Name ________KEY _________________

Finance 8310
Holland, Exit Exam

1. Determining the best way to raise cash for a business falls primarily into which of the following
topics?
a. capital budgeting
b. working capital management
c. net working capital management
* d. capital structure
e. financial distress

Answer: Raising cash for a business involves changes in the right side of the balance sheet, which
involves capital structure.

2. Which of the following is NOT a cash expense on the income statement?

a. income taxes paid
* b. depreciation
c. loan interest payments
d. wages paid
e. cost of goods sold

Answer: Depreciation is a non-cash deduction designed to account for the

fact that fixed assets wear out over time even though they were paid for at
the time of installation.

3. Which of the following should be the goal of the financial manager of a

corporation?
a. to minimize the variance of share prices in the long run
b. to maximize profit
* c. to maximize current stock value
d. to maximize earnings
e. to maximize market share

Answer: A goal of financial management is to maximize the value of the firm, which also translates
into maximizing the current stock price.

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Use the following information to answer questions 4 - 9.
Young, Inc.
Balance Sheets as of December 31, 1990 and 1991
($ in millions)
Assets Liabilities and Owners' Equity
Current Assets 1990 1991 Current Liabilities 1990 1991
Cash $ 95 $ 102 Accounts Payable $ 200 $ 325
Accounts Receivable 335 400 Notes Payable 351 410
Inventory 369 438 Total 551 735
Total 799 940 Long-term debt 501 626
Fixed Assets 1556 1841 Common Stock 605 584
Total Assets $2355 $2781 Retained Earnings 698 836
Total Liabilities $2355 $2781

Young, Inc.
1991 Income Statement
($ in millions)
Net Sales $795
Less: Cost of Goods Sold298
Less: Depreciation 182
Earnings before interest and taxes 315
Less: Interest paid 87
Taxable income 228
Less: Taxes 72
Net income $156
Retained Earnings 138
Dividends Paid 18

4. What was Young's operating cash flow for 1991?

a. $159
b. $341
c. $351
* d. $425
e. $477

Answer: OCF = EBIT + Depreciation – Taxes = 315 + 182- 72 = 425

5. What was the company's capital spending for 1991?

a. $385
* b. $467

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 c. $637
d. $656
e. $822

Answer: Capital Spending = Ending NFA – Beginning NFA + Depreciation=1841-1556+182=467

6. What was the addition to net working capital for 1991?

* a. -$43
b. $2
c. $77
d. $161
e. $205

Answer: Ending NWC – Beginning NWC = (940-735) – (799-551) = 205-248 = -43

7. What was Young's cash flow from assets during 1991?

a. -$44
b. -$13
* c. $1
d. $79
e. $124

Answer: CF from Assets = OCF – Capital Spending - NWC = 425 - 467 - (-43) = 1

8. What was the company's cash flow to creditors in 1991?

a. $212
b. $87
c. $41
* d. -$38
e. -$212

Answer: CF to Creditors = Interest – Net New Debt = 87 – (626 – 501) = 87 – 125 = -38

9. What was the cash flow to stockholders?

a. -$3
b. $18
* c. $39
d. $61
e. $93

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 Answer: CF to Stockholders = Dividends – Net New Equity = 18 – (584 - 605) = 18 – (-21) = 39

10. Which of the following are sources of cash?

I. Increase in fixed assets
II. Accounts payable increase
III. Accounts receivable decrease
IV. Inventory increases
a. I only
* b. II and III only
c. III and IV only
d. I, II, and III only
e. I, II, III, and IV

Answer: I. An increase in assets is a use, II. An increase in liabilities is a source, III. A decrease
in assets is a source, and IV. An increase in assets is a use. So II. and III. are sources of cash.

11. In words, what does a profit margin of .15 mean?

* a. For each $1 of sales generated, the firm has a net income of fifteen cents.
b. For each $1 of sales generated, the firm earns fifteen cents before operating expenses.
c. The percentage by which costs have been "marked-up" in order to arrive at sales.
d. For every $1 in net income, the firm must generate fifteen cents in sales.
e. The firm is operating above the break-even point.

Answer: The definition of profit margin is net income over sales, so “a” is correct.

12. Assume a firm's current ratio equals 3.5. Which of the following actions would
decrease it?
* a. discarding and writing off spoiled inventory
b. receiving payment on an account receivable
c. paying off a short-term loan with long-term debt
d. receiving payment of an overdue bill from a customer
e. selling inventory for cash

Answer: “a” is correct since a write-off of inventory will reduce the inventory account but not
affect other current assets or current liabilities, thus reducing the current ratio. “b” is incorrect
because receiving a payment will decrease accounts receivable but increase cash the same amount
leaving current assets at the same level. “c” is incorrect because paying off a short-term loan with
long-term debt will decrease current liabilities without affecting current assets, thus increasing the
current ratio. “d” is incorrect because receiving an overdue payment will again reduce accounts
receivable but increase cash by the same amount, thus leaving the current ratio the same. “e” is
incorrect because selling inventory for cash will reduce the inventory account but increase the cash
account (probably by a larger amount since the selling price will be above the carrying cost in
inventory) and thus not decrease the current ratio.

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13. Between 1989 and 1993, the return on equity (ROE) of General Motors rose from 12.1% to
44.1%. During this same time, the profit margin actually declined as did the return on assets.
Which of the following caused this apparent contradiction?

a. Net income increased even though sales did not change much.
* b. The balance sheet was restated to reflect pension liabilities, and this caused equity to
decrease drastically, driving the equity multiplier way up.
c. The asset turnover increased dramatically, which indicates that assets were being used much
more efficiently.
d. A large amount of inventory was written off, which reduced profits, but increased cash flow.
e. Foreign competition caused GMs market share to decrease, which caused the stock price to
fall and ROE to increase.

