1). If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks
a. the stock is experiencing super normal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.
2). The preemptive right is important to shareholders because it
a. allows managers to buy additional shares below the current market price.
b. will result in higher dividends per share.
c. is included in every corporate charter.
d. protects the current shareholders against a dilution of their ownership interests.
e. protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate.
3). Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT?
a. All common stocks fall into one of three classes: A, B, and C.
b. All common stocks, regardless of class, must have the same voting rights.
c. All firms have several classes of common stock.
d. All common stock, regardless of class, must pay the same dividend.
e. Some class or classes of common stock are entitled to more votes per share than other classes.
4). If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.
a. The expected return on the stock is 5% a year.
b. The stock’s dividend yield is 5%.
c. The price of the stock is expected to decline in the future.
d. The stock’s required return must be equal to or less than 5%.
e. The stock’s price one year from now is expected to be 5% above the current price.
5). Which of the following statements is CORRECT?
a. To implement the corporate valuation model, we discount projected free cash flows at the weighted average cost of capital.
b. To implement the corporate valuation model, we discount net operating profit after taxes (NOPAT) at the weighted average cost of capital.
c. To implement the corporate valuation model, we discount projected net income at the weighted average cost of capital.
d. To implement the corporate valuation model, we discount projected free cash flows at the cost of equity capital.
e. The corporate valuation model requires the assumption of a constant growth rate in all years.
6). Which of the following statements is CORRECT?
a. A major disadvantage of financing with preferred stock is that preferred stockholders typically have supernormal voting rights.
b. Preferred stock is normally expected to provide steadier, more reliable income to investors than the same firm’s common stock, and, as a result, the expected after-tax yield on the preferred is lower than the after-tax expected return on the common stock.
c. The preemptive right is a provision in all corporate charters that gives preferred stockholders the right to purchase (on a pro rata basis) new issues of preferred stock.
d. One of the disadvantages to a corporation of owning preferred stock is that 70% of the dividends received represent taxable income to the corporate recipient, whereas interest income earned on bonds would be tax free.
e. One of the advantages to financing with preferred stock is that 70% of the dividends paid out are tax deductible to the issuer.
7). If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock’s expected total return for the coming year?
a. 7.54%
b. 7.73%
c. 7.93%
d. 8.13%
e. 8.34%
8). Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.
9). When working with the CAPM, which of the following factors can be determined with the most precision?
a. The market risk premium (RPM).
b. The beta coefficient, bi, of a relatively safe stock.
c. The most appropriate risk-free rate, rRF.
d. The expected rate of return on the market, rM.
e. The beta coefficient of “the market,” which is the same as the beta of an average stock.
10). LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
11). O’Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm’s cost of equity from retained earnings based on the CAPM?
a. 11.30%
b. 11.64%
c. 11.99%
d. 12.35%
e. 12.72%
12). Scanlon Inc.’s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?
a. 9.67%
b. 9.97%
c. 10.28%
d. 10.60%
e. 10.93%
13). A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm’s bonds is 8.75%, and your firm’s economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm’s own cost of debt. What is an estimate of the firm’s cost of equity from retained earnings?
a. 12.60%
b. 13.10%
c. 13.63%
d. 14.17%
e. 14.74%
14). You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC?
a. 8.98%
b. 9.26%
c. 9.54%
d. 9.83%
e. 10.12%
15). Which of the following statements is CORRECT?
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
16). Which of the following statements is CORRECT?
a. The component cost of preferred stock is expressed as rp(1 – T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.
b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested.
c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are “free.”
d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years.
e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.
17). Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. A project’s NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
b. The lower the WACC used to calculate it, the lower the calculated NPV will be.
c. If a project’s NPV is less than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be less than zero.
e. The NPV of a relatively low-risk project should be found using a relatively high WACC.
18). 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.
19). Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects
20). Which of the following statements is CORRECT?
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
