Exam 3—Summer
Sample Questions
INSTRUCTIONS: Read each question carefully.
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to see how well you score on this exam and to determine in what areas you might
need to study more.
1. Everything else equal, which of the
following situations would cause a firm’s business risk to decrease?
a. less stable sales
b. decreased common equity in the firm’s
capital structure
c. less certain input prices
d. greater flexibility in adjusting selling
prices
e. higher degree of financial leverage
2. Payment of a stock dividend
a. increases the number of shares of stock
held by the firm’s stockholders.
b. increases the per share price of the firm’s
stock.
c. requires stockholders to invest more money
in the firm’s stock.
d. has no effect on the firm’s balance sheet.
e. generally decreases the total value
of the firm that pays the stock dividend.
3. If a firm has a degree of financial
leverage (DFL) that is greater than 1.0, then we know that a 1.0 percent change
in ______ will cause a change in ______ that is ______ 1.0 percent.
a. EBIT;
sales; greater
b. sales;
net income; greater
c. sales;
EBIT; less than
d. sales;
EBIT; greater than
e. EBIT; net income; less
4. In
essence, who sets (determines) the cost of capital for a firm?
a. top executives, such as the chief
executive officer (CEO) and the chief financial officer (CFO)
b. Congress
c. investment bankers
d. insurance companies
e. investors
5. Analysts of the
ICM Corporation have indicated that the company is expected to grow at a 5 percent
rate for as long as it is in business. Currently the ICM’s stock is selling for
$70 per share. The most recent dividend
paid by the company was $5.60 per share. If ICM issues new common stock it
will incur flotation costs equal to 7 percent. If ICM’s marginal tax rate is 35
percent, what is its cost of retained earnings—that is, its internal equity?
a. 13.4%
b. 8.7%
c. 8.4%
d. 9.0%
e. 14.0%
6. When a firm conducts EBIT/EPS analysis to
determine the appropriate combination of debt and equity that should be used in
its capital structure, the firm should select the capital structure that
generates the ________.
a. highest
EBIT
b. highest
EPS
c. lowest
EBIT
d. lowest
EPS
e. highest
sales
7. A firm’s optimal capital structure is the combination
of debt and equity where _______ is maximized.
a. sales
b. earnings
c. operating
costs
d. dividends.
e. None
of the above is correct.
8. Consider the discussions concerning the
cost of common equity. What is the relationship between the cost of retained
earnings (internal equity), rs, and the
cost of new common equity (external equity), re?
a. rs > re; because new stockholders
are willing to accept a lower return, and thus “pay their dues,” before they
start receiving the higher returns that existing, loyal stockholders receive.
b. 0
= rs < re; because there is
no “real” cost to the income that the firm decides to retain to reinvest in
assets rather than to payout to common stockholders as dividends, but there is
a real cost to issuing new common stock.
c. 0
< rs < re, because there
is a real cost to retaining income (earnings) for reinvestment, but the firm has
to pay flotation costs when issuing new common stock, which makes new common
equity more costly than retained earnings.
d. rs =
re, because they both represent essentially the same source of
funds, so they must have the same cost.
e. None
of the above is a correct answer.
9. For
the past few years, the net income of Dino’s Delicious Dinners (DDD) has been
constant. It is expected that this trend will continue for several years into
the future. On the other hand, DDD’s investment opportunities—that is, capital
budgeting projects with positive net present values—have fluctuated rather
significantly during the past few years, and expectations are that this
fluctuation will continue long into the future. Everything else equal and based
on this information, which of the following dividend policies would produce the
greatest fluctuation in the future dividend payments of DDD (if
followed)?
a. residual
dividend
b. stable,
predictable dividend
c. constant
payout ratio
d. low
regular dividend plus extras
e. None
of the above dividend policies will produce fluctuating dividends.
10. Options Infinity Limited (OIL) is considering the following independent, non-divisible capital budgeting projects:
Initial investment Internal rate
Project outlay (cost) of
return, IRR
R $250,000 18.5%
W 200,000 15.0
Z 180,000 14.0
OIL can raise new funds to invest in capital budgeting projects based on the following schedule:
Amount raised Cost,
r = WACC
$ 1 - $150,000 12.0%
$150,001 - $400,000 14.5
$400,001 and above 16.0
According to this information, which project(s) should OIL accept?
a. Project R only
b. Projects R and W
c. Projects R, W, and Z
d. Projects W and Z
e. None of the above is correct.
11.
a. The
dividends paid by
b. The
dividends paid by
c. The
dividends paid by
d. The
dividends paid by
e. None
of the above is correct.
