Finance 3010 Test 1 Version A Spring 2006

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Version A.

Dr. Michello
Finance 3010
Test 1

Part I: All questions in this section are worth 2 points


1. Which of the following statements is most correct?
a. One advantage of forming a corporation is that you have limited
liability.
b. Corporations face fewer regulations than sole proprietorships.
c. One disadvantage of being a sole proprietor is that you have to
pay corporate taxes, even though you dont realize the benefits
of being a corporation.
d. Statements b and c are correct.
e. None of the statements above is correct.
2. Which of the following statements is most correct?
a. Corporations generally face fewer regulations than sole
proprietor-ships do.
b. Corporate shareholders have unlimited liability.
c. It is usually easier to transfer ownership in a corporation than
it is to transfer ownership in a sole proprietorship.
d. All of the above statements are correct.
e. None of the above statements is correct
3. The primary goal of a publicly-owned firm interested in serving its
stockholders should be to
a.
b.
c.
d.
e.

Maximize
Maximize
Minimize
Maximize
Maximize

expected total corporate profit.


expected EPS.
the chances of losses.
the stock price per share.
expected net income.

4. Which of the following actions are likely to reduce agency conflicts


between stockholders and managers?
a.
b.
c.
d.
e.

Paying managers a large fixed salary.


Increasing the threat of corporate takeover.
Placing restrictive covenants in debt agreements.
All of the statements above are correct.
Statements b and c are correct.

5. Which of the following statements is most correct?


a. Corporations are taxed more favorably than sole proprietorships.
b. Corporations have unlimited liability.
c. Because of their size, large corporations face fewer regulations
than smaller corporations and sole proprietorships.
d. Reducing the threat of corporate takeover increases the
likelihood that managers will act in shareholders interest.
e. Bond covenants are designed to reduce potential conflicts
between stockholders and bondholders.
6. Which of the following items is included as part of a companys
current assets?
a.
b.
c.
d.
e.

Accounts payable.
Inventory.
Accounts receivable.
Statements b and c are correct.
All of the statements above are correct.

7. All else equal, which of the following actions will increase the
amount of cash on a companys balance sheet?
a.
b.
c.
d.
e.

The
The
The
The
All

company issues new common stock.


company repurchases common stock.
company pays a dividend.
company purchases a new piece of equipment.
of the statements above are correct.

8. Assume that a company currently depreciates its fixed assets over


7 years. Which of the following would occur if a tax law change
forced the company to depreciate its fixed assets over 10 years
instead?
a.
b.
c.
d.
e.

The companys tax payment would increase.


The companys cash position would increase.
The companys net income would increase.
Statements a and c are correct.
Statements b and c are correct.

9. Which of the following statements is most correct?


a. Corporations are allowed to exclude 70 percent of their
interest income from corporate taxes.
b. Corporations are allowed to exclude 70 percent of their
dividend income from corporate taxes.
c. Individuals pay taxes on only 30 percent of the income
realized from municipal bonds.
d. Statements a and b are correct.
e. None of the statements above is correct.

10.

All else being equal, which


companys current ratio?
a.
b.
c.
d.
e.

of

the

following

will

increase

An increase in accounts receivable.


An increase in accounts payable.
An increase in net fixed assets.
Statements a and b are correct.
All of the statements above are correct

11. The New York Stock Exchange is primarily


a.
b.
c.
d.
e.

A secondary market.
A physical location auction market.
An over-the-counter market.
Statements a and b are correct.
Statements b and c are correct.

12. Which of the following is an example of a capital market instrument?


a.
b.
c.
d.
e.
13.

Commercial paper.
Preferred stock.
U.S. Treasury bills.
Bankers acceptances.
Money market mutual funds

Money markets are markets for


a. Foreign currency exchange.
b. Consumer automobile loans.
c. Corporate stocks.
d. Long-term bonds.
e. Short-term debt securities

14. You recently sold 200 shares of Disney stock to your brother.
is an example of:
a.
b.
c.
d.
e.

This

A money market transaction.


A primary market transaction.
A secondary market transaction.
A futures market transaction.
Statements a and b are correct

15. Your uncle would like to limit his interest rate risk and his default
risk, but he would still like to invest in corporate bonds. Which
of the possible bonds listed below best satisfies your uncles
criteria?
a.
b.
c.
d.
e.