Answer: “a” is incorrect because the problem states the profit margin decreased, so income could
not have increased and cause the profit margin to decrease unless the sales increased dramatically,
but the answer says that sales did not change much. “b” is correct because a reduction in the value
for equity would make the equity multiplier go up, and from the DuPont equation this could
increase ROE even though the profit margin and the asset turnover declined somewhat. “c” is
incorrect because the asset turnover could not have increase dramatically. “d” is incorrect because
writing off inventory reduces the reported net income, but this would reduce ROE (Net Income /
Equity). “e” is incorrect because a fall in the stock price does not change reported ROE, which is
calculated from book values.

14. A firm's ________ indicates the amount by which sales and assets can grow without the firm
needing to sell additional equity or change its debt to equity ratio or payout ratio.

a. dividend payout ratio b. retention ratio

* c. sustainable growth rate d. growth rate with no external financing
e. projected sales growth rate

Answer: This is the definition of the sustainable growth rate.

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Use the following information to answer questions 15 - 20.
Stansfield Corporation
Income Statement
($ in millions)
Sales $250
Costs 200
Taxable Income 50
Taxes 17
Net Income 33
Ret. Earnings 27
Dividends 6

Stansfield Corporation
Balance Sheet
($ in millions)
Assets Liabilities and Owners' Equity
Current Assets Current Liabilities
Cash $ 5 Accounts Payable $ 40
Accounts Receivable 40 Notes Payable 10
Inventory 75 Total 50
Total 120 Long-term debt 100
Fixed Assets Owners Equity
Property, Plant, Common Stock and APIC 75
and Equipment 180 Retained Earnings 75
Total Assets 300 Total 150
Total Liabilities 300

15. How much external financing is needed for a 20 percent increase in sales if the Corporation is
currently operating at full capacity?
a. $0 million
b. $13.2 million
* c. $19.6 million
d. $28 million
e. $37 million

Answer: This can be calculated by using the percent of sales Excel spreadsheet template.

16. Assume Stansfield Corporation is utilizing its fixed assets at 80 percent capacity. What would be
the external financing need if sales increase by 20 percent?
a. -$26.4 million
* b. -$16.4 million
 c. $13.2 million
d. $19.6 million
e. $28.0 million

Answer: This can be calculated from the spreadsheet template, changing the % capacity to 80%.

17. What is the internal growth rate for Stansfield Corporation?

a. 3.68 %
b. 6.53%
c. 9.89%
* d. 11.59%
e. 15.24%

Answer: This is calculated on the spreadsheet template using the formula

IGR = b*ROA/(1-b*ROA).

18. What is Stansfield Corporation's sustainable growth rate?

a. 3.68 %
b. 6.53 %
c. 10.83 %
d. 11.59 %
* e. 21.95 %

Answer: This is calculated on the spreadsheet template using the formula

SGR = b*ROE/(1-b*ROE).

19. What is the actual internal growth rate assuming 80% capacity?
a. 6.53%
b. 9.89%
c. 11.59%
* d. 31.98%
e. 46.72%

Answer: The actual internal growth rate must be calculated with trial and error using the
spreadsheet template. The easiest way to solve this problem is to use the answers in the multiple
choice question as the trial choices.

20. What is the actual sustainable growth rate assuming 80% capacity?
a. 21.95%
b. 31.98%
* c. 46.72%
d. 51.17%
e. 63.55%
 Answer: The actual sustainable growth rate must be calculated with trial and error using the
spreadsheet template by changing the growth rate and then adding the resulting EFN to one of the
debt accounts. The correct answer is reached when the debt to equity ratio for the pro forma
balance sheet equals the debt to equity ratio of the actual numbers. The easiest way to solve this
problem is to use the multiple choice answers as the trial guesses.

21. Suppose you notice in the Higgins textbook the formula for the growth rate of the firm,
which after some effort to re-arrange the notation looks like g=b*ROE. However, you also note
in the Ross et. al. textbook that the sustainable growth rate formula is different,
SGR=b*ROE/(1-b*ROE). Since these two formulas are clearly different, which one
is correct? (Make sure you pick the most correct answer here, not one that simply has some
correctness).
a. Higgins is correct, and Ross, et. al. is incorrect.
b. Ross, et. al. is correct, and Higgins is incorrect.
* c. They are both correct, but the Higgins formula looks different because the ROE uses
beginning of period equity rather than the standard end of period equity as in the Ross, et.al.
equation. Given this modified definition, they both yield the same number.
d. Actually, neither equation is correct even given the simplified assumptions that are made.
The sustainable growth rate is better determined using the dividend growth model.

Answer: “c” gives the correct explanation for the difference in the equations. Actually, Higgins
points this difference out clearly in a footnote to the equation.

22. A student who was testing my Excel template on the percent of sales pro forma forecasting
method noted that the Internal Growth Rate (IGR) formula (IGR=b*ROA/(1-b*ROA) ) did not
give the correct answer of EFN=0 when the capacity utilization in the actual year was less than
100%. Which of the following is most correct?
a. The equation is correct, so the spreadsheet must have an error in it.
b. The spreadsheet can certainly be correct with an EFN=0 at the IGR , so the formula in the
cell may be in error.
* c. Neither is really in error. The formula naively assumes all items in the income statement and
the left side of the balance sheet (when NWC is on the left side) grow at the same rate as
sales. When capacity is less than 100%, the fixed assets do not grow at the same rate as
sales. Thus, the pro forma approach would yield a higher actual Internal Growth Rate than
the formula. So the EFN should not be zero at the IGR when capacity is less than 100%.
d. Answer c is correct except that the pro forma approach should give a lower IGR.
Answer: The formula does indeed assume that everything other than debt and equity grows at the
same rate as sales. At any level of capacity utilization other than 100%, this assumption is violated.

