling!your!stock!at!the!end!of!year!two,!right!after!the!$1.50!dividend!is!paid.!!The!dividend!yield!
that!you!will!receive!on!your!investment!is!closest!to:!
A)!!5.75%!
B)!!6.50%!
C)!!6.25%!
D)!!4.00%!
Answer:!!!C!
B)!!
C)!! Div2 P2 1.50 25.00
P1!=!! !=!!! =!$24.10
1 (1 .10)
(1 rE )
So!dividend!yield!=!$1.50!/!$24.10!=!.0622!or!6.22%!
D)!!
Diff:!3!
Skill:!Analytical!
!
plan!on!selling!your!stock!at!the!end!of!year!two,!right!after!the!$1.50!dividend!is!paid.!!The!total!return!that!
you!will!receive!on!your!investment!is!closest!to:!
A)!!9.50%!
B)!!10.75%!
C)!!10.25%!
D)!!10.00%!
Answer:!!!D!
B)!!
C)!!
D)!! Div2 P2 1.50 25.00
P1!=! !=!!! =!$24.10
1 (1 .10)
(1 rE )
So!dividend!yield!=!$1.50!/!$24.10!=!.0622!or!6.22%
So!capital!gain!rate!=!(P2!-!P1)!/!P1!=!($25.00!-!$24.10)!/!$24.10!=!.03734!or!3.73%
Total!return!=!capital!gains!rate!+!dividend!yield!=!3.73%!+!6.22%!=!9.95%!
Diff:!3!
Skill:!Analytical!
!
17)!!Suppose!you!plan!to!hold!Von!Bora!stock!for!only!one!year.!!Calculate!your!total!return!from!holding!Von!
Bora!stock!for!the!first!year.!
Answer:!!! Div2 P2 1.50 25.00
P1!=!! !=!!! !=!$24.10
1 (1 .10)
(1 rE )
Div1 Div2 P2 1.40 1.50 25.00

P0!=!! !+! !=!! !+! !=!$23.17
1 rE (1 rE ) 2 1 .10 (1 .10) 2
Capital!Gain!=!P1!-'P0!=!24.10!-!23.17!=!$0.93
Capital!Gain!rate!=!capital!gain!/!P0!=!0.93!/!23.17!=!.0401!or!4.0%
Dividend!yield!=!Div1!/!P0!=!$1.40!/!23.17!=!.0604!or!6.0%
Total!return!=!capital!gain!rate!+!dividend!yield!=!4.0%!+!6.0%!=!10%!
Diff:!3!
Skill:!Analytical!
9.2!The!Dividend-Discount!Model!
1)!!Which!of!the!following!is!not!a!way!that!a!firm!can!increase!its!dividend?!
A)!!By!increasing!its!retention!rate!
B)!!By!decreasing!its!shares!outstanding!
C)!!By!increasing!its!earnings!(net!income)!
D)!!By!increasing!its!dividend!payout!rate!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!9.2!The!Dividend-Discount!Model!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!is!false!regarding!profitable!and!unprofitable!growth?!
A)!!If!a!firm!wants!to!increase!its!share!price,!it!must!cut!its!dividend!and!invest!more.!
B)!!If!the!firm!retains!more!earnings,!it!will!be!able!to!pay!out!less!of!those!earnings,!which!means!that!the!
firm!will!have!to!reduce!its!dividend.!
C)!!A!firm!can!increase!its!growth!rate!by!retaining!more!of!its!earnings.!
D)!!Cutting!the!firm’s!dividend!to!increase!investment!will!raise!the!stock!price!if,!and!only!if,!the!new!
investments!have!a!positive!NPV.!
Answer:!!!A!
Explanation:!!! A)!!This!will!only!increase!the!share!price!if!the!reinvested!money!is!invested!in!positive!NPV!
projects.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Estimating!dividends,!especially!for!the!distant!future,!is!difficult.!
B)!!A!firm!can!only!pay!out!its!earnings!to!investors!or!reinvest!their!earnings.!
C)!!Successful!young!firms!often!have!high!initial!earnings!growth!rates.!
D)!!According!to!the!constant!dividend!growth!model,!the!value!of!the!firm!depends!on!the!current!
dividend!level,!divided!by!the!equity!cost!of!capital!plus!the!grow!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!According!to!the!constant!dividend!growth!model,!the!value!of!the!firm!depends!on!the!
current!dividend!level,!divided!by!the!equity!cost!of!capital!adjusted!by!the!growth!rate.!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!cannot!use!the!general!dividend!discount!model!to!value!the!stock!of!a!firm!with!rapid!or!changing!
growth.!
B)!!As!firms!mature,!their!growth!slows!to!rates!more!typical!of!established!companies.!
C)!!The!dividend!discount!model!values!the!stock!based!on!a!forecast!of!the!future!dividends!paid!to!
shareholders.!
D)!!The!simplest!forecast!for!the!firm’s!future!dividends!states!that!they!will!grow!at!a!constant!rate,!g,!
forever.!
Answer:!!!A!
Explanation:!!! A)!!A!multistage!model!can!be!used.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!common!approximation!is!to!assume!that!in!the!long!run,!dividends!will!grow!at!a!constant!rate.!
B)!!The!dividend!each!year!is!the!firm’s!earnings!per!share!(EPS)!multiplied!by!its!dividend!payout!rate.!
C)!!There!is!a!tremendous!amount!of!uncertainty!associated!with!any!forecast!of!a!firm’s!future!dividends.!
D)!!During!periods!of!high!growth,!it!is!not!unusual!for!firms!to!pay!out!100%!of!their!earnings!to!
shareholders!in!the!form!of!dividends.!
Answer:!!!D!
B)!!
C)!!
D)!!During!periods!of!high!growth,!it!is!not!unusual!for!these!firms!to!retain!100%!of!their!
earnings!to!exploit!profitable!investment!opportunities.!
Diff:!2!
Skill:!Conceptual!
!
A)!!As!firms!mature,!their!earnings!exceed!their!investment!needs!and!they!begin!to!pay!dividends.!
B)!!Total!return!equals!earnings!multiplied!by!the!dividend!payout!rate.!
C)!!Cutting!the!firm’s!dividend!to!increase!investment!will!raise!the!stock!price!if,!and!only!if,!the!new!
investments!have!a!positive!NPV.!
D)!!We!cannot!use!the!constant!dividend!growth!model!to!value!the!stock!of!a!firm!with!rapid!or!changing!
growth.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!g!=!retention!rate!×!return!on!new!investment!
B)!!Divt!=!EPSt!×!Dividend!Payout!Rate!
C)!! Div1
P0!=!
rE g
D)!! Div1
rE!=! !+!g'
P0
Answer:!!!D!
B)!!
C)!!
D)!! Div1
rE!=! !-!g'
P0
Diff:!2!
Skill:!Conceptual!
!
A)!! earningst
Divt!=!! ×!Dividend!Payout!Rate!
shares outstandingt
B)!! DivN
PN!=!
rE g
C)!!earnings!growth!rate!=!retention!rate!x!return!on!new!investment!
D)!! Div1 Div2 DivN 1 DivN 1
P0!=! !+!! +!...!+! !+!! ×!
1 rE 2 N N rE g
(1 rE ) (1 rE ) (1 rE )
Answer:!!!B!
B)!! DivN 1
PN!=!
rE g
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!NoGrowth!industries!presently!pays!an!annual!dividend!of!$1.50!per!share!and!it!is!expected!that!these!
dividend!payments!will!continue!indefinitely.!!If!NoGrowth^s!equity!cost!of!capital!is!12%,!then!the!value!of!a!
share!of!NoGrowth^s!stock!is!closest!to:!
A)!!$10.00!
B)!!$15.00!
C)!!$14.00!
D)!!$12.50!
Answer:!!!D!
B)!!
C)!!
D)!!P0!=!Div1!/!(rE!-!g)!=!$1.50!/!(.12!-!0)!=!$12.50!
Diff:!1!
Skill:!Analytical!
!
10)!!Von!Bora!Coporation!(VBC)!is!expected!to!pay!a!$2.00!dividend!at!the!end!of!this!year.!If!you!expect!VBC^s!!
dividend!to!grow!by!5%!per!year!forever!and!VBC^s!equity!cost!of!capital!is!13%,!then!the!value!of!a!share!of!
VBS!stock!is!closest!to:!
A)!!$25.00!
B)!!$40.00!
C)!!$15.40!
D)!!$11.10!
Answer:!!!A!
Explanation:!!! A)!!P0!=!Div1!/!(rE!-!g)!=!2.00!/!(.13!-!.05)!=!!$25.00!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!Luther!Industries!has!a!dividend!yield!of!4.5%!and!and!a!cost!of!equity!capital!of!12%.!!Luther!Industries!
dividends!are!expected!to!grow!at!a!constant!rate!indefinitely.!!The!grow!rate!of!Luther^s!dividends!are!closest!
to:!
A)!!7.5%!
B)!!5.5%!
C)!!16.5%!
D)!!12%!
Answer:!!!A!
Explanation:!!! A)!!rE!='Div1!/!P0!+!g
.12!=!.045!+!g!so!g!=!.075!!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!The!Sisyphean!Company^s!common!stock!is!currently!trading!for!$25.00!per!share.!The!stock!is!expected!to!
pay!a!$2.50!dividend!at!the!end!of!the!year!and!the!Sisyphean!Company^s!equity!cost!of!capital!is!14%.!!If!the!
dividend!payout!rate!is!expected!to!remain!constant,!then!the!expected!growth!rate!in!the!Sisyphean!
Company^s!earnings!is!closest!to:!
A)!!8%!
B)!!6%!
C)!!4%!
D)!!2%!
Answer:!!!C!
B)!!
C)!!P0!=!Div1!/!(rE!-!g)!=!25.00!=!2.50!/!(.14!-!g)!so!g!=!.04!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!You!expect!KT!industries!(KTI)!will!have!earnings!per!share!of!$3!this!year!and!expect!that!they!will!pay!out!
$1.50!of!these!earnings!to!shareholders!in!the!form!of!a!dividend.!!KTI^s!return!on!new!investments!is!15%!and!
their!equity!cost!of!capital!is!12%.!!The!expected!growth!rate!for!KTI^s!dividends!is!closest!to:!
A)!!6.0%!
B)!!7.5%!
C)!!4.5%!
D)!!3.0%!
Answer:!!!B!
B)!!g'=!retention!rate!×!return!on!new!investment
!!!=!(3.00!-!1.50)!/!3.00!×!.15!=!.075!or!7.5%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
14)!!You!expect!KT!industries!(KTI)!will!have!earnings!per!share!of!$3!this!year!and!expect!that!they!will!pay!out!
$1.50!of!these!earnings!to!shareholders!in!the!form!of!a!dividend.!!KTI^s!return!on!new!investments!is!15%!and!
their!equity!cost!of!capital!is!12%.!!The!value!of!a!share!of!KTI^s!stock!is!closest!to:!
A)!!$39.25!
B)!!$20.00!
C)!!$33.35!
D)!!$12.50!
Answer:!!!C!
B)!!
C)!!g!=!retention!rate!×!return!on!new!investment
!!!=!(3.00!-!1.50)!/!3.00!×!.15!=!.075!or!7.5%
P0!=!Div1!/!(rE!-!g)!=!1.50!/!(.12!-!.075)!=!!33.33!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!JRN!enterprises!just!announced!that!it!plans!to!cut!its!dividend!from!$2.50!to!$1.50!per!share!and!use!the!extra!
funds!to!expand!its!operations.!!Prior!to!this!announcement,!JRN^s!dividends!were!expected!to!grow!at!4%!per!
year!and!JRN^s!stock!was!trading!at!$25.00!per!share.!!With!the!new!expansion,!JRN^s!dividends!are!expected!
to!grow!at!8%!per!year!indefinitely.!!Assuming!that!JRN^s!risk!is!unchanged!by!the!expansion,!the!value!of!a!
share!of!JRN!after!the!announcement!is!closest!to:!
A)!!$25.00!
B)!!$15.00!
C)!!$31.25!
D)!!$27.50!
Answer:!!!A!
Explanation:!!! A)!!Two!steps.
Step!#1!solve!for!rE,
rE!=!Div1!/!P0!+!g!=!!2.50!/!25.00!+!.04!=!.14!or!14%
Step!#2
solve!for!new!stock!price:
P0!=!Div1!/!(rE!-!g)!=!1.50!/!(.14!-!.08)!=!!25.00!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
16)!!You!expect!that!Bean!Enterprises!will!have!earnings!per!share!of!$2!for!the!coming!year.!!Bean!plans!to!retain!
all!of!its!earnings!for!the!next!three!years.!!For!the!subsequent!two!years,!the!firm!plans!on!retaining!50%!of!its!
earnings.!!It!will!then!retain!only!25%!of!its!earnings!from!that!point!forward.!!Retained!earnings!will!be!
invested!in!projects!with!an!expected!return!of!20%!per!year.!!If!Bean^s!equity!cost!of!capital!is!12%,!then!the!
price!of!a!share!of!Bean^s!stock!is!closest!to:!
A)!!$17.00!
B)!!$10.75!
C)!!$27.75!
D)!!$43.50!
Answer:!!!C!
B)!!
C)!!Year Earnings Dividends g(
1 $2.00 $0.00 20%!
2 $2.40 $0.00 20%!
3 $2.88 $0.00 20%!
4 $3.46 $1.73 10%!
5 $3.80 $1.90 10%!
6 $4.18 $3.14 5%!
P0!=!1.73!/!(1.12)4!+!1.90!/!1.125!+!(3.14!/!(.12!-!.05))!/!1.125!=!27.63!
Each!g!is!calculated!as!the!20%!return!on!the!projects!×!the!retention!ratio.!
D)!!
Diff:!3!
Skill:!Analytical!
!
17)!!Monsters!Inc.!is!a!utility!company!that!recently!paid!a!common!stock!dividend!of!$2.35!per!share.!!Determine!
the!current!price!of!a!share!of!Monsters^!common!stock!if!its!divided!growth!rate!is!expected!to!remain!at!7!
percent!per!year!indefinitely!and!its!equity!cost!of!capital!is!12!percent.!
Answer:!!!Using!the!constant!growth!dividend!valuation!model
VC!!'='D1!/!(kc!-!g)
!!!!!!=!D0!!×!(1!+!g)!/!(kc!-!g)
!!!!!!=!$2.35!×!(1.07)!/!(0.12!-!0.07)!=!$!50.29!
Diff:!2!
Skill:!Analytical!
!
18)!!MJ!LTD!is!expected!to!grow!at!various!rates!over!the!next!five!years.!!The!company!just!paid!a!$1.00!dividend.!!
The!company!expects!to!grow!at!20%!for!the!next!two!years!(effecting!D1!and!D2),!then!the!company!expects!
to!grow!at!10%!for!three!additional!years!(D3,!D4,!D5)!after!which!the!company!expects!to!grow!at!a!constant!
rate!of!5%!per!year!indefinitely.!!If!the!required!rate!of!return!on!MJ^s!common!stock!is!12%,!then!what!is!a!
share!of!MJ^s!stock!worth?!
!
Answer:!!!Time!
Period! Dividend! Present!Value!
!1! $1.00(1.20)! $1.00(1.20)!/!(1.12)!=!1.071!
!2! $1.00(1.20)2! $1.00(1.20)2!/!(1.12)2!=!1.148!
!3! $1.00(1.20)2(1.10)1! $1.00(1.20)2(1.10)!/!(1.12)3!=!1.127!
!4! $1.00(1.20)2(1.10)2! $1.00(1.20)2(1.10)2!/!(1.12)4!=!1.107!
!5! $1.00(1.20)2(1.10)3! $1.00(1.20)2(1.10)3!/!(1.12)5!=!1.088!
!6! $1.00(1.20)2(1.10)3(1.05)! $1.00(1.20)2(1.10)3(1.05)!/![(.12-.05)(1.12)5]!=!16.313!
!
Current!Value!of!Share!=!1.071!+!1.148!+!1.127!+!1.107!+!1.088!+!16.313!=!$21.85!
Diff:!3!
Skill:!Analytical!
!
19)!!Growing!Real!Fast!Company!(GRF)!is!expected!to!have!a!25!percent!growth!rate!for!the!next!four!years!
(effecting!D1,!D2,!D3,!and!D4).!!Beginning!in!year!five,!the!growth!rate!is!expected!to!drop!to!7!percent!per!
year!and!last!indefinitely.!!If!GRF!just!paid!a!$2.00!dividend!and!the!appropriate!discount!rate!is!15!percent,!
then!what!is!the!value!of!a!share!of!GRE?!
!
Answer:!!!Time!
Period! Dividend! Present!Value!
!1! $2.50(1.25)1! $2.00(1.25)!/!(1.15)!=!2.174!
2! $2.00(1.25) !2 $2.00(1.25)2!/!(1.15)2!=!2.363!
3! $2.00(1.25)3! $2.00(1.25)3!/!(1.15)3!=!2.568!
4! $2.00(1.25) !4 $2.00(1.25)4!/!(1.15)4!=!2.792!
5! $2.00(1.25)4(1.07)! $2.00(1.25)4(1.07)!/![(.15-.07)(1.15)4!]!=!37.34!
!
Current!Value!of!Share!=!2.174!+!2.363!+!2.568!+!2.792!+!37.34!=!$47.24!
Diff:!3!
Skill:!Analytical!
9.3!Total!Payout!and!Free!Cash!Flow!Valuation!Models!
A)!!The!total!payout!model!allows!us!to!ignore!the!firm’s!choice!between!dividends!and!share!repurchases.!
B)!!By!repurchasing!shares,!the!firm!increases!its!share!count,!which!decreases!its!earning!and!dividends!on!
a!per-share!basis.!
C)!!The!total!payout!model!discounts!the!total!payouts!that!the!firm!makes!to!shareholders,!which!is!the!
total!amount!spent!on!both!dividends!and!share!repurchases.!
D)!!In!the!dividend!discount!model!we!implicitly!assume!that!any!cash!paid!out!to!the!shareholders!takes!
the!form!of!a!dividend.!
Answer:!!!B!
B)!!By!repurchasing!shares,!the!firm!decreases!its!share!count,!which!increases!its!earning!and!
dividends!on!a!per-share!basis.!
C)!!
D)!!
Diff:!1!
Topic:!9.3!Total!Payout!and!Free!Cash!Flow!Valuation!Models!
Skill:!Conceptual!
!
2)!!If!you!want!to!value!a!firm!that!consistently!pays!out!its!earnings!as!dividends,!the!simplest!model!for!you!to!
use!is:!
A)!!Enterprise!value!model!
B)!!Total!payout!model!
C)!!Dividend!discount!model!
D)!!Discounted!free!cash!flow!model!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!If!you!want!to!value!a!firm!that!has!consistent!earnings!grow,!but!varies!how!it!pays!out!these!earnings!to!
shareholders!between!dividends!and!repurchases,!the!simplest!model!for!you!to!use!is:!
A)!!Enterprise!value!model!
B)!!Dividend!discount!model!
C)!!Total!payout!model!
D)!!Discounted!free!cash!flow!model!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!If!you!want!to!value!a!firm!but!don^t!want!to!explicitly!forecast!its!dividends,!share!repurchases!,!or!its!use!of!
debt,!what!is!the!simplest!model!for!you!to!use?!
A)!!Discounted!free!cash!flow!model!
B)!!Dividend!discount!model!
C)!!Enterprise!value!model!
D)!!Total!payout!model!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!In!a!share!repurchase,!the!firm!uses!excess!cash!to!buy!back!its!own!stock.!
B)!!The!discounted!free!cash!flow!model!begins!by!determining!the!value!of!the!firm^s!equity.!
C)!!The!discounted!free!cash!flow!model!focuses!on!the!cash!flows!to!all!of!the!firm’s!investors,!both!debt!
and!equity!holders,!and!allows!us!to!avoid!estimating!the!impact!of!the!firm’s!borrowing!decisions!on!
earnings.!
D)!!In!recent!years!an!increasing!number!of!firms!have!replaced!dividend!payouts!with!share!repurchases.!
Answer:!!!B!
B)!!The!discounted!free!cash!flow!model!is!used!to!find!the!value!of!the!firm.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!To!estimate!a!firm’s!enterprise!value,!we!compute!the!present!value!of!the!free!cash!flows!(FCF)!that!the!
firm!has!available!to!pay!equity!holders.!
B)!!The!NPV!of!any!individual!project!represents!its!contribution!to!the!firm’s!enterprise!value.!
C)!!When!using!the!total!payout!model,!we!discount!total!dividends!and!share!repurchases,!and!use!the!
growth!rate!in!earnings!when!forecasting!the!growth!of!the!firm’s!payout.!
D)!!In!the!total!payout!model,!we!first!value!the!firm’s!equity,!rather!than!just!a!single!share.!
Answer:!!!A!
Explanation:!!! A)!!FCF!is!available!to!pay!both!debt!and!equity!holders.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!more!cash!the!firm!uses!to!repurchase!shares,!the!less!it!has!available!to!pay!dividends.!
B)!!Free!cash!flow!measures!the!cash!generated!by!the!firm!after!payments!to!debt!or!equity!holders!are!
considered.!
C)!!We!estimate!a!firm^s!current!enterprise!value!by!computing!the!present!value!of!the!firm^s!free!cash!flow.!
D)!!We!can!interpret!the!enterprise!value!as!the!net!cost!of!acquiring!the!firm^s!equity,!taking!its!cash!and!
paying!off!all!debts.!
Answer:!!!B!
B)!!FCF!is!cash!generated!by!the!firm!before!payments!to!debt!and!equity!holders.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!firm’s!weighted!average!cost!of!capital!(WACC)!denoted!rwacc!is!the!cost!of!capital!that!reflects!the!
risk!of!the!overall!business,!which!is!the!combined!risk!of!the!firm’s!equity!and!debt.!
B)!!Intuitively,!the!difference!between!the!discounted!free!cash!flow!model!and!the!dividend-discount!
model!is!that!in!the!divided-discount!model!the!firm’s!cash!and!debt!are!included!indirectly!through!the!
effect!of!interest!income!and!expenses!on!earnings!in!the!dividend-discount!model.!
C)!!We!interpret!rwacc!as!the!expected!return!the!firm!must!pay!to!investors!to!compensate!them!for!the!risk!
of!holding!the!firm^s!debt!and!equity!together.!
D)!!When!using!the!discounted!free!cash!flow!model!we!should!use!the!firm^s!equity!cost!of!capital.!
Answer:!!!D!
B)!!
C)!!
D)!!You!would!use!the!firm^s!weighted!average!cost!of!capital.!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!long-run!growth!rate!gFCF!is!typically!based!on!the!expected!long-run!growth!rate!of!the!firm^s!
revenues.!
B)!!Because!the!firm^s!free!cash!flow!is!equal!to!the!sum!of!the!free!cash!flows!from!the!firm^s!current!and!
future!investments,!we!can!interpret!the!firm^s!enterprise!value!as!the!total!NPV!that!the!firm!will!earn!
from!continuing!its!existing!projects!and!initiating!new!ones.!
C)!!If!the!firm!has!no!debt!then!rwacc!!=!the!risk-free!rate!of!return.!
D)!!When!using!the!discounted!free!cash!flow!model,!we!forecast!the!firm^s!free!cash!flow!up!to!some!
horizon,!together!with!some!terminal!(continuation)!value!of!the!enterprise.!
Answer:!!!C!
B)!!
C)!!If!the!firm!has!no!debt!then!rwacc!!=!the!cost!of!equity.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! V0 + Debt - Cash
P0!=!
Shares Outstanding
B)!! FCF1 FCF2 FCFN VN
V0!=! !+! !+!...!+! +
2 N
1 rwacc (1 rwacc ) (1 rwacc ) (1 rwacc ) N
C)!!Free!Cash!Flow!=!EBIT!×!(1!-! c)!+!Depreciation!-!Capital!Expenditures!-!DNWC'
D)!!Enterprise!Value!=!Market!Value!of!Equity!+!Debt!-!Cash!
Answer:!!!A!
Explanation:!!! A)!! V + Debt - Cash
P0!=! 0
Shares Outstanding
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
11)!!The!Rufus!Corporation!has!125!million!shares!outstanding!and!analysts!expect!Rufus!to!have!earnings!of!$500!
million!this!year.!!Rufus!plans!to!pay!out!!40%!of!its!earnings!in!dividends!and!they!expect!to!use!another!20%!
of!their!earnings!to!repurchase!shares.!!If!Rufus^!equity!cost!of!capital!is!15%!and!Rufus^!earnings!are!expected!
to!grow!at!a!rate!of!3%!per!year,!then!the!value!of!a!share!of!Rufus!stock!is!closest!to:!
A)!!$13.35!
B)!!$33.50!
C)!!$20.00!
D)!!$16.00!
Answer:!!!C!
B)!!
C)!!Dividends!=!$500!×!.40!=!$200!million
Repurchases!=!$500!×!.20!=!$100!million
PV(Future!Total!Dividends!and!Repurchases)!=!($200!+!$100)!/!(.15!-!.03)!=!$2,500!million
P0!=!$2,500!million/125!million!shares!=!$20!per!share!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
You!expect!!CCM!Corporation!to!generate!the!following!free!cash!flows!over!the!next!five!years:
Year 1 2 3 4 5!
FCF!($!millions) 25 28 32 37 40!
Following!year!five,!you!estimate!that!CCM^s!free!cash!flows!will!grow!at!5%!per!year!and!that!CCM^s!weighted!average!
cost!of!capital!is!13%.!
!
12)!!The!enterprise!value!of!CCM!corporation!is!closest!to:!
A)!!$396!million!
B)!!$290!million!
C)!!$382!million!
D)!!$350!million!
Answer:!!!A!
Explanation:!!! A)!! FCF1 FCF2 FCFN VN
V0!=!! !+! !+!...!+! +
2 N
40
25 28 32 37
V0!=! !+! !+! + + .13 .05 =!395.58!million!
1 .13 (1 .13)2 (1 .13)3 (1 .13) 4 (1 .13) 4
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!If!CCM!has!$200!million!of!debt!and!8!million!shares!of!stock!outstanding,!then!the!share!price!for!CCM!is!
closest!to:!
A)!!$49.50!
B)!!$12.50!
C)!!$19.35!
D)!!$24.50!
Answer:!!!D!
B)!!
C)!!
D)!! FCF1 FCF2 FCFN VN
V0!=!! !+! !+!...!+! +
2 N
40
25 28 32 37
V0!=! !+! !+! + + .13 .05 =!395.58!million!or!396!million.
1 .13 (1 .13)2 (1 .13)3 (1 .13) 4 (1 .13) 4
Equity!value!=!$396!-!$200!(debt)!=!$196!million!/!8!million!shares!=!$24.50!
Diff:!2!
Skill:!Analytical!
!
14)!!If!CCM!has!$150!million!of!debt!and!12!million!shares!of!stock!outstanding,!then!the!share!price!for!CCM!is!
closest!to:!
A)!!$49.50!
B)!!$11.25!
C)!!$20.50!
D)!!$22.75!
Answer:!!!C!
B)!!
C)!! FCF1 FCF2 FCFN VN
V0!=!! !+! !+!...!+! +
2 N
40
25 28 32 37 .13 .05 =!395.58!million!or!396!million.
V0!= !+! !+! + +
2 3 4
1 .13 (1 .13) (1 .13) (1 .13) (1 .13) 4
Equity!value!=!$396!-!$150!(debt)!=!$246!million!/!12!million!shares!=!$20.50!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Defenestration!industries!plans!to!pay!a!$4.00!dividend!this!year!and!you!expect!that!the!firm^s!earnings!are!on!track!to!
grow!at!5%!per!year!for!the!foreseeable!future.!Defenestration^s!equity!cost!of!capital!is!13%.!
!
15)!!Assuming!that!Defenestration^s!dividend!payout!rate!and!expected!growth!rate!remain!constant,!and!
Defenestration!does!not!issue!or!repurchase!shares,!then!Defenestration^s!stock!price!is!closest!to:!
A)!!$50.00!
B)!!$32.30!
C)!!$22.25!
D)!!$30.75!
Answer:!!!A!
Explanation:!!! A)!! Div1 $4
P0!=! != !=!$50!
rE g .13 .05
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
16)!!Suppose!that!Defenestration!decides!to!pay!a!dividend!of!only!$2!per!share!this!year!and!use!the!remaining!$2!
per!share!to!repurchase!stock.!!If!Defenestration^s!payout!rate!remains!constant,!then!Defenestration^s!stock!
price!is!closest!to:!
A)!!$50.00!
B)!!$22.25!
C)!!$32.30!
D)!!$30.75!
Answer:!!!A!
Explanation:!!! A)!! Total Payouts1 $4
P0!=! != =!$50!
rE g .13 .05
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!Suppose!that!Defenestration!decides!to!pay!a!dividend!of!only!$2!per!share!this!year!and!use!the!remaining!$2!
per!share!to!repurchase!stock.!!If!Defenestration!maintains!this!dividend!and!total!payout!rate,!then!the!rate!at!
which!Defenestration^s!dividends!and!earnings!per!share!are!expected!to!grow!is!closest!to:!
A)!!7%!
B)!!13%!
C)!!9%!
D)!!5%!
Answer:!!!C!
B)!!
C)!! Total Payouts1 $4
P0!=!! != !=!$50
rE g .13 .05
g!=!rE!-'Div1!/!P0!=!.13!-!$2!/!$50!=!.09!or!9%
D)!
Diff:!2!
Skill:!Analytical!
!
!
You!expect!!DM!Corporation!to!generate!the!following!free!cash!flows!over!the!next!five!years:
Year 1 2 3 4 5!
FCF!($!millions) 75 84 96 111 120!
Beginning!with!year!six,!you!estimate!that!DM^s!free!cash!flows!will!grow!at!6%!per!year!and!that!DM^s!weighted!average!
cost!of!capital!is!15%.!
!
18)!!Calculate!the!enterprise!value!for!DM!Corporation.!
Answer:!!! FCF1 FCF2 FCFN VN
V0!=! !+! !+!...!+! +
1 rwacc (1 rwacc ) 2 (1 rwacc ) N (1 rwacc ) N
120
75 84 96 111 120
V0!=! !+! !+! + + + .15 .06 =!1017.66!million!
1 .15 (1 .15) 2 (1 .15)3 (1 .15) 4 (1 .15)5 (1 .15)5
Diff:!2!
Skill:!Analytical!
!
19)!!If!DM!has!$500!million!of!debt!and!14!million!shares!of!stock!outstanding,!then!what!is!the!price!per!share!for!
DM!Corporation?!
Answer:!!! FCF1 FCF2 FCFN VN
V0!=!! !+! !+!...!+! +
2 N
120
75 84 96 111 120
V0!= !+! !+! + + + .15 .06 !=!1017.66!million!or!$1018!
1 .15 (1 .15) 2 (1 .15)3 (1 .15) 4 (1 .15)5 (1 .15)5
million
Equity!value!=!$1018!-!$500!(debt)!=!$518!million/14!million!shares!=!$37.00
Diff:!3!
Skill:!Analytical!
!
9.4!Valuation!Based!on!Comparable!Firms!
A)!!Even!two!firms!in!the!same!industry!selling!the!same!types!of!products,!while!similar!in!many!respects,!
are!likely!to!be!of!different!size!or!scale.!
B)!!In!the!method!of!comparables!we!estimate!the!value!of!the!firm!based!on!the!value!of!other,!comparable!
firms!or!investments!that!we!expect!will!generate!very!similar!cash!flows!in!the!future.!
C)!!Consider!the!case!of!a!new!firm!that!is!identical!to!an!existing!publicly!traded!company.!!If!these!firms!
will!generate!identical!cash!flows,!the!Law!of!One!Price!implies!that!we!can!use!the!value!of!the!existing!
company!to!determine!the!value!of!the!new!firm.!
D)!!A!valuation!multiple!is!a!ratio!of!some!measure!of!the!firm’s!scale!!to!the!value!of!the!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!A!valuation!multiple!is!a!ratio!of!the!value!of!the!firm!to!some!measure!of!the!firm’s!scale.!
Diff:!1!
Topic:!9.4!Valuation!Based!on!Comparable!Firms!
Skill:!Conceptual!
!
A)!!The!most!common!valuation!multiple!is!the!price-earnings!(P/E)!ratio.!
B)!!You!should!be!willing!to!pay!proportionally!more!for!a!stock!with!lower!current!earnings.!
C)!!A!firm’s!P/E!ratio!is!equal!to!the!share!price!divided!by!its!earnings!per!share.!
D)!!The!intuition!behind!the!use!of!the!P/E!ratio!is!that!when!you!buy!a!stock,!you!are!in!sense!buying!the!
rights!to!the!firm’s!future!earnings!and!differences!in!the!scale!of!firms’!earnings!are!likely!to!persist.!
Answer:!!!B!
B)!!You!should!be!willing!to!pay!proportionally!more!for!a!stock!with!higher!current!earnings.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!can!estimate!the!value!of!a!firm’s!shares!by!multiplying!its!current!earnings!per!share!by!the!average!
P/E!ratio!of!comparable!firms.!
B)!!For!valuation!purposes,!the!trailing!P/E!ratio!is!generally!preferred,!since!it!is!based!on!actual!not!
expected!earnings.!
C)!!Forward!earnings!are!the!expected!earnings!over!the!coming!12!months.!
D)!!Trailing!earnings!are!the!earnings!over!the!previous!12!months.!
Answer:!!!B!
B)!!For!valuation!purposes,!the!leading!P/E!ratio!is!generally!preferred,!since!it!is!based!on!t!
expected!earnings.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!the!enterprise!value!represents!the!entire!value!of!the!firm!before!the!firm!pays!its!debt,!to!form!
an!appropriate!multiple,!we!divide!it!by!a!measure!of!earnings!or!cash!flows!after!interest!payments!are!
made.!
B)!!We!can!compute!a!firm^s!P/E!ratio!by!using!either!trailing!earnings!or!forward!earnings!with!the!
resulting!ratio!called!the!trailing!P/E!or!forward!P/E.!
C)!!It!is!common!practice!to!use!valuation!multiples!based!on!the!firm’s!enterprise!value.!
D)!!Using!a!valuation!multiple!based!on!comparables!is!best!viewed!as!a!lshortcutl!to!the!discounted!cash!
flow!method!of!valuation.!
Answer:!!!A!
Explanation:!!! A)!!Because!the!enterprise!value!represents!the!entire!value!of!the!firm!before!the!firm!pays!its!
debt,!to!form!an!appropriate!multiple,!we!divide!it!by!a!measure!of!earnings!or!cash!flows!
before!interest!payments!are!made.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!fact!that!a!firm!has!an!exceptional!management!team,!has!developed!an!efficient!manufacturing!
process,!or!has!just!secured!a!patient!on!a!new!technology!is!ignored!when!we!apply!a!valuation!
multiple.!
B)!!Valuation!multiples!have!the!advantage!that!they!allow!us!to!incorporate!specific!information!about!the!
firm’s!cost!of!capital!or!future!growth.!
C)!!For!firms!with!substantial!tangible!assets,!the!ratio!of!price!to!book!value!of!equity!per!share!is!
sometimes!used.!
D)!!Using!multiples!will!not!help!us!determine!if!an!entire!industry!is!overvalued.!
Answer:!!!B!
B)!!Discounted!cash!flows!methods!have!the!advantage!that!they!allow!us!to!incorporate!specific!
information!about!the!firm^s!cost!of!capital!or!future!growth.!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!Because!capital!expenditures!can!vary!substantially!from!period!to!period,!most!practitioners!rely!on!
enterprise!value!to!free!cash!flow!multiples.!
B)!!Common!multiples!to!consider!are!enterprise!value!to!EBIT,!EBITDA,!and!free!cash!flow.!
C)!!If!two!stocks!have!the!same!payout!and!EPS!growth!rates!as!well!as!equivalent!risk,!then!they!should!
have!the!same!P/E!ratio.!
D)!!Looking!at!enterprise!value!as!a!multiple!of!sales!can!be!useful!if!it!is!reasonable!to!assume!that!the!firms!
will!maintain!similar!margins!in!the!future.!
Answer:!!!A!
Explanation:!!! A)!!Because!capital!expenditures!can!vary!substantially!from!period!to!period!(e.g.,!a!firm!may!
need!to!add!capacity!and!build!a!new!plant!one!year,!but!then!not!need!to!expand!further!for!
many!years),!most!practitioners!rely!on!enterprise!value!to!EBITDA!multiples.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!! P Dividend Payout Rate
Forward! !=!
E rE g
B)!! EPS1
P Div1
Forward! !=!
E rE g
C)!! FCF1
V0 EBITDA1
!=!
EBITDA1 rwacc g
D)!! P P0
Forward! !=
E EPS1
Answer:!!!B!
B)!! Div1
P EPS1
Forward! !=!
E rE g
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!You!expect!Whirlpool!Corporation!(WHR)to!have!earnings!per!share!of!$6.10!over!the!coming!year.!!If!the!
average!P/E!ratio!for!the!appliance!industry!sector!is!17.0,!the!the!value!of!a!share!of!Whirlpool!stock!based!
upon!the!comparables!approach!is!closest!to:!
A)!!$103.75!
B)!!$27.90!
C)!!$35.90!
D)!!$23.10!
Answer:!!!A!
Explanation:!!! A)!!Price!=!Forward!earnings!×!P'/!E!=!$6.10!×!17!=!$103.70!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!You!expect!Whirlpool!Corporation!(WHR)to!have!earnings!per!share!of!$6.10!over!the!coming!year.!!If!
Whirlpool!stock!is!currently!trading!at!$87.00!per!share,!then!Whirlpool^s!P/E!ratio!is!closest!to:!
A)!!17.00!
B)!!13.50!
C)!!14.25!
D)!!7.00!
Answer:!!!C!
B)!!
C)!!P!/!E!=!price!/!forward!earnings!=!$87!/!$6.10!=!14.262!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Suppose!that!Texas!Trucking!(TT)!has!earnings!per!share!of!$3.45!and!EBITDA!of!$45!million.!!TT!also!has!5!million!shares!
outstanding!and!debt!o!$150!million!(net!of!cash).!!You!believe!that!Oklahoma!Logistics!and!Transport!(OLT)!is!comparable!
to!TT!in!terms!of!its!underlying!business,!but!OLT!has!no!debt.!!OLT!has!a!P/E!of!12.5!and!an!enterprise!value!to!EBITDA!
multiple!of!7.!
!
10)!!Based!upon!the!price!earnings!multiple,!the!value!of!a!share!of!Texas!Trucking!is!closest!to:!
A)!!$49.30!
B)!!$43.10!
C)!!$24.15!
D)!!$27.60!
Answer:!!!B!
B)!!Price!=!forward!earnings!×!P'/!E!=!3.45!×!12.5!=!43.12!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!Based!upon!the!enterprise!value!to!EBITDA!ratio,!the!value!of!a!share!of!Texas!Trucking!is!closest!to:!
A)!!$33.00!
B)!!$82.50!
C)!!$43.10!
D)!!$21.25!
Answer:!!!A!
Explanation:!!! A)!!Enterprise!value!=!EBITDA!×!multiple!=!$45!×!7!=!$315!-!$150!debt!=!$165!equity!value!/!5!
million!shares!=!$33.00!per!share!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!What!are!some!common!multiples!used!to!value!stocks?!
Answer:!!!Price!to!Earnings
Enterprise!value!to!sales
Enterprise!value!to!free!cash!flow
Enterprise!value!to!EBITDA
Enterprise!value!to!EBIT
Price!to!book!value!per!share!
Diff:!2!
Skill:!Conceptual!
!
13)!!What!are!some!implicit!assumptions!that!are!made!when!valuing!a!firm!using!multiples!based!on!comparable!
firms?!
Answer:!!!Comparable!firms!have!similar!future!prospects.
No!fundamental!differences!between!firms.
Same!growth!rates.
Same!costs!of!capital.
Industry!is!correctly!valued.!
Diff:!2!
Skill:!Conceptual!
!
9.5!Information,!Competition,!and!Stock!Prices!
1)!!Which!of!the!following!is!not!a!situation!where!a!trader!is!able!to!identify!positive!NPV!trading!opportunities!
in!the!securities!markets?!
A)!!An!investor!who!has!access!to!information!known!only!to!a!few!investors.!
B)!!An!investor!who!has!lower!trading!costs!than!other!market!participants.!
C)!!An!investor!who!gets!up!really!early!in!the!morning!so!he!can!be!the!first!to!read!and!act!upon!the!
information!contained!in!that!days!Wall!Street!Journal.!
D)!!An!investor!who!has!expertise!!in!a!highly!complicated!area!for!which!a!company!has!just!released!
information.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!9.5!Information,!Competition,!and!Stock!Prices!
Skill:!Conceptual!
!
A)!!Many!managers!make!the!mistake!of!focusing!on!accounting!earnings!as!opposed!to!free!cash!flows.!
B)!!Given!accurate!information!about!any!two!of!these!variables!(a!firm’s!future!cash!flows,!its!cost!of!capital,!
and!its!share!price)!a!valuation!model!allows!use!to!make!inferences!about!the!third!variable.!
C)!!A!valuation!model!will!tell!us!the!most!about!the!variable!for!which!our!prior!information!is!the!least!
reliable.!
D)!!The!idea!that!investors!are!able!to!identify!positive!NPV!trading!opportunities!is!referred!to!as!the!
efficient!markets!hypothesis.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Stock!markets!aggregate!the!information!and!view!of!many!different!investors.!
B)!!Only!in!the!relatively!rare!case!in!which!we!have!some!superior!information!that!other!investors!lack!
regarding!the!firm^s!cash!flows!and!cost!of!capital!would!it!make!sense!to!second-guess!the!market!stock!
price.!
C)!!In!most!situations,!a!valuation!model!is!best!applied!to!tell!us!something!about!the!value!of!the!firm^s!
stock.!
D)!!The!efficient!market!hypothesis!implies!that!securities!will!be!fairly!priced,!based!on!their!future!cash!
flows,!given!all!information!that!is!available!to!investors.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!If!the!profit!opportunities!from!having!private!information!are!large,!other!individuals!will!attempt!to!
gain!the!expertise!and!devote!the!resources!needed!to!acquire!it.!
B)!!When!private!information!is!relegated!to!the!hands!of!a!relatively!small!number!of!investors,!these!
investors!may!be!able!to!profit!by!trading!on!their!information.!
C)!!When!a!buyer!seeks!to!buy!a!stock,!the!willingness!of!other!parties!to!sell!the!same!stock!suggests!that!
they!value!the!stock!differently.!
D)!!Since!stock!markets!aggregate!the!information!and!view!of!many!different!investors,!we!expect!the!stock!
price!to!react!slowly!to!new!publicly!available!information!as!the!investors!continue!to!trade!until!a!
consensus!is!reached!as!to!the!new!value!of!the!stock.!
Answer:!!!D!
B)!!
C)!!
D)!!Since!stock!markets!aggregate!the!information!and!view!of!many!different!investors,!we!
expect!the!stock!price!to!react!quickly!to!new!publicly!available!information!as!the!investors!
continue!to!trade!until!a!consensus!is!reached!as!to!the!new!value!of!the!stock.!
Diff:!2!
Skill:!Conceptual!
!
5)!!Because!of!a!catastrophic!plane!crash,!the!FAA!announced!that!it!is!withdrawing!its!air!worthiness!
certification!for!Fly!by!Night!Aviation^s!(FBNA)!new!four!seat!private!plane.!!As!a!result!FBNA’s!future!
expected!free!cash!flows!will!decline!by!$40!million!a!year!for!the!next!eight!years.!!FBNA!has!20!million!
shares!outstanding,!no!debt,!and!an!equity!cost!of!capital!of!12%!!If!this!news!is!a!complete!surprise!to!
investors,!then!the!amount!that!FBNA’s!stock!price!should!fall!upon!the!announcement!is!closest!to:!
A)!!$2.00!
B)!!$16.00!
C)!!$16.70!
D)!!$9.90!
Answer:!!!D!
B)!!
C)!!
D)!!FV!=!0
PMT!=!40
I!=!12
N!=!8
Compute!PV!=!198.71!/!20!shares!=!$9.94!
Diff:!2!
Skill:!Analytical!
!
!
In!a!surprise!announcement,!NASA!released!details!of!a!major!contract!with!Lockheed-Martin!(LMT)!that!would!increase!
LMT^s!market!value!by!$7.5!billion.!!It!was!widely!expected!by!the!market!that!this!contract!would!be!awarded!to!LMT^s!
major!competitor!Boeing!(BA).!!Assume!that!Boeing!has!800!million!shares!outstanding!and!Lockheed!Martin!has!!425!
million!shares!outstanding.!!Prior!to!this!announcement,!the!market!felt!that!the!probability!of!Boeing!winning!the!contract!
was!90%!and!that!Lockheed-Martin^s!chance!was!only!about!10%.!
!
6)!!What!do!you!anticipate!will!happen!to!Lockheed-Martin!and!Boeings^!stock!prices!are!a!result!of!this!surprise!
announcement?!
Answer:!!!Lockheed-Martin
Price!increase!=!$7500!million!×!.90!(probability!not!already!incorporated!in!price)!=!6750!/!425!shares!=!
15.88!increase
Boeing
Price!decrease!=!$7500!million!×!.90!(probability!already!incorporated!in!price)!=!6750!/!800!shares!=!8.44!
decrease!
Diff:!3!
Skill:!Analytical!
!
7)!!What!are!the!implications!of!the!efficient!market!hypothesis!for!corporate!managers?!
Answer:!!!A!manager!seeking!to!boost!the!price!of!her!firm^s!stock!should!make!investments!that!increase!the!
present!value!of!the!firm’s!free!cash!flows.
Many!managers!make!the!mistake!of!focusing!on!accounting!earnings!as!opposed!to!free!cash!flows.
With!efficient!markets,!the!accounting!consequences!of!a!decision!do!not!directly!affect!the!value!of!the!
firm!and!should!not!drive!decision!making.
With!efficient!markets,!the!firm!can!sell!its!shares!at!a!fair!price!to!new!investors.!!Thus,!the!firm!should!
not!be!constrained!from!raising!capital!to!fund!positive!NPV!investment!opportunities.!
Diff:!3!
Skill:!Conceptual!
!
Chapter!10!-!Capital!Markets!and!the!Pricing!of!Risk!
!
!
10.1!A!First!Look!at!Risk!and!Return!
1)!!Which!of!the!following!investments!offered!the!lowest!overall!return!over!the!past!eighty!years?!
A)!!Small!Stocks!
B)!!Treasury!Bills!
C)!!S&P!500!
D)!!Corporate!Bonds!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!10.1!A!First!Look!at!Risk!and!Return!
Skill:!Definition!
!
2)!!Which!of!the!following!investments!offered!the!highest!overall!return!over!the!past!eighty!years?!
A)!!Treasury!Bills!
B)!!S&P!500!
C)!!Small!stocks!
D)!!Corporate!Bonds!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!Which!of!the!following!investments!had!the!largest!fluctuations!overall!return!over!the!past!eighty!years?!
A)!!Small!stocks!
B)!!S&P!500!
C)!!Corporate!Bonds!
D)!!Treasury!Bills!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
10.2!Common!Measures!of!Risk!and!Return!
A)!!The!variance!increases!with!the!magnitude!of!the!deviations!from!the!mean.!
B)!!The!variance!is!the!expected!squared!deviation!from!the!mean.!
C)!!Two!common!measures!of!the!risk!of!a!probability!distribution!are!its!variance!and!standard!deviation.!!!
D)!!If!the!return!is!riskless!and!never!deviates!from!its!mean,!the!variance!is!equal!to!one.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!return!is!riskless!and!never!deviates!from!its!mean,!the!variance!is!equal!to!zero.!
Diff:!1!
Topic:!10.2!Common!Measures!of!Risk!and!Return!
Skill:!Conceptual!
!
A)!!When!an!investment!is!risky,!there!are!different!returns!it!may!earn.!
B)!!In!finance,!the!variance!of!a!return!is!also!referred!to!as!its!volatility.!
C)!!The!expected!or!mean!return!is!calculated!as!a!weighted!average!of!the!possible!returns,!where!the!
weights!correspond!to!the!probabilities.!
D)!!The!variance!is!a!measure!of!how!Tspread!outT!the!distribution!of!the!return!is.!
Answer:!!!B!
B)!!In!finance,!the!standard!deviation!of!a!return!is!also!referred!to!as!its!volatility.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!standard!deviation!is!the!square!root!of!the!variance.!
B)!!Because!investors!dislike!only!negative!resolutions!of!uncertainty,!alternative!measures!that!focus!solely!
on!downside!risk!have!been!developed,!such!as!the!semi-variance!and!the!expected!tail!loss.!
C)!!While!the!variance!and!the!standard!deviation!are!the!most!common!measures!of!risk,!they!do!not!
differentiate!between!upside!and!downside!risk.!
D)!!While!the!variance!and!the!standard!deviation!both!measure!the!variability!of!the!returns,!the!variance!is!
easier!to!interpret!because!it!is!in!the!same!units!as!the!returns!themselves.!
Answer:!!!D!
B)!!
C)!!
D)!!While!the!variance!and!the!standard!deviation!both!measure!the!variability!of!the!returns,!the!
standard!deviation!is!easier!to!interpret!because!it!is!in!the!same!units!as!the!returns!
themselves.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Var(R)%= SD( R)
B)!!SD(R)!= ( R E R )2
R PR
C)!!Var(R)!=!!
R PR ( R E R )2
D)!!E[R]!=!% R PR R
Answer:!!!A!
Explanation:!!! A)!!SD(R)%=% Var ( R )
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Use%the%table%for%the%question(s)%below.!
!
Consider!the!following!probability!distribution!of!returns!for!Alpha!Corporation:!
Current!Stock! Stock!Price!in! Probability!

Price!($) One!Year!($) Return!R PR(
$35! 40% 25%!
$25! $25! 0% 50%!
$20! -20% 25%!
5)!!The!expected!return!for!Alpha!Corporation!is!closest!to:!
A)!!6.67%!
B)!!5.00%!
C)!!10%!
D)!!0.00%!
Answer:!!!B!
B)!!E[R]!=! R PR R %=!.25(40%)!+!.50(0%)!+!.25(-20%)!=!5%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!The!variance!of!the!return!on!Alpha!Corporation!is!closest!to:!
A)!!5.00%!
B)!!4.75%!
C)!!3.625%!
D)!!3.75%!
Answer:!!!B!
B)!!E[R]!=! R PR R %=!.25(40%)!+!.50(0%)!+!.25(-20%)!=!5%
Var(R)!=!! R PR ( R E R ) 2 =!.25(.40!-!.05)2!+!.50(.00!-!.05)2!+!.25(-20!-!.05)2!=!.0475!or!4.75%!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!The!standard!deviation!of!the!return!on!Alpha!Corporation!is!closest!to:!
A)!!22.4%!
B)!!19.0%!
C)!!21.8%!
D)!!19.4%!
Answer:!!!C!
B)!!
C)!!E[R]!=! R PR R %=!.25(40%)!+!.50(0%)!+!.25(-20%)!=!5%
Var(R)!=% R PR ( R E R ) 2 !=!.25(.40!-!.05)2!+!.50(.00!-!.05)2!+!.25(-20!-!.05)2!=!.0475!or!4.75%!
SD(R)!=! Var ( R) !=!! .0475 =!.2179!or!21.79%!

D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!Suppose!an!investment!is!equally!likely!to!have!a!35%!return!or!a!-!20%!return.!!The!expected!return!for!this!
investment!is!closest!to:!
A)!!7.5%!
B)!!15%!
C)!!5%!
D)!!10%!
Answer:!!!A!
Explanation:!!! A)!!E[R]!= R PR R !=!.50(35%)!+!.50(-20%)!=!7.5%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!Suppose!an!investment!is!equally!likely!to!have!a!35%!return!or!a!-!20%!return.!!The!variance!on!the!return!for!
this!investment!is!closest!to:!
A)!!.151!
B)!!.0378!
C)!!0!
D)!!.075!
Answer:!!!D!
B)!!
C)!!
D)!!E[R]!= R PR R !=!.50(35%)!+!.50(-20%)!=!7.5%
Var(R)!=! R PR ( R E R ) 2 !=!.50(.35!-!.075)2!+!.50(-.20!-!.075)2!!=!.07563!
Diff:!2!
Skill:!Analytical!
!
10)!!Suppose!an!investment!is!equally!likely!to!have!a!35%!return!or!a!-20%!return.!!The!standard!deviation!on!the!
return!for!this!investment!is!closest!to:!
A)!!38.9%!
B)!!0%!
C)!!19.4%!
D)!!27.5%!
Answer:!!!D!
B)!!
C)!!
D)!!E[R]!=! R PR R !=!.50(35%)!+!.50(-20%)!=!7.5%
Var(R)!=! R PR ( R E R ) 2 !=!.50(.35!-!.075)2!+!.50(-.20!-!.075)2!!=!.07563
Sdev!=!.07563(1/2)!=!.2750!
Diff:!2!
Skill:!Analytical!
!
!
10.3!Historical!Returns!of!Stocks!and!Bonds!
A)!!The!expected!return!is!the!return!is!the!return!that!actually!occurs!over!a!particular!time!period.!
B)!!If!you!hold!the!stock!beyond!the!date!of!the!first!dividend,!then!to!compute!you!return!you!must!specify!
how!you!invest!any!dividends!you!receive!in!the!interim.!!
C)!!The!average!annual!return!of!an!investment!during!some!historical!period!is!simply!the!average!of!the!
realized!returns!for!each!year.!
D)!!The!realized!return!is!the!total!return!we!earn!from!dividends!and!capital!gains,!expressed!as!a!
percentage!of!the!initial!stock!price.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!10.3!Historical!Returns!of!Stocks!and!Bonds!
Skill:!Definition!
!
A)!!We!measure!the!degree!of!estimation!error!statistically!through!the!standard!error!of!the!estimate.!
B)!!When!focusing!on!the!returns!of!a!single!security,!its!common!practice!to!assume!that!all!dividends!are!
immediately!invested!at!the!risk-free!rate.!
C)!!We!estimate!the!standard!deviation!or!volatility!as!the!square!root!of!the!variance.!
D)!!We!estimate!the!variance!by!computing!the!average!squared!deviation!from!the!average!realized!return.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!standard!error!provides!an!indication!of!how!far!the!sample!average!might!deviate!from!the!
expected!return.!
B)!!The!95%!confidence!interval!for!the!expected!return!is!defined!as!the!Historical!Average!Return!plus!or!
minus!three!standard!errors.!
C)!!We!can!use!a!securityas!historical!average!return!to!estimate!its!actual!expected!return.!
D)!!The!standard!error!is!the!standard!deviation!of!the!average!return.!
Answer:!!!B!
B)!!The!95%!confidence!interval!for!the!expected!return!is!defined!as!the!Historical!Average!
Return!plus!or!minus!two!standard!errors.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!compounded!geometric!average!return!is!most!often!used!for!comparative!purposes.!
B)!!We!should!use!the!arithmetic!average!return!when!we!are!trying!to!estimate!an!investmentas!expected!
return!over!a!future!horizon!based!on!its!past!performance.!
C)!!The!geometric!average!return!will!always!be!above!the!arithmetic!average!return!and!the!difference!
grows!with!the!volatility!of!the!annual!returns.!
D)!!The!geometric!average!return!is!a!better!description!of!the!long-run!historical!performance!of!an!
investment.!
Answer:!!!C!
B)!!
C)!!The!geometric!average!return!will!always!be!below!the!arithmetic!average!return!and!the!
difference!grows!with!the!volatility!of!the!annual!returns.!
D)!!
Diff:!3!
Skill:!Conceptual!
!
5)!!If!a!stock!pays!dividends!at!the!end!of!each!quarter,!with!realized!returns!of!R1,!R2,!R3,!and!R4!each!quarter,!
then!the!annual!realized!return!is!calculated!as!
A)!!
Rannual!=!
B)!!Rannual!=!(1!+!R1)(1!+!R2)(1!+%R3)(1!+!R4)!
C)!!Rannual!=!(1!+!R1)(1!+!R2)(1!+%R3)(1!+!R4)!-!1!
D)!!Rannual!=!R1!+!R2!+!R3!+!R4!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
Use%the%table%for%the%question(s)%below.
!
Consider!the!following!Price!and!Dividend!data!for!Ford!Motor!Company:
Date Price!($) Dividend!($)!

December!31,!2004 $14.64
January!26,!2005 $13.35 $0.10!
April!28,!2005 $9.14 $0.10!
July!29,!2005 $10.74 $0.10!
October!28,!2005 $8.02 $0.10!
December!30,!2005 $7.72
!
6)!!Assume!that!you!purchased!Ford!Motor!Company!stock!at!the!closing!price!on!December!31,!2004!and!sold!it!
after!the!dividend!had!been!paid!at!the!closing!price!on!January!26,!2005.!!Your!dividend!yield!for!this!period!
is!closest!to:!
A)!!-8.15%!
B)!!0.75%!
C)!!0.70%!
D)!!-8.80%!
Answer:!!!C!
B)!!
C)!!=!div%/!P0!=!.10!/!14.64!!=!.0068!
D)!!
Diff:!2!
Skill:!Analytical!
!
after!the!dividend!had!been!paid!at!the!closing!price!on!January!26,!2005.!!Your!capital!gains!rate!(yield)!for!
this!period!is!closest!to:!
A)!!0.75%!
B)!!0.70%!
C)!!-8.80%!
D)!!-8.15%!
Answer:!!!C!
B)!!
C)!!=!(P1!-!P0)!/!P0!=!(13.35!-!14.64)!/!14.64!=!-.088115!
D)!!
Diff:!2!
Skill:!Analytical!
!
after!the!dividend!had!been!paid!at!the!closing!price!on!January!26,!2005.!!Your!total!return!rate!(yield)!for!this!
period!is!closest!to:!
A)!!0.75%!
B)!!-8.80%!
C)!!0.70%!
D)!!-8.15%!
Answer:!!!D!
B)!!
C)!!
D)!!=!(P1!+!D1!-%P0)!/!P0!=!(13.35!+!.10!-!14.64)!/!14.64!=!-.08128!
Diff:!2!
Skill:!Analytical!
!
at!the!closing!price!on!December!30,!2005.!!Your!realized!annual!return!is!!for!the!year!2005!is!closest!to:!
A)!!-45.1%!
B)!!-44.5%!
C)!!-48.5%!
D)!!-47.3%!
Answer:!!!A!
Explanation:!!! A)!!Date Price!($) Dividend!($) Return (1!+!return)
December!31,!2004 $14.64 1 1!
January!26,!2005 $13.35 $0.10 -8.13% 0.918716 0.918716!
April!28,!2005 $9.14 $0.10 -30.79% 0.692135 0.635875!
July!29,!2005 $10.74 $0.10 18.60% 1.185996 0.754145!
October!28,!2005 $8.02 $0.10 -24.39% 0.756052 0.570173!
December!30,!2005 $7.72 -3.74% 0.962594 0.548845!
The!Product!of!!
(1!+!returns)!-!1!= -0.45116!
The!last!column!in!the!table!contains!the!cummulative!product!of!(1!+!returns)!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Consider!the!following!realized!annual!returns:
S&P!500! IBM!
Realized! Realized!
Year!End Return Return!
1996 23.6% 46.3%!
1997 24.7% 26.7%!
1998 30.5% 86.9%!
1999 9.0% 23.1%!
2000 -2.0% 0.2%!
2001 -17.3% -3.2%!
2002 -24.3% -27.0%!
2003 32.2% 27.9%!
2004 4.4% -5.1%!
2005 7.4% -11.3%!
!
10)!!The!average!annual!return!on!the!S&P!500!from!1996!to!2005!is!closest!to:!
A)!!7.10%!
B)!!4.00%!
C)!!9.75%!
D)!!8.75%!
Answer:!!!D!
B)!!
C)!!
D)!! R R2 ... RN R R2 ... R10 0.878
Rannual!=! 1 !=! 1 !=! !=!8.82%!
N 10 10
Diff:!1!
Skill:!Analytical!
!
11)!!The!average!annual!return!on!IBM!from!1996!to!2005!is!closest!to:!
A)!!29.9%!
B)!!16.40%!
C)!!18.2%!
D)!!18.7%!
Answer:!!!B!
B)!! R R2 ... RN R R2 ... R10 1.638
Rannual!=! 1 !=! 1 !=! =!16.45%!
N 10 10
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
12)!!The!variance!of!the!returns!on!the!S&P!500!from!1996!to!2005!is!closest!to:!
A)!!.0450!
B)!!.3400!
C)!!.1935!
D)!!.0375!
Answer:!!!D!
B)!!
C)!!
D)!! R R2 ... RN R R2 ... R10 0.878
Rannual!= 1 !=! 1 !=! !=!8.8%!
N 10 10
S&P!500!
Realized!!
Year!End Return (R!-!R) (R!-!R)2!
1996 23.6% 14.78% 0.0218448!
1997 24.7% 15.88% 0.0252174!
1998 30.5% 21.68% 0.0470022!
1999 9.0% 0.18% 3.24E-06!
2000 -2.0% -10.82% 0.0117072!
2001 -17.3% -26.12% 0.0682254!
2002 -24.3% -33.12% 0.1096934!
2003 32.2% 23.38% 0.0546624!
2004 4.4% -4.42% 0.0019536!
2005 7.4% -1.42% 0.0002016!
Variance!=!SUM!of!(R!-!R)2!/!T!-!1!=!!0.3405116!/!9!=!0.0378346!
Diff:!2!
Skill:!Analytical!
!
13)!!The!variance!of!the!returns!on!IBM!from!1996!to!2005!is!closest!to:!
A)!!.3145!
B)!!.0990!
C)!!.1100!
D)!!.9890!
Answer:!!!C!
B)!!
C)!! R R2 ... RN 1.638
Rannual!=! 1 !=! !=!16.45%!
N 10
IBM!
Realized!
1996 46.3% 29.85% 0.0891023!
1997 26.7% 10.25% 0.0105063!
1998 86.9% 70.45% 0.4963203!
1999 23.1% 6.65% 0.0044223!
2000 0.2% -16.25% 0.0264063!
2001 -3.2% -19.65% 0.0386123!
2002 -27.0% -43.45% 0.1887903!
2003 27.9% 11.45% 0.0131103!
2004 -5.1% -21.55% 0.0464403!
2005 -11.3% -27.75% 0.0770063!
Variance!=!SUM!of!(R%-!R)2!/!T!-!1!=!!0.9907165!/!9!=!0.1100796!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!The!standard!deviation!of!the!returns!on!the!S&P!500!from!1996!to!2005!is!closest!to:!
A)!!19.5%!
B)!!20.5%!
C)!!3.8%!
D)!!8.8%!
Answer:!!!A!
Explanation:!!! A)!! R R2 ... RN R R2 ... R10 0.878
Rannual!=! 1 !=! 1 !=! !=!8.8%!
N 10 10
S&P!500!
Realized!!
1996 23.6% 14.78% 0.0218448!
1997 24.7% 15.88% 0.0252174!
1998 30.5% 21.68% 0.0470022!
1999 9.0% 0.18% 3.24E-06!
2000 -2.0% -10.82% 0.0117072!
2001 -17.3% -26.12% 0.0682254!
2002 -24.3% -33.12% 0.1096934!
2003 32.2% 23.38% 0.0546624!
2004 4.4% -4.42% 0.0019536!
2005 7.4% -1.42% 0.0002016!
Variance!=!SUM!of!(R!-!R)2!/!T!-!1!=!!0.3405116!/!9!=!0.0378346
Standard!deviation!=!! Variance !=! 0.0378346 =!0.1945112!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!The!standard!deviation!of!the!returns!on!IBM!from!1996!to!2005!is!closest!to:!
A)!!33.2%!
B)!!16.4%!
C)!!31.5%!
D)!!11.0%!
Answer:!!!A!
Explanation:!!! A)!! R R2 ... RN 1.638
Rannual!=! 1 !=! !!=!16.45%!
N 10
!
IBM!
Realized!
1996 46.3% 29.85% 0.0891023!
1997 26.7% 10.25% 0.0105063!
1998 86.9% 70.45% 0.4963203!
1999 23.1% 6.65% 0.0044223!
2000 0.2% -16.25% 0.0264063!
2001 -3.2% -19.65% 0.0386123!
2002 -27.0% -43.45% 0.1887903!
2003 27.9% 11.45% 0.0131103!
2004 -5.1% -21.55% 0.0464403!
2005 -11.3% -27.75% 0.0770063!
!
Variance!=!SUM!of(!R%-!R)2!/!T!-!1!=!!0.9907165!/!9!=!0.1100796
Standard!deviation!=! Variance !=!! 0.1100796 =!0.3317825!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
16)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!the!S&P!500!to!forecast!the!expected!
future!return!on!the!S&P!500.!!The!standard!error!of!your!estimate!of!the!expect!return!is!closest!to:!
A)!!19.4%!
B)!!3.8%!
C)!!8.8%!
D)!!1.95%!
Answer:!!!D!
B)!!
C)!!
D)!! R R2 ... RN R R2 ... R10 0.878
Rannual!=! 1 !=! 1 !=! !=!8.8%!
N 10 10
S&P!500!
Realized!!
1996 23.6% 14.78% 0.0218448!
1997 24.7% 15.88% 0.0252174!
1998 30.5% 21.68% 0.0470022!
1999 9.0% 0.18% 3.24E-06!
2000 -2.0% -10.82% 0.0117072!
2001 -17.3% -26.12% 0.0682254!
2002 -24.3% -33.12% 0.1096934!
2003 32.2% 23.38% 0.0546624!
2004 4.4% -4.42% 0.0019536!
2005 7.4% -1.42% 0.0002016!
Standard!deviation!=! Variance !=! 0.0378346 !=!0.1945112
Standard!error!=!Standard!Deviation!/!T!=!0.1945112!/!10!=!.01945!or!1.95%!
Diff:!3!
Skill:!Analytical!
!
17)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!IBM!to!forecast!the!expected!future!
return!on!IBM.!!The!standard!error!of!your!estimate!of!the!expect!return!is!closest!to:!
A)!!16.4%!
B)!!3.32%!
C)!!3.15%!
D)!!33.20%!
Answer:!!!B!
B)!! R R2 ... RN 1.638
Rannual!=! 1 !=! !=!16.45%!
N 10
IBM!
Realized!
1996 46.3% 29.85% 0.0891023!
1997 26.7% 10.25% 0.0105063!
1998 86.9% 70.45% 0.4963203!
1999 23.1% 6.65% 0.0044223!
2000 0.2% -16.25% 0.0264063!
2001 -3.2% -19.65% 0.0386123!
2002 -27.0% -43.45% 0.1887903!
2003 27.9% 11.45% 0.0131103!
2004 -5.1% -21.55% 0.0464403!
2005 -11.3% -27.75% 0.0770063!
!
Variance!=!SUM!of!(R%-!R)2!/!T!-!1!=!!0.9907165!/!9!=!0.1100796
Standard!error!=!Standard!Deviation!/!T!=!0.3317825!/!10!=!.03318!or!3.32%!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
18)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!the!S&P!500!to!forecast!the!expected!
future!return!on!the!S&P!500.!!The!95%!confidence!interval!for!your!estimate!of!the!expect!return!is!closest!to:!
A)!!-10.6%!to!28.2%!
B)!!6.8%!to!10.7%!
C)!!-37.0%!to!47.6%!
D)!!4.9%!to!12.7%!
Answer:!!!D!
B)!!
C)!!
D)!! R R2 ... RN 0.878
Rannual!=! 1 !=!! !=!8.8%
N 10
S&P!500!
Realized!!
1996 23.6% 14.78% 0.0218448!
1997 24.7% 15.88% 0.0252174!
1998 30.5% 21.68% 0.0470022!
1999 9.0% 0.18% 3.24E-06!
2000 -2.0% -10.82% 0.0117072!
2001 -17.3% -26.12% 0.0682254!
2002 -24.3% -33.12% 0.1096934!
2003 32.2% 23.38% 0.0546624!
2004 4.4% -4.42% 0.0019536!
2005 7.4% -1.42% 0.0002016!
Standard!error!=!Standard!Deviation!/!T!=!0.1945112!/!10!=!.01945!or!1.95%
95%!Confidence!Interval!=!mean!return!+!or!-!2!standard!errors,!so
lower!bound!=!.0878!-!2!×!.0195!=!0.0488
upper!bound!=!.0878!+!2!×!.0195!=!.1268!
Diff:!3!
Skill:!Analytical!
!
19)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!IBM!to!forecast!the!expected!future!
return!on!IBM.!!The!95%!confidence!interval!for!your!estimate!of!the!expect!return!is!closest!to:!
A)!!13.2%!to!19.5%!
B)!!10.1%!to!22.7%!
C)!!6.5%!to!26.3%!
D)!!-15.1%!to!47.8%!
Answer:!!!B!
B)!! R R2 ... RN 1.638
Rannual!=! 1 !=! !=!16.45%!
N 10
!
IBM!
Realized!
1996 46.3% 29.85% 0.0891023!
1997 26.7% 10.25% 0.0105063!
1998 86.9% 70.45% 0.4963203!
1999 23.1% 6.65% 0.0044223!
2000 0.2% -16.25% 0.0264063!
2001 -3.2% -19.65% 0.0386123!
2002 -27.0% -43.45% 0.1887903!
2003 27.9% 11.45% 0.0131103!
2004 -5.1% -21.55% 0.0464403!
2005 -11.3% -27.75% 0.0770063!
!
Variance!=!SUM!of!(R%-!R)2!/!T!-!1!=!!0.9907165!/!9!=!0.1100796
lower!bound!=!.1638!-!2!×!.0332=!.101
upper!bound!=!.1638!+!2!×!.0332!=!.227!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
20)!!The!geometric!average!annual!return!on!the!S&P!500!from!1996!to!2005!is!closest!to:!
A)!!9.75%!
B)!!8.75%!
C)!!7.10%!
D)!!8.35%!
Answer:!!!C!
B)!!
C)!!Geometric!Average!= T (1 R1 )(1 R2 )....(1 RT ) !-!1
=! 10
1.986857 !-!1!=!1.071067!-!1!=!0.071067!
D)!!
Diff:!3!
Skill:!Analytical!
!
21)!!The!geometric!average!annual!return!on!IBM!from!1996!to!2005!is!closest!to:!
A)!!12.4%!
B)!!16.7%!
C)!!13.2%!
D)!!17.8%!
Answer:!!!A!
Explanation:!!! A)!!Geometric!Average!=! T (1 R1 )(1 R2 )....(1 RT ) !-!1
=!! 10 3.232227 -!1!=!1.124476!-!1!=!0.124476!

B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Consider!the!following!Price!and!Dividend!data!for!General!Motors:
Date Price!($) Dividend!($)!

December!31,!2004 $40.06
February!9,!2005 $36.80 $0.50!
May!7,!2005 $30.41 $0.50!
August!10,!2005 $34.86 $0.50!
November!8,!2005 $25.86 $0.50!
December!30,!2005 $18.86
!
22)!!Assume!that!you!purchased!General!Motors!stock!at!the!closing!price!on!December!31,!2004!and!sold!it!at!the!
closing!price!on!December!30,!2005.!!Calculate!your!realized!annual!return!is!!for!the!year!2005.!
!
Answer:!!!Date Price!($) Dividend!($) Return (1!+!return)
December!31,!2004 $40.06 0.00% 1 1!
January!26,!2005 $36.80 $0.50 -6.89% 0.931103 0.931103!
April!28,!2005 $30.41 $0.50 -16.01% 0.839946 0.782076!
July!29,!2005 $34.86 $0.50 16.28% 1.162775 0.909379!
October!28,!2005 $25.86 $0.50 -24.38% 0.756168 0.687643!
December!30,!2005 $18.86 -27.07% 0.729312 0.501506!
The!Product!of!(1!+!returns)!-!1!=!!-0.49849
The!last!column!in!the!table!contains!the!cummulative!product!of!(1!+!returns)!
Diff:!3!
Skill:!Analytical!
!
Consider!the!following!realized!annual!returns:
!
Market! Microsoft!
Realized! Realized!
Year!End Return Return!
1996 21.2% 88.3%!
1997 30.3% 56.4%!
1998 22.3% 114.6%!
1999 25.3% 68.4%!
2000 -11.0% -62.8%!
2001 -11.3% 52.7%!
2002 -20.8% -22.0%!
2003 33.1% 6.9%!
2004 13.0% 9.2%!
2005 7.3% -0.9%!
!
23)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!the!Market!to!forecast!the!expected!
future!return!on!the!S&P!500.!!Calculate!the!95%!confidence!interval!for!your!estimate!of!the!expect!return.!
Answer:!!! R R2 ... RN 1.093
Rannual!=! 1 =! !=!10.93%
N 10
Market!
Realized!
1996 21.2% 10.23% 0.0104625!
1997 30.3% 19.40% 0.03763!
1998 22.3% 11.35% 0.0128899!
1999 25.3% 14.32% 0.0205182!
2000 -11.0% -21.98% 0.0483043!
2001 -11.3% -22.20% 0.0492984!
2002 -20.8% -31.78% 0.1009717!
2003 33.1% 22.21% 0.0493349!
2004 13.0% 2.07% 0.0004274!
2005 7.3% -3.63% 0.0013148!
Standard!deviation!=! Variance !=!! 0.0367947 !=!0.1918194
Standard!error!=!Standard!Deviation!/!T!=!!0.1918194!/!10!=!.01918!or!1.92%
lower!bound!=!.1093!-!2!×!.0192!=!.0709!or!!!7.09%
upper!bound!=!.1093!+!2!×!.0192!=!.1477!or!14.77%!
Diff:!3!
Skill:!Analytical!
!
24)!!Suppose!that!you!want!to!use!the!10!year!historical!average!return!on!Microsoft!to!forecast!the!expected!future!
return!on!Microsoft.!!Calculate!the!95%!confidence!interval!for!your!estimate!of!the!expect!return.!
Answer:!!! R R2 ... RN 3.11
Rannual!=! 1 !=!! !=!31.1%!
N 10
Microsoft!
Realized!
1996 88.3% 57.24% 0.3276925!
1997 56.4% 25.36% 0.0642878!
1998 114.6% 83.53% 0.6977065!
1999 68.4% 37.29% 0.1390502!
2000 -62.8% -93.92% 0.8821468!
2001 52.7% 21.66% 0.0469291!
2002 -22.0% -53.04% 0.281292!
2003 6.9% -24.19% 0.058501!
2004 9.2% -21.92% 0.0480275!
2005 -0.9% -32.02% 0.1025221!
!
lower!bound!=!.311!-!2!×!.0542!=!.2026!or!20.26%
upper!bound!=!.311!+!2!×!.0542!=!.4194!or!41.94%!!
Diff:!3!
Skill:!Analytical!
!
25)!!Using!the!data!provided!in!the!table,!calculate!the!average!annual!return,!the!variance!of!the!annual!returns,!
and!the!standard!deviation!of!the!average!returns!for!the!market!from!1996!to!2005.!
Answer:!!! R R2 ... RN 1.093
Rannual!=! 1 !=! !=!10.93%!
N 10
Market!
Realized!
1996 21.2% 10.23% 0.0104625!
1997 30.3% 19.40% 0.03763!
1998 22.3% 11.35% 0.0128899!
1999 25.3% 14.32% 0.0205182!
2000 -11.0% -21.98% 0.0483043!
2001 -11.3% -22.20% 0.0492984!
2002 -20.8% -31.78% 0.1009717!
2003 33.1% 22.21% 0.0493349!
2004 13.0% 2.07% 0.0004274!
2005 7.3% -3.63% 0.0013148!
Standard!deviation!=! Variance !=! 0.0367947 !=!0.1918194!
Diff:!2!
Skill:!Analytical!
!
26)!!Using!the!data!provided!in!the!table,!calculate!the!average!annual!return,!the!variance!of!the!annual!returns,!
and!the!standard!deviation!of!the!average!returns!for!Microsoft!from!1996!to!2005.!
Answer:!!! R R2 ... RN 3.11
Rannual!=! 1 !=!! !=!31.1%
N 10
Microsoft!
Realized!
1996 88.3% 57.24% 0.3276925!
1997 56.4% 25.36% 0.0642878!
1998 114.6% 83.53% 0.6977065!
1999 68.4% 37.29% 0.1390502!
2000 -62.8% -93.92% 0.8821468!
2001 52.7% 21.66% 0.0469291!
2002 -22.0% -53.04% 0.281292!
2003 6.9% -24.19% 0.058501!
2004 9.2% -21.92% 0.0480275!
2005 -0.9% -32.02% 0.1025221!
Variance!=!SUM!of!(R!-!R)2!/!T!-1!=!!2.6481554!/!9!=!0.2942395
Standard!deviation!=! Variance !=!!! 0.2942395 !=!0.5424385!
Diff:!2!
Skill:!Analytical!
!
10.4!The!Historical!Tradeoff!Between!Risk!and!Return!
1)!!The!excess!return!if!the!difference!between!the!average!return!on!a!security!and!the!average!return!for!
A)!!Treasury!Bonds.!
B)!!a!portfolio!of!securities!with!similar!risk.!
C)!!a!broad!based!market!portfolio!like!the!S&P!500!index.!
D)!!Treasury!Bills.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!10.4!The!Historical!Tradeoff!Between!Risk!and!Return!
Skill:!Definition!
!
A)!!Expected!return!should!rise!proportionately!with!volatility.!
B)!!Investors!would!not!choose!to!hold!a!portfolio!that!is!more!volatile!unless!they!expected!to!earn!a!higher!
return.!
C)!!Smaller!stocks!have!lower!volatility!than!larger!stocks.!
D)!!The!largest!stocks!are!typically!more!volatile!than!a!portfolio!of!large!stocks.!
Answer:!!!C!
B)!!
C)!!Smaller!stocks!have!higher!volatility!than!larger!stocks.!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Investments!with!higher!volatility!have!rewarded!investors!with!higher!average!returns.!
B)!!Investments!with!higher!volatility!should!have!a!higher!risk!premium!and!therefore!higher!returns.!
C)!!Volatility!seems!to!be!a!reasonable!measure!of!risk!when!evaluating!returns!on!large!portfolios!and!the!
returns!of!individual!securities.!
D)!!Riskier!investments!must!offer!investors!higher!average!returns!to!compensate!them!for!the!extra!risk!
they!are!taking!on.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
Consider!the!following!average!annual!returns:
Investment Average!Return!
Small!Stocks 23.2%!
S&P!500 13.2%!
Corporate!Bonds 7.5%!
Treasury!Bonds 6.2%!
Treasury!Bills 4.8%!
!
4)!!What!is!the!excess!return!for!the!portfolio!of!small!stocks?!
A)!!10.0%!
B)!!15.7%!
C)!!18.4%!
D)!!17.0%!
Answer:!!!C!
B)!!
C)!! Average!Return!-!Tbill!
Investment Average!Return Return!
Small!Stocks 23.2% 18.40%!
S&P!500 13.2% 8.40%!
Corporate!Bonds 7.5% 2.70%!
Treasury!Bonds 6.2% 1.40%!
Treasury!Bills 4.8% 0.0%!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!What!is!the!excess!return!for!the!S&P!500?!
A)!!5.7%!
B)!!7.0%!
C)!!0%!
D)!!8.4%!
Answer:!!!D!
B)!!
C)!!
D)!! Average!Return!-!Tbill!
S&P!500 13.2% 8.40%!
Treasury!Bills 4.8%
Diff:!1!
Skill:!Analytical!
!
6)!!What!is!the!excess!return!for!Corporate!Bonds?!
A)!!2.7%!
B)!!1.3%!
C)!!-5.7%!
D)!!0%!
Answer:!!!A!
Explanation:!!! A)!! Average!Return!-!Tbill!
S&P!500 13.2% 8.40%!
Treasury!Bills 4.8%
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!What!is!the!excess!return!for!Treasury!Bills?!
A)!!0%!
B)!!-8.4%!
C)!!-2.7%!
D)!!-1.4%!
Answer:!!!A!
Explanation:!!! A)!! Average!Return!-!Tbill!
S&P!500 13.2% 8.40%!
Treasury!Bills 4.8% 0.00%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!Do!expected!returns!for!individual!stocks!increase!proportionately!with!volatility?!
Answer:!!!No,!although!there!is!a!proportional!relationship!with!large!portfolios!of!stocks,!this!relationship!
doesnat!hold!for!individual!securities.!
Diff:!1!
Skill:!Conceptual!
10.5!Common!Versus!Independent!Risk!
1)!!Common!risk!is!also!called!
A)!!diversifiable!risk.!
B)!!correlated!risk.!
C)!!uncorrelated!risk.!
D)!!independent!risk.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!10.5!Common!Versus!Independent!Risk!
Skill:!Definition!
!
Use%the%information%for%the%question(s)%below.!
!
Big!Cure!and!Little!Cure!are!both!pharmaceutical!companies.!!Big!Cure!presently!has!a!potential!TblockbusterT!drug!before!
the!Food!and!Drug!Administration!(FDA)!waiting!for!approval.!!If!approved,!Big!Cureas!blockbuster!drug!will!produce!$1!
billion!in!net!income!for!Big!Cure.!!Little!Cure!has!10!separate!less!important!drugs!before!the!FDA!waiting!for!approval.!!If!
approved,!each!of!Little!Cureas!drugs!would!produce!$100!million!in!net!income!for!Little!Cure.!!The!probability!of!the!
FDA!approving!a!drug!is!50%.
2)!!What!is!the!expected!payoff!for!Big!Cureas!Blockbuster!drug?!
A)!!$100!million!
B)!!$0!
C)!!$1!billion!
D)!!$500!million!
Answer:!!!D!
B)!!
C)!!
D)!!expected!payoff!=!prob!of!payoff!×!amount!if!successful
=!.5!×!$1!billion!=!$500!million!
Diff:!1!
Skill:!Analytical!
!
3)!!What!is!the!expected!payoff!for!Little!Cureas!ten!drugs?!
A)!!$500!million!
B)!!$100!million!
C)!!$1!billion!
D)!!$0!
Answer:!!!A!
Explanation:!!! A)!!expected!payoff!=!prob!of!payoff!×!amount!if!successful
=!.5!×!$100!=!$50!million!for!each!drug!
$50!million!×!10!drugs!=!$500!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!What!is!the!standard!deviation!of!Big!Cureas!average!net!income!for!their!new!blockbuster!drug?!
A)!!$0!
B)!!$1!billion!
C)!!$100!million!
D)!!$500!million!
Answer:!!!D!
B)!!
C)!!
D)!!expected!payoff!=!prob!of!payoff!×!amount!if!successful
=!.5!×!$1!billion!=!$500!million
Standard!deviation!=! !=!500!million!
Diff:!2!
Skill:!Analytical!
!
5)!!The!standard!deviation!of!Little!Cureas!average!net!income!for!their!ten!new!drugs!is!closest!to:!
A)!!$50!million!
B)!!$25!million!
C)!!$16!million!
D)!!$500!million!
Answer:!!!C!
B)!!
C)!!expected!payoff!=!prob!of!payoff!×!amount!if!successful
Standard!deviation!for!one!drug=! !=!50!million
Standard!deviation(all!drugs)!=!SD(one!drug)!/! number of drugs !=!50!/! 10 !=!15.81!million!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Which!pharmaceutical!company!faces!less!risk?!
Answer:!!!Little!Cure,!because!it!has!a!lower!standard!deviation!of!expected!net!income.
Big!Cure
expected!payoff!=!prob!of!payoff!x!!amount!if!successful
Standard!deviation!=! !=!500!million
Little!Cure
expected!payoff!=!prob!of!payoff!x!!amount!if!successful
Standard!deviation!for!one!drug=! !=!50!million
Standard!deviation(all!drugs)!=!SD(one!drug)!/! number of drugs !=!50!/!! 10 =!15.81!million!

Diff:!2!
Skill:!Analytical!
10.6!Diversification!in!Stock!Portfolios!
1)!!Which!of!the!following!is!not!a!diversifiable!risk?!
A)!!The!risk!that!oil!prices!rise,!increasing!production!costs!
B)!!The!risk!of!a!product!liability!lawsuit!
C)!!The!risk!that!the!CEO!is!killed!in!a!plane!crash!
D)!!The!risk!of!a!key!employee!being!hired!away!by!a!competitor!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!10.6!Diversification!in!Stock!Portfolios!
Skill:!Conceptual!
!
2)!!Which!of!the!following!is!not!a!systematic!risk?!
A)!!The!risk!that!oil!prices!rise,!increasing!production!costs!
B)!!The!risk!that!the!Federal!Reserve!raises!interest!rates!
C)!!The!risk!that!the!economy!slows,!reducing!demand!for!your!firmas!products!
D)!!The!risk!that!your!new!product!will!not!receive!regulatory!approval!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!of!the!following!types!of!risk!doesnat!belong?!
A)!!Market!risk!
B)!!Unique!risk!
C)!!Idiosyncratic!risk!
D)!!Unsystematic!risk!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
4)!!Which!of!the!following!types!of!risk!doesnat!belong?!
A)!!Idiosyncratic!risk!
B)!!Undiversifiable!risk!
C)!!Market!risk!
D)!!Systematic!risk!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!Firm!specific!new!is!good!or!bad!news!about!the!company!itself.!
B)!!Firms!are!affected!by!both!systematic!and!firm-specific!risk.!
C)!!When!firms!carry!both!types!of!risk,!only!the!firm-specific!risk!will!be!diversified!when!we!combine!
many!firmsa!stocks!into!a!portfolio.!
D)!!The!risk!premium!for!a!stock!is!affected!by!its!idiosyncratic!risk.!
Answer:!!!D!
B)!!
C)!!
D)!!The!risk!premium!for!a!stock!is!affected!by!its!systematic!risk.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!investors!are!risk!averse,!they!will!demand!a!risk!premium!to!hold!unsystematic!risk.!
B)!!Over!any!given!period,!the!risk!of!holding!a!stock!is!that!the!dividends!plus!the!final!stock!price!will!be!
higher!or!lower!than!expected,!which!makes!the!realized!return!risky.!
C)!!The!risk!premium!for!diversifiable!risk!is!zero,!so!investors!are!not!compensated!for!holding!
firm-specific!risk.!
D)!!Because!investors!can!eliminate!firm-specific!risk!Tfor!freeT!by!diversifying!their!portfolios,!they!will!not!
require!a!reward!or!risk!premium!for!holding!it.!
Answer:!!!A!
Explanation:!!! A)!!Because!investors!are!risk!averse,!they!will!demand!a!risk!premium!to!hold!systematic!risk.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Fluctuations!of!a!stockas!returns!that!are!due!to!firm-specific!news!are!common!risks.!
B)!!The!volatility!in!a!large!portfolio!will!decline!until!only!the!systematic!risk!remains.!
C)!!When!we!combine!many!stocks!in!a!large!portfolio,!the!firm-specific!risks!for!each!stock!will!average!out!
and!be!diversified.!
D)!!The!risk!premium!of!a!security!is!determined!by!its!systematic!risk!and!does!not!depend!on!its!
diversifiable!risk.!
Answer:!!!A!
Explanation:!!! A)!!Fluctuations!of!a!stockas!returns!that!are!due!to!firm-specific!news!are!not!common!risks.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Consider!an!economy!with!two!types!of!firms,!S!and!I.!!S!firms!always!move!together,!but!I!firms!move!independently!of!
each!other.!!For!both!types!of!firms!there!is!a!70%!probability!that!the!firm!will!have!a!20%!return!and!a!30%!probability!
that!the!firm!will!have!a!-30%!return.
8)!!What!is!the!expected!return!for!an!individual!firm?!
A)!!14%!
B)!!3%!
C)!!5%!
D)!!-5%!
Answer:!!!C!
B)!!
C)!!expected!return!=!.7(20%)!+!.3(-30%)!=!5%!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!standard!deviation!for!the!return!on!an!individual!firm!is!closest!to:!
A)!!23.0%!
B)!!5.25%!
C)!!15.0%!
D)!!10.0%!
Answer:!!!A!
Explanation:!!! A)!!expected!return!=!.7(20%)!+!.3(-30%)!=!5%
standard!deviation!=! !=!.2291!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!The!standard!deviation!for!the!return!on!an!portfolio!of!20!type!S!firms!is!closest!to:!
A)!!5.10%!
B)!!23.0%!
C)!!15.0%!
D)!!5.25%!
Answer:!!!B!
B)!!expected!return!=!.7(20%)!+!.3(-30%)!=!5%
standard!deviation!=! !=!.2291
Since!all!these!firms!move!the!same,!there!is!no!adjustment!to!the!standard!deviation.!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!The!standard!deviation!for!the!return!on!an!portfolio!of!20!type!I!firms!is!closest!to:!
A)!!5.25%!
B)!!5.10%!
C)!!15.0%!
D)!!23.0%!
Answer:!!!B!
B)!!expected!return!=!.7(20%)!+!.3(-30%)!=!5%
standard!deviation!=! !=!.2291
Since!all!these!firms!move!independently!stdev!=!stdev(single!firm)/ number of obs !=!.2291!/!
20 !=!.0512!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10.7!Estimating!the!Expected!Return!
A)!!In!exchange!for!bearing!systematic!risk,!investors!want!to!be!compensated!by!earning!a!higher!return.!
B)!!A!key!step!to!measuring!systematic!risk!is!finding!a!portfolio!that!contains!only!unsystematic!risk.!
C)!!When!evaluating!the!risk!of!an!investment,!an!investor!will!care!about!its!systematic!risk,!which!cannot!
be!eliminated!through!diversification.!
D)!!To!measure!the!systematic!risk!of!a!stock,!we!must!determine!how!much!of!the!variability!of!its!return!is!
due!to!systematic,!market-wide!risks!versus!diversifiable,!firm!specific!risks.!
Answer:!!!B!
B)!!A!key!step!to!measuring!systematic!risk!is!finding!a!portfolio!that!contains!only!systematic!
risk!(the!market!portfolio).!
C)!!
D)!!
Diff:!1!
Topic:!10.7!Estimating!the!Expected!Return!
Skill:!Conceptual!
!
A)!!The!portfolio!that!contains!all!shares!of!all!stocks!and!securities!in!the!market!is!called!the!efficient!
portfolio.!
B)!!The!market!portfolio!is!an!efficient!portfolio.!
C)!!We!can!measure!the!systematic!risk!of!a!securityas!return!by!its!beta.!
D)!!Because!it!is!difficult!to!find!data!for!the!returns!of!many!bonds!and!small!stocks,!it!is!common!practice!
to!use!the!S&P!500!portfolio!as!a!proxy!for!the!market!portfolio,!under!the!assumption!that!the!S&P!500!
is!large!enough!to!be!essentially!fully!diversified.!
Answer:!!!A!
Explanation:!!! A)!!The!portfolio!that!contains!all!shares!of!all!stocks!and!securities!in!the!market!is!called!the!
market!portfolio.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Beta!differs!from!volatility.!
B)!!The!risk!premium!investors!can!earn!by!holding!the!market!portfolio!is!the!difference!between!the!
market!portfolioas!expected!return!and!the!risk-free!interest!rate.!
C)!!Stocks!in!cyclical!industries,!in!which!revenues!tend!to!vary!greatly!over!the!business!cycle,!are!likely!to!
be!more!sensitive!to!systematic!risk!and!have!higher!betas!than!stocks!in!less!sensitive!industries.!
D)!!If!we!assume!that!the!market!portfolio!(or!the!S&P!500)!is!efficient,!then!changes!in!the!value!of!the!
market!portfolio!represent!unsystematic!shocks!to!the!economy.!
Answer:!!!D!
B)!!
C)!!
D)!!If!we!assume!that!the!market!portfolio!(or!the!S&P!500)!is!efficient,!then!changes!in!the!value!
of!the!market!portfolio!represent!systematic!shocks!to!the!economy.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Beta!measures!the!sensitivity!of!a!security!to!market!wide!risk!factors.!
B)!!Volatility!measures!total!risk,!while!beta!measures!only!systematic!risk.!
C)!!The!beta!is!the!expected!percentage!change!in!the!excess!return!of!the!market!portfolio!for!a!1%!change!
in!the!excess!return!of!a!security.!
D)!!Utilities!tend!to!be!stable!and!highly!regulated,!and!thus!are!insensitive!to!fluctuations!in!the!overall!
market.!
Answer:!!!C!
B)!!
C)!!The!beta!is!the!expected!percentage!change!in!the!excess!return!of!a!security!for!a!1%!change!
in!the!excess!return!of!the!market!portfolio.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!diversification!improves!with!the!number!of!stocks!held!in!a!portfolio!an!efficient!portfolio!
should!be!a!large!portfolio!containing!many!different!stocks.!
B)!!The!beta!of!a!security!is!the!sensitivity!of!the!securityas!return!to!the!return!of!the!overall!market.!
C)!!An!efficient!portfolio!cannot!be!diversified!further,!that!is!there!is!no!way!to!reduce!the!risk!of!the!
portfolio!without!lowering!its!expected!return.!
D)!!We!call!a!portfolio!that!contains!only!unsystematic!risk!an!efficient!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!We!call!a!portfolio!that!contains!only!systematic!risk!an!efficient!portfolio.!
Diff:!2!
Skill:!Conceptual!
!
!
Suppose!the!market!portfolioas!excess!return!tends!to!increase!by!30%!when!the!economy!is!strong!and!decline!by!20%!
when!the!economy!is!weak.!!A!type!S!firm!has!excess!returns!increase!by!45%!when!the!economy!is!strong!and!decrease!by!
30%!when!the!economy!is!weak.!!A!type!I!firm!will!also!have!excess!returns!of!either!45%!or!-30%,!but!the!type!I!firmas!
excess!returns!will!depend!only!upon!firm-specific!events!and!will!be!completely!independent!of!the!state!of!the!economy.!
!
6)!!What!is!the!Beta!for!a!type!I!firm?!
A)!!1.0!
B)!!0.75!
C)!!0.0!
D)!!1.5!
Answer:!!!C!
B)!!
C)!!The!systematic!risk!of!the!strength!of!the!economy!produces!at!30%!-!-20%!=!50%!change!in!
return!for!the!market!portfolio.
The!type!I!firmas!return!is!independent!of!the!economy!as!a!whole!so!its!change!=!0%
Beta!=!0%!/!50%!=!0!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!What!is!the!Beta!for!a!type!S!firm?!
A)!!1.5!
B)!!0.0!
C)!!1.0!
D)!!0.75!
Answer:!!!A!
Explanation:!!! A)!!The!systematic!risk!of!the!strength!of!the!economy!produces!at!30%!-!-20%!=!50%!change!in!
return!for!the!market!portfolio.
The!type!S!firmas!return!changes!by!45%!-!-30%!=!75%,!so!Beta!=!75%!/!50%!=!1.5!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Suppose!that!Lutheras!Beta!is!0.9.!!If!the!market!risk!premium!is!8%!and!the!risk-free!interest!rate!is!4%,!then!
then!expected!return!for!Luther!stock!is?!
A)!!7.6%!
B)!!11.6%!
C)!!11.2%!
D)!!12.9%!
Answer:!!!C!
B)!!
C)!!E[R]!=%Rf!+!Beta!×!Risk!Premium!=!.04!+!.9!×!.08!=!.112!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!Suppose!that!KANas!Beta!is!1.5.!!If!the!market!risk!premium!is!8%!and!the!risk-free!interest!rate!is!4%,!then!
then!expected!return!for!KAN!stock!is?!
A)!!8.0%!
B)!!16.0%!
C)!!13.5%!
D)!!10.0%!
Answer:!!!B!
B)!!E[R]!=%Rf!+!Beta!×!Risk!Premium!=!.04!+!1.5!×!.08!=!.16!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!Suppose!that!Gold!Diggeras!Beta!is!-0.8.!!If!the!market!risk!premium!is!8%!and!the!risk-free!interest!rate!is!4%,!
then!then!expected!return!for!Gold!Diggeras!stock!is?!
A)!!-2.4%!
B)!!4.8%!
C)!!2.4%!
D)!!10.4%!
Answer:!!!A!
Explanation:!!! A)!!E[R]!=%Rf!+!Beta!×!Risk!Premium!=!.04!+!-0.8!×!.08!=!-0.024!!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!What!is!the!market!portfolio?!
Answer:!!!The!portfolio!that!contains!all!shares!of!all!stocks!and!securities!in!the!market!is!called!the!market!
portfolio.!
Diff:!1!
Skill:!Definition!
!
!
10.8!Risk!and!the!Cost!of!Capital!
A)!!The!Capital!Asset!Pricing!Model!is!the!most!important!method!for!estimating!the!cost!of!capital!that!is!
used!in!practice.!
B)!!Because!the!risk!that!determines!expected!returns!is!unsystematic!risk,!which!is!measured!by!beta,!the!
cost!of!capital!for!an!investment!is!the!expected!return!available!on!securities!with!the!same!beta.!
C)!!A!common!assumption!is!that!the!project!has!the!same!risk!as!the!firm.!
D)!!To!determine!a!projectas!cost!of!capital!we!need!to!estimate!its!beta.!
Answer:!!!B!
B)!!Because!the!risk!that!determines!expected!returns!is!systematic!risk,!which!is!measured!by!
beta,!the!cost!of!capital!for!an!investment!is!the!expected!return!available!on!securities!with!
the!same!beta.!
C)!!
D)!!
Diff:!2!
Topic:!10.8!Risk!and!the!Cost!of!Capital!
Skill:!Conceptual!
!
!
Suppose!that!in!the!coming!year,!you!expect!Exxon-Mobil!stick!to!have!a!volatility!of!42%!and!a!beta!of!0.9,!and!Merckas!
stock!to!have!a!volatility!of!24%!and!a!beta!of!1.1.!!The!risk!free!interest!rate!is!4%!and!the!markets!expected!return!is!12%.!
!
2)!!Which!stock!has!the!highest!total!risk?!
A)!!Merck!since!it!has!a!lower!volatility!
B)!!Merck!since!it!has!a!higher!Beta!
C)!!Exxon-Mobil!since!it!has!a!higher!volatility!
D)!!Exxon-Mobil!since!it!has!a!lower!beta!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!stock!has!the!highest!systematic!risk?!
A)!!Merck!since!it!has!a!higher!Beta!
B)!!Exxon-Mobil!since!it!has!a!lower!beta!
C)!!Exxon-Mobil!since!it!has!a!higher!volatility!
D)!!Merck!since!it!has!a!lower!volatility!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!The!cost!of!capital!for!a!project!with!the!same!beta!as!Exxon!Mobilas!stock!is!closest!to:!
A)!!11.6%!
B)!!11.2%!
C)!!12.8%!
D)!!7.6%!
Answer:!!!B!
B)!!E[R]!=!Rf!+!Beta!×!Risk!Premium!=!.04!+!.9!!×!(.12!-!.04)!=!.112!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!The!cost!of!capital!for!a!project!with!the!same!beta!as!Merckas!stock!is!closest!to:!
A)!!11.2%!
B)!!12.8%!
C)!!12.4%!
D)!!11.6%!
Answer:!!!B!
B)!!E[R]!=%Rf!+!Beta!×!Risk!Premium!=!.04!+!1.1!×!(.12!-!.04)!=!.128!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
10.9!Capital!Market!Efficiency!
1)!!Which!of!the!following!is!consistent!with!the!CAPM!and!efficient!capital!markets?!
A)!!A!security!with!a!beta!of!1!has!a!return!last!year!of!8%!when!the!market!has!a!return!of!12%.!
B)!!Small!stocks!with!a!beta!of!1.5!tend!to!have!higher!returns!on!average!than!large!stocks!with!a!beta!of!1.5.!
C)!!A!security!with!only!diversifiable!risk!has!an!expected!return!that!exceeds!the!risk-free!interest!rate.!
D)!!A!security!with!only!systematic!risk!has!an!expected!return!that!exceeds!the!risk-free!interest!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!10.9!Capital!Market!Efficiency!
Skill:!Conceptual!
!
A)!!If!the!market!portfolio!were!not!efficient,!investors!could!find!strategies!that!would!Tbeat!the!marketT!
with!higher!average!returns!and!lower!risk.!
B)!!The!CAPM!states!that!the!cost!of!capital!depends!only!on!systematic!risk.!
C)!!Efficient!capital!markets!is!a!much!stronger!hypothesis!than!the!CAPM.!
D)!!The!market!portfolio!is!an!efficient!portfolio.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!10.9!Capital!Market!Efficiency!
Skill:!Conceptual!
!
Chapter!11!-!Optimal!Portfolio!Choice!
!
11.1!The!Expected!Return!of!a!Portfolio!!
A)!!Without!trading,!the!portfolio!weights!will!decrease!for!the!stocks!in!the!portfolio!whose!returns!are!
above!the!overall!portfolio!return.!
B)!!The!expected!return!of!a!portfolio!is!simply!the!weighted!average!of!the!expected!returns!of!the!
investments!within!the!portfolio.!
C)!!Portfolio!weights!add!up!to!1!so!that!they!represent!the!way!we!have!divided!our!money!between!the!
different!individual!investments!in!the!portfolio.!
D)!!A!portfolio!weight!is!the!fraction!of!the!total!investment!in!the!portfolio!held!in!an!individual!investment!
in!the!portfolio.!
Answer:!!!A!
Explanation:!!! A)!!Without!trading,!the!portfolio!weights!will!increase!for!the!stocks!in!the!portfolio!whose!
returns!are!above!the!overall!portfolio!return.!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!11.1!The!Expected!Return!of!a!Portfolio!
Skill:!Conceptual!
!
A)!! Total value of portfolio
xi!=!
Value of investment i
B)!!R !=! %x R
p i i i%
C)!!Rp!=!x1R1!+!x2R2!+!...!+!xnRn%
D)!!E[R }!=!E[ %x R ]!
p i i i
Answer:!!!A!
Explanation:!!! A)!! Value of investment i
xi!=! !
Total value of portfolio
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Suppose!you!invest!$20,000!by!purchasing!200!shares!of!Abbott!Labs!(ABT)!at!$50!per!share,!200!shares!of!Lowes!(LOW)!at!
$30!per!share,!and!100!shares!of!Ball!Corporation!(BLL)!at!$40!per!share.!
!
3)!!The!weight!on!Abbott!Labs!in!your!portfolio!is:!
A)!!50%!
B)!!40%!
C)!!30%!
D)!!20%!
Answer:!!!A!
Explanation:!!! A)!!Value!of!portfolio!=!200!×!$50!+!200!×!$30!+!100!×!$40!=!$20,000%
xi%=!value!of!security!/!value!of!portfolio!=!(200!×!$50)!/!$20000!=!.50!or!50%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!The!weight!on!Lowes!in!your!portfolio!is:!
A)!!40%!
B)!!20%!
C)!!50%!
D)!!30%!
Answer:!!!D!
B)!!
C)!!
D)!!Value!of!portfolio!=!200!×!$50!+!200!×!$30!+!100!×!$40!=!$20,000!
Diff:!1!
Skill:!Analytical!
!
5)!!The!weight!on!Ball!Corporation!in!your!portfolio!is:!
A)!!50%!
B)!!40%!
C)!!20%!
D)!!30%!
Answer:!!!C!
B)!!
C)!!Value!of!portfolio!=!200!×!$50!+!200!×!$30!+!100!×!$40!=!$20,000%
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Suppose!over!the!next!year!Ball!has!a!return!of!12.5%,!Lowes!has!a!return!of!20%,!and!Abbott!Labs!has!a!
return!of!-10%.!!The!return!on!your!portfolio!over!the!year!is:!
A)!!0%!
B)!!7.5%!
C)!!3.5%!
D)!!5.0%!
Answer:!!!C!
B)!!
C)!!Stock Weight Return W!×!R(
ABT 0.5 -0.1 -0.05!
LOW 0.3 0.2 0.06!
BLL 0.2 0.125 0.025!
Rp!= 0.035!
D)!!
Diff:!2!
Skill:!Analytical!
!
return!of!-10%.!!The!value!of!your!portfolio!over!the!year!is?!
A)!!$21,000!
B)!!$20,000!
C)!!$20,700!
D)!!$21,500!
Answer:!!!C!
B)!!
C)!!Stock Weight Return W!×!R(
ABT 0.5 -0.1 -0.05!
LOW 0.3 0.2 0.06!
BLL 0.2 0.125 0.025!
Rp!= 0.035!
Value!of!portfolio!=!20000(1!+!.035)!=!20700!
D)!!
Diff:!2!
Skill:!Analytical!
!
return!of!-10%.!!The!weight!on!Ball!Corporation!in!your!portfolio!after!one!year!is!closest!to:!
A)!!20.0%!
B)!!12.5%!
C)!!20.7%!
D)!!21.7%!
Answer:!!!D!
B)!!
C)!!
D)!!Stock Weight Return W!×!R(
ABT 0.5 -0.1 -0.05!
LOW 0.3 0.2 0.06!
BLL 0.2 0.125 0.025!
Rp!= 0.035!
Value!of!portfolio!=!20000(1!+!.035)!=!20700
Value!of!BLL!=!$4000(1!+!.125)!=!$4500
Weight!for!BLL!=!4500!/!20700!=!0.217391!
Diff:!3!
Skill:!Analytical!
!
return!of!-10%.!!The!weight!on!Abbott!Labs!in!your!portfolio!after!one!year!is!closest!to:!
A)!!-10.0%!
B)!!43.5%!
C)!!45.0%!
D)!!50.0%!
Answer:!!!B!
B)!!Stock Weight Return W!×!R(
ABT 0.5 -0.1 -0.05!
LOW 0.3 0.2 0.06!
BLL 0.2 0.125 0.025!
Rp!= 0.035!
Value!of!ABT!=!$10000(1!+!-.10)!=!$9000
Weight!for!ABT!=!9000!/!20700!=!0.434783!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
return!of!-10%.!!The!weight!on!Lowes!in!your!portfolio!after!one!year!is!closest!to:!
A)!!20.0%!
B)!!34.8%!
C)!!30.0%!
D)!!36.0%!
Answer:!!!B!
B)!!Stock Weight Return W!×!R(
ABT 0.5 -0.1 -0.05!
LOW 0.3 0.2 0.06!
BLL 0.2 0.125 0.025!
Rp!= 0.035!
Value!of!LOW!=!$6000(1!+!.20)!=!$7200
Weight!for!LOW!=!7200!/!20700!=!0.347826!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
11)!!Suppose!you!invest!$15,000!in!Merck!stock!and!$25,000!in!Home!Depot!stock.!!You!expect!a!return!of!16%!for!
Merck!and!12%!for!Home!Depot.!!What!is!the!expected!return!on!your!portfolio?!
A)!!13.50%!
B)!!14.00%!
C)!!13.75%!
D)!!14.50%!
Answer:!!!A!
Explanation:!!! A)!!=!(15,000!/!40,000)(.16)!+!(25,000!/!40,000)(.12)!=!.135!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
12)!!Suppose!you!invest!$15,000!in!Merck!stock!and!$25,000!in!Home!Depot!stock.!!You!receive!an!actual!return!of!
-8%!for!Merck!and!12%!for!Home!Depot.!!What!is!the!actual!return!on!your!portfolio?!
A)!!4.50%!
B)!!4.00%!
C)!!10.00%!
D)!!2.00%!
Answer:!!!A!
Explanation:!!! A)!!=!(15,000!/!40,000)(-0.08)!+!(25,000!/!40,000)(.12)!=!.045!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
11.2!The!Volatility!of!a!Two-Stock!Portfolio!
A)!!The!covariance!and!correlation!allow!us!to!measure!the!co-movement!of!returns.!
B)!!Correlation!is!the!expected!product!of!the!deviations!of!two!returns.!
C)!!Because!the!prices!of!the!stocks!do!not!move!identically,!some!of!the!risk!is!averaged!out!in!a!portfolio.!
D)!!The!amount!of!risk!that!is!eliminated!in!a!portfolio!depends!on!the!degree!to!which!the!stocks!face!
common!risks!and!their!prices!move!together.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!11.2!The!Volatility!of!a!Two-Stock!Portfolio!
Skill:!Conceptual!
!
A)!!While!the!sign!of!the!correlation!is!easy!to!interpret,!its!magnitude!is!not.!
B)!!Independent!risks!are!uncorrelated.!
C)!!When!the!covariance!equals!0,!the!returns!are!uncorrelated.!
D)!!To!find!the!risk!of!a!portfolio,!we!need!to!know!more!than!the!risk!and!return!of!the!component!stocks;!
we!need!to!know!the!degree!to!which!the!stocksb!returns!move!together.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Dividing!the!covariance!by!the!volatilities!ensures!that!correlation!is!always!between!-1!and!+1.!
B)!!Volatility!is!the!square!root!of!variance.!
C)!!The!closer!the!correlation!is!to!0,!the!more!the!returns!tend!to!move!together!as!a!result!of!common!risk.!
D)!!If!two!stocks!move!together,!their!returns!will!tend!to!be!above!or!below!average!at!the!same!time,!and!
the!covariance!will!be!positive.!
Answer:!!!C!
B)!!
C)!!The!closer!the!correlation!is!to!1,!the!more!the!returns!tend!to!move!together!as!a!result!of!
common!risk.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Stock!returns!will!tend!to!move!together!if!they!are!affect!similarly!by!economic!events.!
B)!!Stocks!in!the!same!industry!tend!to!have!more!highly!correlated!returns!than!stocks!in!different!
industries.!
C)!!Almost!all!of!the!correlations!between!stocks!are!negative,!illustrating!the!general!tendency!of!stocks!to!
move!together.!
D)!!With!a!positive!amount!invest!in!each!stock,!the!more!the!stocks!move!together!and!the!higher!their!
covariance!or!correlation,!the!more!variable!the!portfolio!will!be.!
Answer:!!!C!
B)!!
C)!!Almost!all!of!the!correlations!between!stocks!are!positive,!illustrating!the!general!tendency!of!
stocks!to!move!together.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!stockbs!return!is!perfectly!positively!correlated!with!itself.!
B)!!When!the!covariance!equals!0,!the!stocks!have!no!tendency!to!move!either!together!or!in!opposition!of!
one!another.!
C)!!The!closer!the!correlation!is!to!-1,!the!more!the!returns!tend!to!move!in!opposite!directions.!
D)!!The!variance!of!a!portfolio!depends!only!on!the!variance!of!the!individual!stocks.!
Answer:!!!D!
B)!!
C)!!
D)!!The!variance!of!a!portfolio!depends!on!the!variance!and!correlations!of!the!individual!stocks.!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!two!stocks!move!in!opposite!directions,!one!will!tend!to!be!above!average!when!to!other!is!below!
average,!and!the!covariance!will!be!negative.!
B)!!The!correlation!between!two!stocks!has!the!same!sign!as!their!covariance,!so!it!has!a!similar!
interpretation.!
C)!!The!covariance!of!a!stock!with!itself!is!simply!its!variance.!
D)!!The!covariance!allows!us!to!gauge!the!strength!of!the!relationship!between!stocks.!
Answer:!!!D!
B)!!
C)!!
D)!!The!correlation!allows!us!to!gauge!the!strength!of!the!relationship!between!stocks.!
Diff:!1!
Skill:!Conceptual!
!
A)!! 1
Cov(Ri,Rj)!=! (Ri!-!Ri)(Rj!-!Rj)!
T 1
B)!!Var(Rp)!=!x12Var(R1)!+!x22Var(R2)!+!2X1X2Cov(R1,R2)!
C)!! Cov( Ri, Rj )
Corr(Ri,Rj)!=!
Var ( Ri )Var ( Rj )
D)!!Cov(Ri,Rj)!=%E[(Ri!-!E[Ri])(Rj!-!E[Rj])]!
Answer:!!!C!
B)!!
C)!! Cov( Ri, Rj )
Corr(Ri,Rj)!=!
SD( Ri ) SD( Rj )
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!returns:
!
Lowes! Home!Depot! IBM!
Realized! Realized! !Realized!
Year!End Return Return Return!
2000 20.1% -14.6% 0.2%!
2001 72.7% 4.3% -3.2%!
2002 -25.7% -58.1% -27.0%!
2003 56.9% 71.1% 27.9%!
2004 6.7% 17.3% -5.1%!
2005 17.9% 0.9% -11.3%!
!!
8)!!The!covariance!between!Lowesb!and!Home!Depotbs!returns!is!closest!to:!
A)!!0.10!
B)!!0.29!
C)!!0.12!
D)!!0.69!
Answer:!!!A!
Explanation:!!! A)!! Lowes! Home!Depot! Lowes! Home!Depot! (RL!-!RL)!!
Realized! Realized! Deviation!! Deviation!! ×!
Year!End Return Return (RL!-!RL) (RH!-!RH) (RH!-!RH)!
2000 20.1% -14.6% -4.7% -18.1% 0.00843889!
2001 72.7% 4.3% 47.9% 0.8% 0.00391456!
2002 -25.7% -58.1% -50.5% -61.6% 0.31079056!
2003 56.9% 71.1% 32.1% 67.6% 0.21727489!
2004 6.7% 17.3% -18.1% 13.8% -0.02496211!
2005 17.9% 0.9% -6.9% -2.6% 0.00177389!
average!= 24.8% 3.5%
Variance!= 0.125447467 0.177795367

