1. Incorrect The firm of Sun and Moon purchased a share of Acme.com common stock exactly one year ago for $45. During the past year the common stock paid an annual dividend of $2.40. The firm sold the security today for $85. What is the rate of return the firm has earned?Your answer: 194.2%The correct answer: 94.2%

Incorrect. Return is over the two-year period and includes both dividends and capital gains. Return = [($2.40) + ($85 - $45)] / $45 = 94.2%

2. Incorrect A set of possible values that a random variable can assume and their associated probabilities of occurrence are referred to as __________.Your answer: the expected returnThe correct answer: probability distribution

Incorrect. The expected return is the weighted average of possible returns, with the weights being the probabilities of occurrence.

3. Correct A statistical measure of the variability of a distribution around its mean is referred to as __________.Your answer: the standard deviation

Correct.

4. Incorrect The ratio of the standard deviation of a distribution to the mean of that distribution is referred to as __________.Your answer: the expected returnThe correct answer: coefficient of variation

Incorrect. The expected return is the weighted average of possible returns, with the weights being the probabilities of occurrence.

5. Correct The weighted average of possible returns, with the weights being the probabilities of occurrence is referred to as __________.Your answer: the expected return

Correct.

6. Incorrect Clive Rodney Megabucks offers your friend, Melanie, an interesting gamble involving giving her the choice of the contents in one of two sealed, identical-looking boxes. One box has $20,000 in cash and the second has nothing inside. There is an equal probability that the chosen box contains cash versus nothing. Melanie states that she would not call off the gamble if you offered her a certain $10,999 instead of her choice of box. However, she would be indifferent if $11,000 was offered in place of the risky gamble; and she would definitely take $11,001 to call off the gamble. We would describe Melanie as __________ in this instance.

Your answer: being risk averseThe correct answer: having a risk preference

Incorrect. Melanie would have had to tell us that a minimum guarantee less than $10,000 would be necessary to call off the gamble. Thus, the expected value > the certainty equivalent.

7. Incorrect Clive Rodney Megabucks offers your friend, Yunyoung, an interesting gamble involving giving her the choice of the contents in one of two sealed, identical-looking boxes. One box has $20,000 in cash and the second has nothing inside. There is an equal probability that the chosen box contains cash versus nothing. Yunyoung states that she would not call off the gamble if you offered her a certain $4,999 instead of her choice of box. However, she would be indifferent if $5,000 was offered in place of the risky gamble; and she would definitely take $5,001 to call off the gamble. We would describe Yunyoung as __________ in this instance.Your answer: having a risk preferenceThe correct answer: being risk averse

Incorrect. Yunyoung would have had to tell us that a minimum guarantee exceeding $10,000 would be necessary to call off the gamble. Thus the expected value < the certainty equivalent.

8. Incorrect Which of the following statements regarding covariance is correct?Your answer: Covariance, because it involves a squared value, must always be a positive number (or zero). The correct answer: Covariances can take on positive, negative, or zero values.

Incorrect. Covariance can take on any positive, negative, or zero value.

9. Incorrect Which of the following portfolio statistics statements is correct?Your answer: A portfolio's standard deviation of return is a simple weighted average of individual security return standard deviations.The correct answer: A portfolio's expected return is a simple weighted average of expected returns of the individual securities comprising the portfolio.

Incorrect. A portfolio's standard deviation of return involves covariances and nothing about it is "simple."

10. Correct Total portfolio risk is __________.Your answer: equal to systematic risk plus diversifiable risk

Correct.

11. Correct __________ is the variability of return on stocks or portfolios not explained by general market movements. It is avoidable through diversification.

Your answer: Unsystematic risk

Correct.

12. Incorrect __________ is the variability of return on stocks or portfolios associated with changes in return on the market as a whole.Your answer: Standard deviation.The correct answer: Systematic risk

Incorrect. Systematic risk is the nondiversifiable portion of total risk and is associated with changes in return on the market as a whole.

