Selected practice questions from Chapters 6 – 8, FIN 335, with Dr. Graham From Chapter 6 – Bonds and Bond Value 1. The stated interest payment, in dollars, made on a bond each period is called the bond’s: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: A 2. The principal amount of a bond that is repaid at the end of the loan term is called the bond’s: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: B 3. The rate of return required by investors in the market for owning a bond is called the: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: D 4. The annual coupon of a bond divided by its face value is called the bond’s: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: E 5. A bond with a face value of $1,000 that sells for less than $1,000 in the market is called a: A) Par bond. B) Discount bond. C) Premium bond. D) Zero coupon bond. E) Floating rate bond. Answer: B 6. A bond with a face value of $1,000 that sells for more than $1,000 in the market is called a: A) Par bond. B) Discount bond. C) Premium bond. D) Zero coupon bond. E) Floating rate bond. Answer: C 7. The long-term bonds issued by the United States government are called: A) Treasury bonds. B) Municipal bonds. C) Floating rate bonds. D) Junk bonds. E) Zero coupon bonds. Answer: A 8. A bond that makes no coupon payments (and thus is initially priced at a deep discount to par value) is called a _______ bond. A) Treasury B) municipal C) floating rate D) junk E) zero coupon Answer: E 9. A bond which, at the election of the holder, can be swapped for a fixed number of shares of common stock at any time prior to the bond’s maturity is called a _____________ bond. A) zero coupon B) callable C) putable D) convertible E) warrant Answer: D 10. The annual coupon payment of a bond divided by its market price is called the: A) Coupon rate. B) Current yield. C) Yield to maturity. D) Bid-ask spread. E) Capital gains yield. Answer: B 11. The price a dealer is willing to accept for selling a security to an investor is called the: A) Equilibrium price. B) Auction price. C) Bid price. D) Ask price. E) Bid-ask spread. Answer: D 12. A bond with a face value of $1,000 has annual coupon payments of $100 and was issued 10 years ago. The bond currently sells for $1,000 and has 8 years remaining to maturity. This bond’s ______________ must be 10%. I. yield to maturity II. market premium III. coupon rate A) I only B) I and II only C) III only D) I and III only E) I, II and III Answer: D 13. If you divide a bond’s annual coupon payment by its current yield you get the ___________. A) yield to maturity B) investors’ required rate of return C) annual coupon rate D) cost of capital E) bond price Answer: E 14. Which of the following statements regarding bond pricing is true? A) The lower the discount rate, the more valuable the coupon payments are today. B) Bonds with high coupon payments are generally (all else the same) more sensitive to changes in interest rates than bonds with lower coupon payments. C) When market interest rates rise, bond prices will also rise, all else the same. D) Bonds with short maturities are generally (all else the same) more sensitive to changes in interest rates than bonds with longer maturities. E) All else the same, bonds with larger coupon payments will have a lower price today. Answer: A 15. Your broker offers you the opportunity to purchase a bond with coupon payments of $90 per year and a face value of $1000. If the yield to maturity on similar bonds is 8%, this bond should: A) Sell for the same price as the similar bond regardless of their respective maturities. B) Sell at a premium. C) Sell at a discount. D) Sell for either a premium or a discount but it’s impossible to tell which. E) Sell for par value. Answer: B 16. When pricing bonds, if a bond’s coupon rate is less than the required rate of return, then: A) The holder of the bond is assured of a profit regardless of when the bond is eventually sold. B) The holder of the bond will realize a capital gain if the bond is held to maturity. C) The bond sells at par because the required rate of return is adjusted to reflect the discrepancy. D) The bond sells at a premium if it has a long maturity and at a discount if it has a short maturity. E) The bond sells at a discount if it has a long maturity and at a premium if it has a short maturity. Answer: B 17. All else the same, a(n) __________ will decrease the required return on a bond. A) call provision B) lower bond rating C) sinking fund D) increase in inflation E) increase in the size of a bond issuance Answer: C 18. Which of the following items generally appears in a corporate bond quote from The Wall Street Journal? A) Yield to maturity B) Original issue