Short ESSAY Questions:
1) Capital budgeting projects looks at net present value or return on investments computations in determining project priorities (those projects management should pursue first). Explain each method and identify which you believe to be the more appropriate measurement.
2) Discuss what the weighted average cost of capital is and why managers need to know this.
Multiple choice questions 1-60:
1. An issue of preferred stock is paying an annual dividend of $5. The growth rate for the firm’s common stock is 15%. What is the preferred stock price if the required rate of return is 12%?
- $45.45
- $41.67
- $33.33
- none of the above
2. Valuation of financial assets requires knowledge of
- future cash flows
- appropriate discount rate
- past asset performance
- a and b
3. The market allocates capital to companies based on
- risk
- efficiency
- expected returns
- all of the above
4. If expected dividends grow at 8% and the appropriate discount rate is 12%, what is the value of a stock with an expected dividend of $1.37?
a. $36.99
- $11.42
- $17.13
- $34.25
5. The dividend valuation model stresses the
a. importance of earnings per share
- importance of dividends and legal rules for maximum payment
- relationship of dividends to market prices
- relationship of dividends to earnings per share
6. Stock valuation models are dependent upon
a. expected dividends, future dividend growth and an appropriate discount rate
b. past dividends, flotation costs and bond yields
- historical dividends, historical growth and an appropriate discount rate
- all of the above
7. Which is a characteristic of the cost of preferred stock?
- since preferred stock dividends are fixed, they are tax deductible
- because preferred stock has no maturity, the cost analysis is similar to that of gold.
- preferred stock is valued as a perpetuity
- none of the above
8. An increase in the riskiness of a particular security would NOT affect
a. the risk premium for that security
b. the premium for expected inflation
c. the total required return for the security
d. investors’ willingness to buy the security
9. A common stock which pays a constant dividend can be valued as if it were a
a. corporate bond
b. stock paying a growing dividend
c. preferred stock
d. discount bond
10. In general sense, the value of any asset is the
a. value of the dividends received from the asset
b. present value of the cash flows received from the asset
c. value of past dividends and price increases for the asset
d. future value of the expected cash flows discounted by the asset’s cost of capital
11. If a firm’s bonds are currently yielding 8% in the marketplace, why would the firm’s cost of debt be lower?
a. interest rates have changed
b. additional debt can be issued more cheaply than the original debt
c. there should be no difference; cost of debt is the same as the bond’s market yield.
d. interest is tax-deductible
12. Although debt financing is usually the cheapest component of capital, it cannot be used to excess because
a. interest rates may change
b. the firm’s stock price will increase and raise the cost of equity financing
c. the financial risk of the firm may increase and thus drive up the cost of all sources of financing
d. underwriting costs may change
13. The after-tax cost of preferred stock to the issuing corporation
a. is the same as the before-tax cost
b. is usually lower than the cost of debt
c. is dependent on the firm’s tax bracket
d. none of the above
14. A firm in a cyclical industry should use
a. a large amount of debt to lower the cost of capital
b. no debt at all
c. preferred stock in place of debt
d. a limited amount of debt to lower the cost of capital
15. A firm’s debt to equity ratio varies at times because
a. a firm will want to sell common stock when prices are high and bonds when interest rates are low
b. a firm will want to take advantage of timing its fund raising in order to minimize costs over the long run
c. the market allows some leeway in the debt to equity ratio before penalizing the firm with a higher cost of capital
d. all of the above are accurate statements
16. Marginal cost of capital
a. recognizes that cost of capital does not stay constant as more funds are raised
b. usually provides the same capital budgeting choices as the use of weighted average cost of capital
c. can be defined as the cost of capital when no retained earnings are available for expansion
d. none of the above apply
17. A firm is paying an annual dividend of $3.30 for its new preferred stock that is selling for $57.00. There is a selling cost of $3.00. What is the after-tax cost of preferred stock for the firm?
