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savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/comprehensive_makeup_review.htm
1.
b.
c.
d.
ANSWER:
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2.
Money serves as
a.
b.
c.
a medium of exchange
d.
a risk-free liability
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3.
M-2 includes
1.
demand deposits
2.
savings accounts
3.
a.
1 and 2
b.
2 and 3
c.
1 and 3
d.
all three
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4.
b.
c.
d.
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5.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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6.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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7.
A specialist
a.
b.
c.
d.
ANSWER:
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8.
Nasdaq
b.
SEC
c.
SIPC
d.
FDIC
ANSWER:
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9.
commercial loans
b.
demand deposits
c.
common stock
d.
equity
ANSWER:
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10.
b.
c.
d.
ANSWER:
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11.
b.
c.
d.
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12.
b.
demand deposits
c.
total reserves
d.
excess reserves
ANSWER:
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13.
b.
c.
d.
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14.
selling securities
2.
buying securities
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
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15.
b.
c.
d.
ANSWER:
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16.
b.
c.
d.
taxation
ANSWER:
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17.
b.
c.
d.
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18.
b.
c.
d.
ANSWER:
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19.
Systematic risk
1.
is the tendency for a stock's return and the return on the market to move together
2.
3.
4.
a.
1 and 2
b.
2 and 3
c.
1 and 4
d.
2 and 4
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20.
b.
equal to 1.0
c.
d.
negative
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21.
2.
3.
4.
a.
1 and 2
b.
1 and 4
c.
2 and 3
d.
3 and 4
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22.
b.
c.
d.
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23.
must generate a greater return than the average return on the portfolio
b.
c.
should have a return that is negatively correlated with the return on other securities in the
portfolio
d.
ANSWER:
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24.
b.
c.
d.
a firm's earnings
ANSWER:
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25.
b.
c.
d.
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26.
b.
accrued interest
c.
accounts payable
d.
ANSWER:
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27.
b.
c.
d.
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28.
b.
cash
c.
retained earnings
d.
depreciation
ANSWER:
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29.
b.
c.
the maximum amount that may be depreciated is the cost of the investment
d.
ANSWER:
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30.
b.
c.
d.
ANSWER:
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31.
b.
c.
d.
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32.
liquidity
b.
leverage
c.
performance
d.
turnover
ANSWER:
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33.
investments
2.
3.
retained earnings
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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34.
assets to increase
b.
equity to increase
c.
d.
assets to decrease
ANSWER:
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35.
b.
c.
d.
ANSWER:
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36.
A stock dividend
a.
b.
c.
d.
ANSWER:
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37.
Stock repurchases
a.
b.
c.
increase liabilities
d.
decrease liabilities
ANSWER:
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38.
According to the dividend-growth model, the value of a stock does not depend on
a.
future dividends
b.
past dividends
c.
future growth
d.
ANSWER:
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39.
risk is increased
2.
risk is decreased
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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40.
b.
c.
d.
ANSWER:
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41.
An increase in investors' required return should cause the value of a common stock to
a.
rise
b.
fall
c.
remain unchanged
d.
ANSWER:
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42.
b.
c.
d.
ANSWER:
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43.
b.
c.
d.
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44.
Which of the following reduces the investor's risk associated with investing in bonds?
1.
a sinking fund
2.
3.
a call feature
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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45.
repurchases
2.
a sinking fund
3.
a call feature
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
all three
ANSWER:
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46.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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47.
calling it
2.
repurchasing it
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
only 2
ANSWER:
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48.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
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49.
b.
c.
d.
ANSWER:
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50.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
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51.
tax deductible
b.
variable
c.
paid in stock
d.
fixed
ANSWER:
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52.
b.
c.
d.
ANSWER:
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53.
paid-in capital
b.
retained earnings
c.
preferred stock
d.
debentures
ANSWER:
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54.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
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55.
b.
c.
the value of convertible bonds rises but convertible preferred stock falls
d.
ANSWER:
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56.
an indenture
2.
perpetual life
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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57.
interest rates
b.
c.
d.
ANSWER:
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58.
b.
c.
d.
ANSWER:
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59.
Mutual funds
a.
b.
c.
d.
ANSWER:
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60.
b.
c.
d.
ANSWER:
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61.
b.
c.
d.
ANSWER:
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62.
LLCs
b.
corporations
c.
sole proprietorships
d.
limited partnerships
ANSWER:
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63.
salaries
b.
rent
c.
wages
d.
insurance premiums
ANSWER:
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64.