Stdev!= 0.354185639 0.421657879
Covariance!= 0.103446133!
Correlation!= 0.692664763!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!The!Volatility!on!Lowesb!returns!is!closest!to:!
A)!!35%!
B)!!10%!
C)!!13%!
D)!!42%!
Answer:!!!A!
2000 20.1% -14.6% -4.7% -18.1% 0.00843889!
2001 72.7% 4.3% 47.9% 0.8% 0.00391456!
2002 -25.7% -58.1% -50.5% -61.6% 0.31079056!
2003 56.9% 71.1% 32.1% 67.6% 0.21727489!
2004 6.7% 17.3% -18.1% 13.8% -0.02496211!
2005 17.9% 0.9% -6.9% -2.6% 0.00177389!
average!= 24.8% 3.5%
Variance!= 0.125447467 0.177795367

Stdev!= 0.354185639 0.421657879
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!The!Volatility!on!Home!Depotbs!returns!is!closest!to:!
A)!!35%!
B)!!31%!
C)!!42%!
D)!!18%!
Answer:!!!C!
B)!!
C)!! Lowes! Home!Depot! Lowes! Home!Depot! (RL!-!RL)!!
2000 20.1% -14.6% -4.7% -18.1% 0.00843889!
2001 72.7% 4.3% 47.9% 0.8% 0.00391456!
2002 -25.7% -58.1% -50.5% -61.6% 0.31079056!
2003 56.9% 71.1% 32.1% 67.6% 0.21727489!
2004 6.7% 17.3% -18.1% 13.8% -0.02496211!
2005 17.9% 0.9% -6.9% -2.6% 0.00177389!
average!= 24.8% 3.5%
Variance!= 0.125447467 0.177795367

Stdev!= 0.354185639 0.421657879
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!The!Correlation!between!Lowesb!and!Home!Depotbs!returns!is!closest!to:!
A)!!0.58!
B)!!0.29!
C)!!0.69!
D)!!0.10!
Answer:!!!C!
B)!!
C)!! Lowes! Home!Depot! Lowes! Home!Depot! (RL!-!RL)!!
2000 20.1% -14.6% -4.7% -18.1% 0.00843889!
2001 72.7% 4.3% 47.9% 0.8% 0.00391456!
2002 -25.7% -58.1% -50.5% -61.6% 0.31079056!
2003 56.9% 71.1% 32.1% 67.6% 0.21727489!
2004 6.7% 17.3% -18.1% 13.8% -0.02496211!
2005 17.9% 0.9% -6.9% -2.6% 0.00177389!
average!= 24.8% 3.5%
Variance!= 0.125447467 0.177795367

Stdev!= 0.354185639 0.421657879
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!The!variance!on!a!portfolio!that!is!made!up!of!equal!investments!in!Lowes!and!Home!Depot!stock!is!closest!to:!
A)!!0.12!
B)!!0.10!
C)!!0.69!
D)!!0.29!
Answer:!!!A!
2000 20.1% -14.6% -4.7% -18.1% 0.00843889!
2001 72.7% 4.3% 47.9% 0.8% 0.00391456!
2002 -25.7% -58.1% -50.5% -61.6% 0.31079056!
2003 56.9% 71.1% 32.1% 67.6% 0.21727489!
2004 6.7% 17.3% -18.1% 13.8% -0.02496211!
2005 17.9% 0.9% -6.9% -2.6% 0.00177389!
average!= 24.8% 3.5%
Variance!= 0.125447467 0.177795367

Stdev!= 0.354185639 0.421657879
!
Var(Rp)%=%x12Var(R1)%+%x22Var(R2)%+%2X1X2Cov(R1,R2)
=!(.50)2(0.125447467)!+!(.50)2(0.177795367)!+!2(.5)(.5)(0.103446133)!=!0.118913264!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
13)!!The!covariance!between!Lowesb!and!IBMbs!returns!is!closest!to:!
A)!!0.05!
B)!!0.06!
C)!!0.10!
D)!!0.71!
Answer:!!!A!
Explanation:!!! A)!! Lowes! IBM! Lowes! IBM!! (RL!-!RL)!!
Realized! !Realized! Deviation!! Deviation!! ×!
Year!End Return Return (RL!-!RL) (RI!-!RI) (RI!-!RI)!
2000 20.1% 0.2% -4.7% 3.3% -0.00155542!
2001 72.7% -3.2% 47.9% -0.1% -0.00048871!
2002 -25.7% -27.0% -50.5% -23.9% 0.12061406!
2003 56.9% 27.9% 32.1% 30.9% 0.09943858!
2004 6.7% -5.1% -18.1% -2.0% 0.00367960!
2005 17.9% -11.3% -6.9% -8.2% 0.00565832!
average!= 24.8% -3.1%
Variance!= 0.125447467 0.032239975

Stdev!= 0.354185639 0.179554936
Var(Port)!= 0.062156504!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!The!Correlation!between!Lowesb!and!IBMbs!returns!is!closest!to:!
A)!!0.71!
B)!!0.60!
C)!!0.62!
D)!!0.05!
Answer:!!!A!
Explanation:!!! A)!! Lowes! IBM! Lowes! IBM!! (RL!-!RL)!!
2000 20.1% 0.2% -4.7% 3.3% -0.00155542!
2001 72.7% -3.2% 47.9% -0.1% -0.00048871!
2002 -25.7% -27.0% -50.5% -23.9% 0.12061406!
2003 56.9% 27.9% 32.1% 30.9% 0.09943858!
2004 6.7% -5.1% -18.1% -2.0% 0.00367960!
2005 17.9% -11.3% -6.9% -8.2% 0.00565832!
average!= 24.8% -3.1%
Variance!= 0.125447467 0.032239975

Stdev!= 0.354185639 0.179554936
Var(Port)!= 0.062156504!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
15)!!The!variance!on!a!portfolio!that!is!made!up!of!equal!investments!in!Lowes!and!IBM!stock!is!closest!to:!
A)!!0.62!
B)!!0.05!
C)!!0.12!
D)!!0.06!
Answer:!!!D!
B)!!
C)!!
D)!! Lowes! IBM! Lowes! IBM!! (RL!-!RL)!!
2000 20.1% 0.2% -4.7% 3.3% -0.00155542!
2001 72.7% -3.2% 47.9% -0.1% -0.00048871!
2002 -25.7% -27.0% -50.5% -23.9% 0.12061406!
2003 56.9% 27.9% 32.1% 30.9% 0.09943858!
2004 6.7% -5.1% -18.1% -2.0% 0.00367960!
2005 17.9% -11.3% -6.9% -8.2% 0.00565832!
average!= 24.8% -3.1%
Variance!= 0.125447467 0.032239975

Stdev!= 0.354185639 0.179554936
Var(Port)!= 0.062156504!
!
Var(Rp)!=!x12Var(R1)!+!x22Var(R2)!+!2X1X2Cov(R1,R2)
=!(.50)2(0.125447467)!+!(.50)2(0.032239975!+!2(.5)(.5)(0.045469287)!=!0.062156504!
Diff:!3!
Skill:!Analytical!
!
16)!!The!Volatility!on!IBMbs!returns!is!closest!to:!
A)!!3%!
B)!!13%!
C)!!16%!
D)!!18%!
Answer:!!!D!
B)!!
C)!!
D)!! Lowes! IBM! Lowes! IBM!! (RL!-!RL)!!
2000 20.1% 0.2% -4.7% 3.3% -0.00155542!
2001 72.7% -3.2% 47.9% -0.1% -0.00048871!
2002 -25.7% -27.0% -50.5% -23.9% 0.12061406!
2003 56.9% 27.9% 32.1% 30.9% 0.09943858!
2004 6.7% -5.1% -18.1% -2.0% 0.00367960!
2005 17.9% -11.3% -6.9% -8.2% 0.00565832!
average= 24.8% -3.1%
Variance!= 0.125447467 0.032239975

Stdev!= 0.354185639 0.179554936
Var(Port)!= 0.062156504!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!covariances!between!securities:
Duke Microsoft Wal-Mart%

Duke 0.0568 -0.0193 0.0037!
Microsoft -0.0193 0.2420 0.1277!
Wal-Mart 0.0037 0.1277 0.1413!
!
!
17)!!The!variance!on!a!portfolio!that!is!made!up!of!equal!investments!in!Duke!Energy!and!Microsoft!stock!is!
closest!to:!
A)!!.065!
B)!!0.090!
C)!!.149!
D)!!-0.020!
Answer:!!!A!
Explanation:!!! A)!!Var(Rp)!=!x12Var(R1)!+!x22Var(R2)!+!2X1X2Cov(R1,R2)
=!(.50)2(0.0568)!+!(.50)2(0.2420)!+!2(.5)(.5)(-0.0193)!=!0.0651!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!The!variance!on!a!portfolio!that!is!made!up!of!a!$6000!investments!in!Duke!Energy!and!a!$4000!investment!in!
Wal-Mart!stock!is!closest!to:!
A)!!.050!
B)!!.045!
C)!!.051!
D)!!-0.020!
Answer:!!!B!
B)!!Total!invested!=!$6000!+!$4000!=!$10,000!
$6, 000
XDuke!=! !=!.60!
$10, 000
$4, 000
XWal-Mart!=! !=!.40!
$10, 000
%
=!(.60)2(0.0568)!+!(.40)2(0.1413)!+!2(.6)(.4)(0.0037)!=!0.0449!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!returns:
!
Lowes! Home!Depot! IBM!
Realized! Realized! !Realized!
Year!End Return Return Return!
2000 20.1% -14.6% 0.2%!
2001 72.7% 4.3% -3.2%!
2002 -25.7% -58.1% -27.0%!
2003 56.9% 71.1% 27.9%!
2004 6.7% 17.3% -5.1%!
2005 17.9% 0.9% -11.3%!
!
19)!!Calculate!the!covariance!between!Home!Depotbs!and!IBMbs!returns.!
Answer:!!! Home!Depot! IBM! Home!Depot! IBM!! (RL!-!RL)!!
Year!End Return Return (RH!-!RH) (RI!-!RI) (RH!-!RI)!
2000 -14.6% 0.2% -18.1% 3.3% -0.00602724!
2001 4.3% -3.2% 0.8% -0.1% -0.00000833!
2002 -58.1% -27.0% -61.6% -23.9% 0.14718262!
2003 71.1% 27.9% 67.6% 30.9% 0.20924394!
2004 17.3% -5.1% 13.8% -2.0% -0.00281401!
2005 0.9% -11.3% -2.6% -8.2% 0.00212874!
average!= 3.5% -3.1%
Variance!= 0.177795367 0.032239975

Stdev!= 0.421657879 0.179554936
Var(Port)!= 0.087479407!
Diff:!2!
Skill:!Analytical!
!
20)!!Calculate!the!correlation!between!Home!Depotbs!and!IBMbs!returns.!
2000 -14.6% 0.2% -18.1% 3.3% -0.00602724!
2001 4.3% -3.2% 0.8% -0.1% -0.00000833!
2002 -58.1% -27.0% -61.6% -23.9% 0.14718262!
2003 71.1% 27.9% 67.6% 30.9% 0.20924394!
2004 17.3% -5.1% 13.8% -2.0% -0.00281401!
2005 0.9% -11.3% -2.6% -8.2% 0.00212874!
average!= 3.5% -3.1%
Variance!= 0.177795367 0.032239975

Stdev!= 0.421657879 0.179554936
Var(Port)!= 0.087479407!
Diff:!2!
Skill:!Analytical!
!
21)!!Calculate!the!variance!on!a!portfolio!that!is!made!up!of!equal!investments!in!Home!Depot!and!IBM!stock.!
!
2000 -14.6% 0.2% -18.1% 3.3% -0.00602724!
2001 4.3% -3.2% 0.8% -0.1% -0.00000833!
2002 -58.1% -27.0% -61.6% -23.9% 0.14718262!
2003 71.1% 27.9% 67.6% 30.9% 0.20924394!
2004 17.3% -5.1% 13.8% -2.0% -0.00281401!
2005 0.9% -11.3% -2.6% -8.2% 0.00212874!
average!= 3.5% -3.1%
Variance!= 0.177795367 0.032239975

Stdev!= 0.421657879 0.179554936
Var(Port)!= 0.087479407!
=!(.50)2(0.177795367)!+!(.50)2(0.032239975!+!2(.5)(.5)(00.069941142!=!0.087479407!
Diff:!3!
Skill:!Analytical!
!
!

Duke 0.0568 -0.0193 0.0037!
Microsoft -0.0193 0.2420 0.1277!
Wal-Mart 0.0037 0.1277 0.1413!
!
!
22)!!The!variance!on!a!portfolio!that!is!made!up!of!a!$6000!investments!in!Microsoft!and!a!$4000!investment!in!
Wal-Mart!stock!is!closest!to:!
Answer:!!!Total!invested!=!$6000!+!$4000!=!$10,000!
$6, 000
XMicrosoft!=! !=!.60!
$10, 000
$4, 000
XWal-Mart!=! !=!.40!
$10, 000
%
=!(.60)2(0.2420)!+!(.40)2(0.1413)!+!2(.6)(.4)(0.1277)!=!0.1710!
Diff:!2!
Skill:!Analytical!
!
11.3!The!Volatility!of!a!Large!Portfolio!
A)!!The!variance!of!a!portfolio!is!equal!to!the!weighted!average!correlation!of!each!stock!within!the!portfolio.!
B)!!The!variance!of!a!portfolio!is!equal!to!the!sum!of!the!covariances!of!the!returns!of!all!pairs!of!stocks!in!the!
portfolio!multiplied!by!each!of!their!portfolio!weights.!
C)!!The!variance!of!a!portfolio!is!equal!to!the!weighted!average!covariances!of!each!stock!within!the!
portfolio.!
D)!!The!volatility!declines!as!the!number!of!stocks!in!a!portfolio!grows.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!11.3!The!Volatility!of!a!Large!Portfolio!
Skill:!Conceptual!
!
A)!!The!volatility!declines!as!the!number!of!stocks!in!a!portfolio!grows.!
B)!!An!equally!weighted!portfolio!is!a!portfolio!in!which!the!same!amount!is!invested!in!each!stock.!
C)!!As!the!number!of!stocks!in!a!portfolio!grows!large,!the!variance!of!the!portfolio!is!determined!primarily!
by!the!average!covariance!among!the!stocks.!
D)!!When!combining!stocks!into!a!portfolio!that!puts!positive!weight!on!each!stock,!unless!all!of!the!stocks!
are!uncorrelated!with!the!portfolio,!the!risk!of!the!portfolio!will!be!lower!than!the!weighted!average!
volatility!of!the!individual!stocks.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!expected!return!of!a!portfolio!is!equal!to!the!weighted!average!expected!return,!but!the!volatility!of!a!
portfolio!is!less!than!the!weighted!average!volatility.!
B)!!Each!security!contributes!to!the!volatility!of!the!portfolio!according!to!its!volatility,!scaled!by!its!
covariance!with!the!portfolio,!which!adjusts!for!the!fraction!of!the!total!risk!that!is!common!to!the!
portfolio.!
C)!!Nearly!half!of!the!volatility!of!individual!stocks!can!be!eliminated!in!a!large!portfolio!as!a!result!of!
diversification.!
D)!!The!overall!variability!of!the!portfolio!depends!on!the!total!co-movement!of!the!stocks!within!it.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! 1 1
Variance!of!an!equally!Weighted!Portfolio!=!(1!-! )(Average!Variance!of!Individual!Stocks)!+! !
n n
(Average!covariance!between!the!stocks)!
B)!!Variance!of!a!portfolio!=! xixjCov( Ri, Rj )
i j
C)!!Variance!of!a!portfolio!=! xiCov( Ri, Rp )

i
D)!!Variance!of!a!portfolio!=! xiCov( Ri, xjRj )
i j
Answer:!!!A!
Explanation:!!! A)!! 1
Variance!of!an!equally!Weighted!Portfolio!=! !(Average!Variance!of!Individual!Stocks)!+!!
n
1
(1!-! )(Average!covariance!between!the!stocks)!
n
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Consider!an!equally!weighted!portfolio!that!contains!five!stocks.!!If!the!average!volatility!of!these!stocks!is!
40%!and!the!average!correlation!between!the!stocks!is!.5,!then!the!volatility!of!this!equally!weighted!portfolio!
is!closest!to:!
A)!!.17!
B)!!.44!
C)!!.41!
D)!!.19!
Answer:!!!B!
B)!! 1
n
1
(1!-! )(Average!covariance!between!the!stocks)!
n
!
Var(Rp)%=%x12Var(R1)%+%x22Var(R2)%+%2X1X2Cov(R1,R2)!
Var!=!(1!/!5)(.40)2!!+!(1!-!1/5)(.5)( .40 )( .40 )
Var%=!.2(.16)!+!.8(.5)(.40)!=!.192
stdev%=! .192 !=!.438!

C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Consider!an!equally!weighted!portfolio!that!contains!20!stocks.!!If!the!average!volatility!of!these!stocks!is!35%!
and!the!average!correlation!between!the!stocks!is!.4,!then!the!volatility!of!this!equally!weighted!portfolio!is!
closest!to:!
A)!!.17!
B)!!.41!
C)!!.14!
D)!!.37!
Answer:!!!D!
B)!!
C)!!
D)!! 1
n
1
(1!-! )(Average!covariance!between!the!stocks)
n
Var%=!(1/20)(.35)2!!+!(1!-!1!/!20)(.4)( .35 )( .35 )!

Var%=!.05(.1225)!+!.95(.4)(.35)!=!.139125
stdev!=! .139125 !=!.372995!

Diff:!2!
Skill:!Analytical!
!
7)!!Consider!an!equally!weighted!portfolio!that!contains!100!stocks.!!If!the!average!volatility!of!these!stocks!is!50%!
and!the!average!correlation!between!the!stocks!is!.7,!then!the!volatility!of!this!equally!weighted!portfolio!is!
closest!to:!
A)!!.72!
B)!!.63!
C)!!.40!
D)!!.50!
Answer:!!!B!
B)!! 1
n
1
(1!-! )(Average!covariance!between!the!stocks)
n
Var%=!(1!/!100)(.50)2!!+!(1!-!1!/!100)(.7)( .50 )( .50 )!

Var!=!.01(.25)!+!.99(.8)(.50)!=!.3985
stdev!=! .3985 !=!.6312!

C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!

Duke 0.0568 -0.0193 0.0037!
Microsoft -0.0193 0.2420 0.1277!
Wal-Mart 0.0037 0.1277 0.1413!
!
!
8)!!What!is!the!variance!on!a!portfolio!that!has!$2000!invested!in!Duke!Energy,!$3000!invested!in!Microsoft,!and!
$5000!invested!in!Wal-Mart!stock?!
Answer:!!!COV Duke Microsoft Wal-Mart%
Duke 0.0568 -0.0193 0.0037!
Microsoft -0.0193 0.2420 0.1277!
Wal-Mart 0.0037 0.1277 0.1413!
Weights 0.2 0.3 0.5!
XiXj XDuke XMicrosoft XWal-Mart%

XDuke 0.04 0.06 0.1!
XMicrosoft 0.06 0.09 0.15!
XWal-Mart 0.1 0.15 0.25!
XiXjCOV(I,j) Duke Microsoft Wal-Mart%

Duke 0.002272 -0.00116 0.000367!
Microsoft -0.00116 0.021776 0.019153!
Wal-Mart 0.000367 0.019153 0.035318!
Var(P)!= 0.096086
Variance!of!a!portfolio!=! xixjCov( Ri, Rj )
i j
Diff:!3!
Skill:!Analytical!
!
9)!!What!is!the!variance!on!a!portfolio!that!has!$3000!invested!in!Duke!Energy,!$4000!invested!in!Microsoft,!and!
$3000!invested!in!Wal-Mart!stock?!
Answer:!!!Variance!of!a!portfolio!=! xixjCov( Ri, Rj )
i j
COV Duke Microsoft Wal-Mart%

Duke 0.0568 -0.0193 0.0037!
Microsoft -0.0193 0.2420 0.1277!
Wal-Mart 0.0037 0.1277 0.1413!
Weights 0.3 0.4 0.3!
XiXj XDuke XMicrosoft XWal-Mart%

XDuke 0.09 0.12 0.09!
XMicrosoft 0.12 0.16 0.12!
XWal-Mart 0.09 0.12 0.09!
XiXjCOV(I,j) Duke Microsoft Wal-Mart%

Duke 0.005112 -0.00232 0.00033!
Microsoft -0.00232 0.038714 0.015322!
Wal-Mart 0.00033 0.015322 0.012715!
Var(P)!= 0.083205
Diff:!3!
Skill:!Analytical!
!
11.4!Risk!Versus!Return:!Choosing!an!Efficient!Portfolio!
A)!!We!say!a!portfolio!is!an!efficient!portfolio!whenever!it!is!possible!to!find!another!portfolio!that!is!better!
in!terms!of!both!expected!return!and!volatility.!
B)!!We!can!rule!out!inefficient!portfolios!because!they!represent!inferior!investment!choices.!
C)!!The!volatility!of!the!portfolio!will!differ,!depending!on!the!correlation!between!the!securities!in!the!
portfolio.!
D)!!Correlation!has!no!effect!on!the!expected!return!on!a!portfolio.!
Answer:!!!A!
Explanation:!!! A)!!We!say!a!portfolio!is!an!efficient!portfolio!whenever!it!is!not!possible!to!find!another!portfolio!
that!is!better!in!terms!of!both!expected!return!and!volatility.!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!11.4!Risk!Versus!Return:!Choosing!an!Efficient!Portfolio!
Skill:!Conceptual!
!
A)!!When!stocks!are!perfectly!positively!correlated,!the!set!of!portfolios!is!identified!graphically!by!a!straight!
line!between!them.!
B)!!An!investor!seeking!high!returns!and!low!volatility!should!only!invest!in!an!efficient!portfolio.!
C)!!When!the!correlation!between!securities!is!less!than!1,!the!volatility!of!the!portfolio!is!reduced!due!to!
diversification.!
D)!!Efficient!portfolios!can!be!easily!ranked,!because!investors!will!choose!from!among!them!those!with!the!
highest!expected!returns.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!say!a!portfolio!is!long!those!stocks!that!have!negative!portfolio!weights.!
B)!!The!efficient!portfolios!are!those!portfolios!offering!the!highest!possible!expected!return!for!a!given!level!
of!volatility.!
C)!!When!two!stocks!are!perfectly!negatively!correlated,!it!becomes!possible!to!hold!a!portfolio!that!bears!
absolutely!no!risk.!
D)!!The!lower!the!correlation!of!the!securities!in!a!portfolio!the!lower!the!volatility!we!can!obtain.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!short!sale!is!a!transaction!in!which!you!buy!a!stock!that!you!do!not!own!and!then!agree!to!sell!that!
stock!back!in!the!future.!
B)!!The!efficient!portfolios!are!those!portfolios!offering!the!lowest!possible!level!of!volatility!for!a!given!level!
of!expected!return.!
C)!!A!positive!investment!in!a!security!can!be!referred!to!as!a!long!position!in!the!security.!
D)!!It!is!possible!to!invest!a!negative!amount!in!a!stock!or!security!call!a!short!position.!!
Answer:!!!A!
Explanation:!!! A)!!A!short!sale!is!a!transaction!in!which!you!sell!a!stock!that!you!do!not!own!and!then!agree!to!
buy!that!stock!back!in!the!future.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Graphically,!the!efficient!portfolios!are!those!on!the!northeast!edge!of!the!set!of!possible!portfolios,!an!
area!which!we!call!the!efficient!frontier.!
B)!!To!arrive!at!the!best!possible!set!of!risk!and!return!opportunities,!we!should!keep!adding!stocks!until!all!
investment!opportunities!are!represented.!
C)!!We!say!a!portfolio!is!short!those!stocks!that!have!negative!portfolio!weights.!
D)!!Adding!new!investment!opportunities!allows!for!greater!diversification!and!improves!the!efficient!
frontier.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
6)!!Suppose!you!have!$10,000!in!cash!to!invest.!!You!decide!to!sell!short!$5,000!worth!of!Kinston!stock!and!invest!
the!proceeds!from!your!short!sale,!plus!your!$10,000!into!one-year!U.S.!treasury!bills!earning!5%.!!At!the!end!
of!the!year,!you!decide!to!liquidate!your!portfolio.!!Kinston!Industries!has!the!following!realized!returns:
P0 Div1 P1!
Kinston $25.00! $1.00! $29.00!!
The!return!on!your!portfolio!is!closest!to?!
A)!!-0.5%!
B)!!13.5%!
C)!!-2.5%!
D)!!14.5%!
Answer:!!!C!
B)!!
C)!!You!short!sold!$5000!/!$25!=!200!shares!of!Kinston!and!invested!the!$5,000!+!$10,000!in!!
T-notes.!!In!one!year!you!will!have!(15,000)(1.05)!=!$15,750!-!200!×!($29!+!$1)!=!$9,750.!
$9, 750 $10, 000
So,!your!total!return!is!equal!to! !=!-0.025!or!-2.5%!
$10, 000
D)!!
Diff:!3!
Skill:!Analytical!
!
Consider!the!following!expected!returns,!volatilities,!and!correlations:
Expected! Standard! Correlation!with!Correlation!with!Correlation!with!

Stock Return Deviation Duke!Energy Microsoft Wal-Mart!
Duke!Energy 14% 6% 1.0 -1.0 0.0!
Microsoft 44% 24% -1.0 1.0 0.7!
Wal-Mart 23% 14% 0.0 0.7 1.0!
!
7)!!Consider!a!portfolio!consisting!of!only!Duke!Energy!and!Microsoft.!!!The!percentage!of!your!investment!
(portfolio!weight)!that!you!would!place!in!Duke!Energy!stock!to!achieve!a!risk-free!investment!would!be!
closest!to:!
A)!!15%!
B)!!4%!
C)!!23%!
D)!!10%!
Answer:!!!B!
B)!!Var(Rp)!=!x12Var(R1)!+%x22Var(R2)!+!2X1X2Corr(R1,R2)SD1SD2
0!=!x12(.06)2!+!(1!-!x1)2(.24)2!+!2(!x1)(1!-!x1)(-1)(.06)(.24)
.0036x12!+!.0576(1!-!x1)2!!=!2(!x1)(1!-!x1)(.06)(.24)
.0612x12!+!.1152x1!+!.0576=!.029376!x1!-!.029376x12
.090576x12!+!.085824.x1!+!.0576=!0
x1!=!.037!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!The!expected!return!of!a!portfolio!that!is!equally!invested!in!Duke!Energy!and!Microsoft!is!closest!to:!
A)!!28%!
B)!!29%!
C)!!24%!
D)!!23%!
Answer:!!!B!
B)!!.5(14%)!+!.5(44%)!=!29%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!volatility!of!a!portfolio!that!is!equally!invested!in!Duke!Energy!and!Microsoft!is!closest!to:!
A)!!8%!
B)!!9%!
C)!!11%!
D)!!6%!
Answer:!!!B!
=!.52(.06)2!+!.52(.24)2!+!2(.5)(.5)(-1)(.06)(.24)
=!.0081
stdev!=! .0081 !=!.09!

C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!The!expected!return!of!a!portfolio!that!is!consists!of!a!long!position!of!$10000!in!Wal-Mart!and!a!short!position!
of!$2000!in!Microsoft!is!closest!to:!
A)!!21%!
B)!!12%!
C)!!27%!
D)!!18%!
Answer:!!!D!
B)!!
C)!!
D)!!=!(10,000!/!8,000)(.23)!+!(-2000!/!8,8000)(.44)!
=!(1.25)(.23)!+!(-.25)(.44)!=!.1775!
Diff:!2!
Skill:!Analytical!
!
11)!!The!volatility!of!a!portfolio!that!is!consists!of!a!long!position!of!$10000!in!Wal-Mart!and!a!short!position!of!
$2000!in!Microsoft!is!closest!to:!
A)!!9%!
B)!!14%!
C)!!11%!
D)!!12%!
Answer:!!!B!
=!1.252(.14)2!+(-!25)2(.24)2!+!2(1.25)(-.25)(0.7)(.14)(.24)
=!.019525
stdev!=! .019525 !=!.139732!

C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!Consider!a!portfolio!consisting!of!only!Microsoft!and!Wal-Mart!stock.!!Calculate!the!expected!return!on!such!a!
portfolio!when!the!weight!on!Microsoft!stock!is!0%,!25%,!50%,!75%,!and!100%!
Answer:!!!Rp!=!x1R1!+!x2R2!+!...!+!xnRn
Weight!on! Weight!on! Portfolio!

Microsoft Wal-Mart Return!
0% 100% 23%!
25% 75% 28%!
50% 50% 34%!
75% 25% 39%!
100% 0% 44%!
Diff:!2!
Skill:!Analytical!
!
13)!!Consider!a!portfolio!consisting!of!only!Microsoft!and!Wal-Mart!stock.!!Calculate!the!volatility!of!such!a!
portfolio!when!the!weight!on!Microsoft!stock!is!0%,!25%,!50%,!75%,!and!100%!
Answer:!!!Var(Rp)!=!x12Var(R1)!+%x22Var(R2)!+!2X1X2Corr(R1,R2)SD1SD2!
Weight!on! Weight!on! Portfolio! Portfolio! Portfolio!

Microsoft Wal-Mart Return Variance Volatility!
0% 100% 23% 0.0196 0.140!
25% 75% 28% 0.023445 0.153!
50% 50% 34% 0.03106 0.176!
75% 25% 39% 0.042445 0.206!
100% 0% 44% 0.0576 0.240!
Diff:!3!
Skill:!Analytical!
!
14)!!What!is!the!efficient!frontier!and!how!does!it!change!when!more!stocks!are!used!to!construct!portfolios?!
Answer:!!!The!efficient!portfolios!are!those!portfolios!offering!the!highest!possible!expected!return!for!a!given!
level!of!volatility.
The!efficient!portfolios!are!those!portfolios!offering!the!lowest!possible!level!of!volatility!for!a!given!
level!of!expected!return.
Graphically,!the!efficient!portfolios!are!those!on!the!northwest!edge!of!the!set!of!possible!portfolios,!an!
area!which!we!call!the!efficient!frontier.
Adding!new!investment!opportunities!allows!for!greater!diversification!and!improves!the!efficient!
frontier!(moves!it!to!the!northwest,!thereby!providing!better!risk!/!return!opportunities).
To!arrive!at!the!best!possible!set!of!risk!and!return!opportunities,!we!should!keep!adding!stocks!until!all!
investment!opportunities!are!represented.
Diff:!2!
Skill:!Conceptual!
11.5!Risk-Free!Saving!and!Borrowing!
A)!!A!portfolio!that!consists!of!a!long!position!in!the!risk-free!investment!is!known!as!a!levered!portfolio.!
B)!!The!optimal!portfolio!will!not!depend!on!the!investorbs!personal!tradeoff!between!risk!and!return.!
C)!!The!volatility!of!the!risk-free!investment!is!zero.!
D)!!Our!total!volatility!is!only!a!fraction!of!the!volatility!of!the!efficient!portfolio,!based!on!the!amount!we!
invest!in!the!risk!free!asset.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!11.5!Risk-Free!Saving!and!Borrowing!
Skill:!Conceptual!
!
A)!!Margin!investing!is!a!risky!investment!strategy.!
B)!!Because!our!return!on!the!risk-free!investments!is!fixed!and!does!not!move!with!(or!against)!our!
portfolio,!the!correlation!between!the!risk-free!investment!and!the!portfolio!is!always!equal!to!one.!
C)!!Short!selling!the!risk!free!investment!is!equivalent!to!borrowing!money!at!the!risk-free!interest!rate!
through!a!standard!loan.!
D)!!Margin!investing!can!provide!higher!expected!returns!than!investing!in!the!efficient!portfolio!using!only!
the!funds!we!have!available.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!Sharpe!ratio!measures!the!ratio!of!volatility!-to-reward!provided!by!a!portfolio.!
B)!!Borrowing!money!to!invest!in!stocks!is!referred!to!as!buying!stocks!on!margin.!
C)!!The!Sharpe!ratio!is!the!number!of!stand!deviations!the!portfoliobs!return!would!have!to!fall!to!
under-perform!the!risk-free!investment.!
D)!!The!slope!of!the!line!through!a!given!portfolio!is!often!referred!to!as!the!Sharpe!ratio!of!the!portfolio.!
Answer:!!!A!
Explanation:!!! A)!!The!Sharpe!ratio!measures!the!ratio!of!reward-to-volatility!provided!by!a!portfolio.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!tangent!portfolio!is!efficient!and!that,!once!we!include!the!risk-free!investment,!all!efficient!
portfolios!are!combinations!of!the!risk-free!investment!and!the!tangent!portfolio.!
B)!!The!optimal!portfolio!of!risky!investments!depends!on!how!conservative!or!aggressive!the!investor!is.!
C)!!By!combining!the!efficient!portfolio!with!the!risk-free!investment,!an!investor!will!earn!the!highest!
possible!expected!return!for!any!level!of!volatility!her!or!she!is!willing!to!bear.!
D)!!The!efficient!portfolio!is!the!tangent!portfolio,!the!portfolio!with!the!highest!Sharpe!ratio!in!the!economy.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!we!increase!the!fraction!invested!in!the!efficient!portfolio!beyond!100%m!we!are!short!selling!the!
risk-free!investment.!
B)!!As!we!increase!the!fraction!invested!in!the!efficient!portfolio,!we!increase!our!risk!premium!but!not!our!
risk!proportionately.!!
C)!!To!earn!the!highest!possible!expected!return!for!any!level!of!volatility!we!must!find!the!portfolio!that!
generates!the!steepest!possible!line!when!combined!with!the!risk-free!investment.!
D)!!Every!investor!should!invest!in!the!tangent!portfolio!independent!of!his!or!her!taste!for!risk.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!An!investorbs!preferences!will!determine!only!how!much!to!invest!in!the!tangent!or!efficient!portfolio!
versus!the!risk-free!investment.!
B)!!Conservative!investors!will!invest!a!small!amount!in!the!tangent!or!efficient!portfolio,!choosing!a!
portfolio!on!the!line!near!the!risk-free!investment!
C)!!Only!aggressive!investors!will!choose!to!hold!the!portfolio!of!risky!assets,!the!tangent!or!efficient!
portfolio.!
D)!!Aggressive!investors!will!invest!more!in!the!tangent!portfolio!choosing!a!portfolio!that!is!near!the!
tangent!portfolio!or!even!beyond!it!by!buying!stocks!on!margin.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!E[Rxp]!=!rf!+!x(E[Rp]!-!rf)!
B)!!E[Rxp]!=!(1!-!x)rf!+!xE[Rp]!
C)!! portfolio return
Sharpe!ratio!=!
portfolio volatility
D)!!SD(!Rxp)!=%xSD(Rp)!
Answer:!!!C!
B)!!
C)!! portfolio excess return
Sharpe!ratio!=!
portfolio volatility
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Suppose!you!have!$10,000!in!cash!and!you!decide!to!borrow!another!$10,000!at!a!6%!interest!rate!to!invest!in!the!stock!
market.!!You!invest!the!entire!$20,000!in!an!exchange!traded!fund!(ETF)!with!a!12%!expected!return!and!a!20%!volatility.!
!
8)!!The!expected!return!on!your!of!your!investment!is!closest!to:!
A)!!18%!
B)!!20%!
C)!!12%!
D)!!24%!
Answer:!!!A!
Explanation:!!! A)!!E[Rxp]!=!rf%+!x(E[Rp]!-!rf)
!=!.06!+!2(.12!-!.06)!=!.18!or!18%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!volatility!of!your!of!your!investment!is!closest!to:!
A)!!40%!
B)!!20%!
C)!!30%!
D)!!24%!
Answer:!!!A!
Explanation:!!! A)!!SD(!Rxp)!=!xSD(Rp)
!=!2(.20)!=!.40!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!Assume!that!the!EFT!you!invested!in!returns!-10%,!then!the!realized!return!on!your!investment!is!closest!to:!
A)!!-20%!
B)!!-10%!
C)!!-24%!
D)!!-26%!
Answer:!!!D!
B)!!
C)!!
D)!!Value!of!portfolio!=!$20,000(1!+!-.10)!=!$18,000!-!$10,600!loan!&!interest!=!7,400!!
So,!return!=!(7400!-!10000)!/!10000!=!-26%!
Diff:!1!
Skill:!Analytical!
!
!
Suppose!that!you!currently!have!$250,000!invested!in!a!portfolio!with!an!expected!return!of!12%!and!a!volatility!of!10%.!!
The!efficient!(tangent)!portfolio!has!an!expected!return!of!17%!and!a!volatility!of!12%.!!The!risk-free!rate!of!interest!is!5%.!
!
11)!!The!Sharpe!ratio!for!your!portfolio!is!closest!to:!
A)!!1.2!
B)!!0.6!
C)!!1.0!
D)!!0.7!
Answer:!!!D!
B)!!
C)!!
D)!! excess portfolio return .12 .05
Sharpe!ratio!=! !=! !=!.7!
portfolio volatility .10
Diff:!1!
Skill:!Analytical!
!
12)!!The!Sharpe!ratio!for!the!efficient!portfolio!is!closest!to:!
A)!!0.7!
B)!!1.0!
C)!!1.4!
D)!!1.2!
Answer:!!!B!
B)!! excess portfolio return .17 .05
Sharpe!ratio!=! !=! !=!1.0!
portfolio volatility .12
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!You!want!to!maximize!your!expected!return!without!increasing!your!risk.!!Without!increasing!your!volatility!
beyond!its!current!10%,!the!maximum!expected!return!you!could!earn!is!closest!to:!
A)!!.12.0%!
B)!!12.5%!
C)!!13.4%!
D)!!15.0%!
Answer:!!!D!
B)!!
C)!!
D)!!SD(!Rxp)!=!xSD(Rp)!
.10!=!x(.12)!!
x!=!.10!/!.12
x!=!.833333
So,!E[Rxp]!=!rf!+!x(E[Rp]!-!rf)
!=!.05!+!.8333(.17!-.05)!=!.15!or!15%!
Diff:!2!
Skill:!Analytical!
!
14)!!Suppose!that!you!want!to!maximize!your!expected!return!without!increasing!your!risk.!How!can!you!achieve!
this!goal?!!Without!increasing!your!risk,!what!is!the!maximum!expected!return!you!can!expect?!
Answer:!!!By!investing!in!a!combination!of!the!risk-free!asset!and!the!efficient!portfolio.!!We!find!the!weights!and!
expected!returns!as!follows:
SD(!Rxp)!=!xSD(Rp)!
.10!=!x(.12)!!
x!=!.10!/!.12
x!=!.833333!invested!in!the!efficient!portfolio
So,!E[Rxp]!=!rf!+!x(E[Rp]!-!rf)
!=!.05!+!.8333(.17!-!.05)!=!.15!or!15%!
Diff:!2!
Skill:!Analytical!
!
11.6!The!Efficient!Portfolio!and!the!Cost!of!Capital!
A)!!A!portfolio!is!efficient!if!it!has!the!highest!possible!Sharpe!ratio;!that!is!it!is!efficient!if!it!provides!the!
largest!increase!in!expected!return!possible!for!a!given!increase!in!volatility.!
B)!!The!required!return!for!an!investment!is!equal!to!a!risk!premium!that!is!equal!to!the!risk!premium!of!the!
p
investorbs!current!portfolio!scaled!by! .!
i
C)!!Increasing!the!investment!in!investment!I!will!increase!the!Sharpe!ratio!of!portfolio!P!if!its!expected!
p
return!E[Ri]!exceeds!the!required!return!ri,!which!is!given!by!ri!=!rf!+! !×!(E[Rp]!-!rf).!
i
D)!!If!a!security!ibs!expected!return!is!less!than!the!required!return!ri,!we!should!reduce!our!holding!of!
security!i.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!11.6!The!Efficient!Portfolio!and!the!Cost!of!Capital!
Skill:!Conceptual!
!
A)!!The!Sharpe!ratio!if!the!portfolio!tells!us!how!much!our!expected!return!will!increase!for!a!given!increase!
in!volatility.!
B)!!We!should!continue!to!trade!securities!until!the!expected!return!of!each!security!equals!its!required!
return.!
C)!!The!required!return!is!the!expected!return!that!is!necessary!to!compensate!for!the!risk!that!an!investment!
will!contribute!to!the!portfolio.!
D)!!If!security!i’s!required!return!exceeds!its!expected!return,!then!adding!more!of!it!will!improve!the!
performance!of!the!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!all!other!risk!is!diversifiable,!it!is!an!investment’s!beta!with!respect!to!the!efficient!portfolio!that!
measures!its!sensitivity!to!systematic!risk,!and!therefore!determines!its!cost!of!capital.!
B)!!If!a!securitybs!expected!return!exceeds!its!required!return!given!our!current!portfolio,!then!we!can!
improve!the!performance!of!our!portfolio!by!adding!more!of!the!security.!
C)!!The!appropriate!risk!premium!for!an!investment!can!be!determined!from!its!beta!with!the!efficient!
portfolio.!
D)!!As!we!buy!shares!of!a!security!i,!its!correlation!with!our!portfolio!P!will!increase,!ultimately!raising!its!
required!return!until!E[Ri]!=!Rp.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
You!are!presently!invested!in!the!Luther!Fund,!a!broad!based!mutual!fund!that!invest!in!stocks!and!other!securities.!!The!
Luther!Fund!has!an!expected!return!of!14%!and!a!volatility!of!20%.!!Risk-free!Treasury!bills!are!currently!offering!returns!
of!4%.!!You!are!considering!adding!a!precious!metals!fund!to!your!current!portfolio.!!The!metals!fund!has!an!expected!
return!of!10%!,!a!volatility!of!30%,!and!a!correlation!of!-.20!with!the!Luther!Fund.!
!
4)!! Luther
The!beta!of!the!precious!metals!fund!with!the!Luther!Fund! !is!closest!to:!
Metals
A)!!-0.3!
B)!!-0.6!
C)!!0.3!
D)!!0.6!
Answer:!!!A!
Explanation:!!! A)!!! Luther SD(rpmf )Corr (rpmf , rLF ) (.30)( .20)
!=!-0.3!
Metals SD(rLF ) .20
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!The!expected!return!on!the!precious!metals!fund!is!closest!to:!
A)!!-3%!
B)!!4%!
C)!!1%!
D)!!10%!
Answer:!!!C!
B)!!
C)!! Luther SD(rpmf )Corr (rpmf , rLF ) (.30)( .20)
=!-0.3
Metals SD(rLF ) .20
p
ri!=!rf!+! !×!(E[Rp]!-%rf)!=!.04!+!(-0.3)(.14!-!.04)!=!.01!
i
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Sisyphean!industries!is!seeking!to!raise!capital!from!a!large!group!of!investors!to!fund!a!new!project.!!Suppose!that!the!
efficient!portfolio!has!an!expected!return!of!14%!and!a!volatility!of!20%.!!Sisypheanbs!new!project!is!expected!to!have!a!
volatility!of!40%!and!a!70%!correlation!with!the!efficient!portfolio.!!The!risk-free!rate!is!4%.!
!
6)!!The!beta!for!Sisypheanbs!new!project!is!closest!to:!
A)!!1.25!
B)!!1.40!
C)!!0.70!
D)!!1.75!
Answer:!!!B!
B)!! EP SD(rproject )Corr (rproject , rEP ) (.40)(.70
!=!1.4!
project SD(rEP ) .20
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!required!return!for!Sisypheanbs!new!project!is!closest!to:!
A)!!24%!
B)!!14%!
C)!!18%!
D)!!10%!
Answer:!!!C!
B)!!
C)!! EP SD(rproject )Corr (rproject , rEP ) (.40)(.70)
!=!1.4
project SD(rEP ) .20
p
ri!=!rf!+! !×!(E[Rp]!-!rf)!=!.04!+!(1.4)(.14!-!.04)!=!.18!
i
D)!!
Diff:!2!
Skill:!Analytical!
!
!
You!are!presently!invested!in!the!Luther!Fund,!a!broad!based!mutual!fund!that!invest!in!stocks!and!other!securities.!!The!
Luther!Fund!has!an!expected!return!of!14%!and!a!volatility!of!20%.!!Risk-free!Treasury!bills!are!currently!offering!returns!
of!4%.!!You!are!considering!adding!a!precious!metals!fund!to!your!current!portfolio.!!The!metals!fund!has!an!expected!
return!of!10%,!a!volatility!of!30%,!and!a!correlation!of!-.20!with!the!Luther!Fund.!
!
8)!!Will!adding!the!precious!metals!fund!improve!your!portfolio?!
Answer:!!!Yes
Luther SD(rpmf )Corr (rpmf , rLF ) (.30)( .20)
=!-0.3
Metals SD(rLF ) .20
p
ri!=!rf!+! !×!(E[Rp]!-!rf)!=!.04!+!(-0.3)(.14!-!.04)!=!.01!<!.10!(the!expected!return!on!metals!fund)
i
Since!the!required!return!is!less!than!the!expected!return,!you!can!benefit!from!adding!the!precious!
metals!fund!to!your!portfolio.!
Diff:!2!
Skill:!Analytical!
!
!
Chapter(12(-(The(Capital(Asset(Pricing(Model(
!
12.1(The(Efficiency(of(the(Market(Portfolio(
A)!!All!investors!should!demand!the!same!efficient!portfolio!of!securities!in!the!same!proportions.!
B)!!The!Capital!Asset!Pricing!Model!(CAPM)!allows!corporate!executives!to!identify!the!efficient!portfolio!
(of!risky!assets)!by!using!knowledge!of!the!expected!return!of!each!security.!
C)!!If!investors!hold!the!efficient!portfolio,!then!the!cost!of!capital!for!any!investment!project!is!equal!to!its!
required!return!calculated!using!its!beta!with!the!efficient!portfolio.!
D)!!The!CAPM!identifies!the!market!portfolio!as!the!efficient!portfolio.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!12.1!The!Efficiency!of!the!Market!Portfolio!
Skill:!Conceptual!
!
A)!!If!investors!have!homogeneous!expectations,!then!each!investor!will!identify!the!same!portfolio!as!
having!the!highest!Sharpe!ratio!in!the!economy.!
B)!!Homogeneous!expectations!are!when!all!investors!have!the!same!estimates!concerning!future!
investments!and!returns.!
C)!!There!are!many!investors!in!the!world,!and!each!must!have!identical!estimates!of!the!volatilities,!
correlations,!and!expected!returns!of!the!available!securities.!
D)!!The!combined!portfolio!of!risky!securities!of!all!investors!must!equal!the!efficient!portfolio.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!If!some!security!were!not!part!of!the!efficient!portfolio,!then!every!investor!would!want!to!own!it,!and!
demand!for!this!security!would!increase!causing!its!expected!return!to!fall!until!it!is!no!longer!an!
attractive!investment.!
B)!!The!efficient!portfolio,!the!portfolio!that!all!investors!should!hold,!must!be!the!same!portfolio!as!the!
market!portfolio!of!all!risky!securities.!
C)!!Because!every!security!is!owned!by!someone,!the!sum!of!all!investorsP!portfolios!must!equal!the!portfolio!
of!all!risky!securities!available!in!the!market.!
D)!!If!all!investors!demand!the!efficient!portfolio,!and!since!the!supply!of!securities!is!the!market!portfolio,!
then!two!portfolios!must!coincide.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!all!investors!should!hold!the!risky!securities!in!the!same!proportions!as!the!efficient!portfolio,!
their!combined!portfolio!will!also!reflect!the!same!proportions!as!the!efficient!portfolio.!
B)!!When!the!CAPM!assumptions!hold,!choosing!an!optimal!portfolio!is!relatively!straightforward:!!it!is!the!
combination!of!the!risk-free!investment!and!the!market!portfolio.!
C)!!Graphically,!when!the!tangent!line!goes!through!the!market!portfolio,!it!is!called!the!security!market!line!
(SML).!
D)!!A!portfolioPs!risk!premium!and!volatility!are!determined!by!the!fraction!that!is!invested!in!the!market.!
Answer:!!!C!
B)!!
C)!!Graphically,!when!the!tangent!line!goes!through!the!market!portfolio,!it!is!called!the!capital!
market!line!(CML).!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Which!of!the!following!is!not!an!assumption!used!in!deriving!the!Capital!Asset!Pricing!Model!(CAPM)?!
A)!!Investors!have!homogeneous!expectations!regarding!the!volatilities,!correlation,!and!expected!returns!of!
securities.!
B)!!Investors!have!homogeneous!risk!adverse!preferences!toward!taking!on!risk.!
C)!!Investors!hold!only!efficient!portfolios!of!traded!securities,!that!is!portfolios!that!yield!the!maximum!
expected!return!for!the!given!level!of!volatility.!
D)!!Investors!can!buy!and!sell!all!securities!at!competitive!market!prices!without!incurring!taxes!or!
transactions!cost!and!can!borrow!and!lend!at!the!risk-free!interest!rate.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!E[RxCML]!=!rf!+!x(E[RMkt]!++rf)!
B)!!ri!=!rf!+!b(E[RMkt]!-!rf)!
C)!!SD(RxCML)=!xSD(RMkt)!
D)!!E[RxCML]!=!(1!-!x)rf!+!xE[RMkt]!
Answer:!!!A!
Explanation:!!! A)!!E[RxCML]!=!rf!+!x(E[RMkt]!-+rf)!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
Use+the+information+for+the+question(s)+below.!
!
TomPs!portfolio!consists!solely!of!an!investment!in!Merck!stock.!!Merck!has!an!expected!return!of!13%!and!a!volatility!of!
25%.!!The!market!portfolio!has!an!expected!return!of!12%!and!a!volatility!of!18%.!!The!risk-free!rate!is!4%.!!Assume!that!the!
CAPM!assumptions!hold!in!the!market.!
!
7)!!Assuming!that!Tom!wants!to!maintain!the!current!volatility!of!his!portfolio,!then!the!amount!that!Tom!should!
invest!in!the!market!portfolio!to!maximize!his!expected!return!is!closest!to:!
A)!!72%!
B)!!92%!
C)!!110%!
D)!!140%!
Answer:!!!D!
B)!!
C)!!
D)!!SD(RxCML)!=!xSD(RMkt)
.25!=!x(.18)!!=>!x!=!.25!/!.18!=!1.39!
Diff:!1!
Skill:!Analytical!
!
8)!!Assuming!that!Tom!wants!to!maintain!the!current!volatility!of!his!portfolio,!then!the!maximum!expected!
return!that!Tom!could!achieve!by!investing!in!the!market!portfolio!and!risk-free!investment!is!closest!to:!
A)!!13%!
B)!!15%!
C)!!16%!
D)!!12.%!
Answer:!!!B!
B)!!SD(RxCML)=!xSD(RMkt)
.25!=!x(.18)!!=>!x!=!.25!/!.18!=!1.39
E[RxCML]!=!rf!+!x(E[RMkt]!-!rf)
E[RxCML]!=!.04!+!1.39(.12!-!.04)!=!.1512!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Assuming!that!Tom!wants!to!maintain!the!current!expected!return!on!his!portfolio,!then!the!amount!that!Tom!
should!invest!in!the!market!portfolio!to!minimize!his!volatility!is!closest!to:!
A)!!100%!
B)!!90%!
C)!!125%!
D)!!110%!
Answer:!!!D!
B)!!
C)!!
D)!!E[RxCML]!=!rf!+!x(E[RMkt]!-!rf)
.13!=!.04!+!x(.12!-!.04)
x!=!.09!/!.08!=!1.125!
Diff:!1!
Skill:!Analytical!
!
10)!!Assuming!that!Tom!wants!to!maintain!the!current!expected!return!on!his!portfolio,!then!the!minimum!
volatility!that!Tom!could!achieve!by!investing!in!the!market!portfolio!and!risk-free!investment!is!closest!to:!
A)!!20%!
B)!!25%!
C)!!22%!
D)!!18%!
Answer:!!!A!
Explanation:!!! A)!!E[RxCML]!=!rf!+!x(E[RMkt]!-!rf)
.13!=!.04!+!x(.12!-!.04)
x!=!.09!/!.08!=!1.125
SD(RxCML)!=!xSD(RMkt)
1.125(.18)!=!.2025!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!You!currently!own!$100,000!worth!of!Wal-Mart!stock.!!Suppose!that!Wal-Mart!has!an!expected!return!of!14%!
and!a!volatility!of!23%.!!The!market!portfolio!has!an!expected!return!of!12%!and!a!volatility!of!16%.!!The!
risk-free!rate!is!5%.!!Assuming!the!CAPM!assumptions!hold,!what!alternative!investment!has!the!lowest!
possible!volatility!while!having!the!same!expected!return!as!Wal-Mart?!!What!is!the!volatility!of!this!portfolio?!
Answer:!!!E[RxCML]!=!rf!+!x(E[RMkt]!-!rf)
.14!=!.05!+!x(.12!-!.05)
x!=!.09!/!.07!=!1.286!!So!the!portfolio!is!long!129%!market!and!short!29%!risk-free!asset
SD(RxCML)=!xSD(RMkt)
1.286(.16)!=!.2057!=!20.6%!
Diff:!2!
Skill:!Analytical!
!
12)!!You!currently!own!$100,000!worth!of!Wal-Mart!stock.!!Suppose!that!Wal-Mart!has!an!expected!return!of!14%!
and!a!volatility!of!23%.!!The!market!portfolio!has!an!expected!return!of!12%!and!a!volatility!of!16%.!!The!
risk-free!rate!is!5%.!!Assuming!the!CAPM!assumptions!hold,!what!alternative!investment!has!the!highest!
possible!expected!return!while!having!the!same!volatility!as!Wal-Mart?!!What!is!the!expected!return!of!this!
portfolio?!
Answer:!!!SD(RxCML)=!xSD(RMkt)
.23!=!x(.16)!!=>!x!=!.23!/!.16!=!1.4375,!so!long!144%!market!and!short!44%!risk-free
E[RxCML]!=!rf!+!x(E[RMkt]!-!rf)
E[RxCML]!=!.05!+1.4375(.12!-!.05)!=!.2081!or!20.8%!
Diff:!2!
Skill:!Analytical!
(
12.2(Determining(the(Risk(Premium(
A)!!The!risk!premium!of!a!security!is!equal!to!the!market!risk!premium!(the!amount!by!which!the!marketPs!
expected!return!exceeds!the!risk-free!rate),!divided!by!the!amount!of!market!risk!present!in!the!securityPs!
returns!measured!by!its!beta!with!the!market.!
B)!!We!refer!to!the!beta!of!a!security!with!the!market!portfolio!simply!as!the!securities!beta.!
C)!!There!is!a!linear!relationship!between!a!stockPs!beta!and!its!expected!return.!
D)!!A!security!with!a!negative!beta!has!a!negative!correlation!with!the!market,!which!means!that!this!
security!tend!to!perform!will!when!the!rest!of!the!market!is!doing!poorly.!
Answer:!!!A!
Explanation:!!! A)!!The!risk!premium!of!a!security!is!equal!to!the!market!risk!premium!(the!amount!by!which!the!
market’s!expected!return!exceeds!the!risk-free!rate),!multiplied!by!the!amount!of!market!risk!
present!in!the!security’s!returns!measured!by!its!beta!with!the!market.!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!12.2!Determining!the!Risk!Premium!
Skill:!Conceptual!
!
A)!!The!expected!return!of!a!portfolio!should!correspond!to!the!portfolioPs!beta.!
B)!!Graphically!the!line!through!the!risk-free!investment!and!the!market!portfolio!is!called!the!capital!
market!line!(CML).!
C)!!The!beta!of!a!portfolio!is!the!weighted!average!beta!of!the!securities!in!the!portfolio.!
D)!!By!holding!a!negative!beta!security,!an!investor!can!reduce!the!overall!market!risk!of!her!portfolio.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!To!improve!the!performance!of!their!portfolios,!investors!who!are!holding!the!market!portfolio!will!
compare!the!expected!return!of!each!security!with!its!required!return!from!the!security!market!line.!
B)!!The!Sharpe!ratio!of!a!portfolio!will!increase!if!we!sell!stocks!with!positive!alphas.!
C)!!When!a!stockPs!alpha!is!not!zero,!investors!can!improve!upon!the!performance!of!the!market!portfolio.!
D)!!When!the!market!portfolio!is!efficient,!all!stocks!are!on!the!security!market!line!and!have!an!alpha!of!
zero.!
Answer:!!!B!
B)!!The!Sharpe!ratio!of!a!portfolio!will!decrease!if!we!sell!stocks!with!positive!alphas.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!We!can!improve!the!performance!of!our!portfolio!by!selling!stocks!with!negative!alphas.!
B)!!The!market!portfolio!is!on!the!SML,!and!according!to!the!CAPM,!since!all!other!portfolios!are!inefficient!
they!will!not!fall!on!the!SML.!
C)!!The!difference!between!a!stockPs!expected!return!and!its!required!return!according!to!the!security!
market!line!is!called!the!stockPs!alpha.!
D)!!The!risk!premium!for!any!security!is!proportional!to!its!beta!with!the!market.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!market!portfolio!is!the!efficient!portfolio.!
B)!!Many!practitioners!believe!it!is!sensible!to!use!the!CAPM!and!the!security!market!line!as!a!practical!
means!to!estimate!a!stockPs!required!return!and!therefore!a!firmPs!equity!cost!of!capital.!
C)!!If!we!plot!individual!securities!according!to!their!expected!return!and!beta,!the!CAPM!implies!that!they!
should!all!fall!along!the!CML.!
D)!!As!savvy!investors!attempt!to!trade!to!improve!their!portfolios,!they!raise!the!price!and!lower!the!
expected!return!of!the!positive!alpha!stocks,!and!they!depress!the!price!and!raise!the!expected!return!of!
negative!alpha!stocks,!until!the!stocks!are!once!again!on!the!security!market!line!and!the!market!
portfolio!is!efficient.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!The!beta!for!the!market!portfolio!is!closest!to:!
A)!!1!
B)!!0!
C)!!Unable!to!answer!this!question!without!knowing!the!markets!expected!return!
D)!!Unable!to!answer!this!question!without!knowing!the!markets!volatility!
Answer:!!!A!
Explanation:!!! A)!! SD( Rmkt )Corr ( Rmkt , Rmkt )
Beta!of!the!Market!Portfolio!=!bmkt!=! !=!Corr(Rmkt,Rmkt)=!1!(since!the!
SD( Rmkt )
market!is!perfectly!correlated!with!itself.)!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!beta!for!the!risk!free!investment!is!closest!to:!
A)!!1!
B)!!0!
C)!!Unable!to!answer!this!question!without!knowing!the!risk!free!rate!
D)!!Unable!to!answer!this!question!without!knowing!the!markets!volatility!
Answer:!!!B!
B)!! SD( Rrf )Corr ( Rmkt , Rrf ) 0 Corr ( Rmkt , Rrf )
Beta!of!the!Market!Portfolio!=!brf!=! !=! !
SD( Rmkt ) SD( Rmkt )
since!the!risk!free!investment!has!zero!volatility,!the!Beta!must!equal!zero.!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
Use+the+information+for+the+question(s)+below.!
!
Suppose!that!the!risk-free!rate!is!5%!and!the!market!portfolio!has!an!expected!return!of!13%!with!a!volatility!of!18%.!!
Monsters!Inc.!has!a!24%!volatility!and!a!correlation!with!the!market!of!.60,!while!California!Gold!Mining!has!a!32%!
volatility!and!a!correlation!with!the!market!of!-.7.!!Assume!the!CAPM!assumptions!hold.!
!
8)!!MonstersP!!Beta!with!the!market!is!closest!to:!
A)!!1.3!
B)!!1.0!
C)!!0.6!
D)!!0.8!
Answer:!!!D!
B)!!
C)!!
D)!! SD( RMonsters )Corr ( RMonsters, Rmkt ) (.24)(.6)
+bMonsters!=! !=! !=!.80!
SD( Rmkt ) .18
Diff:!1!
Skill:!Analytical!
!
9)!!MonstersP!required!return!is!closest!to:!
A)!!10.0%!
B)!!13.0%!
C)!!11.5%!
D)!!15.5%!
Answer:!!!C!
B)!!
C)!! SD( RMonsters )Corr ( RMonsters, Rmkt ) (.24)(.6)
+bMonsters!=! !=! !=!.80
SD( Rmkt ) .18
ri!=!rf!+!b(E[RMkt]!-!rf)
=!.05!+!.8(.13!-!.05)!=.114!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Suppose!that!MonstersP!expected!return!is!12%.!!Then!MonstersP!!alpha!is!closest!to:!
A)!!-2.0%!
B)!!-1.0%!
C)!!1.0%!
D)!!0.5%!
Answer:!!!D!
B)!!
C)!!
D)!! SD( RMonsters )Corr ( RMonsters, Rmkt ) (.24)(.6)
+bMonsters!=! !=! !=!.80
SD( Rmkt ) .18
=!.05!+!.8(.13!-!.05)!=.114!so!alpha!=!.12!-!11.4!=!0.6%!
Diff:!2!
Skill:!Analytical!
!
11)!!California!Gold!MiningPs!Beta!with!the!market!is!closest!to:!
A)!!0.9!
B)!!1.25!
C)!!-0.9!
D)!!-1.25!
Answer:!!!D!
B)!!
C)!!
D)!! SD( RCGM )Corr ( RCGM , Rmkt ) (.32)( .7)
!bCGM!=! !=! !=!-1.24!
SD( Rmkt ) .18
Diff:!1!
Skill:!Analytical!
!
12)!!California!Gold!MiningPs!required!return!is!closest!to:!
A)!!-5%!
B)!!13%!
C)!!15%!
D)!!5%!
Answer:!!!A!
Explanation:!!! A)!! SD( RCGM )Corr ( RCGM , Rmkt ) (.32)( .7)
bCGM!=! !=! !=!-1.24
SD( Rmkt ) .18
=!.05!+!-1.24(.13!-!.05)!=!-.05!or!-5%!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!Suppose!that!California!Gold!MiningPs!expected!return!is!2%.!!Then!california!Gold!MiningPs!alpha!is!closest!
to:!
A)!!-3%!
B)!!-13%!
C)!!7%!
D)!!-11%!
Answer:!!!C!
B)!!
C)!! SD( RCGM )Corr ( RCGM , Rmkt ) (.32)( .7)
bCGM!=! !=! !=!-1.24
SD( Rmkt ) .18
=!.05!+!-1.24(.13!-!.05)!=!-.05!or!-5%!!Alpha!=!.02!-!-.05!=!7%!
D)!!
Diff:!2!
Skill:!Analytical!
!
Use+the+table+for+the+question(s)+below.
!
Consider!the!following!three!individuals!portfolios!consisting!of!investments!in!four!stocks:
PeterBs( PaulBs( MaryBs(

Stock Beta Investment Investment Investment(
Eenie 1.3 2500 5000 10000!
Meenie 1.0 2500 5000 10000!
Minie 0.8 2500 5000 -5000!
Moe -0.5 2500 -5000 -5000!
!
!
14)!!The!Beta!on!PeterPs!Portfolio!is!closest!to:!
A)!!0.7!
B)!!0.8!
C)!!1.8!
D)!!1.0!
Answer:!!!A!
Explanation:!!! A)!!bportfolio!=! xibi
PeterBs( PaulBs( MaryBs( PeterBs( PaulBs( MaryBs(

Stock Beta Investment Investment Investment Weights Weights Weights(
Eenie 1.3 2500 5000 10000 25% 50% 100%!
Meenie 1.0 2500 5000 10000 25% 50% 100%!
Minie 0.8 2500 5000 -5000 25% 50% -50%!
Moe -0.5 2500 -5000 -5000 25% -50% -50%!
Port!Beta= 0.65 1.80 2.15!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
15)!!Assuming!that!the!risk-free!rate!is!4%!and!the!expected!return!on!the!market!is!12%,!then!required!return!on!
PeterPs!Portfolio!is!closest!to:!
A)!!10%!
B)!!12%!
C)!!9%!
D)!!8%!
Answer:!!!C!
B)!!
C)!!bportfolio!=! ibi
=!.04!+!.65(.12!-!.04)!=!.092!
!
Eenie 1.3 2500 5000 10000 25% 50% 100%!
Meenie 1.0 2500 5000 10000 25% 50% 100%!
Minie 0.8 2500 5000 -5000 25% 50% -50%!
Moe -0.5 2500 -5000 -5000 25% -50% -50%!
Port!Beta= 0.65 1.80 2.15!
D)!!
Diff:!2!
Skill:!Analytical!
!
16)!!The!Beta!on!PaulPs!Portfolio!is!closest!to:!
A)!!1.5!
B)!!1.8!
C)!!1.3!
D)!!1.0!
Answer:!!!B!
B)!!bportfolio!=! xibi+
+
Eenie 1.3 2500 5000 10000 25% 50% 100%!
Meenie 1.0 2500 5000 10000 25% 50% 100%!
Minie 0.8 2500 5000 -5000 25% 50% -50%!
Moe -0.5 2500 -5000 -5000 25% -50% -50%!
Port!Beta= 0.65 1.80 2.15!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
17)!!Assuming!that!the!risk-free!rate!is!4%!and!the!expected!return!on!the!market!is!12%,!then!required!return!on!
PeterPs!Portfolio!is!closest!to:!
A)!!20%!
B)!!22%!
C)!!18%!
D)!!16%!
Answer:!!!C!
B)!!
C)!!bportfolio!=! xibi
=!.04!+!1.8(.12!-!.04)!=!.184
!
Eenie 1.3 2500 5000 10000 25% 50% 100%!
Meenie 1.0 2500 5000 10000 25% 50% 100%!
Minie 0.8 2500 5000 -5000 25% 50% -50%!
Moe -0.5 2500 -5000 -5000 25% -50% -50%!
Port!Beta= 0.65 1.80 2.15!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Assuming!that!the!risk-free!rate!is!4%!and!the!expected!return!on!the!market!is!12%,!then!calculate!the!
required!return!on!MaryPs!Portfolio.!
Answer:!!!bportfolio!=! xibi
ri!=!rf!+!b(E[RMkt]!-!rf)!
=!.04!+!2.15(.12!-!.04)!=!.212!
!
Eenie 1.3 2500 5000 10000 25% 50% 100%!
Meenie 1.0 2500 5000 10000 25% 50% 100%!
Minie 0.8 2500 5000 -5000 25% 50% -50%!
Moe -0.5 2500 -5000 -5000 25% -50% -50%!
Port!Beta= 0.65 1.80 2.15!
Diff:!2!
Skill:!Analytical!
!
19)!!Suppose!that!the!risk-free!rate!is!5%!and!the!market!portfolio!has!an!expected!return!of!13%!with!a!volatility!of!
18%.!!Luther!Industries!has!a!volatility!of!24%!and!a!correlation!with!the!market!of!.5.!!If!you!assume!that!the!
CAPM!assumptions!hold,!then!what!is!the!expected!return!on!Luther!stock?
Answer:!!! SD( RLuther )Corr ( RLuther , Rmkt ) (.24)(.5)

!bMonsters!=! !=! != .66667
SD( Rmkt ) .18
=!.05!+!.66667(.13!-!.05)!=.103333!
Diff:!2!
Skill:!Analytical!
(
12.3(The(Market(Portfolio(
A)!!The!market!portfolio!contains!more!of!the!smallest!stocks!and!less!of!the!larger!stocks.!
B)!!For!the!market!portfolio,!the!investment!in!each!security!is!proportional!to!its!market!capitalization.!
C)!!Because!the!market!portfolio!is!defined!as!the!total!supply!of!securities,!the!proportions!should!
correspond!exactly!to!the!proportion!of!the!total!market!that!each!security!represents.!
D)!!Market!capitalization!is!the!total!market!value!of!the!outstanding!shares!of!a!firm.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!12.3!The!Market!Portfolio!
Skill:!Conceptual!
!
A)!!A!value-weighted!portfolio!is!an!equal-ownership!portfolio:!!We!hold!an!equal!fraction!of!the!total!
number!of!shares!outstanding!of!each!security!in!the!portfolio.!
B)!!When!buying!a!value-weighted!portfolio,!we!end!up!purchasing!the!same!percentage!of!shares!of!each!
firm.!
C)!!To!maintain!a!value-weighted!portfolio,!we!do!not!need!to!trade!securities!and!rebalance!the!portfolio!
unless!the!number!of!shares!outstanding!of!some!security!changes.!
D)!!In!a!value!weighted!portfolio!the!fraction!of!money!invested!in!any!security!corresponds!to!its!share!of!
the!total!number!of!shares!outstanding!of!all!securities!in!the!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!most!familiar!stock!index!in!the!United!States!is!the!Dow!Jones!Industrial!Average!(DJIA).!
B)!!A!portfolio!in!which!each!security!is!held!in!proportion!to!its!market!capitalization!is!called!a!
price-weighted!portfolio.!
C)!!The!Dow!Jones!Industrial!Average!(DJIA)!consists!of!a!portfolio!of!30!large!industrial!stocks.!
D)!!The!Dow!Jones!Industrial!Average!(DJIA)!is!a!price-weighted!portfolio.!
Answer:!!!B!
B)!!A!portfolio!in!which!each!security!is!held!in!proportion!to!its!market!capitalization!is!called!a!
value-weighted!portfolio.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!very!little!trading!is!required!to!maintain!it,!an!equal-weighted!portfolio!is!called!a!passive!
portfolio.!
B)!!If!the!number!of!shares!in!a!value!weighted!portfolio!does!not!change,!but!only!the!prices!change,!the!
portfolio!will!remain!value!weighted.!
C)!!The!CAPM!says!that!individual!investors!should!hold!the!market!portfolio,!a!value-weighted!portfolio!
of!all!risky!securities!in!the!market.!
D)!!A!price!weighted!portfolio!holds!an!equal!number!of!shares!of!each!stock,!independent!of!their!size.!
Answer:!!!A!
Explanation:!!! A)!!Because!very!little!trading!is!required!to!maintain!it,!a!value-weighted!portfolio!is!called!a!
passive!portfolio.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!A!market!index!reports!the!value!of!a!particular!portfolio!of!securities.!
B)!!The!S&P!500!is!the!standard!portfolio!used!to!represent!gthe!marketg!when!using!the!CAPM!in!practice.!
C)!!Even!though!the!S&P!500!includes!only!500!of!the!more!than!7,000!individual!U.S.!Stocks!in!existence,!it!
represents!more!than!70%!of!the!U.S.!stock!market!in!terms!of!market!capitalization.!
D)!!The!S&P!500!is!an!equal-weighted!portfolio!of!500!of!the!largest!U.S.!stocks.!
Answer:!!!D!
B)!!
C)!!
D)!!The!S&P!500!is!a!value-weighted!portfolio!of!500!of!the!largest!U.S.!stocks.!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!S&P!500!and!the!Wilshire!5000!indexes!are!both!well-diversified!indexes!that!roughly!correspond!to!
the!market!of!U.S.!stocks.!
B)!!Practitioners!commonly!use!the!S&P!500!as!the!market!portfolio!in!the!CAPM!with!the!belief!that!this!
index!is!the!market!portfolio.!
C)!!Standard!&!PoorPs!Depository!Receipts!(SPDR,!nicknamed!gspiderg)!trade!on!the!American!Stock!
Exchange!and!represent!ownership!in!the!S&P!500.!
D)!!The!S&P!500!was!the!first!widely!publicized!value!weighted!index!and!it!has!become!a!benchmark!for!
professional!investors.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!In!practice!which!market!index!is!most!widely!used!as!a!proxy!for!the!market!portfolio!in!the!CAPM?!
A)!!Dow!Jones!Industrial!Average!
B)!!Wilshire!5000!
C)!!S&P!500!
D)!!U.S.!Treasury!Bill!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
8)!!In!practice!which!market!index!would!best!be!used!as!a!proxy!for!the!market!portfolio!in!the!CAPM?!
A)!!S&P!500!
B)!!Dow!Jones!Industrial!Average!
C)!!U.S.!Treasury!Bill!
D)!!Wilshire!5000!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Use+the+table+for+the+question(s)+below.
!
Consider!the!following!stock!price!and!shares!outstanding!data:
Shares(
Stock( Price(per( Outstanding(
Name Share (Billions)(
Lowes $28.80 1.53!
Wal-Mart $47.90! 4.17!
Intel $19.60! 5.77!
Boeing $75.00! 0.79!
9)!!The!market!capitalization!for!Wal-Mart!is!closest!to:!
A)!!$415!Billion!
B)!!$276!Billion!
C)!!$479!Billion!
D)!!$200!Billion!
Answer:!!!D!
B)!!
C)!!
D)!!!
Shares( Market(
Stock( Price(per( Outstanding( Capitalization(
Name Share (Billions)( (Billions)(
Lowes $28.80! 1.53 $44.06!!
Wal-Mart $47.90! 4.17 $199.74!!
Intel $19.60! 5.77 $113.09!!
Boeing $75.00! 0.79 $59.25!!
Total $416.15!!
Diff:!1!
Skill:!Analytical!
!
10)!!The!total!market!capitalization!for!all!four!stocks!is!closest!to:!
A)!!$479!Billion!
B)!!$415!Billion!
C)!!$2,100!Billion!
D)!!$200!Billion!
Answer:!!!B!
B)!!!
Shares( Market(
Stock( Price(per( Outstanding( Capitalization(
Name Share (Billions)( (Billions)(
Lowes $28.80! 1.53 $44.06!!
Wal-Mart $47.90! 4.17 $199.74!!
Intel $19.60! 5.77 $113.09!!
Boeing $75.00! 0.79 $59.25!!
Total $416.15!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!If!you!are!interested!in!creating!a!value-weighted!portfolio!of!these!four!stocks,!then!the!percentage!amount!
that!you!would!invest!in!Lowes!is!closest!to:!
A)!!25%!
B)!!11%!
C)!!20.0%!
D)!!12%!
Answer:!!!B!
B)!!!
Shares( Market(
Stock( Price(per( Outstanding( Capitalization( Percent(of(
Name Share (Billions)( (Billions)( Total(
Lowes $28.80! 1.53 $44.06!! 10.6%!
Wal-Mart $47.90! 4.17 $199.74!! 48.0%!
Intel $19.60! 5.77 $113.09!! 27.2%!
Boeing $75.00! 0.79 $59.25!! 14.2%!
Total $416.15!! !
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!Assume!that!you!have!$100,000!to!invest!and!you!are!interested!in!creating!a!value-weighted!portfolio!of!
these!four!stocks.!!The!number!of!shares!of!Wal-Mart!that!you!would!hold!in!your!portfolio!is!closest!to:!
A)!!710!
B)!!1390!
C)!!1000!
D)!!870!
Answer:!!!C!
B)!!
C)!!!
Shares( Market(
Stock( Price(per( Outstanding( Capitalization( Percent( Number(
Name Share (Billions)( (Billions)( of(Total( of(Shares(
Lowes $28.80! 1.53 $44.06! 10.6% 368!!
Wal-Mart $47.90! 4.17 $199.74! 48.0% 1,002!!
Intel $19.60! 5.77 $113.09! 27.2% 1,387!!
Boeing $75.00! 0.79 $59.25! 14.2% 190!!
Total $416.15!
percent of total $100, 000

Number!of!shares!=! !
price per share
D)!!
Diff:!2!
Skill:!Analytical!
!
these!four!stocks.!!The!percentage!of!the!shares!outstanding!of!Boeing!that!you!would!hold!in!your!portfolio!is!
closest!to:!
A)!!.000018%!
B)!!.000020%!
C)!!.000024%!
D)!!.000031%!
Answer:!!!C!
B)!!
C)!! Shares( Market(
Lowes $28.80! 1.53 $44.06! 10.6% 368!!
Wal-Mart $47.90! 4.17 $199.74! 48.0% 1,002!!
Intel $19.60! 5.77 $113.09! 27.2% 1,387!!
Boeing $75.00! 0.79 $59.25! 14.2% 190!!
Total $416.15!

Number!of!shares!=!
price per share
percentage!shares!outstanding!=!190!/!790000000!=!.000024%!
D)!!
Diff:!2!
Skill:!Analytical!
these!four!stocks.!!How!many!shares!of!each!of!the!four!stocks!will!you!hold?!!What!percentage!of!the!shares!
outstanding!of!each!stock!will!you!hold?!
Answer:!!!!
Shares( Market(
Lowes $28.80! 1.53 $44.06! 10.6% 368!!
Wal-Mart $47.90! 4.17 $199.74! 48.0% 1,002!!
Intel $19.60! 5.77 $113.09! 27.2% 1,387!!
Boeing $75.00! 0.79 $59.25! 14.2% 190!!
Total $416.15!
%!of!Shares 0.000060%

Number!of!shares!=! !
price per share
In!a!value!weighted!portfolio,!the!percentage!of!shares!of!every!stock!will!be!the!same.!
Diff:!3!
Skill:!Analytical!
(
12.4(Determing(Beta(
A)!!Beta!is!the!expected!percent!change!in!the!excess!return!of!the!security!for!a!1%!change!in!the!excess!
return!of!the!market!portfolio.!
B)!!Beta!represents!the!amount!by!which!risks!that!affect!the!overall!market!are!amplified!for!a!given!stock!
or!investment.!
C)!!It!is!common!practice!to!estimate!beta!based!on!the!historical!correlation!and!volatilities.!
D)!!Beta!measures!the!diversifiable!risk!of!a!security,!as!opposed!to!its!market!risk,!and!is!the!appropriate!
measure!of!the!risk!of!a!security!for!an!investor!holding!the!market!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!Beta!measures!the!nondiversifiable!risk!of!a!security.!
Diff:!1!
Topic:!12.4!Determining!Beta!
Skill:!Conceptual!
!
A)!!One!difficulty!when!trying!to!estimate!beta!for!a!security!is!that!beta!depends!on!the!correlation!and!
volatilities!of!the!securityPs!and!marketPs!returns!in!the!future.!
B)!!It!is!common!practice!to!estimate!beta!based!on!the!expectations!of!future!correlations!and!volatilities.!
C)!!One!difficulty!when!trying!to!estimate!beta!for!a!security!is!that!beta!depends!on!investors!expectations!
of!the!correlation!and!volatilities!of!the!securityPs!and!marketPs!returns.!
D)!!Securities!that!tend!to!move!less!than!the!market!have!betas!below!1.!
Answer:!!!B!
B)!!Beta!is!measured!using!past!information.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Securities!that!tend!to!move!more!than!the!market!have!betas!higher!than!0.!
B)!!Securities!whose!returns!tend!to!move!in!tandem!with!the!market!on!average!have!a!beta!of!1.!
C)!!Beta!corresponds!to!the!slope!of!the!best!fitting!line!in!the!plot!of!the!securities!excess!returns!versus!the!
market!excess!return.!
D)!!The!statistical!technique!that!identifies!the!bets-fitting!line!through!a!set!of!points!is!called!linear!
regression.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Use+the+equation+for+the+question(s)+below.
!
Consider!the!following!linear!regression!model:
(Ri!-!rf)!=!ai!+!bi(RMkt!-!rf)!+!ei
4)!!The!bi!in!the!regression!
A)!!measures!the!sensitivity!of!the!security!to!market!risk.!
B)!!measures!the!historical!performance!of!the!security!relative!to!the!expected!return!predicted!by!the!SML.!
C)!!measures!the!deviation!from!the!best!fitting!line!and!is!zero!on!average.!
D)!!measures!the!diversifiable!risk!in!returns.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
5)!!The!ai!in!the!regression!
A)!!measures!the!sensitivity!of!the!security!to!market!risk.!
B)!!measures!the!deviation!from!the!best!fitting!line!and!is!zero!on!average.!
C)!!measures!the!diversifiable!risk!in!returns.!
D)!!measures!the!historical!performance!of!the!security!relative!to!the!expected!return!predicted!by!the!SML.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!The!ei!in!the!regression!
A)!!measures!the!market!risk!in!returns.!
B)!!measures!the!deviation!from!the!best!fitting!line!and!is!zero!on!average.!
C)!!measures!the!sensitivity!of!the!security!to!market!risk.!
D)!!measures!the!historical!performance!of!the!security!relative!to!the!expected!return!predicted!by!the!SML.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
(
12.5(Extending(the(CAPM(
A)!!Short-term!margin!loans!from!a!broker!are!often!1%!to!2%!lower!than!the!rates!paid!on!short-term!
Treasury!securities.!
B)!!In!the!real!world!investors!have!different!information!and!expectations!regarding!securities.!
C)!!The!SML!is!still!valid!when!interest!rates!differ.!
D)!!When!borrowing!and!lending!occur!at!different!rates!there!are!different!tangent!portfolios!identified.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!12.5!Extending!the!CAPM!
Skill:!Conceptual!
!
A)!!A!combination!of!portfolios!on!the!efficient!frontier!of!risky!investments!is!also!on!the!efficient!frontier!
of!risky!investments.!
B)!!The!conclusion!of!the!CAPM!that!investors!should!hold!the!market!portfolio!combined!with!the!risk-free!
investment!depends!on!the!quality!of!an!investorPs!information.!
C)!!The!SML!holds!with!some!rate!r*!between!rs!and!rb!in!place!of!rf,!where!r*!depends!on!the!proportion!of!
savers!and!borrowers!in!the!economy.!!
D)!!In!reality,!investors!have!different!information!and!spend!varying!amounts!of!effort!on!research!for!
assorted!stocks.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!an!investor!chooses!her!optimal!portfolio,!she!will!do!so!by!finding!the!tangent!line!using!the!
risk-free!rate!that!corresponds!to!her!investment!horizon.!
B)!!If!the!market!portfolio!is!not!efficient,!savvy!investors!who!recognize!that!the!market!portfolio!is!not!
optimal!will!push!prices!and!expected!returns!back!into!balance.!
C)!!Even!though!different!investors!may!research!different!stocks,!their!information!will!not!impact!the!
market!portfolio!since!there!is!no!way!to!share!this!information!with!other!investors.!!
D)!!In!the!real!world!borrowers!pay!higher!interest!rates!than!savers!receive.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Investors!may!have!different!information!regarding!expected!returns,!correlations,!and!volatilities,!but!
they!correctly!interpret!that!information!and!the!information!contained!in!market!prices!and!they!adjust!
their!estimates!of!expected!returns!in!a!rational!way.!
B)!!Investors!may!learn!different!information!through!their!own!research!and!observations,!but!as!long!as!
they!understand!the!differences!in!information!and!learn!from!other!investors!by!observing!prices,!the!
CAPM!conclusions!still!stand.!
C)!!Every!investor,!regardless!of!how!much!information!he!has!access!to,!can!guarantee!himself!an!alpha!of!
zero!by!holding!the!market!portfolio.!
D)!!The!CAPM!requires!making!the!strong!assumption!of!homogeneous!expectations.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!Because!of!the!higher!and!uncompensated!risk!involved,!no!investor!should!choose!a!portfolio!with!a!
negative!alpha.!
B)!!Because!the!average!portfolio!of!all!investors!is!the!market!portfolio,!the!average!alpha!for!all!investors!is!
zero.!
C)!!The!market!portfolio!can!be!inefficient!if!a!significant!number!of!investors!misinterpret!information!and!
believe!they!are!earning!a!positive!alpha!when!they!are!actually!earning!a!negative!alpha.!!
D)!!If!no!investor!earns!a!positive!alpha,!then!no!investor!can!earn!a!negative!alpha,!and!the!market!portfolio!
must!be!efficient.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!Explain!how!having!different!interest!rates!for!borrowing!and!lending!affects!the!CAPM!and!the!SML.!
Answer:!!!The!basic!conclusions!of!the!CAPM!will!still!hold.!!However,!investors!will!now!be!faced!with!a!group!
of!efficient!portfolios!of!risky!assets!along!the!efficient!frontier.!!An!individual!investors!optimal!
efficient!portfolio!will!be!the!one!identified!by!the!line!tangent!to!the!efficient!frontier!that!intersects!at!
their!appropriate!interest!rate.!!The!market!portfolio!will!become!the!average!of!all!the!individual!
efficient!portfolios,!and!an!average!interest!rate!can!be!used!to!generalize!the!CAPM!and!SML!to!all!
investors!using!the!market!portfolio.!
Diff:!2!
Skill:!Conceptual!
!
12.6(The(CAPM(in(Practice(
1)!!Which!of!the!following!is!not!considered!a!difficulty!with!regards!to!the!CAPM?!
A)!!Betas!are!not!observed.!
B)!!Expected!returns!are!not!observed.!
C)!!The!market!proxy!is!not!correct.!
D)!!Investors!risk!preferences!are!not!observed.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!12.6!The!CAPM!in!Practice!
Skill:!Conceptual!
!
2)!!Which!of!the!following!is!not!considered!to!be!an!important!choice!when!estimating!beta?!
A)!!The!choice!of!the!time!horizon!to!use!for!estimation!
B)!!The!choice!of!method!used!to!extrapolate!beta!
C)!!The!choice!between!weekly!and!monthly!returns!
D)!!The!choice!of!index!used!as!the!market!portfolio!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Many!practitioners!prefer!to!use!average!industry!betas!rather!than!individual!stock!betas.!
B)!!When!estimating!beta!by!using!past!returns!it!is!best!to!use!the!longest!time!horizon!of!returns!available.!
C)!!The!CAPM!predicts!that!a!securityPs!expected!return!depends!on!its!beta!with!regard!to!the!market!
portfolio!of!all!risky!investments!available!to!investors.!
D)!!If!we!use!too!short!a!time!horizon!when!estimating!beta,!our!estimate!of!beta!will!be!unreliable.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!should!be!suspicious!of!beta!estimates!that!are!extreme!relative!to!industry!norms.!
B)!!When!using!historical!data,!there!is!always!the!possibility!of!estimation!error.!
C)!!Evidence!suggests!that!betas!tend!to!revert!toward!zero!over!time.!
D)!!For!stocks,!common!practice!is!to!use!at!least!two!years!of!weekly!return!data!or!five!years!of!monthly!
return!data!when!estimating!beta.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!There!may!be!reasons!to!exclude!certain!historical!data!as!anomalous!when!estimating!beta.!
B)!!Many!practitioners!use!adjusted!betas,!which!are!calculated!by!averaging!the!estimated!beta!with!1.0.!
C)!!The!beta!estimated!we!obtain!from!linear!regression!can!be!very!sensitive!to!outliers,!which!are!returns!
of!unusually!small!magnitude.!
D)!!If!we!use!very!old!data!to!when!estimating!beta,!they!data!may!be!unrepresentative!of!the!current!
market!risk!of!the!security.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Many!practitioners!analyze!other!financial!characteristics!of!a!firm,!when!they!forecast!betas.!
B)!!U.S.!Treasuries!are!never!subject!to!interest!rate!risk!unless!we!select!a!maturity!equal!to!our!investment!
horizon.!
C)!!If!a!firm!where!to!change!industries,!using!its!historical!beta!would!be!inferior!to!using!the!beta!of!other!
firms!in!the!new!industry.!
D)!!When!using!historical!returns!to!forecast!future!betas,!we!must!be!mindful!of!changes!in!the!
environment!that!might!cause!the!future!to!differ!from!the!past.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!CAPM!states!that!we!should!use!the!risk-free!interest!rate!corresponding!to!the!investment!horizon!
of!the!firmPs!investors.!
B)!!To!determine!the!risk!premium!for!a!stock!using!the!security!market!line,!we!need!an!estimate!of!the!
market!risk!premium.!
C)!!When!surveyed,!the!vast!majority!of!large!firms!and!financial!analysts!reported!using!the!yields!of!
Treasury!Bills!!to!determine!the!risk-free!rate.!
D)!!The!risk-free!interest!rate!is!generally!determined!using!the!yields!of!U.S.!Treasury!securities,!which!are!
free!from!default!risk.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!The!CAPM!remains!the!predominant!model!use!in!practice!to!determine!the!equity!cost!of!capital.!
B)!!Low!beta!stocks!have!tended!to!perform!somewhat!better!than!the!CAPM!predicts.!
C)!!The!empirically!estimated!security!market!line!is!somewhat!steeper!than!that!predicted!by!the!CAPM.!
D)!!Some!evidence!suggests!that!the!market!risk!premium!has!declined!over!time.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!The!imperfections!in!the!CAPM!may!be!critical!in!the!context!of!capital!budgeting!and!corporate!finance,!
where!errors!in!estimating!the!cost!of!capital!are!likely!to!be!far!more!important!than!small!discrepancies!
in!the!project!cash!flows.!
B)!!To!estimate!the!expected!market!risk!premium!we!can!look!at!the!historical!average!excess!return!of!the!
market!over!the!risk!free!interest!rate.!
C)!!The!highest!beta!stocks!have!tended!to!under!perform!what!the!CAPM!predicts.!
D)!!Given!an!assessment!of!an!indexPs!future!cash!flows,!we!can!estimate!the!expected!return!of!the!market!
by!solving!for!the!discount!rate!that!is!consistent!with!the!current!level!of!the!index.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
10)!!Assume!that!the!S&P!500!currently!has!a!dividend!yield!of!3%!and!that!on!average,!the!dividends!of!S&P!500!
firms!have!increased!by!about!5%!per!year.!!If!the!risk-free!interest!rate!is!4%,!then!your!estimate!for!the!future!
market!risk!premium!is:!
A)!!7%!
B)!!8%!
C)!!6%!
D)!!4%!
Answer:!!!D!
B)!!
C)!!
D)!!r+=!d1!/!p0!+g!=!dividend!yield!+!g!=!.03!+!.05!=!.08
Risk!premium!=!expected!return!on!market!-!risk!free!rate!=!.08!-!.04!=!.04!
Diff:!2!
Skill:!Analytical!
!
11)!!Assume!that!the!Wilshire!5000!currently!has!a!dividend!yield!of!2%!and!that!on!average,!the!dividends!of!
Wilshire!5000!firms!have!increased!by!about!7%!per!year.!!If!the!risk-free!interest!rate!is!4%,!then!your!
estimate!for!the!future!market!risk!premium!is:!
A)!!4%!
B)!!7%!
C)!!8%!
D)!!5%!
Answer:!!!D!
B)!!
C)!!
D)!!r+=!d1!/!p0!+g!=!dividend!yield!+!g!=!.02!+!.07!=!.09
Risk!premium!=!expected!return!on!market!-!risk!free!rate!=!.09!-!.04!=!.05!
Diff:!2!
Skill:!Analytical!
!
Chapter(13(-(Alternative(Models(of(Systematic(Risk(
!
!
13.1(The(Efficiency(of(the(Market(Portfolio(
A)!!If!the!market!portfolio!is!efficient,!then!all!securities!and!portfolios!must!plot!on!the!SML,!not!just!
individual!stocks.!
B)!!For!most!stocks!the!standard!errors!of!the!alpha!estimates!are!large,!so!it!is!impossible!to!conclude!that!
the!alphas!are!statistically!different!from!zero.!
C)!!It!is!not!difficult!to!find!individual!stocks!that,!in!the!past!have!not!plotted!on!the!SML.!
D)!!Small!stocks!(those!with!lower!market!capitalization)!have!lower!average!returns.!
Answer:!!!D!
B)!!
C)!!
D)!!Small!stocks!(those!with!lower!market!capitalization)!have!higher!average!returns.!
Diff:!1!
Topic:!13.1The!Efficiency!of!the!Market!Portfolio!
Skill:!Conceptual!
!
A)!!The!size!effect!is!the!observation!that!small!stocks!have!positive!alphas.!
B)!!When!considering!portfolios!formed!based!on!the!market-to-book!ratio,!most!of!the!portfolios!plot!
below!the!security!market!line.!
C)!!The!largest!alphas!occur!in!the!smallest!size!deciles.!!
D)!!When!considering!portfolios!formed!based!on!size,!although!the!portfolios!with!the!higher!betas!yield!
higher!returns,!most!size!portfolios!plot!above!the!security!market!line.!
Answer:!!!B!
B)!!When!considering!portfolios!formed!based!on!the!market-to-book!ratio,!most!of!the!portfolios!
plot!above!the!security!market!line.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Portfolios!with!high!market!capitalizations!will!have!positive!alphas!if!the!market!portfolio!is!not!
efficient.!
B)!!The!book-to-market!is!the!observation!that!firms!with!high!book-to-market!ratios!have!positive!alphas.!
C)!!If!the!market!portfolio!is!not!efficient,!then!a!portfolio!of!high!book-to-market!stocks!will!likely!have!
positive!alphas.!
D)!!Portfolios!with!low!book-to-market!rations!will!have!negative!alphas!if!the!market!portfolio!is!not!
efficient.!
Answer:!!!A!
Explanation:!!! A)!!Portfolios!with!low!market!capitalizations!will!have!positive!alphas!if!the!market!portfolio!is!
not!efficient.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!momentum!strategy!is!one!where!you!buy!stocks!that!have!had!low!past!returns!and!(short)!sell!stocks!
that!have!had!high!past!returns.!
B)!!Over!the!years!since!the!discovery!of!the!CAPM,!it!has!become!increasing!clear!to!researchers!and!
practitioners!alike!that!forming!portfolios!based!on!market!capitalization,!book-to-market!ratios,!and!
past!returns,!one!can!construct!trading!strategies!that!have!a!positive!alpha.!
C)!!Portfolios!containing!firms!with!the!highest!realized!returns!over!the!previous!six!months!have!positive!
alphas!over!the!next!six!months.!
D)!!If!the!market!portfolio!is!not!efficient,!then!a!portfolio!of!small!stocks!will!likely!have!positive!alphas.!
Answer:!!!A!
Explanation:!!! A)!!A!momentum!strategy!is!one!where!you!buy!stocks!that!have!had!high!past!returns!and!(short)!
sell!stocks!that!have!had!low!past!returns.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Use$the$figure$for$the$question(s)$below.
!
Consider!the!following!graph!of!the!security!market!line:!
!
!
5)!!Portfolio!TBT!!
A)!!is!less!risky!than!the!market!portfolio.!
B)!!is!overpriced.!
C)!!has!a!positive!alpha.!
D)!!falls!above!the!SML.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
6)!!Portfolio!TAT!!
A)!!has!a!relatively!lower!expected!return!than!predicted.!
B)!!has!a!positive!alpha.!
C)!!falls!below!the!SML.!
D)!!is!overpriced.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!Portfolio!TCT!!
A)!!is!less!risky!than!the!market!portfolio.!
B)!!has!a!relatively!lower!expected!return!than!predicted.!
C)!!is!underpriced.!
D)!!has!a!negative!alpha.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!Portfolio!TDT!!
A)!!falls!below!the!SML.!
B)!!has!a!negative!alpha.!
C)!!is!overpriced.!
D)!!offers!an!expected!return!equal!to!the!risk-free!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!The!market!portfolio!
A)!!is!underpriced.!
B)!!has!a!positive!alpha.!
C)!!is!overpriced.!
D)!!falls!on!the!SML.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
10)!!Which!of!the!following!statements!regarding!portfolio!TAT!is/are!correct?!
!
1.! Portfolio!TAT!has!a!positive!alpha.!
2.! Portfolio!TAT!is!over!priced.!
3.! Portfolio!TAT!is!less!risky!than!the!market!portfolio.!
4.! Portfolio!TAT!should!not!exist!if!the!market!portfolio!is!efficient.!
A)!!1!and!2!
B)!!1,!3,!and!4!
C)!!1!and!3!
D)!!1,!2,!3,!and!4!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
11)!!Which!of!the!following!statements!regarding!portfolio!TBT!is/are!correct?!
!
1.! Portfolio!TBT!has!a!positive!alpha.!
2.! Portfolio!TBT!is!over!priced.!
3.! Portfolio!TBT!is!less!risky!than!the!market!portfolio.!
4.! Portfolio!TBT!should!not!exist!if!the!market!portfolio!is!efficient.!
A)!!2!and!4!
B)!!4!only!
C)!!1,!3,!and!4!
D)!!1!and!4!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
12)!!Which!of!the!following!statements!regarding!portfolio!TCT!is/are!correct?!
!
1.! Portfolio!TCT!has!a!negative!alpha.!
2.! Portfolio!TCT!is!over!priced.!
3.! Portfolio!TCT!is!less!risky!than!the!market!portfolio.!
4.! Portfolio!TCT!should!not!exist!if!the!market!portfolio!is!efficient.!
A)!!1!and!3!
B)!!2!and!4!
C)!!1,!3,!and!4!
D)!!3!only!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
Consider!two!firms,!Chihuahua(Corporation!and!Bernard!Industries!that!are!each!expected!to!pay!the!same!$1.5!million!
dollar!dividend!every!year!in!perpetuity.!!Chihuahua!Corporation!is!riskier!and!has!a!cost!of!capital!of!15%.!!Bernard!
Industries!is!not!as!shaky!as!Chihuahua,!so!Bernard!has!a!cost!of!capital!of!only!10%.!!Assume!that!the!market!portfolio!is!
not!efficient.!!Both!stocks!have!the!same!beta!and!the!CAPM!would!assign!them!both!an!expected!return!of!12%!to!both.!
!
13)!!The!market!value!for!Chihuahua!is!closest!to:!
A)!!$10.0!million!
B)!!$12.5!million!
C)!!$12.0!million!
D)!!$15!million!
Answer:!!!A!
Explanation:!!! A)!! Dividends $1.5 M
MV!=! !=! !=!$10M!
Cost of Capital .15
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
14)!!The!market!value!for!Bernard!is!closest!to:!
A)!!$12.0!million!
B)!!$10!million!
C)!!$15.0!million!
D)!!$12.5!million!
Answer:!!!C!
B)!!
C)!! Dividends $1.5 M
MV!=! !=! !=!$15M!
Cost of Capital .10
D)!!
Diff:!1!
Skill:!Analytical!
!
15)!!The!alpha!for!Chihuahua!is!closest!to:!
A)!!+2%!
B)!!-5%!
C)!!-3%!
D)!!+3%!
Answer:!!!D!
B)!!
C)!!
D)!!Alpha!=!actual!return!-!predicted!return!(from!CAPM)!=!.15!-!.12!=!.03!
Diff:!2!
Skill:!Analytical!
!
16)!!The!alpha!for!Bernard!is!closest!to:!
A)!!+5%!
B)!!-2%!
C)!!-3%!
D)!!+2%!
Answer:!!!B!
B)!!Alpha!=!actual!return!-!predicted!return!(from!CAPM)!=!.10!-!.12!=!.-.02!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
13.2(Implication(of(Positive(Alphas(
1)!!Various!trading!strategies!appear!to!offer!non-zero!alphas!when!we!examine!real!world!data.!!If!indeed!these!
alphas!are!positive,!it!could!be!explained!by!any!of!the!following!except:!
A)!!Investors!are!systematically!ignoring!positive-NPV!investment!opportunities.!
B)!!The!market!portfolio!is!inefficient,!but!the!market!portfolio!proxy!used!to!calculate!the!alphas!is!efficient.!
C)!!A!stock`s!beta!with!the!market!portfolio!does!not!adequately!measure!a!stock`s!systematic!risk.!
D)!!The!positive!alpha!trading!strategies!contain!risk!that!investors!are!unwilling!to!bear!but!the!CAPM!does!
not!capture.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!13.2!Implication!of!Positive!Alphas!
Skill:!Conceptual!
!
2)!!Which!of!the!following!is!not!an!investment!likely!to!be!found!in!any!proxy!for!the!market!portfolio?!
A)!!Human!capital!
B)!!Stocks!
C)!!Bonds!
D)!!Precious!metals!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!If!the!CAPM!correctly!computes!the!risk!premium,!investors!would!stop!investing!only!when!they!
expected!the!alpha!of!an!investment!strategy!to!be!negative.!
B)!!If!the!CAPM!correctly!computes!the!risk!premium,!an!investment!opportunity!with!a!positive!alpha!is!a!
positive!NPV!investment!opportunity.!
C)!!If!the!CAPM!correctly!computes!the!risk!premium,!investors!should!flock!to!invest!in!positive!alpha!
stocks.!
D)!!Anyone!can!implement!a!momentum!trading!strategy!and!therefore!generate!a!positive!investment!
opportunity.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!indeed!alphas!are!positive,!it!is!possible!that!the!positive!alpha!trading!strategies!contain!risk!that!
investors!are!unwilling!to!bear!but!the!CAPM!does!not!capture.!
B)!!If!indeed!alphas!are!positive,!it!is!possible!that!the!costs!of!implementing!investment!strategies!are!larger!
than!the!NPVs!of!undertaking!them.!
C)!!If!indeed!alphas!are!positive,!then!investors!have!to!be!systematically!ignoring!positive-NPV!
investments!opportunities.!
D)!!The!only!way!a!positive!NPV!investment!opportunity!can!exist!in!a!market!is!if!some!barrier!to!entry!
restricts!competition.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!existence!of!the!momentum!trading!strategy!has!been!widely!known!for!at!least!ten!years.!
B)!!The!information!required!to!implement!a!momentum!strategy!is!not!readily!available!to!investors.!
C)!!If!the!market!portfolio!is!not!efficient,!then!a!stock`s!beta!with!the!market!is!not!an!adequate!measure!of!
its!systematic!risk.!
D)!!If!the!market!portfolio!is!not!efficient,!then!the!so-called!profits!from!a!positive!alpha!trading!strategy!are!
really!returns!for!bearing!risk!that!investors!are!averse!to!and!the!CAPM!doesn`t!capture.!
Answer:!!!B!
B)!!The!information!required!to!implement!a!momentum!strategy!is!readily!available!to!investors.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!significant!fraction!of!investors!might!care!about!aspects!of!their!portfolios!other!than!expected!return!
and!volatility,!and!so!would!be!unwilling!to!hold!inefficient!investment!portfolios.!
B)!!Although!the!true!market!portfolio!of!all!invested!wealth!might!be!efficient,!the!proxy!portfolio!might!
not!track!the!actual!market!very!well.!
C)!!We!might!be!using!the!wrong!proxy!portfolio!when!we!calculate!alphas.!
D)!!The!true!market!portfolio!consists!of!all!traded!investment!wealth!in!the!economy.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Nonzero!alphas!may!merely!indicate!that!the!wrong!market!proxy!is!beings!used;!they!do!not!
necessarily!indicate!forgone!positive!NPV!investment!opportunities.!
B)!!The!true!market!portfolio!contains!much!more!than!just!stocks,!it!includes!bonds,!real!estate,!art,!
precious!metals,!and!any!other!investment!vehicles!available.!
C)!!If!the!true!market!portfolio!is!efficient,!but!the!proxy!portfolio!is!not!highly!correlated!with!the!true!
market!portfolio,!then!the!true!market!portfolio!will!not!be!efficient!and!stocks!will!have!nonzero!alphas.!
D)!!Much!of!the!investment!wealth!cannot!be!included!in!the!proxy!for!the!market!portfolio!since!it!does!not!
trade!in!competitive!markets.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!The!most!important!example!of!non-tradeable!wealth!is!human!capital.!
B)!!If!investors!have!a!significant!amount!of!non-tradeable!wealth,!this!wealth!will!be!an!important!part!of!
their!portfolios,!but!will!not!be!part!of!the!market!portfolio!of!tradeable!securities.!!
C)!!If!the!entire!portfolio!of!investments!is!efficient,!then!just!the!tradeable!part!of!the!portfolio!should!be!
efficient!also.!
D)!!Researchers!have!found!evidence!that!the!presence!of!human!capital!can!explain!at!least!part!of!the!
reason!for!the!inefficiency!of!the!most!commonly!used!market!proxies.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
9)!!What!does!the!existence!of!a!positive!alpha!investment!strategy!imply?!
Answer:!!!If,!indeed,!these!alphas!are!positive,!we!are!left!to!draw!one!of!two!conclusions:
1.! Investors!are!systematically!ignoring!positive-NPV!investment!opportunities.!That!is,!the!CAPM!
correctly!computes!risk!premiums,!but!investors!are!ignoring!opportunities!to!earn!extra!returns!
without!bearing!any!extra!risk,!either!because!they!are!unaware!of!them!or!because!the!costs!to!
implement!the!strategies!are!larger!than!the!NPV!of!undertaking!them.!
2.! The!positive-alpha!trading!strategies!contain!risk!that!investors!are!unwilling!to!bear!but!the!
CAPM!does!not!capture.!That!is,!a!stock`s!beta!with!the!market!portfolio!does!not!adequately!measure!a!
stock`s!systematic!risk,!and!so!the!CAPM!does!not!correctly!compute!the!risk!premium.!
Diff:!3!
Skill:!Conceptual!
!
10)!!Explain!why!the!market!portfolio!proxy!may!not!be!efficient.!
Answer:!!!The!true!market!portfolio!consists!of!all!traded!investment!wealth!in!the!economy.!It!therefore!contains!
much!more!than!just!stocks—it!includes!bonds,!real!estate,!art,!precious!metals,!and!any!other!
investment!vehicles!available.!Yet,!we!cannot!include!most!of!these!investments!in!the!market!proxy!
because!they!do!not!trade!in!competitive!markets.!Instead,!researchers!use!a!proxy!portfolio!like!the!
S&P!500!and!assume!that!it!will!be!highly!correlated!to!the!true!market!portfolio.
If!the!true!market!portfolio!is!efficient!but!the!proxy!portfolio!is!not!highly!correlated!with!the!true!
market,!then!the!proxy!will!not!be!efficient!and!stocks!will!have!nonzero!alphas.!In!this!case,!the!alphas!
merely!indicate!that!the!wrong!proxy!is!being!used;!they!do!not!indicate!forgone!positive-NPV!
investment!opportunities.
Another!possibility!is!that!the!true!market!portfolio!is!inefficient—investors!might!care!about!
characteristics!other!than!the!expected!returns!and!volatility!of!their!portfolios.!
Diff:!3!
Skill:!Conceptual!
!
13.3(Multifactor(Models(of(Risk(
1)!!A!group!of!portfolios!from!which!we!can!form!an!efficient!portfolio!are!called!
A)!!factor!portfolios.!
B)!!semi-efficient!portfolios.!
C)!!partially!efficient!portfolios.!
D)!!characteristic!portfolios.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!13.3!Multifactor!Models!of!Risk!
Skill:!Definition!
!
Use$the$equation$for$the$question(s)$below.
!
Consider!the!following!regression!model:!
Rs!-!rf!=! s!+! sF 1 !(RF1!-!rf)!+! sF 2 !(RF2!-!rf)!+!
2)!!The!term! s!is!a(n)!
A)!!error!term!that!has!an!expectation!of!zero!and!is!uncorrelated!with!either!factor.!
B)!!measure!of!the!expected!percent!change!in!the!excess!return!of!a!security!for!a!1%!change!in!the!excess!
return!of!the!first!factor!portfolio.!
C)!!measure!of!the!expected!percent!change!in!the!excess!return!of!a!security!for!a!1%!change!in!the!excess!
return!of!the!second!factor!portfolio.!
D)!!constant!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!The!term! F 1 !is!a(n)!
s
A)!!measure!of!the!expected!percent!change!in!the!excess!return!of!a!security!for!a!1%!change!in!the!excess!
B)!!error!term!that!has!an!expectation!of!zero!and!is!uncorrelated!with!either!factor.!
C)!!constant!term.!
D)!!measure!of!the!expected!percent!change!in!the!excess!return!of!a!security!for!a!1%!change!in!the!excess!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!The!term+! F 2 !is!a(n)!
s
B)!!constant!term.!
C)!!error!term!that!has!an!expectation!of!zero!and!is!uncorrelated!with!either!factor.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
5)!!The!term! is!a(n)!
D)!!constant!term.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!risk!premium!of!any!marketable!security!can!be!written!as!the!sum!of!the!risk!premium!of!each!
factor!multiplied!by!the!sensitivity!of!the!stock!with!that!factor.!
B)!!The!factor!betas!measure!the!sensitivity!of!the!stock!to!a!particular!factor.!
C)!!If!we!use!more!than!one!portfolio!as!factors,!then!together!these!factors!will!capture!systematic!risk,!but!
each!factor!captures!different!components!of!the!systematic!risk.!
D)!!When!we!use!more!than!one!portfolio!to!capture!risk,!the!model!is!known!as!a(single!factor!model.!
Answer:!!!D!
B)!!
C)!!
D)!!When!we!use!more!than!one!portfolio!to!capture!risk,!the!model!is!known!as!a(multi-factor!
model.!
Diff:!1!
Skill:!Conceptual!
!
A)!!It!is!not!actually!necessary!to!identify!the!efficient!portfolio!itself.!All!that!is!required!is!to!identify!a!
collection!of!portfolios!from!which!the!efficient!portfolio!can!be!constructed.!
B)!!Although!we!might!not!be!able!to!identify!the!efficient!portfolio!itself,!we!know!some!characteristics!of!
the!efficient!portfolio.!
C)!!An!efficient!portfolio!can!be!constructed!from!other!diversified!portfolios.!
D)!!An!efficient!portfolio!need!not!be!well!diversified.!
Answer:!!!D!
B)!!
C)!!
D)!!An!efficient!portfolio!needs!to!be!well!diversified.!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!portfolio!costs!nothing!to!construct!is!called!a!self-financing!portfolio.!
B)!!The!most!obvious!portfolio!to!use!in!a!multifactor!model!is!the!market!portfolio!itself.!
C)!!In!general,!a!self-financing!portfolio!is!any!portfolio!with!portfolio!weights!that!sum!to!one!rather!than!
zero.!
D)!!We!can!construct!a!self-financing!portfolio!by!going!long!some!stocks,!and!going!short!other!stocks!with!
equal!market!value.!
Answer:!!!C!
B)!!
C)!!In!general,!a!self-financing!portfolio!is!any!portfolio!with!portfolio!weights!that!sum!to!zero!
rather!than!one.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Rather!than!relying!on!the!efficiency!of!a!single!portfolio!(such!as!the!market),!multifactor!models!rely!
on!the!weaker!condition!that!an!efficient!portfolio!can!be!constructed!from!a!collection!of!
well-diversified!portfolios!or!factors.!
B)!!A!positive!alpha!in!a!single!factor!model!means!that!the!portfolios!that!implement!the!trading!strategy!
capture!risk!that!is!not!captured!by!the!market!portfolio.!
C)!!Multifactor!models!have!a!distinct!advantage!over!single-factor!models!in!that!it!is!much!easier!to!
identify!a!collection!of!portfolios!that!captures!systematic!risk!than!just!a!single!portfolio.!
D)!!Trading!strategies!based!on!market!capitalization,!book-to-market!ratios,!and!momentum!have!been!
developed!that!appear!to!have!zero!alphas.!
Answer:!!!D!
B)!!
C)!!
D)!!Trading!strategies!based!on!market!capitalization,!book-to-market!ratios,!and!momentum!
have!been!developed!that!appear!to!have!positive!alphas.!
Diff:!3!
Skill:!Conceptual!
A)!!Because!expected!returns!are!not!easy!to!estimate,!each!portfolio!that!is!added!to!a!multifactor!model!
increases!the!difficulty!of!implementing!the!model.!
B)!!The!self-financing!portfolio!made!from!high!minus!low!book-to-market!stocks!is!called!the!
high-minus-low!(HML)!portfolio.!
C)!!The!FFC!factor!specification!was!identified!a!little!more!than!ten!years!ago.!Although!it!is!widely!used!in!
academic!literature!to!measure!risk,!much!debate!persists!about!whether!it!really!is!a!significant!
improvement!over!the!CAPM.!
D)!!A!trading!strategy!that!each!year!short!sells!portfolio!S!(small!stocks)!and!uses!this!position!to!buy!
portfolio!B!(big!stocks)!has!produced!positive!risk!adjusted!returns!historically.!This!self-financing!
portfolio!is!widely!known!as!the!small!minus!big!(SMB)!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!A!trading!strategy!that!each!year!buys!portfolio!S!(small!stocks)!and!finances!this!position!by!
short!selling!portfolio!B!(big!stocks)!has!produced!positive!risk!adjusted!returns!historically.!
This!self-financing!portfolio!is!widely!known!as!the!small!minus!big!(SMB)!portfolio.!
Diff:!3!
Skill:!Conceptual!
!
A)!!As!a!practical!matter,!it!is!extremely!difficult!to!identify!portfolios!that!are!efficient!because!we!cannot!
measure!the!expected!return!and!the!standard!deviation!of!a!portfolio!with!great!accuracy.!
B)!!The!portfolios!in!a!multifactor!model!can!be!thought!of!as!either!risk!factors!themselves!or!portfolios!of!
stocks!correlated!with!unobservable!risk!factors.!
C)!!Each!factor!beta!is!the!expected!percent!change!in!the!excess!return!of!a!security!for!a!1%!change!in!the!
excess!return!of!the!factor!portfolio.!
D)!!Even!if!the!market!portfolio!is!not!efficient,!it!still!must!capture!all!components!of!systematic!risk.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
Consider!the!following!factor!model:!
E[Rs]!-!rf!=! Mkt
s !(E[RMkt]!-!rf)!+! s
SMB E[R HML E[R
SMB]!+! s
PR1 YR E[RPR1!YR]
HML]!+! s
12)!!The!term! Mkt !measures!the!sensitivity!of!the!securities!returns!to!

