Test 1 Finance 488 Spring 1999 Name ______________

Jim Mahar Section(time)_______________

Answer the BEST answer.

Relax. You will do better…just show me what you know! You have all learned a great deal. Just let it show!

Make Haste Slowly. I am sure some will not have time to finish but alas in the real world time is the most valuable commodity. Answer what you can. Do not get hung up on a single question. I do curve at the end of the year so you will not be unduly harmed by a single bad grade.

Have confidence!

jim

Name:__________________

1. 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.

B. Internal Rate of Return is not the best method to evaluate capital budgeting decisions for mutually exclusive projects because for projects of different sizes or maturates IRR can lead to inaccurate results. NPV should be used as first choice.

2. Which of the following is not a trend in the utility industry?

1. deregulation
2. Diversification
3. Wheeling
4. Cogeneration
5. Increased dividend payout ratios

E. Many utilities have cut dividend payout ratios in response to deregulation.

3. What is the implied discount rate of a perpetuity that pays $4 and has a present value of $50? (Choose the closest answer)

a. 12% b. 20% c. 8.33% d. 10.30% e. 8%

E. Value of a perpetuity= payment/interest rate

50=4/r r=.08

4. 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.

1. In the event of a firm's bankruptcy most shareholders can and will lose their original investment in the firm's stock. The most senior debts will be paid first, then junior debt, then preferred stock and finally common shareholders. However because of limited liability shareholders will not have to pay any more into the firm.

5. New issue corporate bonds are yielding 9%. You’re in the 28% tax bracket. Municipal bonds are yielding 5.7%. Which of the following is true? (assume each are AAA rated and for have a maturity of 4 years)

a. You should buy tax-free municipal bonds.

b. You should buy corporate bonds.

c. You would be indifferent between the two.

d. Which you would prefer depends on your risk preferences

2. You would prefer the corporate bonds because they are paying 7.2% (which is calculated 9*(1-.28)= 7.2% after taxes, which is much more than the municipal bonds of similar risk.

6. You purchased a 12% annual coupon bond for 101% of par. One year later, the bond matures. What was your holding period of return?

a. 9.9% b. 12.2% c. 12.0% d. 10.1% e. 10.9%

5. A $1000 face value bond, where the PV=1010 (101% of par) and the coupon payment is $120 illistrates that the return would be 10.9% based on the present value formula.

PV=CF/(1+r)

1+r=1120/1010

1+r=1.10891

r=10.9%

7. Mutual funds have been tremendously successful. Which of the following is not an explanation of their success?

a. They provide liquidity to investors by allowing them to buy/sell fractional shares.

b. They allow small investors to pool risks (diversify).

c. Reduce record-keeping.

d. They lower transaction costs.

e. They tend to out-perform the rest of the stock market.

5. Mutual funds do not tend to out-perform the market. Empirical studies suggest that managed mutual funds slightly under-perform the market.

8. People are REMPS (formerly REMMs). What does this mean?

a. People are always unethical.

b. People are always ethical.

c. People will behave best when everyone is paid equally.

d. People will evaluate their surroundings and do what is in their own best interest.

1. Shareholders need not worry about the principal agent problem.

3. People will evaluate their surroundings and do what is in their best interest, which may lead to ethical or unethical behavior. Shareholders must worry about the principal agent problem to the extent that their interests are not aligned with the agent's interests.

9. The Blanco Blanket company is considering issuing an interesting bond. It is a new 10-year bond that only pays interest at the end of every even year. (To avoid problems with accrued interest suppose the bond is issued on January 1^st, 1999 and today is January 1st. The first coupon payment will be made on December 31^st, 2000. The bond pays a 10% coupon. What is the price of the bond if investors require a 10% return for the bond?

a. $1000 b. $899 c. $788 d. $716 e. $678

5. PVb=100/(1.1)²+ 100/(1.1)⁴+ 100/(1.1)⁶ + 100/(1.1)⁸ + 1100/(1.1)¹⁰

10. Suppose that you were an investment banker who had the following information:

(assume all bonds are AAA rated)

A zero coupon bond that matures in 365 days is selling for $934.58

A 7% coupon bond that matures in 2 years sells at par

A three-year zero coupon bond sells for $808.74

a. below par b. $1000 c. $1017 d. $1044 e. $1052

D. The AAA rated bonds are paying 7% and to offer a 7% return this bond will sell for 1044.

PV=90/(1.07)¹+90/(1.07)²+1090/(1.07)³=1044.25

11. The New Radical Corporation was recently spun-off by the Free Radical Company. Which of the following is least likely?

