SCHOOL OF BANKING AND FINANCE FINS1613 BUSINESS FINANCE PRACTICE QUESTIONS Note – in some of these questions it may be possible to use tables instead of calculating the values directly. 1. What is the corporate objective? a. To maximise capital b. To maximise shareholder wealth c. To minimise capital d. To minimise shareholder wealth e. To minimise shareholder risk 2. Which of the following actions are likely to reduce agency conflicts between stockholders and managers? a. Paying managers a large fixed salary. b. Increasing the threat of corporate takeover. c. Placing restrictive covenants in debt agreements. d. All of the statements above are correct. e. Statements b and c are correct. 3. Which of the following statements is most correct? a. The proper goal of the financial manager should be to maximize the firm's expected cash flow, because this will add the most wealth to each of the individual shareholders (owners) of the firm. b. One way to state the decision framework most useful for carrying out the firm's objective is as follows: "The financial manager should seek that combination of assets, liabilities, and capital that will generate the largest expected projected after-tax income over the relevant time horizon." c. The riskiness inherent in a firm's earnings per share (EPS) depends on the characteristics of the projects the firm selects, which means it depends upon the firm's assets, but EPS does not depend on the manner in which those assets are financed. d. Since large, publicly-owned firms are controlled by their management teams, and typically, ownership is widely dispersed, managers have great freedom in managing the firm. Managers may operate in stockholders' best interests, but they may also operate in their own personal best interests. As long as managers stay within the law, there simply aren't any effective controls over managerial decisions in such situations.

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e. Agency problems exist between stockholders and managers, and between stockholders and creditors. 4. Which of the following statements is most correct? a. A 5-year $100 annuity due will have a higher present value than a 5-year $100 ordinary annuity. b. A 15-year mortgage will have larger monthly payments than a 30-year mortgage of the same amount and same interest rate. c. If an investment pays 10 percent interest compounded annually, its effective rate will also be 10 percent. d. Statements a and c are correct. e. All of the statements above are correct. 5. Which of the following investments will have the highest future value at the end of 5 years? Assume that the effective annual rate for all investments is the same. a. A pays $50 at the end of every 6-month period for the next 5 years (a total of 10 payments). b. B pays $50 at the beginning of every 6-month period for the next 5 years (a total of 10 payments). c. C pays $500 at the end of 5 years (a total of one payment). d. D pays $100 at the end of every year for the next 5 years (a total of 5 payments). e. E pays $100 at the beginning of every year for the next 5 years (a total of 5 payments). 6. Your bank account pays an 8 percent nominal rate of interest. The interest is compounded quarterly. Which of the following statements is most correct? a. The periodic rate of interest is 2 percent and the effective rate of interest is 4 percent. b. The periodic rate of interest is 8 percent and the effective rate of interest is greater than 8 percent. c. The periodic rate of interest is 4 percent and the effective rate of interest is 8 percent. d. The periodic rate of interest is 8 percent and the effective rate of interest is 8 percent. e. The periodic rate of interest is 2 percent and the effective rate of interest is greater than 8 percent. 7. Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary (or deferred) annuity, the other is an annuity due. Which of the following statements is most correct? a. The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due. b. The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity. c. The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity. d. If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same. e. Statements a and d are correct. 8. You deposited $1,000 in a savings account that pays 8 percent interest, compounded quarterly, planning to use it to finish your last year in college. Eighteen months later, you decide to go to the

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Rocky Mountains to become a ski instructor rather than continue in school, so you close out your account. How much money will you receive? a. $1,171 b. $1,126 c. $1,082 d. $1,163 e. $1,008 9. You have the opportunity to buy a perpetuity that pays $1,000 annually. Your required rate of return on this investment is 15 percent. You should be essentially indifferent to buying or not buying the investment if it were offered at a price of a. $5,000.00 b. $6,000.00 c. $6,666.67 d. $7,500.00 e. $8,728.50 10. Assume that you will receive $2,000 a year in Years 1 through 5, $3,000 a year in Years 6 through 8, and $4,000 in Year 9, with all cash flows to be received at the end of the year. If you require a 14 percent rate of return, what is the present value of these cash flows? a. $ 9,851 b. $13,250 c. $11,714 d. $15,129 e. $17,353 11. If a 5-year ordinary annuity has a present value of $1,000, and if the interest rate is 10 percent, what is the amount of each annuity payment? a. $240.42 b. $263.80 c. $300.20 d. $315.38 e. $346.87 12. Gomez Electronics needs to arrange financing for its expansion program. Bank A offers to lend Gomez the required funds on a loan in which interest must be paid monthly, and the annual rate is 8 percent. Bank B will charge 9 percent, with interest due at the end of the year. What is the difference in the effective annual rates charged by the two banks? a. 0.25% b. 0.50% c. 0.70% d. 1.00% e. 1.25% 13. Bill plans to deposit $200 into a bank account at the end of every month. The bank account has a nominal interest rate of 8 percent and interest is compounded monthly. How much will Bill have in the account at the end of 2 and a half years (30 months)? a. $ 6,617.77 b. $ 502.50 c. $ 6,594.88

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d. $22,656.74 e. $ 5,232.43 14. You have been offered an investment that pays $500 at the end of every 6 months for the next 3 years. The nominal interest rate is 12 percent; however, interest is compounded quarterly. What is the present value of the investment? a. $2,458.66 b. $2,444.67 c. $2,451.73 d. $2,463.33 e. $2,437.56 15. You just put $1,000 in a bank account that pays 6 percent nominal annual interest, compounded monthly. How much will you have in your account after 3 years? a. $1,006.00 b. $1,056.45 c. $1,180.32 d. $1,191.00 e. $1,196.68 16. You plan to invest $5,000 at the end of each of the next 10 years in an account that has a 9 percent nominal rate with interest compounded monthly. How much will be in your account at the end of the 10 years? a. $ 75,965 b. $967,571 c. $ 84,616 d. $ 77,359 e. $ 80,631 17. Assume that a 10-year bond has a 12 percent annual coupon, while a 15-year bond has an 8 percent annual coupon. The yield curve is flat; all bonds have a 10 percent yield to maturity. Which of the following statements is most correct? a. The 10-year bond is selling at a discount, while the 15-year bond is selling at a premium. b. The 10-year bond is selling at a premium, while the 15-year bond is selling at par. c. If interest rates decline, the price of both bonds will increase, but the 15-year bond will have a larger percentage increase in price. d. If the yield to maturity on both bonds remains at 10 percent over the next year, the price of the 10-year bond will increase, but the price of the 15-year bond will fall. e. Statements c and d are correct. 18. A 12-year bond has an annual coupon rate of 9 percent. The coupon rate will remain fixed until the bond matures. The bond has a yield to maturity of 7 percent. Which of the following statements is most correct? a. The bond is currently selling at a price below its par value. b. If market interest rates decline today, the price of the bond will also decline today. c. If market interest rates remain unchanged, the bond's price one year from now will be lower than it is today. d. All of the statements above are correct. e. None of the statements above is correct.