s
A)!!size.!
B)!!book!to!market.!
C)!!momentum.!
D)!!the!overall!market.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
13)!!The!term! SMB !measures!the!sensitivity!of!the!securities!returns!to!
s
A)!!momentum.!
B)!!the!overall!market.!
C)!!book!to!market.!
D)!!size.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
14)!!The!term! HML !measures!the!sensitivity!of!the!securities!returns!to!
s
A)!!book!to!market.!
B)!!momentum.!
C)!!size.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
15)!!The!term! PR1 YR !measures!the!sensitivity!of!the!securities!returns!to!
s
A)!!the!overall!market.!
C)!!size.!
D)!!momentum.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Consider!the!following!information!regarding!the!Fama!French!Carhart!four!factor!model:
Average( Wal-Mart(
Factor( Monthly( IBM(Factor(GE(Factor( Factor(
Portfolio Return((%) Betas Betas Betas(
Rm!-!rf 0.64 0.712 0.937 0.782!
SMB 0.17 -0.103 -0.214 0.224!
HML 0.53 0.124 0.154 0.123!
PR1$YR 0.76 0.276 -0.147 0.247!
16)!!Using!the!FFC!four!factor!model!and!the!historical!average!monthly!returns,!the!expected!monthly!return!for!
IBM!is!closest!to:!
A)!!0.79%!
B)!!0.53%!
C)!!0.71%!
D)!!1.01%!
Answer:!!!C!
B)!!
C)!! Average( IBM( GE( IBM( GE( Wal-Mart(
Factor( Monthly( Factor( Factor( Wal-Mart( Return( Return( Return(
Portfolio Return((%) Betas Betas Factor(Betas Calc. Calc. Calc.(
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
!
The!return!calculation!involves!multiplying!the!average!monthly!return!by!the!factor!beta.!
D)!!
Diff:!2!
Skill:!Analytical!
!
GE!is!closest!to:!
A)!!0.53%!
B)!!0.73%!
C)!!0.79%!
D)!!0.71%!
Answer:!!!A!
B)!!
C)!!
D)!! Average( IBM( GE( IBM( GE( Wal-Mart(
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
Diff:!2!
Skill:!Analytical!
!
Wal-Mart!is!closest!to:!
A)!!0.71%!
B)!!0.53%!
C)!!1.38%!
D)!!0.79%!
Answer:!!!D!
Explanation:!!! A)!! Average( IBM( GE( IBM( GE( Wal-Mart(
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
!
Rs!-!rf!=! s!+! sF 1 (RF1!-!rf)!+! sF 2 (RF2!-!rf)!+!
D)!!constant!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
s
C)!!constant!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
s
B)!!constant!term.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
5)!!The!term! is!a(n)!
D)!!constant!term.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
model.!
Diff:!1!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!2!
Skill:!Conceptual!
!
zero.!
Answer:!!!C!
B)!!
rather!than!one.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!3!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!3!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
E[Rs]!-!rf!=! Mkt
s (E[RMkt]!-!rf)!+! s
SMB E[R HML E[R
SMB]!+! s
PR1 YR E[RPR1!YR]
HML]!+! s
12)!!The!term! Mkt !measures!the!sensitivity!of!the!securities!returns!to!

s
A)!!size.!
C)!!momentum.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
13)!!The!term! SMB !measures!the!sensitivity!of!the!securities!returns!to!
s
A)!!momentum.!
D)!!size.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
14)!!The!term! HML !measures!the!sensitivity!of!the!securities!returns!to!
s
B)!!momentum.!
C)!!size.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
15)!!The!term! PR1 YR !measures!the!sensitivity!of!the!securities!returns!to!
s
C)!!size.!
D)!!momentum.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Average( Wal-Mart(
Rm!-!rf 0.64 0.712 0.937 0.782!
SMB 0.17 -0.103 -0.214 0.224!
HML 0.53 0.124 0.154 0.123!
PR1$YR 0.76 0.276 -0.147 0.247!
$
IBM!is!closest!to:!
A)!!0.79%!
B)!!0.53%!
C)!!0.71%!
D)!!1.01%!
Answer:!!!C!
B)!!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
!
D)!!The!return!calculation!involves!multiplying!the!average!monthly!return!by!the!factor!beta.
Diff:!2!
Skill:!Analytical!
!
GE!is!closest!to:!
A)!!0.53%!
B)!!0.73%!
C)!!0.79%!
D)!!0.71%!
Answer:!!!A!
B)!!
C)!!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
Diff:!2!
Skill:!Analytical!
!
A)!!0.71%!
B)!!0.53%!
C)!!1.38%!
D)!!0.79%!
Answer:!!!D!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
!
Rs!-!rf!=! s!+! sF 1 !(RF1!-!rf)!+! sF 2 !(RF2!-!rf)!+!
D)!!constant!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!!3)!The!term! F 1 is!a(n)!
s
C)!!constant!term.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
! 4)!!The!term! F 2 !is!a(n)!
s
B)!!constant!term.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
! 5)!!The!term! is!a(n)!
D)!!constant!term.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
model.!
Diff:!1!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!2!
Skill:!Conceptual!
!
zero.!
Answer:!!!C!
B)!!
rather!than!one.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!3!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
Diff:!3!
Skill:!Conceptual!
!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
!
E[Rs]!-!rf!=! Mkt
s !(E[RMkt]!-!rf)!+! s
SMB E[R HML E[R
SMB]!+! s
PR1 YR E[RPR1!YR]
HML]!+! s
! 12)!!The!term! Mkt !measures!the!sensitivity!of!the!securities!returns!to!

s
A)!!size.!
C)!!momentum.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
! 13)!!The!term! SMB !measures!the!sensitivity!of!the!securities!returns!to!
s
A)!!momentum.!
D)!!size.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!!14)!!The!term! HML !measures!the!sensitivity!of!the!securities!returns!to!
s
B)!!momentum.!
C)!!size.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
! 15)!!The!term! PR1 YR !measures!the!sensitivity!of!the!securities!returns!to!
s
C)!!size.!
D)!!momentum.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Average( Wal-Mart(
Rm!-!rf 0.64 0.712 0.937 0.782!
SMB 0.17 -0.103 -0.214 0.224!
HML 0.53 0.124 0.154 0.123!
PR1$YR 0.76 0.276 -0.147 0.247!
$
IBM!is!closest!to:!
A)!!0.79%!
B)!!0.53%!
C)!!0.71%!
D)!!1.01%!
Answer:!!!C!
B)!!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
!
The!return!calculation!involves!multiplying!the!average!monthly!return!by!the!factor!beta.!
D)!!
Diff:!2!
Skill:!Analytical!
!
GE!is!closest!to:!
A)!!0.53%!
B)!!0.73%!
C)!!0.79%!
D)!!0.71%!
Answer:!!!A!
B)!!
C)!!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
Diff:!2!
Skill:!Analytical!
!
A)!!0.71%!
B)!!0.53%!
C)!!1.38%!
D)!!0.79%!
Answer:!!!D!
Rm !-!rf 0.64 0.712 0.937 0.782 0.456 0.600 0.500!
SMB 0.17 -0.103 -0.214 0.224 -0.018 -0.036 0.038!
HML 0.53 0.124 0.154 0.123 0.066 0.082 0.065!
PR1$YR 0.76 0.276 -0.147 0.247 0.210 -0.112 0.188!
E[Rs]!= 0.714 0.533 0.791!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Chapter(14(-(Capital(Structure(in(a(Perfect(Market(
!
!
14.1(Equity(Versus(Debt(Financing((
(
A)!!The!relative!proportions!of!debt,!equity,!and!other!securities!that!a!firm!has!outstanding!constitute!its!
capital!structure.!
B)!!The!most!common!choices!are!financing!through!equity!alone!and!financing!through!a!combination!of!
debt!and!equity.!
C)!!The!projectCs!NPV!represents!the!value!to!the!new!investors!of!the!firm!created!by!the!project.!
D)!!When!corporations!raise!funds!from!outside!investors,!they!must!choose!which!type!of!security!to!issue.!
Answer:!!!C!
B)!!
C)!!The!projectCs!NPV!represents!the!value!to!the!existing!shareholders!of!the!firm!created!by!the!
project.!
D)!!
Diff:!1!
Topic:!14.1!Equity!Versus!Debt!Financing!
Skill:!Conceptual!
!
2)!!Equity!in!a!firm!with!debt!is!called!
A)!!levered!equity.!
B)!!riskless!equity.!
C)!!unlevered!equity.!
D)!!risky!equity.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!Equity!in!a!firm!with!no!debt!is!called!
A)!!levered!equity.!
B)!!unlevered!equity.!
C)!!riskless!equity.!
D)!!risky!equity.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
A)!!Modigliani!and!MillerCs!conclusion!verified!the!common!view,!which!stated!that!even!with!perfect!
capital!markets,!leverage!would!affect!a!firmCs!value.!
B)!!We!can!evaluate!the!relationship!between!risk!and!return!more!formally!by!computing!the!sensitivity!of!
each!securityCs!return!to!the!systematic!risk!of!the!economy.!
C)!!Investors!in!levered!equity!require!a!higher!expected!return!to!compensate!for!its!increased!risk.!
D)!!Leverage!increases!the!risk!of!equity!even!when!there!is!no!risk!that!the!firm!will!default.!
Answer:!!!A!
Explanation:!!! A)!!Modigliani!and!MillerCs!conclusion!went!against!the!common!view!that!even!with!perfect!
capital!markets,!leverage!would!affect!a!firm’s!value.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Leverage!decreases!the!risk!of!the!equity!of!a!firm.!
B)!!Because!the!cash!flows!of!the!debt!and!equity!sum!to!the!cash!flows!of!the!project,!by!the!Law!of!One!
Price!the!combined!values!of!debt!and!equity!must!be!equal!to!the!cash!flows!of!the!project.!
C)!!Franco!Modigliani!and!Merton!Miller!argued!that!with!perfect!capital!markets,!the!total!value!of!a!firm!
should!not!depend!on!its!capital!structure.!
D)!!It!is!inappropriate!to!discount!the!cash!flows!of!levered!equity!at!the!same!discount!rate!that!we!use!for!
unlevered!equity.!
Answer:!!!A!
Explanation:!!! A)!!Leverage!increases!the!risk!of!the!equity!of!a!firm.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Consider!a!project!with!free!cash!flows!in!one!year!of!$90,000!in!a!weak!economy!or!$117,000!in!a!strong!economy,!with!
each!outcome!being!equally!likely.!!The!initial!investment!required!for!the!project!is!$80,000,!and!the!projectCs!cost!of!capital!
is!15%.!!The!risk-free!interest!rate!is!5%.
6)!!The!NPV!for!this!project!is!closest!to:!
A)!!$6,250!
B)!!$14,100!
C)!!$10,000!
D)!!$18,600!
Answer:!!!C!
B)!!
C)!! (.5)$90, 000 (.5)$117, 000
NPV!=! !-!$80,000!=!$10,000!
1.15
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Suppose!that!to!raise!the!funds!for!the!initial!investment,!the!project!is!sold!to!investors!as!an!all-equity!firm.!
The!equity!holders!will!receive!the!cash!flows!of!the!project!in!one!year.!!The!market!value!of!the!unlevered!
equity!for!this!project!is!closest!to:!
A)!!$94,100!
B)!!$90,000!
C)!!$86,250!
D)!!$98,600!
Answer:!!!B!
B)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!
1.15
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Suppose!that!to!raise!the!funds!for!the!initial!investment!the!firm!borrows!$80,000!at!the!risk!free!rate,!then!the!
cash!flow!that!equity!holders!will!receive!in!one!year!in!a!weak!economy!is!closest!to:!
A)!!$6,000!
B)!!$10,000!
C)!!$0!
D)!!$33,000!
Answer:!!!A!
Explanation:!!! A)!!!$90,000!-!$80,000(1.05)!=!$6,000!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
cash!flow!that!equity!holders!will!receive!in!one!year!in!a!strong!economy!is!closest!to:!
A)!!$0!
B)!!$6,000!
C)!!$33,000!
D)!!$10,000!
Answer:!!!C!
B)!!
C)!!$117,000!-!$80,000(1.05)!=!$33,000!
D)!!
Diff:!2!
Skill:!Analytical!
!
value!of!the!firmCs!levered!equity!from!the!project!is!closest!to:!
A)!!$0!
B)!!$10,000!
C)!!$6,000!
D)!!$8,600!
Answer:!!!B!
B)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!-!$80,000!=!$10,000!
1.15
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
cost!of!capital!for!the!firmCs!levered!equity!is!closest!to:!
A)!!45%!
B)!!25%!
C)!!15%!
D)!!95%!
Answer:!!!D!
B)!!
C)!!
D)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!-!$80,000!=!$10,000!(value!of!
1.15
levered!equity)!
(.5)$6, 000 (.5)$33, 000

So,!$10,000!=! !
1 x
(.5)$6, 000 (.5)$33, 000
So,!1!+!x!=! !!
$10, 000
So,!x!=!.95!
Diff:!2!
Skill:!Analytical!
12)!!Suppose!that!to!raise!the!funds!for!the!initial!investment!the!firm!borrows!$40,000!at!the!risk!free!rate!and!
issues!new!equity!to!cover!the!remainder.!!In!this!situation,!the!cash!flow!that!equity!holders!will!receive!in!
one!year!in!a!weak!economy!is!closest!to:!
A)!!$90,000!
B)!!$0!
C)!!$50,000!
D)!!$48,000!
Answer:!!!D!
B)!!
C)!!
D)!!$90,000!-!$40,000(1.05)!=!$48,000!
Diff:!2!
Skill:!Analytical!
!
issues!new!equity!to!cover!the!remainder.!!In!this!situation,!the!cash!flow!that!equity!holders!will!receive!in!
one!year!in!a!strong!economy!is!closest!to:!
A)!!$117,000!
B)!!$75,000!
C)!!$50,000!
D)!!$0!
Answer:!!!B!
B)!!$117,000!-!$40,000(1.05)!=!$75,000!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
issues!new!equity!to!cover!the!remainder.!!In!this!situation,!the!value!of!the!firmCs!levered!equity!from!the!
A)!!$0!
B)!!$50,000!
C)!!$90,000!
D)!!$40,000!
Answer:!!!B!
B)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!-!$40,000!=!$50,000!
1.15
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
issues!new!equity!to!cover!the!remainder.!!In!this!situation,!the!cost!of!capital!for!the!firmCs!levered!equity!is!
closest!to:!
A)!!23%!
B)!!25%!
C)!!15%!
D)!!18%!
Answer:!!!A!
Explanation:!!! A)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!-!$40,000!=!$50,000!(value!of!
1.15
levered!equity)
(.5)$48, 000 (.5)$75, 000

So,!$50,000!=! !
1 x
(.5)$48, 000 (.5)$75, 000
So,!1!+!x!=! !!
$50, 000
So,!x!=!.23!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
issues!new!equity!to!cover!the!remainder.!!In!this!situation,!calculate!the!value!of!the!firmCs!levered!equity!
from!the!project.!!What!is!the!cost!of!capital!for!the!firmCs!levered!equity?!
Answer:!!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows)!=! !=!$90,000!-!$45,000!=!$45,000!(value!of!levered!
1.15
equity)!
!
90,000!-!45,000(1.05)!=!$42,770!
117,000!-!45,000(1.05)!=!$69,750
(.5)$42, 750 (.5)$69, 750

So,!$45,000!=!
1 x
(.5)$42, 750 (.5)$69, 750
So,!1!+!x!=! !
$45, 000
So,!x!=!.25!
Diff:!2!
Skill:!Analytical!
!
17)!!Two!separate!firms!are!considering!investing!in!this!project.!!Firm!unlevered!plans!to!fund!the!entire!$80,000!
investment!using!equity,!while!firm!levered!plans!to!borrow!$45,000!at!the!risk-free!rate!and!use!equity!to!
finance!the!remainder!of!the!initial!investment.!!Construct!a!table!detailing!the!percentage!returns!to!the!
equity!holders!of!both!the!levered!and!unlevered!firms!for!both!the!weak!and!strong!economy.!
Answer:!!! Returns( Returns(
Initial( C/F(Strong( C/F(Weak( Strong( Weak(
Value Economy Economy Economy Economy(
Debt $45,000 !$!!47,250! !$47,250! 5% 5%!
Levered!Equity $45,000 !$!!69,750! !$42,750! 55% -5%!
Unlevered!Equity $90,000 !$117,000! !$90,000! 30% 0%!
(.5)$90, 000 (.5)$117, 000

PV(equity!cash!flows)!=! !=!$90,000
1.15
C/F!(weak!economy)!=!$90,000!(unlevered)!-!$45,000(1.05)!(debt)!=!$42,750!(levered)
C/F!(strong!economy)!=!$117,000!(unlevered)!-!$45,000(1.05)!(debt)!=!$69,750!(levered)
C/F
Returns!=!
initial value
Diff:!3!
Skill:!Analytical!
!
finance!the!remainder!of!the!initial!investment.!!Calculate!the!expected!returns!for!both!the!levered!and!
unlevered!firm.!
Initial( C/F(Strong(C/F(Weak( Strong( Weak( Expected(
Value Economy Economy Economy Economy Return(
Debt $45,000 !$!!47,250! !$47,250! 5% 5% 5%!
Levered!
Equity $45,000 !$!!69,750! !$42,750! 55% -5% 25%!
Unlevered!
Equity $90,000 !$117,000! !$90,000! 30% 0% 15%!
(.5)$90, 000 (.5)$117, 000

1.15
C/F!(weak!economy)!=!$90,000!(unlevered)!-!$45,000(1.05)!(debt)!=!$42,750!(levered)
C/F!(strong!economy)!=!$117,000!(unlevered)!-!$45,000(1.05)!(debt)!=!$69,750!(levered)
C/F
Returns!=!
initial value
Expected!return!=!.5(strong!return)!+!.5(weak!return)!
Diff:!3!
Skill:!Analytical!
!
finance!the!remainder!of!the!initial!investment.!!Calculate!the!risk!premiums!for!both!the!levered!and!
unlevered!firm.!
Initial( C/F(Strong(C/F(Weak( Strong( Weak( Expected(
Value Economy Economy Economy Economy Return(
Debt $45,000 !$!!47,250! !$47,250! 5% 5% 5%!
Levered!
Equity $45,000 !$!!69,750! !$42,750! 55% -5% 25%!
Unlevered!
Equity $90,000 !$117,000! !$90,000! 30% 0% 15%!
(.5)$90, 000 (.5)$117, 000

1.15
C/F!(weak!economy)!=!$90,000!(unlevered)!-!$45,000(1.05)!(debt)=!$42,750!(levered)
C/F!(strong!economy)!=!$117,000!(unlevered)!-!$45,000(1.05)!(debt)=!$69,750!(levered)
C/F
Returns!=!
initial value
Expected!return!=!.5(strong!return)!+!.5(weak!return)
Risk!premium!=!expected!return!-!risk!free!rate!
Diff:!3!
Skill:!Analytical!
(
14.2(Modigliani-Miller(I:(Leverage,(Arbitrage,(and(Firm(Value((
(
1)!!Which!of!the!following!is!not!one!of!Modigliani!and!MillerCs!set!of!conditions!referred!to!as!perfect!capital!
markets?!
A)!!All!investors!hold!the!efficient!portfolio!of!assets.!
B)!!There!are!no!taxes,!transaction!costs,!or!issuance!costs!associated!with!security!trading.!
C)!!A!firmCs!financing!decisions!do!not!change!the!cash!flows!generated!by!its!investments,!nor!do!they!
reveal!new!information!about!them.!
D)!!Investors!and!firms!can!trade!the!same!set!of!securities!at!competitive!market!prices!equal!to!the!present!
value!of!their!future!cash!flows.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!14.2!Modigliani-Miller!I:!Leverage,!Arbitrage,!and!Firm!Value!
Skill:!Conceptual!
!
A)!!The!Law!of!One!Price!implies!that!leverage!will!affect!the!total!value!of!the!firm!under!perfect!capital!
market!conditions.!
B)!!In!the!absence!of!taxes!or!other!transaction!costs,!the!total!cash!flow!paid!out!to!all!of!a!firmCs!security!
holders!is!equal!to!the!total!cash!flow!generated!by!the!firmCs!assets.!
C)!!With!perfect!capital!markets,!leverage!merely!changes!the!allocation!of!cash!flows!between!debt!and!
equity,!without!altering!the!total!cash!flows!of!the!firm.!
D)!!In!a!perfect!capital!market,!the!total!value!of!a!firm!is!equal!to!the!market!value!of!the!total!cash!flows!
generated!by!its!assets!and!is!not!affected!by!its!choice!of!capital!structure.!
Answer:!!!A!
Explanation:!!! A)!!The!Law!of!One!Price!implies!that!leverage!will!not!affect!the!total!value!of!the!firm!under!
perfect!capital!market!conditions.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!As!long!as!the!firmCs!choice!of!securities!does!not!change!the!cash!flows!generated!by!its!assets,!the!
capital!structure!decision!will!not!change!the!total!value!of!the!firm!or!the!amount!of!capital!it!can!raise.!
B)!!If!securities!are!fairly!priced,!then!buying!or!selling!securities!has!an!NPV!of!zero!and,!therefore,!should!
not!change!the!value!of!a!firm.!
C)!!The!future!repayments!that!the!firm!must!make!on!its!debt!are!equal!in!value!to!the!amount!of!the!loan!it!
receives!up!front.!
D)!!An!investor!who!would!like!more!leverage!than!the!firm!has!chosen!can!lend!and!add!leverage!to!his!or!
her!own!portfolio.!
Answer:!!!D!
B)!!
C)!!
D)!!An!investor!who!would!like!more!leverage!than!the!firm!has!chosen!can!borrow!and!add!
leverage!to!his!or!her!own!portfolio.!
Diff:!2!
Skill:!Conceptual!
!
A)!!As!long!as!investors!can!borrow!or!lend!at!the!same!interest!rate!as!the!firm,!homemade!leverage!is!a!
perfect!substitute!for!the!use!of!leverage!by!the!firm.!
B)!!When!investors!use!leverage!in!their!own!portfolios!to!adjust!the!leverage!choice!made!by!the!firm,!we!
say!that!they!are!using!homemade!leverage.!
C)!!The!value!of!the!firm!is!determined!by!the!present!value!of!the!cash!flows!from!its!current!and!future!
investments.!
D)!!The!investor!can!re-create!the!payoffs!of!unlevered!equity!by!borrowing!and!using!the!proceeds!to!
purchase$the!equity!of!the!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!The!investor!can!re-create!the!payoffs!of!levered!equity!by!borrowing!and!using!the!proceeds!
to!purchase$the!equity!of!the!firm.!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!a!firm!issues!new!shares!that!account!for!a!significant!percentage!of!its!outstanding!shares,!the!
transaction!is!called!a!leveraged!recapitalization.!
B)!!MM!Proposition!I!applies!to!capital!structure!decisions!made!at!any!time!during!the!life!of!the!firm.!
C)!!By!choosing!positive-NPV!projects!that!are!worth!more!than!their!initial!investment,!the!firm!can!
enhance!its!value.!
D)!!Holding!fixed!the!cash!flows!generated!by!the!firmCs!assets,!however,!the!choice!of!capital!structure!does!
not!change!the!value!of!the!firm.!
Answer:!!!A!
Explanation:!!! A)!!When!a!firm!borrows!money!to!repurchase!shares!that!account!for!a!significant!percentage!of!
its!outstanding!shares,!the!transaction!is!called!a!leveraged!recapitalization.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!Investors!can!alter!the!leverage!choice!of!the!firm!to!suit!their!personal!tastes!either!by!borrowing!and!
reducing!leverage!or!by!holding!bonds!and!adding!more!leverage.!
B)!!On!the!market!value!balance!sheet!the!total!value!of!all!securities!issued!by!the!firm!must!equal!the!total!
value!of!the!firmCs!assets.!
C)!!The!market!value!balance!sheet!captures!the!idea!that!value!is!created!by!a!firmCs!choice!of!assets!and!
investments.!
D)!!One!application!of!MM!Proposition!I!is!the!useful!device!known!as!the!market!value!balance!sheet!of!the!
firm.!
Answer:!!!A!
Explanation:!!! A)!!Investors!can!alter!the!leverage!choice!of!the!firm!to!suit!their!personal!tastes!either!by!
borrowing!and!increasing!leverage!or!by!holding!bonds!and!reducing!leverage.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
Consider!two!firms,!With!and!Without,!that!have!identical!assets!that!generate!identical!cash!flows.!!Without!is!an!
all-equity!firm,!with!1!million!shares!outstanding!that!trade!for!a!price!of!$24!per!share.!!With!has!2!million!shares!
outstanding!and!$12!million!dollars!in!debt!at!an!interest!rate!of!5%.!
7)!!According!to!MM!Proposition!1,!the!stock!price!for!With!is!closest!to:!
A)!!$8.00!
B)!!$24.00!
C)!!$6.00!
D)!!$12.00!
Answer:!!!C!
B)!!
C)!!Under!MM!I,!the!total!value!of!With!and!Without!must!be!the!same.!
Value(Without)!=!1,000,000!×!$24!=!$24!million
Value(levered!equity)!=!value(With)!-!debt!=!$24!M!-!$12M!=!$12!M
$12M
Price!per!share!=! !=!$6.00!
2M
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!Assume!that!MMCs!perfect!capital!markets!conditions!are!met!and!that!you!can!borrow!and!lend!at!the!same!
5%!rate!as!with.!!You!have!$5000!of!your!own!money!to!invest!and!you!plan!on!buying!Without!stock.!!Using!
homemade!leverage,!how!much!do!you!need!to!borrow!in!your!margin!account!so!that!the!payoff!of!your!
margined!purchase!of!Without!stock!will!be!the!same!as!a!$5000!investment!in!With!stock?!
A)!!$10,000!
B)!!$5000!
C)!!$2,500!
D)!!$0!
Answer:!!!B!
B)!!Under!MM!I,!the!total!value!of!With!and!Without!must!be!the!same.!
So,!the!leverage!ratio!of!with!is!50%!equity!to!50%!debt.!!To!duplicate!this!in!homemade!
leverage!we!need!to!have!equal!proportions!in!out!portfolio,!this!means!we!need!50%!equity!
and!50%!from!a!margin!loan.!!So!$5000!is!our!equity,!and!we!need!to!match!it!with!$5000!in!a!
margin!loan.!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5%!rate!as!with.!!You!have!$5000!of!your!own!money!to!invest!and!you!plan!on!buying!Without!stock.!!Using!
homemade!leverage!you!borrow!enough!in!your!margin!account!so!that!the!payoff!of!your!margined!
purchase!of!Without!stock!will!be!the!same!as!a!$5000!investment!in!with!stock.!!The!number!of!shares!of!
Without!stock!you!purchased!is!closest!to:!
A)!!425!
B)!!1650!
C)!!2000!
D)!!825!
Answer:!!!B!
Value(levered!equity)!=!value(With)!-!debt!=!$24!M!-!$12M!=!$12!M!
$12M
Price!per!share!=! !=!$6.00
2M
and!50%!from!a!margin!loan.!!So!$5000!is!our!equity!we!need!to!match!it!with!$5000!in!a!
margin!loan.!!So!the!total!invested!is!$10,000!/!$6!per!share!=!1667!shares!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
5%!rate!as!with.!!You!have!$5000!of!your!own!money!to!invest!and!you!plan!on!buying!With!stock.!!Using!
homemade!(un)leverage,!how!much!do!you!need!to!invest!at!the!risk-free!rate!so!that!the!payoff!of!your!
account!will!be!the!same!as!a!$5000!investment!in!Without!stock?!
A)!!$5000!
B)!!$0!
C)!!$2,500!
D)!!$4,000!
Answer:!!!C!
Explanation:!!! A)!!Under!MM!I,!the!total!value!of!With!and!Without!must!be!the!same.!
and!50%!fin!the!risk!free!asset.!!So!$5000!is!our!total!portfolio!we!need!$2500!in!equity!(With!
stock)!and!$2500!in!the!risk!free!asset.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5%!rate!as!with.!!You!have!$5000!of!your!own!money!to!invest!and!you!plan!on!buying!With!stock.!!Using!
homemade!(un)leverage!you!invest!enough!at!the!risk-free!rate!so!that!the!payoff!of!your!account!will!be!the!
same!as!a!$5000!investment!in!Without!stock?!!The!number!of!shares!of!With!stock!you!purchased!is!closest!to:!
A)!!100!
B)!!425!
C)!!1650!
D)!!825!
Answer:!!!B!
Value(levered!equity)!=!value(With)!-!debt!=!$24!M!-!$12M!=!$12!M!
$12M
2M
So!the!leverage!ratio!of!with!is!50%!equity!to!50%!debt.!!To!duplicate!this!in!homemade!
and!50%!fin!the!risk!free!asset.!!So!$5000!is!our!total!portfolio!we!need!$2500!in!equity!(With!
stock)!and!$2500!in!the!risk!free!asset.!
!
$2500
=! =!417!shares!
$6 per share
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
Luther!is!a!successful!logistical!services!firm!that!currently!has!$5!billion!in!cash.!!Luther!has!decided!to!use!this!cash!to!
repurchase!shares!from!its!investors,!and!has!already!announced!the!stock!repurchase!plan.!!Currently!Luther!is!an!all!
equity!firm!with!1.25!billion!shares!outstanding.!!LutherCs!shares!are!currently!trading!at!$20!per!share.
12)!!The!market!value!of!LutherCs!non-cash!assets!is!closest!to:!
A)!!$20!billion!
B)!!$19!billion!
C)!!$25!billion!
D)!!$24!billion!
Answer:!!!A!
Explanation:!!! A)!!=!1.25B!×!$20!per!share!=!$25!billion!-!$5!billion!cash!=!$20!billion!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!After!the!repurchase!how!many!shares!will!Luther!have!outstanding?!
A)!!0.75!billion!
B)!!1.0!billion!
C)!!1.1!billion!
D)!!1.2!billion!
Answer:!!!B!
B)!!$5!billion!/!$20!Share!=!.250!billion!shares!repurchased.
Shares!outstanding!=!1.25!-!.25!=!1.0!billion!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
14)!!With!perfect!capital!markets,!what!is!the!market!value!of!LutherCs!equity!after!the!share!repurchase?!
A)!!$15!billion!
B)!!$10!billion!
C)!!$25!billion!
D)!!$20!billion!
Answer:!!!D!
B)!!
C)!!
D)!!=!1.25B!×!$20!per!share!=!$25!billion!-!$5!billion!cash!=!$20!billion!
Diff:!2!
Skill:!Analytical!
!
15)!!With!perfect!capital!markets,!what!is!the!market!price!per!share!of!LutherCs!stock!after!the!share!repurchase?!
A)!!$25!
B)!!$24!
C)!!$15!
D)!!$20!
Answer:!!!D!
B)!!
C)!!
D)!!=!1.25B!×!$20!per!share!=!$25!billion!-!$5!billion!cash!=!$20!billion!/!1!billion!shares!=!$20!
Diff:!2!
Skill:!Analytical!
!
16)!!Assume!that!in!addition!to!1.25!billion!common!shares!outstanding,!Luther!has!stock!options!given!to!
employees!valued!at!$2!billion.!!The!market!value!of!LutherCs!non-cash!assets!is!closest!to:!
A)!!$22!billion!
B)!!$20!billion!
C)!!$25!billion!
D)!!$18!billion!
Answer:!!!A!
Explanation:!!! A)!!=!1.25B!×!$20!per!share!=!$25!billion!+!$2!billion!options!-!$5!billion!cash!=!$22!billion!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!Assume!that!in!addition!to!1.25!billion!common!shares!outstanding,!Luther!has!stock!options!given!to!
employees!valued!at!$2!billion.!After!the!repurchase!how!many!shares!will!Luther!have!outstanding?!
A)!!1.0!billion!
B)!!1.2!billion!
C)!!0.75!billion!
D)!!1.1!billion!
Answer:!!!A!
Explanation:!!! A)!!$5!billion!/!$20!Share!=!.250!billion!shares!repurchased.
Shares!outstanding!=!1.25!-!.25!=!1.0!billion!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Consider!two!firms:!firm!Without!has!no!debt,!and!firm!With!has!debt!of!$10,000!on!which!it!pays!interest!of!5%!per!year.!!
Both!companies!have!identical!projects!that!generate!free!cash!flows!of!$1000!or!$2000!each!year.!!Suppose!that!there!are!no!
taxes,!and!after!paying!any!interest!on!debt,!both!companies!use!all!remaining!cash!free!cash!flows!to!pay!dividends!each!
year.!
!
18)!!Fill!in!the!table!below!showing!the!payments!debt!and!equity!holders!of!each!firm!will!receive!given!each!of!
the!two!possible!levels!of!free!cash!flows:
Without With
Free!Cash! Interest! Equity! Interest! Equity!
Flow Payments Dividends Payments Dividends!
1000
2000
Answer:!!! Without With
1000 0 1000 500 500!
2000 0 2000 500 1500!
Diff:!2!
Skill:!Analytical!
!
19)!!Suppose!you!own!10%!of!the!equity!of!Without.!!What!is!another!portfolio!you!could!hold!that!would!provide!
you!with!the!same!exact!cash!flows?!
Answer:!!!The!cash!flows!for!a!10%!ownership!stake!in!With!and!Without!are!shown!below:!
!
Without With
100 0 100 50 50!
200 0 200 50 150!
!
To!achieve!the!same!payout!as!Without!you!would!need!to!invest!$1000!in!With!BondCs!paying!5%!
interest!and!purchase!a!10%!stake!in!WithCs!equity!paying!$50!or!$150!in!dividends.
So!your!payoff!when!the!firmCs!FCF!is!1000!=!50!(interest)!+!50!(dividends)!=!$100!(same!as!WithoutCs!
dividends)
Payoff!when!firmCs!FCF!is!2000!=!50!(interest)!+!150!(dividends)!=!$200!(same!as!WithoutCs!dividends)!
Diff:!3!
Skill:!Analytical!
!
20)!!Suppose!you!own!10%!of!the!equity!of!With.!!What!is!another!portfolio!you!could!hold!that!would!provide!
you!with!the!same!exact!cash!flows?!
Answer:!!!The!cash!flows!for!a!10%!ownership!stake!in!With!and!Without!are!shown!below:!
!
Without With
100 0 100 50 50!
200 0 200 50 150!
!
To!achieve!the!same!payout!as!Without!you!would!need!to!borrow!$1000!at!the!risk!free!rate!of!5%!
interest!and!purchase!a!10%!stake!in!WithoutCs!equity!paying!$100!or!$20!in!dividends.
So!your!payoff!when!the!firmCs!FCF!is!1000!=!-50!(interest)!+!100!(dividends)!=!$50!(same!as!WithCs!
dividends)
Payoff!when!firmCs!FCF!is!2000!=!-50!(interest)!+!200!(dividends)!=!$150!(same!as!WithCs!dividends)!
Diff:!3!
Skill:!Analytical!
!
21)!!What!is!a!market!value!balance!sheet!and!how!does!it!differ!from!a!book!value!balance!sheet?!
Answer:!!!! One!application!of!MM!Proposition!I!is!the!useful!device!known!as!the!market!value!balance!sheet!
of!the!firm.!A!market!value!balance!sheet(is!similar!to!an!accounting!balance!sheet,!with!two!important!
distinctions.!First,!all$assets!and!liabilities!of!the!firm!are!included–even!intangible!assets!such!as!
reputation,!brand!name,!or!human!capital!that!are!missing!from!a!standard!accounting!balance!sheet.!
Second,!all!values!are!current!market!values!rather!than!historical!costs.!On!the!market!value!balance!
sheet!the!total!value!of!all!securities!issued!by!the!firm!must!equal!the!total!value!of!the!firm’s!assets.!
!
! The!market!value!balance!sheet!captures!the!idea!that!value!is!created!by!a!firm’s!choice!of!assets!
and!investments.!By!choosing!positive-NPV!projects!that!are!worth!more!than!their!initial!investment,!
the!firm!can!enhance!its!value.!Holding!fixed!the!cash!flows!generated!by!the!firm’s!assets,!however,!
the!choice!of!capital!structure!does!not!change!the!value!of!the!firm.!Instead,!it!merely!divides!the!value!
of!the!firm!into!different!securities.!
Diff:!2!
Skill:!Conceptual!
14.3(Modigliani-Miller(II:(Leverage,(Risk,(and(the(Cost(of(Capital((
(
1)!!Consider!the!following!equation:
E!+!D!=!U!=!A
The!E!in!this!equation!represents!
A)!!the!value!of!the!firmCs!equity.!
B)!!the!value!of!the!firmCs!debt.!
C)!!the!value!of!the!firmCs!unlevered!equity.!
D)!!the!market!value!of!the!firmCs!assets.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!14.3!Modigliani-Miller!II:!Leverage,!Risk,!and!the!Cost!of!Capital!
Skill:!Conceptual!
!
E!+!D!=!U!=!A
The!U!in!this!equation!represents!
A)!!the!value!of!the!firmCs!equity.!
B)!!the!market!value!of!the!firmCs!assets.!
C)!!the!value!of!the!firmCs!unlevered!equity.!
D)!!the!value!of!the!firmCs!debt.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
E!+$D!=!U!=!A
The!A!in!this!equation!represents!
A)!!the!value!of!the!firmCs!debt.!
B)!!the!market!value!of!the!firmCs!assets.!
C)!!the!value!of!the!firmCs!equity.!
D)!!the!value!of!the!firmCs!unlevered!equity.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!While!debt!itself!may!be!cheap,!it!increases!the!risk!and!therefore!the!cost!of!capital!of!the!firmCs!equity.!
B)!!Although!debt!does!not!have!a!lower!cost!of!capital!than!equity,!we!can!consider!this!cost!in!isolation.!
C)!!We!can!use!Modigliani!and!MillerCs!first!proposition!to!derive!an!explicit!relationship!between!leverage!
and!the!equity!cost!of!capital.!
D)!!The!total!market!value!of!the!firmCs!securities!is!equal!to!the!market!value!of!its!assets,!whether!the!firm!
is!unlevered!or!levered.!
Answer:!!!B!
B)!!Although!debt!has!a!lower!cost!of!capital!than!equity,!we!can!consider!this!cost!in!isolation.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!levered!equity!return!equals!the!unlevered!return,!plus!an!extra!fkickf!due!to!leverage.!
B)!!By!holding!a!portfolio!of!the!firm’s!equity!and!its!debt,!we!can!replicate!the!cash!flows!from!holding!its!
levered!equity.!
C)!!The!cost!of!capital!of!levered!equity!is!equal!to!the!cost!of!capital!of!unlevered!equity!plus!a!premium!
that!is!proportional!to!the!market!value!debt-equity!ratio.!
D)!!If!a!firm!is!unlevered,!all!of!the!free!cash!flows!generated!by!its!assets!are!available!to!be!paid!out!to!its!
equity!holders.!
Answer:!!!B!
B)!!By!holding!a!portfolio!of!the!firmCs!equity!and!its!debt,!we!can!replicate!the!cash!flows!from!
holding!its!unlevered!equity.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!we!can!identify!a!comparison!firm!whose!assets!have!the!same!risk!as!the!project!being!evaluated,!and!
if!the!comparison!firm!is!levered,!then!we!can!use!its!equity!cost!of!capital!as!the!cost!of!capital!for!the!
project.!
B)!!We!can!calculate!the!cost!of!capital!of!the!firmCs!assets!by!computing!the!weighted!average!of!the!firm’s!
equity!and!debt!cost!of!capital,!which!we!refer!to!as!the!firm’s!weighted!average!cost!of!capital!(WACC).!
C)!!The!portfolio!of!a!firmCs!equity!and!debt!replicates!the!returns!we!would!earn!if!the!firm!were!unlevered.!
D)!!When!evaluating!any!potential!investment!project,!we!must!use!a!discount!rate!that!is!appropriate!given!
the!risk!of!the!project’s!free!cash!flow.!
Answer:!!!A!
Explanation:!!! A)!!If!we!can!identify!a!comparison!firm!whose!assets!have!the!same!risk!as!the!project!being!
evaluated,!and!if!the!comparison!firm!is!levered,!then!we!can!use!its!unlevered!equity!cost!of!
capital!as!the!cost!of!capital!for!the!project.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!With!no!debt,!the!WACC!is!equal!to!the!unlevered!equity!cost!of!capital.!
B)!!With!perfect!capital!markets,!a!firmCs!WACC!is!dependent!of!its!capital!structure!and!is!equal!to!its!
equity!cost!of!capital!only!the!firm!it!is!unlevered.!
C)!!As!the!firm!borrows!at!the!low!cost!of!capital!for!debt,!its!equity!cost!of!capital!rises,!but!the!net!effect!is!
that!the!firmCs!WACC!is!unchanged.!
D)!!Although!debt!has!a!lower!cost!of!capital!than!equity,!leverage!does!not!lower!a!firmCs!WACC.!
Answer:!!!B!
B)!!With!perfect!capital!markets,!a!firmCs!WACC!is!independent!of!its!capital!structure!and!is!
equal!to!its!equity!cost!of!capital!only!the!firm!it!is!unlevered.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Holding!cash!has!the!opposite!effect!of!leverage!on!risk!and!return.!
B)!!We!use!the!market!value!of!the!firmC!net!debt!when!computing!its!WACC!and!unlevered!beta!to!
measure!the!cost!of!capital!and!market!risk!of!the!firm’s!business!assets.!
C)!!Since!the!WACC!does!not!change!with!the!use!of!leverage,!the!value!of!the!firmCs!free!cash!flow!
evaluated!using!the!WACC!does!not!change,!and!so!the!enterprise!value!of!the!firm!does!not!depend!on!
its!financing!choices.!
D)!!Even!if!the!firmCs!capital!structure!is!more!complex,!the!WACC!is!calculated!by!computing!the!weighted!
average!cost!of!only!the!firm’s!debt!and!equity.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!unlevered!beta!measures!the!market!risk!of!the!firm’s!business!activities,!ignoring!any!additional!
risk!due!to!leverage.!
B)!!If!a!firm!holds!$1!in!cash!and!has!$1!of!risk-free!debt,!then!the!interest!earned!on!the!cash!will!equal!the!
interest!paid!on!the!debt.!The!cash!flows!from!each!source!cancel!each!other,!just!as!if!the!firm!held!no!
cash!and!no!debt.!
C)!!The!unlevered!beta(measures!the!market!risk!of!the!firm!without!leverage,!which!is!equivalent!to!the!
beta!of!the!firmCs!assets.!
D)!!When!a!firm!changes!its!capital!structure!without!changing!its!investments,!its!levered!beta!will!remain!
unaltered,!however,!its!asset!beta!will!change!to!reflect!the!effect!of!the!capital!structure!change!on!its!
risk.!
Answer:!!!D!
B)!!
C)!!
D)!!When!a!firm!changes!its!capital!structure!without!changing!its!investments,!its!unlevered!beta!
will!remain!unaltered,!however,!its!equity!beta!will!change!to!reflect!the!effect!of!the!capital!
structure!change!on!its!risk.!
Diff:!2!
Skill:!Conceptual!
!
10)!!The!following!equation:
E D
X!=! !rE!+! !rD
E D E D
can!be!used!to!calculate!all!of!the!following!except:!
A)!!The!cost!of!capital!for!the!firmCs!assets.!
B)!!The!levered!cost!of!equity.!
C)!!The!unlevered!cost!of!equity.!
D)!!The!weighted!average!cost!of!capital.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
11)!!Which!of!the!following!equations!would!not!be!appropriate!to!use!in!a!firm!with!risky!debt?!
A)!! D
E!=! U!+! ( U!-! D)!
E
B)!! D
U!=!! E$+! ( U!-! D)!
E
C)!! D
E!=! U!+! U$
E
D)!! E D
U!+! E!+! D$
E D E D
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
E D
U!=! E!+! D
E D E D
E
The!term+! !in!the!equation!is!
E D
A)!!the!required!return!on!the!firmCs!equity.!
B)!!the!same!as!the!beta!of!the!firmCs!assets.!
C)!!equal!to!zero!if!the!firmCs!debt!is!riskless.!
D)!!the!proportion!of!the!firm!financed!with!equity.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
E D
U!=! E!+! D!
E D E D
The!term! D!in!the!equation!is?!
A)!!the!same!as!the!beta!of!the!firmCs!assets.!
B)!!the!required!return!on!the!firmCs!equity.!
C)!!the!proportion!of!the!firm!financed!with!equity.!
D)!!equal!to!zero!if!the!firmCs!debt!is!riskless.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
E D
U!=! E!+! D
E D E D
The!term! U!in!the!equation!is?!
A)!!the!same!as!the!beta!of!the!firmCs!assets.!
B)!!the!required!return!on!the!firmCs!equity.!
C)!!the!proportion!of!the!firm!financed!with!equity.!
D)!!equal!to!zero!if!the!firmCs!debt!is!riskless.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
You!are!evaluating!a!new!project!and!need!an!estimate!for!your!projectCs!beta.!!You!have!identified!the!following!
information!about!three!firms!with!comparable!projects:
Firm( Equity( Debt(to(Equity(

Name Beta Debt(Beta Ratio(
Lincoln 1.25 0 0.25!
Blinkin 1.6 0.2 1!
Nod 2.3 0.3 1.5!
!
15)!!The!unlevered!beta!for!Lincoln!is!closest!to:!
A)!!0.95!
B)!!1.00!
C)!!1.05!
D)!!0.90!
Answer:!!!B!
B)!!Firm( Equity( Debt( Debt(to( Percent( Percent( Unlevered(
Name Beta Beta Equity(Ratio( Equity( Debt( Beta(
Lincoln 1.25 0 0.25 0.8 0.2 1!
Blinkin 1.6 0.2 1 0.5 0.5 0.9!
Nod 2.3 0.3 1.5 0.4 0.6 1.1!
!
1
%!equity!is!calculated!as!
D
1
E
D
%!debt!is!calculated!as! E
D
1
E
the!unlevered!beta!is!calculated!as! U!=!%!equity!! E!+!%!debt! D$

C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
16)!!The!unlevered!beta!for!Blinkin!is!closest!to:!
A)!!0.95!
B)!!1.10!
C)!!1.00!
D)!!0.90!
Answer:!!!D!
B)!!
C)!!Firm( Equity( Debt( Debt(to( Percent( Percent( Unlevered(
Lincoln 1.25 0 0.25 0.8 0.2 1!
Blinkin 1.6 0.2 1 0.5 0.5 0.9!
Nod 2.3 0.3 1.5 0.4 0.6 1.1!
!
1
D
1
E
D
D
1
E

D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!The!unlevered!beta!for!Nod!is!closest!to:!
A)!!1.00!
B)!!0.90!
C)!!0.95!
D)!!1.10!
Answer:!!!D!
Explanation:!!! A)!!Firm( Equity( Debt( Debt(to( Percent( Percent( Unlevered(
Lincoln 1.25 0 0.25 0.8 0.2 1!
Blinkin 1.6 0.2 1 0.5 0.5 0.9!
Nod 2.3 0.3 1.5 0.4 0.6 1.1!
!
1
D
1
E
D
D
1
E
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!Based!upon!the!three!comparable!firms,!what!asset!beta!would!you!recommend!using!for!your!firmCs!new!
project?!
Answer:!!!Firm( Equity( Debt( Debt(to( Percent( Percent( Unlevered(
Lincoln 1.25 0 0.25 0.8 0.2 1!
Blinkin 1.6 0.2 1 0.5 0.5 0.9!
Nod 2.3 0.3 1.5 0.4 0.6 1.1!
!
1
D
1
E
D
D
1
E
the!unlevered!beta!is!calculated!as! U!=!%!equity!! E!+!%!debt! D

1.0 0.9 1.1
the!average!unlevered!beta!for!the!three!comparables!=! !=!1.0,!so!this!is!the!recommended!
3
beta!to!use.!
Diff:!2!
Skill:!Analytical!
19)!!Suppose!that!you!borrow!only!$30,000!in!financing!the!project.!!According!to!MM!proposition!II,!the!firmCs!
equity!cost!of!capital!will!be!closest!to:!
A)!!21%!
B)!!15%!
C)!!20%!
D)!!25%!
Answer:!!!C!
B)!!
C)!! (.5)$90, 000 (.5)$117, 000
PV(equity!cash!flows!-!unlevered)!=! !=!$90,000
1.15
D
Given$rE$=$rU$+! (rU$-$rD)$
E
30000
rE!=!.15!+! (.15!-!.05)!=!.20!or!20%!
90000 30000
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!Suppose!that!you!borrow!only!$60,000!in!financing!the!project.!!According!to!MM!proposition!II,!the!firmCs!
equity!cost!of!capital!will!be!closest!to:!
A)!!45%!
B)!!30%!
C)!!25%!
D)!!35%!
Answer:!!!D!
B)!!
C)!!
D)!! (.5)$90, 000 (.5)$117, 000
1.15
D
Given!rE$=$rU$+! $(rU$-$rD)$
E
60000
rE!=!.15!+! !(.15!-!.05)!=!.35!or!35%!
90000 60000
Diff:!2!
Skill:!Analytical!
!
!
Luther!Industries!has!no!debt,!a!total!equity!capitalization!of!$20!billion,!and!a!beta!of!1.8.!!Included!in!LutherCs!assets!are!
$4!billion!in!cash!and!risk-free!securities.!!!
21)!!What!is!LutherCs!enterprise!value?!
A)!!$16!billion!
B)!!$10.5!billion!
C)!!$24!billion!
D)!!$20!billion!
Answer:!!!A!
Explanation:!!! A)!!Enterprise!value!=!market!value!-!cash!=!$20!billion!-!$4!billion!=!$16!billion!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
22)!!Considering!the!fact!that!LutherCs!Cash!is!risk-free,LutherCs!unlevered!beta!is!closest!to:!
A)!!1.90!
B)!!2.25!
C)!!1.50!
D)!!1.45!
Answer:!!!B!
B)!! E D
U$=! E$+! D
E D E D
20 4
U!=! 1.8!+! 0!=!2.25!
20 4 20 4
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
23)!!Suppose!that!you!borrow!only!$45,000!in!financing!the!project.!!According!to!MM!proposition!II,!calculate!the!
firmCs!equity!cost!of!capital.!
Answer:!!! (.5)$90, 000 (.5)$117, 000
1.15
D
Given!rE$=$rU$+! (rU$-$rD)$
E
45000
rE!=!.15!+! (.15!-!.05)!=!.25!or!25%!
90000 45000
Diff:!2!
Skill:!Analytical!
!
24)!!Sisyphean!Bolder!Movers!Incorporated!has!no!debt,!a!total!equity!capitalization!of!$50!billion,!and!a!beta!of!
2.0.!!Included!in!SisypheanCs!assets!are!$12!billion!in!cash!and!risk-free!securities.!!!Calculate!SisypheanCs!
enterprise!value!and!unlevered!cost!of!equity!considering!the!fact!that!SisypheanCs!cash!is!risk-free.!
Answer:!!!Enterprise!value!=!market!value!-!cash!=!$50!billion!-!$12!billion!=!$38!billion
E D
U$=! E$+! D
E D E D
50 12
U!=! 2.0!+! 0!=!2.631579!
50 12 50 12
Diff:!2!
Skill:!Analytical!
14.4(Capital(Structure(Fallacies((
(
A)!!The!money!taken!in!by!the!firm!as!a!result!of!the!share!issue!exactly!offsets!the!dilution!of!the!shares.!
B)!!Most!analysts!prefer!to!use!performance!measures!and!valuation!multiples!that!are!based!on!the!firm’s!
earnings!before!interest!has!been!deducted.!
C)!!Because!the!firm’s!earnings!per!share!and!price-earnings!ratio!are!affected!by!leverage!implies!that!we!
can!always!reliably!compare!these!measures!across!firms!with!different!capital!structures.!
D)!!In!general,!as!long!as!the!firm!sells!the!new!shares!of!equity!at!a!fair!price,!there!will!be!no!gain!or!loss!to!
shareholders!associated!with!the!equity!issue!itself.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!14.4!Capital!Structure!Fallacies!
Skill:!Conceptual!
!
!
Assume!that!Rose!CorporationCs!(RC)!EBIT!is!not!expected!to!grow!in!the!future!and!that!all!earnings!are!paid!out!as!
dividends.!!RC!is!currently!an!all!equity!firm.!!It!expects!to!generate!earnings!before!interest!and!taxes!(EBIT)!of!$6!million!
over!the!next!year.!!Currently!RC!has!5!million!shares!outstanding!and!its!stock!is!trading!for!a!price!of!$12.00!per!share.!!
RC!is!considering!borrowing!$12!million!at!a!rate!of!6%!and!using!the!proceeds!to!repurchase!shares!at!the!current!price!of!
$12.00.
2)!!Prior!to!any!borrowing!and!share!repurchase,!RCCs!EPS!is!closest!to:!
A)!!$0.60!
B)!!$1.00!
C)!!$1.20!
D)!!$0.50!
Answer:!!!C!
B)!!
C)!!EPS!=!EBIT$/!Shares!outstanding!=!$6M!/!5M!shares!=!$1.20!EPS!
D)!!
Diff:!1!
Skill:!Analytical!
!
3)!!Prior!to!any!borrowing!and!share!repurchase,!the!equity!cost!of!capital!for!RC!is!closest!to:!
A)!!10%!
B)!!10%!
C)!!12%!
D)!!9%!
Answer:!!!B!
B)!!EPS!=!EBIT$/!Shares!outstanding!=!$6M!/!5M!shares!=!$1.20!EPS
EPS
V$=$
rU
1.20
$12.00!=$ so!rU!=!.10!
rU
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!Following!the!borrowing!of!$12!and!subsequent!share!repurchase,!the!number!of!shares!that!RC!will!have!
outstanding!is!closest!to:!
A)!!4.0!million!
B)!!6.0!million!
C)!!4.9!million!
D)!!4.5!.million!
Answer:!!!A!
Explanation:!!! A)!!$12!million!/!$12!per!share!=!1!million!shares!repurchased,!so!5M!shares!initially!-!1M!shares!
repurchased!=!4M!total!shares!outstanding!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Following!the!borrowing!of!$12!and!subsequent!share!repurchase,!the!equity!cost!of!capital!for!RC!is!closest!to:!
A)!!12%!
B)!!9%!
C)!!11.0%!
D)!!10%!
Answer:!!!C!
B)!!
C)!!EPS!=!EBIT$/!Shares!outstanding!=!$6M!/!5M!shares!=!$1.20!EPS
EPS
V$=$
rU
1.20
$12.00!=$ so!rU!=!.10
rU
D
rE$=$rU$+$ (rU$-$rD)
E
12
rE!=!.10!+$ (.10!-!.06)!=!.11!or!11%!
60 12
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Following!the!borrowing!of!$12!and!subsequent!share!repurchase,!the!expected!earnings!per!share!for!RC!is!
closest!to:!
A)!!$1.32!
B)!!$1.44!
C)!!$1.40!
D)!!$1.20!
Answer:!!!A!
Explanation:!!! A)!!EPS!=!(EBIT)!/!Shares!outstanding!=!($6M)!/!5M!shares!=!$1.20!EPS!(unlevered)!
!
$12!million!/!$12!per!share!=!1!million!shares!repurchased,!so!5M!shares!initially!-!1M!shares!
repurchased!=!4M!total!shares!outstanding.
EPS!=!(EBIT!-!Interest)!/!Shares!outstanding!=!($6M!-!.06!×!$12)!/!4M!shares!=!$1.32!EPS!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Following!the!borrowing!of!$12!and!subsequent!share!repurchase,!the!value!of!a!share!for!RC!is!closest!to:!
A)!!$14.00!
B)!!$13.20!
C)!!$12.00!
D)!!$10.80!
Answer:!!!C!
B)!!
C)!!EPS!=!(EBIT)!/!Shares!outstanding!=!($6M)!/!5M!shares!=!$1.20!EPS!(unlevered)
EPS
V$=$
rU
1.20
$12.00!=$ so!rU!=!.10
rU
D
E
12
rE!=!.10!+$ (.10!-!.06)!=!.11!or!11%!
60 12
$12!million!/!$12!per!share!=!1!million!shares!repurchased,!so!5M!shares!initially!-!1M!shares!
repurchased!=!4M!total!shares!outstanding.
EPS!=!(EBIT!-!Interest)!/!Shares!outstanding!=!($6M!-!.06!×!$12)!/!4M!shares!=!$1.32!EPS
$1.32
V!=$ !=!$12.00!
.11
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Rockwood!Enterprises!is!currently!an!all!equity!firm!and!has!just!announced!plans!to!expand!their!current!business.!!In!
order!to!fund!this!expansion,!Rockwood!will!need!to!raise!$100!million!in!new!capital.!!After!the!expansion,!Rockwood!is!
expected!to!produce!earnings!before!interest!and!taxes!of!$50!million!per!year!in!perpetuity.!!Rockwood!has!already!
announced!the!planned!expansion,!but!has!not!yet!determined!how!best!to!fund!the!expansion.!!Rockwood!currently!has!
16!million!shares!outstanding!and!following!the!expansion!announcement!these!shares!are!trading!at!$25!per!share.!!
Rockwood!has!the!ability!to!borrow!at!a!rate!of!5%!or!to!issue!new!equity!at!$25!per!share.
8)!!If!Rockwood!finances!their!expansion!by!issuing!new!stock,!what!will!RockwoodCs!cost!of!equity!capital!be?!
A)!!12%!
B)!!15%!
C)!!8%!
D)!!10%!
Answer:!!!D!
B)!!
C)!!
D)!!FIrst,!since!the!project!is!already!announced,!any!positive!NPV!is!already!reflected!into!
Rockwoods!current!stock!price.!!So,!to!raise!the!needed!$100!million!at!$25!per!share,!
$100M
Rockwood!will!need!to!issue! !=!4!million!new!shares!for!a!total!of!16!+!4!=!20!million!
$25
shares!outstanding.!!So!EPS!per!share!=!$50/20!=!$2.50
EPS
V$=$
rU
$2.50
$25.00!=$ ,!so!rU!=!.10!
rU
Diff:!2!
Skill:!Analytical!
!
9)!!If!Rockwood!finances!their!expansion!by!issuing!$100!million!in!debt!at!5%,!what!will!RockwoodCs!cost!of!
equity!capital!be?!
A)!!11.25%!
B)!!10.70%!
C)!!12.50%!
D)!!12.00%!
Answer:!!!A!
Explanation:!!! A)!!FIrst,!since!the!project!is!already!announced,!any!positive!NPV!is!already!reflected!into!
Rockwoods!current!stock!price.!!So,!to!raise!the!needed!$100!million!at!$25!per!share,!
$100M
Rockwood!will!need!to!issue! !=!4!million!new!shares!for!a!total!of!16!+!4!=!20!million!
$25
shares!outstanding.!!So!EPS!per!share!=!$50/20!=!$2.50
EPS
V$=$
rU
$2.50
$25.00!=$ ,!so!rU!=!.10
rU
Now!
D
E
100
rE!=!.10!+$ (.10!-!.05)!=!.1125!or!11.25%!
500 100
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Show!mathematically!that!the!stock!price!of!Rockwood!does!not!depend!on!whether!they!issue!new!stock!or!
borrow!to!fund!their!expansion.!
Answer:!!!First,!since!the!project!is!already!announced,!any!positive!NPV!is!already!reflected!into!Rockwoods!
current!stock!price.!!So,!to!raise!the!needed!$100!million!at!$25!per!share,!Rockwood!will!need!!
$100M
to!issue! !=!4!million!new!shares!for!a!total!of!16!+!4!=!20!million!shares!outstanding.!!!
$25
So!EPS!per!share!=!$50/20!=!$2.50
EPS
V$=$
rU
$2.50
$25.00!=$ ,!so!rU!=!.10
rU
!
Remember!the!price!here!is!$25.00!per!share.
!
Now:
D
E
100
rE!=!.10!+$ (.10!-!.05)!=!.1125!or!11.25%
500 100
First,!since!the!project!is!already!announced,!any!positive!NPV!is!already!reflected!into!Rockwoods!
current!stock!price.!
EBIT Interest $50 .05($100)

EPS!=! !=$ !=!!2.8125!
Number of Shares 16
EPS 2.8125
V!=$ !=$ !=!$25.00!same!as!all!equity!option.!
rU .1125
Diff:!3!
Skill:!Analytical!
!
!
Assume!that!Rose!CorporationCs!(RC)!EBIT!is!not!expected!to!grow!in!the!future!and!that!all!earnings!are!paid!out!as!
dividends.!!RC!is!currently!an!all!equity!firm.!!It!expects!to!generate!earnings!before!interest!and!taxes!(EBIT)!of!$6!million!
over!the!next!year.!!Currently!RC!has!5!million!shares!outstanding!and!its!stock!is!trading!for!a!price!of!$12.00!per!share.!!
RC!is!considering!borrowing!$12!million!at!a!rate!of!6%!and!using!the!proceeds!to!repurchase!shares!at!the!current!price!of!
$12.00.
11)!!Show!mathematically!that!the!stock!price!of!RC!wonCt!change!following!the!debt!issuance!and!share!
repurchase.!
Answer:!!!EPS!=!(EBIT)!/!Shares!outstanding!=!($6M)!/!5M!shares!=!$1.20!EPS!(unlevered)!
EPS
V$=$
rU
1.20
$12.00!=$ so!rU!=!.10
rU
D
E
12
rE!=!.10!+$ (.10!-!.06)!=!.11!or!11%
60 12
EPS!=!(EBIT!-!Interest)!/!Shares!outstanding!=!($6M!-!.06!×!$12)!/!4M!shares!=!$1.32!EPS
$1.32
V!=! !=!$12.00!which!equals!the!original!stock.!
.11
Diff:!2!
Skill:!Analytical!
!
14.5(MM:(Beyond(the(Propositions((
(
A)!!Since!the!publication!of!their!original!paper,!Modigliani!and!Miller’s!ideas!have!greatly!influenced!
finance!research!and!practice.!
B)!!Proposition!I!was!one!of!the!first!arguments!to!show!that!the!Law!of!One!Price!could!have!strong!
implications!for!security!prices!and!firm!values!in!a!competitive!market;!it!marks!the!beginning!of!the!
modern!theory!of!corporate!finance.!
C)!!The!conservation!of!value!principle!extends!far!beyond!questions!of!debt!versus!equity
or!even!capital!structure.!
D)!!The!conservation!of!value!principle!for!financial!markets!states!that!with!perfect!capital!markets,!
financial!transactions!neither!add!nor!destroy!value,!but!instead!represent!a!repackaging!of!risk!(and!
therefore!return).!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!14.5!MM:!Beyond!the!Propositions!
Skill:!Conceptual!
!
!
Chapter(15(-(Debt(and(Taxes(
!
!
15.1(The(Interest(Tax(Deduction(
A)!!In!general,!the!gain!to!investors!from!the!tax!deductibility!of!interest!payments!is!referred!to!as!the!
interest!tax!shield.!
B)!!The!interest!tax!shield!is!the!additional!amount!that!a!firm!would!have!paid!in!taxes!if!it!did!not!have!
leverage.!
C)!!Because!Corporations!pay!taxes!on!their!profits!after!interest!payments!are!deducted,!interest!expenses!
reduce!the!amount!of!corporate!tax!firms!must!pay.!
D)!!As!Modigliani!and!Miller!made!clear!in!their!original!work,!capital!structure!matters!in!perfect!capital!
markets.!!Thus,!if!capital!structure!does!not!matter,!then!it!must!stem!from!a!market!imperfection.!
Answer:!!!D!
B)!!
C)!!
D)!!As!Modigliani!and!Miller!made!clear!in!their!original!work,!capital!structure!does!not!matter!
in!perfect!capital!markets.!!Thus,!if!capital!structure!matters,!then!it!must!stem!from!a!market!
imperfection.!
Diff:!1!
Topic:!15.1!The!Interest!Tax!Deduction!
Skill:!Conceptual!
!
!
Consider!the!following!income!statement!for!Kroger!Inc.!(all!figures!in!$!Millions):
Year 2006 2005 2004(

Total!Sales 60,553 56,434 53,791!
Cost!of!goods!sold 45,565 42,140 39,637!
Selling,!general!&!admin!expenses 11,688 12,191 11,575!
Depreciation 1,265 1,256 1,209!
Operating!Income 2,035 847 1,370!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Interest!expense 510 557 604!
Earnings!before!tax 1,525 290 766!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
!
2)!!The!interest!rate!tax!shield!for!Kroger!in!2006!is!closest!to:!
A)!!$187!million!
B)!!$332!million!
C)!!$534!million!
D)!!$179!million!
Answer:!!!D!
B)!!
C)!!
D)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
Tax!Shield!=!.35!×!Interest!Exp 178.5 194.95 211.4!
Diff:!1!
Skill:!Analytical!
!
A)!!$362!million!
B)!!$36!million!
C)!!$102!million!
D)!!$195!million!
Answer:!!!D!
B)!!
C)!!
D)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
Diff:!1!
Skill:!Analytical!
!
A)!!$268!million!
B)!!$393!million!
C)!!$211!million!
D)!!$94!million!
Answer:!!!C!
B)!!
C)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
Tax!Shield!=!.35!x!Interest!Exp 178.5 194.95 211.4!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!The!total!amount!available!to!payout!to!all!the!investors!in!Kroger!in!2006!is!closest!to:!
A)!!$990!million!
B)!!$1,525!million!
C)!!$1,500!million!
D)!!$2,035!million!
Answer:!!!C!
B)!!
C)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
! ! ! !
Total!available!to!all!investors!
Interest!expense!+!net!income 1,501 746 1,102!
Total!available!to!S.H.!if!no!!
leverage!=!EBIT(1!-!0.35) 1322.75 550.55 890.5!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!The!total!amount!available!to!payout!to!all!the!investors!in!Kroger!in!2005!is!closest!to:!
A)!!$190!million!
B)!!$847!million!
C)!!$745!million!
D)!!$290!million!
Answer:!!!C!
B)!!
C)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
! ! ! !
Total!available!to!S.H.!if!!no!leverage
=!EBIT(1!-!0.35) 1322.75 550.55 890.5!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!income!that!would!be!available!to!equity!holders!in!2006!if!Kroger!was!not!levered!is!closest!to:!
A)!!$1,525!million!
B)!!$2,035!million!
C)!!$1,500!million!
D)!!$1,325!million!
Answer:!!!D!
B)!!
C)!!
D)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
! ! ! !
=!EBIT(1!-!0.35) 1322.75 550.55 890.5!
Diff:!2!
Skill:!Analytical!
!
8)!!The!income!that!would!be!available!to!equity!holders!in!2005!if!Kroger!was!not!levered!is!closest!to:!
A)!!$290!million!
B)!!$745!million!
C)!!$847!million!
D)!!$550!million!
Answer:!!!D!
B)!!
C)!!
D)!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
! ! ! !
=!EBIT(1!-!0.35) 1322.75 550.55 890.5!
Diff:!2!
Skill:!Analytical!
!
!
Rosewood!Industries!has!EBIT!of!$450!million,!interest!expense!of!$175!million,!and!a!corporate!tax!rate!of!35%.!
!
9)!!Rosewood\s!net!income!is!closest!to:!
A)!!$450!million!
B)!!$180!million!
C)!!$290!million!
D)!!$95!million!
Answer:!!!B!
B)!!Net!income!=!(EBIT!-!Interest!expense)(1!-! C)
=!(450!-!175)(1!-!.35)!=!$178.75!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!The!total!of!Rosewood\s!net!income!and!interest!payments!is!closest!to:!
A)!!$270!million!
B)!!$355!million!
C)!!$290!million!
D)!!$450!million!
Answer:!!!B!
B)!!Net!income!+!Interest!expense!=!(EBIT!-!Interest!expense)(1!-! C)
=!(450!-!175)(1!-!.35)!=!$178.75!+!$175!=!$353.73!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!If!Rosewood!had!no!interest!expense,!its!net!income!would!be!closest!to:!
A)!!$405!million!
B)!!$160!million!
C)!!$450!million!
D)!!$290!million!
Answer:!!!D!
B)!!
C)!!
D)!!Net!income!=!(EBIT!-!Interest!expense)(1!-! C)
=!(450!-!0)(1!-!.35)!=!$292.50!
Diff:!1!
Skill:!Analytical!
!
12)!!The!amount!of!Rosewood\s!interest!tax!shield!is!closest!to:!
A)!!$115!million!
B)!!$290!million!
C)!!$175!million!
D)!!$60!million!
Answer:!!!D!
B)!!
C)!!
D)!!Interest!expense( C)!=!175(.35)!=!$61.25!
Diff:!1!
Skill:!Analytical!
!
!
Fly!by!Night!Aviation!(FBNA)!expects!to!have!net!income!next!year!of!$24!million!and!Free!Cash!Flow!of!$27!million.!!
FBNA\s!marginal!corporate!tax!rate!is!40%.!
!
13)!!FBNA\s!EBIT!is!closest!to:!
A)!!$43!million!
B)!!$40!Million!
C)!!$45!million!
D)!!$60!million!
Answer:!!!A!
Explanation:!!! A)!!EBIT!=!NI!+!Taxes!+!Interest!expense
FCF!=!NI!+!Interest!expense!=>!27!=!24!+!interest!expense,!so!interest!expense!=!3
(EBIT!-!Interest!Expense)(1!-!.4)!=!NI
(EBIT!-!3)(.6)!=!24
EBIT!=!24!/!.6!+!3!=!$43!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!IF!FBNA!increases!leverage!so!that!its!interest!expense!rises!by!$1!million,!then!the!amount!its!net!income!will!
change!is!closest!to:!
A)!!-$400,000!
B)!!-$600,000!
C)!!$400,000!
D)!!$600,000!
Answer:!!!B!
B)!!(EBIT!-!Interest!Expense!-!chg!IE)(1!-!.4)!=!NI!+!chg!NI
(-1)(chg!IE)(.6)!=!chg!NI
-1,000,000(.6)!=!-600,000!
!
Or,!-$1!million(1!-!.6)!=!-$600,000!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
15)!!IF!FBNA!increases!leverage!so!that!its!interest!expense!rises!by!$1!million,!then!the!amount!its!Free!Cash!flow!
will!change!is!closest!to:!
A)!!-$600,000!
B)!!-$400,000!
C)!!$600,000!
D)!!$400,000!
Answer:!!!D!
Explanation:!!! A)!!(EBIT!-!Interest!Expense!-!chg!IE)(1!-!.4)!=!NI!+!chg!NI
(-1)(chg!IE)(.6)!=!chg!NI
-1,000,000(.6)!=!-600,000
FCF!=!NI!+!Interest!expense
chg!FCF!=!chg!NI!+!chg!Interest!expense!=!-600,000!+!1,000,000!=!+400,000
Or,!$1,000,000(.4)!=!$400,000!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Consider!the!following!income!statement!for!Kroger!Inc.!(all!figures!in!$!Millions):
Year 2006 2005 2004(

Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
!
16)!!Calculate!the!interest!tax!shield,!the!total!amount!available!to!payout!to!all!the!investors,!and!the!income!that!
would!be!available!to!equity!holders!if!Kroger!was!not!levered!all!for!the!year!2004.!
Answer:!!!Year 2006 2005 2004(
Total!Sales 60,553 56,434 53,791!
Depreciation 1,265 1,256 1,209!
Other!Income 0 0 0!
EBIT 2,035 847 1,370!
Taxes!(35%) 534 102 268!
Net!Income 991 189 498!
! ! ! !
! ! ! !
=!EBIT(1!-!0.35) 1322.75 550.55 890.5!
Diff:!2!
Skill:!Analytical!
(
15.2(Valuing(the(Interest(Tax(Shield(
A)!!To!determine!the!benefit!of!leverage!for!the!value!of!the!firm,!we!must!compute!the!present!value!of!the!
stream!of!future!interest!tax!shields!the!firm!will!receive.!
B)!!Because!the!cash!flows!of!the!levered!firm!are!equal!to!the!sum!of!the!cash!flows!from!the!unlevered!firm!
plus!the!interest!tax!shield,!by!the!Law!of!One!Price!the!same!must!be!true!for!the!present!values!of!these!
cash!flows.!
C)!!By!increasing!the!amount!paid!to!debt!holders!through!interest!payments,!the!amount!of!the!pretax!cash!
flows!that!must!be!paid!as!taxes!increases.!
D)!!When!a!firm!uses!debt,!the!interest!tax!shield!provides!a!corporate!tax!benefit!each!year.!
Answer:!!!C!
B)!!
C)!!By!increasing!the!amount!paid!to!debt!holders!through!interest!payments,!the!amount!of!the!
pretax!cash!flows!that!must!be!paid!as!taxes!decreases.!
D)!!
Diff:!1!
Topic:!15.2!Valuing!the!Interest!Tax!Shield!
Skill:!Conceptual!
!
A)!!Given!a!forecast!of!future!interest!payments,!we!can!determine!the!interest!tax!shield!and!compute!its!
present!value!by!discounting!it!at!a!rate!that!corresponds!to!its!risk.!
B)!!The!total!value!of!the!unlevered!firm!exceeds!the!value!of!the!firm!with!leverage!due!to!the!present!value!
of!the!tax!savings!from!debt.!
C)!!To!compute!the!increase!in!the!firm\s!total!value!associated!with!the!interest!tax!shield,!we!need!to!
forecast!how!a!firm’s!debt–and!therefore!its!interest!payments.!
D)!!There!is!an!important!tax!advantage!to!the!use!of!debt!financing.!
Answer:!!!B!
B)!!The!total!value!of!the!levered!firm!exceeds!the!value!of!the!firm!without!leverage!due!to!the!
present!value!of!the!tax!savings!from!debt.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Given!a!35%!corporate!tax!rate,!for!every!$1!in!new!permanent!debt!that!the!firm!issues,!the!value!of!the!
firm!increases!by!$0.65.!
B)!!The!firm’s!marginal!tax!rate!may!fluctuate!due!to!changes!in!the!tax!code!and!changes!in!the!firm’s!
income!bracket.!
C)!!Many!large!firms!have!a!policy!of!maintaining!a!certain!amount!of!debt!on!their!balance!sheets.!
D)!!Typically,!the!level!of!future!interest!payments!varies!due!to!changes!the!firm!makes!in!the!amount!of!
debt!outstanding,!changes!in!the!interest!rate!on!that!debt,!and!the!risk!that!the!firm!may!default!and!fail!
to!make!an!interest!payment.!
Answer:!!!A!
Explanation:!!! A)!!Given!a!35%!corporate!tax!rate,!for!every!$1!in!new!permanent!debt!that!the!firm!issues,!the!
value!of!the!firm!increases!by!$0.35.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!tax!deductibility!of!interest!lowers!the!effective!cost!of!debt!financing!for!the!firm.!
B)!!When!a!firm!uses!debt!financing,!the!cost!of!the!interest!it!must!pay!is!offset!to!some!extent!by!the!tax!
savings!from!the!interest!tax!shield.!
C)!!With!tax-deductible!interest,!the!effective!after-tax!borrowing!rate!is!r( C).!
D)!!The!WACC!represents!the!cost!of!capital!for!the!free!cash!flow!generated!by!the!firm’s!assets.!
Answer:!!!C!
B)!!
C)!!With!tax-deductible!interest,!the!effective!after-tax!borrowing!rate!is!r(1!-! C).!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!higher!the!firm\s!leverage,!the!more!the!firm!exploits!the!tax!advantage!of!debt,!and!the!lower!its!
WACC.!
B)!!Corporate!taxes!lower!the!effective!cost!of!debt!financing,!which!translates!into!a!reduction!in!the!
weighted!average!cost!of!capital.!
C)!!Because!the!firm\s!free!cash!flow!is!computed!without!considering!the!firm\s!leverage,!we!account!for!
the!benefit!of!the!interest!tax!shield!by!calculating!the!WACC!using!the!before!tax!cost!of!debt.!
D)!!The!reduction!in!the!WACC!increases!with!the!amount!of!debt!financing.!
Answer:!!!C!
B)!!
C)!!Because!the!firm\s!free!cash!flow!is!computed!without!considering!the!firm\s!leverage,!we!
account!for!the!benefit!of!the!interest!tax!shield!by!calculating!the!WACC!using!the!after!tax!
cost!of!debt.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! Dr
VL$=$VU$+ c D $
rD
B)!!VL$=$VU$+$ cD$
C)!! E D D
rwacc$=$ rE$+$ rD$-+$ rD c$
E D E D E D
D)!! E D
rwacc$=$ rE$+$ rD(1$+$ c)!
E D E D
Answer:!!!D!
B)!!
C)!!
D)!! E D
rwacc$=$ rE$+$ rD(1$-$ c)!
E D E D
Diff:!2!
Skill:!Conceptual!
!
7)!!Consider!the!following!formula:
c DrD
VL$=$VU$+
rD
Dr
The!term! c D $represents!
rD
A)!!the!value!of!firm!with!leverage.!
B)!!the!present!value!of!the!interest!tax!shield.!
C)!!the!preset!value!of!the!future!interest!payments.!
D)!!the!interest!tax!shield!each!year.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
VL$=$VU$+$ cD
The!term! cD!represents!
A)!!the!present!value!of!the!interest!tax!shield.!
B)!!the!value!of!firm!with!leverage.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
E D D
rwacc$=$ rE$+$ rD$-$ rD c
E D E D E D
D
The!term+$ rD c!represents!
E D
A)!!the!reduction!due!to!the!interest!tax!shield.!
B)!!the!present!value!of!the!interest!tax!shield.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
E D D
rwacc$=$ rE$+$ rD$-$ rD c
E D E D E D
E D
The!terms$ rE$+$ rD!represent!
E D E D
A)!!the!after!tax!wacc.!
B)!!the!reduction!due!to!equity!financing.!
C)!!the!before!tax!wacc.!
D)!!the!reduction!due!to!the!interest!tax!shield.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Flagstaff!Enterprises!expected!to!have!free!cash!flow!in!the!coming!year!of!$8!million,!and!this!free!cash!flow!is!expected!to!
grow!at!a!rate!of!3%!per!year!thereafter.!!Flagstaff!has!an!equity!cost!of!capital!of!13%,!a!debt!cost!of!capital!of!7%,!and!it!is!
in!the!35%!corporate!tax!bracket.!!
!
11)!!If!Flagstaff!maintains!a!.5!debt!to!equity!ratio,!then!Flagstaff\s!pre-tax!WACC!is!closest!to:!
A)!!10.5%!
B)!!11.0%!
C)!!9.0%!
D)!!10.0%!
Answer:!!!B!
B)!! E D
rwacc$=$ rE$+$ rD
E D E D
1 .5
rwacc$=$ .13!+$ .07!=!.11!
1 .5 1 .5
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!If!Flagstaff!currently!maintains!a!.5!debt!to!equity!ratio,!then!the!value!of!Flagstaff!as!an!all!equity!firm!would!
be!closest!to:!
A)!!$80!million!
B)!!$100!million!
C)!!$73!million!
D)!!$115!million!
Answer:!!!B!
B)!! E D
rwacc$=$ rE$+$ rD!(Pre!tax)
E D E D
rwacc!=$ 1 .13!+$ .5 .07!=!.11
1 .5 1 .5
FCF $ $80
VU$= = !!=!$100!million!
rE g .11 .03
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!If!Flagstaff!currently!maintains!a!.5!debt!to!equity!ratio,!then!Flagstaff\s!after-tax!WACC!is!closest!to:!
A)!!10.00%!
B)!!10.25%!
C)!!9.50%!
D)!!8.75%!
Answer:!!!B!
B)!! E D
rwacc$=$ rE$+$ rD$(1$-$ c)
E D E D
1 .5
rwacc$= .13!+! .07!(1!-!.35)!=!.101833!
1 .5 1 .5
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!If!Flagstaff!currently!maintains!a!.5!debt!to!equity!ratio,!then!the!value!of!Flagstaff!as!a!levered!firm!is!closest!
to:!
A)!!$114!million!
B)!!$100!million!
C)!!$111!million!
D)!!$140!million!
Answer:!!!C!
B)!!
C)!! E D
rwacc$=$ rE$+$ rD$(1$-$ c)
E D E D
1 .5
rwacc!= .13!+! .07!(1!-!.35)!=!.101833
1 .5 1 .5
FCF $8
VL$= !=! !=!$111.37!million!
rE g .101833 .03
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!If!Flagstaff!currently!maintains!a!.5!debt!to!equity!ratio,!then!the!value!of!Flagstaff\s!interest!tax!shield!is!
closest!to:!
A)!!$11!million!
B)!!$18!million!
C)!!$10!million!
D)!!$24!million!
Answer:!!!A!
Explanation:!!! A)!! E D
rwacc$=$ $rE$+$ $rD!(Pre!tax)
E D E D
1 .5
rwacc!= .13!+! !.07!=!.11
1 .5 1 .5
FCF $8
VU!= !=! !=!$100!million$
rE g .11 .03
E D
rwacc$=$ rE$+$ $rD$(1$-$ c)!(after!tax)
E D E D
1 .5
rwacc$= !.13!+! .07!(1!-!.35)!=!.101833
1 .5 1 .5
FCF $8
VL$=$ !=! !=!$111.37!million
rE g .101833 .03
PV!of!tax!shield!=!VL$-$VU$=!$111.37!-!$100!=!$11.37!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
16)!!If!Flagstaff!maintains!a!debt!to!equity!ratio!of!1,!then!Flagstaff\s!pre-tax!WACC!is!closest!to:!
A)!!11.0%!
B)!!10.5%!
C)!!10.0%!
D)!!9.0%!
Answer:!!!C!
rwacc$=$ $rE$+$ $rD
E D E D
1 1
rwacc!= .13!+ .07!=!.10!
1 1 1 .1
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!If!Flagstaff!currently!maintains!a!debt!to!equity!ratio!of!1,!then!the!value!of!Flagstaff!as!an!all!equity!firm!
would!be!closest!to:!
A)!!$73!million!
B)!!$80!million!
C)!!$115!million!
D)!!$100!million!
Answer:!!!C!
B)!!
C)!!
D)!! E D
rwacc$=$ $rE$+$ $rD$(Pre!tax)
E D E D
1 1
rwacc!= .13!+ .07!=!.10
1 1 1 .1
FCF $8
VU$=$ !=! !=!$114.29!million!
rE g .10 .03
Diff:!2!
Skill:!Analytical!
!
18)!!If!Flagstaff!currently!maintains!a!debt!to!equity!ratio!of!1,!then!Flagstaff\s!after-tax!WACC!is!closest!to:!
A)!!10.25%!
B)!!10.00%!
C)!!9.50%!
D)!!8.75%!
Answer:!!!D!
rwacc$=$ $rE$+$ rD!(1!-! c)
E D E D
1 1
rwacc!= .13!+ .07!(1!-!.35)!=!.087750!
1 1 1 .1
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
19)!!If!Flagstaff!currently!maintains!a!debt!to!equity!ratio!of!1,!then!the!value!of!Flagstaff!as!a!levered!firm!is!closest!
to:!
A)!!$114!million!
B)!!$100!million!
C)!!$111!million!
D)!!$140!million!
Answer:!!!D!
B)!!
C)!! E D
rwacc$=$ $rE$+$ rD!(1!-! c)
E D E D
1 1
rwacc!= .13!+ .07!(1!-!.35)!=!.087750
1 1 1 .1
FCF $8
VL$=$ !=! !=!$138.53!million!
rE g .087750 .03
D)!!
Diff:!2!
Skill:!Analytical!
!
20)!!If!Flagstaff!currently!maintains!a!debt!to!equity!ratio!of!1,!then!the!value!of!Flagstaff\s!interest!tax!shield!is!
closest!to:!
A)!!$10!million!
B)!!$18!million!
C)!!$11!million!
D)!!$24!million!
Answer:!!!D!
B)!!
C)!! E D
rwacc$=$ $rE$+$ rD!(Pre!tax)
E D E D
1 1
rwacc!= .13!+ .07!=!.10
1 1 1 .1
FCF $8
VU$=$ !=! !=!$114.29!million
rE g .10 .03
E D
rwacc$=$ $rE$+$ rD!(1!-! c)
E D E D
1 1
rwacc!= .13!+ .07!(1!-!.35)!=!.087750
1 1 1 .1
FCF $8
VL$=$ !=! !=!$138.53!million
rE g .087750 .03
PV!of!tax!shield!=!VL$-$VU!=!$138.53!-!$114.29!=!$24.24!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
LCMS!Industries!has!$70!million!in!debt!outstanding.!!The!firm!will!pay!only!interest!on!this!debt!(the!debt!is!perpetual).!!
LCMS\!marginal!tax!rate!is!35%!and!the!firm!pays!a!rate!of!8%!interest!on!its!debt.!
21)!!LCMS\!annual!interest!tax!shield!is!closest!to:!
A)!!$2.8!million!
B)!!$2.0!million!
C)!!$3.6!million!
D)!!$5.6!million!
Answer:!!!B!
B)!!annual!Tax!shield!=!debt!×! C!=!$70M!×!.35!×!.08!=!1.96M!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
22)!!Assuming!that!the!risk!is!the!same!as!the!loan,!the!present!value!of!LCMS\!interest!tax!shield!is!closest!to:!
A)!!$45.5!million!
B)!!$20.0!million!
C)!!$24.5!million!
D)!!$35.0!million!
Answer:!!!C!
B)!!
C)!!PV!of!Tax!shield!=!debt!×! C!=!$70M!×!.35!=!24.5M!
D)!!
Diff:!1!
Skill:!Analytical!
!
23)!!Assuming!that!the!risk!of!the!tax!shield!is!only!6%!even!though!the!loan!pays!8%,!then!the!present!value!of!
LCMS\!interest!tax!shield!is!closest!to:!
A)!!$24.5!million!
B)!!$18!million!
C)!!$33.0!million!
D)!!$20.0!million!
Answer:!!!C!
Explanation:!!! A)!!PV!of!Tax!shield!=!debt!×! C!×!rD!/!RD2=!$70M!×!.35!×!.08/.06!=!32.67!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Flagstaff!Enterprises!expected!to!have!free!cash!flow!in!the!coming!year!of!$8!million,!and!this!free!cash!flow!is!expected!to!
grow!at!a!rate!of!3%!per!year!thereafter.!!Flagstaff!has!an!equity!cost!of!capital!of!13%,!a!debt!cost!of!capital!of!7%,!and!it!is!
in!the!35%!corporate!tax!bracket.!!
!
24)!!If!Flagstaff!currently!maintains!a!.8!debt!to!equity!ratio,!then!calculate!the!value!of!Flagstaff\s!interest!tax!
shield.!
Answer:!!! E D
rwacc$=$ $rE$+$ rD!(Pre!tax)
E D E D
1 8
rwacc!= .13!+ .07!=!.103333
1 .8 1 .8
FCF $8
VU$=$ !=! !=!$109.09!million
rE g .103333 .03
E D
rwacc$=$ $rE$+$ rD!(1!-! c)!(after!tax)
E D E D
1 8
rwacc!= .13!+ .07!(1!-!.35)!=!.092444
1 .8 1 .8
FCF $8
VL$=$ !=! !=!$128.11!million!
rE g .092444 .03
PV!of!tax!shield!=!VL$-$VU!=!$128.11!-!$109.09!=!$19.02!
Diff:!3!
Skill:!Analytical!
!
25)!!Your!firm!currently!has!$250!million!in!debt!outstanding!with!an!8%!interest!rate.!!The!terms!of!the!loan!
require!the!firm!to!repay!$50!million!of!the!balance!each!year.!!Suppose!that!the!marginal!corporate!tax!rate!is!
35%!and!that!the!interest!tax!shields!have!the!same!risk!as!the!loan.!!What!is!the!present!value!of!the!interest!
tax!shields!from!this!debt?!
Answer:!!! (
Beginning( Interest( EndingB (Tax( PV(of(Tax(
Year Balance Expense alance Shield Shield(
1 250 20 200 7 6.4815!
2 200 16 150 5.6 4.8011!
3 150 12 100 4.2 3.3341!
4 100 8 50 2.8 2.0581!
5 50 4 0 1.4 0.9528!
Total!= 17.6276!
!
Interest!expense!=!beginning!balance!×!.08
Tax!shield!=!interest!expense!×!.35
PV!of!tax!shield!=!tax!shield/(1.08)n$
Diff:!3!
Skill:!Analytical!
!
26)!!Raceway!Products!has!a!market!debt-to-equity!ratio!of!.60,!a!corporate!tax!rate!of!40%,!and!pays!8%!interest!
on!its!debt.!!The!interest!tax!shield!on!Raceway\s!debt!lowers!its!WACC!by!what!amount?!
Answer:!!! E D D
Use!the!formula!rwacc$=$ $rE$+$ rD$-$ rD c
E D E D E D
D
The!last!term$ rD c$captures!the!amount!that!the!wacc!is!lowered!because!of!the!interest!tax!
E D
shield.
D .6
So,$ rD c$=$ .08(.40)!=!.012!or!1.2%!
E D 1 .6
Diff:!2!
Skill:!Analytical!
!
15.3(Recapitalizing(to(Capture(the(Tax(Shield(
A)!!Once!investors!know!the!recap!will!occur,!the!share!price!will!rise!immediately!to!a!level!that!reflects!the!
value!of!the!interest!tax!shield!that!the!firm!will!receive!from!its!recapitalization.!
B)!!When!securities!are!fairly!priced,!the!original!shareholders!of!a!firm!capture!the!full!benefit!of!the!
interest!tax!shield!from!an!increase!in!leverage.!
C)!!In!the!presence!of!corporate!taxes,!we!do!not!include!the!interest!tax!shield!as!one!of!the!firm\s!assets!on!
its!market!value!balance!sheet.!
D)!!We!can!analyze!the!recapitalization!using!the!market!value!balance!sheet;!it!states!that!the!total!market!
value!of!a!firm\s!securities!must!equal!the!total!market!value!of!the!firm\s!assets.!
Answer:!!!C!
B)!!
C)!!In!the!presence!of!corporate!taxes,!we!include!the!interest!tax!shield!as!one!of!the!firm\s!assets!
on!its!market!value!balance!sheet.!
D)!!
Diff:!1!
Topic:!15.3!Recapitalizing!to!Capture!the!Tax!Shield!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!regarding!recapitializations!is!false?!
A)!!With!a!recapitalization,!even!though!leverage!reduces!the!total!value!of!equity,!shareholders!capture!the!
benefits!of!the!interest!tax!shield!up!front.!
B)!!The!share!price!rises!after!the!completion!of!the!recapitalization.!
C)!!Leveraged!recaps!were!especially!popular!in!the!mid-!to!late-1980s,!when!many!firms!found!that!these!
transactions!could!reduce!their!tax!payments.!
D)!!When!a!firm!makes!a!significant!change!to!its!capital!structure,!the!transaction!is!called!a!recapitalization.!
Answer:!!!B!
B)!!This!is!only!always!true!if!we!ignore!the!other!potential!side!effects!of!leverage,!such!as!the!
costs!of!financial!distress.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
KD!Industries!has!30!million!shares!outstanding!with!a!market!price!of!$20!per!share!and!no!debt.!!KD!has!had!consistently!
stable!earnings,!and!pays!a!35%!tax!rate.!!Management!plans!to!borrow!$200!million!on!a!permanent!basis!through!a!
leveraged!recapitalization!in!which!they!would!use!the!borrowed!funds!to!repurchase!outstanding!shares.!
!
3)!!The!value!of!KD\s!unlevered!equity!is!closest!to:!
A)!!$600!million!
B)!!$470!million!
C)!!$390!million!
D)!!$400!million!
Answer:!!!A!
Explanation:!!! A)!!VU!=!(30!million!shares)!×!$20!per!share!=!$600!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!The!preset!value!of!KD\s!interest!tax!shield!is!closest!to:!
A)!!$130!million!
B)!!$200!million!
C)!!$400!million!
D)!!$70!million!
Answer:!!!D!
B)!!
C)!!
D)!!Tax!Shield!=!Debt!×! C!=!$200!million!×!.35!=!$70!million!
Diff:!1!
Skill:!Analytical!
!
5)!!After!the!recapitalization,!the!total!value!of!KD!as!a!levered!firm!is!closest!to:!
A)!!$470!million!
B)!!$730!million!
C)!!$670!million!
D)!!$530!million!
Answer:!!!C!
B)!!
C)!!VU!=!(30!million!shares)!×!$20!per!share!=!$600!million
Tax!Shield!=!Debt!×! C!=!$200!million!×!.35!=!$70!million
VL!=$VU!+!Interest!Tax!shield!=!600M!+!70M!=!670M!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!After!the!recapitalization,!the!value!of!KD\s!levered!equity!is!closest!to:!
A)!!$670!million!
B)!!$400!million!
C)!!$330!million!
D)!!$470!million!
Answer:!!!D!
Explanation:!!! A)!!VU!=!(30!million!shares)!×!$20!per!share!=!$600!million
VL!=!VU!+!Interest!Tax!shield!=!600M!+!70M!=!670M!-200M!debt!=!$470!M!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!After!the!recapitalization,!the!value!of!a!share!of!KD\s!stock!is!closest!to:!
A)!!$22.35!
B)!!$22.00!
C)!!$22.65!
D)!!$23.50!
Answer:!!!D!
B)!!
C)!!
D)!!VU!=!(30!million!shares)!×!$20!per!share!=!$600!million
VL!=!VU!+!Interest!Tax!shield!=!600M!+!70M!-200M!=!470M!/!20M!shares!=!23.50!
Diff:!2!
Skill:!Analytical!
!
!
Shepard!Industries!expects!free!cash!flow!of!$10!million!each!year.!!Shepard\s!corporate!tax!rate!is!35%,!and!its!unlevered!
cost!of!equity!is!10%.!!The!firm!also!has!outstanding!debt!of!$40!million!and!it!expects!to!maintain!amount!of!debt!
permanently.!
!
8)!!The!value!of!Shepard!Industries!without!leverage!is!closest!to:!
A)!!$114!million!
B)!!$50!million!
C)!!$100!million!
D)!!$64!million!
Answer:!!!C!
B)!!
C)!!VU!=!FCF$/!rE!=!10!/!.10!=!$100M!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!value!of!Shepard!Industries!with!leverage!is!closest!to:!
A)!!$64!million!
B)!!$100!million!
C)!!$135!million!
D)!!$114!million!
Answer:!!!D!
B)!!VU$=$FCF$/!rE!=!10!/!.10!=!$100M
PV!of!Tax!shield!=!$40!×!.35!=!14
VL!=!VU$+$PV!of!tax!shield!=!100!+!14!=!114!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!MJ!Enterprises!has!50!million!shares!outstanding!with!a!market!price!of!$25!per!share!and!no!debt.!!MJ!has!
had!consistently!stable!earnings,!and!pays!a!35%!tax!rate.!!Management!plans!to!borrow!$500!million!on!a!
permanent!basis!through!a!leveraged!recapitalization!in!which!they!would!use!the!borrowed!funds!to!
repurchase!outstanding!shares.!!Calculate!MJ\s!share!price!following!announcement!of!the!recapitalization!
plan.!
Answer:!!!VU!=!(50!million!shares)!×!$25!per!share!=!$1,250!million
Tax!Shield!=!Debt!×! c!=!$500!million!×!.35!=!$175!million
VL$=$VU!+!Interest!Tax!shield!=!1250M!+!175M!=!1425M!/!50M!shares!=28.50!
Diff:!2!
Skill:!Analytical!
!
15.4(Personal(Taxes((
(
A)!!The!value!of!a!firm!is!equal!to!the!amount!of!money!the!firm!can!raise!by!issuing!securities.!
B)!!By!reducing!a!firm\s!corporate!tax!liability,!debt!allows!the!firm!to!pay!more!of!its!cash!flows!to!investors.!
C)!!Equity!investors!must!pay!taxes!on!dividends!but!not!capital!gains.!
D)!!For!individuals,!interest!payments!received!from!debt!are!taxed!as!income.!
Answer:!!!C!
B)!!
C)!!Equity!investors!must!pay!taxes!on!dividends!and!capital!gains.!
D)!!
Diff:!1!
Topic:!15.4!Personal!Taxes!
Skill:!Conceptual!
!
A)!!Personal!taxes!have!the!potential!to!offset!some!of!the!corporate!tax!benefits!of!leverage.!
B)!!The!actual!interest!tax!shield!depends!on!the!reduction!in!the!total!taxes!(both!corporate!and!personal)!
that!are!paid.!
C)!!The!amount!of!money!an!investor!will!pay!for!a!security!ultimately!depends!on!the!benefits!the!investor!
will!receive—namely,!the!cash!flows!the!investor!will!receive!before!all!taxes!have!been!paid.!
D)!!Just!like!corporate!taxes,!personal!taxes!reduce!the!cash!flows!to!investors!and!diminish!firm!value.!
Answer:!!!C!
B)!!
C)!!The!amount!of!money!an!investor!will!pay!for!a!security!ultimately!depends!on!the!benefits!
the!investor!will!receive—namely,!the!cash!flows!the!investor!will!receive!after!all!taxes!have!
been!paid.!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!To!determine!the!true!tax!benefit!of!leverage,!we!need!to!evaluate!the!combined!effect!of!both!corporate!
and!personal!taxes.!
B)!!A!personal!tax!disadvantage!for!debt!causes!the!WACC!to!decline!more!slowly!with!leverage!than!it!
otherwise!would.!
C)!!Personal!taxes!have!an!indirect!effect!on!the!firm\s!weighted!average!cost!of!capital.!
D)!!In!the!United!States!and!many!other!countries,!capital!gains!from!equity!have!historically!been!taxed!
more!heavily!than!interest!income.!
Answer:!!!D!
B)!!
C)!!
D)!!In!the!United!States!and!many!other!countries,!capital!gains!from!equity!have!historically!
been!taxed!at!a!lower!rate!than!interest!income.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Unlike!taxes!on!capital!gains!or!interest!income,!which!are!paid!annually,!taxes!on!dividends!are!paid!
only!at!the!time!the!investor!sells!the!stock.!
B)!!Deferring!the!payment!of!capital!gains!taxes!lowers!the!present!value!of!the!taxes,!which!can!be!
interpreted!as!a!lower!effective!capital!gains!tax!rate.!
C)!!Investors!with!longer!holding!periods!or!with!accrued!losses!face!a!lower!tax!rate!on!equity!income,!
decreasing!the!effective!tax!advantage!of!debt.!
D)!!Investors!with!accrued!losses!that!they!can!use!to!offset!gains!face!a!zero!effective!capital!gains!tax!rate.!
Answer:!!!A!
Explanation:!!! A)!!Unlike!taxes!on!dividends!or!interest!income,!which!are!paid!annually,!taxes!on!capital!gains!!
are!paid!only!at!the!time!the!investor!sells!the!stock.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
1 i (1 c )(1 e)
*!=!
(1 i)
The!term! *!is!
A)!!the!effective!tax!advantage!of!debt.!
B)!!the!effective!personal!tax!rate!on!interest!income.!
C)!!the!effective!personal!tax!rate!on!equity.!
D)!!the!effective!corporate!tax!rate!on!income.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
1 i (1 c )(1 e)
*!=!
(1 i)
The!term! e!is!
A)!!the!effective!personal!tax!rate!on!equity.!
B)!!the!effective!tax!advantage!of!debt.!
C)!!the!effective!corporate!tax!rate!on!income.!
D)!!the!effective!personal!tax!rate!on!interest!income.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
1 i (1 c )(1 e)
*!=!
(1 i)
The!term! i!is!
A)!!the!effective!personal!tax!rate!on!interest!income.!
B)!!the!effective!personal!tax!rate!on!equity.!
C)!!the!effective!corporate!tax!rate!on!income.!
D)!!the!effective!tax!advantage!of!debt.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
Consider!the!following!top!federal!tax!rates!in!the!United!States:
!
! Personal(Tax(Rates
Corporate( Interest( Capital(
Year Tax(Rate Income Dividends Gains(
2000 35% 40% 40% 20%!
2005 35% 35% 15% 15%!
!
8)!!In!2000,!the!effective!tax!rate!for!debt!holders!was!closest!to:!
A)!!61%!
B)!!52%!
C)!!64%!
D)!!40%!
Answer:!!!D!
B)!!
C)!!
D)!!Since!there!is!no!corporate!tax!on!interest!payments!the!interest!rate!is!simply!the!personal!
rate!on!interest!income!which!is!40%.!
Diff:!1!
Skill:!Analytical!
!
9)!!In!2000,!assuming!an!average!dividend!payout!ratio!of!50%,!the!effective!tax!rate!for!equity!holders!was!
closest!to:!
A)!!69%!
B)!!65%!
C)!!55%!
D)!!30%!
Answer:!!!C!
B)!!
C)!!The!average!personal!tax!rate!on!equity!is!(40%!+!20%)!/!2!=!30%
So,!the!effective!tax!rate!=!1!-!(1!-! c)(1!-! e)!=!1!-!(1!-!.35)(1!-!.30)!=!.545!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!In!2000,!assuming!an!average!dividend!payout!ratio!of!50%,!the!effective!tax!advantage!for!debt!(t*)!was!
closest!to:!
A)!!40%!
B)!!24%!
C)!!30%!
D)!!18%!
Answer:!!!B!
B)!!The!average!personal!tax!rate!on!equity!is!(40%!+!20%)!/!2!=!30%
1 i (1 c )(1 e ) 1 .40 (1 .35)(1 .30)
*!=! !=! !=!0.241667!
(1 i ) (1 .40)
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!In!2005,!the!effective!tax!rate!for!debt!holders!was!closest!to:!
A)!!58%!
B)!!35%!
C)!!40%!
D)!!65%!
Answer:!!!B!
B)!!Since!there!is!no!corporate!tax!on!interest!payments!the!interest!rate!is!simply!the!personal!
rate!on!interest!income!which!is!35%.!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
12)!!In!2005,!assuming!an!average!dividend!payout!ratio!of!50%,!the!effective!tax!rate!for!equity!holders!was!
closest!to:!
A)!!30%!
B)!!55%!
C)!!45%!
D)!!50%!
Answer:!!!C!
B)!!
C)!!The!average!personal!tax!rate!on!equity!is!(15%!+!15%)!/!2!=!15%
So,!the!effective!tax!rate!=!1!-!(1!-! c)(1!-! e)!=!1!-!(1!-!.35)(1!-!.15)!=!.4475!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!In!2005,!assuming!an!average!dividend!payout!ratio!of!50%,!the!effective!tax!advantage!for!debt!( *)!was!
closest!to:!
A)!!24%!
B)!!18%!
C)!!35%!
D)!!15%!
Answer:!!!D!
B)!!
C)!!
D)!!The!average!personal!tax!rate!on!equity!is!(15%!+!15%)!/!2!=!15%
1 i (1 c )(1 e ) 1 .35 (1 .35)(1 .15)
*!=! !=! !=!0.15!
(1 i ) (1 .35)
Diff:!2!
Skill:!Analytical!
!
!
KD!Industries!has!30!million!shares!outstanding!with!a!market!price!of!$20!per!share!and!no!debt.!!KD!has!had!consistently!
stable!earnings,!and!pays!a!35%!tax!rate.!!Management!plans!to!borrow!$200!million!on!a!permanent!basis!through!a!
leveraged!recapitalization!in!which!they!would!use!the!borrowed!funds!to!repurchase!outstanding!shares.!
!
14)!!Assume!the!following!tax!schedule:!
!
( Personal(Tax(Rates!
Corporate( Interest( Capital(
Year Tax(Rate Income Dividends Gains(
2000 35% 40% 40% 20%!
2005 35% 35% 15% 15%!
Considering!the!effect!of!personal!taxes,!calculate!the!PV!of!the!interest!tax!shield!provided!by!KD\s!
recapitalization!in!2005.!
Answer:!!!The!average!personal!tax!rate!on!equity!is!(15%!+!15%)!/!2!=!15%!
1 i (1 c )(1 e) 1 .35 (1 .35)(1 .15)

