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Question 1
Which of the following statements is CORRECT?
Answer
An option’s value is determined by its exercise value, which is the market price of the stock less its striking price. Thus, an option can’t sell for more than its exercise value.
As the stock’s price rises, the time value portion of an option on a stock increases because the difference between the price of the stock and the fixed strike price increases.
Issuing options provides companies with a low cost method of raising capital.
The market value of an option depends in part on the option’s time to maturity and also on the variability of the underlying stock’s price.
The potential loss on an option decreases as the option sells at higher and higher prices because the profit margin gets bigger.
2 points
Question 2
Which of the following statements is CORRECT?
Answer
Put
options give investors the right to buy a stock at a certain strike price before a specified date.
Call options give investors the right to sell a stock at a certain strike price before a specified date.
Options typically sell for less than their exercise value.
LEAPS are very short-term options that were created relatively recently and now trade in the market.
An option holder is not entitled to receive dividends unless he or she exercises their option before the stock goes ex dividend.
2 points
Question 3
Other things held constant, the value of an option depends on the stock’s price, the risk-free rate, and the
Answer
Strike price.
Variability of the stock price.
Option’s time to maturity.
All of the above.
None of the above.
2 points
Question 4
Warner Motors’ stock is trading at $20 a share. Call options that expire in three months with a strike price of $20 sell for $1.50. Which of the following will occur if the stock price increases 10%, to $22 a share?
Answer
The price of the call option will increase by $2.
The price of the call option will increase by more than $2.
The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.
The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.
The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.
2 points
Question 5
GCC Corporation is planning to issue options to its key employees, and it is now discussing the terms to be set on those options. Which of the following actions would decrease the value of the options, other things held constant?
Answer
GCC’s stock price suddenly increases.
The exercise price of the option is increased.
The life of the option is increased, i.e., the time until it expires is lengthened.
The Federal Reserve takes actions that increase the risk-free rate.
GCC’s stock price becomes more risky (higher variance).
2 points
Question 6
An investor who writes standard call options against stock held in his or her portfolio is said to be selling what type of options?
Answer
In-the-money
Put
Naked
Covered
Out-of-the-money
2 points
Question 7
The current price of a stock is $50, the annual risk-free rate is 6%, and a 1-year call option with a strike price of $55 sells for $7.20. What is the value of a put option, assuming the same strike price and expiration date as for the call option?
Answer
$7.33
$7.71
$8.12
$8.55
$9.00
2 points
Question 8
Which of the following statements is CORRECT?
Answer
If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.
Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
2 points
Question 9
Suppose you believe that Johnson Company’s stock price is going to increase from its current level of $22.50 sometime during the next 5 months. For $310.25 you can buy a 5-month call option giving you the right to buy 100 shares at a price of $25 per share. If you buy this option for $310.25 and Johnson’s stock price actually rises to $45, what would your pre-tax net profit be?
Answer
-$310.25
$1,689.75
$1,774.24
$1,862.95
$1,956.10
2 points
Question 10
Call options on XYZ Corporation’s common stock trade in the market. Which of the following statements is most correct, holding other things constant?
Answer
The price of these call options is likely to rise if XYZ’s stock price rises.
The higher the strike price on XYZ’s options, the higher the option’s price will be.
Assuming the same strike price, an XYZ call option that expires in one month will sell at a higher price than one that expires in three months.
If XYZ’s stock price stabilizes (becomes less volatile), then the price of its options will increase.
If XYZ pays a dividend, then its option holders will not receive a cash payment, but the strike price of the option will be reduced by the amount of the dividend.
2 points
Question 11
Which of the following statements is CORRECT?
Answer
If the underlying stock does not pay a dividend, it makes good economic sense to exercise a call option as soon as the stock’s price exceeds the strike price by about 10%, because this permits the option holder to lock in an immediate profit.
Call options generally sell at a price less than their exercise value.
If a stock becomes riskier (more volatile), call options on the stock are likely to decline in value.
Call options generally sell at prices above their exercise value, but for an in-the-money option, the greater the exercise value in relation to the strike price, the lower the premium on the option is likely to be.
Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
2 points
Question 12
Suppose you believe that Delva Corporation’s stock price is going to decline from its current level of $82.50 sometime during the next 5 months. For $510.25 you could buy a 5-month put option giving you the right to sell 100 shares at a price of $85 per share. If you bought this option for $510.25 and Delva’s stock price actually dropped to $60, what would your pre-tax net profit be?
Answer
-$510.25
$1,989.75
$2,089.24
$2,193.70
$2,303.38
2 points
Question 13
An option that gives the holder the right to sell a stock at a specified price at some future time is
Answer
a call option.
a put option.
an out-of-the-money option.
a naked option.
a covered option.
2 points
Question 14
Which of the following statements is CORRECT?
Answer
If the underlying stock does not pay a dividend, it does not make good economic sense to exercise a call option prior to its expiration date, even if this would yield an immediate profit.
Call options generally sell at a price greater than their exercise value, and the greater the exercise value, the higher the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the greater the exercise value, the lower the premium on the option is likely to be.
Call options generally sell at a price below their exercise value, and the lower the exercise value, the lower the premium on the option is likely to be.
Because of the put-call parity relationship, under equilibrium conditions a put option on a stock must sell at exactly the same price as a call option on the stock.
2 points
Question 15
The current price of a stock is $22, and at the end of one year its price will be either $27 or $17. The annual risk-free rate is 6.0%, based on daily compounding. A 1-year call option on the stock, with an exercise price of $22, is available. Based on the binominal model, what is the option’s value?
Answer
$2.43
$2.70
$2.99
$3.29
$3.62
2 points
Question 16
Which of the following statements is CORRECT?
Answer
The WACC is calculated using before-tax costs for all components.
The after-tax cost of debt usually exceeds the after-tax cost of equity.
For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
Retained earnings that were generated in the past and are reported on the firm’s balance sheet are available to finance the firm’s capital budget during the coming year.
The WACC that should be used in capital budgeting is the firm’s marginal, after-tax cost of capital.
2 points
Question 17
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Answer
Long-term debt.
Accounts payable.
Retained earnings.
Common stock.
Preferred stock.
2 points
Question 18
Which of the following statements is CORRECT?
Answer
The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
If the calculated beta underestimates the firm’s true investment risk–i.e., if the forward-looking beta that investors think exists exceeds the historical beta–then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.
Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well diversified.
An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both “objective” as opposed to “subjective,” hence little or no judgment is required.
The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
2 points
Question 19
Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.
Answer
If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets.
If a firm’s managers want to maximize the value of their firm’s stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project’s expected future cash flows.
If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas.
Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. A’s returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
2 points
Question 20
Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B’s projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?
Answer
A Division B project with a 13% return.
A Division B project with a 12% return.
A Division A project with an 11% return.
A Division A project with a 9% return.
A Division B project with an 11% return.
2 points
Question 21
Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
Answer
The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
The accept/reject decision depends on the
firm’s risk-adjustment policy. If Norris’ policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project.
Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
2 points
Question 22
Which of the following statements is CORRECT?
Answer
In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company’s WACC for capital budgeting purposes.
The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
A firm’s cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
The component cost of preferred stock is expressed as rp(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
2 points
Question 23
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.
Answer
rs> re > rd > WACC.
re> rs > WACC >rd.
WACC > re > rs> rd.
rd> re > rs > WACC.
WACC > rd > rs >re.
2 points
Question 24
Which of the following statements is CORRECT?
Answer
The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm’s outstanding debt.
Suppose some of a publicly-traded firm’s
stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value.
The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital.
2 points
Question 25
Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company’s market risk is an average of the pre-merger companies’ market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?
Answer
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
Safeco/Risco’s WACC, as a result of the merger, would be 10%.
After the merger, Safeco/Risco should
select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
2 points
Question 26
Which of the following statements is CORRECT?
Answer
When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible
by the paying corporation.
When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible
by the paying corporation.
Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
Higher flotation costs reduce investors’ expected returns, and that leads to a reduction in a company’s WACC.
2 points
Question 27
Which of the following statements is CORRECT?
Answer
The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
The WACC as used in capital budgeting would
be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
2 points
Question 28
Schalheim Sisters Inc. has always paid out all of its earnings as dividends; hence, the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?
