1.
A firm has notes payable of $1,546,000, longterm
debt of $13,000,000, and total interest expense of $1,300,000. If the firm pays
8 percent interest on its longterm debt, what interest rate does it pay on its
notes payable?
¡P
16.8%
2.
A startup firm is making an initial investment in
new plant and equipment. Currently, equipment is depreciated on a straightline
basis over 10 years. Assume that Congress is considering legislation that will
allow the corporation to depreciate the equipment over 7 years. If the
legislation becomes law, and the firm implements the 7year depreciation basis,
which of the following will occur?
¡P
The firm's net cash flow will increase.
3.
A stock analyst has acquired the following
information for Palmer Products:
Ø Retained
earnings on the yearend 2001 balance sheet was $700,000.
Ø Retained
earnings on the yearend 2002 balance sheet was $320,000.
Ø The company does not pay
dividends.
Ø The company's depreciation
expense is its only noncash expense.
Ø The company has no
noncash revenues.
Ø The company's net cash
flow for 2002 was $150,000.
On the basis of this information, which
of the following statements is most correct?
¡P
Palmer Products had negative net income in 2002.
4.
A stock market analyst has forecasted the following
yearend numbers for Raedebe Technology:
Ø
Sales $70
million
Ø
EBITDA $20
million
Ø
Depreciation $
7 million
Ø
Amortization $
0
The company's
tax rate is 40 percent. The company does not expect any changes in its net
operating working capital. This year the company's planned gross capital
expenditures will total $12 million. (Gross capital expenditures represent
capital expenditures before deducting depreciation.) What is the company's
forecasted free cash flow for the year?
¡P
$ 2.8 million
5.
All else equal, which of the following actions will
increase the amount of cash on a company's balance sheet?
¡P
The company issues new common stock.
6.
An analyst has acquired the following information
regarding Company A and Company B:
Ø Company A has a higher net
cash flow than Company B.
Ø Company B has higher net
income than Company A.
Ø Company B has a higher
operating cash flow than Company A.
Ø The companies have the
same tax rate, investorsupplied operating capital, and cost of capital (WACC).
Assume that
noncash revenues equal zero for both companies, and depreciation is the only
noncash expense for both companies. Which of the following statements is most
correct?
¡P
All of the statements above are correct.
7.
An analyst has collected the following information
regarding Gilligan Grocers:
Ø Earnings
before interest and taxes (EBIT) = $700 million.
Ø Earnings
before interest, taxes, depreciation and amortization (EBITDA) = $850 million.
Ø Interest
expense = $200 million.
Ø The corporate
tax rate is 40 percent.
Ø Depreciation
is the company's only noncash expense or revenue.
What is the
company's net cash flow?
¡P
$450 million
8.
Analysts who follow Cascade Technology recently
noted that, relative to the previous year, the company's operating income
(EBIT) and net income had declined but its operating cash flow had increased.
What could explain these changes?
¡P
The company's depreciation and amortization
expenses increased.
9.
Analysts who follow Sierra Nevada Inc. recently
noted that, relative to the previous year, the company's net cash flow was larger
but cash on the firm's balance sheet had declined. What factors could explain
these changes?
¡P
The company made a large investment in new plant
and equipment.
10.
Armstrong Inc. is a profitable corporation with a
40 percent corporate tax rate. The company is deciding between depreciating the
equipment it purchased this year on a straightline basis over five years or
over three years. Changing the depreciation schedule will have no impact on the
equipment's economic value. If Armstrong chooses to depreciate the equipment
over three years, which of the following will occur next year, relative to what
would have happened, if it had depreciated the equipment over five years?
¡P
Statements a and b are
correct.
11. Assume that a company currently
depreciates its fixed assets over 7 years. Which of the following would occur
if a tax law change forced the company to depreciate its fixed assets over 10
years instead?
¡P
Statements a and c are correct.
12.
Assume that the depreciation level used for tax and
accounting purposes equals the true economic depreciation. Which of the
following statements is most correct?
¡P
A firm can increase its EVA even if its operating
income falls.
13.
At the beginning of the year, Gonzales Corporation
had $100,000 in cash. The company undertook a major expansion during this same
year. Looking at its statement of cash flows, you see that the net cash
provided by its operations was $300,000 and the company's investing activities
required cash expenditures of $800,000. The company's cash position at the end of
the year was $50,000. What was the net cash provided by the company's financing
activities?
¡P
$450,000
14.
At the end of 2001, Lehnhoff Inc. had $75 million
in cash on its balance sheet. During 2002, the following events occurred:
Ø
The cash flow from Lehnhoff's operating activities totaled $325 million.
Ø
Lehnhoff issued $500 million in common stock.
Ø
Lehnhoff's notes payable decreased by $100 million.
Ø
Lehnhoff purchased fixed assets totaling $600 million.
How much cash did Lehnhoff Inc. have on
its balance sheet at the end of 2002?
¡P
$ 200 million
15. At the end of 2001, Scaringe Medical Supply had $275
million of retained earnings on its balance sheet. During 2002, Scaringe paid a
pershare dividend of $0.25 and produced earnings per share of $0.75. Scaringe
has 20 million shares of stock outstanding. What was the level of retained
earnings that Scaringe had on its balance sheet at the end of 2002?
¡P
$285
million
Beckham Broadcasting Company
Beckham Broadcasting Company (BBC) has operating income (EBIT) of $2,500,000.
The company's depreciation expense is $500,000 and it has no amortization
expense. The company is 100 percent equity financed (that is, its interest
expense is zero). The company has a 40 percent tax rate, and its net investment
in operating capital is $1,000,000.
16.
Refer to Beckham Broadcasting Company. What is
BBC's net income?
¡P
$1,500,000
17.
Refer to Beckham Broadcasting Company. What is
BBC's net operating profit after taxes (NOPAT)?
¡P
$1,500,000
18. Below are the 2001 and 2002 yearend
balance sheets for Kewell Boomerangs:
Assets: 
2002 
2001 
Cash 
$ 100,000 
$ 85,000 
Accounts
receivable 
432,000 
350,000 
Inventories 
1,000,000 
700,000 
Total
current assets 
$1,532,000 
$1,135,000 
Net fixed
assets 
3,000,000 
2,800,000 
Total assets 
$4,532,000 
$3,935,000 



Liabilities
and equity: 


Accounts
payable 
$ 700,000 
$ 545,000 
Notes payable 
800,000 
900,000 
Total
current liabilities 
$1,500,000 
$1,445,000 
Longterm debt 
1,200,000 
1,200,000 
Common stock 
1,500,000 
1,000,000 
Retained
earnings 
332,000 
290,000 
Total
common equity 
$1,832,000 
$1,290,000 
Total
liabilities and equity 
$4,532,000 
$3,935,000 



Kewell Boomerangs has never paid a dividend on its common stock. Kewell issued
$1,200,000 of longterm debt in 1997. This debt was noncallable and is
scheduled to mature in 2027. As of the end of 2002, none of the principal on
this debt has been repaid. Assume that 2001 and 2002 sales were the same in
both years. Which of the following statements is most correct?
¡P
Kewell
issued new common stock in 2002.
19.
Below is the equity portion (in millions) of the
yearend balance sheet that Glenn Technology has reported for the last two
years:

2002 
2001 
Preferred stock 
$
80 
$
80 
Common stock 
2,000 
1,000 
Retained earnings 
2,000 
2,340 
Total equity 
$4,080 
$3,420 
Glenn does not pay a dividend to its
common stockholders. Which of the following statements is most correct?
¡P
Glenn issued common stock in 2002.
20.
Brooks Sisters' operating income (EBIT) is
$500,000. The company's tax rate is 40 percent, and its operating cash flow is
$450,000. The company's interest expense is $100,000. What is the company's net
cash flow? (Assume that depreciation is the only noncash item in the firm's
financial statements.)
¡P
$ 390,000
21. Byrd Lumber has 2 million shares of
common stock outstanding and its stock price is $15 a share. On the balance sheet, the company has $40 million of
common equity. What is the company's Market Value Added (MVA)?
¡P
$10,000,000
22.
Casey Motors recently reported the following
information:
Ø
Net income = $600,000.
Ø
Tax rate = 40%.
Ø
Interest expense = $200,000.
Ø
Total investorsupplied operating capital employed = $9 million.
Ø
Aftertax cost of capital = 10%.
What is the company's EVA?
¡P
$180,000
23.
Cochrane, Inc. had $75,000 in cash on the balance
sheet at the end of 2001. At yearend 2002, the company had $155,000 in cash.
We know cash flow from operating activities totaled $1,250,000 and cash flow
from longterm investing activities totaled $1,000,000. Furthermore, Cochrane
issued $250,000 in longterm debt last year to fund new projects, increase
liquidity, and to buy back some common stock. If dividends paid to common
stockholders equaled $25,000, how much common stock did Cochrane repurchase
last year? (Assume that the only financing activities in which Cochrane engaged
involved longterm debt, payment of common dividends, and common stock.)
¡P
$395,000
24.
Congress recently passed a provision that will
enable Piazza Cola to double its depreciation expense for the upcoming year.
The new provision will have no effect on the company's sales revenue. Prior to
the new provision, Piazza's net income was forecasted to be $4 million. The
company's tax rate is 40 percent. Which of the following best describes the
impact that this provision will have on Piazza's financial statements?
¡P
None of the statements above is correct.
25. Coolidge Cola is forecasting the following income
statement:
Sales 
$30,000,000 
Operating
costs excluding depreciation and amortization 
20,000,000 
EBITDA 
$10,000,000 
Depreciation
and amortization 
5,000,000 
Operating
income (EBIT) 
$ 5,000,000 
Interest
expense 
2,000,000 
Taxable income
(EBT) 
$ 3,000,000 
Taxes (40%) 
1,200,000 
Net income 
$ 1,800,000 


Assume that, with the exception of
depreciation, all other noncash revenues and expenses sum to zero.
Congress is considering a proposal that will allow companies to depreciate
their equipment at a faster rate. If this provision were put in place,
Coolidge's depreciation expense would be $8,000,000 (instead of $5,000,000).
This proposal would have no effect on the economic value of the company's
equipment, nor would it affect the company's tax rate, which would remain at 40
percent. If this proposal were to be implemented, what would be the company's
net cash flow?
¡P
$8,000,000
26. Cox Corporation recently reported an
EBITDA of $22.5 million and $5.4 million of net income. The company has $6 million interest expense and the
corporate tax rate is 35 percent. What was the company's depreciation and amortization expense?
¡P
$
8,192,308
27.
Edge Brothers recently reported net income of
$385,000. The tax rate is 40 percent. The company's interest expense was
$200,000. What would have been the company's net income if it would have been
able to double its operating income (EBIT), assuming that the company's tax
rate and interest expense remain unchanged?
¡P
$ 890,000
Garfield
Industries is expanding its operations throughout the
¡P
$
60,000 increase
28.
Haskell Motors' common equity on the balance sheet
totals $700 million, and the company has 35 million shares of common stock
outstanding. Haskell has significant growth opportunities. Its headquarters has
a book value of $5 million, but its market value is estimated to be $10
million. Over time, Haskell has issued outstanding debt that has a book value
of $10 million and a market value of $5 million. Which of the following
statements is most correct?
¡P
Statements a and c are
correct.
29.
Hayes Corporation has $300 million of common equity
on its balance sheet and 6 million shares of common stock outstanding. The
company's Market Value Added (MVA) is $162 million. What is the company's stock
price?
¡P
$ 77
30.
Holmes Aircraft recently announced an increase in
its net income, yet its net cash flow declined relative to last year. Which of
the following could explain this performance?
¡P
The company's depreciation and amortization expenses
declined.
31. Hebner Housing Corporation has forecast the following numbers for
this upcoming year:
Ø
Sales
= $1,000,000.
Ø
Cost
of goods sold = 600,000.
Ø
Interest
expense = 100,000.
Ø
Net
income = 180,000.
The company is in the 40 percent tax bracket. Its cost of goods
sold always represents 60 percent of its sales. That is, if the company's sales
were to increase to $1.5 million, its cost of goods sold would increase to
$900,000.
The company's CEO is unhappy with the forecast and wants the firm to achieve a net
income equal to $240,000. In order to achieve this level of net income, what
level of sales will the company have to achieve? Assume that Hebner's interest
expense remains constant.
¡P
$1,250,000
32.
In its recent income statement, Smith Software Inc.
reported $25 million of net income, and in its yearend balance sheet, Smith
reported $405 million of retained earnings. The previous year, its balance
sheet showed $390 million of retained earnings. What were the total dividends
paid to shareholders during the most recent year?
¡P
$10,000,000
33.
Keaton Enterprises is a very profitable company,
which recently purchased some equipment. It plans to depreciate the equipment
on a straightline basis over the next 10 years. Congress, however, is
considering a change in the Tax Code that would allow Keaton to depreciate the
equipment on a straightline basis over 5 years instead of 10 years.
If Congress were to change the law, and Keaton does decide to depreciate the
equipment over 5 years, what effect would this change have on the company's
financial statements for the coming year? (Note that the change in the law
would have no effect on the economic or physical value of the equipment.)
¡P
Statements a and c are
correct.
34.
Kramer Corporation recently announced that its net
income was lower than last year. However, analysts estimate that the company's
net cash flow increased. What factors could explain this discrepancy?
¡P
The company's depreciation and amortization
expenses increased.
35.
Last year Aldrin Co. had negative net cash flow,
yet its cash on the balance sheet increased. What could explain these events?
¡P
Statements a and c are
correct.
36.
Last year, Blanda Brothers had positive net cash
flow, yet cash on the balance sheet decreased. Which of the following could
explain the company's financial performance?
¡P
The company purchased a lot of new fixed assets.
37.
Last year, Sewickley Shoes had negative net cash
flow; however, cash on its balance sheet increased. Which of the following
could explain this?
¡P
The company issued a large amount of longterm
debt.
Laiho Industries
Laiho Industries recently reported the following information in its annual
report:
Ø
Net income = $7.0 million.
Ø
NOPAT = $60 million.
Ø
EBITDA = $120 million.
Ø
Net profit margin = 5.0%.
Laiho has depreciation expense, but it does not have amortization
expense. Laiho has $300 million in operating capital, its aftertax cost of
capital is 10 percent (that is, its WACC = 10%), and
the firm's tax rate is 40 percent.
38.
Refer to Laiho Industries. What is Laiho's
depreciation expense?
¡P
$20.0 million
39.
Refer to Laiho Industries. What is Laiho's EVA?
¡P
$30.0 million
40. Refer to Laiho
Industries. What is Laiho's interest expense?
¡P
$88.3 million
41.
Refer to Laiho Industries. What is
Laiho's sales?
¡P
$140.0 million
42. Last year, Owen Technologies reported negative net cash flow and negative free cash flow. However, its cash on the balance sheet increased. Which of the following could explain these changes in its cash position?
¡P
The company issued new common stock.
43.
McGwire Aerospace expects to have net cash flow of
$12 million. The company forecasts that its operating costs excluding
depreciation and amortization will equal 75 percent of the company's sales.
Depreciation and amortization expenses are expected to be $5 million and the
company has no interest expense. All of McGwire's sales will be collected in
cash, costs other than depreciation and amortization will be paid in cash
during the year, and the company's tax rate is 40 percent. What is the company's expected sales?
¡P
$ 66.67 million
44.
New Mexico Lumber recently reported that its
earnings per share were $3.00. The company has 400,000 shares of common stock
outstanding, its interest expense is $500,000, and its corporate tax rate is 40
percent. What is the company's operating income (EBIT)?
¡P
$2,500,000
45.
New Hampshire Services reported $2.3 million of
retained earnings on its 2001 balance sheet. In 2002, the company lost
moneyits net income was $500,000 (negative $500,000). Despite the loss, the
company still paid a $1.00 per share dividend. The company's earnings per share
for 2002 were $2.50 (negative $2.50). What was the level of retained earnings
on the company's 2002 balance sheet?
¡P
$1.6 million
46.
On its 2001 balance sheet, Sherman Books had
retained earnings equal to $510 million. On its 2002 balance sheet, retained
earnings were also equal to $510 million. Which of the following statements is
most correct?
¡P
If the company's net income in 2002 was $200
million, dividends paid must have also equaled $200 million.
47.
Ozark Industries reported net income of $75 million
in 2002. The company's corporate tax rate was 40 percent and its interest
expense was $25 million. The company had $500 million in sales and its cost of
goods sold was $350 million. Ozark's goal is for its net income to increase by
20 percent (to $90 million) in 2003. It forecasts that the tax rate will remain
at 40 percent, interest expense will increase by 40 percent, and cost of goods
sold will remain at 70 percent of sales. What level of sales (to the closest
million) will Ozark have to produce in 2003 in order to meet its goal for net
income?
¡P
$617 million
48.
Sanguillen Corp. had retained earnings of $400,000
on its 2001 balance sheet. In 2002, the company¡¦s earnings per share (EPS) were
$3.00 and its dividends paid per share (DPS) were $1.00. The company has
200,000 shares of common stock outstanding. What will be the level of retained
earnings on the company¡¦s 2002 balance sheet?
¡P
$800,000
49.
Scranton Shipyards has $20 million in total
investorsupplied operating capital. The company¡¦s WACC is 10 percent. The
company has the following income statement:
Sales $10.0
million
Operating
costs
6.0 million
Operating
income (EBIT) $ 4.0 million
Interest
expense 2.0
million
Earnings
before taxes (EBT) $ 2.0 million
Taxes (40%)
0.8 million
Net income $ 1.2 million
What is
¡P
$ 400,000
Sebring Corporation
You have just obtained financial information for the
past 2 years for Sebring Corporation.
SEBRING CORPORATION:
INCOME STATEMENTS 


2002 
2001 
Sales 
$3,600.0 
$3,000.0 
Operating
costs (excluding depreciation and amortization) 
3,060.0 
2,550.0 
EBITDA 
$ 540.0 
$ 450.0 
Depreciation
and amortization 
90.0 
75.0 
Earnings
before interest and taxes 
$ 450.0 
$ 375.0 
Interest

65.0 
60.0 
Earnings
before taxes 
$ 385.0 
$ 315.0 
Taxes
(40%) 
154.0 
126.0 
Net
income available to common stockholders 
$ 231.0 
$ 189.0 
Common
dividends 
$ 181.5 
$ 13.2 



SEBRING
CORPORATION: BALANCE SHEETS 


2002 
2001 
Assets: 


Cash
and marketable securities 
$ 36.0 
$ 30.0 
Accounts
receivable 
540.0 
450.0 
Inventories 
540.0 
600.0 
Total
current assets 
$1,116.0 
$1,080.0 
Net
plant and equipment 
900.0 
750.0 
Total
assets 
$2,016.0 
$1,830.0 



Liabilities
and equity: 


Accounts
payable 
$ 324.0 
$ 270.0 
Notes
payable 
201.0 
155.0 
Accruals 
216.0 
180.0 
Total
current liabilities 
$ 741.0 
$ 605.0 
Longterm
bonds 
450.0 
450.0 
Total
debt 
$1,191.0 
$1,055.0 
Common
stock (50 million shares) 
150.0 
150.0 
Retained
earnings 
675.0 
625.0 
Total
common equity 
$ 825.0 
$ 775.0 
Total
liabilities and equity 
$2,016.0 
$1,830.0 



