CORPORATE FINANCE
Practice Exam 1
1) The primary goal of a publicly-owned firm interested in serving its stockholders should be to
A) Maximize expected total corporate profit.
B) Maximize expected EPS.
C) Minimize the chances of losses.
D) Maximize the stock price per share.
E) Maximize expected net income.
2) Joe, who has substantial personal wealth and income, is considering the possibility of opening a new business in the chemical waste management field. She will be the sole owner. The business will have a relatively high degree of risk, and it is expected that the firm will incur losses for the first few years. However, the prospects for growth and positive income look good, and Jane expects to realize substantial cash flows from dividends the firm will eventually pay out. Which of the legal forms of business organization would probably best suit her needs?
A) Proprietorship, because of ease of raising capital.
B) Regular corporation, because of the unlimited liability.
C) Partnership, to share costs and profits.
D) S corporation, to enjoy tax advantages and gain limited liability.
3) Holmes Aircraft recently announced an increase in its net income, yet its net cash flow declined relative to last year. Which of the following could explain this performance?
A) The company’s interest expense increased.
B) The company’s depreciation expense declined.
C) The company’s operating income declined.
D) All of the statements above are correct.
E) None of the statements above is correct.
4) Which of the following would not cause an increase in net operating working capital?
A) Inventory increases.
B) Accounts receivable increases.
C) Short-term investments increase.
D) Accounts payable decreases.
E) Accruals decrease.
5) Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which of the following definitely cannot help explain this decline?
A) Sales revenues decreased.
B) Cost of goods sold increased.
C) Depreciation increased.
D) Interest expense increased.
E) Taxes increased.
6) A person can investor in two types of debt. She can earn 7.5 percent if invests in municipal bonds. The investor can also earn 8.5 percent (before-tax) by investing in corporate bonds. Assume that the two investments have equal risk. What is the break-even corporate tax rate which makes the investor indifferent between the two investments?
- 88.24%
- 24.88%
- 11.76%
- 39.22%
- 49.33%
7) Hayes Corporation has $300 million worth of common equity on its balance sheet, and 6 million shares of stock outstanding. The company’s Market Value Added (MVA) is $162 million. What is the company’s stock price?
A) $ 23
B) $ 32
C) $ 50
D) $ 77
E) $138
8) Bates Motors has the following information for the previous year: Net income = $200; Net operating profit after taxes (NOPAT) = $300; Total assets = $1,000; and Total operating capital = $800. The information for the current year is: Net income = $500; Net operating profit after taxes (NOPAT) = $400; Total assets = $1,300; and Total operating capital = $900. What is the free cash flow for the current year?
A) $100
B) $200
C) $300
D) $400
E) $500
9) Pepsi Corporation’s current ratio is 0.5, while Coke Company’s current ratio is 1.5. Both firms want to “window dress” their coming end-of-year financial statements. As part of their window dressing strategy, each firm will double its current liabilities by adding short-term debt and placing the funds obtained in the cash account. Which of the statements below best describes the actual results of these transactions?
A) The transactions will have no effect on the current ratios.
B) The current ratios of both firms will be increased.
C) The current ratios of both firms will be decreased.
D) Only Pepsi Corporation’s current ratios will be increased.
E) Only Coke Company’s current ratio will be increased.
10) Company J and Company K each recently reported the same earnings per share (EPS). Company J’s stock, however, trades at a higher price. Which of the following statements is more correct?
A) Company J must have a higher P/E ratio.
B) Company J must have a higher market to book ratio.
C) Company J must be riskier.
D) Company J must have fewer growth opportunities.
11) Company R and Company S each have the same operating income (EBIT) and basic earning power (BEP) ratio. Company S, however, has a lower times-interest-earned (TIE) ratio. Which of the following statements is most correct?
A) Company S has a higher ROA.
B) Company S has a higher net income.
C) Company S has a higher interest expense.
D) Company S has a higher debt ratio.
E) Company S has a higher equity multiplier.
12) A firm is considering actions which will raise its debt ratio. It is anticipated that these actions will have no effect on sales, operating income, or on the firm’s total assets. If the firm does increase its debt ratio, which of the following will occur?
A) Return on assets will increase.
B) Basic earning power will decrease.
C) Times interest earned will increase.
D) Profit margin will decrease.
E) Total assets turnover will increase.
13) Your are given the following information: Stockholders’ equity = $1,250; price/earnings ratio = 5; shares outstanding = 25; market/book ration = 1.5. Calculate the market price of a share of the company’s stock.
A) $ 33.33
B) $ 75.00
C) $ 10.00
D) $ 166.67
E) $ 133.32
14) 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 firm’s ROA?
A) 8.4%
B) 10.9%
C) 12.0%
D) 13.3%
E) 15.1%
15) Traditional financial statements are designed more for use by _____ and ______than for ______and ______. Therefore, certain modifications and re-calculations of the financials are used for corporate decision-making and stock valuations.
A) corporate officers, board of directors; lenders, IRS.
B) managers, equity analysts; creditors, tax collectors.
C) institutional investors, funds managers; bankers, IRS.
D) creditors, tax collectors; managers, equity analysts.
16) (OMIT) Assume the interest rates on long-term 30 year bonds were as follows:
T-bond = 7.72% A = 9.64%
AAA = 8.72% BBB = 10.18%
The difference in rates among these issues were caused primarily by
A) Tax effects,
B) Default risk differences.
C) Maturity risk differences.
D) Inflation differences.
E) Answers b and d are correct.
