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Determining the best way to raise money to fund a firm’s long-term investments

  1. Determining the best way to raise money to fund a firm’s long-term investments is called:
  2. the capital budgeting decision
  3. the money flow processing decision
  4. the portfolio decision
  5. the capital structure decision
  6. 2. Which of the following is NOT true regarding mortgaged-backed securities (MBS)?
  7. Securitization provides liquidity to the mortgage market and makes it possible for banks to

loan more money to home buyers.

  1. MBS are sold to investors who can hold them as an investment or resell them to other

investors.

  1. The MBS process allows the mortgage bank or other financial institution that made the

original mortgage loan to get its money back out of the loan and lend it to someone else.

  1. All of the above.
  2. To measure value, the concept of time value of money is used:
  3. to bring the future benefits and costs of a project, measured by its cash flows, back to the

present

  1. to determine the interest rate paid on corporate debt
  2. to bring the future benefits and costs of a project, measured by its expected profits, back

to the present

  1. to ensure that expected future profits exceed current profits today
  2. An investor is considering two equally risky investments. Investment A is expected to return

$1,000 per year for the next 5 years. Investment B is expected to return $6,000 at the end of

5 years. Which of the following statements is MOST correct if both investments A and B have

the same cost?

  1. A risk averse investor will select investment A because it provides cash earlier than

investment B.

  1. A risk averse investor will select investment B because it is expected to provide the most

cash ($6,000 > $5,000).

  1. The investor will select investment A only if the cost is less than $1,000.
  2. The investor may select investment A or investment B depending on the opportunity cost

of money. 5. Assume that you won the Lotta Dough Lotto jackpot for $20 million. Further assume that you

were offered a choice to receive the $20 million today, or receive it in equal installments of

$1 million per year for 20 years. According to one of the principles of finance, which would

you take?

  1. You would be indifferent as to when you would receive the $20 million since the total

number of dollars received is the same either way.

  1. You would take the $20 million in equal installments of $1 million per year for 20 years

because it would be worth more than if you would receive it today.

  1. You would take the $20 million in equal installments of $1 million per year for 20 years

because you would be afraid of spending it all right away.

  1. You would take the $20 million today because it would be worth more than if you would

receive it in equal installments of $1 million per year for 20 years.

  1. Maximization of shareholder wealth:
  2. is achieved only if cash flows exceed accounting profits
  3. represents a zero sum game in which one corporation gains at the expense of others
  4. is not a practical goal since it cannot be measured effectively
  5. provides benefits to society as scarce resources are directed to their most productive use
  6. Which of the following securities will likely have the highest liquidity premium?
  7. U.S. Treasury Bond maturing in 2027
  8. U.S. Treasury Bill
  9. AAA-rated corporate bond maturing in 2015 not actively traded
  10. BBB-rated corporate bond maturing in 2020 actively traded on a major exchange
  11. Private placements usually have several advantages associated with them, but also tend

to suffer from specific disadvantages. Which of the following is a disadvantage of a private

placement when compared to other methods of selling new securities?

  1. higher interest costs
  2. reduced flotation costs
  3. avoidance of registration with the SEC
  4. strictly standardized features/terms
  5. Common examples of financial intermediaries include all of the following EXCEPT:
  6. life insurance companies
  7. venture capital firms
  8. pension funds
  9. mutual funds10. A life insurance company purchases $1 billion of corporate bonds from premiums collected on

its life insurance policies. Therefore:

  1. the corporate bonds are direct securities and the life insurance policies are direct

securities

  1. the corporate bonds are indirect securities and the life insurance policies are indirect

securities

  1. the corporate bonds are indirect securities and the life insurance policies are direct

securities.

  1. the corporate bonds are direct securities and the life insurance policies are indirect

securities.

  1. Which of the following represents an attempt to measure the net results of the firm’s

operations (revenues versus expenses) over a given time period?

