Name _______________________

11/16/99

Good luck!

Test 2

1. A financial manager reviewing a project that has a positive NPV is concerned that there may be a high degree of variability in the forecasted cash flows. Identification of the variable that has the greatest effect on your forecast can be accomplished by _______.

a. scenario analysis. b. simulation analysis.

c. sensitivity analysis d. break-even analysis.

e. strategic options analysis.

2. It is customary in some industries to compensate sales people with a base salary plus a

commission based on the amount of sales they make in excess of a set goal. For capital budgeting purposes (assume less than one year), the commission should be classified as

a. a fixed cost since without a decent salary the sales people would quit.

b. a fixed cost since this is the customary procedure.

e. a variable cost along with the base salary.

3. Which of the following is not a possible cost of financial distress as we defined it in class?

a. Reduced revenues from lost sales.

b. Lower average employee quality for the same average labor costs.

c. Higher labor costs.

d. Direct and Indirect bankrupcty costs

e. all of the above are costs of financial distress

4. Firms which specialize in helping companies raise capital by selling securities are called ________.

a. commercial banks b. investment banks c. savings banks d. credit unions e. all of the above

5. An investor owns 100 shares of stock in a firm that has no debt. The

a. Borrow $2,000 and buy 200 new shares.

b. Borrow $1,000 and buy 100 new shares.

c. Sell 50 shares and lend $500

d. Sell 25 shares and lend $250

e. Sell all of the stock since the desired D/E ratio can=t be created using homemade leverage

6. A firm that uses its WACC as a cutoff without considering the risk involved in a project will

I. tend to become riskier over time.

II. tend to accept unprofitable projects over time.

III. likely see its WACC rise over time.

IV. tend to accept projects with risks lower than those of existing operations.

a. I and II only

b. II and III only

c. I, II and III only

d. I, II and IV only

e. II, III and IV only

7. Which of the following is NOT true about underwriting?

b. The number of new shareholders is determined by the by the company itself.

8. What is a difference between privately placed and publicly offered debt issues?

a. Private placements must be registered with the SEC

b. Public issues are likely to have more restrictive convenants

d. Costs are lower for public placements

e. all of the above

9. In the event of the firm=s bankruptcy

a. the most shareholders can lose in their original investment in the firm=s stock.

b. common shareholders are the first in line to receive their claims on the firm=s assets.

c. bondholders have claim to what is left from the liquidation of the firm=s assets after paying the shareholders.

d. the claims of junior bond holders shareholders are honored before those senior bondholders.

e. a and d.

10. In which situations would we accept the project? (Presume we use the WACC as the hurdle rate)

A. IRR>WACC NPV > 0 PI > 1.0

B. IRR<WACC NPV > 0 PI > 0.0

C. WACC<IRR NPV < 0 PI = 1.0

D. WACC<IRRe NPV = 0 PI < 1.0

E. WACC>IRR NPV > 0 PI > 1.0

11.Company A and Company B are identical in every way except their capital structure.

Each firm can borrow at 10% and each is taxed at 40%..

Company A Company B

Assets 1000 1000

Equity 600 1000

Debt 400 00

EBIT 100 100

Which firm had the higher Net Income? Which firm had the higher ROE?

A. Company B had a higher net income but the ROEs were identical.

B. Company A had a higher net income, company A had a higher ROE.

C. Company B had a higher net income, company B had a higher ROE.

D. Company A had a higher net income, company B had a higher ROE.

E. Company B had a higher net income, company A had a higher ROE.

12. Which of the following does NOT change the capital structure of a firm? (HINT: think of the debt ratios we used in class)

a. A firm sells bonds and uses the proceeds to buy back stock

b. A firm refunds a bond issue by issuing new bonds

c. A firm uses the proceeds of a sale of common stock to pay-off bank debt

d. A firm uses the proceeds of a sale of preferred stock to repurchase bonds

e. A firm undertakes a rights offering to its stockholders, using the proceeds for capital investment

13. Pearsall Sails is financed entirely by common stock which is priced to offer a 15 percent expected return. If the company repurchases 25 percent of the common stock and substitutes an equal value of debt yielding 6 percent, what is the expected return on the common stock after the refinancing? (assume no taxes)

a. 12.75 percent. b. 13.50 percent. c. 18.00 percent.

d. 17.00 percent e. None of the above.