Variable costs
a.
b.
c.
d.
ANSWER:
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65.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
only 2
ANSWER:
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66.
b.
c.
d.
ANSWER:
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67.
2.
Lower variable costs increase the variability of earnings before interest and taxes
3.
Higher fixed costs increase the variability of earnings before interest and taxes
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
3 and 4
ANSWER:
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68.
b.
c.
increased taxes
d.
ANSWER:
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69.
Retained earnings
a.
have no cost
b.
c.
d.
ANSWER:
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70.
If the capital asset pricing model is used, the cost of equity depends on
1.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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71.
because the cost of retained earnings exceeds the cost of new shares
2.
because the cost of new shares exceeds the cost of retained earnings
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
ANSWER:
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72.
cost of debt
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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73.
In the capital assets pricing model, the cost of equity is investors' required return and includes
1.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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74.
b.
c.
d.
ANSWER:
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75.
b.
c.
d.
ANSWER:
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Problem
76.
What is a nation's cash inflow (outflow) on its current account and its capital account given the following
information? Was there a net currency inflow or outflow?
imports
$145
exports
211
72
143
86
29
37
22
RESPONSE:
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ANSWER:
Debit
Credit
Current account
exports
$211
imports
$145
22
37
$81
Capital account
direct investment abroad
72
143
29
86
$128
In this problem there is a net credit balance on both the current and capital accounts,
which means there is a currency inflow. This inflow may be used to increase foreign
reserves or repay any loans from the IMF.
POINTS:
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77.
If you open an individual retirement account (IRA) at a commercial bank and deposit $1,000 in the
account per year, how much will be in the account after 20 years if the funds earn 7% annually?
RESPONSE:
ANSWER:
$1,000(40.995) = $40,995
40.995 is the interest factor for the future value of an annuity at 7% for twenty years.
(PV = 0; N = 20; I = 7; PMT = -1000, and FV = ?. FV = 40995.)
POINTS:
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REF:
78.
You borrow $100,000 to buy a house; if the annual interest rate is 6% and the term of the loan is 20
years, what is the annual payment required to retire the mortgage loan?
RESPONSE:
ANSWER:
X = $100,000/11.470 = $8,718.40
8.514 is the interest factor for the present value of an annuity at 6% for twenty years.
(PV = 100000; N = 20; I = 6; PMT = ?, and FV = 0. PMT = -8718.46.)
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REF:
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79.
An investor expects a stock to double in 7 years. What is the expected annual rate of growth in the price
of the stock?
RESPONSE:
ANSWER:
$1(1 + g) 7 = $2
(1 + g) 7 = $2/$1 = 2
g is approximately 10%.
(PV = -1; N = 7; I = ?; PMT = 0, and FV = 2. I = 10.41.)
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REF:
80.
An apartment will generate $12,000 a year for 5 years, after which you expect to sell the property for
$100,000. What is the maximum you should pay for the property if your cost of money is 10%?
RESPONSE:
ANSWER:
This is another valuation problem set as a real estate investment. The maximum
price you should pay is the present value of the estimated cash flow and sale price:
$12,000(3.791) + $100,000(0.621) = $107,592.
The annual cash flows are insufficient to justify buying the property. (PV = ?; N = 5; I
= 10; PMT = 12000, and FV = 100,000. PV = -107582.)
POINTS:
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REF:
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81.
The Big-Sox currently have 30,000 spectators per game and anticipate annual growth in attendance of
9%. If the Big Stadium holds 65,000 people, how long will it take for the team reach capacity?
RESPONSE:
ANSWER:
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REF:
82.
You bought a Picasso for $50,000 and sold it after 5 years for $88,000. What was the annual return on the
investment?
RESPONSE:
ANSWER:
(1 + x) 5 = $88,000/$50,000 = 1.760
x = 12%
Look up 1.760 in the interest table for the future value of $1 for 5 years, and
determine the annual growth rate. (PV = -50000; N = 5; I = ?; PMT = 0, and FV =
88000. I = 11.97.)
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83.
AZ's dividend rose from $1 to $1.61 in five years. What has the dividend's annual rate of growth?
RESPONSE:
ANSWER:
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REF:
84.
If a company paid a dividend of $1 in 2006 and the dividend grows annually by 7 percent, what will be the
dividend in 2011?
RESPONSE:
ANSWER:
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85.