23. What is the operating leverage of a company if all costs are variable?
a. Zero
* b. 1
c. Infinite or undefined
d. None of the above

Answer: One formula for calculating the operating leverage is OL = 1 + Fixed Cost/OCF.
So when fixed costs are zero, the operating leverage is 1.
24. Which of the following is true concerning the IGR formula.
a. The IGR formula assumes a degree of operating leverage of zero.
* b. The IGR formula assumes a degree of operating leverage of 1.
c. The IGR formula assumes a degree of financial leverage of zero.
d. The IGR formula assumes a degree of financial leverage of 1.
e. The IGR formula makes no assumption about operating leverage.

Answer: Since the formula assumes all items increase at the rate of sales except debt and equity,
this by definition means that there are no fixed costs. Thus the operating leverage is assumed to be
equal to 1.

25. What would your monthly payment be on a 30-year, $150,000 mortgage at nine percent
compounded monthly?
a. $416.67
b. $934.14
c. $1,000.39
* d. $1,206.93
e. $1,541.29

Answer: Use the spreadsheet template TVMoney.xls to solve the time value of money problems.
N=360, Interest rate=.09/12=.0075, Present Value = 150,000. Therefore the Payment = $1,206.93.

26. How much money will you have in eight years if you deposit $250 in a savings account today that
earns 6.5 percent compounded annually?
a. $251.30 b. $316.89
c. $412.28 * d. $413.75
e. $417.04

Answer: N=8, Interest rate=6.5%, Present Value=250. Therefore, the Future Value=$413.75.

27. The mortgage on your house has a payment of $663.81 per month. It is a 30 year mortgage at 9.0
percent compounded monthly. How much did you borrow?
a. $75,000 b. $77,500
c. $80,000 * d. $82,500
e. $85,000

Answer: N=360, Interest rate=.09/12=.0075, the Payment=663.81. Therefore, the PV=82,500.

28. What is the effective annual rate of eight percent compounded semiannually?
a. 8.00 percent * b. 8.16 percent
c. 8.46 percent d. 8.73 percent
e. 16.64 percent

Answer: APY = 1.042 –1 = 1.0816 – 1 = .0816 or 8.16%

29. You are saving money to buy a house in ten years. You will need $25,000 to make the down
payment at that time. How much must you deposit in a savings account each month for the next
ten years in order to save up $25,000 if the savings account pays interest at 12 percent per year
compounded monthly?
a. $93.42
* b. $108.68
c. $152.97
d. $208.33
e. $271.21

Answer: N=120, Interest rate = .12/12= .01, Future Value = 25,000. Therefore, Payment=$108.68

30. Darwin Davis just established an IRA (Individual Retirement Account.) Darwin decides to put $50
per month into this account for the next 40 years. Since he plans to invest in a small stock mutual
fund, he estimates he will earn 18 percent per year compounded monthly. How much money would
be in this account after 40 years?
a. $24,000
b. $372,421
c. $913,652
* d. $4,228,992
e. $17,576,113

Answer: N=480, Payment=50, Interest rate=.18/12 = .015. Therefore, Future Value = $4,278,992

31. How much would you have to invest today at 12 percent compounded semiannually to have
$25,000 to buy a trailer house in 4 years?
a. $13,492.13 b. $13,957.87
c. $14,789.36 * d. $15,685.31
e. $16,665.73

Answer: N=8, Interest rate=.12/12 = .01, Future Value = 25,000. Therefore, Present Value =
$15,685.31

32. You need to borrow $18,000 to buy a truck. The current loan rate is 11.9 percent compounded
monthly, and you want to pay off the loan in equal monthly payments over 5 years. What is your
monthly payment?
a. $363.39 b. $394.04
* c. $399.49 d. $407.86
e. $621.43

Answer: N = 60, Interest rate = .119/12 = .00991667, Present Value = 18,000. Therefore, the
Payment=$399.49

33. A local automobile dealer is offering 1.9% financing on a 3-year car loan or
 $2,000 for the purchase of an $18,000 car. Suppose you also have available
financing at 9% for a 3-year car loan through your bank. Given these two
options, you would like to know which is the better deal. Which option would
be the lowest monthly payment over 3 years for purchasing the car?
(Assume you finance the entire purchase price at 1.9% or $16,000 at 9%).
a. $500.00 per month.
b. $503.56 per month.
* c. $508.80 per month.
d. $514.78 per month.
e. $518.56 per month.

Answer: Both monthly payments must be calculated. The $2,000 rebate is

the best option.
1.9% APR: N=36, Interest rate=.019/12, Present Value=18,000. Thus,
Payment=$514.78
Rebate: N=36, Interest rate=.09/12, Present Value=16,000. Therefore,
Payment=$508.80

34. In 1889, Vincent Van Goghs painting, Sunflowers, sold for $125. One
hundred years later, it sold for $36 million. Had the painting been purchased
by your great-grandfather and passed on to you, how much would your
average compounded rate of return have been?
a. 9.1%
b. 10.1%
c. 11.9%
d. 12.0%
* e. 13.4%

Answer: N=100, Present Value=125, Future Value=36,000,000. Thus, Int.

rate=13.4%
35. All else being equal, if interest rates rise,
I. bond prices will fall,
II. coupon payments will rise,
III. the prices on long-term bonds will fall more (on a percentage basis)
than prices on short-term bonds, and
IV. the number of years to maturity increases.
* a. I and III only b. I and IV only
c. II and IV only d. I, III, and IV only
e. I, II, III, and IV

Answer: I is true because interest rates and bond prices move in opposite directions. II is false
because the coupon interest payament is constant throughout the life of a bond. III is true because
Long-Term bonds are exposed a longer time to changes in interest rates (i.e. more sensitive). IV is
false because the maturity date is independent of changes in interest rates.