Answer
The market risk premium declines.
The flotation costs associated with issuing new common stock increase.
The company’s beta increases.
Expected inflation increases.
The flotation costs associated with issuing preferred stock increase.
2 points
Question 29
Which of the following statements is CORRECT?
Answer
The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company’s own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal.
The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used.
An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity.
The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm’s target capital structure.
Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm’s stockholders are well diversified.
2 points
Question 30
The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm’s overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time?
Answer
The company will take on too many high-risk projects and reject too many low-risk projects.
The company will take on too many low-risk projects and reject too many high-risk projects.
Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.
The company’s overall WACC should decrease
over time because its stock price should be increasing.
The CEO’s recommendation would maximize the firm’s intrinsic value.
Question 1
Which of the following items is NOT included in current assets?
Answer
Accounts receivable.
Inventory.
Bonds.
Cash.
Short-term, highly liquid, marketable securities.
2 points
Question 2
Which of the following factors could explain why Dellva Energy had a negative net cash flow last year, even though the cash on its balance sheet increased?
Answer
The company sold a new issue of bonds.
The company made a large investment in new plant and equipment.
The company paid a large dividend.
The company had high amortization expenses.
The company repurchased 20% of its common stock.
2 points
Question 3
Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance?
Answer
The company’s operating income declined.
The company’s expenditures on fixed assets declined.
The company’s cost of goods sold increased.
The company’s depreciation and amortization expenses declined.
The company’s interest expense increased.
2 points
Question 4
Which of the following statements is CORRECT?
Answer
Since depreciation is a source of funds, the more depreciation a company has, the larger its retained earnings will be, other things held constant.
A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments.
Common equity includes common stock and retained earnings, less accumulated depreciation.
The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying dividends.
If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative.
2 points
Question 5
Analysts who follow Howe Industries recently noted that, relative to the previous year, the company’s operating net cash flow increased, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?
Answer
The company cut its dividend.
The company made a large investment in a profitable new plant.
The company sold a division and received cash in return.
The company issued new common stock.
The company issued new long-term debt.
2 points
Question 6
Which of the following statements is CORRECT?
Answer
Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible.
Interest paid to an individual is counted as income for tax purposes and taxed at the individual’s regular tax rate, which in 2008 could go up to 35%, but dividends received were taxed at a maximum rate of 15%.
The maximum federal tax rate on corporate income in 2008 was 50%.
Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.
The maximum federal tax rate on personal income in 2008 was 50%.
2 points
Question 7
Below are the 2008 and 2009 year-end balance sheets for Wolken Enterprises:
Assets: 2009 2008
Cash $ 200,000 $ 170,000
Accounts receivable 864,000 700,000
Inventories 2,000,000 1,400,000
Total current assets $ 3,064,000 $2,270,000
Net fixed assets 6,000,000 5,600,000
Total assets $ 9,064,000 $7,870,000
Liabilities and equity:
Accounts payable $ 1,400,000 $1,090,000
Notes payable 1,600,000 1,800,000
Total current liabilities $ 3,000,000 $2,890,000
Long-term debt 2,400,000 2,400,000
Common stock 3,000,000 2,000,000
Retained earnings 664,000 580,000
Total common equity $ 3,664,000 $2,580,000
Total liabilities and equity $ 9,064,000 $7,870,000
Wolken has never paid a dividend on its common stock, and it issued $2,400,000 of 10-year non-callable, long-term debt in 2008. As of the end of 2009, none of the principal on this debt had been repaid. Assume that the company’s sales in 2008 and 2009 were the same. Which of the following statements must be CORRECT?
Answer
Wolken increased its short-term bank debt in 2009.
Wolken issued long-term debt in 2009.
Wolken issued new common stock in 2009.
Wolken repurchased some common stock in 2009.
Wolken had negative net income in 2009.
2 points
Question 8
Which of the following statements is CORRECT?
Answer
One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital.
If a firm reports positive net income, its EVA must also be positive.
One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free.
One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital.
Actions that increase reported net income will always increase net cash flow.
