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Finance Final Study Guide Problems

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Question;I. Multiple choice1. Which of the following statements is CORRECT?a.b.c.d.e.One advantage of the NPV over the IRR is that NPV takes account of cash flows over a projectsfull life whereas IRR does not.One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvestedat the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPVassumption is generally more appropriate.One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over aprojects full life whereas MIRR does not.One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas theMIRR is based on undiscounted cash flows.Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC),these two methods always rank mutually exclusive projects in the same order.2. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of15%, while Project Ls IRR is 12%. The two projects have the same NPV when the WACC is 7%.Which of the following statements is CORRECT?a.b.c.d.e.If the WACC is 10%, both projects will have positive NPVs.If the WACC is 6%, Project S will have the higher NPV.If the WACC is 13%, Project S will have the lower NPV.If the WACC is 10%, both projects will have a negative NPV.Project Ss NPV is more sensitive to changes in WACC than Project L's.3. Which of the following statements is most correct?a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost ofretained earnings is not zero, the cost of retained earnings is generally lower than the after-taxcost of debt financing.b. The capital structure that minimizes the firms cost of capital is also the capital structure thatmaximizes the firms stock price.c. The capital structure that minimizes the firms cost of capital is also the capital structure thatmaximizes the firms earnings per share.d. If a firm finds that the cost of debt financing is currently less than the cost of equity financing, anincrease in its debt ratio will always reduce its cost of capital.e. Statements a and b are correct.4. In the real world, we find that dividendsa. Usually exhibit greater stability than earnings.b. Fluctuate more widely than earnings.c. Tend to be a lower percentage of earnings for mature firms.d. Are usually changed every year to reflect earnings changes.e. Are usually set as a fixed percentage of earnings.5. Which of the following statements is most correct?a. The bird-in-the-hand theory implies that a company can reduce its WACC by reducing itsdividend payout.b. The bird-in-the-hand theory implies that a company can increase its stock price by reducing itsdividend payout.c. One problem with following a residual distribution policy (with all distributions in the form ofdividends) is that it can lead to erratic dividend payouts that may prevent the firm fromestablishing a reliable clientele of investors who prefer a particular dividend policy.d. Statements a and c are correct.e. All of the statements above are correct.6. A stock split will cause a change in the total dollar amounts shown in which of the following balance sheetaccounts?a. Cash.b. Common stock.c. Paid-in capital.d. Retained earnings.e. None of the above.7. Which of the following statements is most correct?a. One reason that companies tend to avoid stock repurchases is that dividend payments are taxedmore favorably than stock repurchases.b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid payingtaxes on the dividends that they choose to reinvest.c. If a company announces a 2-for-1 stock split and the overall value of the firm remains unchanged,the companys stock price must have doubled.d. All of the statements above are correct.e. None of the statements above is correct.8. Which of the following statements is most correct?a. If the dividend irrelevance theory (which is associated with the names Modigliani and Miller)were exactly correct, and if this theory could be tested with "clean" data, then we would find, in aregression of dividend yield and capital gains, a line with a slope of -1.0.b. The tax preference and bird-in-the-hand theories lead to identical conclusions as to the optimaldividend policy.c. If a company raises its dividend by an unexpectedly large amount, the announcement of this newand higher dividend is generally accompanied by an increase in the stock price. This is consistentwith the bird-in-the-hand theory, and Modigliani and Miller used these findings to support theirposition on dividend theory.d. If it could be demonstrated that a clientele effect exists, this would suggest that firms could altertheir dividend payment policies from year to year to take advantage of investment opportunitieswithout having to worry about the effects of changing dividends on capital costs.e. Each of the statements above is false.9. Which of the following statements concerning common stock and the investment banking process is false?a. The preemptive right gives each existing common stockholder the right to purchase his or herproportionate share of a new stock issue.b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primarymarket.c. Listing a large firm's stock is often considered to be beneficial to stockholders because theincreases in liquidity and status probably outweigh the additional costs to the firm.d. Stockholders have the right to elect the firm's direc tors, who in turn select the officers whomanage the business. If stockholders are dissatisfied with management's performance, an outsidegroup may ask