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19. A bond with 6 years to maturity and sells at par has an 8 percent semi-annual coupon (that is, the bond pays a $40 coupon every six months). Another bond of equal risk and maturity pays 8 percent interest annually. Both bonds are non-callable and have face values of $1,000. What is the price of the bond that pays annual interest? a. $689.08 b. $712.05 c. $980.43 d. $986.72 e. $992.64 20. What annually compounded rate is equivalent to an interest rate of 12% compounded monthly? a. 12.36 b. 12.55 c. 12.68 d. 12.73 e. 12.75 21. A stock's dividend is expected to grow at a constant rate of 5 percent a year. Which of the following statements is most correct? a. The expected return on the stock is 5 percent a year. b. The stock's dividend yield is 5 percent. c. The stock's price one year from now is expected to be 5 percent higher. d. Statements a and c are correct. e. All of the statements above are correct. You are given the following information Bridges & Associates. Use this information for the next two questions, numbers 22 and 23. Bridges & Associates' stock is expected to pay a $0.75 per-share dividend at the end of the year. The dividend is expected to grow 25 percent the next year and 35 percent the following year. After t = 3, the dividend is expected to grow at a constant rate of 6 percent a year. The company's cost of common equity is 10 percent and it is expected to remain constant. 22. Refer to Bridges & Associates. What is the expected price of the stock today? a. $18.75 b. $27.61 c. $30.77 d. $34.50 e. $35.50 23. Refer to Bridges & Associates. What is the expected price of the stock 10 years from today? a. $47.58 b. $49.45 c. $50.43 d. $53.46 e. $55.10 24. Next year, ABC group will have earnings per share of $4. It expects to plowback 60% of its earnings to fund new projects which offer a return on equity of 20%. If its required return is 16%, what should be its current stock price? a. $10

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b. $20 c. $30 d. $40 e. $50 25. Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct? a. All else equal, a project's IRR increases as the cost of capital declines. b. All else equal, a project's NPV increases as the cost of capital declines. c. All else equal, a project's MIRR is unaffected by changes in the cost of capital. d. Statements a and b are correct. e. Statements b and c are correct. 26. Sacramento Paper is considering two mutually exclusive projects. Project A has an internal rate of return (IRR) of 12 percent, while Project B has an IRR of 14 percent. The two projects have the same risk, and when the cost of capital is 7 percent the projects have the same net present value (NPV). Assume each project has an initial cash outflow followed by a series of inflows. Given this information, which of the following statements is most correct? a. If the cost of capital is 13 percent, Project B's NPV will be higher than Project A's NPV. b. If the cost of capital is 9 percent, Project B's NPV will be higher than Project A's NPV. c. If the cost of capital is 9 percent, Project B's modified internal rate of return (MIRR) will be less than its IRR. d. Statements a and c are correct. e. All of the statements above are correct. 27. Two projects being considered by a firm are mutually exclusive and have the following projected cash flows: Year Project A Cash Flow Project B Cash Flow 0 -$100,000 -$100,000 1 39,500 0 2 39,500 0 3 39,500 133,000 Based only on the information given, which of the two projects would be preferred, and why? a. Project A, because it has a higher IRR. b. Project B, because it has a higher IRR. c. Indifferent, because the projects have equal IRRs. d. Include both in the capital budget, since the sum of the cash inflows exceeds the initial investment in both cases. e. Choose neither, since their NPVs are negative. You are given the following information Garcia Paper. Use this information for the next four questions, numbers 28, 29, 30 and 31. Garcia Paper is deciding whether to build a new plant. The proposed project would have an upfront cost (at t = 0) of $30 million. The project's cost can be depreciated on a straight-line basis over three years. Consequently, the depreciation expense will be $10 million in each of the first three years, t = 1, 2, and 3. Even though the project is depreciated over three years, the project has an economic life of five years. The project is expected to increase the company's sales by $20 million. Sales will remain at this higher level for each year of the project (t = 1, 2, 3, 4, and 5). The operating costs, not including

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depreciation, equal 60 percent of the increase in annual sales. The project's interest expense is $5 million per year and the company's tax rate is 40 percent. The company is very profitable, so any accounting losses on this project can be used to reduce the company's overall tax burden. The project does not require any additions to net operating working capital. The company estimates that the project's after-tax salvage value at t = 5 will be $1.2 million. The project is of average risk, and, therefore, the CFO has decided to discount the operating cash flows at the company's overall weighted average cost of capital of 10 percent. However, the salvage value is more uncertain, so the CFO has decided to discount it at 12 percent. 28. Refer to Garcia Paper. What is the operating cash flows in year 1? a. $2.4 million b. $3.2 million c. $4.8 million d. $6.0 million e. $8.8 million 29. Refer to Garcia Paper. What is the operating cash flows in year 5? a. $2.4 million b. $3.2 million c. $4.8 million d. $6.0 million e. $8.8 million 30. Refer to Garcia Paper. What is the present value of the project’s after-tax salvage value? a. $0.4272 million b. $0.6809 million c. $0.7451 million d. $1.2 million e. $2.4 million 31. Refer to Garcia Paper. What is the net present value (NPV) of the entire proposed project? a. $11.86 million b. $14.39 million c. -$26.04 million d. -$12.55 million e. -$ 1.18 million You are given the following information Bucholz Brands. Use this information for the next two questions, numbers 32 and 33. Bucholz Brands is considering the development of a new ketchup product. The ketchup will be sold in a variety of different colours and will be marketed to young children. In evaluating the proposed project, the company has collected the following information: • The company estimates that the project will last for four years. • The company will need to purchase new machinery that has an up-front cost of $300 million (incurred at t = 0). At t = 4, the machinery has an estimated salvage value of $50 million. • The machinery will be depreciated on a 4-year straight-line basis. • Production on the new ketchup product will take place in a recently vacated facility that the company owns. The facility is empty and Bucholz does not intend to lease the facility. • The project will require a $60 million increase in inventory at t = 0. The company expects that its accounts payable will rise by $10 million at t = 0. After t = 0, there will be no changes in

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net operating working capital, until t = 4 when the project is completed, and the net operating working capital is completely recovered. • The company estimates that sales of the new ketchup will be $200 million each of the next four years. • The operating costs, excluding depreciation, are expected to be $100 million each year. • The company's tax rate is 40 percent. • The project's WACC is 10 percent. 32. Refer to Bucholz Brands. What is the project's after-tax operating cash flow the first year (t = 1)? a. $22.5 million b. $45.0 million c. $60.0 million d. $72.5 million e. $90.0 million 33. Refer to Bucholz Brands. What is the project's estimated net present value (NPV)? a. -$10.07 million b. -$25.92 million c. -$46.41 million d. -$60.07 million e. +$ 5.78 million 34. Whalen Maritime Research Inc. regularly takes real options into account when evaluating its proposed projects. Specifically, Whalen considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option). In addition, it usually evaluates whether it makes sense to invest in a project today or whether to wait to collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is most correct? a. The abandonment option tends to reduce a project's NPV. b. The abandonment option tends to reduce a project's risk. c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project. d. Statements a and b are correct. e. All of the statements above are correct. You are given the following information Diplomat.com. Use this information for the next two questions, numbers 35 and 36. Diplomat.com is considering a project that has an up-front cost of $3 million and produces an expected cash flow of $500,000 at the end of each of the next five years. The project's cost of capital is 10 percent. 35. Refer to Diplomat.com. Based on this information what is the project's net present value? a. -$ 875,203 b. -$ 506,498 c. $ 54,307 d. -$1,104,600 e. $ 105,999

