FIN517 Sample Exam 1 PDF

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Sample Exam #1 Dr. Ghosh

1.

Which of the following statements is most correct? a. A hostile takeover is the main method of transferring ownership interest in a corporation. b. The corporation is a legal entity created by the state and is a direct extension of the legal status of its owners and managers; that is, the owners and managers are the corporation. c. Unlimited liability and limited life are two key advantages of the corporate form over other forms of business organization. d. In part due to limited liability and ease of ownership transfer, corporations usually have less trouble raising money in financial markets than other organizational forms have. e. None of the above answers is correct. Answer: d

2.

Which of the following statements is most correct? a. One of the advantages of the corporate form of organization is that there is no double taxation. b. The partnership form of organization has easy transfer of ownership. c. One of the disadvantages of the sole proprietorship form of organization is that there is unlimited liability. d. Both b and c are correct. e. None of the answers above is correct. Answer:

c

Statement c is correct. The other statements are false. The corporate form is subject to double taxation, and partnerships are not easily transferred.

3. Your uncle has agreed to deposit $3,000 in your brokerage account at the ends of each of the next five years. You estimate that you can earn 9 percent a year on your investments. How much will you have in your account five years from now? a. $13,719.39 b. $17,954.13 c. $19,570.00 d. $21,430.45 e. $22,436.12 Answer: b

Financial calculator solution: N = 5 I = 9 PV = 0 PMT = -3,000 FV=? FV = $17,954.13

4. You just put $1,000 in a bank account which pays 6% annual interest compounded monthly. How much will you have in your account after 3 years? a. b. c. d. e.

$1,006.00 $1,056.45 $1,180.32 $1,191.00 $1,196.68

Answer: e Numerical solution: $1,000(1.005)36 = $1,196.68. Financial calculator solution: N = 3  12 = 36 I = 6/12 = 0.5 PV = -1,000 PMT = 0 Solve for FV = $1,196.68.

5.

Which of the following bank accounts has the highest effective annual rate? a. An account which pays 10 percent nominal interest with monthly compounding b. An account which pays 10 percent nominal interest with daily compounding c. An account which pays 10 percent nominal interest with annual compounding d. An account which pays 9 percent nominal interest with daily compounding e. All of the investments above have the same effective annual rate. Answer: b The bank account which pays the highest nominal rate with the most frequent rate of compounding will have the highest EAR. Consequently, statement b is the correct choice.

6. Assume that you will receive $2,000 a year in years 1 through 5, $3,000 a year in years 6 through 8, and $4,000 in year 9, with all cash flows to be received at the ends of the years. If your cost of capital is 14%, what is the present value of these cash flows if no cash is exchanged at present time? a. b. c. d. e.

$ 9,851 $10,714 $11,714 $15,129 $17,353

Answer: c Time Line: 0 14% 1 2 3 4 5 6 7 8 9 Yrs ├───────┼─────────┼────────┼─────────┼───────┼────────┼───────┼───────┼───── ──┤ PV = ? 2,000 2,000 2,000 2,000 2,000 3,000 3,000 3,000 4,000

Financial calculator solution: Using cash flows Inputs: CF0 = 0; CF 1 = 2,000; freq. = 5; CF2 = 3,000; freq. = 3; CF3 = 4,000; I = 14. Output: NPV = $11,713.54  $11,714.

7. The tighter the probability distribution of expected future returns, the smaller the risk of a given investment as measured by the standard deviation. a. True b. False Answer: a

8. While the portfolio return is a weighted average of security returns, portfolio risk is not necessarily a weighted average of the standard deviations of the securities in the portfolio. It is this aspect of portfolios that allows investors to combine stocks and actually reduce the riskiness of a portfolio. a. True b. False Answer: a

9. Even if the correlation between the returns on two different securities is perfectly positive, if the securities are combined in the correct unequal proportions, the resulting portfolio can have less risk than either security held alone. a. True b. False Answer: b

10.

Which of the following statements is most correct? a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate all of the market risk from the portfolio. b. If you form a large portfolio of stocks each with a beta greater than 1.0, this portfolio will have more market risk than a single stock with a beta = 0.8. c. Company-specific risk can be reduced by forming a large portfolio, but normally even highly diversified portfolios are subject to market risk. d. Answers a, b, and c are correct. e. Answers b and c are correct. Answer: e

Assume that the Wilshire 5000 currently has a dividend yield of 2% and that, on average, the dividends of Wilshire 5000 firms have increased by about 7% per year. If the risk-free interest rate is 4%, then your estimate for the future market risk premium is 11.

a. b. c. d.

4%. 7%. 8%. 5%.

Answer: d Explanation: r = D1/Vs +g = dividend yield + g = .02 + .07 = .09 Market risk premium = expected return on market - risk free rate = .09 - .04 = .05

12. Assume that you wish to purchase a bond with a 30-year maturity, an annual coupon rate of 10 percent, a face value of $1,000, and semiannual interest payments. If you require a 9 percent yield to maturity on this investment, what is the maximum price you should be willing to pay for the bond? a. b. c. d. e.

$905.35 $1,102.74 $1,103.19 $1,106.76 $1,149.63

Answer: c

Time Line: 0

4.5%

|

1

| 50

2 | 50

3 | 50

4 | 50

60 . .