50.
Refer to Sebring Corporation. What is Sebring's
amount of total investorsupplied operating capital for 2002?
¡P
$1,476,000,000
51.
Refer
to Sebring Corporation. What is Sebring's free cash flow for 2002?
¡P
$174,000,000
52.
Refer to Sebring Corporation. What is Sebring's net
operating profit after taxes (NOPAT) for 2002?
¡P
$270,000,000
53.
Refer to Sebring Corporation. What is Sebring's net
operating working capital for 2002?
¡P
$ 576,000,000
Sharpe Radios
Last year, Sharpe Radios had a net operating profit
aftertaxes (NOPAT) of $7.8 million. Its EBITDA was $15.5 million and
net income amounted to $3.8 million. During the year, Sharpe Radios made $5.5
million in net capital expenditures (that is, capital expenditures net of
depreciation). Finally, Sharpe Radios' finance staff has concluded that the
firm's total aftertax capital costs were $5.9 million and its tax rate was 40
percent.
54.
Refer to Sharpe Radios. What is Sharpe Radios'
depreciation and amortization expense?
¡P
$2.5 million
55.
Refer to Sharpe Radios. What is Sharpe Radios' EVA?
¡P
$1.9 million
56.
Refer to Sharpe Radios. What is Sharpe Radios' free
cash flow?
¡P $2.3 million
57.
Refer to Sharpe Radios. What is Sharpe Radios'
interest expense?
¡P
$ 6.67 million
58.
Solo Company has been depreciating its fixed assets
over 15 years. It is now clear that these assets will only last a total of 10
years. Solo's accountants have encouraged the firm to revise its annual
depreciation to reflect this new information. Which of the following would
occur as a result of this change?
¡P
Statements a and b are
correct.
59.
Swann Systems is forecasting the following income
statement for the upcoming year:
Sales 
$5,000,000 
Operating costs (excluding depreciation and amortization) 
3,000,000 
EBITDA 
$2,000,000 
Depreciation and amortization 
500,000 
EBIT 
$1,500,000 
Interest 
500,000 
EBT 
$1,000,000 
Taxes (40%) 
400,000 
Net income 
$
600,000 
The company's president is disappointed
with the forecast and would like to see Swann generate higher sales and a
forecasted net income of $2,000,000.
Assume that operating costs (excluding depreciation and amortization) are
always 60 percent of sales. Also, assume that depreciation and amortization,
interest expense, and the company's tax rate, which is 40 percent, will remain
the same even if sales change. What level of sales would Swann have to obtain
to generate $2,000,000 in net income?
¡P
$10,833,333
60. The Campbell Corporation just purchased an expensive piece of
equipment. Which of the following will occur as a result of this Congressional
action?
¡P
All
of the statements above are correct.
61.
The Campbell Corporation just purchased an
expensive piece of equipment. Originally, the firm was planning on depreciating
the equipment over 5 years on a straightline basis. However, Congress just
passed a provision that will force the company to depreciate its equipment over
7 years on a straightline basis. Which of the following will occur as a result
of this Congressional action?
¡P
All of the statements above are correct.
62.
The CFO of Mulroney Brothers has suggested that the
company should issue $300 million worth of common stock and use the proceeds to
reduce some of the company's outstanding debt. Assume that the company adopts
this policy, and that total assets and operating income (EBIT) remain the same.
The company's tax rate will also remain the same. Which of the following will
occur?
¡P
The company's net income will increase.
63.
Which
of the following are likely to occur if Congress passes legislation that forces
Carter Manufacturing to depreciate their equipment over a longer time period?
¡P
The
company's cash position would decline.
64.
Which of the following factors could explain why
last year Cleaver Energy had negative net cash flow, but the cash on its
balance sheet increased?
¡P
The company issued new debt.
65.
Which of the following items is included as part of
a company's current assets?
¡P
Statements b and c are correct.
66.
Which of the following items can be found on a
firm's balance sheet listed as a current asset?
¡P
Accounts receivable.
67.
Which of the following statements is most correct?
¡P
One way to increase EVA is to maintain the same
operating income with less capital.
¡P
If a company pays more in dividends than it
generates in net income, its balance of retained earnings reported on the
balance sheet will fall.
68.
Whitehall Clothiers had $5,000,000 of retained
earnings on its balance sheet at the end of 2001. One year later,
¡P
$1.80
1. A firm has a debt/equity ratio of 50
percent. Currently, it has interest expense of $500,000 on $5,000,000 of total
debt outstanding. Its tax rate is 40 percent. If the firm's ROA is 6 percent,
by how many percentage points is the firm's ROE greater than its ROA?
¡P
3.0%
2. A firm has a profit margin of 15 percent
on sales of $20,000,000. If the firm has debt of $7,500,000, total assets of
$22,500,000, and an aftertax interest cost on total debt of 5 percent, what is
the firm's ROA?
¡P
13.3%
3. A firm that has an equity multiplier of
4.0 will have a debt ratio of
¡P
0.75
4. A fire has destroyed a large percentage
of the financial records of the Carter Company. You have the task of piecing
together information in order to release a financial report. You have found the
return on equity to be 18 percent. If sales were $4 million, the debt ratio was
0.40, and total liabilities were $2 million, what would be the return on assets
(ROA)?
¡P
10.80%
5.
Aaron Aviation recently reported the following information:
Net income 
$500,000 
ROA 
10% 
Interest expense 
$200,000 


The company's average tax rate is 40 percent. What is the company's basic
earning power (BEP)?
¡P
20.67%
6. All else being equal, which of the
following will increase a company's current ratio?
¡P
An
increase in accounts receivable.
7.
Alumbat Corporation has $800,000 of debt
outstanding, and it pays an interest rate of 10 percent annually on its bank loan. Alumbat's
annual sales are $3,200,000, its average tax rate is 40 percent, and its net
profit margin on sales is 6 percent. If the company does not maintain a TIE
ratio of at least 4 times, its bank will refuse to renew its loan, and
bankruptcy will result. What is Alumbat's current TIE ratio?
¡P
5.0
8. Amazon Electric wants to increase its
debt ratio, which will also increase its interest expense. Assume that the
higher debt ratio will have no effect on the company's operating income, total
assets, or tax rate. Also, assume that the basic earning power ratio exceeds
the beforetax cost of debt financing. Which of the following will occur if the
company increases its debt ratio?
¡P
All
of the statements above are correct.
9.
An analyst has obtained the following information regarding
two companies, Company X and Company Y
Ø Company X and
Company Y have the same total assets.
Ø Company X has
a higher interest expense than Company Y.
Ø Company X has
a lower operating income (EBIT) than Company Y.
Ø Company X and
Company Y have the same return on equity (ROE).
Ø Company X and
Company Y have the same total assets turnover (TATO).
Ø Company X and
Company Y have the same tax rate.
On the basis of this information, which
of the following statements is most correct?
¡P
Company X has a lower profit margin.
10. As a shortterm creditor concerned with a
company's ability to meet its financial obligation to you, which one of the
following combinations of ratios would you most likely prefer?
Current ratio; TIE; Debt ratio
¡P
1.5; 1.5; 0.50
11. Assume Meyer Corporation is 100 percent
equity financed. Calculate the return on equity, given the following
information:
Earnings
before taxes 
$1,500 
Sales 
$5,000 
Dividend
payout ratio 
60% 
Total assets
turnover 
2.0 
Tax rate 
30% 
¡P
42%
12. Aurillo
Equipment Company (AEC) projected that its ROE for next year would be just 6
percent. However, the financial staff has determined that the firm can increase its ROE by refinancing some
high interest bonds currently outstanding. The firm's total debt will remain at
$200,000 and the debt ratio will hold constant at 80 percent, but the interest
rate on the refinanced debt will be 10 percent. The rate on the old debt is 14
percent. Refinancing will not affect sales, which are projected to be $300,000.
EBIT will be 11 percent of sales and the firm's tax rate is 40 percent. If AEC refinances
its high interest bonds, what will be its projected new ROE?
¡P
15.6%
13. Austin & Company has a debt ratio of
0.5, a total assets turnover ratio of 0.25, and a profit margin of 10 percent.
The Board of Directors is unhappy with the current return on equity (ROE), and
they think it could be doubled. This could be accomplished (1) by increasing
the profit margin to 12 percent and (2) by increasing debt utilization. Total
assets turnover will not change. What new debt ratio, along with the new 12
percent profit margin, would be required to double the ROE?
¡P
70%
14. Bedford Hotels
and Breezewood Hotels both have $100 million in total assets and a 10 percent
return on assets (ROA). Each company has a 40 percent tax rate.
¡P
15. Bichette Furniture Company recently
issued new common stock and used the proceeds to reduce its shortterm notes
payable and accounts payable. This action had no effect on the company's total
assets or operating income. Which of the following effects did occur as a
result of this action?
¡P
The
company's equity multiplier decreased.
16. Blair Company has $5 million in total
assets. The company's assets are financed with $1 million of debt and $4
million of common equity. The company's income statement is summarized below:
Operating
income (EBIT) 
$1,000,000 
Interest 
100,000 
Earnings
before taxes (EBT) 
$ 900,000 
Taxes (40%) 
360,000 
Net income 
$ 540,000 
The company wants to increase its assets by $1 million, and it
plans to finance this increase by issuing $1 million in new debt. This action
will double the company's interest expense but its operating income will remain
at 20 percent of its total assets, and its average tax rate will remain at 40
percent. If the company takes this action, which of the following will occur:
¡P
Statements
a and b are correct.
17. Cannon Company has enjoyed a rapid
increase in sales in recent years, following a decision to sell on credit.
However, the firm has noticed a recent increase in its collection period. Last
year, total sales were $1 million, and $250,000 of these sales were on credit. During the year, the accounts receivable
account averaged $41,096. It is expected that sales will increase in the
forthcoming year by 50 percent, and, while credit sales should continue to be
the same proportion of total sales, it is expected that the days
sales outstanding will also increase by 50 percent. If the resulting increase
in accounts receivable must be financed externally, how much external funding
will Cannon need? Assume a 365day year.
¡P
$
51,370
18. Cartwright
Brothers has the following balance sheet (all numbers are expressed in millions
of dollars):
Cash 
$ 250 

Accounts payable 
$ 300 
Accounts receivable 
250 

Notes payable 
300 
Inventories 
250 

Longterm debt 
600 
Net fixed assets 
1,250 

Common stock 
800 
Total assets 
$2,000 

Total claims 
$2,000 





Cartwright's average daily sales are $10 million. Currently, Cartwright's days sales outstanding (DSO) is well above the industry
average of 15. Cartwright is implementing a plan that is designed to reduce its
DSO to 15 without reducing its sales. If successful the plan will free up cash,
half of which will be used to reduce notes payable and the other half will be
used to reduce accounts payable. What will be the current ratio if Cartwright
fully succeeds in implementing this plan?
¡P
1.30
19. Cleveland Corporation has 100,000 shares
of common stock outstanding, its net income is $750,000, and its P/E is 8. What
is the company's stock price?
¡P
$60.00
20. Collins
Company had the following partial balance sheet and complete income statement
information for 2002:
Partial Balance Sheet:
Cash 
$ 20 
A/R 
1,000 
Inventories 
2,000 
Total current assets 
$3,020 
Net fixed assets 
2,980 
Total assets 
$6,000 
Income Statement:
Sales 
$10,000 
Cost of goods sold 
9,200 
EBIT 
$ 800 
Interest (10%) 
400 
EBT 
$ 400 
Taxes (40%) 
160 
Net income 
$ 240 
The industry average DSO is 30 (assuming a 365day year). Collins plans to
change its credit policy so as to cause its DSO to equal the industry average,
and this change is expected to have no effect on either sales or cost of goods
sold. If the cash generated from reducing receivables is used to retire debt
(which was outstanding all last year and has a 10 percent interest rate), what
will Collins' debt ratio (Total debt/Total assets) be after the change in DSO
is reflected in the balance sheet?
¡P
65.65%
21. Companies A and B have the same profit
margin and debt ratio. However, Company A has a higher return on assets and a
higher return on equity than Company B. Which of the following can explain
these observed ratios?
¡P
Company
A must have a higher total assets turnover than Company B.
22. Company A and
Company B have the same tax rate, total assets, and
basic earning power. Both companies have positive
net incomes. Company A has a higher debt ratio, and therefore, higher interest
expense than Company B. Which of the following statements is true?
¡P
Company A pays less in taxes than Company B.
23. Company A and Company B have the same total assets, return on assets (ROA), and
profit margin. However, Company A has a higher debt ratio and interest expense
than Company B. Which of the following statements is most correct?
¡P
Statements
a and c are correct.
24. Company A and
Company B have the same total assets, tax rate, and
net income. Company A, however, has a lower profit margin than Company B.
Company A also has a higher debt ratio and, therefore, higher interest expense
than Company B. Which of the following statements is most correct?
¡P
All of the statements above are correct.
25. Company A has sales of $1,000, assets of
$500, a debt ratio of 30 percent, and an ROE of 15 percent. Company B has the
same sales, assets, and net income as Company A, but its ROE is 30 percent.
What is B's debt ratio? (Hint: Begin by looking at the Du Pont equation.)
¡P
65.0%
26. Company A's ROE is 20 percent, while
Company B's ROE is 15 percent. Which of the following statements is most
correct?
¡P
None
of the statements above is correct.
27. company has just been taken over by new management that
believes it can raise earnings before taxes (EBT) from $600 to $1,000, merely
by cutting overtime pay and reducing cost of goods sold. Prior to the change,
the following data applied:
Total assets 
$8,000 
Debt ratio 
45% 
Tax rate 
35% 
BEP ratio 
13.3125% 
EBT 
$600 
Sales 
$15,000 
These data have been constant for
several years, and all income is paid out as dividends. Sales, the tax rate,
and the balance sheet will remain constant. What is the company's cost of debt?
(Hint: Work only with old data.)
¡P
12.92%
28. Company J and Company K each recently
reported the same earnings per share (EPS). Company J's stock, however, trades
at a higher price. Which of the following statements is most correct?
¡P
Company
J must have a higher P/E ratio
29. Company X has a higher ROE than Company
Y, but Company Y has a higher ROA than Company X. Company X also has a higher
total assets turnover ratio than Company Y; however, the two companies have the
same total assets. Which of the following statements is most correct?
¡P
Statements
b and c are correct.
30. Culver Inc. has earnings after interest
but before taxes of $300. The company's times interest earned ratio is 7.00.
Calculate the company's interest charges.
¡P
$50.00
31. Daggy
Corporation has the following simplified balance sheet:
Cash 
$ 25,000 

Current liabilities 
$200,000 
Inventories 
190,000 



Accounts receivable 
125,000 

Longterm debt 
300,000 
Net fixed assets 
360,000 

Common equity 
200,000 
Total assets 
$700,000 

Total claims 
$700,000 
The company has been advised that their
credit policy is too generous and that they should reduce their days sales outstanding to 36 days (assume a 365day year).
The increase in cash resulting from the decrease in accounts receivable will be
used to reduce the company's longterm debt. The interest rate on longterm
debt is 10 percent and the company's tax rate is 30 percent. The tighter credit
policy is expected to reduce the company's sales to $730,000 and result in EBIT
of $70,000. What is the company's expected ROE after the change in credit
policy?
¡P
15.86%
32. Dean Brothers Inc. recently reported net
income of $1,500,000. The company has 300,000 shares of common stock, and it
currently trades at $60 a share. The company continues to expand and
anticipates that one year from now its net income will be $2,500,000. Over the
next year the company also anticipates issuing an additional 100,000 shares of
stock, so that one year from now the company will have 400,000 shares of common
stock. Assuming the company's price/earnings ratio remains at its current
level, what will be the company's stock price one year from now?
¡P
$75
33. Devon Inc. has a higher ROE than Berwyn
Inc. (17 percent compared to 14 percent), but it has a lower EVA than
¡P
34. Division A has a higher ROE than Division
B, yet Division B creates more value for shareholders and has a higher EVA than
Division A. Both divisions, however, have positive ROEs and EVAs. What could
explain these performance measures?
¡P
Division
A is riskier than Division B.
Dokic, Inc.
Dokic, Inc. reported the following balance sheets for yearend 2001 and 2002
(dollars in millions):

2002 
2001 
Cash 
$ 650 
$ 500 
Accounts
receivable 
450 
700 
Inventories 
850 
600 
Total current
assets 
$1,950 
$1,800 
Net fixed
assets 
2,450 
2,200 
Total assets 
$4,400 
$4,000 



Accounts
payable 
$ 680 
$ 300 
Notes payable 
200 
600 
Wages payable 
220 
200 
Total current
liabilities 
$1,100 
$1,100 
Longterm
bonds 
1,000 
1,000 
Common stock 
1,500 
1,200 
Retained
earnings 
800 
700 
Total common
equity 
$2,300 
$1,900 
Total
liabilities and equity 
$4,400 
$4,000 
35. Refer to Dokic, Inc. The total dividends paid to the company's common stockholders during 2002 was
$50 million. What was the company's net income during the year 2002?
¡P
$150 million
36. Refer to
Dokic, Inc. When reviewing the company's performance for 2002, its CFO observed
that the company's inventory turnover ratio was below the industry average
inventory turnover ratio of 6.0. In addition, the company's DSO (days sales outstanding, calculated on a 365day basis) was
less than the industry average of 50 (that is, DSO < 50). On the basis of
this information, what is the most likely estimate of the company's sales (in
millions of dollars) for 2002?
¡P
$ 5,038
37. Refer to Dokic, Inc. Which of the following
statements is most correct?
¡P
Statements
a and c are correct.
38. Drysdale Financial Company and Commerce
Financial Company have the same total assets, the same total assets turnover,
and the same return on equity. However, Drysdale has a higher return on assets
than Commerce. Which of the following can explain these ratios?
¡P
Drysdale
has a higher profit margin and a lower debt ratio than Commerce.
Fama¡¦s French Bakery
Fama's French Bakery has a return on assets (ROA) of 10 percent and a
return on equity (ROE) of 14 percent. Fama's total assets equal total debt plus
common equity (that is, there is no preferred stock). Furthermore, we know that
the firm's total assets turnover is 5.
1.
Refer to Fama¡¦s French Bakery. What is Fama's debt
ratio?
¡P
28.57%
39. Georgia Electric reported the following
income statement and balance sheet for the previous year:
Balance Sheet:
Cash 
$
100,000 



