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PART 1
Question 1
Which of the following statements is CORRECT?
Answer
The New York Stock Exchange is an auction market with a physical location.
Capital market transactions involve only the purchase and sale of equity securities, i.e., common stocks.
If an investor sells shares of stock through a broker, then this would be a primary market transaction.
Consumer automobile loans are evidenced by legal documents called “promissory notes,” and these individual notes are traded in the money market.
While the distinctions are blurring as investment banks are today buying commercial banks, and vice versa, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.
Question 2
Which of the following statements is CORRECT?
Answer
Capital market instruments include both long-term debt and common stocks.
An example of a primary market transaction would be your uncle transferring 100 shares of Wal-Mart stock to you as a birthday gift.
The NYSE does not exist as a physical location; rather, it represents a loose collection of dealers who trade stocks electronically.
If your uncle in New York sold 100 shares of Microsoft through his broker to an investor in Los Angeles, this would be a primary market transaction.
While the two frequently perform similar functions, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise large blocks of capital from investors.
Question 3
You recently sold 100 shares of your new company, XYZ Corporation, to your brother at a family reunion. At the reunion your brother gave you a check for the stock and you gave your brother the stock certificates. Which of the following statements best describes this transaction?
Answer
This is an example of an exchange of physical assets.
This is an example of a primary market transaction.
This is an example of a direct transfer of capital.
This is an example of a money market transaction.
This is an example of a derivatives market transaction
Question 4
Which of the following statements is CORRECT?
Answer
While the distinctions are blurring, investment banks generally specialize in lending money, whereas commercial banks generally help companies raise capital from other parties.
A security whose value is derived from the price of some other “underlying” asset is called a liquid security.
Money market mutual funds usually invest most of their money in a well-diversified portfolio of liquid common stocks.
Money markets are markets for common stocks and long-term debt.
The NYSE operates as an auction market, whereas the Nasdaq is a dealer market.
Question 5
Money markets are markets for
Answer
Foreign stocks.
Consumer automobile loans.
U.S. stocks.
Short-term debt securities.
Long-term bonds.
Question 6
Which of the following could explain why a business might choose to operate as a corporation rather than as a sole proprietorship or a partnership?
Answer
Corporations generally find it relatively difficult to raise large amounts of capital.
Less of a corporation’s income is generally subjected to taxes than would be true if the firm were a partnership.
Corporate shareholders escape liability for the firm’s debts, but this factor may be offset by the tax disadvantages of the corporate form of organization.
Corporate investors are exposed to unlimited liability.
Corporations generally face relatively few regulations.
Question 7
You recently sold 200 shares of Apple stock to your brother. The transfer was made through a broker, and the trade occurred on the NYSE. This is an example of:
Answer
An over-the-counter market transaction
A futures market transaction.
A primary market transaction.
A secondary market transaction.
A money market transaction.
Question 8
Which of the following statements is CORRECT?
Answer
If expected inflation increases, interest rates are likely to increase.
If individuals in general increase the percentage of their income that they save, interest rates are likely to increase.
If companies have fewer good investment opportunities, interest rates are likely to increase.
Interest rates on all debt securities tend to rise during recessions because recessions increase the possibility of bankruptcy, hence the riskiness of all debt securities.
Interest rates on long-term bonds are more volatile than rates on short-term debt securities like T-bills.
Question 9
Which of the following statements is CORRECT?
Answer
The maximum federal tax rate on personal income in 2010 was 50%.
Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible.
Interest paid to an individual is counted as income for tax purposes and taxed at the individual’s regular tax rate, which in 2010 could go up to 35%, but dividends received were taxed at a maximum rate of 15%.
The maximum federal tax rate on corporate income in 2010 was 50%.
Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.
Question 10
Other things held constant, which of the following actions would increase the amount of cash on a company’s balance sheet?
Answer
The company purchases a new piece of equipment.
The company repurchases common stock.
The company pays a dividend.
The company issues new common stock.
The company gives customers more time to pay their bills.
Question 11
Aubey Aircraft recently announced that its net income increased sharply from the previous year, yet its net cash flow from operations declined. Which of the following could explain this performance?
Answer
The company’s operating income declined.
The company’s expenditures on fixed assets declined.
The company’s cost of goods sold increased.
The company’s depreciation and amortization expenses declined.
The company’s interest expense increased.
Question 12
Which of the following statements is CORRECT?