1. Management of the New Radical Company now has more of their compensation tied to market-based measures.
2. The stock price of the Free Radical Corporation jumped on the announcement of the pending spin-off.
3. The external capital market will now be better able to evaluate the worth of New Radical's investment decisions.
4. The Free Radical Corporation used the money they raised in the spin-off to buy back an equal amount of stock, thus allowing them to offset any dilution.
5. Both companies will likely improve performance as a result of better incentives and reduced interdivisional "fighting."

D. Prior to the spin off it was difficult to tie manager performance to stock price, since stock price was a function of multiple divisions. Manager performance is reflected by the stock price after the spin off. Therefore, stock market reaction to spin off announcement is positive. D is false since no new money is raised because of the spin off and money is not distributed to shareholders.

12. Which of the following has not been in the news in recent weeks?

1. Japan passed the US as the world's largest issuer of debt securities.
2. Russia hid money from their creditors by moving it out of the country.
3. India's stock market became the world's second largest. Behind only the NYSE.
4. The NYSE and the SEC agreed to loosen circuit breakers that were designed to control volatility.
5. Amazon.com issued a convertible debt issue.

1. ABD and E are true but India's stock market is not the world's second largest.

13. ______ 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. idexed bonds

15. If both the interest rate paid by borrowers and the interest rate received by savers accurately reflect the rate of inflation:

a. borrowers will gain and savers will lose because real returns are lower.

b. savers gain and borrowers lose.

c. both borrowers and savers lose.

d. lenders will lose because of the inflation premium.

e. neither borrowers nor savers gain.

E. On average, neither borrowers nor savers gain because both get their expected rate of return.

16. Secondary markets are important for a firm because:

a. the firm may be able to take advantage of unknowing investors.

b. large price discontinuities and high spreads are associated with better liquidity.

c. CEOs can trade on inside information easier if they announce they are trading.

d. firms get a portion of each trade, thus high volume is important

e. lower transaction costs lead to a lower cost of capital.

1. Transaction costs come out of returns so with higher transactions costs, investors will require a higher rate of return which implies a high cost of capital.

17. 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

20. What is the effective annual rate on a savings account that pays 6% interest compounded monthly?

a. 6.00% b. 6.17% c. 6.36% d. 6.79% e. None of the above

B. (1.005)¹²-1=6.17%

21. Which of the following is false concerning financial intermediation?

a. The main purpose of financial intermediaries is to reduce transaction costs.

b. Mutual funds are an example of financial intermediation.

c. Financial intermediaries allow small investors to pool their money.

d. Banks accept deposits and provide loans.

F. F is false because Mutual Funds, like all other equity positions have the possibility of loss. ABC and D are true.

22. If you had purchased two (2) February 35 call contracts on San Marcos Enterprises at $2.50 a share and the price of San Marcos’ stock is $39 a share at expiration, what would your total percentage return on investment if you paid cash for the calls? (ignore commissions and taxes)

a. -$30% b. +60% c. +200% d +333%

e. None of the above

2. 39-35=$4 difference between the market price and the strike price, but you paid $2.50 for the call so your total percentage return is $4-$2.50= $1.50/$2.50= 60%

23. A put option on a stock is said to be out-of-the-money if

a. the exercise price is higher than the stock price.

b. the exercise price is less than the stock price.

c. the exercise price is equal to the stock price.

d. the price of the put is higher than the price of the call.

1. it can be profitably exercised

B.A put option is out of the money when the exercise price is less than the stock price because then the put cannot be profitably exercised.

24. The maximum loss a buyer of a stock call option can suffer is equal to

a. the striking price minus the stock price.

b. the stock price minus the value of the call.

c. the price paid for the call.

d. the stock price.

1. none of the above.