2 points
Question 9
Which of the following would be most likely to occur in the year after Congress, in an effort to increase tax revenue, passed legislation that forced companies to depreciate equipment over longer lives? Assume that sales, other operating costs, and tax rates are not affected, and assume that the same depreciation method is used for tax and stockholder reporting purposes.
Answer
Companies’ net operating profits after taxes (NOPAT) would decline.
Companies’ physical stocks of fixed assets would increase.
Companies’ net cash flows would increase.
Companies’ cash positions would decline.
Companies’ reported net incomes would decline.
2 points
Question 10
Which of the following statements is CORRECT?
Answer
In the statement of cash flows, a decrease in accounts receivable is reported as a use
of cash.
Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity.
In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.
In the statement of cash flows, depreciation charges are reported as a use of cash.
In the statement of cash flows, a decrease in inventories is reported as a use
of cash.
2 points
Question 11
Which of the following statements is CORRECT?
Answer
Operating cash flow (OCF) is defined as follows:
(1-T) – Depreciation and Amortization.
Changes in working capital have no effect on free cash flow.
Free cash flow (FCF) is defined as follows:
(1 – T)
+ Depreciation and Amortization
– Capital expenditures required to sustain operations
– Required changes in net operating working capital.
Free cash flow (FCF) is defined as follows:
(1-T)+ Depreciation and Amortization + Capital expenditures.
Operating cash flow is the same as free cash flow (FCF).
2 points
Question 12
For managerial purposes, i.e., making decisions regarding the firm’s operations, the standard financial statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm’s operations. Related to these modifications, which of the following statements is CORRECT?
Answer
The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements.
The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions’ performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units.
The standard statements provide useful information on the firm’s individual operating units, but management needs more information on the firm’s overall operations than the standard statements provide.
The standard statements focus on cash flows, but managers are less concerned with cash flows than with accounting income as defined by GAAP.
The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to “adjust” the results to make earnings look better.
2 points
Question 13
Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?
Answer
The company repurchases common stock.
The company pays a dividend.
The company issues new common stock.
The company gives customers more time to pay their bills.
The company purchases a new piece of equipment.
2 points
Question 14
A security analyst obtained the following information from Prestopino Products’ financial statements:
− Retained earnings at the end of 2009 were $700,000, but retained earnings at the end of 2010 had declined to $320,000.
− The company does not pay dividends.
– The company’s depreciation expense is its only non-cash expense; it has no amortization charges.
– The company has no non-cash revenues.
–The company’s net cash flow (NCF) for 2010 was $150,000.
On the basis of this information, which of the following statements is CORRECT?
Answer
Prestopino had negative net income in 2010.
Prestopino’s depreciation expense in 2010 was less than $150,000.
Prestopino had positive net income in 2010, but its income was less than its 2009 income.
Prestopino’s NCF in 2010 must be higher than its NCF in 2009.
Prestopino’s cash on the balance sheet at the end of 2010 must be lower than the cash it had on the balance sheet at the end of 2009.
2 points
Question 15
Which of the following statements is CORRECT?
Answer
The balance sheet for a given year, say 2008, is designed to give us an idea of what happened to the firm during that year.
The balance sheet for a given year, say 2008, tells us how much money the company earned during that year.
The difference between the total assets reported on the balance sheet and the debts reported on this statement tells us the current market value of the stockholders’ equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP).
For most companies, the market value of the stock equals the book value of the stock as reported on the balance sheet.
A typical industrial company’s balance sheet lists the firm’s assets that will be converted to cash first, and then goes on down to list the firm’s longest lived assets last.
2 points
Question 16
Which of the following statements is CORRECT?
Answer
A reduction in inventories held would have no effect on the current ratio.
An increase in inventories would have no effect on the current ratio.
If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.
A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.
If a firm increases its sales while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease.
2 points
Question 17
A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio?
Answer
Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2)lead to an increase in accounts receivable.
Issue new common stock and use the proceeds to increase inventories.
Speed up the collection of receivables and use the cash generated to increase inventories.
Use some of its cash to purchase additional inventories.
Issue new common stock and use the proceeds to acquire additional fixed assets.