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36. Refer to Diplomat.com. If Diplomat goes ahead with this project today, the project will create additional opportunities five years from now (t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information that is available today, the company estimates that there is a 35 percent chance that its technology will be successful, in which case the future investment opportunities will have a net present value of $6 million at t = 5. There is a 65 percent chance that its technology will not succeed, in which case the future investment opportunities will have a net present value of -$6 million at t = 5. Diplomat.com does not have to decide today whether it wants to pursue these additional opportunities. Instead, it can wait until after it finds out if its technology is successful. However, Diplomat.com cannot pursue these additional opportunities in the future unless it makes the initial investment today. What is the estimated net present value of the project, after taking into account the future opportunities? a. $ 199,342 b. $ 561,947 c. $ 898,205 d. -$1,104,600 e. -$2,222,265 37. Dumpty Inc is comparing the operating costs of two types of equipment  Model A costs $50,000 and will have a useful life of 4 years. Operating costs are expected to be $4,000 per year.  Model B costs $90,000 and will have a useful life of 6 years. Its operating costs are expected to be $2,500 per year. Both models will be able to operate at the same level and quality of output and generate the same cash flows. The applicable discount rate is 8 percent. What annual cost saving will Dumpty achieve if it purchases the cheaper model? a. $ 38.31 b. $ 410.30 c. $2,872.14 d. $3,665.34 e. $6,127.39 38. Which of the following statements is most correct? (Assume that the risk-free rate remains constant.) a. If the market risk premium increases by 1 percentage point, then the required return on all stocks will rise by 1 percentage point. b. If the market risk premium increases by 1 percentage point, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. c. If the market risk premium increases by 1 percentage point, then the required return will increase by 1 percentage point for a stock that has a beta equal to 1.0. d. Statements a and c are correct. e. None of the statements above is correct. 39. Stock X has a beta of 0.5 and stock Y has a beta of 1.5. Which of the following statements is most correct? a. Stock Y’s return this year will be higher than stock X’s return. b. Stock Y’s return has a higher standard deviation than stock X. c. If expected inflation increases (but the market risk premium is unchanged), the required returns on the two stocks will increase by the same amount.

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d. If the market risk premium declines (leaving the risk-free rate unchanged), stock X will have a larger decline in its required return than will stock Y. e. If you invest $50,000 in stock X and $50,000 in stock Y, your portfolio will have a beta less than 1.0, provided the stock returns on the two stocks are not perfectly correlated. 40. Which of the following is not a difficulty concerning beta and its estimation? a. Sometimes a security or project does not have a past history that can be used as a basis for calculating beta. b. Sometimes, during a period when the company is undergoing a change such as toward more leverage or riskier assets, the calculated beta will be drastically different than the “true” or “expected future” beta. c. The beta of an “average stock” or “the market” can change over time, sometimes drastically. d. Sometimes the past data used to calculate beta do not reflect the likely risk of the firm for the future because conditions have changed. 41. A money manager is holding a $10 million portfolio that consists of the following five stocks: Stock Amount Invested A $4 million B 2 million C 2 million D 1 million E 1 million

Beta 1.2 1.1 1.0 0.7 0.5

The portfolio has a required return of 11 percent, and the market risk premium (k M – k R F ) is 5 percent. What is the required return on Stock C? a. 7.2% b. 10.0% c. 10.9% d. 11.0% e. None of these answers 42. A money manager is holding the following portfolio: Stock Amount Invested Beta 1 $300,000 0.6 2 300,000 1.0 3 500,000 1.4 4 500,000 1.8 The risk-free rate is 6 percent and the portfolio’s required rate of return is 12.5 percent. The manager would like to sell all of her holdings of Stock 1 and use the proceeds to purchase more shares of Stock 4. What would be the portfolio’s required rate of return following this change? a. 13.63% b. 10.29% c. 11.05% d. 12.52% e. 14.33% 43. An analyst has estimated how a particular stock’s return will vary depending on what will happen to the economy

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State of economy Prob. of occurring E(r) if the state occurs Recession 0.1 -60% Below average 0.2 -10% Average 0.4 15% Above average 0.2 40% Boom 0.1 90% What is the coefficient of variation (defined to be the standard deviation divided by the expected value) on the company’s stock? a. 2.121 b. 2.201 c. 2.472 d. 3.334 e. 3.727 44. Which of the following statements is most correct? a. If a company’s tax rate increases but the yield to maturity of its noncallable bonds remains the same, the company’s marginal cost of debt capital used to calculate its weighted average cost of capital will fall. b. All else equal, an increase in a company’s stock price will increase the marginal cost of retained earnings, ks. c. All else equal, an increase in a company’s stock price will increase the marginal cost of issuing new common equity, ke. d. Statements a and b are correct. e. Statements b and c are correct. 45. Which of the following statements is most correct? a. In the weighted average cost of capital calculation, we must adjust the cost of preferred stock for the tax exclusion of 70% of dividend income. b. We ideally would like to use historical measures of the component costs from prior financings in estimating the appropriate WACC. c. The cost of a new equity issuance could possibly be lower than the cost of retained earnings if the market risk premium and risk-free rate decline by a substantial amount. d. Statements b and c are correct. e. None of the statements above is correct. 46. The Barabas Company has an equal amount of low-risk projects, average-risk projects, and high-risk projects. Barabas estimates that the overall company’s WACC is 12%. This is also the correct cost of capital for the company’s average-risk projects. The company’s CFO argues that, even though the company’s projects have different risks, the cost of capital for each project should be the same because the company obtains its capital from the same sources. If the company follows the CFO’s advice, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. The company will take on too many high-risk projects and reject too many low-risk projects. c. Things will generally even out over time, therefore the risk of the firm should remain constant over time. d. Statements a and c are correct. e. Statements b and c are correct.

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47. Halls Corp. wants to calculate its WACC. The company’s CFO has collected the following information: The company’s long-term bonds currently offer a yield to maturity of 8%. The company’s stock price is $32 per share. The company’s recently paid a dividend of $2 per share. The dividend is expected to grow at a constant rate of 6% per year. The company pays 10% flotation cost whenever it issues new common stock. The company’s target capital structure is 75% equity and 25% debt. The company’s tax rate is 40%. The firm will be able to use retained earnings to fund the equity portion of its capital budget. What is the company’s WACC? a. 10.67% b. 11.22% c. 11.47% d. 12.02% e. 12.56% 48. Assume you are the director of capital budgeting for an all-equity firm. The firm’s current cost of equity is 16%. The risk-free rate and the market risk premium are 10% and 5% respectively. You are considering a new project that has 50% more beta risk than your firm’s assets currently have. The expected return on the new project is 18%. Should the project be accepted if beta risk is the appropriate measure? a. Yes, its expected return is greater than the firm’s cost of capital. b. Yes, the project’s risk-adjusted required return is less than its expected return. c. No, a 50% increase in beta risk gives risk-adjusted required return of 24%. d. No, the projects risk-adjusted required return is 2% above its expected return. e. No, the projects risk-adjusted required return is 1% above its expected return. 49. Jones Co. currently is 100 percent equity financed. The company is considering changing its capital structure. More specifically, Jones' CFO is considering a recapitalization plan in which the firm would issue long-term debt with a yield of 9 percent and use the proceeds to repurchase common stock. The recapitalization would not change the company's total assets nor would it affect the company's basic earning power, which is currently 15 percent. The CFO estimates that the recapitalization will reduce the company's WACC and increase its stock price. Which of the following is also likely to occur if the company goes ahead with the planned recapitalization? a. The company's net income will increase. b. The company's earnings per share will decrease. c. The company's cost of equity will increase. d. The company's ROA will increase. e. The company's ROE will decrease. 50. A consultant has collected the following information regarding Young Publishing: Total assets Operating income (EBIT) Interest expense Net income Share price

$3,000 million $800 million $0 million $480 million $32.00

Tax rate Debt ratio WACC M/B ratio EPS = DPS

40% 0% 10% 1.00  $3.20

The company has no growth opportunities (g = 0), so the company pays out all of its earnings as dividends (EPS = DPS). Young's stock price can be calculated by simply dividing earnings per share by the required return on equity capital, which currently equals the WACC because the company has no debt.

