Exam 3
Sample Questions
INSTRUCTIONS: Read each question carefully.
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to see how well you score on this exam and to determine in what areas you might
need to study more.
1. Everything else equal, which of the
following situations would cause a firm’s business risk to decrease?
a. less stable
sales
b. decreased
common equity in the firm’s capital structure
c. less certain
input prices
d. greater
flexibility in adjusting selling prices
e. higher degree
of financial leverage
2. Payment of a stock dividend
a. increases the number of shares of stock
held by the firm’s stockholders.
b. increases the per share price of the
firm’s stock.
c. requires stockholders to invest more money
in the firm’s stock.
d. has no effect on the firm’s balance sheet.
e. generally decreases the total value
of the firm that pays the stock dividend.
3. If a firm has a degree of financial
leverage (DFL) that is greater than 1.0, then we know that a 1.0 percent change
in ______ will cause a change in ______ that is ______ 1.0 percent.
a. EBIT;
sales; greater
b. sales; net income; greater
c. sales; EBIT; less than
d. sales; EBIT; greater than
e. EBIT; net income; less
4. Sam’s Orthodontic Services (SOS) will retain for reinvestment $300,000 of the net income it expects to generate next year. Recently, the CFO determined that the firm’s after-tax cost of debt, rdT, is 5 percent, its cost of internal equity (retained earnings), rs, is 10 percent, and its cost of external equity (new common stock), re, is 13 percent. Next year, SOS expects to finance capital budgeting projects so as to maintain its current capital structure, which consists of 60 percent debt. SOS has no preferred stock. What will SOS’s marginal cost of capital be if its total capital budgeting needs are $700,000 for next year?
a. 7.0%
b. 7.5%
c. 8.2%
d. 9.0%
e. The cost of capital for SOS cannot be determined without knowing the tax rate.
5. Given the following information, what is
the firm’s financial breakeven point?
Debt
$150,000
@ 12%
Preferred
stock $ 0
Selling
price per unit $ 100
Variable
cost per unit sold $ 80
Fixed
operating cost $200,000
a. $200,000
b. $150,000
c. $1,000,000
d. $18,000
e. None
of the above.
6. When a firm conducts EBIT/EPS analysis to
determine the appropriate combination of debt and equity that should be used in
its capital structure, the firm should select the capital structure that
generates the ________.
a. highest EBIT
b. highest EPS
c. lowest EBIT
d. lowest EPS
e. highest sales
7. The CFO of
Most Initial
Recent Pro Forma
Current
assets $3,000 $3,300
Fixed
plant and equipment 5,000
5,000
Total
Assets $8,000 $8,300
Payables
and accruals $2,000
Long-term
debt 2,000
Common
stock 2,000
Retained
earnings
2,000
Total
liabilities and equity $8,000
The
CFO estimates that CCS will pay all income as dividends, which is
expected to total $50. CCS has excess capacity that is sufficient to support
the projected increase in sales. According to the initial pass (initial pro
forma), what amount of external funding does CCS need to support the 10 percent
growth—that is, what is CCS’s initial AFN?
a. $100
b. $
50
c. $300
d. There
is not enough information to answer this question
e. None
of the above is correct.
8. A firm’s optimal capital structure is the
combination of debt and equity where _______ is maximized.
a. sales
b. earnings
c. operating costs
d. dividends.
e. None
of the above is correct.
9. For
the past few years, the net income of Dino’s Delicious Dinners (DDD) has been
constant. It is expected that this trend will continue for several years into
the future. On the other hand, DDD’s investment opportunities—that is, capital budgeting projects with positive net present
values—have fluctuated rather significantly during the past few years, and
expectations are that this fluctuation will continue long into the future.
Everything else equal and based on this information, which of the following
dividend policies would produce the greatest fluctuation in the future
dividend payments of DDD (if followed)?
a. residual dividend
b. stable, predictable dividend
c. constant payout ratio
d. low regular dividend plus extras
e. None
of the above dividend policies will produce fluctuating dividends.
10. In essence, who sets (determines) the cost of capital for a
firm?
a. top executives, such as the chief
executive officer (CEO) and the chief financial officer (CFO)
b. Congress
c. investment bankers
d. insurance companies
e. investors
11. Analysts of the ICM Corporation have indicated that the company is
expected to grow at a 5 percent rate for as long as it is in business.
Currently the ICM’s stock is selling for $70 per share. The most recent
dividend paid by the company was $5.60 per share. If ICM issues new common
stock it will incur flotation costs equal to 7 percent. If ICM’s marginal tax
rate is 35 percent, what is its cost of retained earnings—that is, its internal
equity?
a. 13.4%
b. 8.7%
c. 8.4%
d. 9.0%
e. 14.0%
12. Consider
the economic effect of paying a stock dividend and the economic effect of a
splitting a stock. Assume that the firm engages in no other action or activity
in either case and that stockholders have all the same information as the firm’s managers. If this is true,
everything else equal, which of the following statements is correct?
a. Both
the stock dividend and the stock split have the same relative economic impact;
both actions should not change the total
market value of the firm’s stock.
b. Both
the stock dividend and the stock split will cause the per-share value of the
stock to decline, but the stock dividend will have a greater relative economic
impact than the split.
c. Both
the stock dividend and the stock split will cause the per-share value of the
stock to decline, but the split will have a greater relative economic impact
than the stock dividend.
d. In
general, both the stock dividend and the stock split will result in a decrease
in the total market value of the firm’s stock.
e. None
of the above is correct.