2 points
Question 18
HD Corp. and LD Corp. have identical assets, sales, interest rates paid on their debt, tax rates, and EBIT. However, HD uses more debt than LD. Which of the following statements is CORRECT?
Answer
Without more information, we cannot tell if HD or LD would have a higher or lower net income.
HD would have the lower equity multiplier for use in the Du Pont equation.
HD would have to pay more in income taxes.
HD would have the lower net income as shown on the income statement.
HD would have the higher net income as shown on the income statement.
2 points
Question 19
Companies HD and LD have the same sales, tax rate, interest rate on their debt, total assets, and basic earning power. Both companies have positive net incomes. Company HD has a higher debt ratio and, therefore, a higher interest expense. Which of the following statements is CORRECT?
Answer
Company HD pays less in taxes.
Company HD has a lower equity multiplier.
Company HD has a higher ROA.
Company HD has a higher times interest earned (TIE) ratio.
Company HD has more net income.
2 points
Question 20
Considered alone, which of the following would increase a company’s current ratio?
Answer
An increase in net fixed assets.
An increase in accrued liabilities.
An increase in notes payable.
An increase in accounts receivable.
An increase in accounts payable.
2 points
Question 21
Companies E and P each reported the same earnings per share (EPS), but Company E’s stock trades at a higher price. Which of the following statements is CORRECT?
Answer
Company E probably has fewer growth opportunities.
Company E is probably judged by investors to be riskier.
Company E must have a higher market-to-book ratio.
Company E must pay a lower dividend.
Company E trades at a higher P/E ratio.
2 points
Question 22
Which of the following statements is CORRECT?
Answer
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will increase.
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10% and its debt increases from 40% of total assets to 60%. Without additional information, we cannot tell what will happen to the ROE.
The modified Du Pont equation provides information about how operations affect the ROE, but the equation does not include the effects of debt on the ROE.
Other things held constant, an increase in the debt ratio will result in an increase in the profit margin on sales.
Suppose a firm’s total assets turnover ratio falls from 1.0 to 0.9, but at the same time its profit margin rises from 9% to 10%, and its debt increases from 40% of total assets to 60%. Under these conditions, the ROE will decrease.
2 points
Question 23
Amram Company’s current ratio is 1.9. Considered alone, which of the following actions would reduce the company’s current ratio?
Answer
Borrow using short-term notes payable and use the proceeds to reduce accruals.
Borrow using short-term notes payable and use the proceeds to reduce long-term debt.
Use cash to reduce accruals.
Use cash to reduce short-term notes payable.
Use cash to reduce accounts payable.
2 points
Question 24
If a bank loan officer were considering a company’s request for a loan, which of the following statements would you consider to be CORRECT?
Answer
The lower the company’s EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm.
Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.
Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.
The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.
Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.
2 points
Question 25
Which of the following statements is CORRECT?
Answer
The use of debt financing will tend to lower the basic earning power ratio, other things held constant.
A firm that employs financial leverage will have a higher equity multiplier than an otherwise identical firm that has no debt in its capital structure.
If two firms have identical sales, interest rates paid, operating costs, and assets, but differ in the way they are financed, the firm with less debt will generally have the higher expected ROE.
Holding bonds is better than holding stock for investors because income from bonds is taxed on a more favorable basis than income from stock.
All else equal, increasing the debt ratio will increase the ROA.
2 points
Question 26
Which of the following statements is CORRECT?
Answer
If a security analyst saw that a firm’s days’ sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength.
If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding (DSO) will increase.
There is no relationship between the days’ sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things.
A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.
If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days’ sales outstanding will decline.
2 points
Question 27
Which of the following statements is CORRECT?
Answer
If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
Other things held constant, the higher a firm’s expected future growth rate, the lower its P/E ratio is likely to be.
The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).
If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.
2 points
Question 28
If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., “grading” the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant.
Answer
The division’s basic earning power ratio is above the average of other firms in its industry.
The division’s total assets turnover ratio is below the average for other firms in its industry.
The division’s debt ratio is above the average for other firms in the industry.
The division’s inventory turnover is 6, whereas the average for its competitors is 8.
The division’s DSO (days’ sales outstanding) is 40, whereas the average for its competitors is 30.