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The consultant believes that the company would be much better off if it were to change its capital structure to 40 percent debt and 60 percent equity. After meeting with investment bankers, the consultant concludes that the company could issue $1,200 million of debt at a before-tax cost of 7 percent, leaving the company with interest expense of $84 million. The $1,200 million raised from the debt issue would be used to repurchase stock at $32 per share. The repurchase will have no effect on the firm's EBIT; however, after the repurchase, the cost of equity will increase to 11 percent. If the firm follows the consultant's advice, what will be its estimated stock price after the capital structure change? a. $32.00 b. $33.48 c. $31.29 d. $32.59 e. $34.72 51. Which of the following statements is most correct? a. The bird-in-the-hand theory argues that investors prefer dividends because dividends are taxed more favourably than capital gains. b. Stock repurchases increase the number of outstanding shares. c. The clientele effect can explain why companies tend to vary their dividends a lot on a year-to-year basis. d. Statements a and b are correct. e. None of the statements above is correct. 52. A decrease in a firm's willingness to pay dividends is likely to result from an increase in its a. Earnings stability. b. Access to capital markets. c. Profitable investment opportunities. d. Collection of accounts receivable. e. Stock price. 53. Which of the following statements is most correct? a. The tax preference theory states that, all else equal, investors prefer stocks that pay low dividends because retained earnings can lead to capital gains that are taxed at a lower rate. b. An increase in the cost of equity capital (ks) when a company announces an increase in its dividend per share, would be consistent with the bird-in-the-hand theory. c. An increase in the stock price when a company decreases its dividend is consistent with the signaling theory. d. A dividend policy that involves paying a consistent percentage of net income is the best policy if the clientele effect is correct. e. Statements a and d are correct. 54. Which of the following statements is most correct? a. A firm's business risk is solely determined by the financial characteristics of its industry. b. The factors that affect a firm's business risk are determined partly by industry characteristics and partly by economic conditions. Unfortunately, these and other factors that affect a firm's business risk are not subject to any degree of managerial control. c. One of the benefits to a firm of being at or near its target capital structure is that financial flexibility becomes much less important. d. The firm's financial risk may have both market risk and diversifiable risk components. e. None of the statements above is correct.

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55. The firm's target capital structure is consistent with which of the following? a. Maximum earnings per share (EPS). b. Minimum cost of debt (k d ). c. Minimum risk. d. Minimum cost of equity (k S ). e. Minimum weighted average cost of capital (WACC). 56. Flood Motors is an all-equity firm with 200,000 shares outstanding. The company's EBIT is $2,000,000, and EBIT is expected to remain constant over time. The company pays out all of its earnings each year, so its earnings per share equals its dividends per share. The company's tax rate is 40 percent. The company is considering issuing $2 million worth of bonds (at par) and using the proceeds for a stock repurchase. If issued, the bonds would have an estimated yield to maturity of 10 percent. The risk-free rate in the economy is 6.6 percent, and the market risk premium is 6 percent. The company's beta is currently 0.9, but its investment bankers estimate that the company's beta would rise to 1.1 if it proceeds with the recapitalization. Assume that the shares are repurchased at a price equal to the stock market price prior to the recapitalization. What would be the company's stock price following the recapitalization? a. $51.14 b. $53.85 c. $56.02 d. $68.97 e. $76.03 57. Which of the following statements is most correct? a. If you were testing dividend theories and found that a dividend increase resulted in higher stock prices, then you could rule out all other theories and conclude that the bird-in-the-hand theory was most consistent with the evidence you found. b. The clientele effect suggests that investors choose their investments based on firms' past dividend policies and changes to established dividend policies may be costly to investors. c. Dividends paid under a residual dividend policy might send conflicting signals to investors. d. Statements b and c are correct. e. All of the statements above are correct. 58. Plato Inc. expects to have net income of $5,000,000 during the next year. Plato's target capital structure is 35 percent debt and 65 percent equity. The company's director of capital budgeting has determined that the optimal capital budget for the coming year is $6,000,000. If Plato follows a residual dividend policy to determine the coming year's dividend, then what is Plato's payout ratio? a. 38% b. 42% c. 58% d. 33% e. 22% 59. Which of the following statements is likely to encourage a firm to increase its debt ratio in its capital structure?

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Practice Questions

a. Its sales become less stable over time. b. Its corporate tax rate declines. c. Management believes that the firm's stock is overvalued. d. Statements a and b are correct. e. None of the statements above is correct. 60. Zippy Pasta Corporation (ZPC) has a constant growth rate of 7 percent. The company retains 30 percent of its earnings to fund future growth. ZPC's expected EPS (EPS1) and ks for various capital structures are given below. What is the optimal capital structure for ZPC? Debt/Total Assets Expected EPS kS 20% $2.50 15.0% 30 3.00 15.5 40 3.25 16.0 50 3.75 17.0 70 4.00 18.0 a. Debt/Total Assets = 20% b. Debt/Total Assets = 30% c. Debt/Total Assets = 40% d. Debt/Total Assets = 50% e. Debt/Total Assets = 70% 61. Etchabarren Electronics has made the following forecast for the upcoming year based on the company's current capitalization: Interest expense Operating income (EBIT) Earnings per share

$ 2,000,000 $20,000,000 $3.60

The company has $20 million worth of debt outstanding and all of its debt yields 10 percent. The company's tax rate is 40 percent. The company's price earnings (P/E) ratio has traditionally been 12´, so the company forecasts that under the current capitalization its stock price will be $43.20 at year end. The company's investment bankers have suggested that the company recapitalize. Their suggestion is to issue enough new bonds at a yield of 10 percent to repurchase 1 million shares of common stock. Assume that the stock can be repurchased at today's $40 stock price. Assume that the repurchase will have no effect on the company's operating income; however, the repurchase will increase the company's dollar interest expense. Also, assume that as a result of the increased financial risk the company's price earnings (P/E) ratio will be 11.5 after the repurchase. Given these assumptions, what would be the expected year-end stock price if the company proceeded with the recapitalization? a. $48.30 b. $42.56 c. $44.76 d. $40.34 e. $46.90 62. Which of the following statements is most correct? a. The optimal capital structure minimizes the WACC.