Answer
The primary difference between EVA and accounting net income is that when net income is calculated, a deduction is made to account for the cost of common equity, whereas EVA represents net income before deducting the cost of the equity capital the firm uses.
MVA gives us an idea about how much value a firm’s management has added during the last year.
MVA stands for market value added, and it is defined as follows:
MVA = (Shares outstanding)(Stock price) + Book value of common equity.
EVA stands for economic value added, and it is defined as follows:
EVA = EBIT(1 – T) – (Investor-supplied op. capital) x (A – T cost of capital).
EVA gives us an idea about how much value a firm’s management has added over the firm’s life.
Question 13
Which of the following statements is CORRECT?
Answer
All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income.
The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses.
All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code.
Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm’s income as personal income and pay taxes on that income.
Congress recently changed the tax laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was first taxed on the income and stockholders were taxed again on the income when it was paid to them as dividends.
Question 14
Which of the following factors could explain why Regal Industrial Fixtures had a negative net cash flow last year, even though the cash on its balance sheet increased?
Answer
The company repurchased 20% of its common stock.
The company sold a new issue of bonds.
The company made a large investment in new plant and equipment.
The company paid a large dividend.
The company had high amortization expenses.
Question 15
Which of the following statements is CORRECT?
Answer
The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year.
The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders’ equity.
The balance sheet gives us a picture of the firm’s financial position at a point in time.
The income statement gives us a picture of the firm’s financial position at a point in time.
The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.
Question 16
Which of the following statements is CORRECT?
Answer
Net cash flow (NCF) is defined as follows:
NCF = Net income – Depreciation and Amortization.
Changes in working capital have no effect on free cash flow.
Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 – T)
+ Depreciation and Amortization
– Capital expenditures required to sustain operations
– Required changes in net operating working capital.
Free cash flow (FCF) is defined as follows:
FCF = EBIT(1 – T)+ Depreciation and Amortization + Capital expenditures.
Net cash flow is the same as free cash flow (FCF).
Question 17
Analysts following Armstrong Products recently noted that the company’s operating net cash flow increased over the prior year, yet cash as reported on the balance sheet decreased. Which of the following factors could explain this situation?
Answer
The company issued new long-term debt.
The company cut its dividend.
The company made a large investment in a profitable new plant.
The company sold a division and received cash in return.
The company issued new common stock.
Question 18
If a bank loan officer were considering a company’s request for a loan, which of the following statements would you consider to be CORRECT?
Answer
Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm.
The lower the company’s EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm.
Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm.
Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.
The lower the company’s TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.
Question 19
Which of the following statements is CORRECT?
Answer
If a firm has the highest price/earnings ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
If a firm has the highest market/book ratio of any firm in its industry, then, other things held constant, this suggests that the board of directors should fire the president.
Other things held constant, the higher a firm’s expected future growth rate, the lower its P/E ratio is likely to be.
The higher the market/book ratio, then, other things held constant, the higher one would expect to find the Market Value Added (MVA).
If a firm has a history of high Economic Value Added (EVA) numbers each year, and if investors expect this situation to continue, then its market/book ratio and MVA are both likely to be below average.
Question 20
A firm wants to strengthen its financial position. Which of the following actions would increase its current ratio?
Answer
Use cash to increase inventory holdings
Reduce the company’s days’ sales outstanding to the industry average and use the resulting cash savings to purchase plant and equipment
Use cash to repurchase some of the company’s own stock.
Borrow using short-term debt and use the proceeds to repay debt that has a maturity of more than one year.
Issue new stock and then use some of the proceeds to purchase additional inventory and hold the remainder as cash
Question 21
Cordelion Communications is considering issuing new common stock and using the proceeds to reduce its outstanding debt. The stock issue would have no effect on total assets, the interest rate Cordelion pays, EBIT, or the tax rate. Which of the following is likely to occur if the company goes ahead with the stock issue?
Answer
The times interest earned ratio will decrease.
The ROA will decline.
Taxable income will decrease.
The tax bill will increase.
Net income will decrease.
Question 22
If the CEO of a large, diversified, firm were filling out a fitness report on a division manager (i.e., “grading” the manager), which of the following situations would be likely to cause the manager to receive a better grade? In all cases, assume that other things are held constant.
Answer
The division’s DSO (days’ sales outstanding) is 40, whereas the average for its competitors is 30.
The division’s basic earning power ratio is above the average of other firms in its industry.
The division’s total assets turnover ratio is below the average for other firms in its industry.