2 points
Question 29
Which of the following statements is CORRECT?
Answer
If Firms X and Y have the same P/E ratios, then their market-to-book ratios must also be the same.
If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their P/E ratios must also be the same.
If Firms X and Y have the same earnings per share and market-to-book ratio, they must have the same price earnings ratio.
If Firm X’s P/E ratio exceeds that of Firm Y, then Y is likely to be less risky and also to be expected to grow at a faster rate.
If Firms X and Y have the same net income, number of shares outstanding, and price per share, then their market-to-book ratios must also be the same.
2 points
Question 30
Other things held constant, which of the following alternatives would increase
a company’s cash flow for the current year?
Answer
Increase the number of years over which fixed assets are depreciated for tax purposes.
Pay down the accounts payables.
Reduce the days’ sales outstanding (DSO) without affecting sales or operating costs.
Pay workers more frequently to decrease the accrued wages balance.
Reduce the inventory turnover ratio without affecting sales or operating costs.
2 points
Question 1
Which of the following statements is CORRECT?
Answer
For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.
To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.
The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.
If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.
If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.
2 points
Question 2
Which of the following statements is CORRECT?
Answer
If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.
A project’s MIRR can never exceed its IRR.
If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.
If the NPV is negative, the IRR must also be negative.
2 points
Question 3
Which of the following statements is CORRECT?
Answer
The regular payback method recognizes all cash flows over a project’s life.
The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money.
The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.
The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.
The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.
2 points
Question 4
Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s NPV is more sensitive to changes in the WACC?
Answer
Project S.
Project L.
Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.
Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.
The solution cannot be determined because the problem gives us no information that can be used to determine the projects’ relative IRRs.
2 points
Question 5
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
The lower the WACC used to calculate a project’s NPV, the lower the calculated NPV will be.
If a project’s NPV is less than zero, then its IRR must be less than the WACC.
If a project’s NPV is greater than zero, then its IRR must be less than zero.
The NPV of a relatively low-risk project should be found using a relatively high WACC.
2 points
Question 6
Which of the following statements is CORRECT?
Answer
The MIRR and NPV decision criteria can never conflict.
The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.
One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.
The higher the WACC, the shorter the discounted payback period.
The MIRR method assumes that cash flows are reinvested at the crossover rate.
2 points
Question 7
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money.
If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
2 points
Question 8
Which of the following statements is CORRECT?
Answer
The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
The percentage difference between the MIRR and the IRR is equal to the project’s WACC.
2 points
Question 9
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.
The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
If a project’s NPV is greater than zero, then its IRR must be less than zero.
The NPVs of relatively risky projects should be found using relatively low WACCs.
2 points
Question 10
Which of the following statements is CORRECT?
Answer
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
2 points
Question 11
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer
A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.
If a project’s IRR is smaller than the WACC, then its NPV will be positive.
A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
If a project’s IRR is positive, then its NPV must also be positive.
2 points
Question 12
Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?
Answer
Project D probably has a higher IRR.
Project D is probably larger in scale than Project C.
Project C probably has a faster payback.
Project C probably has a higher IRR.
The crossover rate between the two projects is below 12%.
2 points
Question 13
Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?
Answer
If the WACC is 10%, both projects will have positive NPVs.
If the WACC is 6%, Project S will have the higher NPV.
If the WACC is 13%, Project S will have the lower NPV.
If the WACC is 10%, both projects will have a negative NPV.
Project S’s NPV is more sensitive to changes in WACC than Project L’s.
2 points
Question 14
Which of the following statements is CORRECT?
Answer
An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.
An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.
An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.
We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV.
2 points
Question 15
Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B’s IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?
Answer
If the WACC is 13%, Project A’s NPV will be higher than Project B’s.
If the WACC is 9%, Project A’s NPV will be higher than Project B’s.
If the WACC is 6%, Project B’s NPV will be higher than Project A’s.
If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s.
If the WACC is 9%, Project B’s NPV will be higher than Project A’s.
2 points
Question 16
Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear–there is no mortgage on it. Which of the following statements is CORRECT?
Answer
Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.
If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
2 points
Question 17
Which of the following rules is CORRECT for capital budgeting analysis?
Answer
The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.