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Practice Questions

b. If the after-tax cost of equity financing exceeds the after-tax cost of debt financing, firms are always able to reduce their WACC by increasing the amount of debt in their capital structure. c. Increasing the amount of debt in a firm’s capital structure is likely to increase the costs of both debt and equity financing. d. Statements a and c are correct. e. Statements b and c are correct. 63. Which of the following statements is most correct? a. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase the company’s WACC. b. Since debt financing is cheaper than equity financing, increasing a company’s debt ratio will always reduce the company’s WACC. c. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, it still may raise the company’s WACC. d. Statements a and c are correct. e. None of the statements above is correct. 64. Which of the following statements is most correct? a. The cost of retained earnings is the rate of return stockholders require on a firm's common stock. b. The component cost of preferred stock is expressed as k P (1 - T) c. The higher the firm's flotation cost for new common stock, the more likely the firm is to use preferred stock, which has no flotation cost. d. All of these answers are correct e. None of the statements above is correct. 65. Trenton Publishing follows a strict residual dividend policy. All else being equal, which of the following factors are likely to cause an increase in the firm's per-share dividend? a. An increase in its net income. b. The company increases the proportion of equity financing in its target capital structure. c. An increase in the number of profitable projects that it wants to fund this year. d. Statements a and b are correct. e. All of the statements above are correct. 66. Brock Brothers wants to maintain its capital structure that consists of 30 percent debt and 70 percent equity. The company forecasts that its net income this year will be $1,000,000. The company follows a residual dividend policy and anticipates a dividend payout ratio of 40 percent. What is the size of the company's capital budget? a. $ 600,000 b. $ 857,143 c. $1,000,000 d. $1,428,571 e. $2,000,000 67. A decrease in a firm's willingness to pay dividends is likely to result from an increase in its a. Earnings stability. b. Access to capital markets. c. Profitable investment opportunities.

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Practice Questions

d. Collection of accounts receivable. e. Stock price. 68. Trenton Publishing follows a strict residual dividend policy. All else being equal, which of the following factors are likely to cause an increase in the firm's per-share dividend? a. An increase in its net income. b. The company increases the proportion of equity financing in its target capital structure. c. An increase in the number of profitable projects that it wants to fund this year. d. Statements a and b are correct. e. All of the statements above are correct. 69. Imagine that the government has passed a new tax law that reduces long-term capital gains tax rates from 28 percent to 20 percent. The maximum tax rate for ordinary personal income is 38.6 percent. Which of the following statements is most correct for an investor in a high personal tax bracket? (Assume the Classical taxation system is in place) a. The stock of a company that pays high cash dividends and has a dividend reinvestment plan (DRIP) is a good investment for this individual because he/she will receive more money that can then be reinvested in the company's stock. b. A 2-for-1 stock split is announced for a stock that the investor currently holds. The company had split the stock because the stock price had increased beyond the optimal price range and is expected to continue to grow. This is good news to the investor because it means that any gains from increased stock value will be taxed at a new lower long-term capital gains rate when the stock is sold. c. One of the companies in the investor's portfolio recently announced that it will embark on a stock repurchase plan. The lower long-term capital gains tax rate will reduce the investor's taxes if he/she decides to tender some shares of stock in the company. d. Statements b and c are correct. e. All of the statements above are correct. 70. Stock dividends are often used to a. Increase the firm’s stock price. b. Reduce the number of available shares c. Constrain the firm’s stock price. d. All of these answers e. None of these answers 71. Tarheel Computing's stock was trading at $150 per share before its recent 3-for-1 stock split. The 3-for-1 split led to a 5 percent increase in Tarheel's market capitalization. (Market capitalization equals the stock price times the number of shares.) What was Tarheel's price after the stock split? a. $472.50 b. $ 50.00 c. $ 47.62 d. $428.57 e. $ 52.50 72. Grant Grocers is considering the following independent, average-risk investment projects: Project Size of Project Project IRR Project V $1.0 million 12.0% Project W 1.2 million 11.5%

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Practice Questions

Project X 1.2 million 11.0% Project Y 1.2 million 10.5% Project Z 1.0 million 10.0% The company has a target capital structure that consists of 50 percent debt and 50 percent equity. Its after-tax cost of debt is 8 percent, its cost of equity is estimated to be 13.5 percent, and its net income is $2.5 million. If the company follows a residual dividend policy, what will be its payout ratio? a. 12% b. 32% c. 54% d. 66% e. 100% 73. You are an Australian resident taxpayer and you have just received a dividend cheque for $1,400 from Telstra Corporation. The dividend is fully franked and carries franking credits at the corporate rate of tax of 30%. If your personal tax rate is 46 percent in your next tax return you will, as a consequence of this dividend: a. Receive a tax refund of $600 b. Have to pay additional tax of $320 c. Have to pay additional tax of $224 d. There are no taxes on fully franked dividends. e. None of the above. Answers 1. Answer is b. 2. Answer is b. Corporate takeovers are most likely to occur when a firm is underperforming. Managers who fear losing their jobs will try to maximize shareholder wealth. The other statements are false. Statement a will exacerbate the agency conflict, while statement c reduces the agency conflict between stockholders and bondholders. 3. Answer is e. 4. Answer is e. 5. Answer is e. As the effective rate is the same, the correct answer must be the one that has the largest amount of money compounding for the longest time. This would be statement e. The easiest way to see this is to assume an effective annual rate and then do the calculations Assuming an effective interest rate of 10% per annual. For b, the interest rate should be use is i EFF  (1  Nom ) m  1 m i iPer  Nom  (1  EFF )1/ m  1  (1  10%)1/ 2  1  4.88% m

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Practice Questions

(1  i ) n  1 ](1  i ) i (1  4.88%)10  1  50[ ](1  4.88%) 4.88%  $655.93 For e, the interest rate should be use is 10% directly (1  i ) n  1 FVAn  PMT [ ](1  i ) i (1  10%)5  1 ](1  10%)  100[ 10%  $671.56 FVAn  PMT [

6. Answer is e. If the nominal rate is 8 percent and there is quarterly compounding, the periodic rate must be 8%/4 = 2%. The effective rate will be greater than the nominal rate; it will be 8.24 percent. 7. Answer is c. By definition, an annuity due is received at the beginning of the year while an ordinary annuity is received at the end of the year. Because the payments are received earlier, both the present and future values of the annuity due are greater than those of the ordinary annuity. 8. Answer is b. Time Line: 0

1

2

3

4

5

6

2%

Qtrs

-1,000

FV=?

Future value calculation, remembering to adjust for quarterly compounding n 6 FVn  PV 1  i   10001  0.2  $1126.16 9. Answer is c Present value of a perpetuity, PV perpetuity 

PMT 1000   $6,666.67 i 0.15

10. Answer is c. 0

1

2

3

4

5

6

7

8

14% PV=?

Years 2,000

2,000

2,000

2,000

2,000

3,000

3,000

Present value here is the sum of the discounted values of each cash flow: 1

2

 1   1   1  PV  CF    ... CF     CF  1 i  1 i  1 i 

n

Calculating the discounted value of each cash flow gives:

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Practice Questions

3,000

3,000

Time Original amount 1 2,000 2 2,000 3 2,000 4 2,000 5 2,000 6 3,000 7 3,000 8 3,000 9 4,000 Total of discounted values

Discounted value 1,754.386 1,538.935 1,349.943 1,184.161 1,038.737 1,366.760 1,198.912 1,051.677 1,230.032 1,1713.54

11. Answer is b. Time line: 0

1

2

3

4

5

10% PV=1,000

PMT=?