Inventories 
1,000,000 



Accounts receivable 
500,000 



Current assets 
$1,600,000 






Total debt 
$4,000,000 
Net fixed assets 
4,400,000 

Total equity 
2,000,000 
Total assets 
$6,000,000 

Total claims 
$6,000,000 
Income Statement:
Sales 
$3,000,000 
Operating costs 
1,600,000 
Operating income (EBIT) 
$1,400,000 
Interest 
400,000 
Taxable income (EBT) 
$1,000,000 
Taxes (40%) 
400,000 
Net income 
$
600,000 
The company's interest cost is 10 percent, so the company's interest expense
each year is 10 percent of its total debt.
While the company's financial performance is quite strong, its CFO (Chief Financial
Officer) is always looking for ways to improve. The CFO has noticed that the
company's inventory turnover ratio is considerably weaker than the industry
average, which is 6.0. As an exercise, the CFO asks
what would the company's ROE have been last year if
the following had occurred:
Ø
The company maintained the same sales, but was able
to reduce inventories enough to achieve the industry average inventory turnover
ratio.
Ø
The cash that was generated from the reduction in
inventories was used to reduce part of the company's outstanding debt. So, the
company's total debt would have been $4 million less the freedup cash from the
improvement in inventory policy. The company's interest expense would have been
10 percent of new total debt.
Ø
Assume equity does not change. (The company pays
all net income as dividends.)
Under this scenario, what would have
been the company's ROE last year?
¡P
31.5%
40. Given the following information,
calculate the market price per share of WAM Inc.:
Net income 
$200,000.00 
Earnings per
share 
$2.00 
Stockholders'
equity 
$2,000,000.00 
Market/Book
ratio 
0.20 
¡P
$
4.00
41. Harte Motors
and Mills Automotive each have the same total assets, the same level of sales,
and the same return on equity (ROE). Harte Motors, however, has less equity and
a higher debt ratio than does Mills Automotive. Which of the following
statements is most correct?
¡P
All of the statements above are correct.
42.
¡P
5.25%
43. Huxtable
Medical's CFO recently estimated that the company's EVA for the past year was
zero. The company's cost of
equity capital is 14 percent, its cost of debt is 8 percent, and its debt ratio
is 40 percent. Which of the following statements is most correct?
¡P
The company's ROE was 14 percent.
44. Iken Berry Farms has $5 million in
current assets, $3 million in current liabilities, and its initial inventory
level is $1 million. The company plans to increase its inventory, and it will
raise additional shortterm debt (that will show up as notes payable on the
balance sheet) to purchase the inventory. Assume that the value of the remaining
current assets will not change. The company's bond covenants require it to
maintain a current ratio that is greater than or equal to 1.5. What is the
maximum amount that the company can increase its inventory before it is
restricted by these covenants?
¡P
$1.00
million
45. Jefferson Co.
has $2 million in total assets and $3 million in sales. The company has the
following balance sheet:
Cash 
$
100,000 

Accounts payable 
$
200,000 
Accounts receivable 
200,000 

Accruals 
100,000 
Inventories 
500,000 

Notes payable 
200,000 
Net fixed assets 
1,200,000 

Longterm debt 
700,000 



Common equity 
800,000 



Total liabilities 

Total assets 
$2,000,000 

and equity 
$2,000,000 





¡P
1.50
46. Kansas Office Supply had $24,000,000 in sales
last year. The company's net income was $400,000, its total assets turnover was
6.0, and the company's ROE was 15 percent. The company is financed entirely
with debt and common equity. What is the company's debt ratio?
¡P
0.33
Kewell Boomerangs
Below are the 2001 and 2002 yearend balance sheets for Kewell Boomerangs:

2002 
2001 
Cash 
$ 100,000 
$ 85,000 
Accounts
receivable 
432,000 
350,000 
Inventories 
1,000,000 
700,000 
Total current
assets 
$1,532,000 
$1,135,000 
Net fixed
assets 
3,000,000 
2,800,000 
Total assets 
$4,532,000 
$3,935,000 



Accounts payable 
$ 700,000 
$ 545,000 
Notes payable 
800,000 
900,000 
Total current
liabilities 
$1,500,000 
$1,445,000 
Longterm debt 
1,200,000 
1,200,000 
Common stock 
1,500,000 
1,000,000 
Retained
earnings 
332,000 
290,000 
Total common
equity 
$1,832,000 
$1,290,000 
Total
liabilities and equity 
$4,532,000 
$3,935,000 
Kewell Boomerangs has never paid a dividend on its common stock. Kewell issued
$1,200,000 of longterm debt in 1997. This debt was noncallable and is
scheduled to mature in 2027. As of the end of 2002, none of the principal on
this debt has been repaid. Assume that 2001 and 2002 sales were the same in
both years.
47. Refer to Kewell Boomerangs. During 2002,
Kewell's days sales outstanding (DSO) was 40 days. The industry average DSO was
30 days. Assume instead that in 2002, Kewell had been able to achieve the
industryaverage DSO without reducing its sales, and that the freedup cash
would have been used to reduce accounts payable. If this reduction in DSO had
successfully occurred, what would have been Kewell's new current ratio in 2002?
(Assume Kewell uses a 365day accounting year.)
¡P
1.023
48. Refer to Kewell Boomerangs. Which of the
following statements is most correct?
¡P
Kewell's
current ratio in 2002 was higher than it was in 2001.
49. Lancaster Co. and York Co. both have the
same return on assets (ROA). However,
¡P
Statements
a and c are correct.
50. Lancaster
Motors has total assets of $20 million. Its basic earning power is 25 percent,
its return on assets (ROA) is 10 percent, and the company's tax rate is 40
percent. What is
¡P
3.0
51. Lombardi Trucking Company has the
following data:
Assets 
$10,000 
Profit margin 
3.0% 
Tax rate 
40% 
Debt ratio 
60.0% 
Interest rate 
10.0% 
Total assets turnover 
2.0 


What is Lombardi's TIE ratio?
¡P
2.67
52. Lone Star Plastics has the following data:
Assets 
$100,000 
Profit margin 
6.0% 
Tax rate 
40% 
Debt ratio 
40.0% 
Interest rate 
8.0% 
Total assets turnover 
3.0 


What is Lone Star's EBIT?
¡P
$33,200
53. Meyersdale Office Supplies has common
equity of $40 million. The company's stock price is $80 per share and its
market/book ratio is 4.0. How many shares of stock does the company have
outstanding?
¡P
2,000,000
Miller Technologies
Miller Technologies recently reported the following balance sheet in its annual
report (all numbers are in millions of dollars):
Cash 
$ 100 

Accounts
payable 
$ 300 
Accounts
receivable 
300 

Notes payable 
500 
Inventory 
500 

Total current
liabilities 
$ 800 
Total current
assets 
$ 900 

Longterm debt 
1,500 



Total debt 
$2,300 



Common stock 
500 



Retained
earnings 
400 
Net fixed
assets 
2,300 

Total common
equity 
$ 900 
Total assets 
$3,200 

Total
liabilities and equity 
$3,200 





Miller also reported sales revenues of $4.5 billion and a 20 percent ROE for
this same year.
54. Refer to
Miller Technologies. Miller Technologies is always looking for ways to expand
their business. A plan has been proposed that would entail issuing $300 million
in notes payable to purchase new fixed assets (for this problem, ignore
depreciation). If this plan were carried out, what would Miller's current ratio
be immediately following the transaction?
¡P
0.818
55. Refer to Miller Technologies. What is
Miller's ROA?
¡P
5.625%
56. Moss Motors has $8 billion in assets, and
its tax rate is 40 percent. The company's basic earning power (BEP) ratio is 12
percent, and its return on assets (ROA) is 3 percent. What is Moss' times interest earned (TIE) ratio?
¡P
1.71
57. Nelson Company is thinking about issuing
new common stock. The proceeds from the stock issue will be used to reduce the
company's outstanding debt and interest expense. The stock issue will have no
effect on the company's total assets, EBIT, or tax rate. Which of the following
is likely to occur if the company goes ahead with the stock issue?
¡P
All
of the above statements are correct.
58. Parcells Jets has the following balance
sheet (in millions):
Cash 
$ 100 

Notes payable 
$ 100 
Inventories 
300 

Accounts payable 
200 
Accounts receivable 
400 

Accruals 
100 
Total current assets 
$ 800 

Total current liabilities 
$ 400 
Net fixed assets 
1,200 

Longterm bonds 
600 



Total debt 
$1,000 

______ 

Total common equity 
1,000 
Total assets 
$2,000 

Total liabilities and equity 
$2,000 





Parcells' DSO (on a 365day basis) is 40, which is above the industry average
of 30. Assume that Parcells is able to reduce its DSO to the industry average
without reducing sales, and the company takes the freedup cash and uses it to
reduce its outstanding longterm bonds. If this occurs, what will be the new
current ratio?
¡P
1.75
59. Pepsi Corporation's current ratio is 0.5, while Coke Company's current ratio is 1.5. Both firms want to "window dress" their coming endofyear financial statements. As part of its window dressing strategy, each firm will double its current liabilities by adding shortterm debt and placing the funds obtained in the cash account. Which of the statements below best describes the actual results of these transactions?
¡P
Only Pepsi Corporation's current
ratio will be increased.
60. Peterson
Packaging Corp. has $9
billion in total assets. The company's basic earning power (BEP) ratio is 9
percent, and its times interest earned ratio is 3.0. Peterson's depreciation
and amortization expense totals $1 billion. It has $0.6 billion in lease
payments and $0.3 billion must go towards principal payments on outstanding
loans and longterm debt. What is Peterson's EBITDA coverage ratio?
¡P
2.06
61. Reeves Corporation forecasts that its
operating income (EBIT) and total assets will remain the same as last year, but
that the company's debt ratio will increase this year. What can you conclude
about the company's financial ratios? (Assume that there will be no change in
the company's tax rate.)
¡P
Statements
b and c are correct.
62. Ricardo Entertainment recently reported
the following income statement:
Sales 
$12,000,000 
Cost of goods sold 
7,500,000 
EBIT 
$ 4,500,000 
Interest 
1,500,000 
EBT 
$ 3,000,000 
Taxes (40%) 
1,200,000 
Net income 
$ 1,800,000 
The company's CFO, Fred Mertz, wants to
see a 25 percent increase in net income over the next year. In other words, his
target for next year's net income is $2,250,000. Mertz has made the following
observations:
Ø Ricardo's
operating margin (EBIT/Sales) was 37.5 percent this past year. Mertz expects
that next year this margin will increase to 40 percent.
Ø Ricardo's
interest expense is expected to remain constant.
Ø Ricardo's tax
rate is expected to remain at 40 percent.
On the basis of these numbers, what is
the percentage increase in sales that Ricardo needs in order to meet Mertz's
target for net income?
¡P
9.38%
63. Roland & Company has a new management
team that has developed an operating plan to improve upon last year's ROE. The
new plan would place the debt ratio at 55 percent, which will result in
interest charges of $7,000 per year. EBIT is projected to be $25,000 on sales
of $270,000, it expects to have a total assets turnover ratio of 3.0, and the
average tax rate will be 40 percent. What does Roland & Company expect its
return on equity to be following the changes?
¡P
26.67%
64. Roll's Boutique currently has total
assets of $3 million in operation. Over this year, its performance yielded a
basic earning power (BEP) of 25 percent and a return on assets (ROA) of 12
percent. The firm's earnings are subject to a 35 percent tax rate. On the basis
of this information, what is the firm's times interest
earned (TIE) ratio?
¡P
3.82
65. Russell Securities has $100 million in
total assets and its corporate tax rate is 40 percent. The company recently
reported that its basic earning power (BEP) ratio was 15 percent and its return
on assets (ROA) was 9 percent. What was the company's interest expense?
¡P
$0
66. Ruth Company
currently has $1,000,000 in accounts receivable. Its days
sales outstanding (DSO) is 50 days. The company wants to reduce its DSO to the
industry average of 32 days by pressuring more of its customers to pay their
bills on time. The company's CFO estimates that if this policy is adopted the
company's average sales will fall by 10 percent. Assuming that the company adopts this change and succeeds in
reducing its DSO to 32 days and does lose 10 percent of its sales, what will be
the level of accounts receivable following the change? Assume a 365day year.
¡P
$576,000
67. Samuels
Equipment has $10 million in sales. Its ROE is 15 percent and its total assets
turnover is 3.5„e. The company is 100 percent equity financed. What is the
company's net income?
¡P
$ 428,571
68. Savelots Stores' current financial
statements are shown below:
Balance Sheet:
Inventories 
$ 500 

Accounts
payable 
$ 100 
Other current
assets 
400 

Shortterm
notes payable 
370 
Fixed assets 
370 

Common equity 
800 
Total assets 
$1,270 

Total liab.
and equity 
$1,270 
Income
Statement:
Sales 
$2,000 
Operating
costs 
1,843 
EBIT 
$ 157 
Interest 
37 
EBT 
$ 120 
Taxes (40%) 
48 
Net income 
$ 72 
A recently released report indicates that Savelots' current ratio
of 1.9 is in line with the industry average. However, its accounts payable,
which have no interest cost and are due entirely to purchases of inventories,
amount to only 20 percent of inventories versus an industry average of 60
percent. Suppose Savelots took actions to increase its accounts payable to
inventories ratio to the 60 percent industry average, but it (1) kept all of
its assets at their present levels (that is, the asset side of the balance
sheet remains constant) and (2) also held its current ratio constant at 1.9.
Assume that Savelots' tax rate is 40 percent, that its cost of shortterm debt
is 10 percent, and that the change in payments will not affect operations. In
addition, common equity will not change. With the changes, what will be
Savelots' new ROE?
¡P
10.5%
69. Selzer Inc. sells all its merchandise on
credit. It has a profit margin of 4 percent, days
sales outstanding equal to 60 days, receivables of $150,000, total assets of $3
million, and a debt ratio of 0.64. What is the firm's return on equity (ROE)? Assume
a 365day year.
¡P
3.4%
70. Some key financial data and ratios are
reported in the table below for Hemmingway Hotels and for its competitor,
Fitzgerald Hotels:
Ratio 
Hemmingway Hotels 
Fitzgerald Hotels 
Profit margin 
4% 
3% 
ROA 
9% 
8% 
Total assets 
$2.0 billion 
$1.5 billion 
BEP 
20% 
20% 
ROE 
18% 
24% 
On the basis of the information above, which of the following statements is
most correct?
¡P
Hemmingway
has higher net income than Fitzgerald.
71. Stennett Corp.'s CFO has proposed that
the company issue new debt and use the proceeds to buy back common stock. Which
of the following are likely to occur if this proposal is adopted? (Assume that
the proposal would have no effect on the company's operating income.)
¡P
Statements
a and c are correct.
72. Strack Houseware Supplies Inc. has $2
billion in total assets. The other side of its balance sheet consists of $0.2
billion in current liabilities, $0.6 billion in longterm debt, and $1.2
billion in common equity. The company has 300 million shares of common stock
outstanding, and its stock price is $20 per share. What is Strack's market/book
ratio?
¡P
5.00
73. Taft Technologies has the following
relationships:
Annual sales 
$1,200,000.00 
Current liabilities 
$
375,000.00 
Days sales outstanding (DSO) (365day year) 
40.00 
Inventory turnover ratio 
4.80 
Current ratio 
1.20 
The company's current assets consist of cash, inventories, and accounts
receivable. How much cash does Taft have on its balance sheet?
¡P
$ 68,493
74. Tapley Dental Supply Company has the following
data:
Net income 
$240 
Sales 
$10,000 
Total assets 
$6,000 
Debt ratio 
75% 
TIE ratio 
2.0 
Current ratio 
1.2 
BEP ratio 
13.33% 


75. If Tapley
could streamline operations, cut operating costs, and raise net income to $300
without affecting sales or the balance sheet (the additional profits will be
paid out as dividends), by how much would its ROE
increase?
¡P
4.00%
76. The Amer Company has the following
characteristics:
Sales 
$1,000 
Total assets 
$1,000 
Total
debt/Total assets 
35.00% 
Basic earning
power (BEP) ratio 
20.00% 
Tax rate 
40.00% 
Interest rate
on total debt 
4.57% 
What is Amer's ROE?
¡P 16.99%
77. The Charleston Company is a relatively
small, privately owned firm. Last year the company had net income of $15,000
and 10,000 shares were outstanding. The owners were trying to determine the
equilibrium market value for the stock prior to taking the company public. A
similar firm that is publicly traded had a price/earnings ratio of 5.0. Using
only the information given, estimate the market value of one share of
¡P
$
7.50
78. The Merriam Company has determined that
its return on equity is 15 percent. Management is interested in the various
components that went into this calculation. You are given the following
information: total debt/total assets = 0.35 and total assets turnover = 2.8.
What is the profit margin?
¡P
3.48%
79. The Wilson Corporation has the following
relationships:
Sales/Total
assets 
2.0„e 
Return on
assets (ROA) 
4.0% 
Return on
equity (ROE) 
6.0% 
What is
¡P
2%;
0.33
80. Van Buren Company has a current ratio =
1.9. Which of the following actions will increase the company's current ratio?
¡P
All
of the statements above are correct.
81. Victoria Enterprises has $1.6 million of
accounts receivable on its balance sheet. The company's DSO is 40 (based on a
365day year), its current assets are $2.5 million, and its current ratio is
1.5. The company plans to reduce its DSO from 40 to the industry average of 30
without causing a decline in sales. The resulting decrease in accounts
receivable will free up cash that will be used to reduce current liabilities.
If the company succeeds in its plan, what will
¡P
1.66
82. Viera Company
has $500,000 in total assets. The company's basic earning power (BEP) is 10
percent, its times interest
earned (TIE) ratio is 5, and the company's tax rate is 40 percent. What is the
company's return on assets (ROA)?
¡P
4.8%
83. Which of the following actions can a firm
take to increase its current ratio?
¡P
None
of the statements above is correct.
84. Which of the following alternatives could potentially
result in a net increase in a company's cash flow for the current year?
¡P
Reduce the days sales
outstanding ratio.
85. Which of the following statements is most
correct?
¡P
A
firm with financial leverage has a larger equity multiplier than an otherwise
identical firm with no debt in its capital structure.
¡P
An
increase in a firm's debt ratio, with no changes in its sales and operating
costs, could be expected to lower its profit margin on sales.
¡P
Firms
A and B have the same net income, taxes paid, and total assets. If Firm A has a
higher interest expense, its basic earnings power ratio (BEP) must be greater
than that of Firm B.
¡P
If a
company's ROE is greater than its cost of equity, its EVA is positive.
¡P
If a
firm has positive EVA, this implies that its ROE exceeds its cost of equity.
86. Which of the following statements is most
correct about Economic Value Added (EVA)?
¡P
None
of the statements above is correct.
87. XYZ's balance sheet and income statement
are given below:
Balance Sheet:
Cash 
$ 50 

Accounts
payable 
$ 100 
A/R 
150 

Notes payable 
0 
Inventories 
300 

Longterm debt
(10%) 
700 
Fixed assets 
500 

Common equity
(20 shares) 
200 
Total assets 
$1,000 

Total
liabilities and equity 
$1,000 
Income Statement:
Sales 
$1,000 
Cost of goods
sold 
855 
EBIT 
$ 145 
Interest 
70 
EBT 
$ 75 
Taxes
(33.333%) 
25 
Net income 
$ 50 
The industry average inventory turnover is 5, the interest rate on the firm's
longterm debt is 10 percent, 20 shares are outstanding, and the stock sells at
a P/E of 8.0. If XYZ changed its inventory methods so as to operate at the
industry average inventory turnover, if it used the funds generated by this
change to buy back common stock at the current market price and thus to reduce
common equity, and if sales, the cost of goods sold, and the P/E ratio remained
constant, by what dollar amount would its stock price increase?
¡P
$
6.67
88. You are an analyst following two
companies, Company X and Company Y. You have collected the following
information:
Ø
The
two companies have the same total assets.
Ø
Company
X has a higher total assets turnover than Company Y.
Ø
Company
X has a higher profit margin than Company Y.
Ø
Company
Y has a higher inventory turnover ratio than Company X.
Ø
Company
Y has a higher current ratio than Company X.
Which of the following statements is most correct?
¡P
Company
X must have a higher net income.
89. You are given the following information:
Stockholders' equity = $1,250; price/earnings ratio = 5; shares outstanding =
25; and market/book ratio = 1.5. Calculate the market price of a share of the
company's stock.
¡P
$
75.00
90. You have collected the following
information regarding Companies C and D:
Ø The two companies have the same total assets.
Ø The two companies have the same operating income (EBIT).
Ø The two companies have the same tax rate.
Ø Company C has a higher debt ratio and interest expense than Company D.
Ø Company C has a lower profit margin than Company D.
On the basis of this information, which of the following
statements is most correct?
¡P
Company
C must have a lower ROA.
91. You observe that a firm's profit margin
is below the industry average, while its return on equity and
debt ratio exceed the industry average. What can you conclude?
¡P Total assets turnover must be above the industry average.
92. Your company had the following balance
sheet and income statement information for 2002:
Balance Sheet:
Cash 
$ 20 