The division’s debt ratio is above the average for other firms in the industry.
The division’s inventory turnover is 6, whereas the average for its competitors is 8.
Question 23
Considered alone, which of the following would increase a company’s current ratio?
Answer
An increase in accounts payable.
An increase in net fixed assets.
An increase in accrued liabilities.
An increase in notes payable.
An increase in accounts receivable.
Question 24
Which of the following would, generally, indicate an improvement in a company’s financial position, holding other things constant?
Answer
The total assets turnover decreases.
The TIE declines.
The DSO increases.
The EBITDA coverage ratio increases.
The current and quick ratios both decline.
Question 25
Companies A and C each reported the same earnings per share (EPS), but Company A’s stock trades at a higher price. Which of the following statements is CORRECT?
Answer
Company A trades at a higher P/E ratio.
Company A probably has fewer growth opportunities.
Company A is probably judged by investors to be riskier.
Company A must have a higher market-to-book ratio.
Company A must pay a lower dividend.
PART 2
1. At the end of 10 years, which of the following investments would have the highest future value? Assume that the effective annual rate for all investments is the same and is greater than zero.
Answer
Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10 payments).
Investment B pays $125 at the end of every 6-month period for the next 10 years (a total of 20 payments).
Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a total of 20 payments).
Investment D pays $2,500 at the end of 10 years (just one payment).
Investment E pays $250 at the end of every year for the next 10 years (a total of 10 payments).
2. Which of the following statements is CORRECT?
Answer
An investment that has a nominal rate of 6% with semiannual payments will have an effective rate that is smaller than 6%.
The present value of a 3-year, $150 ordinary annuity will exceed the present value of a 3-year, $150 annuity due.
If a loan has a nominal annual rate of 7%, then the effective rate will never be less than 7%.
If a loan or investment has annual payments, then the effective, periodic, and nominal rates of interest will all be different.
The proportion of the payment that goes toward interest on a fully amortized loan increases over time.
3. Which of the following statements is CORRECT?
Answer
If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity.
The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods.
If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity.
The cash flows for an annuity due must all occur at the ends of the periods.
The cash flows for an annuity must all be equal, and they must occur at regular intervals, such as once a year or once a month.
4. Which of the following statements regarding a 30-year monthly payment amortized mortgage with a nominal interest rate of 8% is CORRECT?
Answer
Exactly 8% of the first monthly payment represents interest.
The monthly payments will decline over time.
A smaller proportion of the last monthly payment will be interest, and a larger proportion will be principal, than for the first monthly payment.
The total dollar amount of principal being paid off each month gets smaller as the loan approaches maturity.
The amount representing interest in the first payment would be higher if the nominal interest rate were 6% rather than 8%.
5. A U.S. Treasury bond will pay a lump sum of $1,000 exactly 3 years from today. The nominal interest rate is 6%, semiannual compounding. Which of the following statements is CORRECT?
Answer
The PV of the $1,000 lump sum has a smaller present value than the PV of a 3-year, $333.33 ordinary annuity.
The periodic interest rate is greater than 3%.
The periodic rate is less than 3%.
The present value would be greater if the lump sum were discounted back for more periods.
The present value of the $1,000 would be larger if interest were compounded monthly rather than semiannually.
6. You are considering two equally risky annuities, each of which pays $25,000 per year for 10 years. Investment ORD is an ordinary (or deferred) annuity, while Investment DUE is an annuity due. Which of the following statements is CORRECT?
Answer
If the going rate of interest decreases from 10% to 0%, the difference between the present value of ORD and the present value of DUE would remain constant.
A rational investor would be willing to pay more for DUE than for ORD, so their market prices should differ.
The present value of DUE exceeds the present value of ORD, while the future value of DUE is less than the future value of ORD.
The present value of ORD exceeds the present value of DUE, and the future value of ORD also exceeds the future value of DUE.
The present value of ORD exceeds the present value of DUE, while the future value of DUE exceeds the future value of ORD.
7. Which of the following statements is CORRECT?
Answer
Most sinking funds require the issuer to provide funds to a trustee, who saves the money so that it will be available to pay off bondholders when the bonds mature.
A sinking fund provision makes a bond more risky to investors at the time of issuance.
Sinking fund provisions never require companies to retire their debt; they only establish “targets” for the company to reduce its debt over time.
If interest rates have increased since a company issued bonds with a sinking fund, the company is less likely to retire the bonds by buying them back in the open market, as opposed to calling them in at the sinking fund call price.
Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond has been issued.
8. Assume that interest rates on 15-year noncallable Treasury and corporate bonds with different ratings are as follows:
T-bond = 7.72% A = 9.64%
AAA = 8.72% BBB = 10.18%
The differences in rates among these issues were most probably caused primarily by:
Answer
Tax effects.
Default risk differences.
Maturity risk differences.
Inflation differences.
Real risk-free rate differences.
9. Which of the following statements is CORRECT?
Answer
All else equal, long-term bonds have less interest rate price risk than short-term bonds.
All else equal, low-coupon bonds have less interest rate price risk than high-coupon bonds.
All else equal, short-term bonds have less reinvestment rate risk than long-term bonds.
All else equal, long-term bonds have less reinvestment rate risk than short-term bonds.
All else equal, high-coupon bonds have less reinvestment rate risk than low-coupon bonds.
10. Which of the following statements is CORRECT?
Answer
Long-term bonds have less interest rate price risk but more reinvestment rate risk than short-term bonds.
If interest rates increase, all bond prices will increase, but the increase will be greater for bonds that have less interest rate risk.
Relative to a coupon-bearing bond with the same maturity, a zero coupon bond has more interest rate price risk but less reinvestment rate risk.
Long-term bonds have less interest rate price risk and also less reinvestment rate risk than short-term bonds.
One advantage of a zero coupon Treasury bond is that no one who owns the bond has to pay any taxes on it until it matures or is sold.
11. Which of the following statements is CORRECT?
Answer
If a 10-year, $1,000 par, 10% coupon bond were issued at par, and if interest rates then dropped to the point where rd = YTM = 5%, we could be sure that the bond would sell at a premium above its $1,000 par value.
Other things held constant, a corporation would rather issue noncallable bonds than callable bonds.
Other things held constant, a callable bond would have a lower required rate of return than a noncallable bond.
Reinvestment rate risk is worse from an investor’s standpoint than interest rate price risk if the investor has a short investment time horizon.
If a 10-year, $1,000 par, zero coupon bond were issued at a price that gave investors a 10% yield to maturity, and if interest rates then dropped to the point where rd = YTM = 5%, the bond would sell at a premium over its $1,000 par value.
12. Which of the following statements is CORRECT?
Answer
The total yield on a bond is derived from dividends plus changes in the price of the bond.
Bonds are riskier than common stocks and therefore have higher required returns.
Bonds issued by larger companies always have lower yields to maturity (less risk) than bonds issued by smaller companies.
The market value of a bond will always approach its par value as its maturity date approaches, provided the bond’s required return remains constant.
If the Federal Reserve unexpectedly announces that it expects inflation to increase, then we would probably observe an immediate increase in bond prices.
13. Bonds A and B are 15-year, $1,000 face value bonds. Bond A has a 7% annual coupon, while Bond B has a 9% annual coupon. Both bonds have a yield to maturity of 8%, which is expected to remain constant for the next 15 years. Which of the following statements is CORRECT?
Answer
One year from now, Bond A’s price will be higher than it is today.
Bond A’s current yield is greater than 8%.
Bond A has a higher price than Bond B today, but one year from now the bonds will have the same price.
Both bonds have the same price today, and the price of each bond is expected to remain constant until the bonds mature.
Bond B has a higher price than Bond A today, but one year from now the bonds will have the same price.
14. Which of the following statements is CORRECT?
Answer
If the risk-free rate rises, then the market risk premium must also rise.
If a company’s beta is halved, then its required return will also be halved.
If a company’s beta doubles, then its required return will also double.
The slope of the security market line is equal to the market risk premium, (rM rRF)
Beta is measured by the slope of the security market line.
15. Recession, inflation, and high interest rates are economic events that are best characterized as being
Answer
company-specific risk factors that can be diversified away.
among the factors that are responsible for market risk.
risks that are beyond the control of investors and thus should not be considered by security analysts or portfolio managers.
irrelevant except to governmental authorities like the Federal Reserve.
systematic risk factors that can be diversified away.
16. Assume that the risk-free rate is 5%. Which of the following statements is CORRECT?
Answer
If a stock’s beta doubled, its required return under the CAPM would also double.
If a stock’s beta doubled, its required return under the CAPM would more than double.
If a stock’s beta were 1.0, its required return under the CAPM would be 5%.