17) (OMIT) Given the following data, find the expected rate of inflation during the next year.
k* = real risk-free rate = 3%.
Maturity risk premium on 10-year T-bond = 2%. It is zero on 1-year bonds, and a linear relationship exists.
Default risk premium on 10-year, A-rated bonds = 1.5%.
Liquidity premium = 0%.
Going interest rate on 1-year T-bonds = 8.5%
A) 3.5%
B) 4.5%
C) 5.5%
D) 6.5%
E) 7.5%
18) (OMIT) Your are given the following data:
k* = real risk-free rate = 4%
Constant inflation premium = 7%
Maturity risk premium = 1%
Default risk premium for AAA bonds = 3%
Liquidity premium for long-term T-bonds = 2%
Assume that a highly liquid market does not exist for long-term T-bonds, and the expected rate of inflation
is a constant. Given these conditions, the nominal risk-free rate for T-bills is ______. And the rate on long-term treasury bonds is ______.
A) 4%: 14%
B) 4%: 15%
C) 11%: 14%
D) 11%: 15%
E) 11%: 17%
19) (OMIT) You read in The Wall Street Journal that one-year T-bills are currently yielding 8 percent. Your brother-in-law, a broker at Kyoto Securities, has given you the following estimates of current interest rate premiums:
Inflation premium 5%
Liquidity premium 1%
Maturity risk premium 2%
Default risk premium 2%
Based on these data, the real risk-free rate of return is
A) 0%
B) 1%
C) 2%
D) 3%
E) 4%
20) You are interested in investing your money in a bank account. Which of the following banks provides you with the highest effective rate of interest?
A) Bank 1; 8 percent with monthly compounding.
B) Bank 2; 8 percent with annual compounding.
C) Bank 3; 8 percent with quarterly compounding.
D) Bank 4; 8 percent with daily (365-day) compounding.
E) Bank 5; 7.8 percent with annual compounding.
21) Suppose someone offered you the choice of two equally risky annuities, each paying $10,000 per year for five years. One is an ordinary (or deferred) annuity, the other is an annuity due. Which of the following statements is correct?
A) The present value of the ordinary annuity must exceed the present value of the annuity due, but the future value of an ordinary annuity may be less than the future value of the annuity due.
B) The present value of the annuity due exceeds the present value of the ordinary annuity, while the future value of the annuity due is less than the future value of the ordinary annuity.
C) The present value of the annuity due exceeds the present value of the ordinary annuity, and the future value of the annuity due also exceeds the future value of the ordinary annuity.
D) If interest rates increase, the difference between the present value of the ordinary annuity and the present value of the annuity due remains the same.
22) If $100 is placed in an account that earns a nominal 4 percent, compounded quarterly, what will it be worth in 5 years?
A) $122.02
B) $105.10
C) $135.41
D) $120.90
E) $117.48
23) In 1958 the average tuition for one year at an Ivy League school was $1,800. Thirty years later, in 1988, the average cost was #13,700. What was the growth rate in tuition over the 30-year period?
A) 12%
B) 9%
C) 6%
D) 7%
E) 8%
24) South Penn Trucking is financing a new truck with a loan of $10,000 to be repaid in 5 annual end-of-year installments of $2,504.56. What annual interest rate is the company paying?
A) 7%
B) 8%
C) 9%
D) 10%
E) 11%
25) All of the following except one are problems or limitations with ratio analysis. Which IS NOT?
A) Ratios may be distorted by seasonal factors or manipulated by management via “window dressing”.
B) Inflation distorts financial statement results.
C) Ratios are often not useful for analyzing operations of large firms which operate in many different industries.
D) When used by itself, ratio analysis provides strong insights into the company’s operations.
E) Ratios that reflect average performance levels are not necessarily good.
PROBLEMS
1. Swann Systems is forecasting the following income statement for the upcoming year:
Sales / $ 5,000,000Operating costs (excl. depr.) / 3,000,000
Gross margin / $ 2,000,000
Depreciation / 500,000
EBIT / $ 1,500,000
Interest / 500,000
EBT / $ 1,000,000
Taxes (40%) / 400,000
Net income / $ 600,000
The company's president is disappointed with the forecast and would like to see Swann generate higher sales and a forecasted net income of $2,000,000. Assume the operating costs (excluding depreciation) are always 60 percent of sales. Also, assume that depreciation, interest expense, and the company's tax rate, which is 40 percent, will remain the same even sales change. What level of sales would Swann have to obtain to generate $ 2,000,000 in net income?
A= $10,833,333
2. A firm has total assets of $1,000,000 and a debt ratio of 30 percent. Currently, it has sales of $2,500,000, total fixed costs of $1,000,000, and EBIT of $50,000. If the firm’s before-tax cost of debt is 10 percent and the firm’s tax rate is 40 percent, what is the firm’s ROE?
A=1.7%
3. Lone Star Plastics has the following data:
Assets: / $100,000 / Profit margin: / 6.0% / Tax rate: / 40%Debt ratio: / 40.0% / Interest rate / 8.0% / Total assets turnover: / 3.0
What is Lone Starr's EBIT?
A=$33,200
4. Your are interested in saving money for your first house. Your plan is to make regular deposits into a brokerage account which will earn 14 percent. Your first deposit of $5,000 will be made today. You also plan to make four additional deposits at the beginning of each of the next four years. Your plan is to increase your deposits by 10 percent a year. (That is, you plan to deposit $5,500 at t = 1, and $6,050 at t+ 2, etc.) How much money will be in your account in five years?
A=$44,873