A/R 
1,000 



Inventories 
5,000 



Total current
assets 
$6,020 

Debt 
$4,000 
Net fixed
assets 
2,980 

Equity 
5,000 
Total assets 
$9,000 

Total claims 
$9,000 
Income Statement:
Sales 
$10,000 
Cost of goods
sold 
9,200 
EBIT 
$ 800 
Interest (10%) 
400 
EBT 
$ 400 
Taxes (40%) 
160 
Net income 
$ 240 
The industry average inventory turnover is 5. You think you can change your
inventory control system so as to cause your turnover to equal the industry
average, and this change is expected to have no effect on either sales or cost
of goods sold. The cash generated from reducing inventories will be used to buy
taxexempt securities that have a 7 percent rate of return. What will your
profit margin be after the change in inventories is reflected in the income
statement?
¡P
4.5%
FIN 350 MINI TEST 3 CHAPTER 5
1.
A
financial analyst is forecasting the expected return for the stock of Himalayan
Motors. The analyst estimates the following probability distribution of
returns:
Probability 
Return 
20% 
5% 
40 
10 
20 
20 
10 
25 
10 
50 
On the basis of this analyst's forecast, what is the stock's
coefficient of variation?
¡P
1.04
2.
A
fund manager is holding the following stocks:
Stock 
Amount Invested 
Beta 
1 
$300 million 
1.2 
2 
560 million 
1.4 
3 
320 million 
0.7 
4 
230 million 
1.8 
The riskfree rate is 5 percent and the market risk premium is
also 5 percent. If the manager sells half of her investment in Stock 2 ($280
million) and puts the money in Stock 4, by how many percentage points will her portfolio's required return increase?
¡P
0.40%
3.
A
highly riskaverse investor is considering the addition of an asset to a
10stock portfolio. The two securities under consideration both have an
expected return, ,
equal to 15 percent. However, the distribution of possible returns associated
with Asset A has a standard deviation of 12 percent, while Asset B's standard
deviation is 8 percent. Both assets are correlated with the market with r equal
to 0.75. Which asset should the riskaverse investor add to his/her portfolio?
¡P
Asset
B
4.
A
money manager is holding a $10 million portfolio that consists of the following
five stocks:
Stock 
Amount Invested 
Beta 
A 
$4 million 
1.2 
B 
2 million 
1.1 
C 
2 million 
1.0 
D 
1 million 
0.7 
E 
1 million 
0.5 
The portfolio has a required return of 11 percent, and the market
risk premium, k_{M}  k_{RF}, is 5 percent. What is the
required return on Stock C?
¡P
10.9%
5.
A
money manager is managing the account of a large investor. The investor holds
the following stocks:
Stock 
Amount Invested 
Estimated Beta 
A 
$2,000,000 
0.80 
B 
5,000,000 
1.10 
C 
3,000,000 
1.40 
D 
5,000,000 
???? 
The portfolio's required rate of return is 17 percent. The
riskfree rate, k_{RF}, is 7 percent and the return on the market, k_{M},
is 14 percent. What is Stock D's estimated beta?
¡P
2.026
6.
A
mutual fund manager has a $200,000,000 portfolio with a beta = 1.2. Assume that
the riskfree rate is 6 percent and that the market risk premium is also 6
percent. The manager expects to receive an additional $50,000,000 in funds
soon. She wants to invest these funds in a variety of stocks. After making
these additional investments she wants the fund's expected return to be 13.5
percent. What should be the average beta of the new stocks added to the
portfolio?
¡P
1.45
7.
A
portfolio manager is holding the following investments:
Stock 
Amount Invested 
Beta 
X 
$10 million 
1.4 
Y 
20 million 
1.0 
Z 
40 million 
0.8 
The manager plans to sell his holdings of Stock Y. The money from
the sale will be used to purchase another $15 million of Stock X and another $5
million of Stock Z. The riskfree rate is 5 percent and the market risk premium
is 5.5 percent. How many percentage points higher will the required return on
the portfolio be after he completes this transaction?
¡P
0.39%
8.
A
portfolio manager is holding the following investments in her portfolio:
Stock 
Amount Invested 
Beta 
1 
$300 million 
0.7 
2 
200 million 
1.0 
3 
500 million 
1.6 



The riskfree rate, k_{RF}, is 5 percent and the portfolio has a
required return of 11.655 percent. The manager is thinking about selling all of
her holdings of Stock 3, and instead investing the money in Stock 4, which has
a beta of 0.9. If she were to do this, what would be the new portfolio's
required return?
¡P
9.73%
9.
A
portfolio manager is managing a $10 million portfolio. Currently the portfolio
is invested in the following manner:
Investment 
Dollar Amount Invested 
Beta 
Stock 1 
$2 million 
0.6 
Stock 2 
3 million 
0.8 
Stock 3 
3 million 
1.2 
Stock 4 
2 million 
1.4 
Currently, the riskfree rate is 5 percent and the portfolio has
an expected return of 10 percent. Assume that the market is in equilibrium so
that expected returns equal required returns. The manager is willing to take on
additional risk and wants to instead earn an expected return of 12 percent on
the portfolio. Her plan is to sell Stock 1 and use the proceeds to buy another
stock. In order to reach her goal, what should be the beta of the stock that
the manager selects to replace Stock 1?
¡P
2.60
10. A stock market analyst estimates that
there is a 25 percent chance the economy will be weak, a 50 percent chance the
economy will be average, and a 25 percent chance the economy will be strong.
The analyst estimates that Hartley Industries' stock will have a 5 percent
return if the economy is weak, a 15 percent return if the economy is average,
and a 30 percent return if the economy is strong. On the basis of this
estimate, what is the coefficient of variation for Hartley Industries' stock?
¡P
0.54934
11. A stock has an expected return of 12.25
percent. The beta of the stock is 1.15 and the riskfree rate is 5 percent.
What is the market risk premium?
¡P
6.30%
12. An analyst has estimated Williamsport
Equipment's returns under the following economic states:
Economic State 
Probability 
Expected Return 
Recession 
0.20 
24% 
Below average 
0.30 
3 
Above average 
0.30 
+15 
Boom 
0.20 
+50 
What is
¡P
2.80
13. An analyst has estimated how a particular
stock's return will vary depending on what will happen to the economy:


Stock's Expected 
Recession 
0.10 
60% 
Below Average 
0.20 
10 
Average 
0.40 
15 
Above Average 
0.20 
40 
Boom 
0.10 
90 
What is the coefficient of variation on the company's stock?
¡P
2.472
14. An investor has $5,000 invested in a
stock that has an estimated beta of 1.2, and another $15,000 invested in the
stock of the company for which she works. The riskfree rate is 6 percent and
the market risk premium is also 6 percent. The investor calculates that the
required rate of return on her total ($20,000) portfolio is 15 percent. What is
the beta of the company for which she works?
¡P
1.6
15. An investor is forming a portfolio by
investing $50,000 in stock A that has a beta of 1.50,
and $25,000 in stock B that has a beta of 0.90. The return on the market is
equal to 6 percent and Treasury bonds have a yield of 4 percent. What is the
required rate of return on the investor's portfolio?
¡P
6.6%
16. Assume a new law is passed that restricts
investors to holding only one asset. A riskaverse investor is considering two
possible assets as the asset to be held in isolation. The assets' possible
returns and related probabilities (that is, the probability distributions) are
as follows:
Asset
X 
Asset
Y 

P 
k 
P 
k 
0.10 
3% 
0.05 
3% 
0.10 
2 
0.10 
2 
0.25 
5 
0.30 
5 
0.25 
8 
0.30 
8 
0.30 
10 
0.25 
10 
Which asset should be preferred?
¡P
Asset
Y, since its coefficient of variation is lower and its expected return is
higher.
17. Assume that investors become increasingly
risk averse, so that the market risk premium increases. Also, assume that the
riskfree rate and expected inflation remain the same. Which of the following
is most likely to occur?
¡P
None
of the statements above is correct.
18. Assume that the riskfree rate, k_{RF},
increases but the market risk premium, (k_{M}  k_{RF})
declines. The net effect is that the overall expected return on the market, k_{M},
remains constant. Which of the following statements is
most correct?
¡P
The
required return will increase for stocks that have a beta less than 1.0 but
will decline for stocks that have a beta greater than 1.0.
19. Assume that the riskfree rate, k_{RF},
ot, (k_{M}  k_{RF}) declines. The net
effect is that the overall expected return on the market, k_{M}, remains constant. Which of the following statements is most
correct?
¡P
The
required return will increase for stocks that have a beta less than 1.0 but
will decline for stocks that have a beta greater than 1.0.
20. Assume that the riskfree rate is 5
percent and that the market risk premium is 7 percent. If a stock has a
required rate of return of 13.75 percent, what is its beta?
¡P
1.25
21. Assume that the riskfree rate is 5
percent. Which of the following statements is most correct?
¡P
If a
stock has a negative beta, the stock's required return is less than 5 percent.
22. Assume that the riskfree rate is 5.5
percent and the market risk premium is 6 percent. A money manager has $10
million invested in a portfolio that has a required return of 12 percent. The
manager plans to sell $3 million of stock with a beta of 1.6 that is part of
the portfolio. She plans to reinvest this $3 million into another stock that
has a beta of 0.7. If she goes ahead with this planned transaction, what will
be the required return of her new portfolio?
¡P
10.38%
23. Assume that the riskfree rate remains
constant, but that the market risk premium declines. Which of the following is
likely to occur?
¡P
The
required return on a stock with a beta < 1.0 will decline.
24. Below are the stock returns for the past
five years for Agnew Industries:
Year 
Stock Return 
2002 
22% 
2001 
33 
2000 
1 
1999 
12 
1998 
10 
What was the stock's coefficient of variation during this 5year
period? (Use the population standard deviation to calculate the coefficient of
variation.)
¡P
1.46
25. Bob has a $50,000 stock portfolio with a
beta of 1.2, an expected return of 10.8 percent, and a standard deviation of 25
percent. Becky has a $50,000 portfolio with a beta of 0.8, an expected return
of 9.2 percent, and a standard deviation of 25 percent. The correlation
coefficient, r, between Bob's and Becky's portfolios is 0. Bob and Becky are
engaged to be married. Which of the following best describes their combined
$100,000 portfolio?
¡P
All
of the statements above are correct.
26.
¡P 3.0%
27. Calculate the required rate of return for
Mercury Inc., assuming that investors expect a 5 percent rate of inflation in
the future. The real riskfree rate is equal to 3 percent and the market risk
premium is 5 percent. Mercury has a beta of 2.0, and its realized rate of
return has averaged 15 percent over the last 5 years.
¡P
18%
CAPM Analysis
You have been asked to use a CAPM analysis to choose
between Stocks R and S, with your choice being the one whose expected rate of
return exceeds its required rate of return by the widest margin. The riskfree
rate is 6 percent, and the required return on an average stock (or "the
market") is 10 percent. Your security analyst tells you that Stock S's
expected rate of return, , is equal to 11 percent,
while Stock R's expected rate of return, , is equal to 12 percent.
The CAPM is assumed to be a valid method for selecting stocks, but the expected
return for any given investor (such as you) can differ from the required rate
of return for a given stock. The following past rates of return are to be used
to calculate the two stocks' beta coefficients, which are then to be used to
determine the stocks' required rates of return:
Year 
Stock R 
Stock S 
Market 
1 
15% 
0% 
5% 
2 
5 
5 
5 
3 
25 
10 
15 
Note: The averages
of the historical returns are not needed, and they are generally not equal to
the expected future returns.
28. Refer to CAPM Analysis. Calculate both
stocks' betas. What is the difference between the betas? That is, what
is the value of beta_{R}  beta_{S}? (Hint: The graphical
method of calculating the rise over run, or (Y_{2}  Y_{1})
divided by (X_{2}  X_{1}) may aid you.)
¡P
1.5
29. Refer to CAPM Analysis. Set up the SML
equation and use it to calculate both stocks' required rates of return, and
compare those required returns with the expected returns given above. You
should invest in the stock whose expected return exceeds its required return by
the widest margin. What is the widest margin, or greatest excess return (
 k)?
¡P
3.0%
30. Certain firms and industries are
characterized by consistently low or high betas, depending on the particular
situation. On the basis of that notion, which of the following companies seems
out of place with its stated beta? (That is, one of the following companies
definitely could not have the indicated beta, while the other companies seem
well matched with their stated betas.)
¡P
31. Company X has a beta of 1.6, while
Company Y's beta is 0.7. The riskfree rate is 7 percent, and the required rate
of return on an average stock is 12 percent. Now the expected rate of inflation
built into k_{RF} rises by 1 percentage point, the real riskfree rate
remains constant, the required return on the market rises to 14 percent, and
betas remain constant. After all of these changes have been reflected in the
data, by how much will the required return on Stock X exceed that on Stock Y?
¡P
5.40%
Consider the
following information for three stocks, Stock A, Stock B, and Stock C. The
returns on each of the three stocks are positively correlated, but they are not
perfectly correlated. (That is, all of the correlation coefficients are between
0 and 1.)

Expected 
Standard 

Stock A 
10% 
20% 
1.0 
Stock B 
10 
20 
1.0 
Stock C 
12 
20 
1.4 
32. Portfolio P has half of its funds
invested in Stock A and half invested in Stock B. Portfolio Q has one third of
its funds invested in each of the three stocks. The riskfree rate is 5
percent, and the market is in equilibrium. (That is, required returns equal
expected returns.) What is the market risk premium (k_{M}  k_{RF})?
¡P
5.0%
33. Portfolio P has half of its funds
invested in Stock A and half invested in Stock B. Portfolio Q has one third of
its funds invested in each of the three stocks. The riskfree rate is 5
percent, and the market is in equilibrium. (That is, required returns equal
expected returns.) Which of the following statements is most correct?
¡P
Portfolio
Q's expected return is 10.67 percent.
34. Currently, the riskfree rate is 5
percent and the market risk premium is 6 percent. You have your money invested
in three assets: an index fund that has a beta of 1.0, a riskfree security
that has a beta of 0, and an international fund that has a beta of 1.5. You
want to have 20 percent of your portfolio invested in the riskfree asset, and
you want your overall portfolio to have an expected return of 11 percent. What
portion of your overall portfolio should you invest in the international fund?
¡P
40%
35. Currently, the riskfree rate is 6
percent and the market risk premium is 5 percent. On the basis of this
information, which of the following statements is most correct?
¡P
An
index fund with beta = 1.0 has a required return of 11 percent.
36. Currently, the riskfree rate, k_{RF},
is 5 percent and the required return on the market, k_{M}, is 11
percent. Your portfolio has a required rate of return of 9 percent. Your sister
has a portfolio with a beta that is twice the beta of your portfolio. What is
the required rate of return on your sister's portfolio?
¡P 13.0%
37. Given the following information,
determine which beta coefficient for Stock A is consistent with equilibrium:
=
11.3%; k_{RF} = 5%; k_{M} = 10%
¡P
1.26
38. Given the following probability
distribution, what are the expected return and the standard deviation of
returns for Security J?
State 
P_{i} 
k_{ J} 
1 
0.2 
10% 
2 
0.6 
15 
3 
0.2 
20 
¡P
15%;
3.16%
39. Given the following returns on Stock J
and "the market" during the last three years, what is the beta coefficient
of Stock J? (Hint: Think rise over run.)
Year 
Stock J 
Market 
1 
13.85% 
8.63% 
2 
22.90 
12.37 
3 
35.15 
19.37 
¡P
1.75
40. Given the following returns on Stock Q
and "the market" during the last three years, what is the difference
in the calculated beta coefficient of Stock Q when Year 1Year 2 data are used
as compared to Year 2Year 3 data? (Hint: Think rise over run.)
Year 
Stock Q 
Market 
1 
6.30% 
6.10% 
2 
3.70 
12.90 
3 
21.71 
16.20 
¡P
9.17
41. Historical rates of return for the market
and for Stock A are given below:
Year 
Market 
Stock A 
1 
6.0% 
8.0% 
2 
8.0 
3.0 
3 
8.0 
2.0 
4 
18.0 
12.0 
If the required return on the market is 11 percent and the
riskfree rate is 6 percent, what is the required return on Stock A, according
to CAPM/SML theory?
¡P 8.27%
42. In a portfolio of three different stocks,
which of the following could not be true?
¡P
The
beta of the portfolio is less than the beta of each of the individual stocks.
43. In general, which of the following will
tend to occur if you randomly add additional stocks to your portfolio, which
currently consists of only three stocks
¡P
The
companyspecific risk of your portfolio will usually decline, but the market
risk will tend to remain the same.
44. In recent years, both expected inflation
and the market risk premium (k_{M}  k_{RF}) have declined.
Assume that all stocks have positive betas. Which of the following is likely to
have occurred as a result of these changes?
¡P
The
required returns on all stocks have fallen, but the decline has been greater
for stocks with higher betas.
45. In the years ahead the market risk
premium, (k_{M}  k_{RF}), is expected to fall, while the
riskfree rate, k_{RF}, is expected to remain at current levels. Given
this forecast, which of the following statements is most correct?
¡P
The
required return will fall for all stocks but will fall more for stocks with
higher betas.
46. Inflation, recession, and high interest
rates are economic events that are characterized as
¡P
Market
risk.
47. Jane has randomly selected a portfolio of
20 stocks, and Dick has randomly selected a portfolio of two stocks. Which of
the following statements is most correct?
¡P
None
of the statements above is correct
48. Jane holds a large diversified portfolio
of 100 randomly selected stocks and the portfolio's beta = 1.2. Each of the
individual stocks in her portfolio has a standard deviation of 20 percent. Jack
has the same amount of money invested in a single stock with a beta equal to
1.6 and a standard deviation of 20 percent. Which of the following statements
is most correct?
¡P
Jane's
portfolio has less market risk since it has a lower beta.
49. Oakdale Furniture Inc. has a beta
coefficient of 0.7 and a required rate of return of 15 percent. The market risk
premium is currently 5 percent. If the inflation premium increases by 2
percentage points, and Oakdale acquires new assets that increase its beta by 50
percent, what will be Oakdale's new required rate of return?
¡P
18.75%
50. Other things held constant, (1) if the
expected inflation rate decreases, and (2) investors become more risk averse,
the Security Market Line would shift
¡P
Down
and have a steeper slope.
51. Over the past 75 years, we have observed
that investments with higher average annual returns also tend to have the
highest standard deviations in their annual returns. This observation supports
the notion that there is a positive correlation between risk and return. Which
of the following lists correctly ranks investments from having the highest
returns and risk to those with the lowest returns and risk?
¡P
Smallcompany
stocks, largecompany stocks, longterm corporate bonds, longterm government
bonds, U.S. Treasury bills
52. Partridge Plastic's stock has an
estimated beta of 1.4, and its required rate of return is 13 percent. Cleaver
Motors' stock has a beta of 0.8, and the riskfree rate is 6 percent. What is
the required rate of return on Cleaver Motors' stock?
¡P
10.0%
Portfolio
Manager
A portfolio manager has a $10 million portfolio, which consists of $1 million
invested in 10 separate stocks. The portfolio beta is 1.2. The riskfree rate
is 5 percent and the market risk premium is 6 percent.
53. Refer to Portfolio Manager. What is the
portfolio's required return?
¡P
12.20%
54. Refer to Portfolio Manager. The manager
sells one of the stocks in her portfolio for $1 million. The stock she sold has
a beta of 0.9. She takes the $1 million and uses the money to purchase a new
stock that has
¡P
12.62%
55. Portfolio P has 30 percent invested in
Stock X and 70 percent in Stock Y. The riskfree rate of interest is 6 percent
and the market risk premium is 5 percent. Portfolio P has a required return of
12 percent and Stock X has a beta of 0.75. What is the beta of Stock Y?
¡P
1.39
56. Ripken Iron Works faces the following
probability distribution:


