Deck 18: Financial and Operating Leverage: Analysis and Calculation

Question 1

PQR Manufacturing Corporation has $1,500,000 in debt outstanding. The company's before-tax cost of debt is 10%. Sales for the year totaled $3,500,000 and variable costs were 60% of sales. Net income was equal to $600,000 and the company's tax rate was 40%. If PQR's degree of total leverage is equal to 1.40, what is its degree of operating leverage?

A) 1.2174
B) 1.3422
C) 1.2783
D) 1.1565
E) 1.0987

Answer 1

A

Question 2

Which of the following statements is CORRECT?

A) An increase in fixed costs, (holding sales and variable costs constant) will reduce the company's degree of operating leverage.
B) If a firm's degree of operating leverage increases, its degree of financial leverage must also have increased.
C) An increase in interest expense will reduce the company's degree of financial leverage.
D) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.
E) If the company has no debt outstanding, then its degree of total leverage equals its degree of financial leverage.

Answer 2

D

Question 3

The degree of operating leverage has which of the following characteristics?

A) A change in quantity demanded will produce the same percentage change in EBIT as an identical change in price per unit of output, other things held constant.
B) The DOL relates the change in net income to the change in operating income.
C) If the firm has no debt, the DOL will equal 1.
D) The closer the firm is operating to the breakeven quantity, the smaller the DOL.
E) The DOL is not a fixed number for a given firm, but will depend upon the time zero values of the economic variable Q (Quantity), P (Price), and V (Volume).

Answer 3

E

Question 4

The use of financial leverage by the firm has a potential impact on which of the following?
(1) The risk associated with the firm.
(2) The return experienced by the shareholder.
(3) The variability of net income.
(4) The degree of operating leverage.
(5) The degree of financial leverage.

A) 1, 2, 3, 5
B) 2, 3, 5
C) 1, 3, 5
D) 2, 3, 4, 5
E) 1, 2, 5

Question 5

Your firm's EPS last year was $1.00. You expect sales to increase by 15% during the coming year. If your firm has a degree of operating leverage equal to 1.25 and a degree of financial leverage equal to 3.50, then what is its expected EPS?

A) $1.66
B) $1.83
C) $1.92
D) $1.74
E) $1.57

Question 6

Assume that a firm currently has EBIT of $2,000,000, a degree of total leverage of 7.5, and a degree of financial leverage of 1.875. If sales decline by 20% next year, then what will be the firm's expected EBIT in one year?

A) $380,000
B) $441,000
C) $400,000
D) $361,000
E) $420,000

Question 7

Which of the following statements is CORRECT?

A) For a given change in sales, the corresponding percentage change in net income could be more or less than the percentage change in operating income.
B) The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).
C) The degree of total leverage (DTL) is equal to the DFL divided by the degree of operating leverage (DOL).
D) Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant. Therefore, the formula shows that the greater the degree of financial leverage, the smaller the degree of operating leverage.
E) The degree of operating leverage (DOL) depends on a company's fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.

Question 8

Coats Corp. generates $10,000,000 in sales. Its variable costs equal 85% of sales and its fixed costs are $500,000. Therefore, the company's operating income (EBIT) equals $1,000,000. The company estimates that if its sales were to increase 10%, its net income and EPS would increase 17.5%. What is the company's interest expense?

A) $150,000
B) $142,857
C) $128,929
D) $135,714
E) $122,482

Question 9

A company currently sells 75,000 units annually. At this sales level, its EBIT is $4 million, and its degree of total leverage is 2.0. The firm's debt consists of $15 million in bonds with a 9.5% coupon. The company is considering a new production method which will entail an increase in fixed costs but a decrease in variable costs, and will result in a degree of operating leverage of 1.600. The president, who is concerned about the stand-alone risk of the firm, wants to keep the degree of total leverage at 2.0. If EBIT remains at $4 million, what dollar amount of bonds must be retired to accomplish this?

A) $6,250,000
B) $6,907,895
C) $6,578,947
D) $5,937,500
E) $5,640,625

Question 10

Assume that a firm has a degree of financial leverage of 1.25. If sales increase by 20%, the firm will experience a 60% increase in EPS, and it will have an EBIT of $100,000. What will be the EBIT for this firm if sales do not increase?