  1. statement of cash flows
  2. sources and uses of funds statement
  3. balance sheet
  4. income statement
  5. Gross profit is equal to:
  6. revenues minus expenses
  7. profits plus depreciation
  8. sales minus cost of goods sold
  9. earnings before taxes minus taxes payable
  10. An income statement may be represented as follows:
  11. Sales – Expenses = Retained Earnings
  12. Sales – Expenses = Profits
  13. Revenues – Liabilities = Net Income
  14. Sales – Liabilities = Profits
  15. Which of the following ratios would be the poorest indicator of how rapidly the firm’s credit

accounts are being collected?

  1. average collection period
  2. cash conversion cycle
  3. times interest earned
  4. accounts receivable turnover ratio15. An analyst is evaluating two companies, A and B. Company A has a debt ratio of 50% and

Company B has a debt ratio of 25%. In his report, the analyst is concerned about Company B’s

debt level, but not about Company A’s debt level. Which of the following would best explain

this position?

  1. Company A has a lower times interest earned ratio and thus the analyst is not worried

about the amount of debt.

  1. Company B has much higher operating income than Company A.
  2. Company B has a higher operating return on assets than Company A, but Company A has a

higher return on equity than Company B.

  1. Company B has more total assets than Company A.
  2. Jeter Industries has an accounts receivable turnover ratio of 4.5. If Jeter has an accounts

receivable balance of $100,000, what is Jeter’s average daily credit sales?

  1. $1,232.88
  2. $22,222.22
  3. $1,893.45
  4. $745.23
  5. As of today, the most severe economic crisis to afflict the United States’ economy is

considered to be:

  1. the Great Depression of the 1930s
  2. the Reagan Tax Law Changes of 1985
  3. the Great Recession of 2007-2009
  4. the Savings and Loan Crisis of 1978 -1982
  5. A corporate treasurer is typically responsible for each of the following duties EXCEPT:
  6. credit management
  7. capital expenditures
  8. cash management
  9. cost accounting
  10. A wealthy private investor providing a direct transfer of funds is called:
  11. a financial intermediary
  12. an angel investor
  13. an investment banker
  14. a venture capitalist
  15. Rogue Industries reported the following items for the current year: Sales = $3,000,000;

Cost of Goods Sold = $1,500,000; Depreciation Expense = $170,000;

Administrative Expenses = $150,000; Interest Expense = $30,000;

Marketing Expenses = $80,000; and Taxes = $300,000. Rogue’s net profit margin is equal to:

  1. 35.67%
  2. 36.67%
  3. 25.67%
  4. 50.00%
  5. Septon Inc. has an average collection period of 74 days. What is the accounts receivable

turnover ratio for Septon Inc.?

  1. 2.66
  2. 1.74
  3. 4.93
  4. 2.47
  5. Which form of organization is free of initial legal requirements?
  6. sole proprietorship
  7. general partnership
  8. corporation
  9. both a and b
  10. Which of the following is NOT a benefit provided by the existence of organized security

exchanges?

  1. a. standardization of all debt agreements
  2. helping businesses raise new capital
  3. providing a continuous market
  4. establishing and publicizing fair security prices
  5. California Retailing Inc. has sales of $4,000,000; the firm’s cost of goods sold is $2,500,000;

and its total operating expenses are $600,000. The firm’s interest expense is $250,000, and

the corporate tax rate is 40%. What is California Retailing’s net income?

  1. $288,000
  2. $377,000
  3. $350,000
  4. $390,00025. Company A and Company B have the same gross profit margin and the same total asset

turnover, but company A has a higher return on equity. This may result from:

  1. Company B has more common stock.
  2. Company A has lower selling and administrative expenses, resulting in a higher net profit

margin.

  1. Company A has lower cost of goods sold, resulting in a higher net profit margin.
  2. Company A has a lower debt ratio.
  3. What is the present value of an annuity of $120 received at the end of each year for 11 years?

Assume a discount rate of 7%. The first payment will be received one year from today (round

to nearest $1).

  1. $570
  2. $250
  3. $400
  4. $900
  5. You bought a racehorse that has had a winning streak for six years, bringing in $250,000 at

the end of each year before dying of a heart attack. If you paid $1,155,720 for the horse 4

years ago, what was your annual return over this 4-year period?