12. Consider
the economic effect of paying a stock dividend and the economic effect of a
splitting a stock. Assume that the firm engages in no other action or activity
in either case and that stockholders have all the same information as the firm’s managers. If this is true,
everything else equal, which of the following statements is correct?
a. Both
the stock dividend and the stock split have the same relative economic impact;
both actions should not change the total
market value of the firm’s stock.
b. Both
the stock dividend and the stock split will cause the per-share value of the stock
to decline, but the stock dividend will have a greater relative economic impact
than the split.
c. Both
the stock dividend and the stock split will cause the per-share value of the
stock to decline, but the split will have a greater relative economic impact
than the stock dividend.
d. In
general, both the stock dividend and the stock split will result in a decrease
in the total market value of the firm’s stock.
e. None
of the above is correct.
13. Kimbes Karstore has fixed charges associated
with the manufacture and sale of its inventory, including depreciation. As a
result, if Kimbes’ sales increase by 5 percent, its _______ will increase by
_______ 5 percent.
a. earnings
before interest and taxes (EBIT); less than
b. EBIT;
the same
c. EBIT;
greater than
d. EPS;
less than
e. gross
profit; greater than
14. A firm that is evaluating two capital
structures using EBIT/EPS analysis finds that it generally generates an EBIT
much greater than the EPS indifference point. If the firm expects that its EBIT
will not fall below the EPS indifference point in the future, then it
a. should
choose the capital structure with the higher amount of debt, because the
leverage associated with the capital structure will generate higher EPS.
b. should
choose the capital structure with the lower amount of debt, because there will
be less leverage and thus higher EPS.
c. can
choose either capital structure, because they both would have about the same
leverage and thus the same EPS.
d. should
not issue any debt—that is, have an all-equity capital structure—if it wants to
maximize its EPS.
e. There
is not enough information to answer this question.
15. Why
would the ex-dividend date associated with a stock be important to an investor
who is considering purchasing the company’s common stock?
a. It
is on this date that the firm determines which stockholders will receive the
next dividend that will be paid.
b. On
this date the market value of the stock drops by approximately the amount of
the next dividend payment (per share).
c. This
is the date that the firm pays the dividend.
d. This
is the date the dividend becomes a liability to the firm.
e. This
is the date the Board of Directors declares the amount of the next dividend
payment.
16. Express
Press evaluates many different capital budgeting projects each year. The risks
of the projects often differ significantly, from very little risk to risks that
are substantially greater than the average risk associated with the firm. If
Express Press always uses its weighted average cost of capital, or average
required rate of return, to evaluate all of its capital budgeting projects,
then the company might make an incorrect decision, or a mistake, by
a. accepting projects that actually should be
rejected.
b. accepting projects with internal rates of
return that are too high.
c. rejecting
projects that actually should be rejected.
d. rejecting projects with internal rates of
return that are lower than the appropriate risk-adjusted required rate of return.
e. accepting projects that actually should be
accepted.
17. Depreciation
must be considered when evaluating the incremental operating cash flows
associated with a capital budgeting project because
a. it represents a tax-deductible cash
expense.
b. the firm has a cash outflow equal to the
depreciation expense each year.
c. although it is a non-cash expense,
depreciation has an impact on the taxes paid by the firm, which is a cash flow.
d. depreciation is a sunk cost.
e. None of the above is correct.
18. Hill
Top Lumber Company is considering building a sawmill
in the state of
a. Hill Top owns acreage that is large
enough and would be an ideal location for the sawmill. The land, which was
purchased five years ago, has a current value of $3 million.
b. It
is estimated that the cost of building the sawmill
will be $175 million.
c. It
will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
d. It
is estimated that $20 million of business from existing customers will move to
the new sawmill.
e. All
of these cash flows should be included in the computation of the
sawmill’s initial investment outlay.
19. A
firm is evaluating a new machine to replace an existing, older machine. The old
(existing) machine is being depreciated at $20,000 per year, whereas the new
machine’s depreciation will be $18,000. The firm’s marginal tax rate is 30
percent. Everything else equal, if the new machine is purchased, what effect
will the change in depreciation have on the firm’s incremental operating cash
flows?
a. There
should be no effect on the firm’s cash flows, because depreciation is a noncash
expense.
b. Operating
cash flows will increase by $2,000.
c. Operating
cash flows will increase by $1,400.
d. Operating
cash flows will decrease by $600.
e. None of the above is correct.
20. When evaluating the cash flows associated with
a capital budgeting project, shipping and installation costs associated with
the purchase of an asset, such as a lathe, are considered part of the
a. initial investment outlay; these expenses effectively are part of the asset’s purchase price.
b. incremental operating cash flows because shipping and installation costs represent expenses that have to be written off over the life of the asset.
c. terminal cash flows, because these expenses aren’t paid until the end of the asset’s life.
d. sunk costs because these expenses do not
affect any current or future cash flows associated with investing in the asset.
e. None
of the above is a correct answer.