FIN 360 chapters 6,7,9,8,12

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1. ABC Corporation has a capital structure that consists of $20 million in debt and $40 million in equity. The debt $1.76
has a coupon rate of 10%, while the industry return on equity is 15%. ABC Corporation is unsure of the state of the
economy in the next year. The tax rate facing the company is 40%.
State of the Economy BAD GOOD GREAT
EBIT $2,000,000 $5,000,000 $10,000,000
Probability 0.40 .40 0.20
Refer to ABC Corporation. The company is considering the issue of $10 million in new debt at a rate of 10%. The
funds from the new debt will be used to retire $10 million in equity. Currently, there are 1 million shares
outstanding trading at $40 per share. Assuming the stock price will remain the same, what is the expected
earnings per share in the next year if the company goes through with the re-capitalization?
2. According to historical data, in the last 106 years returns on stocks in the U.S. have been negative about ____ of 26%
the time.
3. According to the CAPM (capital asset pricing model), the security market line is a straight line. The intercept of the risk free
this line should be equal to rate
4. The accounting rate of return is calculated as: d. net
a. net income/stock price income/book
b. sales/stock price value of
c. sales/book value of assets assets
d. net income/book value of assets
5. An all-equity firm has 80,000 shares outstanding worth $20 each. The firm is considering a project requiring an $20.38
investment of $500,000 and has an NPV of $30,000. The company is also considering financing this project with a
new issue of equity.
Refer to Exhibit 12-1. What is the price at which the firm needs to issue the new shares so that the existing
shareholders capture the full benefit associated with the new project?
6. As Chief Financial Officer of the Kennesaw Steel Corporation (KSC), you are considering a recapitalization plan 8.8%
that would convert KSC from its current all-equity capital structure to one including substantial financial
leverage. KSC now has 100,000 shares of common stock outstanding, which are selling for $50.00 each, and the
recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and
use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation. The tax rate is 40%. What is the return on equity under the new plan if
EBIT is $600,000 in the next year? (assume that the stock can be repurchased at $50 per share)
7. As Chief Financial Officer of the Kennesaw Steel Corporation (KSC), you are considering a recapitalization plan 0.67
that would convert KSC from its current all-equity capital structure to one including substantial financial
leverage. KSC now has 100,000 shares of common stock outstanding, which are selling for $50.00 each, and the
recapitalization proposal is to issue $2,000,000 worth of long-term debt at an interest rate of 8.0 percent and
use the proceeds to repurchase $2,000,000 of common stock.
Refer to Kennesaw Steel Corporation. What is the new debt-to-equity ratio if the recapitalization is completed?
(assume that the stock can be repurchased at $50 per share)
8. Asset 1 has a beta of 1.2 and Asset 2 has a beta of 0.6. Which of the following statements is correct? a. Asset 1 has
a. Asset 1 has a higher expected return than Asset 2. a higher
b. In a regression with individual asset's return as the dependent variable and the market's return as the expected
independent variable, the R-squared value is higher for Asset 1 than it is for Asset 2. return than
c. Asset 1 is more volatile than Asset 2. Asset 2
d. All of the above statements are correct
9. As the discount rate increases, the IRR of a project: a. is
a. is unaffected. unaffected
b. increases.
c. cannot be determined with out knowing the discount rate.
d. decreases.
10. Bavarian Brew, an unlevered firm, has an expected EBIT of $500,000. The required return on assets for the firm's 34%
assets is 10%. The company has 250,000 shares outstanding. The company is considering raising $1 million in debt
with a required return of 6% and would use the proceeds to repurchase outstanding stock.
Refer to Bavarian Brew. If the corporate tax rate equals 34% and dividend income is tax free, at which personal tax
rate on interest income is there no gain from leverage?
11. Bavarian Brew, an unlevered firm, has an expected EBIT of $500,000. The required return on assets for the firm's $5,340,000
assets is 10%. The company has 250,000 shares outstanding. The company is considering raising $1 million in debt
with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew after restructuring? Assume corporate taxes of 34%.