  1. 12%
  2. 8%
  3. 18%
  4. 33%
  5. How much money do I need to place into a bank account that pays a 1.08% rate in order to

have $500 at the end of 7 years?

  1. $751.81
  2. $463.78
  3. $629.51
  4. $332.54
  5. Your daughter is born today and you want her to be a millionaire by the time she is 40 years

old. You open an investment account that promises to pay 11.5% per year. How much money

must you deposit today so your daughter will have $1,000,000 by her 35th birthday?

  1. $20,100
  2. $18,940
  3. $28,575
  4. $22,150
  5. If you want to have $3,575 in 29 months, how much money must you put in a savings account

today? Assume that the savings account pays 12% and it is compounded monthly (round to

nearest $1).

  1. $2,438
  2. $2,679
  3. $3,147
  4. $3,008

Unit 2 Examination

  1. U.S. Savings Bonds are sold at a discount. The face value of the bond represents its value on

its future maturity date. Therefore:

  1. The current price of a $50 face value bond that matures in 10 years will be greater than

the current price of a $50 face value bond that matures in 5 years.

  1. The current prices of all $50 face value bonds will be the same, regardless of their

maturity dates because they will all be worth $50 in the future.

  1. The current price of a $50 face value bond will be higher if interest rates increase.
  2. The current price of a $50 face value bond that matures in 10 years will be less than the

current price of a $50 face value bond that matures on 5 years.

  1. You are considering a sales job that pays you on a commission basis or a salaried position that

pays you $50,000 per year. Historical data suggests the following probability distribution for

your commission income. Which job has the higher expected income?

Probability of…

Commission Occurrence

$15,000 .15

$35,000 .20

$48,000 .35

$67,000 .22

$80,000 .18

  1. The salary of $50,000 is less than the expected commission of $50,050.
  2. The salary of $50,000 is less than the expected commission of $52,720.
  3. The salary of $50,000 is greater than the expected commission of $49,630.
  4. The salary of $50,000 is greater than the expected commission of $48,400.
  5. Beginning with an investment in one company’s securities, as we add securities of other

companies to our portfolio, which type of risk declines?

  1. unsystematic risk
  2. market risk
  3. systematic risk
  4. non-diversifiable risk
  5. Assume the risk-free rate of return is 2% and the market risk premium is 8%. If you are a risk

averse investor, which project should you choose?

  1. Project 3
  2. Project 2
  3. Project 1
  4. Either Project 2 or Project 3 because the higher expected return on project 3 offsets its

higher risk.

  1. Stock A has a beta of 1.2 and a standard deviation of returns of 14%. Stock B has a beta of

1.8 and a standard deviation of returns of 18%. If the risk-free rate of return increases and the

market risk premium remains constant, then:

  1. the required returns on stocks A and B will not change
  2. the required returns on stocks A and B will both increase by the same amount
  3. the required return on stock A will increase more than the required return on stock B
  4. the required return on stock B will increase more than the required return on stock A

Unit 2 Ex

  1. Suppose interest rates have been at historically low levels the past two years. A reasonable

strategy for bond investors during this time period would be to:

  1. buy only junk bonds which have higher interest rates
  2. invest in long-term bonds to reduce interest rate risk
  3. invest in short-term bonds to reduce interest rate risk
  4. invest in long-term bonds to lock in a bond position for when interest rates increase in the

future

  1. Fred and Ethel are both considering buying a corporate bond with a coupon rate of 8%, a face

value of $1,000, and a maturity date of January 1, 2025. Which of the following statements is

MOST correct?

  1. Fred and Ethel will only buy the bonds if the bonds are rated BBB or above.
  2. Because both Fred and Ethel will receive the same cash flows if they each buy a bond,

they both must assign the same value to the bond.

  1. If Fred decides to buy the bond, then Ethel will also decide to buy the bond if markets are

efficient.

  1. Fred may determine a different value for a bond than Ethel because each investor may

have a different level of risk aversion, and hence a different required return.