Stock's Expected 
Boom 
0.25 
25% 

0.50 
15 
Recession 
0.25 
5 
What is the coefficient of variation on the company's stock?
¡P 0.47
57. Some returns data for the market and for
Countercyclical Corp. are given below:
Year 
Market 
Countercyclical 
1999 
2.0% 
8.0% 
2000 
12.0 
3.0 
2001 
8.0 
18.0 
2002 
21.0 
7.0 
The required return on the market is 14 percent and the riskfree rate is 8
percent. What is the required return on Countercyclical Corp. according to
CAPM/SML theory?
¡P
3.42%
58. Stock A and Stock B both have an expected
return of 10 percent and a standard deviation of 25 percent. Stock A has a beta
of 0.8 and Stock B has a beta of 1.2. The correlation coefficient, r, between
the two stocks is 0.6. Portfolio P is a portfolio with 50 percent invested in
Stock A and 50 percent invested in Stock B. Which of the following statements
is most correct?
¡P
Portfolio
P has more market risk than Stock A but less market
risk than Stock B.
59. Stock A and Stock B each have an expected
return of 12 percent, a beta of 1.2, and a standard deviation of 25 percent.
The returns on the two stocks have a correlation of 0.6. Portfolio P has half
of its money invested in Stock A and half in Stock B. Which of the following
statements is most correct?
¡P
Statements
a and c are correct.
60. Stock A and Stock B each have an expected
return of 15 percent, a standard deviation of 20 percent, and a beta of 1.2.
The returns of the two stocks are not perfectly correlated; the correlation
coefficient is 0.6. You have put together a portfolio that consists of 50
percent Stock A and 50 percent Stock B. Which of the following statements is
most correct?
¡P
The
portfolio's expected return is 15 percent.
61. Stock X, and
"the market" have had the following rates of returns over the past
four years.
Year 
Stock X 
Market 
1999 
12% 
14% 
2000 
5 
2 
2001 
11 
14 
2002 
7 
3 
60 percent of your portfolio is invested in Stock X, and the
remaining 40 percent is invested in Stock Y. The riskfree rate is 6 percent
and the market risk premium is also 6 percent. You estimate that 14 percent is
the required rate of return on your portfolio. What is the beta of Stock Y?
¡P
1.91
62. Stocks A, B, and
C all have an expected return of 10 percent and a standard deviation of 25
percent. Stocks A and B have returns that are independent of one another.
(Their correlation coefficient, r, equals zero.) Stocks A and C have returns
that are negatively correlated with one another (that is, r < 0).
¡P
Statements
a and c are correct.
63. Stock A has a beta = 0.8, while Stock B
has a beta = 1.6. Which of the following statements is most correct?
¡P
If
market participants become more risk averse, the required return on Stock B
will increase more than the required return for Stock A.
64. Stock A has a beta of 0.7, whereas Stock
B has a beta of 1.3. Portfolio P has 50 percent invested in both Stocks A and
B. Which of the following would occur if the market risk premium increased by 1
percentage point? (Assume that the riskfree rate remains constant.)
¡P
The
required return for Portfolio P would increase by 1 percentage point
65. Stock A has a beta of 0.8, Stock B has a
beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts
invested in each of the three stocks. Each of the stocks has a standard
deviation of 25 percent. The returns of the three stocks are independent of one
another (i.e., the correlation coefficients all equal zero). Assume that there
is an increase in the market risk premium, but that the riskfree rate remains
unchanged. Which of the following statements is most correct?
¡P
The
required return on Stock A will increase by less than the increase in the
market risk premium, while the required return on Stock C will increase by more
than the increase in the market risk premium.
66. Stock A has a beta of 0.8, Stock B has a
beta of 1.0, and Stock C has a beta of 1.2. Portfolio P has equal amounts
invested in each of the three stocks. Each of the stocks has a standard
deviation of 25 percent. The returns of the three stocks are independent of one
another (i.e., the correlation coefficients all equal zero). Which of the
following statements is most correct?
¡P
Statements
a and b are correct.
67. Stock A has a beta of 0.8 and Stock B has
a beta of 1.2. 50 percent of Portfolio P is invested in Stock A and 50 percent
is invested in Stock B. If the market risk premium (k_{M}  k_{RF})
were to increase but the riskfree rate (k_{RF}) remained constant,
which of the following would occur?
¡P
The
required return will increase for both stocks but the increase will be greater
for Stock B than for Stock A.
68. Stock A has a beta of 1.2 and a standard
deviation of 25 percent. Stock B has a beta of 1.4 and a standard deviation of
20 percent. Portfolio P was created by investing in a combination of Stocks A
and B. Portfolio P has a beta of 1.25 and a standard deviation of 18 percent.
Which of the following statements is most correct?
¡P
Portfolio
P's required return is greater than Stock A's required return.
69. Stock A has a beta of 1.2 and a standard
deviation of 20 percent. Stock B has a beta of 0.8 and a standard deviation of
25 percent. Portfolio P is a $200,000 portfolio consisting of $100,000 invested
in Stock A and $100,000 invested in Stock B. Which of the following statements
is most correct? (Assume that the required return is determined by the Security
Market Line.)
¡P
Portfolio
P has a beta equal to 1.0.
70. Stock A has a beta of 1.5 and Stock B has
a beta of 0.5. Which of the following statements must be true about
these securities? (Assume the market is in equilibrium.)
¡P
The
expected return on Stock A will be greater than that on Stock B.
71. Stock A has an expected return of 10
percent and a beta of 1.0. Stock B has a beta of 2.0. Portfolio P is a
twostock portfolio, where part of the portfolio is invested in Stock A and the
other part is invested in Stock B. Assume that the riskfree rate is 5 percent,
that required returns are determined by the CAPM, and that the market is in
equilibrium so that expected returns equal required returns. Portfolio P has an
expected return of 12 percent. What proportion of Portfolio P consists of Stock
B?
¡P
40%
72. Stock A has an expected return of 10
percent and a standard deviation of 20 percent. Stock B has an expected return
of 12 percent and a standard deviation of 30 percent. The riskfree rate is 5
percent and the market risk premium, k_{M}  k_{RF}, is 6
percent. Assume that the market is in equilibrium. Portfolio P has 50 percent
invested in Stock A and 50 percent invested in Stock B. The returns of Stock A
and Stock B are independent of one another. (That is, their correlation
coefficient equals zero.) Which of the following statements is most correct?
¡P
Statements
a and b are correct.
73. Stock A has an expected return of 12
percent, a beta of 1.2, and a standard deviation of 20 percent. Stock B has an
expected return of 10 percent, a beta of 1.2, and a standard deviation of 15
percent. Portfolio P has $900,000 invested in Stock A and $300,000 invested in
Stock B. The correlation between Stock A's returns and Stock B's returns is
zero (that is, r = 0). Which of the following statements is most correct?
¡P
Portfolio
P's expected return is 11.5 percent.
74. Stock X has a beta of 0.5 and Stock Y has
a beta of 1.5. Which of the following statements is most correct?
¡P
If
expected inflation increases (but the market risk premium is unchanged), the
required returns on the two stocks will increase by the same amount.
75. Stock X has a beta of 0.6, while Stock Y
has a beta of 1.4. Which of the following statements is most correct?
¡P
If
the market risk premium decreases (but expected inflation is unchanged), the
required return on both stocks will decrease but the decrease will be greater
for Stock Y.
76. Stock X has a beta of 0.7 and Stock Y has
a beta of 1.3. The standard deviation of each stock's returns is 20 percent.
The returns are independent of each other. (In other words, the correlation
coefficient, r, between Stock X and Stock Y is zero.) Portfolio P has 50
percent of its wealth invested in Stock X and the other 50 percent is invested
in Stock Y. Given this information, which of the following statements is most
correct?
¡P
The
required return on Portfolio P is the same as the required return on the market
(k_{M}).
77. Stock X has a beta of 1.5 and Stock Y has
a beta of 0.5. The market is in equilibrium (that is, required returns equal
expected returns). Which of the following statements is most correct?
¡P
None
of the statements above is correct.
78. The CFO of Brady Boots has estimated the
rates of return to Brady's stock, depending on the state of the economy. He has
also compiled analysts' expectations for the economy.
Economy 
Probability 
Return 
Recession 
0.1 
23% 
Below average 
0.1 
8 
Average 
0.4 
6 
Above average 
0.2 
17 
Boom 
0.2 
24 
Given this data, what is the company's coefficient of variation?
(Use the population standard deviation, not the sample standard deviation when
calculating the coefficient of variation.)
¡P
1.84
79. The current riskfree rate is 6 percent
and the market risk premium is 5 percent. Erika is preparing to invest $30,000
in the market and she wants her portfolio to have an expected return of 12.5
percent. Erika is concerned about bearing too much standalone risk; therefore,
she will diversify her portfolio by investing in three different assets (two
mutual funds and a riskfree security). The three assets she will be investing
in are an aggressive growth mutual fund that has a beta of 1.6, an S&P 500
index fund with a beta of 1, and a riskfree security that has a beta of 0. She
has already decided that she will invest 10 percent of her money in the
riskfree asset. In order to achieve the desired expected return of 12.5
percent, what proportion of Erika's portfolio must be invested in the S&P
500 index fund?
¡P
23.33%
80. The combined portfolio's expected return
is a simple average of the expected returns of the two individual portfolios
(10%).
¡P
The
combined portfolio's beta is a simple average of the betas of the two
individual portfolios (1.0).
81. The following probability distributions
of returns for two stocks have been estimated:

Returns 

Probability 
Stock A 
Stock B 
0.3 
12% 
5% 
0.4 
8 
4 
0.3 
6 
3 
What is the coefficient of variation for the stock that is less
risky, assuming you use the coefficient of variation to rank riskiness?
¡P
0.19
82. The realized returns for the market and
Stock J for the last four years are given below:
Year 
Market 
Stock J 
1 
10% 
5% 
2 
15 
0 
3 
5 
14 
4 
0 
10 
An average stock has an expected return of 12 percent and the
market risk premium is 4 percent. If Stock J's expected rate of return as
viewed by a marginal investor is 8 percent, what is the difference between J's
expected and required rates of return?
¡P
2.64%
83. The riskfree rate is 5 percent. Stock A
has a beta = 1.0 and Stock B has a beta = 1.4. Stock A has a required return of
11 percent. What is Stock B's required return?
¡P
13.4%
84. The riskfree rate is 6 percent. Stock A
has a beta of 1.0, while Stock B has a beta of 2.0. The market risk premium (k_{M}
 k_{RF}) is positive. Which of the following statements is most
correct?
¡P
If
Stock A's required return is 11 percent, the market risk premium is 5 percent.
85. The riskfree rate of interest, k_{RF},
is 6 percent. The overall stock market has an expected return of 12 percent.
Hazlett, Inc. has a beta of 1.2. What is the required return of Hazlett, Inc.
stock?
¡P
13.2%
86. The returns of United Railroad Inc. (URI)
are listed below, along with the returns on "the market":
Year 
URI 
Market 
1 
14% 
9% 
2 
16 
11 
3 
22 
15 
4 
7 
5 
5 
2 
1 
If the riskfree rate is 9 percent and the required return on
URI's stock is 15 percent, what is the required return on the market? Assume
the market is in equilibrium. (Hint: Think rise over run.)
¡P
13%
87. The riskfree rate, k_{RF}, is 6
percent and the market risk premium, (k_{M}  k_{RF}), is 5
percent. Assume that required returns are based on the CAPM. Your $1 million
portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and
$300,000 invested in a stock that has a beta of 0.8. Which of the following
statements is most correct?
¡P
If
the riskfree rate remains unchanged but the market risk premium increases by 2
percentage points, the required return on your portfolio will increase by more
than 2 percentage points.
88. Walter Jasper currently manages a
$500,000 portfolio. He is expecting to receive an additional $250,000 from a
new client. The existing portfolio has a required return of 10.75 percent. The
riskfree rate is 4 percent and the return on the market is 9 percent. If
Walter wants the required return on the new portfolio to be 11.5 percent, what
should be the average beta for the new stocks added to the portfolio?
¡P
1.80
89. Which of the following statements best
describes what would be expected to happen as you randomly add stocks to
your portfolio?
¡P
Adding
more stocks to your portfolio reduces the portfolio's companyspecific risk.
90. Which of the following statements is most
correct?
¡P
A
security's beta measures its nondiversifiable (systematic, or market) risk
relative to that of an average stock
¡P
An
increase in expected inflation could be expected to increase the required
return on a riskless asset and on an average stock by the same amount, other
things held constant.
¡P
All
of the statements above are correct.
Wrong ans. i.
Statements
a and b are correct.
¡P
None
of the statements above is correct.
Wrong ans. i.
The
slope of the security market line is beta.
Wrong ans. ii.
If a
stock has a beta equal to 1.0, its required rate of return will be unaffected
by changes in the market risk premium.
Wrong ans. iii.
A
portfolio with a large number of randomly selected stocks will have less market
risk than a single stock that has a beta equal to 0.5.
¡P
Statements
a and c are correct
¡P
Statements
a and b are correct.
Wrong ans. i.
If
investors became more risk averse, then the new security market line would have
a steeper slope.
¡P
Statements
b and c are correct.
Wrong ans. i.
All
of the statements above are correct.
¡P
Statements
b and d are correct.
Ans . b.
If
you formed a portfolio that included a large number of lowbeta stocks (stocks
with betas less than 1.0 but greater than 1.0), the portfolio would itself
have a beta coefficient that is equal to the weighted average beta of the
stocks in the portfolio, so the portfolio would have a relatively low degree of
risk.
Ans . d.
Diversifiable
risk can be eliminated by forming a large portfolio, but normally even
highlydiversified portfolios are subject to market risk.
¡P
Suppose
the returns on two stocks are negatively correlated. One has a beta of 1.2 as
determined in a regression analysis, while the other has a beta of 0.6. The
returns on the stock with the negative beta will be negatively correlated with
returns on most other stocks in the market
¡P
The
slope of the security market line is the market risk premium, (k_{M} 
k_{RF}).
¡P
The
beta coefficient of a stock is normally found by running a regression of past
returns on the stock against past returns on a stock market index. One could
also construct a scatter diagram of returns on the stock versus those on the
market, estimate the slope of the line of best fit, and use it as beta.
¡P
The
beta coefficient used in the SML equation should reflect the expected
volatility of a given stock's return versus the return on the market during
some future period.
¡P
The
SML relates required returns to firms' market risk. The slope and intercept of
this line cannot be controlled by the financial manager.
91. Which of the following statements is most
correct about a stock that has a beta = 1.2?
¡P
If
expected inflation increases 3 percent, the stock's expected return will
increase by 3 percent
92. Which of the following statements is incorrect?
¡P
The
slope of the security market line is measured by beta.
93. Which of the following is not a
difficulty concerning beta and its estimation?
¡P The beta of an "average stock," or "the market," can change over time, sometimes drastically.
94. You are an investor in common stocks, and
you currently hold a welldiversified portfolio that has an expected return of
12 percent, a beta of 1.2, and a total value of $9,000. You plan to increase
your portfolio by buying 100 shares of AT&E at $10 a share. AT&E has an
expected return of 20 percent with a beta of 2.0. What will be the expected
return and the beta of your portfolio after you purchase the new stock?
¡P
k_hat
= 12.8%; b_{p} = 1.28
95. You are holding a stock that has a beta
of 2.0 and is currently in equilibrium. The required return on the stock is 15
percent, and the return on an average stock is 10 percent. What would be the percentage
change in the return on the stock, if the return on an average stock
increased by 30 percent while the riskfree rate remained unchanged?
¡P
+40%
96. You have been managing a $1 million
portfolio. The portfolio has a beta of 1.6 and a required rate of return of 14
percent. The current riskfree rate is 6 percent. Assume that you receive
another $200,000. If you invest the money in a stock that has a beta of 0.6,
what will be the required return on your $1.2 million portfolio?
¡P
13.17%
97. You have been scouring The Wall Street
Journal looking for stocks that are "good values" and have
calculated expected returns for five stocks. Assume the riskfree rate (k_{RF})
is 7 percent and the market risk premium (k_{M}  k_{RF}) is 2
percent. Which security would be the best investment? (Assume you must choose
just one.)
Expected Return Beta
¡P
7.06%
0.00
98. You have developed data that give (1) the
average annual returns on the market for the past five years, and (2) similar
information on Stocks A and B. If these data are as follows, which of the
possible answers best describes the historical betas for A and B?
Years 
Market 
Stock A 
Stock B 
1 
0.03 
0.16 
0.05 
2 
0.05 
0.20 
0.05 
3 
0.01 
0.18 
0.05 
4 
0.10 
0.25 
0.05 
5 
0.06 
0.14 
0.05 
¡P
b_{A}
< 0; b_{B} = 0
99. You have developed the following data on
three stocks:
Stock 
Standard Deviation 
Beta 
A 
0.15 
0.79 
B 
0.25 
0.61 
C 
0.20 
1.29 
If you are a risk minimizer, you should choose Stock __________ if
it is to be held in isolation and Stock __________ if it is to be held as part
of a welldiversified portfolio.
¡P
A; B
100.
You
hold a diversified portfolio consisting of a $10,000 investment in each of 20
different common stocks (that is, your total investment is $200,000). The
portfolio beta is equal to 1.2. You have decided to sell one of your stocks
that has a beta equal to 0.7 for $10,000. You plan to
use the proceeds to purchase another stock that has a beta equal to 1.4. What
will be the beta of the new portfolio?
¡P
1.235
101.
You
hold a diversified portfolio consisting of a $5,000 investment in each of 20
different common stocks. The portfolio beta is equal to 1.15. You have decided
to sell one of your stocks, a lead mining stock whose b is equal to 1.0, for
$5,000 net and to use the proceeds to buy $5,000 of stock in a steel company
whose b is equal to 2.0. What will be the new beta of the portfolio?
¡P
1.20
102.
You
observe the following information regarding Company X and Company Y:
Ø
Company
X has a higher expected mean return than Company Y.
Ø
Company
X has a lower standard deviation than Company Y.
Ø
Company
X has a higher beta than Company Y.
Given this information, which of the following statements is most
correct?
¡P
Company
X has a lower coefficient of variation than Company Y.
103.
Your
portfolio consists of $100,000 invested in a stock that has a beta = 0.8,
$150,000 invested in a stock that has a beta = 1.2, and $50,000 invested in a
stock that has a beta = 1.8. The riskfree rate is 7 percent. Last year this
portfolio had a required rate of return of 13 percent. This year nothing has
changed except for the fact that the market risk premium has increased by 2
percent (two percentage points). What is the portfolio's current required rate
of return?
¡P
15.33%
104.
Your
portfolio consists of $50,000 invested in Stock X and $50,000 invested in Stock
Y. Both stocks have an expected return of 15 percent, a beta of 1.6, and a
standard deviation of 30 percent. The returns of the two stocks are
independentthe correlation coefficient, r, is zero. Which of the following
statements best describes the characteristics of your portfolio?
¡P
Your
portfolio has a beta equal to 1.6 and its expected return is 15 percent.
1.
A $10,000 loan is to be amortized over 5 years, with
annual endofyear payments. Given the following facts, which of these
statements is most correct?
¡P
The proportion
of each payment that represents interest as opposed to repayment of principal
would be higher if the interest rate were higher.
2.
A 10year
security generates cash flows of $2,000 a year at the end of each of the next
three years (t = 1, 2, and 3). After three years, the security pays some
constant cash flow at the end of each of the next six years (t = 4, 5, 6, 7, 8,
and 9). Ten years from now (t = 10) the security will mature and pay $10,000.
The security sells for $24,307.85 and has a yield to maturity of 7.3 percent.
What annual cash flow does the security pay for years 4 through 9?
¡P
$3,700
3.
A baseball player is offered a 5year contract that
pays him the following amounts:
Year 1: 
$1.2 million 
Year 2: 
1.6 million 
Year 3: 
2.0 million 
Year 4: 
2.4 million 
Year 5: 
2.8 million 
Under
the terms of the agreement all payments are made at the end of each year.
Instead of accepting the contract, the baseball player asks his agent to
negotiate a contract that has a present value of $1 million more than that
which has been offered. Moreover, the player wants to receive his payments in
the form of a 5year annuity due. All cash flows are discounted at 10 percent.
If the team were to agree to the player's terms, what would be the player's
annual salary (in millions of dollars)?
¡P
$1.989
4.
A real estate investment has the following expected cash
flows:
Year 
Cash Flows 
1 
$10,000 
2 
25,000 
3 
50,000 
4 
35,000 
The
discount rate is 8 percent. What is the investment's present value?
¡P
96,110
5.
A financial planner has offered you three possible
options for receiving cash flows. You must choose the option that has the
highest present value.
(1) $1,000 now and another $1,000 at the beginning of
each of the 11 subsequent months during the remainder of the year, to be
deposited in an account paying a 12 percent nominal annual rate, but compounded
monthly (to be left on deposit for the year).
(2) $12,750 at the end of the year (assume a 12 percent
nominal interest rate with semiannual compounding).
(3) A payment scheme of 8 quarterly payments made over
the next two years. The first payment of $800 is to be made at the end of the
current quarter. Payments will increase by 20 percent each quarter. The money
is to be deposited in an account paying a 12 percent nominal annual rate, but
compounded quarterly (to be left on deposit for the entire 2year period).
Which
one would you choose?
¡P
Choice 1
6.
A project with a
3year life has the following probability distributions for possible
endofyear cash flows in each of the next three years:
Year 1 
Year 2 
Year 3 