price C) Current yield D) Name of the trustee E) Bond rating Answer: C 19. For a discount bond, the current yield is _________ the yield to maturity, and the coupon rate is _____________ the yield to maturity. A) less than; less than B) less than; greater than C) greater than; less than D) greater than; greater than E) equal to; equal to Answer: A 20. For a premium bond, the required return is less than the: I. Current yield. II. Yield to maturity. III. Coupon rate. A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III 21. If investors are uncertain that they will be able to sell a corporate bond quickly, the investors will demand a higher yield in the form of a(n) ____________. A) inflation premium B) liquidity risk premium C) interest rate risk premium D) default risk premium E) increased real rate of interest Answer: B 22. Dizzy Corp. bonds bearing a coupon rate of 12%, pay coupons semiannually, have 3 years remaining to maturity, and are currently priced at $940 per bond. What is the yield to maturity? A) 12.00% B) 13.99% C) 14.54% D) 15.25% E) 15.57% Answer: C Response: $940 = 1000 FV, 60 PMT, 6 N, -940 PV, CPT I/Y = 7.27%; YTM = 7.27% x 2 = 14.54% 23. Whitesell Athletic Corporation’s bonds have a face value of $1,000 and a 9% coupon paid semiannually; the bonds mature in 8 years. What current yield would be reported in The Wall Street Journal if the yield to maturity is 7%? A) 4% B) 5% C) 6% D) 7% E) 8% Answer: E Response: 1000 FV, 45 PMT, 16 N, 3.5 I/Y, CPT PV = $1,120.94; Annual coupon is 45 x 2 = 90. Current Yield (CY) = $90 / 1,120.94 = 8.03% 24. D&G Enterprises issues bonds with a $1,000 face value that make coupon payments of $30 every 3 months. What is the coupon rate? A) 0.30% B) 3.00% C) 9.00% D) 12.00% E) 30.00% Answer: D Response: coupon rate = ($30 x 4) / 1,000 = 12% 25. Suppose you purchase a zero coupon bond with face value $1,000, maturing in 25 years, for $180. What is the implicit interest, in dollars, in the first year of the bond’s life? A) $ 2.86 B) $ 9.84 C) $12.78 D) $19.27 E) $30.00 Answer: C 1000 FV, 25 N, -180 PV, CPT I/Y = YTM = 7.1%; Year 1 interest = $180 x .071 = $12.78 26. Suppose you purchase a zero coupon bond with a face value of $1,000 and a maturity of 25 years, for $180. If the yield to maturity on the bond remains unchanged, what will the price of the bond be 5 years from now? A) $253.64 B) $287.52 C) $310.91 D) $380.58 E) $500.00 Answer: A 1000 FV, 25 N, -180 PV, CPT I/Y = 7.1%; -180 PV, 5 N, 7.1 I/Y, CPT FV = $253.64 27. What is the yield to maturity on an 18-year, zero coupon bond selling for 30% of par value? A) 4.86% B) 5.86% C) 6.37% D) 6.92% E) 30.00% Answer: D 1000 FV, 18 N, -300 PV, CPT I/Y = YTM = 6.92% 28. J&J Enterprises wants to issue sixty 20-year, $1,000 zero-coupon bonds. If each bond is to yield 7%, how much will J&J receive (ignoring issuance costs) when the bonds are first sold? A) $11,212 B) $12,393 C) $15,505 D) $18,880 E) $20,000 Answer: C Response: price = $1,000 / 1.0720 = $258.42; proceeds = $258.42 x 60 = $15,505 There is the algebra, but what are the entries using your TVOM keys on your TI BA II Plus? And what of the algebra and keystrokes for numbers 29-40 below? Recognizing the algebra is important, and extending that recognition to the keystrokes is “key.” 29. J&J Enterprises wants to issue 20-year, $1,000 face value zero-coupon bonds. If each bond is to yield 7%, what is the minimum number of bonds J&J must sell if they wish to raise $5 million from the sale? (Ignore issuance costs.) A) 17,290 B) 19,349 C) 20,164 D) 23,880 E) 26,159 Answer: B Response: price = $1,000 / 1.0720 = $258.42; # of bonds = $5,000,000 / 258.42 = 19,349 30. What is the market value of a bond that will pay a total of fifty semiannual coupons of $80 each over the remainder of its life? Assume the bond has a $1,000 face value and a 12% yield to maturity. A) $ 734.86 B) $ 942.26 C) $1,135.90 D) $1,315.24 E) $1,545.62 Answer: D 50 N, 80 PMT, 1000 FV, 12/2 = I/Y, CPT PV = -1,315 31. J&J Manufacturing just issued a bond with a $1,000 face and a coupon rate of 8%. The bond has a life of 20 years, annual coupons, and a yield to maturity is 7.5%, what will the bond sell for? A) $ 975 B) $1,020 C) $1,051 D) $1,087 E) $1,162 Answer: C 1000 FV, 80 PMT, 20 N, 7.5 I/Y, CPT PV = -1,051 32. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what percent of the bond’s total price is represented by the present value of the coupons? A) 45.7% B) 56.1% C) 77.6% D) 93.2% E) 100.0% Answer: C Response: Using the TVOM keystrokes above, you get the price of around $1,051. Now, in this problem, you must calculate the value of the annuity stream (the interest payments or coupons) and divide that into the bond price. Recall that the total bond value is comprised of the PV of the coupons plus the PV of the maturity payoff of $1000. Keystrokes for the PV of the coupons? 