1. If the call expires out the money, the buyer loses only the premium or the price paid for the call.

25. Bear market normal market bull market

probability .3 .5 .2

stock

Lockhart Locks -5% 10% 15%

Alamo Alarms -7% 18% 26%

You own 200 shares of Lockhart Locks (price=$23) and 300 shares of Alamo (price $35).

What is the standard deviation for the Lockhart Lock Company?

a. 8.5% b. 7.8% c. 8.2% d. 6.5% e. none of the above

B. =.3(-.05) + .5(10) +.2(.15)= 6.5%

26. Suppose you have two stocks in your portfolio: Republica and ExFed. You have twice as much Republica as ExFed. Assume that the correlation coefficient between the two stocks is .65 and that their variances are .04 and .25 respectively. What is the standard deviation of your portfolio?

a. 8.06% b. 14.5% c. 25.1% d. 27.3% e. None of the above

D. W1=2/3 W2=1/3

varience of the portfolio = (2/3)²(.04)+(1/3)(.25)+(2/3)(4/3)(.65)(.04^1/2)(.25^1/2)

take the square root to find the standard deviation

27. What is the duration of Uvalde Umbrella Company's ten-year bond with 3 years remaining until maturity if the bond has an 8% annual coupon, $1000 face value, and currently sells for $974.69?

a. 4.1 years b. 3 years c. 2.5 years d. 2.78 years e. 2.2 years

D.

Year PMT PV of PMT % weight Year Year * Weight

1 80 73.39 .075 1 .075

2 80 67.33 .069 2 .13816

3 1080 833.96 .8556 3 2.556

Duration=2.779

28. An 8% bond with a duration of 7.0 years has a price of $1000. If the YTM rises 9%, what will be the new price of the bond?

a. 1101.51 b. 1024.71 c. 924.56 d. 935.20 e. $1000

2. Price change = Duration/ 1+ YTM

7/1.08= 6.48%

(1-.065)(1000)=935.18

29. The longer the maturity and the smaller the coupon payment of a bond,

a. the lower the sensitivity of the bond’s price to interest rate changes.

b. the shorter the bond’s duration.

c. the greater the sensitivity of the bond’s price to interest rate changes.

d. the lower the bond’s risk or volatility.

1. both A & B are correct.

1. Duration measures how soon you get your investment back, so longer maturity and smaller coupon level bonds have a higher duration and are more sensitive to interest rate changes..

30. Which one of the following would provide evidence against the semi-strong form of the efficient market theory?

a. About 50% of pension funds outperform the market in any year.

b. All investors have learned to exploit signals about future performance.

c. Trend analysis appears worthless in determining stock prices.

d. Low P/E stocks tend to have positive abnormal returns over the long run.

1. The stock market has gone up for 3 years in a row.

D. If low P/E stocks do outperform the market on a risk-adjusted basis, then this should be predictable and market prices should reflect his.

31. Suppose DUKE Publishing has EBIT of $30,000 and is in the 40% tax bracket. What is their value if they have no debt and a payout ratio of 100% and the required return for investments of this risk level is 15%?

1. If the payout ratio is 100%, then the dividend = net income and g= 0,

so NI= EBIT (1-.40)

NI= 30,000*.6 =18,000 and the value is 18,000/.15= 120,000

32. Reverse floaters are instruments whose interest payments go down as interest rates go up. Assuming a floor of zero on coupon payments, which of the following would be true with respect to these securities?

1. They would tend to be more volatile than zero coupon bonds.
2. They would move in a direction opposite normal coupon bonds.
3. They have duration that is less than the maturity.
4. They allow the investor to make a high return in interest rates go up.
5. All of the above are true.

1. As interest rates rise, coupon payments fall and the required return rises so bond price falls dramatically (and vice versa) but reverse floaters still have duration less than maturity.

31. We spoke of common equity of a levered firm as a call option. If this line of reasoning is true, the bondholders have a position that is most like what derivative position?

1. A long call position
2. A long future position
3. A short future position
4. A long put position
5. A short put position

E. Draw Diagram

33. Which of the following is not a drawback of the Discounted Payback Period method?

a. May lead to improper investment decision.

b. Could lead to short term thinking.

c. It ignores cash flows after payback period.

d. It ignores Time Value of money.