36. A bond sold five years ago for $950. The bond is worth $900 in today's
 market. Assuming no changes in risk, which of the following is true?
a. The face value of the bond must be $900.
b. The bond must be within one year of maturity.
c. Interest rates must be lower now than they were five years ago.
* d. Interest rates must be higher now than they were five years ago.
e. The coupon payment of the bond must have increased.

Answer: Five years ago, the bond sold at a discount. Today, it sells for even
more of a discount. Normally, I would expect the price of the bond to increase
as its value marches toward $1,000 at maturity. The fact that the price went
down means that interest rates must have increased.

37. Terminator Bug Company bonds have a 14% coupon rate. Interest is paid
semiannually. The bonds have a par value of $1,000 and will mature 10 years
from now. Compute the value of Terminator Bonds if the investors required
rate of return is 12%.
a. $894.06 b. $1,000
* c. $1,114.70 d. $1,149.39
e. $1,215.62

Answer: N=20, Payment=70, Future Value=1000, Interest Rate=6%. Thus,

PV=1114.70

38. The dividend on Soviet Motors common stock will be $6.00 in one year,
$6.50 in two years, and $7.00 in three years. You know you can sell the stock
for $75 in three years, and you require a 10 percent return on your
investment. How much would you be willing to pay for a share of this stock?
a. $61.50 b. $64.65
c. $68.90 * d. $72.43
e. $88.50

Answer: P0 = 6.00/1.10 + 6.50/1.10 2 + (7+75)/1.10 3 = 72.43

39. The current price of ABC Corporation is $50.00. Dividends are expected to
grow at 4 percent indefinitely, and the most recent dividend was $2.00. What
is the required rate of return on ABC's stock?
* a. 8.2 percent b. 9.1 percent
c. 10.2 percent d. 11.6 percent
e. 13.2 percent

Answer: RE = (2.00*1.04)/50.00 + .04 = .0816 or 8.16%

40. What would you pay for a share of ABC Corporation stock if it is going to pay a
$5 dividend and be worth $110 in one year? You require a 15 percent return
on your equity investments, and ABC Corporation's bonds currently yield 9
percent.
a. $95 * b. $100
c. $110 d. $115
e. $120

Answer: P0 = (110+5)/1.15 = $100

41. What would you pay for a stock that just paid a $5 dividend if the expected
dividend growth rate is 4 percent and you require a 16 percent return on your
investment?
a. $33.33 * b. $43.33
c. $51.43 d. $77.14
e. $84.30

Answer: P0 = (5.00*1.04)/(.16-.04) = $43.33

42. Etling, Inc., dividend is expected to grow at 10 percent for the next 2 years
and then at 5 percent forever. The current dividend is $2, and the required
return is 22 percent. What is a fair price for this stock?
* a. $13.47 b. $14.00
c. $14.15 d. $15.10
e. $19.05

Answer: P0=(2.00*1.1)/1.22+(2.00*1.1 2)/1.222+((2.00*1.12*1.05)/

(.22-.05))/1.222 = 13.47
You could also use the TVMoney spreadsheet with the stock valuation
worksheet.

43. Which of the following consider the time value of money in their computation?
I. Payback
II. Net Present Value
III. Profitability index
IV. Internal rate of return
a. III only b. II only
 c. II and IV only * d. II, III, and IV only
e. I, II, III, and IV

Answer: Payback is the only one that does not use the time value of money
concept.

44. If you wish to quantify, in dollar terms, how stockholder wealth will be
affected by undertaking a project under consideration, you should use:
a. discounted payback analysis. b. the average accounting return.
c. internal rate of return. * d. net present value.
e. the profitability index.

Answer: This is the concept of net present value.

45. What is the decision rule for IRR?

a. accept a project when IRR > 0
b. accept a project when IRR > r where r is the going market rate on the
firm's bonds
c. accept a project when IRR > 100 percent, indicating that the project has
more than recaptured its initial cost
d. accept a project if the IRR exceeds the risk free rate of return
* e. accept a project if the IRR exceeds the firm's required rate of return

Answer: When the IRR is larger than the required rate of return, the NPV will
be positive.

46. What is the decision rule for NPV?

* a. accept a project when NPV is positive
b. accept a project when NPV exceeds average accounting net income
c. accept a project when NPV > cost, indicating that the project has more
than recaptured its initial cost in terms of net income
d. accept a project when NPV exceeds the firm's target NPV
e. accept a project when NPV is negative only if the IRR is positive

Answer: When the NPV is positive, the project earns more than the required
rate of return.

47. What is the decision rule for Profitability Index (PI)?

a. accept a project when the PI is positive.
* b. accept a project when the PI is greater than 1.
c. accept a project when the PI is greater than the required rate of return.
d. accept a project when the PI is greater than the Internal Rate of Return
(IRR).
e. accept a project when the PI is greater than the risk free rate.

Answer: When the PI is greater than 1, you can earn more than $1.00 for
every dollar you invest in the initial outlay.

48. Consider a project with an initial investment and positive future cash flows.
As the discount rate is decreased, the:
* a. IRR remains constant while NPV increases.
b. IRR decreases while NPV remains constant.
c. IRR remains constant while NPV decreases.
d. IRR increases while NPV remains constant.
e. IRR increases while NPV decreases.

Answer: When the discount rate is decreased, the NPV will increase. The IRR
is independent of the required rate of return.

49. Suppose you are considering a project that costs $10 and has expected cash
flows of $4, $4, and $5 over the next three years. If the appropriate discount
rate for the project's cash flows is 14 percent, what is the net present value of
this project?
* a. -$0.04 b. $0.21
c. $0.71 d. $9.79
e. $10.71

Answer: Use TVMoney spreadsheet and the Capital Budgeting worksheet.