12. Bavarian Brew, an unlevered firm, has an expected EBIT of $500,000. The required return on assets for the firm's $4,590,000
assets is 10%. The company has 250,000 shares outstanding. The company is considering raising $1 million in debt
with a required return of 6% and would use the proceeds to repurchase outstanding stock.
What is the value of Bavarian Brew after the restructuring, if the PV of bankruptcy cost is $750,000? Assume a
corporate tax rate of 34%
13. Bulldog Electronics Corporation finances its operations with $75 million in stock with a required return of 12 13.00%
percent and $45 million in bonds with a required return of 8 percent. Suppose the firm issues $15 million in
additional bonds at 8 percent, using the proceeds to retire $15 million worth of equity. If the WACC remains the
same, what will be the firm's new cost of equity? (Assume zero taxes and perfect capital markets)
14. The CAPM (capital asset pricing model) assumes that: d. all of the
a. investors are risk-averse above
b. investors have homogeneous expectations
c. all assets can be traded
d. all of the above
15. The cash flows associated with an investment project are as follows: $694,215
Cash Flows
Initial Outflow -$7,000,000
Year 1 $ 100,000
Year 2 $ 200,000
Year 3 $ 540,000
In year 4 and beyond, cash flows would continue to grow at 4 percent per year. Assume a discount rate of 10%.
What is the NPV of this investment?
16. Cash Flows that occur if and only if a project is accepted are: d.
a. sunk costs. incremental
b. current cash flows. cash flows
c. terminal costs.
d. incremental cash flows.
17. A cash outlay that has already been committed whether a project is accepted or not is known as a: sunk cost
18. A certain investment will require an immediate cash outflow of $3 million. At the end of each of the next three $232,908
years, the investment will generate cash inflows of $1.3 million. If the discount rate is 10%, what is the project's
NPV?
19. The Commerce Company is evaluating a project with the following cash flows: 3.59 years
Year Cash Flow
0 ($10,000)
1 $ 2,000
2 $ 3,000
3 $ 4,000
4 $ 5,000
5 $ 6,000
What is the discounted payback period of the proposed Commerce Company project if the discount rate is 7%?
20. Commerce Company The Commerce Company is evaluating a project with the following cash flows: 23.29%
Year Cash Flow
0 ($10,000)
1 $ 2,000
2 $ 3,000
3 $ 4,000
4 $ 5,000
5 $ 6,000
What is the IRR of the proposed Commerce Company project?
21. Consider the adjusted closing prices for Roxy Stock .007
Year Adj. Price
2011 $ 26.00
2010 $ 24.00
2009 $ 21.00
2008 $ 22.00
2007 $ 20.00
What is the variance of returns for Roxy stock?
22. Consider the following historical returns for Big Diesel Incorporated and inflation for the United States 4.00%
economy:
YEAR Big Diesel Return Inflation
1999 5% 2.00%
2000 9% 2.00%
2001 -8% 2.20%
2002 5% 2.20%
2003 20% 2.20%
What is the average real return for Big Diesel over the five-year time period?
23. Consider the following historical returns for Big Diesel Incorporated: 10.03%
YEAR Return
1999 5%
2000 9%
2001 -8%
2002 5%
2003 20%
Refer to Big Diesel Incorporated. What is the standard deviation of the returns over the five year time period?
24. Consider the following information concerning stock returns and bond returns over the last 75 years: 10.10%
Average Return 1934-2004
Stocks 11.7%
Treasury Bills 4.1%
Refer to Exhibit 6-3. Currently, Treasury bills yield 2.50% on the secondary market. What is a good estimate for
the return on the stock market in the next year given this information?
25. The difference between the return on the market portfolio and the risk-free rate is known as the: d. market risk
a. unsystematic return. premium.
b. systematic premium.
c. total return.
d. market risk premium.