Prob 
Cash Flow 
Prob 
Cash Flow 
Prob 
Cash Flow 
0.30 
$300 
0.15 
$100 
0.25 
$200 
0.40 
500 
0.35 
200 
0.75 
800 
0.30 
700 
0.35 
600 


0.15 
900 




Using
an interest rate of 8 percent, find the expected present value of these
uncertain cash flows. (Hint: Find the expected cash flow in each year, then evaluate those cash flows.)
¡P
$1,347.61
7.
A young couple is planning for the education of their
two children. They plan to invest the same amount of money at the end of each
of the next 16 years. The first contribution will be made at the end of the
year and the final contribution will be made at the end of the year the older
child enters college.
The money will be invested in securities that are certain to earn a return of 8
percent each year. The older child will begin college in 16 years and the
second child will begin college in 18 years. The parents anticipate college
costs of $25,000 a year (per child). These costs must be paid at the end of
each year. If each child takes four years to complete their college degrees,
then how much money must the couple save each year?
¡P
$ 5,477.36
8.
An investment costs $3,000 today and provides cash
flows at the end of each year for 20 years. The investment's expected return is
10 percent. The projected cash flows for Years 1, 2, and 3 are $100, $200, and
$300, respectively. What is the annual cash flow received for each of Years 4
through 20 (17 years)? (Assume the same payment for each of these years.)
¡P
$417.87
9.
An investment pays $100 every six months (semiannually)
over the next 2.5 years. Interest, however, is compounded quarterly, at a
nominal rate of 8 percent. What is the future value of the investment after 2.5
years?
¡P
$542.07
10. An investment pays you $5,000 at the end
of each of the next five years. Your plan is to invest the money in an account
that pays 8 percent interest, compounded monthly. How much will you have in the
account after receiving the final $5,000 payment in 5 years (60 months)?
¡P
$
29,508.98
11. An investment pays you 9 percent interest
compounded semiannually. A second investment of equal risk,
pays interest compounded quarterly. What nominal rate of interest would you
have to receive on the second investment in order to make you indifferent
between the two investments?
¡P
8.90%
12. Assume one bank offers you a nominal
annual interest rate of 6 percent compounded daily while another bank offers
you continuous compounding at a 5.9 percent nominal annual rate. You decide to
deposit $1,000 with each bank. Exactly two years later you withdraw your funds
from both banks. What is the difference in your withdrawal amounts between the
two banks?
¡P
$
2.25
13. Assume that you will receive $2,000 a
year in Years 1 through 5, $3,000 a year in Years 6 through 8, and $4,000 in
Year 9, with all cash flows to be received at the end of the year. If you
require a 14 percent rate of return, what is the present value of these cash
flows?
¡P
$11,714
14. At an inflation rate of 9 percent, the
purchasing power of $1 would be cut in half in 8.04 years. How long to the
nearest year would it take the purchasing power of $1 to be cut in half if the
inflation rate were only 4 percent?
¡P
18 years
Bill
Bill and Paula just purchased a car. They financed the car with a fouryear
(48month) $15,000 loan. The loan is fully amortized after four years (i.e.,
the loan will be fully paid off after four years). Loan payments are due at the
end of each month. The loan has a 12 percent nominal annual rate and the
interest is compounded monthly.
15. Refer to Bill. What are the monthly
payments on the loan
¡P
$395.01
16. Refer to Bill. What is the effective annual rate on
the loan?
¡P
12.68%
17. Bill and Bob are both 25 years old today. Each wants
to begin saving for his retirement. Both plan on contributing
a fixed amount each year into brokerage accounts that have annual returns of 12
percent. Both plan on retiring at age 65, 40 years from today, and both want to
have $3 million saved by age 65. The only difference is that Bill wants to
begin saving today, whereas Bob wants to begin saving one year from today. In
other words, Bill plans to make 41 total contributions (t = 0, 1, 2, ... 40), while Bob plans to make 40 total contributions
(t = 1, 2, ... 40). How much more than Bill will Bob need to save each year in
order to accumulate the same amount as Bill does by age 65?
¡P
$423.09
Bill plans to
deposit $200 into a bank account at the end of every month. The bank account
has a nominal interest rate of 8 percent and interest is compounded monthly.
How much will Bill have in the account at the end of 2.5 years (30 months)?
$ 6,617.77
Birthday
Today is your 21st birthday and your parents gave you
a gift of $2,000. You just put this money in a brokerage account, and your plan
is to add $1,000 to the account each year on your birthday, starting on your
22nd birthday.
18. Refer to Birthday. Assume that you want
to have $1,000,000 in the account by age 60 (39 years from today). What annual
rate of return will you need to earn on your investments in order to reach this
goal?
¡P
12.57%
19. Refer to Birthday. If you earn 10 percent a year in
the brokerage account, what is the minimum number of whole years it will take
for you to have at least $1,000,000 in the account?
¡P
47
20. Bob is 20 years old today and is starting
to save money, so that he can get his MBA. He is interested in a 1year MBA
program. Tuition and expenses are currently $20,000 per year, and they are expected
to increase by 5 percent per year. Bob plans to begin his MBA when he is 26
years old, and since all tuition and expenses are due at the beginning of the
school year, Bob will make his one single payment six years from today. Right
now, Bob has $25,000 in a brokerage account, and he plans to contribute a fixed
amount to the account at the end of each of the next six years (t = 1, 2, 3, 4,
5, and 6). The account is expected to earn an annual return of 10 percent each
year. Bob plans to withdraw $15,000 from the account two years from today (t =
2) to purchase a used car, but he plans to make no other withdrawals from the
account until he starts the MBA program. How much does Bob need to put in the
account at the end of each of the next six years to have enough money to pay
for his MBA?
¡P
$
580
21. Carla is interested in saving for retirement. Today,
on her 40th birthday, she has $100,000 in her investment
account. She plans to make additional contributions on each of her subsequent
birthdays. Specifically, she plans to:
Ø Contribute $10,000 per year each year during her 40's. (This will entail 9 contributionsthe first will occur on her 41 st birthday and the 9th on her 49th birthday.)
Ø Contribute $20,000 per year each year during her 50's. (This will entail 10 contributionsthe first will occur on her 50th birthday and the 10th on her 59th birthday.)
Ø Contribute $25,000 per year thereafter until age 65. (This will entail 6 contributionsthe first will occur on her 60th birthday and the 6th on her 65th birthday.)
Assume
that her investment account has an expected return of 11 percent per year. If
she sticks to her plan, how much will Carla have in her account on her 65th
birthday after her final contribution?
¡P $2,934,143
22.
¡P
11.07%
23. Erika opened a savings account today and she
immediately put $10,000 into it. She plans to contribute another $20,000 one
year from now, and $50,000 two years from now. The savings account pays a 6
percent annual interest rate. If she makes no other deposits or withdrawals,
how much will she have in the account 10 years from today?
¡P
$131,390.46
24. Find the present value of an income stream that has a
negative flow of $100 per year for 3 years, a positive flow of $200 in the 4th
year, and a positive flow of $300 per year in Years 5 through 8. The
appropriate discount rate is 4 percent for each of the first 3 years and 5
percent for each of the later years. Thus, a cash flow accruing in Year 8
should be discounted at 5 percent for some years and 4 percent in other years.
All payments occur at yearend.
¡P
$
792.49
25. For a 10year deposit, what annual rate payable
semiannually will produce the same effective rate as 4 percent compounded
continuously?
¡P
4.04%
26. Foster Industries has a project that has the
following cash flows:
Year 
Cash Flow 
0 
$300.00 
1 
100.00 
2 
125.43 
3 
90.12 
4 
? 
What
cash flow will the project have to generate in the fourth year in order for the
project to have a 15 percent rate of return?
¡P
$103.10
27. Frank Lewis has a 30year, $100,000 mortgage with a
nominal interest rate of 10 percent and monthly compounding. Which of the
following statements regarding his mortgage is most correct?
¡P
Statements b and
c are correct.
28. Gilhart First National Bank offers an investment
security with a 7.5 percent nominal annual return, compounded quarterly.
Gilhart's competitor, Olsen Savings and Loan, is offering a similar security
that bears the same risk and same effective rate of return. However, Olsen's
security pays interest monthly. What is the nominal annual return of the
security offered by Olsen?
¡P
7.45%
29. Gomez Electronics needs to arrange financing for its
expansion program. Bank A offers to lend Gomez the required funds on a loan in
which interest must be paid monthly, and the quoted rate is 8 percent. Bank B will
charge 9 percent, with interest due at the end of the year. What is the
difference in the effective annual rates charged by the two banks?
¡P
0.70%
30. Hillary is trying to determine the cost
of health care to college students and parents' ability to cover those costs. She assumes that the
cost of one year of health care for a college student is $1,000 today, that the
average student is 18 when he or she enters college, that inflation in health
care cost is rising at the rate of 10 percent per
year, and that parents can save $100 per year to help cover their children's
costs. All payments occur at the end of the relevant period, and the $100/year
savings will stop the day the child enters college (hence 18 payments will be
made). Savings can be invested at a nominal rate of 6 percent, annual
compounding. Hillary wants a health care plan that covers the fully inflated
cost of health care for a student for 4 years, during Years 19 through 22 (with
payments made at the end of Years 19 through 22). How much would the government
have to set aside now (when a child is born), to supplement the average
parent's share of a child's college health care cost? The lump sum the
government sets aside will also be invested at 6 percent, annual compounding.
¡P
$7,472.08
31. How much should you
be willing to pay for an account today that will have a value of $1,000 in 10
years under continuous compounding if the nominal rate is 10 percent?
¡P
$368
House
Your family recently bought a house. You have a $100,000, 30year mortgage with
a 7.2 percent nominal annual interest rate. Interest is compounded monthly and
all payments are made at the end of the month.
32. Refer to House. What is the monthly payment on the mortgage?
33. If $100 is placed in an account that earns a nominal
4 percent, compounded quarterly, what will it be worth in 5 years?
¡P
$122.02
34. If a 5year ordinary annuity has a
present value of $1,000, and if the interest rate is 10 percent, what is the
amount of each annuity payment?
¡P
$263.80
35. If it were evaluated with an interest
rate of 0 percent, a 10year regular annuity would have a present value of
$3,755.50. If the future (compounded) value of this annuity, evaluated at Year
10, is $5,440.22, what effective annual interest rate must the analyst be using to find the future value?
¡P
8%
36. If you buy a factory for $250,000 and the terms are
20 percent down, the balance to be paid off over 30 years at a 12 percent rate
of interest on the unpaid balance, what are the 30 equal annual payments?
¡P
$24,829
37. If you receive $15,000 today and can invest
it at a 5 percent annual rate compounded continuously, what will be your ending
value after 20 years?
¡P
$40,774
38. In 1958 the average tuition for one year at an Ivy
League school was $1,800. Thirty years later, in 1988, the average cost was
$13,700. What was the growth rate in tuition over the 30year period?
¡P
7%
39. In order to purchase your first home you need a down
payment of $19,000 four years from today. You currently have $14,014 to invest.
In order to achieve your goal, what nominal interest rate, compounded
continuously, must you earn on this investment?
¡P
7.61%
40. In six years' time, you are scheduled to
receive money from a trust established for you by your grandparents. When the
trust matures there will be $100,000 in the account. If the account earns 9
percent compounded continuously, how much is in the account today?
¡P
$
58,275
41. Jerry plans to retire on the same day
(which will be his 65^{th} birthday); however, until now, he has saved
nothing for retirement. Jerry's plan is to start contributing a fixed amount
each year on his birthday; the first contribution will occur today. Jerry's 36^{th},
and final, contribution will occur on his 65^{th} birthday. Jerry's
goal is to have the same amount when he retires at age 65 that Donald will have
at age 60. Assume that both accounts have an expected annual return of 12
percent. How much does Jerry need to contribute each year in order to meet his
goal?
¡P
$
9,838
42. Jill currently has $300,000 in a
brokerage account. The account pays a 10 percent annual interest rate. Assuming
that Jill makes no additional contributions to the account, how many years will
it take for her to have $1,000,000 in the account?
¡P
12.63
years
43. Jim and Nancy just got married today.
They want to start saving so they can buy a house five years from today. The
average house in their town today sells for $120,000. Housing prices are
expected to increase 3 percent a year. When they buy their house five years
from now, Jim and Nancy expect to get a 30year (360month) mortgage with a 7
percent nominal interest rate. They want the monthly payment on their mortgage
to be $500 a month.
Jim and Nancy want to buy an average house in their town. They are starting to
save today for a down payment on the house. The down payment plus the mortgage
will equal the expected price of the house. Their plan is to deposit $2,000 in
a brokerage account today and then deposit a fixed amount at the end of each of
the next five years. Assuming that the brokerage account has an annual return
of 10 percent, how much do Jim and
¡P
$
9,949
44. Joe and Jane are interested in saving money to put
their two children, John and Susy through college. John is currently 12 years
old and will enter college in six years. Susy is 10 years old and will enter
college in 8 years. Both children plan to finish college in four years.
College costs are currently $15,000 a year (per child), and are expected to
increase at 5 percent a year for the foreseeable future. All college costs are
paid at the beginning of the school year. Up until now, Joe and Jane have saved
nothing but they expect to receive $25,000 from a favorite uncle in three
years.
To provide for the additional funds that are needed, they expect to make 12 equal
payments at the beginning of each of the next 12 yearsthe first payment will
be made today and the final payment will be made on Susy's 21st birthday (which
is also the day that the last payment must be made to the college). If all
funds are invested in a stock fund that is expected to earn 12 percent, how
large should each of the annual contributions be?
¡P
$ 7,475.60
45. John and Jessica are saving for their child's
education. Their daughter is currently eight years old and will be entering
college 10 years from now (t = 10). College costs are currently $15,000 a year
and are expected to increase at a rate of 5 percent a year. They expect their
daughter to graduate in four years, and that all annual payments will be due at
the beginning of each year (t = 10, 11, 12, and 13).
Right now, John and Jessica have $5,000 in their college savings account.
Starting today, they plan to contribute $3,000 a year at the beginning of each
of the next five years (t = 0, 1, 2, 3, and 4). Then their plan is to make six equal
annual contributions at the end of each of the following six years (t = 5, 6,
7, 8, 9, and 10). Their investment account is expected to have an annual return
of 12 percent. How large of an annual payment do they have to make in the
subsequent six years (t = 5, 6, 7, 8, 9, and 10) in order to meet their child's
anticipated college costs?
¡P
$4,411
46. John Keene recently invested $2,566.70 in a project
that is promising to return 12 percent per year. The cash flows are expected to
be as follows:
End of Year 
Cash Flow 
1 
$325 
2 
400 
3 
550 
4 
? 
5 
750 
6 
800 
What
is the cash flow at the end of the 4th year?
¡P
$1,157
Jordan
The
47. Refer to
¡P
$1,553.10
48. Refer to
¡P
$158,937.91
49. Josh and John (2 brothers) are each trying to save
enough money to buy their own cars. Josh is planning to save $100 from every
paycheck. (He is paid every 2 weeks.) John plans to put aside $150 each month
but has already saved $1,500. Interest rates are currently quoted at 10
percent. Josh's bank compounds interest every two weeks while John's bank
compounds interest monthly. At the end of 2 years they will each spend all
their savings on a car. (Each brother will buy a car.) What is the price of the
most expensive car purchased?
¡P
$5,797.63
50. Karen
Karen and Keith have a $300,000, 30year (360month) mortgage. The mortgage has
a 7.2 percent nominal annual interest rate. Mortgage payments are made at the end
of each month.
¡P
$2,036.36
51. Karen and her twin sister, Kathy, are celebrating
their 30th birthday today. Karen has been saving for her retirement ever since
their 25th birthday. On their 25th birthday, she made a $5,000 contribution to
her retirement account. Every year thereafter on their birthday, she has added
another $5,000 to the account. Her plan is to continue contributing $5,000
every year on their birthday. Her 41st, and final, $5,000 contribution will
occur on their 65th birthday.
So far, Kathy has not saved anything for her retirement but she wants to begin
today. Kathy's plan is to also contribute a fixed amount every year. Her first
contribution will occur today, and her 36th, and final, contribution will occur
on their 65th birthday. Assume that both investment accounts earn an annual
return of 10 percent. How large does Kathy's annual contribution have to be for
her to have the same amount in her account at age 65, as Karen will have in her
account at age 65?
¡P
$8,154.60
52. Katherine wants to open a savings account, and she
has obtained account information from two banks. Bank A has a nominal annual
rate of 9 percent, with interest compounded quarterly. Bank B offers the same
effective annual rate, but it compounds interest monthly. What is the nominal
annual rate of return for a savings account from Bank B?
¡P
8.933%
53. Kelly and Brian Johnson are a recently married couple whose parents have counseled
them to start saving immediately in order to have enough money down the road to
pay for their retirement and their children's college expenses. Today (t = 0)
is their 25^{th} birthday (the couple shares the same birthday).
The couple plan to have two children (Dick and Jane). Dick is expected to enter
college 20 years from now (t = 20); Jane is expected to enter college 22 years
from now (t = 22). So in years t = 22 and t = 23 there will be two children in
college. Each child will take 4 years to complete college, and college costs
are paid at the beginning of each year of college.
College costs per child will be as follows:
Year 
Cost per child 
Children in college 
20 
$58,045 
Dick 
21 
62,108 
Dick 
22 
66,456 
Dick and Jane 
23 
71,108 
Dick and Jane 
24 
76,086 
Jane 
25 
81,411 
Jane 
Kelly and Brian plan to retire 40 years from now at age 65 (at t = 40). They
plan to contribute $12,000 per year at the end of each year for the next 40
years into an investment account that earns 10 percent per year. This account
will be used to pay for the college costs, and also to provide a nest egg for
Kelly and Brian's retirement at age 65. How big will Kelly and Brian's nest egg
(the balance of the investment account) be when they retire at age 65 (t = 40)?
¡P
$2,393,273
54.
Linda needs a new car and she is deciding whether
it makes sense to buy or lease the car. She estimates that if she buys the car
it will cost her $17,000 today (t = 0) and that she would sell the car four
years from now for $7,000 (at t = 4). If she were to lease the car she would
make a fixed lease payment at the end of each of the next 48 months (4 years).
Assume that the operating costs are the same regardless of whether she buys or
leases the car. Assume that if she leases, there are no upfront costs and that there is no option to buy the car
after four years. Linda estimates that she should use a 6 percent nominal
interest rate to discount the cash flows. What is the breakeven lease payment?
(That is, at what monthly lease payment would she be indifferent between buying
and leasing the car?)