Years PMT

PMT

PMT

PMT

Financial calculator solution: Inputs: N = 5; I = 10; PV = -1000; FV = 0. Output: PMT = $263.80. 12. Answer is c. Bank A: 8%, monthly. m 12  i Nom   0.08  EFF  1    1  1    1  8 .3 % 12  m    Bank B: 9%, annual EFF  9% Therefore, difference in effect interest rates is 0.7% 13. Answer is a. Convert the given interest rate to match the payment period: i 8% Periodic rate i Per  Nom   0.667% m 12 Now find the future value of the annuity  1  i n  1   1  0.00667 30  1    200   6617.77 FVAn  PMT     i 0.00667     14. Answer is c. First, find the effective annual rate for a nominal rate of 12% with quarterly compounding m 4  i   12%  EFF  1  Nom   1  1    1  12.55% 4  m    In order to discount the cash flows properly, it is now necessary to find the nominal rate with semiannual compounding that corresponds to the effective rate calculated above

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Practice Questions

2

 i  12.55%  1  Nom   1  i Nom  12.18% 2   Now find the Present value of the investment, adjusting the nominal rate calculated here to semiannual compounding   1 1 1 1    $2451.73   500 PVAn  PMT    n  6    6.09% 6.09%1  6.09%    i i1  i  

15. Answer is e.

FVn  PV 1  i 

n

 6%   10001   12  

36

 $1196.68

16. Answer is d. Step 1: Find the effective annual rate: m 12  i   9%  EFF  1  Nom   1  1    1  9.3807% m  12    Step 2: Calculate the FV of the $5,000 annuity at the end of 10 years:  1  i n  1   1  9.3807%10  1    5000   77,358.79 FVAn  PMT     i 9 . 3807 %     17. Answer is c. Statement a is false; the reverse is true. Statement b is false; the 15-year bond is selling at a discount because its coupon payment is less than the yield to maturity. Statement c is true; longermaturity and lower-coupon bonds have a larger percentage price change than short-maturity, highcoupon bonds. Statement d is false; the reverse is true. 18. Answer is c. If the yield to maturity is 7 percent, but the coupon rate is 9 percent, then investors are getting a better coupon payment from this bond than they could from a new bond issued in the market today. Therefore, this bond is more valuable and must be selling at a premium. Therefore, statement a is false. Whenever interest rates fall, the price of a bond increases. Therefore, statement b is false. If interest rates remain un-changed, as the bond gets closer to its maturity, its price will approach par value. Since the bond is selling at a premium, its price must decline to its par value as it gets closer to maturity. Therefore, statement c is true. 19. Answer is e. EffectiveR  (1  4%)2  1  8.16% N

VB   t 1

 INT [

6 INT M 80 1000    N N t   (1  kd ) (1  kd ) (1 8.16%) (1 8.16%)6 t 1

1 1 M  ] N kd kd (1  kd ) (1  kd ) N

1 1 1000  ] 6 8.16% 8.16%(1  8.16%) (1  8.16%)6  368.042  624.597  $992.64  80[

20. Answer is c.

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Practice Questions

(1 

12% 12 )  1  12.68% 12

21. Answer is c. Statement c is true; the others are false. Statement a would be true only if the dividend yield were zero. Statement b is false; we've been given no information about the dividend yield. Statement c is true; the constant rate at which dividends are expected to grow is also the expected growth rate of the stock's price. Bridges & Associates 22. Answer is b. Step 1: Determine dividends: D1 = 0.75 D2 = 0.9375 (0.75 × 1.25 = 0.9375) D3 = 1.265625 (0.9375 × 1.35 = 1.265625) Step 2: Determine terminal value in Year 3, using the Year 4 dividend: D4 = 1.3415625 (1.265625 × 1.06 = 1.3415625) P3 



D4 D (1  25%)(1  35%)(1  6%)  1 ks  g ks  g

1.3415625  $33.5390625 10%  6%

Step 3: Compute price at time 0 D P D1 D2 P0    3 33 2 (1  ks ) (1  k s ) (1  k s ) 0.75 0.9375 1.265625  33.5390625   1.10 1.102 1.103  0.6818  0.7748  26.1493  $27.6059  $27.61 

23. Answer is c. Take the terminal value P3 calculated in the previous question and use the constant growth rate to find P10 : P10  P3 (1  g )7

 $33.5391 (1  6%)7  $50.43 24. Answer is d. Dividend growth = plowback x ROE = 0.6 x 20% = 12% Dividend paid out = 40% x $4 = $1.60 Price = 1.60/(0.16-0.12) = $40. 25. Answer is b. A project's NPV increases as the cost of capital declines. A project's IRR is independent of its cost of capital, while a project's MIRR is dependent on the cost of capital since the terminal value in the MIRR equation is compounded at the cost of capital.

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Practice Questions

26. Answer is e. Statement a is true because at any point to the right of the crossover point B will have a higher NPV than A. Statement b is true for the same reason that statement a is true; at any point to the right of the crossover point, B will have a higher NPV than A. Statement c is true. If B's cost of capital is 9 percent, the MIRR assumes reinvestment of the cash flows at 9 percent. When IRR is used, the IRR calculation assumes that cash flows are reinvested at the IRR (which is higher than the cost of capital). Since statements a, b, and c are true, statement e is the correct choice. 27. Answer is b. Project A: NPV = 0 = -100,000+39500(PVIFA ?, 3) IRR = 9% Project B: NPV = 0 = -100,000+ 0 + 0 + 133,000 (PVIF ?, 3) IRR = 10% The firm's cost of capital is not given in the problem; so use the IRR decision rule. Since IRRB > IRRA ; Project B is preferred. Garcia Paper Initial invest. outlay Sales Oper. Cost Depreciation Oper. Inc. before taxes Taxes (40%) Oper. Inc. after taxes Add Depreciation Net oper. cash flows

0 -$30.0

-$30.0

1

2

3

4

5

$20.0 $12.0 $10.0 -$2.0 -$0.8 -$1.2 $10.0 $8.8

$20.0 $12.0 $10.0 -$2.0 -$0.8 -$1.2 $10.0 $8.8

$20.0 $12.0 $10.0 -$2.0 -$0.8 -$1.2 $10.0 $8.8

$20.0 $12.0 $0.0 $8.0 $3.2 $4.8 $0.0 $4.8

$20.0 $12.0 $0.0 $8.0 $3.2 $4.8 $0.0 $4.8

28. Answer is e, $8.8 million 29. Answer is c, $4.8 million 30. Answer is b. $1.2 /(1.12)5  $0.6809million 31. Answer is e. Step 1: Determine the NPV of net operating cash flows: NPV  $30  $8.8 /1.10  $8.8(1.10)2  $8.8 /(1.10)3  $4.8 /(1.10)4  $4.8 /(1.10)5  -30  8  7.2727  6.6116  3.2785  2.9804  $1.8568 million