13. Correct Which of the following indexes would be most the appropriate proxy to measure the return of the market portfolio in the CAPM?Your answer: Standard & Poor's 500

Correct.

14. Incorrect The __________ describes the linear relationship between expected rates of return for individual securities (or portfolios) and __________.Your answer: security market line; standard deviationThe correct answer: security market line; beta

Incorrect. Change standard deviation to beta and you've got it.

15. Correct The __________ describes the relationship between an individual security's returns and returns on the market portfolio. The slope of this line is __________.Your answer: characteristic line; beta

Correct.

16. Incorrect Which of the following items describes an index measure of systematic risk?Your answer: Coefficent of variationThe correct answer: Beta

Incorrect. The coefficient of variation is a measure of relative risk.

17. Incorrect Which of the following items is a model that describes the relationship between risk and expected return (in this model the expected return is equal to the risk-free return plus a premium based on the systematic risk of the security)?Your answer: Characteristic lineThe correct answer: Capital asset pricing model

Incorrect. The characteristic line describes the relationship between an individual security's returns and returns on the market portfolio.

18. Correct What is the beta for an average risk security? What is the beta for a Treasury bill? Hint Refer to the "Capital-Asset Pricing Model" section. Your answer: 1; 0.

Correct.

19. Correct Assume that a firm's common stock can be valued using the constant dividend growth model. As an analyst you expect that the return on the market will be 15% and the risk-free rate is 7%. You have estimated that the dividend next period will be $1.50, the firm will grow at a constant 6%, and the firm beta is 0.50. The common stock is currently selling for $30.00 in the market place. Which of the following statements is correct?Your answer: The firm's stock is fairly priced.

Correct.

20. Incorrect Which form of market efficiency states that current security prices fully reflect all information, both public and private?Your answer: Semi-strongThe correct answer: Strong

Incorrect. This form states that current prices fully reflect all publicly available information.

21. Incorrect Which form of market efficiency states that current prices fully reflect the historical sequence of prices?Your answer: Semi-strongThe correct answer: Weak

Incorrect. This form states that current prices fully reflect all publicly available information.

22. Correct Which form of market efficiency states that current prices fully reflect all publicly available information?Your answer: Semi-strong

Correct.1. Correct The return on common stocks is a combination of income paid to the

stockholder plus any appreciation in stock price.Your answer: TRUECorrect.

2. Incorrect As long as the correlation coefficient between two securities is less than 1.0, the standard deviation of a portfolio made up of these two securities will be less than the weighted average of the two individual standard deviations.Your answer: FALSEThe correct answer: TRUE

Incorrect. Combining two securities will always reduce risk with the

exception of when two securities that are perfectly positively correlated.

3. Incorrect Investors can expect to be compensated with higher returns for bearing avoidable or unsystematic risk.Your answer: TRUEThe correct answer: FALSE

Incorrect. Since investors can eliminate this risk by diversifying among a number of different firms, there is no additional compensation. It is the bearing of systematic risk that brings additional expected return.

4. Incorrect The "risk-free rate" is usually represented by the yield on short-term U.S. Treasury securities.Your answer: FALSEThe correct answer: TRUE

Incorrect. A short-term U.S. Treasury security is considered risk-free.

5. Incorrect The CAPM is a multifactor model.Your answer: TRUEThe correct answer: FALSE

Incorrect. The CAPM is a single-factor model.

1. You have invested in a ski resort that has the following distribution of returns under different snow conditions:

POSSIBLE SNOW

CONDITIONS

PROBABILITY OF

THIS CONDITION

RATE OF RETURNUNDER THIS CONDITION

Poor .10 .03Fair .30 .07

Good .40 .10Excellent .20 .18

What is the expected value of return on your investment?

2. You have an investment with an expected value of return of 30% or .30 and a standard deviation of .20. (Assume a normal distribution.) What is the probability that the actual future return will be less than zero? What is the probability of a return below 30%?