26. Emma International has an EBIT of $35 million, debt with a market value of $30 Million and a required return on $269,230,769
assets of 13%. Assuming no taxes, what is the firm 's value?
27. Exhibit 7-2 30.71%
Outcome Probability Return
Recession 40% -25%
Expansion 25% 20%
Boom 35% 45%
Given Exhibit 7-2, what is the expected standard deviation?
28. Exhibit 7-3 14.1%
Security Weight Expected Return
1 30% 10%
2 15%
3 10% 21%
Given Exhibit 7-3, what is the expected return on the portfolio?
29. Exhibit 7-4 12%
Security Weight Expected Return
1 7%
2 35% 9%
3 40%
30. Exhibit 7-6 0.9273
Security $ Invested Beta
1 $9,000 0.7
2 $5,000 0.9
3 $8,000 1.2
Given Exhibit 7-6, what is the portfolio beta?
31. Exhibit 8-3 A firm is evaluating two investment proposals. The following data is provided for the two investment both projects
alternatives.
Initial cash outflow IRR NPV(@18%)
Project 1 $250m 28% $80m
Project 2 $50m 36% $20m
Refer to Exhibit 8-3. If the two projects are independent, which project should the firm choose based on the IRR
rule?
32. Expected returns are: a. inherently
a. inherently unobservable. unobservable
b. always greater than the risk-free rate.
c. usually equal to actual returns.
d. always positive.
33. Financial managers prefer a capital budgeting technique with which of the following characteristics? all of the
a. Easily-applied and considers cash flows above
b. Recognizes the time value of money and accounts for risk and return
c. When applied leads to higher stock prices
d. all of the above
e. (a) and (b) only
34. A financial publication states that Stone Cold stock had a return of 15% last year. If the price of Stone Cold went 11.25%
from $20 to $20.75 over the last year, what was the dividend yield over the last year?
35. Firm Y issued $100,000,000 of bonds last year for the purpose of building a new widget manufacturing plant. a. The Asset
Firm Y instead used the proceeds to fund Blackjack gamblers in Las Vegas. Which of the following best Substitution
describes the general problem that Y's investors must deal with? Problem
a. The Asset Substitution Problem
b. The Overinvestment Problem
c. The Underinvestment Problem
d. The Enron Problem
36. Fox Entertainment is evaluating the NPV of launching a new iPet product. Fox paid a market research firm sunk cost
$120,000 last year to test the market viability of iPet. Fox Entertainment should treat this $120,000 as a ____ for
the capital budgeting decision now confronting the firm
37. Gamma Electronics is considering the purchase of testing equipment that will cost $500,000. The equipment has $49,158
a 5-year lifetime with no salvage value. Assume the new machine will generate after-tax savings of $100,000
per year for the five years. If the firm has a 15% cost of capital, what is the equivalent annual cost of the
equipment?
38. Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old 1.4
equipment. Assume the new machine will generate after-tax savings of $250,000 per year over the next four
years.
If Gamma Electronics has a 15% cost of capital, what's the profitability index of the investment?
39. Gamma Electronics is considering the purchase of testing equipment that will cost $500,000 to replace old 2.6 years
equipment. Assume the new machine will generate after-tax savings of $250,000 per year over the next four
years.
Refer to Gamma Electronics. If the firm has a 15% cost of capital, what's the discount payback period of the
investment?
40. The Globe Incorporated has EBIT of $20 million for the current year. On the firm balance sheet, there is $80 $32 million
million of debt outstanding that carries a coupon rate of 8 percent. Investors seek a return of 12 percent on the
firm, and the firm has a corporate tax rate of 40%. What is the present value of the firm's tax shields?