AAA
BBB
BBB
AAA
BBB

bond with
perpetual
bond with
bond with
bond with

10 years to maturity.
bond.
10 years to maturity.
5 years to maturity.
5 years to maturity.

16. Which of the following statements is most correct?


a. If the maturity risk premium (MRP) is greater than zero, the
yield curve must be upward sloping.
b. If the maturity risk premium (MRP) equals zero, the yield curve
must be flat.
c. If interest rates are expected to increase in the future and the
maturity risk premium (MRP) is greater than zero, the yield
curve will be upward sloping.
d. If the expectations theory holds, the yield curve will never be
downward sloping.
e. All of the statements above are correct.
17. Which of the following is likely to increase the level of interest
rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their plans for expansion and increase
their demand for capital.
c. The level of inflation is expected to decline.
d. All of the statements above are correct.
e. None of the statements above is correct.
18. Which of the following is likely to increase the level of interest
rates in the economy?
a. Households start saving a larger percentage of their income.
b. Corporations step up their plans for expansion and increase
their demand for capital.
c. The level of inflation is expected to decline.
d. All of the statements above are correct.
e. None of the statements above is correct.
19. Which of the following is likely to lead to an increase in the cost
of funds?
a. Companies production opportunities decline, leading to a
decline in the demand for funds.
b. Households save a larger portion of their income.
c. Households increase the amount of money they borrow from their
local banks.
d. Statements a and b are correct.
e. Statements a and c are correct

20. Which of the following statements is most correct?


a. The expectations theory of the term structure implies that longterm interest rates should always equal short-term interest
rates.
b. If the expectations theory of the term structure is correct, an
upward sloping yield curve implies a positive maturity risk
premium (MRP).
c. If the expectations theory of the term structure is correct, an
upward sloping yield curve implies that market participants
believe that interest rates are going to be higher in the future
than they are today.
d. Statements a and b are correct.
e. Statements b and c are correct.
21. Which of the following statements is most correct
a. operating cash flow is defined as the difference between sales
revenue and operating expenses paid, after taxes on operating
income.
b. operating capital is the amount of investor supplied capital
used to acquire the companys net operating assets.
c. NOPAT is the amount of net income a company would generate if
it had no debt and held no none operating assets.
d. free cash flow is the cash flow available for distribution
between investors.
e. statements a , b, and c are correct
22. Which of the following statements is most correct?
a. The yield on a 2-year corporate bond will always exceed the
yield on a 2-year Treasury bond.
b. The yield on a 3-year corporate bond will always exceed the
yield on a 2-year corporate bond.
c. The yield on a 3-year Treasury bond will always exceed the yield
on a 2-year Treasury bond.
d. All of the statements above are correct.
e. Statements a and c are correct.
23. If the Federal Reserve sells $50 billion of short-term U.S. Treasury
securities to the public, other things held constant, what will
this tend to do to short-term security prices and interest rates?
a.
b.
c.
d.
e.

Prices and interest rates will both rise.


Prices will rise and interest rates will decline.
Prices and interest rates will both decline.
Prices will decline and interest rates will rise.
There will be no changes in either prices or interest rates.

Part II. All questions in this section are worth 2 points


24. An analyst has collected the following information regarding Gilligan
Grocers:

Earnings before interest and taxes (EBIT) = $700 million.


Earnings before interest, taxes, depreciation and amortization
(EBITDA) = $850 million.
Interest expense = $200 million.
The corporate tax rate is 40 percent.
Depreciation is the companys only non-cash expense or revenue.

What is the companys net cash flow?


a.
b.
c.
d.
e.

$850
$650
$570
$450
$500

million
million
million
million
million

25. Casey Motors recently reported the following information:

Net income = $600,000.


Tax rate = 40%.
Interest expense = $200,000.
Total investor-supplied operating capital employed = $9 million.
After-tax cost of capital = 10%.

What is the companys EVA?


a. -$300,000
b. -$180,000
c. $
0
d. $200,000
e. $400,000
26. Whitehall Clothiers had $5,000,000 of retained earnings on its
balance sheet at the end of 2001. One year later, Whitehall had
$6,000,000 of retained earnings on its balance sheet. Whitehall
has one million shares of common stock outstanding, and it paid a
dividend of $0.80 per share in 2002. What was Whitehalls earnings
per share in 2002?
a.
b.
c.
d.
e.