*!=! !=! !=!0.15
(1 i) (1 .35)
Tax!Shield!=!Debt!×! *!=!$200!million!×!.15!=!$30!million!
Diff:!2!
Skill:!Analytical!
!
15)!!The!Grant!Corporation!is!considering!permanently!adding!$500!million!of!debt!to!its!capital!structure.!!
Grant\s!corporate!tax!rate!is!35%!and!investors!pay!a!tax!rate!of!40%!on!their!interest!income!and!20%!on!their!
income!from!capital!gains!and!dividends.!!Calculate!the!present!value!of!the!interest!tax!shield!provided!by!
this!new!debt.!
Answer:!!! 1 i (1 c )(1 e ) 1 .40 (1 .35)(1 .20)
*!=! !=! !=!0.1333333
(1 i ) (1 .40)
Tax!Shield!=!Debt!×! *!=!$500!million!×!.1333333!=!$66.67!million!
Diff:!2!
Skill:!Analytical!
!
15.5(Optimal(Capital(Structure(with(Taxes(
A)!!Even!after!adjusting!for!personal!taxes,!the!value!of!an!unlevered!firm!exceeds!the!value!of!a!levered!
firm,!and!there!is!a!tax!advantage!to!using!debt!financing.!
B)!!In!Modigliani!and!Miller\s!setting!of!perfect!capital!markets,!firms!could!use!any!combination!of!debt!
and!equity!to!finance!their!investments!without!changing!the!value!of!the!firm.!
C)!!When!firms!raise!new!capital!from!investors,!they!do!so!primarily!by!issuing!debt.!
D)!!In!most!years!aggregate!equity!issues!are!negative,!meaning!that!firms!are!reducing!the!amount!of!
equity!outstanding!by!buying!shares.!
Answer:!!!A!
Explanation:!!! A)!!Even!after!adjusting!for!personal!taxes,!the!value!of!an!levered!firm!exceeds!the!value!of!a!
unlevered!firm,!and!there!is!a!tax!advantage!to!using!debt!financing.!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!15.5!Optimal!Capital!Structure!with!Taxes!
Skill:!Conceptual!
!
A)!!The!data!show!a!clear!preference!for!equity!as!a!source!of!external!financing!for!the!total!population!of!
U.S.!firms.!
B)!!Debt!as!a!fraction!of!firm!value!has!varied!in!a!range!from!30-45%!for!the!average!firm.!
C)!!Capital!expenditures!greatly!exceed!firms’!external!financing,!implying!that!most!investment!and!
growth!is!supported!by!internally!generated!funds,!such!as!retained!earnings.!
D)!!Firms!in!growth!industries!like!biotechnology!or!high!technology!carry!very!little!debt,!whereas!airlines,!
auto!makers,!utilities,!and!financial!firms!have!high!leverage!ratios.!
Answer:!!!A!
Explanation:!!! A)!!The!data!show!a!clear!preference!for!debt!as!a!source!of!external!financing!for!the!total!
population!of!U.S.!firms.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Even!though!firms!have!not!issued!new!equity,!the!market!value!of!equity!has!risen!over!time!as!firms!
have!grown.!
B)!!While!firms!seem!to!prefer!debt!when!raising!external!funds,!not!all!investment!is!externally!funded.!
C)!!To!receive!the!full!tax!benefits!of!leverage!a!firm!needs!to!use!100%!debt!financing.!
D)!!If!bankruptcy!is!costly,!these!costs!might!offset!the!tax!advantages!of!debt!financing.!
Answer:!!!C!
B)!!
C)!!To!receive!the!full!tax!benefits!of!leverage!a!firm!needs!to!be!paying!taxes.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Aside!from!taxes,!another!important!difference!between!debt!and!equity!financing!is!that!debt!payments!
must!be!made!to!avoid!bankruptcy,!whereas!firms!have!no!similar!obligation!to!pay!dividends!or!realize!
capital!gains.!
B)!!Increasing!the!level!of!debt!increases!the!probability!of!bankruptcy.!
C)!!A!firm!receives!a!tax!benefit!only!if!it!is!paying!taxes!in!the!first!place.!
D)!!To!the!extent!that!a!firm!has!other!tax!shields,!its!taxable!earnings!will!be!increased!and!it!will!rely!more!
heavily!on!the!interest!tax!shield.!
Answer:!!!D!
B)!!
C)!!
D)!!To!the!extent!that!a!firm!has!other!tax!shields,!its!taxable!earnings!will!be!decreased!and!it!will!
rely!less!heavily!on!the!interest!tax!shield.!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!biotech!firm!might!be!developing!drugs!with!tremendous!potential,!but!it!has!yet!to!receive!any!
revenue!from!these!drugs.!Such!a!firm!will!not!have!taxable!earnings.!In!that!case,!a!tax-optimal!capital!
structure!does!not!include!debt.!
B)!!No!corporate!tax!benefit!arises!from!incurring!interest!payments!that!regularly!exceed!EBIT.!
C)!!The!optimal!level!of!leverage!from!a!tax!saving!perspective!is!the!level!such!that!interest!equals!EBIT.!
D)!!In!general,!as!a!firm\s!interest!expense!approaches!its!expected!taxable!earnings,!the!marginal!tax!
advantage!of!debt!increases,!limiting!the!amount!of!equity!the!firm!should!use.!
Answer:!!!D!
B)!!
C)!!
D)!!In!general,!as!a!firm\s!interest!expense!approaches!its!expected!taxable!earnings,!the!marginal!
tax!advantage!of!debt!decreases,!limiting!the!amount!of!equity!the!firm!should!use.!
Diff:!3!
Skill:!Conceptual!
!
A)!!If!there!is!uncertainty!regarding!EBIT,!then!with!a!higher!interest!expense!there!is!a!greater!risk!that!
interest!will!exceed!EBIT.!
B)!!Even!for!a!firm!with!positive!earnings,!growth!will!affect!the!optimal!leverage!ratio.!
C)!!From!a!tax!perspective,!the!firm\s!optimal!level!of!debt!is!proportional!to!its!current!earnings.!
D)!!The!optimal!proportion!of!debt!in!the!firm\s!capital!structure!will!be!higher,!the!higher!the!firm’s!growth!
rate.!
Answer:!!!D!
B)!!
C)!!
D)!!The!optimal!proportion!of!debt!in!the!firm’s!capital!structure!will!be!higher,!the!lower!the!
firm\s!growth!rate.!
Diff:!2!
Skill:!Conceptual!
!
7)!!With!its!current!leverage,!WELS!Corporation!will!have!net!income!net!year!of!2.6!million.!!If!WELS!corporate!
tax!rate!is!35%!and!it!pays!8%!interest!on!its!debt,!how!much!additional!debt!can!WELS!issue!this!year!and!still!
receive!the!benefit!of!the!interest!tax!shield!next!year?!
Answer:!!!First!convert!NI!back!to!FCF!!!
FCF!=!NI/(1!- c)!=!2.6!/!.65!=!4,000,000!
Next,!divide!FCF!by!the!interest!rate!to!calculate!the!amount!of!debt!that!could!be!issued:
4,000,000!/!.08!=!$50,000,000!in!new!debt!
Diff:!2!
Skill:!Analytical!
!
8)!!KAHR!Incorporated!will!have!EBIT!this!coming!year!of!$45!million.!!It!will!also!spend!$18!million!on!total!
capital!expenditures!and!increases!in!net!working!capital,!and!have!$9!million!in!depreciation!expenses.!!
KAHR!is!currently!an!all-equity!firm!with!a!corporate!tax!rate!of!35%!and!a!cost!of!capital!of!10%!!If!the!
interest!rate!on!new!KAHR!debt!is!8%,!how!much!should!KAHR!borrow!today!if!they!want!to!maximize!there!
interest!tax!shield?!
Answer:!!!Amount!to!issue!=!EBIT$/!rD!=!45!/!.08!=!562.5!million!
Diff:!1!
Skill:!Analytical!
!
!
Chapter(16(-(Financial(Distress,(Managerial(Incentives,(and(Information(
!
!
16.1(Default(and(Bankruptcy(in(a(Perfect(Market(
A)!!Equity!holders!expect!to!receive!dividends!and!the!firm!is!legally!obligated!to!pay!them.!
B)!!A!firm!that!fails!to!make!the!required!interest!or!principal!payments!on!the!debt!is!in!default.!
C)!!In!the!extreme!case,!the!debt!holders!take!legal!ownership!of!the!firmEs!assets!through!a!process!called!
bankruptcy.!
D)!!After!a!firm!defaults,!debt!holders!are!given!certain!rights!to!the!assets!of!the!firm.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.1!Default!and!Bankruptcy!in!a!Perfect!Market!
Skill:!Conceptual!
!
A)!!An!important!consequence!of!leverage!is!the!risk!of!bankruptcy.!
B)!!Whether!default!occurs!depends!on!the!cash!flows,!not!on!the!relative!values!of!the!firmEs!assets!and!
liabilities.!
C)!!Economic!distress!is!a!significant!decline!in!the!value!of!a!firmEs!assets,!whether!or!not!it!experiences!
financial!distress!due!to!leverage.!
D)!!Modigliani!and!MillerEs!results!continue!to!hold!in!a!perfect!market!even!when!debt!is!risky!and!the!firm!
may!default.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Monsters!Incorporated!(MI)!in!ready!to!launch!a!new!product.!!Depending!upon!the!success!of!this!product,!MI!will!have!a!
value!of!either!$100!million,!$150!million,!or!$191!million,!with!each!outcome!being!equally!likely.!!The!cash!flows!are!
unrelated!to!the!state!of!the!economy!(i.e.!risk!from!the!project!is!diversifiable)!so!that!the!project!has!a!beta!of!0!and!a!cost!
of!capital!equal!to!the!risk-free!rate,!which!is!currently!5%.!!Assume!that!the!capital!markets!are!perfect.!
!
3)!!The!initial!value!of!MIEs!equity!without!leverage!is!closest!to:!
A)!!$133!million!
B)!!$147!million!
C)!!$140!million!
D)!!$150!million!
Answer:!!!C!
B)!!
C)!! U 1/ 3(100) 1/ 3(150) 1/ 3(191)
V !=! !=!$140!million!
1.05
D)!!
Diff:!1!
Skill:!Analytical!
!
4)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!initial!value!of!MIEs!
debt!is!closest!to:!
A)!!$125!million!
B)!!$111!million!
C)!!$100!million!
D)!!$116!million!
Answer:!!!B!
B)!! 1/ 3(100) 1/ 3(125) 1/ 3(125)
Vdebt!=! !=!$111.11!million!
1.05
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!yield!to!maturity!of!
MIEs!debt!is!closest!to:!
A)!!12.5%!
B)!!7.8%!
C)!!25.0%!
D)!!5.0%!
Answer:!!!A!
Explanation:!!! A)!! 1/ 3(100) 1/ 3(125) 1/ 3(125)
Vdebt!=! !=!$111.11!million
1.05
$125
YTM!=! !-!1!=!!.125011!or!12.5%!
$111.11
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!expected!return!of!
A)!!25.0%!
B)!!12.5%!
C)!!5.0%!
D)!!7.8%!
Answer:!!!C!
B)!!
C)!! 1/ 3(100) 1/ 3(125) 1/ 3(125)
1.05
1/ 3(100) 1/ 3(125) 1/ 3(125)

Expected!Return!=! !=!.05!or!5%!
$111.11
D)!!
Diff:!3!
Skill:!Analytical!
!
7)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!initial!value!of!MIEs!
equity!is!closest!to:!
A)!!$30!million!
B)!!$15!million!
C)!!$29!million!
D)!!$24!million!
Answer:!!!C!
B)!!
C)!! L 1/ 3(0) 1/ 3(25) 1/ 3(66)
V !=! !=!$28.89!million!
1.05
D)!!
Diff:!2!
Skill:!Analytical!
8)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!total!value!of!MI!
with!leverage!is!closest!to:!
A)!!$133!million!
B)!!$140!million!
C)!!$147!million!
D)!!$125!million!
Answer:!!!B!
B)!! L 1/ 3(0) 1/ 3(25) 1/ 3(66)
V !=! !=!$28.89!million
1.05
1/ 3(100) 1/ 3(125) 1/ 3(125)

1.05
Total!Value!=!VL!+!Vdebt!=!$28.89!+!$111.11!=!$140!million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Kinston!Enterprises!has!no!debt!and!a!debt!obligation!of!$47!million!that!is!due!now.!!The!market!value!of!KinstonEs!assets!
is!$102!million,!and!the!firm!has!no!other!liabilities.!!Assume!that!capital!markets!are!perfect!and!that!Kinston!has!5!million!
shares!outstanding.!
!
9)!!KinstonEs!current!share!price!is!closest!to:!
A)!!$20.40!
B)!!$9.40!
C)!!$11.00!
D)!!$10.00!
Answer:!!!C!
B)!!
C)!! $102M $47M
Price!=! !=!$11.00!per!share!
5M Shares
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!The!number!of!new!shares!that!Kinston!must!issue!to!raise!the!capital!needed!to!pay!its!debt!obligation!is!
closest!to:!
A)!!4.3!million!
B)!!4.7!million!
C)!!5.0!million!
D)!!4.0!million!
Answer:!!!A!
B)!!
C)!!
D)!! $102M $47M
Price!=! !=!$11.00!per!share!
5M Shares
$47 million
Number!of!Shares!=! !=!4,272,728!shares!
$11.00
Diff:!2!
Skill:!Analytical!
!
!
!
11)!!Suppose!that!MI!has!zero-coupon!debt!with!a!$140!million!face!value!due!next!year.!!Calculate!the!value!of!
levered!equity,!the!value!of!debt,!and!the!total!value!of!MI!with!leverage.!
Answer:!!! L 1/ 3(0) 1/ 3(10) 1/ 3(51)
V !=! !=!$19.37!million
1.05
1/ 3(100) 1/ 3(140) 1/ 3(140)

1.05
Total!Value!=!VL!+!Vdebt!=!$19.37!+!$120.63!=!$140!million!
Diff:!2!
Skill:!Analytical!
16.2(The(Costs(of(Bankruptcy(and(Financial(Distress((
(
A)!!When!a!firm!fails!to!make!a!required!payment!to!debt!holders,!it!is!in!bankruptcy.!
B)!!With!perfect!capital!markets,!the!risk$of!bankruptcy!is!not!a!disadvantage!of!debt–bankruptcy!simply!
shifts!the!ownership!of!the!firm!from!equity!holders!to!debt!holders!without!changing!the!total!value!
available!to!all!investors.!
C)!!Bankruptcy!is!a!long!and!complicated!process!that!imposes!both!direct!and!indirect!costs!on!the!firm!and!
its!investors!that!the!assumption!of!perfect!capital!markets!ignores.!
D)!!Bankruptcy!is!rarely!simple!and!straightforward–equity!holders!don’t!just!“hand!the!keys”!to!debt!
holders!the!moment!the!firm!defaults!on!a!debt!payment.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.2!The!Costs!of!Bankruptcy!and!Financial!Distress!
Skill:!Conceptual!
!
A)!!The!U.S.!bankruptcy!code!was!created!to!organize!this!process!so!that!creditors!are!treated!fairly!and!the!
value!of!the!assets!is!not!needlessly!destroyed.!
B)!!Because!the!assets!of!the!firm!might!be!more!valuable!if!kept!together,!creditors!seizing!assets!in!a!
piecemeal!fashion!might!destroy!much!of!the!remaining!value!of!the!firm.!
C)!!Debt!holders!can!then!take!legal!action!against!the!firm!to!collect!payment!by!seizing!the!firm’s!assets.!
D)!!Because!most!firms!have!multiple!creditors,!coordination!makes!it!difficult!to!guarantee!that!each!
creditor!will!be!treated!fairly.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!According!to!the!provisions!of!the!1978!Bankruptcy!Reform!Act,!U.S.!firms!can!file!for!two!forms!of!
bankruptcy!protection:!Chapter!11!or!Chapter!13.!
B)!!The!Chapter!11!reorganization!plan!specifies!the!treatment!of!each!creditor!of!the!firm.!In!addition!to!
cash!payment,!creditors!may!receive!new!debt!or!equity!securities!of!the!firm.!The!value!of!cash!and!
securities!is!generally!less!than!the!amount!each!creditor!is!owed,!but!more!than!the!creditors!would!
receive!if!the!firm!were!shut!down!immediately!and!liquidated.!
C)!!In!the!more!common!form!of!bankruptcy!for!large!corporations,!Chapter!11!reorganization,!all!pending!
collection!attempts!are!automatically!suspended,!and!the!firm’s!existing!management!is!given!the!
opportunity!to!propose!a!reorganization!plan.!
D)!!While!developing!a!Chapter!11!reorganization!plan,!management!continues!to!operate!the!business.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!creditors!must!vote!to!accept!the!Chapter!11!reorganization!plan,!and!the!bankruptcy!court!must!
approve!it.!If!an!acceptable!plan!is!not!put!forth,!the!court!may!ultimately!force!a!Chapter!7!liquidation!
of!the!firm.!
B)!!In!Chapter!13!liquidation,!a!trustee!is!appointed!to!oversee!the!liquidation!of!the!firm’s!assets!through!an!
auction.!!The!proceeds!from!the!liquidation!are!used!to!pay!the!firm’s!creditors,!and!the!firm!ceases!to!
exist.!
C)!!When!a!corporation!becomes!financially!distressed,!outside!professionals,!such!as!legal!and!accounting!
experts,!consultants,!appraisers,!auctioneers,!and!others!with!experience!selling!distressed!assets,!are!
generally!hired.!
D)!!In!the!case!of!Chapter!11!reorganization,!creditors!must!often!wait!several!years!for!a!reorganization!
plan!to!be!approved!and!to!receive!payment.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Whether!paid!by!the!firm!or!its!creditors,!the!indirect!costs!of!bankruptcy!increase!the!value!of!the!assets!
that!the!firm’s!investors!will!ultimately!receive.!
B)!!In!addition!to!the!money!spent!by!the!firm,!the!creditors!may!incur!costs!during!the!bankruptcy!process.!
C)!!The!bankruptcy!code!is!designed!to!provide!an!orderly!process!for!settling!a!firm’s!debts.!
D)!!To!ensure!that!their!rights!and!interests!are!respected,!and!to!assist!in!valuing!their!claims!in!a!proposed!
reorganization,!creditors!may!seek!separate!legal!representation!and!professional!advice.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!direct!costs!of!bankruptcy!are!likely!to!be!higher!for!firms!with!more!complicated!business!
operations!and!for!firms!with!larger!numbers!of!creditors,!because!it!may!be!more!difficult!to!reach!
agreement!among!many!creditors!regarding!the!final!disposition!of!the!firm’s!assets.!
B)!!In!a!prepackaged!bankruptcy((or!“prepack”)!a!firm!will!first!develop!a!reorganization!plan!with!the!
agreement!of!its!main!creditors,!and!then$file!Chapter!7!to!implement!the!plan!and!pressure!any!
creditors!who!attempt!to!hold!out!for!better!terms.!
C)!!A!study!of!Chapter!7!liquidations!of!small!businesses!found!that!the!average!direct!costs!of!bankruptcy!
were!12%!of!the!value!of!the!firm’s!assets.!
D)!!Studies!typically!report!that!the!average!direct!costs!of!bankruptcy!are!approximately!3%!to!4%!of!the!
pre-bankruptcy!market!value!of!total!assets.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Although!indirect!costs!of!bankruptcy!are!difficult!to!measure!accurately,!they!are!typically!much!
smaller!than!the!direct!costs!of!bankruptcy.!
B)!!Bankruptcy!protection!can!be!used!by!management!to!delay!the!liquidation!of!a!firm!that!should!be!shut!
down.!
C)!!Because!many!aspects!of!the!bankruptcy!process!are!independent!of!the!size!of!the!firm,!the!costs!are!
typically!higher,!in!percentage!terms,!for!smaller!firms.!
D)!!Aside!from!the!direct!legal!and!administrative!costs!of!bankruptcy,!many!other!indirect!costs!are!
associated!with!financial!distress!(whether!or!not!the!firm!has!formally!filed!for!bankruptcy).!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!costs!of!selling!assets!below!their!value!are!greatest!for!firms!with!assets!that!lack!competitive,!
liquid!markets.!
B)!!Firms!in!financial!distress!tend!to!have!difficulty!collecting!money!that!is!owed!to!them.!
C)!!Suppliers!may!be!unwilling!to!provide!a!firm!with!inventory!if!they!fear!they!will!not!be!paid.!
D)!!The!loss!of!customers!is!likely!to!be!large!for!producers!of!raw!materials!(such!as!sugar!or!aluminum),!as!
the!value!of!these!goods,!once!delivered,!depends!on!the!sellerEs!continued!success.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!Which!of!the!following!is!not!an!indirect!cost!of!bankruptcy?!
A)!!Legal!Fees!
B)!!Delayed!Liquidation!
C)!!Costs!to!Creditors!
D)!!Loss!of!Customers!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
10)!!Which!of!the!following!is!not!an!indirect!cost!of!bankruptcy?!
A)!!Loss!of!Suppliers!
B)!!Fire!Sales!of!Assets!
C)!!Costs!of!Appraisers!
D)!!Loss!of!Employees!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
11)!!Which!of!the!following!is!not!a!direct!cost!of!bankruptcy?!
A)!!Costs!to!Creditors!
B)!!Investment!Banking!Costs!
C)!!Costs!of!accounting!experts!
D)!!Legal!Costs!and!Fees!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
12)!!List!five!general!categories!of!indirect!costs!associated!with!bankruptcy.!
Answer:!!!Indirect!Costs:
Costs!to!Creditors
Loss!of!Customers
Loss!of!Suppliers
Loss!of!Employees
Loss!of!Receivables
Fire!Sales!of!Assets
Delayed!Liquidation!
Diff:!1!
Skill:!Conceptual!
16.3(Financial(Distress(Costs(and(Firm(Value((
(
A)!!Debt!holders!are!not!foolish—they!recognize!that!when!the!firm!defaults,!they!will!not!be!able!to!get!the!
full!value!of!the!assets.!As!a!result,!they!will!pay!less!for!the!debt!initially.!
B)!!The!costs!of!financial!distress!represent!an!important!departure!from!Modigliani!and!MillerEs!
assumption!of!perfect!capital!markets.!
C)!!Levered!firms!risk!incurring!financial!distress!costs!that!reduce!the!cash!flows!available!to!investors.!
D)!!When!securities!are!fairly!priced,!the!original!shareholders!of!a!firm!pay!the!future!value!of!the!costs!
associated!with!bankruptcy!and!financial!distress.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.3!Financial!Distress!Costs!and!Firm!Value!
Skill:!Conceptual!
!
!
!
2)!!Assuming!that!in!the!event!of!!default,!20%!of!the!value!of!MIEs!assets!will!be!lost!in!bankruptcy!costs,!the!
initial!value!of!MIEs!equity!without!leverage!is!closest!to:!
A)!!$150!million!
B)!!$147!million!
C)!!$140!million!
D)!!$133!million!
Answer:!!!C!
B)!!
C)!! U 1/ 3(100) 1/ 3(150) 1/ 3(191)
V !=! !=!$140!million!
1.05
D)!!
Diff:!1!
Skill:!Analytical!
!
3)!!Assume!that!in!the!event!of!default,!20%!of!the!value!of!MIEs!assets!will!be!lost!in!bankruptcy!costs!and!
suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!initial!value!of!MIEs!
debt!is!closest!to:!
A)!!$110!million!
B)!!$105!million!
C)!!$125!million!
D)!!$111!million!
Answer:!!!B!
B)!! 1/ 3(100(1 .20)) 1/ 3(125) 1/ 3(125)
Vdebt!=! !=!$104.76!million!
1.05
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!yield!to!maturity!of!
A)!!13.75%!
B)!!5.00%!
C)!!19.25%!
D)!!12.50%!
Answer:!!!C!
B)!!
C)!! 1/ 3(100(1 .20)) 1/ 3(125) 1/ 3(125)
1.05
$125
YTM!=! !-!1!=!.193182!or!19.3%!
$104.76
D)!!
Diff:!2!
Skill:!Analytical!
!
suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!initial!value!of!MIEs!
equity!is!closest!to:!
A)!!$30!million!
B)!!$29!million!
C)!!$15!million!
D)!!$24!million!
Answer:!!!B!
B)!! L 1/ 3(0) 1/ 3(25) 1/ 3(66)
V !=! !=!$28.89!million!
1.05
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!total!value!of!MI!
with!leverage!is!closest!to:!
A)!!$140!million!
B)!!$100!million!
C)!!$125!million!
D)!!$134!million!
Answer:!!!D!
B)!!
C)!!
D)!! L 1/ 3(0) 1/ 3(25) 1/ 3(66)
V !=! !=!$28.89!million
1.05
1/ 3(100(1 .20)) 1/ 3(125) 1/ 3(125)

1.05
Total!Value!=!VL!+!Vdebt!=!$28.89!+!$104.76!=!$133.65!million!
Diff:!2!
Skill:!Analytical!
!
suppose!that!MI!has!zero-coupon!debt!with!a!$125!million!face!value!due!next!year.!!The!present!value!of!MIEs!
financial!distress!costs!is!closest!to:!
A)!!$20.0!million!
B)!!$6.6!million!
C)!!$6.3!million!
D)!!$19.0!million!
Answer:!!!C!
B)!!
C)!! 1/ 3(20) 1/ 3(0) 1/ 3(0)
PV(Financial!Distress!Costs)!=! !=!$6.349!million!
1.05
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Assume!that!in!the!event!of!default,!20%!of!the!value!of!MIEs!assets!will!be!lost!in!bankruptcy!costs.!!Suppose!
that!at!the!start!of!the!year,!MI!has!no!debt!outstanding,!but!has!5.6!million!shares!of!stock!outstanding.!!If!MI!
does!not!issue!debt,!its!share!price!is!closest!to:!
A)!!$5.15!
B)!!$23.75!
C)!!$23.90!
D)!!$25.00!
Answer:!!!D!
B)!!
C)!!
D)!! U 1/ 3(100) 1/ 3(150) 1/ 3(191)
V !=! !=!$140!million
1.05
Price!per!Share!=!$140M!/!5.6!million!shares!=!$25.00!
Diff:!1!
Skill:!Analytical!
!
9)!!Assume!that!in!the!event!of!default,!20%!of!the!value!of!MIEs!assets!will!be!lost!in!bankruptcy!costs.!!Suppose!
that!at!the!start!of!the!year,!MI!has!no!debt!outstanding,!but!has!5.6!million!shares!of!stock!outstanding.!!If!MI!
issues!debt!of!$125!million!due!next!year!and!uses!the!proceeds!to!repurchase!shares,!the!share!price!following!
the!announcement!of!the!repurchase!will!be!closest!to:!
A)!!$23.90!
B)!!$23.75!
C)!!$25.00!
D)!!$5.15!
Answer:!!!A!
Explanation:!!! A)!! L 1/ 3(0) 1/ 3(25) 1/ 3(66)
V !=! !=!$28.89!million
1.05
1/ 3(100(1 .20)) 1/ 3(125) 1/ 3(125)

1.05
Total!Value!=!VL!+$Vdebt!=!$28.89!+!$104.76!=!$133.65!million
Price!per!Share!=!$133.65M!/!5.6!million!shares!=!$23.87!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
suppose!that!MI!has!zero-coupon!debt!with!a!$140!million!face!value!due!next!year.!!Calculate!the!value!of!
levered!equity,!the!value!of!debt,!and!the!total!value!of!MI!with!leverage.!
Answer:!!! L 1/ 3(0) 1/ 3(10) 1/ 3(51)
V !=! !=!$19.37!million
1.05
1/ 3(100(1 .20)) 1/ 3(140) 1/ 3(140)

1.05
Total!Value!=!VL!+!Vdebt!=!$19.37!+!$114.29!=!$133.66!million!
Diff:!3!
Skill:!Analytical!
16.4(Optimal(Capital(Structure:(The(Tradeoff(Theory((
(
A)!!The!tradeoff!theory(weighs!the!costs!of!debt!that!result!from!shielding!cash!flows!from!taxes!against!the!
benefits!from!the!effects!of!financial!distress!associated!with!leverage.!
B)!!Leverage!has!costs!as!well!as!benefits.!
C)!!According!to!the!tradeoff!theory,!the!total!value!of!a!levered!firm!equals!the!value!of!the!firm!without!
leverage!plus!the!present!value!of!the!tax!savings!from!debt,!less!the!present!value!of!financial!distress!
costs.!
D)!!Firms!have!an!incentive!to!increase!leverage!to!exploit!the!tax!benefits!of!debt.!But!with!too!much!debt,!
they!are!more!likely!to!risk!default!and!incur!financial!distress!costs.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.4!Optimal!Capital!Structure:!The!Tradeoff!Theory!
Skill:!Conceptual!
!
A)!!Calculating!the!precise!present!value!of!financial!distress!costs!is!a!relatively!straightforward!process.!
B)!!Two!key!qualitative!factors!determine!the!present!value!of!financial!distress!costs:!(1)!the!probability!of!
financial!distress!and!(2)!the!magnitude!of!the!costs!after!a!firm!is!in!distress.!
C)!!Technology!firms!are!likely!to!incur!high!costs!when!they!are!in!financial!distress,!due!to!the!potential!
for!loss!of!customers!and!key!personnel,!as!well!as!a!lack!of!tangible!assets!that!can!be!easily!liquidated.!
D)!!The!magnitude!of!the!financial!distress!costs!will!depend!on!the!relative!importance!of!the!sources!of!
these!costs!and!is!likely!to!vary!by!industry.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Real!estate!firms!are!likely!to!have!low!costs!of!financial!distress,!as!much!of!their!value!derives!from!
assets!that!can!be!sold!relatively!easily.!
B)!!For!low!levels!of!debt,!the!risk!of!default!remains!low!and!the!main!effect!of!an!increase!in!leverage!is!an!
increase!in!the!interest!tax!shield,!which!has!present!value! *D,$where! *!is!the!effective!tax!advantage!of!
debt.!
C)!!Firms!whose!value!and!cash!flows!are!very!volatile!(for!example,!semiconductor!firms)!must!have!much!
higher!levels!of!debt!to!avoid!a!significant!risk!of!default.!
D)!!The!probability!of!financial!distress!depends!on!the!likelihood!that!a!firm!will!be!unable!to!meet!its!debt!
commitments!and!therefore!default.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Firms!with!steady,!reliable!cash!flows,!such!as!utility!companies,!are!able!to!use!high!levels!of!debt!and!
still!have!a!very!low!probability!of!default.!
B)!!If!there!were!no!costs!of!financial!distress,!the!value!of!the!firm!would!continue!to!increase!with!
increasing!debt!until!the!interest!on!the!debt!exceeds!the!firm’s!earnings!before!interest!and!taxes!and!the!
tax!shield!is!exhausted.!
C)!!The!costs!of!financial!distress!reduce!the!value!of!the!levered!firm,!VL.!!The!amount!of!the!reduction!
decreases!with!the!probability!of!default,!which!in!turn!increases!with!the!level!of!the!debt!D.!
D)!!The!tradeoff!theory!states!that!firms!should!increase!their!leverage!until!it!reaches!the!level!D*!for!which!
VL!is!maximized.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!presence!of!financial!distress!costs!can!explain!why!firms!choose!debt!levels!that!are!too!high!to!fully!
exploit!the!interest!tax!shield.!
B)!!With!higher!costs!of!financial!distress,!it!is!optimal!for!the!firm!to!choose!lower!leverage.!
C)!!Differences!in!the!magnitude!of!financial!distress!costs!and!the!volatility!of!cash!flows!can!explain!the!
differences!in!the!use!of!leverage!across!industries.!
D)!!At!the!point!D*,!where!VL!is!maximized,!the!tax!savings!that!result!from!increasing!leverage!are!just!
offset!by!the!increased!probability!of!incurring!the!costs!of!financial!distress.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!Which!of!the!following!industries!is!likely!to!have!the!lowest!costs!of!financial!distress?!
A)!!Airlines!
B)!!Computer!Software!
C)!!Biotechnology!
D)!!Electric!Utilities!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
7)!!Which!of!the!following!industries!likely!to!have!the!highest!costs!of!financial!distress?!
A)!!Grocery!store!
B)!!Semiconductors!
C)!!Real!estate!
D)!!Utilities!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
Big!Blue!Banana!(BBB)!is!a!clothing!retailer!with!a!current!share!price!of!$10.00!and!with!25!million!shares!outstanding.!!
Suppose!that!Big!Blue!Banana!announces!plans!to!lower!its!corporate!taxes!by!borrowing!$100!million!and!using!the!
proceeds!to!repurchase!shares.!
!
8)!!Assuming!perfect!capital!markets,!the!share!price!for!BBB!after!this!announcement!is!closest!to:!
A)!!$11.40!
B)!!$10.85!
C)!!$10.00!
D)!!$8.60!
Answer:!!!C!
B)!!
C)!!In!perfect!capital!markets,!VL$=$VU!so!even!with!the!announcement!of!the!increase!in!leverage!
the!stock!price!wonEt!change.!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!Suppose!that!BBB!pays!corporate!taxes!of!35%!and!that!shareholders!expects!the!change!in!debt!to!be!
permanent.!!Assuming!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes,!the!share!
price!for!BBB!after!this!announcement!is!closest!to:!
A)!!$10.00!
B)!!$10.85!
C)!!$8.60!
D)!!$11.40!
Answer:!!!D!
B)!!
C)!!
D)!!VU!=!$10.00!×!25!million!shares!=!$250!million
VL$=$VU!+! cB!=!$250!+!.35($100)!=!$285!million!/!25!million!shares!=!$11.40!
Diff:!2!
Skill:!Analytical!
!
permanent.!!Assume!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes!and!financial!
distress!costs.!!If!the!price!of!BBBEs!stock!rises!to!$10.85!per!share!following!the!announcement!,!then!the!
present!value!of!BBBEs!financial!distress!costs!is!closest!to:!
A)!!$21.25!million!
B)!!$35.00!million!
C)!!$11.40!million!
D)!!$13.75!million!
Answer:!!!D!
B)!!
C)!!
D)!!VU!=!$10.00!×!25!million!shares!=!$250!million
VL!=!VU!+! cB!=!$250!+!.35($100)!=!$285!million!/!25!million!shares!=!$11.40
PV!of!financial!distress!costs!=!($11.40!-!$10.85)!×!25!million!shares!=!$13.75!million!
Diff:!2!
Skill:!Analytical!
!
!
Luther!Industries!has!no!debt!and!expects!to!generate!free!cash!flows!of!$48!million!each!year.!!Luther!believes!that!if!it!
permanently!increases!its!level!of!debt!to!$100!million,!the!risk!of!financial!distress!may!cause!it!to!lose!some!customers!and!
receive!less!favorable!terms!from!its!suppliers.!!As!a!result,!LutherEs!expected!free!cash!flows!with!debt!will!be!only!$44!
million!per!year.!!Suppose!LutherEs!tax!rate!is!40%,!the!risk-free!rate!is!6%,!the!expected!return!of!the!market!is!14%,!and!the!
beta!of!LutherEs!free!cash!flows!is!1.25!(with!or!without!leverage).!
!
11)!!The!value!of!Luther!without!leverage!is!closest!to:!
A)!!$315!million!
B)!!$300!million!
C)!!$205!million!
D)!!$340!million!
Answer:!!!B!
B)!!RE$=$rf!-! (rM!-!rf)!=!.06!+!1.25(.14!-!.06)!=!.16
FCF $48
VU!=! !=! !=!$300!million!
rE .16
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!The!value!of!Luther!with!leverage!is!closest!to:!
A)!!$315!million!
B)!!$340!million!
C)!!$205!million!
D)!!$300!million!
Answer:!!!A!
Explanation:!!! A)!!RE!=!rf!-! (rM!-!rf)!=!.06!+!1.25(.14!-!.06)!=!.16
FCF $40
VU!=! !=! !=!$275!million!(using!lower!cash!flow!from!leverage)
rE .16
VL$=$VU$+$ cD!=!$275!+!.4($100)!=!$315!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Big!Blue!Banana!(BBB)!is!a!clothing!retailer!with!a!current!share!price!of!$10.00!and!with!25!million!shares!outstanding.!!
Suppose!that!Big!Blue!Banana!announces!plans!to!lower!its!corporate!taxes!by!borrowing!$100!million!and!using!the!
proceeds!to!repurchase!shares.!
!
permanent.!!Assume!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes!and!financial!
distress!costs.!!If!the!price!of!BBBEs!stock!rises!to!$10.80!per!share!following!the!announcement,!then!the!
present!value!of!BBBEs!financial!distress!costs!is!closest!to:!
Answer:!!!VU!=!$10.00!×!25!million!shares!=!$250!million
VL!=!VU!+! cB!=!$250!!+!.40($100)!=!$290!million!/!25!million!shares!=!$11.60
PV!of!financial!distress!costs!=!($11.60!-!$10.80)!×!25!million!shares!=!$20!million!
Diff:!2!
Skill:!Analytical!
!
16.5(Exploiting(Debt(Holders:(The(Agency(Costs(of(Leverage((
(
A)!!When!a!firm!faces!financial!distress,!creditors!can!gain!by!making!sufficiently!risky!investments,!even!if!
they!have!negative!NPV.!
B)!!When!a!firm!has!leverage,!a!conflict!of!interest!exists!if!investment!decisions!have!different!
consequences!for!the!value!of!equity!and!the!value!of!debt.!
C)!!In!some!circumstances,!managers!may!take!actions!that!benefit!shareholders!but!harm!the!firm’s!
creditors!and!lower!the!total!value!of!the!firm.!
D)!!Agency!costs!are!costs!that!arise!when!there!are!conflicts!of!interest!between!stakeholders.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.5!Exploiting!Debt!Holders:!The!Agency!Costs!of!Leverage!
Skill:!Conceptual!
A)!!When!a!firm!faces!financial!distress,!shareholders!have!an!incentive!not!to!invest!and!to!withdraw!
money!from!the!firm!if!possible.!
B)!!Because!top!managers!often!hold!shares!in!the!firm!and!are!hired!and!retained!with!the!approval!of!the!
board!of!directors,!which!itself!is!elected!by!shareholders,!managers!will!generally!make!decisions!that!
increase!the!value!of!the!firm’s!equity.!
C)!!An!over-investment!problem!occurs!when!shareholders!have!an!incentive!to!invest!in!risky!
positive-NPV!projects.!
D)!!A!negative-NPV!project!destroys!value!for!the!firm!overall.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!agency!costs!of!debt!can!arise!only!if!there!is!no!chance!the!firm!will!default!and!impose!losses!on!its!
debt!holders.!
B)!!Agency!costs!represent!another!cost!of!increasing!the!firm’s!leverage!that!will!affect!the!firmEs!optimal!
capital!structure!choice.!
C)!!An!under-investment!problem!occurs!when!shareholders!choose!to!not!invest!in!a!positive-NPV!project.!
D)!!When!a!firm!faces!financial!distress,!it!may!choose!not!to!finance!new,!positive-NPV!projects.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Creditors!often!place!restrictions!on!the!actions!that!the!firm!can!take.!Such!restrictions!are!referred!to!as!
debt!covenants.!
B)!!Covenants!are!often!designed!to!prevent!management!from!exploiting!debt!holders,!so!they!may!help!to!
reduce!agency!costs.!
C)!!Agency!costs!are!smallest!for!long-term!debt.!
D)!!Covenants!may!limit!the!firmEs!ability!to!pay!large!dividends!or!the!types!of!investments!that!the!firm!
can!make.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
JR!Industries!has!a!$20!million!loan!due!at!the!end!of!the!year!and!under!its!current!business!strategy!its!assets!will!have!a!
market!value!of!only!$15!million!when!the!loan!comes!due.!!JR!is!considering!a!new!much!riskier!business!strategy.!!While!
this!new!riskier!strategy!can!be!implemented!using!JREs!existing!assets!without!any!additional!investment,!the!new!
strategy!has!only!a!40%!probability!of!succeeding.!!If!the!new!strategy!is!a!success,!the!market!value!of!JREs!assets!will!be!
$30,!but!if!the!strategy!fails!the!assets!will!be!worth!only!$5!million.!
!
5)!!What!is!the!overall!expected!payoff!under!JREs!new!riskier!business!strategy?!
A)!!$4!million!
B)!!$11!million!
C)!!$20!million!
D)!!$15!million!
Answer:!!!D!
B)!!
C)!!
D)!!Expected!payoff!=!(.4)$30!+!(.6)$5!=!$15!million!
Diff:!1!
Skill:!Analytical!
!
6)!!What!is!the!expected!payoff!to!debt!holders!under!JREs!new!riskier!business!strategy?!
A)!!$20!million!
B)!!$4!million!
C)!!$15!million!
D)!!$11!million!
Answer:!!!D!
B)!!
C)!!
Diff:!1!
Skill:!Analytical!
!
7)!!What!is!the!expected!payoff!to!equity!holders!under!JREs!new!riskier!business!strategy?!
A)!!$15!million!
B)!!$11!million!
C)!!$20!million!
D)!!$4!million!
Answer:!!!D!
B)!!
C)!!
Diff:!1!
Skill:!Analytical!
!
!
Wildcat!Drilling!is!an!oil!and!gas!exploration!company!that!currently!operating!two!active!oil!fields!with!a!market!value!of!
$200!million!dollars!each.!!Unfortunately,!Wildcat!Drilling!has!$500!million!in!debt!coming!due!at!the!end!of!the!year.!!A!
large!oil!company!has!offered!Wildcat!drilling!a!highly!speculative,!but!potentially!very!valuable,!oil!and!gas!lease!in!
exchange!for!one!of!their!active!oil!fields.!!If!Wildcat!accepts!the!trade,!there!is!a!10%!chance!that!Wildcat!will!discover!a!
major!new!oil!field!that!would!be!worth!$1.2!billion,!a!15%!that!Wildcat!will!discover!a!productive!oil!field!that!would!be!
worth!$600!million,!and!a!75%!chance!that!Wildcat!will!not!discover!oil!at!all.!
!
8)!!What!is!the!overall!expected!payoff!to!Wildcat!from!the!speculative!oil!lease!deal?!
A)!!$360!million!
B)!!$275!million!
C)!!$85!million!
D)!!$160!million!
Answer:!!!A!
Explanation:!!! A)!!Expected!payoff!=!(.1)($1200!)!+!!(.15)($600)!+!(.75)($200)!=!$360!million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!What!is!the!expected!payoff!to!debt!holders!with!the!speculative!oil!lease!deal?!
A)!!$10!million!
B)!!$275!million!
C)!!$85!million!
D)!!$160!million!
Answer:!!!B!
B)!!Expected!payoff!=!(.1)($500)!+!!(.15)($500)!+!(.75)($200)!=!$275!million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!What!is!the!expected!payoff!to!equity!holders!with!the!speculative!oil!lease!deal?!
A)!!$10!million!
B)!!$160!million!
C)!!$275!million!
D)!!$85!million!
Answer:!!!D!
B)!!
C)!!
D)!!Expected!payoff!=!(.1)($1200!-!$500)!+!!(.15)($600!-!$500)!+!(.75)($0)!=!$85!million!
Diff:!2!
Skill:!Analytical!
!
11)!!Rose!Industries!has!a!$20!million!loan!due!at!the!end!of!the!year!and!its!assets!will!have!a!market!value!of!only!
$15!million!when!the!loan!comes!due.!!Currently!Rose!has!$2!million!in!cash.!!Rose!is!considering!two!possible!
alternative!uses!for!this!cash.!!One!possibility!is!to!pay!the!$2!million!out!to!shareholders!in!the!form!of!a!
special!dividend.!!The!second!possibility!is!to!invest!the!$2!million!into!a!project!that!offers!a!$4!million!NPV.!!
What!are!the!payoffs!to!the!debt!and!equity!holders!under!each!of!the!two!alternatives?!!Which!alternative!
would!equity!holders!prefer?!!Which!alternative!would!debt!holders!prefer?!!What!is!the!economic!term!that!
describes!this!situation?!
Answer:!!!Case!#1!Pay!special!dividend
Payoff!to!equity!holders!=!$2!million
Payoff!to!debt!holders!=!$15!million!-!$2!million!=!$13!million
Case!#2!Invest!in!Positive!NPV!project
Payoff!to!equity!holders!=!$0
Payoff!to!debt!holders!=!$15!million!+!$4!million!=!$19!million
So!debt!holders!prefer!+NPV!project!and!equity!holders!prefer!special!dividend.
This!is!an!under!investment!problem,!where!a!firm!does!not!engage!in!a!+!NPV!project!because!of!
agency!costs!between!shareholders!and!debt!holders.!
Diff:!2!
Skill:!Analytical!
!
16.6(Motivating(Managers:(The(Agency(Benefits(of(Leverage((
(
A)!!One!disadvantage!of!using!leverage!is!that!it!does!not!allow!the!original!owners!of!the!firm!to!maintain!
their!equity!stake.!
B)!!The!separation!of!ownership!and!control!creates!the!possibility!of!management!entrenchment;!facing!
little!threat!of!being!fired!and!replaced,!managers!are!free!to!run!the!firm!in!their!own!best!interests.!
C)!!Managers!also!have!their!own!personal!interests,!which!may!differ!from!those!of!both!equity!holders!
and!debt!holders.!
D)!!The!costs!of!reduced!effort!and!excessive!spending!on!perks!are!another!form!of!agency!cost.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.6!Motivating!Managers:!The!Agency!Benefits!of!Leverage!
Skill:!Conceptual!
!
A)!!A!serious!concern!for!large!corporations!is!that!managers!may!make!large,!unprofitable!investments.!
B)!!While!overspending!on!personal!perks!may!be!a!problem!for!large!firms,!these!costs!are!likely!to!be!
small!relative!to!the!overall!value!of!the!firm.!
C)!!Some!financial!economists!explain!a!managerEs!willingness!to!engage!in!negative-NPV!investments!as!
empire!building.!
D)!!While!ownership!is!often!diluted!for!small,!young!firms,!ownership!typically!becomes!concentrated!over!
time!as!a!firm!grows.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Leverage!can!reduce!the!degree!of!managerial!entrenchment!because!managers!are!more!likely!to!be!
fired!when!a!firm!faces!financial!distress.!
B)!!When!a!firm!is!highly!levered,!creditors!themselves!will!closely!monitor!the!actions!of!managers,!
providing!an!additional!layer!of!management!oversight.!
C)!!According!to!the!empire!building!hypothesis,!leverage!increases!firm!value!because!it!commits!the!firm!
to!making!future!interest!payments,!thereby!reducing!excess!cash!flows!and!wasteful!investment!by!
managers.!
D)!!Managers!of!large!firms!tend!to!earn!higher!salaries,!and!they!may!also!have!more!prestige!and!garner!
greater!publicity!than!managers!of!small!firms.!As!a!result,!managers!may!expand!(or!fail!to!shut!down)!
unprofitable!divisions,!pay!too!much!for!acquisitions,!make!unnecessary!capital!expenditures,!or!hire!
unnecessary!employees.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
You!own!your!own!firm!and!you!need!to!raise!$50!million!to!fund!an!expansion.!!Following!the!expansion,!your!firm!will!
be!worth!$75!million!in!its!unlevered!form.!!You!want!to!go!ahead!with!the!expansion,!but!you!are!concerned!that!you!may!
not!be!able!to!maintain!ownership!of!over!50%!of!your!firmEs!equity.!!In!other!words,!you!are!concerned!that!if!you!use!
equity!to!finance!the!expansion,!you!may!loose!control!of!your!firm.!
!
4)!!Assume!that!capital!markets!are!perfect,!you!issue!$30!million!in!new!debt,!and!you!issue!$20!million!in!new!
equity.!!You!ownership!stake!in!the!firm!following!these!new!issues!of!debt!and!equity!is!closest!to:!
A)!!58%!
B)!!50%!
C)!!33%!
D)!!55%!
Answer:!!!D!
B)!!
C)!!
D)!!OwnerEs!equity!=!value!-!debt!-!new!equity!=!75!-!30!-!20!=!$25!million
Total!equity!=!owners!equity!+!new!equity!=!$25!+!$20!=!$45!million
$25
OwnerEs!stake!=! !=!.555555!or!55.56%!
$45
Diff:!1!
Skill:!Analytical!
!
5)!!Assume!that!capital!markets!are!perfect,!you!issue!$25!million!in!new!debt,!and!you!issue!$25!million!in!new!
equity.!!You!ownership!stake!in!the!firm!following!these!new!issues!of!debt!and!equity!is!closest!to:!
A)!!50%!
B)!!55%!
C)!!58%!
D)!!33%!
Answer:!!!A!
Explanation:!!! A)!!OwnerEs!equity!=!value!-!debt!-!new!equity!=!75!-!25!-!25!=!$25!million
$25
OwnerEs!stake!=! !=!.50!or!50.0%!
$50
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Assume!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes.!!Your!firm!pays!40%!of!
earnings!in!taxes!and!you!decide!to!issue!$25!million!in!new!debt!and!$25!million!in!new!equity.!!You!
ownership!stake!in!the!firm!following!these!new!issues!of!debt!and!equity!is!closest!to:!
A)!!58%!
B)!!55%!
C)!!33%!
D)!!50%!
Answer:!!!A!
Explanation:!!! A)!!VU!=!$75!million
VL!=!VU!+! cD!=!$75!+!.40($25)!=!$85!million
OwnerEs!equity!=!value!-!debt!-!new!equity!=!85!-!25!-!25!=!$35!million
$35
OwnerEs!stake!=! !=!.5833!or!58.33%!
$60
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Assume!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes!and!that!your!firm!pays!
40%!of!earnings!in!taxes.!!If!you!want!to!maintain!ownership!of!at!least!a!50%,!then!the!minimum!amount!of!
debt!that!you!must!issue!to!fund!the!expansion!is!closest!to:!
A)!!$19!million!
B)!!$18!million!
C)!!$16!million!
D)!!$20!million!
Answer:!!!B!
B)!!VU!=!$75!million
VL new debt new equity
%!Ownership!=!
VL new debt
Given:
VL$=$VU$+$ cD
new!equity!=!$50!million!needed!for!expansion!-!the!amount!of!new!debt:
!
$75 .4(debt) debt (50 debt)
%!Ownership!=!
$75 .4(debt) debt
$25 .4(debt)
%!Ownership!=! !=!.50!(given!we!want!50%!ownership)
$75 .6(debt)
$25!+!.4(debt)!=!.50($75!-!.6(debt))
50!+!1.4(debt)!=!75
25
Debt!=! !=!$17.857!million!
1.4
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!Assume!that!capital!markets!are!perfect!except!for!the!existence!of!corporate!taxes!and!that!your!firm!pays!
35%!of!earnings!in!taxes.!!If!you!want!to!maintain!ownership!of!at!least!a!50%,!then!calculate!the!minimum!
amount!of!debt!that!you!must!issue!to!fund!the!expansion.!!
Answer:!!!VU!=!$75!million
VL new debt new equity
%!Ownership!=!
VL new debt
Given:
VL$=$VU$+$ cD
New!equity!=!$50!million!needed!for!expansion!-!the!amount!of!new!debt:
!
$75 .35(debt) debt (50 debt)
%!Ownership!=!
$75 .35(debt) debt
$25 .35(debt)
%!Ownership!=! !=!.50!(given!we!want!50%!ownership)
$75 .65(debt)
$25!+!.35(debt)!=!.50($75!-!.65(debt))
50!+!1.35(debt)!=!75
25
Debt!=! !=!$18.52!million!
1.35
Diff:!3!
Skill:!Analytical!
!
16.7(Agency(Costs(and(the(Tradeoff(Theory((
(
A)!!The!optimal!level!of!debt!D*,!balances!the!costs!and!benefits!of!leverage.!
B)!!As!the!debt!level!increases,!the!firm!benefits!from!the!interest!tax!shield!(which!has!present!value! *D).!
C)!!If!the!debt!level!is!too!large!firm!value!is!reduced!due!to!the!loss!of!tax!benefits!(when!interest!exceeds!
EBIT),!financial!distress!costs,!and!the!agency!costs!of!leverage.!
D)!!As!the!debt!level!increases,!the!firm!faces!worse!incentives!for!management,!which!increase!wasteful!
investment!and!perks.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.7!Agency!Costs!and!the!Tradeoff!Theory!
Skill:!Conceptual!
!
A)!!Firms!with!high!R&D!costs!and!future!growth!opportunities!typically!maintain!high!debt!levels.!
B)!!The!tradeoff!theory!explains!how!firms!should!choose!their!capital!structures!to!maximize!value!to!
current!shareholders.!
C)!!With!tangible!assets,!the!financial!distress!costs!of!leverage!are!likely!to!be!low,!as!the!assets!can!be!
liquidated!for!close!to!their!full!value.!
D)!!Proponents!of!the!management!entrenchment!theory(of!capital!structure!believe!that!managers!choose!a!
capital!structure!to!avoid!the!discipline!of!debt!and!maintain!their!own!job!security.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Which!of!the!following!firms!is!likely!to!maintain!low!levels!of!debt?!
A)!!An!electric!utility!
B)!!A!tobacco!company!
C)!!An!internet!firm!
D)!!A!mature!restaurant!chain!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
If!it!is!managed!efficiently,!Luther!industries!will!have!assets!with!market!value!of!$100!million,!$300,!million,!or!$500!
million!next!year,!with!each!outcome!being!equally!likely.!!Managers!may,!however,!engage!in!wasteful!empire!building!
which!will!reduce!the!firmEs!market!value!by!$20!million!in!all!cases.!!Managers!may!also!increase!the!risk!of!the!firm,!
changing!the!probability!of!each!outcome!to!50%,!20%,!and!30%!respectively.!
!
4)!!If!it!is!managed!efficiently,!then!the!expected!market!value!of!LutherEs!assets!is!closest!to:!
A)!!$300!million!
B)!!$260!
C)!!$240!
D)!!$280!million!
Answer:!!!A!
Explanation:!!! A)!! $100 $300 $500
Expected!value!= !=!$300!million!
3
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!If!its!managers!engage!in!empire!building,!then!the!expected!market!value!of!LutherEs!assets!is!closest!to:!
A)!!$260!
B)!!$280!million!
C)!!$240!
D)!!$300!million!
Answer:!!!B!
B)!! 80 280 480
Expected!value!=! !=!$280!million!
3
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!If!its!managers!increase!the!risk!of!the!firm,!then!the!expected!market!value!of!LutherEs!assets!is!closest!to:!
A)!!$260!
B)!!$240!
C)!!$300!million!
D)!!$280!million!
Answer:!!!A!
Explanation:!!! A)!!Expected!value!=!.5(100)!+!.2(300)!+!.3(500)!=!$260!million!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
16.8(Asymmetric(Information(and(Capital(Structure((
(
1)!!The!idea!that!managers!who!perceive!the!firmEs!equity!is!under-priced!will!have!a!preference!to!fund!
investment!using!retained!earnings,!or!debt,!rather!than!equity!is!known!as!the!
A)!!signaling!theory!of!debt.!
B)!!lemons!principle.!
C)!!pecking!order!hypothesis.!
D)!!credibility!principle.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.8!Asymmetric!Information!and!Capital!Structure!
Skill:!Definition!
!
2)!!The!idea!that!claims!in!oneEs!self-interest!are!credible!only!if!they!are!supported!by!actions!that!would!be!too!
costly!to!take!if!the!claims!were!untrue!is!known!as!the!
A)!!pecking!order!hypothesis.!
B)!!credibility!principle.!
C)!!lemons!principle.!
D)!!signaling!theory!of!debt.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!The!idea!that!when!a!seller!has!private!information!about!the!value!of!good,!buyers!will!discount!the!price!
they!are!willing!to!pay!due!to!adverse!selection!is!known!as!the!
A)!!pecking!order!hypothesis.!
B)!!signaling!theory!of!debt.!
C)!!lemons!principle.!
D)!!credibility!principle.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
!
Electronic!Gaming!Incorporated!(EGI)!is!a!firm!with!no!debt!and!its!20!million!shares!are!currently!trading!for!$16!per!
share.!!Based!on!the!prospects!for!EGIEs!new!hand!held!video!game,!management!feels!the!true!value!of!the!firm!is!$20!per!
share.!!Management!believes!that!the!share!price!will!reflect!this!higher!value!after!the!video!game!is!released!next!fall.!!
EGI!has!already!announced!plans!to!raise!$100!million!from!investors!to!build!a!new!factory.
4)!!Assume!that!EGI!decides!to!raise!the!$100!million!through!the!issuance!of!new!shares!prior!to!the!release!of!
the!new!video!game.!!The!number!of!new!shares!that!EGI!will!issue!is!closest!to:!
A)!!5.0!million!
B)!!6.25!million!
C)!!10!million!
D)!!1.6!million!
Answer:!!!B!
B)!! $100 M
shares!=! !=!6,250,000!new!shares!
$16 per share
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Assume!that!EGI!decides!to!wait!until!after!the!release!of!the!new!video!game!before!they!raise!the!$100!
million!through!the!issuance!of!new!shares.!!The!number!of!new!shares!that!EGI!will!issue!is!closest!to:!
A)!!1.6!million!
B)!!5.0!million!
C)!!10!million!
D)!!6.25!million!
Answer:!!!B!
B)!! $100 M
shares!=! !=!5,000,000!new!shares!
$20 per share
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Assume!that!EGI!decides!to!raise!the!$100!million!through!the!issuance!of!new!shares!prior!to!the!release!of!
the!new!video!game.!!EGIEs!share!price!following!the!release!of!the!new!video!game!will!be!closest!to:!
A)!!$18.00!
B)!!$19.00!
C)!!$20.00!
D)!!$16.00!
Answer:!!!B!
B)!! $100 M
shares!=! !=!6,250,000!new!shares
$16 per share
Total!shares!=!20M!(existing)!+!6.25M!new!=!26.25!million.
Total!Value!=!existing!value!+!$100M!new!factory
Total!Value!=!$20!per!share!(true!value)!×!20!million!shares!+!$100!=!$500!million
$500
26.25
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Assume!that!EGI!decides!to!wait!until!after!the!release!of!the!new!video!game!before!they!raise!the!$100!
million!through!the!issuance!of!new!shares.!!EGIEs!share!price!following!the!release!of!the!new!video!game!
will!be!closest!to:!
A)!!$18.00!
B)!!$20.00!
C)!!$16.00!
D)!!$19.00!
Answer:!!!B!
B)!! $100 M
shares!=! !=!5M!new!shares
$20 per share
Total!shares!=!20M!(existing)!+!5M!new!=!25!million.
Total!value!=!existing!value!+!$100M!new!factory
Total!value!=!$20!per!share!(true!value)!×!20!million!shares!+!$100!=!$500!million
$500
25
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
16.9(Capital(Structure:(The(Bottom(Line((
(
A)!!The!most!important!insight!regarding!capital!structure!goes!back!to!Modigliani!and!Miller:!With!perfect!
capital!markets,!a!firmEs!security!choice!alters!the!risk!of!the!firm’s!equity,!but!it!does!not!change!its!
value!or!the!amount!it!can!raise!from!outside!investors.!
B)!!When!agency!costs!are!significant,!short-term!debt!may!be!the!most!attractive!form!of!external!financing.!
C)!!Too!much!debt!can!motivate!managers!and!equity!holders!to!take!excessive!risks!or!over-invest!in!a!firm.!
D)!!Of!all!the!different!possible!imperfections!that!drive!capital!structure,!the!most!clear-cut,!and!possibly!
the!most!significant,!is!taxes.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!16.9!Capital!Structure:!The!Bottom!Line!
Skill:!Conceptual!
!
!
Chapter(17(-(Payout(Policy(
!
!
17.1(Distributions(to(Shareholders(
1)!!The!date!on!which!the!board!authorizes!the!dividend!is!the!
A)!!declaration!date.!
B)!!distribution!date.!
C)!!record!date.!
D)!!ex-dividend!date.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!17.1!Distributions!to!Shareholders!
Skill:!Definition!
!
2)!!The!firm!will!pay!the!dividend!to!all!shareholders!who!are!registered!owners!on!a!specific!date,!set!by!the!
board,!called!the!
A)!!declaration!date.!
B)!!record!date.!
C)!!distribution!date.!
D)!!ex-dividend!date.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!Anyone!who!purchases!the!stock!on!or!after!the!________!date!will!not!receive!the!dividend.!
A)!!distribution!
B)!!record!
C)!!ex-dividend!
D)!!declaration!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
4)!!The!firm!mails!dividend!checks!to!the!registered!shareholders!on!the!
A)!!ex-dividend!date.!
B)!!declaration!date.!
C)!!distribution!date.!
D)!!record!date.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!From!an!accounting!perspective,!dividends!generally!reduce!the!firm’s!current!(or!accumulated)!
retained!earnings.!
B)!!The!way!a!firm!chooses!between!paying!dividends!and!retaining!earnings!is!referred!to!as!its!payout!
policy.!
C)!!Most!companies!that!pay!dividends!pay!them!semi-annually.!
D)!!Occasionally,!a!firm!may!pay!a!one-time,!special!dividend!that!is!usually!much!larger!than!a!regular!
dividend.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!A!firm!can!repurchase!shares!through!a(n)!________!in!which!it!offers!to!buy!shares!at!a!prespecified!price!
during!a!short!time!period–generally!within!20!days.!
A)!!tender!offer!!
B)!!open!market!share!repurchases!
C)!!targeted!repurchase!
D)!!Dutch!auction!share!repurchase!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
7)!!Another!to!method!to!repurchase!shares!is!the!________,!in!which!the!firm!lists!different!prices!at!which!it!is!
prepared!to!buy!shares,!and!shareholders!in!turn!indicate!how!many!shares!they!are!willing!to!sell!at!each!
price.!
A)!!tender!offer!!
B)!!Dutch!auction!share!repurchase!
C)!!targeted!repurchase!
D)!!open!market!share!repurchases!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
8)!!A(n)!________!may!occur!if!a!major!shareholder!desires!to!sell!a!large!number!of!shares!but!the!market!for!the!
shares!is!not!sufficiently!liquid!to!sustain!such!a!large!sale!without!severely!affecting!the!price.!
A)!!open!market!share!repurchases!
C)!!tender!offer!!
D)!!targeted!repurchase!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
9)!!A(n)!________!is!the!most!common!way!that!firms!repurchase!shares.!
A)!!targeted!repurchase!
C)!!tender!offer!!
D)!!open!market!share!repurchases!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
17.2(Comparison(of(Dividends(and(Share(Repurchases((
(
A)!!In!perfect!capital!markets,!holding!fixed!the!investment!policy!of!a!firm,!the!firm’s!choice!of!dividend!
policy!is!irrelevant!and!does!not!affect!the!initial!share!price.!
B)!!In!a!perfect!capital!market,!when!a!dividend!is!paid,!the!share!price!drops!by!the!amount!of!the!dividend!
when!the!stock!begins!to!trade!ex-dividend."
C)!!In!perfect!capital!markets,!an!open!market!share!repurchase!has!no!effect!on!the!stock!price,!and!the!
stock!price!is!the!same!as!the!ex-dividend!price!if!a!dividend!were!paid!instead.!
D)!!In!perfect!capital!markets,!investors!are!indifferent!between!the!firm!distributing!funds!via!dividends!or!
share!repurchases.!By!reinvesting!dividends!or!selling!shares,!they!can!replicate!either!payout!method!
on!their!own.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!17.2!Comparison!of!Dividends!and!Share!Repurchases!
Skill:!Conceptual!
!
Use"the"information"for"the"question(s)"below.!
!
Omicron!Technologies!has!$50!million!in!excess!cash!and!no!debt.!!The!firm!expects!to!generate!additional!free!cash!flows!
of!$40!million!per!year!in!subsequent!years!and!will!pay!out!these!future!free!cash!flows!as!regular!dividends.!!omicrons!
unlevered!cost!of!capital!is!10%!and!there!are!10!million!shares!outstanding.!!Omicron^s!board!is!meeting!to!decide!whether!
to!pay!out!its!$50!million!in!excess!cash!as!a!special!dividend!or!to!use!it!to!repurchase!shares!of!the!firm^s!stock.!
!
2)!!Omicron^s!enterprise!value!is!closest!to:!
A)!!$500!million!
B)!!$900!million!
C)!!$450!million!
D)!!$400!million!
Answer:!!!D!
B)!!
C)!!
D)!! $40
Enterprise!Value!=!PV(Future!FCF)!=! !=!$400!million!!
.10
Diff:!1!
Skill:!Analytical!
!
3)!!Including!its!cash,!Omicron^s!total!market!value!is!closest!to:!
A)!!$500!million!
B)!!$900!million!
C)!!$400!million!
D)!!$450!million!
Answer:!!!D!
B)!!
C)!!
D)!! $40
Enterprise!Value!-!PV(Future!FCF)!=! !=!$400!million
.10
Market!value!=!Enterprise!Value!+!cash!=!$400!+!$50!=!$450!million!
Diff:!1!
Skill:!Analytical!
!
4)!!Assume!that!Omicron!uses!the!entire!$50!million!in!excess!cash!to!pay!a!special!dividend.!!The!amount!of!the!
special!dividend!is!closest!to:!
A)!!$5.00!
B)!!$9.00!
C)!!$4.00!
D)!!$4.50!
Answer:!!!A!
Explanation:!!! A)!! $50 million cash
Dividend!=! !=!$5!per!share!
10 million shares
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Assume!that!Omicron!uses!the!entire!$50!million!in!excess!cash!to!pay!a!special!dividend.!!The!amount!of!the!
regular!yearly!dividends!in!the!future!is!closest!to:!
A)!!$4.50!
B)!!$5.00!
C)!!$4.00!
D)!!$9.00!
Answer:!!!C!
B)!!
C)!! $40 million free cash flow
Dividend!=! !=!$4!per!share!
10 million shares
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Assume!that!Omicron!uses!the!entire!$50!million!in!excess!cash!to!pay!a!special!dividend.!!Omicron^s!
cum-dividend!price!is!closest!to:!
A)!!$50.00!
B)!!$40.00!
C)!!$5.00!
D)!!$45.00!
Answer:!!!D!
B)!!
C)!!
D)!! $40
.10
Market!value!=!Enterprise!Value!+!cash!=!$400!+!$50!=!$450!million
Market value $450M

Share!price!=! !=! !=!$45.00!
shares outstanding 10M
Diff:!2!
Skill:!Analytical!
!
7)!!Assume!that!Omicron!uses!the!entire!$50!million!in!excess!cash!to!pay!a!special!dividend.!!Omicron^s!
ex-dividend!price!is!closest!to:!
A)!!$40.00!
B)!!$5.00!
C)!!$50.00!
D)!!$45.00!
Answer:!!!A!
B)!!
C)!!
D)!! $40
.10
However,!once!the!$50!million!in!cash!is!used!to!pay!the!dividend,!the!new!market!value!
becomes!$450!-!$50!=!$400!Million
Market value $450M

Share!price!=! !=! !=!$40.00!
Diff:!2!
Skill:!Analytical!
!
8)!!Assume!that!Omicron!uses!the!entire!$50!million!to!repurchase!shares.!!The!number!of!shares!that!Omicron!
will!repurchase!is!closest!to:!
A)!!1.0!million!
B)!!1.2!million!
C)!!1.1!million!
D)!!0.9!million!
Answer:!!!C!
B)!!
C)!! $40
.10
Market value $450M

Share!price!=! !=! !=!$45.00
$50M
Number!of!shares!repurchased!=! !=!1,111,111!shares!
$45
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Assume!that!Omicron!uses!the!entire!$50!million!to!repurchase!shares.!!The!number!of!shares!that!Omicron!
will!have!outstanding!following!the!repurchase!is!closest!to:!
A)!!8.8!million!
B)!!1.2!million!
C)!!9.0!million!
D)!!8.9!million!
Answer:!!!D!
B)!!
C)!! $40
.10
Market value $450M

Share!price!=! !=! !=!$45.00
$50M
Number!of!shares!repurchased!=! !=!1,111,111!shares
$45
Shares!outstanding!=!10!million!-!1,111,111!=!8,888,889!shares!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Assume!that!!Omicron!uses!the!entire!$50!million!to!repurchase!shares.!!The!amount!of!the!regular!yearly!
dividends!in!the!future!is!closest!to:!
A)!!$9.00!
B)!!$5.00!
C)!!$4.50!
D)!!$4.00!
Answer:!!!C!
Explanation:!!! A)!! $40
.10
Market value $450M

Share!price!=! !=! !=!$45.00
$50M
$45
Shares!outstanding!=!10!million!-!1,111,111!=!8,888,889!shares
$40 million free cash flow

Dividend!=! !=!$4.50!per!share!
8,888,889 shares
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
11)!!Assume!that!you!own!2500!shares!of!Omicron!stock!and!that!Omicron!uses!the!entire!$50!million!to!
repurchase!shares.!!Suppose!you!are!unhappy!with!Omicron^s!decision!and!would!prefer!that!Omicron!used!
the!excess!cash!to!pay!a!special!dividend.!!The!number!of!shares!that!you!would!have!to!sell!in!order!to!
receive!the!same!amount!of!cash!as!if!Omicron!paid!the!special!dividend!is!closest!to:!
A)!!275!
B)!!310!
C)!!125!
D)!!250!
Answer:!!!A!
.10
Market value $450M

Share!price!=! !=! !=!$45.00
Dividends!that!you!wanted!to!receive!=!2,500!shares!×!$5!share!=!$12,500
$12,500
Number!of!shares!to!sell!=! !=!277.78!shares!
$45 per share
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
12)!!Assume!that!you!own!2500!shares!of!Omicron!stock!and!that!Omicron!uses!the!entire!$50!million!to!pay!a!
special!dividend.!!Suppose!you!are!unhappy!with!Omicron^s!decision!and!would!prefer!that!Omicron!used!
the!excess!cash!to!repurchase!shares.!!The!number!of!shares!that!you!would!have!to!buy!in!order!to!undo!the!
special!cash!dividend!that!Omicron!paid!is!closest!to:!
A)!!125!
B)!!275!
C)!!250!
D)!!310!
Answer:!!!D!
B)!! $40
.10
However,!once!the!$50!million!in!cash!is!used!to!pay!the!dividend,!the!new!market!value!
becomes!$450!-!$50!=!$400!Million
Market value $400M

Share!price!=! !=! !=!$40.00
Dividends!that!you!did!not!want!to!receive!=!2,500!shares!×!$5!share!=!$12,500
$12,500
Number!of!shares!to!sell!=! !=!312.50!shares!
$40 per share
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
13)!!Assume!that!you!own!4000!shares!of!Omicron!stock!and!that!Omicron!uses!the!entire!$50!million!to!
repurchase!shares.!!Suppose!you!are!unhappy!with!Omicron^s!decision!and!would!have!preferred!that!
Omicron!used!the!excess!cash!to!pay!a!special!dividend.!!Detail!exactly!how!you!could!create!a!homemade!
dividend!that!will!provide!you!with!the!same!combination!of!cash!and!stock!that!you!would!have!received!if!
Omicron!paid!the!special!dividend.!
Answer:!!!What!you!have:
$40
Enterprise!Value!=!PV(Future!FCF)!=! !=!$400!million
.10
Market value $450M

Share!price!=! !=! !=!$45.00!×!4000!shares!=!$180,000!of!stock.
What!you!want:
$40
.10
However,!once!the!$50!million!in!cash!is!used!to!pay!the!dividend,!the!new!market!value!becomes!$450!
-!$50!=!$400!Million
Market value $400M

Share!price!=! !=! !=!$40.00!×!4,000!shares!=!$160,000!of!stock
Dividends!that!you!want!to!receive!=!4,000!shares!×!$5!share!=!$20,000!cash
What!you!need!to!do:
You!have!$180,000!in!stock!and!want!$160,000!in!stock!and!$20,000!in!cash,!so!you!must!sell!$20,000!
worth!of!stock.!!!To!accomplish!this:
$20,000
Number!of!shares!to!sell!=! !=!444.44!shares
$45 per share
So!by!selling!444.44!shares!you!obtain!the!desired!results.!
Diff:!3!
Skill:!Analytical!
!
14)!!Assume!that!you!own!4000!shares!of!Omicron!stock!and!that!Omicron!uses!the!entire!$50!million!to!pay!a!
special!dividend.!!Suppose!you!are!unhappy!with!Omicron^s!decision!and!would!have!preferred!that!
Omicron!used!the!excess!cash!to!repurchase!stock.!!Detail!exactly!how!you!could!undo!the!dividend!in!a!way!
that!will!provide!you!with!the!same!combination!of!cash!and!stock!that!you!would!have!received!if!Omicron!
had!not!paid!the!special!dividend.!
Answer:!!!What!you!want:
$40
.10
Market value $450M

Share!price!=! !=! !=!$45.00!×!4000!shares!=!$180,000!of!stock.
What!you!have:
$40
.10
However,!once!the!$50!million!in!cash!is!used!to!pay!the!dividend,!the!new!market!value!becomes!$450!
-!$50!=!$400!Million
Market value $400M

Share!price!=! !=! !=!$40.00!×!4,000!shares!=!$160,000!of!stock
Dividends!that!you!did!not!want!to!receive!=!4,000!shares!×!$5!share!=!$20,000!cash
What!you!need!to!do:
You!have!$160,000!in!stock!and!$20,000!in!cash!and!you!want!$180,000!in!stock,!so!you!must!buy!
$20,000!worth!of!stock.!!!To!accomplish!this:
$20,000
Number!of!shares!to!buy!=! !=!500!shares
$40 per share
So!by!buying!500!shares!you!obtain!the!desired!results.!
Diff:!3!
Skill:!Analytical!
17.3(The(Tax(Disadvantage(of(Dividends((
(
A)!!Unlike!with!capital!structure,!taxes!are!not!an!important!market!imperfection!that!influence!a!firm^s!
decision!to!pay!dividends!or!repurchase!shares.!
B)!!If!dividends!are!taxed!at!a!higher!rate!than!capital!gains,!which!has!been!true!until!the!most!recent!
change!to!the!tax!code,!shareholders!will!prefer!share!repurchases!to!dividends.!
C)!!Shareholders!typically!must!pay!taxes!on!the!dividends!they!receive.!They!must!also!pay!capital!gains!
taxes!when!they!sell!their!shares.!
D)!!But!because!long-term!investors!can!defer!the!capital!gains!tax!until!they!sell,!there!is!still!a!tax!
advantage!for!share!repurchases!over!dividends.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!17.3!The!Tax!Disadvantage!of!Dividends!
Skill:!Conceptual!
!
A)!!When!a!firm!pays!a!dividend,!shareholders!are!taxed!according!to!the!dividend!tax!rate.!If!the!firm!
repurchases!shares!instead,!and!shareholders!sell!shares!to!create!a!homemade!dividend,!the!homemade!
dividend!will!be!taxed!according!to!the!capital!gains!tax!rate.!
B)!!When!the!tax!rate!on!dividends!exceeds!the!tax!rate!on!capital!gains,!shareholders!will!pay!lower!taxes!if!
a!firm!uses!share!repurchases!for!all!payouts!rather!than!dividends.!
C)!!Firms!that!use!dividends!will!have!to!pay!a!lower!after-tax!return!to!offer!their!investors!the!same!
pre-tax!return!as!firms!that!use!share!repurchases.!
D)!!The!optimal!dividend!policy!when!the!dividend!tax!rate!exceeds!the!capital!gain!tax!rate!is!to!pay!no!
dividends!at!all.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!While!firms!do!still!pay!dividends,!substantial!evidence!shows!that!many!firms!have!recognized!their!
tax!disadvantage.!
B)!!The!fact!that!firms!continue!to!issue!dividends!despite!their!tax!disadvantage!is!often!referred!to!as!the!
dividend!puzzle.!
C)!!At!the!end!of!the!1990s!dividend!payments!exceeded!the!value!of!repurchases!for!U.S.!industrial!firms.!
D)!!While!evidence!is!indicative!of!the!growing!importance!of!share!repurchases!as!a!part!of!firms^!payout!
policies,!it!also!shows!that!dividends!remain!a!key!form!of!payouts!to!shareholders.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
The!JRN!Corporation!will!pay!a!constant!dividend!of!$3!per!share,!per!year,!in!perpetuity.!!Assume!that!all!investors!pay!a!
20%!tax!on!dividends!and!that!there!is!no!capital!gains!tax.!!The!cost!of!capital!for!investing!in!JRN!stock!is!12%.!
!
4)!!The!price!of!a!share!of!JRN^s!stock!is!closest!to:!
A)!!$20.00!
B)!!$24.00!
C)!!$25.00!
D)!!$18.00!
Answer:!!!A!
Explanation:!!! A)!! Dividend(1 D ) $3.00(1 .20)
Price!=! !=! !=!$20.00!
rE .12
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Assume!that!management!makes!a!surprise!announcement!that!JRN!will!no!longer!pay!dividends!but!will!use!
the!cash!to!repurchase!stock!instead.!!The!price!of!a!share!of!JRN^s!stock!is!now!closest!to:!
A)!!$20.00!
B)!!$25.00!
C)!!$18.00!
D)!!$24.00!
Answer:!!!B!
B)!!In!a!perfect!capital!market!the!dividend!/!repurchase!decision!does!not!impact!firm!value.!!!
Since!the!tax!rate!for!repurchases!is!zero,!the!stock!price!would!be!the!same!as!if!the!firm!paid!
out!the!dividend!and!the!dividends!were!not!taxed,!so:
Dividend $3.00
Price!=! !=! !=!$25.00!
rE .12
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
17.4(Dividend(Capture(and(Tax(Clienteles((
(
A)!!Tax!rates!vary!by!income,!by!jurisdiction,!and!by!whether!the!stock!is!held!in!a!retirement!account.!
Because!of!these!differences,!firms!may!attract!different!groups!of!investors!depending!on!their!
dividend!policy.!
B)!!While!many!investors!have!a!tax!preference!for!share!repurchases!rather!than!dividends,!the!strength!of!
that!preference!depends!on!the!difference!between!the!dividend!tax!rate!and!the!capital!gains!tax!rate!
that!they!face.!
C)!!Long-term!investors!are!more!heavily!taxed!on!capital!gains,!so!they!would!prefer!dividend!payments!to!
share!repurchases.!
D)!!One-year!investors,!pension!funds,!and!other!non-taxed!investors!have!no!tax!preference!for!share!
repurchases!over!dividends,!they!would!prefer!a!payout!policy!that!most!closely!matches!their!cash!
needs.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!17.4!Dividend!Capture!and!Tax!Clienteles!
Skill:!Conceptual!
!
A)!!Individuals!in!the!highest!tax!brackets!have!a!preference!for!stocks!that!pay!high!dividends,!whereas!
tax-free!investors!and!corporations!have!a!preference!for!stocks!with!no!or!low!dividends.!
B)!!To!compare!investor!preferences,!we!must!quantify!the!combined!effects!of!dividend!and!capital!gains!
taxes!to!determine!an!effective!dividend!tax!rate!for!an!investor.!
C)!!The!dividend-capture!theory!states!that!absent!transaction!costs,!investors!can!trade!shares!at!the!time!of!
the!dividend!so!that!non-taxed!investors!receive!the!dividend.!
D)!!Differences!in!tax!preferences!create!clientele!effects,!in!which!the!dividend!policy!of!a!firm!is!optimized!
for!the!tax!preference!of!its!investor!clientele.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
d g
Pcum"-"Pex"="Div"×" 1
1 g
The!term!Pcum!is!
A)!!the!personal!tax!rate!for!capital!gains.!
B)!!the!price!per!share!after!a!dividend!is!paid.!
C)!!the!price!per!share!before!a!dividend!is!paid.!
D)!!the!personal!tax!rate!for!dividend.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
d g
1 g
The!term! g!is!
A)!!the!personal!tax!rate!for!dividend.!
B)!!the!personal!tax!rate!for!capital!gains.!
C)!!the!price!per!share!before!a!dividend!is!paid.!
D)!!the!price!per!share!after!a!dividend!is!paid.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
d g
1 g
The!term!Pex!is!
A)!!the!personal!tax!rate!for!dividend.!
B)!!the!price!per!share!before!a!dividend!is!paid.!
C)!!the!price!per!share!after!a!dividend!is!paid.!
D)!!the!personal!tax!rate!for!capital!gains.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
d g
1 g
The!term! d!is!
A)!!the!price!per!share!after!a!dividend!is!paid.!
B)!!the!price!per!share!before!a!dividend!is!paid.!
C)!!the!personal!tax!rate!for!capital!gains.!
D)!!the!personal!tax!rate!for!dividend.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
A)!! d g
Pcum"-"Pex"="Div!×" 1
1 g
B)!! 1 d
Pcum!-!Pex!=!Div!×"
1 g
C)!! d g
d "×" ""
1 g
D)!!(Pcum!-!Pex)(1!-! d)!=!Div(1!-! g)!

Answer:!!!D!
B)!!
C)!!
D)!!Correct!formula!(Pcum!-!Pex)(1!-!! g)!=!Div(1!-! d)!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!tax!rates:
Capital( Ordinary( Dividend(

Year Gains(Rate Income(Rate Rate(
1997-2000 20% 40% 40%!
2001-2002 20% 39% 39%!
2003- 15% 35% 15%!
*The!current!tax!rates!are!set!to!expire!in!2008!unless!Congress!extends!them.!The!tax!rates!shown!are!for!financial!assets!
held!for!one!year.!For!assets!held!less!than!one!year,!capital!gains!are!taxed!at!the!ordinary!income!tax!rate!(currently!35%!
for!the!highest!bracket);!the!same!is!true!for!dividends!if!the!assets!are!held!for!less!than!61!days.!
!
8)!!The!effective!dividend!tax!rate!for!a!buy!and!hold!individual!investor!in!2006!is!closest!to:!
A)!!0%!
B)!!35%!
C)!!15%!
D)!!20%!
Answer:!!!C!
B)!!
C)!! d!=!15%,! g!=!0%!(Buy!and!Hold)
d g .15 0
d "×" "=! !=!.15!
1 g 1 0
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!The!effective!dividend!tax!rate!for!a!one-year!individual!investor!in!2006!is!closest!to:!
A)!!20%!
B)!!15%!
C)!!35%!
D)!!0%!
Answer:!!!D!
B)!!
C)!!
D)!! d!=!15%,! g!=!15%!(one!year)
d g .15 .15
d "×" "=! !=!0!
1 g 1 .15
Diff:!1!
Skill:!Analytical!
!
10)!!The!effective!dividend!tax!rate!for!a!pension!fund!in!2006!is!closest!to:!
A)!!20%!
B)!!0%!
C)!!25%!
D)!!15%!
Answer:!!!B!
B)!! d!=!0%,! g!=!0%!(pension!fund)
d g .15 .15
d "×" "=! !=!0!
1 g 1 .15
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!The!effective!dividend!tax!rate!for!a!buy!and!hold!individual!investor!in!1999!is!closest!to:!
A)!!25%!
B)!!0%!
C)!!20%!
D)!!40%!
Answer:!!!D!
B)!!
C)!!
D)!! d!=!40%,! g!=!0%!(buy!and!hold)
d g .40 0
d "×" "=! !=!.40!
1 g 1 0
Diff:!2!
Skill:!Analytical!
!
12)!!The!effective!dividend!tax!rate!for!a!one-year!individual!investor!in!1999!is!closest!to:!
A)!!0%!
B)!!20%!
C)!!25%!
D)!!40%!
Answer:!!!C!
B)!!
C)!! d!=!40%,! g!=!20%!(one!year)
d g .40 .20
d "×" "=! !=!.25!
1 g 1 .20
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!The!effective!dividend!tax!rate!for!a!pension!fund!in!1999!is!closest!to:!
A)!!40%!
B)!!20%!
C)!!0%!
D)!!25%!
Answer:!!!C!
B)!!
C)!! d!=!0%,! g!=!0%!(pension!fund)
d g 0 0
d "×" "=! !=!0!
1 g 1 0
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!Using!the!available!tax!information!for!2002,!calculate!the!effective!dividend!tax!rate!for!a:
(1)! one-year!individual!investor
(2)! buy!and!hold!individual!investor
(3)! pension!fund!
Answer:!!!(1)! d!=!39%,! g!=!20%!(one!year)
d g .39 .20
d "×" "=! !=!.2375
1 g 1 .20
(2)! d!=!39%,! g!=!0%!(buy!and!hold)

d g .39 0
d "×" "=! !=!.39
1 g 1 0
(3)! d!=!0%,! g!=!0%!(pension!fund)

d g 0 0
d "×" "=! !=!0
1 g 1 0
Diff:!2!
Skill:!Analytical!
17.5(Payout(Versus(Retention(of(Cash((
(
A)!!In!perfect!capital!markets,!buying!and!selling!securities!is!a!zero-NPV!transaction,!so!it!should!not!affect!
firm!value.!
B)!!Making!positive-NPV!investments!will!create!value!for!the!firm’s!investors,!whereas!saving!the!cash!or!
paying!it!out!will!not.!
C)!!In!perfect!capital!markets,!if!a!firm!invests!excess!cash!flows!in!financial!securities,!the!firm’s!choice!of!
payout!versus!retention!is!irrelevant!and!does!not!affect!the!initial!share!price.!
D)!!After!adjusting!for!investor!taxes,!there!remains!a!substantial!tax!advantage!for!the!firm!to!retain!excess!
cash.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!17.5!Payout!Versus!Retention!of!Cash!
Skill:!Conceptual!
!
A)!!A!firm!must!therefore!balance!the!tax!costs!of!holding!cash!with!the!potential!benefits!of!having!to!raise!
external!funds!in!the!future.!
B)!!Paying!out!excess!cash!through!dividends!or!share!repurchases!can!boost!the!stock!price!by!reducing!
managers’!ability!and!temptation!to!waste!resources.!
C)!!If!there!is!a!reasonable!likelihood!that!future!earnings!will!be!insufficient!to!fund!future!positive-NPV!
investment!opportunities,!a!firm!may!start!accumulating!cash!to!make!up!the!difference.!
D)!!According!to!the!managerial!entrenchment!theory!of!payout!policy,!managers!pay!out!cash!only!when!
pressured!to!do!so!by!the!firm’s!investors.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!! (1 i )(1 g )
retain!=!
(1 c )
B)!! Div (1 d)
Pretain!=!
r f (1 i)
C)!! (1 c )(1 g)
Pretain!=!Pcum!×!
(1 i)
D)!!Pretain!=!Pcum!×!(1!-! *retain)!
Answer:!!!A!
Explanation:!!! A)!! (1 C )(1 g)
*retain!=! 1
(1 i)
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
(1 c )(1 g)
Pretain!=!Pcum!×!
(1 i)
The!term! i!in!this!equation!represents!
A)!!the!corporation^s!tax!rate!on!interest!income.!
B)!!the!investor^s!tax!rate!on!capital!gains.!
C)!!the!investor^s!tax!rate!on!interest!income.!
D)!!the!investor^s!tax!rate!on!cumulative!dividends.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
(1 c )(1 g)
Pretain!=!Pcum!×!
(1 i)
The!term!Pretain!in!this!equation!represents!
A)!!the!price!of!the!stock!if!it!retains!and!invests!the!cash.!
B)!!the!percentage!of!net!income!retained!or!reinvested!back!into!the!firm.!
C)!!the!percentage!of!net!income!paid!out!as!a!cash!dividend.!
D)!!the!price!of!the!stock!if!it!retains!cash!to!use!in!a!share!repurchase.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
(1 c )(1 g)
Pretain!=!Pcum!×!
(1 i)
The!term! c!in!this!equation!represents!
A)!!the!corporation^s!tax!rate!on!interest!income.!
B)!!the!investor^s!tax!rate!on!interest!income.!
C)!!the!investor^s!tax!rate!on!cumulative!dividends.!
D)!!the!investor^s!tax!rate!on!capital!gains.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Luther!Industries!has!$5!million!in!excess!cash!and!1!million!shares!outstanding.!!Luther!is!considering!investing!the!cash!
in!one-year!treasury!bills!that!are!currently!paying!5%!interest,!and!then!using!the!cash!to!pay!a!dividend!next!year.!!
Alternatively,!Luther!can!pay!the!cash!out!as!a!dividend!immediately!and!the!shareholders!can!invest!in!the!treasury!bills!
themselves.!!Assume!that!capital!markets!are!perfect.
7)!!If!Luther!invests!the!excess!cash!in!treasury!bills,!then!the!dividend!per!share!next!year!will!be!closest!to:!
A)!!$5.00!
B)!!$5.25!
C)!!$4.75!
D)!!$1.05!
Answer:!!!B!
B)!!$5M!(1.05)!=!$5,250,000!/!1,000,000!shares!=!$5.25!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!If!Luther!decides!to!pay!the!dividend!immediately!the!dividend!per!share!will!be!closest!to:!
A)!!$1.05!
B)!!$5.25!
C)!!$5.00!
D)!!$4.75!
Answer:!!!C!
B)!!
C)!!$5,000,000!/!1,000,000!shares!=!$5.00!
D)!!
Diff:!1!
Skill:!Analytical!
!
!
Consider!the!following!tax!rates:!
!
Corporate( Capital( Ordinary( Dividend(
Year Tax(Rate Gains(Rate Income(Rate Rate(
1997-2000 35% 20% 40% 40%!
2001-2002 35% 20% 39% 39%!
2003- 35% 15% 35% 15%!
!
!
9)!!In!2006,!Luther!Incorporated!paid!a!special!dividend!of!$5!per!share!for!the!100!million!shares!outstanding.!!If!
Luther!has!instead!retained!that!cash!permanently!and!invested!it!into!treasury!bills!earning!6%,!then!the!
present!value!of!the!additional!taxes!paid!by!Luther!would!be!closest!to:!
A)!!$35!million!
B)!!$290!million!
C)!!$175!million!
D)!!$585!million!
Answer:!!!C!
B)!!
C)!! cash r f Tc
PV!=! !=!$5!×!100M!shares!×!.35!=!$175!million!
rf
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!The!effective!tax!disadvantage!for!retaining!cash!in!2006!is!closest!to:!
A)!!14.75%!
B)!!12.50%!
C)!!35.00%!
D)!!15.00%!
Answer:!!!D!
B)!!
C)!!
D)!! * (1 c )(1 g ) (1 .35)(1 .15)
retain !=! 1 !=! 1 !=!.15!
(1 i ) (1 .35)
Diff:!2!
Skill:!Analytical!
!
A)!!15.00%!
B)!!14.75%!
C)!!30.00%!
D)!!35.00%!
Answer:!!!B!
B)!! * (1 c )(1 g ) (1 .35)(1 .20)
retain !=! 1 !=! 1 !=.1475!
(1 i ) (1 .39)
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!15.00%!
B)!!13.35%!
C)!!14.75%!
D)!!35.00%!
Answer:!!!B!
B)!! * (1 C )(1 g ) (1 .35)(1 .20)
retain !=! 1 !=! 1 !=!.13333!
(1 i ) (1 .40)
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Iota!Industries!is!an!all-equity!firm!with!50!million!shares!outstanding.!!Iota!has!$200!million!in!cash!and!expects!future!free!
cash!flows!of!$75!million!per!year.!!Management!plans!to!use!the!cash!to!expand!the!firm^s!operations,!which!in!turn!will!
increase!future!free!cash!flows!by!12%.!!Iota^s!cost!of!capital!is!10%!and!assume!that!capital!markets!are!perfect.
13)!!The!value!of!Iota!if!they!use!the!$200!million!to!expand!is!closest!to:!
A)!!$825!million!
B)!!$688!million!
C)!!$840!million!
D)!!$950!million!
Answer:!!!C!
B)!!
C)!! $75(1.12)
value!=! !=!$840!million!
.10
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!The!value!of!Iota!if!they!not!to!use!the!$200!million!to!expand!and!hold!the!cash!instead!is!closest!to:!
A)!!$840!million!
B)!!$825!million!
C)!!$950!million!
D)!!$688!million!
Answer:!!!C!
value!=! !=!$750!million!+!$200!million!cash!=!$950!million!
.10
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
15)!!The!price!per!share!of!Iota!if!they!use!the!$200!million!to!expand!is!closest!to:!
A)!!$13.75!
B)!!$16.50!
C)!!$19.00!
D)!!$16.80!
Answer:!!!D!
B)!!
C)!!
D)!! $75(1.12)
Value!=! !=!$840!million!
.10
$840 million
50 million shares
Diff:!2!
Skill:!Analytical!
!
16)!!The!price!per!share!of!Iota!if!they!not!to!use!the!$200!million!to!expand!and!hold!the!cash!instead!is!closest!to:!
A)!!$16.50!
B)!!$16.80!
C)!!$19.00!
D)!!$13.75!
Answer:!!!C!
B)!!
C)!! $75
Value!=! !=!$750!million!+!$200!million!cash!=!$950!million
.10
$950 million
50 million shares
D)!!
Diff:!2!
Skill:!Analytical!
!
17)!!The!NPV!of!Iota^s!expansion!project!is!closest!to:!
A)!!-$110!million!
B)!!-$137.5!million!
C)!!$0!
D)!!$75!million!
Answer:!!!A!
Explanation:!!! A)!! $75(.12)
NPV!=!-200!+! !=!-$110!million!
.10
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
18)!!A!member!of!Iota^s!board!of!directors!suggests!that!Iota^s!stock!price!would!be!higher!if!they!used!the!$200!
million!to!repurchase!shares!instead!of!funding!the!expansion.!!If!you!were!advising!the!board,!what!course!of!
action!would!you!recommend,!expansion!or!repurchase?!!Which!provides!the!higher!stock!price?!
Answer:!!!Value!with!expansion:
$75(1.12)
.10
$840 million
50 million shares
Value!with!repurchase!(since!capital!markets!are!perfect!we!know!that!the!stock!price!with!the!
repurchase!will!be!identical!to!the!stock!price!before!the!repurchase!takes!place):
$75
.10
$950 million
50 million shares
The!other!way!to!show!that!the!expansion!is!a!bad!idea!is!to!calculate!the!NPV!of!the!project:
$75(.12)
NPV!=!-200!+! !=!-$110!million
.10
So,!you!should!recommend!that!they!use!the!cash!for!a!share!repurchase.!
Diff:!3!
Skill:!Analytical!
!
19)!!Suppose!that!Iota!is!able!to!invest!the!$200!million!in!excess!cash!into!a!project!that!will!increase!future!free!
cash!flows!by!30%.!If!you!were!advising!the!board,!what!course!of!action!would!you!recommend,!investing!
the!$200!million!in!an!expansion!project!that!will!raise!future!free!cash!flows!by!30%!or!use!the!$200!million!to!
repurchase!shares?!!Which!provides!the!higher!stock!price?!
Answer:!!!Value!with!expansion:
$75(1.30)
.10
$975 million
50 million shares
Value!with!repurchase!(since!capital!markets!are!perfect!we!know!that!the!stock!price!with!the!
repurchase!will!be!identical!to!the!stock!price!before!the!repurchase!takes!place):
$75
.10
$950 million
50 million shares
The!other!way!to!show!that!the!expansion!is!a!good!idea!is!to!calculate!the!NPV!of!the!project:
$75(.30)
NPV!=!-200!+! !=!$25!million
.10
So,!you!should!recommend!that!they!invest!in!the!expansion!project!that!offers!the!30%!increase!in!FCF.!
Diff:!2!
Skill:!Analytical!
!
!
Consider!the!following!tax!rates:!
!
Corporate( Capital( Ordinary( Dividend(
Year Tax(Rate Gains(Rate Income(Rate Rate(
1997-2000 35% 20% 40% 40%!
2001-2002 35% 20% 39% 39%!
2003- 35% 15% 35% 15%!
!
!
20)!!Calculate!the!effective!tax!disadvantage!for!retaining!cash!in!1999,!2001,!and!2005.!
Answer:!!! *
(1 C )(1 g ) (1 .35)(1 .20)
1999:! retain !=! 1 !=! 1 !=!.13333
(1 i ) (1 .40)
*
(1 c )(1 g) (1 .35)(1 .20)
2001:! retain !=! 1 !=! 1 !=!.1475
(1 i) (1 .39)
*
(1 c )(1 g) (1 .35)(1 .15)
2005:! retain !=! 1 !=! 1 !=!.15!
(1 i) (1 .35)
Diff:!2!
Skill:!Analytical!
17.6(Signaling(with(Payout(Policy((
(
A)!!Firms!adjust!dividends!relatively!infrequently,!and!dividends!are!much!less!volatile!than!earnings.!This!
practice!of!maintaining!relatively!constant!dividends!is!called!dividend!signaling.!
B)!!When!a!firm!increases!its!dividend,!it!sends!a!positive!signal!to!investors!that!management!expects!to!be!
able!to!afford!the!higher!dividend!for!the!foreseeable!future.!
C)!!The!average!size!of!the!stock!price!reaction!increases!with!the!magnitude!of!the!dividend!change,!and!is!
larger!for!dividend!cuts.!
D)!!When!managers!cut!the!dividend,!it!may!signal!that!they!have!given!up!hope!that!earnings!will!rebound!
in!the!near!term!and!so!need!to!reduce!the!dividend!to!save!cash.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!17.6!Signaling!with!Payout!Policy!
Skill:!Conceptual!
!
A)!!If!firms!smooth!dividends,!the!firm’s!dividend!choice!will!contain!information!regarding!management’s!
expectations!of!future!earnings.!
B)!!Because!of!the!increasing!popularity!of!repurchases,!firms!cut!dividends!much!more!frequently!than!
they!increase!them.!
C)!!Announcing!a!share!repurchase!today!does!not!necessarily!represent!a!long-term!commitment!to!
repurchase!shares.!
D)!!While!cutting!the!dividend!is!costly!for!managers!in!terms!of!their!reputation!and!the!reaction!of!
investors,!it!is!by!no!means!as!costly!as!failing!to!make!debt!payments.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Managers!are!much!less!committed!to!dividend!payments!than!to!share!repurchases.!
B)!!Share!repurchases!are!a!credible!signal!that!the!shares!are!under-priced,!because!if!they!are!over-priced!a!
share!repurchase!is!costly!for!current!shareholders.!
C)!!While!an!increase!of!a!firm’s!dividend!may!signal!management’s!optimism!regarding!its!future!cash!
flows,!it!might!also!signal!a!lack!of!investment!opportunities.!
D)!!Managers!will!clearly!be!more!likely!to!repurchase!shares!if!they!believe!the!stock!to!be!under-valued.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Rockwood!Industries!has!100!million!shares!outstanding,!a!current!share!price!of!$25,!and!no!debt.!!Rockwood^s!
management!believes!that!the!shares!are!under-priced,!and!that!the!true!value!is!$30!per!share.!!Rockwood!plans!to!pay!
$250!million!in!cash!to!its!shareholders!by!repurchasing!shares.!!Management!expects!that!very!soon!new!information!will!
come!out!that!will!cause!investors!to!revise!their!opinion!of!the!firm!and!agree!with!Rockwood^s!assessment!of!the!firm^s!
true!value.!
!
4)!!If!Rockwood!is!able!to!repurchase!shares!prior!to!the!market!becoming!aware!of!the!new!information!
regarding!Rockwood^s!true!value,!then!the!number!of!shares!outstanding!following!the!repurchase!is!closest!
to:!
A)!!92!million!
B)!!10!million!
C)!!75!million!
D)!!90!million!
Answer:!!!D!
B)!!
C)!!
D)!! $250 Million Cash
Number!of!shares!repurchased!=! !=!10!million!shares
$25 per share
So,!total!shares!outstanding!after!repurchase!=!100!million!initial!-!10!million!repurchased!=!90!
million!remaining.!
Diff:!1!
Skill:!Analytical!
!
5)!!Assume!that!Rockwood!is!not!able!to!repurchase!shares!prior!to!the!market!becoming!aware!of!the!new!
information!regarding!Rockwood^s!true!value.!!If!Rockwood!repurchases!the!shares!following!the!release!of!
the!new!information,!then!the!number!of!shares!outstanding!following!the!repurchase!is!closest!to:!
A)!!92!million!
B)!!90!million!
C)!!75!million!
D)!!10!million!
Answer:!!!A!
Explanation:!!! A)!! $250 Million Cash
$30 per share
So,!total!shares!outstanding!after!repurchase!=!100,000,000!million!initial!-!8,333,333!
repurchased!=!91,666,667!total!shares!outstanding!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Assume!that!Rockwood!is!able!to!repurchase!shares!prior!to!the!market!becoming!aware!of!the!new!
information!regarding!Rockwood^s!true!value.!!After!the!repurchase,!and!following!the!release!of!the!new!
information!regarding!the!true!value!of!Rockwood,!the!firm^s!share!price!is!closest!to:!
A)!!$30.00!
B)!!$31.50!
C)!!$28.75!
D)!!$30.60!
Answer:!!!D!
B)!!
C)!!
D)!! $250 Million Cash
$25 per share
So,!total!shares!outstanding!after!repurchase!=!100!million!initial!-!10!million!repurchased!=!90!
million!remaining.
True!value!of!the!firm!before!repurchase!=!$30!×!100!million!shares!=!3,000!million.
True!value!after!repurchase!=!$3,000!million!-!$250!million!in!cash!spent!on!repurchase!=!
$2,750!million
$2,750M
90M shares
Diff:!2!
Skill:!Analytical!
!
7)!!Assume!that!Rockwood!is!not!able!to!repurchase!shares!prior!to!the!market!becoming!aware!of!the!new!
information!regarding!Rockwood^s!true!value.!!After!the!release!of!the!new!information!regarding!the!true!
value!of!Rockwood,!and!following!the!repurchase,!the!firm^s!share!price!is!closest!to:!
A)!!$30.00!
B)!!$30.60!
C)!!$28.75!
D)!!$31.50!
Answer:!!!A!
Explanation:!!! A)!! $250 Million Cash
$30 per share
So,!total!shares!outstanding!after!repurchase!=!100,000,000!million!initial!-!8,333,333!
repurchased!=!91,666,667!total!shares!outstanding
True!value!after!repurchase!=!$3,000!million!-!$250!million!in!cash!spent!on!repurchase!=!
$2,750!million
$2,750M
91,666,667
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Calculate!Rockwood^s!stock!price!following!the!market!becoming!aware!of!the!new!information!regarding!
Rockwood^s!true!value,!if!(1)!Rockwood!completed!the!repurchase!prior!to!the!market!becoming!aware!of!the!
information!and!(2)!Rockwood!completed!the!repurchase!following!the!market!becoming!aware!of!the!new!
information.!
Answer:!!!(1)!Rockwood!completed!the!repurchase!prior!to!the!market!becoming!aware!of!the!information
$250 Million Cash
$25 per share
So,!total!shares!outstanding!after!repurchase!=!100!million!initial!-!10!million!repurchased!=!90!million!
remaining.
True!value!after!repurchase!=!$3,000!million!-!$250!million!in!cash!spent!on!repurchase!=!$2,750!million
$2,750M
90M shares
(2)!Rockwood!completed!the!repurchase!following!the!market!becoming!aware!of!the!new!information
$250 Million Cash
$30 per share
So,!total!shares!outstanding!after!repurchase!=!100,000,000!million!initial!-!8,333,333!repurchased!=!
91,666,667!total!shares!outstanding
True!value!after!repurchase!=!$3,000!million!-!$250!million!in!cash!spent!on!repurchase!=!$2,750!million
$2,750M
91,666,667
Diff:!3!
Skill:!Analytical!
!
17.7(Stock(Dividends,(Splits,(and(Spin-offs((
(
A)!!Stocks!generally!trade!in!lots!of!1000!shares,!and!in!any!case!do!not!trade!in!units!less!than!one!share.!
B)!!Non-cash!special!dividends!are!commonly!used!to!spin!off!assets!or!a!subsidiary!as!a!separate!company.!
C)!!The!typical!motivation!for!a!stock!split!is!to!keep!the!share!price!in!a!range!thought!to!be!attractive!to!
small!investors.!
D)!!If!a!company!declares!a!10%!stock!dividend,!each!shareholder!will!receive!one!new!share!of!stock!for!
every!10!shares!already!owned.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!17.7!Stock!Dividends,!Splits,!and!Spin-offs!
Skill:!Conceptual!
!
A)!!With!a!stock!dividend,!a!firm!does!not!pay!out!any!cash!to!shareholders.!As!a!result,!the!total!market!
value!of!the!firm’s!assets!and!liabilities,!and!therefore!of!its!equity,!is!unchanged.!
B)!!If!the!price!of!the!stock!falls!too!low,!a!company!can!engage!in!a!reverse!split(and!reduce!the!number!of!
shares!outstanding.!
C)!!Stock!dividends!of!50%!or!higher!are!generally!referred!to!as!stock!splits.!
D)!!Rather!than!pay!a!dividend!using!cash!or!shares!of!its!own!stock,!a!firm!can!also!distribute!shares!of!a!
subsidiary!in!a!transaction!referred!to!as!a!off-shoot.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
Luther!Industries!currently!has!5!million!shares!outstanding!and!it!stock!is!currently!trading!at!$40!per!share.!
!
3)!!Assuming!Luther!issues!a!25%!stock!dividend,!then!Luther^s!new!share!price!is!closest!to:!
A)!!$24.00!
B)!!$30.00!
C)!!$16.00!
D)!!$32.00!
Answer:!!!D!
B)!!
C)!!
D)!! $40
New!share!price!=! !=!$32!
1.25
Diff:!1!
Skill:!Analytical!
!
4)!!Assuming!Luther!issues!a!5:2!stock!split,!then!Luther^s!new!share!price!is!closest!to:!
A)!!$32.00!
B)!!$16.00!
C)!!$24.00!
D)!!$30.00!
Answer:!!!B!
B)!! $40
New!share!price!=! 5 !=!$16!
2
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Assuming!Luther!issues!a!5:2!stock!split,!then!the!number!of!shares!Luther!will!have!outstanding!following!
the!split!is!closest!to:!
A)!!25.0!million!
B)!!12.5!million!
C)!!2.0!million!
D)!!16.0!million!
Answer:!!!B!
New!share!price!=! 5 !=!$16!
2
B)!!shares!outstanding!following!split!=!current!shares!outstanding!×!split
5
=!5!million!×! !=!12.5!million!
2
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Delta!Products!has!decided!to!spin-off!one!of!its!subsidiaries,!Gamma!Technologies.!!Each!Delta!shareholder!
will!receive!0.125!shares!of!Gamma!for!each!share!of!Delta!they!own.!Delta^s!price!is!$35.00!cum-dividend!and!
immediately!after!the!spin-off!Gamma!Technologies!was!trading!for!$24.00!per!share.!!In!a!perfect!capital!
market,!what!would!Delta!Product^s!ex-dividend!share!price!be!after!this!transaction?!
Answer:!!!The!value!of!the!special!dividend!is:
0.125!Gamma!shares!×!$24.00!per!share!=!$3.00
So!we!expect!Delta^s!stock!price!to!drop!by!$3.00!per!share.!!So!final!stock!price!=!$35.00!-!$3.00!=!$32.00!
Diff:!2!
Skill:!Analytical!
!
!
Chapter(18(-(Capital(Budgeting(and(Valuation(with(Leverage(
!
!
18.1(Overview(
1)!!Which!of!the!following!is!not!one!of!the!simplifying!assumptions!made!for!the!three!main!methods!of!capital!
budgeting?!
A)!!The!firm!pays!out!all!earnings!as!dividends.!
B)!!The!project!has!average!risk.!
C)!!Corporate!taxes!are!the!only!market!imperfection.!
D)!!The!firm’s!debt-equity!ratio!is!constant.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.1!Overview!
Skill:!Conceptual!
(
18.2((The(Weight(Average(Cost(of(Capital(Method(
(
A)!!Because!the!WACC!incorporates!the!tax!savings!from!debt,!we!can!compute!the!levered!value!of!an!
investment,!which!is!its!value!including!the!benefit!of!interest!tax!shields!given!the!firmLs!leverage!policy,!
by!discounting!its!future!free!cash!flow!using!the!WACC.!
B)!!The!WACC!incorporates!the!benefit!of!the!interest!tax!shield!by!using!the!firmLs!before-tax!cost!of!capital!
for!debt.!
C)!!When!the!market!risk!of!the!project!is!similar!to!the!average!market!risk!of!the!firmLs!investments,!then!
its!cost!of!capital!is!equivalent!to!the!cost!of!capital!for!a!portfolio!of!all!of!the!firmLs!securities;!that!is,!the!
projectLs!cost!of!capital!is!equal!to!the!firm’s!weighted!average!cost!of!capital!(WACC).!
D)!!A!projectLs!cost!of!capital!depends!on!its!risk.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.2!The!Weighted!Average!Cost!of!Capital!Method!
Skill:!Conceptual!
!
A)!!The!WACC!can!be!used!throughout!the!firm!as!the!company!wide!cost!of!capital!for!new!investments!
that!are!of!comparable!risk!to!the!rest!of!the!firm!and!that!will!not!alter!the!firm’s!debt-equity!ratio.!
B)!!A!disadvantage!of!the!WACC!method!is!that!you!need!to!know!how!the!firmLs!leverage!policy!is!
implemented!to!make!the!capital!budgeting!decision.!
C)!!The!intuition!for!the!WACC!method!is!that!the!firmLs!weighted!average!cost!of!capital!represents!the!
average!return!the!firm!must!pay!to!its!investors!(both!debt!and!equity!holders)!on!an!after-tax!basis.!
D)!!To!be!profitable,!a!project!should!generate!an!expected!return!of!at!least!the!firmLs!weighted!average!cost!
of!capital.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!of!the!following!is!not!a!step!in!the!WACC!valuation!method?!
A)!!Compute!the!value!of!the!investment,!including!the!tax!benefit!of!leverage,!by!discounting!the!free!cash!
flow!of!the!investment!using!the!WACC.!
B)!!Compute!the!weighted!average!cost!of!capital.!
C)!!Determine!the!free!cash!flow!of!the!investment.!
D)!!Adjust!the!WACC!for!the!firmLs!current!debt/equity!ratio.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
E D
rwacc!=! rE!+! rD(1!-! c)
E D E D
the!term!E!in!this!equation!is?!
A)!!the!dollar!amount!of!equity.!
B)!!the!dollar!amount!of!debt!
C)!!the!required!rate!of!return!on!debt!
D)!!the!required!rate!of!return!on!equity!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
E D
E D E D
the!term!D!in!this!equation!is?!
A)!!the!dollar!amount!of!debt!
B)!!the!required!rate!of!return!on!equity!
C)!!the!required!rate!of!return!on!debt!
D)!!the!dollar!amount!of!equity.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
E D
E D E D
the!term!rE!in!this!equation!is?!
A)!!the!after!tax!required!rate!of!return!on!debt!
B)!!the!required!rate!of!return!on!debt!
C)!!the!required!rate!of!return!on!equity!
D)!!the!dollar!amount!of!equity.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
E D
E D E D
the!term!rD(1!-! c)!in!this!equation!is?!
A)!!the!required!rate!of!return!on!debt!
B)!!the!dollar!amount!of!equity.!
C)!!the!after!tax!required!rate!of!return!on!debt!
D)!!the!required!rate!of!return!on!equity!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Dt!=!d!×! Vt L
the!term!Dt!in!this!equation!is?!
A)!!the!firms!target!debt!to!value!ratio.!
B)!!the!firms!target!debt!to!equity!ratio.!
C)!!the!investmentLs!debt!capacity.!
D)!!the!dollar!amount!of!debt!outstanding!at!time!t.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Dt!=!d!×! Vt L
the!term!d!in!this!equation!is?!
A)!!the!firms!target!debt!to!value!ratio.!
B)!!the!dollar!amount!of!debt!outstanding!at!time!t.!
C)!!the!firms!target!debt!to!equity!ratio.!
D)!!the!investmentLs!debt!capacity.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Use!the!table!for!the!question(s)!below.
Consider!the!information!for!the!following!four!firms:
Firm Cash Debt Equity rD rE c%

