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savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/q4_review.htm
1.
unsecured bonds
b.
income bonds
c.
d.
debentures
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2.
Default is
a.
b.
c.
d.
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3.
Which of the following reduces the investor's risk associated with investing in bonds?
1.
a sinking fund
2.
3.
a call feature
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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4.
Which of the following bonds are exempt from federal income taxation?
a.
b.
debenture bonds
c.
convertible bonds
d.
municipal bonds
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5.
b.
c.
d.
interest plus price appreciation (or loss) achieved by holding the bond to maturity
ANSWER:
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6.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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7.
b.
c.
d.
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8.
calling it
2.
repurchasing it
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
only 2
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9.
b.
c.
d.
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10.
b.
c.
d.
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11.
b.
c.
d.
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12.
b.
c.
d.
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13.
tax deductible
b.
variable
c.
paid in stock
d.
fixed
ANSWER:
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14.
b.
c.
limited life
d.
deductibility of dividends
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15.
b.
c.
d.
ANSWER:
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16.
b.
c.
d.
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17.
b.
c.
d.
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18.
2.
3.
total sales
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
all three
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19.
variable
b.
fixed
c.
a non-cash expense
d.
undetermined
ANSWER:
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20.
issuing debt
2.
leasing
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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21.
b.
c.
d.
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22.
2.
3.
increased risk
4.
lower risk
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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23.
b.
c.
d.
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24.
The greater the usage of financial leverage, the larger is the variability of
a.
revenues
b.
gross profits
c.
operating earnings
d.
net earnings
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25.
If a firm's fixed costs rise relative to variable costs, ____ and ____.
a.
b.
c.
d.
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26.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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27.
2.
decrease risk
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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28.
2.
3.
4.
a.
1 and 3
b.
1 and 4
c.
2 and 3
d.
2 and 4
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29.
Retained earnings
a.
have no cost
b.
c.
d.
ANSWER:
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30.
If the capital asset pricing model is used, the cost of equity depends on
1.
2.
3.
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
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31.
b.
c.
d.
ANSWER:
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32.
If equity is negative,
a.
b.
c.
d.
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33.
b.
c.
d.
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34.
retained earnings
2.
3.
interest rate
a.
1 and 2
b.
1 and 3
c.
2 and 3
d.
1, 2, and 3
ANSWER:
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35.
b.
c.
d.
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Problem
36.
You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond
matures after ten years. What is the yield to maturity?
RESPONSE:
ANSWER:
The yield to maturity equates the present value of the interest payments and principal
repayment. In this problem, that rate is 10%:
($40)(12.462) + ($1,000)(0.377) = $875.48.
(PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)
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37.
An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have
passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?
RESPONSE:
ANSWER:
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38.
The price of a product is $1 a unit. A firm can produce this good with variable costs of $0.50 per unit and
total fixed costs of $100.
a.
b.
What is the break-even level of output if fixed costs increase to $180 and variable costs decline to
$0.40 per unit?
RESPONSE:
ANSWER:
a.
b.
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39.
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b.
If the firm sells 1,300 units, what are its earnings or losses?
c.
If sales rise to 2,000 units, what are the firm's earnings or losses?
d.
RESPONSE:
ANSWER:
a.
b.
Earnings
c.
Earnings
d.
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40.
You want to start a firm whose output you believe you can sell for $25 per unit. The operation will require
fixed costs of $10,000, and the variable costs are expected to be $18 a unit. What will be the break-even
level of output?
RESPONSE:
ANSWER:
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41.
Given the following information, what happens to operating income and net income if output is increased
by 10 percent? Verify your answer.
Total assets
$100,000
$80,000
Equity
$20,000
$27,000
Units sold
12,300
$19.75
RESPONSE:
ANSWER:
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42.
(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales
$200
Expenses
$185
Tax rate
a.
33% of earnings
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b.
If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?
c.
What is the return on the owners' investment in each case? Why do the returns differ?
d.
e.
f.
RESPONSE:
ANSWER:
a.
and b.
Sales
no financial
with financial
leverage
leverage
$200
$200
185
185
Expenses
EBIT
15
15
Interest
EBT
15
11
Taxes
c.