  1. Which of the following statements is true?
  2. Short-term bonds have greater interest rate risk than do long-term bonds.
  3. Long-term bonds have greater interest rate risk than do short-term bonds.
  4. Interest rate risk is highest during periods of high interest rates.
  5. All bonds have equal interest rate risk.
  6. Crandle’s common stock is currently selling for $79.00. It just paid a dividend of $4.60 and

dividends are expected to grow at a rate of 5% indefinitely. What is the required rate of return

on Crandle’s stock?

  1. 11.76%
  2. 11.11%
  3. 12.2%
  4. 14.21%
  5. An example of the growth factor in common stock is:
  6. retaining profits in order to reinvest into the firm
  7. two strong companies merging together to increase their economies of scale
  8. acquiring a loan to fund an investment in Asia
  9. issuing new stock to provide capital for future growth

Unit 2 Ex

  1. Waterfront Solutions, Inc. paid a dividend of $5.00 per share on its common stock yesterday.

Dividends are expected to grow at a constant rate of 4% for the next two years, at which point

the stock is expected to sell for $56.00. If investors require a rate of return on Waterfront’s

common stock of 18%, what should the stock sell for today?

  1. $40.22
  2. $50.22
  3. $44.76
  4. $48.51
  5. Andre’s parents established a college savings plan for him when he was born. They deposited

$50 into the account on the last day of each month. The account has earned 10.9%

compounded monthly, tax-free. How much can they withdraw on his 18th birthday to spend on

his education?

  1. $33,307
  2. $30,028
  3. $43,730
  4. $27,560
  5. Charlie wants to retire in 15 years, and he wants to have an annuity of $50,000 a year for

20 years after retirement. Charlie wants to receive the first annuity payment the day he

retires. Using an interest rate of 8%, how much must Charlie invest today in order to have his

retirement annuity (round to nearest $10).

  1. $167,130
  2. $315,240
  3. $256,890
  4. $200,450

An investor currently holds the following portfolio:

Amount

Invested

4,000 shares of Stock H $8,000 Beta = 1.3

7,500 shares of Stock I $24,000 Beta = 1.8

12,500 shares of Stock J $48,000 Beta = 2.2

  1. The beta for the portfolio is:
  2. 1.45
  3. 1.27
  4. 1.99
  5. 1.77
  6. Which of the following will cause the value of a bond to increase, if other things held the

same?

  1. interest rates decrease
  2. the company’s debt rating drops from AAA to BBB
  3. investors’ required rate of return increases
  4. the bond is callable
  5. A small biotechnology research corporation has been experiencing losses for the first three

years of its existence, and thus has a negative balance in retained earnings. The corporation’s

stock price, however, is $1 per share. Which of the following statements is MOST correct?

  1. The required return on the stock will be small because the company has very few assets.
  2. Investors believe the stock is worth $1 per share because future earnings (and cash flows)

are expected to be positive.

  1. The corporation’s accountants must have made a mistake because retained earnings may

not be negative.

  1. Investors are irrational to pay $1 per share when earnings per share have been negative for

three years.

  1. How much money must be put into a bank account yielding 6.42% (compounded annually) in

order to have $1,671 at the end of 11 years? (round to nearest $1)

  1. $798
  2. $886
  3. $921
  4. $843
  5. Wendy purchased 800 shares of Robotics Stock at $3 per share on 1/1/09. Wendy sold the

shares on 12/31/09 for $3.45. Genetics stock has a beta of 1.3, the risk-free rate of return is

3%, and the market risk premium is 8%. The required return on Genetics Stock is:

  1. 21.1%
  2. 13.4%
  3. 16.5%
  4. 17.6%
  5. Bart’s Moving Company bonds have a 11% coupon rate. Interest is paid semiannually. The

bonds have a par value of $1,000 and will mature 8 years from now. Compute the value of

Bart’s Moving Company bonds if investors’ required rate of return is 9.5%.