Eenie 0 150 150 5% 10% 40%!
Meenie 0 250 750 6% 12% 35%!
Minie 25 175 325 6% 11% 35%!
Moe 50 350 150 7.50% 15% 30%!
!
!
10)!!The!weighted!average!cost!of!capital!for!ZEenieZ!is!closest!to:!
A)!!6.0%!
B)!!6.5%!
C)!!7.5%!
D)!!5.5%!
Answer:!!!B!
B)!! E D
rwacc!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash!
E D E D
Firm Cash Debt Equity rD rE c% Wacc%

Eenie 0 150 150 5% 10% 40% 6.50%!
Meenie 0 250 750 6% 12% 35% 9.98%!
Minie 25 175 325 6% 11% 35% 8.76%!
Moe 50 350 150 7.50% 15% 30% 8.50%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
11)!!The!weighted!average!cost!of!capital!for!ZMeenieZ!is!closest!to:!
A)!!10.5%!
B)!!7.4%!
C)!!10.0%!
D)!!8.8%!
Answer:!!!C!
B)!!
C)!! E D
E D E D
!
Eenie 0 150 150 5% 10% 40% 6.50%!
Meenie 0 250 750 6% 12% 35% 9.98%!
Minie 25 175 325 6% 11% 35% 8.76%!
Moe 50 350 150 7.50% 15% 30% 8.50%!
D)!!
Diff:!1!
Skill:!Analytical!
!
12)!!The!weighted!average!cost!of!capital!for!ZMinieZ!is!closest!to:!
A)!!9.50%!
B)!!8.75%!
C)!!6.75%!
D)!!8.25%!
Answer:!!!B!
B)!! E D
E D E D
!
Eenie 0 150 150 5% 10% 40% 6.50%!
Meenie 0 250 750 6% 12% 35% 9.98%!
Minie 25 175 325 6% 11% 35% 8.76%!
Moe 50 350 150 7.50% 15% 30% 8.50%!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!The!weighted!average!cost!of!capital!for!ZMoeZ!is!closest!to:!
A)!!10.00%!
B)!!7.75%!
C)!!8.25%!
D)!!8.50%!
Answer:!!!D!
B)!!
C)!!
D)!! E D
E D E D
!
Eenie 0 150 150 5% 10% 40% 6.50%!
Meenie 0 250 750 6% 12% 35% 9.98%!
Minie 25 175 325 6% 11% 35% 8.76%!
Moe 50 350 150 7.50% 15% 30% 8.50%!
Diff:!2!
Skill:!Analytical!
!
Use!the!information!for!the!question(s)!below.
Omicron(IndustriesI(Market(Value(Balance(Sheet(($(Millions)(and(Cost(of(Capital
Assets Liabilities Cost(of(Capital
Cash 0 Debt 200 Debt 6%!
Other!Assets 500 Equity 300 Equity 12%!
c 35%!
Omicron(Industries(New(Project(Free(Cash(Flows
Year 0 1 2 3(
Free!Cash!Flows ($100) $40 $50 $60!
Assume!that!this!new!project!is!of!average!risk!for!Omicron!and!that!the!firm!wants!to!hold!constant!its!debt!to!equity!ratio.!
!
14)!!OmicronLs!weighted!average!cost!of!capital!is!closest!to:!
A)!!7.10%!
B)!!7.50%!
C)!!9.60%!
D)!!8.75%!
Answer:!!!D!
B)!!
C)!!
D)!! E D
rwacc!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash
E D E D
300 200
rwacc!=! (.12)!+! !(.06)(1!-!.35)!=!.0876!
300 200 300 200
Diff:!1!
Skill:!Analytical!
!
15)!!The!NPV!for!OmicronLs!new!project!is!closest!to:!
A)!!$23.75!
B)!!$27.50!
C)!!$28.75!
D)!!$25.75!
Answer:!!!D!
B)!!
C)!!
D)!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
40 50 60
NPV!=!-100!+! 1
!+! 2
!+! !=!$25.69!
(1.0876) (1.0876) (1.0876)3
Diff:!2!
Skill:!Analytical!
!
16)!!The!Debt!Capacity!for!OmicronLs!new!project!in!year!0!is!closest!to:!
A)!!$38.75!
B)!!$75.50!
C)!!$50.25!
D)!!$10.25!
Answer:!!!C!
B)!!
C)!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
40 50 60
V0L !=! 1
!+! 2
!+! !=!$125.69
(1.0876) (1.0876) (1.0876)3
D0!=!d!×! V0L
200
D0!=! ($125.69)!=!$50.28!
300 200
D)!!
Diff:!3!
Skill:!Analytical!
!
A)!!$38.75!
B)!!$48.25!
C)!!$50.25!
D)!!$58.00!
Answer:!!!A!
rwacc!=! rE!+! rD(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
50 60
V1L !=! 1
!+! !=!$96.70
(1.0876) (1.0876) 2
D1!=!d!×! V1L
200
D1!=! ($96.70)!=!$38.68!
300 200
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
A)!!$55.25!
B)!!$38.75!
C)!!$22.00!
D)!!$33.00!
Answer:!!!C!
B)!!
C)!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
60
V2L !=! =!$55.17
(1.0876)1
D2!=!d!×! V2L
200
D2!=! ($55.17)!=!$22.06!
300 200
D)!!
Diff:!2!
Skill:!Analytical!
!
Use!the!information!for!the!question(s)!below.!
Iota(Industries(Market(Value(Balance(Sheet(($(Millions)(and(Cost(of(Capital
c 35%!
Iota(Industries(New(Project(Free(Cash(Flows
Year 0 1 2 3(
Free!Cash!Flows ($250) $75 $150 $100!
Assume!that!this!new!project!is!of!average!risk!for!Iota!and!that!the!firm!wants!to!hold!constant!its!debt!to!equity!ratio.!
!
!
19)!!IotaLs!weighted!average!cost!of!capital!is!closest!to:!
A)!!8.40%!
B)!!9.75%!
C)!!10.85%!
D)!!11.70%!
Answer:!!!C!
B)!!
C)!! E D
E D E D
800 400
rwacc!=! (.14)!+! (.07)(1!-!.35)!=!.1085!
800 400 800 400
D)!!
Diff:!3!
Skill:!Analytical!
!
20)!!The!NPV!for!IotaLs!new!project!is!closest!to:!
A)!!$25.25!
B)!!$13.25!
C)!!$9.00!
D)!!$18.50!
Answer:!!!B!
B)!! E D
E D E D
800 400
rwacc!=! (.14)!+! (.07)(1!-!.35)!=!.1085
800 400 800 400
75 150 100
NPV!=!-250!+! 1
!+! 2
!+! !=!$13.14!
(1.1085) (1.1085) (1.1085)3
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
21)!!The!Debt!Capacity!for!IotaLs!new!project!in!year!0!is!closest!to:!
A)!!$263.25!
B)!!87.75!
C)!!$50.25!
D)!!$118.00!
Answer:!!!B!
B)!! E D
E D E D
800 400
rwacc!=! (.14)!+! (.07)(1!-!.35)!=!.1085
800 400 800 400
75 150 100
V0L! !+! !+! !=!$263.14
(1.1085)1 (1.1085) 2 (1.1085)3
D0!=!d!×! V0L
400
D0!=! ($263.14)!=!$87.71!
800 400
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
22)!!Calculate!the!NPV!for!IotaLs!new!project.!
Answer:!!! E D
E D E D
800 400
rwacc!=! (.14)!+! (.07)(1!-!.35)!=!.1085
800 400 800 400
75 150 100
NPV!=!-250!+! 1
!+! 2
!+! !=!$13.14!
(1.1085) (1.1085) (1.1085)3
Diff:!3!
Skill:!Analytical!
!
Omicron(IndustriesI(Market(Value(Balance(Sheet(($(Millions)(and(Cost(of(Capital(

c 35%!
Year 0 1 2 3(
Free!Cash!Flows ($100) $40 $50 $60!
!
23)!!Calculate!the!debt!capacity!of!OmicronLs!new!project!for!years!0,!1,!and!2.!
Answer:!!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
!
Year!0
40 50 60
V0L !=! 1
!+! 2
!+! !=!$125.69
(1.0876) (1.0876) (1.0876)3
D0!=!d!× V0L
200
D0!=! ($125.69)!=!$50.28
300 200
Year!1
50 60
V1L !=! 1
!+! !=!$96.70
(1.0876) (1.0876) 2
D1!=!d!× V1L
200
D1!=! ($96.70)!=!$38.68
300 200
Year!2
60
V2L !=! !=!$55.17
(1.0876)1
D2!=!d!× V2L
200
D2!=! ($55.17)!=!$22.06!
300 200
Diff:!3!
Skill:!Analytical!
!
24)!!Suppose!Luther!Industries!is!considering!divesting!one!of!its!product!lines.!!The!product!line!is!expected!to!
generate!free!cash!flows!of!$2!million!per!year,!growing!at!a!rate!of!3%!per!year.!!Luther!has!an!equity!cost!of!
capital!of!10%,!a!debt!cost!of!capital!of!7%,!a!marginal!tax!rate!of!35%,!and!a!debt-equity!ratio!of!2.!!If!this!
product!line!is!of!average!risk!and!Luther!plans!to!maintain!a!constant!debt-equity!ratio,!what!after-!tax!
amount!must!it!receive!for!the!product!line!in!order!for!the!divestiture!to!be!profitable?!
Answer:!!! 1 2
rwacc!=! (.10)!+! (.07)(1!-!.35)!=!.063667
3 3
L $2 million
V0 !=! !=!$59.406!million!
.063667 .03
Diff:!2!
Skill:!Analytical!
!
18.3((The(Adjusted(Present(Value(Method(
(
1)!!Which!of!the!following!is!not!a!step!in!the!adjusted!present!value!method?!
A)!!Deducting!costs!arising!from!market!imperfections!
B)!!Calculating!the!unlevered!value!of!the!project!
C)!!Calculating!the!after-tax!WACC!
D)!!Calculating!the!value!of!the!interest!tax!shield!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!18.3!The!Adjusted!Present!Value!Method!
Skill:!Conceptual!
!
A)!!The!firmLs!unlevered!cost!of!capital!is!equal!to!its!pretax!weighted!average!cost!of!capital–that!is,!using!
the!pretax!cost!of!debt,!rd!,!rather!than!its!after-tax!cost,!rd!(1!-! c!).!
B)!!A!firmLs!levered!cost!of!capital!is!a!weighted!average!of!its!equity!and!debt!costs!of!capital.!
C)!!When!the!firm!maintains!a!target!leverage!ratio,!its!future!interest!tax!shields!have!similar!risk!to!the!
projectLs!cash!flows,!so!they!should!be!discounted!at!the!projectLs!unlevered!cost!of!capital.!
D)!!The!first!step!in!the!APV!method!is!to!calculate!the!value!of!free!cash!flows!using!the!projectLs!cost!of!
capital!if!it!were!financed!without!leverage.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!To!determine!the!projectLs!debt!capacity!for!the!interest!tax!shield!calculation,!we!need!to!know!the!value!
of!the!project.!
B)!!To!compute!the!present!value!of!the!interest!tax!shield,!we!need!to!determine!the!appropriate!cost!of!
capital.!
C)!!Because!we!don’t!value!the!tax!shield!separately,!with!the!APV!method!we!need!to!include!the!benefit!of!
the!tax!shield!in!the!discount!rate!as!we!do!in!the!WACC!method.!
D)!!A!target!leverage!ratio(means!that!the!firm!adjusts!its!debt!proportionally!to!the!project’s!value!or!its!
cash!flows.!!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!APV!approach!explicitly!values!the!market!imperfections!and!therefore!allows!managers!to!
measure!their!contribution!to!value.!
B)!!We!need!to!know!the!debt!level!to!compute!the!APV,!but!with!a!constant!debt-equity!ratio!we!need!to!
know!the!projectLs!value!to!compute!the!debt!level.!
C)!!The!WACC!method!is!more!complicated!than!the!APV!method!because!we!must!compute!two!separate!
valuations:!the!unlevered!project!and!the!interest!tax!shield.!
D)!!Implementing!the!APV!approach!with!a!constant!debt-equity!ratio!requires!solving!for!the!projectLs!debt!
and!value!simultaneously.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Consider!the!information!for!the!following!four!firms:
Firm Cash Debt Equity rD rE c%

Eenie 0 150 150 5% 10% 40%!
Meenie 0 250 750 6% 12% 35%!
Minie 25 175 325 6% 11% 35%!
Moe 50 350 150 7.50% 15% 30%!
!
!
5)!!The!unlevered!cost!of!capital!for!ZEenieZ!is!closest!to:!
A)!!6.0%!
B)!!5.5%!
C)!!7.5%!
D)!!6.5%!
Answer:!!!C!
B)!!
C)!! E D
runlevered!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash!
E D E D
Firm Cash Debt Equity rD rE c% runlevered%

Eenie 0 150 150 5% 10% 40% 7.50%!
Meenie 0 250 750 6% 12% 35% 10.50%!
Minie 25 175 325 6% 11% 35% 9.42%!
Moe 50 350 150 7.50% 15% 30% 10.00%!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!The!unlevered!cost!of!capital!for!ZMoeZ!is!closest!to:!
A)!!8.25%!
B)!!7.75%!
C)!!8.50%!
D)!!10.00%!
Answer:!!!D!
B)!!
C)!!
D)!! E D
runlevered!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash!
E D E D
!
Firm Cash Debt Equity rD rE c% runlevered%
Eenie 0 150 150 5% 10% 40% 7.50%!
Meenie 0 250 750 6% 12% 35% 10.50%!
Minie 25 175 325 6% 11% 35% 9.42%!
Moe 50 350 150 7.50% 15% 30% 10.00%!
Diff:!2!
Skill:!Analytical!
!
Suppose!Luther!Industries!is!considering!divesting!one!of!its!product!lines.!!The!product!line!is!expected!to!generate!free!
cash!flows!of!$2!million!per!year,!growing!at!a!rate!of!3%!per!year.!!Luther!has!an!equity!cost!of!capital!of!10%,!a!debt!cost!
of!capital!of!7%,!a!marginal!tax!rate!of!35%,!and!a!debt-equity!ratio!of!2.!!This!product!line!is!of!average!risk!and!Luther!
plans!to!maintain!a!constant!debt-equity!ratio.!
!
7)!!LutherLs!Unlevered!cost!of!capital!is!closest!to:!
A)!!8.0%!
B)!!8.5%!
C)!!9.0%!
D)!!6.4%!
Answer:!!!A!
Explanation:!!! A)!! 1 2
runlevered!=! (.10)!+! (.07)!=!.08!or!8%!
3 3
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!The!unlevered!value!of!LutherLs!Product!Line!is!closest!to:!
A)!!$25!million!
B)!!$60!million!
C)!!$45!million!
D)!!$40!million!
Answer:!!!D!
B)!!
C)!!
D)!! 1 2
runlevered!=! (.10)!+! (.07)!=!.08!or!8%
3 3
$2 million
VU!=! !=!$40!million!
.08 .03
Diff:!2!
Skill:!Analytical!
!
Omicron(IndustriesI(Market(Value(Balance(Sheet(($(Millions)((
((and(Cost(of(Capital
c 35%!
Year 0 1 2 3(
Free!Cash!Flows ($100) $40 $50 $60!
!
9)!!OmicronLs!Unlevered!cost!of!capital!is!closest!to:!
A)!!8.75%!
B)!!7.10%!
C)!!9.60%!
D)!!7.50%!
Answer:!!!C!
B)!!
C)!! E D
runlevered!=! rE!+! rD,!where!D!=!net!debt!=!Debt!-!Cash
E D E D
300 200
runlevered!=! (.12)!+! !(.06)!=!.096!
300 200 300 200
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!The!unlevered!value!of!OmicronLs!new!project!is!closest!to:!
A)!!$96!
B)!!$124!
C)!!$126!
D)!!$25!
Answer:!!!B!
B)!! E D
E D E D
300 200
runlevered!=! (.12)!+! (.06)!=!.096
300 200 300 200
40 50 60
VU!=! 1
!+! 2
!+=! !=!$123.70!
(1.096) (1.096) (1.096)3
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!The!interest!tax!shield!provided!by!OmicronLs!new!project!in!year!1!is!closest!to:!
A)!!$3.00!
B)!!$1.05!
C)!!$50.25!
D)!!$17.60!
Answer:!!!B!
B)!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
40 50 60
V0L !=! 1
!+! 2
!+=! !=!$125.69
(1.0876) (1.0876) (1.0876)3
D0!=!d!×! V0L
200
D0!=! ($125.69)!=!$50.28
300 200
So,!Interest!tax!shield!in!year!1!=!50.28(.06)(.35)!=!1.055880!or!1.06!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Suppose!that!Rose!Industries!is!considering!the!acquisition!of!another!firm!in!its!industry!for!$100!million.!!The!acquisition!
is!expected!to!increase!RoseLs!free!cash!flow!by!$5!million!the!first!year,!and!this!contribution!us!expected!to!grow!at!a!rate!
of!3%!every!year!there!after.!!Rose!currently!maintains!a!debt!to!equity!ratio!of!1,!its!marginal!tax!rate!is!40%,!its!cost!of!debt!
rD!is!6%,!and!its!cost!of!equity!rE!is!10%.!!Rose!Industries!will!maintain!a!constant!debt-equity!ratio!for!the!acquisition.!
!
12)!!RoseLs!unlevered!cost!of!capital!is!closest!to:!
A)!!8.0%!
B)!!7.5%!
C)!!7.0%!
D)!!9.0%!
Answer:!!!A!
E D E D
1 1
runlevered!=! (.10)!+! (.06)!=!.08!
1 1 1 1
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!The!unlevered!value!of!RoseLs!acquisition!is!closest!to:!
A)!!$63!million!
B)!!$50!million!
C)!!$167!million!
D)!!$100!million!
Answer:!!!D!
B)!!
C)!!
D)!! E D
E D E D
1 1
runlevered!=! (.10)!+! (.06)!=!.08
1 1 1 1
5
VU!=! !=!$100!million!
.08 .03
Diff:!2!
Skill:!Analytical!
!
14)!!Given!that!Rose!issues!new!debt!of!$50!million!initially!to!fund!the!acquisition,!the!present!value!of!the!
interest!tax!shield!for!this!acquisition!is!closest!to:!
A)!!$24!million!
B)!!$50!million!
C)!!$20!million!
D)!!$15!million!
Answer:!!!A!
E D E D
1 1
runlevered!=! (.10)!+! (.06)!=!.08
1 1 1 1
Interest!tax!shield!in!first!year!=!$50(.06)(.40)!=!$1.2!million
1.2
PV(tax!shield)!=! !=!$24!million!
.08 .03
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
15)!!Given!that!Rose!issues!new!debt!of!$50!million!initially!to!fund!the!acquisition,!the!total!value!of!this!
acquisition!using!the!APV!method!is!closest!to:!
A)!!$100!million!
B)!!$120!million!
C)!!$124!million!
D)!!$115!million!
Answer:!!!C!
B)!!
C)!! E D
runlevered!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash
E D E D
1 1
runlevered!=! (.10)!+! (.06)!=!.08
1 1 1 1
5
VU!=! !=!$100!million
.08 .03
1.2
PV(tax!shield)=! !=!$24!million
.08 .03
VL!=!VU!+!PV(interest!tax!shield)!=!$100!million!+!$24!million!=!$124!million!
D)!!
Diff:!3!
Skill:!Analytical!
!
Omicron(IndustriesI(Market(Value(Balance(Sheet(($(Millions)(and(Cost(of(Capital
c 35%!
Year 0 1 2 3(
Free!Cash!Flows ($100) $40 $50 $60!
16)!!Calculate!the!present!value!of!the!interest!tax!shield!provided!by!OmicronLs!new!project.!
Answer:!!! E D
E D E D
300 200
rwacc!=! (.12)!+! (.06)(1!-!.35)!=!.0876
300 200 300 200
Year!0
40 50 60
V0L !=! !+! !+! !=!$125.69
(1.0876)1 (1.0876) 2 (1.0876)3
D0!=!d!×! V0L
200
D0!=! ($125.69)!=!$50.28
300 200
Interest!tax!shield!year!1!=!50.28(.06)(.35)!=!1.055880!or!1.06
Year!1
50 60
V1L !=! 1
!+! !=!$96.70
(1.0876) (1.0876) 2
D1!=!d!×! V1L
200
D1!=! ($96.70)!=!$38.68
300 200
Interest!tax!shield!year!2!=!38.68(.06)(.35)!=!0.812280!or!.81
Year!2
60
V2L !=! !=!$55.17
(1.0876)1
D2!=!d!×! V2L
200
D2!=! ($55.17)!=!$22.06
300 200
Interest!tax!shield!year!3!=!22.06(.06)(.35)!=!0.463260!or!.46
E D
E D E D
300 200
runlevered!=! (.12)!+! !(.06)!=!.096
300 200 300 200
1.06 .81 .46
PV!of!tax!shield!=! !+! 2
!+! !=!1.99!
1.096 (1.096) (1.096)3
Diff:!3!
Skill:!Analytical!
!
!
!
17)!!Given!that!Rose!issues!new!debt!of!$50!million!initially!to!fund!the!acquisition,!the!total!value!of!this!
acquisition!using!the!APV!method!is!equal!to?!
Answer:!!! E D
runlevered!=! rE!+! rD!(1!-! c),!where!D!=!net!debt!=!Debt!-!Cash
E D E D
1 1
runlevered!=! (.10)!+! (.06)!=!.08
1 1 1 1
5
VU!=! !=!$100!million
.08 .03
1.2
PV(tax!shield)!=! !=!$24!million
.08 .03
VL!=!VU!+!PV(interest!tax!shield)!=!$100!million!+!$24!million!=!$124!million!
Diff:!3!
Skill:!Analytical!
(
18.4((The(Flow-to-Equity(Method(
(
A)!!In!the!flow-to-equity!valuation!method,!the!cash!flows!to!equity!holders!are!then!discounted!using!the!
weighted!average!cost!of!capital.!
B)!!In!the!WACC!and!APV!methods,!we!value!a!project!based!on!its!free!cash!flow,!which!is!computed!
ignoring!interest!and!debt!payments.!
C)!!In!the!flow-to-equity!(FTE)!valuation!method,!we!explicitly!calculate!the!free!cash!flow!available!to!
equity!holders!taking!into!account!all!payments!to!and!from!debt!holders.!
D)!!The!first!step!in!the!FTE!method!is!to!determine!the!project’s!free!cash!flow!to!equity!(FCFE).!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.4!The!Flow-to-Equity!Method!
Skill:!Conceptual!
!
A)!!The!projectLs!free!cash!flow!to!equity!shows!the!expected!amount!of!additional!cash!the!firm!will!have!
available!to!pay!dividends!(or!conduct!share!repurchases)!each!year.!
B)!!The!value!of!the!project’s!FCFE!should!be!identical!to!the!NPV!computed!using!the!WACC!and!APV!
methods.!
C)!!The!value!of!the!project’s!FCFE!represents!the!gain!to!shareholders!from!the!project.!
D)!!Because!interest!payments!are!deducted!before!taxes,!we!adjust!the!firmLs!FCF!by!their!before-tax!cost.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!the!debt-equity!ratio!changes!over!time,!the!risk!of!equity–and,!therefore,!its!cost!of!capital–will!
change!as!well.!
B)!!The!FTE!method!can!offer!an!advantage!when!calculating!the!value!of!equity!for!the!entire!firm,!if!the!
firm’s!capital!structure!is!complex!and!the!market!values!of!other!securities!in!the!firm’s!capital!structure!
are!not!known.!
C)!!The!FTE!approach!does!not!have!the!same!disadvantage!associated!with!the!APV!approach:!We!donLt!
need!to!compute!the!projectLs!debt!capacity!to!determine!interest!and!net!borrowing!before!we!can!make!
the!capital!budgeting!decision.!
D)!!The!WACC!and!APV!methods!compute!the!firmLs!enterprise!value,!so!that!a!separate!valuation!of!the!
other!components!of!the!firm’s!capital!structure!is!needed!to!determine!the!value!of!equity.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!Which!of!the!following!is!not!a!step!in!valuation!using!the!flow!to!equity!method?!
A)!!Determine!the!equity!cost!of!capital,!rE.!
B)!!Compute!the!equity!value,!E,!by!discounting!the!free!cash!flow!to!equity!using!the
equity!cost!of!capital.!
C)!!Determine!the!free!cash!flow!to!equity!of!the!investment.!
D)!!Determine!the!before-tax!cost!of!capital,!rU.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
!
5)!!The!Free!Cash!Flow!to!Equity!(FCFE)!for!the!acquisition!in!year!0!is!closest!to:!
A)!!$5!million!
B)!!$100!million!
C)!!-$100!million!
D)!!-$50!million!
Answer:!!!D!
B)!!
C)!!
D)!!FCFE0!=!-100!(cost!of!acquisition)!+!50!(issuance!of!new!debt)!=!-$50!million!
Diff:!1!
Skill:!Analytical!
!
6)!!The!Free!Cash!Flow-to-Equity!(FCFE)!for!the!acquisition!in!year!1!is!closest!to:!
A)!!$4.7!million!
B)!!$6.5!million!
C)!!$8.3!million!
D)!!$6.8!million!
Answer:!!!A!
Explanation:!!! A)!!In!one!year!the!interest!on!the!debt!will!be!6%!×!$50!=!$3!million.!!Because!Rose!maintains!a!
constant!debt-equity!ratio,!the!debt!associated!with!the!acquisition!is!also!expected!to!grow!at!
a!3%!rate,!so!D1!=!D0(1!+!g)!=!$50(1.03)!=!$51.5!million,!therefore!the!net!borrowing!(lending)!
is!$51.5!-!50!=!$1.5!million!
FCFE1!=!FCF!from!project!-!after!tax!interest!payments!+!new!borrowing
FCFE1!=!+5.0!-!(1!-!.40)(3)!+!1.5!=!$4.7!million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Describe!the!key!steps!in!the!flow!to!equity!method!for!valuing!a!levered!investment.!
Answer:!!!The!key!steps!in!the!flow-to-equity!method!for!valuing!a!levered!investment!are!as!follows:
! 1.! Determine!the!free!cash!flow!to!equity!of!the!investment.
! 2.! Determine!the!equity!cost!of!capital,!rE.
! 3.! Compute!the!equity!value,!E,!by!discounting!the!free!cash!flow!to!equity!using!the!equity!cost!
of!capital.!
Diff:!2!
Skill:!Conceptual!
18.5((Project-Based(Costs(of(Capital(
(
A)!!In!the!real!world,!specific!projects!should!differ!only!slightly!from!the!average!investment!made!by!the!
firm.!
B)!!We!can!estimate!rU!for!a!new!project!by!looking!at!single-division!firms!that!have!similar!business!risks.!
C)!!The!projectLs!equity!cost!of!capital!depends!on!its!unlevered!cost!of!capital,!rU,!and!the!debt-equity!ratio!
of!the!incremental!financing!that!will!be!put!in!place!to!support!the!project.!
D)!!Projects!may!vary!in!the!amount!of!leverage!they!will!support–for!example,!acquisitions!of!real!estate!or!
capital!equipment!are!often!highly!levered,!whereas!investments!in!intellectual!property!are!not.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.5!Project-Based!Costs!of!Capital!
Skill:!Conceptual!
!
A)!!For!capital!budgeting!purposes,!the!project’s!financing!is!the!incremental!financing!that!results!if!the!
firm!takes!on!the!project.!
B)!!Projects!with!safer!cash!flows!can!support!more!debt!before!they!increase!the!risk!of!financial!distress!for!
the!firm.!
C)!!If!the!positive!free!cash!flow!from!a!project!will!increase!the!firmLs!cash!holdings,!then!this!growth!in!
cash!is!equivalent!to!a!reduction!in!the!firm’s!leverage.!
D)!!The!incremental!financing!of!a!project!corresponds!directly!to!the!financing!that!is!directly!tied!to!the!
project.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
rwacc!=!rU!-! cdrD
The!term!d!in!this!equation!is!
A)!!the!projectLs!unlevered!cost!of!capital.!
B)!!the!projectLs!dollar!amount!of!debt.!
C)!!the!firmLs!unlevered!cost!of!debt.!
D)!!the!projectLs!debt!to!value!ratio.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
rwacc!=!rU!-! cdrD
The!term!rU!in!this!equation!is!
A)!!the!firmLs!unlevered!cost!of!debt.!
B)!!the!firmLs!cost!of!debt.!
C)!!the!projectLs!unlevered!cost!of!capital.!
D)!!the!projectLs!debt!to!value!ratio.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
The!Aardvark!Corporation!is!considering!launching!a!new!product!and!is!trying!to!determine!an!appropriate!discount!rate!
for!evaluating!this!new!product.!!Aardvark!has!identified!the!following!information!for!three!single!division!firms!that!
offer!products!similar!to!the!one!Aardvark!is!interested!in!launching:
Equity(Cost( Debt(Cost( Debt-to-Value(

Comparable(Firm of(Capital of(Capital Ratio(
Anteater!Enterprises 12.50% 6.50% 50%!
Armadillo!Industries 13% 6.10% 40%!
Antelope!Inc. 14% 7.10% 60%!
!
5)!!The!unlevered!cost!of!capital!for!Anteater!Enterprises!is!closest!to:!
A)!!10.1%!
B)!!9.5%!
C)!!9.9%!
D)!!10.3%!
Answer:!!!B!
B)!! D D
rU!=! 1 rE!+! rD!
D E D E
!
Comparable(Firm of(Capital of(Capital Ratio( rU%
Anteater!Enterprises 12.50% 6.50% 50% 9.50%!
Armadillo!Industries 13% 6.10% 40% 10.30%!
Antelope!Inc. 14% 7.10% 60% 9.90%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!The!unlevered!cost!of!capital!for!Armadillo!Industries!is!closest!to:!
A)!!10.3%!
B)!!10.1%!
C)!!9.5%!
D)!!9.9%!
Answer:!!!A!
Explanation:!!! A)!! D D
rU!=! 1 rE!+! rD!
D E D E
!
Antelope!Inc. 14% 7.10% 60% 9.90%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!The!unlevered!cost!of!capital!for!Antelope!Incorporated!is!closest!to:!
A)!!10.3%!
B)!!9.9%!
C)!!10.1%!
D)!!9.5%!
Answer:!!!B!
B)!! D D
rU!=! 1 rE!+! rD!
D E D E
!
Antelope!Inc. 14% 7.10% 60% 9.90%!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
KT!Enterprises!is!considering!undertaking!a!new!project.!!Based!upon!analysis!of!firms!with!similar!projects,!KT!has!
determined!that!an!unlevered!cost!of!equity!of!12%!is!suitable!for!their!project.!!KTLs!marginal!tax!rate!is!35%,!its!borrowing!
rate!is!7%,!and!KT!does!not!believe!that!its!borrowing!rate!will!change!if!the!new!project!is!accepted.!
!
8)!!If!KT!expects!to!maintain!a!debt!to!equity!ratio!for!this!project!of!1,!then!KTLs!equity!cost!of!capital,!rE,!for!this!
A)!!17.0%!
B)!!5.0%!
C)!!15.0%!
D)!!12%!
Answer:!!!A!
Explanation:!!! A)!! D
rE!=!rU!+! (rU!-!rD)
E
rE!=!.12!+!1(.12!-!.07)!=!.17!or!17%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!If!KT!expects!to!maintain!a!debt!to!equity!ratio!for!this!project!of!.6!!then!KTLs!equity!cost!of!capital,!rE,!for!this!
A)!!5.0%!
B)!!12%!
C)!!15.0%!
D)!!17.0%!
Answer:!!!C!
B)!!
C)!! D
rE!=!rU!+! (rU!-!rD)
E
rE!=!.12!+!.6(.12!-!.07)!=!.15!or!15%!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!If!KT!expects!to!maintain!a!debt!to!equity!ratio!for!this!project!of!.6!!then!KTLs!project!based!WACC,!rwacc,!for!
this!project!is!closest!to:!
A)!!10.5%!
B)!!11.1%!
C)!!9.6%!
D)!!10.8%!
Answer:!!!B!
B)!!rwacc!=!rU!-! crD!!
.6
rwacc!=!.12!-! (.35)(.07)!=!!.1108!or!11.08%!!!!!
1 .6
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!If!KT!expects!to!maintain!a!debt!to!equity!ratio!for!this!project!of!1!then!KTLs!project!based!WACC,!rwacc,!for!
this!project!is!closest!to:!
A)!!11.1%!
B)!!10.8%!
C)!!9.6%!
D)!!10.5%!
Answer:!!!B!
B)!!rwacc!=!rU!-! crD!
1
rwacc!=!.12!-! (.35)(.07)!=!!.107750!or!10.8%!!!!!
1 1
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
The!Aardvark!Corporation!is!considering!launching!a!new!product!and!is!trying!to!determine!an!appropriate!discount!rate!
for!evaluating!this!new!product.!!Aardvark!has!identified!the!following!information!for!three!single!division!firms!that!
offer!products!similar!to!the!one!Aardvark!is!interested!in!launching:

Comparable(Firm of(Capital of(Capital Ratio(
Anteater!Enterprises 12.50% 6.50% 50%!
Armadillo!Industries 13% 6.10% 40%!
Antelope!Inc. 14% 7.10% 60%!
12)!!Based!upon!the!three!comparable!firms,!calculate!that!most!appropriate!unlevered!cost!of!capital!for!
Aardvark!to!use!on!this!new!product.!
Answer:!!! D D
rU!=! 1 rE!+! rD!
D E D E
!
Antelope!Inc. 14% 7.10% 60% 9.90%!
! ! ! average!=! 9.90%!
Diff:!2!
Skill:!Analytical!
!
18.6((APV(and(Other(Leverage(Policies(
(
A)!!Rather!than!set!debt!according!to!a!target!debt-equity!ratio!or!interest!coverage!level,!a!firm!may!adjust!
its!debt!according!to!a!fixed!schedule!that!is!known!in!advance.!
B)!!When!we!relax!the!assumption!of!a!constant!debt-equity!ratio,!the!equity!cost!of!capital!and!WACC!for!a!
project!will!change!over!time!as!the!debt-equity!ratio!changes.!
C)!!When!we!relax!the!assumption!of!a!constant!debt-equity!ratio,!the!APV!and!FTE!methods!are!difficult!to!
implement.!
D)!!If!a!firm!is!using!leverage!to!shield!income!from!corporate!taxes,!then!it!will!adjust!its!debt!level!so!that!
its!interest!expenses!grow!with!its!earnings.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.6!APV!with!Other!Leverage!Policies!
Skill:!Conceptual!
!
A)!!When!we!relax!the!assumption!of!a!constant!debt-equity!ratio,!the!FTE!method!is!relatively!
straightforward!to!use!and!is!therefore!the!preferred!method!with!alternative!leverage!policies.!
B)!!When!debt!levels!are!set!according!to!a!fixed!schedule,!we!can!discount!the!predetermined!interest!tax!
shields!using!the!debt!cost!of!capital,!rD.!
C)!!With!a!constant!interest!coverage!policy,!the!value!of!the!interest!tax!shield!is!proportional!to!the!
projectLs!unlevered!value.!
D)!!When!the!firm!keeps!its!interest!payments!to!a!target!fraction!of!its!FCF,!we!say!it!has!a!constant!interest!
coverage!ratio.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!As!a!general!rule,!the!WACC!method!is!the!easiest!to!use!when!the!firm!will!maintain!a!fixed!
debt-to-value!ratio!over!the!life!of!the!investment.!
B)!!The!FTE!method!is!typically!used!only!in!complicated!settings!for!which!the!values!of!other!securities!in!
the!firm’s!capital!structure!or!the!interest!tax!shield!are!themselves!difficult!to!determine.!
C)!!For!alternative!leverage!policies,!the!FTE!method!is!usually!the!most!straightforward!approach.!
D)!!When!used!consistently,!the!WACC,!APV,!and!FTE!methods!produce!the!same!valuation!for!the!
investment.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Aardvark!Industries!is!considering!a!project!that!will!generate!the!following!free!cash!flows:
Year 0 1 2 3(
Free!Cash!Flows ($200) $100 $80 $60!
You!are!also!provided!with!the!following!market!value!balance!sheet!and!information!regarding!AardvarkLs!cost!of!capital:

c 35%!
4)!!AardvarkLs!unlevered!cost!of!equity!is!closest!to:!
A)!!10.0%!
B)!!10.4%!
C)!!9.5%!
D)!!9.0%!
Answer:!!!A!
Explanation:!!! A)!! D D
rU!=! 1 rE!+! rD
D E D E
400 400
rU!=! 1 .12!+! .07!=!10.0%!
400 600 400 600
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
5)!!The!unlevered!value!of!AardvarkLs!new!project!is!closest!to:!
A)!!$205!
B)!!$100!
C)!!$164!
D)!!$202!
Answer:!!!D!
B)!! D D
rU!=! 1 rE!+! rD
D E D E
400 400
rU!=! 1 .12!+! .07!=!10.0%
400 600 400 600
100 80 60
VU!=! 1
!+! 2
!+! !=!$202.10!
(1.10) (1.10) (1.10)3
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
6)!!Suppose!that!to!fund!this!new!project,!Aardvark!borrows!$120!!with!the!principal!to!be!paid!in!three!equal!
installments!at!the!end!each!year.!!The!present!value!of!AardvarkLs!interest!tax!shield!is!closest!to:!
A)!!$5.15!
B)!!$5.00!
C)!!$5.90!
D)!!$5.25!
Answer:!!!D!
B)!!
C)!!
D)!! Dr Dr Dr
PV(interest!tax!shield)!=! 0 D c1 !+! 1 D c2 !+=! 2 D c3
(1 rD ) (1 rD ) (1 rD )
120(.07)(.35) 80(.07)(.35) 40(.07)(.35)
PV(interest!tax!shield)!=! !+! !+=! !=!$5.2596!
(1.07)1 (1.07) 2 (1.07)3
Diff:!3!
Skill:!Analytical!
!
7)!!Suppose!that!to!fund!this!new!project,!Aardvark!borrows!$120!!with!the!principal!to!be!paid!in!three!equal!
installments!at!the!end!each!year.!!The!levered!value!of!AardvarkLs!new!project!is!closest!to:!
A)!!$210.15!
B)!!$207.35!
C)!!$207.00!
D)!!$210.50!
Answer:!!!B!
B)!! D D
rU!=! 1 rE!+! rD
D E D E
400 400
rU!=! 1 .12!+! .07!=!10.0%
400 600 400 600
100 80 60
VU!=! 1
!+! 2
!+! !=!$202.10
(1.10) (1.10) (1.10)3
D0 rD c D1rD c D2 rD c
PV(interest!tax!shield)!=! 1
!+! 2
!+=!
(1 rD ) (1 rD ) (1 rD )3
120(.07)(.35) 80(.07)(.35) 40(.07)(.35)
!+! 2
!+=! !=!$5.2596
(1.07) (1.07) (1.07)3
VL!=!VU!+!PV(interest!tax!shield)!=!$202.10!+!$5.26!=!$207.36!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!Suppose!that!to!fund!this!new!project,!Aardvark!borrows!$150!with!the!principal!to!be!paid!in!three!equal!
installments!at!the!end!each!year.!!Calculate!the!present!value!of!AardvarkLs!interest!tax!shield.!
Answer:!!! Dr Dr Dr
PV(interest!tax!shield)!=! 0 D c1 !+! 1 D c2 !+=! 2 D c3
(1 rD ) (1 rD ) (1 rD )
150(.07)(.35) 100(.07)(.35) 50(.07)(.35)
!+! 2
!+! !=!$6.286!
(1.07) (1.07) (1.07)3
Diff:!2!
Skill:!Analytical!
!
9)!!Suppose!that!to!fund!this!new!project,!Aardvark!borrows!$150!with!the!principal!to!be!paid!in!three!equal!
installments!at!the!end!each!year.!!Calculate!the!The!levered!value!of!AardvarkLs!new!project.!
Answer:!!! D D
rU!=! 1 rE!+! rD
D E D E
400 400
rU!=! 1 .12!+! .07!=!10.0%
400 600 400 600
100 80 60
VU!=! 1
!+! 2
!+! !=!$202.10
(1.010) (1.010) (1.010)3
D0 rD c D1rD c D2 rD c
!+! 2
!+=! 3
(1 rD ) (1 rD ) (1 rD )
150(.07)(.35) 100(.07)(.35) 50(.07)(.35)
PV(interest!tax!shield)!=! !+! !+! !=!$6.286
(1.07)1 (1.07) 2 (1.07)3
VL!=!VU!+!PV(interest!tax!shield)!=!$202.10!+!$6.29!=!$208.39!
Diff:!3!
Skill:!Analytical!
!
18.7((Other(Effects(of(Financing(
(
A)!!With!perfect!capital!markets,!all!securities!are!fairly!priced!and!issuing!securities!is!a!zero-NPV!
transaction.!
B)!!The!fees!associated!with!the!financing!of!the!project!are!independent!of!the!projectLs!required!cash!flows!
and!should!be!ignored!when!calculating!the!NPV!of!the!project.!
C)!!When!a!firm!borrows!funds,!a!mispricing!scenario!arises!if!the!interest!rate!charged!differs!from!the!rate!
that!is!appropriate!given!the!actual!risk!of!the!loan.!
D)!!The!WACC,!APV,!and!FTE!methods!determine!the!value!of!an!investment!incorporating!the!tax!shields!
associated!with!leverage.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.7!Other!Effects!of!Financing!
Skill:!Conceptual!
!
A)!!Sometimes!management!may!believe!that!the!securities!they!are!issuing!are!priced!at!less!than!(or!more!
than)!their!true!value.!!If!so,!the!NPV!of!the!transaction,!which!is!the!difference!between!the!actual!
money!raised!and!the!true!value!of!the!securities!sold,!should!not!be!included!in!the!value!of!the!project.!
B)!!An!alternative!method!of!incorporating!financial!distress!and!agency!costs!is!to!first!value!the!project!
ignoring!these!costs,!and!then!value!the!incremental!cash!flows!associated!with!financial!distress!and!
agency!problems!separately.!
C)!!When!the!debt!level—and,!therefore,!the!probability!of!financial!distress—is!high,!the!expected!free!cash!
flow!will!be!reduced!by!the!expected!costs!associated!with!financial!distress!and!agency!problems.!
D)!!If!the!financing!of!the!project!involves!an!equity!issue,!and!if!management!believes!that!the!equity!will!
sell!at!a!price!that!is!less!than!its!true!value,!this!mispricing!is!a!cost!of!the!project!for!the!existing!
shareholders.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Luther!Industries!is!considering!borrowing!$500!million!to!fund!a!new!product!line.!!Given!investorsL!
uncertainty!regarding!its!prospects,!Luther!will!pay!a!7%!interest!rate!on!this!loan.!!The!firmLs!management!
knows,!that!the!actual!risk!of!the!loan!is!extremely!low!and!that!the!appropriate!rate!on!the!loan!is!5%.!!
Suppose!the!loan!is!for!four!years,!with!all!principal!being!repaid!in!the!fourth!year.!!If!LutherLs!marginal!
corporate!tax!rate!is!35%,!then!the!net!effect!of!the!loan!on!the!value!of!the!new!product!line!is!closest!to:!
A)!!$22!million!
B)!!$34!million!
C)!!$35!million!
D)!!$24!million!
Answer:!!!D!
B)!!
C)!!
D)!!Luther!Industries!is!paying!(7%!-!5%!=!2%)!more!for!the!loan!than!the!risk!demands.!!
However,!part!of!this!2%!premium!in!the!interest!rate!is!being!offset!by!the!interest!tax!shield.!!
Therefore!the!true!cost!in!any!year!is!the!amount!of!debt!×!(2%)!×!(1!-! c).
Cost!per!year!=!$500M(.02)(.65)!=!$6.5M,!we!need!to!discount!this!amount!each!year!by!the!
correct!rD!of!5%,!!this!is!amount!is!constant!and!occurs!each!year!for!four!years!we!have!an!
annuity,!solving:
PMT!=!6.5
I!=!5%
FV!=!0
N!=!4
Compute!PV!=!$23.04!million!
Diff:!2!
Skill:!Analytical!
18.8((Advanced(Topics(in(Capital(Budgeting(
(
1)!!Consider!the!following!equation!for!the!Project!WACC!with!a!fixed!debt!schedule:
rwacc!=!rU!-! c[rD!+!f(rU!-!rD)]
The!term!d!in!this!equations!represents!
A)!!a!measure!of!the!permanence!of!the!debt!level.!
B)!!the!annual!adjustment!percentage!to!the!amount!of!debt.!
C)!!the!debt-to-value!ratio.!
D)!!the!dollar!amount!of!debt!outstanding.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!18.8!Advanced!Topics!in!Capital!Budgeting!
Skill:!Analytical!
!
2)!!Consider!the!following!equation!for!the!Project!WACC!with!a!fixed!debt!schedule:
rwacc!=!rU!-! c[rD!+!f(rU!-!rD)]!
The!term!f!in!this!equations!represents!
A)!!the!annual!adjustment!percentage!to!the!amount!of!debt.!
B)!!a!measure!of!the!permanence!of!the!debt!level.!
C)!!the!dollar!amount!of!debt!outstanding.!
D)!!the!debt-to-value!ratio.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!18.8!Advanced!Topics!in!Capital!Budgeting!
Skill:!Analytical!
!
!
Chapter(19(-(Valuation(and(Financial(Modeling:(A(Case(Study(
!
!
19.1(Valuation(Using(Comparables(
$
Estimated(2005(Income(Statement(and(Balance(Sheet(Data(for(Ideko(Corporation
Year 2005 Year 2005(
Income(Statement(($(000) Balance(Sheet(($(000)
1!!Sales 75,000 Assets
2!!Cost!of!Goods!Sold 1!!Cash!and!Equivalents 12,664!
3!!!!!Raw!Materials (16,000) 2!!Accounts!Receivable 18,493!
4!!!!!Direct!Labor!Costs (18,000) 3!!Inventories 6,165!
5!(Gross(Profit( 1,000 4!!Total(Current(Assets 37,322!
6!!Sales!and!Marketing (11,250) 5!!Property,!Plant,!and!Equipment 49,500!
7!!Administrative (13,500) 6!!Goodwill ---
8!!EBITDA 16,250 7!!Total(Assets 86,822!
9!!Depreciation (5,500) Liabilities(and(StockholderPs(Equity
10!!EBIT 10,750 8!!Accounts!Payable 4,654!
11!!Interest!Expense!(net) (75) 9!!Debt 4,500!
12!!Pretax(Income 10,675 10!!Total(Liabilities 9,154!
13!!Income!Tax (3,736) 11!!Stockholder’’s(Equity 77,668!
14!!Net(Income 6,939 12!!Total(Liabilities(and(Equity 86,822!
!
The!following!are!financial!ratios!for!three!comparable!companies:
Ratio Oakley,(Inc. Luxottica(Group Nike,(Inc.(
P/E 24.8x 28x 18.2x!
EV/Sales 2x 2.7x 1.5x!
EV/EBITDA 11.6x 14.4x 9.3x!
EBITDA/Sales 17.0% 18.5% 15.9!
!
1)!!Based!upon!the!average!P/E!ratio!of!the!comparable!firms,!IdekoYs!target!market!value!of!equity!is!closest!to:!
A)!!$157!million!
B)!!$155!million!
C)!!$193!million!
D)!!$165!million!
E)!!$191!million!
Answer:!!!D!
B)!!
C)!!
D)!! 24.8 28.0 18.2
Average!P/E!=! !=!23.67
3
Price!=!earnings!×!P/E!=!6.939!×!23.67!=!$164.22!million!
E)!!
Diff:!1!
Topic:!19.1!Valuation!Using!Comparables!
Skill:!Analytical!
2)!!Based!upon!the!average!EV/Sales!ratio!of!the!comparable!firms,!IdekoYs!target!economic!value!is!closest!to:!
A)!!$191!million!
B)!!$155!million!
C)!!$165!million!
D)!!$157!million!
E)!!$193!million!
Answer:!!!B!
B)!! 2.0 2.7 1.5
Average!EV$/!Sales!=! !=!2.07
3
EV!=!EV$/!Sales!x!Sales!=!2.07!×!$75!million!=!$155.25!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Analytical!
!
3)!!Based!upon!the!average!EV/Sales!ratio!of!the!comparable!firms,!if!Ideko!holds!$6.5!million!of!cash!in!excess!of!
its!working!capital!needs,!then!IdekoYs!target!market!value!of!equity!is!closest!to:!
A)!!$165!million!
B)!!$157!million!
C)!!$193!million!
D)!!$191!million!
E)!!$155!million!
Answer:!!!B!
B)!! 2.0 2.7 1.5
Average!EV$/!Sales!=! !=!2.07
3
EV!=!EV$/!Sales!+!Sales!=!2.07!×!$75!million!=!$155.25
EV!=!Equity!+!Debt!-!Cash!in!excess!of!NWC!needs
Equity!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$155.25!-!$4.5!+!$6.5!=!$157.25!million!
C)!!
D)!!
E)!!
Diff:!2!
Skill:!Analytical!
!
4)!!Based!upon!the!average!EV/EBITDA!ratio!of!the!comparable!firms,!IdekoYs!target!economic!value!is!closest!to:!
A)!!$191!million!
B)!!$155!million!
C)!!$157!million!
D)!!$193!million!
E)!!$165!million!
Answer:!!!A!
Explanation:!!! A)!! 11.6 14.4 9.3
Average!EV$/!EBITDA$=! !=!11.77
3
EV!=!EV$/!EBITDA!×!EBITDA!=!11.77!×!$16.25!million!=!$191.26!million!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Analytical!
!
5)!!Based!upon!the!average!EV/EBITDA!ratio!of!the!comparable!firms,!if!Ideko!holds!$6.5!million!of!cash!in!excess!
of!its!working!capital!needs,!then!IdekoYs!target!market!value!of!equity!is!closest!to:!
A)!!$155!million!
B)!!$157!million!
C)!!$165!million!
D)!!$191!million!
E)!!$193!million!
Answer:!!!E!
B)!!
C)!!
D)!!
E)!! 11.6 14.4 9.3
Average!EV$/!EBITDA$=! !=!11.77
3
EV!=!EV$/!EBITDA!×!EBITDA!=!11.77!×!$16.25!million!=!$191.26!million
EV!=!Equity!+!Debt!-!Cash!in!excess!of!NWC!needs
Equity!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$191.26!-!$4.5!+!$6.5!=!$193.26!million!
Diff:!2!
Skill:!Analytical!
!
6)!!What!range!for!the!market!value!of!equity!for!Ideko!is!implied!by!the!range!of!P/E!multiples!for!the!
comparable!firms?!
Answer:!!!Low!P/E!(Nike)!=!18.2!
Low!Price!=!earnings!×!P/E!=!6.939!×!18.2!=!$126.29!million
High!P/E!(Luxottica!Group)!=!28.0
High!Price!=!earnings!×!P/E!=!6.939!×!28.0!=!$194.29!million!
Diff:!2!
Skill:!Analytical!
!
7)!!What!range!for!the!market!value!of!equity!for!Ideko!is!implied!by!the!range!of!EV/Sales!multiples!for!the!
comparable!firms!if!Ideko!holds!$6.5!million!of!cash!in!excess!of!its!working!capital!needs?!
Answer:!!!Low!EV/Sales!(Nike)!=!1.5
Low!EV!=!Sales!×!EV/Sales!=!$75!million!x!1.5!=!$112.50!million
Low!EV!=!Equity!+!Debt!-!Cash!in!excess!of!NWC!needs
Low!Equity!Price!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$112.50!-!$4.5!+!$6.5!=!$114.50!million
High!EV/Sales!(Luxottica)!=!2.7
High!EV!=!Sales!×!EV/Sales!=!$75!million!x!2.7!=!$202.50!million
High!EV!=!Equity!+!Debt!-!Cash!in!excess!of!NWC!needs
High!Equity!Price!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$202.50!-!$4.5!+!$6.5!=!$204.50!million!
Diff:!3!
Skill:!Analytical!
!
8)!!What!range!for!the!market!value!of!equity!for!Ideko!is!implied!by!the!range!of!EV/EBITDA!multiples!for!the!
comparable!firms!if!Ideko!holds!$6.5!million!of!cash!in!excess!of!its!working!capital!needs?!
Answer:!!!Low!EV/EBITDA!(Nike)!=!9.3
Low!EV!=!EBITDA!×!EV/EBITDA!=!$16.25!million!×!9.3!=!$151.13!million
Low!EV!=!Equity!+!Debt!!-!Cash!in!excess!of!NWC!needs
Low!Equity!Price!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$151.13!-!$4.5!+!$6.5!=!$153.13!million
High!EV/EBITDA!(Luxottica)!=!14.4
High!EV!=!EBITDA!×!EV/EBITDA!=!$16.25!million!×!14.4!=!$234.00!million
High!EV!=!Equity!+!Debt!-!Cash!in!excess!of!NWC!needs
High!Equity!Price!=!EV!-!Debt!+!cash!in!excess!of!NWC!needs!=!$234.00!-!$4.5!+!$6.5!=!$236.00!million!
Diff:!3!
Skill:!Analytical!
19.2((The(Business(Plan(
(
Use$the$table$for$the$question(s)$below.$
$
Ideko(Sales(and(Operating(Cost(Assumptions$
Year( 2005( 2006( 2007( 2008( 2009( 2010(
Sales Data Growth/Year
1!!Market!Size!(000!units)! 5.0%! ! 10,000! 10,500! 11,025! 11,576! 12,155! 12,763!
2!!Market!Share! 1.0%! ! 10.0%! 11.0%! 12.0%! 13.0%! 14.0%! 15.0%!
3!!Average!Sales!Price!
($/unit)! 2.0%! ! 75.00! 76.50! 78.03! 79.59! 81.18! 82.81!
Cost(of(Goods(Data( ( ( ( ( ( ( ( (
4!!Raw!Materials!($/unit)! 1.0%! ! 16.00! 16.16! 16.32! 16.48! 16.65! 16.82!
5!!Direct!Labor!Costs!($/unit)! 4.0%! ! 18.00! 18.72! 19.47! 20.25! 21.06! 21.90!
Operating(Expense((
and(Tax(Data( ( ( ( ( ( ( ( (
6!!Sales!and!Marketing!!
(%!sales)! ! ! 15.0%! 16.5%! 18.0%! 19.5%! 20.0%! 20.0%!
7!!Administrative!(%!sales)! ! ! 18.0%! 15.0%! 15.0%! 14.0%! 13.0%! 13.0%!
8!!Tax!Rate! ! ! 35.0%! 35.0%! 35.0%! 35.0%! 35.0%! 35.0%!
!
1)!!Based!upon!IdekoYs!Sales!and!Operating!Cost!Assumptions,!what!production!capacity!will!Ideko!require!in!
2007?!
A)!!1,505!units!
B)!!1,323!units!
C)!!1,914!units!
D)!!1,115!units!
E)!!1,702!units!
Answer:!!!B!
B)!!Production!volume!each!year!can!be!estimated!by!multiplying!the!total!market!size!and!
Ideko’s!market!share!from!the!table!above:
Year 2005 2006 2007 2008 2009 2010(
Production Volume
(000 units)
1!!Market!Size 10,000 10,500 11,025 11,576 12,155 12,763!
2!!Market!Share 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%!
3!!Production!Volume!
(1!×!2) 1,000 1,155 1,323 1,505 1,702 1,914!
C)!!
D)!!
E)!!
Diff:!1!
Topic:!19.2!The!Business!Plan!
Skill:!Analytical!
!
2008?!
A)!!1,702!units!
B)!!1,323!units!
C)!!1,505!units!
D)!!1,914!units!
E)!!1,115!units!
Answer:!!!C!
B)!!
C)!!Production!volume!each!year!can!be!estimated!by!multiplying!the!total!market!size!and!
IdekoYs!market!share!from!the!table!above::!
Year 2005 2006 2007 2008 2009 2010(
Production Volume
(000 units)
1!!Market!Size 10,000 10,500 11,025 11,576 12,155 12,763!
2!!Market!Share 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%!
(1!×!2) 1,000 1,155 1,323 1,505 1,702 1,914!
D)!!
E)!!
Diff:!1!
Skill:!Analytical!
!
2009?!
A)!!1,505!units!
B)!!1,115!units!
C)!!1,323!units!
D)!!1,702!units!
E)!!1,914!units!
Answer:!!!D!
B)!!
C)!!
D)!!Production!volume!each!year!can!be!estimated!by!multiplying!the!total!market!size!and!
Ideko’s!market!share!from!the!table!above:(
Year 2005 2006 2007 2008 2009 2010(
Production Volume
(000 units)
1!!Market!Size 10,000 10,500 11,025 11,576 12,155 12,763!
2!!Market!Share 10.0% 11.0% 12.0% 13.0% 14.0% 15.0%!
(1!×!2) 1,000 1,155 1,323 1,505 1,702 1,914!
E)!!
Diff:!1!
Skill:!Analytical!
!
$
Estimated(2005(Income(Statement(and(Balance(Sheet(Data(for(Ideko(Corporation
Year 2005 Year 2005(
Income(Statement(($(000) Balance(Sheet(($(000)
1!!Sales 75,000 Assets
2!!Cost!of!Goods!Sold 1!!Cash!and!Equivalents 12,664!
3!!!!!Raw!Materials (16,000) 2!!Accounts!Receivable 18,493!
4!!!!!Direct!Labor!Costs (18,000) 3!!Inventories 6,165!
5!(Gross(Profit( 1,000 4!!Total(Current(Assets 37,322!
6!!Sales!and!Marketing (11,250) 5!!Property,!Plant,!and!Equipment 49,500!
7!!Administrative (13,500) 6!!Goodwill ---
8!!EBITDA 16,250 7!!Total(Assets 86,822!
9!!Depreciation (5,500) Liabilities(and(StockholderPs(Equity
10!!EBIT 10,750 8!!Accounts!Payable 4,654!
11!!Interest!Expense!(net) (75) 9!!Debt 4,500!
12!!Pretax(Income 10,675 10!!Total(Liabilities 9,154!
13!!Income!Tax (3,736) 11!!Stockholder’’s(Equity 77,668!
14!!Net(Income 6,939 12!!Total(Liabilities(and(Equity 86,822!
!
4)!!IdekoYs!Accounts!Receivable!Days!is!closest!to:!
A)!!84!days!
B)!!95!days!
C)!!90!days!
D)!!75!days!
Answer:!!!C!
B)!!
C)!! 18, 493
Accounts!Receivable!Days!=! !×!365!=!90!days!
75, 000
D)!!
Diff:!1!
Skill:!Analytical!
19.3((Building(the(Financial(Model(
Pro!Forma!Income!Statement!for!Ideko,!2005-2010
Year( 2005( 2006( 2007( 2008( 2009( 2010(
Income Statement ($ 000)
1!!Sales( ( 75,000! 88,358! 103,234! 119,777! 138,149! 158,526!
2!!Cost!of!Goods!Sold! ! ! ! ! ! ! !
3!!Raw!Materials! !(16,000)! (18,665)! (21,593)! (24,808)! (28,333)! (32,193)!
4!!Direct!Labor!Costs! !(18,000)! (21,622)! (25,757)! (30,471)! (35,834)! (41,925)!
5((Gross(Profit( ( 41,000! 48,071! 55,883! 64,498! 73,982! 84,407!
6!!Sales!and!Marketing! !(11,250)! (14,579)! (18,582)! (23,356)! (27,630)! (31,705)!
7!!Administrative! !(13,500)! (13,254)! (15,485)! (16,769)! (17,959)! (20,608)!
8((EBITDA( ( 16,250! 20,238! 21,816! 24,373! 28,393! 32,094!
9!!Depreciation! ! (5,500)! (5,450)! (5,405)! (6,865)! (7,678)! (7,710)!
10((EBIT( ( 10,750! 14,788! 16,411! 17,508! 20,715! 24,383!
11!!Interest!Expense!(net)! ! (75)! (6,800)! (6,800)! (6,800)! (7,820)! (8,160)!
12((Pretax(Income( ( 10,675! 7,988! 9,611! 10,708! 12,895! 16,223!
13!!Income!Tax! ! (3,736)! (2,796)! (3,364)! (3,748)! (4,513)! (5,678)!
14((Net(Income( ( 6,939( 5,193( 6,247( 6,960( 8,382( 10,545(
!
1)!!With!the!proper!changes!it!is!believed!that!IdekoYs!credit!policies!will!allow!for!an!account!receivables!days!of!
60.!!The!forecasted!accounts!receivable!for!Ideko!in!2006!is!closest!to:!
A)!!$19,690!
B)!!$16,970!
C)!!22,710!
D)!!$14,525!
Answer:!!!D!
B)!!
C)!!
D)!! annual sales
Accounts!receivable!=!60!days!×! !
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Working Capital ($ 000)
Assets
1!!Accounts!Receivable! ! 18,493! 14,525! 16,970! 19,689! 22,709! 26,059!
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
4!!Minimum!Cash!Balance! ! 6,164! 7,262! 8,485! 9,845! 11,355! 13,030!
5!!Total!Current!Assets! ! 30,822! 28,288! 33,067! 38,388! 44,304! 50,872!
Liabilities( ( ( ( ( ( ( (
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
8!!Total!Current!Liabilities! ! 4,654! 5,532! 6,648! 7,879! 9,110! 10,448!
Net(Working(Capital( ( ( ( ( ( ( (
9!!Net!Working!!
Capital!(5(-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
10!!Increase!in!Net!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
Diff:!2!
Topic:!19.3!Building!the!Financial!Model!
Skill:!Analytical!
!
A)!!$14,525!
B)!!$16,970!
C)!!22,710!
D)!!$19,690!
Answer:!!!B!
B)!! annual sales
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5(-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$14,525!
B)!!$19,690!
C)!!22,710!
D)!!$16,970!
Answer:!!!B!
B)!! annual sales
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!The!amount!of!net!working!capital!for!Ideko!in!2006!is!closest!to:!
A)!!$22,750!
B)!!$35,195!
C)!!$30,510!
D)!!$26,420!
Answer:!!!A!
Explanation:!!! A)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
NWC!=!CA!-!CL!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$30,510!
B)!!$26,420!
C)!!$22,170!
D)!!$35,195!
Answer:!!!B!
B)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$35,195!
B)!!$26,420!
C)!!$22,170!
D)!!$30,510!
Answer:!!!D!
B)!!
C)!!
D)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
Diff:!2!
Skill:!Analytical!
!
7)!!The!amount!of!the!increase!in!net!working!capital!for!Ideko!in!2007!is!closest!to:!
A)!!$4,090!
B)!!$4,685!
C)!!$3,665!
D)!!$5,230!
Answer:!!!C!
B)!!
C)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
Increase!in!NWC!=!NWCt!-!NWCt$-!1!
D)!!
Diff:!3!
Skill:!Analytical!
!
A)!!$4,685!
B)!!$3,665!
C)!!$4,090!
D)!!$5,230!
Answer:!!!C!
B)!!
C)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
D)!!
Diff:!3!
Skill:!Analytical!
!
9)!!Using!the!income!statement!above!and!the!following!information:!
!
Year( 2006(( 2007(( 2008(( 2009(( 2010((
Increases!in!NWC! 2,250!! 3,000!! 3,250!! 3,600!! 4,000!!
Capital!Expenditures! 5,000!! 5,000!! 20,000!! 15,000!! 8,000!!
Net!Borrowing! 0!! 0!! 15,000!! 5,000!! 0!!
!
Calculate!IdekoYs!Free!Cash!Flow!to!the!Firm!and!Free!Cash!Flow!to!Equity!in!2007.!
Answer:!!!Year( 2006(( 2007(( 2008(( 2009(( 2010((
Net!Income! 5,193!! 6,247!! 6,960!! 8,382!! 10,545!!
Plus:!After!Tax-Interest!Expense! 4,420!! 4,420!! 4,420!! 5,083!! 5,304!!
Unlevered!Net!Income! 9,613!! 10,667!! 11,380!! 13,465!! 15,849!!
Plus:!Depreciation! 5,450!! 5,405!! 6,865!! 7,678!! 7,710!!
Less:!Increases!in!NWC! (2,250)! (3,000)! (3,250)! (3,600)! (4,000)!
Less:!Capital!Expenditures! (5,000)! (5,000)! (20,000)! (15,000)! (8,000)!
Free!Cash!Flow!of!Firm! 7,813!! 8,072!! (5,005)! 2,543!! 11,559!!
Plus:!Net!Borrowing! 0!! 0!! 15,000!! 5,000!! 0!!
Less:!After-Tax!Interest!Expense! (4,420)! (4,420)! (4,420)! (5,083)! (5,304)!
Free!Cash!Flow!to!Equity! 3,393!! 3,652!! 5,575!! 2,460!! 6,255!!
!
After!Tax!interest!expense!is!=!interest!expense(1!-! c)!! c!is!35%!and!can!be!computed!from!the!income!
statement.!
Diff:!3!
Skill:!Analytical!
!
!
Year( 2006(( 2007(( 2008(( 2009(( 2010((
Increases!in!NWC! 2,250!! 3,000!! 3,250!! 3,600!! 4,000!!
Net!Borrowing! 0!! 0!! 15,000!! 5,000!! 0!!
!
Answer:!!!Year( 2006(( 2007(( 2008(( 2009(( 2010((
Net!Income! 5,193!! 6,247!! 6,960!! 8,382!! 10,545!!
!
statement.!
Diff:!3!
Skill:!Analytical!
19.3((Building(the(Financial(Model(
Pro!Forma!Income!Statement!for!Ideko,!2005-2010
Year( 2005( 2006( 2007( 2008( 2009( 2010(
1!!Sales( ( 75,000! 88,358! 103,234! 119,777! 138,149! 158,526!
3!!Raw!Materials! !(16,000)! (18,665)! (21,593)! (24,808)! (28,333)! (32,193)!
5((Gross(Profit( ( 41,000! 48,071! 55,883! 64,498! 73,982! 84,407!
7!!Administrative! !(13,500)! (13,254)! (15,485)! (16,769)! (17,959)! (20,608)!
8((EBITDA( ( 16,250! 20,238! 21,816! 24,373! 28,393! 32,094!
9!!Depreciation! ! (5,500)! (5,450)! (5,405)! (6,865)! (7,678)! (7,710)!
10((EBIT( ( 10,750! 14,788! 16,411! 17,508! 20,715! 24,383!
12((Pretax(Income( ( 10,675! 7,988! 9,611! 10,708! 12,895! 16,223!
13!!Income!Tax! ! (3,736)! (2,796)! (3,364)! (3,748)! (4,513)! (5,678)!
14((Net(Income( ( 6,939( 5,193( 6,247( 6,960( 8,382( 10,545(
!
A)!!$19,690!
B)!!$16,970!
C)!!22,710!
D)!!$14,525!
Answer:!!!D!
B)!!
C)!!
D)!! annual sales
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5(-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
Diff:!2!
Skill:!Analytical!
!
A)!!$14,525!
B)!!$16,970!
C)!!22,710!
D)!!$19,690!
Answer:!!!B!
B)!! annual sales
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5(-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$14,525!
B)!!$19,690!
C)!!22,710!
D)!!$16,970!
Answer:!!!B!
B)!! annual sales
365 days/year
Year 2005 2006 2007 2008 2009 2010(

Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$22,750!
B)!!$35,195!
C)!!$30,510!
D)!!$26,420!
Answer:!!!A!
Explanation:!!! A)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
NWC!=!CA!-!CL!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$30,510!
B)!!$26,420!
C)!!$22,170!
D)!!$35,195!
Answer:!!!B!
B)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
A)!!$35,195!
B)!!$26,420!
C)!!$22,170!
D)!!$30,510!
Answer:!!!D!
B)!!
C)!!
D)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
Diff:!2!
Skill:!Analytical!
!
A)!!$4,090!
B)!!$4,685!
C)!!$3,665!
D)!!$5,230!
Answer:!!!C!
B)!!
C)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
D)!!
Diff:!3!
Skill:!Analytical!
!
A)!!$4,685!
B)!!$3,665!
C)!!$4,090!
D)!!$5,230!
Answer:!!!C!
B)!!
C)!! Year 2005 2006 2007 2008 2009 2010(
Assets
2!!Raw!Materials! ! 1,973! 1,534! 1,775! 2,039! 2,329! 2,646!
3!!Finished!Goods! ! 4,192! 4,967! 5,838! 6,815! 7,911! 9,138!
6!!Wages!Payable! ! 1,294! 1,433! 1,695! 1,941! 2,211! 2,570!
7!!Other!Accounts!
Payable! ! 3,360! 4,099! 4,953! 5,938! 6,900! 7,878!
9!!Net!Working!!
Capital!(5-8)( ( 26,168! 22,756! 26,419! 30,509! 35,194! 40,425!
Working!Capital! ! ! (3,412)! 3,663! 4,089! 4,685! 5,231!
!
D)!!
Diff:!3!
Skill:!Analytical!
!
!
Year( 2006(( 2007(( 2008(( 2009(( 2010((
Increases!in!NWC! 2,250!! 3,000!! 3,250!! 3,600!! 4,000!!
Net!Borrowing! 0!! 0!! 15,000!! 5,000!! 0!!
!
Answer:!!!Year( 2006(( 2007(( 2008(( 2009(( 2010((
Net!Income! 5,193!! 6,247!! 6,960!! 8,382!! 10,545!!
!
statement.!
Diff:!3!
Skill:!Analytical!
!
!
Year( 2006(( 2007(( 2008(( 2009(( 2010((
Increases!in!NWC! 2,250!! 3,000!! 3,250!! 3,600!! 4,000!!
Net!Borrowing! 0!! 0!! 15,000!! 5,000!! 0!!
!
Answer:!!!Year( 2006(( 2007(( 2008(( 2009(( 2010((
Net!Income! 5,193!! 6,247!! 6,960!! 8,382!! 10,545!!
!
statement.!
Diff:!3!
Skill:!Analytical!
19.4((Estimating(the(Cost(of(Capital(
(
!
Capital!Structure!and!Unlevered!Beta!Estimates!for!Comparable!Firms!
(
Firm ! ! E! D( U!
Oakley! 1.00! 0.00! 1.50! ---! 1.50!
Luxottica! 0.83! 0.17! 0.75! 0! 0.62!
Nike! 1.05! -0.05! 0.60! 0! 0.63!
1)!!The!unlevered!beta!for!Oakley!is!closest!to:!
A)!!0.70!
B)!!1.50!
C)!!1.00!
D)!!0.60!
Answer:!!!B!
B)!! Equity Value Net Debt Value
U!=! E!+! D!=!1.00(1.50)!+!0(0)!=!1.50!
Enterprise Value Enterprise Value
C)!!
D)!!
Diff:!1!
Topic:!19.4!Estimating!the!Cost!of!Capital!
Skill:!Analytical!
!
2)!!If!the!risk-free!rate!of!interest!is!6%!and!the!market!risk!premium!has!historically!averaged!5%,!then!the!cost!of!
capital!for!Oakley!is!closest!to:!
A)!!13.5%!
B)!!10.2%!
C)!!9.1%!
D)!!14.7%!
Answer:!!!A!
B)!!
C)!! Equity Value Net Debt Value
U!=! E!+! D!=!1.00(1.50)!+!0(0)!=!1.50!
rwacc$=$rf$+$$ U(rM$-$rf)!
rOakley!=!.06!+!1.50(.05)!=!.135!or!13.5%!
D)!!
Diff:!2!
Skill:!Analytical!
!
3)!!The!unlevered!beta!for!Luxottica!is!closest!to:!
A)!!1.00!
B)!!0.60!
C)!!0.70!
D)!!1.50!
Answer:!!!B!
B)!! Equity Value Net Debt Value
U!=! E!+! D!=!0.83(0.75)!+!0.17(0)!=!0.62!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
capital!for!Luxottica!is!closest!to:!
A)!!10.2%!
B)!!13.5%!
C)!!9.1%!
D)!!14.7%!
Answer:!!!C!
B)!!
U!=! E!+! D!=!0.83(0.75)!+!0.17(0)!=!0.62!
rLuxottica!=!.06!+!!.62(.05)!=!.091!or!9.1%!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!The!unlevered!beta!for!Nike!is!closest!to:!
A)!!0.70!
B)!!1.00!
C)!!1.50!
D)!!0.60!
Answer:!!!D!
B)!!
C)!!
D)!! Equity Value Net Debt Value
U!=! E!+! D!=!1.05(0.60)!+!-0.05(0)!=!0.63!
Diff:!2!
Skill:!Analytical!
!
capital!for!Nike!is!closest!to:!
A)!!14.7%!
B)!!10.2%!
C)!!9.1%!
D)!!13.5%!
Answer:!!!C!
B)!!
U!=! E!+! D!=!1.05(0.60)!+!-0.05(0)!=!0.63!
rLuxottica!=!.06!+!!.63(.05)!=!.0915!or!9.15%!
D)!!
Diff:!2!
Skill:!Analytical!
19.5((Valuing(the(Investment(
(
Use$the$tables$for$the$question(s)$below.$
$
Pro(Forma(Income(Statement(for(Ideko,(2005-2010
Year( 2005( 2006( 2007( 2008( 2009( 2010(
1!!Sales( ( 75,000! 88,358! 103,234! 119,777! 138,149! 158,526!
3!!Raw!Materials! !(16,000)! (18,665)! (21,593)! (24,808)! (28,333)! (32,193)!
5((Gross(Profit( ( 41,000! 48,071! 55,883! 64,498! 73,982! 84,407!
7!!Administrative! !(13,500)! (13,254)! (15,485)! (16,769)! (17,959)! (20,608)!
8((EBITDA( ( 16,250! 20,238! 21,816! 24,373! 28,393! 32,094!
9!!Depreciation! ! (5,500)! (5,450)! (5,405)! (6,865)! (7,678)! (7,710)!
10((EBIT( ( 10,750! 14,788! 16,411! 17,508! 20,715! 24,383!
12((Pretax(Income( ( 10,675! 7,988! 9,611! 10,708! 12,895! 16,223!
13!!Income!Tax! ! (3,736)! (2,796)! (3,364)! (3,748)! (4,513)! (5,678)!
14((Net(Income( ( 6,939( 5,193( 6,247( 6,960( 8,382( 10,545(
$
Pro(Forma(Balance(Sheet(for(Ideko,(2005-2010
Year 2005 2006 2007 2008 2009 2010(
Balance Sheet ($ 000)
Assets
1!!Cash!and!Cash!Equivalents 6,164 7,262 8,485 9,845 11,355 13,030!
2!!Accounts!Receivable 18,493 14,525 16,970 19,689 22,709 26,059!
3!!Inventories 6,165 6,501 7,613 8,854 10,240 11,784!
4((Total(Current(Assets 30,822 28,288 33,067 38,388 44,304 50,872!
5!!Property,!Plant,!and!Equipment 49,500 49,050 48,645 61,781 69,102 69,392!
6!!Goodwill 72,332 72,332 72,332 72,332 72,332 72,332!
7((Total(Assets 152,654 149,670 154,044 172,501 185,738 192,597!
Liabilities
8!!Accounts!Payable 4,654 5,532 6,648 7,879 9,110 10,448!
9!!Debt 100,000 100,000 100,000 115,000 120,000 120,000!
10((Total(Liabilities 104,654 105,532 106,648 122,879 129,110 130,448!
Stockholder’s(Equity
11!!Starting!Stockholder’s!Equity 48,000 44,138 47,396 49,621 56,628!
12!!Net!Income 5,193 6,247 6,960 8,382 10,545!
13!!Dividends (2,000) (9,055) (2,989) (4,735) (1,375) (5,024)!
14!!Capital!Contributions 50,000 --- --- --- --- ---
15((Stockholder’s(Equity! ! 48,000! 44,138! 47,396! 49,621! 56,628! 62,149!
16((Total(Liabilities(and(Equity( ( 152,654! 149,670! 154,044! 172,501! 185,738! 192,597!
!
1)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!8.5,!then!the!continuation!enterprise!value!of!Ideko!in!2010!is!
closest!to:!
A)!!$152.8!million!
B)!!$272.8!million!
C)!!$301.7!million!
D)!!$181.7!million!
Answer:!!!B!
B)!!Continuation!Enterprise!Value!=!EBITDA!×!EBITDA!Multiple!=!32.094!×!8.5!=!$272.8!million!
C)!!
D)!!
Diff:!1!
Topic:!19.5!Valuing!the!Investment!
Skill:!Analytical!
!
2)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!8.5,!then!the!continuation!equity!value!of!Ideko!in!2010!is!
closest!to:!
A)!!$181.7!million!
B)!!$272.8!million!
C)!!$152.8!million!
D)!!$301.7!million!
Answer:!!!C!
B)!!
C)!!Continuation!Enterprise!Value!=!EBITDA!×!EBITDA!Multiple!=!32.094!×!8.5!=!$272.8!million
Continuation!equity!value!=!continuation!enterprise!value!-!debt!=!$272.8!-!$120!=!$152.8!
million!
D)!!
Diff:!2!
Skill:!Analytical!
!
3)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!9.4,!then!the!continuation!enterprise!value!of!Ideko!in!2010!is!
closest!to:!
A)!!$181.7!million!
B)!!$152.8!million!
C)!!$272.8!million!
D)!!$301.7!million!
Answer:!!!D!
B)!!
C)!!
D)!!Continuation!Enterprise!Value!=!!EBITDA!×!EBITDA!Multiple!=!32.094!×!9.4!=!$301.7!million!
Diff:!1!
Skill:!Analytical!
!
4)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!9.4,!then!the!continuation!equity!value!of!Ideko!in!2010!is!
closest!to:!
A)!!$152.8!million!
B)!!$181.7!million!
C)!!$301.7!million!
D)!!$272.8!million!
Answer:!!!B!
B)!!Continuation!Enterprise!Value!=!EBITDA!x!EBITDA!Multiple!=!32.094!×!9.4!=!$301.7!million
million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!8.5,!then!the!continuation!EV/Sales!ratio!of!Ideko!in!2010!is!
closest!to:!
A)!!1.7!
B)!!1.9!
C)!!1.6!
D)!!1.8!
Answer:!!!A!
Explanation:!!! A)!!Continuation!Enterprise!Value!=!EBITDA!×!EBITDA!Multiple!=!32.094!×!8.5!=!$272.8!million
$272.8
EV/Sales!=! !=!1.72!
$158.526
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!9.4,!then!the!continuation!EV/Sales!ratio!of!Ideko!in!2010!is!
closest!to:!
A)!!1.9!
B)!!1.7!
C)!!1.6!
D)!!1.8!
Answer:!!!A!
$301.7
EV/Sales!=! !=!1.90!
$158.526
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!8.5,!then!the!continuation!unlevered!P/E!ratio!of!Ideko!in!2010!
is!closest!to:!
A)!!17.6!
B)!!16.4!
C)!!14.5!
D)!!19.0!
Answer:!!!A!
$272.8
P/E!=! !=!17.55!
$15.545
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!9.4,!then!the!continuation!unlevered!P/E!ratio!of!Ideko!in!2010!
is!closest!to:!
A)!!17.2!
B)!!16.4!
C)!!14.5!
D)!!19.4!
Answer:!!!D!
B)!!
C)!!
D)!!Continuation!Enterprise!Value!=!EBITDA!×!EBITDA!Multiple!=!32.094!×!9.4!=!$301.7!million
$301.7
P/E!=! !=!19.36!
$15.585
Diff:!2!
Skill:!Analytical!
!
9)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!8.5,!then!the!continuation!levered!P/E!ratio!of!Ideko!in!2010!is!
closest!to:!
A)!!19.0!
B)!!17.2!
C)!!16.4!
D)!!14.5!
Answer:!!!D!
B)!!
C)!!
D)!!Continuation!Enterprise!Value!=!EBITDA!×!EBITDA!Multiple!=!32.094!×!8.5!=!$272.8!million
million
$152.8
P/E!=! !=!14.50!
$10.545
Diff:!2!
Skill:!Analytical!
10)!!Assuming!that!Ideko!has!a!EBITDA!multiple!of!9.4,!then!the!continuation!levered!P/E!ratio!of!Ideko!in!2010!is!
closest!to:!
A)!!17.2!
B)!!14.5!
C)!!19.0!
D)!!16.4!
Answer:!!!A!
million
$181.7
P/E!=! !=!17.2!
$10.545
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
19.6((Sensitivity(Analysis(
(
1)!!What!is!the!purpose!of!the!sensitivity!analysis?!
Answer:!!!Any!financial!valuation!is!only!as!accurate!as!the!estimates!on!which!it!is!based.!Before!concluding!our!
analysis,!it!is!important!to!assess!the!uncertainty!of!our!estimates!and!to!determine!their!potential!
impact!on!the!value!of!the!deal.!!Once!we!have!developed!the!spreadsheet!model!it!is!straightforward!
to!perform!a!sensitivity!analysis!to!determine!the!impact!of!changes!in!different!parameters!on!the!
deal’s!value.!
Diff:!2!
Topic:!19.6!Sensitivity!Analysis!
Skill:!Conceptual!
!
Chapter(20(-(Financial(Options(
!
!
20.1(Options(Basics(
(
A)!!A!call!option(gives!the!owner!the!right!to!buy!the!asset.!
B)!!A!put!option(gives!the!owner!the!right!to!sell!the!asset.!
C)!!A!financial!option(contract!gives!the!writer!the!right!(but!not!the!obligation)!to!purchase!or!sell!an!asset!
at!a!fixed!price!at!some!future!date.!
D)!!A!stock!option!gives!the!holder!the!option!to!buy!or!sell!a!share!of!stock!on!or!before!a!given!date!for!a!
given!price.!
Answer:!!!C!
B)!!
C)!!A!financial!option(contract!gives!the!owner!the!right!(but!not!the!obligation)!to!purchase!or!
sell!an!asset!at!a!fixed!price!at!some!future!date.!
D)!!
Diff:!1!
Topic:!20.1!Options!Basics!
Skill:!Conceptual!
!
A)!!When!a!holder!of!an!option!enforces!the!agreement!and!buys!or!sells!a!share!of!stock!at!the!agreed-upon!
price,!he!is!exercising(the!option.!
B)!!There!are!two!kinds!of!options.!European!options!allow!their!holders!to!exercise!the!option!on!any!date!
up!to!and!including!a!final!date!called!the!expiration!date.!
C)!!Because!an!option!is!a!contract!between!two!parties,!for!every!owner!of!a!financial!option,!there!is!also!
an!option!writer,!the!person!who!takes!the!other!side!of!the!contract.!
D)!!The!price!at!which!the!holder!buys!or!sells!the!share!of!stock!when!the!option!is!exercised!is!called!the!
strike!price(or!exercise!price.!
Answer:!!!B!
B)!!There!are!two!kinds!of!options.!American!options!allow!their!holders!to!exercise!the!option!on!
any!date!up!to!and!including!a!final!date!called!the!expiration!date.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!option!buyer,!also!called!the!option!holder,!holds!the!right!to!exercise!the!option!and!has!a!long!
position!in!the!contract.!
B)!!The!market!price!of!the!option!is!also!called!the!exercise!price.!
C)!!If!the!payoff!from!exercising!an!option!immediately!is!positive,!the!option!is!said!to!be!in-the-money.!
D)!!As!with!other!financial!assets,!options!can!be!bought!and!sold.!Standard!stock!options!are!traded!on!
organized!exchanges,!while!more!specialized!options!are!sold!through!dealers.!
Answer:!!!B!
B)!!The!market!price!of!the!option!is!also!called!the!option!premium.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!holder!would!not!exercise!an!in-the-money!option.!
B)!!The!option!seller,!also!called!the!option!writer,!sells!(or!writes)!the!option!and!has!a!short!position!in!the!
contract.!
C)!!Because!the!long!side!has!the!option!to!exercise,!the!short!side!has!an!obligation!to!fulfill!the!contract.!
D)!!When!the!exercise!price!of!an!option!is!equal!to!the!current!price!of!the!stock,!the!option!is!said!to!be!
at-the-money.!
Answer:!!!A!
Explanation:!!! A)!!A!holder!would!not!exercise!an!out-of-the-money!option.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Options!also!allow!investors!to!speculate,!or!place!a!bet!on!the!direction!in!which!they!believe!the!market!
is!likely!to!move.
B)!!Options!where!the!strike!price!and!the!stock!price!are!very!far!apart!are!referred!to!as!deep!in-the-money(
or!deep!out!of-the-money.!
C)!!Call!options!with!strike!prices!above!the!current!stock!price!are!in-the!money,!as!are!put!options!with!
strike!prices!below!the!current!stock!price.!
D)!!European!options(allow!their!holders!to!exercise!the!option!only!on!the!expiration!date–holders!cannot!
exercise!before!the!expiration!date.!
Answer:!!!C!
B)!!
C)!!Call!options!with!strike!prices!below!the!current!stock!price!are!in-the!money,!as!are!put!
options!with!strike!prices!above!the!current!stock!price.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!The!writer!of!a!call!option!has!
A)!!the!obligation!to!sell!a!security!for!a!given!price.!
B)!!the!obligation!to!buy!a!security!for!a!given!price.!
C)!!the!right!to!sell!a!security!for!a!given!price.!
D)!!the!right!to!buy!a!security!for!a!given!price.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
7)!!The!holder!of!a!put!option!has!
A)!!the!obligation!to!sell!a!security!for!a!given!price.!
B)!!the!right!to!buy!a!security!for!a!given!price.!
C)!!the!right!to!sell!a!security!for!a!given!price.!
D)!!the!obligation!to!buy!a!security!for!a!given!price.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
8)!!Using!options!to!reduce!risk!is!called?!
A)!!Speculation.!
B)!!A!naked!position.!
C)!!Hedging.!
D)!!A!covered!position.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
9)!!Using!options!to!place!a!bet!on!the!direction!in!which!you!believe!the!market!is!likely!to!move!is!called?!
A)!!Speculation.!
B)!!Hedging.!
C)!!A!covered!position.!
D)!!A!naked!position.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
Consider!the!following!information!on!options!from!the!CBOE!for!Merck:!
!
!
!
10)!!Assume!you!want!to!buy!one!option!contract!that!with!an!exercise!price!closest!to!being!at-the-money!and!
that!expires!January!2009.!The!current!price!that!you!would!have!to!pay!for!such!a!contract!is:!
A)!!$680!
B)!!$380!
C)!!$650!
D)!!$420!
Answer:!!!A!
Explanation:!!! A)!!One!contract!is!for!100!shares.!!The!option!closest!to!being!at!the!money!has!an!exercise!price!
of!$40.00!and!currently!has!an!ask!price!of!$6.80.!!Since!you!are!buying!the!option,!you!will!
have!to!pay!the!ask!price.!!So!$6.80!×!100!shares!per!contract!=!$680!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!The!open!interest!for!January!2009!put!option!that!is!closest!to!being!at-the-money!is:!
A)!!7174!
B)!!982!
C)!!319!
D)!!8422!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!How!many!of!the!January!2009!put!options!are!in!the!money?!
A)!!1!
B)!!3!
C)!!2!
D)!!4!
Answer:!!!C!
B)!!
C)!!For!a!put!option!to!be!in!the!money,!its!current!stock!price!must!be!less!than!the!exercise!price.!!
The!current!stock!price!for!Merck!is!$41.95,!so!only!the!put!options!with!strike!prices!of!$45.00!
and!$50.00!are!in!the!money.!!So!there!are!two!put!options!in!the!money.!
D)!!
Diff:!1!
Skill:!Analytical!
!
13)!!How!many!of!the!January!2009!call!options!are!in!the!money?!
A)!!2!
B)!!4!
C)!!1!
D)!!3!
Answer:!!!B!
B)!!For!a!call!option!to!be!in!the!money,!its!current!stock!price!must!be!greater!than!the!exercise!
price.!!The!current!stock!price!for!Merck!is!$41.95,!so!the!call!options!with!strike!prices!of!
$25.00,!$30.00,!$35.00,!and!$40.00!are!in!the!money.!!So!there!are!four!call!options!in!the!money.!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
14)!!You!have!decided!to!sell!(write)!5!January!2009!put!options!on!Merck!with!an!exercise!price!of!$45!per!share.!!
How!much!money!will!you!receive!and!are!these!contracts!in!or!out!of!the!money?!
Answer:!!!If!you!write!5!put!option!contracts!you!will!receive!5!×!100!(shares!per!contract)!×!$5.90!(since!you!are!
selling!you!get!bid!price)!=!$2,950.!!These!options!are!in!the!money!since!the!exercise!price!is!greater!
than!the!current!market!price.!
Diff:!2!
Skill:!Analytical!
!
15)!!You!have!decided!to!buy!10!January!2009!call!options!on!Merck!with!an!exercise!price!of!$45!per!share.!!How!
much!will!this!transaction!cost!you!and!are!these!contracts!in!or!out!of!the!money?!
Answer:!!!If!you!buy!10!call!option!contracts!you!will!pay!10!×!100!(shares!per!contract)!×!$4.50!(since!you!are!
buying!you!pay!the!ask!price)!=!$4,500.!!These!options!are!out!of!the!money!since!the!exercise!price!is!
greater!than!the!current!market!price.!
Diff:!2!
Skill:!Analytical!
(
20.2((Option(Payoffs(at(Expiration(
(
1)!!The!payoff!to!the!holder!of!a!call!option!is!given!by:!
A)!!C!=!max(S!-!K,!0)!
B)!!C!=!min(K,!0)!
C)!!C!=!max(K!-!S,!0)!
D)!!C!=!min(K!-!S,!0)!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!20.2!Option!Payoffs!at!Expiration!
Skill:!Conceptual!
!
2)!!The!payoff!to!the!holder!of!a!put!option!is!given!by:!
A)!!P!=!max(K!-!S,!0)!
B)!!P=!max(S!-!K,!0)!
C)!!P!=!min(S!-!K,!0)!
D)!!P!=!max(K,!0)!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Use!the!figure!for!the!question(s)!below.!
!
!
3)!!This!graph!depicts!the!payoffs!of!a!
A)!!a!short!position!in!a!put!option!at!expiration.!
B)!!short!position!in!a!call!option!at!expiration.!
C)!!a!long!position!in!a!put!option!at!expiration.!
D)!!a!long!position!in!a!call!option!at!expiration.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
Use!the!figure!for!the!question(s)!below.!
!
!
4)!!This!graph!depicts!the!payoffs!of!a!
A)!!a!long!position!in!a!put!option!at!expiration.!
B)!!short!position!in!a!call!option!at!expiration.!
C)!!a!short!position!in!a!put!option!at!expiration.!
D)!!a!long!position!in!a!call!option!at!expiration.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
5)!!An!option!strategy!in!which!you!hold!a!long!position!in!both!a!put!and!a!call!option!with!the!same!strike!price!
is!called!
A)!!a!strangle.!
B)!!portfolio!insurance.!
C)!!a!butterfly!spread.!
D)!!a!straddle.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Definition!
!
A)!!Because!a!short!position!in!an!option!is!the!other!side!of!a!long!position,!the!profits!from!a!short!position!
in!an!option!are!just!the!negative!of!the!profits!of!a!long!position.!
B)!!The!deeper!out-of-the-money!the!put!option!is,!the!less!negative!its!beta,!and!the!higher!is!its!expected!
return.!
C)!!Although!payouts!on!a!long!position!in!an!option!contract!are!never!negative,!the!profit!from!
purchasing!an!option!and!holding!it!to!expiration!could!well!be!negative!because!the!payout!at!
expiration!might!be!less!than!the!initial!cost!of!the!option.!
D)!!The!put!position!has!a!higher!return!in!states!with!low!stock!prices;!that!is,!if!the!stock!has!a!positive!beta,!
the!put!has!a!negative!beta.!
Answer:!!!B!
B)!!The!deeper!out-of-the-money!the!put!option!is,!the!less!negative!its!beta,!and!the!lower!is!its!
expected!return.!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
7)!!You!pay!$3.25!for!a!call!option!on!Luther!Industries!that!expires!in!three!months!with!a!strike!price!of!$40.00.!!
Three!months!later,!at!expiration,!Luther!Industries!is!trading!at!$41.00!per!share.!!Your!profit!per!share!on!
this!transaction!is!closest!to?!
A)!!-$1.00!
B)!!$1.00!
C)!!-$2.25!
D)!!$2.25!
Answer:!!!C!
B)!!
C)!!At!expiration!you!will!choose!to!excerise!the!option!since!the!option!is!in!the!money.!!Your!
payoff!will!be!$41!-!$40!=!$1!for!exercising!the!option!however!to!calculate!the!profit!we!need!
to!subtract!the!option!premium!so:!
!
Profit!=!$1.00!-!$3.25!=!-$2.25!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Graph!the!payoff!at!expiration!of!a!short!position!in!a!put!option!with!a!strike!price!of!$20.!
Answer:!!!!
!
Diff:!2!
Skill:!Graphing!
!
9)!!You!are!long!both!a!put!option!and!a!call!option!on!Rockwood!stock!with!the!same!expiration!date.!The!
exercise!price!of!the!call!option!is!$40!and!the!exercise!price!of!the!put!option!is!$30.!Graph!the!payoff!of!the!
combination!of!options!at!expiration.!
Answer:!!!!
!
This!option!strategy!is!known!as!a!strangle.!
Diff:!2!
Skill:!Graphing!
20.3((Put-Call(Parity(
(
1)!!Consider!the!following!equation:!
C!=!P!+!S!-!PV(K)!-!PV(Div)!
!
In!this!equation!the!term!S!refers!to!
A)!!the!payoff!of!a!zero!coupon!bond.!
B)!!the!strike!price!of!the!option.!
C)!!the!value!of!the!call!option.!
D)!!the!stocks!current!price.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!20.3!Put-Call!Parity!
Skill:!Conceptual!
!
C!=!P!+!S!-!PV(K)!-!PV(Div)!
!
In!this!equation!the!term!C!refers!to!
A)!!the!value!of!the!call!option.!
B)!!the!stocks!current!price.!
C)!!the!payoff!of!a!zero!coupon!bond.!
D)!!the!strike!price!of!the!option.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
C!=!P!+!S!-!PV(K)!-!PV(Div)!
!
In!this!equation!the!term!K!refers!to?!
A)!!the!value!of!the!call!option.!
B)!!the!strike!price!of!the!option.!
C)!!the!price!of!a!zero!coupon!bond.!
D)!!the!stocks!current!price.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
4)!!Luther!Industries!is!currently!trading!for!$27!per!share.!!The!stock!pays!no!dividends.!!A!one-year!European!
put!option!on!Luther!with!a!strike!price!of!$30!is!currently!trading!for!$2.60.!!If!the!risk-free!interest!rate!is!6%!
per!year,!then!the!price!of!a!one-year!European!call!option!on!Luther!with!a!strike!price!of!$30!will!be!closest!
to:!
A)!!$1.30!
B)!!$7.10!
C)!!$2.60!
D)!!$1.95!
Answer:!!!A!
Explanation:!!! A)!!C!=!P!+!S!-!PV(K)!-!PV(Div)!
$30
C!=!$2.60!+!$27!-! !-!$0!=!$1.2981!
1.06
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Rose!Industries!is!currently!trading!for!$47!per!share.!!The!stock!pays!no!dividends.!!A!one-year!European!call!
option!on!Luther!with!a!strike!price!of!$45!is!currently!trading!for!$7.45.!!If!the!risk-free!interest!rate!is!6%!per!
year,!then!calculate!the!price!of!a!one-year!European!put!option!on!Luther!with!a!strike!price!of!$45.!
Answer:!!!C!=!P!+!S!-!PV(K)!-!PV(Div)!
$45
$7.45!=!P!+!$47!-! !-!$0!!
1.06
$45
P!=!$7.45!-!$47!+! !=!$2.90!
1.06
Diff:!2!
Skill:!Analytical!
!
20.4((Factors(Affecting(Option(Prices(
(
1)!!Which!of!the!following!will!not!increase!the!value!of!a!put!option?!
A)!!An!increase!in!the!time!to!maturity!
B)!!A!decrease!in!the!stock!price!
C)!!A!decrease!in!the!stocks!volatility!
D)!!An!increase!in!the!exercise!price!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!20.4!Factors!Affecting!Option!Prices!
Skill:!Conceptual!
!
A)!!Put-call!parity!gives!the!price!of!a!European!call!option!in!terms!of!the!price!of!a!European!put,!the!
underlying!stock,!and!a!zero-coupon!bond.!
B)!!For!a!given!strike!price,!the!value!of!a!call!option!is!higher!if!the!current!price!of!the!stock!is!higher,!as!
there!is!a!greater!likelihood!the!option!will!end!up!in-the-money.!
C)!!The!value!of!an!otherwise!identical!call!option!is!higher!if!the!strike!price!the!holder!must!pay!to!buy!the!
stock!is!higher.!
D)!!Because!a!put!is!the!right!to!sell!the!stock,!puts!with!a!lower!strike!price!are!less!valuable.!
Answer:!!!C!
B)!!
C)!!The!value!of!an!otherwise!identical!call!option!is!higher!if!the!strike!price!the!holder!must!pay!
to!buy!the!stock!is!lower.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!intrinsic!value!of!an!option!is!the!value!it!would!have!if!it!expired!immediately.!
B)!!A!European!option!cannot!be!worth!less!than!its!American!counterpart.!
C)!!Put!options!increase!in!value!as!the!stock!price!falls.!
D)!!A!put!option!cannot!be!worth!more!than!its!strike!price.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!an!American!option!cannot!be!worth!less!than!its!intrinsic!value,!it!cannot!have!a!negative!time!
value.!
B)!!An!American!option!with!a!later!exercise!date!cannot!be!worth!less!than!an!otherwise!identical!
American!option!with!an!earlier!exercise!date.!
C)!!The!value!of!an!option!generally!decreases!with!the!volatility!of!the!stock.!
D)!!The!intrinsic!value!is!the!amount!by!which!the!option!is!currently!in-the!money!or!0!if!the!option!is!
out-of-the-money.!
Answer:!!!C!
B)!!
C)!!The!value!of!an!option!generally!increases!with!the!volatility!of!the!stock.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!KD!Industries!stock!is!currently!trading!at!$32!per!share.!!Consider!a!put!option!on!KD!stock!with!a!strike!
price!of!$30.!!The!intrinsic!value!of!this!put!option!is:!
A)!!$0!
B)!!-$2!
C)!!$2!
D)!!$30!
Answer:!!!A!
Explanation:!!! A)!!Intrinsic!value!=!max(K!-!S,!0)!=!max(30!-!32,!0)!=!$0!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!KD!Industries!stock!is!currently!trading!at!$32!per!share.!!Consider!a!put!option!on!KD!stock!with!a!strike!
price!of!$30.!!The!maximum!value!of!this!put!option!is:!
A)!!$0!
B)!!$32!
C)!!$30!
D)!!$2!
Answer:!!!C!
B)!!
C)!!maximum!value!for!a!put!equals!its!strike!price!=!$30!
D)!!
Diff:!1!
Skill:!Analytical!
!
20.5((Exercising(Options(Early(
(
C!=!S!-!K!+!dis(K)!+!P!
!
In!this!equation,!S!-!K!tells!us!
A)!!the!market!value!of!the!option.!
B)!!the!time!value!of!the!option.!
C)!!the!option!spread.!
D)!!the!intrinsic!value!of!the!option.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!20.5!Exercising!Options!Early!
Skill:!Conceptual!
!
C!=!S!-!K!+!dis(K)!+!P!-!PV(Div)!
!
In!this!equation,!dis(K)!+!P!-!PV(Div)!tells!us!
A)!!the!market!value!of!the!option.!
B)!!the!difference!in!the!price!of!an!American!option!over!a!European!option!because!of!dividend!capture.!
C)!!the!intrinsic!value!of!the!option.!
D)!!the!time!value!of!the!option.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!An!American!call!on!a!non-dividend!paying!stock!has!the!same!price!as!its!European!counterpart.!
B)!!The!price!of!any!call!option!on!a!non-dividend-paying!stock!always!exceeds!its!intrinsic!value.!
C)!!It!is!never!optimal!to!exercise!a!call!option!on!a!dividend!paying!stock!early–you!are!always!better!off!
just!selling!the!option.!
D)!!If!present!value!of!the!dividend!payment!is!large!enough,!the!time!value!of!a!European!call!option!can!be!
negative,!implying!that!its!price!could!be!less!than!its!intrinsic!value.!
Answer:!!!C!
B)!!
C)!!It!is!never!optimal!to!exercise!a!call!option!on!a!non-dividend!paying!stock!early–you!are!
always!better!off!just!selling!the!option.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!Describe!the!conditions!when!it!would!be!optimal!to!exercise!an!American!Call!and!an!American!Put!option!
prior!to!their!expiration.!
Answer:!!!One!might!guess!that!the!ability!to!exercise!the!American!option!early!would!make!an!American!option!
more!valuable!than!an!equivalent!European!option.!!Since!the!price!of!any!call!option!on!a!
non-dividend-paying!stock!always!exceeds!its!intrinsic!value,!it!is!never!optimal!to!exercise!a!call!option!
on!a!non-dividend!paying!stock!early–you!are!always!better!off!just!selling!the!option.!!!
!
It!does!make!sense!to!exercise!an!American!Put!early!under!certain!circumstances.!To!see!why,!note!
that!we!can!rearrange!the!put-call!parity!relationship!as!expressed!to!get!the!price!of!a!European!put!
option:!
!
P K S dis ( K ) C !
Intrinsic value Time value
!
In!this!case,!the!time!value!of!the!option!includes!a!negative!term,!the!discount!on!a!bond!with!face!
value!K.!When!the!put!option!is!sufficiently!deep!in-the-money,!this!discount!will!be!large!relative!to!
the!value!of!the!call,!and!the!time!value!of!a!European!put!option!will!be!negative.!In!that!case,!the!
European!put!will!sell!for!less!than!its!intrinsic!value.!However,!its!American!counterpart!cannot!sell!
for!less!than!its!intrinsic!value!(because!otherwise!arbitrage!profits!would!be!possible!by!immediately!
exercising!it),!which!implies!that!the!American!option!can!be!worth!more!than!an!otherwise!identical!
European!option.!Because!the!only!difference!between!the!two!options!is!the!right!to!exercise!the!option!
early,!this!right!must!be!valuable–there!must!be!states!in!which!it!is!optimal!to!exercise!the!American!
put!early.!
!
When!stocks!pay!dividends,!the!right!to!exercise!an!option!on!them!early!is!generally!valuable!for!both!
calls!and!puts.!To!see!why,!let’s!write!out!the!put-call!parity!relationship!for!a!dividend-paying!stock:!
!
C S K dis ( K ) P PV ( Div) !
Intrinsic value Time value
!
If!PV(Div)!is!large!enough,!the!time!value!of!a!European!call!option!can!be!negative,!implying!that!its!
price!could!be!less!than!its!intrinsic!value.!Because!an!American!option!can!never!be!worth!less!than!its!
intrinsic!value,!the!price!of!the!American!option!can!exceed!the!price!of!a!European!option.!
!
To!understand!when!it!is!optimal!to!exercise!the!American!call!option!early,!note!that!when!a!company!
pays!a!dividend,!investors!expect!the!price!of!the!stock!to!drop!to!reflect!the!cash!paid!out.!This!price!
drop!hurts!the!owner!of!a!call!option!because!the!stock!price!falls,!but!unlike!the!owner!of!the!stock,!the!
option!holder!does!not!get!the!dividend!as!compensation.!However,!by!exercising!early!and!holding!
the!stock,!the!owner!of!the!call!option!can!capture!the!dividend.!!Thus!the!decision!to!exercise!early!
trades!off!the!benefits!of!waiting!to!exercise!the!call!option!versus!the!loss!of!the!dividend.!Because!a!
call!should!only!be!exercised!early!to!capture!the!dividend,!it!will!only!be!optimal!to!do!so!just!before!
the!stock’s!ex-dividend!date.!
Diff:!3!
Skill:!Conceptual!
20.6((Options(and(Corporate(Finance(
(
A)!!The!option!price!is!more!sensitive!to!changes!in!volatility!for!at-the-money!options!than!it!is!for!
in-the-money!options.!
B)!!A!share!of!stock!can!be!thought!of!as!a!put!option!on!the!assets!of!the!firm!with!a!strike!price!equal!to!the!
value!of!debt!outstanding.!
C)!!In!the!context!of!corporate!finance,!equity!is!at-the!money!when!a!firm!is!close!to!bankruptcy.!
D)!!Because!the!price!of!equity!is!increasing!with!the!volatility!of!the!firmfs!assets,!equity!holders!benefit!
from!a!zero-NPV!project!that!increases!the!volatility!of!the!firmfs!assets.!
Answer:!!!B!
B)!!A!share!of!stock!can!be!thought!of!as!a!call!option!on!the!assets!of!the!firm!with!a!strike!price!
equal!to!the!value!of!debt!outstanding.!
C)!!
D)!!
Diff:!2!
Topic:!20.6!Options!and!Corporate!Finance!
Skill:!Conceptual!
!
A)!!If!the!value!of!the!firm’s!assets!exceeds!the!required!debt!payment,!debt!holders!are!fully!repaid.!
B)!!Another!way!to!view!corporate!debt:!as!a!portfolio!of!riskless!debt!and!a!short!position!in!a!call!option!
on!the!firmfs!assets!with!a!strike!price!equal!to!the!required!debt!payment.!
C)!!Viewing!debt!as!an!option!portfolio!is!useful!as!it!provides!insight!into!how!credit!spreads!for!risky!debt!
are!determined.!
D)!!You!can!think!of!the!debt!holders!as!owning!the!firm!and!having!sold!a!call!option!with!a!strike!price!
equal!to!the!required!debt!payment.!
Answer:!!!B!
B)!!Another!way!to!view!corporate!debt:!as!a!portfolio!of!riskless!debt!and!a!short!position!in!a!
put!option!on!the!firm’s!assets!with!a!strike!price!equal!to!the!required!debt!payment.!
C)!!
D)!!
Diff:!2!
Topic:!20.6!Options!and!Corporate!Finance!
Skill:!Conceptual!
!
!
Chapter(21(-(Option(Valuation(
!
!
21.1(The(Binomial(Option(Pricing(Model(
A)!!A!replicating!portfolio!is!a!portfolio!of!other!securities!that!has!exactly!the!same!value!in!one!period!as!
the!option.!
B)!!By!using!the!Law!of!One!Price,!we!are!able!to!solve!for!the!price!of!the!option!as!long!as!we!know!the!
probabilities!of!the!states!in!the!binomial!tree.!
C)!!The!binomial!tree!contains!all!the!information!we!currently!know:!the!value!of!the!stock,!bond,!and!call!
options!in!each!state!in!one!period,!as!well!as!the!price!of!the!stock!and!bond!today.!
D)!!The!idea!that!you!can!replicate!the!option!payoff!by!dynamically!trading!in!a!portfolio!of!the!underlying!
stock!and!a!risk-free!bond!was!one!of!the!most!important!contributions!of!the!original!Black-Scholes!
paper.!Today,!this!kind!of!replication!strategy!is!called!a!dynamic!trading!strategy.!
Answer:!!!B!
B)!!By!using!the!Law!of!One!Price,!we!are!able!to!solve!for!the!price!of!the!option!without!
knowing!the!probabilities!of!the!states!in!the!binomial!tree.!
C)!!
D)!!
Diff:!2!
Topic:!21.1!The!Binomial!Option!Pricing!Model!
Skill:!Conceptual!
!
A)!!The!techniques!of!the!binomial!option!pricing!model!are!specific!to!European!call!and!put!options.!
B)!!We!can!summarize!the!payoffs!for!the!Binomial!Option!Pricing!Model!in!a!binomial!tree–a!timeline!with!
two!branches!at!every!date!that!represent!the!possible!events!that!could!happen!at!those!times.!
C)!!We!define!the!state!in!which!the!stock!price!goes!up!as!the!up!state!and!the!state!in!which!the!stock!price!
goes!down!as!the!down!state.!
D)!!When!using!the!Binomial!Option!Pricing!Model,!by!the!Law!of!One!Price,!the!price!of!the!option!today!
must!equal!the!current!market!value!of!the!replicating!portfolio.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
C Cd
!=! u !
Su S d
!
In!this!equation,!the!term! ,!represents!
A)!!the!change!in!the!stock!price!from!the!low!state!to!the!high!state.!
B)!!the!number!of!shares!of!stock!to!buy!for!the!replicating!portfolio.!
C)!!the!position!in!bonds!for!the!replicating!portfolio.!
D)!!the!change!in!the!stock!price!from!the!high!state!to!the!low!state.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
C Sd
B!=! d !
1 rf
!
In!this!equation,!the!term!B,!represents!
A)!!the!bid!price!for!the!option.!
B)!!the!position!in!bonds!for!the!replicating!portfolio.!
C)!!the!highest!price!at!which!it!is!advantageous!to!buy!the!option.!
D)!!the!number!of!shares!of!stock!to!buy!for!the!replicating!portfolio.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
The!current!price!of!KD!Industries!stock!is!$20.!!In!the!next!year!the!stock!price!will!either!go!up!by!20%!or!go!down!by!20%.!!
KD!pays!no!dividends.!!The!one!year!risk-free!rate!is!5%!and!will!remain!constant.!!
!
5)!!Using!the!binomial!pricing!model,!the!calculated!price!of!a!one-year!call!option!on!KD!stock!with!a!strike!price!
of!$20!is!closest!to:!
A)!!$2.40!
B)!!$2.00!
C)!!$2.15!
D)!!$1.45!
Answer:!!!A!
Cu Cd $4 $0
!=! !=! !=!.5!
Su Sd $24 $16
Cd S d $0 $16(.5)
B!=! !=! !=!-7.619048!
1 rf 1.05
C!=!S !+!B!=!$20(.5)!+!(-7.618048)!=!$2.38!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Using!the!binomial!pricing!model,!the!calculated!price!of!a!one-year!put!option!on!KD!stock!with!a!strike!price!
A)!!$2.00!
B)!!$1.45!
C)!!$2.40!
D)!!$2..15!
Answer:!!!B!
B)!!!
!
P Pd $0 $4
!=! u !=! !=!-0.5!
Su Sd $24 $16
Pd Sd $4 $16( 0.5)
B!=! !=! !=!11.428571!
1 rf 1.05
P!=!S !+!B!=!$20(-0.5)!+!11.428571!=!1.43!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Construct!a!binomial!tree!detailing!the!option!information!and!payoffs!for!a!call!option!with!a!$20!strike!price!
that!expires!in!one!year.!
Answer:!!!!
!
Diff:!2!
Skill:!Graphing!
!
!
The!current!price!of!Kinston!Corporation!stock!is!$10.!!In!each!of!the!next!two!years,!this!stock!price!can!wither!go!up!by!
$3.00!or!go!down!by!$2.00.!!Kinston!stock!pays!no!dividends.!!The!one!year!risk-free!interest!rate!is!5%!and!will!remain!
constant.!
!
8)!!Using!the!binomial!pricing!model,!calculate!the!price!of!a!two-year!call!option!on!Kinston!stock!with!a!strike!
price!of!$9.!
Answer:!!!This!problem!requires!a!two!period!binomial!tree.!!The!solution!will!start!by!solving!the!value!of!the!call!
option!for!the!up!and!down!branches!as!of!year!1!and!then!solve!for!the!final!value!of!the!option!at!year!
0.!
!
Up!branch!
C Cd $7 $2
!=! u !=! !=!1!
Su S d $16 $11
Cd S d $2 $11(1)
B!=! !=! !=!-8.571429!
1 rf 1.05
C!=!S !+!B!=!$13(1)!+!(-8.571429)!=!$4.43!
!
Down!Branch!
C Cd $2 $0
!=! u !=! !=!.4!
Su S d $11 $6
Cd S d $0 $6(.4)
B!=! !=! !=!-2.285714!
1 rf 1.05
C!=!S !+!B!=!$8(.4)!+!(-2.285714)!=!$0.91!
!
Value!at!year!0!
C Cd $4.43 $0.91
!=! u !=! !=!.7040!
Su S d $13 $8
Cd S d $0.91 $8(.704)
B!=! !=! !=!-4.497143!
1 rf 1.05
C!=!S !+!B!=!$10(.704)!+!(-4.497143)!=!$2.54!
Diff:!3!
Skill:!Analytical!
!
9)!!Using!the!binomial!pricing!model,!calculate!the!price!of!a!two-year!put!option!on!Kinston!stock!with!a!strike!
price!of!$9.!
Answer:!!!This!problem!requires!a!two!period!binomial!tree.!!The!solution!will!start!by!solving!the!value!of!the!call!
option!for!the!up!and!down!branches!as!of!year!1!and!then!solve!for!the!final!value!of!the!option!at!year!
0.!
!
Up!branch!
C Cd $0 $0
!=! u !=! !=!0!
Su S d $16 $11
Cd S d $0 $11(0)
B!=! !=! !=!0!
1 rf 1.05
C!=!S !+!B!=!$13(0)!+!(0)!=!$0!
!
Down!Branch!
C Cd $0 $3
!=! u !=! !=!-0.6!
Su S d $11 $6
Cd S d $3 $6( 0.6)
B!=! !=! !=!6.285714!
1 rf 1.05
C!=!S !+!B!=!$8(-0.6)!+!(6.285714)!=!$1.49!
!
Value!at!year!0!
C Cd $0 $1.49
!=! u !=! !=!-0.298!
Su S d $13 $8
Cd S d $1.49 $8( 0.298)
B!=! !=! !=!3.874!
1 rf 1.05
C!=!S !+!B!=!$10(-0.298)!+!3.874!=!$0.89!
Diff:!3!
Skill:!Analytical!
21.2((The(Black-Scholes(Option(Pricing(Model(
(
1)!!Which!of!the!following!is!not!an!input!required!by!the!Black-Scholes!option!pricing!model?!
A)!!The!expected!volatility!of!the!stock!
B)!!The!expected!return!on!the!stock!
C)!!The!risk-free!interest!rate!
D)!!The!current!stock!price!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!21.2!The!Black-Scholes!Option!Pricing!Model!
Skill:!Conceptual!
!
A)!!N(d)!is!the!cumulative!normal!distribution–that!is,!the!probability!that!a!normally!distributed!variable!is!
greater!than!d.!
B)!!Of!the!five!required!inputs!in!the!Black-Scholes!formula,!four!are!directly!observable.!
C)!!The!Black-Scholes!formula!is!derived!assuming!that!the!call!is!a!European!option.!
D)!!The!Black-Scholes!Option!Pricing!Model(can!be!derived!from!the!Binomial!Option!Pricing!Model!by!
making!the!length!of!each!period,!and!the!movement!of!the!stock!price!per!period,!shrink!to!zero!and!
letting!the!number!of!periods!grow!infinitely!large.!
Answer:!!!A!
Explanation:!!! A)!!N(d)!is!the!cumulative!normal!distribution–that!is,!the!probability!that!a!normally!distributed!
variable!is!less!than!d.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!you!take!the!option!price!quoted!in!the!market!as!an!input!and!solve!for!the!volatility!you!will!have!an!
estimate!of!a!stock^s!volatility!known!as!the!implied!volatility.!
B)!!The!Black-Scholes!formula!can!be!used!to!price!American!or!European!call!options!on!
non-dividend-paying!stocks.!
C)!!We!need!to!know!the!expected!return!on!the!stock!to!calculate!the!option!price!in!the!Black-Scholes!
Option!Pricing!Model.!
D)!!We!can!use!the!Black-Scholes!formula!to!compute!the!price!of!a!European!put!option!on!a!
non-dividend-paying!stock!by!using!the!put-call!parity!formula.!
Answer:!!!C!
B)!!
C)!!We!do!not!need!to!know!the!expected!return!on!the!stock!to!calculate!the!option!price!in!the!
Black-Scholes!Option!Pricing!Model.!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!
change!in!the!price!of!the!option.!
B)!!Because!a!leveraged!position!in!a!stock!is!riskier!than!the!stock!itself,!this!implies!that!call!options!on!a!
positive!beta!stock!are!more!risky!than!the!underlying!stock!and!therefore!have!higher!returns!and!
higher!betas.!
C)!!Only!one!parameter!input!for!the!Black-Scholes!formula,!the!volatility!of!the!stock!price,!is!not!
observable!directly.!
D)!!Because!a!stock^s!volatility!is!much!easier!to!measure!(and!forecast)!than!its!expected!return,!the!
Black-Scholes!formula!can!be!very!precise.!
Answer:!!!A!
given!a!$1!change!in!the!price!of!the!stock.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
S S
1n 1n
PV ( K ) T PV ( K ) T
C!=!S!×!N !-!PV(K)!×!N T !
T 2 T 2
A)!!the!number!of!days!to!expiration.!
B)!!the!number!of!years!to!expiration.!
C)!!the!expected!return!on!the!stock.!
D)!!the!annual!volatility!of!the!stock.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
S S
1n 1n
PV ( K ) T PV ( K ) T
C!=!S!×!N !-!PV(K)!×!N T !
T 2 T 2
!
In!this!equation,!the!term!T!represents!
A)!!the!number!of!years!to!expiration.!
B)!!the!annual!volatility!of!the!stock.!
C)!!the!expected!return!on!the!stock.!
D)!!the!number!of!days!to!expiration.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
S S
1n 1n
PV ( K ) T PV ( K ) T
C!=!S!×!N !-!PV(K)!×!N T !
T 2 T 2
!
In!this!equation,!the!term!S!represents!
A)!!the!current!price!of!the!stock.!
B)!!the!stock!price!at!expiration.!
C)!!the!annual!volatility!of!the!stock.!
D)!!strike!price!for!the!option.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!Luther!Industries!does!not!pay!dividend!and!is!currently!trading!at!$25!per!share.!!The!current!risk-free!rate!of!
interest!is!5%.!!Calculate!the!price!of!a!call!option!on!Luther!Industries!with!a!strike!price!of!$30!that!expires!in!
75!days!!when!N(d1)!=!.639!and!N(d2)!=!.454.!
Answer:!!! $30
C!=!S!×!N(d1)!-!PV(K)!×!N(d2)!=!$25!×!.639!-! 75
!×!.454!=!$2.49!
1.05 365
Diff:!2!
Skill:!Analytical!
21.3((Risk-Neutral(Probabilities(
(
A)!!In!both!the!Binomial!and!Black-Scholes!Pricing!Models,!we!need!to!know!the!risk!neutral!probability!of!
each!possible!future!stock!price!to!calculate!the!option!price.!
B)!!In!the!real!world,!investors!are!risk!averse.!Thus,!the!expected!return!of!a!typical!stock!includes!a!
positive!risk!premium!to!compensate!investors!for!risk.!
C)!!Because!no!assumption!on!the!risk!preferences!of!investors!is!necessary!to!calculate!the!option!price!
using!either!the!Binomial!Model!or!the!Black-Scholes!formula,!the!models!must!work!for!any!set!of!
preferences,!including!risk-neutral!investors.!
D)!!If!all!market!participants!were!risk!neutral,!then!all!financial!assets!(including!options)!would!have!the!
same!cost!of!capital–the!risk!free!rate!of!interest.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!21.3!Risk-Neutral!Probabilities!
Skill:!Conceptual!
!
A)!!After!we!have!constructed!the!tree!and!calculated!the!probabilities!in!the!risk-neutral!world,!we!can!use!
them!to!price!the!derivative!by!simply!discounting!its!expected!payoff!(using!the!risk!neutral!
probabilities)!at!the!risk-free!rate.!
B)!!By!using!the!probabilities!in!the!risk-neutral!world!we!can!price!any!derivative!security–that!is,!any!
security!whose!payoff!depends!solely!on!the!prices!of!other!marketed!assets.!
C)!!To!ensure!that!all!assets!in!the!risk-neutral!world!have!an!expected!return!equal!to!the!risk-free!rate,!
relative!to!the!true!probabilities,!the!risk-neutral!probabilities!underweight!the!bad!states!and!
overweight!the!good!states.!
D)!!In!Monte!Carlo!simulation,!the!expected!payoff!of!the!derivative!security!is!estimated!by!calculating!its!
average!payoff!after!simulating!many!random!paths!for!the!underlying!stock!price.!!
Answer:!!!C!
B)!!
C)!!To!ensure!that!all!assets!in!the!risk-neutral!world!have!an!expected!return!equal!to!the!
risk-free!rate,!relative!to!the!true!probabilities,!the!risk-neutral!probabilities!overweight!the!
bad!states!and!underweight!the!good!states.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Risk!neutral!probabilities!are!also!known!as!all!of!the!following!except!
A)!!contingent!probabilities.!
B)!!state-contingent!prices.!
C)!!martingale!prices.!
D)!!state!prices.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
!
!
4)!!The!risk!neutral!probability!of!an!up!state!for!KD!industries!is!closest!to:!
A)!!37.5%!
B)!!60.0%!
C)!!40.0%!
D)!!62.5%!
Answer:!!!D!
B)!!
C)!!
D)!! (1 r f ) S Sd (1.05)($20) $16
p!=! !=! !=!.625!or!62.5%!
Su S d $24 $16
Diff:!1!
Skill:!Analytical!
!
5)!!The!risk!neutral!probability!of!a!down!state!for!KD!industries!is!closest!to:!
A)!!37.5%!
B)!!62.5%!
C)!!40.0%!
D)!!60.0%!
Answer:!!!A!
Explanation:!!! A)!! (1 r f ) S Sd (1.05)($20) $16
p!=! !=! !=!.625!or!62.5%!
Su S d $24 $16
down!state!prob!=!(!1!-!p)!=!(1!-!.625)!=!.375!or!37.5%!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Using!risk!neutral!probabilities,!the!calculated!price!of!a!one-year!call!option!on!KD!stock!with!a!strike!price!of!
$20!is!closest!to:!
A)!!$1.45!
B)!!$2.40!
C)!!$2.00!
D)!!$2.15!
Answer:!!!B!
B)!! (1 r f ) S Sd (1.05)($20) $16
p!=! !=! !=!.625!or!62.5%!
Su S d $24 $16
.625($4) .(1 .625)($0)
C!=! !=!$2.38!
1.05
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!Using!risk!neutral!probabilities,!the!calculated!price!of!a!one-year!put!option!on!KD!stock!with!a!strike!price!of!
$20!is!closest!to:!
A)!!$2.00!
B)!!$2.15!
C)!!$1.45!
D)!!$2.40!
Answer:!!!C!
B)!!
C)!! (1 r f ) S Sd (1.05)($20) $16
p!=! !=! !=!.625!or!62.5%!
Su S d $24 $16
.625($0) .(1 .625)($4)
P!=! !=!$1.43!
1.05
D)!!
Diff:!2!
Skill:!Analytical!
!
!
The!current!price!of!Kinston!Corporation!stock!is!$10.!!In!each!of!the!next!two!years,!this!stock!price!can!wither!go!up!by!
$3.00!or!go!down!by!$2.00.!!Kinston!stock!pays!no!dividends.!!The!one!year!risk-free!interest!rate!is!5%!and!will!remain!
constant.!
!
8)!!Using!risk!neutral!probabilities,!calculate!the!price!of!a!two-year!call!option!on!Kinston!stock!with!a!strike!
price!of!$9.!
Answer:!!! (1 r f ) S Sd (1.05)($10) $8
p!=! !=! !=!.50!or!50%!
Su S d $13 $8
(.25)($16 $9) (.50)($11 $9) (.25)($0)
C!=! !=!$2.49!
(1.05) 2
Diff:!3!
Skill:!Analytical!
!
9)!!Using!risk!neutral!probabilities,!calculate!the!price!of!a!two-year!put!option!on!Kinston!stock!with!a!strike!
price!of!$9.!
Answer:!!! (1 r f ) S Sd (1.05)($10) $8
p!=! !=! !=!.50!or!50%!
Su S d $13 $8
!
(.5)(.5)(0) 2(.5)(.5)($0) (.5)(.5)($3)
C!=! !=!$0.68!
(1.05) 2
Diff:!3!
Skill:!Analytical!
!
21.4((Risk(and(Return(of(an(Option(
(
A)!!Out-of-the-money!calls!have!the!highest!expected!returns!and!out-of-the-money!puts!have!the!lowest!
expected!returns.!
B)!!The!expression!S S +!B)!is!the!ratio!of!the!amount!of!money!in!the!stock!position!in!the!replicating!
portfolio!to!the!value!of!the!replicating!portfolio!(or!the!option!price);!it!is!known!as!the(leverage!ratio.!
C)!!The!beta!of!a!portfolio!is!just!the!weighted!average!beta!of!the!constituent!securities!that!make!up!the!
portfolio.!
D)!!The!magnitude!of!the!leverage!ratio!for!options!is!usually!very!small,!especially!for!out-of-the-money!
options.!
Answer:!!!D!
B)!!
C)!!
D)!!The!magnitude!of!the!leverage!ratio!for!options!is!usually!very!large,!especially!for!
out-of-the-money!options.!
Diff:!2!
Topic:!21.4!Risk!and!Return!of!an!Option!
Skill:!Conceptual!
!
A)!!For!a!call!written!on!a!stock!with!positive!beta,!the!beta!of!the!call!always!exceeds!the!beta!of!the!stock.!
B)!!The!beta!of!a!put!option!written!on!a!negative!beta!stock!is!always!negative.!
C)!!As!the!stock!price!changes,!the!beta!of!an!option!will!change,!with!its!magnitude!falling!as!the!option!
goes!in-the-money.!
D)!!A!put!option!is!a!hedge,!so!its!price!goes!up!when!the!stock!price!goes!down.!
Answer:!!!B!
B)!!The!beta!of!a!put!option!written!on!a!negative!beta!stock!is!always!positive.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
S B
option!=! S!+! B!
S B S B
!
B
The!term! B!is!
S B
A)!!always!equal!to!zero!since! B!=!0.!
B)!!always!positive!since!B!is!always!positive.!
C)!!could!be!positive!or!negative!depending!on!whether!the!option!in!question!is!a!put!or!a!call.!
D)!!always!negative!since!B!is!always!negative.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
!
4)!!Assuming!the!Beta!on!KD!stock!is!1.1,!the!calculated!beta!for!!a!one-year!call!option!on!KD!stock!with!a!strike!
price!of!$20!is!closest!to:!
A)!!-1.8!
B)!!2.4!
C)!!-7.7!
D)!!4.6!
Answer:!!!D!
B)!!
C)!!
D)!! C Cd $4 $0
!=! u !=! !=!.5!
Su S d $24 $16
Cd S d $0 $16(.5)
B!=! !=! !=!-7.619048!
1 rf 1.05
S $20(.5)
option!=! S!=! (1.1)!=!4.62!
S B $20(.5) ( 7.619048)
Diff:!2!
Skill:!Analytical!
!
5)!!Using!the!binomial!pricing!model,!the!calculated!price!of!a!one-year!put!option!on!KD!stock!with!a!strike!price!
A)!!-7.7!
B)!!2.4!
C)!!4.6!
D)!!-1.8!
Answer:!!!A!
Explanation:!!! A)!! C Cd $4 $0
!=! u !=! !=!-0.5!
Su S d $24 $16
Cd S d $4 $16( 0.5)
B!=! !=! !=!11.428571!
1 rf 1.05
S $20( 0.5)
option!=! S!=! (1.1)!=!-7.7!
S B $20( 0.5) (11.428571)
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
21.5((Beta(of(Risk(Debt(
(
A)!!For!companies!with!high!debt-to-equity!ratios,!the!approximation!that!the!beta!of!debt!is!zero!is!
unrealistic;!such!corporations!have!a!positive!probability!of!bankruptcy,!and!this!uncertainty!usually!has!
systematic!components.!
B)!!When!the!debt!is!risky,!the!firm^s!equity!is!always!in-the- =!1.!
C)!!If!we!let!A!be!the!value!of!the!firm^s!assets,!E!be!the!value!of!equity,!and!D!be!the!value!of!debt,!then!
because!equity!is!a!call!option!on!the!assets!of!the!firm,!E!=! +!B!with!A!=!E!+!D!=!S.!
D)!!Equity!can!be!viewed!as!a!call!option!on!the!firm^s!assets.!
Answer:!!!B!
B)!!When!the!debt!is!riskless,!the!firm’s!equity!is!always!in-the- =!1.!
C)!!
D)!!
Diff:!3!
Topic:!21.5!Beta!of!Risky!Debt!
Skill:!Conceptual!
!
A D
E!=! U!=! 1 U!
E E
!
the!term! U!refers!to!
A)!!the!unlevered!beta!for!the!firm^s!debt.!
B)!!the!beta!of!the!firm^s!assets.!
C)!!the!beta!for!the!firm^s!equity.!
D)!!the!beta!for!the!firm^s!debt.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A D
E!=! U!=! 1 U!
E E
!
the!term! !refers!to!
A)!!the!change!in!the!debt-to-value!ratio.!
B)!!the!marginal!tax!rate.!
C)!!the!number!of!shares!of!stock!to!buy!for!the!replicating!portfolio.!
D)!!the!change!in!the!debt-to-equity!ratio.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A E
D!=!(1!- U!=!(1!- 1 U!
D D
!
the!term! D!refers!to!
A)!!the!unlevered!beta!for!the!firm^s!debt.!
B)!!the!beta!of!the!firm^s!assets.!
C)!!the!beta!for!the!firm^s!debt.!
D)!!the!beta!for!the!firm^s!equity.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!You!would!like!to!know!the!beta!of!debt!for!KT!Industries.!!The!value!of!KT^s!outstanding!equity!is!$50!
million,!and!you!have!estimated!its!beta!to!be!1.62.!!You!cannot,!however,!find!enough!market!data!to!estimate!
the!beta!of!tis!debt,!so!you!decide!to!use!the!Black-Scholes!formula!to!find!an!approximate!value!for!the!debt.!!
KT!has!a!five!year!zero!coupon!bond!outstanding!with!a!market!value!of!$80!million.!!If!you!estimated! !from!
the!Black-Scholes!model!is!.60,!then!the!beta!for!KT^s!debt!is!closest!to:!
A)!!1.00!
B)!!0.59!
C)!!0.90!
D)!!2.70!
Answer:!!!B!
B)!!
C)!!First!we!need!to!solve!for!the!unlevered!beta:!
A D
E!=! U!=! 1 U!
E E
E 1.62
U!=! !=! !=!.90!
D 80
1 .60 1
E 40
D !=!(1!-! )(1!+!E! D) U !=!(1!-!.60)(1!+! =!.585!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Chapter(22(-(Real(Options(
!
!
22.1(Real(Versus(Financial(Options(
A)!!In!particular,!because!real!options!allow!a!decision!maker!to!choose!the!most!attractive!alternative!after!
new!information!has!been!learned,!the!presence!of!real!options!adds!value!to!an!investment!opportunity.!
B)!!To!make!an!investment!decision!correctly,!the!value!of!embedded!real!options!must!be!included!in!the!
decision-making!process.!
C)!!A!key!distinction!between!a!real!option!and!a!financial!option!is!that!real!options,!and!the!underlying!
assets!on!which!they!are!based,!are!often!traded!in!competitive!markets.!
D)!!We!can!compute!the!value!of!the!real!option!by!comparing!the!expected!profit!without!the!real!option!to!
the!value!with!the!option.!
Answer:!!!C!
B)!!
C)!!A!key!distinction!between!a!real!option!and!a!financial!option!is!that!real!options,!and!the!
underlying!assets!on!which!they!are!based,!are!not!traded!in!competitive!markets.!
D)!!
Diff:!1!
Topic:!22.1!Real!Versus!Financial!Options!
Skill:!Conceptual!
!
2)!!Which!of!the!following!is!not!a!real!option?!
A)!!A!stock!option!
B)!!An!abandonment!option!
C)!!An!investment!timing!option!
D)!!An!expansion!option!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!22.1!Real!Versus!Financial!Options!
Skill:!Conceptual!
22.2((Decision(Tree(Analysis(
(
A)!!Decision!nodes!are!nodes(in!which!uncertainty!is!involved!that!is!out!of!the!control!of!the!decision!
maker.!
B)!!Most!investment!projects!allow!for!the!possibility!of!reevaluating!the!decision!to!invest!at!a!later!point!in!
time.!
C)!!A!decision!tree!is!a!graphical!representation!of!future!decisions!and!uncertainty!resolution.!
D)!!With!binomial!trees!the!uncertainty!is!not!under!the!control!of!the!decision!maker.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!22.2!Decision!Tree!Analysis!
Skill:!Conceptual!
!
22.3((The(Option(to(Delay(an(investment(Opportunity(
(
A)!!One!way!to!see!why!you!sometimes!choose!not!to!invest!in!a!positive-NPV!project!is!to!think!about!the!
decision!of!when!to!invest!as!a!choice!between!two!mutually!exclusive!projects:!(1)!invest!today!or!(2)!
wait.!
B)!!You!invest!today!only!when!the!NPV!of!investing!today!exceeds!the!value!of!the!option!of!waiting,!
which!from!option!pricing!theory!we!know!to!be!always!positive.!
C)!!When!you!do!not!have!the!option!to!wait,!it!is!optimal!to!invest!in!any!positive-NPV!project.!
D)!!When!you!have!the!option!of!deciding!when!to!invest,!it!is!usually!optimal!to!invest!only!when!the!NPV!
is!positive!but!close!to!zero.!
Answer:!!!D!
B)!!
C)!!
D)!!When!you!have!the!option!of!deciding!when!to!invest,!it!is!usually!optimal!to!invest!only!
when!the!NPV!is!substantially!positive.!
Diff:!2!
Topic:!22.3!The!Option!to!Delay!an!Investment!Opportunity!
Skill:!Conceptual!
!
A)!!If!there!is!a!lot!of!uncertainty,!the!benefit!of!waiting!is!diminished.!
B)!!In!the!real!option!context,!the!dividends!correspond!to!any!value!from!the!investment!that!we!give!up!by!
waiting.!
C)!!By!delaying!an!investment,!we!can!base!our!decision!on!additional!information.!
D)!!Given!the!option!to!wait,!an!investment!that!currently!has!a!negative!NPV!can!have!a!positive!value.!
Answer:!!!A!
Explanation:!!! A)!!If!there!is!a!lot!of!uncertainty,!the!benefit!of!waiting!is!increased.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!Aside!from!the!current!NPV!of!the!investment,!other!factors!affect!the!value!of!an!investment!and!the!
decision!to!wait.!
B)!!The!option!to!wait!is!most!valuable!when!there!is!a!great!deal!of!uncertainty!regarding!what!the!value!of!
the!investment!will!be!in!the!future.!
C)!!The!smaller!the!cost!of!waiting,!the!less!attractive!the!option!to!delay!becomes.!
D)!!It!is!always!better!to!wait!to!invest!unless!there!is!a!cost!to!doing!so.!
Answer:!!!C!
B)!!
C)!!The!smaller!the!cost!of!waiting,!the!more!attractive!the!option!to!delay!becomes.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Kinston!Industries!has!come!up!with!a!new!mountain!bike!prototype!and!is!ready!to!go!ahead!with!pilot!production!and!
test!marketing.!The!pilot!production!and!test!marketing!phase!will!last!for!one!year!and!cost!$500,000.!Your!management!
team!believes!that!there!is!a!50%!chance!that!the!test!marketing!will!be!successful!and!that!there!will!be!sufficient!demand!
for!the!new!mountain!bike.!!If!the!test-marketing!phase!is!successful,!then!Kinston!Industries!will!invest!$3!million!in!year!
one!to!build!a!plant!that!will!generate!expected!annual!after!tax!cash!flows!of!$400,000!in!perpetuity!beginning!in!year!two.!!
If!the!test!marketing!is!not!successful,!Kinston!can!still!go!ahead!and!build!the!new!plant,!but!the!expected!annual!after!tax!
cash!flows!would!be!only!$200,000!in!perpetuity!beginning!in!year!two.!!Kinston!has!the!option!to!stop!the!project!at!any!
time!and!sell!the!prototype!mountain!bike!to!an!overseas!competitor!for!$300,000.!!Kinston\s!cost!of!capital!is!10%.!
!
4)!!Assuming!that!Kinston!has!the!ability!to!sell!the!prototype!in!year!one!for!$300,000,!the!NPV!of!the!Kinston!
Industries!Mountain!Bike!Project!is!closest!to:!
A)!!$90,000!
B)!!$590,000!
C)!!$455,000!
D)!!-$45,000!
Answer:!!!A!
Explanation:!!! A)!!Value$if$test$is$successful!
$400, 000
Build!plant!:!!NPV!=!-$3,000,000!+! !=!$1,000,000!
.10
Value$if$test$unsuccessful!
$200, 000
Build!plant!NPV!=!-$3,000,000!+! !=!-$1,000,000!
.10
Don\t!Build!(Sell!Prototype)!NPV!=!$300,000!
Since!$300,000!>!-$500,000!you!should!sell!prototype!
!
(.5)$1, 000, 000 (.5)$300, 000
NPV!=! !-!$500,000!=!$90,909!
1.10
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
5)!!Assuming!that!Kinston!does!not!have!the!ability!to!sell!the!prototype!in!year!one!for!$300,000,!the!NPV!of!the!
Kinston!Industries!Mountain!Bike!Project!is!closest!to:!
A)!!-$45,000!
B)!!$455,000!
C)!!$590,000!
D)!!$90,000!
Answer:!!!A!
Explanation:!!! A)!!Value$if$test$is$successful!
$400, 000
Build!plant!:!NPV!=!-$3,000,000!+! !=!$1,000,000!
.10
!
Value$if$test$unsuccessful!
$200, 000
Build!plant!NPV!=!-$3,000,000!+! !=!-$1,000,000!
.10
Don\t!Build!(abandon)!NPV!=!$0!
Since!$0!>!-$500,000!you!should!abandon!
!
(.5)$1, 000, 000 (.5)$0
NPV!=! !-!$500,000!=!-$45,455!
1.10
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
6)!!Assume!that!Kinston!has!the!ability!to!ignore!the!pilot!production!and!test!marketing!and!to!go!ahead!and!
build!their!manufacturing!plant!immediately.!!Assuming!that!the!probability!of!high!or!low!demand!is!still!
50%,!the!NPV!of!the!Kinston!Industries!Mountain!Bike!Project!is!closest!to:!
A)!!$0!
B)!!$90,000!
C)!!-$45,000!
D)!!$1,000,000!
Answer:!!!A!
Explanation:!!! A)!! (.5)$400, 000 (.5)$200, 000
NPV!=! !-!$3,000,000!=!$0!
.10
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
build!their!manufacturing!plant!immediately!and!that!the!probability!of!high!or!low!demand!would!still!be!
50%.!!What!is!the!value!of!the!the!option!to!do!pilot!production!and!test!marketing?!
Answer:!!!The!NPV!of!going!ahead!and!building!today!(No!pilot!production!and!test!marketing!option):!
!
(.5)$400, 000 (.5)$200, 000
NPV!=! !-!$3,000,000!=!$0!
.10
NPV!with!pilot!production!and!test!marketing!option:!
!
Value$if$test$is$successful$
$400, 000
Build!plant!:!!NPV!=!-$3,000,000!+! !=!$1,000,000!
.10
!
Value$if$test$unsuccessful$
$200, 000
Build!plant!NPV!=!-$3,000,000!+! !=!-$1,000,000!
.10
Don\t!Build!(Sell!Prototype)!NPV!=!$300,000!
Since!$300,000!>!-$500,000!you!should!sell!prototype!
!
(.5)$1, 000, 000 (.5)$300, 000
NPV!=! !-!-$500,000!=!$90,909!
1.10
So,!value!of!option!=!$90,909!-!$0!=!$90,909!
!
Diff:!3!
Skill:!Analytical!
!
8)!!Assuming!that!Kinston!has!the!ability!to!sell!the!prototype!in!year!one!for!$300,000,!draw!a!decision!tree!
detailing!the!Kinston!Industries!Mountain!Bike!Project.!
Answer:!!!!
!
!
Diff:!2!
Skill:!Analytical!
!
9)!!Assuming!that!Kinston!does!not!have!the!ability!to!sell!the!prototype!in!year!one!for!$300,000,!draw!a!decision!
tree!detailing!the!Kinston!Industries!Mountain!Bike!Project.!
Answer:!!!!
!
!
Diff:!2!
Skill:!Analytical!
!
build!their!manufacturing!plant!immediately.!!Further!assume!that!the!probability!of!high!or!low!demand!is!
still!50%.!Draw!a!decision!tree!that!details!Kinston!Industries!Mountain!Bike!project!if!Kinston!goes!ahead!and!
builds!the!plant!immediately.!
Answer:!!!
!
Diff:!2!
Skill:!Analytical!
!
11)!!Describe!the!two!factors!that!affect!the!value!of!an!investment!timing!option?!
Answer:!!!Volatility:$By!delaying!an!investment,!we!can!base!our!decision!on!additional!information.!The!option!to!
wait!is!most!valuable!when!there!is!a!great!deal!of!uncertainty!regarding!what!the!value!of!the!
investment!will!be!in!the!future.!If!there!is!little!uncertainty,!the!benefit!of!waiting!is!diminished.!
!
Dividends:$Recall!that!absent!dividends,!it!is!not!optimal!to!exercise!a!call!option!early.!!In!the!real!
option!context,!the!dividends!correspond!to!any!value!from!the!investment!that!we!give!up!by!waiting.!
It!is!always!better!to!wait!unless!there!is!a!cost!to!doing!so.!!The!greater!the!cost,!the!less!attractive!the!
option!to!delay!becomes.!
Diff:!2!
Skill:!Conceptual!
!
12)!!Luther!Industries!is!considering!launching!a!new!toy!just!in!time!for!the!Christmas!season.!!They!estimate!that!
if!Luther!launches!the!new!toy!this!year!it!will!have!an!NPV!of!$25!million.!!Luther!has!the!option!to!wait!one!
year!until!the!next!Christmas!season!to!launch!the!toy,!however,!the!demand!next!year!will!depend!upon!
what!new!toys!Luther\s!competitors!introduce!and!therefore!greater!uncertainty!about!next!years!demand.!!
Launching!the!new!today!will!involve!a!total!capital!expenditure!of!$100!million.!!If!the!risk-free!rate!is!5%,!
N(d1)!is!.62!and!N(d2)!is!.65,!then!what!is!the!value!of!the!option!to!wait!until!next!year!to!launch!the!new!toy?!
Answer:!!!C!=!S!×!N(d1)!-!PV(K)!×!N(d2)!
$100
C!=!($100!+!$25)!×!.62!-! !×!.65!=!$15.595!or!$15.6!million!
1.05
Diff:!2!
Skill:!Analytical!
!
22.4((Growth(Options(
(
A)!!It!is!tempting!to!use!the!Black-Scholes!formula!to!value!future!growth!options,!but!often!there!are!good!
reasons!why!this!formula!might!not!price!these!options!correctly.!
B)!!When!a!firm!has!a!real!option!to!invest!in!the!future!it!is!known!as!a!growth!option.!
C)!!Because!growth!options!have!value,!they!contribute!to!the!value!of!any!firm!that!has!future!possible!
investment!opportunities.!
D)!!Future!growth!opportunities!can!be!thought!of!as!a!collection!of!real!put!options!on!potential!projects.!
Answer:!!!D!
B)!!
C)!!
D)!!Future!growth!opportunities!can!be!thought!of!as!a!collection!of!real!call!options!on!potential!
projects.!
Diff:!2!
Topic:!22.4!Growth!Options!
Skill:!Conceptual!
!
A)!!An!alternative!to!using!the!Black-Scholes!formula!is!to!compute!the!value!of!growth!options!using!risk!
neutral!probabilities.!
B)!!Future!growth!options!are!not!only!important!to!firm!value,!but!can!also!be!important!in!the!value!of!an!
individual!project.!
C)!!While!the!Black-Scholes!formula!values!American!options,!most!growth!options!cannot!be!exercised!at!
any!time.!
D)!!Out-of-the-money!calls!are!riskier!than!in-the-money!calls,!and!because!most!growth!options!are!likely!
to!be!out-of-the-money,!the!growth!component!of!firm!value!is!likely!to!be!riskier!than!the!ongoing!
assets!of!the!firm.!
Answer:!!!C!
B)!!
C)!!While!the!Black-Scholes!formula!values!European!options,!most!growth!options!can!be!
exercised!at!any!time.!
D)!!
Diff:!2!
Topic:!22.4!Growth!Options!
Skill:!Conceptual!
!
22.5((Abandonment(Options(
(
A)!!Abandonment!options!can!add!value!to!a!project!because!a!firm!can!drop!a!project!if!it!turns!out!to!be!
unsuccessful.!
B)!!Corporate!bonds!often!contain!embedded!abandonment!options:!The!issuing!firm!sometimes!has!the!
option!to!convert$the!bond–that!is,!to!repay!it.!
C)!!An!abandonment!option!is!the!option!to!walk!away.!
D)!!An!important!abandonment!option!that!most!people!encounter!at!some!point!in!their!lives!is!the!option!
to!abandon!their!mortgage.!
Answer:!!!B!
B)!!Corporate!bonds!often!contain!embedded!abandonment!options:!The!issuing!firm!sometimes!
has!the!option!to!call$the!bond–that!is,!to!repay!it.!
C)!!
D)!!
Diff:!2!
Topic:!22.5!Abandonment!Options!
Skill:!Conceptual!
!
A)!!Often,!the!decision!to!abandon!a!project!entails!costs,!which!may!be!either!positive!or!negative.!
B)!!Mortgage!interest!rates!are!higher!than!Treasury!rates!because!mortgages!have!an!abandonment!option!
that!Treasuries!do!not!have:!You!can!prepay(your!mortgage!at!any!time,!while!the!U.S.!government!can!
repay!its!debt!only!according!to!the!schedule!outlined!in!the!bond!contract.!
C)!!A!popular!option!gives!holders!of!the!bond!the!option!to!convert!the!bond!into!equity.!These!kinds!of!
bonds!are!termed!callable!bonds.!
D)!!More!often!than!not,!there!is!an!opportunity!cost!of!abandoning!a!project:!If!you!shut!down!the!project!
and!later!decide!to!start!it!up!again,!you!have!to!pay!the!costs!of!restarting!the!project.!
Answer:!!!C!
B)!!
C)!!A!popular!option!gives!holders!of!the!bond!the!option!to!convert!the!bond!into!equity.!These!
kinds!of!bonds!are!termed!convertible!bonds.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
You!own!a!small!manufacturing!plant!that!currently!generates!revenues!of!$2!million!per!year.!!Next!year,!based!upon!a!
decision!on!a!long-term!government!contract,!your!revenues!will!either!increase!by!20%!or!decrease!by!25%,!with!equal!
probability,!and!stay!at!that!level!as!long!as!you!operate!the!plant.!!Other!costs!run!$1.6!million!dollars!per!year.!You!can!
sell!the!plant!at!any!time!to!a!large!conglomerate!for!$5!million!and!your!cost!of!capital!is!10%.!
!
3)!!If!you!are!awarded!the!government!contract!and!your!sales!increase!by!20%,!then!the!value!of!your!plant!will!
be!closest!to:!
A)!!$5!million!
B)!!$8!million!
C)!!$0!
D)!!$4!million!
Answer:!!!B!
B)!! $2.0(1.20) $1.6
V!=! !=!$8!million!
.10
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!If!you!are!not!awarded!the!government!contract!and!your!sales!decrease!by!25%,!then!the!value!of!your!plant!
will!be!closest!to:!
A)!!-$1!million!
B)!!$5!million!
C)!!$8!million!
D)!!$0!
Answer:!!!B!
B)!! $2.0(.75) $1.6
V!=! !=!-$1!million,!however!we!could!abandon!at!any!time!and!receive!$0,!or!
.10
better!yet,!we!could!sell!the!plant!for!$5!million,!so!this!becomes!the!appropriate!value.!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Given!the!embedded!option!to!sell!the!plant,!the!value!of!your!plant!will!be!closest!to:!
A)!!$5.0!million!
B)!!$4.0!million!
C)!!$6.5!million!
D)!!$8.0!million!
Answer:!!!C!
B)!!
C)!!Value$if$revenues$increase$
$2.0(1.20) $1.6
V!=! !=!$8!million!
.10
!
Value$if$revenue$decreases!
$2.0(.75) $1.6
V!=! !=!-$1!million,!however!you!could!sell!the!plant!for!$5!million,!so!this!
.10
becomes!the!appropriate!value.!
!
Value$with$embedded$options$
V!=!(.5)($8)!+!(.5)($5)!=!$6.5!million!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Assume!that!you!are!not!able!to!sell!the!plant,!but!you!are!able!to!shut!down!the!plant!at!no!cost!at!any!time.!!
Given!the!embedded!option!to!abandon!production!the!value!of!your!plant!will!be!closest!to:!
A)!!$8.0!million!
B)!!$4.0!million!
C)!!$5.0!million!
D)!!$6.5!million!
Answer:!!!B!
B)!!Value$if$revenues$increase!
$2.0(1.20) $1.6
V!=! !=!$8!million!
.10
!
Value$if$revenue$decreases$
$2.0(.75) $1.6
V!=! !=!-$1!million,!however!you!could!abandon!production!and!receive!$0,!so!
.10
this!becomes!the!appropriate!value.!
!
Value$with$embedded$options$
V!=!(.5)($8)!+!(.5)($0)!=!$4.0!million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
The!value!of!the!option!to!abandon!production!will!be!closest!to:!
A)!!$1.0!million!
B)!!$0.5!million!
C)!!-$1.0!million!
D)!!$3.0!million!
Answer:!!!B!
B)!!Value$if$revenues$increase!
$2.0(1.20) $1.6
V!=! !=!$8!million!
.10
!
$2.0(.75) $1.6
V!=! !=!-$1!million,!!
.10
however!if!you!could!abandon!production!you!would!receive!$0!
!
Value$with$embedded$option$
V!=!(.5)($8)!+!(.5)($0)!=!$4.0!million!
!
Value$without$embedded$option:$
V!=!(.5)($8)!+!(.5)(-$1)!=!$3.5!million!
!
So,!the!option!to!abandon!is!worth!$4!million!-!$3.5!million!=!$0.5!million!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Assume!that!it!will!cost!you!$1!million!to!shut!down!the!plant,!but!you!are!able!to!sell!the!plant!for!$5!million!
at!any!time.!!The!value!of!the!option!to!sell!the!plant!will!be!closest!to:!
A)!!$3.0!million!
B)!!$6.0!million!
C)!!$5.0!million!
D)!!$0.5!million!
Answer:!!!A!
Explanation:!!! A)!!Value!if!revenues!increase!
$2.0(1.20) $1.6
V!=! !=!$8!million!
.10
!
$2.0(.75) $1.6
V!=! !=!-$1!million,!!
.10
however!if!you!could!sell!the!plant!you!would!receive!$5!million!
!
Value$with$embedded$option$
V!=!(.5)($8)!+!(.5)($5)!=!$6.5!million!
!
Value$without$embedded$option$
V!=!(.5)($8)!+!(.5)(-$1)!=!$3.5!million!
!
So,!the!option!to!abandon!is!worth!$6.5!million!-!$3.5!million!=!$3.0!million!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
9)!!Assuming!you!are!able!to!see!the!plant,!draw!a!decision!tree!detailing!this!problem.!
Answer:!!!!
!
!
Diff:!2!
Skill:!Analytical!
Draw!a!decision!tree!detailing!this!problem.!
Answer:!!!!
!
!
Diff:!2!
Skill:!Analytical!
22.6((Application:(Deciding(Between(Mutually(Exclusive(Investments(of(Different(Lengths(
(
A)!!Traditionally,!managers!have!used!the!equivalent!annual!benefit!method!to!choose!between!projects!of!
different!lives.!
B)!!The!equivalent!annual!benefit!method!ignores!the!value!of!any!real!options!because!it!assumes!that!the!
projects!will!always!be!replaced!at!their!original!terms.!
C)!!If!the!future!costs!(or!benefits)!are!certain!with!mutually!exclusive!projects,!then!we!must!use!a!real!
options!approach!to!determine!the!correct!decision.!
D)!!The!equivalent!annual!benefit!method!accounts!for!the!difference!in!project!lengths!by!calculating!the!
constant!payment!over!the!life!of!the!project!that!is!equivalent!to!receiving!the!NPV!today!and!then!
selecting!the!project!with!the!higher!equivalent!annual!benefit.!
Answer:!!!C!
B)!!
C)!!If!the!future!costs!(or!benefits)!are!certain!with!mutually!exclusive!projects,!then!we!can!
ignore!the!real!options!approach!when!determining!the!correct!decision.!
D)!!
Diff:!2!
Topic:!22.6!Application:!Deciding!Between!Mutually!Exclusive!Investments!of!Different!Lengths!
Skill:!Conceptual!
!
!
Consider!the!following!mutually!exclusive!projects:!
!
Year(0( Year(1( Year(2( Year(3( Year(4( Year(5( Year(6( Year(7( Discount(
Project( C/F( C/F( C/F( C/F( C/F( C/F( C/F( C/F( Rate(
A! -79! 20! 25! 30! 35! 40! N/A! N/A! 15%!
B! -80! 25! 25! 25! 25! 25! 25! 25! 15%!
!
!
2)!!The!NPV!of!project!A!is!closest!to:!
A)!!$21.70!
B)!!$24.00!
C)!!$18.10!
D)!!$16.90!
Answer:!!!D!
B)!!
C)!!
D)!!C/F0!=!-79!
C/F1!=!20!
C/F2!=!25!
C/F3!=!30!
C/F4!=!35!
C/F5!=!40!
I!=!15!
Compute!NPV!=!$16.92!
Diff:!2!
Skill:!Analytical!
3)!!The!NPV!of!project!B!is!closest!to:!
A)!!$18.10!
B)!!$21.70!
C)!!$24.00!
D)!!$16.90!
Answer:!!!C!
B)!!
C)!! 1 1
NPV!=!-80!+!25 !=!$24.01!
.15 .15(1.15)7
D)!!
Diff:!2!
Skill:!Analytical!
!
4)!!The!equivalent!annual!benefit!of!project!A!is!closest!to:!
A)!!$21.70!
B)!!$5.05!
C)!!$24.00!
D)!!$3.40!
Answer:!!!B!
B)!!C/F0!=!-79!
C/F1!=!20!
C/F2!=!25!
C/F3!=!30!
C/F4!=!35!
C/F5!=!40!
I!=!15!
!
PV!=!-16.92!
FV!=!0!
N!=!5!
I!=!15!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!The!equivalent!annual!benefit!of!project!B!is!closest!to:!
A)!!$5.05!
B)!!$5.75!
C)!!3.45!
D)!!$3.40!
Answer:!!!B!
B)!! 1 1
NPV!=!-80!+!25 !=!$24.01!
.15 .15(1.15)7
!
PV!=!-24.01!
FV!=!0!
N!=!7!
I!=!15!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
6)!!Using!the!equivalent!annual!benefit!method,!which!project!would!you!select!and!why?!
Answer:!!!Project$A!
C/F0!=!-79!
C/F1!=!20!
C/F2!=!25!
C/F3!=!30!
C/F4!=!35!
C/F5!=!40!
I!=!15!
!
PV!=!-16.92!
FV!=!0!
N!=!5!
I!=!15!
!
Project$B!
1 1
NPV!=!-80!+!25 !=!$24.01!
.15 .15(1.15)7
PV!=!-24.01!
FV!=!0!
N!=!7!
I!=!15!
!
Since!the!equivalent!annual!benefit!of!B!>!A!you!should!take!B.!
Diff:!2!
Skill:!Analytical!
22.7((Rules(of(Thumb(
(
A)!!The!profitability!index!rule!of!thumb!raises!the!bar!on!the!NPV!to!take!into!account!the!option!to!wait.!
B)!!In!practice,!correctly!modeling!the!sources!of!uncertainty!and!the!appropriate!dynamic!decisions!usually!
requires!an!extensive!amount!of!time!and!financial!expertise.!
C)!!Some!firms!use!the!following!rule!of!thumb:!Invest!whenever!the!profitability!index!is!below!a!specified!
level.!
D)!!Instead!of!raising!the!bar!on!the!NPV,!the!hurdle!rate!rule!raises!the!discount!rate.!
Answer:!!!C!
B)!!
C)!!Some!firms!use!the!following!rule!of!thumb:!Invest!whenever!the!profitability!index!is!above!a!
specified!level.!
D)!!
Diff:!1!
Topic:!22.7!Rules!of!Thumb!
Skill:!Conceptual!
!
A)!!When!the!investment!cannot!be!delayed,!the!optimal!rule!is!to!invest!whenever!the!profitability!index!is!
greater!than!zero.!
B)!!It!is!often!better!to!wait!too!long!(use!a!profitability!index!criterion!that!is!too!high)!than!to!invest!too!
soon!(use!a!profitability!index!criterion!that!is!too!low).!
C)!!When!the!source!of!uncertainty!that!creates!a!motive!to!wait!is!interest!rate!uncertainty,!the!hurdle!rate!is!
relatively!easy!to!calculate.!
D)!!When!there!is!an!option!to!delay,!a!good!rule!of!thumb!is!to!invest!only!when!the!profitability!index!is!at!
least!1.!
Answer:!!!B!
B)!!It!is!often!better!to!wait!too!long!(use!a!profitability!index!criterion!that!is!too!low)!than!to!
invest!too!soon!(use!a!profitability!index!criterion!that!is!too!high).!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!hurdle!rate!rule!for!projects!with!the!option!to!delay!uses!a!lower!discount!rate!than!the!cost!of!
capital!to!compute!the!NPV,!but!then!applies!the!regular!NPV!rule:!Invest!whenever!the!NPV!calculated!
using!this!lower!discount!rate!is!positive.!
B)!!While!using!a!hurdle!rate!rule!for!deciding!when!to!invest!might!be!a!cost-effective!way!to!make!
investment!decisions,!it!is!important!to!remember!that!this!rule!does!not!provide!an!accurate!measure!of$
value.!
C)!!When!the!cash!flows!are!constant!and!perpetual,!and!the!reason!to!wait!derives!solely!from!interest!rate!
uncertainty,!the!hurdle!rate!rule!of!thumb!is!always!exact.!!However,!when!these!conditions!are!not!
satisfied,!the!rule!of!thumb!merely!approximates!the!correct!decision.!
D)!!When!a!firm!faces!the!same!uncertainty!for!most!of!its!investment!decisions,!using!a!single!profitability!
index!criterion!for!all!projects!can!provide!a!useful!rule!of!thumb!to!account!for!cash!flow!uncertainty.!
Answer:!!!A!
Explanation:!!! A)!!The!hurdle!rate!rule!for!projects!with!the!option!to!delay!uses!a!higher!discount!rate!than!the!
cost!of!capital!to!compute!the!NPV,!but!then!applies!the!regular!NPV!rule:!Invest!whenever!
the!NPV!calculated!using!this!lower!discount!rate!is!positive.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Chapter(23(-(The(Mechanics(of(Raising(Equity(Capital(
!
(
23.1(Equity(Financing(for(Private(Companies(
1)!!Which!of!the!following!statements!is!not!true!regarding!Angel!Investors?!
A)!!They!are!typically!arranged!as!limited!partnerships.!
B)!!For!many!start-ups,!the!first!round!of!outside!private!equity!financing!is!often!obtained!from!them.!
C)!!Because!their!capital!investment!is!often!large!relative!to!the!amount!of!capital!already!in!place!at!the!
firm,!they!typically!receive!a!sizeable!equity!share!in!the!business!in!return!for!their!funds.!
D)!!These!investors!are!frequently!friends!or!acquaintances!of!the!entrepreneur.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!23.1!Equity!Financing!for!Private!Companies!
Skill:!Conceptual!
!
2)!!Which!of!the!following!statements!is!not!true!regarding!venture!capitalists?!
A)!!They!can!provide!substantial!capital!for!young!companies.!
B)!!They!firms!offer!limited!partners!a!number!of!advantages!over!investing!directly!in!start-ups!themselves!
as!angel!investors.!
C)!!They!use!their!control!to!protect!their!investments,!so!they!may!therefore!perform!a!key!nurturing!and!
monitoring!role!for!the!firm.!
D)!!They!might!invest!for!strategic!objectives!in!addition!to!the!desire!for!investment!returns.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!of!the!following!is!not!a!common!name!for!a!corporation!that!invests!in!private!companies?!
A)!!Strategic!investor!
B)!!Corporate!partner!
C)!!Venture!partner!
D)!!Strategic!partner!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!A!venture!capital!firm(is!a!limited!partnership!that!specializes!in!raising!money!to!invest!in!the!private!
equity!of!young!firms.!
B)!!Venture!capitalists!typically!control!about!three-quarters!of!the!seats!on!a!start-upQs!board!of!directors,!
and!often!represent!the!single!largest!voting!block!on!the!board.!
C)!!The!initial!capital!that!is!required!to!start!a!business!is!usually!provided!by!the!entrepreneur!herself!and!
her!immediate!family.!
D)!!Individual!investors!who!buy!equity!in!small!private!firms!are!called!angel!investors.!
Answer:!!!B!
B)!!Venture!capitalists!typically!control!about!one-third!of!the!seats!on!a!start-upQs!board!of!
directors,!and!often!represent!the!single!largest!voting!block!on!the!board.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!general!partners!work!for!the!venture!capital!firm!and!run!the!venture!capital!firm;!they!are!called!
venture!capitalists.!
B)!!An!important!consideration!for!investors!in!private!companies!is!their!exit!strategy–how!they!will!
eventually!realize!the!return!from!their!investment.!
C)!!When!a!company!founder!decides!to!sell!equity!to!outside!investors!for!the!first!time,!it!is!common!
practice!for!private!companies!to!issue!common!stock!rather!than!preferred!stock!to!raise!capital.!
D)!!Institutional!investors!such!as!pension!funds,!insurance!companies,!endowments,!and!foundations!
manage!large!quantities!of!money.!
Answer:!!!C!
B)!!
C)!!When!a!company!founder!decides!to!sell!equity!to!outside!investors!for!the!first!time,!it!is!
common!practice!for!private!companies!to!issue!preferred!stock!rather!than!common!stock!to!
raise!capital.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!preferred!stock!issued!by!young!companies!typically!does!not!pay!regular!cash!dividends.!
B)!!The!preferred!stock!issued!by!young!companies!usually!gives!the!owner!an!option!to!convert!it!into!
common!stock!on!some!future!date,!so!it!is!often!called!callable!preferred!stock.!
C)!!If!the!company!runs!into!financial!difficulties,!the!preferred!stockholders!have!a!senior!claim!on!the!
assets!of!the!firm!relative!to!any!common!stockholders.!
D)!!Preferred!stock(issued!by!mature!companies!such!as!banks!usually!has!a!preferential!dividend!and!
seniority!in!any!liquidation!and!sometimes!special!voting!rights.!
Answer:!!!B!
B)!!The!preferred!stock!issued!by!young!companies!usually!gives!the!owner!an!option!to!convert!
it!into!common!stock!on!some!future!date,!so!it!is!often!called!convertable!preferred!stock.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
You!founded!your!own!firm!three!years!ago.!!You!initially!contributed!$200,000!of!your!own!money!and!in!return!you!
received!2!million!shares!of!stock.!!Since!then,!you!have!sold!an!additional!1!million!shares!of!stock!to!angel!investors.!!You!
are!now!considering!raising!capital!from!a!venture!capital!firm.!!This!venture!capital!firm!would!invest!$5!million!and!
would!receive!2!million!newly!issued!shares!in!return.!
!
7)!!The!post-money!valuation!of!your!firm!is!closest!to:!
A)!!$12.5!million!
B)!!$5.2!million!
C)!!$10.0!million!
D)!!$5.0!million!
Answer:!!!A!
Explanation:!!! A)!!Total!shares!outstanding!=!2M!(yours)!+!1M!(angels)!+!2M!(Venture)!=!5!million!shares!
$5 million
The!venture!capitalist!would!be!paying! !=!$2.50!per!share!
2 million shares
Therefore!post-money!valuation!=!$2.50!×!5!million!shares!=!$12.5!million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Assuming!that!this!is!the!venture!capitalistQs!first!investment!in!your!firm,!what!percentage!of!the!firm!will!the!
venture!capitalist!own?!
A)!!50%!
B)!!40%!
C)!!25%!
D)!!33%!
Answer:!!!B!
B)!!Total!shares!outstanding!=!2M!(yours)!+!1M!(angels)!+!2M!(Venture)!=!5!million!shares!
2 million shares
The!venture!capitalist!ownership!percentage!=! !=!40%!
5 million shares
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
9)!!Assuming!that!this!is!the!venture!capitalistQs!first!investment!in!your!firm,!what!percentage!of!the!firm!will!
you!own?!
A)!!50%!
B)!!40%!
C)!!33%!
D)!!25%!
Answer:!!!B!
B)!!Total!shares!outstanding!=!2M!(yours)!+!1M!(angels)!+!2M!(Venture)!=!5!million!shares!
2 million shares
Your!ownership!percentage!=! !=!40%!
5 million shares
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!Assuming!that!this!is!the!venture!capitalistQs!first!investment!in!your!firm,!the!post-money!valuation!of!your!
shares!are!closest!to:!
A)!!$5.0!million!
B)!!$12.5!million!
C)!!$4.0!million!
D)!!$2.5!million!
Answer:!!!A!
Explanation:!!! A)!!Total!shares!outstanding!=!2M!(yours)!+!1M!(angels)!+!2M!(Venture)!=!5!million!shares!
$5 million
2 million shares
Therefore!your!post-money!valuation!=!$2.50!×!2!million!shares!=!$5!million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!Assuming!that!this!is!the!venture!capitalistQs!first!investment!in!your!firm,!the!post-money!valuation!of!the!
angel!investorQs!shares!are!closest!to:!
A)!!$12.5!million!
B)!!$4.0!million!
C)!!$5.0!million!
D)!!$2.5!million!
Answer:!!!D!
B)!!
C)!!
D)!!Total!shares!outstanding!=!2M!(yours)!+!1M!(angels)!+!2M!(Venture)!=!5!million!shares!
$5 million
2 million shares
Therefore!your!post-money!valuation!=!$2.50!×!1!million!shares!=!$2.5!million!
Diff:!2!
Skill:!Analytical!
(
23.2((The(Initial(Public(Offering(
(
A)!!The!process!of!selling!stock!to!the!public!for!the!first!time!is!called!a!seasoned!equity!offering!(SEO).!
B)!!Public!companies!typically!have!access!to!much!larger!amounts!of!capital!through!the!public!markets.!
C)!!By!going!public,!companies!give!their!private!equity!investors!the!ability!to!diversify.!
D)!!The!two!advantages!of!going!public!are!greater!liquidity!and!better!access!to!capital.!
Answer:!!!A!
Explanation:!!! A)!!The!process!of!selling!stock!to!the!public!for!the!first!time!is!called!an!initial!public!offering!
(IPO).!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!23.2!The!Initial!Public!Offering!
Skill:!Conceptual!
!
A)!!Once!a!company!goes!public,!it!must!satisfy!all!of!the!requirements!of!public!companies.!
B)!!Organizations!such!as!the!Securities!and!Exchange!Commission!(SEC),!the!securities!exchanges!
(including!the!New!York!Stock!Exchange!and!the!Nasdaq),!and!Congress!(through!the!Sarbanes-Oxley!
Act!of!2002)!adopted!new!standards!that!focused!on!more!thorough!financial!disclosure,!greater!
accountability,!and!more!stringent!requirements!for!the!board!of!directors.!
C)!!The!major!advantage!of!undertaking!an!IPO!is!also!one!of!the!major!disadvantages!of!an!IPO:!When!
investors!diversify!their!holdings,!the!equity!holders!of!the!corporation!become!more!concentrated.!
D)!!Several!high!profile!corporate!scandals!during!the!early!part!of!the!twenty-first!century!prompted!
tougher!regulations!designed!to!address!corporate!abuses.!
Answer:!!!C!
B)!!
C)!!The!major!advantage!of!undertaking!an!IPO!is!also!one!of!the!major!disadvantages!of!an!IPO:!
When!investors!diversify!their!holdings,!the!equity!holders!of!the!corporation!become!more!
dispersed.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!After!deciding!to!go!public,!managers!of!the!company!work!with!an!underwriter,!an!investment!
banking!firm!that!manages!the!offering!and!designs!its!structure.!
B)!!The!shares!that!are!sold!in!the!IPO!may!either!be!new!shares!that!raise!new!capital,!known!as!a!
secondary!offering,!or!existing!shares!that!are!sold!by!current!shareholders!(as!part!of!their!exit!strategy),!
known!as!a!primary!offering.!
C)!!Many!IPOs,!especially!the!larger!offerings,!are!managed!by!a!group!of!underwriters.!
D)!!At!an!IPO,!a!firm!offers!a!large!block!of!shares!for!sale!to!the!public!for!the!first!time.!
Answer:!!!B!
B)!!The!shares!that!are!sold!in!the!IPO!may!either!be!new!shares!that!raise!new!capital,!known!as!
a!primary!offering,!or!existing!shares!that!are!sold!by!current!shareholders!(as!part!of!their!
exit!strategy),!known!as!a!secondary!offering.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!Which!of!the!following!statements!regarding!best!efforts!IPOs!is!false?!
A)!!For!smaller!IPOs,!the!underwriter!commonly!accepts!the!deal!on!this(basis.!
B)!!The!underwriter!does!not!guarantee!that!the!stock!will!be!sold,!but!instead!tries!to!sell!the!stock!for!the!
best!possible!price.!
C)!!Often!these!arrangements!have!an!all-or-none!clause:!either!all!of!the!shares!are!sold!in!the!IPO,!or!the!
deal!is!called!off.!
D)!!If!the!entire!issue!does!not!sell!out,!the!underwriter!is!on!the!hook.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!entire!issue!does!not!sell!out,!the!underwriter!is!off!on!the!hook!since!this!is!not!a!firm!
commitment!offering.!
Diff:!2!
Skill:!Conceptual!
!
5)!!Which!of!the!following!statements!regarding!firm!commitment!IPOs!is!false?!
A)!!If!the!entire!issue!does!not!sell!out,!the!remaining!shares!must!be!sold!at!a!lower!price!and!the!
underwriter!must!take!the!loss.!
B)!!The!underwriter!purchases!the!entire!issue!(at!a!the!offer!price)!and!then!resells!it!at!a!slightly!higher!
price!to!interested!investors.!
C)!!It!is!the!most!common!underwriting!arrangement.!
D)!!The!underwriter!guarantees!that!it!will!sell!all!of!the!stock!at!the!offer!price.!
Answer:!!!B!
B)!!The!underwriter!purchases!the!entire!issue!(at!a!price!slightly!lower!than!the!offer!price)!and!
then!resells!it!at!the!offer!price!to!interested!investors.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!In!recent!years,!the!investment!banking!firm!of!W.R.!Hambrecht!and!Company!has!attempted!to!change!
the!IPO!process!by!selling!new!issues!directly!to!the!public!using!an!online!auction!IPO!mechanism!
called!Open!IPO.!
B)!!The!lead!underwriter(is!the!primary!banking!firm!responsible!for!managing!the!deal.!The!lead!
underwriter!provides!most!of!the!advice!and!arranges!for!a!group!of!other!underwriters,!called!the!
syndicate,!to!help!market!and!sell!the!issue.!
C)!!Because!of!the!potential!conflict!of!interest,!the!underwriter!will!not!make!a!market!in!the!stock!after!the!
issue.!
D)!!The!SEC!requires!that!companies!prepare!a!registration!statement,!a!legal!document!that!provides!
financial!and!other!information!about!the!company!to!investors,!prior!to!an!IPO.!Company!managers!
work!closely!with!the!underwriters!to!prepare!this!registration!statement!and!submit!it!to!the!SEC.!
Answer:!!!C!
B)!!
C)!!Most!underwriters!will!commit!to!make!a!market!in!the!stock!after!the!issue.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!As!part!of!the!registration!statement,!called!the!preliminary!prospectus,!circulates!to!investors!before!the!stock!
is!offered.!!This!preliminary!prospectus!is!also!called!a(n)!
A)!!IPO!filing.!
B)!!10-K!filing.!
C)!!blue!whale.!
D)!!red!herring.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!Once!the!issue!price!(or!offer!price)!is!set,!underwriters!may!invoke!another!mechanism!to!protect!
themselves!against!a!loss–the!over-allotment!allocation.!
B)!!Before!the!offer!price!is!set,!the!underwriters!work!closely!with!the!company!to!come!up!with!a!price!
range!that!they!believe!provides!a!reasonable!valuation!for!the!firm.!
C)!!Before!an!IPO,!the!company!prepares!the!final!registration!statement!and!final!prospectus(containing!all!
the!details!of!the!IPO,!including!the!number!of!shares!offered!and!the!offer!price.!
D)!!A!droad!tripd!is!where!senior!management!and!the!lead!underwriters!travel!around!the!country!(and!
sometimes!around!the!world)!promoting!the!company!and!explaining!their!rationale!for!the!offer!price!
to!the!underwriters’!largest!customers–mainly!institutional!investors!such!as!mutual!funds!and!pension!
funds.!
Answer:!!!D!
B)!!
C)!!
D)!!A!droad!showd!is!where!senior!management!and!the!lead!underwriters!travel!around!the!
country!(and!sometimes!around!the!world)!promoting!the!company!and!explaining!their!
rationale!for!the!offer!price!to!the!underwriters’!largest!customers–mainly!institutional!
investors!such!as!mutual!funds!and!pension!funds.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Underwriters!appear!to!use!the!information!they!acquire!during!the!book-building!stage!to!intentionally!
under!price!the!IPO,!thereby!reducing!their!exposure!to!losses.!
B)!!The!blue!tooth!option!allows!the!underwriter!to!issue!more!stock,!amounting!to!15%!of!the!original!offer!
size,!at!the!IPO!offer!price.!
C)!!The!lead!underwriter!usually!makes!a!market!in!the!stock!and!assigns!an!analyst!to!cover!it.!
D)!!In!most!cases,!the!preexisting!shareholders!are!subject!to!a!180-day!lockup;!they!cannot!sell!their!shares!
for!180!days!after!the!IPO.!Once!the!lockup!period!expires,!they!are!free!to!sell!their!shares.!
Answer:!!!B!
B)!!The!green!shoe!option!allows!the!underwriter!to!issue!more!stock,!amounting!to!15%!of!the!
original!offer!size,!at!the!IPO!offer!price.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
10)!!Which!of!the!following!is!not!one!of!the!four!characteristics!of!IPOs!that!puzzle!financial!economists?!
A)!!On!average,!IPOs!appear!to!be!underpriced.!
B)!!The!long-run!performance!of!a!newly!public!company!(three!to!five!years!from!the!date!of!issue)!is!
superior!to!the!overall!market!return.!
C)!!The!number!of!issues!is!highly!cyclical.!
D)!!The!costs!of!the!IPO!are!very!high,!and!it!is!unclear!why!firms!willingly!incur!such!high!costs.!
Answer:!!!B!
B)!!
C)!!The!long-run!performance!of!a!newly!public!company!(three!to!five!years!from!the!date!of!
issue)!is!inferior!to!the!overall!market!return.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
11)!!Which!of!the!following!statements!regarding!exit!strategies!is!false?!
A)!!An!alternative!way!to!provide!liquidity!to!its!investors!is!for!the!company!to!become!a!publicly!traded!
company.!
B)!!An!important!consideration!for!investors!in!private!companies!is!their!exit!strategy!or!how!they!will!
eventually!realize!the!return!from!their!investment!
C)!!Often!large!corporations!purchase!successful!start-up!companies.!In!such!a!case,!the!acquiring!company!
purchases!the!outstanding!stock!of!the!private!company,!allowing!all!investors!to!cash!out.!!
D)!!Roughly!25%!of!venture!capital!exits!from!2001-2005!occurred!through!mergers!or!acquisitions.!!
Answer:!!!D!
B)!!
C)!!
D)!!Roughly!85%!of!venture!capital!exits!from!2001-2005!occurred!through!mergers!or!
acquisitions.!
Diff:!2!
Skill:!Conceptual!
!
Luther!Industries!is!in!the!process!of!selling!shares!of!stock!in!an!auction!IPO.!!At!the!end!of!the!bidding!period,!LutherQs!
investment!bank!has!received!the!following!bids:
Number(of(
Price(($) Shares(Bid(
$19.50! 50,000!
$19.25! 25,000!
$19.10! 25,000!
$19.00! 100,000!
$18.75! 125,000!
$18.50! 75,000!!
$18.25! 150,000!
$18.00! 240,000!
$17.75! 80,000!
$17.50! 125,000!
$17.25! 150,000!
$17.00! 100,000!
$16.90! 60,000!
$16.75! 80,000!
$16.50! 75,000!
$16.25! 200,000!
!
12)!!What!will!the!offer!price!of!these!shares!be!if!Luther!is!selling!1!million!shares?!
A)!!$17.00!
B)!!$17.50!
C)!!$17.25!
D)!!$16.75!
Answer:!!!C!
B)!!
C)!! Number(of( Cumulative(
Price(($) Shares(Bid Demand(
$19.50! 50,000 50,000!
$19.25! 25,000 75,000!
$19.10! 25,000 100,000!
$19.00! 100,000 200,000!
$18.75! 125,000 325,000!
$18.50! 75,000! 400,000!
$18.25! 150,000 550,000!
$18.00! 240,000 790,000!
$17.75! 80,000 870,000!
$17.50! 125,000 995,000!
$17.25! 150,000 1,145,000!
$17.00! 100,000 1,245,000!
$16.90! 60,000 1,305,000!
$16.75! 80,000 1,385,000!
$16.50! 75,000 1,460,000!
$16.25! 200,000 1,660,000!
By!looking!at!cumulative!demand,!we!see!that!a!cumulative!demand!of!1!million!shares!
corresponds!to!a!price!of!$17.25.!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!The!proceeds!from!the!IPO!be!if!Luther!is!selling!1.25!million!shares!is!closest!to:!
A)!!$20.6!million!
B)!!$21.6!million!
C)!!$21.1!million!
D)!!$20.9!million!
Answer:!!!C!
B)!!
C)!! Number(of( Cumulative(
$19.50! 50,000 50,000!
$19.25! 25,000 75,000!
$19.10! 25,000 100,000!
$19.00! 100,000 200,000!
$18.75! 125,000 325,000!
$18.50! 75,000! 400,000!
$18.25! 150,000 550,000!
$18.00! 240,000 790,000!
$17.75! 80,000 870,000!
$17.50! 125,000 995,000!
$17.25! 150,000 1,145,000!
$17.00! 100,000 1,245,000!
$16.90! 60,000 1,305,000!
$16.75! 80,000 1,385,000!
$16.50! 75,000 1,460,000!
$16.25! 200,000 1,660,000!
By!looking!at!cumulative!demand,!we!see!that!a!cumulative!demand!of!1.25!million!shares!
corresponds!to!a!price!of!$16.90
So!proceeds!=!$16.90!×!1,250,000!=!$21,125,000!
D)!!
Diff:!2!
Skill:!Analytical!
!
14)!!What!will!the!offer!price!of!these!shares!be!if!Luther!is!selling!800,000!shares?!
Answer:!!! Number(of( Cumulative(
$19.50! 50,000 50,000!
$19.25! 25,000 75,000!
$19.10! 25,000 100,000!
$19.00! 100,000 200,000!
$18.75! 125,000 325,000!
$18.50! 75,000! 400,000!
$18.25! 150,000 550,000!
$18.00! 240,000 790,000!
$17.75! 80,000 870,000!
$17.50! 125,000 995,000!
$17.25! 150,000 1,145,000!
$17.00! 100,000 1,245,000!
$16.90! 60,000 1,305,000!
$16.75! 80,000 1,385,000!
$16.50! 75,000 1,460,000!
$16.25! 200,000 1,660,000!
By!looking!at!Cumulative!demand,!we!see!that!a!cumulative!demand!of!800,000!shares!corresponds!to!a!
price!of!$17.75.!
Diff:!2!
Skill:!Analytical!
!
15)!!What!will!the!proceeds!from!the!IPO!be!if!Luther!is!selling!1.1!million!shares?!
Answer:!!! Number(of( Cumulative(
$19.50! 50,000 50,000!
$19.25! 25,000 75,000!
$19.10! 25,000 100,000!
$19.00! 100,000 200,000!
$18.75! 125,000 325,000!
$18.50! 75,000! 400,000!
$18.25! 150,000 550,000!
$18.00! 240,000 790,000!
$17.75! 80,000 870,000!
$17.50! 125,000 995,000!
$17.25! 150,000 1,145,000!
$17.00! 100,000 1,245,000!
$16.90! 60,000 1,305,000!
$16.75! 80,000 1,385,000!
$16.50! 75,000 1,460,000!
$16.25! 200,000 1,660,000!
By!looking!at!cumulative!demand,!we!see!that!a!cumulative!demand!of!1.1!million!shares!corresponds!
to!a!price!of!$17.25
So,!proceeds!=!$17.25!×!1,100,000!=!$18,975,000!
Diff:!2!
Skill:!Analytical!
!
During!the!most!recent!fiscal!year,!KT!Industries!had!revenues!of!$400!million!and!earnings!of!$30!million.!!KD!has!filed!a!
registration!statement!with!the!SEC!for!its!IPO.!!Before!it!is!offered,!KDQs!investment!bankers!would!like!to!estimate!the!
value!of!the!company!using!comparable!companies.!!The!investment!bankers!have!assembled!the!following!information!
based!on!data!for!other!companies!in!the!same!industry!that!have!recently!gone!public.!!In!each!case!the!ratios!are!based!
upon!the!IPO!price.
Comparable(Company Price/Earnings Price/Revenues(