Step 2: Determine the NPV of the project's AT salvage value: $1.2 /(1.12)5  $0.6809million Step 3: Determine the project's NPV: FINS 1613

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Practice Questions

Add the PV of the salvage value to the NPV of the cash flows to get the project's NPV. NPV  -$1.8568  $0.6809  -$1.1759 million  -$1.18 million Bucholz Brands Up-front costs Increase in NOWC Sales Operating costs Depreciation EBIT Taxes (40%) EBIT(1 - T) Depreciation Operating CF AT(SV) NOWC recovery Net CF

0 -300 -50

-350

1

2

3

4

200 -100 -75 25 -10 15 75 90

200 -100 -75 25 -10 15 75 90

200 -100 -75 25 -10 15 75 90

90

90

90

200 -100 -75 25 -10 15 75 90 30 50 170

32. Answer is e; 90 million 33. Answer is a. -350M + 90/(1.1)1+ 90/(1.1)2+ 90/(1.1)3+170/(1.1)4 = -$10.07M Note: After-tax salvage value AT(SV) = 50 – (0.40 x 50) = 30M 34. Answer is b. The correct answer is statement b. Statement a is incorrect; the abandonment option will tend to increase a project's NPV. Statement b is correct; the abandonment option will tend to reduce a project's risk. Statement c is incorrect; if there are first-mover advantages, it may be harmful (lowers value) to wait a year to collect information. Diplomat.com 35. Answer is d.

NPV  3, 000, 000  500, 000( PVIFA10%,5 )

 3, 000, 000  500, 000(3.7908)  $1,104, 600

36. Answer is a. Step 1: Find the NPV at t = 0 of the first project: NPV  3, 000, 000  500, 000( PVIFA10%,5 )

 3, 000, 000  500, 000(3.7908)  $1,104, 600

Step 2: Find the NPV at t = 0 of the new projects:

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Practice Questions

If at t = 5 the firm's technology is not successful, the firm will choose to not do the additional projects (since their NPV is -$6,000,000). Therefore, the NPV at t = 5 is calculated as 0.35($6,000,000) + 0.65($0) = $2,100,000. However, this is the NPV at t = 5, so we need to discount this NPV to find the NPV of the additional projects today. PV  2,100, 000 /(1.1)5  1,303,942.87 Step 3: Find the NPV of the entire project considering its future opportunities: 1,104,600+1,303,942=$199,342 37. Answer is c.

PV ( A)  50, 000  4, 000 PVIFA8%,4  50, 000  4, 000  3.3121

 63, 248.4

EAC of A 

PV ( A) 63,248.4 = =19,096.16 PVIFA8%,4 3.3121

PV ( B )  90, 000  2,500 PVIFA8%,6  90, 000  2,500  4.6229  101,557.25

PV ( B ) 202,557.25 = =21,968.30 PVIFA8%,6 4.6229  EAC  21,968.30-19,096.16=2,872.14 EAC of B 

38. Answer is c. 39. Answer is c. 40. Answer is c. 41. Answer is c. You are given the required return on the portfolio, the RPM, and enough information to calculate the beta of the original portfolio. With this information you can find kRF. Once you have kRF, you can find the required return on Stock C. Step 1: Find the portfolio beta: Take a weighted average of the individual stocks' betas to find the portfolio beta. The total amount invested in the portfolio is: $4 million + $2 million + $2 million + $1 million + $1 million = $10 million. The weighted average portfolio beta is:



1 (4  1.2  2  1.1  2  1.0  1  0.7  1  0.5)  1.02 10

Step 2: Use the CAPM and the portfolio's required return to calculate kRF, the risk-free rate: kp = kRF + RPM(bp) 11% = kRF + 5%(1.02) 5.9% = kRF. Step 3: Use the CAPM to calculate the required return on Stock C: kC = kRF + RPM(bC) k C = 5.9% + 5%(1.0) kC = 10.9%. 42. Answer is a. Portfolio required return FINS 1613

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Practice Questions

Step 1: Find the beta of the original portfolio by taking a weighted average of the individual stocks’ betas. We calculate a beta of 1.3.  $300,000   (0.6)    $1,600,000

 $300,000    (1)   $1,600,000

 $500,000    (1.4)   $1,600,000

  $500,000    (1.8) $1,600,000   

Step 2: Find the market risk premium using the original portfolio. ks = 0.125 = 0.06 + (kM - kRF)1.3. If you substitute for all the values you know, you calculate a market risk premium of 0.05. Step 3: Calculate the new portfolio’s beta. The question asks for the new portfolio’s required rate of return. We have all of the necessary information except the new portfolio’s beta. Now, Stock 1 has 0 weight (we sold it) and Stock 4 has a weight of $800,000/$1,600,000 = 0.5. The portfolio’s new beta is:  $300,000    (1)   $1,600,000

 $500,000    (1.4)   $1,600,000

 $800,000    (1.8)  1.525.  $1,600,000

Step 4: Find the portfolio’s required return. Thus, ks = 0.06 + (0.05)1.525 = 13.625%  13.63%. 43. Answer is c. The Coefficient of Variation is the standard deviation divided by the expected return. Therefore: n

kˆ  Pk 1 1  P2 k 2  ...  Pn k n   Pk i i i 1

  0.1 0.60    0.2  0.10    0.4  0.15    0.2  0.40    0.1 0.90   15%

S tan dard Deviation   

  k  kˆ  n

i 1

Pi

 0.60  0.15 0.1   0.10  0.15 0.2   0.15  0.15  2 2   0.40  0.15  0.2   0.90  0.15 0.1 2



2

i

Coefficient of Variation  CV 

2

 kˆ



2

0.4

 37.08%

37.081  2.472 15

44. Answer is a. 45. Answer is e. 46. Answer is b. 47. Answer is a. Flotation cost is irrelevant as it can fund its capital budget from retained earnings. The cost of existing equity: D (1  g ) 2  (1  6%) ke  0 g  6%  12.625% P0 32 Thus WACC: WACC = wdkd(1 - T) + wcke = (0.25)(0.11)(0.6) + (0.75)(0.12625) = 10.67%.