  1. $1,133.05
  2. $1,098.99
  3. $1,082.75
  4. $1,197.27
  5. Jackson Corp. common stock paid $2.50 in dividends last year (D0). Dividends are expected to

grow at a 12-percent annual rate forever. If Jackson’s current market price is $40.00, what is

the stock’s expected rate of return? (nearest .01 percent)

  1. 18.25%
  2. 5.50%
  3. 11.00%
  4. 19.00%
  5. The DEF Company is planning a $64 million expansion. The expansion is to be financed by

selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax

required rate of return on debt is 9 percent and the required rate of return on equity is 14

percent. If the company is in the 35 percent tax bracket, what is the firm’s cost of capital?

  1. 8.92%
  2. 10.74%
  3. 11.50%
  4. 9.89%

Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax

rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a

coupon of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity

available for investment at this time, but can issue new common stock at a price of $45. The

next expected dividend on the stock is $2.70. The dividend for the firm is expected to grow at

constant annual rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00

per share. The company has the following independent investment projects available:

Project Initial Outlay IRR

1 $100,000 10%

2 $10,000 8.5%

3 $50,000 12.5%

  1. Which of the above projects should the company take on?
  2. Project 3 only
  3. Projects 1, 2 and 3
  4. Projects 1 and 3
  5. Projects 1 and 2
  6. PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred

stock, and $11 million of common equity, based upon current market values. The firm’s yield

to maturity on its bonds is 7.4%, and investors require an 8% return on the firm’s preferred

stock and a 14% return on PrimaCare’s common stock. If the tax rate is 35%, what is

PrimaCare’s WACC?

  1. 7.21%
  2. 10.18%
  3. 12.25%
  4. 8.12%

Unit 3 Examination

136

BAM 313 Introduction to Financial Management

  1. JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects

to earn $30 million in net income next year and retain 40% of it, how large can the capital

budget be before common stock must be sold?

  1. $15.5 million
  2. $7.5 million
  3. $16.0 million
  4. $12.0 million
  5. All else equal, an increase in beta results in:
  6. an increase in the cost of retained earnings
  7. an increase in the cost of common equity, whether or not the funds come from retained

earnings or newly issued common stock

  1. an increase in the cost of newly issued common stock
  2. an increase in the after-tax cost of debt
  3. Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and

dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5%

of the selling price. What is the cost of Haroldson’s retained earnings?

  1. 12.09%
  2. 11.78%
  3. 11.45%
  4. 5.73%
  5. A company has preferred stock that can be sold for $21 per share. The preferred stock pays

an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with

the sale of preferred stock equal $1.25 per share. The company’s marginal tax rate is 35%.

Therefore, the cost of preferred stock is:

  1. 14.26%
  2. 12.94%
  3. 18.87%
  4. 17.72%
  5. Which of the following should NOT be considered when calculating a firm’s WACC?
  6. after-tax YTM on a firm’s bonds
  7. cost of newly issued preferred stock
  8. after-tax cost of accounts payable
  9. cost of newly issued common stock

Unit 3 Examination

137

BAM 313 Introduction to Financial Management

  1. Your firm is considering an investment that will cost $920,000 today. The investment will

produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in

year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the

investment’s profitability index?

  1. 1.26
  2. 1.69
  3. 1.21
  4. 1.43
  5. Your firm is considering investing in one of two mutually exclusive projects. Project A requires

an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next

three years. Project B requires an initial outlay of $2,500 with expected future cash flows of

$1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and

it is not subject to capital rationing. Assuming both projects can be replaced with a similar

investment at the end of their respective lives, compute the NPV of the two chain cycle for

Project A and three chain cycle for Project B.