$0.80
$1.00
$1.80
$5.00
$6.00

27. New Mexico Lumber recently reported that its earnings per share were
$3.00. The company has 400,000 shares of common stock outstanding,
its interest expense is $500,000, and its corporate tax rate is 40
percent. What is the companys operating income (EBIT)?
a.
b.
c.
d.
e.

$ 980,000
$1,220,000
$2,000,000
$2,500,000
$3,500,000

(The following information applies to the next four problems.)


You have just obtained financial information for the past 2 years for
Sebring Corporation.
SEBRING CORPORATION:

INCOME STATEMENTS FOR YEAR ENDING DECEMBER 31


(MILLIONS OF DOLLARS)

Sales
Operating costs (excluding depreciation and amortization)
2,550.0
EBITDA
450.0
Depreciation and amortization
75.0
Earnings before interest and taxes
375.0
Interest
60.0
Earnings before taxes
315.0
Taxes (40%)
126.0
Net income available to common stockholders
189.0
Common dividends
13.2

SEBRING CORPORATION:

2002
2001
$3,600.0
$3,000.0
3,060.0
$

540.0
90.0

450.0
65.0

385.0
154.0

231.0

181.5

BALANCE SHEETS FOR YEAR ENDING DECEMBER 31


(MILLIONS OF DOLLARS)
2002
2001

Assets:
Cash and marketable securities
30.0
Accounts receivable
450.0
Inventories
600.0

36.0
540.0
540.0

Total current assets

$1,116.0
$1,080.0
900.0

Net plant and equipment


750.0
Total assets
Liabilities and equity:
Accounts payable
270.0
Notes payable
155.0
Accruals
180.0
Total current liabilities
605.0
Long-term bonds
450.0
Total debt
Common stock (50 million shares)
150.0
Retained earnings
625.0
Total common equity
775.0
Total liabilities and equity

28.

324.0
201.0
216.0

741.0
450.0

$1,191.0
$1,055.0
150.0
675.0
$

825.0
$2,016.0
$1,830.0

$100,000,000
$150,000,000
$225,000,000
$270,000,000
$375,000,000

What is Sebrings net operating working capital for 2002?


a.
b.
c.
d.
e.

30.

What is Sebrings net operating profit after taxes (NOPAT) for


2002?
a.
b.
c.
d.
e.

29.

$2,016.0
$1,830.0

$ 540,000,000
$ 576,000,000
$ 750,000,000
$ 985,000,000
$1,116,000,000

What is Sebrings amount of total investor-supplied operating


capital for 2002?
a. $
b. $
c. $

576,000,000
888,000,000
900,000,000

d. $1,275,000,000
e. $1,476,000,000
31.

What is Sebrings free cash flow for 2002?


a.
b.
c.
d.
e.

$ 85,000,000
$146,000,000
$174,000,000
$255,000,000
$366,000,000

32. A firm has a profit margin of 15 percent on sales of $20,000,000. If


the firm has debt of $7,500,000, total assets of $22,500,000, and
an after-tax interest cost on total debt of 5 percent, what is the
firms ROA?
a.
b.
c.
d.
e.

8.4%
10.9%
12.0%
13.3%
15.1%

33. The Wilson Corporation has the following relationships:


Sales/Total assets
Return on assets (ROA)
Return on equity (ROE)

2.0
4.0%
6.0%

What is Wilsons profit margin and debt ratio?


a.
b.
c.
d.
e.

2%;
4%;
4%;
2%;
4%;

0.33
0.33
0.67
0.67
0.50

34. Selzer Inc. sells all its merchandise on credit.


It has a profit
margin of 4 percent, days sales outstanding equal to 60 days,
receivables of $150,000, total assets of $3 million, and a debt
ratio of 0.64. What is the firms return on equity (ROE)? Assume
a 365-day year.
a. 7.1%
b. 33.4%
c. 3.4%
d. 71.0%
e. 8.1%
35. A firm that has an equity multiplier of 4.0 will have a debt ratio of

a.
b.
c.
d.
e.

4.00
3.00
1.00
0.75
0.25

(The following information applies to the next two problems.)


Famas French Bakery has a return on assets (ROA) of 10 percent and a
return on equity (ROE) of 14 percent. Famas total assets equal total
debt plus common equity (that is, there is no preferred stock).
Furthermore, we know that the firms total assets turnover is 5.
36. What is Famas debt ratio?
a.
b.
c.
d.
e.