A) $60,980
B) $70,946
C) $67,568
D) $57,931
E) $64,189

Question 11

Stromburg Corporation makes surveillance equipment for intelligence organizations. Its sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and also permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

A) 3.7500
B) 4.5581
C) 4.3411
D) 4.1344
E) 3.9375

Question 12

Bell Brothers has $3,000,000 in sales. Fixed costs are estimated to be $100,000 and variable costs are equal to 50% of sales. The company has $1,000,000 in debt outstanding at a before-tax cost of 10%. If Bell Brothers' sales were to increase by 20%, how much of a percentage increase would you expect in the company's net income?

A) 20.83%
B) 19.79%
C) 21.92%
D) 23.08%
E) 18.80%

Question 13

A company has an EBIT of $4 million, and its degree of total leverage is 2.4. The firm's debt consists of $20 million in bonds with a YTM of 10%. The company is considering a new production process that will require an increase in fixed costs but a decrease in variable costs. If adopted, the new process will result in a degree of operating leverage of 1.4. The president wants to keep the degree of total leverage at 2.4. If EBIT remains at $4 million, what dollar amount of bonds must be outstanding to accomplish this (assuming the yield to maturity remains at 10%)?

A) $16,666,667
B) $20,258,438
C) $19,293,750
D) $18,375,000
E) $17,500,000

Question 14

Maxvill Motors has annual sales of $15,000. Its variable costs equal 60% of its sales and its fixed costs equal $1,000. If the company's sales increase 10%, what will be the percentage increase in the company's earnings before interest and taxes (EBIT)?

A) 13.89%
B) 14.59%
C) 13.23%
D) 12.60%
E) 12.00%

Question 15

Monroe Corporation currently sells 150,000 units a year at a price of $4.00 a unit. Its variable costs are approximately 30% of sales, and its fixed costs amount to 50% of revenues at its current output level. Although fixed costs are based on revenues at the current output level, the cost level is fixed. What is Marcus's degree of operating leverage in sales dollars?

A) 3.6750
B) 3.5000
C) 3.3250
D) 3.8588
E) 3.1588

Question 16

Kulwicki Corporation wants to determine the effect of an expansion of its sales on its operating income (EBIT). The firm's current degree of operating leverage is 2.50. It projects new unit sales to be 170,000, an increase of 45,000 over last year's level of 125,000 units. Last year's EBIT was $60,000. Based on a degree of operating leverage of 2.5, what is this year's expected EBIT with the increase in sales?

A) $108,300
B) $ 97,741
C) $ 92,854
D) $102,885
E) $114,000

Question 17

Alvarez Technologies has sales of $3,000,000. The company's fixed operating costs total $500,000 and its variable costs equal 60% of sales, so the company's current operating income is $700,000. The company's interest expense is
$500,000. What is the company's degree of total leverage (DTL)?

A) 6.0000
B) 5.4150
C) 5.7000
D) 4.8870
E) 5.1443

Question 18

If a firm uses debt financing (Debt ratio = 0.40) and sales change from the current level, which of the following statements is CORRECT?

A) The percentage change in EBIT will equal the percentage change in net income.
B) Since debt is used, the degree of operating leverage must be greater than 1.
C) The percentage change in operating income will be less than the percentage change in net income.
D) The percentage change in operating income (EBIT) resulting from the change in sales will exceed the percentage change in net income.
E) The percentage change in net income relative to the percentage change in sales (and in EBIT) will not depend on the interest rate paid on the debt.

Question 19

Which of the following is a key benefit of using the degree of leverage concept in financial analysis?

A) It shows how a given change in leverage will affect sales.
B) It identifies, with certainty, the future net income based upon sales projections about the future.
C) It establishes the optimal capital structure for the firm.
D) It allows decision makers a relatively clear assessment of the consequences of alternative actions.
E) None of the above statements is correct.

Question 20

The Quick Company expects its sales to increase by 50% in the coming year. The firm's current EPS is $3.25. Its degree of operating leverage is 1.6, while its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year using the DTL approach?

A) $7.86
B) $7.47
C) $9.15
D) $8.27
E) $8.71

Question 21

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.

Question 22

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 23

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) Chapters 11 and 7 are the most important bankruptcy chapters for financial management purposes. If a reorganization plan cannot be worked out under Chapter 11, then the company will be liquidated as prescribed in Chapter 7 of the Act.
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 24

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 25

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 26

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 27

Stock X and the "market" have had the following rates of returns over the past four years.
$$\begin{array} { c r r } \text { Year } & \text { Stock X } & \text { Market } \\\hline 1 & 12.00 \% & 14.00 \% \\2 & 5.00 \% & 2.00 \% \\3 & 11.00 \% & 14.00 \% \\4 & - 7.00 \% & - 3.00 \%\end{array}$$

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

Question 28

Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000, and their risks are average for the firm. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,785 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,750 at the end of each of the next 4 years. The firm's WACC is 11%. Determine the equivalent annual annuity of the most profitable project.