14. The Fredericksburg Forge Company is financed entirely by common stock, which has a beta of 0.7 and a total market value of $80 million. Suppose the firm repurchases $30 million of stock and replaces it with risk-free debt. What is the beta of the firm=s equity after the refinancing?

a. 0.44 b. 1.12 c. 1.19 d 1.35 e. None of the above.

15.If IPOs were "correctly priced," that is so the average abnormal return is zero, then the average, uninformed investor who wants to buy an equal amount of each new issue will_____ .

a. lose money since he will have a higher percentage of losers than winners

b. break even since there is an equal number of winners and losers

c. make money since on average the shares of IPOs rises by 15 to 30% on the initial day of trading

d. lose money since the stocks are generally underpriced

e. Make money since the IPOs are generally overpriced at the issue.

16. Because of the "lemon problem" (that is the informational asymmetries that exist between managers and shareholders), corporations generally raise funds in the following order: (hint think Myers And Majluf)

a. internally generated cash, debt, preferred stock, common stock.

b. common stock, bonds, preferred stock, internally generated cash.

c. debt, internally generated cash, common stock, preferred stock.

d. common stock, retained earnings, preferred stock, debt.

e. internally generated cash, preferred stock, common stock, debt.

17. Modigliani and Miller contend that capital structure does not matter because:

a. in perfect makets investors can create any capital structure they want.

b. debt payments are deductible.

c. common stock is more expensive to issue, but then cheaper than debt.

d. debt and stock both have the same riskiness.

e. stock adds more risk to the firm, but is less risky to the investor

18. Pharr Inc. has a complex capital structure. The company is 70% debt financed by a 10% bond issue that is currently yielding 8.5%. The company also has two types of preferred stock outstanding. One preferred stock (called Pfd. A) makes up 5% of the financing. It pays a constant $2.00 dividend each year and is currently selling for $21.00. It has no maturity. The other type of preferred stock, also a perpetuity, makes up 6% of the capital structure and has a yield 10%. The remainder of the financing comes from common stock. The beta of Pharr=s common equity is 1.5. If the expected return on the market is 12% and the risk free rate is 4%, what is Pharr=s WACC if they are in the 31% tax bracket?

a. 7.45% b. 8.26% c. 9.33% d. 10.6% e. None of the above

19. The main lesson to be learned from Modigliani and Miller=s theory of capital structure is that _______ .

a. capital structure matters

b. at any level of leverage there is a positive net cost of debt

c. a firm=s value is generally maximized at 90% equity for this is the level that reduces the agency costs associated with debt.

d. as debt increases, expected return generally decreases.

e. operations and cash flows are most important in determining firm value.

20. A firm simultaneously announces a stock buyback and a new bond issue. Which of the following is true?

a. Those who advocate the free-cash flow explanation to capital structure changes would predict the stock should go down because of reduced monitoring.

b. Those who believe that informational asymmetry is the best explanation of capital market changes would predict a stock price increase as a result of managerial signaling.

c. The firms debt ratios would decrease.

d. The stock would likely increase due to increased flexibility in operations and a lower level of risk.

e. The beta of equity will decrease since bondholders will now will share the risk.

21. Which explanation is the BEST explanation for including a call provision in a bond issue?

22. AFN is

23. Consider the following pro forma statement. What number should replace the CCC?

a. $70 b. $50 c. $89 d. $30 e. $75

24. 2. A firm, pursued by an unfriendly suitor, may turn to a _____________ who is a friendly suitor.

a. golden parachute b. shark repellent c. white knight

d. crown jewel e. stand still agreement

25. One way to look at the equity of a levered firm is as a call option. If this is the case, what is the strike price of the call?

a. The value of the debt=s equity.

b. The value of firm=s debt and equity.

c. The value of the firm=s debt.

d. The liquidation value of the firm.

26. Consider a project with the following cash flows and assume that the correct discount rate is 10%.

cost c1 c2 c3 c4 c5

10 2 3 4 5 6

What the Net Present Value (NPV) of the investment?

a. 4.44 b. -6.36 c. 14.44 d. 10 e. none of the above

27. Using the cash flows from the previous question, what is the payback period?

a. 3.2 years b. 4 years c. greater than 4 years. d. 3.7 years.

e. none of the above.

