Exam 2
Sample Questions
INSTRUCTIONS: Read each question carefully.
After you choose an answer, you can check to see if it is correct by clicking
“CHECK ANSWER” below the question.
1. If you buy a bond that is selling for greater
than its face, or maturity, value what will happen to the price (value) of
the bond as the maturity date nears if market interest rates do not change
during the life of the bond?
a. Because
interest rates remain constant, nothing happens to the market value of the
bond.
b. The
price of the bond should increase even further above the bond's face value
because the rates in the market are too low.
c. The
price of the bond must decrease as the bond gets closer to its maturity because
the bond’s value has to equal its face value at maturity.
d. This
question cannot be answered without additional information.
e. None
of the above is a correct answer.
2. Xandu, Inc. has
paid very large dividends ever since it started business. Recently, however, Xandu has decided to quit paying dividends and announced
that there never will be another dividend payment or any other payments
to stockholders during the remaining life of the company. Assuming this
information is correct, what should be the value of Xandu’s
stock?
a. zero
b. greater than
zero
c. less than zero
d. There is not enough information to answer
this question.
3.
Devine Divots issued a bond a few years ago
that has a face value equal to $1,000 and pays investors $30 interest every six
months. The bond has eight years remaining until maturity. If you require a 7
percent rate of return to invest in this bond, what is the maximum price you
should be willing to pay to purchase the bond?
a. $761.15
b. $939.53
c. $940.29
d. $965.63
e. $1,062.81
4. Richard
evaluated a capital budgeting project—a new machine that is needed to
manufacture inventory—using his firm’s required rate of return and found that
the project’s net present value (NPV) is negative. Based on this
information, which of the following must be correct?
a. The
project’s internal rate of return is also negative.
b. The
project’s discounted payback period is greater than its economic life.
c. As
long as its initial investment outlay is fairly low, the firm should purchase
the new machine if it is used to replace an older machine that is required to
produce inventory.
d. The
project’s traditional payback period must be greater than the maximum payback
period that the firm has established.
e. None
of the above is correct.
5. According to the Capital Asset Pricing
Model (CAPM), under what circumstances should an investor expect to be paid for
the total, or stand-alone, risk associated with a particular investment?
a. When
the investment is held in isolation—that is, the investor holds a single-asset
portfolio.
b. When
the investment is held in a well-diversified portfolio.
c. When
the total risk associated with the investment is comprised of firm-specific
risk only.
d. When
the total risk associated with the investment is comprised of market risk
only.
e. Investors
should always expect to be paid for the total risk associated with an
investment.
6.
Express Press evaluates many different
capital budgeting projects each year. The risks of the projects often differ
significantly, from very little risk to risks that are substantially greater
than the average risk associated with the firm. If Express Press always uses
its weighted average cost of capital, or average required rate of return, to
evaluate all of its capital budgeting projects, then the company might make an incorrect
decision, or a mistake, by
a. accepting projects that actually should be
rejected.
b. accepting projects with internal rates of
return that are too high.
c. rejecting
projects that actually should be rejected.
d. rejecting projects with internal rates of
return that are lower than the appropriate risk-adjusted required rate of
return.
e. accepting projects that actually should be
accepted.
7. If market interest rates for corporate
bonds of similar risk drop from 7 percent to 6 percent, which of the following
bonds would sell for a premium?
a. 5 percent coupon bond with 10 years
remaining until maturity
b. 6 percent coupon bond with one year
remaining until maturity
c. 5 percent coupon bond with one year
remaining until maturity
d. 7 percent coupon bond that matures
today.
e. 7 percent coupon bond with 10 years
remaining until maturity
8. Depreciation
must be considered when evaluating the incremental operating cash flows associated
with a capital budgeting project because
a. it represents a tax-deductible cash
expense.
b. the firm has a cash outflow equal to the
depreciation expense each year.
c. although it is a non-cash expense,
depreciation has an impact on the taxes paid by the firm, which is a cash flow.
d. depreciation is a sunk cost.
e. None of the above is correct.
9. Based on the information given below, which
of the investments would be considered best based on its risk and return
relationship? Assume all investors are risk-averse and the investments will be
held in isolation, not in a portfolio.
Investment
D E F
Expected return,
10.0% 18.0% 18.0%
Standard
deviation, σ 7.0% 12.0% 20.0%
a. D, because its total risk is lowest.
b. E. because its coefficient of variation is
lowest.
c. F, because its standard deviation, σ,
is highest.
d. E and F, because the have the same
expected return, .
e. None of the above.
10. Susan has an investment portfolio that
contains the following two stocks:
Stock Amount Invested Beta
A $40,000 2.5
B 60,000 0.5
If the risk-free
rate is 4 percent and the market rate is 10 percent, what return should Susan’s
portfolio earn?
a. 11.8%
b. 10.0%
c. 14.4%
d. 17.0%
e. None of the above is correct.