If a new college graduate wants a car costing $15,000, how much must be saved annually if the funds
earn 5 percent?
RESPONSE:
ANSWER:
This is an example of the future value of an annuity. The question is, what amount
(X) times the interest factor for the future sum of an ordinary annuity of $1.00 for 4
years at 5 percent (interest factor = 4.310) equals $10,000?
X(4.310) = $15,000
X = $15,000/4.310 = $3,480
The graduate will have to save $3,480 annually to have accumulated the $15,000.
(PV = 0; N = 4; I = 5; FV = 15000; PMT = ?; PMT = 3480.18.)
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REF:
86.
If an annuity costs $200,000 and yields 7 percent annually for 5 years, how much cash can an individual
withdraw each year such that the principal is consumed at the end of the time period?
RESPONSE:
ANSWER:
This illustrates the present value of an annuity of $1.00. The interest factor at 7
percent for 5 years is 4.10.
(FVAIF)(X) = $200,000
4.1X = $200,000
X = $200,000/4.1 = $48,780
The person may withdraw over $48,778 annually for five years. (PV = -200000; N =
5; FV = 0; I = 7; PMT = ? PMT = 48778.14.)
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87.
A firm earns 10 percent annually on its investments. One possible investment offers $50,000 a year for
10 years and costs $300,000. Should the firm make this investment?
RESPONSE:
ANSWER:
This problem is an example of the present value of an annuity. The interest factor for
the present value of the annuity of $1.00 at 10 percent for 10 years is 6.145.
X = $50,000 6.145
X = $307,250
The firm should make this investment because the present value of the cash inflow
generated by the investment ($307,250) exceeds the cost (cash outflow) of the
investment ($300,000). (PMT = 50000; N = 10; FV = 0; I = 10; PV = ? PV = 307228.36.)
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REF:
88.
You inherit a trust account that promises to pay $13,000 a year for 10 years and then distribute $100,000.
If current yields are 10 percent, what is the value of the trust?
RESPONSE:
ANSWER:
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89.
If a creditor owes $24,000 and annually pays $3,000, how quickly will the loan be retired if the interest
rate is 8 percent annually?
RESPONSE:
ANSWER:
This is an example of the present value of an annuity in which the number of years is
the unknown. Solve for the interest factor:
$3,000(PVAIF) = $24,000
PVIF = 24,000/3,000 = 8.
The number of years to retire the loan is slightly more than thirteen, using the interest
table for the present value of an annuity. (PMT = -3000; FV = 0; I = 8; PV = 24000; N
= ?; N = 13.27.)
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REF:
90.
An annuity offers $1,000 for 10 years. If you can earn 12 percent annually on your funds, what is the
maximum amount you should pay for this annuity?
RESPONSE:
ANSWER:
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91.
How much additional interest will you earn on $1,000 at 10 percent for 10 years if interest is compounded
semi-annually instead of annually?
RESPONSE:
ANSWER:
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92.
You bought a stock with a beta of 1.4 and earned a return of 8.3%. Did you outperform the market if,
during the same period, the market rose by 7.4% and you could have earned 5.4% by investing in a
Treasury bill?
RESPONSE:
ANSWER:
The material in this problem was not explicitly covered in the chapter. You may use
the problem to set up the question, "What return should you have earned during a
particular investment horizon?" The answer uses the capital asset model to evaluate
performance. Thus, the return that should have been realized is
Rf + (R m - Rf) beta = 5.4% + (8.3 - 5.4)1.4 = 9.46%.
The actual return (8.3% return) is less than the return that would be expected given
the beta and the market performance. The stock under-performed the market on a
risk-adjusted basis.
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REF:
93.
4,000
Accumulated depreciation
30,000
10,000
Retained earnings
86,000
Accrued wages
11,000
Work in process
5,000
Finished goods
30,000
100,000
10,000
Land
10,000
Accounts receivable
32,000
2,000
15,000
Long-term debt
15,000
Raw materials
7,000
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Investments
10,000
Taxes due
1,000
20,000
RESPONSE:
ANSWER:
Firm XYZ
Balance Sheet for the Period Ending December 31, 20XX
Assets
Current assets
Cash and marketable securities
Accounts receivable
$10,000
$32,000
(2,000)
30,000
Inventory
Finished goods
30,000
Work in process
5,000
Raw materials
7,000
42,000
$82,000
Long-term assets
Plant and equipment
$100,000
Less accumulated
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depreciation
Land
(30,000)
70,000
10,000
$80,000
Investments
$ 10,000
Total assets
$172,000
$10,000
Accrued wages
11,000
Bank notes
15,000
4,000
Accrued taxes
1,000
$41,000
Long-term debt
$15,000
Total liabilities
$56,000
Stockholders' equity
Common stock ($1 par value; 20,000
shares authorized; 10,000 shares
outstanding)
$ 10,000
Paid-in capital
20,000
Retained earnings
Total stockholders' equity
86,000
$116,000
$172,000
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REF:
94.