13. Kimbes Karstore has fixed charges associated with the manufacture
and sale of its inventory, including depreciation. As a result, if Kimbes’ sales increase by 5 percent, its _______ will
increase by _______ 5 percent.
a. earnings before interest and taxes (EBIT);
less than
b. EBIT;
the same
c. EBIT;
greater than
d. EPS;
less than
e. gross profit; greater than
14. A firm that is evaluating two capital
structures using EBIT/EPS analysis finds that it generally generates an EBIT
much greater than the EPS indifference point. If the firm expects that its EBIT will not fall below the EPS indifference point in
the future, then it
a. should choose the capital structure with
the higher amount of debt, because the leverage associated with the capital
structure will generate higher EPS.
b. should choose the capital structure with the
lower amount of debt, because there will be less leverage and thus higher EPS.
c. can choose either capital structure,
because they both would have about the same leverage and thus the same EPS.
d. should not issue any debt—that is, have an
all-equity capital structure—if it wants to maximize its EPS.
e. There
is not enough information to answer this question.
15. Why
would the ex-dividend date associated with a stock be important to an investor
who is considering purchasing the company’s common stock?
a. It
is on this date that the firm determines which stockholders will receive the
next dividend that will be paid.
b. On
this date the market value of the stock drops by approximately the amount of
the next dividend payment (per share).
c. This
is the date that the firm pays the dividend.
d. This
is the date the dividend becomes a liability to the firm.
e. This
is the date the Board of Directors declares the amount of the next dividend
payment.
16. Consider the discussions concerning the cost
of common equity. What is the relationship between the cost of retained
earnings (internal equity), rs, and the
cost of new common equity (external equity), re?
a. rs > re; because new stockholders
are willing to accept a lower return, and thus “pay their dues,” before they start
receiving the higher returns that existing, loyal stockholders receive.
b. 0
= rs < re; because there is
no “real” cost to the income that the firm decides to retain to reinvest in assets
rather than to payout to common stockholders as dividends, but there is a real
cost to issuing new common stock.
c. 0
< rs < re, because there
is a real cost to retaining income (earnings) for reinvestment, but the firm
has to pay flotation costs when issuing new common stock, which makes new
common equity more costly than retained earnings.
d. rs =
re, because they both represent essentially the same source of
funds, so they must have the same cost.
e. None
of the above is a correct answer.
17.
a. The
dividends paid by
b. The
dividends paid by
c. The
dividends paid by
d. The
dividends paid by
e. None
of the above is correct.
18. After the CFO of a firm constructed preliminary,
or initial, pro forma financial statements for next year’s projected
operations she told you that AFNInitial =
$1.5 million. If the projections that were made are based on a 6 percent growth
in operations, what information has the CFO provided you?
a. To
grow 6 percent next year, the firm must raise exactly $1.5 million in
external, or additional, funds.
b. If
the firm increases its operations by 6 percent, taxes are forecasted to be $1.5
million next year.
c. The
total amount of funds (financing) the firm needs to raise to support a 6
percent growth in operations next year is less than $1.5 million.
d. To
grow 6 percent next year, the firm must raise greater than $1.5 million
in external, or additional, funds.
e. None of the above is a correct answer.
19. Smart Office Supplies (SOS) reported the
following taxable incomes from 2000-2005:
Year Taxable Income
2000 $300,000
2001 200,000
2002 100,000
2003 0
2004 (100,000)
2005 (300,000)
How much
of the operating losses that are incurred in 2004 and 2005 can SOS carry
forward after 2005?
a. $200,000
b. $300,000
c. $400,000
d. $0
e. $100,000
20. Samples
Galore constructed the following pro forma income statement for next year:
Sales $20,000
Variable operating
costs (14,000)
Gross profit 6,000
Fixed operating
costs (4,000)
EBIT = NOI 2,000
Interest (1,000)
Taxable income 1,000
Taxes (40%) ( 400)
Net income $ 600
If
sales actually turn out to be 4 percent higher than expected, net income will
be _______ higher than expected.
a. 24%
b. 12%
c. 8%
d. 96%
e. None of the above is correct.
21. Options Infinity Limited (OIL) is considering the following independent, non-divisible capital budgeting projects:
Initial investment Internal rate
Project outlay (cost) of
return, IRR
R $250,000 18.5%
W 200,000 15.0
Z 180,000 14.0
OIL can raise new funds to invest in capital budgeting projects based on the following schedule:
Amount raised Cost,
r = WACC
$ 1 - $150,000 12.0%
$150,001 - $400,000 14.5
$400,001 and above 16.0
According to this information, which project(s) should OIL accept?
a. Project R only
b. Projects R and W
c. Projects R, W, and Z
d. Projects W and Z
e. None of the above is correct.