Cash flows = {-10,4,4,5}, Required Return=14%. Then the NPV = $.04

50. A project has an initial investment of $10,000. The expected future cash
flows are $3,000 per year for the next 4 years. If the required rate of return is
15 percent, what is the NPV?
a. -2,084 * b. -1,435
c. -132 d. 0
e. +2,076

Answer: Use TVMoney spreadsheet and the Capital Budgeting worksheet.

Cash flows = {-10,3,3,3,3}, Required Return=15%. Then the NPV = -$1.435

51. You are considering an investment with the following cash flows. Your
required return is 10 percent, and all else being equal, you prefer at least a
payback of 2 years. If your primary objective is to maximize your wealth,
should you take this investment? (Hint: use the best approach to evaluate
this project.)
 Year Cash Flow
0 -100,000
1 60,000
2 60,000
3 10,000
4 10,000
5 -50,000
a. Yes, the payback is 1.67 years.
b. Yes, the discounted payback is 1.92 years.
c. Yes, because both the payback and discounted payback are less than 2
years.
* d. No, because the NPV is $-12,571.
e. You cannot decide because the decision rules conflict.

Answer: Since you want to know how much your wealth changes, NPV is the
correct statistic to calculate. Use the TVMoney spreadsheet and the Capital
Budgeting worksheet.
Cash flows = {-100,60,60,10,10,-50}, Required return = 10%. Then NPV = -
$12,571
The payback is okay, but that doesn’t matter because your primary objective
is to increase your wealth.

52. Suppose you are the operator for a large football stadium with thousands
of stadium lights. A light bulb salesman has given you a pitch that his better
quality bulbs, though somewhat more expensive, last for seven years as
compared to standard bulbs that last only three years. Both types of bulbs
give the same lumen output (i.e., brightness). Which of the following is the
best and easiest way to determine whether it is better to buy the high quality
or standard bulbs?
a. Multiply the price of the high quality bulbs times 3/7 and if that is lower
than the price of standard bulbs, choose the
high quality bulbs.
b. Find the NPV of a 3 year project for standard bulbs and the NPV of a 7 year
project for high quality bulbs using only costs.
Choose the one with the lowest cost (the smallest negative
number).
 c. Same as b except choose the largest negative number.
d. Same as b except chain the projects for 21 years so they will be of an
equivalent project life.
* e. Find the equivalent annual annuity for each project and choose the one
with the lowest cost per year (the smallest
negative number).

Answer: The correct approach is to find the equivalent annual annuity,

because the projects are of different length. Answer “a” does not count the
time value of money. Answer “b” incorrectly compares projects of different
length (i.e., the 7-year project is productive for four more years, even more
than two consecutive 3-year projects). Since only costs are included, the
smallest negative number is correct. If instead you entered a negative
number as a cost, this turns the projects into positive cash flows and the
largest positive number should be chosen. Answer “d” would also work, but
the process is cumbersome. Answer “e” is by far the easiest way to solve this
problem.

53. The government has been trying to decide whether to purchase any of the
stealth bombers. One of the arguments in favor of purchasing the bombers is
that since so much money has been spent on its development, it would be a
waste of money not to buy any. What is the major problem with this
argument?
a. It doesn't consider the opportunity cost of the money that has been spent.
* b. It includes sunk costs in the decision.
c. It includes possible erosion of the purchase of other bombers.
d. It includes changes in net working capital.
e. It includes financing costs in the decision.

Answer: This is the classic problem of not counting expenditures that have
already been made. Obviously, this will not change what the future holds,
which is the only thing that matters.

54. Your company purchased a piece of land seven years ago for $150,000 and
subsequently added $75,000 in improvements. The current book value of the
property is $225,000. There are three options for future use of the land: (1)
the land can be sold today for $375,000, (2) the land can be leased to
another party on a long-term basis, or (3) your company can destroy the past
improvements and build a factory on the land. In consideration of the factory
project, at what amount (if any) should the land be valued?
a. the present book value of $225,000
 b. the sales price of $375,000 plus $75,000 in improvements
c. the sales price of $375,000 less the book value of the improvements since
they will be destroyed anyway
* d. whichever amount represents the greatest opportunity cost; that is, the
best alternative use you must forego in order to build the factory
($375,000 or the value of the long-term lease, whichever is greater)
e. The property should be valued at zero since it is a sunk cost.

Answer: You have to count the incremental cost of foregoing the opportunity
to earn $375,000 by selling the property or perhaps even more from a long-
term lease. Answer “a” is incorrect because the book value has nothing to do
with incremental cash flow (it merely reflects historically how much was paid
less accumulated depreciation). Answer “b” is not correct because the
$75,000 improvements are a sunk cost. Answer “c” is incorrect again
because the book value of improvements do not affect incremental cash
flows. Answer “e” is incorrect because the property has the potential of
future cash flows, which will be eliminated if the project proceeds.
Use the following table to answer the next three questions.