Given the following information, construct the statement of cash flow. What happened to the firm's
liquidity position during the year?
Net income
$16.7
6.1
13.6
Sale of bonds
55.1
Dividends
14.8
Retirement of bonds
10.8
Increase in inventory
15.2
Depreciation expense
56.0
72.1
5.0
Sale of stock
0.4
91.0
Beginning cash
1.1
Repurchase of stock
5.6
RESPONSE:
ANSWER:
Statement of Cash Flows for the Period Ending
December 31, 20XX
Operating activities
Net income
$16.7
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Depreciation
56.0
6.1
Increase in inventory
(15.2)
13.6
(5.0)
$72.2
Investment activities
Increase in plant
(91.0)
($91.0)
Financing activities
Proceeds from sale of long-term debt
55.1
(10.8)
Dividends
(14.8)
Repurchase of stock
(5.6)
Sale of stock
0.4
$24.3
$1.1
$6.6
The firm's cash position has increased, but that does not mean the firm is more liquid
since inventory and accounts payable increased while accounts receivable declined.
You should also note that the firm increased its investment in plant by using the cash
generated through depreciation and the issuing of new long-term debt. The earnings
and sale of stock did not cover dividends and stock repurchases. This indicates that
the firm is more financially leveraged.
POINTS:
REF:
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95.
The inventory turnover for an industry is 6 (every two months) but Slow Corp. turns over its inventory 4
times a years (every three months). If annual sales are $1,000,000 and the interest cost to carry inventory
is 12 percent, what is the potential savings in interest expense if the firm achieves the industry for the
turnover of its inventory?
RESPONSE:
ANSWER:
The current level of inventory is
Inventory turnover: Sales/Average inventory
1,000,000/X = 4
X = $250,000.
The potential savings in interest expense (if the firm can achieve the industry
average for the turnover of its inventory):
$83,888 0.12 = $10,000.
POINTS:
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REF:
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96.
What is the debt/net worth ratio and the debt to total assets ratio for a firm with total debt of $600,000 and
equity of $400,000?
RESPONSE:
ANSWER:
POINTS:
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REF:
97.
Currently the price of a stock is $58 a share. The firm's balance sheet is as follows:
Assets
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
10,000,000
receivable
Inventory
120,000,000
Plant and
325,000,000
equipment
$705,000,000
90,000,000
185,000,000
$705,000,000
Construct a new balance sheet showing the impact of a two-for-one stock split. What will be the new price
of the stock?
RESPONSE:
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ANSWER:
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
10,000,000
receivable
Inventory
120,000,000
2,000,000 shares
outstanding)
Plant and
325,000,000
equipment
Retained earnings
$705,000,000
90,000,000
185,000,000
$705,000,000
The only changes are the entries under common stock since there are now
2,000,000 shares of $5 par stock outstanding.
The new price of the stock is $58/2 = $29.
POINTS:
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REF:
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98.
Construct a new balance sheet showing the impact of a 5 percent stock dividend. What will be the new
price of the stock?
RESPONSE:
ANSWER:
Cash
$ 10,000,000
Accounts payable
$ 20,000,000
Accounts
250,000,000
Long-term debt
400,000,000
10,500,000
receivable
Inventory
120,000,000
1,050,000 shares
outstanding)
Plant and
325,000,000
equipment
Retained earnings
$705,000,000
92,400,000
182,100,000
$705,000,000
The firm issues (.05)(1,000,000) = 50,000 shares with a $10 par value. The common
stock entry is increased by $500,000 to $10,500,000.
The market value of the stock is $58 50,000 = $2,900,000.
Retained earnings are reduced by $2,900,000 to $182,100,000.
Since retained earnings are reduced by $2,900,000 and common stock is increased
only by $500,000, $2,400,000 is unaccounted for. In order to balance the balance
sheet, additional paid-in capital is increased by $2,400,000.