80 PMT, 7.5 I/Y, 20 N, CPT PV = -815.56. Divide that into 1051 and you get $815.56 / 1,050.97 = 77.6%. 33. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is the present value of the bond’s face value? A) $ 235.41 B) $ 341.15 C) $ 815.56 D) $1,000.00 E) $1,050.97 Answer: A, Response: PV of par = $1,000 / 1.07520 = $235.41 (1000 FV, 20 N, 7.5 I/Y, CPT PV = 235.41) 34. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is the total present value of the bond’s coupon payments? A) $ 235.41 B) $ 341.15 C) $ 815.56 D) $1,000.00 E) $1,050.97 Answer: C Response: PV of coupons = $80 [(1 1/1.07520)/ .075] = $815.56 Using the TVOM keys instead of algebra? Coupon payments are 8% of $1000 or $80. So, 80 PMT, 20 N, 7.5I/Y, CPT PV = 815.56 35. The market price of a bond is $1,236.94, it has 14 years to maturity, a $1,000 face value, and pays an annual coupon of $100 in semiannual installments. What is the yield to maturity? A) 3.18% B) 4.26% C) 5.37% D) 6.11% E) 7.27% Answer: E Response: $1,236.94 = $50 {[1 – 1/(1 + R)28] / R} + 1,000 / (1 + R)28; R = 3.637%; YTM = 3.64% x 2 = 7.27% The algebra is a bit annoying, so do the TVOM stuff, thusly: -1,236.94PV, 1000 FV, 28 N, 50 PMT, CPT I/Y = 3.637. I/Y x 2 = 3.637 x 2 = 7.274 or 7.27% 36. What would you pay for a bond that pays an annual coupon of $45, has a face value of $1,000, matures in 11 years, and has a yield to maturity of 10%? A) $642.77 B) $775.34 C) $800.18 D) $910.14 E) $976.38 Answer: A Response: price = $45 [(1 – 1/1.111) / .1] + 1,000 / 1.111 = $642.77 TVOM stuff? 1000 FV, 45 PMT, 11 N, 10 I/Y, CPT PV = -642.77 37. King Noodles’ bonds have a 9% coupon rate. Interest is paid quarterly and the bonds have a maturity of 10 years. If the appropriate discount rate is 10% on similar bonds, what is the price of King Noodles’ bonds? A) $937.24 B) $938.55 C) $971.27 D) $989.63 E) $991.27 Answer: A 1000 FV, 90/4 = 22.5 PMT, 10 x 4 = 40 N, 10/4=2.5 I/Y, CPT PV = -937.24 38. Cornerstone Industries has a bond outstanding with an 8% coupon rate and a market price of $874.68. If the bond matures in 6 years and interest is paid semiannually, what is the YTM? A) 4.9% B) 6.9% C) 8.9% D) 10.9% E) 12.9% Answer: D Response: $874.68 = $40 {[1 – 1/(1 + R)12] / R} + 1,000 / (1 + R)12; R = 5.45%; YTM = 5.45% x 2 = 10.9% TVOM keystrokes? 40 PMT, 12 N, 1000 FV, -874.68 PV, CPT I/Y = 5.45 x 2 = YTM = 10.9% 39. The make-believe bonds of Facebook carry a 12% annual coupon, have a $1,000 face value, and mature in 5 years. Bonds of equivalent risk yield 9%. What is the market value of Facebook bonds? A) $1,011.20 B) $1,087.25 C) $1,095.66 D) $1,116.69 E) $1,160.25 Answer: D Response: price = $120 [(1 – 1/1.095) / .09] + 1,000 / 1.095 = $1,116.69 1000 FV, 120 PMT, 5 N, 9 I/Y, CPT PV = -1,116.69 40. If the following bonds are identical except for coupon, what is the price of bond B? A) $ 944.58 B) $ 975.31 C) $1,037.86 D) $1,150.00 E) $1,279.47 Answer: A Response: Bond A: $1,150 = $50 {[1 – 1/(1 + R)50 ]/ R} + 1,000 / (1 + R)50; R = 4.27%; Bond B: price = $40 [(1 – 1/1.042750) / .0427] + 1,000 / 1.042750 = $944.58 First, compute the YTM for bond A, thusly: 1000 FV, 25×2=N, 50 PMT, -1,150 PV, CPT I/Y = YTM = 4.27. Then compute PV of bond B: 1000 FV, 40 PMT, 25×2= N, 4.27 I/Y, CPT PV = -944.58 41. If corporate bond yields are at 8.4% and you are in the 34% federal marginal income tax bracket, at what level of municipal bond yields would you be indifferent between owning corporate bonds or muni bonds? Ignore the impact of state and local taxes. A) 5.95% B) 5.54% C) 5.03% D) 4.67% E) 4.11% Answer: B Response: 8.4(1 – .34) = 5.54% CHAPTER 6 QUESTIONS END HERE. CHAPTER 7 QUESTIONS BEGIN HERE 1. The stock valuation model that determines the current stock price as the next dividend divided by the (discount rate less the dividend growth rate) is called the: A) Zero growth model. B) Dividend growth model. C) Capital Asset Pricing Model. D) Earnings capitalization model. Answer: B 2. A stock’s next expected dividend divided by the current stock price is the: A) Current yield. B) Total yield. C) Dividend yield. D) Capital gains yield. E) Earnings yield. Answer: C 3. The rate at which the stock price is expected to appreciate (or depreciate) is the: A) Current yield. B) Total yield. C) Dividend yield. D) Capital gains yield. E) Earnings yield. Answer: D 4. Payments made by a corporation to its shareholders, in the form of either cash, stock, or payments in kind, are called: A) Retained earnings. B) Net income. C) Dividends. D) Redistributions. E) Infused equity. Answer: C 5. The market in