Eenie 12.4 1.6!
Meenie 14.6 1.4!
Minie 16.2 1.2!
Moe 20.4 0.8!
!
16)!!Based!upon!the!price/revenue!ratio,!what!would!be!a!reasonable!value!for!KD?!
Answer:!!!
Eenie 12.4 1.6!
Meenie 14.6 1.4!
Minie 16.2 1.2!
Moe 20.4 0.8!
Average 15.9 1.25!
Taking!the!average!Price/Revenue!ratio!of!1.25!×!$400!million!in!revenue!=!$500!million!
Diff:!1!
Skill:!Analytical!
!
17)!!Based!upon!the!price/earnings!ratio,!what!would!be!a!reasonable!value!for!KD?!
Answer:!!!
Eenie 12.4 1.6!
Meenie 14.6 1.4!
Minie 16.2 1.2!
Moe 20.4 0.8!
Average 15.9 1.25!
Taking!the!average!Price/Revenue!ratio!of!15.9!×!$30!million!in!earnings!=!$477!million!
Diff:!1!
Skill:!Analytical!
!
18)!!Describe!the!four!characteristics!of!IPOs!that!puzzle!financial!economists.!!
Answer:!!!First,!on!average,!IPOs!appear!to!be!underpriced:!The!price!at!the!end!of!trading!on!the!first!day!is!often!
substantially!higher!than!the!IPO!price.!Second,!the!number!of!issues!is!highly!cyclical.!When!times!are!
good,!the!market!is!flooded!with!new!issues;!when!times!are!bad,!the!number!of!issues!dries!up.!Third,!
the!costs!of!the!IPO!are!very!high,!and!it!is!unclear!why!firms!willingly!incur!such!high!costs.!Finally,!
the!long-run!performance!of!a!newly!public!company!(three!to!five!years!from!the!date!of!issue)!is!poor.!
That!is,!on!average,!a!three-!to!five-year!buy!and!hold!strategy!appears!to!be!a!bad!investment.!
Diff:!2!
Skill:!Conceptual!
!
19)!!When!referring!to!IPOs,!what!is!book!building?!
Answer:!!!At!the!end!of!the!road!show,!customers!inform!the!underwriters!of!their!interest!by!telling!the!
underwriters!how!many!shares!they!may!want!to!purchase.!Although!these!commitments!are!
nonbinding,!the!underwritersQ!customers!value!their!long-term!relationships!with!the!underwriters,!so!
they!rarely!go!back!on!their!word.!The!underwriters!then!add!up!the!total!demand!and!adjust!the!price!
until!it!is!unlikely!that!the!issue!will!fail.!This!process!for!coming!up!with!the!offer!price!based!on!
customers’!expressions!of!interest!is!called!book!building.!
Diff:!2!
Skill:!Conceptual!
!
23.3((The(Seasoned(Equity(Offering(
(
A)!!More!often!than!not,!firms!return!to!the!equity!markets!and!offer!new!shares!for!sale,!a!type!of!offering!
called!a!seasoned!equity!offering!(SEO).!
B)!!Usually,!profitable!growth!opportunities!occur!throughout!the!life!of!the!firm,!and!in!some!cases!it!is!not!
feasible!to!finance!these!opportunities!out!of!retained!earnings.!
C)!!When!a!firm!issues!stock!using!an!SEO,!it!follows!many!of!the!same!steps!as!for!an!IPO.!!The!main!
difference!is!that!a!market!price!for!the!stock!already!exists,!so!the!price-setting!process!is!not!necessary.!
D)!!A!firm’s!need!for!outside!capital!usually!ends!at!the!IPO.!
Answer:!!!D!
B)!!
C)!!
D)!!A!firmQs!need!for!outside!capital!rarely!ends!at!the!IPO.!
Diff:!1!
Topic:!23.3!The!Seasoned!Equity!Offering!
Skill:!Conceptual!
!
A)!!Primary!shares!are!new!shares!issued!by!the!company.!
B)!!Today,!investors!become!informed!about!the!impending!sale!of!stock!by!the!news!media,!via!a!road!
show,!or!through!the!book-building!process,!so!tombstones!are!purely!ceremonial.!
C)!!In!a!cash!offer,!the!firm!offers!the!new!shares!to!existing!shareholders.!
D)!!Historically,!intermediaries!would!advertise!the!sale!of!stock!(both!IPOs!and!SEOs)!by!taking!out!
advertisements!in!newspapers!called!tombstones.!
Answer:!!!C!
B)!!
C)!!In!a!rights!offer,!the!firm!offers!the!new!shares!to!existing!shareholders.!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!In!a!rights!offer,!the!firm!offers!the!new!shares!only!to!existing!shareholders.!
B)!!Secondary!shares!are!shares!sold!by!existing!shareholders,!including!the!companyQs!founder.!
C)!!If!a!firmQs!management!is!concerned!that!its!equity!may!be!under!priced!in!the!market,!by!using!a!rights!
offering!the!firm!can!continue!to!issue!equity!without!imposing!a!loss!on!its!current!shareholders.!
D)!!In!the!United!States!most!offers!are!rights!offers.!
Answer:!!!D!
B)!!
C)!!
D)!!In!the!United!States!most!offers!are!cash!offers.!
Diff:!2!
Skill:!Conceptual!
!
A)!!SEO!rights!offers!have!lower!costs!than!cash!offers.!
B)!!The!decision!to!raise!financing!externally!usually!implies!that!a!firm!plans!to!pursue!an!investment!
opportunity.!
C)!!Although!not!as!costly!as!IPOs,!seasoned!offerings!are!still!expensive.!
D)!!Researchers!have!found!that,!on!average,!the!market!greets!the!news!of!an!SEO!with!a!price!increase.!
Answer:!!!D!
B)!!
C)!!
D)!!Researchers!have!found!that,!on!average,!the!market!greets!the!news!of!an!SEO!with!a!price!
decrease.!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!one!advantage!of!a!cash!offer!is!that!the!underwriter!takes!on!a!larger!role!and,!therefore,!can!
credibly!certify!the!issueQs!quality.!
B)!!SEO!underwriting!fees!average!about!5%!of!the!proceeds!of!the!issue!and,!as!with!IPOs,!the!variation!
across!issues!of!different!sizes!is!relatively!small.!
C)!!As!with!IPOs,!evidence!suggests!that!companies!over!perform!following!a!seasoned!offering.!
D)!!Often!the!value!destroyed!by!the!price!decline!can!be!a!significant!fraction!of!the!new!money!raised!with!
a!SEO.!
Answer:!!!C!
B)!!
C)!!As!with!IPOs,!evidence!suggests!that!companies!under!perform!following!a!seasoned!offering.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!Luther!Industries!currently!has!100!million!shares!of!stock!outstanding!at!a!price!of!$25!per!share.!The!
company!would!like!to!raise!money!and!has!announced!a!rights!issue.!Every!existing!shareholder!will!be!sent!
one!right!per!share!of!stock!that!he!or!she!owns.!The!company!plans!to!require!twenty!rights!to!purchase!one!
share!at!a!price!of!$20!per!share.!The!amount!of!money!that!Luther!will!raise!through!its!rights!offering!is!
closest!to?!
A)!!$500!million!
B)!!$125!million!
C)!!$100!million!
D)!!$400!million!
Answer:!!!C!
B)!!
C)!! 100 million existing shares
The!number!of!new!shares!issues!=! !=!5!million!shares!
20 rights per new share
Amount!raised!=!5!million!new!shares!×!$20!price!per!new!share!=!$100!million!
D)!!
Diff:!2!
Skill:!Analytical!
!
!
Luther!Industries!sold!10!million!shares!of!stock!in!an!SEO.!!The!market!price!of!Luther!at!the!time!was!$25!per!share.!!Of!
the!10!million!shares!sold,!6!million!shares!were!primary!shares!being!sold!by!the!company,!and!the!remaining!4!million!
shares!were!being!sold!by!venture!capitalists.!!LutherQs!underwriters!charges!5%!of!the!gross!proceeds!as!an!underwriting!
fee.!
!
7)!!How!much!money!did!Luther!raise?!
Answer:!!!6!million!shares!×!$25!per!share!=!$150!million!gross!proceeds!
Underwriter!receives!$150!×!5%!=!$7.5!million!so,!
net!proceeds!=!$150!million!-!$7.5!million!=!$142.5!million!
Diff:!2!
Skill:!Analytical!
!
8)!!How!much!money!did!the!venture!capitalists!receive?!
Answer:!!!4!million!shares!×!$25!per!share!=!$100!million!gross!proceeds!
Underwriter!receives!$100!×!5%!=!$5!million!so,!
net!proceeds!=!$100!million!-!$5!million!=!$95!million!
Diff:!2!
Skill:!Analytical!
!
Chapter(24(–(Debt(Financing(
(
24.1(Corporate(Debt((
(
1)##What#kind#of#corporate#debt#must#be#secured#by#real#property?#
A)##Mortgage#bonds#
B)##Notes#
C)##Asset-backed#bonds#
D)##Debentures#
Answer:###A#
Explanation:### A)##
B)##
C)##
D)##
Diff:#1#
Topic:#24.1#Corporate#Debt#
Skill:#Definition#
#
2)##What#kind#of#corporate#debt#can#be#secured#by#any#specified#assets?#
A)##Mortgage#bonds#
B)##Notes#
C)##Asset-backed#bonds#
D)##Debentures#
Answer:###C#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
3)##What#kind#of#corporate#debt#has#a#maturity#of#less#than#10#years?#
A)##Asset-backed#bonds#
B)##Debentures#
C)##Notes#
D)##Mortgage#bonds#
Answer:###C#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
4)##What#kind#of#unsecured#corporate#debt#has#a#maturity#of#less#than#10#years?#
A)##Mortgage#bonds#
B)##Asset-backed#bonds#
C)##Debentures#
D)##Notes#
Answer:###C#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
5)##Bonds#issued#by#a#local#entity,#denominated#in#the#local#currency,#traded#in#a#local#market,#but#purchased#by#
foreigners#are#called#
A)##Domestic#bonds.#
B)##Yankee#bonds.#
C)##Eurobonds.#
D)##Foreign#bonds.#
Answer:###A#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
6)##Bonds#issued#by#a#foreign#company#in#a#local#market,#intended#for#local#investors,#and#denominated#in#the#
local#currency#are#known#as#
A)##Domestic#bonds.#
B)##Yankee#bonds.#
C)##Eurobonds.#
D)##Foreign#bonds.#
Answer:###D#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
7)##Which#of#the#following#statements#is#false?#
A)##Global#bonds(combine#the#features#of#domestic,#foreign,#and#Eurobonds,#and#are#offered#for#sale#in#
several#different#markets#simultaneously.#
B)##In#a#leveraged#buyout#(LBO),#a#group#of#private#investors#purchases#all#the#equity#of#a#public#
corporation.#
C)##A#term#loan#is#a#bank#loan#that#lasts#for#a#specific#term.#
D)##Eurobonds(are#international#bonds#that#are#denominated#in#the#local#European#currency#of#the#country#
in#which#they#are#issued.#
Answer:###D#
B)##
C)##
D)##Eurobonds(are#international#bonds#that#are#not#denominated#in#the#local#currency#of#the#
country#in#which#they#are#issued.#
Diff:#2#
Skill:#Conceptual#
#
A)##With#registered#bonds,#on#each#coupon#payment#date,#the#bond#issuer#consults#its#list#of#registered#
owners#and#mails#each#owner#a#check#(or#directly#deposits#the#coupon#payment#into#the#ownerYs#
brokerage#account).#
B)##If#a#coupon#bond#is#issued#at#a#discount,#it#is#called#an#original#issue#discount#bond.#
C)##The#face#value#or#principal#amount#of#the#bond#is#denominated#in#standard#increments,#most#often#
$10,000.#
D)##In#a#public#offering,#the#indenture#lays#out#the#terms#of#the#bond#issue.#
Answer:###C#
B)##
C)##The#face#value#or#principal#amount#of#the#bond#is#denominated#in#standard#increments,#most#
often#$1,000.#
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##In#the#event#of#default,#the#assets#not#pledged#as#collateral#for#outstanding#bonds#cannot#be#used#to#pay#
off#the#holders#of#subordinated#debentures#until#all#more#senior#debt#has#been#paid#off.#
B)##Because#more#than#one#debenture#might#be#outstanding,#the#bondholderYs#priority#in#claiming#assets#in#
the#event#of#default,#known#as#the#bondYs#seniority,#is#important.#
C)##When#a#firm#conducts#a#subsequent#debenture#issue#that#has#lower#priority#than#its#outstanding#debt,#
the#new#debt#is#known#as#a#subordinated#debenture.#
D)##Most#debenture#issues#contain#clauses#restricting#the#company#from#issuing#new#debt#with#equal#or#
lower#priority#than#existing#debt.#
Answer:###D#
B)##
C)##
D)##Most#debenture#issues#contain#clauses#restricting#the#company#from#issuing#new#debt#with#
equal#or#higher#priority#than#existing#debt.#
Diff:#2#
Skill:#Conceptual#
#
10)##Which#of#the#following#statements#regarding#the#private#debt#market#is#false?#
A)##Private#debt#has#the#advantage#that#it#avoids#the#cost#of#registration.#
B)##Bank#loans#are#an#example#of#private#debt,#debt#that#is#not#publicly#traded.#
C)##Private#debt#has#the#disadvantage#of#being#illiquid.#
D)##The#public#debt#market#is#larger#than#the#private#debt#market.#
Answer:###D#
B)##
C)##
D)##The#private#debt#market#is#larger#than#the#public#debt#market.#
Diff:#2#
Skill:#Conceptual#
#
A)##Almost#all#bonds#that#are#issued#today#are#registered#bonds.#
B)##The#trust#company#represents#the#bondholders#and#makes#sure#that#the#terms#of#the#indenture#are#
enforced.#
C)##For#private#placements,#the#prospectus#must#include#an#indenture,#a#formal#contract#between#the#bond#
issuer#and#a#trust#company.#
D)##In#the#case#of#default,#the#trust#company#represents#the#bondholdersY#interests.#
Answer:###C#
B)##
C)##For#public#debt#issue,#the#prospectus#must#include#an#indenture,#a#formal#contract#between#
the#bond#issuer#and#a#trust#company.#
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##The#registered#bond#system#also#facilitates#tax#collection#because#the#government#can#easily#keep#track#
of#all#interest#payments#made.#
B)##Asset#backed#bonds#and#mortgage#bonds#are#secured#debt:#Specific#assets#are#pledged#as#collateral#that#
bondholders#have#a#direct#claim#to#in#the#event#of#bankruptcy.#
C)##Notes#typically#have#longer#maturities#(more#than#ten#years)#than#debentures.#
D)##Although#the#word#]bond]#is#commonly#used#to#mean#any#kind#of#debt#security,#technically#a#corporate#
bond#must#be#secured.#
Answer:###C#
B)##
C)##Notes#typically#have#shorter#maturities#(less#than#ten#years)#than#debentures.#
D)##
Diff:#2#
Skill:#Conceptual#
#
13)##Which#of#the#following#statements#regarding#private#placements#is#false?#
A)##A#private#placement#is#a#bond#issue#that#does#not#trade#on#a#public#market#but#rather#is#sold#to#a#small#
group#of#investors.#
B)##Privately#placed#debt#need#not#conform#to#the#same#standards#as#public#debt;#as#a#consequence,#it#can#be#
tailored#to#the#particular#situation.#
C)##In#1990,#the#U.S.#Securities#and#Exchange#Commission#(SEC)#issued#Rule#144A,#which#significantly#
decreased#the#liquidity#of#certain#privately#placed#debt.#
D)##Because#a#private#placement#does#not#need#to#be#registered,#it#is#less#costly#to#issue.#
Answer:###C#
B)##
C)##In#1990,#the#U.S.#Securities#and#Exchange#Commission#(SEC)#issued#Rule#144A,#which#
significantly#increased#the#liquidity#of#certain#privately#placed#debt.#
D)##
Diff:#2#
Skill:#Conceptual#
24.2((Other(Types(of(Debt(
(
1)##Treasury#securities#that#are#pure#discount#bonds#with#original#maturities#ranging#from#a#few#days#to#26#weeks##
are#called#
A)##TIPS.#
B)##Treasury#bonds.#
C)##Treasury#notes.#
D)##Treasury#bills.#
Answer:###D#
B)##
C)##
D)##
Diff:#1#
Topic:#24.2#Other#Types#of#Debt#
Skill:#Definition#
#
2)##Treasury#securities#that#are#semi-annual#coupon#bonds#with#original#maturities#of#between#1#and#10#years#are#
called#
A)##Treasury#bonds.#
B)##Treasury#bills.#
C)##Treasury#notes.#
D)##TIPS.#
Answer:###C#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
3)##Treasury#securities#that#are#semiannual-paying#coupon#bonds#with#maturities#longer#than#10#years#are#called#
A)##Treasury#bonds.#
B)##TIPS.#
C)##Treasury#bills.#
D)##Treasury#notes.#
Answer:###A#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
4)##Treasury#securities#that#are#standard#coupon#bonds#where#the#outstanding#principal#is#adjusted#for#inflation#
are#called#
A)##Treasury#notes.#
B)##Treasury#bonds.#
C)##TIPS.#
D)##Treasury#bills.#
Answer:###C#
B)##
C)##
D)##
Diff:#1#
Skill:#Definition#
#
A)##Zero-coupon#Treasury#securities#with#maturities#longer#than#one#year#also#trade#in#the#bond#market.#
B)##Treasury#securities#are#initially#sold#to#the#public#through#dealers.#
C)##Municipal#bonds#(]munis])#are#issued#by#state#and#local#governments.#
D)##Municipal#bondsY#distinguishing#characteristic#is#that#the#income#on#municipal#bonds#is#not#taxable#at#
the#federal#level.#
Answer:###B#
B)##Treasury#securities#are#initially#sold#to#the#public#through#auction.#
C)##
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##In#the#case#of#a#Treasury#note#or#Treasury#bond#offering,#the#stop-out#yield#determines#the#coupon#of#the#
bond#and#then#all#bidders#pay#the#discounted#value#for#the#bond#or#note.#
B)##All#competitive#bidders#submit#sealed#bids#in#terms#of#yields#and#the#amount#of#bonds#they#are#willing#
to#purchase.#
C)##In#the#past,#the#Treasury#has#issued#bonds#with#maturities#of#30#years#(often#called#long#bonds)#and#20#
years.#
D)##Noncompetitive#bidders#(usually#individuals)#just#submit#the#amount#of#bonds#they#wish#to#purchase#
and#are#guaranteed#to#have#their#orders#filled#at#the#auction.#
Answer:###A#
Explanation:### A)##In#the#case#of#a#Treasury#note#or#Treasury#bond#offering,#the#stop-out#yield#determines#the#
coupon#of#the#bond#and#then#all#bidders#pay#the#par#value#for#the#bond#or#note.#
B)##
C)##
D)##
Diff:#2#
Skill:#Conceptual#
#
7)##Which#of#the#following#statements#regarding#municipal#bonds#is#false?#
A)##A#single#municipal#bond#issue#will#often#contain#a#number#of#different#maturity#dates.#Such#issues#are#
often#called#multi-muni#bonds(because#the#bonds#are#scheduled#to#mature#over#a#multiple#number#of#
years.#
B)##Revenue#bonds#are#where#the#local#government#pledges#specific#revenues#generated#by#projects#that#
were#initially#financed#by#the#bond#issue.#
C)##Municipal#bonds#are#sometimes#also#referred#to#as#tax-exempt#bonds.#
D)##Bonds#backed#by#the#full#faith#and#credit#of#a#local#government#are#known#as#general#obligation#bonds(
and#are#not#as#secure#as#bonds#backed#by#the#full#faith#and#credit#of#the#federal#government.#
Answer:###A#
Explanation:### A)##A#single#municipal#bond#issue#will#often#contain#a#number#of#different#maturity#dates.#Such#
issues#are#often#called#serial#bonds(because#the#bonds#are#scheduled#to#mature#over#a#multiple#
number#of#years.#
B)##
C)##
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##Mortgage-backed#securities,#such#as#GNMAs,#are#pass-through(securities.#That#is,#each#security#is#
backed#by#an#underlying#portfolio#or#pool(of#mortgages.#
B)##The#Government#National#Mortgage#Association#(GNMA,#or#]Ginnie#Mae])#is#an#example#of#an#
enterprise;#the#Student#Loan#Marketing#Association#(]Sallie#Mae])#is#an#example#of#a#
government-sponsored#agency.#
C)##Sovereign#debt#is#debt#issued#by#national#governments.#
D)##Agency#securities(are#issued#by#agencies#of#the#U.S.#government#or#by#U.S.#government#sponsored#
enterprises.#
Answer:###B#
B)##The#Government#National#Mortgage#Association#(GNMA,#or#]Ginnie#Mae])#is#an#example#of#
an#agency;#the#Student#Loan#Marketing#Association#(]Sallie#Mae])#is#an#example#of#a#
government-sponsored#enterprise.#
C)##
D)##
Diff:#3#
Skill:#Conceptual#
#
9)##Suppose#that#in#January#2001,#the#U.S.#Treasury#issued#a#ten-year#inflation-indexed#note#with#a#coupon#of#3#
1/2%.##On#the#date#of#issue#the#consumer#price#index#(CPI)#was#175.1.##In#January#2006,#the#CPI#had#increased#
to#198.3.##What#coupon#payment#was#made#on#this#bond#in#January#2006?#
Answer:### 198.3
Between#January#2001#and#January#2006#the#CPI#appreciated#by# #=#1.132496,#
175.1
Consequently,#the#principal#amount#of#the#bond#increase#by#this#amount,#that#is#the#original#face#value#
of#$1000#increased#to#$1132.50.##Because#the#bond#pays#semi-annual#coupons,#the#coupon#payment#was#
$1132.50#×#.035#/#2#=#$19.82#
Diff:#2#
Skill:#Analytical#
24.3((Bond(Covenants(
(
A)##If#the#issuer#fails#to#live#up#to#any#covenant,#the#issuer#goes#into#bankruptcy.#
B)##The#stronger#the#covenants#in#the#bond#contract,#the#less#likely#the#issuer#will#default#on#the#bond,#and#so#
the#lower#the#interest#rate#investors#will#require#to#buy#the#bond.#
C)##Covenants(are#restrictive#clauses#in#a#bond#contract#that#limit#the#issuer#from#taking#actions#that#may#
undercut#its#ability#to#repay#the#bonds.#
D)##Bond#agreements#often#contain#covenants#that#restrict#the#ability#of#management#to#pay#dividends.#
Answer:###A#
Explanation:### A)##If#the#issuer#fails#to#live#up#to#any#covenant,#the#issuer#goes#into#default.#
B)##
C)##
D)##
Diff:#1#
Topic:#24.3#Bond#Covenants#
Skill:#Conceptual#
#
A)##By#including#more#covenants,#issuers#increase#their#costs#of#borrowing.#
B)##Once#bonds#are#issued,#equity#holders#have#an#incentive#to#increase#dividends#at#the#expense#of#debt#
holders.#
C)##Covenants#may#restrict#the#level#of#further#indebtedness#and#specify#that#the#issuer#must#maintain#a#
minimum#amount#of#working#capital.#
D)##If#the#covenants#are#designed#to#reduce#agency#costs#by#restricting#managementYs#ability#to#take#negative#
NPV#actions#that#exploit#debt#holders,#then#the#reduction#in#the#firmYs#borrowing#cost#can#more#than#
outweigh#the#cost#of#the#loss#of#flexibility#associated#with#covenants.#
Answer:###A#
Explanation:### A)##By#including#more#covenants,#issuers#decrease#their#costs#of#borrowing.#
B)##
C)##
D)##
Diff:#2#
Topic:#24.3#Bond#Covenants#
Skill:#Conceptual#
24.4((Repayment(Provisions(
(
1)##Which#of#the#following#statements#is#false#regarding#a#call#provision?#
A)##The#issuer#can#repurchase#a#fraction#of#the#outstanding#bonds#in#the#market#or#it#can#make#a#tender#offer#
for#the#entire#issue.#
B)##A#call!provision#allows#the#issuer#to#repurchase#the#bonds#at#a#predetermined#price.#
C)##The#call#price#is#generally#set#at#or#below,#and#expressed#as#a#percentage#of,#the#bondYs#face#value.#
D)##A#call#feature#allows#the#issuer#of#the#bond#the#right#(but#not#the#obligation)#to#retire#all#outstanding#
bonds#on#(or#after)#a#specific#date#(the#call#date),#for#the#call#price.#
Answer:###C#
B)##
C)##The#call#price#is#generally#set#at#or#above,#and#expressed#as#a#percentage#of,#the#bond’s#face#
value.#
D)##
Diff:#1#
Topic:#24.4#Repayment#Provisions#
Skill:#Conceptual#
#
A)##When#bond#yields#have#increased,#by#exercising#the#call#on#the#callable#bond#and#then#immediately#
refinancing,#the#issuer#can#lower#its#borrowing#costs.#
B)##To#understand#how#call#provisions#affect#the#price#of#a#bond,#we#first#need#to#consider#when#an#issuer#
will#exercise#its#right#to#call#the#bond.#
C)##If#the#call#provision#offers#a#cheaper#way#to#retire#the#bonds#the#issuer#will#forgo#the#option#of#
purchasing#the#bonds#in#the#open#market#and#call#the#bonds#instead.#
D)##An#issuer#can#always#retire#one#of#its#bonds#early#by#repurchasing#the#bond#in#the#open#market.#
Answer:###A#
Explanation:### A)##When#bond#yields#have#decreased,#by#exercising#the#call#on#the#callable#bond#and#then#
immediately#refinancing,#the#issuer#can#lower#its#borrowing#costs.#
B)##
C)##
D)##
Diff:#1#
Skill:#Conceptual#
#
A)##The#holder#of#a#callable#bond#faces#reinvestment#risk#precisely#when#it#hurts:#when#market#rates#are#
lower#than#the#coupon#rate#she#is#currently#receiving.#
B)##When#yields#have#risen,#the#issuer#will#not#choose#to#exercise#the#call#on#the#callable#bond.#
C)##The#issuer#will#exercise#the#call#option#only#when#the#prevailing#market#rate#exceeds#the#coupon#rate#of#
the#bond.#
D)##A#callable#bond#is#relatively#less#attractive#to#the#bondholder#than#the#identical#non-callable#bond.#
Answer:###C#
B)##
C)##The#issuer#will#exercise#the#call#option#only#when#the#prevailing#market#rate#is#below#the#
coupon#rate#of#the#bond.#
D)##
Diff:#2#
Skill:#Conceptual#
A)##Before#the#call#date,#investors#anticipate#the#optimal#strategy#that#the#issuer#will#follow,#and#the#bond#
price#reflects#this#strategy.#
B)##The#yield#to#maturity#of#a#callable#bond#is#calculated#as#if#the#bond#were#called#at#the#earliest#
opportunity.#
C)##A#callable#bond#will#trade#at#a#lower#price#(and#therefore#a#higher#yield)#than#an#otherwise#equivalent#
non-callable#bond.#
D)##The#price#of#a#callable#bond#can#be#low#when#yields#are#high,#but#does#not#rise#above#the#call#value#when#
the#yield#is#low.#
Answer:###B#
B)##The#yield#to#call#of#a#callable#bond#is#calculated#as#if#the#bond#were#called#at#the#earliest#
opportunity.#
C)##
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##The#assumption#that#underlies#the#yield#calculation#of#a#callable#bond—that#it#will#not#be#called—is#not#
always#realistic,#so#bond#traders#often#quote#the#yield#to#call.#
B)##The#yield#to#call#(YTC)(is#the#annual#yield#of#a#callable#bond#assuming#that#the#bond#is#called#at#the#
earliest#opportunity.#
C)##We#can#think#of#the#yield#to#maturity#of#a#callable#bond#as#the#interest#rate#the#bondholder#receives#if#the#
bond#is#not#called#and#repaid#in#full.#
D)##Because#the#price#of#a#callable#bond#is#higher#than#the#price#of#an#otherwise#identical#non-callable#bond,#
the#yield#to#maturity#of#a#callable#bond#will#be#lower#than#the#yield#to#maturity#for#its#non-callable#
counterpart.#
Answer:###D#
B)##
C)##
D)##Because#the#price#of#a#callable#bond#is#lower#than#the#price#of#an#otherwise#identical#
non-callable#bond,#the#yield#to#maturity#of#a#callable#bond#will#be#higher#than#the#yield#to#
maturity#for#its#non-callable#counterpart.#
Diff:#2#
Skill:#Conceptual#
#
6)##Which#of#the#following#statements#regarding#sinking#fund#provisions#is#false?#
A)##With#a#sinking#fund,#if#a#bond#is#trading#at#below#its#face#value,#because#the#bonds#are#repurchased#at#
par#the#decision#as#to#which#bonds#to#repurchase#is#made#by#lottery.#
B)##With#a#sinking#fund,#instead#of#repaying#the#entire#principal#balance#on#the#maturity#date,#the#company#
makes#regular#payments#into#a#sinking#fund#administered#by#a#trustee#over#the#life#of#the#bond.#
C)##Sinking#fund#provisions#usually#specify#a#minimum#rate#at#which#the#issuer#must#contribute#to#the#fund.#
D)##Because#the#sinking#fund#allows#the#issuer#to#repurchase#the#bonds#at#par,#the#option#to#accelerate#the#
payments#is#another#form#of#call#provision.#
Answer:###A#
Explanation:### A)##With#a#sinking#fund,#if#a#bond#is#trading#at#a#premium,#because#the#bonds#are#repurchased#at#
par#the#decision#as#to#which#bonds#to#repurchase#is#made#by#lottery.#
B)##
C)##
D)##
Diff:#2#
Skill:#Conceptual#
#
A)##A#convertible#bond#can#be#thought#of#as#a#regular#bond#plus#a#special#type#of#call#option#called#a#warrant.#
B)##On#the#maturity#date#of#the#bond,#the#strike#price#of#the#embedded#warrant#in#a#convertible#bond#is#
equal#to#the#face#value#of#the#bond#divided#by#the#conversion#ratio—that#is,#the#conversion#price.#
C)##Calling#a#convertible#bond#transfers#the#remaining#time#value#of#the#conversion#option#from#
shareholders#to#bondholders.#
D)##If#the#stock#price#is#low#so#that#the#embedded#warrant#is#deep#out-of-the-money,#the#conversion#
provision#is#not#worth#much#and#the#bond’s#value#is#close#to#the#value#of#a#straight#bond—an#otherwise#
identical#bond#without#the#conversion#provision.#
Answer:###C#
B)##
C)##Calling#a#convertible#bond#transfers#the#remaining#time#value#of#the#conversion#option#from#
bondholders#to#shareholders.#
D)##
Diff:#3#
Skill:#Conceptual#
#
Use!the!information!for!the!question(s)!below.#
#
Luther#Industries#has#just#issued#a#callable#(at#102)#ten-year,#8%#coupon#bond#with#semi-annual#coupon#payments.##The#
bond#can#be#called#at#102#in#three#years#or#anytime#thereafter#on#a#coupon#payment#date.##It#has#a#current#price#of#99.#
#
8)##What#is#the#Yield#to#Maturity#(YTM)#on#this#bond?#
Answer:###N#=#20#(10#×#2)#
PMT#=#40#($80/2)#
FV#=#1000#
PV#=#-990#
Compute#i#=#4.074065#×#2#=#8.148#or#8.15%#
Diff:#2#
Skill:#Analytical#
#
9)##What#is#the#Yield#to#Call#(YTC)#on#this#bond?#
Answer:####N!=#6#(3#×#2)!
PMT#=#40#($80/2)#
FV#=#1020#
PV#=#-990#
Compute#i#=#4.492#×#2#=#8.9834#or#8.98%#
Diff:#2#
Skill:#Analytical#
#
Use!the!information!for!the!question(s)!below.#
#
KT#Enterprises#has#just#issued#a#callable#(at#par)#fifteen-year,#7%#coupon#bond#with#semi-annual#coupon#payments.##The#
bond#can#be#called#at#par#in#five#years#or#anytime#thereafter#on#a#coupon#payment#date.##It#has#a#current#price#of#101.#
#
10)##What#is#the#Yield#to#Maturity#(YTM)#on#this#bond?#
Answer:###N#=#30#(15#×#2)#
PMT#=#35#($70/2)#
FV#=#1000#
PV#=#-1010#
Compute#i#=#3.445996#×#2#=#6.892#or#6.89%#
Diff:#2#
Skill:#Analytical#
#
11)##What#is#the#Yield#to#Call#(YTC)#on#this#bond?#
Answer:###N#=#10#(5#×#2)#
PMT#=#35#($70/2)#
FV#=#1000#
PV#=#-1010#
Compute#i#=#3.380482#×#2#=#6.761#or#6.76%#
Diff:#2#
Skill:#Analytical#
#
Chapter(25(-(Leasing(
!
!
25.1(The(Basics(of(Leasing(
A)!!A!lease!is!a!contract!between!two!parties:!the!lessee!and!the!lessor.!
B)!!Most!leases!involve!little!or!no!upfront!payment.!
C)!!The!lessee(is!the!owner!of!the!asset,!who!is!entitled!to!the!lease!payments!in!exchange!for!lending!the!
asset.!
D)!!At!the!end!of!the!contract!term,!the!lease!specifies!who!will!retain!ownership!of!the!asset!and!at!what!
terms.!
Answer:!!!C!
B)!!
C)!!The!lessor(is!the!owner!of!the!asset,!who!is!entitled!to!the!lease!payments!in!exchange!for!
lending!the!asset.!
D)!!
Diff:!1!
Topic:!25.1!The!Basics!of!Leasing!
Skill:!Conceptual!
!
A)!!In!a!direct!lease,(the!lessor!is!the!manufacturer!(or!a!primary!dealer)!of!the!asset.!
B)!!The!lease!specifies!any!cancellation!provisions,!the!options!for!renewal!and!purchase,!and!the!
obligations!for!maintenance!and!related!servicing!costs.!
C)!!If!a!firm!already!owns!an!asset!it!would!prefer!to!lease,!it!can!arrange!a!sale!and!leaseback!transaction.!
D)!!With!many!leases,!the!lessor!provides!the!initial!capital!necessary!to!purchase!the!asset,!and!then!
receives!and!retains!the!lease!payments.!
Answer:!!!A!
Explanation:!!! A)!!In!a!direct!lease,(the!lessor!is!an!independent!company!that!owns!the!asset.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!In!a!leveraged!lease!the!lessor!borrows!from!a!bank!or!other!lender!to!obtain!the!initial!capital!for!the!
purchase,!using!the!lease!payments!to!pay!interest!and!principal!on!the!loan.!
B)!!In!some!circumstances,!the!lessor!is!not!an!independent!company!but!rather!a!separate!business!
partnership,!called!a!special-purpose!entity!(SPE),!which!is!created!by!the!lessee!for!the!sole!purpose!of!
obtaining!the!lease.!
C)!!In!a!direct!lease,!the!lessor!is!not!the!manufacturer,!but!is!often!an!independent!company!that!specializes!
in!purchasing!assets!and!leasing!them!to!customers.!
D)!!SPEs!are!commonly!used!in!synthetic!leases,!which!are!designed!to!obtain!specific!accounting!and!tax!
treatment.!
Answer:!!!B!
B)!!In!some!circumstances,!the!lessee!is!not!an!independent!company!but!rather!a!separate!
business!partnership,!called!a!special-purpose!entity!(SPE),!which!is!created!by!the!lessor!for!
the!sole!purpose!of!obtaining!the!lease.!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
4)!!A!lease!that!gives!the!lessee!the!option!to!purchase!the!asset!at!its!fair!market!value!at!the!termination!of!the!
lease!is!called!a!
A)!!fair!market!value!cap!lease.!
B)!!fair!market!value!lease.!
C)!!$1.00!out!lease.!
D)!!fixed!price!lease.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
5)!!A!lease!where!ownership!of!the!asset!transfers!to!the!lessee!at!the!end!of!the!lease!for!a!nominal!cost!is!called!a!
A)!!fair!market!value!cap!lease.!
B)!!fixed!price!lease.!
C)!!$1.00!out!lease.!
D)!!fair!market!value!lease.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
6)!!A!lease!where!!the!lessee!has!the!option!to!purchase!the!asset!at!the!end!of!the!lease!for!a!set!price!that!is!set!
upfront!in!the!lease!contract!is!called!a!
A)!!fixed!price!lease.!
B)!!$1.00!out!lease.!
C)!!fair!market!value!lease.!
D)!!fair!market!value!cap!lease.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
7)!!A!lease!where!the!lessee!can!purchase!the!asset!at!the!minimum!of!its!fair!market!value!and!a!fixed!price!is!
called!a!
A)!!$1.00!out!lease.!
B)!!fixed!price!lease.!
C)!!fair!market!value!lease.!
D)!!fair!market!value!cap!lease.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!Because!we!are!getting!the!entire!asset!when!we!purchase!it!with!the!loan,!the!loan!payments!are!higher!
than!the!lease!payments.!
B)!!In!a!perfect!market,!the!cost!of!leasing!and!then!purchasing!the!asset!is!equivalent!to!the!cost!of!
borrowing!to!purchase!the!asset.!
C)!!With!a!lease!we!are!financing!the!entire!cost!of!the!asset,!with!a!standard!loan!we!are!financing!only!the!
cost!of!the!economic!depreciation!of!the!asset!during!its!life.!
D)!!The!amount!of!the!lease!payment!will!depend!on!the!purchase!price,!the!residual!value,!and!the!
appropriate!discount!rate!for!the!cash!flows.!
Answer:!!!C!
B)!!
C)!!With!a!standard!loan!we!are!financing!the!entire!cost!of!the!asset,!with!a!lease!we!are!
financing!only!the!cost!of!the!economic!depreciation!of!the!asset!during!its!life.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Absent!market!imperfections,!leases!represent!another!form!of!zero-NPV!financing!available!to!a!firm,!
and!the!Modigliani-Miller!propositions!apply:!Leases!neither!increase!nor!decrease!firm!value,!but!serve!
only!to!divide!the!firmZs!cash!flows!and!risks!in!different!ways.!
B)!!In!a!perfect!market,!the!cost!of!leasing!is!equivalent!to!the!cost!of!purchasing!and!reselling!the!asset.!
C)!!Each!lease!agreement!can!be!tailored!to!fit!the!precise!nature!of!the!asset!and!the!needs!of!the!parties!at!
hand.!
D)!!Features!of!leases!will!be!priced!as!part!of!the!lease!payment.!Terms!that!give!valuable!options!to!the!
lessee!lower!the!amount!of!the!lease!payments,!whereas!terms!that!restrict!these!options!will!raise!them.!
Answer:!!!D!
B)!!
C)!!
D)!!Features!of!leases!will!be!priced!as!part!of!the!lease!payment.!Terms!that!give!valuable!options!
to!the!lessee!raise!the!amount!of!the!lease!payments,!whereas!terms!that!restrict!these!options!
will!lower!them.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Leases!may!include!early!cancellation!options!that!allow!the!lessee!to!end!the!lease!early!(perhaps!for!a!
fee).!
B)!!The!cost!of!the!lease!will!depend!on!the!assetZs!residual!value,!which!is!its!book!value!at!the!end!of!the!
lease.!
C)!!Leases!may!allow!the!lessee!to!trade!in!and!upgrade!the!equipment!to!a!newer!model!at!certain!points!in!
the!lease.!
D)!!Leases!may!contain!buyout!options!that!allow!the!lessee!to!purchase!the!asset!before!the!end!of!the!lease!
term.!
Answer:!!!B!
B)!!The!cost!of!the!lease!will!depend!on!the!assetZs!residual!value,!which!is!its!market!value!at!the!
end!of!the!lease.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Suppose!the!purchase!price!of!a!bulldozer!is!$90,000,!its!residual!value!in!four!years!is!certain!to!be!$15,000,!and!there!is!no!
risk!that!the!lessee!will!default!on!the!lease.!Assume!that!capital!markets!are!perfect!and!the!risk-free!interest!rate!is!6%!
APR!with!monthly!compounding.!
!
11)!!The!monthly!lease!payments!for!a!four!year!lease!of!the!Bulldozer!are!closest!to:!
A)!!$1,870!
B)!!$1,825!
C)!!$1,750!
D)!!$2,115!
Answer:!!!B!
B)!!Set!calculator!to!BEG!mode!(Annuity!Due!mode)!
PV!=!90,000!
FV!=!-15,000!
N!=!48!(4!years!×!12!months/year)!
I!=!.5!(6%/12!months)!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
12)!!Suppose!that!instead!of!leasing!the!bulldozer,!the!company!is!considering!purchasing!a!bulldozer!outright!by!
borrowing!the!purchase!price!using!a!four-year!annuity!loan.!!The!monthly!loan!payments!for!a!four!year!loan!
to!purchase!the!Bulldozer!are!closest!to:!
A)!!$2,115!
B)!!$1,825!
C)!!$1,870!
D)!!$1,750!
Answer:!!!A!
Explanation:!!! A)!!Set!calculator!to!END!mode!(Ordinary!Annuity!mode)!
PV!=!90,000!
FV!=!0!
I!=!.5!(6%/12!months)!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
13)!!Calculate!the!monthly!lease!payments!for!a!four!year!$1.00!out!lease!of!the!Bulldozer.!
Answer:!!!Set!calculator!to!BEG!mode!(Annuity!Due!mode)!
PV!=!90,000!
FV!=!-1!
I!=!.5!(6%/12!months)!
Diff:!2!
Skill:!Analytical!
!
14)!!Calculate!the!monthly!lease!payments!for!a!four!year!fixed!price!lease!that!allows!the!lessee!to!buy!the!
Bulldozer!at!the!end!of!the!lease!for!$8,000.!
Answer:!!!Set!calculator!to!BEG!mode!(Annuity!Due!mode)!
PV!=!90,000!
FV!=!-8000!
I!=!.5!(6%/12!months)!
Diff:!2!
Skill:!Analytical!
(
25.2((Accounting,(Tax,(and(Legal(Consquences(of(Leasing(
(
1)!!The!lease!is!treated!as!a!capital!lease!(financial!lease)!for!the!lessee!and!must!be!listed!on!the!firmZs!balance!
sheet!if!it!satisfies!any!of!the!following!conditions!except:!
A)!!The!lease!contains!an!option!to!purchase!the!asset!at!its!fair!market!value.!
B)!!The!present!value!of!the!minimum!lease!payments!at!the!start!of!the!lease!is!90%!or!more!of!the!assetZs!
fair!market!value.!
C)!!The!title!to!the!property!transfers!to!the!lessee!at!the!end!of!the!lease!term.!
D)!!The!lease!term!is!75%!or!more!of!the!estimated!economic!life!of!the!asset.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!25.2!Accounting,!Tax,!and!Legal!Consequences!of!Leasing!
Skill:!Conceptual!
!
2)!!A!lease!will!be!treated!as!a!non!tax!lease!if!it!satisfies!any!of!the!following!conditions!except:!
A)!!The!property!may!be!acquired!the!fair!market!value!of!the!asset!at!the!time!when!the!option!may!be!
exercised.!
B)!!Some!portion!of!the!lease!payments!is!specifically!designated!as!interest!or!its!equivalent.!
C)!!The!lessee!receives!ownership!of!the!asset!on!completion!of!all!lease!payments.!
D)!!The!total!amount!that!the!lessee!is!required!to!pay!for!a!relatively!short!period!of!use!constitutes!an!
inordinately!large!proportion!of!the!total!value!of!the!asset.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!Which!of!the!following!statements!regarding!operating!leases!is!false?!
A)!!They!are!also!called!a!finance!leases.!
B)!!The!lease(is!viewed!as!a!rental!for!accounting!purposes.!
C)!!The!lessee!reports!the!entire!lease!payment!as!an!operating!expense.!
D)!!They!are!disclosed!in!the!footnotes!of!the!lesseeZs!financial!statements.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
4)!!Which!of!the!following!statements!regarding!capital!leases!is!false?!
A)!!Because!capital!leases!increase!the!apparent!leverage!on!the!firmZs!balance!sheet,!firms!sometimes!prefer!
to!have!a!lease!categorized!as!an!operating!lease!to!keep!it!off!the!balance!sheet.!
B)!!The!firm!does!not!report!the!present!value!of!the!future!lease!payments!as!a!liability!on!the!balance!sheet.!
C)!!The!asset!acquired!is!listed!on!the!lesseeZs!balance!sheet,!and!the!lessee!incurs!depreciation!expenses!for!
the!asset.!
D)!!They!are!viewed!as!an!acquisition!for!accounting!purposes.!
Answer:!!!B!
B)!!The!firm!does!report!the!present!value!of!the!future!lease!payments!as!a!liability!on!the!
balance!sheet.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!decision!to!lease!is!often!driven!by!real-world!market!imperfections!related!to!leasingZs!accounting,!
tax,!and!legal!treatment.!
B)!!When!publicly!traded!firms!disclose!leasing!transactions!in!their!financial!statements,!they!must!follow!
the!recommendations!of!the!Financial!Accounting!Standards!Board!(FASB).!
C)!!In!its!Statement!of!Financial!Accounting!Standards!No.!13!(FAS13),!the!FASB!provides!specific!criteria!
that!distinguish!a!true!tax!lease!from!a!non!tax!lease.!
D)!!The!categories!used!to!report!leases!on!the!financial!statements!affect!the!values!of!assets!on!the!balance!
sheet,!but!they!have!no!direct!effect!on!the!cash!flows!that!result!from!a!leasing!transaction.!
Answer:!!!C!
B)!!
C)!!The!IRS!provides!specific!criteria!that!distinguish!a!true!tax!lease!from!a!non!tax!lease.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!the!lease!is!deemed!to!be!a!true!lease,!the!firm!is!assumed!to!have!effective!ownership!of!the!asset!and!
the!asset!is!protected!against!seizure.!
B)!!Although!the!legal!ownership!of!the!asset!resides!with!the!lessor,!in!a!non-tax!lease(the!lessee!receives!
the!depreciation!deductions.!
C)!!The!treatment!of!leased!property!in!bankruptcy!will!depend!on!whether!the!lease!is!classified!as!a!
security!interest!or!a!true!lease!by!the!bankruptcy!judge.!
D)!!In!a!non-tax!lease,(the!interest!portion!of!the!lease!payment!is!interest!income!for!the!lessor.!
Answer:!!!A!
Explanation:!!! A)!!If!the!lease!is!deemed!to!be!a!security!interest,!the!firm!is!assumed!to!have!effective!ownership!
of!the!asset!and!the!asset!is!protected!against!seizure.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!Which!of!the!following!statements!regarding!leases!and!bankruptcy!is!false?!
A)!!Operating!and!true!tax!leases!are!generally!viewed!as!true!leases!by!the!courts,!whereas!capital!and!
non-tax!leases!are!more!likely!to!be!viewed!as!a!security!interest.!
B)!!By!retaining!ownership!of!the!asset,!the!lessor!has!the!right!to!repossess!it!if!the!lease!payments!are!not!
made,!even!if!the!firm!seeks!bankruptcy!protection.!
C)!!If!a!lease!contract!is!characterized!as!a!true!lease!in!bankruptcy,!the!lessor!is!in!a!somewhat!superior!
position!than!a!lender!if!the!firm!defaults.!
D)!!If!the!lease!is!classified!as!a!true!lease(in!bankruptcy,!then!the!lessee!retains!ownership!rights!over!the!
asset.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!lease!is!classified!as!a!true!lease(in!bankruptcy,!then!the!lessor!retains!ownership!rights!
over!the!asset.!
Diff:!3!
Skill:!Conceptual!
!
8)!!Which!of!the!following!statements!regarding!leases!and!taxes!is!false?!
A)!!In!a!non-tax!lease,(the!lessee!can!deduct!the!interest!portion!of!the!lease!payments!as!an!interest!expense.!
B)!!In!a!true!tax!lease,!the!lease!payments!are!treated!as!revenue!for!the!lessor.!
C)!!In!a!true!tax!lease,!the!lessee!receives!the!depreciation!deductions!associated!with!the!ownership!of!the!
asset.!
D)!!The!IRS!separates!leases!into!two!broad!categories:!true!tax!leases!and!non-tax!leases.!
Answer:!!!C!
B)!!
C)!!In!a!true!tax!lease,!the!lessor!receives!the!depreciation!deductions!associated!with!the!
ownership!of!the!asset.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Luther!Industries!currently!has!the!following!balance!sheet!(in!Thousands!of!dollars):
Assets Liabilities
Cash $500! Debt $4,500!!
Property,!Plant,!and!Equipment $7,000! Equity $3,000!!
Total!Assets $7,500! Total!Debt!plus!Equity $7,500!!
Luther!is!about!to!add!a!new!fleet!of!delivery!trucks.!!The!price!of!the!fleet!is!$1.5!million.!
!
9)!!If!Luther!acquires!the!new!fleet!of!delivery!trucks!using!a!capital!lease,!LutherZs!Debt!to!Equity!ratio!will!be!
closest!to:!
A)!!0.66!
B)!!1.5!
C)!!0.80!
D)!!2.0!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!firm!acquires!the!fleet!through!a!capital!lease!it!is!the!same!as!if!Luther!borrowed!the!
money!and!purchased!the!fleet!directly.!!The!fleet!is!must!be!listed!as!an!asset!and!the!lease!
will!show!up!as!a!liability.!!Therefore,!LutherZs!balance!sheet!will!look!like:!
Assets Liabilities
Cash $500! Debt $6,000!!
Property,!Plant,!and!
Equipment $8,500! Equity $3,000!!
Total!Assets $9,000!Total!Debt!plus!Equity $9,000!!
$6, 000
LutherZs!Debt!to!Equity!ratio!therefore!is!equal!to! !=!2.0!
$3, 000
Diff:!2!
Skill:!Analytical!
!
10)!!If!Luther!acquires!the!new!fleet!of!delivery!trucks!using!an!operating!lease,!LutherZs!Debt!to!Equity!ratio!will!
be!closest!to:!
A)!!2.0!
B)!!1.5!
C)!!0.80!
D)!!0.66!
Answer:!!!B!
B)!!If!the!firm!acquires!the!fleet!through!an!operating!lease,!there!is!no!change!in!the!original!
balance!sheet.!!The!fleet!is!not!listed!as!an!asset!and!the!lease!is!not!view!as!a!liability.!!The!
transaction!is!off-balance!sheet!and!will!be!disclosed!in!a!foot-note.!!Therefore,!LutherZs!
balance!sheet!will!look!like:
Assets Liabilities
Cash $500! Debt $4,500!!
$4,500
LutherZs!Debt!to!Equity!ratio!therefore!is!equal!to! !=!1.5!
$3, 000
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
11)!!What!will!LutherZs!balance!sheet!look!like!if!they!acquire!the!new!fleet!of!delivery!trucks!using!a!capital!lease?!
Answer:!!!If!the!firm!acquires!the!fleet!through!a!capital!lease!it!is!the!same!as!if!Luther!borrowed!the!money!and!
purchased!the!fleet!directly.!!The!fleet!is!must!be!listed!as!an!asset!and!the!lease!will!show!up!as!!a!
liability.!!Therefore,!LutherZs!balance!sheet!will!look!like:!
Assets Liabilities
Cash $500! Debt $6,000!!
Diff:!2!
Skill:!Analytical!
!
12)!!What!will!LutherZs!balance!sheet!look!like!if!they!acquire!the!new!fleet!of!delivery!trucks!using!an!operating!
lease?!
Answer:!!!If!the!firm!acquires!the!fleet!through!an!operating!lease,!there!is!no!change!in!the!original!balance!sheet.!!
The!fleet!is!not!listed!as!an!asset!and!the!lease!is!not!view!as!a!liability.!!The!transaction!is!off-balance!
sheet!and!will!be!disclosed!in!a!foot-note.!!Therefore,!LutherZs!balance!sheet!will!look!like:!
Assets Liabilities
Cash $500! Debt $4,500!!
Property,!Plant,!and!Equipment $7,000! Equity $3,000!!
Diff:!2!
Skill:!Analytical!
!
25.3((The(Leasing(Decision(
(
A)!!Lease!payments!are!a!fixed!obligation!of!the!firm.!
B)!!The!risk!of!the!lease!payments!is!no!greater!than!the!risk!of!secured!debt,!so!it!is!reasonable!to!discount!
the!lease!payments!at!the!firmZs!secured!borrowing!rate.!
C)!!If!a!firm!purchases!a!piece!of!equipment,!the!expense!is!a!capital!expenditure.!Therefore,!the!purchase!
price!can!be!depreciated!over!time,!generating!a!depreciation!tax!shield.!
D)!!If!the!equipment!is!leased!and!the!lease!is!a!non-tax!lease,!there!is!no!capital!expenditure,!but!the!lease!
payments!are!an!operating!expense.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!equipment!is!leased!and!the!lease!is!a!true!tax!lease,!there!is!no!capital!expenditure,!but!
the!lease!payments!are!an!operating!expense.!
Diff:!1!
Topic:!25.3!The!Leasing!Decision!
Skill:!Conceptual!
!
A)!!The!lease-equivalent!loan!is!the!loan!that!is!required!on!the!purchase!of!the!asset!that!leaves!the!
purchaser!with!the!same!obligations!as!the!lessor!would!have.!
B)!!Lease!obligations!themselves!could!trigger!financial!distress.!
C)!!When!a!firm!enters!into!a!lease,!it!is!committing!to!lease!payments!that!are!a!fixed!future!obligation!of!
the!firm.!
D)!!When!a!firm!leases!an!asset,!it!is!effectively!adding!leverage!to!its!capital!structure!(whether!or!not!the!
lease!appears!on!the!balance!sheet!for!accounting!purposes).!
Answer:!!!A!
Explanation:!!! A)!!The!lease-equivalent!loan!is!the!loan!that!is!required!on!the!purchase!of!the!asset!that!leaves!
the!purchaser!with!the!same!obligations!as!the!lessee!would!have.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!We!can!compare!leasing!to!buying!the!asset!using!equivalent!leverage!by!discounting!the!incremental!
cash!flows!of!leasing!versus!buying!using!the!after-tax!borrowing!rate.!
B)!!A!non-tax!lease!is!attractive!if!it!offers!a!better!interest!rate!than!would!be!available!with!a!loan.!
C)!!Evaluating!a!true!tax!lease!is!much!more!straightforward!than!evaluating!a!non-tax!lease.!
D)!!To!determine!whether!a!non-tax!lease!offers!a!better!rate,!we!discount!the!lease!payments!at!the!firmZs!
pretax!borrowing!rate!and!compare!it!to!the!purchase!price!of!the!asset.!
Answer:!!!C!
B)!!
C)!!Evaluating!a!non-tax!lease!is!much!more!straightforward!than!evaluating!a!true!tax!lease.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
St.!MartinZs!Hospital!plans!to!purchase!or!lease!a!$2!million!dollar!CT!scanner.!!If!purchased,!the!CT!scanner!will!be!
depreciated!on!a!straight-line!basis!over!five!years,!after!which!it!will!be!worthless.!!If!leased,!the!annual!lease!payments!
will!be!$500,000!per!year!for!five!years.!!St.!MartinZs!borrowing!cost!is!8%,!and!its!tax!rate!is!35%.!
!
4)!!If!St.!Martin!purchases!the!CT!scanner,!what!is!the!amount!of!the!lease-equivalent!loan?!
Answer:!!!First!we!construct!the!FCF!from!leasing!and!buying.!!The!FCF!from!leasing!are!the!annual!lease!
payments!×!(1!-! c)!since!these!payments!are!deductible!for!tax!purposes.!!The!FCF!from!buying!
represents!the!original!cost!of!the!purchase!in!year!0!and!the!depreciation!tax!shield!!
of!($2M!/!5!years)!×!.35.!!The!free!cash!flows!are!as!follows:
!
Year 0 1 2 3 4 5(
FCF,!Lease (325,000) (325,000) (325,000) (325,000) (325,000)
Less:!FCF!Buy (2,000,000) 140,000 140,000 140,000! 140,000 140,000!
Lease-Buy 1,675,000 (465,000) (465,000) (465,000) (465,000) (140,000)!
!
The!amount!of!the!lease!equivalent!loan!is!equal!to!the!present!value!of!the!difference!in!FCFs!from!
years!1!to!5!discounted!at!the!after!tax!borrowing!rate!(.08)(1!-!.35)!=!.052!or!5.2%.
$465, 000 $465, 000 $465, 000 $465, 000 $140, 000
LEL!=! 1
!+! 2
!+! 3
!+=! 4
!+=! !=!$1,749,890!
(1.052) (1.052) (1.052) (1.052) (1.052)5
Diff:!2!
Skill:!Analytical!
!
5)!!Is!St.!MartinZs!better!off!leasing!the!CT!scanner!or!financing!the!purchase!of!the!CT!scanner!with!a!
lease-equivalent!loan!and!by!how!much!is!St!MartinZs!better!off?!
Answer:!!!First!we!construct!the!FCF!from!leasing!and!buying.!!The!FCF!from!leasing!are!the!annual!lease!
payments!×!(1!-! c)!since!these!payments!are!deductible!for!tax!purposes.!!The!FCF!from!buying!
represents!the!original!cost!of!the!purchase!in!year!0!and!the!depreciation!tax!shield!of!($2M!/!5!years)!
×!.35.!!The!free!cash!flows!are!as!follows:
Year 0 1 2 3 4 5(
FCF,!Lease (325,000) (325,000) (325,000) (325,000) (325,000)
Less:!FCF!Buy (2,000,000) 140,000 140,000 140,000! 140,000 140,000!
Lease-Buy 1,675,000 (465,000) (465,000) (465,000) (465,000) (140,000)!
The!amount!of!the!lease!equivalent!loan!is!equal!to!the!present!value!of!the!difference!in!FCFs!from!
years!1!to!5!discounted!at!the!after!tax!borrowing!rate!(.08)(1!-!.35)!=!.052!or!5.2%.
$465, 000 $465, 000 $465, 000 $465, 000 $140, 000
LEL!=! 1
!+! 2
!+! 3
!+=! 4
!+=! !=!$1,749,890
(1.052) (1.052) (1.052) (1.052) (1.052)5
Therefore,!St.!MartinZs!is!better!off!not!using!the!lease!since!1,749,890!>!1,675,000
St.!MartinZs!is!better!of!by!1,749,890!-!1,650,000!=!$74,890!
Diff:!3!
Skill:!Analytical!
!
25.4((Reasons(for(Leasing(
(
A)!!For!a!lease!to!be!attractive!to!both!the!lessee!and!the!lessor,!the!gains!must!come!from!some!underlying!
economic!benefits!that!the!leasing!arrangement!provides.!
B)!!With!a!true!tax!lease,!the!lessor!replaces!depreciation!and!interest!tax!deductions!with!a!deduction!for!
the!lease!payments.!
C)!!Generally!speaking,!if!the!assetZs!tax!depreciation!deductions!are!more!rapid!than!its!lease!payments,!a!
true!tax!lease!is!advantageous!if!the!lessor!is!in!a!higher!tax!bracket!than!the!lessee.!
D)!!A!tax!gain!occurs!if!the!lease!shifts!the!more!valuable!deductions!to!the!party!with!the!higher!tax!rate.!
Answer:!!!B!
B)!!With!a!non-tax!lease,!the!lessor!replaces!depreciation!and!interest!tax!deductions!with!a!
deduction!for!the!lease!payments!
C)!!
D)!!
Diff:!2!
Topic:!25.4!Reasons!for!Leasing!
Skill:!Conceptual!
!
A)!!If!a!firm!only!needs!to!use!the!asset!for!a!short!time,!it!is!probably!less!costly!to!lease!it!than!to!buy!and!
resell!the!asset.!
B)!!While!owners!of!assets!are!likely!to!resell!them!only!if!the!assets!are!clemons,c!a!short-term!lease!can!
commit!the!user!of!an!asset!to!return!it!regardless!of!its!quality.!In!this!way!leases!can!help!mitigate!the!
adverse!selection!problem!in!the!used!goods!market.!
C)!!Car!dealerships!are!in!a!better!position!to!sell!a!used!car!at!the!end!of!a!lease!than!a!consumer!is.!
D)!!If!the!assetZs!tax!depreciation!deductions!are!faster!than!its!lease!payments,!there!are!tax!gains!from!a!
true!tax!lease!if!the!lessor!is!in!a!lower!tax!bracket!than!the!lessee.!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!assetZs!tax!depreciation!deductions!are!slower!than!its!lease!payments,!there!are!tax!
gains!from!a!true!tax!lease!if!the!lessor!is!in!a!lower!tax!bracket!than!the!lessee.!
Diff:!2!
Skill:!Conceptual!
!
A)!!By!offering!assets!together!with!complementary!services,!lessors!can!achieve!efficiency!gains!and!offer!
attractive!lease!rates.!
B)!!Assets!leased!under!a!true!lease!are!afforded!bankruptcy!protection!and!cannot!be!seized!in!the!event!of!
default.!
C)!!Because!of!the!higher!recovery!value!in!the!event!of!default,!a!lessor!may!be!able!to!offer!more!attractive!
financing!through!the!lease!than!an!ordinary!lender!could.!
D)!!Lessors!often!have!efficiency!advantages!over!lessees!in!maintaining!or!operating!certain!types!of!assets.!
Answer:!!!B!
B)!!Assets!leased!under!a!true!lease!are!not!afforded!bankruptcy!protection!and!can!be!seized!in!
the!event!of!default.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Most!financial!analysts!and!sophisticated!investors!consider!operating!leases!(which!must!be!listed!in!
the!footnotes!of!the!financial!statements)!to!be!additional!sources!of!leverage.!
B)!!By!carefully!avoiding!the!four!criteria!that!define!a!operating!lease!for!accounting!purposes,!a!firm!can!
avoid!listing!the!long-term!lease!as!a!liability.!
C)!!Because!a!lease!is!equivalent!to!a!loan,!the!firm!can!increase!its!actual!leverage!without!increasing!the!
debt-to-equity!ratio!on!its!balance!sheet.!
D)!!For!most!large!corporations,!the!amount!of!leverage!the!firm!can!obtain!through!a!lease!is!unlikely!to!
exceed!the!amount!of!leverage!the!firm!can!obtain!through!a!loan.!
Answer:!!!B!
B)!!By!carefully!avoiding!the!four!criteria!that!define!a!capital!lease!for!accounting!purposes,!a!
firm!can!avoid!listing!the!long-term!lease!as!a!liability.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Leasing!allows!the!party!best!able!to!bear!the!risk!to!hold!it.!For!example,!small!firms!with!a!low!
tolerance!for!risk!may!prefer!to!lease!rather!than!purchase!assets.!
B)!!When!the!lessor!is!the!manufacturer,!a!lease!in!which!the!lessor!bears!the!risk!of!the!residual!value!can!
improve!incentives!and!lower!agency!costs.!
C)!!For!leases!in!which!the!lessor!retains!a!substantial!interest!in!the!assetZs!residual!value,!the!lessee!has!
more!of!an!incentive!to!take!proper!care!of!an!asset!that!is!leased!rather!than!purchased.!
D)!!Whether!they!appear!on!the!balance!sheet!or!not,!lease!commitments!are!a!liability!for!the!firm.!
Answer:!!!C!
B)!!
C)!!For!leases!in!which!the!lessee!retains!a!substantial!interest!in!the!assetZs!residual!value,!the!
lessee!has!more!of!an!incentive!to!take!proper!care!of!an!asset!that!is!leased!rather!than!
purchased.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Chapter(26(-(Working(Capital(Management(
!
!
26.1(Overview(of(Working(Capital((
(
1)!!The!difference!between!a!firm2s!operating!cycle!and!its!cash!cycle!is!
A)!!there!is!no!difference!between!the!cash!and!operating!cycles.!
B)!!its!account!receivable!days.!
C)!!its!accounts!payable!days.!
D)!!its!inventory!days.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!26.1!Overview!of!Working!Capital!
Skill:!Definition!
!
2)!!The!cash!conversion!cycle!(CCC)(is!defined!as!
A)!!Inventory!Days!+!Accounts!Receivable!Days!-!Accounts!Payable!Days.!
B)!!Inventory!Days!-!Accounts!Receivable!Days!-!Accounts!Payable!Days.!
C)!!Inventory!Days!+!Accounts!Receivable!Days!+!Accounts!Payable!Days.!
D)!!Inventory!Days!+!Accounts!Payable!Days!-!Accounts!Receivable!Days.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!The!main!components!of!net!working!capital!are!cash,!inventory,!receivables,!and!payables.!
B)!!The!firm2s!cash!cycle(is!the!average!length!of!time!between!when!a!firm!originally!purchases!its!
inventory!and!when!it!receives!the!cash!back!from!selling!its!product.!
C)!!Working!capital!includes!the!cash!that!is!needed!to!run!the!firm!on!a!day-to-day!basis.!It!does!not!
include!excess!cash,!which!is!cash!that!is!not!required!to!run!the!business!and!can!be!invested!at!a!
market!rate.!
D)!!If!the!firm!pays!cash!for!its!inventory,!the!firm2s!operating!cycle!is!identical!to!the!firm2s!cash!cycle!
Answer:!!!B!
B)!!The!firm’s!operating!cycle(is!the!average!length!of!time!between!when!a!firm!originally!
purchases!its!inventory!and!when!it!receives!the!cash!back!from!selling!its!product.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!firm2s!cash!cycle(is!the!length!of!time!between!when!the!firm!pays!cash!to!purchase!its!initial!inventory!
and!when!it!receives!cash!from!the!sale!of!the!output!produced!from!that!inventory.!
B)!!The!longer!a!firm2s!cash!cycle,!the!more!working!capital!it!has,!and!the!more!cash!it!needs!to!carry!to!
conduct!its!daily!operations.!
C)!!Most!firms!buy!their!inventory!on!credit,!which!increases!the!amount!of!time!between!the!cash!
investment!and!the!receipt!of!cash!from!that!investment.!
D)!!Any!reduction!in!working!capital!requirements!generates!a!positive!free!cash!flow!that!the!firm!can!
distribute!immediately!to!shareholders.!
Answer:!!!C!
B)!!
C)!!Most!firms!buy!their!inventory!on!credit,!which!reduces!the!amount!of!time!between!the!cash!
investment!and!the!receipt!of!cash!from!that!investment.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
Luther!Industries!had!sales!of!$980!million!and!a!cost!of!goods!sold!of!$560!million!in!2006.!!A!simplified!balance!sheet!for!
the!firm!appears!below:
Luther!Industries
Balance!Sheet
As!of!December!31,!2006
(millions!of!dollars)
Assets Liabilities(and(Equity
Cash 25 Accounts!payable 60!
Accounts!receivable 85 Notes!payable 425!
Inventory 90 Accruals 45!
Total!current!assets 200 Total!current!liabilities 530!
Net!plant,!property,!and!equipment 6,100 Long!term!debt 2,725!
Total!assets 6,300 Total!liabilities 3,255!
Common!equity 3,045!
Total!liabilities!and!equity 6,300!
5)!!Luther2s!Inventory!days!is!closest!to:!
A)!!32!days!
B)!!59!days!
C)!!39!days!
D)!!42!days!
Answer:!!!B!
B)!! Inventory $90
Inventory!days!=! !=! !=!58.66!days!
COGS / 365 $560 / 365
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
6)!!Luther2s!Accounts!Receivable!days!is!closest!to:!
A)!!42!days!
B)!!39!days!
C)!!32!days!
D)!!59!days!
Answer:!!!C!
B)!!
C)!! Accounts Receivable $85
Accounts!Receivable!days!=! !=! !=!31.66!days!
Sales / 365 $980 / 365
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!Luther2s!Accounts!Payable!days!is!closest!to:!
A)!!39!days!
B)!!32!days!
C)!!59!days!
D)!!42!days!
Answer:!!!A!
Explanation:!!! A)!! Accounts Payable $60
Accounts!Payables!days!=! !=! !=!39.11!days!
COGS / 365 $560 / 365
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!Luther2s!cash!conversion!cycle!is!closest!to:!
A)!!51!days!
B)!!66!days!
C)!!71!days!
D)!!129!days!
Answer:!!!A!
Explanation:!!! A)!! Inventory $90
COGS / 365 $560 / 365
Accounts Receivable $85
Sales / 365 $980 / 365
Accounts Payable $60
Accounts!Payables!days!=! !=! !=!39.11!days!
COGS / 365 $560 / 365
CCC!=!Inventory!days!+!Accounts!Receivable!days!-!Accounts!Payable!days!!
CCC!=!58.66!+!31.66!-!39.11!=!51.21!days!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Calculate!the!number!of!days!in!Luther2s!Operating!Cycle.!
Answer:!!! Inventory $90
COGS / 365 $560 / 365
Accounts Receivable $85
Sales / 365 $980 / 365
Operating!Cycle!=!Inventory!days!+!accounts!receivable!days!=!58.66!+!31.66!=!90.32!days!
Diff:!2!
Skill:!Analytical!
!
10)!!KT!Enterprises!would!like!to!construct!and!operate!a!new!ice!skating!rink.!!In!addition!to!the!capital!
expenditures!on!the!rink,!management!estimates!that!the!project!will!require!an!investment!today!of!$220,000!
in!net!working!capital.!!!The!firm!will!recover!the!investment!in!net!working!capital!fifteen!years!from!today,!
when!management!anticipates!closing!the!rink.!!The!discount!rate!for!this!type!of!cash!flow!is!8%!per!year.!!
Calculate!the!present!value!of!the!cost!of!working!capital!for!the!ice!skating!rink.!
Answer:!!! $220, 000
NPV!=!-$220,000!+! !=!-$150,646.82!
(1.08)15
Diff:!1!
Skill:!Analytical!
(
26.2((Trade(Credit(
(
1)!!Collection!float!is!made!up!of!all!of!the!following!except!
A)!!disbursement!float.!
B)!!processing!float.!
C)!!mail!float.!
D)!!availability!float.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!26.2!Trade!Credit!
Skill:!Conceptual!
!
A)!!Under!the!Modigliani-Miller!assumptions!of!perfect!capital!markets,!the!amounts!of!payables!and!
receivables!are!irrelevant.!
B)!!One!factor!that!contributes!to!the!length!of!a!firm2s!receivables!and!payables!is!the!delay!between!the!
time!a!bill!is!paid!and!the!cash!is!actually!received.!
C)!!Collection!float(is!the!amount!of!time!it!takes!before!payments!to!suppliers!actually!result!in!a!cash!
outflow!for!the!firm.!
D)!!The!credit!that!the!firm!is!extending!to!its!customer!is!known!as!trade!credit.!
Answer:!!!C!
B)!!
C)!!Disbursement!float(is!the!amount!of!time!it!takes!before!payments!to!suppliers!actually!result!
in!a!cash!outflow!for!the!firm.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!Check!Clearing!for!the!21st!Century!Act!(Check!21),!which!became!effective!on!October!28,!2004,!
eliminated!the!disbursement!float!due!to!the!check-clearing!process.!
B)!!Trade!credit!is,!in!essence,!a!loan!from!the!selling!firm!to!its!customer.!
C)!!The!accounts!receivable!balance!represents!the!amount!that!a!firm!owes!its!suppliers!for!goods!that!it!
has!received!but!for!which!it!has!not!yet!paid.!
D)!!Providing!financing!at!below-market!rates!is!an!indirect!way!to!lower!prices!for!only!certain!customers.!
Answer:!!!C!
B)!!
C)!!The!accounts!payable!balance!represents!the!amount!that!a!firm!owes!its!suppliers!for!goods!
that!it!has!received!but!for!which!it!has!not!yet!paid.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!The!term!2/10!net!30!means?!
A)!!If!the!invoice!is!paid!within!10!days!a!2%!discount!can!be!taken.!!If!the!invoice!is!paid!between!11!and!29!
days!a!1%!discount!can!be!taken.!!After!30!days!the!full!invoice!is!due.!
B)!!If!the!invoice!is!paid!within!2!days!a!10%!discount!can!be!taken,!otherwise!the!full!invoice!is!due!in!30!
days.!
C)!!If!the!invoice!is!paid!within!2!days!a!10%!discount!can!be!taken,!otherwise!a!2%!discount!can!be!taken!if!
the!invoice!is!paid!in!30!days.!
D)!!If!the!invoice!is!paid!within!10!days!a!2%!discount!can!be!taken,!otherwise!the!full!invoice!is!due!in!30!
days.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
5)!!Your!firm!purchases!goods!from!its!supplier!on!terms!of!1/10,!net!30.!!The!effective!annual!cost!to!your!firm!if!
it!chooses!not!to!take!advantage!of!the!trade!discount!offered!is!closest!to:!
A)!!16.8%!
B)!!44.6%!
C)!!20.1%!
D)!!13.0%!
Answer:!!!C!
B)!!
C)!!The!difference!in!days!=!30!-!10!=!20!days.!!You!will!either!pay!$0.99!on!a!dollar!of!sales!in!10!
days!or!$1.00!on!a!dollar!of!sales!in!30!days.!
!
365
$1.00 20
EAR!=! !-!1!=!.201317!or!20.13%!
$0.99
D)!!
Diff:!1!
Skill:!Analytical!
!
6)!!Your!firm!purchases!goods!from!its!supplier!on!terms!of!2/10,!net!45.!!Calculate!the!effective!annual!cost!to!
your!firm!if!it!chooses!not!to!take!advantage!of!the!trade!discount!offered.!
Answer:!!!The!difference!in!days!=!45!-!10!=!35!days.!!You!will!either!pay!$0.98!on!a!dollar!of!sales!in!10!days!or!
$1.00!on!a!dollar!of!sales!in!45!days.!
!
365
$1.00 35
EAR!=! !-!1!=!.234524!or!23.45%!
$0.99
Diff:!1!
Skill:!Analytical!
!
26.3((Receivables(Management(
(
1)!!Which!one!of!the!following!is!not!one!of!the!three!steps!involved!in!establishing!a!credit!policy?!
A)!!Establishing!credit!payment!patterns!
B)!!Establishing!credit!standards!
C)!!Establishing!a!collection!policy!
D)!!Establishing!credit!terms!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!26.3!Receivables!Management!
Skill:!Conceptual!
!
A)!!After!a!firm!decides!on!its!credit!standards,!it!must!next!establish!its!credit!terms.!
B)!!The!decision!of!how!much!credit!risk!to!assume!plays!a!large!role!in!determining!how!much!money!a!
firm!ties!up!in!its!payables.!
C)!!Knowledge!of!the!payments!pattern!is!also!useful!for!forecasting!the!firm2s!working!capital!
requirements.!
D)!!An!aging!schedule(categorizes!accounts!by!the!number!of!days!they!have!been!on!the!firm2s!books.!
Answer:!!!B!
B)!!The!decision!of!how!much!credit!risk!to!assume!plays!a!large!role!in!determining!how!much!
money!a!firm!ties!up!in!its!receivables.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!aging!schedule!is!also!sometimes!augmented!by!analysis!of!the!payments!pattern,!which!provides!
information!on!the!percentage!of!monthly!sales!that!the!firm!collects!in!each!month!after!the!sale.!
B)!!Because!accounts!receivable!days!can!be!calculated!from!the!firm’s!financial!statement,!outside!investors!
commonly!use!this!measure!to!evaluate!a!firm’s!credit!management!policy.!
C)!!If!the!aging!schedule!gets!dtop-heavyd that!is,!if!the!percentages!in!the!upper!half!of!the!schedule!begin!
to!increase–the!firm!will!likely!need!to!revisit!its!credit!policy.!
D)!!Seasonal!sales!patterns!may!cause!the!number!calculated!for!the!accounts!receivable!days!to!change!
depending!on!when!the!calculation!takes!place.!
Answer:!!!C!
B)!!
C)!!If!the!aging!schedule!gets!dbottom-heavyd that!is,!if!the!percentages!in!the!lower!half!of!the!
schedule!begin!to!increase–the!firm!will!likely!need!to!revisit!its!credit!policy.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!Luther!Industries!bills!its!accounts!on!terms!of!2/10,!net!30.!The!firm2s!accounts!receivable!include!$250,000!
that!has!been!outstanding!for!10!or!fewer!days,!$375,000!outstanding!for!11!to!30!days,!$70,000!outstanding!for!
31!to!40!days,!$35,000!outstanding!for!41!to!50!days,!$20,000!outstanding!for!51!to!60!days,!and!$8,000!
outstanding!for!more!than!60!days.!Prepare!an!aging!schedule!for!Luther!Industries.!
Answer:!!!Days( Amount( Percentage(
Outstanding Outstanding(($) Outstanding((%)(
1!-!10 $250,000! 33.0%!
11!-!30 $375,000! 49.5%!
31!-!40 $70,000! 9.2%!
41!-!50 $35,000! 4.6%!
51!-!60 $20,000! 2.6%!
60!+ $8,000! 1.1%!
Total!= $758,000!
Diff:!2!
Skill:!Analytical!
26.4((Payables(Management(
(
A)!!The!lower!the!discount!percentage!offered,!the!greater!the!cost!of!forgoing!the!discount!and!using!trade!
credit.!
B)!!A!firm!should!choose!to!borrow!using!accounts!payable!only!if!trade!credit!is!the!cheapest!source!of!
funding.!
C)!!A!firm!should!always!pay!on!the!latest!day!allowed.!
D)!!A!firm!should!strive!to!keep!its!money!working!for!it!as!long!as!possible!without!developing!a!bad!
relationship!with!its!suppliers!or!engaging!in!unethical!practices.!
Answer:!!!A!
Explanation:!!! A)!!The!higher!the!discount!percentage!offered,!the!greater!the!cost!of!forgoing!the!discount!and!
using!trade!credit.!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!26.4!Payables!Management!
Skill:!Conceptual!
!
A)!!Similar!to!the!situation!with!its!accounts!receivable,!a!firm!should!monitor!its!accounts!payable!to!ensure!
that!it!is!making!its!payments!at!an!optimal!time.!
B)!!Some!firms!ignore!the!payment!due!period!and!pay!later,!in!a!practice!referred!to!as!pushing!the!
accounts!payable.!
C)!!Suppliers!may!react!to!a!firm!whose!payments!are!always!late!by!imposing!terms!of!cash!on!delivery!
(COD)!or!cash!before!delivery!(CBD).!
D)!!If!the!accounts!payable!outstanding!is!40!days!and!the!terms!are!2/10,!net!30,!the!firm!can!conclude!that!it!
generally!pays!late!and!may!be!risking!supplier!difficulties.!
Answer:!!!B!
B)!!Some!firms!ignore!the!payment!due!period!and!pay!later,!in!a!practice!referred!to!as!
stretching!the!accounts!payable.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
it!chooses!not!to!take!advantage!of!the!trade!discount!offered!and!stretches!the!accounts!payable!to!45!days!is!
closest!to:!
A)!!13.0%!
B)!!11.1%!
C)!!15.9%!
D)!!20.1%!
Answer:!!!B!
B)!!The!difference!in!days!=!45!-!10!=!35!days.!!You!will!either!pay!$0.99!on!a!dollar!of!sales!in!10!
!
365
$1.00 35
EAR!=! !-!1!=!.110500!or!11.05%!
$0.99
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
it!chooses!not!to!take!advantage!of!the!trade!discount!offered!and!stretches!the!accounts!payable!to!60!days!is!
closest!to:!
A)!!20.1%!
B)!!15.9%!
C)!!13.0%!
D)!!11.1%!
Answer:!!!B!
B)!!The!difference!in!days!=!60!-!10!=!50!days.!!You!will!either!pay!$0.98!on!a!dollar!of!sales!in!10!
!
365
$1.00 50
EAR!=! !-!1!=!.11589!or!15.89%!
$0.98
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
5)!!Kinston!Industries!has!an!average!accounts!payable!balance!of!$220,000.!!Its!annual!cost!of!goods!sold!is!
$5,475,000,!and!it!receives!terms!of!2/10,!net!30!from!its!suppliers.!!Kinston!chooses!to!forgo!this!discount.!!Is!
Kinston!managing!its!accounts!payables!well?!
Answer:!!!The!firm!is!not!managing!its!accounts!payables!well.!!Kinston2s!days!payable!outstanding!is!
$220, 000
!=!14.67!days.!!If!Kinston!made!the!payments!less!than!five!days!earlier,!they!could!take!
$5, 475, 000 / 365
a!2%!discount.!!If,!for!some!reason,!they!choose!to!forgo!the!discount,!then!they!should!not!be!paying!
the!full!amount!until!30!days.!
Diff:!2!
Skill:!Analytical!
6)!!Goldsboro!Industries!has!an!average!accounts!payable!balance!of!$680,000.!!Its!annual!cost!of!goods!sold!is!
$4,500,000,!and!it!receives!terms!of!1/10,!net!40!from!its!suppliers.!!Goldsboro!chooses!to!forgo!this!discount.!!Is!
Goldsboro!managing!its!accounts!payables!well?!
Answer:!!!The!firm!is!not!managing!its!accounts!payables!well.!Goldsboro2s!days!payable!outstanding!!is!
$680, 000
!=!55.16!days.!!They!are!over!the!term!of!40!days!offer!by!their!suppliers.!!Goldsboro!is!
$4,500, 000 / 365
stretching!the!terms!of!the!credit!agreement!and!risks!having!problems!with!their!suppliers!as!a!result.!
Diff:!2!
Skill:!Analytical!
!
26.5((Inventory(Management(
(
1)!!Which!of!the!following!is!not!a!direct!costs!associated!with!inventory?!
A)!!Acquisition!costs!
B)!!Order!costs!
C)!!Carrying!costs!
D)!!Stock!out!costs!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!26.5!Inventory!Management!
Skill:!Definition!
!
A)!!Under!the!Modigliani-Miller!assumptions!of!perfect!capital!markets,!the!amount!of!inventory!is!
irrelevant.!
B)!!Unlike!trade!credit,!inventory!represents!one!of!the!required!factors!of!production.!
C)!!It!is!the!firm’s!financial!manager!who!must!arrange!for!the!financing!necessary!to!support!the!firm2s!
inventory!policy!and!who!is!responsible!for!ensuring!the!firm’s!overall!profitability.!
D)!!Inventory!management!receives!extensive!coverage!in!courses!on!operations!management.!
Answer:!!!A!
Explanation:!!! A)!!Even!in!a!perfect!markets!setting!in!which!the!Modigliani-Miller!propositions!hold,!firms!still!
need!inventory.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Firms!may!hold!inventory!because!factors!such!as!seasonality!in!demand!mean!that!customer!purchases!
do!not!perfectly!match!the!most!efficient!production!cycle.!
B)!!Inventory!helps!minimize!the!risk!that!the!firm!will!not!be!able!to!obtain!an!input!it!needs!for!production.!
C)!!If!a!firm!holds!too!much!inventory,!stock-outs,!the!situation!when!a!firm!runs!out!of!product,!may!occur,!
leading!to!lost!sales.!
D)!!Because!excessive!inventory!uses!cash,!efficient!management!of!inventory!increases!firm!value.!
Answer:!!!C!
B)!!
C)!!If!a!firm!holds!too!little!inventory,!stock-outs,!the!situation!when!a!firm!runs!out!of!product,!
may!occur,!leading!to!lost!sales.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
4)!!Describe!djust-in-timed!inventory!management.!
Answer:!!!Some!firms!seek!to!reduce!their!carrying!costs!as!much!as!possible.!With!djust-in!timed!(JIT)!inventory!
management,!a!firm!acquires!inventory!precisely!when!needed!so!that!its!inventory!balance!is!always!
zero,!or!very!close!to!it.!This!technique!requires!exceptional!coordination!with!suppliers!as!well!as!a!
predictable!demand!for!the!firm2s!products.!In!addition,!there!may!be!a!trickle-down!effect!when!one!
firm!in!an!industry!adopts!JIT.!For!example,!in!1999,!Toys!2R!Us!instituted!JIT,!which!caused!one!of!its!
suppliers,!toy!manufacturer!Hasbro,!to!make!changes!in!its!production!schedule.!
Diff:!2!
Skill:!Conceptual!
!
26.6((Cash(Management(
(
1)!!Which!of!the!following!money!market!investments!is!a!short-term!debt!obligations!of!the!U.S.!government?!
A)!!Treasury!Bill!
B)!!Repurchase!Agreement!
C)!!Commercial!Paper!
D)!!Certificates!of!Deposit!(CD)!
E)!!Banker’s!Acceptance!
Answer:!!!A!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Topic:!26.6!Cash!Management!
Skill:!Definition!
!
2)!!Which!of!the!following!money!market!investments!is!short-term!debt!issued!by!a!bank!with!a!minimum!
denomination!of!$100,000?!
A)!!Treasury!Bill!
B)!!Banker’s!Acceptance!
C)!!Repurchase!Agreement!
D)!!Commercial!Paper!
E)!!Certificates!of!Deposit!(CD)!
Answer:!!!E!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Definition!
!
3)!!Which!of!the!following!money!market!investments!is!essentially!a!loan!arrangement!wherein!a!securities!
dealer!is!the!dborrowerd!and!the!investor!is!the!dlender.d!The!investor!buys!securities!from!the!securities!dealer,!
with!an!agreement!to!sell!the!securities!back!to!the!dealer!at!a!later!date!for!a!specified!higher!price?!
A)!!Certificates!of!Deposit!(CD)!
B)!!Commercial!Paper!
C)!!Banker2s!Acceptance!
D)!!Repurchase!Agreement!
E)!!Treasury!Bill!
Answer:!!!D!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Definition!
!
4)!!Which!of!the!following!money!market!investments!is!a!draft!written!by!the!borrower!and!guaranteed!by!the!
bank!on!which!the!draft!is!drawn.!Typically!used!in!international!trade!transactions.!The!borrower!is!an!
importer!who!writes!the!draft!in!payment!for!goods?!
A)!!Treasury!Bill!
B)!!Repurchase!Agreement!
C)!!Certificates!of!Deposit!(CD)!
D)!!Banker2s!Acceptance!
E)!!Commercial!Paper!
Answer:!!!D!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Definition!
!
5)!!Which!of!the!following!money!market!investments!is!a!short-term,!unsecured!debt!obligation!issued!by!a!
large!corporation.!The!minimum!denomination!is!$25,000,!but!most!have!a!face!value!of!$100,000!or!more?!
A)!!Banker2s!Acceptance!
B)!!Commercial!Paper!
C)!!Repurchase!Agreement!
D)!!Certificates!of!Deposit!(CD)!
E)!!Treasury!Bill!
Answer:!!!B!
B)!!
C)!!
D)!!
E)!!
Diff:!1!
Skill:!Definition!
!
6)!!The!amount!of!cash!a!firm!needs!to!be!able!to!pay!its!bills!is!sometimes!referred!to!as!a(n)!
A)!!operating!balance!
B)!!compensating!balance.!
C)!!transactions!balance.!
D)!!precautionary!balance.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
7)!!The!amount!of!cash!a!firm!holds!to!counter!the!uncertainty!surrounding!its!future!cash!needs!is!known!as!a(n)!
A)!!speculative!balance.!
B)!!compensating!balance.!
C)!!operating!balance!
D)!!precautionary!balance.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
8)!!What!is!a!compensating!balance?!
Answer:!!!A!firm2s!bank!may!require!it!to!hold!a!compensating!balance!in!an!account!at!the!bank!as!compensation!
for!services!that!the!bank!performs.!!Compensating!balances!are!typically!deposited!in!accounts!that!
either!earn!no!interest!or!pay!a!very!low!interest!rate.!This!arrangement!is!similar!to!a!bank!offering!
individuals!free!checking!so!long!as!their!balances!do!not!fall!below!a!certain!level–say,!$1000.!
Essentially,!the!customer!has!$1000!cash!that!he!cannot!use!unless!he!is!willing!to!pay!a!service!charge.!
Similarly,!the!cash!that!a!firm!has!tied!up!to!meet!a!compensating!balance!requirement!is!unavailable!
for!other!uses.!
Diff:!2!
Skill:!Conceptual!
!
!
Chapter(27(-(Short-Term(Financial(Planning(
!
!
27.1(Forecasting(Short-Term(Financing(Needs((
(
1)!!Occasionally,!a!company!will!encounter!circumstances!in!which!cash!flows!are!temporarily!negative!for!an!
unexpected!reason.!We!refer!to!such!a!situation!as!a!
A)!!a!liquidity!shock.!
B)!!negative!cash!flow!shock.!
C)!!a!negative!liquidity!shock.!
D)!!a!cash!crunch.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!27.1!Forecasting!Short-Term!Financing!Needs!
Skill:!Conceptual!
!
2)!!When!a!company!analyzes!its!short-term!financing!needs,!it!typically!examines!cash!flows!at!
A)!!monthly!intervals.!
B)!!yearly!intervals.!
C)!!quarterly!intervals.!
D)!!weekly!intervals.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!Which!of!the!following!firms!is!likely!to!have!the!highest!short-term!financing!needs?!
A)!!A!pharmaceutical!manufacturer!
B)!!A!grocery!store!
C)!!An!electric!utility!
D)!!A!toy!store!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!If!a!company!anticipates!an!ongoing!surplus!of!cash,!it!may!choose!to!increase!its!dividend!payout.!
B)!!Seasonal!sales!can!create!large!short-term!cash!flow!deficits!and!surpluses.!
C)!!The!first!step!in!short-term!financial!planning!is!to!forecast!the!companyPs!future!net!working!capital.!
D)!!Deficits!resulting!from!investments!in!long-term!projects!are!often!financed!using!long-term!sources!of!
capital,!such!as!equity!or!long-term!bonds.!
Answer:!!!C!
B)!!
C)!!The!first!step!in!short-term!financial!planning!is!to!forecast!the!company’s!future!cash!flows.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Firms!with!seasonal!cash!flows!may!find!themselves!with!a!surplus!of!cash!during!some!months!that!is!
sufficient!to!compensate!for!a!shortfall!during!other!months.!However,!because!of!timing!differences,!
such!firms!often!have!short-term!financing!needs.!
B)!!A!company!forecasts!its!cash!flows!to!determine!whether!it!will!have!surplus!cash!or!a!cash!deficit!for!
each!period.!
C)!!Like!seasonalities,!positive!cash!flow!shocks!can!create!short-term!financing!needs.!
D)!!When!sales!are!concentrated!during!a!few!months,!sources!and!uses!of!cash!are!also!likely!to!be!seasonal.!
Answer:!!!C!
B)!!
C)!!Like!seasonalities,!negative!cash!flow!shocks!can!create!short-term!financing!needs.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
The!quarterly!working!capital!levels!for!Hasbeen!Toys!are!presented!in!the!following!table!(in!$!millions):
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Accounts!Receivable 585 745 1,260 760!
Inventory 410 540 725 375!
Accounts!Payable 835 910 1,055 1,145!
!
6)!!In!which!quarter!are!HasbeenPs!seasonal!working!capital!needs!the!greatest?!
A)!!4!
B)!!2!
C)!!3!
D)!!1!
Answer:!!!C!
B)!!
C)!!
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
Working!capital 765 1,000 1,105 990!
!
Working!capital!=!Cash!+!AR!+!Inventory!-!AP.!!Note!quarter!3!has!the!highest!Working!
capital!needs.!
D)!!
Diff:!2!
Skill:!Analytical!
(
27.2((The(Matching(Principle(
(
1)!!Which!of!the!following!is!not!a!specific!financing!option!for!temporary!working!capital?!
A)!!Secured!financing!
B)!!Commercial!paper!
C)!!Bank!loans!
D)!!Repurchase!agreements!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!27.2!The!Matching!Principle!
Skill:!Conceptual!
!
A)!!The!matching!principle!indicates!that!the!firm!should!finance!permanent!working!capital!with!
short-term!sources!of!funds.!
B)!!Following!the!matching!principle!should,!in!the!long!run,!help!minimize!a!firmPs!transaction!costs.!
C)!!In!a!perfect!capital!market,!the!choice!of!financing!is!irrelevant;!thus!how!the!firm!chooses!to!finance!its!
short-term!cash!needs!cannot!affect!value.!
D)!!A!portion!of!a!firmPs!investment!in!its!accounts!receivable!and!inventory!is!temporary!and!results!from!
seasonal!fluctuations!in!the!firmPs!business!or!unanticipated!shocks.!
Answer:!!!A!
Explanation:!!! A)!!The!matching!principle!indicates!that!the!firm!should!finance!permanent!working!capital!
with!long-term!sources!of!funds.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Because!investment!in!permanent!working!capital!is!required!so!long!as!the!firm!remains!in!business,!it!
constitutes!a!long-term!investment.!
B)!!Because!temporary!working!capital!represents!a!short-term!need,!the!firm!should!finance!this!portion!of!
its!investment!with!short-term!financing.!
C)!!Temporary!working!capital(is!the!difference!between!the!lowest!level!of!investment!in!short-term!assets!
and!the!permanent!working!capital!investment.!
D)!!The!matching!principle(states!that!short-term!needs!should!be!financed!with!short-term!debt!and!
long-term!needs!should!be!financed!with!long-term!sources!of!funds.!
Answer:!!!C!
B)!!
C)!!Temporary!working!capital(is!the!difference!between!the!actual!level!of!investment!in!
short-term!assets!and!the!permanent!working!capital!investment.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!With!a!discount!loan,!the!borrower!is!required!to!pay!the!interest!at!the!end$of!the!loan!period.!!
B)!!Bridge!loans!are!often!quoted!as!discount!loans!with!fixed!interest!rates.!
C)!!A!bridge!loan(is!another!type!of!short-term!bank!loan!that!is!often!used!to!abridge!the!gapa!until!a!firm!
can!arrange!for!long-term!financing.!!
D)!!After!a!natural!disaster,!lenders!may!provide!businesses!with!short-term!loans!to!serve!as!bridges!until!
they!receive!insurance!payments!or!long-term!disaster!relief.!
Answer:!!!A!
Explanation:!!! A)!!With!a!discount!loan,!the!borrower!is!required!to!pay!the!interest!at!the!beginning$of!the!loan!
period.
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!Financing!part!or!all!of!the!permanent!working!capital!with!short-term!debt!is!known!as!an!aggressive!
financing!policy.!
B)!!When!the!yield!curve!is!downward!sloping,!the!interest!rate!on!short-term!debt!is!lower!than!the!rate!on!
long-term!debt.!In!that!case,!short-term!debt!may!appear!cheaper!than!long-term!debt.!
C)!!The!value!of!short-term!debt!is!less!sensitive!to!the!firmPs!credit!quality!than!long-term!debt;!therefore,!
its!value!will!be!less!affected!by!managementPs!actions!or!information.!
D)!!Permanent!working!capital!is!the!amount!that!a!firm!must!keep!invested!in!its!short-term!assets!to!
support!its!continuing!operations.!
Answer:!!!B!
B)!!When!the!yield!curve!is!upward!sloping,!the!interest!rate!on!short-term!debt!is!lower!than!the!
rate!on!long-term!debt.!In!that!case,!short-term!debt!may!appear!cheaper!than!long-term!debt.!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!On!the!other!hand,!by!relying!on!short-term!debt!the!firm!exposes!itself!to!funding!risk,!which!is!the!risk!
of!incurring!financial!distress!costs!should!the!firm!not!be!able!to!refinance!its!debt!in!a!timely!manner!or!
at!a!reasonable!rate.!
B)!!An!ultra-conservative!policy!would!involve!financing!even!some!of!the!plant,!property,!and!equipment!
with!short-term!sources!of!funds.!
C)!!With!a!conservative!financing!policy,!the!firm!would!use!short-term!debt!very!sparingly!to!meet!its!peak!
seasonal!needs.!
D)!!Short-term!debt!can!have!lower!agency!and!lemons!costs!than!long-term!debt,!and!an!aggressive!
financing!policy!can!benefit!shareholders.!
Answer:!!!B!
B)!!An!ultra-aggressive!policy!would!involve!financing!even!some!of!the!plant,!property,!and!
equipment!with!short-term!sources!of!funds.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!following!a!conservative!financing!policy,!a!firm!would!use!long-term!sources!of!funds!to!finance!
its!fixed!assets,!permanent!working!capital,!and!some!of!its!seasonal!needs.!
B)!!An!aggressive!financing!policy!also!increases!the!possibility!that!managers!of!the!firm!will!use!this!
excess!cash!nonproductively—for!example,!on!perquisites!for!themselves.!
C)!!A!firm!could!finance!its!short-term!needs!with!long-term!debt,!a!practice!known!as!a!conservative!
financing!policy.!
D)!!To!implement!a!conservative!financing!policy!effectively,!there!will!necessarily!be!periods!when!excess!
cash!is!available—those!periods!when!the!firm!requires!little!or!no!investment!in!temporary!working!
capital.!
Answer:!!!B!
B)!!A!conservative!financing!policy!also!increases!the!possibility!that!managers!of!the!firm!will!
use!this!excess!cash!nonproductively for!example,!on!perquisites!for!themselves.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
The!quarterly!working!capital!levels!for!Hasbeen!Toys!are!presented!in!the!following!table!(in!$!millions):
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
!
8)!!The!permanent!working!capital!needs!for!Hasbeen!Toys!is!closest!to:!
A)!!$1,100!million!
B)!!$2,435!million!
C)!!$1,275!million!
D)!!$770!million!
Answer:!!!D!
B)!!
C)!!
D)!!
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
Working!capital 765 1,000 1,105 990!
Working!capital!=!Cash!+!AR!+!inventory!-!AP
Permanent!working!capital!equals!the!minimum!level!of!working!capital!which!occurs!at!
quarter!1!in!the!amount!of!$765!million.!
Diff:!2!
Skill:!Analytical!
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9)!!The!temporary!working!capital!needs!for!Hasbeen!Toys!in!quarter!1!is!closest!to:!
A)!!$0!million!
B)!!$340!million!
C)!!$770!million!
D)!!$845!million!
Answer:!!!A!
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
Working!capital 765 1,000 1,105 990!
quarter!1!in!the!amount!of!$765!million.
Temporary!working!capital!=!working!capital!-!permanent!working!capital!=!$765!-!$765!=!$0!
million!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!The!temporary!working!capital!needs!for!Hasbeen!Toys!in!quarter!3!is!closest!to:!
A)!!$845!million!
B)!!$0!million!
C)!!$770!million!
D)!!$!340!million!
Answer:!!!D!
B)!!
C)!!
D)!!
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
Working!capital 765 1,000 1,105 990!
quarter!1!in!the!amount!of!$765!million.
Temporary!working!capital!=!working!capital!-!permanent!working!capital!=!$1105!-!$765!=!
$340!million!
Diff:!2!
Skill:!Analytical!
!
11)!!Calculate!the!temporary!working!capital!needs!for!each!of!the!four!quarters!for!Hasbeen!Toys.!
Answer:!!!
Quarter 1 2 3 4(
Cash 605 625 175 1,000!
Inventory 410 540 725 375!
Working!capital 765 1,000 1,105 990!

