Deck 22: Financial Management and Stock Equilibrium

Question 1

If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions concerning the relationship between risk and return are true, then which of the following should be true?

A) If an asset's beta is larger than the firm's beta, then the required return on the asset is less than the required return on the firm.
B) If the beta of the asset is smaller than the firm's beta, then the required return on the asset is greater than the required return on the firm.
C) If the beta of the asset is greater than the firm's beta prior to the addition of that asset, then the firm's beta after the purchase of the asset will be smaller than the original firm's beta.
D) If the beta of an asset is larger than the firm's beta prior to the addition of that asset, then the required return on the firm will be greater after the purchase of that asset than prior to its purchase.
E) None of the statements is true.

Answer 1

D

Question 2

Using the Security Market Line concept in capital budgeting, which of the following statements is CORRECT?

A) If the expected rate of return on a given capital project lies above the SML, the project should be accepted even if its beta is above the beta of the firm's average project.
B) If a project's return lies below the SML, it should be rejected if it has a beta greater than the firm's existing beta but accepted if its beta is below the firm's beta.
C) If two mutually exclusive projects' expected returns are both above the SML, the project with the lower risk should be accepted.
D) If a project's expected rate of return is greater than the expected rate of return on an average project, it should be accepted.
E) None of the statements is correct.

Answer 2

A

Question 3

Other things held constant, which of the following would increase the NPV of a project being considered?

A) A shift from MACRS to straight-line depreciation.
B) Making the initial investment in the first year rather than spreading it over the first three years.
C) A decrease in the discount rate associated with the project.
D) An increase in required net working capital.
E) The project would decrease sales of another product line.

Answer 3

C

Question 4

If a stock's market price exceeds its intrinsic value as seen by the marginal investor, then the investor will sell the stock until its price has fallen down to the level of the investor's estimate of the intrinsic value.

Question 5

If markets are in equilibrium, which of the following conditions will exist?

A) Each stock's expected return should equal its realized return as seen by the marginal investor.
B) Each stock's expected return should equal its required return as seen by the marginal investor.
C) All stocks should have the same expected return as seen by the marginal investor.
D) The expected and required returns on stocks and bonds should be equal.
E) All stocks should have the same realized return during the coming year.

Question 6

In six years' time, you are scheduled to receive money from a trust established by your grandparents. When the trust matures there will be $100,000 in the account. If the account earns 9% compounded continuously, how much is in the account today?

A) $55,361.08
B) $58,274.83
C) $61,188.57
D) $64,247.99
E) $67,460.39

Question 7

Louisiana Enterprises, an all-equity firm, is considering a new capital investment. Analysis has indicated that the proposed investment has a beta of 0.5 and will generate an expected return of 7%. The firm currently has a required return of 10.75% and a beta of 1.25. The investment, if undertaken, will double the firm's total assets. If rRF is 7% and the market risk premium is 3%, should the firm undertake the investment?

A) Yes; the expected return of the asset (7%) exceeds the required return (6.5%).
B) Yes; the beta of the asset will reduce the risk of the firm.
C) No; the expected return of the asset (7%) is less than the required return (8.5%).
D) No; the risk of the asset (beta) will increase the firm's beta.
E) No; the expected return of the asset is less than the firm's required return, which is 10.75%.

Question 8

Which of the following methods involves calculating an average beta for comparable firms and using that beta to determine a project's beta?

A) Risk premium method
B) Pure play method
C) Accounting beta method
D) CAPM method
E) Discounted cash flow model

Question 9

Sunshine Inc. has two equally-sized divisions. Division A has a beta of 0.8 and Division B has a beta of 1.2. The company is 100% equity financed. The risk-free rate is 6% and the market risk premium is 5%. Sunshine assigns different hurdle rates to each division based on each division's market risk. Which of the following statements is CORRECT?

A) Sunshine's composite WACC is 10%.
B) Division B has a lower WACC than Division A.
C) If the same WACC is used for each division, the firm would select too many Division A projects and reject too many Division B projects.
D) If the same WACC is used for each division, the firm would select too many Division B projects and reject too many Division A projects.
E) Sunshine's composite WACC is 12%.