Net earnings
10
Return on equity
$10/$100 = 10%
3.63
$
7.37
$7.37/$60 = 12.28%
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The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)
d.
Sales
no financial
with financial
leverage
leverage
$200
$200
194
194
Expenses
POINTS:
EBIT
Interest
EBT
Taxes
0.66
Net earnings
Return on equity
$4/$100 = 4%
1.34
$1.34/$60 = 2.23%
e.
The return on equity fell more for the firm that was financially leveraged.
f.
The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.
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REF:
43.
a.
cost of
cost of
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debt/assets s
debt
equity
0%
7%
14%
10
14
20
14
30
14
40
16
50
10
18
60
12
20
What is firm's cost of capital at the various combinations of debt and equity?
b.
What is the firm's optimal capital structure? Construct a balance sheet showing that combination
of debt and equity financing.
$100
Debt
Equity
$100
c.
If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their
required rate of return if the firm uses its optimal combination of debt and equity financing?
d.
If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if
the cost of new shares is one percentage point higher at the firm's optimal capital structure?
e.
If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital
structure if the firm needs $2,000,000?
RESPONSE:
ANSWER:
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ANSWER:
a.
b.
$100
Liabilities
Equity
$ 30
70
$100
c.
If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the
stockholders will not receive their required return of 14%. With 30% debt
financing, $2.40 must go to creditors ($30 .08 = $2.40), which leaves $7.60
for stockholders ($10 - 2.40). Since the stockholders have invested $70, they
earn a return of 10.86% ($7.60/$70).
For the stockholders to earn their required return, the firm must earn at 12.2%.
Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80)
so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 =
14%).
d.
If the cost of new equity rises to 15 percent, the cost of capital at the optimal
capital structure becomes:
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e.
If the firm has retained earnings of $1,500,000, the breakpoint in the marginal
cost of capital schedule is
$1,500,000/.7 = $2,142,857.
The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is
$142,857 at 12.2 percent and $1,857,143 at 12.7 percent.
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44.
Case B
- firm uses 30% debt with a 10% interest rate and 70% equity
Case C
- firm uses 50% debt with a 12% interest rate and 50% equity
Debt outstanding
300
300
300
Stockholders' equity
Earnings before
interest and taxes
Interest expense
Earnings before taxes
Taxes (40% of earnings)
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Net earnings
Return on stockholders'
investment
What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why
did the rate of interest increase in case C?
RESPONSE:
ANSWER:
A
0
$ 600
$1,000
Debt outstanding
Stockholders' equity
2,000
1,400
1,000
Earnings before
300
300
300
Interest expense
60
120
300
240
180
120
96
72
Net earnings
$ 180
$ 144
$ 108
Return on stockholders'
9%
10.3%
10.8%
investment
The rate of return to stockholders rises because the after tax cost of debt in B is .1(1 .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial leverage.
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45.
The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.
b.
c.
How much total financing may the firm have before the marginal cost of capital rises?
RESPONSE:
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ANSWER:
a.
b.
Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.
c.
The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However, after
$36,428 of total financing, the retained earnings are exhausted, and the firm
must start using more expensive new equity.
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46.
8%
tax rate
30%
dividend
$ 1
$50
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7%
debt ratio
40%
a.
b.
If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of
capital?
c.
If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock
falls to $30, what is the cost of capital? Why is this cost different?
RESPONSE:
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ANSWER:
a.
costs
.4
.056
.0224
.6
.091
.0546
.0770 = 7.7%
b.
The cost of debt and equity are unchanged. Only the weights are changed.
Cost of capital:
weights
costs
.5
.056
.0280
.5
.091
.0455
.0735 = 7.35%
c.
costs
.6
.063
.0378
.4
.106
.0424
.0802 = 8.02%
The cost of capital changes as any of the components are changed. As the
firm initially substitutes cheaper debt financing, the cost of capital declines
(7.7% to 7.35%). However, as the firm uses more debt financing and
becomes more financial leveraged, it becomes riskier, and the cost of capital
rises (7.35% to 8.02%).
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