PV = ?

| 50 FV = 1,000

6-month Periods

Numerical solution: VB = $50((1- 1/1.04560)/0.045) + $1,000(1/1.04560) = $50(20.6380) + $1,000(0.071289) = $1,103.19 $1,103. Financial calculator solution: Inputs: N = 60; I = 4.5; PMT = 50; FV = 1,000. Output: PV = -$1,103.19; VB  $1,103.19

13. A share of common stock has just paid a dividend of $3.00. If the expected longrun growth rate for this stock is 5 percent, and, if investors require an 11 percent rate of return, what is the price of the stock? a. b. c. d. e.

$50.00 $50.50 $52.50 $53.00 $63.00

Answer: c Vs =

D0 (1  g ) $3 .00(1.05)  = $52.50. 0.11 - 0.05 ks  g

14. Grant Corporation's stock is selling for $40 in the market. The company's beta is 0.8, the market risk premium is 6 percent, and the risk-free rate is 9 percent. The dividend just paid was $2, and dividends are expected to grow at a constant rate. What is the growth rate for this stock? a. b. c. d. e.

5.52% 5.00% 13.80% 8.80% 8.38%

Answer: e

The required rate of return on the stock is 9% + (6%)0.8 = 13.8%. Using the constant growth model, we can solve for the growth rate as $40 = [$2(1 + g)]/(0.138 - g) or g = 0.0838 = 8.38%.

15. Assume JUP has debt with a book value of $20 million, trading at 120% of par value. The firm has book equity of $20 million and 2 million shares trading at $18 per share. What weights should JUP use in calculating its WACC? a. 40% for debt, 60% for equity b. 50% for debt, 50% for equity c. 36% for debt, 64%% for equity d. 45% for debt, 55% for equity Answer: a Explanation: A) Market Value Debt = $20 million × 120% = $24 million Market Value Equity = 2 million × $18 = $36 million Total Market Value = $60 million W d = $24/$60 = 40% W e = $36/$60 = 60% Multiple part: (The following information applies to the next 3 problems.) Rollins Corporation is estimating its WACC. Its target capital structure is 20 percent debt and 80 percent common equity. Its bonds have a 12 percent coupon rate paid semiannually, a current maturity of 20 years, and a price of $1,000. Rollins's beta is 1.2, the risk-free rate is 4 percent, and the market risk premium is 5 percent. The firm's marginal tax rate is 40 percent. 16.

What is Rollins's component cost of debt? a. b. c. d. e.

10.0% 9.1% 8.6% 8.0% 7.2%

Answer: e Time line: 1 0 rd / 2  ?

2

3

4

40

6-month

├───────────┼─────┼────────┼─────────┼───∙∙∙───────┤ Periods PMT = 60 VB = 1,000

60

60

60

60+ 1,000

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are equal. Thus, the before-tax cost of debt to Rollins is 12 percent. The after-tax cost of debt equals: Cost of debt = 12.0%(1 - 0.40) = 7.2%. Financial calculator solution: Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000; Output: I = 6.0% = rd/2. rd = 6.0%  2 = 12%. rd(1 - T) = 12.0%(1-0.40) = 7.2%.

17. What is Rollins’s cost of common stock? a. 5.2% b. 10.0% c. 16.0% d. 17.0% Answer: b CAPM: cos ts  rs  rrf   (rM  rrf ) = 4% + 1.2(5%) = 10.0% Do not confuse the market return rM with the market risk premium (rM  rrf ) . The problem gives the market risk premium as 5%.

18. What is Rollins’s WACC? a. 5.6% b. 7.76% c. 9.16% d. 9.44% Answer: d WACC = (0.20)(7.2%) + (0.80)(10.0%) = 9.44% 19. Suppose you invested $60 in the Ishares Dividend Stock Fund (DVY) a month ago. It paid a dividend of $0.70 today and then you sold it for $65. What was your return on the investment? a. 8.25% b. 9.00% c. 9.50% d. 9.75% Answer: c Explanation: $65 + $0.70 -$60 = $5.70; $5.70 /$ 60 = 9.50%

20. The average annual return over the period 1886-2006 for stocks that comprise the S&P 500 is 10%, and the standard deviation of returns is 20%. Based on these numbers, what is a 95% confidence interval for 2007 returns? a. -15%,25% b. -20%,40% c. -30%, 50% d. -30%,40% Answer: c Explanation: 10% - 2 × 20% = -30%; 10% + 2 × 20% = 50% (because 2 standard deviations is a 95% confidence interval)

21. A company issues a callable (at par) five-year, 7% coupon bond with annual coupon payments. The bond can be called at par in one year after release or any time after that on a coupon payment date. On release, it has a price of $1,030 per $1,000 of face value. What is the yield to call (YTC) of this bond when it is released?

a. 1.40% b. 2.73% c. 3.88% d. 6.28% Answer: c Explanation: Using a financial calculator, PV = -1030, FV = 1000, PMT = 70, N =1; computing interest = 3.88% 22. A bond has a face value of $1,000 and a conversion ratio of 28. What is the conversion price? a. $3.57 b. $28.00 c. $35.71 d. $2,800.00 Answer: c Explanation: $1,000 /28 shares = $35.71 per share 23. Which of the following best describes a bond that is issued by a local entity and traded in a local market but may be purchased by foreigners? a. a domestic bond b. a foreign bond c. a Eurobond d. a global bond Answer: a 24. Which of the following best describes an international bond that is not denominated in the local currency of the country in which it is issued? a. a domestic bond b. a foreign bond c. a Eurobond d. a global bond Answer: c 25. In a leveraged buyout (LBO), a group of investors purchases all of the equity of a public corporation by financing this purchase primarily with debt. a. True b. False Answer: a...