the stockholders to vote for it in an effort to take control of the business. Thisaction is called a tender offer.e. A large issue of new stock could cause the stock price to fall. This loss is called "marketpressure," and it is treated as a flotation cost because it is a cost associated with the new issue.10. Which of the following statements is most correct?a. If new debt is used to refund old debt, the correct discount rate to use in discounting cash flows isthe before-tax cost of new debt.b. The key benefit associated with refunding debt is the reduction in the firm's debt ratio andcreation of reserve borrowing capacity.c. The mechanics of analyzing the NPV of a refunding decision are fairly straightforward.However, the decision of when to refund is not as clear because it requires a forecast of futureinterest rates.d. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firmcan still claim the entire interest savings by locking in a low coupon rate when the rates are low,even though it refunds the debt after rates rise.e.If a firm is considering refunding and interest rates rise, this would tend to lower the expectedprice of the new bonds which will make them cheaper to the firm and increase the expectedinterest savings.11. Which of the following statements about warrants and convertibles is false?a. Both warrants and convertibles are types of option securities.b. One primary difference between warrants and convertibles is that warrants bring in additional fundswhen exercised, while convertibles do not.c. The coupon rate on convertible debt is lower than the coupon rate on similar straight debt becauseconvertibles are less risky.d. The value of a warrant depends on its exercise price, its term, and the underlying stock price.e. Warrants usually can be detached and traded separately from their associated debt.12. Which of the following statements concerning preferred stock is most correct?a. Preferred stock generally has a higher component cost to the firm than does common stock.b. By law in most states, all preferred stock issues must be cumulative, meaning that the cumulative,compounded total of all unpaid preferred dividends must be paid before dividends can be paid onthe firms common stock.c. From the issuers point of view, preferred stock is less risky than bonds.d. Preferred stock, because of the current tax treatment of dividends, is bought mostly by individuals inhigh tax brackets.e. Unlike bonds, preferred stock cannot have a convertible feature.13. Which of the following statements concerning commercial paper is incorrect?a. Commercial paper is generally written for terms less than 270 days.b. Commercial paper generally carries an interest rate below the prime rate.c. Commercial paper is sold to money market mutual funds, as well as to other financial institutionsand nonfinancial corporations.d. Commercial paper can be issued by virtually any firm so long as it is willing to pay the goinginterest rate.e. Commercial paper is a type of unsecured promissory note issued by large, strong firms.14. A swap is a method for reducing financial risk. Which of the following statements about swaps, if any, isincorrect?a. A swap involves the exchange of cash payment obligations.b. The earliest swaps were currency swaps, in which companies traded debt denominated indifferent currencies, say dollars and pounds.c. Swaps are generally arranged by a financial intermediary, who may or may not take the positionof one of the counterparties.d. A problem with swaps is the lack of standardized contracts, which limits the development of asecondary market.e. All of the statements above are correct.15. Which of the following statements is most correct?a. One advantage of forward contracts is that they are default free.b. Futures contracts generally trade on an organized exchange and are marked to market daily.c. Goods are never delivered under forward contracts, but are almost always delivered under futurescontracts.d. Answers a and c are correct.e. None of the answers above is correct.16. A commercial bank recognizes that its net income suffers whenever interest rates increase. Which of thefollowing strategies would protect the bank against rising interest rates?a. Buying inverse floaters.b. Entering into an interest rate swap where the bank receives a fixed payment stream, and in returnagrees to make payments that float with market interest rates.c. Purchase principal only (PO) strips that decline in value whenever interest rates rise.d. Enter into a short hedge where the bank agrees to sell interest rate futures.e. Sell some of the banks floating-rate loans and use the proceeds to make fixed-rate loans.17. Which of the following statements about interest rate and reinvestment rate risk is CORRECT?a. Variable (or floating) rate securities have more interest rate (price) risk than fixed rate securities.b. Interest rate price risk exists because fixed-rate debt securities lose value when interest rates rise,while reinvestment rate risk is the risk of earning less than expected when interest payments ordebt principal are reinvested.c. Interest rate price risk can be eliminated by holding zero coupon bonds.d. Reinvestment rate risk can be eliminated by holding variable (or floating) rate bonds.e. All of the statements above are correct.18. Which of the following are NOT ways risk management can be used to increase the value of a firm?a. Risk management can increase debt capacity.b. Risk management can help a firm maintain