a. 2.02%
b. 4.09%
c. 5.79%
d. 6.11%
18. The optimal capital structure for firms in cyclical industries should contain ______firms in stable industries.
a. more debt than
b. less debt than
c. an equal amount of debt as
d. none of the above. There is no relationship between the cyclical nature of an industry and optimal capital structure
19. For many firms, the most important source of equity capital is in the form of
a. debt
b. common stock
c. preferred stock
d. retained earnings
20. Which of the following statements is not true with respect to organized securities exchanges?
a. organized exchanges have a physical location
b. exchanges operate as “auction” markets
c. stocks traded on exchanges are referred to as unlisted securities
d. securities exchanges provide corporations and stockholders increased liquidity for their securities
21. Which of the following is not true about the over-the-counter market?
a. the OTC market is a network of dealers connected by phone and computer
b. there is no central market location
c. the OTC market is a network of brokers acting as agents for buyers and sellers
d. the OTC is by far the largest market for bond trading
22. The basic difference between brokers and dealers is that
a. brokers can trade only on organized exchanges and dealers can trade only over-the-counter
b. brokers own the securities they trade and dealers act as agent for buyer and seller
c. dealers own the securities they trade and brokers act as agent for buyer and seller
d. there is no difference
23. The bulk of bond trading is generally done
a. on the NYSE
b. on the regional exchanges
c. over-the-counter
d. on the New York Bond Exchange
24. The efficient market hypothesis deals primarily with
a. random speculation in securities
b. the degree to which prices adjust to new information
c. degrees to which price movements are the result of past trends
d. how an investor can significantly outperform the market in general
25. The largest source of external financing for corporations traditionally has been
a. preferred stock
b. common stock
c. corporate bonds
d. equipment trust certificates
26. Which of the following is not a money market instrument?
a. treasury bills
b. commercial paper
c. negotiable certificates of deposit
d. treasury bonds
27. An investment banker makes his money from
a. commissions from buyers
b. fees from other investment bankers in the syndicate
c. the spread between issue price and proceeds to the issuer
d. artificially supporting the stock price during and after the offering
28. Which of the following is considered an advantage (for the corporation) of going public?
a. the president becomes a public relations man
b. extensive and time-consuming reporting requirements
c. increased liquidity for the corporation’s shareholders
d. the cost of flotation
29. Dilution of earnings occurs because
a. a new issue of common stock creates more shares outstanding which reduces earnings per share temporarily
b. the company suffers a decline in earnings after taxes
c. the investment banker collects an underwriting fee
d. all of the above
30. Maxwell Corp. is coming to the market with a new offering of 300,000 shares of
stock at $25 to the public. Maxwell will receive $22 per share. The firm currently has 1 million shares outstanding and has earnings of $6 million. What is the amount of dilution in earnings per share?
a. $2.00
b. $1.38
c. $1.77
d. No dilution occurs since new money is received by Maxwell
31. Which of the following is a characteristic of leveraged buyouts?
a. buyouts are usually financed by debt
b. some corporate assets are often sold after the buy-out is completed
c. funds for the buy-out are raised through securities markets
d. all the above are characteristics
32. Corporate debt has
a. increased rapidly in the last three decades
b. increased slowly in the last three decades
c. held fairly steady over the last forty years
d. none of the above
33. The term debenture refers to
a. long-term, secured debt
b. long-term, unsecured debt
c. the after-acquired property clause
d. a 100-page document covering the specific terms of the offering
34. Prices of existing bonds move ______as market interest rates move ______
a. down, down
b. up, up
c. up, down
d. Bond prices don’t move as market interest rates move
35. International capital markets are now more important due to
a. the Pacific Rim countries’ rapid growth
b. a more tariff free Europe as of 1993
c. the collapse of the iron curtain in 1990
d. all of the above
- The document that outlines the covenants and duties existing between bondholders and the issuing corporation is called
a. an indenture
b. an debenture
c. secured debt
d. protective covenants
37. The “call” provision on some bonds allows
a. the bondholder to redeem the bond earlier than maturity, but usually involves a
call premium
b. the corporation to request additional capital contributions from the bondholder
c. the corporation to redeem the bonds earlier than maturity but usually for a premium over the par value
d. the bondholder to convert the bond into preferred stock
38. Bond refunding occurs when
a. interest rates in the market are sufficiently less than the coupon rate on the old bond
b. interest rates in the market have risen over the coupon rates on the old bond
c. the price of the old bond is less than par
d. the sinking fund has accumulated enough money to retire the bond issue
39. A bond’s rating can depend on all of the following except
a. the corporation’s debt-equity ratio
b. the corporation’s size
c. the ability of the firm to make interest payments
d. the coupon rate on the bond
40. The most important feature of the preemptive right is that the rights
a. may be sold for profit
b. afford stockholders protection against dilution
c. may be cumulatively voted
d. are nontransferable
41. If a corporate charter includes a provision for preemptive rights, the stockholders
a. must sell their stock to the company
b. get first option to buy additional issues of common stock
c. may purchase existing treasury stock
d. cannot utilize cumulative voting procedures
42. If a preferred stock is of the cumulative type
a. dividends must be paid on a equal basis with common so long as earnings permit
b. dividends cannot be passed if they are earned
c. the cumulative voting rule applies in the exercise of the voting privilege
d. unpaid dividends of one period must be carried forward and paid in subsequent periods before anything can be paid to common stockholders