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Practice Questions

48. Answer is e. 49. Answer is c. The correct answer is statement c. The company will have higher debt interest payments, so net income will decline. Thus, statement a is false. The effect on EPS is ambiguous. Earnings decline (NI), but so will the number of shares. Therefore, statement b is false. The firm's recapitalization will not change total assets. However, since net income declines, ROA will decrease; so statement d is false. As long as the BEP ratio is greater than the cost of debt, ROE will increase. However, you don't have enough information to determine the cost of debt, so you can make no determination about ROE. Thus, statement e is false. The increase in debt will increase the risk to shareholders, so the cost of equity will increase. Therefore, statement c is correct. 50. Answer is e. Step 1: Find the current number of shares outstanding: Shares = NI/EPS = $480 million/$3.20 = 150 million shares. Step 2: Find the number of shares after the repurchase: New shares = 150 - $1,200/$32 = 150 - 37.5 = 112.5 million shares. Step 3: Find the new EPS after the repurchase: EPS = [(EBIT - INT)(1 - T)]/New shares = [($800 - $84)  0.6]/112.5 = $3.818667 Step 4:Find the new stock price: Stock price = EPS/New cost of equity = $3.818667/0.11 = $34.72 51. Answer is e. Statement a is false; the theory states that investors prefer dividends because they are more certain about receiving dividends than they are about capital gains. In addition, the statement is false because capital gains are taxed more favorably than dividends. Statement b is false because stock repurchases decrease the number of outstanding shares. Statement c is false. If a company attracts a particular clientele, it would want to keep that clientele. Changing its dividends frequently would make it impossible for any one clientele to be happy. Therefore, the correct choice is statement e. 52. Answer is c. 53. Answer is a. Statement a is true; the other statements are false. The bird-in-the-hand theory states that investors prefer dividends; therefore, if dividends are increased, the cost of equity decreases. The signaling theory states that dividend decreases are bad news, so stock price will decrease. Paying a consistent percentage of net income will result in fluctuating dividends because net income fluctuates. The clientele effect states that investors prefer a stock that has a high or low steady dividend, but not a fluctuating one. 54. Answer is d. 55. Answer is e. 56. Answer is a. First, find the company's current cost of capital, dividends per share, and stock price: ks = 0.066 + (0.06)0.9 = 12%. To find the stock price, you still need the dividends per share or DPS = ($2,000,000(1 - 0.4))/200,000 = $6.00. Thus, the stock price is P0 = $6.00/0.12 = $50.00.

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Thus, by issuing $2,000,000 in new debt the company can repurchase $2,000,000/$50.00 = 40,000 shares. Now after recapitalization, the new cost of capital, DPS, and stock price can be found: ks = 0.066 + (0.06)1.1 = 13.20%. DPS for the remaining (200,000 - 40,000) = 160,000 shares are thus [($2,000,000 - ($2,000,000  0.10))(1 - 0.4)]/ 160,000 = $6.75. And, finally, P0 = $6.75/0.132 = $51.14. 57. Answer is d. Statements b and c are true; therefore, statement d is the correct choice. A dividend increase leading to an increase in stock price is consistent with signaling also. 58. Answer is e. If the firm's optimal capital budget requires $6,000,000 in financing, then, to stay at its target capital structure, Plato will retain earnings of $6,000,000  0.65 = $3,900,000. This leaves $5,000,000 $3,900,000 = $1,100,000 available for dividends. Thus, Plato's payout ratio is $1,100,000/$5,000,000 = 0.22 = 22%. 59. Answer is e. Less stable sales would lead a firm to reduce its debt ratio. A lower corporate tax rate reduces the tax advantage of the deductibility of interest expense. This reduction in the tax shield provided by debt would encourage less use of debt. If management believes the firm's stock is overvalued, then it would want to issue equity rather than debt, thereby increasing the firm's equity ratio. 60. Answer is d. The optimal capital structure maximizes the firm's stock price. When the debt ratio is 20%, expected EPS is $2.50. Given the firm's policy of retaining 30% of earnings, the expected dividend per share D1 is $2.50  0.70 = $1.75. The stock price P0 is $1.75/(15% - 7%) or $21.88. When the debt ratio is 30%, expected EPS is $3.00 and expected D1 is $3.00  0.70 = $2.10. The stock price P0 is $2.10/(15.5% - 7%) = $24.71. Similarly, when the debt ratio is 40%, D1 = $2.275 and P0 = $25.28. When the debt ratio is 50%, D1 = $2.625 and P0 = $26.25. When the debt ratio is 70%, D1 = $2.80 and P0 = $25.45. The stock price is highest when the debt ratio is 50%. 61. Answer is a. To answer this we need to determine the following: 1. How many shares are currently outstanding? 2. What are the interest expense and net income, before and after the change? Before recapitalization: EBIT $20,000,000 Interest 2,000,000 EBT $18,000,000 Taxes (40%) 7,200,000 NI $10,800,000 EPS = $3.60. Shares outstanding = $10,800,000/$3.60 = 3,000,000 shares. After recapitalization: New shares = 3 million - 1 million = 2 million shares.

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Total debt = $20,000,000 + ($1,000,000)($40) = $60,000,000. Interest payment = ($60,000,000)(0.1) = $6,000,000. Net income: EBIT $20,000,000 Interest 6,000,000 EBT $14,000,000 Taxes (40%) 5,600,000 NI $ 8,400,000 EPS = $8,400,000/2,000,000 = $4.20 P/E = 11.5 P0 = ($4.20)(11.5) = $48.30. 62. Answer is d. 63. Answer is e. 64. Answer is a. 65. Answer is a. If net income increases, and all else are equal (that is, the same number of projects are available to invest in as before, etc.), the company will have more money left over after making its investments to pay out as dividends. Statement b is false. If the company increases the proportion of equity financing in its target capital structure, it will need to either increase the proportion of equity (by increasing retained earnings, therefore, leaving less money for dividends) or reduce the proportion of debt it uses (meaning it will have less debt to finance new projects and will need more of its retained earnings to make investments). Statement c is false. If the company has more profitable projects, this will leave less money for dividends. 66. Answer is b. The company expects to pay out 40% of net income or $400,000, it must expect to have $600,000 of retained earnings available for capital investment. Given that the firm will finance new investment with 70% equity and 30% debt, $600,000 must represent 70 percent of the firm's capital budget, that is, $600,000 = (0.7)CB or CB = $857,143. 67. Answer is c. 68. Answer is a. Statement a is true. If net income increases, and all else is equal (that is, the same number of projects are available to invest in as before, etc.), the company will have more money left over after making its investments to pay out as dividends. Statement b is false. If the company increases the proportion of equity financing in its target capital structure, it will need to either increase the proportion of equity (by increasing retained earnings, therefore, leaving less money for dividends) or reduce the proportion of debt it uses (meaning it will have less debt to finance new projects and will need more of its retained earnings to make investments). Statement c is false. If the company has more profitable projects, this will leave less money for dividends. 69. Answer is d.

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Statements b and c are true; therefore, d is the correct answer. The dividends in a DRIP are still taxed at the personal income tax rate; this would be a bad investment for an individual in a high tax bracket. Stock splits are good signals because management believes the stock price will continue to increase. The increases in the stock price will be taxed at the lower long-term capital gains tax rate when the stock is sold. The investor will be taxed at the lower long-term capital gains rate if she tenders her shares in a stock repurchase. 70. Answer is c. 71. Answer is e. If the stock splits 3-for-1, there will be 3 shares now for each one that used to exist. If the number of shares triples, the price of each share would be 1/3 of what it was before. Therefore, the price would immediately be 1/3 of $150, or $50. However, the stock split also led to a 5 percent increase in the stock price. Therefore, the new price would be $50  1.05 = $52.50. 72. Answer is b. Residual dividend policy The company’s WACC is 8%(0.5) + 13.5%(0.5) = 10.75%. Comparing the WACC with the project IRRs reveals that the company will undertake projects V, W, and X. Total financing costs for these projects is $3,400,000. Of this amount, 0.5($3,400,000) = $1,700,000 will be financed from retained earnings. Thus, $2,500,000 - $1,700,000 = $800,000 will be available for dividends. The payout ratio is then $800,000/$2,500,000 = 32%. 73. Answer is b. Taxable income = 1,400 / 70% Additional personal income tax = Taxable income * (Personal tax rate – Corporate tax rate) = 1,400 / 70% * (46% - 30%) = $320

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Practice Questions