A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.
If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.
2 points
Question 18
A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
Answer
Increase the estimated IRR of the project to reflect its greater risk.
Increase the estimated NPV of the project to reflect its greater risk.
Reject the project, since its acceptance would increase the firm’s risk.
Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
2 points
Question 19
Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
Answer
The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm’s products.
The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment.
The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.
The new product will cut into sales of some of the firm’s other products.
If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the project’s life.
2 points
Question 20
Which of the following statements is CORRECT?
Answer
Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV.
2 points
Question 21
A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?
Answer
In calculating the project’s operating cash flows, the firm should not
deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.
Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
Capital budgeting decisions should be based on before-tax cash flows.
The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.
2 points
Question 22
Which of the following statements is CORRECT?
Answer
A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.
A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
2 points
Question 23
Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project’s sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?
Answer
The proposed new project would have more stand-alone risk than the firm’s typical project.
The proposed new project would increase the firm’s corporate risk.
The proposed new project would increase the firm’s market risk.
The proposed new project would not affect the firm’s risk at all.
The proposed new project would have less stand-alone risk than the firm’s typical project.
2 points
Question 24
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer
The new project is expected to reduce sales of one of the company’s existing products by 5%.
Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost.
The company has spent and expensed $1 million on R&D associated with the new project.
The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
2 points
Question 25
Which of the following statements is CORRECT?
Answer
Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
Well-diversified stockholders do not need to consider market risk when determining required rates of return.
Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
2 points
Question 26
Which of the following statements is CORRECT?
Answer
Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV.
The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.
Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables’ values.
As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.
2 points
Question 27
Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%
Which set of projects would maximize shareholder wealth?
Answer
A and B.
A, B, and C.
A, B, and D.
A, B, C, and D.
A, B, C, D, and E.
2 points
Question 28
Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
Answer
Changes in net working capital.
Shipping and installation costs.
Cannibalization effects.
Opportunity costs.
Sunk costs that have been expensed for tax purposes.
2 points
Question 29
Which of the following statements is CORRECT?
Answer
If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.
If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.
If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.
Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
2 points
Question 30
When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer
Changes in net working capital attributable to the project.
Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
The value of a building owned by the firm that will be used for this project.
A decline in the sales of an existing product, provided that decline is directly attributable to this project.
The salvage value of assets used for the project that will be recovered at the end of the project’s life.
Question 1
All of the following are reported as current liabilities except
unearned revenues.
accounts payable.
notes payable.
bonds payable.
Question 2
The relationship between current liabilities and current assets is
useful in evaluating a company’s liquidity.
useful in determining income.
called the matching principle.
useful in determining the amount of a company’s long-term debt.
Question 3
Most companies pay current liabilities
by creating long-term liabilities.
out of current assets.
by issuing interest-bearing notes payable.
by issuing stock.
Question 4
From a liquidity standpoint, it is more desirable for a company to have current
assets exceed current liabilities.
assets equal current liabilities.
liabilities exceed long-term liabilities.
liabilities exceed current assets.
Question 5
In most companies, current liabilities are paid within
one year out of current assets.
one year through the creation of other current liabilities.
the operating cycle through the creation of other current liabilities.
the operating cycle out of current assets.
Question 6
The entry to record the issuance of an interest-bearing note credits Notes Payable for the note’s
face value.
maturity value.
cash realizable value.
market value.
Question 7
As interest is recorded on an interest-bearing note, the
Interest Expense
account is
increased; the Notes Payable account is increased.
increased; the Interest Payable account is increased.
increased; the Notes Payable account is decreased.
decreased; the Interest Payable account is increased.
Question 8
Unearned Rental Revenue is
reported as
a current liability.
debited when rent is received in advance.
a revenue account.
a contra account to Rental Revenue.
Question 9
The amount of sales tax collected by a retail store when making sales is
a miscellaneous revenue for the store.
a current liability.
not recorded because it is a tax paid by the customer.
recorded as an operating expense
Question 10
Bonds that are secured by real estate are termed
bearer bonds.
mortgage bonds.
serial bonds.
debentures
Question 11
A major disadvantage resulting from the use of bonds is that
taxes may increase.
interest must be paid on a periodic basis.
earnings per share may be lowered.
bondholders have voting rights.