permanent!W/C 765 765 765 765!
temporary!W/C 0 235 340 225!
Permanent!working!capital!equals!the!minimum!level!of!working!capital!which!occurs!at!quarter!1!in!
the!amount!of!$765!million.
Temporary!working!capital!=!working!capital!-!permanent!working!capital!
Diff:!2!
Skill:!Analytical!
27.3((Short-Term(Financing(with(Bank(Loans(
(
1)!!A!loan!agreement!requires!that!the!firm!pay!interest!on!the!loan!and!pay!back!the!principal!in!one!lump!sum!
at!the!end!of!the!loan!is!called!
A)!!a!short-term!mortgage!loan.!
B)!!a!single,!end-of-period-payment!loan.!
C)!!a!bridge!loan.!
D)!!a!line!of!credit.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!27.3!Short-Term!Financing!with!Bank!Loans!
Skill:!Definition!
!
2)!!A!short-term!bank!loan!that!is!often!used!until!a!firm!can!arrange!for!long-term!financing!is!called!
A)!!a!committed!line!of!credit.!
B)!!a!short-term!mortgage!loan.!
C)!!a!bridge!loan.!
D)!!a!single,!end-of-period-payment!loan.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!A!a!written,!legally!binding!agreement!that!obligates!the!bank!to!lend!a!firm!any!amount!up!to!a!stated!
maximum,!regardless!of!the!financial!condition!of!the!firm!(unless!the!firm!is!bankrupt)!as!long!as!the!firm!
satisfies!any!restrictions!in!the!agreement!!is!called!
A)!!a!bridge!loan.!
C)!!a!short-term!mortgage!loan.!
D)!!a!committed!line!of!credit.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!Bank!loans!are!typically!initiated!with!a!promissory!note,!which!is!a!written!statement!that!indicates!the!
amount!of!the!loan,!the!date!payment!is!due,!and!the!interest!rate.!
B)!!The!most!straightforward!type!of!bank!loan!is!a!single,!end-of-period-payment!loan.!
C)!!With!a!fixed!interest!rate,!the!specific!rate!that!the!bank!will!charge!is!stipulated!at!the!time!the!loan!is!
made.!
D)!!One!of!the!primary!sources!of!short-term!financing,!especially!for!small!businesses,!is!the!investment!
bank.!
Answer:!!!D!
B)!!
C)!!
D)!!One!of!the!primary!sources!of!short-term!financing,!especially!for!small!businesses,!is!the!
commercial!bank.!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!prime!rate(is!the!rate!banks!charge!other!banks.!
B)!!With!a!variable!interest!rate,!the!terms!of!the!loan!may!indicate!that!the!rate!will!vary!with!some!spread!
relative!to!a!benchmark!rate,!such!as!the!yield!on!one-year!Treasury!securities!or!the!prime!rate.!
C)!!With!a!discount!loan,!the!borrower!is!required!to!pay!the!interest!at!the!beginning!of!the!loan!period.!
D)!!A!common!benchmark!rate!is!the!London!Inter-Bank!Offered!Rate,!or!LIBOR,!which!is!the!rate!of!
interest!at!which!banks!borrow!funds!from!each!other!in!the!London!inter!bank!market.!
Answer:!!!A!
Explanation:!!! A)!!The!prime!rate(is!the!rate!banks!charge!their!most!creditworthy!customers.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!Which!of!the!following!statements!regarding!lines!of!credit!is!false?!
A)!!The!line!of!credit!agreement!may!also!stipulate!that!at!some!point!in!time!the!outstanding!balance!must!
be!zero.!This!policy!ensures!that!the!firm!does!not!use!the!short-term!financing!to!finance!its!long-term!
obligations.!
B)!!A!revolving!line!of!credit(is!an!uncommitted!line!of!credit!that!involves!an!informal!agreement!from!the!
bank!for!a!longer!period!of!time,!typically!two!to!three!years.!
C)!!The!line!of!credit!may!be!uncommitted,!meaning!it!is!an!informal!agreement!that!does!not!legally!bind!
the!bank!to!provide!the!funds.!
D)!!A!revolving!line!of!credit!with!no!fixed!maturity!is!called!evergreen!credit.!
Answer:!!!B!
B)!!A!revolving!line!of!credit(is!a!committed!line!of!credit!that!involves!a!solid!commitment!from!
the!bank!for!a!longer!period!of!time,!typically!two!to!three!years.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!Regardless!of!the!loan!structure,!the!bank!may!include!a!compensating!balance!requirement!in!the!loan!
agreement!that!reduces!the!usable!loan!proceeds.!
B)!!Another!common!type!of!fee!is!a!loan!origination!fee,!which!a!bank!charges!to!cover!credit!checks!and!
legal!fees.!
C)!!Firms!frequently!use!lines!of!credit!to!finance!seasonal!needs.!
D)!!The!commitment!fee!associated!with!a!committed!line!of!credit!is!designed!to!decreases!the!effective!cost!
of!the!loan!to!the!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!The!commitment!fee!associated!with!a!committed!line!of!credit!increases!the!effective!cost!of!
the!loan!to!the!firm.!
Diff:!2!
Skill:!Conceptual!
!
8)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!If!this!loan!has!an!
origination!fee!of!1%,!then!the!effective!annual!rate!(EAR)!for!this!loan!is!closest!to:!
A)!!12.0%!
B)!!12.6%!
C)!!4.1%!
D)!!13.8%!
Answer:!!!B!
B)!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!fee!is!equal!
to!.01!×!$1,000,000!=!$10,000,!so!that!the!actual!proceeds!from!the!loan!=!$1,000,000!-!$10,000!=!
.09
$990,000.!!The!interest!on!the!loan!equals!$1,000,000!×! !×!4!months!=!$30,000!
12
$1, 030, 000
The!actual!four!month!interest!rate!is:! !-!1!=!.040404!or!4.04%!
$990, 000
Expressing!this!rate!as!an!EAR!gives!1.040404(12/4)!-!1!=!.126176!or!12.62%!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!If!LutherPs!bank!requires!
that!the!firm!maintain!a!compensating!balance!equal!to!10%!of!the!loan!amount!in!a!non-interest!bearing!
account,!then!the!effective!annual!rate!EAR!for!this!loan!is!closest!to:!
A)!!50.0%!
B)!!12.6%!
C)!!14.4%!
D)!!71.5%!
Answer:!!!A!
Explanation:!!! A)!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!compensating!
balance!is!equal!to!.10!×!$1,000,000!=!$100,000,!so!that!the!actual!proceeds!from!the!loan!=!
.09
$1,000,000!-!$100,000!=!$900,000.!!The!interest!on!the!loan!equals!$1,000,000!×! !×!4!months!
12
=!$30,000!
$1, 030, 000
$900, 000
!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!LutherPs!bank!requires!
account!and!the!bank!charges!a!1%!origination!fee.!!Calculate!the!the!effective!annual!rate!EAR!for!this!loan.!
Answer:!!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!compensating!balance!is!
equal!to!.05!×!$1,000,000!=!$50,000!and!the!amount!of!the!origination!fee!is!equal!to!.01!×!$1,000,000!=!
$10,000,!so!that!the!actual!proceeds!from!the!loan!=!$1,000,000!-!$50,000!-!$10,000!=!$940,000.!!The!
.09
interest!on!the!loan!equals!$1,000,000!×! !×!4!months!=!$30,000!
12
$1, 030, 000
$940, 000
!
Diff:!2!
Skill:!Analytical!
27.3((Short-Term(Financing(with(Bank(Loans(
(
1)!!A!loan!agreement!requires!that!the!firm!pay!interest!on!the!loan!and!pay!back!the!principal!in!one!lump!sum!
at!the!end!of!the!loan!is!called!
A)!!a!short-term!mortgage!loan.!
C)!!a!bridge!loan.!
D)!!a!line!of!credit.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
2)!!A!short-term!bank!loan!that!is!often!used!until!a!firm!can!arrange!for!long-term!financing!is!called!
A)!!a!committed!line!of!credit.!
B)!!a!short-term!mortgage!loan.!
C)!!a!bridge!loan.!
D)!!a!single,!end-of-period-payment!loan.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!A!a!written,!legally!binding!agreement!that!obligates!the!bank!to!lend!a!firm!any!amount!up!to!a!stated!
maximum,!regardless!of!the!financial!condition!of!the!firm!(unless!the!firm!is!bankrupt)!as!long!as!the!firm!
satisfies!any!restrictions!in!the!agreement!!is!called!
A)!!a!bridge!loan.!
C)!!a!short-term!mortgage!loan.!
D)!!a!committed!line!of!credit.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!Bank!loans!are!typically!initiated!with!a!promissory!note,!which!is!a!written!statement!that!indicates!the!
amount!of!the!loan,!the!date!payment!is!due,!and!the!interest!rate.!
B)!!The!most!straightforward!type!of!bank!loan!is!a!single,!end-of-period-payment!loan.!
C)!!With!a!fixed!interest!rate,!the!specific!rate!that!the!bank!will!charge!is!stipulated!at!the!time!the!loan!is!
made.!
D)!!One!of!the!primary!sources!of!short-term!financing,!especially!for!small!businesses,!is!the!investment!
bank.!
Answer:!!!D!
B)!!
C)!!
D)!!One!of!the!primary!sources!of!short-term!financing,!especially!for!small!businesses,!is!the!
commercial!bank.!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!prime!rate(is!the!rate!banks!charge!other!banks.!
B)!!With!a!variable!interest!rate,!the!terms!of!the!loan!may!indicate!that!the!rate!will!vary!with!some!spread!
relative!to!a!benchmark!rate,!such!as!the!yield!on!one-year!Treasury!securities!or!the!prime!rate.!
C)!!With!a!discount!loan,!the!borrower!is!required!to!pay!the!interest!at!the!beginning!of!the!loan!period.!
D)!!A!common!benchmark!rate!is!the!London!Inter-Bank!Offered!Rate,!or!LIBOR,!which!is!the!rate!of!
interest!at!which!banks!borrow!funds!from!each!other!in!the!London!inter!bank!market.!
Answer:!!!A!
Explanation:!!! A)!!The!prime!rate(is!the!rate!banks!charge!their!most!creditworthy!customers.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!Which!of!the!following!statements!regarding!lines!of!credit!is!false?!
A)!!The!line!of!credit!agreement!may!also!stipulate!that!at!some!point!in!time!the!outstanding!balance!must!
be!zero.!This!policy!ensures!that!the!firm!does!not!use!the!short-term!financing!to!finance!its!long-term!
obligations.!
B)!!A!revolving!line!of!credit(is!an!uncommitted!line!of!credit!that!involves!an!informal!agreement!from!the!
bank!for!a!longer!period!of!time,!typically!two!to!three!years.!
C)!!The!line!of!credit!may!be!uncommitted,!meaning!it!is!an!informal!agreement!that!does!not!legally!bind!
the!bank!to!provide!the!funds.!
D)!!A!revolving!line!of!credit!with!no!fixed!maturity!is!called!evergreen!credit.!
Answer:!!!B!
B)!!A!revolving!line!of!credit(is!a!committed!line!of!credit!that!involves!a!solid!commitment!from!
the!bank!for!a!longer!period!of!time,!typically!two!to!three!years.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!Regardless!of!the!loan!structure,!the!bank!may!include!a!compensating!balance!requirement!in!the!loan!
agreement!that!reduces!the!usable!loan!proceeds.!
B)!!Another!common!type!of!fee!is!a!loan!origination!fee,!which!a!bank!charges!to!cover!credit!checks!and!
legal!fees.!
C)!!Firms!frequently!use!lines!of!credit!to!finance!seasonal!needs.!
D)!!The!commitment!fee!associated!with!a!committed!line!of!credit!is!designed!to!decreases!the!effective!cost!
of!the!loan!to!the!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!The!commitment!fee!associated!with!a!committed!line!of!credit!increases!the!effective!cost!of!
the!loan!to!the!firm.!
Diff:!2!
Skill:!Conceptual!
!
8)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!If!this!loan!has!an!
origination!fee!of!1%,!then!the!effective!annual!rate!(EAR)!for!this!loan!is!closest!to:!
A)!!12.0%!
B)!!12.6%!
C)!!4.1%!
D)!!13.8%!
Answer:!!!B!
B)!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!fee!is!equal!
to!.01!×!$1,000,000!=!$10,000,!so!that!the!actual!proceeds!from!the!loan!=!$1,000,000!-!$10,000!=!
.09
$990,000.!!The!interest!on!the!loan!equals!$1,000,000!×! !×!4!months!=!$30,000!
12
$1, 030, 000
$990, 000
!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
9)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!If!LutherPs!bank!requires!
account,!then!the!effective!annual!rate!EAR!for!this!loan!is!closest!to:!
A)!!50.0%!
B)!!12.6%!
C)!!14.4%!
D)!!71.5%!
Answer:!!!A!
Explanation:!!! A)!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!compensating!
balance!is!equal!to!.10!×!$1,000,000!=!$100,000,!so!that!the!actual!proceeds!from!the!loan!=!
.09
$1,000,000!-!$100,000!=!$900,000.!!The!interest!on!the!loan!equals!$1,000,000!×! !×!4!months!
12
=!$30,000!
$1, 030, 000
$900, 000
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
10)!!Luther!Industries!is!offered!a!$1!million!dollar!loan!for!four!months!at!an!APR!of!9%.!!LutherPs!bank!requires!
account!and!the!bank!charges!a!1%!origination!fee.!!Calculate!the!the!effective!annual!rate!EAR!for!this!loan.!
Answer:!!!The!origination!fee!is!charged!on!the!principal!of!the!loan.!!The!amount!of!the!compensating!balance!is!
equal!to!.05!×!$1,000,000!=!$50,000!and!the!amount!of!the!origination!fee!is!equal!to!.01!×!$1,000,000!=!
$10,000,!so!that!the!actual!proceeds!from!the!loan!=!$1,000,000!-!$50,000!-!$10,000!=!$940,000.!!The!
.09
interest!on!the!loan!equals!$1,000,000!×! !×!4!months!=!$30,000!
12
$1, 030, 000
$940, 000
Diff:!2!
Skill:!Analytical!
27.5((Short-Term(Financing(with(Secured(Financing(
(
1)!!Inventory!can!be!used!as!collateral!for!a!loan!in!all!of!the!following!ways!except!
A)!!a!floating!lien.!
B)!!a!warehouse!arrangement.!
C)!!a!factoring!arrangement.!
D)!!a!trust!receipt.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!27.5!Short-Term!Financing!with!Secured!Financing!
Skill:!Conceptual!
!
A)!!If!a!factoring!arrangement!is!with!recourse,!the!factor!will!pay!the!firm!the!amount!due!regardless!of!
whether!the!factor!receives!payment!from!the!firm’s!customers.!
B)!!In!a!factoring!of!accounts!receivable(arrangement,!the!firm!sells!receivables!to!the!lender!(i.e.,!the!factor),!
and!the!lender!agrees!to!pay!the!firm!the!amount!due!from!its!customers!at!the!end!of!the!firmPs!payment!
period.!
C)!!Businesses!can!also!obtain!short-term!financing!by!using!secured!loans,!which!are!loans!collateralized!
with!short-term!assets—most!typically!the!firmPs!accounts!receivables!or!inventory.!
D)!!Both!the!interest!rate!and!the!factorPs!fee!vary!depending!on!such!issues!as!the!size!of!the!borrowing!firm!
and!the!dollar!volume!of!its!receivables.!
Answer:!!!A!
Explanation:!!! A)!!If!a!factoring!arrangement!is!without!recourse,!the!factor!will!pay!the!firm!the!amount!due!
regardless!of!whether!the!factor!receives!payment!from!the!firmPs!customers.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Commercial!banks,!finance!companies,!and!factors,!which!are!firms!that!purchase!the!receivables!of!
other!companies,!are!the!most!common!sources!for!secured!short-term!loans.!
B)!!The!factoring!arrangement!may!be!without!recourse,!in!which!case!the!lender!bears!the!risk!of!bad-debt!
losses.!
C)!!In!a!floating!lien,!general!lien,!or!blanket!lien(arrangement,!specific!inventory!is!used!to!secure!the!loan.!
D)!!If!a!firm!sells!its!goods!on!terms!of!net!30,!then!the!factor!will!pay!the!firm!the!face!value!of!its!
receivables,!less!a!factorPs!fee,!at!the!end!of!30!days.!
Answer:!!!C!
B)!!
C)!!In!a!floating!lien,!general!lien,!or!blanket!lien(arrangement,!all!of!the!inventory!is!used!to!
secure!the!loan.!
D)!!
Diff:!2!
Skill:!Conceptual!
A)!!In!a!pledging!of!accounts!receivable(agreement,!the!lender!reviews!the!invoices!that!represent!the!credit!
sales!of!the!borrowing!firm!and!decides!which!credit!accounts!it!will!accept!as!collateral!for!the!loan,!
based!on!its!own!credit!standards.!
B)!!With!a!trust!receipts!loan!or!floor!planning,!all!inventory!items!are!held!in!a!trust!as!security!for!the!loan.!
C)!!If!the!factoring!agreement!is!without!recourse,!the!borrowing!firm!must!receive!credit!approval!for!a!
customer!from!the!factor!prior!to!shipping!the!goods.!If!the!factor!gives!its!approval,!the!firm!ships!the!
goods!and!the!customer!is!directed!to!make!payment!directly!to!the!lender.!
D)!!In!a!warehouse!arrangement,!the!inventory!that!serves!as!collateral!for!the!loan!is!stored!in!a!warehouse.!
Answer:!!!B!
B)!!With!a!trust!receipts!loan!or!floor!planning,!distinguishable!inventory!items!are!held!in!a!trust!
as!security!for!the!loan.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!public!warehouse!is!a!business!that!exists!for!the!sole!purpose!of!storing!and!tracking!the!inflow!and!
outflow!of!the!inventory.!
B)!!A!warehouse!arrangement!is!the!riskiest!collateral!arrangement!from!the!standpoint!of!the!lender.!
C)!!Because!the!warehouser!is!a!professional!at!inventory!control,!there!is!likely!to!be!little!loss!due!to!
damaged!goods!or!theft,!which!in!turn!lowers!insurance!costs.!
D)!!A!field!warehouse!is!operated!by!a!third!party,!but!is!set!up!on!the!borrowerPs!premises!in!a!separate!
area!so!that!the!inventory!collateralizing!the!loan!is!kept!apart!from!the!borrowerPs!main!plant.!
Answer:!!!B!
B)!!A!warehouse!arrangement!is!the!least!risky!collateral!arrangement!from!the!standpoint!of!the!
lender.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
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6)!!The!Luther!Industries!wants!to!borrow!$1!million!for!two!months.!Using!its!inventory!as!collateral,!it!can!
obtain!a!10%!(APR)!loan!(compounded!monthly).!The!lender!requires!that!a!warehouse!arrangement!be!used.!
The!warehouse!fee!is!$10,000,!payable!at!the!end!of!the!two!months.!Calculate!the!effective!annual!rate!of!this!
loan!for!Row!Cannery.!
Answer:!!! 10%
The!monthly!interest!rate!is! !=!.83333%,!so!at!the!end!of!two!months!Luther!will!owe!!
12
$1!million!×!(1.0083333)2!=!$1,016,736!plus!the!$10,000!warehouse!fee!for!a!total!of!$1,026,736.!
$1, 026, 736
The!actual!interest!paid!is:! !=!1.02674!-!1!=!.02674!for!two!months,!expressing!as!!
1, 000, 000
an!EAR!(1.02674)(12/2)!-!1!=!.17153!or!17.15%!
Diff:!2!
Skill:!Analytical!
Chapter(28(-(Mergers(and(Acquisitions(
!
!
28.1(Background(and(Historical(Trends((
(
1)!!This!period!is!known!as!the!conglomerate!wave!because!firms!typically!acquired!firms!in!unrelated!
businesses:!
A)!!1960s!
B)!!1970s!
C)!!1980s!
D)!!1990s!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!28.1!Background!and!Historical!Trends!
Skill:!Definition!
!
2)!!This!period!is!known!for!hostile,!Mbust-upM!takeovers,!in!which!the!acquirer!purchased!a!poorly!performing!
conglomerate!and!sold!off!its!individual!business!units!for!more!than!the!purchase!price:!
A)!!1960s!
B)!!1970s!
C)!!1980s!
D)!!1990s!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!This!period!is!known!for!known!for!MstrategicM!or!MglobalM!deals!that!were!more!likely!to!be!friendly!and!to!
involve!companies!in!related!businesses;!these!mergers!often!were!designed!to!create!strong!firms!on!a!scale!
that!would!allow!them!to!compete!globally:!
A)!!1960s!
B)!!1970s!
C)!!1980s!
D)!!1990s!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!There!are!two!primary!mechanisms!by!which!ownership!and!control!of!a!public!corporation!can!change:!
Either!another!corporation!or!group!of!individuals!can!acquire!the!target!firm,!or!the!target!firm!can!
merge!with!another!firm.!
B)!!Merger!activity!is!greater!during!economic!contractions!than!during!expansions.!
C)!!Mergers!and!acquisitions!are!part!of!what!is!often!referred!to!as!Mthe!market!for!corporate!control.M!
D)!!The!takeover!market!is!also!characterized!by!merger!waves–peaks!of!heavy!activity!followed!by!quiet!
troughs!of!few!transactions.!
Answer:!!!B!
B)!!Merger!activity!is!greater!during!economic!expansions!than!during!contractions.!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
(
28.2((Market(Reaction(to(a(Takeover(
(
A)!!In!practice,!most!acquirers!pay!a!substantial!acquisition!premium,!which!is!the!percentage!difference!
between!the!acquisition!price!and!the!premerger!price!of!the!target!firm.!
B)!!When!a!bid!is!announced,!the!target!shareholders!enjoy!a!gain!of!16%!on!average!in!their!stock!price.!
C)!!In!most!U.S.!states,!the!law!requires!that!when!existing!shareholders!of!a!target!firm!are!forced!to!sell!
their!shares,!they!receive!the!market!price!for!their!shares.!In!most!cases,!this!concept!is!interpreted!as!
the!value!inclusive!of!any!value!that!arises!because!of!the!merger!itself.!
D)!!A!bidder!is!unlikely!to!acquire!a!target!company!for!less!than!its!current!market!value.!
Answer:!!!C!
B)!!
C)!!In!most!U.S.!states,!the!law!requires!that!when!existing!shareholders!of!a!target!firm!are!
forced!to!sell!their!shares,!they!receive!a!fair!value!for!their!shares.!In!most!cases,!this!concept!
is!interpreted!as!the!value!exclusive!of!any!value!that!arises!because!of!the!merger!itself.!
D)!!
Diff:!2!
Topic:!28.2!Market!Reaction!to!a!Takeover!
Skill:!Conceptual!
28.3((Reasons(to(Acquire(
(
1)!!The!fact!that!a!large!company!can!enjoy!savings!from!producing!goods!in!high!volume,!that!are!not!available!
to!a!small!company!is!called!
A)!!!economies!of!scale.!
B)!!horizontal!integration.!
C)!!vertical!integration.!
D)!!economies!of!scope.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!28.3!Reasons!to!Acquire!
Skill:!Definition!
!
2)!!Savings!that!come!from!combining!the!marketing!and!distribution!of!different!types!of!related!products.!are!
called!
A)!!horizontal!integration.!
B)!!vertical!integration.!
C)!!!economies!of!scale.!
D)!!economies!of!scope.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!The!merger!of!two!companies!in!the!same!industry!that!make!products!required!at!different!stages!of!the!
production!cycle!is!called!
A)!!economies!of!scope.!
B)!!vertical!integration.!
C)!!!economies!of!scale.!
D)!!horizontal!integration.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
4)!!The!justification!for!the!benefits!of!diversification!from!mergers!include!all!of!the!following!except!
A)!!tax!loss!benefits.!
B)!!lower!cost!of!debt!or!increased!debt!capacity.!
C)!!direct!risk!reduction.!
D)!!liquidity!enhancement.!
Answer:!!!A!
Explanation:!!! A)!!The!justification!for!these!benefits!comes!in!three!forms:!direct!risk!reduction,!lower!cost!of!
debt!or!increased!debt!capacity,!and!liquidity!enhancement.!!To!justify!a!takeover!based!on!
operating!losses,!management!would!have!to!argue!that!the!tax!savings!are!over!and!above!
what!the!firm!would!save!using!carryback!and!carryforward!provisions.!In!addition,!the!IRS!
will!disallow!a!tax!break!if!it!can!show!that!the!principal!reason!for!a!takeover!is!tax!avoidance,!
so!it!is!unlikely!that!the!tax!advantage!could,!by!itself,!be!a!valid!reason!to!acquire!another!
firm.!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Chief!among!the!costs!associated!with!size!is!that!larger!firms!are!more!difficult!to!manage.!
B)!!For!most!investors!an!investment!in!the!stock!market!is!a!zero-NPV!investment.!
C)!!Diversification!benefits!are!by!far!the!most!common!justification!that!bidders!give!for!the!premium!they!
pay!for!a!target.!
D)!!An!acquirer!might!be!able!to!add!economic!value,!as!a!result!of!an!acquisition,!that!an!individual!
investor!cannot!add.!
Answer:!!!C!
B)!!
C)!!Large!synergies!are!by!far!the!most!common!justification!that!bidders!give!for!the!premium!
they!pay!for!a!target.!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!Cost-reduction!synergies!are!hard!to!predict!and!achieve.!
B)!!Because!the!CEOs!of!small!firms!receive!information!so!quickly,!small!firms!are!often!able!to!react!in!
timely!way!to!changes!in!the!economic!environment.!
C)!!Synergies!usually!fall!into!two!categories:!cost!reductions!and!revenue!enhancements.!
D)!!There!may!also!be!costs!associated!with!size.!
Answer:!!!A!
Explanation:!!! A)!!Revenue-enhancement!synergies!are!hard!to!predict!and!achieve.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!Which!of!the!following!statements!regarding!vertical!integration!is!false?!
A)!!Vertically!integrated!companies!may!be!large,!but!unlike!other!large!corporations,!since!they!remain!
focused!in!one!industry!they!are!easy!to!run.!
B)!!A!company!might!not!be!happy!with!how!its!products!are!being!distributed,!so!it!might!decide!to!take!
control!of!its!distribution!channels.!
C)!!A!company!might!conclude!that!it!can!enhance!its!product!if!it!has!direct!control!of!the!inputs!required!
to!make!the!product.!
D)!!The!principal!benefit!of!vertical!integration!is!coordination.!By!putting!two!companies!under!central!
control,!management!can!ensure!that!both!companies!work!toward!a!common!goal.!
Answer:!!!A!
Explanation:!!! A)!!Vertically!integrated!companies!are!large,!and!as!large!corporations!they!are!more!difficult!to!
run.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!Which!of!the!following!statements!regarding!monopoly!mergers!is!false?!
A)!!It!is!often!argued!that!merging!with!or!acquiring!a!major!rival!enables!a!firm!to!substantially!reduce!
competition!within!the!industry!and!thereby!increase!profits.!
B)!!Financial!researchers!have!found!that!the!share!prices!of!other!firms!in!the!same!industry!did!not!
significantly!increase!following!the!announcement!of!a!merger!within!the!industry.!
C)!!While!only!the!merging!company!benefits!when!competition!is!reduced,!all!companies!in!an!industry!
pay!the!associated!costs.!
D)!!Society!as!a!whole!bears!the!cost!of!monopoly!strategies,!so!most!countries!have!antitrust!laws!that!limit!
such!activity.!
Answer:!!!C!
B)!!
C)!!While!all!companies!in!an!industry!benefit!when!competition!is!reduced,!only!the!merging!
company!pays!the!associated!costs.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!Which!of!the!following!statements!regarding!efficiency!gains!is!false?!
A)!!Takeovers!relying!on!the!improvement!of!target!management!are!difficult!to!complete,!and!
post-takeover!resistance!to!change!can!be!great.!Thus!not!all!inefficiently!run!organizations!are!
necessarily!more!efficient!following!a!takeover.!
B)!!Although!identifying!poorly!performing!corporations!is!relatively!easy,!fixing!them!is!another!matter!
entirely.!
C)!!A!justification!that!acquirers!cite!for!paying!a!premium!for!a!target!is!efficiency!gains,!which!are!often!
achieved!through!an!elimination!of!duplication.!
D)!!A!chief!executive!of!an!inefficiently!run!corporation!can!be!ousted!by!current!shareholders!voting!to!
replace!the!board!of!directors,!and!in!fact!a!large!number!of!ineffective!managers!are!replaced!in!this!
way.!
Answer:!!!D!
B)!!
C)!!
D)!!Although!in!theory!a!chief!executive!of!an!inefficiently!run!corporation!can!be!ousted!by!
current!shareholders!voting!to!replace!the!board!of!directors,!very!few!managers!are!replaced!
in!this!way.!
Diff:!2!
Skill:!Conceptual!
!
10)!!Which!of!the!following!statements!regarding!mergers!and!taxes!is!false?!
A)!!Carryback!and!carryforward!provisions!essentially!deliver!the!benefits!of!conglomeration!to!a!small!firm!
with!volatile!earnings.!
B)!!It!might!appear!that!a!conglomerate!has!a!tax!advantage!over!a!single-product!firm!simply!because!
losses!in!one!division!can!offset!profits!in!another!division.!
C)!!Companies!with!current-year!losses!can!also!use!them!to!offset!earnings!(carryback)!for!the!twenty!prior!
years.!
D)!!The!IRS!will!disallow!a!tax!break!if!it!can!show!that!the!principal!reason!for!a!takeover!is!tax!avoidance,!
so!it!is!unlikely!that!the!tax!advantage!could,!by!itself,!be!a!valid!reason!to!acquire!another!firm.!
Answer:!!!C!
B)!!
C)!!Companies!with!current-year!losses!can!also!use!them!to!offset!earnings!for!the!two!prior!
years.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
11)!!Which!of!the!following!statements!regarding!mergers!and!taxes!is!false?!
A)!!Because!it!may!be!easier!to!measure!performance!accurately!in!a!conglomerate,!agency!costs!may!be!
reduced!and!resources!may!be!more!efficiently!allocated.!
B)!!Because!these!employees!are!obligated!to!hold!idiosyncratic!risk,!they!benefit!when!the!firm!reduces!that!
risk!by!conglomerating.!
C)!!Like!a!large!portfolio,!large!firms!bear!less!idiosyncratic!risk,!so!often!mergers!are!justified!on!the!basis!
that!the!combined!firm!is!less!risky.!
D)!!Because!most!stockholders!will!already!be!holding!a!well-diversified!portfolio,!they!get!no!further!
benefit!from!the!firm!diversifying!through!acquisition.!
Answer:!!!A!
Explanation:!!! A)!!Because!it!may!be!harder!to!measure!performance!accurately!in!a!conglomerate,!agency!costs!
may!increase!and!resources!may!be!inefficiently!allocated!across!divisions.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!All!else!being!equal,!larger!firms,!because!they!are!more!diversified,!have!an!increased!probability!of!
bankruptcy.!
B)!!To!justify!a!takeover!based!on!operating!losses,!management!would!have!to!argue!that!the!tax!savings!
are!over!and!above!what!the!firm!would!save!using!carryback!and!carryforward!provisions.!
C)!!It!is!possible!to!combine!two!companies!with!the!result!that!the!earnings!per!share!of!the!merged!
company!exceed!the!premerger!earnings!per!share!of!either!company,!even!when!the!merger!itself!
creates!no!economic!value.!
D)!!When!an!acquirer!buys!a!private!target,!it!provides!the!target’s!owners!with!a!way!to!reduce!their!risk!
exposure!by!cashing!out!their!investment!in!the!private!target!and!reinvesting!in!a!diversified!portfolio.!
Answer:!!!A!
Explanation:!!! A)!!All!else!being!equal,!larger!firms,!because!they!are!more!diversified,!have!a!lower!probability!
of!bankruptcy.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Martin!Manufacturing!has!earnings!per!share!(EPS)!of!$3.00,!5!million!shares!outstanding,!and!a!share!price!of!$32.!!Martin!
is!considering!buying!Luther!Industries,!which!has!earnings!per!share!of!$2.50,!2!million!shares!outstanding,!and!a!share!
price!of!$20.!!Marin!will!pay!for!Luther!by!issuing!new!shares.!!There!are!no!expected!synergies!from!the!transaction.!
!
13)!!If!Martin!pays!no!premium!to!acquire!Luther,!what!will!the!earnings!per!share!be!after!the!merger?!
Answer:!!!First,!since!Martin!is!paying!for!the!merger!with!stock!we!need!to!calculate!the!number!of!shares!that!
Martin!must!issue:!
!
Value of Luther $2 million shares $20 per share
Number!of!new!shares!=! !=! !=!1.25!million!
Price per share of Martin $32 per share for Martin
shares.!!So!the!total!number!of!shares!in!the!new!merged!firm!equals!!
5!million!(existing!Martin!shares)!+!1.25!million!new!shares!=!6.25!million!shares.!
!
Total!earnings!for!the!merged!firm!=!earnings!from!Martin!+!earnings!from!Luther.!
Earnings!from!Martin!=!EPS!×!shares!outstanding!=!$3.00!×!5!million!=!$15!million!
Earnings!from!Luther!=!EPS!×!shares!outstanding!=!$2.50!×!2!million!=!$5!million!
!
Total!earnings!=!$15!+!$5!=!$20!million!
!
$20 million earnings
EPS!merged!firm!=! !=!$3.20!
6.25 million shares
Diff:!2!
Skill:!Analytical!
!
14)!!Assume!that!Martin!pays!no!premium!to!acquire!Luther.!!Calculate!Martines!price-earnings!(P/E)!ratio!both!
pre!and!post!merger.!
Answer:!!! $32
Premerger!P/E!=! !=!10.67!
$3
!
First,!since!Martin!is!paying!for!the!merger!with!stock!we!need!to!calculate!the!number!of!shares!that!
Martin!must!issue:!
!
Value of Luther $2 million shares $20 per share
Number!of!new!shares!=! !=! !=!1.25!million!
Price per share of Martin $32 per share for Martin
shares.!!So!the!total!number!of!shares!in!the!new!merged!firm!equals!5!million!(existing!Martin!shares)!+!
1.25!million!new!shares!=!6.25!million!shares.!
!
Total!earnings!for!the!merged!firm!=!earnings!from!Martin!+!earnings!from!Luther.!
Earnings!from!Martin!=!EPS!×!shares!outstanding!=!$3.00!×!5!million!=!$15!million!
Earnings!from!Luther!=!EPS$×!shares!outstanding!=!$2.50!×!2!million!=!$5!million!
!
Total!earnings!=!$15!+!$5!=!$20!million!
!
$20 million earnings
EPS!merged!firm!=! !=!$3.20!
6.25 million shares
!
$32
Post!merger!P/E!=! !=!10!
$3.20
Diff:!3!
Skill:!Analytical!
!
28.4((The(Takeover(Process(
(
NA
x T S NT
$<$ !
NT A
!
The!term!A!in!this!equation!refers!to!
A)!!the!premerger,!or!standalone,!value!of!the!acquirer.!
B)!!new!shares!to!pay!for!the!target.!
C)!!!the!value!of!the!synergies!created!by!the!merger.!
D)!!the!premerger!(standalone)!value!of!the!target.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!28.4!The!Takeover!Process!
Skill:!Conceptual!
!
NA
x T S NT
$<$ !
NT A
!
The!term!S!in!this!equation!refers!to!
A)!!the!premerger!(standalone)!value!of!the!target.!
B)!!the!premerger,!or!standalone,!value!of!the!acquirer.!
C)!!!the!value!of!the!synergies!created!by!the!merger.!
D)!!new!shares!to!pay!for!the!target.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
NA
x T S NT
$<$ !
NT A
!
The!term!x!in!this!equation!refers!to!
A)!!!the!value!of!the!synergies!created!by!the!merger.!
B)!!the!premerger,!or!standalone,!value!of!the!acquirer.!
C)!!new!shares!to!pay!for!the!target.!
D)!!the!premerger!(standalone)!value!of!the!target.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
NA
x T S NT
$<$ !
NT A
!
The!term!T!in!this!equation!refers!to!
A)!!the!premerger,!or!standalone,!value!of!the!acquirer.!
B)!!!the!value!of!the!synergies!created!by!the!merger.!
C)!!the!premerger!(standalone)!value!of!the!target.!
D)!!new!shares!to!pay!for!the!target.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
A)!!The!method!of!payment!(cash!or!stock)!affects!how!the!value!of!the!targetes!assets!is!recorded!for!tax!
purposes!and!it!affects!the!combined!firm’s!financial!statements!for!financial!reporting.!
B)!!The!combined!firm!must!mark!up!the!value!assigned!to!the!targetes!assets!on!the!financial!statements!by!
allocating!the!purchase!price!to!target!assets!according!to!their!fair!market!value.!
C)!!Any!goodwill!created!in!a!merger!deal!can!be!amortized!for!tax!purposes!over!15!years.!
D)!!Many!transactions!are!carried!out!as!acquisitive!reorganizations!under!the!tax!code.!These!structures!
allow!the!target!shareholders!to!defer!their!tax!liability!on!the!part!of!the!payment!made!in!acquirer!
stock!but!they!do!not!allow!the!acquirer!to!step!up!the!book!value!of!the!target!assets.!
Answer:!!!A!
Explanation:!!! A)!!While!the!method!of!payment!(cash!or!stock)!affects!how!the!value!of!the!targetes!assets!is!
recorded!for!tax!purposes,!it!does!not!affect!the!combined!firm’s!financial!statements!for!
financial!reporting.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
A)!!Any!acquirer!shares!received!in!full!or!partial!exchange!for!target!shares!triggers!an!immediate!tax!
liability!for!target!shareholders.!
B)!!In!a!friendly!takeover,!the!target!board!of!directors!supports!the!merger,!negotiates!with!potential!
acquirers,!and!agrees!on!a!price!that!is!ultimately!put!to!a!shareholder!vote.!
C)!!How!the!acquirer!pays!for!the!target!affects!the!taxes!of!both!the!target!shareholders!and!the!combined!
firm.!
D)!!If!the!acquirer!purchases!the!target!assets!directly!(rather!than!the!target!stock),!then!it!can!step!up(the!
book!value!of!the!targetes!assets!to!the!purchase!price.!
Answer:!!!A!
Explanation:!!! A)!!Any!cash!received!in!full!or!partial!exchange!for!shares!triggers!an!immediate!tax!liability!for!
target!shareholders.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!Which!of!the!following!questions!regarding!risk!arbitrage!is!false?!
A)!!Once!a!tender!offer!is!announced,!the!uncertainty!about!whether!the!takeover!will!succeed!reduces!the!
volatility!of!the!stock!price.!This!uncertainty!creates!an!opportunity!for!investors!to!speculate!on!the!
outcome!of!the!deal!without!bearing!the!risk!of!volatility.!!
B)!!Traders!known!as!risk-arbitrageurs,!who!believe!that!they!can!predict!the!outcome!of!a!deal,!take!
positions!based!on!their!beliefs.!
C)!!A!potential!profit!arises!from!the!difference!between!the!targetes!stock!price!and!the!implied!offer!price,!
and!is!referred!to!as!the!merger-arbitrage!spread.!
D)!!However,!it!is!not!a!true!arbitrage!opportunity!because!there!is!a!risk!that!the!deal!will!not!go!through.!If!
the!takeover!did!not!ultimately!succeed,!the!risk-arbitrageur!would!eventually!have!to!unwind!his!
position!at!whatever!market!prices!prevailed.!
Answer:!!!A!
Explanation:!!! A)!!Once!a!tender!offer!is!announced,!the!uncertainty!about!whether!the!takeover!will!succeed!
adds!volatility!to!the!stock!price.!This!uncertainty!creates!an!opportunity!for!investors!to!
speculate!on!the!outcome!of!the!deal.!!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Once!the!acquirer!has!completed!the!valuation!process,!it!is!in!the!position!to!make!a!tender!offer—that!
is,!a!public!announcement!of!its!intention!to!purchase!a!large!block!of!shares!for!a!specified!price.!
B)!!If!we!view!the!pre-bid!market!capitalization!as!the!stand-alone!value!of!the!target,!then!from!the!bidderes!
perspective,!the!takeover!is!a!positive-NPV!project!only!if!the!synergies!created!do!not!exceed!the!
premium!it!pays.!
C)!!Purchasing!a!corporation!usually!constitutes!a!very!large!capital!investment!decision,!so!it!requires!a!
more!accurate!estimate!of!value!that!includes!careful!analysis!of!both!operational!aspects!of!the!firm!and!
the!ultimate!cash!flows!the!deal!will!generate.!
D)!!A!stock-swap!merger!is!a!positive-NPV!investment!for!the!acquiring!shareholders!if!the!share!price!of!
the!merged!firm!(the!acquirer’s!share!price!after!the!takeover)!exceeds!the!premerger!price!of!the!
acquiring!firm.!
Answer:!!!B!
B)!!If!we!view!the!pre-bid!market!capitalization!as!the!stand-alone!value!of!the!target,!then!from!
the!bidderes!perspective,!the!takeover!is!a!positive-NPV!project!only!if!the!premium!it!pays!
does!not!exceed!the!synergies!created.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!KT!corporation!has!announced!plans!to!acquire!MJ!corporation.!!KT!is!trading!for!$45!per!share!and!MJ!is!
trading!for!$25!per!share,!with!a!premerger!value!for!MJ!of!$3!billion!dollars.!!If!the!projected!synergies!from!
the!merger!are!$750!million,!what!is!the!maximum!exchange!ratio!that!KT!could!offer!in!a!stock!swap!and!still!
generate!a!positive!NPV?!
Answer:!!! P S $45 .750
Exchange!ratio!<! T 1 !=! 1 !=!2.25!
PA T $25 3
Diff:!2!
Skill:!Analytical!
!
28.5((Takeover(Defenses(
(
1)!!A!rights!offering!that!gives!existing!target!shareholders!the!right!to!buy!shares!in!either!the!target!or!the!
acquirer!at!a!deeply!discounted!price!once!certain!conditions!are!met!is!called!a!
A)!!golden!parachute.!
B)!!poison!pill.!
C)!!c lassified!board.!
D)!!white!knight.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!28.5!Takeover!Defenses!
Skill:!Definition!
!
2)!!A!situation!where!every!director!serves!a!three-year!term!and!the!terms!are!staggered!so!that!only!one-third!of!
the!directors!are!up!for!election!each!year!is!called!a!
A)!!white!knight.!
B)!!c lassified!board.!
C)!!poison!pill.!
D)!!golden!parachute.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!When!a!hostile!takeover!appears!to!be!inevitable,!a!target!company!will!sometimes!look!for!another,!friendlier!
company!to!acquire!it!called!a!
A)!!poison!pill.!
B)!!c lassified!board.!
C)!!golden!parachute.!
D)!!white!knight.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
4)!!An!extremely!lucrative!severance!package!that!is!guaranteed!to!a!firmes!senior!managers!in!the!event!that!the!
firm!is!taken!over!and!the!managers!are!let!go!is!called!a!
A)!!golden!parachute.!
B)!!white!knight.!
C)!!poison!pill.!
D)!!c lassified!board.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
5)!!Which!of!the!following!statements!regarding!poison!pills!is!false?!
A)!!Companies!with!poison!pills!are!harder!to!take!over,!and!when!they!are!taken!over,!the!premium!that!
existing!shareholders!receive!for!their!stock!is!higher.!
B)!!Because!a!poison!pill!increases!the!cost!of!a!takeover,!all!else!equal,!a!target!company!must!be!in!better!
shape!to!justify!the!expense!of!waging!a!takeover!battle.!
C)!!Poison!pills!also!increase!the!bargaining!power!of!the!target!firm!when!negotiating!with!the!acquirer!
because!poison!pills!make!it!difficult!to!complete!the!takeover!without!the!cooperation!of!the!target!
board.!
D)!!By!adopting!a!poison!pill,!a!company!effectively!entrenches!its!management!by!making!it!much!more!
difficult!for!shareholders!to!replace!bad!managers,!thereby!potentially!destroying!value.!
Answer:!!!B!
B)!!Because!a!poison!pill!increases!the!cost!of!a!takeover,!all!else!equal,!a!target!company!must!be!
in!worse!shape!(there!must!be!a!greater!opportunity!for!profit)!to!justify!the!expense!of!
waging!a!takeover!battle.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
6)!!What!is!a!white!knight?!
Answer:!!!When!a!hostile!takeover!appears!to!be!inevitable,!a!target!company!will!sometimes!look!for!another,!
friendlier!company!to!acquire!it!called!a!white!knight.!
!
The!white!knight!will!make!a!more!lucrative!offer!for!the!target!than!the!hostile!bidder.!Incumbent!
managers!of!the!target!maintain!control!by!reaching!an!agreement!with!the!white!knight!to!retain!their!
positions.!
!
One!variant!on!the!white!knight!defense!is!the!white!squire(defense.!In!this!case,!a!large!investor!or!firm!
agrees!to!purchase!a!substantial!block!of!shares!in!the!target!with!special!voting!rights.!
Diff:!1!
Skill:!Definition!
!
7)!!Which!of!the!following!statements!regarding!recapitalization!as!a!takeover!defense!is!false?!
A)!!Another!defense!against!a!takeover!is!a!recapitalization,!in!which!a!company!changes!its!capital!
structure!to!make!itself!less!attractive!as!a!target.!
B)!!Restructuring!itself!can!produce!efficiency!gains,!often!removing!the!principal!motivation!for!the!
takeover!in!the!first!place.!
C)!!By!increasing!leverage!on!its!own,!the!target!firm!can!reap!the!benefit!of!the!interest!tax!shields.!
D)!!In!many!cases,!a!substantial!portion!of!the!synergy!gains!that!an!acquirer!anticipates!from!a!takeover!are!
savings!from!a!decrease!in!leverage!as!well!as!other!cost!reductions.!
Answer:!!!D!
B)!!
C)!!
D)!!In!many!cases,!a!substantial!portion!of!the!synergy!gains!that!an!acquirer!anticipates!from!a!
takeover!are!from!tax!savings!from!an!increase!in!leverage!as!well!as!other!cost!reductions.!
Diff:!2!
Skill:!Conceptual!
28.6((Who(Gets(the(Value(Added(from(a(Takeover?(
(
A)!!SEC!rules!make!it!difficult!for!investors!to!buy!much!more!than!about!10%!of!a!firm!in!secret.!!!After!an!
acquirer!acquires!such!an!initial!stake!in!the!target,!called!a!toehold,!they!would!have!to!make!their!
intentions!public!by!informing!investors!of!his!large!stake.!
B)!!With!the!availability!of!both!the!freezeout!merger!and!the!leveraged!buyout!as!acquisition!strategies,!
most!of!the!value!added!accrues!to!the!acquiring!shareholders.!
C)!!The!laws!on!tender!offers!allow!the!acquiring!company!to!freeze!existing!shareholders!out!of!the!gains!
from!merging!by!forcing!non-tendering!shareholders!to!sell!their!shares!for!the!tender!offer!price.!
D)!!Premiums!in!LBO!transactions!are!often!quite!substantial—while!they!can!avoid!the!free-rider!problem!
acquirers!must!still!get!board!approval!to!overcome!other!defenses!such!as!poison!pills,!as!well!as!outbid!
other!potential!acquirers.!
Answer:!!!B!
B)!!Despite!the!availability!of!both!the!freezeout!merger!and!the!leveraged!buyout!as!acquisition!
strategies,!most!of!the!value!added!still!appears!to!accrue!to!the!target!shareholders.!
C)!!
D)!!
Diff:!2!
Topic:!28.6!Who!Gets!the!Value!Added!from!a!Takeover?!
Skill:!Conceptual!
!
2)!!You!work!for!a!levered!buyout!firm!and!are!evaluating!a!potential!buyout!of!Boogle!Inc.!!Booglees!stock!price!
is!$18,!and!it!has!3!million!shares!outstanding.!!You!believe!that!if!you!buy!the!company!and!replace!its!dismal!
management!team,!its!value!will!increase!by!50%.!!You!are!planning!on!doing!a!levered!buyout!of!Boogle!and!
will!offer!$25!per!share!for!control!of!the!company.!!Assuming!you!get!50%!control,!what!will!your!gain!from!
the!transaction!be?!
Answer:!!!The!initial!value!of!Boogle!is!$18!×!3!million!shares!=!$54!million.!!Once!you!take!control!the!value!of!the!
firm!should!increase!by!50%!or!by!(.50)$54!!=!$27!million!dollars!for!a!total!value!of!$54!+!$27!=!$81!
million.!
!
You!will!need!to!borrow!$25!x!1.5!million!shares!=!$37.5!million!dollars!to!acquire!50%!of!the!
outstanding!shares.!
!
So,!the!value!of!the!firm!=!$81!million!-!$37.5!million!in!debt!=!$43.5!million!!
!
Of!this!$43.5!million,!$37.5!belongs!to!the!other!50%!of!shareholders!who!did!not!tender!their!shares,!so!
your!net!gain!from!the!transaction!is!$43.5!-!$37.5!=!$6.0!million!
Diff:!3!
Topic:!28.6!Who!Gets!the!Value!Added!from!a!Takeover?!
Skill:!Analytical!
!
!
Chapter(29(-(Corporate(Governance(
!
!
29.1(Corporate(Governance(and(Agency(Costs((
(
A)!!The!conflict!of!interest!between!managers!and!investors!derives!from!the!separation!of!ownership!and!
control!in!a!corporation.!
B)!!Any!discussion!of!corporate!controls—the!system!of!controls,!regulations,!and!incentives!designed!to!
prevent!fraud—is!a!story!of!conflicts!of!interest!and!attempts!to!minimize!them.!
C)!!Once!control!and!ownership!are!separated!a!conflict!of!interest!arises!between!the!owners!and!the!
people!in!control!of!a!corporation.!
D)!!The!separation!of!ownership!and!control!is!perhaps!the!most!important!reason!for!the!success!of!the!
corporate!organizational!form.!!Because!any!investor!can!hold!an!ownership!stake!in!a!corporation,!
investors!are!able!to!diversify!and!thus,!with!no!costs,!reduce!their!risk!exposures.!
Answer:!!!B!
B)!!Any!discussion!of!corporate!governance—the!system!of!controls,!regulations,!and!incentives!
designed!to!prevent!fraud—is!a!story!of!conflicts!of!interest!and!attempts!to!minimize!them.!
C)!!
D)!!
Diff:!1!
Topic:!29.1!Corporate!Governance!and!Agency!Costs!
Skill:!Conceptual!
!
A)!!The!incentives!come!from!owning!stock!in!the!company!and!from!compensation!that!is!sensitive!to!
performance.!
B)!!The!role!of!the!corporate!governance!system!is!to!mitigate!the!conflict!of!interest!that!results!from!the!
combination!of!ownership!and!control!without!unduly!burdening!managers!with!the!risk!of!the!firm.!
C)!!Punishment!comes!when!a!board!fires!a!manager!for!poor!performance!or!fraud,!or!when,!upon!failure!
of!the!board!to!act,!shareholders!or!raiders!launch!control!contests!to!replace!the!board!and!management.!
D)!!The!corporate!governance!system!attempts!to!align!interests!by!providing!incentives!for!taking!the!right!
action!and!punishments!for!taking!the!wrong!action.!
Answer:!!!B!
B)!!The!role!of!the!corporate!governance!system!is!to!mitigate!the!conflict!of!interest!that!results!
from!the!separation!of!ownership!and!control!without!unduly!burdening!managers!with!the!
risk!of!the!firm.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!What!is!corporate!governance?!
Answer:!!!Corporate!governance!is!the!system!of!controls,!regulations,!and!incentives!designed!to!prevent!fraud!
and!to!minimize!the!conflicts!of!interests!between!managers!and!investors.!
Diff:!1!
Skill:!Definition!
29.2((Monitoring(by(the(Board(of(Directors(
(
1)!!Directors!who!are!employees,!former!employees,!or!family!members!of!employees!are!called!
A)!!Managing!Directors.!
B)!!Independent!Directors.!
C)!!Inside!Directors.!
D)!!Gray!Directors.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!29.2!Monitoring!by!the!Board!of!Directors!
Skill:!Definition!
!
2)!!Directors!who!are!not!as!directly!connected!to!the!firm!but!who!have!existing!or!potential!business!
relationships!with!the!firm!are!called!
A)!!Gray!Directors.!
C)!!Advising!Directors.!
D)!!Inside!Directors.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!Directors!who!are!not!employees,!former!employees,!or!family!members!of!employees!and!who!do!not!have!
existing!or!potential!business!relationships!with!the!firm!are!called!
A)!!Monitoring!Directors.!
C)!!Gray!Directors.!
D)!!Inside!Directors.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
A)!!The!shareholders!as!a!group!elect!a!board!of!directors!to!monitor!managers.!The!directors!themselves,!
however,!have!the!same!conflict!of!interest–monitoring!is!costly!and!in!many!cases!directors!do!not!get!
significantly!greater!benefits!than!other!shareholders!from!monitoring!the!managers!closely.!
B)!!In!principle,!the!board!of!directors!hires!the!executive!team,!sets!its!compensation,!approves!major!
investments!and!acquisitions,!and!dismisses!executives!if!necessary.!
C)!!In!the!United!States,!the!board!of!directors!has!a!clear!fiduciary!duty!to!protect!the!interests!of!both!the!
owners!of!the!firm!(the!shareholders)!and!the!interests!of!other!stakeholders!in!the!firm!(such!as!the!
employees).!
D)!!When!the!ownership!of!a!corporation!is!widely!held,!no!one!shareholder!has!an!incentive!to!bear!the!cost!
of!monitoring,!because!she!bears!the!full!cost!of!monitoring!but!the!benefit!is!divided!among!all!
shareholders.!
Answer:!!!C!
B)!!
C)!!In!the!United!States,!the!board!of!directors!has!a!clear!fiduciary!duty!to!protect!the!interests!of!
the!owners!of!the!firm–the!shareholders.!Most!other!countries!give!some!weight!to!the!
interests!of!other!stakeholders!in!the!firm,!such!as!the!employees.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Researchers!have!hypothesized!that!boards!with!a!majority!of!outside!directors!are!better!monitors!of!
managerial!effort!and!actions.!
B)!!Studies!have!found!that!firms!with!independent!boards!make!fewer!value-creating!acquisitions!but!are!
more!likely!to!act!in!shareholdersY!interests!if!targeted!in!an!acquisition.!
C)!!One!early!study!showed!that!a!board!was!more!likely!to!fire!the!firmYs!CEO!for!poor!performance!if!the!
board!had!a!majority!of!outside!directors.!
D)!!Although!the!firmYs!stock!price!increases!on!the!announcement!of!its!addition!of!an!independent!board!
member,!the!increased!firm!value!appears!to!come!from!the!potential!for!the!board!to!make!better!
decisions!on!acquisitions!and!CEO!turnover!rather!than!from!improvements!in!the!firm’s!operating!
performance.!
Answer:!!!B!
B)!!Studies!have!found!that!firms!with!independent!boards!make!fewer!value-destroying!
acquisitions!and!are!more!likely!to!act!in!shareholdersY!interests!if!targeted!in!an!acquisition.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!A!board!is!said!to!be!classified!when!its!monitoring!duties!have!been!compromised!by!connections!or!
perceived!loyalties!to!management.!
B)!!Even!the!most!active!independent!directors!spend!only!one!or!two!days!per!month!on!firm!business,!and!
many!independent!directors!sit!on!multiple!boards,!further!dividing!their!attention.!
C)!!On!a!board!composed!of!insider,!gray,!and!independent!directors,!the!role!of!the!independent!director!is!
really!that!of!a!watchdog.!
D)!!Because!independent!directorsY!personal!wealth!is!likely!to!be!less!sensitive!to!performance!than!that!of!
insider!and!gray!directors,!they!have!less!incentive!to!closely!monitor!the!firm.!
Answer:!!!A!
Explanation:!!! A)!!A!board!is!said!to!be!captured!when!its!monitoring!duties!have!been!compromised!by!
connections!or!perceived!loyalties!to!management.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!the!CEO!is!also!chairman!of!the!board,!the!nominating!letter!offering!a!seat!to!a!new!director!
comes!from!her.!This!process!merely!serves!to!reinforce!the!sense!that!the!outside!directors!owe!their!
positions!to!the!CEO!and!work!for!the!CEO!rather!than!for!the!shareholders.!
B)!!Over!time,!most!of!the!independent!directors!will!have!been!nominated!by!the!CEO.!Even!though!they!
have!no!business!ties!to!the!firm,!they!are!still!likely!to!be!friends!or!at!least!acquaintances!of!the!CEO.!
C)!!Researchers!have!found!the!surprisingly!robust!result!that!larger!boards!are!associated!with!greater!firm!
value!and!performance.!
D)!!The!CEO!can!be!expected!to!stack!the!board!with!directors!who!are!less!likely!to!challenge!her.!
Answer:!!!C!
B)!!
C)!!Researchers!have!found!the!surprisingly!robust!result!that!smaller!boards!are!associated!with!
greater!firm!value!and!performance.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!In!addition!to!the!evidence!that!board!independence!matters!for!major!activities!such!as!firing!CEOs!and!
making!corporate!acquisitions,!researchers!have!found!a!strong!connection!between!board!structure!and!
firm!performance.!
B)!!Theoretical!and!empirical!research!support!the!notion!that!the!longer!a!CEO!has!served,!especially!when!
that!person!is!also!chairman!of!the!board,!the!more!likely!the!board!is!to!become!captured.!
C)!!Most!firms!that!have!just!gone!public!either!as!young!companies!or!as!older!firms!returning!to!public!
status!after!a!leveraged!buyout!(LBO)!choose!to!start!with!smaller!boards.!
D)!!Boards!tend!to!grow!over!time!as!members!are!added!for!various!reasons.!For!example,!boards!are!often!
expanded!by!one!or!two!seats!after!an!acquisition!to!accommodate!the!target!CEO!and!perhaps!one!
other!target!director.!
Answer:!!!A!
Explanation:!!! A)!!Despite!evidence!that!board!independence!matters!for!major!activities!such!as!firing!CEOs!
and!making!corporate!acquisitions,!researchers!have!struggled!to!find!a!connection!between!
board!structure!and!firm!performance.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
9)!!What!is!the!difference!between!Inside,!gray,!and!outside!directors?!
Answer:!!!Inside(directors(are!employees,!former!employees,!or!family!members!of!employees.!Gray(directors(
are!people!who!are!not!as!directly!connected!to!the!firm!as!insiders!are,!but!who!have!existing!or!
potential!business!relationships!with!the!firm.!For!example,!bankers,!lawyers,!and!consultants!who!are!
already!retained!by!the!firm,!or!who!would!be!interested!in!being!retained!may!sit!on!a!board.!Thus!
their!judgment!could!be!compromised!by!their!desire!to!keep!the!CEO!happy.!Finally,!all!other!
directors!are!considered!outside((or!independent)!directors(and!are!the!most!likely!to!make!decisions!
solely!in!the!interests!of!the!shareholders.!
Diff:!1!
Skill:!Definition!
29.3((Compensation(Policies(
(
A)!!Increasing!the!pay-for-performance!sensitivity!comes!with!the!added!benefit!of!reducing!managerYs!risk.!
B)!!Stock!and!option!grants!give!managers!a!direct!incentive!to!increase!the!stock!price!to!make!their!stock!
or!options!as!valuable!as!possible.!
C)!!By!tying!compensation!to!performance,!the!shareholders!effectively!give!the!manager!an!ownership!
stake!in!the!firm.!
D)!!During!the!1990s,!most!companies!adopted!compensation!policies!that!more!directly!gave!managers!an!
ownership!stake!by!including!grants!of!stock!or!stock!options!to!executives.!
Answer:!!!A!
Explanation:!!! A)!!Increasing!the!pay-for-performance!sensitivity!comes!at!the!cost!of!burdening!managers!with!
risk.!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!29.3!Compensation!Policies!
Skill:!Conceptual!
!
A)!!The!substantial!use!of!stock!and!option!grants!in!the!1990s!greatly!increased!managersY!
pay-for-performance!sensitivity.!
B)!!The!optimal!level!of!sensitivity!of!managersY!compensation!to!the!performance!of!their!firms!depends!on!
the!managersY!level!of!risk!aversion,!which!is!hard!to!measure.!
C)!!While!decreasing!managersY!risk!exposure,!increasing!the!sensitivity!of!managerial!pay!and!wealth!to!
firm!performance!does!have!some!negative!effects.!
D)!!In!the!absence!of!monitoring,!the!other!way!the!conflict!of!interest!between!managers!and!owners!can!be!
mitigated!is!by!closely!aligning!their!interests!through!the!managersY!compensation!policy.!
Answer:!!!C!
B)!!
C)!!Besides!increasing!managersY!risk!exposure,!increasing!the!sensitivity!of!managerial!pay!and!
wealth!to!firm!performance!has!some!other!negative!effects.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Backdating!refers!to!the!practice!of!choosing!the!grant!date!of!a!stock!option!retroactively,!so!that!the!
date!of!the!grant!would!coincide!with!a!date!when!the!stock!price!was!at!its!low!for!the!quarter!or!for!the!
year.!
B)!!Unless!it!is!reported!in!a!timely!manner!to!the!IRS!and!to!shareholders,!and!reflected!in!the!firm’s!
financial!statements,!backdating!is!illegal.!
C)!!The!use!of!backdating!suggests!that!some!executive!stock!option!compensation!may!not!truly!have!been!
earned!as!the!result!of!good!future!performance!of!the!firm.!
D)!!By!backdating!the!option!the!executive!receives!a!stock!option!that!is!already!out-of-the-money,!with!a!
strike!price!equal!to!the!higher!price!on!the!supposed!grant!date.!
Answer:!!!D!
B)!!
C)!!
D)!!By!backdating!the!option!the!executive!receives!a!stock!option!that!is!already!in-the-money,!
with!a!strike!price!equal!to!the!lower!price!on!the!supposed!grant!date.!
Diff:!2!
Skill:!Conceptual!
!
A)!!New!SEC!rules!require!firms!to!report!option!grants!within!two!days!of!the!grant!date,!which!may!help!
prevent!further!abuses.!
B)!!Studies!have!found!evidence!that!the!practice!of!timing!the!release!of!information!to!maximize!the!value!
of!CEO!stock!options!is!widespread.!
C)!!Managers!have!an!incentive!to!manipulate!the!release!of!financial!forecasts!so!that!good!news!comes!out!
before!options!are!granted!and!bad!news!is!delayed!until!after!the!options!are!granted.!
D)!!The!factor!contributing!most!to!the!climb!in!CEO!total!compensation!for!the!1990s!was!the!sharp!increase!
in!the!value!of!stock!and!options!granted!each!year.!
Answer:!!!C!
B)!!
C)!!Managers!have!an!incentive!to!manipulate!the!release!of!financial!forecasts!so!that!bad!news!
comes!out!before!options!are!granted!and!good!news!comes!out!after!options!are!granted.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!What!are!some!of!the!negative!effects!of!increasing!the!sensitivity!of!managerial!pay!to!firm!performance?!
Answer:!!!! Increasing!the!pay-for-performance!sensitivity!comes!at!the!cost!of!burdening!managers!with!risk.!!
Besides!increasing!managersY!risk!exposure,!increasing!the!sensitivity!of!managerial!pay!and!wealth!to!
firm!performance!has!some!other!negative!effects.!For!example,!often!options!are!granted!bat!the!
money,b!meaning!that!the!exercise!price!is!equal!to!the!current!stock!price.!Managers!therefore!have!an!
incentive!to!manipulate!the!release!of!financial!forecasts!so!that!bad!news!comes!out!before!options!are!
granted!(to!drive!the!exercise!price!down)!and!good!news!comes!out!after!options!are!granted.!Studies!
have!found!evidence!that!the!practice!of!timing!the!release!of!information!to!maximize!the!value!of!
CEO!stock!options!is!widespread.!!
! More!recently,!Erik!Lie!has!found!evidence!suggesting!that!many!executives!have!engaged!in!a!
more!direct!form!of!manipulating!their!stock!option!compensation:!backdating!their!option!grants.7!
Backdating!refers!to!the!practice!of!choosing!the!grant!date!of!a!stock!option!retroactively,!so!that!the!
date!of!the!grant!would!coincide!with!a!date!when!the!stock!price!was!at!its!low!for!the!quarter!or!for!
the!year.!By!backdating!the!option!in!this!way,!the!executive!receives!a!stock!option!that!is!already!
in-the-money,!with!a!strike!price!equal!to!the!lower!price!on!the!supposed!grant!date.!
Diff:!2!
Skill:!Conceptual!
!
29.4((Managing(Agency(Conflict(
(
A)!!The!relationship!between!managerial!ownership!and!firm!value!is!unlikely!to!be!the!same!for!every!firm,!
or!even!for!different!executives!of!the!same!firm.!
B)!!Even!with!the!risk!benefits!of!separating!ownership!and!control,!there!are!still!examples!of!corporations!
in!which!the!top!managers!have!substantial!ownership!interests.!
C)!!Academic!studies!do!not!support!the!notion!that!greater!managerial!ownership!is!associated!with!fewer!
value-reducing!actions!by!managers.!
D)!!While!increasing!managerial!ownership!may!reduce!perquisite!consumption,!it!also!makes!managers!
harder!to!fire—thus!reducing!the!incentive!effect!of!the!threat!of!dismissal.!
Answer:!!!C!
B)!!
C)!!Academic!studies!have!supported!the!notion!that!greater!managerial!ownership!is!associated!
with!fewer!value-reducing!actions!by!managers.!
D)!!
Diff:!2!
Topic:!29.4!Managing!Agency!Conflict!
Skill:!Conceptual!
!
A)!!If!managers!have!large!ownership!stakes,!then!shareholders!are!more!likely!to!use!compensation!
policies!or!a!stronger!board!to!create!the!desired!incentives.!
B)!!If!all!else!fails,!the!shareholdersY!last!line!of!defense!against!expropriation!by!self-interested!managers!is!
direct!action.!
C)!!A!shareholder!resolution!could!direct!the!board!to!take!a!specific!action,!such!as!discontinue!investing!in!
a!particular!line!of!business!or!country,!or!remove!a!poison!pill.!
D)!!Any!shareholder!can!submit!a!resolution!that!is!put!to!a!vote!at!the!annual!meeting.!
Answer:!!!A!
Explanation:!!! A)!!If!managers!have!small!ownership!stakes,!shareholders!may!use!compensation!policies!or!a!
stronger!board!to!create!the!desired!incentives.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Recently,!shareholders!have!started!organizing!bnob!votes.!That!is,!when!they!are!dissatisfied!with!a!
board,!they!simply!refuse!to!vote!to!approve!the!slate!of!nominees!for!the!board.!
B)!!One!early!study!of!proxy!contests!found!that!the!announcement!of!a!contest!increased!firm!stock!price!
by!8%!on!average,!even!if!the!challenge!was!eventually!unsuccessful!and!the!incumbents!won!reelection.!
C)!!Shareholders’!only!real!role!in!governance!is!in!electing!the!directors!of!the!company.!!
D)!!Perhaps!the!most!extreme!form!of!direct!action!that!disgruntled!shareholders!can!take!is!to!hold!a!proxy!
contest!and!introduce!a!rival!slate!of!directors!for!election!to!the!board.!
Answer:!!!C!
B)!!
C)!!In!addition!to!electing!the!directors!of!the!company,!shareholders!must!approve!many!major!
actions!taken!by!the!board.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!One!study!found!that!firms!with!fewer!restrictions!on!shareholder!power!performed!worse!than!firms!
with!more!restrictions!during!the!1990s.!
B)!!Some!large!public!pension!funds,!such!as!CalPERS!(the!California!Public!Employees!Retirement!System),!
take!an!activist!role!in!corporate!governance.!
C)!!In!2004!with!the!Walt!Disney!Company,!major!shareholders!were!dissatisfied!with!the!recent!
performance!of!Disney!under!long-time!CEO!and!Chairman,!Michael!Eisner.!They!began!an!organized!
campaign!to!convince!the!majority!of!Disney!shareholders!to!withhold!their!approval!of!the!reelection!of!
Eisner!as!director!and!chairman!of!the!board.!
D)!!Given!the!importance!of!shareholder!action!in!corporate!governance,!researchers!and!large!investors!
alike!have!become!increasingly!interested!in!measuring!the!balance!of!power!between!shareholders!and!
managers!in!a!firm.!
Answer:!!!A!
Explanation:!!! A)!!One!study!found!that!firms!with!more!restrictions!on!shareholder!power!performed!worse!
than!firms!with!less!restrictions!during!the!1990s.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!An!active!takeover!market!is!part!of!the!system!through!which!the!threat!of!dismissal!is!maintained.!
B)!!When!internal!governance!systems!such!as!ownership,!compensation,!board!oversight,!and!shareholder!
activism!fail,!the!one!remaining!way!to!remove!poorly!performing!managers!is!by!mounting!a!hostile!
takeover.!
C)!!Likely!because!hostile!takeovers!and!internal!governance!systems!are!substitute!mechanisms,!
researchers!have!found!that!boards!are!less!likely!to!fire!managers!for!poor!performance!during!active!
takeover!markets!than!they!are!during!lulls!in!takeover!activity.!
D)!!The!effectiveness!of!the!corporate!governance!structure!of!a!firm!depends!on!how!well!protected!its!
managers!are!from!removal!in!a!hostile!takeover.!
Answer:!!!C!
B)!!
C)!!Researchers!have!found!that!boards!are!actually!more!likely!to!fire!managers!for!poor!
performance!during!active!takeover!markets!than!they!are!during!lulls!in!takeover!activity.!
D)!!
Diff:!3!
Skill:!Conceptual!
!
6)!!What!is!the!role!of!takeovers!in!corporate!governance?!
Answer:!!!When!internal!governance!systems!such!as!ownership,!compensation,!board!oversight,!and!
shareholder!activism!fail,!the!one!remaining!way!to!remove!poorly!performing!managers!is!by!
mounting!a!hostile!takeover.!Thus!the!effectiveness!of!the!corporate!governance!structure!of!a!firm!
depends!on!how!well!protected!its!managers!are!from!removal!in!a!hostile!takeover.!An!active!takeover!
market!is!part!of!the!system!through!which!the!threat!of!dismissal!is!maintained.!In!fact,!some!research!
has!suggested!that!an!active!takeover!market!complements!a!boardYs!own!vigilance!in!dismissing!
incompetent!managers.!That!research!found!that!boards!are!actually!more!likely!to!fire!managers!for!
poor!performance!during!active!takeover!markets!than!they!are!during!lulls!in!takeover!activity.!!
Diff:!2!
Skill:!Conceptual!
!
29.5((Regulation(
(
1)!!Which!of!the!following!was!not!a!finding!of!the!Cadbury!Commission?!
A)!!Audit!and!compensation!committees!should!be!made!up!entirely!of!independent!directors!or,!at!least,!
have!a!majority!of!them.!
B)!!Auditors!should!be!rotated,!and!there!should!be!fuller!disclosure!of!non-audit!work.!
C)!!The!CEO!should!not!be!chairman!of!the!board,!and!at!the!very!least!there!should!be!a!lead!independent!
director!with!similar!agenda-setting!powers.!
D)!!The!CEO!and!the!CFO!should!personally!attest!to!the!accuracy!of!the!financial!statements!presented!to!
shareholders.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Topic:!29.5!Regulation!
Skill:!Conceptual!
!
2)!!The!Sarbanes-Oxley!Act!requires!all!of!the!following!except?!
A)!!That!audit!partners!rotate!every!five!years!to!limit!the!likelihood!that!auditing!relationships!become!too!
cozy!over!long!periods!of!time.!
B)!!Strict!limits!on!the!amount!of!non-audit!fees!(consulting!or!otherwise)!that!an!accounting!firm!can!earn!
from!the!same!firm!that!it!audits.!
C)!!That!senior!management!and!the!boards!of!public!companies!to!be!comfortable!enough!with!the!process!
through!which!funds!are!allocated!and!controlled,!and!outcomes!monitored!throughout!the!firm,!to!be!
willing!to!attest!to!their!effectiveness!and!validity.!
D)!!The!Auditor!must!personally!attest!to!the!accuracy!of!the!financial!statements!presented!to!shareholders!
and!to!sign!a!statement!to!that!effect.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
3)!!While!the!Sarbanes-Oxley!Act!(SOX)!contains!many!provisions,!the!overall!intent!of!the!legislation!was!to!
improve!the!accuracy!of!information!given!to!both!boards!and!to!shareholders.!!SOX!attempted!to!achieve!this!
goal!in!all!of!the!following!ways!except?!
A)!!Overhauling!incentives!and!independence!in!the!auditing!process!
B)!!Mandating!the!separation!of!the!positions!of!CEO!and!Chairman!of!the!Board!
C)!!Stiffening!penalties!for!providing!false!information!
D)!!!Forcing!companies!to!validate!their!internal!financial!control!processes!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!Cadbury!Commission!stiffened!the!criminal!penalties!for!providing!false!information!to!
shareholders.!
B)!!The!Exchange!Acts!of!1933!and!1934,!among!other!things,!established!the!Securities!and!Exchange!
Commission!(SEC)!and!prohibited!trading!on!private!information!gained!as!an!insider!of!a!firm.!
C)!!Many!of!the!problems!at!Enron,!WorldCom,!and!elsewhere!were!kept!hidden!from!boards!and!
shareholders!until!it!was!too!late.!In!the!wake!of!these!scandals,!many!people!felt!that!the!accounting!
statements!of!these!companies,!while!often!remaining!true!to!the!letter!of!GAAP,!did!not!present!an!
accurate!picture!of!the!financial!health!of!a!company.!
D)!!While!one!study!found!that!those!firms!that!separated!the!position!of!CEO!and!chairman!performed!
better,!another!found!no!relation!between!the!independence!of!key!board!committees!and!firm!
performance!in!the!post-Cadbury!era.!
Answer:!!!A!
Explanation:!!! A)!!The!Cadbury!Commission!offered!only!recommendations.!!SOX!stiffened!the!criminal!
penalties!for!providing!false!information!to!shareholders.!
B)!!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
5)!!Which!of!the!following!statements!regarding!auditors!is!false?!
A)!!Most!auditors!have!a!longstanding!relationship!with!their!audit!clients;!this!extended!relationship!and!
the!auditorsY!desire!to!keep!the!lucrative!auditing!fees!makes!auditors!less!willing!to!challenge!
management.!
B)!!Most!accounting!firms!have!developed!large!and!extremely!profitable!consulting!divisions.!Obviously,!
if!an!audit!team!refuses!to!accommodate!a!request!by!a!clientYs!management,!that!client!will!be!less!likely!
to!choose!the!accounting!firm’s!consulting!division!for!its!next!consulting!contract.!
C)!!Auditing!firms!are!supposed!to!ensure!that!a!companyYs!financial!statements!accurately!reflect!the!
financial!state!of!the!firm.!
D)!!In!the!post!Sarbanes-Oxley!world,!accounting!firms!are!no!longer!allowed!to!offer!both!audit!and!non!
audit!services!to!the!same!firm.!
Answer:!!!D!
B)!!
C)!!
D)!!In!the!post!Sarbanes-Oxley!world,!accounting!firms!are!still!allowed!to!offer!both!audit!and!
non!audit!services!to!the!same!firm,!however!strict!limits!are!put!on!nonaudit!fees!these!audit!
firms!can!receive.!
Diff:!2!
Skill:!Conceptual!
!
6)!!Which!of!the!following!statements!regarding!auditors!is!false?!
A)!!The!Sarbanes-Oxley!Act!called!on!the!SEC!to!force!companies!to!have!audit!committees!that!are!
dominated!by!outside!directors!and!required!that!at!least!one!outside!director!have!a!financial!
background.!
B)!!Whether!information!is!material!has!been!defined!in!the!courts!as!referring!to!whether!the!information!
would!have!been!a!significant!factor!in!an!investorYs!decision!about!the!value!of!the!security.!
C)!!CEOs!and!CFOs!must!return!bonuses!or!profits!from!the!sale!of!stock!or!the!exercise!of!options!during!
any!period!covered!by!statements!that!are!later!restated.!
D)!!The!law!is!especially!strict!with!regard!to!takeover!announcements,!prohibiting!any!insider!with!
nonpublic!information!about!a!pending!or!ongoing!tender!offer!from!trading!on!that!information!or!
revealing!it!to!someone!who!is!likely!to!trade!on!it.!
Answer:!!!D!
B)!!
C)!!
D)!!The!law!is!especially!strict!with!regard!to!takeover!announcements,!prohibiting!anyone!
(whether!an!insider!or!not)!with!nonpublic!information!about!a!pending!or!ongoing!tender!
offer!from!trading!on!that!information!or!revealing!it!to!someone!who!is!likely!to!trade!on!it.!
Diff:!2!
Skill:!Conceptual!
!
7)!!Describe!the!main!requirements!of!the!Sarbanes-Oxley!Act!of!2002.!
Answer:!!!1.! Strict!limits!on!the!amount!of!non-audit!fees!(consulting!or!otherwise)!that!an!accounting!firm!can!
earn!from!the!same!firm!that!it!audits.!
!
2.! That!audit!partners!rotate!every!five!years!to!limit!the!likelihood!that!auditing!relationships!
become!too!cozy!over!long!periods!of!time.!
!
3.! Both!the!CEO!and!the!CFO!must!personally!attest!to!the!accuracy!of!the!financial!statements!
presented!to!shareholders!and!to!sign!a!statement!to!that!effect.!
!
4.! That!senior!management!and!the!boards!of!public!companies!to!be!comfortable!enough!with!the!
process!through!which!funds!are!allocated!and!controlled,!and!outcomes!monitored!throughout!the!
firm,!to!be!willing!to!attest!to!their!effectiveness!and!validity.!
!
5.! SOX!also!stiffened!the!criminal!penalties!for!providing!false!information!to!shareholders.!
!
6.! SOX!called!on!the!SEC!to!force!companies!to!have!audit!committees!that!are!dominated!by!outside!
directors!and!required!that!at!least!one!outside!director!have!a!financial!background.!
!
7.! CEOs!and!CFOs!must!return!bonuses!or!profits!from!the!sale!of!stock!or!the!exercise!of!options!
during!any!period!covered!by!statements!that!are!later!restated.!
Diff:!3!
Skill:!Conceptual!
!
29.6((Corporate(Governance(Around(the(World(
(
A)!!In!many!other!countries,!the!central!conflict!is!between!what!are!called!bcontrolling!shareholdersb!and!
bminority!shareholders.b!
B)!!Controlling!shareholders!can!make!decisions!that!benefit!them!disproportionately!relative!to!the!
minority!shareholders,!such!as!employing!family!members!rather!than!the!most!talented!managers!or!
establishing!contracts!favorable!to!other!family!controlled!firms.!
C)!!As!recent!events!and!corporate!scandals!have!shown,!investor!protection!in!the!United!States!is!
generally!seen!as!substandard!when!compared!to!the!developed!economies!in!the!world.!
D)!!Much!of!the!focus!in!the!United!States!is!on!the!agency!conflict!between!shareholders,!who!own!the!
majority!of!a!firm!but!are!a!dispersed!group,!and!managers,!who!own!little!of!the!firm!and!must!be!
monitored.!
Answer:!!!C!
B)!!
C)!!Recent!events!notwithstanding,!investor!protection!in!the!United!States!is!generally!seen!as!
being!among!the!best!in!the!world.!
D)!!
Diff:!1!
Topic:!29.6!Corporate!Governance!Around!the!World!
Skill:!Conceptual!
!
A)!!The!United!States!is!somewhat!of!an!exception,!in!that!it!focuses!solely!on!maximizing!shareholder!
welfare.!
B)!!A!controlling!family!has!many!opportunities!to!expropriate!minority!shareholders!in!a!pyramid!
structure.!
C)!!One!way!for!families!to!gain!control!over!firms!even!when!they!do!not!own!more!than!half!the!shares!is!
to!issue!dual!class!shares—a!scenario!in!which!companies!have!more!than!one!class!of!shares!and!one!
class!has!superior!voting!rights!over!the!other!class.!
D)!!Researchers!have!claimed!that!the!degree!of!investor!protection!was!largely!determined!by!the!legal!
origin!of!the!country—specifically,!whether!its!legal!system!was!based!on!British!common!law!(less!
protection)!or!French,!German,!and!Scandinavian!civil!law!(more!protection).!
Answer:!!!D!
B)!!
C)!!
D)!!Researchers!have!claimed!that!the!degree!of!investor!protection!was!largely!determined!by!
the!legal!origin!of!the!country—specifically,!whether!its!legal!system!was!based!on!British!
common!law!(more!protection)!or!French,!German,!and!Scandinavian!civil!law!(less!
protection).!
Diff:!2!
Skill:!Conceptual!
!
A)!!Controlling!shareholders!pay!for!their!control!rights!because!the!firm!effectively!faces!a!higher!cost!of!
equity!for!outside!capital.!
B)!!Most!countries!follow!what!is!called!the!stakeholder!model,!giving!explicit!consideration!to!other!
stakeholders—in!particular,!rank-and-file!employees.!
C)!!In!a!pyramid!structure,!a!family!first!creates!a!company!in!which!it!owns!more!than!50%!of!the!shares!
and!therefore!has!a!controlling!interest.!
D)!!A!conflict!of!interest!arises!because!the!family!has!an!incentive!to!try!to!move!profits!(and!hence!
dividends)!down!the!pyramid—that!is,!toward!companies!in!which!it!has!few!cash!flow!rights!and!away!
firms!in!which!it!has!more!cash!flow!rights.!
Answer:!!!D!
B)!!
C)!!
D)!!A!conflict!of!interest!arises!because!the!family!has!an!incentive!to!try!to!move!profits!(and!
hence!dividends)!up!the!pyramid–that!is,!away!from!companies!in!which!it!has!few!cash!flow!
rights!and!toward!firms!in!which!it!has!more!cash!flow!rights.!This!process!is!called!tunneling.!
Diff:!2!
Skill:!Conceptual!
!
4)!!How!does!a!pyramid!structure!work?!
Answer:!!!In!a!pyramid!structure,!a!family!first!creates!a!company!in!which!it!owns!more!than!50%!of!the!shares!
and!therefore!has!a!controlling!interest.!This!company!then!owns!a!controlling!interest—that!is,!at!least!
50%!of!the!shares—in!another!company.!Notice!that!the!family!controls!both!companies,!but!owns!only!
25%!of!the!second!company.!Indeed,!if!the!second!company!purchased!50%!of!the!shares!of!a!third!
company,!then!the!family!would!control!all!three!companies,!even!though!it!would!own!only!12.5%!of!
the!third!company.!The!farther!you!move!down!the!pyramid!the!less!ownership!the!family!has,!but!it!
still!remains!in!complete!control!of!all!the!companies.!
Diff:!2!
Skill:!Conceptual!
!
5)!!Describe!the!bstakeholderb!model!of!corporate!governance.!
Answer:!!!The!agency!costs!and!the!ways!to!control!them!that!we!have!discussed!are!general!to!all!companies!
anywhere!in!the!world.!However,!the!United!States!is!somewhat!of!an!exception,!in!that!it!focuses!
solely!on!maximizing!shareholder!welfare.!Most!countries!follow!what!is!called!the!stakeholder!model,!
giving!explicit!consideration!to!other!stakeholders in!particular,!rank-and-file!employees.!As!noted!
earlier,!countries!such!as!Germany!give!employees!board!representation.!Others!have!mandated!works!
councils,!local!versions!of!labor!unions!that!are!to!be!informed!and!consulted!on!major!corporate!
decisions.!Finally,!some!countries!mandate!employee!participation!in!decision!making!in!their!
constitutions.!
Diff:!2!
Skill:!Conceptual!
!
29.7((The(Tradeoff(of(Corporate(Governance(
(
A)!!It!is!important!to!keep!in!mind!that!good!governance!is!value!enhancing!and!so,!in!principle,!is!
something!investors!in!the!firm!should!strive!for.!
B)!!Corporate!governance!is!a!system!of!checks!and!balances!that!trades!off!costs!and!benefits.!
C)!!Because!good!governance!is!based!upon!a!basic!set!of!principals,!like!those!detailed!in!the!Cadbury!
CommissionYs!findings,!one!should!expect!all!firms!to!display!similar!governance!structures.!
D)!!The!costs!and!benefits!of!a!corporate!governance!system!also!depend!on!cultural!norms.!
Answer:!!!C!
B)!!
C)!!Because!there!are!many!ways!to!implement!good!governance,!one!should!expect!firms!to!
display—and!firms!do!display—wide!variation!in!their!governance!structures.!
D)!!
Diff:!1!
Topic:!29.7!The!Tradeoff!of!Corporate!Governance!
Skill:!Conceptual!
!
!
Chapter(30(-(Risk(Management(
!
!
30.1(Insurance((
(
1)!!To!insure!their!assets!against!hazards!such!as!fire,!storm!damage,!vandalism,!earthquakes,!and!other!natural!
and!environmental!risks!firms!commonly!purchase!
A)!!key!personnel!insurance.!
B)!!business!liability!insurance.!
C)!!business!interruption!insurance.!
D)!!property!insurance.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!30.1!Insurance!
Skill:!Definition!
!
2)!!To!cover!the!costs!that!result!if!some!aspect!of!the!business!causes!harm!to!a!third!party!or!someone!elseKs!
property!a!firm!would!purchase!
A)!!business!interruption!insurance.!
B)!!property!insurance.!
C)!!business!liability!insurance.!
D)!!key!personnel!insurance.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
3)!!To!protect!the!firm!against!the!loss!of!earnings!if!the!business!operations!are!disrupted!due!to!fire,!accident,!or!
some!other!insured!peril!a!firm!would!purchase!
A)!!property!insurance.!
B)!!key!personnel!insurance.!
C)!!business!liability!insurance.!
D)!!business!interruption!insurance.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
4)!!Insurance!that!compensates!for!the!loss!or!unavoidable!absence!of!crucial!employees!in!the!firm!is!called!
A)!!key!personnel!insurance.!
B)!!business!liability!insurance.!
C)!!property!insurance.!
D)!!business!interruption!insurance.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
!
5)!!In!reality!market!imperfections!exist!that!can!raise!the!cost!of!insurance!above!the!actuarially!fair!price!and!
offset!some!of!these!benefits.!!These!insurance!market!imperfections!include!all!of!the!following!except:!
A)!!Adverse!selection!
B)!!Agency!costs!
C)!!Administrative!and!overhead!costs!
D)!!Taxation!of!insurance!payments!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Not!all!insurable!risks!have!a!beta!of!zero.!Some!risks,!such!as!hurricanes!and!earthquakes,!create!losses!
of!tens!of!billions!of!dollars!and!may!be!difficult!to!diversify!completely.!
B)!!When!a!firm!buys!insurance,!it!transfers!the!risk!of!the!loss!to!an!insurance!company.!The!insurance!
company!charges!an!upfront!premium!to!take!on!that!risk.!
C)!!By!its!very!nature,!insurance!for!non!diversifiable!hazards!is!generally!a!positive!beta!asset;!the!
insurance!payment!to!the!firm!tends!to!be!larger!when!total!losses!are!low!and!the!market!portfolio!is!
high.!
D)!!Because!insurance!provides!cash!to!the!firm!to!offset!losses,!it!can!reduce!the!firmKs!need!for!external!
capital!and!thus!reduce!issuance!costs.!
Answer:!!!C!
B)!!
C)!!By!its!very!nature,!insurance!for!non!diversifiable!hazards!is!generally!a!negative!beta!asset!(it!
pays!off!in!bad!times);!the!insurance!payment!to!the!firm!tends!to!be!larger!when!total!losses!
are!high!and!the!market!portfolio!is!low.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Because!insurance!reduces!the!risk!of!financial!distress,!it!can!relax!this!tradeoff!and!allow!the!firm!to!
increase!its!use!of!debt!financing.!
B)!!By!lowering!the!volatility!of!the!stock,!insurance!discourage!concentrated!ownership!by!an!outside!
director!or!investor!who!will!monitor!the!firm!and!its!management.!
C)!!When!a!firm!is!subject!to!graduated!income!tax!rates,!insurance!can!produce!a!tax!savings!if!the!firm!is!in!
a!higher!tax!bracket!when!it!pays!the!premium!than!the!tax!bracket!it!is!in!when!it!receives!the!insurance!
payment!in!the!event!of!a!loss.!
D)!!In!a!perfect!market!without!other!frictions,!insurance!companies!should!compete!until!they!are!just!
earning!a!fair!return!and!the!NPV!from!selling!insurance!is!zero.!The!NPV!is!zero!if!the!price!of!
insurance!equals!the!present!value!of!the!expected!payment;!in!that!case,!we!say!the!price!is!actuarially!
fair.!
Answer:!!!B!
B)!!By!lowering!the!volatility!of!the!stock,!insurance!can!encourage!concentrated!ownership!by!
an!outside!director!or!investor!who!will!monitor!the!firm!and!its!management.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
!
Your!firm!faces!an!8%!chance!of!a!potential!loss!of!$50!million!next!year.!!If!your!firm!implements!new!safety!policies,!it!can!
reduce!the!chance!of!this!loss!to!3%,!but!the!new!safety!policies!have!an!upfront!cost!of!$250,000.!!Suppose!that!the!beta!of!
the!loss!is!0!and!the!risk-free!rate!of!interest!is!5%.!
!
8)!!If!your!firm!is!uninsured,!the!NPV!of!implementing!the!new!safety!policies!is!closest!to:!
A)!!$2.25!million!
B)!!-$.25!million!
C)!!$2.5!million!
D)!!$2.15!million!
Answer:!!!D!
B)!!
C)!!
D)!!Expected!loss!without!new!safety!policies!=!.08!×!$50!million!=!$4!million!
Expected!loss!with!new!safety!policies!=!.03!×!$50!million!=!$1.5!million!
!
Expected!gain!from!safety!program!=!$4!million!-!$1.5!million!=!$2.5!million!
!
$2.5 million
NPV!=!-250,000!+! !=!$2,130,952!
1.05
Diff:!2!
Skill:!Analytical!
!
9)!!If!your!firm!is!fully!insured,!the!NPV!of!implementing!the!new!safety!policies!is!closest!to:!
A)!!$2.15!million!
B)!!$2.5!million!
C)!!$2.25!million!
D)!!-$.25!million!
Answer:!!!D!
B)!!
C)!!
D)!!If!the!firm!is!fully!insured,!the!insurance!company!will!pay!for!the!loss!regardless!if!whether!
the!safety!program!is!in!force!or!not.!!Therefore,!the!end!of!period!cash!flows!will!be!identical!
with!or!without!the!program!and!the!NPV!is!-$250,000!reflecting!the!cost!of!the!safety!
program.!
Diff:!2!
Skill:!Analytical!
!
10)!!What!is!the!actuarially!fair!cost!of!full!insurance?!
Answer:!!! Pr(Loss) E Payment in the Event of Loss
Insurance!Premium!=!
1 rL
(.08)$50 million
The!actuarially!fair!cost!of!full!insurance!=! !=!$3.81!million!
1.05
Diff:!1!
Skill:!Analytical!
!
11)!!Assuming!that!your!firm!will!purchase!insurance,!what!is!the!minimum-size!deductible!that!would!leave!
your!firm!with!an!incentive!to!implement!the!new!safety!policies?!
Answer:!!!If!the!firm!is!fully!insured!(no!deductible),!the!insurance!company!will!pay!for!the!loss!regardless!if!
whether!the!safety!program!is!in!force!or!not.!!Therefore,!the!end!of!period!cash!flows!will!be!identical!
with!or!without!the!program!and!the!NPV!is!-$250,000!reflecting!the!cost!of!the!safety!program.!
!
In!order!to!give!the!firm!the!incentive!to!buy!the!insurance!the!NPV!of!the!safety!program!must!be!
positive.!
!
Another!way!of!looking!at!this!is!to!find!the!point!where!the!PV!of!the!expected!deductible!equals!the!
cost!of!the!safety!program.!!Mathematically!we!have:!
Deductible $250, 000(1.05)
(.08!-!.03)! !=!$250,000,!solving!for!the!Deductible!=+! !=!$5,250,000!
1.05 .05
!
To!show!that!this!indeed!is!the!correct!answer:!
$5.25 million $5.25 million
(.08)! !=!(.03)! !-!$250,000!
1.05 1.05
Diff:!3!
Skill:!Analytical!
!
12)!!Farmville!Industries!is!a!major!agricultural!firm!and!is!concerned!about!the!possibility!of!drought!impacting!
corn!production.!!In!the!event!of!a!drought,!Farmville!Industries!anticipates!a!loss!of!$75!million.!!Suppose!the!
likelihood!of!a!drought!is!10%!per!year,!and!the!beta!associated!with!such!a!loss!is!0.4.!!If!the!risk-free!interest!
rate!is!5%!and!the!expected!return!on!the!market!is!10%,!then!what!is!the!actuarially!fair!insurance!premium?!
Answer:!!!The!expected!loss!=!$75!million!×!.10!=!$7.5!million!
!
Since!the!beta!of!the!loss!is!not!equal!to!zero!we!need!to!calculate!the!appropriate!discount!rate!for!the!
loss!using!the!CAPM:!
!
r!=!rf!+! (rM!-!rf)!
r!=!.05!+!.4(.10!-!.05)!=!.07!
Pr(Loss) E Payment in the Event of Loss

Insurance!Premium!=!
1 rL
$7.5 million
So!the!actuarially!fair!cost!of!full!insurance!=! !=!$7.01!million!
1.07
Diff:!2!
Skill:!Analytical!
(
30.2((Commodity(Price(Risk(
(
1)!!The!risk!that!the!firm!will!not!have,!or!be!able!to!raise,!the!cash!required!to!meet!the!margin!calls!on!its!hedges!
is!called!
A)!!liquidity!risk.!
B)!!basis!risk.!
C)!!commodity!price!risk.!
D)!!speculation!risk.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!30.2!Commodity!Price!Risk!
Skill:!Definition!
!
2)!!The!risk!that!arises!because!the!value!of!the!futures!contract!will!not!be!perfectly!correlated!with!the!firmKs!
exposure!is!called!
A)!!commodity!price!risk.!
B)!!basis!risk.!
C)!!liquidity!risk.!
D)!!speculation!risk.!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Definition!
A)!!Horizontal!integration(entails!the!merger!of!a!firm!and!its!supplier!or!a!firm!and!its!customer.!
B)!!Like!insurance,!hedging!involves!contracts!or!transactions!that!provide!the!firm!with!cash!flows!that!
offset!its!losses!from!price!changes.!
C)!!For!many!firms,!changes!in!the!market!prices!of!the!raw!materials!they!use!and!the!goods!they!produce!
may!be!the!most!important!source!of!risk!to!their!profitability.!
D)!!Because!an!increase!in!the!price!of!the!commodity!raises!the!firmKs!costs!and!the!supplierKs!revenues,!
these!firms!can!offset!their!risks!by!merging.!
Answer:!!!A!
Explanation:!!! A)!!Vertical!integration(entails!the!merger!of!a!firm!and!its!supplier!or!a!firm!and!its!customer.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Firms!generally!do!not!possess!better!information!than!outside!investors!regarding!the!risk!of!future!
commodity!price!changes,!nor!can!they!influence!that!risk!through!their!actions.!
B)!!Cash!flows!are!exchanged!on!a!monthly!basis,!rather!than!waiting!until!the!end!of!the!contract,!through!
a!procedure!called!marking!to!market.!
C)!!The!firm!may!speculate(by!entering!into!contracts!that!do!not!offset!its!actual!risks.!
D)!!When!a!firm!authorizes!managers!to!trade!contracts!to!hedge,!it!opens!the!door!to!the!possibility!of!
speculation.!
Answer:!!!B!
B)!!Cash!flows!are!exchanged!on!a!daily!basis,!rather!than!waiting!until!the!end!of!the!contract,!
through!a!procedure!called!marking!to!market.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
5)!!Which!of!the!following!statements!regarding!futures!contracts!is!false?!
A)!!Both!the!buyer!and!the!seller!can!get!out!of!the!contract!at!any!time!by!selling!it!to!a!third!party!at!the!
current!market!price.!
B)!!Futures!prices!are!not!prices!that!are!paid!today.!Rather,!they!are!prices!agreed!to!today,!to!be!paid!in!the!
future.!
C)!!Futures!contracts!are!traded!anonymously!on!an!exchange!at!a!publicly!observed!market!price!and!are!
generally!very!illiquid.!
D)!!Traders!are!required!to!post!collateral,!called!margin,!when!buying!or!selling!commodities!using!futures!
contracts.!
Answer:!!!C!
B)!!
C)!!Futures!contracts!are!traded!anonymously!on!an!exchange!at!a!publicly!observed!market!
price!and!are!generally!very!liquid.!
D)!!
Diff:!2!
Skill:!Conceptual!
6)!!Which!of!the!following!statements!regarding!long-term!supply!contracts!is!false?!
A)!!The!market!value!of!the!contract!at!any!point!in!time!may!not!be!easy!to!determine,!making!it!difficult!to!
track!gains!and!losses.!
B)!!Long-term!supply!contracts!are!designed!to!eliminate!credit!risk.!
C)!!Long-term!supply!contracts!insulate!the!firms!from!commodity!price!risk.!
D)!!Long-term!supply!contracts!are!bilateral!contracts!negotiated!by!a!buyer!and!a!seller.!!
Answer:!!!B!
B)!!Long-term!supply!contracts!are!designed!to!eliminate!price!risk!but!introduce!credit!risk.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Long-term!supply!contracts!such!contracts!cannot!be!entered!into!anonymously;!the!buyer!and!seller!
know!each!otherKs!identity.!This!lack!of!anonymity!may!have!strategic!disadvantages.!
B)!!A!futures!contract!is!an!agreement!to!trade!an!asset!on!some!future!date,!at!a!price!that!is!locked!in!today.!
C)!!An!alternative!to!vertical!integration!or!storage!is!a!long-term!supply!contract.!
D)!!Long-term!supply!contracts!are!unilateral!contracts!negotiated!by!a!seller.!
Answer:!!!D!
B)!!
C)!!
D)!!Long-term!supply!contracts!are!bilateral!contracts!negotiated!by!a!buyer!and!a!seller.!
Diff:!2!
Skill:!Conceptual!
!
8)!!What!are!some!of!the!disadvantages!of!long-term!supply!contracts?!
Answer:!!!Such!contracts!have!several!potential!disadvantages.!First,!they!expose!each!party!to!the!risk!that!the!
other!party!may!default!and!fail!to!live!up!to!the!terms!of!the!contract.!!Thus,!while!they!insulate!the!
firms!from!commodity!price!risk,!they!expose!them!to!credit!risk.!Second,!such!contracts!cannot!be!
entered!into!anonymously;!the!buyer!and!seller!know!each!otherKs!identity.!This!lack!of!anonymity!may!
have!strategic!disadvantages.!!Finally,!the!market!value!of!the!contract!at!any!point!in!time!may!not!be!
easy!to!determine,!making!it!difficult!to!track!gains!and!losses,!and!it!may!be!difficult!or!even!
impossible!to!cancel!the!contract!if!necessary.!
Diff:!2!
Skill:!Conceptual!
!
9)!!Your!oil!refinery!will!need!to!buy!250,000!barrels!of!crude!oil!in!one!week!and!it!is!worried!about!crude!oil!
prices.!Suppose!you!go!long!250!crude!oil!futures!contracts,!each!for!1000!barrels!of!crude!oil,!at!the!current!
futures!price!of!$68!per!barrel.!Suppose!futures!prices!change!each!day!over!the!next!week!as!follows:
Day 1 2 3 4 5(
Futures!Price 65 65.5 68 67.25 70!
What!is!the!daily!and!cumulative!mark!to!market!profit!or!loss!(in!dollars)!that!you!will!have!on!each!of!the!
next!five!days?!
Answer:!!!Day 1 2 3 (4 5(
Futures!Price 65 65.5 68 67.25 !70!
Daily!mark!to!market!
profit/loss!(one!contract) -3 0.5 2.5 -0.75 2.75!
Daily!mark!to!market!
profit/loss!(250!contracts) -750 125 625 -187.5 687.5!
Cumulative!mark!to!market!
profit/loss!(one!contract) -3 -2.5 0 -0.75 2!
Cumulative!mark!to!market!
profit/loss!(250!contracts) -750 -625 0 -187.5 500!
Diff:!2!
Skill:!Analytical!
!
30.3((Exchange(Rate(Risk(
(
1)!!Like!most!foreign!exchange!rates,!the!dollar/euro!rate!is!a!floating!rate,!which!means!it!changes!constantly!
depending!on!the!quantity!supplied!and!demanded!for!each!currency!in!the!market.!The!supply!and!demand!
for!each!currency!is!driven!directly!by!all!of!the!following!factors!except:!
A)!!Relative!inflation!
B)!!Firms!trading!goods!
C)!!Investors!trading!securities!
D)!!The!actions!of!central!banks!in!each!country!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Topic:!30.3!Exchange!Rate!Risk!
Skill:!Conceptual!
!
2)!!A!currency!forward!contract!specifies!all!of!the!following!except:!
A)!!The!amount!of!currency!to!exchange!
B)!!The!spot!exchange!rate!
C)!!The!delivery!date!on!which!the!exchange!will!take!place!
D)!!The!currencies!to!be!exchanged!
Answer:!!!B!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
3)!!The!cash-and-carry!strategy(consists!of!all!of!the!following!simultaneous!trades!except:!
A)!!Borrow!euros!today!using!a!one-year!loan!with!the!interest!rate!r€!
B)!!Exchange!the!euros!for!dollars!today!at!the!spot!exchange!rate!S!$/€!
C)!!Purchase!a!forward!contract!to!convert!$!to!€!
D)!!Invest!the!dollars!today!for!one!year!at!the!interest!rate!r$!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!most!common!method!firms!use!to!reduce!the!risk!that!results!from!changes!in!exchange!rates!is!to!
hedge!the!transaction!using!currency!forward!contracts.!
B)!!Fluctuating!exchanges!rates!cause!a!problem!known!as!the!importer—exporter!dilemma!for!firms!doing!
business!in!international!markets.!
C)!!Exchange!rate!risk!naturally!arises!whenever!transacting!parties!use!different!currencies:!Both!of!the!
parties!will!be!at!risk!if!exchange!rates!fluctuate.!
D)!!Because!the!supply!and!demand!for!currencies!varies!with!global!economic!conditions,!exchange!rates!
are!volatile.!
Answer:!!!C!
B)!!
C)!!Exchange!rate!risk!naturally!arises!whenever!transacting!parties!use!different!currencies:!One!
of!the!parties!will!be!at!risk!if!exchange!rates!fluctuate.!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!covered!interest!parity!equation!states!that!the!difference!between!the!forward!and!spot!exchange!
rates!is!related!to!the!interest!rate!differential!between!the!currencies.!
B)!!By!entering!into!a!currency!forward!contract,!a!firm!can!lock!in!an!exchange!rate!in!advance!and!reduce!
or!eliminate!its!exposure!to!fluctuations!in!a!currency’s!value.!
C)!!When!the!interest!rate!differs!across!countries,!investors!have!an!incentive!to!borrow!in!the!low-interest!
rate!currency!and!invest!in!the!high!interest!rate!currency!
D)!!A!currency!forward!is!usually!written!between!two!firms,!and!it!fixes!a!currency!exchange!rate!for!a!
transaction!that!will!occur!at!a!future!date.!
Answer:!!!D!
B)!!
C)!!
D)!!A!currency!forward!is!usually!written!between!a!firm!and!a!bank,!and!it!fixes!a!currency!
exchange!rate!for!a!transaction!that!will!occur!at!a!future!date.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Currency!options!allow!firms!to!lock!in!a!future!exchange!rate;!currency!forward!contracts!allow!firms!to!
insure!themselves!against!the!exchange!rate!moving!beyond!a!certain!level.!
B)!!Generally!speaking,!cash-and-carry!strategies!are!used!primarily!by!large!banks,!which!can!borrow!
easily!and!face!low!transaction!costs.!
C)!!Currency!options,!like!the!stock!options,!give!the!holder!the!right–but!not!the!obligation–to!exchange!
currency!at!a!given!exchange!rate.!
D)!!Many!managers!want!the!firm!to!benefit!if!the!exchange!rate!moves!in!their!favor,!rather!than!being!
stuck!paying!an!above-market!rate.!
Answer:!!!A!
Explanation:!!! A)!!Currency!forward!contracts!allow!firms!to!lock!in!a!future!exchange!rate;!currency!options!
allow!firms!to!insure!themselves!against!the!exchange!rate!moving!beyond!a!certain!level.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
7)!!Which!of!the!following!statements!regarding!currency!options!is!false?!
A)!!Firms!often!prefer!forward!contracts!to!currency!options!if!the!transaction!they!are!hedging!might!not!
take!place.!
B)!!Currency!options!are!another!method!that!firms!commonly!use!to!manage!exchange!rate!risk.!Currency!
options,!like!the!stock!options,!give!the!holder!the!right–but!not!the!obligation–to!exchange!currency!at!a!
given!exchange!rate.!
C)!!Currency!forward!contracts!allow!firms!to!lock!in!a!future!exchange!rate;!currency!options!allow!firms!to!
insure!themselves!against!the!exchange!rate!moving!beyond!a!certain!level.!
D)!!Many!managers!want!the!firm!to!benefit!if!the!exchange!rate!moves!in!their!favor,!rather!than!being!
stuck!paying!an!above-market!rate.!
Answer:!!!A!
Explanation:!!! A)!!Firms!often!prefer!options!to!forward!contracts!if!the!transaction!they!are!hedging!might!not!
take!place.!
B)!!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
8)!!In!December!2005,!the!spot!exchange!rate!for!the!British!Pound!was!$1.7188/£.!!Suppose!that!at!the!same!time!
the!on-year!interest!rate!in!the!United!States!was!4.85%!and!the!one-year!interest!rate!in!Great!Britain!was!
3.15%.!!Based!on!these!rates,!what!forward!exchange!rate!is!consistent!with!no!arbitrage.!
Answer:!!! 1 r$ 1.0485
F!=!S!×! !=!$1.7188!×! !=!$1.7471/£!
1 r£ 1.0315
Diff:!2!
Skill:!Analytical!
!
9)!!In!December!2005,!the!spot!exchange!rate!for!the!British!Pound!was!$1.7188/£!and!the!one-year!forward!rate!
was!$1.8675/£.!!Suppose!that!at!the!same!time!Luther!Industries!entered!into!a!contract!to!purchase!goods!
with!a!price!of!£375,000!to!be!delivered!in!one!year.!!Simultaneously!Luther!entered!into!a!one-year!forward!
contract!to!purchase!£375,000.!!What!is!the!amount!of!the!payment!in!U.S.!dollars!that!Luther!Industries!will!
have!to!make!in!one!year!to!pay!for!their!goods?!
Answer:!!!Since!Luther!entered!into!a!forward!contract,!the!exchange!rate!is!fixed!at!the!one-year!forward!rate!of!
$1.8675/£.!!Therefore!Luther!Industries!will!have!to!pay!£375,000!×!$1.8675/£!=!$700,312.50.!
Diff:!1!
Skill:!Analytical!
30.4((Interest(Rate(Risk(
(
A)!!We!can!measure!a!firmKs!sensitivity!to!interest!rates!by!computing!the!duration!of!its!balance!sheet.!
B)!!Just!as!the!interest!rate!sensitivity!of!a!single!cash!flow!increases!with!its!maturity,!the!interest!rate!
sensitivity!of!a!stream!of!cash!flows!increases!with!its!duration.!
C)!!By!restructuring!the!balance!sheet!to!increase!its!duration,!we!can!hedge!the!firmKs!interest!rate!risk.!
D)!!A!firmKs!market!capitalization!is!determined!by!the!difference!in!the!market!value!of!its!assets!and!its!
liabilities.!
Answer:!!!C!
B)!!
C)!!By!restructuring!the!balance!sheet!to!reduce!its!duration,!we!can!hedge!the!firmKs!interest!rate!
risk.!
D)!!
Diff:!1!
Topic:!30.4!Interest!Rate!Risk!
Skill:!Conceptual!
!
A)!!As!interest!rates!change,!the!market!values!of!the!securities!and!cash!flows!in!the!portfolio!change!as!
well,!which!in!turn!alters!the!weights!used!when!computing!the!duration!as!the!value-weighted!average!
maturity.!
B)!!The!duration!of!a!portfolio!of!investments!is!the!simple!average!of!the!durations!of!each!investment!in!
the!portfolio.!
C)!!Adjusting!a!portfolio!to!make!its!duration!neutral!is!sometimes!referred!to!as!immunizing(the!portfolio,!
a!term!that!indicates!it!is!being!protected!against!interest!rate!changes.!
D)!!When!the!durations!of!a!firmKs!assets!and!liabilities!are!significantly!different,!the!firm!has!a!duration!
mismatch.!
Answer:!!!B!
B)!!The!duration!of!a!portfolio!of!investments!is!the!value-weighted!average!of!the!durations!of!
each!investment!in!the!portfolio.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Interest!rate!swaps!are!an!alternative!means!of!modifying!the!firm’s!interest!rate!risk!exposure!without!
buying!or!selling!assets.!
B)!!A!portfolio!with!a!negative!duration!is!called!a!duration-neutral!portfolio!or!an!immunized!portfolio,!
which!means!that!for!small!interest!rate!fluctuations,!the!value!of!equity!should!remain!unchanged.!
C)!!Maintaining!a!duration-neutral!portfolio!will!require!constant!adjustment!as!interest!rates!change.!
D)!!A!duration-neutral!portfolio!is!only!protected!against!interest!rate!changes!that!affect!all!yields!
identically.!
Answer:!!!B!
B)!!A!portfolio!with!a!zero!duration!is!called!a!duration-neutral!portfolio!or!an!immunized!
portfolio,!which!means!that!for!small!interest!rate!fluctuations,!the!value!of!equity!should!
remain!unchanged.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!swap!contract—like!forward!and!futures!contracts—is!typically!structured!as!a!lzero-costl!security.!
B)!!An!interest!rate!swap(is!a!contract!entered!into!with!a!bank,!much!like!a!forward!contract,!in!which!the!
firm!and!the!bank!agree!to!exchange!the!coupons!from!two!different!types!of!loans.!
C)!!In!a!standard!interest!rate!swap,!one!party!agrees!to!pay!coupons!based!on!a!fixed!interest!rate!in!
exchange!for!receiving!coupons!based!on!the!prevailing!market!interest!rate!during!each!coupon!period.!
D)!!If!short-term!interest!rates!were!to!fall!while!long-term!rates!remained!stable,!then!short-term!securities!
would!fall!in!value!relative!to!long-term!securities,!despite!their!shorter!duration.!
Answer:!!!D!
B)!!
C)!!
D)!!If!short-term!interest!rates!were!to!rise!while!long-term!rates!remained!stable,!then!short-term!
securities!would!fall!in!value!relative!to!long-term!securities,!despite!their!shorter!duration.!
Diff:!2!
Skill:!Conceptual!
!
A)!!Corporations!use!interest!rate!swaps!routinely!to!alter!their!exposure!to!interest!rate!fluctuations.!
Firms!can!use!interest!rate!swaps!with!duration-hedging!strategies.!
B)!!The!value!of!a!swap,!while!initially!zero,!will!fluctuate!over!time!as!interest!rates!change.!
C)!!An!interest!rate!that!adjusts!to!current!market!conditions!is!called!a!floating!rate.!
D)!!When!interest!rates!rise,!the!swapKs!value!will!rise!for!the!party!receiving!the!fixed!rate;!conversely,!it!
will!fall!for!the!party!paying!the!fixed!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!When!interest!rates!rise,!the!swapKs!value!will!fall!for!the!party!receiving!the!fixed!rate;!
conversely,!it!will!rise!for!the!party!paying!the!fixed!rate.!
Diff:!2!
Skill:!Conceptual!
!
6)!!What!is!the!duration!of!a!five-year!zero-coupon!bond?!
A)!!2.5!Years!
B)!!1!Year!
C)!!5!Years!
D)!!0!Years!
Answer:!!!C!
B)!!
C)!!
D)!!For!a!zero-coupon!bond,!there!is!only!a!single!cash!flow.!!Thus!PV(CF5)!=!P!and!the!the!
duration!is!qual!to!the!bondKs!maturity!of!five!years.!
Diff:!1!
Skill:!Analytical!
!
7)!!The!duration!of!a!five-year!bond!with!8%!annual!coupons!trading!at!par!is!closest!to:!
A)!!2.5!Years!
B)!!4.3!Years!
C)!!5.0!Years!
D)!!6.2!Years!
Answer:!!!B!
B)!! PV (CFt )
Duration!=! !×!t!
Price
t((years) CFt PV(CFt) PV(CFt)/P [PV(CFt)/P](×(t&

1 8 7.4074 0.0741 0.0741!
2 8 6.8587 0.0686 0.1372!
3 8 6.3507 0.0635 0.1905!
4 8 5.8802 0.0588 0.2352!
5 108 73.5030 0.7350 3.6751!
Bond!Price= 100 100.00%
Duration!= 4.3121!Years!
C)!!
D)!!
Diff:!3!
Skill:!Analytical!
!
8)!!The!Century!22!fund!has!invested!in!a!portfolio!of!mortgaged!backed!securities!that!has!a!current!market!
value!of!$245!million.!!The!duration!of!this!portfolio!of!mortgaged!back!securities!is!14.7!years.!!The!fund!has!
borrowed!to!purchase!these!securities,!and!the!current!value!of!its!liabilities!(i.e.,!the!current!value!of!the!
bonds!Century!22!has!issued)!is!$160!million.!!The!duration!of!these!liabilities!is!5.4!years.!!What!is!the!initial!
duration!of!the!equity!for!the!Century!22!fund?!
Answer:!!! A L 245 160
DE!=!DA!-!L!=! DA!-! DL!=! (14.7)!-! (5.4)!=!32.21!years!
A L A L 85 85
Diff:!2!
Skill:!Analytical!
!
9)!!Luther!Industries!needs!to!borrow!$50!million!in!cash.!!Currently!long-term!AAA!rates!are!9%.!!Luther!can!
borrow!at!9.75%!given!its!current!credit!rating.!!Luther!is!expecting!interest!rates!to!fall!over!the!next!few!years,!
so!it!would!prefer!to!borrow!at!the!short-term!rates!and!refinance!after!rates!have!dropped.!!Luther!
management!is!afraid,!however,!that!its!credit!rating!may!fall!which!could!greatly!increase!the!spread!the!firm!
must!pay!on!new!borrowings.!!How!can!Luther!benefit!from!the!expected!decline!in!future!interest!rates!
without!exposure!to!the!risk!of!the!potential!future!changes!to!its!credit!ratings!bring?!!
Answer:!!!Luther!can!borrow!at!the!long!term!rate!of!9.75%!and!then!enter!into!a!swap!arrangement!where!it!
receives!a!fixed!rate!of!9%!and!pays!the!short-term!rate.!!In!this!way!Luther!locks!in!its!current!credit!
spread!of!0.75%!but!gets!the!benefit!of!lower!rates!if!the!rates!decline.!
Diff:!2!
Skill:!Analytical!
!
!
Chapter(31(-(International(Corporate(Finance(
!
!
31.1(Internationally(Integrated(Capital(Markets((
(
1)!!Which!of!the!following!statements!regarding!international!projects!is!false?!
A)!!Interest!rates!and!costs!of!capital!will!likely!be!different!in!the!foreign!country!as!a!result!of!the!
macroeconomic!environment.!
B)!!The!project!will!most!likely!generate!foreign!currency!cash!flows,!although!the!firm!cares!about!the!
foreign!currency!value!of!the!project.!
C)!!Under!internationally!integrated!capital!markets,!the!value!of!an!investment!does!not!depend!on!the!
currency!we!use!in!the!analysis.!
D)!!The!firm!will!probably!face!a!different!tax!rate!in!the!foreign!country!and!will!be!subject!to!both!foreign!
and!domestic!tax!codes.!
Answer:!!!B!
B)!!The!project!will!most!likely!generate!foreign!currency!cash!flows,!although!the!firm!cares!
about!the!home!currency!value!of!the!project.!
C)!!
D)!!
Diff:!1!
Topic:!31.1!Internationally!Integrated!Capital!Markets!
Skill:!Conceptual!
!
CFC F CFC
S"×" *
"=" !
(1 rFC ) (1 r *$ )
!
The!term!F!in!this!equation!is!
A)!!the!future!spot!exchange!rate.!
B)!!the!current!spot!exchange!rate.!
C)!!the!amount!of!foreign!currency.!
D)!!the!forward!exchange!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
CFC F CFC
S"×" *
"=" !
(1 rFC ) (1 r *$ )
!
The!term!S!in!this!equation!is!
A)!!the!forward!exchange!rate.!
B)!!the!amount!of!foreign!currency.!
C)!!the!future!spot!exchange!rate.!
D)!!the!current!spot!exchange!rate.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
CFC F CFC
S"×" *
"=" !
(1 rFC ) (1 r *$ )
!
The!term! r *$ !in!this!equation!is!
A)!!the!appropriate!cost!of!capital!from!the!standpoint!of!a!U.S.!investor.!
B)!!the!risk-free!rate!for!a!foreign!investor.!
C)!!the!risk-free!rate!for!a!U.S.!investor.!
D)!!the!appropriate!cost!of!capital!from!the!standpoint!of!a!foreign!investor.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
CFC F CFC
S"×" *
"=" !
(1 rFC ) (1 r *$ )
!
The!term! r *FC !in!this!equation!is!
A)!!the!risk-free!rate!for!a!foreign!investor.!
B)!!the!risk-free!rate!for!a!U.S.!investor.!
C)!!the!appropriate!cost!of!capital!from!the!standpoint!of!a!foreign!investor.!
D)!!the!appropriate!cost!of!capital!from!the!standpoint!of!a!U.S.!investor.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
You!are!a!U.S.!Investor!who!is!trying!to!calculate!the!present!value!of!£5!million!cash!inflow!that!will!occur!one!year!in!the!
future.!!The!spot!exchange!rate!is!S!=!$1.8839/£!and!the!forward!rate!is!F1!=!$1.8862/£.!!The!appropriate!dollar!discount!rate!
for!this!cash!flow!is!5.32%!and!the!appropriate!£!discount!rate!is!5.24%.!
!
6)!!The!present!value!of!the!£5!million!cash!inflow!computed!by!first!discounting!the!£s!and!then!converting!into!
dollars!is!closest!to:!
A)!!$8,961,420!
B)!!$8,950,495!
C)!!$8,954,615!
D)!!$8,943,695!
Answer:!!!B!
B)!! ? million
PV£!=! !=!£4,751,045.23!
1.0524
PV$!=!PV£!×!S!=!£4,751,045.23!×!$1.8839/£!=!$8,950,494.10!
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
7)!!The!present!value!of!the!£5!million!cash!inflow!computed!by!first!converting!into!dollars!and!then!
discounting!is!closest!to:!
A)!!$8,950,495!
B)!!$8,954,615!
C)!!$8,943,695!
D)!!$8,961,420!
Answer:!!!B!
B)!!FV$!=!£5!million!×!$1.8862/£!=!$9,431,000!
$9, 431, 000
PV!=! !=!$8,954,615!
1.0532
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
(
31.2((Valuation(of(Foreign(Currency(Cash(Flows(
(
A)!!If!the!foreign!project!is!owned!by!a!domestic!corporation,!managers!and!shareholders!need!to!determine!
the!home!currency!value!of!the!foreign!currency!cash!flows.!
B)!!The!most!obvious!difference!between!a!domestic!project!and!a!foreign!project!is!that!the!foreign!project!
will!most!likely!generate!cash!flows!in!a!foreign!currency.!
C)!!The!risk!of!the!foreign!project!is!unlikely!to!be!exactly"the!same!as!the!risk!of!domestic!projects!(or!the!
firm!as!a!whole),!because!the!foreign!project!contains!residual!exchange!rate!risk!that!the!domestic!
projects!often!do!not!contain.!
D)!!In!an!internationally!integrated!capital!market,!two!equivalent!methods!are!available!for!calculating!the!
NPV!of!a!foreign!project:!Either!we!can!calculate!the!NPV!in!the!foreign!country!and!convert!it!to!the!
local!currency!at!the!forward!rate,!or!we!can!convert!the!cash!flows!of!the!foreign!project!into!the!local!
currency!and!then!calculate!the!NPV!of!these!cash!flows.!
Answer:!!!D!
B)!!
C)!!
D)!!In!an!internationally!integrated!capital!market,!two!equivalent!methods!are!available!for!
calculating!the!NPV!of!a!foreign!project:!Either!we!can!calculate!the!NPV!in!the!foreign!
country!and!convert!it!to!the!local!currency!at!the!spot!rate,!or!we!can!convert!the!cash!flows!
of!the!foreign!project!into!the!local!currency!and!then!calculate!the!NPV!of!these!cash!flows.!
Diff:!1!
Topic:!31.2!Valuation!of!Foreign!Currency!Cash!Flows!
Skill:!Conceptual!
!
1 r¥
r *¥ !=! (1!+" r *$ )!-!1!
1+r$
!
the!term!r¥!in!this!equation!refers!to!
A)!!the!cost!of!capital!for!the!firm!in!terms!of!yen.!
B)!!the!risk-free!rate!of!interest!on!the!dollar.!
C)!!the!cost!of!capital!in!terms!of!dollars.!
D)!!the!risk-free!rate!of!interest!on!the!yen.!
Answer:!!!D!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
1 r¥
r *¥ !=! (1!+" r *$ )!-!1!
1+r$
!
the!term" r *$ !in!this!equation!refers!to!
A)!!the!cost!of!capital!in!terms!of!dollars.!
B)!!the!risk-free!rate!of!interest!on!the!yen.!
C)!!the!risk-free!rate!of!interest!on!the!dollar.!
D)!!the!cost!of!capital!for!the!firm!in!terms!of!yen.!
Answer:!!!A!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
1 r¥
r *¥ !=! (1!+" r *$ )!-!1!
1+r$
!
the!term" r *$ !in!this!equation!refers!to!
A)!!the!risk-free!rate!of!interest!on!the!dollar.!
B)!!the!risk-free!rate!of!interest!on!the!yen.!
C)!!the!cost!of!capital!for!the!firm!in!terms!of!yen.!
D)!!the!cost!of!capital!in!terms!of!dollars.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
1 r¥
r *¥ !=! (1!+" r *$ )!-!1!
1+r$
!
the!term!r$!in!this!equation!refers!to!
A)!!the!cost!of!capital!for!the!firm!in!terms!of!yen.!
B)!!the!cost!of!capital!in!terms!of!dollars.!
C)!!the!risk-free!rate!of!interest!on!the!dollar.!
D)!!the!risk-free!rate!of!interest!on!the!yen.!
Answer:!!!C!
B)!!
C)!!
D)!!
Diff:!1!
Skill:!Conceptual!
!
!
The!current!spot!exchange!rate,!S,!is!$1.8862/£.!!Suppose!that!the!yield!curve!in!both!countries!is!flat.!!The!risk-free!rate!on!
dollars,!r$,!is!5.35%!and!the!risk-free!interest!rat!on!pounds,!r£,!is!4.80%.!
!
6)!!Using!the!covered!interest!parity!condition,!the!calculated!one-year!forward!rate!F1!is!closest!to:!
A)!!$1.8568/£!
B)!!$1.8764/£!
C)!!$1.9161/£!
D)!!$1.8961/£!
Answer:!!!D!
B)!!
C)!!
D)!! 1 r$ 1.0535
F1!=!S!×! !=!$1.8862/£!×! !=!$1.8961/£!
1 r£ 1.0480
Diff:!1!
Skill:!Analytical!
!
7)!!Using!the!covered!interest!parity!condition,!the!calculated!three-year!forward!rate!F3!is!closest!to:!
A)!!$1.8568/£!
B)!!$1.9161/£!
C)!!$1.8961/£!
D)!!$1.8764/£!
Answer:!!!B!
B)!! (1 r$ )3 (1.0535)3
F3!=!S!×! !=!$1.8862/£!×! !=!$1.9161/£!
(1 r£ )3 (1.0480)3
C)!!
D)!!
Diff:!2!
Skill:!Analytical!
!
8)!!Luther!Industries,!a!U.S.!firm,!is!considering!an!investment!in!Japan.!!The!dollar!cost!of!equity!for!Luther!is!
12%.!!The!risk-free!interest!rates!on!dollars!and!yen!are!r$!=!5.5%!and!r¥!=!1.5%!respectively.!!Luther!industries!
is!willing!to!assume!that!capital!markets!are!internationally!integrated.!!Luther!Industries!needs!to!know!the!
comparable!cost!of!equity!in!Japanese!yen!for!a!project!with!free!cash!flows!that!are!uncorrelated!with!spot!
exchange!rates.!!The!yen!cost!of!equity!for!Luther!Industries!is!closest!to:!
A)!!14.0%!
B)!!12.3%!
C)!!7.8%!
D)!!18.5%!
Answer:!!!C!
B)!!
C)!! * 1 r¥ 1.015
r ¥ !=! (1!+" r *$ )!-!1!=! !(1.12)!-!1!=!.0775!or!7.75%!
1 r$ 1.055
!!
D)!!
Diff:!2!
Skill:!Analytical!
!
Use"the"information"for"the"question(s)"below.
!
Luther!Industries,!a!U.S.!Corporation,!is!considering!a!new!project!located!in!Great!Britain.!!The!expected!free!cash!flows!
from!the!project!are!detailed!below:!
!
Free(Cash(Flow(
Year (£(millions)(
0 -20!
1 10!
2 14!
3 18!
You!know!that!the!spot!exchange!rate!is!S!=!1.8862/£.!!In!addition,!the!risk-free!interest!rate!on!dollars!and!pounds!is!5.4%!
and!4.6%!respectively.!!Assume!that!these!markets!are!internationally!integrated!and!the!uncertainty!in!the!free!cash!flow!
is!not!correlated!with!uncertainty!in!the!exchange!rate.!!You!have!determined!that!the!dollar!WACC!for!these!cash!flows!is!
10.2%.!
!
9)!!Calculate!the!pound!denominated!cost!of!capital!for!Luthercs!project.!
Answer:!!! * 1 r£ 1.046
r £ !=! (1!+" r *$ )!-!1!=! (1.102)!-!1=!.093636!or!9.36%!
1 r$ 1.054
Diff:!2!
Skill:!Analytical!
!
10)!!What!is!the!pound!present!value!of!the!project?!
Answer:!!! * 1 r£ 1.046
r £ !=! (1!+" r *$ )!-!1!=! !(1.102)!-!1!=!.093636!or!9.36%!
1 r$ 1.054
10 14 18
NPV£!=!-20!+! !+! 2
!+! !=!£14.613!
1.0936 1.0936 1.09363
Diff:!2!
Skill:!Analytical!
!
11)!!What!is!the!dollar!present!value!of!the!project?!
Answer:!!! * 1 r£ 1.046
r £ !=! (1!+" r *$ )!-!1!=! (1.102)!-!1!=!.093636!or!9.36%!
1 r$ 1.054
10 14 18
NPV£!=!-20!+! !+! 2
!+! !=!£14.613!million!
1.0936 1.0936 1.09363
NPV$!=!NPV£!×!S!=!£14.613!×!1.8862/£!=!$27.562!million!
Diff:!3!
Skill:!Analytical!
31.3((Valuation(and(International(Taxation(
(
A)!!U.S.!tax!policy!requires!U.S.!corporations!to!pay!taxes!on!their!foreign!income!at!the!same!rate!as!profits!
earned!in!the!United!States.!
B)!!The!home!government!gets!an!opportunity!to!tax!the!income!from!a!foreign!project!to!the!domestic!firm.!
C)!!The!general!international!arrangement!prevailing!with!respect!to!taxation!of!corporate!profits!is!that!the!
home!country!gets!the!first!opportunity!to!tax!income.!
D)!!The!home!government!must!establish!a!tax!policy!specifying!its!treatment!of!foreign!income!and!foreign!
taxes!paid!on!that!income.!
Answer:!!!C!
B)!!
C)!!The!general!international!arrangement!prevailing!with!respect!to!taxation!of!corporate!profits!
is!that!the!host!country!gets!the!first!opportunity!to!tax!income!produced!within!its!borders.!
D)!!
Diff:!1!
Topic:!31.3!Valuation!and!International!Taxation!
Skill:!Conceptual!
!
A)!!If!the!foreign!tax!rate!exceeds!the!U.S.!tax!rate,!companies!must!pay!this!higher!rate!on!foreign!earnings.!
B)!!U.S.!tax!policy!allows!companies!to!apply!the!part!of!the!tax!credit!that!is!not!used!to!offset!domestic!
taxes!owed,!so!this!extra!tax!credit!is!not!wasted.!
C)!!If!the!foreign!tax!rate!is!less!than!the!U.S.!tax!rate,!the!company!pays!total!taxes!equal!to!the!U.S.!tax!rate!
on!its!foreign!earnings.!
D)!!A!full!tax!credit!is!given!for!foreign!taxes!paid!up!to"the!amount!of!the!U.S.!tax!liability.!
Answer:!!!B!
B)!!U.S.!tax!policy!does!not!allow!companies!to!apply!the!part!of!the!tax!credit!that!is!not!used!to!
offset!domestic!taxes!owed,!so!this!extra!tax!credit!is!wasted.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!If!the!U.S.!tax!rate!exceeds!the!combined!tax!rate!on!all!foreign!income,!it!is!valid!to!assume!that!the!firm!
pays!the!same!tax!rate!on!all!income!no!matter!where!it!is!earned.!
B)!!Firms!can!lower!their!taxes!by!pooling!multiple!foreign!projects!and!accelerating!the!repatriation!of!
earnings.!
C)!!Under!U.S.!tax!law,!multinational!corporations!may!use!any!excess!tax!credits!generated!in!high-tax!
foreign!countries!to!offset!their!net!U.S.!tax!liabilities!on!earnings!in!low-tax!foreign!countries.!
D)!!If!the!foreign!tax!rate!exceeds!the!U.S.!tax!rate,!because!the!U.S.!tax!credit!exceeds!the!amount!of!U.S.!
taxes!owed,!no!tax!is!owed!in!the!United!States.!
Answer:!!!B!
B)!!Firms!can!lower!their!taxes!by!pooling!multiple!foreign!projects!and!deferring!the!repatriation!
of!earnings.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!When!the!foreign!tax!rate!is!less!than!the!U.S.!tax!rate,!deferral!can!provide!significant!benefits.!
B)!!The!U.S.!tax!liability!is!not!incurred!until!the!profits!are!brought!back!home!if!the!foreign!operation!is!set!
up!as!a!foreign!branch!rather!than!as!a!separately!incorporated!subsidiary.!
C)!!If!a!company!chooses!not!to!repatriate!£12.5!million!in!pre-tax!earnings,!for!example,!it!effectively!
reinvests!those!earnings!abroad!and!defers!its!U.S.!tax!liability.!
D)!!When!the!foreign!tax!rates!exceed!the!U.S.!tax!rates,!there!are!no!benefits!to!deferral!because!in!such!a!
case!there!is!no!additional!U.S.!tax!liability.!
Answer:!!!B!
B)!!The!U.S.!tax!liability!is!not!incurred!until!the!profits!are!brought!back!home!if!the!foreign!
operation!is!set!up!as!a!separately!incorporated!subsidiary!rather!than!as!a!foreign!branch.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!Other!benefits!from!deferral!arise!because!the!firm!effectively!gains!a!real!option!to!repatriate!income!at!
times!when!repatriation!might!be!cheaper.!
B)!!By!pooling!foreign!income,!the!firm!effectively!pays!the!combined!tax!rate!on!all!foreign!income.!
C)!!In!years!in!which!the!U.S.!tax!rate!exceeds!the!combined!tax!rate!on!all!foreign!income,!the!repatriation!
of!additional!income!does!not!incur!an!additional!U.S.!tax!liability,!so!the!earnings!can!be!repatriated!tax!
free.!
D)!!Deferring!repatriation!of!earnings!lowers!the!overall!tax!burden!in!much!the!same!way!as!deferring!
capital!gains!lowers!the!tax!burden!imposed!by!the!capital!gains!tax.!
Answer:!!!C!
B)!!
C)!!In!years!in!which!the!combined!tax!rate!on!all!foreign!income!exceeds!the!U.S.!tax!rate,!the!
repatriation!of!additional!income!does!not!incur!an!additional!U.S.!tax!liability,!so!the!
earnings!can!be!repatriated!tax!free.!
D)!!
Diff:!3!
Skill:!Conceptual!
!
Use"the"information"for"the"question(s)"below.
KT!Enterprises,!a!U.S.!import-export!trading,!is!considering!its!international!tax!situation.!!Currently!KT!is!U.S.!tax!rate!is!
35%.!!KT!has!significant!operations!in!both!Japan!and!Ireland.!!In!Japan!the!current!exchange!rate!is!¥118.4/$!and!earnings!
in!Japan!are!taxed!at!41%.!!In!Ireland!the!current!exchange!rate!is!$1.27/€!and!earnings!in!Ireland!are!taxed!at!12.5%.!!KTcs!
profits,!which!are!fully!and!immediately!repatriated,!and!foreign!taxes!paid!for!the!current!year!are!shown!here!(in!
millions):
Japan Ireland(
Earnings!before!interest!and!taxes!(EBIT) ¥5,920 €32!
Host!country!taxes!paid ¥2,427 €4!
Earnings!before!interest!after!taxes ¥3,493 €28!
!
6)!!After!the!Japanese!taxes!are!paid,!the!amount!of!the!earnings!before!interest!and!after!taxes!in!dollars!from!the!
Japanese!operations!is!closest!to:!
A)!!$20.5!million!
B)!!$29.5!million!
C)!!$5.1!million!
D)!!$50.0!million!
Answer:!!!B!
B)!! ? ,493
!=!$29.50!million!
? 18,4/$
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
7)!!After!the!Irish!taxes!are!paid,!the!amount!of!the!earnings!before!interest!and!after!taxes!in!dollars!from!the!
Ireland!operations!is!closest!to:!
A)!!$5.1!million!
B)!!$20.5!million!
C)!!$35.6!million!
D)!!$29.5!million!
Answer:!!!D!
B)!!
C)!!€28!million!×!$1.27/€!=!$35.56!
D)!!
Diff:!1!
Skill:!Analytical!
!
8)!!The!amount!of!the!taxes!paid!in!dollars!for!the!Japanese!operations!is!closest!to:!
A)!!$29.5!million!
B)!!$5.1!million!
C)!!$50.0!million!
D)!!$20.5!million!
Answer:!!!D!
B)!!
C)!!
D)!! ? ,427
!=!$20.5!million!
? 18,4/$
Diff:!1!
Skill:!Analytical!
!
9)!!The!amount!of!the!taxes!paid!in!dollars!for!the!Irish!operations!is!closest!to:!
A)!!$20.5!million!
B)!!$5.1!million!
C)!!$29.5!million!
D)!!$50.0!million!
Answer:!!!B!
B)!!€4!million!×!$1.27/€!=!$5.08!million!
C)!!
D)!!
Diff:!1!
Skill:!Analytical!
!
10)!!Luther!Industries,!a!U.S.!firm.!has!a!subsidiary!in!the!United!Kingdom.!!This!year,!the!subsidiary!reported!and!
repatriated!earnings!before!interest!and!taxes!(EBIT)!of!£45!million.!!The!current!exchange!rate!is!$1.86/£.!!The!
tax!rate!in!the!U.K.!for!this!activity!is!28%.!!!Under!U.S.!tax!codes,!Luther!is!facing!a!35%!corporate!tax!rate!on!
their!earnings.!!What!is!Luthercs!U.S.!tax!liability!on!its!U.K.!subsidiary?!
Answer:!!!When!the!foreign!tax!rate!is!below!the!U.S.!tax!rate!the!firm!is!only!responsible!for!the!difference!in!the!
tax!rates,!so!Luther!will!only!be!taxed!at!a!rate!of!7%!on!the!£45!million.!
!
Tax!U.S.!=!£45!×!.07!=!£3,150,000!×!$1.86/£!=!$5,859,000.!
Diff:!2!
Skill:!Analytical!
!
31.4((Internationally(Segmented(Capital(Markets(
(
A)!!In!some!countries,!especially!in!the!developing!world,!all!investors!do!not!have!equal!access!to!financial!
securities.!
B)!!Firms!may!face!differential!access!to!markets!if!there!is!any!kind!of!asymmetry!with!respect!to!
information!about!them.!
C)!!In!some!cases,!a!countrycs!risk-free!securities!are!internationally!integrated!but!markets!for!a!specific!
firmcs!securities!are!not.!
D)!!When!countriesc!capital!markets!are!not!integrated!we!call!them!disintegrated!capital!markets.!
Answer:!!!D!
B)!!
C)!!
D)!!When!countriesc!capital!markets!are!not!integrated!we!call!them!segmented!capital!markets.!
Diff:!1!
Topic:!31.4!Internationally!Segmented!Capital!Markets!
Skill:!Conceptual!
!
A)!!Differential!access!to!national!capital!markets!is!common!enough!that!it!provides!the!best!explanation!
for!the!existence!of!currency!swaps,!which!are!like!the!interest!rate!swap!contracts,!but!with!the!holder!
receiving!coupons!in!one!currency!and!paying!coupons!denominated!in!a!different!currency.!
B)!!Currency!swaps!generally!also!have!final!face!value!payments,!also!in!different!currencies.!
C)!!Using!a!currency!swap,!a!firm!can!borrow!in!the!market!where!it!has!the!best!access!to!capital,!and!then!
hswaph!the!coupon!and!principal!payments!to!whichever!currency!it!would!prefer!to!make!payments!in.!
D)!!With!differential!access!to!national!markets,!to!maximize!shareholder!value,!the!firm!should!raise!capital!
in!the!foreign!market;!the!method!of!valuing!the!foreign!project!as!if!it!were!a!domestic!project!would!
then!provide!the!correct!NPV.!
Answer:!!!D!
B)!!
C)!!
D)!!With!differential!access!to!national!markets,!to!maximize!shareholder!value,!the!firm!should!
raise!capital!at!home;!the!method!of!valuing!the!foreign!project!as!if!it!were!a!domestic!project!
would!then!provide!the!correct!NPV.!
Diff:!2!
Skill:!Conceptual!
A)!!Many!countries!regulate!or!limit!capital!inflows!or!outflows,!and!many!do!not!allow!their!currencies!to!
be!freely!converted!into!dollars,!thereby!creating!capital!market!segmentation.!
B)!!The!existence!of!internationally!integrated!capital!markets!makes!many!decisions!in!international!
corporate!finance!more!complicated!but!potentially!more!lucrative!for!a!firm!that!is!well!positioned!to!
exploit!the!market!segmentation.!
C)!!Political,!legal,!social,!and!cultural!characteristics!that!differ!across!countries!may!require!compensation!
in!the!form!of!a!country!risk!premium.!
D)!!Swaps!allow!firms!to!mitigate!their!exchange!rate!risk!exposure!between!assets!and!liabilities,!while!still!
making!investments!and!raising!funds!in!the!most!attractive!locales.!
Answer:!!!B!
B)!!The!existence!of!segmented!capital!markets!makes!many!decisions!in!international!corporate!
finance!more!complicated!but!potentially!more!lucrative!for!a!firm!that!is!well!positioned!to!
exploit!the!market!segmentation.!
C)!!
D)!!
Diff:!2!
Skill:!Conceptual!
!
A)!!The!rate!of!interest!paid!on!government!bonds!or!other!securities!in!a!country!with!a!tradition!of!weak!
enforcement!of!property!rights!is!likely!not!really!a!risk-free!rate.!Instead,!interest!rates!in!the!country!
will!reflect!a!risk!premium!for!the!possibility!of!default,!so!relations!such!as!covered!interest!rate!parity!
will!likely!not!hold!exactly.!
B)!!If!the!return!difference!in!a!segmented!financial!market!results!from!a!market!friction!such!as!capital!
controls,!corporations!can!exploit!this!friction!by!setting!up!projects!and!raising!capital!in!the!
high-return!country/currency.!
C)!!Important!macroeconomic!reasons!for!segmented!capital!markets!include!capital!controls!and!foreign!
exchange!controls!that!create!barriers!to!international!capital!flows!and!thus!segment!national!markets.!
D)!!A!segmented!financial!market!has!an!important!implication!for!international!corporate!finance:!One!
country!or!currency!has!a!higher!rate!of!return!than!another!country!or!currency,!when!the!two!rates!are!
compared!in!the!same!currency.!
Answer:!!!B!
B)!!If!the!return!difference!in!a!segmented!financial!market!results!from!a!market!friction!such!as!
capital!controls,!corporations!can!exploit!this!friction!by!setting!up!projects!in!the!high-return!
country/currency!and!raising!capital!in!the!low-return!country/currency.!
C)!!
D)!!
Diff:!3!
Skill:!Conceptual!
!
5)!!Suppose!the!interest!rate!on!Russian!government!bonds!is!7.8%,!and!the!current!exchange!rate!is!26.8!rubles!
per!dollar.!!If!the!forward!exchange!rate!is!27.2!rubles!per!dollar,!and!the!current!U.S.!risk-free!interest!rate!is!
4.6%,!what!is!the!implied!credit!spread!for!the!Russian!government!bonds?!
Answer:!!!R100,000
!×!1.046!×!R27.2/$!=!R106,161!
R26.8/$
R106,161
So,!true!ruble!risk-free!rate!=! !-!1!=!6.161%!
R100,000
The!risk!premium!=!7.8%!-!6.161%!=!1.639%!
Diff:!2!
Skill:!Analytical!
!
31.5((Capital(Budgeting(with(Exchange(Risk(
(
1)!!What!conditions!cause!the!cash!flows!of!a!foreign!project!to!be!affected!by!exchange!rate!risk?!
Answer:!!!The!working!assumptions!made!thus!far!in!are!that!the!projectcs!free!cash!flows!are!uncorrelated!with!
the!spot!exchange!rates.!Such!an!assumption!often!makes!sense!if!the!firm!operates!as!a!local!firm!in!the!
foreign!market—it!purchases!its!inputs!and!sells!its!outputs!in!that!market,!and!price!changes!of!the!
inputs!and!outputs!are!uncorrelated!with!exchange!rates.!However,!many!firms!use!imported!inputs!in!
their!production!processes!or!export!some!of!their!output!to!foreign!countries.!These!scenarios!alter!the!
nature!of!a!projectcs!foreign!exchange!risk!and,!in!turn,!change!the!valuation!of!the!foreign!currency!
cash!flows.!
Diff:!2!
Topic:!31.5!Capital!Budgeting!with!Exchange!Risk!
Skill:!Conceptual!
!
2)!!How!do!we!make!adjustments!when!a!project!has!inputs!and!outputs!in!different!currencies?!
Answer:!!!Whenever!a!project!has!cash!flows!that!depend!on!the!values!of!multiple!currencies,!the!most!
convenient!approach!is!to!separate!the!cash!flows!according!to!the!currency!they!depend!on.!
Diff:!2!
Topic:!31.5!Capital!Budgeting!with!Exchange!Risk!
Skill:!Conceptual!
!
!

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Corporate(Finance!(Berk/DeMarzo)!

Price!per!share $16 $15!

StockholdersN!Equity 126.6 63.6!

Stockholders’!Equity 126.6 63.6!

Investment Rate Compounding!

Term 1!year 2!years 3!years 5!years 10!years 20!years!

Year!0 Year!1 Year!2 Year!3 Year!4 Discount!

Year One Year!Two Year!Three Year!Four!

Year!0 Year!1 Year!2 Year!3 Year!4 Year!5 Year!6 Year!7 Discount

Year!0 Year!1 Year!2 Year!3 Year!4 Discount!

Year!0 Year!1 Year!2 Year!3 Year!4 Year!5 Year!6 Year!7 Discount

Year One Year!Two Year!Three Year!Four!

Year!0 Year!1 Year!2 Year!3 Year!4 Discount!

Year!0 Year!1 Year!2 Year!3 Year!4 Year!5 Year!6 Year!7 Discount

Project C/F0 C/F1 C/F2 C/F3 C/F4 C/F5 C/F6!

B!-!A ($5,560) $2,500! $1,000! ($1,500) ($3,000) ($5,000) $15,000!!

B!-!A ($5,560) $2,500! $1,000! ($1,500) ($3,000) ($5,000) $15,000!!

Year!0 Year!1 Year!2 Year!3 Year!4 Discount!

Project Investment NPV!

Year One Year!Two Year!Three Year!Four!

WalVerde!Drugs 6,000 147,000 24.5 1!

WalVerde!Drugs 6,000 147,000 24.5 1!

WalVerde!Drugs 6,000 147,000 24.5 1!

Project Investment NPV!

PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

PV!of!FCF!(FCF$/!(1!+!I)n -90,000 33,929 30,293 37,724!

Free!Cash!Flow -125,000 53,582 58,447 58,471!

PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

PV!of!FCF!(FCF/(1!+!I)n) -90,000 33,929 30,293 37,724!

PV!of!FCF!(FCF/(1!+!I)n) -90,000 31,027 27,702 35,411!

PV!of!FCF!(FCF/(1+I)n) -90,000 36,830 32,884 40,038!

Bond Years!to!maturity Coupon YTM!

Bond Years!to!maturity Coupon YTM!

Rating AAA AA A BBB BB!

Div1 Div2 P2 1.40 1.50 25.00

Div1 Div2 P2 1.40 1.50 25.00

Div1 Div2 P2 1.40 1.50 25.00

Current!Stock! Stock!Price!in! Probability!

SD(R)!=! Var ( R) !=!! .0475 =!.2179!or!21.79%!

Date Price!($) Dividend!($)!

Standard!deviation!=! Variance !=! 0.0378346 !=!0.1945112

=!! 10 3.232227 -!1!=!1.124476!-!1!=!0.124476!

Date Price!($) Dividend!($)!

Standard!deviation(all!drugs)!=!SD(one!drug)!/! number of drugs !=!50!/!! 10 =!15.81!million!

Variance!= 0.125447467 0.177795367

Variance!= 0.125447467 0.177795367

Variance!= 0.125447467 0.177795367

Variance!= 0.125447467 0.177795367

Variance!= 0.125447467 0.177795367

Variance!= 0.125447467 0.032239975

Variance!= 0.125447467 0.032239975

Variance!= 0.125447467 0.032239975

Variance!= 0.125447467 0.032239975

Duke Microsoft Wal-Mart%

Variance!= 0.177795367 0.032239975

Variance!= 0.177795367 0.032239975

Variance!= 0.177795367 0.032239975

Duke Microsoft Wal-Mart%

C)!!Variance!of!a!portfolio!=! xiCov( Ri, Rp )

stdev%=! .192 !=!.438!

Var%=!(1/20)(.35)2!!+!(1!-!1!/!20)(.4)( .35 )( .35 )!

stdev!=! .139125 !=!.372995!