which new securities are originally sold to investors is the ________ market. A) dealer B) auction C) over-the-counter (OTC) D) secondary E) primary Answer: E 6. The market in which previously issued securities are traded among investors is the: A) Dealer market. B) Auction market. C) Over-the-counter (OTC) market. D) Secondary market. E) Primary market. Answer: D 7. Common stock valuation requires, among other things, information regarding the: I. Expected dividend growth rate. II. Current dividend payment. III. Par value of the common stock. A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III Answer: B 8. As illustrated using the dividend growth model, the total return on a share of common stock is comprised of a ___________. A) capital gains yield and a dividend growth rate B) capital gains growth rate and a dividend growth rate C) dividend payout ratio and a required rate of return D) dividend yield and the present dividend E) dividend yield and a capital gains yield Answer: E 9. Which of the following items would usually appear for a stock quote in The Wall Street Journal? A) Capital gains rate B) Dividend yield C) Number of shares outstanding D) Par value of the stock E) Dividend growth rate Answer: B 10. If dividends on a common stock are expected to grow at a constant rate forever, and if you are told the most recent dividend paid, the dividend growth rate, and the appropriate discount rate today, you can calculate ___________. I. the price of the stock today II. the dividend that is expected to be paid ten years from now III. the appropriate discount rate ten years from now A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III Answer: B 11. Which of the following statements regarding dividend yields is true? A) It measures how much the stock’s price will increase in a year. B) It incorporates the par value of the stock into the calculation. C) It is analogous to the current yield for a bond. D) It is always greater than the stock’s capital gains yield. E) It measures the total annual return an investor can expect to earn by owning the stock. Answer: C 12. Which of the following is (are) true? I. The dividend yield on a stock is the annual dividend divided by the par value. II. When the constant dividend growth model holds, g = capital gains yield. III. The total return on a share of stock = dividend yield + capital gains yield. A) I only B) II only C) I and II only D) II and III only E) I, II, and III Answer: D 13. If some shareholders have greater voting power than others, it must be that: A) The company has both preferred stock and common stock outstanding. B) The company has outstanding debentures. C) The company is located outside the United States in a tax-haven locale. D) The company has multiple classes of common stock. E) The company is in bankruptcy proceedings. Answer: D 14. What would you pay for a share of ABC Corporation stock today if the next dividend will be $3 per share, your required return on equity investments is 15%, and the stock is expected to be worth $90 one year from now? A) $78.26 B) $80.87 C) $82.56 D) $90.00 E) $98.12 Answer: B Response: P0 = $3 / 1.15 + 90 / 1.15 = $80.87 15. The dividend on Simple Motors common stock will be $3 in 1 year, $4.25 in 2 years, and $6.00 in 3 years. You can sell the stock for $100 in 3 years. If you require a 12% return on your investment, how much would you be willing to pay for a share of this stock today? A) $75.45 B) $77.24 C) $81.52 D) $85.66 E) $91.30 Answer: C Response: P0 = $3.00 / 1.12 + 4.25 / 1.122 + 106 / 1.123 = $81.52 16. A stock that pays a constant dividend of $1.50 forever currently sells for $10.71. What is the required rate of return? A) 10% B) 12% C) 13% D) 14% E) 15% Answer: D Response: $10.71 = $1.50 / R; R = 14% 17. ABC Company’s preferred stock is selling for $30 a share. If the required return is 8%, what will the dividend be two years from now? A) $2.00 B) $2.20 C) $2.40 D) $2.80 E) $3.25 Answer: C Response: $30 = D / .08; D = $2.40 18. What would you pay today for a stock that is expected to make a $2 dividend in one year if the expected dividend growth rate is 5% and you require a 12% return on your investment? A) $28.57 B) $29.33 C) $31.43 D) $43.14 E) $54.30 Answer: A Response: P0 = $2 / (.12 – .05) = $28.57 19. The stock of MTY Golf World currently sells for $90 per share. The firm has a constant dividend growth rate of 6% and just paid a dividend of $5.09. If the required rate of return is 12%, what will the stock sell for one year from now? A) $ 90.00 B) $ 93.52 C) $ 95.40 D) $ 99.80 E) $112.78 Answer: C Response: P1 = P0(1 + g) = $90 (1.06) = $95.40 20. Llano’s stock is currently selling for $40.00. The expected dividend one year