its optimal capital budget.c. Risk management can reduce the expected costs of financial distress.d. Risk management can help firms minimize taxes.e. Risk management can allow managers to defer receipt of their bonuses and thus postpone taxpayments.19. Which of the following statements is most CORRECT?a. Preferred stock generally has a higher component cost of capital to the firm than does commonstock.b. By law in most states, all preferred stock must be cumulative, meaning that the compounded total ofall unpaid preferred dividends must be paid before any dividends can be paid on the firms commonstock.c. From the issuers point of view, preferred stock is less risky than bonds.d. Whereas common stock has an indefinite life, preferred stocks always have a specific maturity date,generally 25 years or less.e. Unlike bonds, preferred stock cannot have a convertible feature.20. Which of the following statements concerning warrants is CORRECT?a. Bonds with warrants and convertible bonds both have option features that their holders can exercise ifthe underlying stocks price increases. However, if the option is exercised, the issuing companys debtdeclines if warrants were used but remains the same if it used convertibles.b. Warrants are long-term put options that have value because holders can sell the firms common stockat the exercise price regardless of how low the market price drops.c. Warrants are long-term call options that have value because holders can buy the firms common stockat the exercise price regardless of how high the stocks price has risen.d. A firms investors would generally prefer to see it issue bonds with warrants than straight bondsbecause the warrants dilute the value of new shareholders, and that value is transferred to existingshareholders.e. A drawback to using warrants is that if the firm is very successful, investors will be less likely toexercise the warrants, and this will deprive the firm of receiving any new capital.21. Which of the following statements concerning common stock and the investment banking process is NOTCORRECT?a. The preemptive right gives each existing common stockholder the right to purchase his or herproportionate share of a new stock issue.b. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primarymarket.c. Listing a large firm's stock is often considered to be beneficial to stockholders because theincreases in liquidity and reputation probably outweigh the additional costs to the firm.d. Stockholders have the right to elect the firm's directors, who in turn select the officers whomanage the business. If stockholders are dissatisfied with management's performance, an outsidegroup may ask the stockholders to vote for it in an effort to take control of the business. Thisaction is called a tender offer.e. The announcement of a large issue of new stock could cause the stock price to fall. This loss iscalled "market pressure," and it is treated as a flotation cost because it is a cost to stockholdersthat is associated with the new issue.22. Which of the following is NOT a reason why companies move into international operations?a. To take advantage of lower production costs in regions where labor costs are relatively low.b. To develop new markets for the firms products.c. To better serve their primary customers.d. Because important raw materials are located abroad.e. To increase their inventory levels.23. If the inflation rate in the United States is greater than the inflation rate in Britain, other things heldconstant, the British pound willa. Appreciate against the U.S. dollar.b. Depreciate against the U.S. dollar.c. Remain unchanged against the U.S. dollar.d. Appreciate against other major currencies.e. Appreciate against the dollar and other major currencies.24. Which of the following statements is most CORRECT?a. A conglomerate merger is one where a firm combines with another firm in the same industry.b. Regulations in the United States prohibit acquiring firms from using common stock to purchaseanother firm.c. Defensive mergers are designed to make a company less vulnerable to a takeover.d. Hostle mergers always create value for the acquiring firm.e. In a tender offer, the target firms management always remain after the merger is completed.25. Which of the following statements is most CORRECT?a. The acquiring firms required rate of return in most horizontal mergers will not be affected,because the 2 firms will have similar betas.b. Financial theory says that the choice of how to pay for a merger is really irrelevant because,although it may affect the firm's capital structure, it will not affect its overall required rate ofreturn.c. The basic rationale for any financial merger is synergy and, thus, the estimation of proforma cashflows is the single most important part of the analysis.d. In most mergers, the benefits of synergy and the premium the acquirer pays over the market priceare summed and then divided equally between the shareholders of the acquiring and target firms.e. The primary rationale for most operating mergers is synergy.26. Which of the following statements is CORRECT?a.b.c.d.e.As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizesexpected EPS.The optimal capital structure simultaneously maximizes EPS and minimizes the WACC.The optimal capital structure minimizes the cost of equity, which is a necessary condition formaximizing the stock price.The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and theWACC.The optimal capital structure