The new price of the stock is $58 /1.05 = $55.24. This price adjustment is necessary
to adjust for the dilution of the old stock that results from the stock dividend.
Be certain to point out that in both the stock split and the stock dividend (1) assets
are not changed, (2) liabilities are not changed, and (3) total equity is not changed.
All that occurs is (1) a reduction in the price of the stock resulting from the increase in
the number of shares, and (2) some changes in the individual entries in the equity
section of the balance sheet.
POINTS:
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REF:
99.
Two stocks each pay a $1 dividend that is growing annually at 8 percent. Stock A's beta = 1.3; stock B's
beta = 0.8.
a.
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b.
If Treasury bills yield 9 percent and you expect the market to rise by 13 percent, what is your riskadjusted required return for each stock?
c.
Using the dividend-growth model, what is the maximum price you would be willing to pay for each
stock?
d.
RESPONSE:
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ANSWER:
a.
b.
For stock A:
Required rate = .09 + (.13 - .09)1.3 = 14.2%
For stock B:
Required rate = .09 + (.13 - .09)0.8 = 12.2%
c.
Valuation of stock A:
Valuation of stock B:
d.
POINTS:
Even though the dividends and growth rates are equal, stock A is riskier
(higher beta) which reduces its valuation.
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REF:
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100.
What is the value of a preferred stock that pays an annual dividend of $3 a share and competitive yields
are 5%, 10%, and 15%?
RESPONSE:
ANSWER:
POINTS:
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REF:
101.
Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent
and answer the following questions.
XY 5 1/4 percent (interest paid annually) for 20 years
AB 14 percent (interest paid annually) for 20 years
a.
Which bond has a current yield that exceeds the yield to maturity?
b.
c.
If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower
rated, what would be its price relative to the XY, Inc bond? Explain.
RESPONSE:
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ANSWER:
102.
a.
The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25%
versus 10%) because the current yield does not consider the loss of the
premium the investors will suffer over the lifetime of the bond.
b.
There is no reason to expect the firm to call the XY bond, because the firm
could repurchase the bonds at a discount. The AB bond, however, may be
called. Current interest rates are lower (10% versus the 14% coupon on that
bond), so the firm could refund the debt. (The instructor should ask what
impact the expectation of such refunding may have on the price of the bond.)
c. Since
the CD
and XY(interest
bonds are
with regard
paid
An investor buys a $1,000,
20 year
7 percent
paididentical
semiannually)
bondtoatinterest
par. After
fiveand
years
term
to
maturity,
the
factor
that
differentiates
them
is
the
credit
rating.
have passed, interest rates are 10 percent. How much did the investor lose on the purchase of The
the bond?
CD bond has a lower credit rating, so its value relative to the XY bond should
be less. Such a lower price will increase the yield to the investor and
presumably would be necessary to induce the investor to purchase the
riskier bond.
RESPONSE:
ANSWER:
POINTS:
(PV
-- / 1= ?; I = 5; N = 30; PMT = 35.50, and FV = 1000, PV = -777.10.)
REF:
POINTS:
Since the investor purchased the bond for $1,000, the loss is $1,000 - $776 = $224.
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REF:
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103.
6.5%
Maturity date
10
Exercise price
$20
Principal
$1,000
Call price
$1,065
years
RESPONSE:
ANSWER:
POINTS:
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REF:
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104.
You bought a stock for $28.29 that paid the following dividends
Year
Dividend
$1.00
$1.50
$1.80
After the third year, you sold the stock for $35. What was the annual rate of return?
RESPONSE:
ANSWER:
Select a rate and determine if it equates both sides of the equation. For example,
select 12 percent:
$1(.893) + 1.50(.797) + 1.80(.712) + 35(.712) = $28.29
The annual rate of return is 12 percent.
The same answer may be derived using a financial calculator, but it requires the
student to enter unequal cash inflows for each period.
POINTS:
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REF:
105.
If an investor purchases shares in a no load fund for $36, receives cash distributions of $1.27 and sells
the shares after one year for $41.29, what is the percentage return on the investment?
RESPONSE:
ANSWER:
POINTS:
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REF:
106.
Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings
of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?
RESPONSE:
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ANSWER:
a.
b.
c.
d.
for $1,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(235,000).39 + (665,000).34 = $340,000
e.
for $10,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(335,000).39 + (665,000).34 + (9,000,000)x.34 =
$3,400,000
POINTS:
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REF:
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107.
The price of a product is $1 a unit. A firm can produce this good with variable costs of $0.50 per unit and
total fixed costs of $100.
a.
b.