Question 10

Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce

A) Higher depreciation charges in the early years of an asset's life.
B) Larger cash flows in the earlier years of an asset's life.
C) Larger total undiscounted profits from the project over the project's life.
D) Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes.
E) Lower tax payments in the earlier years of an asset's life.

Question 11

How much should you be willing to pay for an account today that will have a value of $1,000 in 10 years under continuous compounding if the nominal rate is 10%?

A) $349.49
B) $367.88
C) $386.27
D) $405.59
E) $425.87

Question 12

Interstate Transport has a target capital structure of 50% debt and 50% common equity. The firm is considering a new independent project that has a return of 13% and is not related to transportation. However, a pure-play proxy firm has been identified that has a beta of 1.38. Both firms have a marginal tax rate of 40%, and Interstate's before-tax cost of debt is 12%. The risk-free rate is 10% and the market risk premium is 5%. The firm should:

A) Reject the project; its return is less than the firm's required rate of return on the project of 16.9%.
B) Accept the project; its return is greater than the firm's required rate of return on the project of 12.05%.
C) Reject the project; its return is only 13%.
D) Accept the project; its return exceeds the risk-free rate and the before-tax cost of debt.
E) Be indifferent between accepting or rejecting; the firm's required rate of return on the project equals its expected return.

Question 13

Northern Conglomerate has two divisions, Division A and Division B. Northern looks at competing pure-play firms to estimate the betas of each of the two divisions. After this analysis, Northern concludes that Division A has a beta of 0.8 and Division B has a beta of 1.5. The two divisions are the same size. The risk-free rate is 5% and the market risk premium is 6%. Assume that Northern is 100% equity financed. What is the overall composite WACC for Northern Conglomerate?

A) 10.74%
B) 11.31%
C) 11.90%
D) 12.50%
E) 13.12%

Question 14

For a stock to be in equilibrium, that is, for there to be no long-term pressure for its price to depart from its current level, then

A) the expected future return must be less than the most recent past realized return.
B) The past realized return must be equal to the expected return during the same period.
C) the required return must equal the realized return in all periods.
D) the expected return must be equal to both the required future return and the past realized return.
E) the expected future returns must be equal to the required return.

Question 15

Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock's market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor's required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.

Question 16

You have $5,436.60 in an account that pays 10% interest, compounded continuously. If you deposited some funds 10 years ago, how much was your original deposit?

A) $1,900
B) $2,000
C) $2,100
D) $2,205
E) $2,315

Question 17

For a stock to be in equilibrium, two conditions are necessary: (1) The stock's market price must equal its intrinsic value as seen by the marginal investor and (2) the expected return as seen by the marginal investor must equal this investor's required return.

Question 18

If a stock's expected return as seen by the marginal investor exceeds this investor's required return, then the investor will buy the stock until its price has risen enough to bring the expected return down to equal the required return.

Question 19

If you receive $15,000 today and can invest it at a 5% annual rate compounded continuously, what will be your ending value after 20 years?

A) $38,735.52
B) $40,774.23
C) $42,812.94
D) $44,953.59
E) $47,201.27

Question 20

Assume one bank offers you a nominal annual interest rate of 6% compounded daily while another bank offers you continuous compounding at a 5.9% nominal annual rate. You decide to deposit $1,000 with each bank. Exactly two years later you withdraw your funds from both banks. What is the difference in your withdrawal amounts between the two banks?

A) $2.24
B) $2.35
C) $2.47
D) $2.59
E) $2.72

Question 21

Which of the following statements is CORRECT?

A) If interest rates increase, a 10-year zero coupon bond's price will drop by a greater percentage than will a 10-year, 8% coupon bond.
B) One nice thing about zero coupon bonds is that individual investors do not have to pay any taxes on a zero coupon bond until it matures, even if they are not holding the bonds as part of a tax-deferred account.
C) If a bond with a sinking fund provision has a yield to maturity greater than its coupon rate, the issuing company would prefer to comply with the sinking fund by calling the bonds in at par rather than buying the bonds back in the open market.
D) Because of the IRS's tax treatment of zero coupon bonds, pension funds and other tax-exempt entities rarely, if ever, invest in zero coupon bonds.
E) Interest must be paid on a zero coupon bond's accrued value, but while the first year's interest is taxable at the ordinary income tax rate, subsequent years are taxed at the long-term capital gains rate (since they are received after more than a year).