11. There is no question here.
12. Hill
Top Lumber Company is considering building a sawmill
in the state of
a. Hill Top owns acreage that is large
enough and would be an ideal location for the sawmill. The land, which was
purchased five years ago, has a current value of $3 million.
b. It
is estimated that the cost of building the sawmill
will be $175 million.
c. It
will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
d. It
is estimated that $20 million of business from existing customers will move to
the new sawmill.
e. All
of these cash flows should be included in the computation of the
sawmill’s initial investment outlay.
13. Ms.
Manners Catering (MMC) has paid a constant $1.50 per share dividend to its
common stockholders for the past 25 years. MMC expects to continue this policy
for the next two years, and then begin to increase the dividend at a constant
rate equal to 2 percent per year into perpetuity. Investors require a 12
percent rate of return to purchase MMC’s common stock. What is the market value
of MMC’s common stock?
a. $14.73
b. $15.00
c. $15.58
d. $15.30
e. None
of the above is correct.
14. Stephanie just purchased a corporate bond
that matures in three years. The bond has a coupon interest rate equal to 9
percent and its yield to maturity is 6 percent. If market conditions do not
change—that is market interest rates remain constant—and Stephanie sells the
bond in 12 months, what will be her capital gain from holding the bond?
a. Positive;
because she bought the bond for a discount, which means its price has to
increase as the maturity date nears.
b. Negative;
because she bought the bond for a premium, which means its price has to
decrease as the maturity date nears.
c. Zero,
because she must have bought the bond for par, which means its price will not
change as the maturity date nears.
d. This
question cannot be answered, because the face (maturity) value of the bond is
not given.
e. None
of the above is correct.
15. Many experts forecast that interest rates
will increase during the next few years. If you invest in a corporate bond
today and interest rates do increase, what will happen to the value of your
bond?
a. The
bond’s value should increase also, because the return (yield) on the bond has
to increase so the bond earns a higher rate of return.
b. The
bond’s value should decrease, because the price must be adjusted downward so as
to equate the return on the bond to the higher market rates generated by other
similar risk bonds.
c. The
value of the bond should not change, because, assuming the company does not
default, the value of the bond at maturity must equal its face, or par, value.
d. The
value of the bond will change, but the direction of the change cannot be
determined until the magnitude of the interest rate increase is know.
e. None
of the above is a correct answer.
16.
Cash Flows
Year Project Q Project R
0 $(4,000) $(4,000)
1 0 3,500
2 5,000 1,100
IRR 11.8% 12.0%
If
the firm’s required rate of return (r) is 10 percent, which project should be
purchased?
a. Both
projects should be purchased, because the IRRs for both projects exceed the
firm’s required rate of return.
b. Neither
project should be purchased, because the IRRs for both projects exceed the
firm’s required rate of return.
c. Project
Q, because its net present value (NPV) is higher than Project R’s NPV.
d. Project
R, because its NPV is higher than Project Q’s NPV.
e. None
of the above is a correct answer.
17. A
firm is evaluating a new machine to replace an existing, older machine. The old
(existing) machine is being depreciated at $20,000 per year, whereas the new
machine’s depreciation will be $18,000. The firm’s marginal tax rate is 30
percent. Everything else equal, if the new machine is purchased, what effect
will the change in depreciation have on the firm’s incremental operating cash
flows?
a. There
should be no effect on the firm’s cash flows, because depreciation is a noncash
expense.
b. Operating
cash flows will increase by $2,000.
c. Operating
cash flows will increase by $1,400.
d. Operating
cash flows will decrease by $600.
e. None of the above is correct.
18. According
to the following information, which of the stocks would be considered riskiest
if it is held by itself—that is, there are no other investments in the
portfolio?
Stock s b
ABC 12.5% 1.0
FGH 8.0 0.5
MNO 20.2 2.4
TUV 15.3 3.0
a. Stock MNO, because it has the highest standard deviation.
b. Stock
TUV, because it has the highest beta.
c. Stock FGH, because it has the highest s/b ratio.
d. Stock ABC, because its beta is the same as the market beta (1.0) and the market is always very, very risky.
e. None of the above is a risky investment.
19. Given the following information, compute the
standard deviation for Investment A:
Investment A
Payoff Probability
20% 0.5
10% 0.4
-10% 0.1
a. 81.0%
b. 5.0%
c. 9.0%
d. 17.1%
e. None of the above is correct.
20. When evaluating the cash flows associated
with a capital budgeting project, shipping and installation costs associated
with the purchase of an asset, such as a lathe, are considered part of the
a. initial investment outlay; these expenses effectively are part of the asset’s purchase price.
b. incremental operating cash flows because shipping and installation costs represent expenses that have to be written off over the life of the asset.
c. terminal cash flows, because these expenses aren’t paid until the end of the asset’s life.
d. sunk costs because these expenses do not
affect any current or future cash flows associated with investing in the asset.
e. None
of the above is a correct answer.