Question 12
Which one of the following amounts increases each period when accounting for long-term notes payable?
Cash
payment
Principal balance
Reduction of principal
Interest expense
Question 13
The entry to record an installment payment on a long-term note payable is
Mortgage Notes Payable
Interest Expense
Cash
Mortgage Notes Payable
Cash
Bonds Payable
Cash
Interest Expense
Cash
Question 14
Each of the following may be shown in a supporting schedule instead of the balance sheet except the
current maturities of long-term debt.
interest rates.
conversion privileges.
maturity dates.
Question 15
The discount on bonds payable or premium on bonds payable is shown on the balance sheet as an adjustment to bonds payable to arrive at the carrying value of the bonds. Indicate the appropriate addition or subtraction to bonds payable:
Premium on Bonds Payable
Discount on Bonds Payable
Deduct Deduct
Add Add
Deduct Add
Add Deduct
Question 1
Which one of the following is not an ownership right of a stockholder in a corporation?
To share in assets upon liquidation.
To share in corporate earnings.
To declare dividends on the common stock.
To vote in the election of directors.
Question 2
A corporation has the following account balances: Common stock, $1 par value, $30,000; Paid-in Capital in Excess of Par Value, $1,350,000. Based on this information, the
average price per share issued is $4.60.
number of shares outstanding are 1,380,000.
number of shares issued are 30,000.
legal capital is $1,380,000.
Question 3
If stock is issued for a noncash asset, the asset should be recorded on the books of the corporation at
fair market value.
a nominal amount.
cost.
zero.
Question 4
Which of the following represents the largest number of common shares?
Outstanding shares
Treasury shares
Issued shares
Authorized shares
Question 5
A corporation purchases 20,000 shares of its own $20 par common stock for $35 per share, recording it at cost. What will be the effect on total stockholders’ equity?
Increase by $400,000
Increase by $700,000
Decrease by $700,000
Decrease by $400,000
Question 6
The acquisition of treasury stock by a corporation
has no effect on total assets and total stockholders’ equity.
requires that a gain or loss be recognized on the income statement.
increases its total assets and total stockholders’ equity.
decreases its total assets and total stockholders’ equity.
Question 7
Which of the following is not a right or preference associated with preferred stock?
First claim to dividends.
Preference to corporate assets in case of liquidation.
The right to vote.
To receive dividends in arrears before common stockholders receive dividends.
Question 8
If preferred stock is cumulative, the
preferred dividends not declared in a given year are called dividends in arrears.
preferred shareholders and the common shareholders receive equal dividends.
preferred shareholders and the common shareholders receive the same total dollar amount of dividends.
common shareholders will share in the preferred dividends.
Question 9
When common stock is issued for services or non-cash assets, cost should be
either the fair market value of the consideration given up or the consideration received, whichever is more clearly evident.
the book value of the common stock issued.
only the fair market value of the consideration given up.
only the fair market value of the consideration received.
Question 10
Common Stock Dividends Distributable is classified as a(n)
asset account.
stockholders’ equity account.
expense account.
liability account.
Question 11
Indicate the respective effects of the declaration of a cash dividend on the following balance sheet sections:
Total Assets Total Liabilities Total Stockholders’ Equity
Increase Decrease No change
Decrease No change Increase
No change Increase Decrease
Decrease Increase Decrease
Question 12
Which of the following show the proper effect of a stock split and a stock dividend?
Item Stock Split Stock Dividend
Total paid-in capital Increase Increase
Total retained earnings Decrease Decrease
Total par value (common) Decrease Increase
Par value per share Decrease No change
Question 13
Restricting retained earnings for the cost of treasury stock purchased is a
legal restriction.
contractual restriction.
stock restriction.
voluntary restriction.
Question 14
Retained earnings are occasionally restricted
to set aside cash for dividends.
due to contractual loan restrictions.
to keep the legal capital associated with paid-in capital intact.
if preferred dividends are in arrears
Question 15
Prior period adjustments
may only decrease retained earnings.
do not affect retained earnings.
may only increase retained earnings.
may either increase or decrease retained earnings.