A) $1,112.99
B) $1,236.66
C) $1,374.06
D) $1,526.74
E) $1,679.41

Question 29

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 30

Company D has a 50% debt ratio, whereas Company E has no debt financing. The two companies have the same level of sales and the same degree of operating leverage. Which of the following statements is most CORRECT?

A) If sales increase 10% for both companies, then Company D will have a larger percentage increase in its operating income (EBIT).
B) The two companies have the same degree of total leverage.
C) If sales increase 10% for both companies, then Company D will have a larger percentage increase in its net income.
D) If EBIT increases 10% for both companies, then Company D's net income will rise by more than 10%, while Company E's net income will rise by less than 10%.
E) Company E has a higher degree of financial leverage.

Question 31

Refer to Exhibit 8A.1. 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 32

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 33

Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000, and their risks are average for the firm. Project X has an expected life of 2 years with after-tax cash inflows of $5,300 and $7,000 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $3,500 at the end of each of the next 4 years. The firm's WACC is 8%. Use the replacement chain to determine the NPV of the most profitable project.

A) $1,603.52
B) $1,687.91
C) $1,772.31
D) $1,860.92
E) $1,953.97

Question 34

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 35

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.)
$$\begin{array} { c r r } \text { Year }& \text { Stock J }& \underline { \text { Market } } \\1 & -13.85 \% & -8.63 \% \\2 & 22.90 \% & 12.37 \% \\3 & 35.15 \% & 19.37 \%\end{array}$$

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

Question 36

Lincoln Lodging Inc. estimates that if its sales increase 10% then its net income will increase 18%. The company's EBIT equals $2.4 million, and its interest expense is $400,000. The company's operating costs include fixed and variable costs. What is the level of the company's fixed operating costs?

A) $1,323,000
B) $1,083,000
C) $1,140,000
D) $1,260,000
E) $1,200,000

Question 37

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 38

The "degree of leverage" concept is designed to show how changes in sales will affect EBIT and EPS. If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

A) 5.0000
B) 5.2500
C) 4.7500
D) 4.5125
E) 4.2869

Question 39

Refer to Exhibit 8A.1. 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 40

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 greater than 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.

Question 41

Refer to Exhibit 7A.1. What is the expected after-tax cost of this debt issue?

A) 5.76%
B) 6.06%
C) 6.38%
D) 6.72%
E) 7.06%

Question 42

Which of the following statements is most CORRECT?

A) The primary test of feasibility in a reorganization is whether every claimant 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 43

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 44

Schiffauer Electronics plans to issue 10-year, zero coupon bonds with a par value of $1,000 and a yield to maturity of 9.5%. The company has a tax rate of 30%. How much extra in taxes would the company pay (or save) the second year (at t = 2) if it goes ahead and issues the bonds?

A) $12.59
B) $12.91
C) $13.23
D) $13.56
E) $13.90

Question 45

On January 1st Julie bought a 7-year, zero coupon bond with a face value of $1,000 and a yield to maturity of 6%. Assume that Julie's tax rate is 25%. How much tax will Julie have to pay on the bond the first year she owns it?

A) $ 8.55
B) $ 9.00
C) $ 9.48
D) $ 9.98
E) $10.47

Question 46

A 15-year, $1,000 face value, zero coupon bond has a yield to maturity of 8%. What is the amount of tax an investor in the 33% tax bracket will pay the first year of the bond?

A) $ 8.32
B) $ 8.74
C) $ 9.18
D) $ 9.63
E) $10.12

Question 47

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 48

S. Claus & Co. is planning a zero coupon bond issue that has a par value of $1,000 and matures in 2 years. The bonds will be sold today at a price of $826.45. If the firm's marginal tax rate is 40%, what is the annual after-tax cost of debt to the company on this issue?

A) 5.70%
B) 6.00%
C) 6.30%
D) 6.61%
E) 6.95%

Question 49

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 50

Assume that the City of Tampa sold an issue of $1,000 maturity value, tax-exempt (muni), zero coupon bonds 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 10%, but with semiannual compounding. The bonds are now callable at a premium of 10% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today?