¡P
$269.85
Mortgage
A 30year, $115,000 mortgage has a nominal annual rate
of 7 percent. All payments are made at the end of each month.
55. Refer to Mortgage. What is the monthly payment on the
mortgage?
¡P
$765.10
56. On its savings accounts, the First
National Bank offers a 5 percent nominal interest rate that is compounded monthly. Savings
accounts at the Second National Bank have the same effective annual return, but
interest is compounded quarterly. What nominal rate does the Second National
Bank offer on its savings accounts?
¡P
5.02%
57. Rachel wants to take a trip to
¡P
$6,744.78
58. Steaks Galore needs to arrange financing for its
expansion program. One bank offers to lend the required $1,000,000 on a loan
that requires interest to be paid at the end of each quarter. The quoted rate
is 10 percent, and the principal must be repaid at the end of the year. A
second lender offers 9 percent, daily compounding (365day year), with interest
and principal due at the end of the year. What is the difference in the
effective annual rates (EFF%) charged by the two
banks?
¡P
0.96%
59. Steve and Robert were college roommates,
and each is celebrating their 30^{th} birthday today. When they
graduated from college nine years ago (on their 21^{st} birthday), they
each received $5,000 from family members for establishing investment accounts. Steve and
Robert have added $5,000 to their separate accounts on each of their following
birthdays (22^{nd} through 30^{th} birthdays). Steve has
withdrawn nothing from the account, but Robert made one withdrawal on his 27^{th}
birthday. Steve has invested the money in Treasury bills that have earned a
return of 6 percent per year, while Robert has invested his money in stocks
that have earned a return of 12 percent per year. Both Steve and Robert have
the same amount in their accounts today. How much did Robert withdraw on his 27^{th}
birthday?
¡P
$15,545.07
60. Steven just deposited $10,000 in a bank
account that has a 12 percent nominal interest rate, and the interest is
compounded monthly. Steven also plans to contribute another $10,000 to the
account one year (12 months) from now and another $20,000 to the account two
years from now. How much will be in the account three years (36 months) from
now?
¡P
$49,542
61. South Penn Trucking is financing a new truck with a
loan of $10,000 to be repaid in 5 annual endofyear installments of $2,504.56.
What annual interest rate is the company paying?
¡P
8%
62. Suppose someone offered you the choice of two equally
risky annuities, each paying $10,000 per year for five years. One is an
ordinary (or deferred) annuity, the other is an
annuity due. Which of the following statements is most correct?
¡P
The present
value of the annuity due exceeds the present value of the ordinary annuity, and
the future value of the annuity due also exceeds the future value of the
ordinary annuity.
63. Suppose you are deciding whether to buy
or lease a car. If you buy the car, it will cost $17,000 today (t = 0). You expect
to sell the car four years (48 months) from now for $6,000 (at t = 48). As an alternative to buying the
car, you can lease the car for 48 months. All lease payments would be made at
the end of the month. The first lease payment would occur next month (t = 1)
and the final lease payment would occur 48 months from now (t = 48). If you buy
the car, you would do so with cash, so there is no need to consider financing.
If you lease the car, there is no option to buy it at the end of the contract.
Assume that there are no taxes, and that the operating costs are the same
regardless of whether you buy or lease the car. Assume that all cash flows are
discounted at a nominal annual rate of 12 percent, so the monthly periodic rate
is 1 percent. What is the breakeven lease payment? (That is, at what monthly
payment would you be indifferent between buying and leasing the car?)
¡P
$349.67
64. Suppose you put $100 into a savings account today,
the account pays a nominal annual interest rate of 6 percent, but compounded
semiannually, and you withdraw $100 after 6 months. What would your ending
balance be 20 years after the initial $100 deposit was made?
¡P
$
9.50
65. Terry Austin is 30 years old and is
saving for her retirement. She is planning on making 36 contributions to her retirement
account at the beginning of each of the next 36 years. The first contribution
will be made today (t = 0) and the final contribution will be made 35 years
from today (t = 35). The retirement account will earn a return of 10 percent a
year. If each contribution she makes is $3,000, how much will be in the
retirement account 35 years from now (t = 35)?
¡P
$897,380
66. The Florida Boosters Association has
decided to build new bleachers for the football field. Total costs are
estimated to be
$1 million, and financing will be through a bond issue of the same amount. The
bond will have a maturity of 20 years, a coupon rate of 8 percent, and has
annual payments. In addition, the Association must set up a reserve to pay off
the loan by making 20 equal annual payments into an account that pays 8
percent, annual compounding. The interestaccumulated amount in the reserve
will be used to retire the entire issue at its maturity 20 years hence. The
Association plans to meet the payment requirements by selling season tickets at
a $10 net profit per ticket. How many tickets must be sold each year to service
the debt (to meet the interest and principal repayment requirements)?
¡P
10,186
67. The future value of a lump sum at the end of five
years is $1,000. The nominal interest rate is 10 percent and interest is
compounded semiannually. Which of the following statements is most correct?
¡P
Statements b and
c are correct.
68. The Martin family recently deposited $1,000 in a bank
account that pays a 6 percent nominal interest rate. Interest in the account
will be compounded daily (365 days = 1 year). How much will they have in the
account after 5 years?
¡P
$1,349.82
69. To save money for a new house, you want to begin
contributing money to a brokerage account. Your plan is to make 10 contributions
to the brokerage account. Each contribution will be for $1,500. The
contributions will come at the beginning of each of the next 10 years. The
first contribution will be made at t = 0 and the final contribution will be
made at t = 9. Assume that the brokerage account pays a 9 percent return with
quarterly compounding. How much money do you expect to have in the brokerage
account nine years from now (t = 9)?
¡P
$23,127.49
70. Today, Bruce and Brenda each have $150,000 in an
investment account. No other contributions will be made to their investment
accounts. Both have the same goal: They each want their account to reach $1
million, at which time each will retire. Bruce has his money invested in
riskfree securities with an expected annual return of 5 percent. Brenda has
her money invested in a stock fund with an expected annual return of 10
percent. How many years after Brenda retires will Bruce retire?
¡P
19.0
71. Today is Craig's 24^{th}
birthday, and he wants to begin saving for retirement. To get started, his plan
is to open a brokerage account, and to put $1,000 into the account today. Craig
intends to deposit $X into the account each year on his subsequent birthdays
until the age of 64. In other words, Craig plans to make 40 contributions of
$X. The first contribution will be made one year from now on his 25^{th}
birthday, and the 40^{th} (and final)
contribution will occur on his 64^{th} birthday. Craig plans to retire
at age 65 and he expects to live until age 85. Once he retires, Craig estimates
that he will need to withdraw $100,000 from the account each year on his
birthday in order to meet his expenses. (That is, Craig plans to make 20
withdrawals of $100,000 eachthe first withdrawal will occur on his 65^{th}
birthday and the final one will occur on his 84^{th} birthday.) Craig
expects to earn 9 percent a year in his brokerage account. Given his plans, how
much does he need to deposit into the account for each of the next 40 years, in
order to reach his goal? (That is, what is $X?)
¡P
$2,608.73
72. Today is Janet's 23^{rd}
birthday. Starting today, Janet plans to begin saving for her retirement. Her
plan is to contribute $1,000 to a brokerage account each year on her birthday.
Her first contribution will take place today. Her 42^{nd} and final
contribution will take place on her 64^{th} birthday. Her aunt has
decided to help Janet with her savings, which is why she gave Janet $10,000
today as a birthday present to help get her account started. Assume that the
account has an expected annual return of 10 percent. How much will Janet expect
to have in her account on her 65^{th} birthday?
¡P
$1,139,037.68
73. Today is your 20^{th} birthday.
Your parents just gave you $5,000 that you plan to use to open a stock
brokerage account. Your plan is to add $500 to the account each year on your
birthday. Your first $500 contribution will come one year from now on your 21^{st}
birthday. Your 45^{th} and final $500 contribution will occur on your
65^{th} birthday. You plan to withdraw $5,000 from the account five
years from now on your 25^{th} birthday to take a trip to
¡P
$505,803
74. Today is your 21st birthday, and you are opening up
an investment account. Your plan is to contribute $2,000 per year on your
birthday and the first contribution will be made today. Your 45th, and final, contribution will be made on your 65th birthday. If
you earn 10 percent a year on your investments, how much money will you have in
the account on your 65th birthday, immediately after making your final
contribution?
¡P
$1,437,809.67
75. Today is your 23rd birthday. Your aunt just gave you
$1,000. You have used the money to open up a brokerage account. Your plan is to
contribute an additional $2,000 to the account each year on your birthday, up
through and including your 65th birthday, starting next year. The account has
an annual expected return of 12 percent. How much do you expect to have in the
account right after you make the final $2,000
contribution on your 65th birthday?
¡P
$2,045,442
76. Today is your 25th birthday. Your goal is to have $2
million by the time you retire at age 65. So far you have nothing saved, but
you plan on making the first contribution to your retirement account today. You
plan on making three other contributions to the account, one at age 30, age 35,
and age 40. Since you expect that your income will increase rapidly over the
next several years, the amount that you contribute at age 30 will be double
what you contribute today, the amount at age 35 will be three times what you
contribute today, and the amount at age 40 will be four times what you
contribute today. Assume that your investments will produce an average annual
return of 10 percent. Given your goal and plan, what is the minimum amount you
need to contribute to your account today?
¡P
$10,145
77. Today is Rachel's 30^{th}
birthday. Five years ago, Rachel opened a brokerage account when her
grandmother gave her $25,000 for her 25^{th} birthday. Rachel added
$2,000 to this account on her 26^{th} birthday, $3,000 on her 27^{th}
birthday, $4,000 on her 28^{th} birthday, and $5,000 on her 29^{th}
birthday. Rachel's goal is to have $400,000 in the account by her 40^{th}
birthday.
Starting today, she plans to contribute a fixed amount to the account each year
on her birthday. She will make 11 contributions, the first one will occur
today, and the final contribution will occur on her 40^{th} birthday.
Complicating things somewhat is the fact that Rachel plans to withdraw $20,000
from the account on her 35^{th} birthday to finance the down payment on
a home. How large does each of these 11 contributions have to be for Rachel to
reach her goal? Assume that the account has earned (and will continue to earn)
an effective return of 12 percent a year.
¡P
$11,743.95
78. Today you opened up a local bank account. Your plan
is make five $1,000 contributions to this account. The first $1,000
contribution will occur today and then every six months you will contribute
another $1,000 to the account. (So your final $1,000 contribution will be made
two years from today). The bank account pays a 6 percent nominal annual
interest, and interest is compounded monthly. After two years, you plan to
leave the money in the account earning interest, but you will not make any
further contributions to the account. How much will you have in the account 8
years from today?
¡P
$7,609
Victoria and David have a 30year, $75,000
mortgage with an 8 percent nominal annual interest rate. All payments are due
at the end of the month.
79. Refer to
¡P
$ 51.35
80. What is the future value of a 5year ordinary annuity
with annual payments of $200, evaluated at a 15 percent interest rate?
¡P
$1,348.48
81. Which of the following bank accounts has the highest
effective annual return?
¡P
An account that
pays 10 percent nominal interest with daily compounding.
82. Which of the following investments has the highest effective annual rate
(EAR)? (Assume that all CDs are of equal risk.)
¡P
A bank CD that
pays 10 percent monthly.
83. What
is the present value of a 5year ordinary annuity with annual payments of $200,
evaluated at a 15 percent interest rate?
¡P
$
670.43
84. Which of the following investments will have the
highest future value at the end of 5 years? Assume that the effective annual
rate for all investments is the same.
¡P
E pays $100 at
the beginning of every year for the next 5 years (a total of 5 payments).
85. Which of the following investments would provide an
investor the highest effective annual rate of return?
¡P
An investment
that has a 9 percent nominal rate with quarterly compounding.
86. Which of the following is most correct?
¡P
All of the statements
above are correct.
Wrong ans. i. If there is annual compounding, then the effective, periodic, and nominal rates of interest are all the same.
Wrong ans. ii. If a loan has a nominal rate of 10 percent, then the effective rate can never be less than 10 percent.
Wrong ans. iii.
If
an investment pays 10 percent interest compounded annually, its effective rate
will also be 10 percent.
Wrong ans. iv. compounded annually, its effective rate will also be 10 percent.
¡P Statements a and b are correct.
Wrong ans. i. The nominal interest rate will always be greater than or equal to the effective annual interest rate.
¡P The proportion of the payment of a fully amortized loan that goes toward interest declines over time.
87. Which of the following securities has the largest present value? Assume in
all cases that the annual interest rate is 8 percent and that there are no
taxes.
¡P
A preferred
stock issue that pays an $800 annual dividend in perpetuity. (Assume that the
first dividend is received one year from today.)
88. Which one of the following investments
provides the highest effective rate of return?
¡P
An investment that has a 9.9
percent nominal rate and quarterly annual compounding.
89. You are considering an investment in a 40year
security. The security will pay $25 a year at the end of each of the first three years. The security will then pay
$30 a year at the end of each of the next 20 years. The nominal interest rate is
assumed to be 8 percent, and the current price (present value) of the security
is $360.39. Given this information, what is the equal annual payment to be
received from Year 24 through Year 40 (for 17 years)?
¡P
$40
90. You are considering
buying a new car. The sticker price is $15,000 and you have $2,000 to put
toward a down payment. If you can negotiate a nominal annual interest rate of
10 percent and you wish to pay for the car over a 5year period, what are your
monthly car payments?
¡P
$276.21
91. You are contributing
money to an investment account so that you can purchase a house in five years.
You plan to contribute six payments of $3,000
a year. The first payment will be made today (t = 0) and the final payment will
be made five years from now (t = 5). If you earn 11 percent in your investment
account, how much money will you have in the account five years from now (at t
= 5)?
¡P
$23,739
92. You are currently
investing your money in a bank account that has a nominal annual rate of 7
percent, compounded monthly. How many years will it take for you to double your
money?
¡P
9.93
93. You are given the following cash flows. $1 at yr. 1,
$2,000 at yr. 2, $2,000 at yr. 3, $2,000 at yr. 4, $0 at yr. 5, and $2,000 at
yr. 6. What is the present value (t = 0) if the discount rate is 12 percent?
¡P
$3,277
94. You are given the following cash flows. What is the
present value (t = 0) if the discount rate is 12 percent?
¡P
$3,277
95. You are interested in investing your money in a bank
account. Which of the following banks provides you with the highest effective
rate of interest?
¡P
Bank 4; 8
percent with daily (365day) compounding.
96. You are interested in saving money for your first
house. Your plan is to make regular deposits into a brokerage account that will
earn 14 percent. Your first deposit of $5,000 will be made today. You also plan
to make four additional deposits at the beginning of each of the next four
years. Your plan is to increase your deposits by 10 percent a year. (That is,
you plan to deposit $5,500 at t = 1, and $6,050 at t = 2, etc.) How much money
will be in your account after five years?
¡P
$44,873.90
97.
You are saving for the college education of your
two children. One child will enter college in 5 years, while the other child
will enter college in 7 years. College costs are currently $10,000 per year and
are expected to grow at a rate of 5 percent per year. All college costs are
paid at the beginning of the year. You assume that each child will be in
college for four years.
You currently have $50,000 in your educational fund. Your plan is to contribute
a fixed amount to the fund over each of the next 5 years. Your first
contribution will come at the end of this year, and your final contribution
will come at the date when you make the first tuition payment for your oldest
child. You expect to invest your contributions into various investments, which
are expected to earn 8 percent per year. How much should you contribute each
year in order to meet the expected cost of your children's education?
¡P
$3,712
98. You
are willing to pay $15,625 to purchase a perpetuity that will pay you and your
heirs $1,250 each year, forever. If your required rate of return does not
change, how much would you be willing to pay if this were a 20year annual
payment, ordinary annuity instead of a perpetuity?
¡P
$12,273
99. You deposited $1,000 in a savings account that pays 8
percent interest, compounded quarterly, planning
to use it to finish your last year in college. Eighteen months later, you
decide to go to the
¡P
$1,126
100.
You have $2,000 invested in a bank account that pays a 4
percent nominal annual interest with daily compounding. How much money will you
have in the account at the end of July (in 132 days)? (Assume there are 365
days in each year.)
¡P
$2,029.14
101.
You have $5,438
in an account that has been paying an annual rate of 10 percent, compounded
continuously. If you deposited some funds 10 years ago, how much was your
original deposit?
¡P
$2,000
102.
You have been
offered an investment that pays $500 at the end of every 6 months for the next
3 years. The nominal interest rate is 12 percent; however, interest is
compounded quarterly. What is the present value of the investment?
¡P
$2,451.73
103.
You have determined the profitability of a planned
project by finding the present value of all the cash flows from that project.
Which of the following would cause the project to look more appealing in terms
of the present value of those cash flows?
¡P
The discount
rate decreases.
104.
You have just
bought a security that pays $500 every six months. The security lasts for 10
years. Another security of equal risk also has a maturity of 10 years, and pays
10 percent compounded monthly (that is, the nominal rate is 10 percent). What
should be the price of the security that you just purchased?
¡P
$6,175.82
105.
You have just taken out a 10year, $12,000 loan to
purchase a new car. This loan is to be repaid in 120 equal endofmonth
installments. If each of the monthly installments is $150, what is the
effective annual interest rate on this car loan?
¡P
9.0438%
106.
You
have the choice of placing your savings in an account paying 12.5 percent
compounded annually, an account paying 12.0 percent compounded semiannually, or
an account paying 11.5 percent compounded continuously. To maximize your return
you would choose:
¡P
12.5%
compounded
annually
107.
You
have the opportunity to buy a perpetuity that pays $1,000 annually. Your
required rate of return on this investment is 15 percent. You should be essentially
indifferent to buying or not buying the investment if it were offered at a
price of
¡P
$6,666.67
108.
You just
graduated, and you plan to work for 10 years and then to leave for the
Australian "Outback" bush country.
You figure you can save $1,000 a year for the first 5 years and $2,000 a year