14.29%
28.00%
28.57%
55.56%
71.43%

37. What is Famas profit margin?


a.
b.
c.
d.
e.

2.00%
4.00%
4.33%
5.33%
6.00%

38. Assume interest rates on long-term government and corporate bonds


were as follows:
T-bond = 7.72%
AAA
= 8.72%

A
= 9.64%
BBB = 10.18%

The differences in rates among these issues were caused primarily


by
a.
b.
c.
d.
e.

Tax effects.
Default risk differences.
Maturity risk differences.
Inflation differences.
Statements b and d are correct.

39. One-year government bonds yield 6 percent and 2-year government bonds
yield 5.5 percent. Assume that the expectations theory holds. What
does the market believe the rate on 1-year government bonds will be
one year from today?

a.
b.
c.
d.
e.

5.00%
5.50%
5.75%
6.00%
7.00%

40. You observe the following yield curve for Treasury securities:
Maturity
1 year
2 years
3 years
4 years
5 years

Yield
5.5%
5.8
6.0
6.3
6.5

Assume that the pure expectations hypothesis holds. What does the
market expect will be the yield on 4-year securities, 1 year from
today?
a.
b.
c.
d.
e.

6.00%
6.30%
6.40%
6.75%
7.30%

41. Suppose that the annual expected rates of inflation over each of the
next five years are 5 percent, 6 percent, 9 percent, 13 percent,
and 12 percent, respectively.
What is the average expected
inflation rate over the 5-year period?
a. 6%
b. 7%
c. 8%
d. 9%
e. 10%
(The following information applies to the next two problems.)
42. A 5-year Treasury bond has a 5 percent yield.
A 10-year Treasury
bond
has
a
6 percent yield. A 10-year corporate bond has an 8 percent yield. The
market expects that inflation will average 2.5 percent over the next 10
years (IP10 = 2.5%). Assume that there is no maturity risk premium (MRP =
0), and that the annual real risk-free rate of interest, k*, will remain
constant over the next 10 years. (Hint: Remember that the default risk
premium and the liquidity premium are zero for Treasury securities: DRP
= LP = 0).
What does the market expect that inflation will average over the next
five years?
a. 1.0%

b.
c.
d.
e.
43.

1.5%
2.0%
2.5%
3.5%

5-year corporate bond has the same default risk premium and
liquidity premium as the 10-year corporate bond described above.
What is the yield on this 5-year corporate bond?
a.
b.
c.
d.
e.

6.0%
6.5%
7.0%
7.5%
8.0%

44. The interest rate on Treasury securities that mature in four years
is 8 percent. What is expected inflation in Year 4?
a. 3.0%
b. 5.0%
c. 6.0%
d. 7.0%
e. 8.0%
45. What is the interest rate on Treasury securities that mature in three
years?
a.
b.
c.
d.
e.

6.0%
6.5%
7.0%
7.5%
8.0%

46. The Merriam Company has determined that its return on equity is 15
percent. Management is interested in the various components that
went into this calculation.
You are given the following
information: total debt/total assets = 0.35 and total assets
turnover = 2.8. What is the profit margin?
a. 3.48%
b. 5.42%
c. 6.96%
d. 2.45%
e. 12.82%
47. Cleveland Corporation has 100,000 shares of common stock outstanding,
its net income is $750,000, and its P/E is 8.
What is the
companys stock price?
a. $20.00

b.
c.
d.
e.

$30.00
$40.00
$50.00
$60.00

48. Culver Inc. has earnings after interest but before taxes of $300.
The companys times interest earned ratio is 7.00. Calculate the
companys interest charges.
a.
b.
c.
d.
e.

$42.86
$50.00
$40.00
$60.00
$57.93

49. Meyersdale Office Supplies has common equity of $40 million.


The
companys stock price is $80 per share and its market/book ratio is
4.0. How many shares of stock does the company have outstanding?
a.
500,000
b.
125,000
c.
2,000,000
d. 800,000,000
e. Insufficient information.
50. A 7-year municipal bond yields 4.8 percent. Your marginal tax rate
(including state and federal taxes) is 27 percent. What interest rate on
a 7-year corporate bond of equal risk would provide you with the same
after-tax return?
a.
b.
c.
d.
e.

3.46%
4.80%
6.14%
6.58%
17.14%

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