6. Arbitrary cutoff.

34. Firms A and B are competitors. Both have similar assets and business risks and are all equity firms. Firm A has an after-tax cash flow of $40,000 per year forever and Firm B has an after-tax cash flow of $120,000 per year forever. If the two firms merge, the after-tax cash flow will be $170,000 per year forever. If the appropriate discount rate is 20% what is the increase in value?

a. $9,000 b. $30,000 c. $50,000 d. $60,000 e. $170,000

1. 170,000= 10,000 greater than combined value of 40,000 + 60,000 so 10,000 a year gain

35. Which of the following is true?

a. The adjusted beta for a high-beta stock is generally lower than the measured beta.

b. Dividends are deductible to a firm.

c. As debt increases, the required return on equity decreases.

d. A best effort underwriting is generally better received by the market than a firm commitment underwriting.

e. Most positive NPV projects are found on the financial side of the balance sheet.

1. Adjustments make beta closer to 1.00.

36. Which of the following is false?

1. Miller in 1976 said that he and Modigliani had understated the benefits of debt.
2. Softbank and other venture capital firms are operating much like the Keirtsu of Japan by facilitating cross holdings and encouraging business relationships.
3. W. R. Hambrecht is attempting to revolutionize the way IPOs are sold. They will be sold to individuals as a Dutch Auction.
4. Modigliani and Miller's first paper assumed no taxes.
5. Calpers and other institutional owners are much more active in monitoring firms in the US than in the past.

1. Miller concluded that they had overstated the benefits of debt.

37. Suppose that WinTex Inc. has a 30% tax rate, a required return on equity of 15%, and is 20% financed by common equity. 10% of WinTex’s financing is in the form of preferred shares. They are unusual in that they are adjusted each quarter to yield 200 basis points above the current 30 year treasury bond. Today the 30-year T bond is yielding 7%. The remainder of Wintex’s financing is composed of a single bond issue that has a coupon payment of 8% and is selling for par. It has 10 years until maturity. What is Wintex’s Weighted Average Cost of Capital (WACC)?

a. .069 b. .078 c. .085 d. .098 e. none of the above

2. WACC= .7(.08*.7)+.1(.09)+.2(.15)=.078

38. The net effect of a stock repurchase is ________.

a. similar to the payment of a stock dividend

b. similar to the payment of a cash dividend

c. similar to a stock split

d. similar to a reverse stock split

e. that there are more shares outstanding

B. In both cases cash is paid to shareholders.

39. Consider the following information

The risk free rate is 5% and the expected return on the market is 15%.

What is the expected return on your portfolio?

a. 15% b. 23% c. 8.9% d. 18% e. None of the above

1. None of the Above

Price * # of Shares Weight

Hot Dog Hut 4000 .3125

Taco Tent 7200 .5625

Feddy's Fajitas 1600 .125

12800

Bp= .3125(1.1)+.5625(2.1)+.125(.6)=1.6

Risk Free Rate + B(Market Rate-Risk Free Rate)

5%+1.6(15-5)=21%

40. The main lesson to be learned from M&M is that in the absence of taxes and transaction costs is that _______.

a. capital structure matters

b. debt lowers the value of a firm

c. the WACC increases as debt is added to the capital structure

d. the firm should always use 100% equity

e. it is the operation cash flows that determine the value of the firm

2. M&M conclude that in the absence of taxes and transaction cost, capital structure does not matter, therefore the operation cash flows determine the value of the firm.

41. An unlevered firm has an EBIT of $1 million, net income after tax of $660,000, and a cost

of capital of 15%. A levered firm with the same assets and operations has $2 million in debt,

face and market value, paying an 8% annual coupon. What is the value of the levered firm?