from now is $2 and the required return is 13%. What is this firm’s dividend growth rate assuming the constant dividend growth model is appropriate? A) 8% B) 9% C) 10% D) 11% Answer: A Response: g = .13 – ($2 / 40) = 8% 21. The current price of XYZ stock is $80.00. Dividends are expected to grow at 5% indefinitely and the most recent dividend was $2.75. What is the required rate of return on XYZ stock? A) 7.3% B) 8.7% C) 9.5% D) 10.6% E) 11.2% Answer: B Response: R = ($2.89 / 80) + .05 = 8.7% 22. ABC Corporation’s common stock dividend yield is 3.61%, it just paid a dividend of $2.75, and is expected to pay a dividend of $2.89 one year from now. Dividends are expected to grow at a constant rate indefinitely. What is the required rate of return on ABC stock? A) 7.3% B) 8.7% C) 9.5% D) 10.6% E) 11.2% Answer: B Response: ($2.89 – 2.75) / 2.75 = .051; R = .036 + .051 = 8.7% 23. If Big Amp, Inc. stock closed at $36 and the current quarterly dividend is $0.75 per share, what dividend yield would be reported for the stock in The Wall Street Journal? A) 2.0% B) 3.6% C) 5.7% D) 6.6% E) 8.3% Answer: E Response: DY = ($0.75 x 4) / 36 = 8.3% 24. Suppose NoGro, Inc. has just issued a dividend of $3.25 per share. Subsequent dividends will remain at $3.25 indefinitely. Returns on the stock of firms like NoGro are currently running 10%. What is the value of one share of stock? A) $22.50 B) $27.25 C) $32.50 D) $37.25 E) $39.75 Answer: C Response: P0 = $3.25 / .10 = $32.50 25. Suppose Pale Hose, Inc. has just paid a dividend of $1.80 per share. Sales and profits for Pale Hose are expected to grow at a rate of 8% per year. Its dividend is expected to grow by the same amount. If the required return is 14%, what is the value of a share of Pale Hose? A) $18.00 B) $25.20 C) $27.80 D) $30.60 E) $32.40 Answer: E Response: P0 = [$1.80(1.08)] / (.14 – .08) = $32.40 26. Suppose that you have just purchased a share of stock for $40. The most recent dividend was $2 and dividends are expected to grow at a rate of 7% indefinitely. What must your required return be on the stock? A) 5.45% B) 7.00% C) 10.25% D) 12.35% E) 13.65% Answer: D Response: R = [$2(1.07)] / 40 + – .07 = 12.35% 27. The preferred stock of the Limbaugh Institute pays a constant annual dividend of $4 and sells for $50. You believe the stock will sell for $32 in one year. You must, therefore, believe that the required return on the stock will be _____ percentage points ________ in one year. A) 8; higher B) 8; lower C) 1.5; higher D) 2.5; lower E) 4.5; higher Answer: E Response: current: $50 = $4 / R; R = 8%; future: $32 = $4 / R; R = 12.5 28. A firm’s stock has a required return of 12%. The stock’s dividend yield is 5%. What is the dividend the firm is expected to pay in one year if the current stock price is $50? A) $2.00 B) $2.50 C) $3.00 D) $3.50 E) $4.00 Answer: B Response: D1 = $50 (.05) = $2.50 29. A firm’s stock has a required return of 12%. The stock’s dividend yield is 5%. What dividend did the firm just pay if the current stock price is $50? A) $2.18 B) $2.34 C) $2.50 D) $2.87 E) $3.60 Answer: B Use the following to answer questions 30-36: 30. Duke stock must have closed at ___________ per share on the previous trading day. A) $29.64 B) $30.76 C) $30.99 D) $31.55 E) $32.11 Answer: B Response: 30.76 – 0.56 = 30.20 31. For the current year, the expected dividend per share is: A) $0.25 B) $1.00 C) $2.00 D) $3.30 E) $4.00 Answer: B Doing the algebra? Expected DPS = Yld x Close = .033 x 30.20 = 1 32. Assume the expected growth rate in dividends is 10%. Then the constant growth model suggests that the required return on Duke stock is: A) 7.4% B) 8.9% C) 11.0% D) 13.6% E) 15.8% Answer: D Response: R = [($1.00 x 1.10) / 30.20] + .10 = 13.6% 33. Based on the quote, a good estimate of EPS over the last four quarters is: A) $0.80 B) $1.21 C) $1.68 D) $1.91 E) $2.54 Answer: C Response: EPS = $30.20 / 18 = $1.68 34. On this trading day, the number of Duke shares which changed hands was: A) 209 B) 2,092 C) 20,925 D) 209,250 E) 2,092,500 Answer: E The algebra? How about 20,925 x 100 = 2,092,500 35. Assume that Duke paid a $0.92 annual dividend in the previous period. What is the dividend growth rate based on this quote? A) 4.8% B) 6.0% C) 7.2% D) 8.7% E) 9.9% Answer: D : Response: g = ($1.00 / 0.92) – 1 = 8.7% 36. You believe that the required return on Duke stock is 16% and that the expected dividend growth rate is 12%, which is expected to remain constant for the foreseeable future. Is the stock currently overvalued, undervalued, or fairly priced? A) Overvalued B) Undervalued C) Fairly priced D) Cannot tell without more information Answer: A Response: P0 = [$1.00 (1.12) ] / (.16 – .12) = $28.00; overvalued at $30.20 