Question 22

Stock X and the "market" have had the following rates of returns over the past four years. 60% of your portfolio is invested in Stock X and the remaining 40% is invested in Stock Y. The risk-free rate is 6% and the market risk premium is also 6%. You estimate that 14% is the required rate of return on your portfolio. What is the beta of Stock Y?

A) 1.72
B) 1.91
C) 2.10
D) 2.31
E) 2.54

Question 23

Below are the returns for the past five years for Stock S and for the overall market: What is the estimated beta of Stock S?

A) 1.4320
B) 1.5036
C) 1.5788
D) 1.6577
E) 1.7406

Question 24

Assume you are the director of capital budgeting for an all-equity firm. The firm's current cost of equity is 16%; the risk-free rate is 10%; and the market risk premium is 5%. You are considering a new project that has 50% more beta risk than your firm's assets currently have, that is, its beta is 50% larger than the firm's existing beta. The expected return on the new project is 18%. Should the project be accepted if beta risk is the appropriate risk measure? Choose the correct statement.

A) Yes; its expected return is greater than the firm's WACC.
B) Yes; the project's risk-adjusted required return is less than its expected return.
C) No; a 50% increase in beta risk gives a risk-adjusted required return of 24%.
D) No; the project's risk-adjusted required return is 2% above its expected return.
E) No; the project's risk-adjusted required return is 1% above its expected return.

Question 25

McGwire Company's pension fund projects that most of its employees will take advantage of an early retirement program the company plans to offer in 5 years. Anticipating the need to fund these pensions, the firm bought zero coupon U.S. Treasury Trust Certificates maturing in 5 years. When these instruments were originally issued, they were 12% coupon, 30 year U.S. Treasury bonds. The stripped Treasuries are currently priced to yield 10%. Their total maturity value is $6,000,000. What is their total cost (price) to McGwire today?

A) $3,366,714
B) $3,453,040
C) $3,541,580
D) $3,632,390
E) $3,725,528

Question 26

Given the following returns on Stock J and the "market" during the last three years, what is the beta coefficient of Stock J? (Hint: Think rise over run.)

A) 1.58
B) 1.66
C) 1.75
D) 1.84
E) 1.93

Question 27

(The following information applies to the next two problems.)
You have been asked to use a CAPM analysis to choose between Stocks R and S, with your choice being the one whose expected rate of return exceeds its required return by the widest margin. The risk-free rate is 6%, and the required return on an average stock (or the "market") is 10%. Your security analyst tells you that Stock S's expected rate of return is equal to 11%, while Stock R's expected rate of return is equal to 12%. The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock. The following past rates of return are to be used to calculate the two stocks' beta coefficients, which are then to be used to determine the stocks' required rates of return:
Note: The averages of the historical returns are not needed, and they are generally not equal to the expected future returns.
Set up the SML equation and use it to calculate both stocks' required rates of return, and compare those required returns with the expected returns given above. You should invest in the stock whose expected return exceeds its required return by the widest margin. What is the widest positive margin, or greatest excess return (expected return - required return)?

A) 1.97%
B) 2.19%
C) 2.43%
D) 2.70%
E) 3.00%

Question 28

Chapter 7 of the Bankruptcy Act is designed to do all of the following EXCEPT:

A) Provides safeguards against the withdrawal of assets by the owners of the bankrupt firm.
B) Allows insolvent debtors to discharge all of their obligations and to start over unhampered by a burden of prior debt.
C) Provides for an equitable distribution of the assets among the creditors.
D) Details the procedures to be followed when a firm is liquidated.
E) Establishes the rules of reorganization for firms with projected cash flows that eventually will be sufficient to meet debt payments.

Question 29

Given the following returns on Stock Q and "the market" during the last three years, what is the difference in the calculated beta coefficient of Stock Q when Year 1 and Year 2 data are used as compared to Year 2 and Year 3 data? (Hint: Think rise over run.)

