Test 2 review questions

Quiz 3
Which of the following statements is most correct?

a. Portfolio diversification can reduce the variability of returns on an

individual stock to zero
b. When company-specific risk has been diversified, the inherent risk
that remains is market risk, which is constant for all securities in
the market.
c. It is possible to have a situation where the market risk of a single
stock is less than that of a well diversified portfolio.
d. The SML relates required returns to firms' market risk. The slope
and intercept of this line can be controlled by the financial
manager.
 PS5
• 32. A stock is not expected to pay a dividend over the next four years. Five
years from now, the company anticipates that it will establish a dividend of
$1.00 per share (i.e., D5 = $1.00). Once the dividend is established, the market
expects that the dividend will grow at a constant rate of 5 percent per year
forever. The risk-free rate is 5 percent, the company's beta is 1.2, and the
market risk premium is 5 percent. The required rate of return on the
company’s stock is expected to remain constant. What is the current stock
price?

• a. $ 7.36
• b. $ 8.62
• c. $ 9.89
• d. $10.98
• e. $11.53
 PS5
• If market is weak form efficient and a rational investor
expects a stock to have a higher expected return than the
return to S&P 500 index, then which of the following
statements is true
A. This stock has higher systematic risk (systematic risk= non-
diversifiable risk, I use these two terms interchangeably)
B. The investor has some positive private information about
the stock
C. Some good public news just got released about this stock
D. This stock has outperformed S&P 500 index in the past 
 PS6 Question
23. Scranton Shipyards has $20 million in total net operating capital. The company’s WACC is 10 percent. The
company has the following income statement:
 
Sales $10.0 million
Operating costs 6.0 million
Operating income (EBIT) $ 4.0 million
Interest expense 2.0 million
Earnings before taxes (EBT) $ 2.0 million
Taxes (40%) 0.8 million
Net income $ 1.2 million
 
What is Scranton’s EVA?
 
a. $ 400,000
b. -$ 800,000
c. $1,200,000
d. $2,000,000
e. $4,000,000
 PS6 Question
21. Assume that a company currently depreciates its
fixed assets over 7 years. Which of the following would
occur if a tax law change forced the company to depreciate
its fixed assets over 10 years instead?
a. The company’s tax payment would increase.
b. The company’s cash position would increase.
c. The company’s net income would increase.
d. Answers a and c are correct.
e. Answers b and c are correct.
f. What would happen to net cash flow?
 PS7 Question
8. Perry Technologies Inc. had the following financial information for the past year:

Inventory turnover = 8
Quick ratio = 1.5
Sales = $860,000
Current ratio = 1.75
 
What were Perry’s current liabilities?
 
a. $430,000
b. $500,000
c. $107,500
d. $ 61,429
e. $573,333
 XLU valuation at the end of 2014
Year Sum of Dividends Growth Rate
2003 $ 0.797
2004 $ 0.874 9.7%
2005 $ 1.010 15.6%
2006 $ 1.119 10.8% Assumptions
2007 $ 1.095 -2.1%
2008 $ 1.235 12.8%
• beta=0.4
2009 $ 1.273 3.1% • market risk premium is 6%
2010 $ 1.271 -0.2% • Future growth rate is the
2011 $ 1.368 7.6%
2012 $ 1.445 5.6% average growth rate over
2013 $ 1.465 1.4% the past 5 years
2014 1.506 2.8%

Date 1 Mo 3 Mo 6 Mo 1 Yr 2 Yr 3 Yr 5 Yr 7 Yr 10 Yr 20 Yr 30 Yr

12/29/14 0.01 0.03 0.12 0.25 0.72 1.14 1.72 2.02 2.22 2.51 2.78

12/30/14 0.03 0.03 0.12 0.23 0.69 1.11 1.68 2.00 2.20 2.49 2.76

12/31/14 0.03 0.04 0.12 0.25 0.67 1.10 1.65 1.97 2.17 2.47 2.75
 Ratio analysis
• What is the trend in Microdrive’s ROE from
2011 to 2012?
– A. Improving
– B. Deteriorating
 DuPont/Alt DuPont decomposition
• Microdrive’s CEO invites you to analyze why ROE is
deteriorating.
• Which correctly identifies the sources of the problem?
– A. Inventory Turnover , Days Sales Outstanding, Debt-to-
equity ratio, Operating Profit Margin
– B. Fixed assets turnover ratio, Operating Profit Margin
– C. Inventory Turnover , Operating Profit Margin, Debt-to-
equity ratio,
– D. Inventory Turnover , Days Sales Outstanding, Fixed
assets turnover ratio, Debt-to-equity ratio
– E. Inventory Turnover, Days Sales Outstanding, Fixed assets
turnover ratio, Debt financing cost
 Assume MicroDrive’s 2011 CF statement is
the same as that in 2012
• What would be the FCF in 2011 for MicroDrive?