Review Questions
Provide answers in Excel where applicable and please number the problem to correspond with the number in this document.
Do not re-number
1) A firm has the following accounts and financial data for 2007:
Sales Revenue $ 3,060 Cost of goods sold $1,800
Accounts Receivable 500 Preferred stock dividends 18
Interest expense 126 Tax rate 40%
Total operating expenses 600 Number of shares of common
Accounts payable 240 stocks outstanding 1,000
The firm’s earnings available to common shareholders for 2007 are __________.
2) Asset P has a beta of .9. The risk-free rate of return is 8 percent, while the return on the market portfolio of assets is 14 percent. The asset’s required rate of return is
6) Which of the following capital-budgeting decision criteria are correct?
A.) Accept projects that have a positive NPV.
B.) Accept projects that generate an IRR that is greater than the firms discount rate.
C.) Accept projects that have a profitability index of greater than 1.0.
D.) Accept projects that generate an MIRR that is greater than the firms discount rate.
E.) All of the above are correct.
7) Optimal capital structure is:
A.) The mix of permanent sources of funds used by the firm in a manner that will maximize the companys common stock price.
B.) The mix of all items that appear on the right-hand side of the companys balance sheet.
C.) The mix of funds that will minimize the firms beta.
D.) The mix of securities that will maximize EPS.
8) McMillen House of Books recently paid a $3 dividend on its preferred stock. Investors require a 6% return on the stock. The stock is currently selling for $45. Is the stock a good buy? Why?
A.) Yes, as it is undervalued $5.
B.) Yes, as it is undervalued $10.
C.) No, as it is overvalued $5.
D.) No, as it is overvalued $10.
9) Stock A has a beta = 0.8, while Stock B has a beta = 1.6. Which of the following statements is CORRECT?
A.) Stock Bs required return is double that of Stock As.
B.) If the marginal investor becomes more risk averse, the required return on Stock B will increase by more than the required return on Stock A.
C.) An equally weighted portfolio of Stocks A and B will have a beta lower than 1.2.
D.) If the marginal investor becomes more risk averse, the required return on Stock A will increase by more than the required return on Stock B.
E.) If the risk-free rate increases but the market risk premium remains constant, the required return on Stock A will increase by more than that on Stock B.
10) Which of the following statements is CORRECT?
A.) One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
B.) One defect of the IRR method is that it does not take account of the time value of money.
C.) One defect of the IRR method is that it does not take account of the cost of capital.
D.) One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future.
E.) One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
11) A firm uses 800 units of a product per year on a continuous basis. The product has carrying costs of $50 per unit per year and ordering costs of $300 per order. It takes 30 days to receive a shipment after an order is placed. Calculate the economic order quantity (EOQ).
12) A firm has an expected dividend next year of $1.20 per share, a zero-growth rate of dividends, and a required return of 10 percent. The value of a share of the firms common stock is
13) What is the dividend on a 7 percent preferred stock that currently sells for $45 and has a face value of $50 per share?
14) A firm has sales of $1,000,000, net profit after taxes of $52,500, total assets of $1,850,000, and total liabilities of $800,000. What is the firms return on equity?
18) Sterling Corporation has a beta of 1.2. If the market return is 14 percent and the risk-free rate is 8 percent, was is Sterlings expected return (using CAPM).
19) Omar Corp issued just issued a 10 percent, 20 year bond with a $1000 par value that pays interest semi-annually. How much can the investor expect in interest every six months?
20) What would be more valuable, receiving $500 today or receiving $625 in three years if interest rates are 8 percent? Why?
21) Beck Industries are interested in performing two independent projects.
Project A has an initial investment of $65,000, and has a useful life of 5 years. Cash flows are expected to be $20,000 each year. Project B has an initial investment of $70,000 and has a useful life of 5 years. Cash flows are expected to be $18,000, $24,000, $19,000, $26,000, and $25,000. The firms cost of capital is 10%. What is each projects NPV? What is each projects IRR?
22) Samonne will have worked for Roseberry Industries for 10 years at the end of this year. She plans to retire at the time to pursue a Ph.D. in finance at Catatonic State. Samonne could have worked for Roseberry Industries another 15 years, at which time her pension, at retirement, would have been $25,000 per year, payable for 20 years. Roseberry Industries began making payments into Samonnes retirement plan, which earns 10% at the end of her first year of employment. Under Roseberrys HR policies, Samonne may transfer her pension account balance to some other account provided the balance is 425,000 or less. Will Samonne be able to transfer her account balance?
23) Why is it that for a given firm, the required rate of return on equity is always greater than the required rate of return on its debt? Provide two reasons.
Use the following information for questions 24 and 25:
Ajax, Inc. has common stock outstanding that has a market price of $48 per share. Last years dividend was $2.25 and is expected to grow at a rate of 4% per year, forever. The expected risk-free rate of interest is 2%, and the expected market premium is 5.5%. The companys beta is 1.2.
24) What is the cost of equity for Ajax using the dividend valuation model?
25) What is the cost of equity for Ajax using the capital asset pricing model (CAPM)?
Use the following data for questions 26 and 27:
Ajax, Inc. is expecting to issue new debt at par with a coupon rate of 6%, and to issue new preferred stock with a $2.00 per share dividend at $20 a share. Common stock is currently selling for $25 a share. Ajax expects to pay a dividend of $2.50 per share next year, and a market analysis indicates dividends will grow at a rate of 3% per year. The marginal tax rate is 40%.
26) What is the cost of debt, cost of preferred stock and cost of common stock?
27) If Ajax raises capital using a capital structure of 40% debt, 10% preferred stock and 50% common stock, what is the cost of capital for Ajax, Inc.?
Use the following information to answers questions 28 and 29:
On June 30, 19X1, the Alexander Bosh Coffee Co.’s balance sheet and income statement are as follows:
Balance Sheet Income Statement
June 30, 19X1 June 30, 19X1
Current assets $800,000 Net operating income $600,000
Net fixed assets 700,000 Less: interest expense (108,000)
Total assets $1,500,000 Earnings before taxes 492,000
Accounts payable $300,000 Less: taxes (34%) (167,280)
S-T notes payable (15%) 500,000 Net income $324,720
Total current liabilities $800,000
Long-term debt (11%) $300,000
Common equity 400,000
Total $1,500,000
28) Calculate the current ratio, net working capital, return on total assets, and return on common equity ratio for Alexander Bosh.
29) Recalculate the ratios from (a) and assess the change in the firm’s liquidity if the firm plans to issue $500,000 in common stock and use the proceeds to retire the firm’s notes payable.
30) April’s Stationary and Gift Store is considering two different lines of housewares. The probability distributions of free cash flows in each year associated with the two projects are:
Project A Project B
Probability Outcome Probability Outcome
.25 $4,000 .25 $3,000
.50 $8,000 .50 $6,000
.25 $12,000 .25 $9,000
Both projects will require an initial outlay of $13,000 and will have an estimated life of six years. Project A is considered a riskier investment and will have to have an adjusted required rate of return of 15%, while Project B’s required rate of return is 12%.
a. Determine the expected value of each project.
b. Determine each project’s risk-adjusted net present value.