What is the break-even level of output if fixed costs increase to $180 and variable costs decline
to $0.40 per unit?
RESPONSE:
ANSWER:
a.
b.
POINTS:
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REF:
108.
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b.
If the firm sells 1,300 units, what are its earnings or losses?
c.
If sales rise to 2,000 units, what are the firm's earnings or losses?
d.
RESPONSE:
ANSWER:
a.
b.
Earnings
c.
Earnings
d.
POINTS:
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REF:
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109.
You want to start a firm whose output you believe you can sell for $25 per unit. The operation will require
fixed costs of $10,000, and the variable costs are expected to be $18 a unit. What will be the break-even
level of output?
RESPONSE:
ANSWER:
POINTS:
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REF:
110.
Case B
- firm uses 30% debt with a 10% interest rate and 70% equity
Case C
- firm uses 50% debt with a 12% interest rate and 50% equity
Debt outstanding
300
300
300
Stockholders' equity
Earnings before
interest and taxes
Interest expense
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investment
What happens to the rate of return on the stockholders' investment as the amount of debt increases?
Why did the rate of interest increase in case C?
RESPONSE:
ANSWER:
A
0
$ 600
$1,000
Debt outstanding
Stockholders' equity
2,000
1,400
1,000
Earnings before
300
300
300
Interest expense
60
120
300
240
180
120
96
72
Net earnings
$ 180
$ 144
$ 108
Return on stockholders'
9%
10.3%
10.8%
investment
The rate of return to stockholders rises because the after tax cost of debt in B is .1(1
- .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial
leverage.
POINTS:
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REF:
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111.
An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to
the net present value and internal rate of return methods of capital budgeting, should the firm make this
investment if its cost of capital is (a) 10% or (b) 14%?
RESPONSE:
ANSWER:
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REF:
112.
A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The
cost of capital is 6 percent.
Year
Cash Inflow
A
$175
$1,100
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175
175
175
175
175
175
175
a.
What is the internal rate of return on each investment? Which investment should the firm make?
b.
What is the net present value of each investment? Which investment should the firm make?
c.
If the cash inflows can be reinvested at 8 percent, which investment should be made?
RESPONSE:
ANSWER:
a.
B:
$1,100/(1 + r B) = $1,000
Interest factor = $1,000/$1,100 = .909
rB = 10%
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Since the investments are mutually exclusive, the firm should select B
because it has the higher internal rate of return.
b.
A:
B:
Since the investments are mutually exclusive, the firm should select A
because it has the higher net present value.(This contradicts part a, which
selected investment B.)
c.
If the firm is able to reinvest the annual payments of $175, the terminal value
of A is $175(10.637) = $1,861.48
(10.637 is the interest factor for the future value of an ordinary annuity at 8%
for eight years.)
POINTS:
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REF:
113.
Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and
the investments' estimated cash inflows are
cash inflow
year
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$2,320
---
---
---
---
$2,810
a.
What investment(s) should the firm make according to net present value?
b.
What investment(s) should the firm make according to internal rate of return?
c.
If the firm can reinvest funds earned in year 1 at 10%, which investment(s) should the firm make?
RESPONSE:
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ANSWER:
a.
Since the investments are mutually exclusive, the firm cannot make both and
will select B since it has the higher NPV.
b.
Since the investments are mutually exclusive, the firm cannot make both and
will select A since it has the higher IRR.
c.
POINTS:
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REF:
114.
$250,000
$266,667
$285,715.
The probability of receiving each cash inflow is 80, 75, and 70 percent, respectively. If the firm's cost of
capital is 10 percent, should the investment be made?
RESPONSE:
ANSWER:
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REF:
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115.
$600
$600
$600.
a.
b.
An alternative use for the $1,000 is a three-year U.S. Treasury note that pays $50 annually and
repays the $1,000 at maturity for an annual risk-free return of 5 percent. Management believes
that the cash inflows from the risky investment are only equivalent to 70 percent of the certain
investment. Does this information alter the decision in (a)?
RESPONSE:
ANSWER:
a.
b.
If the cash flows are considered to be only 70 percent certain and the riskfree, certain discount rate is 5 percent, the net present value is
(0.7)$600(PVAIF 5I, 3N) - $1,000 =
$420(2.723) - $1,000 = $143.66.
The adjusted net present value remains positive, so the investment should
be made.
POINTS:
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REF:
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