Modified
ACRS
Year 3-Year 5-Year 7-Year
1 33.33% 20.00% 14.29%
2 44.44% 32.00% 24.49%
3 14.82% 19.20% 17.49%
4 7.41% 11.52% 12.49%
5 11.52% 8.93%
6 5.76% 8.93%
7 8.93%
8 4.45%

55. Your company just purchased a new computer system for $160,000.
Computers have a 5-year ACRS classification. At the end of two years, what
will be the book value of this computer?
a. 0 b. 32,000
c. 51,200 * d. 76,800
e. 160,000

Answer: Book Value = 160,000 - .2000*160,000 - .3200*160,000 =

76,800

56. If the computer is sold for $100,000 in year 2, what would be the salvage
value cash flow? Assume a corporate tax rate of 40 percent and that you get
a full year of depreciation in year 2.
a. $13,900 b. $49,920
c. $60,000 * d. $90,720
e. $100,000

Answer: A/T Salvage CF = 100,000 – (.40)(100,000-76800) = 90,720

57. Your company just bought some new equipment for its manufacturing plant.
The equipment cost $1,000,000. Industrial equipment has an ACRS
classification of 7 years. If the equipment will be sold in 3 years for $224,900,
what is the after-tax cash flow from the sale? The corporate tax rate is 34
percent.
a. $27,784 b. $66,000
c. $72,216 d. $172,216
* e. $297,116

Answer: Book Value=1,000,000-.1429(1,000,000)-.2449(1,000,000)-.1749(1,000,000) = 437,300

A/T Salvage CF = 224,900 - .34(224,900 – 437,300) = 297,1166
The following data applies to the next 5 questions.

The Johnson Jojoba Ranch is considering the acquisition of a new crushing

machine for its refining operation. The machine would save $45,000 per year, but
it would require a maintenance expense of $10,000 per year (for a net savings of
$35,000 a year). The machine would cost $100,000 and has an economic life of
five years. After this time, it is expected that the machine could be sold for
$20,000. Johnson's cost of borrowed funds is 13 percent, and the marginal cost of
capital is 17 percent. The company uses the straight-line method to calculate
depreciation, depreciating toward a zero book value. The marginal corporate tax
rate is 40 percent.

58. What is the operating cash flow per year for this project?
a. $24,000 * b. $29,000
c. $35,000 d. $41,000
e. $55,000

Answer: OCF = (1-t)(Savings) + (t) Depreciation = (1-.40)(35,000) +

(.4)20,000 = 29,000

59. What is the after-tax salvage cash flow?

a. $23,400 b. $20,000
c. $18,000 d. $17,094
* e. $12,000

Answer: Since Book Value = 0, A/T Salvage CF = (1-t)(Salvage) = .6(20,000)

= 12,000

60. What is the Net Present Value (NPV) of this project?

a. -9,642 b. -5,798
* c. -1,745 d. +200
e. +14,560

Answer: Enter the data on the Cash Flows worksheet. NPV = -1,745

61. What is the Internal Rate of Return (IRR) of this project?

a. 0.98% b. 13.15%
* c. 16.27% d. 21.79%
e. 23.41%

Answer: Enter the data on the Cash Flow worksheet. IRR = 16.27%
62. What is the Profitability Index (PI) of this project?
a. -.88 b. -.98
* c. .98 d. 1.17
e. 1.20

Answer: Enter the data on the Cash Flow worksheet. PI = .98

63. What is the Payback for this project?

a. 1.75 years b. 2.36 years
* c. 3.45 years d. 4.16 years
e. 4.95 years

Answer: Enter the data on the Cash Flow worksheet. Payback = 3.45 Years

Use the following information to answer the next five questions.

Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing
equipment will cost $160,000. Bill expects the after tax cash inflows to be
$40,000 annually for 7 years, after which he plans to scrap the equipment and
retire to the beaches of Jamaica.

64. What is the projects payback period?

a. 1.5 years
b. 2.0 years
c. 3.3 years
* d. 4.0 years
e. 4.3 years

Answer: Enter the data on the Capital Budgeting worksheet. Payback = 4.0
Years

65. Assume the required return is 10%. What is the projects discounted
payback period?
a. 3.2 years
b. 4.8 years
* c. 5.4 years
d. 6.5years
e. 7.1 years
 Answer: Enter the data on the Capital Budgeting worksheet. Discounted
Payback = 5.37 Yr.

66. Assume the required return is 10%. What is the projects NPV?
a. $14,111
b. $27,322
c. $32,556
* d. $34,737
e. $45,001

Answer: Enter the data on the Capital Budgeting worksheet. NPV = 34,737

67. Assume the required return is 17%. What is the projects IRR?
a. 12.2%
b. 14.3%
* c. 16.3%
d. 17%
e. 19.3%

Answer: Enter the data on the Capital Budgeting worksheet. IRR = 16.33%
Note that the required rate of return does not change the IRR.

68. Assume the required return is 15%. What is the projects PI?
a. .74
b. .88
c. 1.0
* d. 1.04
e. 1.16

Answer: Enter the data on the Capital Budgeting worksheet. PI = 1.04

69. After ten years as an automobile factory worker, Joe decides he is just tired of working for others.
He decides to enter the highly competitive mountain bike manufacturing business. He finds a large,
positive NPV. Which of the following is probably true about his analysis?
a. The discount rate he used must be too high.
* b. Unless he has added something of value to the manufacturing process, he probably made a
mistake in estimating his cash flows.
c. He has likely been overly pessimistic about the future and has underestimated future cash
flows.
d. His estimates of initial outlays must be on the high side.
e. His analysis is probably correct since he will be able to sell his bikes because they are identical
to those already in the market.

Answer: It is very difficult to find positive NPV projects. It is unlikely that Joe
can easily find a high NPV project in a highly competitive manufacturing
business unless he has incorporated some feature that is not easily duplicated
by the market or has found some way to manufacture the bikes at a lower
cost than the competition. Since he seems to have done neither of these, it is
likely that he has made a mistake in estimating his cash flows too high.

Use the following information about two projects to answer the next 5 problems.

Year Cash Flows A Cash Flows B

0 -$100,000 -$100,000
1 31,250 0
2 31,250 0
3 31,250 0
4 31,250 0
5 31,250 200,000

The required rate of return for both projects is 12%.