in the market CHAPTER 7 QUESTIONS END HERE CHAPTER 8 QUESTIONS BEGIN HERE 1. The difference between the market value of an investment and its cost is the: A) Net present value. B) Internal rate of return. C) Payback period. D) Profitability index. E) Discounted payback period. Answer: A 2. The net present value (NPV) rule can be best stated as: A) An investment should be accepted if, and only if, the NPV is exactly equal to zero. B) An investment should be rejected if the NPV is positive and accepted if it is negative. C) An investment should be accepted if the NPV is positive and rejected if its is negative. D) An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur, will always have a positive NPV and therefore should always be accepted. Answer: C 3. The length of time required for an investment to generate cash flows sufficient to recover its initial cost is the: A) Net present value. B) Internal rate of return. C) Payback period. D) Profitability index. E) Discounted payback period. Answer: C 4. The payback rule can be best stated as: A) An investment is acceptable if its calculated payback period is less than some prespecified number of years. B) An investment should be accepted if the payback is positive and rejected if it is negative. C) An investment should be rejected if the payback is positive and accepted if it is negative. D) An investment is acceptable if its calculated payback period is greater than some prespecified number of years. Answer: A 5. The discount rate that makes the net present value of an investment exactly equal to zero is the: A) Payback period. B) Internal rate of return. C) Average accounting return. D) Profitability index. E) Discounted payback period. Answer: B 6. The internal rate of return (IRR) rule can be best stated as: A) An investment is acceptable if its IRR is exactly equal to its net present value (NPV). B) An investment is acceptable if its IRR is exactly equal to zero. C) An investment is acceptable if its IRR is less than the required return, else it should be rejected. D) An investment is acceptable if its IRR exceeds the required return, else it should be rejected. Answer: D 7. A situation in which taking one investment prevents the taking of another is called: A) Net present value profiling. B) Operational ambiguity. C) Mutually exclusive investment decisions. D) Issues of scale. E) Multiple rates of return. Answer: C 8. The present value of an investment’s future cash flows divided by its intial cost is the: A) Net present value. B) Internal rate of return. C) Average accounting return. D) Profitability index. E) Payback period. Answer: D 9. The profitability index (PI) rule can be best stated as: A) An investment is acceptable if its PI is greater than one. B) An investment is acceptable if its PI is less than one. C) An investment is acceptable if its PI is greater than the internal rate of return (IRR). D) An investment is acceptable if its PI is less than the net present value 10. Which of the following statements is true? A) NPV should never be used if the project under consideration has nonconventional cash flows. B) NPV is similar to a cost/benefit ratio. C) If the financial manager relies on NPV in making capital budgeting decisions, she acts in the shareholders’ best interests. D) NPV can normally be directly observed in the marketplace. E) IRR is generally preferred to NPV in making correct capital budgeting acceptance decisions. Answer: C 11. Net present value _____________. A) is equal to the initial investment in a project B) is equal to the present value of the project benefits C) is equal to zero when the discount rate used is equal to the IRR D) is simplified by the fact that future cash flows are easy to estimate E) requires the firm set an arbitrary cutoff point for determining whether an investment is acceptable Answer: C 12. The _______ decision rule is considered the “best” in principle. A) internal rate of return B) payback period C) average accounting return D) net present value E) profitability index Answer: D 13. Which of the following decision rules is best for evaluating projects for which cash flows beyond a specified point in time, and the time value of money, can both be ignored? A) Payback B) Net present value C) Average accounting return D) Profitability index E) Internal rate of return Answer: A 14. An investment generates $1.10 in present value benefits for each dollar of invested costs. This conclusion was most likely reached by calculating the project’s: A) Net present value B) Profitability index C) Internal rate of return D) Payback period E) Average accounting return Answer: B 15. The use of which of the following would lead to correct decisions when