  1. $2,865 and $94
  2. $3,528 and $136
  3. $5,000 and $1,500
  4. $2,232 and $85
  5. The capital budgeting manager for XYZ Corporation, a very profitable high technology company,

completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the

analysis and changes the depreciation method to 3-year depreciation. This change will:

  1. increase the present value of the NCFs
  2. have no effect on the NCFs because depreciation is a non-cash expense
  3. only change the NCFs if the useful life of the depreciable asset is greater than 5 years
  4. decrease the present value of the NCFs
  5. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000

and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs

$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in

year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects

is 10%. The modified internal rate of return for Project B is:

  1. 18.52%
  2. 22.80%
  3. 19.75%
  4. 17.84%

Unit 3 Examination

138

BAM 313 Introduction to Financial Management

  1. A capital budgeting project has a net present value of $30,000 and a modified internal rate of

return of 15%. The project’s required rate of return is 13%. The internal rate of return is:

  1. greater than $30,000
  2. greater than 15%
  3. between 13% and 15%
  4. less than 13%
  5. A new project is expected to generate $800,000 in revenues, $250,000 in cash operating

expenses, and depreciation expense of $150,000 in each year of its 10-year life. The

corporation’s tax rate is 35%. The project will require an increase in net working capital of

$85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the

free cash flow from the project in year one?

  1. $410,000
  2. $375,000
  3. $380,000
  4. $298,000
  5. A local restaurant owner is considering expanding into another rural area. The expansion

project will be financed through a line of credit with City Bank. The administrative costs of

obtaining the line of credit are $500, and the interest payments are expected to be $1,000

per month. The new restaurant will occupy an existing building that can be rented for $2,500

per month. The incremental cash flows for the new restaurant include:

  1. $2,500 per month rent
  2. $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent
  3. $1,000 per month interest payments, $2,500 per month rent
  4. $500 administrative costs, $2,500 per month rent
  5. Which of the following should be included in the initial outlay?
  6. increased investment in inventory and accounts receivable
  7. preexisting firm overhead reallocated to the new project
  8. first year depreciation expense on any new equipment purchased
  9. taxable gain on the sale of old equipment being replaced

Unit 3 Examination

139

BAM 313 Introduction to Financial Management

  1. QRW Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was

purchased for $50,000 nine years ago and has a current book value of $5,000. (The old

machine is being depreciated on a straight-line basis over a ten-year useful life.) The new

machine costs $100,000. It will cost the company $10,000 to get the new lathe to the factory

and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine

is also being depreciated on a straight-line basis over ten years. Sales are expected to increase

by $8,000 per year while operating expenses are expected to decrease by $12,000 per year.

QRW’s marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain

the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at

the end of the project’s ten-year life. What is the incremental free cash flow during year 1 of

the project?

  1. $11,400
  2. $15,200
  3. $12,800
  4. $14,400
  5. The cost of retained earnings is less than the cost of new common stock because:
  6. dividends are not tax deductible
  7. flotation costs are incurred when new stock is issued
  8. accounting rules allow a deduction when using retained earnings
  9. marginal tax brackets increase
  10. Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent

preferred stock, and 50 percent common equity indefinitely. The required return on each

component source of capital is as follows: debt–8 percent; preferred stock–12 percent;

common equity–16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of

return must the firm earn on its investments if the value of the firm is to remain unchanged?

  1. 12.00 percent
  2. 11.12 percent
  3. 12.40 percent
  4. 10.64 percent
  5. Your firm is considering an investment that will cost $920,000 today. The investment will

produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in

year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the

investment’s internal rate of return?

  1. 15.98%
  2. 27.28%
  3. 20.53%
  4. 21.26%

Unit 3 Examination

140

BAM 313 Introduction to Financial Management

  1. The advantages of NPV are all of the following EXCEPT:
  2. it provides the amount by which positive NPV projects will increase the value of the firm
  3. it allows the comparison of benefits and costs in a logical manner through the use of time

value of money principles

  1. it recognizes the timing of the benefits resulting from the project
  2. it can be used as a rough screening device to eliminate those projects whose returns do

not materialize until later years

  1. Which of the following are included in the terminal cash flow?
  2. recapture of any working capital increase included in the initial outlay
  3. the expected salvage value of the asset
  4. any tax payments or receipts associated with the salvage value of the asset
  5. all of the above
  6. Which of the following differentiates the cost of retained earnings from the cost of newly

issued common stock?