70. What is the Payback period for Project A?

a. 2.5 years * b. 3.2 years c. 3.8 years
d. 4.3 years e. 5 years

Answer: Payback = 3 + (100,000-31250-31250-31250)/31250 = 3.2 years

71. What is the Net Present Value of Project A?

a. -$8,237 b. +$8,237 * c. +$12,649
d. +$13,485 e. +$16,835

Answer: NPV = -100,000+31250/1.12+31250/1.122+31250/1.123+31250/1.124+31250/1.125

NPV = 12,649
72. What is the IRR of Project A?
a. -2.3% b. 8.6% c. 14.9%
* d. 17.0% e. 21.5%
 Answer: Enter cash flows on the Capital Budgeting worksheet. IRR = 16.99% or 17%

73. What is the Profitability Index of Project A?

a. -1.126 b. -1.082 c. 0.893
d. 1.082 * e. 1.126

Answer: Enter cash flows on the Capital Budgeting worksheet. PI = 1.13

74. Given that these two projects are mutually exclusive, what should be your recommendation?
a. Pursue Project A c. Dont pursue either project
* b. Pursue Project B d. Pursue both projects

Answer: Purse Project B because it has the highest NPV.

75. What is the IRR of an investment that costs $76,937 and pays $32,000 a
year for 4 years?
a. 16% b. 18%
c. 20% d. 22%
* e. 24%

Answer: Enter the cash flows into the Capital Budgeting worksheet. IRR = 24%

76. Which of the following is correct about project evaluation?

a. Financing costs must be included in the statement of cash flows because they are not
accounted for elsewhere.
* b. The stand-alone principle calls for evaluation of a project based on the projects
incremental cash flows.
c. Changes in NWC are not considered incremental cash flows.
d. When fixed assets are sold at the end of a project, there are usually no tax consequences of
the sale.
e. Whether straight-line depreciation or MACRS depreciation is used will have no impact on
the NPV of a project.

Answer: Answer “a” is incorrect because financing costs are accounted for in the WACC.
Answer “b” is correct because we are looking only for incremental cash flows as a stand-alone
project. Answer “c” is incorrect because NWC changes are indeed incremental cash flows.
Answer “d” is incorrect because there usually are tax consequences when an asset is sold at the
end of a project. Answer “e” is incorrect because the cash flows are indeed different with
different methods of counting depreciation.
77. Over the past 65 years, which of the following investments has provided the
greatest return?
* a. small company stocks b.common stocks
c. Treasury bills d. Treasury bonds
e. corporate bonds
 Answer: Small company stocks have the highest expected returns and the
highest risk.

78. Using CAPM, what is the expected return on asset A if the expected return
on the market is 17
percent and the risk-free rate is 7.7 percent? Asset A has a beta of .9.
a. 9 percent b. 10 percent
c. 14 percent * d. 16 percent
e. 20 percent

Answer: E(R)=Rf+Beta (Expected Market Risk Premium)=7.7%+.9 (17% -

7.7%)=16%

79. A firm unexpectedly increases its dividend payout and its stock price
rises. The asymmetric information effect at least partially explains the rise
in stock price since:
* a. investors react favorably to the increased dividend because this indicates
a better financial condition in the future.
b. investors will always react favorably to changes in dividends.
c. an unexpected increase in dividends means management is signalling
that the firm has no positive NPV projects in which to invest.
d. this unexpected increase will likely be viewed as an attempt by
management to manipulate the stock price.
e. unexpected changes in dividends will not affect stock prices if the firm
has a written policy.

Answer: Answer “a” reflects the signaling effect from a change in dividends
under asymmetric information. Answer “b” is inconsistent with the clientele
effect. Answer “c” is opposite to the asymmetric information effect. If the
management increases dividends, this could place the firm into financial
distress if the future turns out to be bad. Therefore, the asymmetric
information effect would suggest an increase in dividends only when the
future looks bright. Answer “d” does not reflect the way the market
responds to unexpected increases in dividends. Again, if the management is
not telling the truth, there jobs could be in jeopardy because of possible
financial distress from too high a dividend payout. Answer “e” is incorrect
because the market generally does not respond to statements of policy – the
market generally responds to real changes in cash flow or perceived real
changes in future cash flows.
The next three questions refer to the following:
You are considering a project that requires an initial investment of $10,000. It is depreciable over
four years using straight-line depreciation. The discount rate is ten percent. Your tax bracket is 34
percent.
Base Case
Unit Sales 3,000
Price per Unit $15.00
Variable Cost per Unit $9.00
Fixed Costs $9,000

80. Assume a salvage value of zero. What is the base case accounting break-even?
a. 1,083 b. 1,500
* c. 1,917 d. 2,026
e. 2,237

Answer: Accounting B/E = (Fixed+Depreciation)/(Price-Variable Cost) = (9,000+2500)/(15-9)

= 11,500/6 = 1917

81. What is the base case cash break-even? Ignore taxes and assume a salvage value of zero.
a. 1,083 * b. 1,500
c. 1,917 d. 2,026
e. 2,237

Answer: Cash B/E = (Fixed Cost)/(Price-Variable Cost) = (9000)/(15-9) = 1500

82. What is the base case financial break-even? Ignore taxes and assume a salvage value of zero?
a. 1,083 b. 1,500
c. 1,917 * d. 2,026
e. 2,237

Answer: Financial B/E = (Fixed Cost + OCF*)/(Price-Variable Cost)

First calculate OCF* = 10,000/((1-1/1.104)/.10) = 3154.71
Financial B/E = (9000+3154.71)/(15-9) = 2025.78 or 2026

83. At the financial break-even point, the IRR of a project is equal to

a. 0 percent.
b. its average accounting return (AAR).
* c. its required return.
d. 100 percent
e. -100 percent

Answer: At the financial B/E, the NPV=0, and the IRR equals the required rate
of return.
 84. The time between when inventory is ______________________ is called the
cash cycle.
a. acquired and when it is actually paid for
b. acquired and when it is actually sold
c. acquired and when cash is received for the sale
d. paid for and when it is sold
* e. paid for and when the cash is collected from the sale

Answer: This is the definition of the cash cycle.