comparing mutually exclusive investments? I. Profitability index II. Net present value III. Average accounting return A) I only B) II only C) III only D) I and II only E) I and III only Answer: B 16. You own some manufacturing equipment that must be replaced. Two different suppliers present a purchase and installation plan for your consideration. This is an example of a business decision involving _____________ projects. A) mutually exclusive B) independent C) working capital D) positive NPV E) crossover Answer: A 17. If a project with conventional cash flows has an IRR less than the required return, then: A) The profitability index is less than one. B) The IRR must be zero. C) The AAR is greater than the required return. D) The payback period is less than the maximum acceptable period. E) The NPV is positive. Answer: A 18. Calculate the NPV of the following project using a discount rate of 10%: Yr 0 = –$800; Yr 1 = –$80; Yr 2 = $100; Yr 3 = $300; Yr 4 = $500; Yr 5 = $500 A) $ 8.04 B) $ 87.28 C) $208.04 D) $459.17 E) $887.28 Answer: B Response: NPV = -$800 – 80 / 1.1 + 100 / 1.12 + 300 / 1.13 + 500 / 1.14 + 500 / 1.15 = $87.28 Using your cashflow keys? CF0= -800, CO1 = -80, FO1=1, CO2 = 100, FO2=1, CO3 = 300, FO3=1, CO4 = 500, FO4=2. Then hit the NPV key, type in 10 for “I,” hit the down arrow to get you back to the NPV display, and hit CPT and you get 87.28. 19. You are considering a project that costs $600 and has expected cash flows of $224, $250.88 and $280.99 over the next three years. If the appropriate discount rate for the project’s cash flows is 12%, what is the net present value of this project? A) The NPV is negative B) $ 0.00 C) $ 9.34 D) $49.34 E) $84.75 Answer: B CFO = -600, CO1=224, CO2=250.88, CO3=280.99. All the FO’s are equal to one, with each cash flow occurring once. After entering all the Cashflows (the CO1’s, 2’s and 3’s), hit the NPV key, set I equal to 12, hit the down arrow to get back to NPV, hit CPT and you get about zero, or B. 20. A project costs $300 and has cash flows of $75 for the first three years and $50 in each of the project’s last three years. What is the payback period of the project? A) The project never pays back B) 3.75 years C) 4.50 years D) 5.25 years E) 5.50 years Answer: C Response: recover $275 in 4 years, need $25 / 50 = 4.50 years 21. Suppose a project costs $2,500 and produces cash flows of $400 over each of the following 8 years. What is the IRR of the project? A) There is not enough information; a discount rate is required B) 3.27% C) 5.84% D) 9.61% E) 12.06% Answer: C Response: $2,500 = $400 {[1 – 1/(1 + IRR)8] / IRR}; IRR = 5.84% -2,500 PV, 400 PMT, 8 N, CPT I/Y = 5.84% Or you could use your CF keys … but with equally sized cashflows, the TVOM keys are easier. 22. A project has an initial investment of $25,000, with $6,500 annual inflows for each of the subsequent 5 years. If the required return is 12%, what is the NPV? A) –$6,500.00 B) –$2,447.02 C) –$1,568.95 D) $ 215.46 E) $1,763.81 Answer: C Response: NPV = -$25,000 + 6,500 [(1 – 1/1.125) / .12] = -$1,568.95 6,500 PMT, 5 N, 12 I/Y, CPT PV = 23,431 the present value of your inflows. Your NPV = PV(Inflows) – PV (outflows) = 23,431 – 25,000 or a negative 1,569. 23. What is the NPV of the following set of cash flows if the required return is 15%? A) The NPV is negative B) $ 408.27 C) $ 950.44 D) $1,247.90 E) $4,656.12 Answer: B CF0 = -10000 CO1 = -1000 FO1 = 1 CO2 = 10000 FO2 = 2 CO3 = -5000 I = 15 NPV = 408.27 24. Would you accept a project which is expected to pay $2,500 a year for 6 years if the initial investment is $10,000 and your required return is 8%? A) Yes; the NPV is $1,557 B) Yes; the NPV is $928 C) Yes; the NPV is $63 D) No; the NPV is –$346 E) No; the NPV is –$1,221 Answer: A Response: NPV = + 2,500[(1 – 1/1.086) / .08] = $1,557.20 2,500 PMT, 6 N, 8 I/Y, CPT PV = 11,557, which is greater than the $10,000 cost by $1,557, so you DO THIS DEAL!! You accept. 25. What is the payback period of a $15,000 investment with the following cash flows? A) 2.75 years B) 3.50 years C) 3.75 years D) 4.50 years E) 4.75 years Answer: B Response: recover $12,000 in 3 years, need $3,000 / 6,000 = 3.50 years 26. You are considering an investment which has the following cash flows. If you require a 5 year payback period, should you take the investment? A) Yes, the payback is 3.000 years. B) Yes, the payback is 3.75 years. C) Yes, the payback is 4.25 years. D) No, the payback is 5.25 years. E) No, the payback is 5.75 years. Answer: C Response: recover $27,500 in 4 years, need $2,500 / 10,000 = 4.25 years 27. Your required return is 15%. Should you accept a project with the following cash flows? A) No, because the IRR is 5%. B) No, because the IRR is 