The tax rate is 34%. Assume both pay out their entire earnings.

a. $1,000,000 b. $2,700,000 c. $3,966,667 d. $5,080,000 e. $7,700,000

D. Vu= 660,000/.15=4,400,000

V_L=Vu=2,000,000*cD

V_L=4,400,000+.34(2,000,000)=5,080,000

42. RDJ Inc. has an asset b of 1.2. Its current capital structure is $4 million debt out of total

capital of $10 million. What will happen to the firm’s equity b if debt is increased to $6

million while equity remains unchanged? (assume Beta of Debt is 0 in each case)

a. It increases from 0.8 to 1.2

b. It increases from 2 to 2.4

c. It decreases from 2 to 1.2

d. It decreases from 3 to 2.4

5. e. It increases from 6 to 8.4
7. B. B_A=1.2=W_D(B_D)+W_E(B_E)

43. Which of the following would like yield the lowest cost of capital for a AA rated firm?

1. Jr. Debentures
2. Sr. Debentures
3. Callable Debt
4. Convertible Debt
5. Mortgage bonds

E. Mortgage bonds have the best collateral and thus lowest risk and lowest cost.

43. Suppose the United Nation of Nanumea needs to raise $1 million. They decide to sell debt in the capital markets. How many 20 year bonds ($1000 par value) will they have to sell if the bonds have a coupon rate that increases by 3% a year and the 1^st payment (due in 1 year from issuance) is set at $1.00 and investors require a 15% return?

First calculate the value of a growing perpetuity (ie 1/(.15-.03) ) then calculate the present value of those cashflows from year 21 on. Subtract the latter and add to the present value of the par value.

a. The bond is callable at above par

b. There is a steeply sloped yield curve

c. There is a flat yield curve

d. The bond is callable at par

e. Market interest rates are greater than coupon rate

The maturity value is par. Thus if YTC is greater than that (and coupon yield is constant) then the bond must be called above par.

46. Which of the following is incorrect?

1. A load mutual find is more apt to be recommended by an analyst than a no-load fund.
2. A buy-sell agreement is often used to assure continuity of ownership and to prevent the firm from being sold off in the event of a main shareholder's death.
3. Managers of firms often behave more like bondholders than shareholders would prefer.
4. Diversification at the corporate level is usually beneficial to shareholders.
5. Market based compensation can lead to better incentives than accounting based pay.

D. Diversification (deworsification as Lynch called it) is usually detrimental to shareholders when it is done at the corporate level.

47. As we learned in the Randolph case, 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

1. II, III and IV only

1. IV is false since these lower risk projects will also have lower expected returns which will not be higher than the WACC.

48. If markets are efficient, which of the following is an economically justified reason for analysts and brokers?

1. Advising investors on which stocks are good buys.
2. Making sure investors are properly diversified.
3. Making sure that investors trade frequently so as to lower future capital gains taxes.
4. Helping investors to predict which companies will likely be taken over.
5. All of the above.

1. If markets are efficient the most legitimate purposes of analysts and brokers is to help ensure investors are diversified, to advise investors about asset allocation, and to improve information flow from companies to investors

49. Which of the following is FALSE?

1. The Mergers and Acquisition market has been very active in Europe this year.
2. Online trading is playing a bigger role in retail investment organizations.
3. The Free-cash flow problem as described by Jensen is one of too little cash.
4. Fama and French found that Market to Book (book to market) and Size are better at explaining returns than is Beta.
5. The Small firm effect may be partially described by examining the bid-ask spread around the tax year-end.

1. The free cash flow problem arises from too much not too little extra cash.

50. Which of the following is correct with respect to the Efficient Market Hypothesis?

1. Event studies are a commonly used method of defending claims that the market is weak form efficient.
2. Empirically, insider buying and selling is consistent with strong form market efficiency.
3. Technical analysis is useful activity when the market incorporates all past information but not future information into the price.
4. Most academics believe the market is largely semi-strong form efficient.
5. The bond market, due to informational asymmetries, is less efficient than the stock market.

g. All of the above are true.

1. Most academics do believe that the market is semi-strong form efficient. Event studies tend to support the theory that markets are semi-strong form efficient (A is false). The strong form of market efficiency assumes that insiders cannot beat the market (B is false). Technical analysis in not useful if the market incorporates all past information because technical analysis relies on past information (C is false). The bond market is generally more efficient than the stock market and contains less informational asymmetries.

Bonus: derive the simplified equation for the standard deviation of a 3-asset portfolio. (1 point)

Must put bonus on top of 1^st page of the test.

Merely add up the "boxes."

Bonus #2: Who ended up buying Lucas-Varity? (1 point)

TRW