Given the following information, answer the next five questions.

Item Beginning
Ending
Inventory $15,000 $17,000
Accounts Receivable$23,000 $22,000
Accounts Payable $11,000 $13,000
Net Credit Sales $150,000
Cost of Goods Sold$ 96,000
85. How many days are in the inventory period?
* a. 61 days b. 72 days
c. 53 days d. 104 days
e. 124 days

Answer: First calculate the Inventory Turnover. Inv. T/O = CGS/(Average

Inventory) = 96000/15000 = 6 times
Then calculate the Inventory Period = 365/(Inventory T/O) = 365/6 = 61
days

86. How many days are in the receivables period?

a. 41 days b. 47 days
* c. 55 days d. 72 days
e. 88 days

Answer: A/R Turnover = (Credit Sales)/(Average A/R) = 150000/22500 =

6.666667
Receivables Period = 365/(A/R T/O) = 365/6.6666667 = 55 days

87. How many days are in the operating cycle?

a. 74 days b. 80 days
* c. 116 days d. 141 days
e. 165 days
 Answer: Operating Cycle = Inventory Period + A/R Period = 61+55 = 116
days
88. How many days are in the payables period?
a. 18 days b. 24 days
* c. 46 days d. 53 days
e. 68 days

Answer: A/P Turnover = CGS/(Average A/P) = 96000/12000 = 8 times

Payables Period = 365/(A/P T/O) = 365/8 = 46 days

89. How many days are in the cash cycle?

* a. 70 days b. 88 days
c. 95 days d. 117 days
e. 123 days
Answer: Cash Cycle = Operating Cycle – A/P Period = 116 – 46 = 70 days

90. Given the following information, what is the weighted average cost of
capital (WACC)?
market value of equity = $30 million
market value of debt= $40 million
cost of equity = 20 percent
before tax cost of debt = 9 percent
equity beta = 1.25
corporate tax rate = 40 percent
a. 7.2 percent b. 9.0 percent
c. 10.2 percent * d. 11.7 percent
e. 13.5 percent

Answer: WACC = (40/70)(9%)(1-.40) + (30/70)(20%) = 3.1% + 8.6% = 11.7%

91. Which of the following statements is correct?
* a. Decisions regarding a firm's debt and equity can be called financial
structure decisions.
b. The asset beta is a measure of the unsystematic risk of a firm's assets.
c. In a capital restructuring, the composition of the assets of the firm will
change.
d. The value of the overall firm will not change as a result of a capital
restructuring if the NPV of the restructuring is positive.
e. The use of personal leverage by an investor to alter the degree of
financial leverage of a firm is called reverse leverage.

Answer: Answer “a” is correct because financial structure decisions are those
which affect the right side of the balance sheet. Answer “b” is incorrect
because beta measures systematic risk. Answer “c” is incorrect because
capital restructuring (same as financial restructuring) does not change the left
side of the balance sheet. Answer “d” is incorrect because the value will
change if the NPV is positive for any project (including restructuring). Answer
“e” is incorrect because personal leverage is called home-made leverage, not
reverse leverage.

92. Assume there are no personal or corporate income taxes and that the overall
cost of capital of a firm is unaffected by its capital structure. Which of the
following is true?
I. A firm will benefit from increased leverage.
II. The value of the firm is independent of its capital structure.
III. The cost of equity is a positive, linear function of the firm's capital
structure.
a. I only b. II only
c. III only d. I and III only
* e. II and III only

Answer: M&M proved that there would be no benefit from increased leverage
and no change in the firm value for any level of debt if there are no taxes (so I
is incorrect and II is correct). However, the cost of equity would increase as
debt is added to the firm because of an increase in risk (so III is correct).

93. Which of the following does not correctly complete the following: M&M I with
taxes shows:
a. the value of a levered firm exceeds the value of the unlevered firm by the
amount of the present value of the interest tax shield.
* b. a levered firm can increase its value by reducing debt.
c. the optimal amount of leverage for a firm is one hundred percent.
 d. the value of an unlevered firm is equal to after-tax EBIT divided by the
unlevered cost of capital.
e. there is a linear relationship between the amount of debt in a levered firm
and its value.

Answer: “b” is opposite the the conclusion of M7M with taxes. The firm value
would decrease when debt is reduced.

94. When choosing a capital structure (in the real world), the objective of the firm
should be to:
a. choose the one that minimizes the current value of the stock.
* b. choose the one that maximizes the value of the firm.
c. choose the one that maximizes the firm's WACC.
d. choose the one that results in the greatest possible interest tax shield.
e. choose the one that minimizes the return on equity.

Answer: The object is to maximize the value of the firm or to minimize the
WACC.

95. An unlevered firm has an EBIT of $1 million, net income after tax of $660,000,
and a cost of capital of 15 percent. A levered firm with the same assets and
operations has $5 million in debt, with an 8 percent yield to maturity. What is
the value of the levered firm, using MM with corporate taxes? (Tax rate is 34
percent.)
a. $1,000,000 b. $2,700,000
c. $3,966,667 * d. $6,100,000
e. $6,776,923

Answer: First find the value of an unlevered firm, VU = 660,000/.15 =

4,400,000
Then find the levered value, VL = VU + t Debt = 4,400,000 + .34(5,000,000) =
6,100,000

96. A high income tax bracket investor who wants a low dividend because he has
sufficient current income would be most consistent with the:
a. bird-in-the-hand theory. b. dividend irrelevance theory.
* c. tax differential theory. d. asymmetric information theory
e. residual dividend theory.

Answer: This is the definition of the tax differential theory.