41. The Globe Incorporated has EBIT of $30 million for the current year. On the firm balance sheet, there is $90 $186,000,000
million of debt outstanding that carries a coupon rate of 9 percent. Investors seek a return of 12 percent on the
firm, and the firm has a corporate tax rate of 40%. What is the value of the firm
42. The hurdle rate used in IRR analysis should be: c. the
a. the current corporate bond rate. discount rate
b. the prime rate. used in NPV
c. the discount rate used in NPV analysis. analysis
d. the risk free rate
43. If a firm increases its use of financial leverage, then what would we generally expect for the effect of that a. greater
increased leverage to have on the dispersion of the firm's Net Income distribution? dispersion

a. greater dispersion
b. no effect on dispersion
c. less dispersion
d. there is not enough information to determine
44. If the market portfolio has an expected return of 0.12 and a standard deviation of 0.40, and the risk-free rate is .08
0.04, what is the slope of the security market line?
45. If we are able to eliminate all of the unsystematic risk in a portfolio then, what is the result? a. a portfolio
that contains
a. a portfolio that contains only systematic risk only
b. a portfolio that has an expected return of zero systematic
c. a risk-free portfolio risk
d. such a portfolio cannot be constructed since there will always be unsystematic risk in any portfolio
46. If you believed a stock was going to fall in price, a strategy to profit from the stock decline is known as: selling short

a. buying long.
b. selling short.
c. buying short.
d. selling long.
47. In a world without taxes, distress costs, or agency problems, calculate the value of Lever Co. if its perpetual $10,000,000
EBIT is expected to be $1,000,000 per year based upon total debt of $200,000. The firm's cost of debt is 5% and
its required return on firm's assets is 10%
48. An increase in inventory will ____ net working capital. increase

a. cannot be determined.
b. decrease
c. have no affect on
d. increase
49. An increase in net working capital represents: a cash
a. a cash inflow. outflow
b. a cash outflow.
c. an increase in fixed assets.
d. a decrease in fixed assets.
50. An investor put 40% of her money in Stock A and 60% in Stock B. Stock A has a beta of 1.2 and Stock B has a 15.08%
beta of 1.6. If the risk-free rate is 5% and the expected return on the market is 12%, what's the investor's
expected return?
51. Investors should expect to be compensated for bearing ____ risk, but they should not expect to be compensated c. systematic;
for bearing ____ risk. unsystematic

a. unsystematic; co-movement
b. co-movement; systematic
c. systematic; unsystematic
d. unsystematic; systematic
e. total risk; unsystematic
52. Large Corp. anticipates issuing $5,000,000 of debt to repurchase equity. If Large can issue the debt to yield 8% $136,000
per year, then what is the single year increase in cash flow to Large if it issues the debt and is subject to a 34%
marginal tax rate?
53. Molotov Cranberry Cocktail Corp finds that the value of the firm is equal to $100,000,000 with no debt. It knows $100,000,000
that if it issues new debt, the value of the tax shield will be $3,000,000 while the value of the bankruptcy costs,
outside agency costs and inside agency costs will be $1,000,000, $2,000,000, and $4,000,000 in that order.
What will the value of Molotov be if it issues the debt?
54. The NPV method focuses on: c. cash flows
a. accounting returns.
b. sales.
c. cash flows.
d. profits.
55. Oak Barrel Company has net operating income of $10 million. Further, the company has $80 million of debt $86.55
outstanding with a required rate of return of 7 percent; the required rate of return on the industry is 11 percent; million
and the corporate tax rate is 40 percent. What is the value of the Oak Barrel Company?
56. One year ago, Jason purchased 50 shares of Terry Corporation stock at $20 per share. Today, one year later, the $200
stock pays a $2 per share dividend and the price is now $22 per share.
Refer to Terry Corporation. What is the total dollar return on the investment for the one year?
57. One year ago, Jason purchased 50 shares of Terry Corporation stock at $20 per share. Today, one year later, the 20.00%
stock pays a $2 per share dividend and the price is now $22 per share.
Refer to Terry Corporation. What is the total percentage return on the investment for the one year?
58. Outcome Probability Return 32.54%
Recession 25% -30%
Expansion 40% 15%
Boom 35% 55%
Given Exhibit 7-1, what is the expected standard deviation?