simultaneously maximizes stock price and minimizes the WACC.II. Problem Solving Question: Show all your work.1. Charles River Company has just sold a bond issue with 10 warrants attached. The bonds have a 20-yearmaturity, an annual coupon rate of 12.0 percent, and they sold at their $1,000 par value. The current yield onsimilar straight bonds is 15.0 percent. What is the implied value of each warrant?2. Suppose the September CBOT Treasury bond futures contract has a quoted price of 89-09. What is theimplied annual interest rate inherent in this futures contract?3. Company A can issue floating-rate debt at LIBOR + 1%, and it can issue fixed rate debt at 9%. Company Bcan issue floating-rate debt at LIBOR + 1.5%, and it can issue fixed-rate debt at 9.4%. Suppose A issuesfloating-rate debt and B issues fixed-rate debt, after which they engage in the following swap: A willmake a fixed 7.95% payment to B, and B will make a floating-rate payment equal to LIBOR to A. Whatare the resulting net payments of A and B?4. Suppose the December CBOT Treasury bond futures contract has a quoted price of 80-07. If annual interestrates go up by 1.00 percentage point, what is the gain or loss on the futures contract? (Assume a$1,000 par value, and round to the nearest whole dollar.)5. Suppose hockey skates sell in Canada for 105 Canadian dollars, and 1 Canadian dollar equals 0.71 U.S.dollars. If purchasing power parity (PPP) holds, what is the price of hockey skates in the United States?6. Suppose 90-day investments in Britain have a 6% annualized return and a 1.5% quarterly (90-day) return.In the U.S., 90-day investments of similar risk have a 4% annualized return and a 1% quarterly (90-day)return. In the 90-day forward market, 1 British pound equals $1.65. If interest rate parity holds, what isthe spot exchange rate of pound?7. In 1985, a given Japanese imported automobile sold for 1,476,000 yen, or $8,200. If the car still sold forthe same amount of yen today but the current exchange rate is 144 yen per dollar, what would the car beselling for today in U.S. dollars?8. If one U.S. dollar buys 1.64 Canadian dollars, how many U.S. dollars can you purchase for one Canadiandollar?9. Suppose 144 yen could be purchased in the foreign exchange market for one U.S. dollar today. If the yendepreciates by 8.0% tomorrow, how many yen could one U.S. dollar buy tomorrow?10. Dunbar Hardware, a national hardware chain, is considering purchasing a smaller chain, Eastern Hardware.Dunbar's analysts project that the merger will result in incremental free flows and interest tax savingswith a combined present value of $75.52 million, and they have determined that the appropriatediscount rate for valuing Eastern is 16%. Eastern has 4 million shares outstanding and 5 million debt.Eastern's current price is $15.25. What is the maximum price per share that Dunbar should offer?III. Multiple Problem Solving Question: Show all your work1. Musika World Inc. is considering a project that has the following cash flow and WACC is 14.00% (4points).YearCash flows0-$1,2001$4002$4253$4504$475a. Calculate payback period?b. Calculate discounted payback period?c. Calculate NPV?d. Calculate IRR?2. New Jersey Water Co.(NJWC) is considering whether to refund a $50 million, 14 percent coupon, 30-yearbond issue that was sold 5 years ago. It is amortizing $3 million of flotation costs on the 14 percent bondsover the 30-year life of that issue. NJWC's investment bankers have indicated that the company could sella new 25-year issue at an interest rate of 11.67 percent in today's market. A call premium of 14 percentwould be required to retire the old bonds, and flotation costs on the new issue would amount to $3 million.NJWC's marginal tax rate is 40 percent. The new bonds would be issued at the same time the old bondswere called (6 points).a. What is the relevant refunding investment outlay?b. What are the relevant annual interest savings for NJWC if refunding takes place?c. What are the relevant annual flotation cost tax effects for NJWC if refunding takes place?d. What is the NJWC bond refunding's NPV?3. The following data apply to Saunders Corporation's convertible bondsMaturity:Par value:Annual coupon:10$1,000.005.00%Stock price:Conversion price:Straight-debt yield:$30.00$35.008.00%a.What is the bond's conversion ratio?b.What is the bond's conversion value?c.What is the bond's straight-debt value?d.Based on your answers to the three preceding questions, what is the minimum price (or "floor"price) at which the Saunders' bonds should sell?3.Manning Inc. is considering a leasing arrangement to finance some manufacturing tools that it needs forthe next 3 years. The tools will be obsolete and worthless after 3 years. The firm will depreciate thecost of the tools on a straight-line basis over their 3-year life. It can borrow $4,800,000, the purchaseprice, at 10% and buy the tools, or it can make 3 equal end-of-year lease payments of $2,100,000 eachand lease them. The loan obtained from the bank is a 3-year simple interest loan, with interest paid atthe end of the year. The firm's tax rate is 40%. Annual maintenance costs associated with ownershipare estimated at $240,000, but this cost would be borne by the lessor if it leases. (Suggestion: Delete 3zeros from dollars and work in thousands.)a. What is the cost of owning?b. What is the cost of leasing?c. What is the net advantage of owning or leasing in thousands?

 

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