for the next 5 years. These savings cash flows will start one year from now. In
addition, your family has just given you a $5,000 graduation gift. If you put
the gift now, and your future savings when they start, into an account that
pays 8 percent compounded annually, what will your financial "stake"
be when you leave for
¡P
$31,148
109.
You
just put
$1,000 in a bank account that pays 6 percent nominal annual interest,
compounded monthly. How much will you have in your account after 3 years?
¡P
$1,196.68
110.
You place $1,000
in an account that pays 7 percent interest compounded continuously. You plan to
hold the account exactly three years. Simultaneously, in another account you
deposit money that earns 8 percent compounded semiannually. If the accounts are
to have the same amount at the end of the three years, how much of an initial
deposit do you need to make now in the account that pays 8 percent interest
compounded semiannually?
¡P
$
975.01
111.
You plan to invest $5,000 at the end of each of the next
10 years in an account that has a 9 percent nominal rate with interest
compounded monthly. How much will be in your account at the end of the 10
years?
¡P
$ 77,359
112.
You recently
purchased a 20year investment that pays you $100 at t = 1, $500 at t = 2, $750
at t = 3, and some fixed cash flow, X, at the
end of each of the remaining 17 years. You purchased the investment for
$5,544.87. Alternative investments of equal risk have a required return of 9
percent. What is the annual cash flow received at the end of each of the final
17 years, that is, what is X?
¡P
$675
113.
You recently
received a letter from CuttotheChase National Bank that offers you a new
credit card that has no annual fee. It states that the annual percentage rate
(APR) is 18 percent on outstanding balances. What is the effective annual
interest rate? (Hint: Remember these companies bill you monthly.)
¡P
19.56%
114.
Your bank account pays a nominal interest rate of 6
percent, but interest is compounded daily (on a 365day basis). Your plan is to
deposit $500 in the account today. You also plan to deposit $1,000 in the
account at the end of each of the next three years. How much will you have in
the account at the end of three years, after making your final deposit?
¡P
$3,788
115.
Your
bank account pays an 8 percent nominal rate of interest. The interest is
compounded quarterly. Which of the following statements is most correct?
¡P
The
periodic rate of interest is 2 percent and the effective rate of interest is
greater than 8 percent.
116.
Your
employer has agreed to make 80 quarterly payments of $400 each into a trust
account to fund your early retirement. The first payment will be made 3 months
from now. At the end of 20 years (80 payments), you will be paid 10 equal annual
payments, with the first payment to be made at the beginning of Year 21 (or the
end of Year 20). The funds will be invested at a nominal rate of 8 percent,
quarterly compounding, during both the accumulation and the distribution
periods. How large will each of your 10 receipts be? (Hint: You must find the
EAR and use it in one of your calculations.)
¡P
$10,789
117.
Your
family recently obtained a 30year (360month) $100,000 fixedrate mortgage.
Which of the following statements is most correct? (Ignore all taxes and
transactions costs.)
¡P
The proportion
of the monthly payment that goes towards repayment of principal will be higher
10 years from now than it will be this year.
118.
Your father is
45 years old today. He plans to retire in 20 years. Currently, he has $50,000
in a brokerage account. He plans to make 20 additional contributions of $10,000
a year. The first of these contributions will
occur one year from today. The 20th and final contribution will occur on his
65th birthday. Once he retires, your father plans to withdraw a fixed dollar
amount from the account each year on his birthday. The first withdrawal will
occur on his 66th birthday. His 20th and final withdrawal will occur on his
85th birthday. After age 85, your father expects you to take care of him. Your
father also plans to leave you with no inheritance. Assume that the brokerage
account has an annual expected return of 10 percent. How much will your father
be able to withdraw from his account each year after he retires?
¡P
$106,785.48
119.
Your
father, who is 60, plans to retire in 2 years, and he expects to live
independently for 3 years. Suppose your father wants to have a real income of
$40,000 in today's dollars in each year after he retires. His retirement income
will start the day he retires, 2 years from today, and he will receive a total
of 3 retirement payments.
Inflation is expected to be constant at 5 percent. Your father has $100,000 in
savings now, and he can earn 8 percent on savings now and in the future. How
much must he save each year, starting today, to meet his retirement goals?
¡P
$5,350
120.
Your lease calls
for payments of $500 at the end of each month for the next 12 months. Now your landlord offers you a new 1year lease that calls
for zero rent for 3 months, then rental payments of $700 at the end of each
month for the next 9 months. You keep your money in a bank time deposit that
pays a nominal annual rate of 5 percent. By what amount would your net worth
change if you accept the new lease? (Hint: Your return per month is 5%/12 = 0.4166667%.)
¡P
$253.62
121.
Your
subscription to Jogger's World Monthly is about to run out and you have the
choice of renewing it by sending in the $10 a year regular rate or of getting a
lifetime subscription to the magazine by paying $100. Your cost of capital is 7
percent. How many years would you have to live to make the lifetime
subscription the better buy? Payments for the regular subscription are made at
the beginning of each year. (Round up if necessary to obtain a whole number of
years.)
¡P
15 years
12Year Bond
A 12year bond has an 8 percent annual coupon and a face value of $1,000. The
bond has a yield to maturity of 7 percent.
1. Refer to 12Year Bond. If the yield to
maturity remains at 7 percent, what will be the price of the bond three years
from today?
¡P
$1,065.15
2. Refer to 12Year Bond. What is the price
of the annual coupon bond today?
¡P
$1,079.43
3. A 12year bond pays an annual coupon of
8.5 percent. The bond has a yield to maturity of 9.5 percent and a par value of
$1,000. What is the bond's current yield?
¡P
9.14%
4. A 12year bond has a 9 percent annual
coupon, a yield to maturity of 8 percent, and a face value of $1,000. What is
the price of the bond?
¡P
$1,075
5.
A company is planning to raise
$1,000,000 to finance a new plant. Which of the following statements is most
correct?
¡P
If
debt is used to raise the million dollars, but $500,000 is raised as a first
mortgage bond on the new plant and $500,000 as debentures, the interest rate on
the first mortgage bonds would be lower than it would be if the entire $1
million were raised by selling first mortgage bonds.
6. A 5year corporate bond has an 8 percent
yield. A 10year corporate bond has a 9 percent yield. The two bonds have the
same default risk premium and liquidity premium. The real riskfree rate, k*,
is expected to remain constant at 3 percent. Inflation is expected to be 3
percent a year for the next five years. After five years, inflation is expected
to be constant at some rate, X, which may or may not be 3 percent. The maturity
risk premium equals 0.1%(t  1), where t equals time
until the bond's maturity. In other words, the maturity risk premium on the
5year bond is 0.4 percent or 0.004. What is the market's expectation today of
the average level of inflation for Years 6 through 10, that is, what is X?
¡P
4.0%
7. A 6year bond that pays 8 percent
interest semiannually sells at par ($1,000). Another 6year bond of equal risk
pays 8 percent interest annually. Both bonds are noncallable and have face
values of $1,000. What is the price of the bond that pays annual interest?
¡P
$992.64
8. An 8 percent annual coupon, noncallable
bond has 10 years until it matures and a yield to maturity of 9.1 percent. What
should be the price of a 10year noncallable bond of equal risk that pays an 8
percent semiannual coupon? Assume both bonds have a par value of $1,000.
¡P
$
941.09
9. A 10year bond has a 10 percent annual
coupon and a yield to maturity of 12 percent. The bond can be called in 5 years
at a call price of $1,050 and the bond's face value is $1,000. Which of the
following statements is most correct?
¡P
Statements
a and c are correct.
10. A 10year Treasury bond currently yields 7 percent. The real riskfree
rate of interest, k*, is 3.1 percent. The maturity risk premium has been estimated to be 0.1%(t
 1), where t = the maturity of the bond. (For a 3year bond the maturity risk
premium is 0.2 percent or 0.002.) Inflation is expected to average 2.5 percent
a year for each of the next five years. What is the expected average rate of
inflation between years five and ten?
¡P
3.5%
11. A 10year corporate bond has an annual
coupon payment of 9 percent. The bond is currently selling at par ($1,000).
Which of the following statements is most correct?
¡P
All
of the statements above are correct.
12. A 10year bond with a 9 percent annual
coupon has a yield to maturity of 8 percent. Which of the following statements
is most correct?
¡P
If
the yield to maturity remains constant, the bond's price one year from now will
be lower than its current price.
13. A 10year bond with a 9 percent semiannual
coupon is currently selling at par. A 10year bond with a 9 percent annual
coupon has the same risk, and therefore, the same effective annual return as
the semiannual bond. If the annual coupon bond has a face value of $1,000, what
will be its price?
¡P
$
987.12
14. A 10year bond pays an annual coupon. The
bond has a yield to maturity of 8 percent. The bond currently trades at a
premiumits price is above the par value of $1,000. Which of the following
statements is most correct?
¡P
If
the yield to maturity remains at 8 percent, then the bond's price will decline
over the next year.
15. A 12year bond
has an annual coupon rate of 9 percent. The coupon rate will remain fixed until
the bond matures. The bond has a yield to maturity of 7 percent. Which of the following
statements is most correct?
¡P
If market interest rates remain unchanged, the bond's price one year
from now will be lower than it is today.
16. A 12year bond has an 8 percent
semiannual coupon and a face value of $1,000. The bond pays a $40 coupon every
six months. The bond has a nominal yield to maturity of 7 percent. What is the
price of the bond?
¡P
$1,080.29
17. A 15year bond with a face value of
$1,000 currently sells for $850. Which of the following statements is most
correct?
¡P
The
bond's yield to maturity is greater than its coupon rate.
18. A 15year bond with an 8 percent annual
coupon has a face value of $1,000. The bond's yield to maturity is 7 percent.
What is the bond's current yield?
¡P
7.33%
19. A 15year bond with a 10 percent
semiannual coupon and a $1,000 face value has a nominal yield to maturity of
7.5 percent. The bond, which may be called after five years, has a nominal
yield to call of 5.54 percent. What is the bond's call price?
¡P
$1,040
20. A $1,000 par
value bond pays interest of $35 each quarter and will mature in 10 years. If
your nominal annual
required rate of return is 12 percent with quarterly compounding, how much
should you be willing to pay for this bond?
¡P
$1,115.57
21. A bond that matures in 12 years has a 9
percent semiannual coupon (i.e., the bond pays a $45 coupon every six months)
and a face value of $1,000. The bond has a nominal yield to maturity of 8
percent. What is the price of the bond today?
¡P
$1,076.23
22. A bond with a $1,000 face value and an 8
percent annual coupon pays interest semiannually. The bond will mature in 15
years. The nominal yield to maturity is 11 percent. What is the price of the
bond today?
¡P
$
781.99
23. A bond with 10 years to maturity has a
face value of $1,000. The bond pays an 8 percent semiannual coupon, and the bond
has a 9 percent nominal yield to maturity. What is the price of the bond today?
¡P
$934.96
24. A bond with a face value of $1,000
matures in 10 years. The bond has an 8 percent annual coupon and a yield to
maturity of 10 percent. If market interest rates remain at 10 percent, what
will be the price of the bond two years from today?
¡P
$
893.30
25. A fixedincome analyst has made the
following assessments:
Ø
The
real riskfree rate is expected to remain at 2.5 percent for the next 10 years.
Ø
Inflation
is expected to be 3 percent this year, 4 percent next year, and 5 percent a
year thereafter.
Ø
The
maturity risk premium is 0.1%(t  1), where t = the
maturity of the bond (in years).
A 5year corporate bond currently yields 8.5 percent. What will be
the yield on the bond, one year from now, if the above assessments are correct,
and the bond's default premium and liquidity premium remain unchanged?
¡P
8.75%
26. A Treasury bond has an 8 percent annual
coupon and a yield to maturity equal to 7.5 percent. Which of the following
statements is most correct?
¡P
Statements
b and c are correct
27. All of the following may serve to reduce
the coupon rate that would otherwise be required on a bond issued at par,
except a
¡P
Call
provision
28. All treasury securities have a yield to
maturity of 7 percentso the yield curve is flat. If the yield to maturity on
all Treasuries were to decline to 6 percent, which of the following bonds would
have the largest percentage increase in price?
¡P
15year
zero coupon Treasury bond.
29. An investor is considering buying one of
two bonds issued by Carson City Airlines. Bond A has a 7 percent annual coupon,
whereas Bond B has a 9 percent annual coupon. Both bonds have 10 years to
maturity, face values of $1,000, and yields to maturity of 8 percent. Assume
that the yield to maturity for both of the bonds will remain constant over the
next 10 years. Which of the following statements is most correct?
¡P
One
year from now, Bond A's price will be higher than it is today
30. Assume interest rates on longterm
government and corporate bonds were as follows:
Tbond = 7.72% A
= 9.64% AAA
= 8.72% BBB
= 10.18%
The differences in rates among these
issues were caused primarily by
¡P
Default
risk differences.
31. Assume that a 3year Treasury note has no
maturity risk premium, and that the real riskfree rate of interest is 3
percent. If the Tnote carries a yield to maturity of 13 percent, and if the
expected average inflation rate over the next 2 years is 11 percent, what is
the implied expected inflation rate during Year 3?
¡P
8%
32. Assume that a 10year Treasury bond has a
12 percent annual coupon, while a 15year Treasury bond has an 8 percent annual
coupon. The yield curve is flat; all Treasury securities have a 10 percent
yield to maturity. Which of the following statements is most correct?
¡P
If
interest rates decline, the price of both bonds will increase, but the 15year
bond will have a larger percentage increase in price.
33. Assume that a 15year, $1,000 face value
bond pays interest of $37.50 every 3 months. If you require a nominal annual
rate of return of 12 percent, with quarterly compounding, how much should you
be willing to pay for this bond? (Hint: The PVIFA and PVIF for 3 percent, 60
periods are 27.6756 and 0.1697, respectively.)
¡P
$1,207.57
34. Assume that all interest rates in the
economy decline from 10 percent to 9 percent. Which of the following bonds will
have the largest percentage increase in price?
¡P
A 10year zero coupon bond.
35. Assume that k*
= 2.0%; the maturity risk premium is found as MRP = 0.1%(t  1), where t =
years to maturity; the default risk premium for corporate bonds is found as DRP
= 0.05%(t  1); the liquidity premium is 1 percent for corporate bonds only;
and inflation is expected to be 3 percent, 4 percent, and 5 percent during the
next three years and then 6 percent thereafter. What is the difference in
interest rates between 10year corporate and Treasury bonds?
¡P
1.45%
36. Assume that McDonald's and Burger King
have similar $1,000 par value bond issues outstanding. The bonds are equally
risky. The Burger King bond has an annual coupon rate of 8 percent and matures 20 years from today. The McDonald's bond
has a coupon rate of 8 percent, with interest paid semiannually, and it also
matures in 20 years. If the nominal required rate of return, k_{d},
is 12 percent, semiannual basis, for both bonds, what is the difference in
current market prices of the two bonds?
¡P
$17.53
37. Assume that today is
¡P
2.4%
38. Assume that the City of
¡P
12.37%
39. Assume that the State of
¡P
9.01%
40. Assume that you are considering the
purchase of a $1,000 par value bond that pays interest of $70 each six months
and has 10 years to go before it matures. If you buy this bond, you expect to
hold it for 5 years and then to sell it in the market. You (and other
investors) currently require a nominal annual rate of 16 percent, but you expect the market to
require a nominal rate of only 12 percent when you sell the bond due to a
general decline in interest rates. How much should you be willing to pay for
this bond?
¡P
$
966.99
41. Assume that you wish to purchase a
20year bond that has a maturity value of $1,000 and makes semiannual interest payments of $40. If you require
a 10 percent nominal yield to maturity on this investment, what is the maximum
price you should be willing to pay for the bond?
¡P
$828
Bond Matures
A bond that matures in 10 years sells for $925. The
bond has a face value of $1,000 and an 8 percent annual coupon.
42. Refer to Bond Matures. Assume that the yield
to maturity remains constant for the next three years. What will be the price
of the bond three years from today?
¡P
$
941
43. Refer to Bond Matures. What is the bond's
current yield?
¡P
8.65%
44. Bonds A, B, and
C all have a maturity of 10 years and a yield to maturity equal to 7 percent.
Bond A's price exceeds its par value, Bond B's price equals its par value, and
Bond C's price is less than its par value. Which of the following statements is
most correct?
¡P
If
the yield to maturity on each bond increases to 8 percent, the price of all
three bonds will decline.
45. Bond X has an 8 percent annual coupon,
Bond Y has a 10 percent annual coupon, and Bond Z has a 12 percent annual coupon. Each of the bonds has a
maturity of 10 years and a yield to maturity of 10 percent. Which of the
following statements is most correct?
¡P
If
market interest rates remain at 10 percent, Bond Z's price will be lower one
year from now than it is today.
46. Chapter 7 of
the Bankruptcy Act is designed to do which of the following?
¡P
Statements a and c are
correct.
47. Cold Boxes Ltd. has 100 bonds outstanding
(maturity value = $1,000). The nominal required rate of return on these bonds
is currently 10 percent, and interest is paid semiannually. The bonds mature in
5 years, and their current market value is $768
per bond. What is the annual coupon interest rate?
¡P
4%
48. Consider a $1,000 par value bond with a 7
percent annual coupon. The bond pays interest annually. There are 9 years
remaining until maturity. What is the current yield on the bond assuming that
the required return on
the bond is 10 percent?
¡P
8.46%
49. Consider each of the following bonds:
Bond A: 8year maturity with a 7 percent annual coupon.
Bond B: 10year maturity with a 9 percent annual coupon.
Bond C: 12year maturity with a zero coupon.
Each bond has a face value of $1,000 and a yield to maturity of 8 percent.
Which of the following statements is most correct?
¡P
Statements
a and b are correct.
50. Drongo Corporation's 4year bonds currently yield
7.4 percent. The real riskfree rate of interest, k*, is 2.7 percent and is
assumed to be constant. The maturity risk premium (MRP) is estimated to be 0.1%(t  1), where t is equal to the time to maturity. The
default risk and liquidity premiums for this company's bonds total 0.9 percent
and are believed to be the same for all bonds issued by this company. If the
average inflation rate is expected to be 5 percent for years 5, 6, and 7, what
is the yield on a 7year bond for Drongo Corporation?
¡P
8.34%
51. Due to a number of lawsuits related to
toxic wastes, a major chemical manufacturer has recently experienced a market
reevaluation. The firm has a bond issue outstanding with 15 years to maturity
and a coupon rate of 8
percent, with interest paid semiannually. The required nominal rate on this
debt has now risen to 16 percent. What is the current value of this bond?
¡P
$
550
52. For the foreseeable future, the real riskfree rate of interest,
k*, is expected to remain at 3 percent. Inflation is expected to steadily
increase over time. The maturity risk premium equals 0.1(t  1)%, where t represents the bond's maturity. On the basis of
this information, which of the following statements is most correct?
¡P
Statements
a and c are correct
53. Given the following data, find the
expected rate of inflation during the next year.
Ø
k* =
real riskfree rate = 3%.
Ø
Maturity
risk premium on 10year Tbonds = 2%. It is zero on 1year bonds, and a linear
relationship exists.
Ø
Default
risk premium on 10year, Arated bonds = 1.5%.