  1. the larger dividends paid to the new common stockholders
  2. the flotation costs incurred when issuing new securities
  3. the cost of the pre-emptive rights held by existing shareholders
  4. the greater marginal tax rate faced by the now-larger firm
  5. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000

and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs

$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in

year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects

is 10%. The profitability index for Project B is:

  1. 1.55
  2. 1.39
  3. 1.33
  4. 1.48
  5. When terminating a project for capital budgeting purposes, the working capital outlay required

at the initiation of the project will:

  1. increase the cash flow because it is recaptured
  2. decrease the cash flow because it is an outlay
  3. not affect the cash flow
  4. decrease the cash flow because it is a historical cost

 

  1. A high degree of variability in a firm’s earnings before interest and taxes refers to:
  2. business risk
  3. financial leverage
  4. operating leverage
  5. financial risk
  6. If a firm has no operating leverage and no financial leverage, then a 10% increase in sales will

have what effect on EPS?

  1. EPS will increase by 10%
  2. EPS will remain the same
  3. EPS will increase by less than 10%
  4. EPS will decrease by 10%
  5. According to the moderate view of capital costs and financial leverage, as the use of debt

financing increases:

  1. the cost of capital continuously increases
  2. there is an optimal level of debt financing
  3. the cost of capital remains constant
  4. the cost of capital continuously decreases
  5. The primary weakness of EBIT-EPS analysis is that:
  6. it double counts the cost of debt financing
  7. it applies only to firms with large amounts of debt in their capital structure
  8. it may only be used by firms that are profitable this year
  9. it ignores the implicit cost of debt financing
  10. Potential applications of the break-even model include:
  11. optimizing the cash-marketable securities position of a firm
  12. replacement for time-adjusted capital budgeting techniques
  13. pricing policy
  14. All of the above.

Unit 4 Examination

191

BAM 313 Introduction to Financial Management

  1. The Modigliani and Miller hypothesis does NOT work in the “real world” because:
  2. interest expense is tax deductible, providing an advantage to debt financing
  3. higher levels of debt increase the likelihood of bankruptcy, and bankruptcy has real costs

for any corporation

  1. both a and b
  2. dividend payments are fixed and tax deductible for the corporation
  3. A corporation with very high growth prospects and many positive NPV projects to fund may

want to increase its dividend based on the:

  1. very low agency costs of the corporation
  2. information effect
  3. tax bias against capital gains
  4. residual dividend theory
  5. Which of the following strategies may be used to alter a firm’s capital structure toward a higher

percentage of debt compared to equity?

  1. stock split
  2. stock repurchase
  3. stock dividend
  4. maintain a low dividend payout ratio
  5. AFB, Inc.’s dividend policy is to maintain a constant payout ratio. This year AFB, Inc. paid

out a total of $2 million in dividends. Next year, AFB, Inc.’s sales and earnings per share are

expected to increase. Dividend payments are expected to:

  1. increase above $2 million only if the company issues additional shares of common stock
  2. decrease below $2 million
  3. increase above $2 million
  4. remain at $2 million
  5. Which of the following is true?
  6. In industries with volatile earnings, the residual dividend policy results in the most

consistent dividend stream.

  1. If the clientele effect is correct, firms should follow a constant dividend payout ratio policy.
  2. In general, the higher the number of positive NPV investment opportunities for a firm, the

lower the dividend payout ratio.

  1. According to the informational content of dividends, an increase in dividends is always a

positive signal.

Unit 4 Examination

192

BAM 313 Introduction to Financial Management

  1. Which of the following is always a non-cash expense?
  2. salaries
  3. depreciation
  4. income taxes
  5. None of the above.
  6. Which of the following is a limitation of the “percent of sales method” of preparing pro forma

financial statements?