A) 10.08%
B) 10.61%
C) 11.17%
D) 11.75%
E) 12.37%

Question 51

You just purchased a 12-year, $1,000 face value, zero coupon bond with a yield to maturity of 9%. If your tax rate is 25%, how much in taxes will you have to pay at the end of the first year of holding the bond?

A) $6.86
B) $7.22
C) $7.60
D) $8.00
E) $8.40

Question 52

U.S. Delay Corporation, a subsidiary of the Postal Service, must decide whether to issue zero coupon bonds or quarterly payment bonds to fund construction of new facilities. The $1,000 par value quarterly payment bonds would sell at $795.54, have a 10% coupon rate, and mature in 10 years. At what price would the zero coupon bonds with a maturity of 10 years have to sell to earn the same effective annual rate as the quarterly payment bonds?

A) $220.77
B) $232.39
C) $244.62
D) $257.50
E) $270.37

Question 53

A 4-year, zero coupon Treasury bond sells at a price of $762.8952. A 3-year, zero coupon Treasury bond sells at a price of $827.8491. Assuming the expectations theory is correct, what does the market believe the price of 1-year, zero coupon bonds will be in 3 years?

A) $921.54
B) $939.97
C) $958.77
D) $977.94
E) $997.50

Question 54

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

Question 55

Vogril Company issued 20-year, zero coupon bonds with an expected yield to maturity of 9%. The bonds have a par value of $1,000 and were sold for $178.43 each. What is the expected interest expense on these bonds for Year 8?

A) $29.36
B) $30.82
C) $32.36
D) $33.98
E) $35.68

Question 56

Consider each of the following bonds: Bond A: $\quad 8$ -year maturity with a $7 \%$ annual coupon.
Bond B: $\quad 10$ -year maturity with a $9 \%$ annual coupon.
Bond C: $\quad 12$ -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 risk.
D) Bond C has the most 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 57

A 2-year, zero coupon Treasury bond with a maturity value of $1,000 has a price of $873.4387. A 1-year, zero coupon Treasury bond with a maturity value of $1,000 has a price of $938.9671. If the pure expectations theory is correct, for what price should 1-year, zero coupon Treasury bonds sell one year from now?

A) $797.54
B) $839.52
C) $883.70
D) $930.21
E) $976.72

Question 58

Refer to Exhibit 7A.1. What is the nominal dollar value of the interest tax savings to the firm in the third year of the issue?

A) $38.27
B) $40.29
C) $42.30
D) $44.42
E) $46.64

Question 59

Assume that the State of Florida sold tax-exempt, zero coupon bonds with a $1,000 maturity value 5 years ago. The bonds had a 25-year maturity when they were issued, and the interest rate built into the issue was a nominal 8%, compounded semiannually. The bonds are now callable at a premium of 4% over the accrued value. What effective annual rate of return would an investor who bought the bonds when they were issued and who still owns them earn if they were called today?

A) 7.73%
B) 8.13%
C) 8.56%
D) 9.01%
E) 9.46%

Question 60

Recycler Battery Corporation (RBC) issued zero coupon bonds 5 years ago at a price of $214.50 per bond. RBC's zeros had a 20-year original maturity, with a $1,000 par value. The bonds were callable 10 years after the issue date at a price 7% over their accrued value on the call date. If the bonds sell for $240 in the market today, what annual rate of return should an investor who buys the bonds today expect to earn on them?

A) 9.01%
B) 9.48%
C) 9.98%
D) 10.48%
E) 11.00%

Question 61

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 62

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 63

You need a down payment of $19,000 in order to purchase your first home 4 years from today. You currently have $14,014 to invest. In order to achieve your goal, what nominal interest rate, compounded continuously, must you earn on this investment?

A) 7.61%
B) 7.99%
C) 8.39%
D) 8.81%
E) 9.25%

Question 64

You place $1,000 in an account that pays 7% interest compounded continuously. You plan to hold the account exactly 3 years. Simultaneously, in another account you deposit money that earns 8% compounded semiannually. If the accounts are to have the same amount at the end of the 3 years, how much of an initial deposit do you need to make now in the account that pays 8% interest compounded semiannually?

A) $ 835.94
B) $ 879.93
C) $ 926.24
D) $ 974.99
E) $1,023.74

Question 65

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 66

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 67

For a 10-year deposit, what annual rate payable semiannually will produce the same effective rate as 4% compounded continuously?

A) 3.46%
B) 3.65%
C) 3.84%
D) 4.04%
E) 4.24%