10%. C) Yes, because the IRR is 20%. D) Yes, because the IRR is 30%. E) Yes, because the IRR is 40%. Answer: D Response: $25 = $10 / (1 + IRR) + 10 / (1 + IRR)2 + 25 / (1 + IRR)3; IRR = 30% CF0=-25, CO1=10, FO1=2, CO2=25, FO2=1, IRR, CPT, IRR = 29.97% or about 30% 28. You are going to choose between two investments. Both cost $50,000, but investment A pays $25,000 a year for 3 years while investment B pays $20,000 a year for 4 years. If your required return is 12%, which should you choose? A) A because it pays back sooner. B) A because its IRR exceeds 12%. C) A because it has a higher IRR. D) B because its IRR exceeds 12%. E) B because it has a higher NPV. Answer: E Response: A: NPV = + 25,000 [(1 – 1/1.123) / .12] = $10,046 B: NPV = + 20,000 [(1 – 1/1.124) / .12] = $10,747 29. Using the profitability index, which of the following projects would you choose if you have limited funds? ProjectInitial InvestmentNPV1$50,000$10,000275,00025,000360,00015,000440,00017,000590,00040,000 A) Project 1 B) Project 2 C) Project 3 D) Project 4 E) Project 5 Answer: E Response: Project 1: PI = $60,000 / 50,000 = 1.200; Project 2: PI = $100,000 / 75,000 = 1.333 Project 3: PI = $75,000 / 60,000 = 1.250; Project 4: PI = $57,000 / 40,000 = 1.425 Project 5: PI = $130,000 / 90,000 = 1.444 30. You have a choice between 2 mutually exclusive investments. If you require a 15% return, which investment should you choose? A) Project A, because it has a smaller initial investment. B) Project B, because it has a higher NPV. C) Either one, because they have the same profitability indexes. D) Project A, because it has the higher internal rate of return. E) Project B, because it pays back faster. Answer: B Response: A: NPV = + 20,000 / 1.15 + 40,000 / 1.152 + 80,000 / 1.153 = $238 B: NPV = + 75,000 / 1.15 + 45,000 / 1.152 + 40,000 / 1.153 = $545 31. For a project with an initial investment of $8,000 and cash inflows of $2,000 each year for 6 years, calculate NPV given a required return of 13%. A) –$846 B) –$263 C) $ 0 D) $149 E) $552 Answer: C Response: NPV = -$8,000 + 2,000 [(1 – 1/1.136) / .13] = $0 (actual -$4.90) Use your TVOM keys with equally-sized cash flows. Thusly: 2000 PMT, 6 N, 13 I/Y, CPT PV = 7,995, which is less than 8,000, so your NPV would be about a negative five bucks, as with the algebra above. 32. What is the IRR of an investment that costs $18,500 and pays $5,250 a year for 5 years? A) 13% B) 15% C) 19% D) 25% E) 28% Answer: A Response: $18,500 = $5,250 {[1 – 1/(1 + IRR)5] / IRR}; IRR = 12.92% Just use your TVOM keys with equal cash flows to calculate IRR. Thusly: -18,500 PV, 5,250 PMT, 5 N, CPT I/Y = IRR with equally-sized cash-flows or 12.92% 33. What is the profitability index of the following investment if the required return = 10%? A) 0.94 B) 1.09 C) 1.18 D) 1.27 E) 1.45 Answer: B Response: PV = $50 / 1.1 + 75 / 1.12 + 75 / 1.13 = $163.79; PI = $163.79 / 150 = 1.09 34. What is the payback period for the following investment? A) 4 years B) 3 years C) 2 years D) 1 year E) The investment doesn’t payback Answer: E Response: recover $10,000 + 8,000 + 4,000 + 2,000 = $24,000; never pays back Use the following to answer questions 35-38: Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost $50,000. Bill expects the after-tax cash inflows to be $15,000 annually for 8 years, after which he plans to scrap the equipment and retire to the beaches of Jamaica. 35. What is the project’s payback period? A) 2.67 years B) 3.33 years C) 3.67 years D) 4.33 years E) 5.67 years Answer: B Response: payback = $50,000 / 15,000 = 3.33 years 36. Assume the required return is 10%. What is the project’s NPV? A) $ 887 B) $13,322 C) $22,759 D) $30,024 E) $45,001 Answer: D Response: NPV = + 15,000 [(1 – 1/1.108) / .10] = $30,023.89 Use the CF keys for practice: CF0=-50,000, CO1=15,000, FO1=8, NPV, I=10, NPV = 30,024 Practice these questions using our BA II Plus review sheet problems 18-22. 37. Assume the required return is 20%. What is the project’s IRR? Should it be accepted? A) 15%; yes B) 15%; no C) 25%; yes D) 25%; no E) 20%; indifferent Answer: C Response: $50,000 = $15,000 {[1 – 1/(1 + IRR)8] / IRR}; IRR = 24.95% > 20%; accept -50,000 PV, 15,000 PMT, 8 N, CPT I/Y = IRR = 24.95% 38. Assume the required return is 20%. What is the project’s PI? Should it be accepted? A) 0.85; yes B) 0.85; no C) 1.00; indifferent D) 1.15; yes E) 1.15; no Answer: D Response: PV of inflows = $15,000 [(1 – 1/1.28) / .2] = $57,557; PI = $57,557 / 50,000 = 1.15; accept At a discount rate of 20%, the PV of the inflows equals the NPV of 7,557 plus the cost of 50,000 or 57,557. (Recall the PV(Inflows) = NPV + PV(Outflows)) END OF CHAPTER 8 QUESTIONS

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