  1. Inventory levels are seldom affected by changes in sales volume.
  2. A firm’s investment in accounts receivable is seldom related to sales volume.
  3. Not all assets and liabilities increase or decrease as a constant percent of sales.
  4. The dividend payout ratio may change from one year to the next.
  5. Spontaneous sources of funds refer to all of the below EXCEPT:
  6. accounts payable
  7. accruals
  8. common stock
  9. a bank loan
  10. Selection of a source of short-term financing should include all of the following EXCEPT:
  11. the effect of the use of credit from a particular source on the cost and availability of other

sources of credit

  1. the floatation costs for debentures
  2. the effective cost of credit
  3. the availability of financing in the amount and for the time needed
  4. The terminal warehouse agreement differs from the field warehouse agreement in that:
  5. the cost of the terminal warehouse agreement is lower due to the lower degree of risk
  6. the warehouse procedure differs for both agreements
  7. the terminal agreement transports the collateral to a public warehouse
  8. the borrower of the field warehouse agreement can sell the collateral without the consent

of the lender

Unit 4 Examination

193

BAM 313 Introduction to Financial Management

  1. Your company buys supplies on credit terms of 2/10 net 45. Suppose the company makes a

purchase of $20,000 today. Which of the following payment options makes the most sense as

a general rule?

  1. pay the bill as soon as possible to keep the supplier happy
  2. pay the bill on day 10 to get the discount
  3. either pay the bill on day 10 to get the discount, or wait until day 45
  4. pay the bill on day 45 due to the time value of money
  5. Which of the following statements about financial leverage is true?
  6. Financial leverage is the responsiveness of the firm’s EBIT to fluctuations in sales.
  7. Financial leverage is the responsiveness of the firm’s EPS to fluctuations in EBIT.
  8. Financial leverage involves the incurrence of fixed operating costs in the firm’s income

stream.

  1. Financial leverage reduces a firm’s risk.
  2. Which of the following statements about combined (operating & financial) leverage is true?
  3. Usage of both operating and financial leverage reduces a firm’s risk.
  4. If a firm employs both operating and financial leverage, any percent change in sales will

produce a larger percent change in earnings per share.

  1. High operating leverage and high financial leverage offset one another, meaning that if

sales increase by 10%, then EPS will also increase by 10%.

  1. A firm that is in a capital-intensive industry should use a higher level of financial leverage

than a firm that employs low levels of operating leverage.

  1. The “bird-in-the-hand dividend theory” supports which view of the effect of dividend policy on

company value?

  1. constant dividends increase stock values
  2. high dividends increase stock values
  3. a firm’s dividend policy is irrelevant
  4. low dividends increase stock values
  5. All of the following will increase the discretionary financing needed EXCEPT:
  6. decrease the dividend payout ratio
  7. decrease the spontaneous financing
  8. decrease the sales growth rate
  9. decrease the net profit margin

Unit 4 Examination

194

BAM 313 Introduction to Financial Management

  1. If a firm relies on short-term debt or current liabilities in financing its asset investments, and

all other things remain the same, what can be said about the firm’s liquidity?

  1. The liquidity of the firm will be unchanged.
  2. The firm will be relatively more liquid.
  3. The firm will be relatively less liquid.
  4. The firm will be more liquid only if interest rates are below the company’s weighted

average cost of capital.

  1. Dakota Oil, Inc. reported that its sales and EBIT increased by 10%, but its EPS increased by

30%. The much larger change in earnings per share could be the result of:

  1. high operating leverage
  2. high financial leverage
  3. high fixed costs of production
  4. a high percentage of credit sale collections from prior years
  5. Which of the following statements would be consistent with the bird-in-the-hand dividend

theory?

  1. Dividends are less certain than capital gains.
  2. Investors are indifferent whether stock returns come from dividend income or capital gains

income.

  1. Wealthy investors prefer corporations to defer dividend payments because capital gains

produce greater after-tax income.

  1. Dividends are more certain than capital gains income.
  2. The term “lumpy asset” means:
  3. assets that have economies of scale but not economies of scope
  4. assets that must be purchased in discrete quantities
  5. the same thing as assets that exhibit scale economies
  6. assets that can be purchased in incremental units
  7. All of the following are potential advantages of commercial paper EXCEPT:
  8. ability to borrow very large amounts
  9. flexible repayment terms
  10. no compensating balance requirements
  11. lower interest rates than comparable sources of short-term financing

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