59. A particular stock has an expected return of 11%. If the expected risk premium on the market portfolio is 8%, and .750
the risk-free rate is 5%, what's the stock's CAPM beta?
60. A piece of equipment costs $1.2m. The equipment has a useful life of 4 years. In each of the four years, the $0.2 million
investment generates a cash inflow of $0.5m. The impact of the investment project on net income is derived
by subtracting depreciation from cash flow each year.
Refer to Exhibit 8-2. Assume the equipment is depreciated on a straight-line basis over 4 years, what is the
average contribution to net income across all four years?
61. A project will generate a real cash flow three years from now of $100,000. If the nominal discount rate is 10% $109,273
and expected inflation is 3%, what is the nominal cash flow for year 3?
62. Security I has a beta of 1.3, the risk-free rate is 4%, and the expected return on the market is 11%. What is the 13.1%
expected return for Security I?
63. A situation where shareholders refuse financing a "good" investment, because they think that only the underinvestment
bondholders will benefit will lead to
a. overinvestment
b. underinvestment
c. asset substitution
d. none of the above
64. The stock of Alpha Company has an expected return of 18% and a beta of 1.5, and Gamma Company stock has 6.0%
an expected return of 15.6% and a beta of 1.2. Assume the CAPM holds. What's the risk-free rate?
65. A stock was purchased two years ago for $20. The stock does not pay dividends and sells today for $26.00. If 14%
sold today, what was the annual realized return on your investment?
66. Suppose that over the last 20 years, company XYZ has averaged a return of 13%. Over the same period, the 15.5%
Treasury bond rate has averaged 4%. The current estimate of the Treasury bond rate is 6.5%. Using the
historical approach, what is the estimate of XYZ's expected return
67. Thompson Manufacturing is considering two investment proposals. The first involves a quality improvement 17.9%
project, and the second is about an advertising campaign. The cash flows associated with each project appear
below.
Quality Improvement Advertising Campaign
Initial cash outflow $100,000 $100,000
Cash Inflows:
Year 1 10,000 80,000
Year 2 30,000 45,000
Year 3 125,000 10,000
Refer to Tompson Manufacturing. Suppose the hurdle rate of the firm is 10%. Calculate the cash flows of the
"incremental project" by subtracting the cash flows of the second project from the cash flows of the first
project. What is the IRR of the incremental project?
68. What is the purpose of diversification? To lower the
overall risk of
your portfolio
69. When investors take a short position in one asset to invest more in another asset, they are using: b. financial
leverage
a. corporate leverage
b. financial leverage
c. capital budgeting
d. none of the above
70. Which approach to estimating an asset's expected return assumes that the future and the past share much in historical
common?
71. Which of the following is not a "con" of the Accounting Rate of Return method? e. all of the above
a. The depreciation method used impacts both the numerator and denominator.
b. The choice of the hurdle rate is arbitrary.
c. The method makes no adjustment for the time value of money or project risk.
d. It focuses on net income rather than a company's ability to generate cash.
e. All of the above are cons of the Accounting Rate of Return method.
72. Which of the following statements is false? d. all of the above statements are false
a. Ideas for investment projects stem mainly from the firm's finance department.
b. Capital projects by their nature are easily reversible.
c. Once a capital project is approved, the role of a financial manager is non-
existent.
d. all of the above statements are false.
e. Only (b) and (c) are false
73. Which of the following statements is false? d.
a. If a project has multiple IRRs its NPV profile will cross the x-axis more than
once.
b. Multiple IRRs result when a project's cash flows alternate between negative and
positive values.
c. There are occasions when a project's IRR may involve imaginary numbers.
d. The general rule of thumb is that a project will have as many IRRs are there are
negative cash flows.
e. All of the above statements are true.