A) 9.17
B) 9.63
C) 10.11
D) 10.62
E) 11.15

Question 30

Which of the following statements is most correct?

A) The primary test of feasibility in a reorganization is whether eclaimant agrees with the reorganization plan.
B) The basic doctrine of fairness states that all debt holders must be treated equally.
C) Since the primary issue in bankruptcy is to determine the sharing of losses between owners and creditors, the "public interest" is not a relevant concern.
D) While the firm is in bankruptcy, the existing management is always allowed to remain in control of the firm, though the court monitors its actions closely.
E) To a large extent, the decision to dissolve a firm through liquidation or to keep it alive through reorganization depends upon the value of the firm if it is rehabilitated versus its value if its assets are sold off individually.

Question 31

Hanratty Inc.'s stock and the stock market have generated the following returns over the past five years: What is the estimated beta of Hanratty Inc.'s stock?

A) 1.0333
B) 1.1481
C) 1.2757
D) 1.4032
E) 1.5436

Question 32

Consider each of the following bonds: Bond A: 8-year maturity with a 7% annual coupon.
Bond B: 10-year maturity with a 9% annual coupon.
Bond C: 12-year maturity with a zero coupon.
Each bond has a face value of $1,000 and a yield to maturity of 8%. Which of the following statements is NOT correct?

A) Bond A sells at a discount, while Bond B sells at a premium.
B) If the yield to maturity on each bond falls to 7%, Bond C will have the largest percentage increase in its price.
C) Bond C has the most reinvestment rate risk.
D) Bond C has the most interest rate (price) risk.
E) If the yield to maturity is constant, the price of Bond A will continue to increase over its life until it finally sells at par.

Question 33

(The following information applies to the next two problems.)
You have been asked to use a CAPM analysis to choose between Stocks R and S, with your choice being the one whose expected rate of return exceeds its required return by the widest margin. The risk-free rate is 6%, and the required return on an average stock (or the "market") is 10%. Your security analyst tells you that Stock S's expected rate of return is equal to 11%, while Stock R's expected rate of return is equal to 12%. The CAPM is assumed to be a valid method for selecting stocks, but the expected return for any given investor (such as you) can differ from the required rate of return for a given stock. The following past rates of return are to be used to calculate the two stocks' beta coefficients, which are then to be used to determine the stocks' required rates of return:
Note: The averages of the historical returns are not needed, and they are generally not equal to the expected future returns.
Calculate both stocks' betas. What is the difference between the betas? That is, what is the value of betaR - betaS? (Hint: The graphical method of calculating the rise over run, or (Y2 - Y1) divided by (X2 - X1) may aid you.)

A) 1.3538
B) 1.4250
C) 1.5000
D) 1.5750
E) 1.6538

Question 34

Which of the following statements is most correct?

A) Our bankruptcy laws were enacted in the 1800s, revised in the 1930s, and have remained unaltered since that time.
B) Federal bankruptcy law deals only with corporate bankruptcies. Municipal and personal bankruptcy are governed solely by state laws.
C) All bankruptcy petitions are filed by creditors seeking to protect their claims on firms in financial distress. Thus, all bankruptcy petitions are involuntary as viewed from the perspective of the firm's management.
D)
E) "Restructuring" a firm's debt can involve forgiving a certain portion of the debt but does not involve changing the debt's maturity or its contractual interest rate.

Question 35

Which of the following statements is CORRECT?

A) The CAPM is an ex ante model, which means that all of the variables should be historical values that can reasonably be projected into the future.
B) The beta coefficient used in the SML equation should reflect the expected volatility of a given stock's return versus the return on the market during some future period.
C) The general equation: Y = a + bX + e, is the standard form of a simple linear regression where b = beta, and X equals the independent return on an individual security being compared to Y, the return on the market, which is the dependent variable.
D) The rise-over-run method is not a legitimate method of estimating beta because it measures changes in an individual security's return regressed against time.

Question 36

At the beginning of the year, you purchased a 5-year zero coupon bond with a yield to maturity of 6.8% and a face value of $1,000. Your tax rate is 30%. What is the total tax that you will have to pay on the bond during the first year?

A) $13.95
B) $14.68
C) $15.42
D) $16.19
E) $17.00