43. Which of he following is not true about preferred stock?
a. 70% of dividends are nontaxable to other corporations which hold preferred stock
b. The after-tax cost is higher than debt with the same yield
c. Dividends are legal obligations of the firm
d. Preferred stocks are often cumulative in respect to dividends
44. A rights offer made to existing shareholders with the sole purpose of making it more difficult for another firm acquire the company is called
a. a preemptive right
b. a poison pill
c. ex-rights
d. rights-on
45. An issue of common stock pays an annual dividend of $2.50. Its growth rate is 8%.
What is its price if the market’s rate of return is 16%?
a. $16.67
b. $31.25
c. $33.75
d. none of the above
46. An issue of common stock is expected to pay a dividend of $4 annually. Its growth rate is equal to 8%. If the required rate of return is 13%, what is its current price?
a. $86.40
b. $30.77
c. $80.00
d. none of the above
47. The value of a common stock is based on its
a. past performance
b. dividend yield
c. current earnings
d. value of future benefits to the holder
48. The cost of common stock is usually greater than the simple dividend yield because
a. investors perceive little risk in common stock
b. investors expect both a current dividend and future growth
c. dividends are not tax-deductible
d. the company must make profits before it can pay dividends
49. For a firm paying 7% for new debt, the higher the firm’s tax rate
a. the higher the after-tax cost of debt
b. the lower the after-tax cost of debt
c. after-tax cost is unchanged
d. not enough information to judge
50. New common stock is more expensive than K e
a. to compensate for risk
b. to compensate for more dividends
c. to compensate for expansionary problems
d. to cover distribution costs
51. Within the capital asset pricing model
a. the risk-free rate is usually higher than the return in the market
b. the higher the beta the lower the required rate of return
c. beta measures the volatility of an individual stock relative to a stock market index
d. none of the above
52. A firm’s stock is selling for $75. The dividend yield is 5%. A 7% growth rate is expected for the common stock. What is the firm’s cost of common equity?
a. 8.16%
b. 12.00%
- 12.35%
- cannot be determined
- Ten rights are necessary to purchase one share of stock priced at $84. A right sells for $6.30. The ex-rights value of the stock is
a. $147
- $105
- $63
- $154
- The over-the-counter market
a. trades only stocks of small companies.
- is made up of brokers buying and selling from their inventories.
- is a close-knit organization of dealers linked together by computers
- is all of the above.
- Security markets provide liquidity
a. by assisting corporations to raise funds through the sale of securities.
- by creating a market in which owners may easily turn an investment into cash through its sale.
- a and b are both correct.
- neither a nor b are correct.
- Which of the following best represents the hierarchy of creditor and stockholder claims, from highest to lowest?
a. Common stock, senior secured debt, subordinated debentures
b. Senior debentures, subordinated debentures, junior secured debt
c. Senior secured debt, subordinated debentures, common stock
d. Preferred stock, secured debt, debentures.
- The effect of a rights offering on a stockholder is
a. to increase his/her wealth.
- to increase his/her wealth only if the new stock is purchased.
- to decrease his/her wealth unless the stock is purchased.
- to decrease his/her wealth if nothing is done.
- A proxy is
a. an illegal devise for circumventing regular voting procedures
b. a coupon attached to each share of stock and used by the shareholder in casting his vote on current issues.
c. An authorization of a registered stockholder to another person to act in his place at the meeting.
d. A warrant allowing a stockholder to purchase a specified number of additional shares at a given price.
- A 20-year bond pays 11% on a face value of $1,000. If similar bonds are currently yielding 9%, what is the market value of the bond?
a. over $1,000
b. under $1,000
- $1,000
- not enough information given to tell
- The major supplier of funds for investment in the whole economy is
a. businesses.
b. households
c. federal government
d. state governments