74. Which of the following statements is false? d. The payback method considers all cash
a. The main virtue of the payback method is its simplicity. flows for a project, even those occurring
b. Some managers believe the payback method implicitly accounts for the after the payback period
riskiness of longer-term projects.
c. Some managers may prefer the payback method because it leads to accepting
projects that payback quickly which may be ideal for them in terms of building
their short-term career.
d. The payback method considers all cash flows for a project, even those occurring
after the payback period.
e. Both (a) and (d) are false
75. Which of the following statements is true? e.both (a) and (c)
a. The use of debt may lead to financial distress and bankruptcy, thus firms that
sell expensive, durable products that may have warranties and ongoing service
requirements tend to use less debt.
b. The use of debt may lead to financial distress and bankruptcy, thus firms that
sell expensive, durable products that may have warranties and ongoing service
requirements tend to use more debt.
c. Companies with a large proportion of tangible assets should be more willing to
use debt than firms with mostly intangible assets.
d. Companies with a large proportion of tangible assets should be less willing to
use debt than firms with mostly intangible assets.
e. Both (a) and (c)
76. Which statements are TRUE regarding risk and return? statements II and III only

Statement I: Diversification is the process of removing systematic risk from a

portfolio.
Statement II: In general, the greater the risk, the greater the return required by an
investor.
Statement III: Investors should focus on real returns if they are concerned about
the purchasing power of their wealth.
77. While the NPV approach offers many advantages over some other capital budgeting techniques, several cons b. it seems
exist with respect to the approach. Which of the following is (are) cons of the NPV method? less intuitive
a. It fails to consider the time value of money. to many
b. It seems less intuitive to many users than other methods. users than
c. It fails to consider all of a project's relevant cash flows. other
d. It focuses on net income and not cash flow. methods
e. all of the above are cons of the NPV method.
78. You are considering buying carpet for your university; Grade A carpet costs $19.25 a square yard and lasts 5 grade B
years and Grade B costs $12.25 a square yard and lasts 3 years; Grade C costs $9.25 a yard and lasts 2 years;
which carpet should be chosen if the discount rate is 10%? Assume that due to a large endowment given by the
state's"carpet king" the university is committed to continued carpet use. Which carpet should be chosen?
79. You are introduced to an investment that has an expected return of 20% equal to the standard deviation of the 50%
distribution of returns. What is the probability that the investment will have a return less than 20% in the first
year? Assume a normal distribution.
80. You bought a share of Bavarian Sausage stock for $46.50 at the beginning of the year. During the year the stock $9.00
paid a $2.75 dividend and at the end of the year it trades at $52.75.
Refer to Bavarian Sausage. What is the total dollar return on your investment?
81. You bought a share of Bavarian Sausage stock for $46.50 at the beginning of the year. During the year the stock 19.35%
paid a $2.75 dividend and at the end of the year it trades at $52.75.
Refer to Bavarian Sausage. What is the total return of your stock investment?
82. You have a $1 million capital budget and must make the decision about which investments your firm should project 1 and
undertake for the coming year. There are three projects available and the cash flows of each project appear 2
below. Assume a cost of capital of 12%. Which project or projects do you select?
P1 P2 P3
Cash flow
Year 0 -$400,000 -$500,000 -$1,000,000
Year 1 200,000 300,000 500,000
Year 2 300,000 350,000 700,000
Year 3 300,000 350,000 700,000
83. You have it on good account that the probability of good returns on energy investments is equal to that of poor 0%
returns. If we define good returns as 100% while that of poor returns is 50%, then what is the probability of
getting an exact return of 75% in the next year?
84. You need to calculate the gains from using $1,000,000 of additional leverage on the average company in the U.S. $447,500
economy. You are told that the average investor's personal tax rate on income from stock is 15% and that
investors can generally avoid personal taxes on income from debt. You are also told that the average
corporation is subject to the 35% marginal corporate tax rate. What is the benefit to firm value for this additional
debt load?
85. You purchased stock of Blue McBrushes Corp one year ago for $85 and generated a total return of 20% during $12.50
that time. If you just sold the stock for $89.50, then what were the total dividends that you received during the
year?