28. Which of the following is false with regards to using the WACC in capital budgeting decisions?

a. Each project should be evaluated using a discount rate that is appropriate for its riskiness.

b. The WACC is calculated by multiplying the weights of the firm=s various securities by the cost of that security and then adding up the products. c. It will cause the firm no problems if the project in question has the same average riskiness as the firms other assets.

d. It will likely cause the firm to reject high risk negative NPV projects.

e. It will likely cause the firm to pass up low risk positive NPV investments.

29. A project cost $15 million and is expected to produce cash flows of $3 million a year for 10 years. The opportunity cost of capital is 14 percent. If the firm has to issue stock to undertake the project and issue costs are $500,000, what is the project's APV?

30. All of the following may serve to reduce the required return on a coupon bond except a ____.

31. 18. How many 20 year zero coupon bonds (par value $1000) must be sold in order to raise $3 million if the investors are requiring a 9% return. (ignore transaction costs)

a 178 b. 3,000 c. 11,340 d. 16,814 e. 27,909

32. Which of the following is FALSE concerning capital budgeting techniques?

a. The payback method ignores the time value of money.

b. The Internal Rate of Return method is best for mutually exclusive projects.

c. The Net Present Value method is the preferred method for investment decisions.

d. The profitability index is frequently used in the presence of rationing.

e. The payback method places no emphasis on cash flows after the cutoff period.

33. You discover that a glue your company developed ten years ago can be formed into a super-bouncy ball if cooked at the right temperature. How should you treat the original $125,000 of R&D expenditures that went into developing the glue in your present capital budgeting decision of whether or not to begin production of the balls?

a. As a cash outflow at the beginning of the project

b. The full $125,000 plus the costs involved in the discovery of the glue=s use as a ball should be treated as initial investment

c. As a sunk cost since that R&D expenditure has no bearing on today=s decision

d. As a sunk cost only if the formula cannot presently be sold to another manufacturer

e. As a cash inflow since the formula has obviously increased in value over the years

34. According to Ritter, IPOs tend to be _____ in the short run, and ____ in the longer run.

a. slightly underpriced, correctly priced

b. overpriced, underpriced

c. underpriced, overpriced

d. correctly priced, correctly priced

e. overpriced, overpriced

35. ______ give investors the right to sell their bonds back to the firm in the even of a downgrading or similar event.

a. Putable bonds b. callable bonds c. convertible bonds d. hybrid e. indexed bonds

36.What is the difference between privately placed and publically offered debt issues? a. Private placements are typically easier to renegotiate during financial distress. b. Private placements must be registered with the SEC.

c. Costs are lower for public placements.

d. Public issues are better if you have trade secrets that you do not want to share.

e. Private placements are generally sold to more investors than are public offerings.

37. Which of the following has NOT been a story in the Nat West -Bank of Scotland hostile takeover?

a. Nat West has been approached by the Bank OF New York who would like to use Nat West to remove the spotlight from BONY=s laundering problems.

b. the Bank Of Scotland has reaffirmed their intent to merge the IT systems of the two firms.

c. Royal Bank has expressed interest in buying Nat West.

d. The Office of Fair trade has extended the time the takeover will be allowed to late December.

e. The top executive at Nat West was dismissed.

38. Which of the following is TRUE with respect to the Pfizer,Warner-Lambert, and American Home Products affair?

A. Pfizer wants to take over American Home Products.

B. American Home Product was originally merging with Pfizer.

C. If the original deal falls through, American Home Products will still be paid for their efforts.

D. The stocks of all three companies have fallen on the news of the possible takeover.

39. Which of the following is false?

A. some are saying that the frenzy for IPOs may suggest a market that has grown too speculative.

B. WWF, Martha Stewart, Cobalt, and WebVan are but a few of the IPOS that have done very well in recent weeks.

C. Targeted stock has come under fire at Marathon Oil due to the difficulty in doing stock transactions.

D. Amazon.com has done many acquisitions in recent months including into the drugstore business and grocery business.

E. UPS was just acquired by Federal Express.

40. Which of the following was discussed in class as a potential reason for the IPO underpricing found in many studies?

a. The management and their investment bankers do not want to be sued so they price low so that all shareholders will be happy.

b. The investment bankers are taking advantage of unknowing firms.

c. Investors are irrational and buy when times are good thus driving up the price to unrealistic levels.

d. Underpricing creates publicity and may increase liquidity and make secondary offerings easier.

e. all of the above have been offered.