If a stock’s beta were less than 1.0, its required return under the CAPM would be less than 5%.
If a stock has a negative beta, its required return under the CAPM would be less than 5%.
17. Which of the following is most likely to occur as you add randomly selected stocks to your portfolio, which currently consists of 3 average stocks?
Answer
The expected return of your portfolio is likely to decline.
The diversifiable risk will remain the same, but the market risk will likely decline.
Both the diversifiable risk and the market risk of your portfolio are likely to decline.
The total risk of your portfolio should decline, and as a result, the expected rate of return on the portfolio should also decline.
The diversifiable risk of your portfolio will likely decline, but the expected market risk should not change.
18. Which of the following statements is CORRECT?
Answer
Suppose the returns on two stocks are negatively correlated. One has a beta of 1.2 as determined in a regression analysis using data for the last 5 years, while the other has a beta of -0.6. The returns on the stock with the negative beta must have been negatively correlated with returns on most other stocks during that 5-year period.
Suppose you are managing a stock portfolio, and you have information that leads you to believe the stock market is likely to be very strong in the immediate future. That is, you are convinced that the market is about to rise sharply. You should sell your high-beta stocks and buy low-beta stocks in order to take advantage of the expected market move.
You think that investor sentiment is about to change, and investors are about to become more risk averse. This suggests that you should re-balance your portfolio to include more high-beta stocks.
If the market risk premium remains constant, but the risk-free rate declines, then the required returns on low-beta stocks will rise while those on high-beta stocks will decline.
Paid-in-Full Inc. is in the business of collecting past-due accounts for other companies, i.e., it is a collection agency. Paid-in-Full’s revenues, profits, and stock price tend to rise during recessions. This suggests that Paid-in-Full Inc.’s beta should be quite high, say 2.0, because it does so much better than most other companies when the economy is weak.
19. Stock A’s beta is 1.7 and Stock B’s beta is 0.7. Which of the following statements must be true, assuming the CAPM is correct.
Answer
In equilibrium, the expected return on Stock B will be greater than that on Stock A.
When held in isolation, Stock A has more risk than Stock B.
Stock B would be a more desirable addition to a portfolio than A.
In equilibrium, the expected return on Stock A will be greater than that on B.
Stock A would be a more desirable addition to a portfolio then Stock B.
20. Two constant growth stocks are in equilibrium, have the same price, and have the same required rate of return. Which of the following statements is CORRECT?
Answer
If one stock has a higher dividend yield, it must also have a lower dividend growth rate.
If one stock has a higher dividend yield, it must also have a higher dividend growth rate.
The two stocks must have the same dividend growth rate.
The two stocks must have the same dividend yield.
The two stocks must have the same dividend per share.
21. Merrell Enterprises’ stock has an expected return of 14%. The stock’s dividend is expected to grow at a constant rate of 8%, and it currently sells for $50 a share. Which of the following statements is CORRECT?
Answer
The stock’s dividend yield is 8%.
The current dividend per share is $4.00.
The stock price is expected to be $54 a share one year from now.
The stock price is expected to be $57 a share one year from now.
The stock’s dividend yield is 7%.
22. Franklin Corporation is expected to pay a dividend of $1.25 per share at the end of the year (D1 = $1.25). The stock sells for $32.50 per share, and its required rate of return is 10.5%. The dividend is expected to grow at some constant rate, g, forever. What is the equilibrium expected growth rate?
Answer
6.01%
6.17%
6.33%
6.49%
6.65%
23. You, in analyzing a stock, find that its expected return exceeds its required return. This suggests that you think
Answer
the stock should be sold.
the stock is a good buy.
management is probably not trying to maximize the price per share.
dividends are not likely to be declared.
the stock is experiencing supernormal growth.
24. Stocks A and B have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT?
A B
Price $25 $25
Expected growth (constant) 10% 5%
Required return 15% 15%
Answer
Stock A has a higher dividend yield than Stock B.
Currently the two stocks have the same price, but over time Stock B’s price will pass that of A.
Since Stock A’s growth rate is twice that of Stock B, Stock A’s future dividends will always be twice as high as Stock B’s.
The two stocks should not sell at the same price. If their prices are equal, then a disequilibrium must exist.
Stock A’s expected dividend at t = 1 is only half that of Stock B.
25. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT?
Answer
Stock B must have a higher dividend yield than Stock A.
Stock A must have a higher dividend yield than Stock B.
If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock B’s.
Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B.
If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock B’s.