41. Which of the following is FALSE concerning capital budgeting techniques?

a. The payback method ignores the time value of money.

b. The Net Present Value method is the preferred method for investment decisions.

c. The Internal Rate of Return method is best for mutually exclusive projects.

d. The profitability index is frequently used in the presence of rationing.

e. The payback method places no emphasis on cash flows after the cutoff period

42. Which of the following would be the MOST likely result of a new stock offering whose proceeds are used to prepay debt?

a. a reduction in times interest earned

b. a reduction in the firms ROE.

c. the firm would have a less severe FCF problem.

d. the equity multiplier would go up.

e. the firm=s leverage ratios would go up.

43. Which of the following events would decrease cash flow?

a. A change from paying COD to paying all bills 30 days after receipt of merchandise

b. A switch from an accelerate depreciation method to straight line depreciation

c. The adoption of a JIT inventory system that will reduce inventories by 50%

d. A lower tax rate.

e. Collecting accounts receivable sooner and paying accounts payable later

44. Baytown (see above) now has a new investment that will cost $500,000. The new investment is a line-extension that is viewed as equally risky to their existing operations. After much deliberation, Michael Woolfolk the highly acclaimed CFO of Baytown Bats decides to raise the needed $500,000 by selling zero coupon bonds. These bonds will have a beta of .2. Assume the current market interest rate for bonds with this level of risk is 6.6%. How many $1000 par zero-coupon bonds will Baytown need to sell if the bonds mature in 10 years? (round up and assume no transaction costs)

a. 500 b. 650 c. 742 d. 948 e. none of the above

45. Which of the following is false?

a. Firms with Aassets-in-place@ tend to borrow more heavily than firms with many growth options.

b. Increasing depreciation increases both earnings and cash flow.

c. Most positive NPV Aprojects@ are on the right hand side of the balance sheet.

d. In the absences of taxes, stock dividends are really just Amini-stock splits.

e. Forgetting to include the terminal (also called horizon value) in a discounted cash flow analysis will generally result in an overly pessimistic forecast.

46. Given the following information, what is Edinburgh Egg Corporation=s WACC? market value of stock is $15 million; tax rate = 34%; market value of debt = $7 million; pre-tax cost of debt = 10%; cost of equity is 16%.

a. 13.0% b. 14.3% c. 15.1% d. 16.0% e. none of the above

47. . Which of the following is FALSE?

a. In an MM world, dividend policy does not matter.

c. Lintner found that management was very hesitant to cut dividends.

d. A dividend increase is generally seen as a signal of Agood times@ ahead

e. Increasing dividends can reduce the free cash flow problem

48. Which of the following is false?

a. Market reactions to seasoned stock issues is generally negative.

b. The market reaction to a financial restructuring in which the firm issues straight debt to buy back shares is most likely positive.

c. Firms with highly volatile cash flows can not Asupport@ high debt levels.

d. An investment banker is generally not needed for IPOs of small firms.

e. Dividends are not fully taxed by the investor if the investor is a corporation.

49. With respect to pro forma statements, which of the following is false?

a. an decrease in the cost of capital will increase both NPV and IRR.

b. The horizon or terminal value represents the present value (in the horizon year) of all future cash flows.

c. Finding the cash flows is generally more important than finding the proper discount rate.

d. Firms can carry-back tax losses for fewer years than they can carry them forward.

e. pro forma analysis is generally done in a computer spreadsheet.

50. Edinburg Egg Enterprises is considering undertaking a scale expansion. It would cost $40 million and produce an expected cash flow of $8 million a year in perpetuity before tax at 34 percent. The firm is financed 40 percent by debt. The expected return on the firm=s equity is 20 percent and the interest rate on its debt is 12 percent. What is the NPV of the project using the weighted average cost of capital?

a. -$5.19 million. b. $8.57 million. c. -$9.45 million.

d. $7.62 million e. None of the above.