3. Assuming that the capital-asset pricing model approach is appropriate, compute the required rate of return for each of the following stocks. Assume a risk-free rate of .08 and an expected return for the market portfolio of .13.

STOCK A B C D

BETA 2.0 1.5 1 .7

CHAPTR 2

1. Incorrect To financial analysts, "working capital" means the same thing as __________.Your answer: fixed assetsThe correct answer: current assets

Incorrect. Financial analysts use the term "working capital" when referring to current assets not fixed assets.

2. Incorrect Which of the following would be consistent with an aggressive approach to financing working capital?Your answer: Financing permanent inventory buildup with long-term debt.The correct answer: Financing some long-term needs with short-term funds.

Incorrect. This is a maturity matching approach and is neither aggressive nor conservative in nature (Table 8-1). Rather, it is a moderate approach.

3. Incorrect Which of the following would be consistent with a conservative approach to financing working capital?Your answer: Financing seasonal needs with short-term funds.The correct answer: Financing short-term needs with long-term debt.

Incorrect. This is a moderate (maturity matching) approach as the seasonal short-term demand for funds can be repaid with the eventual short-term cash flows.

4. Correct Which of the following would be consistent with a hedging (maturity matching) approach to financing working capital?Your answer: Financing short-term needs with short-term funds.

Correct.

5. Correct Which of the following is a basic principle of finance as it relates to the management of working capital?Your answer: Profitability moves together with risk.

Correct.

6. Incorrect Which of the following illustrates the use of a hedging approach to financing assets?Your answer: Short-term assets financed with equityThe correct answer: Permanent working capital financed with long-term liabilities.

Incorrect. The hedging approach attempts to match the maturities of both assets and liabilities. In this case the assets are short-term while the liabilities are long-term.

7. Incorrect In deciding the optimal level of current assets for the firm, management is confronted with __________.Your answer: a trade-off between liquidity and riskThe correct answer: a trade-off between profitability and risk

Incorrect. Actually, greater liquidity results in lower profitability and risk.

8. Incorrect Which of the following statements is most correct?Your answer: Strict adherence to the maturity matching approach to financing would call for all current assets to be financed solely with current liabilities.The correct answer: Current assets of the typical manufacturing firm account for over half of its total assets.

Incorrect. Only the "temporary" component of current assets would be financed with current liabilities under the maturity matching approach.

9. Incorrect The amount of current assets required to meet a firm's long-term minimum needs is referred to as __________ working capital.Your answer: netThe correct answer: permanent

Incorrect. This is the amount of current assets less current liabilities.

10. Incorrect The amount of current assets that varies with seasonal requirements is referred to as __________ working capital.Your answer: permanent The correct answer: temporary

Incorrect. This is the amount of current assets required to meet a firm's long-term minimum needs.

11. Incorrect Having defined working capital as current assets, it can be further classified according to __________.Your answer: rate of return and financing methodThe correct answer: components and time

Incorrect. Components (e.g. cash, marketable securities, receivables) and time (permanent or temporary)

12. Incorrect Your firm has a philosophy that is analogous to the hedging (maturity matching) approach. Which of the following is the most appropriate form for financing a new capital investment in plant and equipment?Your answer: 6-month bank notesThe correct answer: Common stock equity

Incorrect. These bank notes are very short-term and would not match closely to the long-term life of the plant and equipment.

13. Correct Your firm has a philosophy that is analogous to the hedging (maturity matching) approach. Which of the following is the most appropriate non-spontaneous form for financing the excess seasonal current asset needs?Your answer: 6-month bank notes

Correct.

14. Correct Under a conservative financing policy a firm would use long-term financing to finance some of the temporary current assets. What should the firm do when a "dip" in temporary current assets causes total assets to fall below the total long-term financing?Your answer: Invest the excess long-term financing in marketable securities.

Correct.

15. Incorrect Which of the following statements is correct for a conservative financing policy for a firm relative to a former aggressive policy?Your answer: The firm will see an increase in its risk profile.The correct answer: The firm uses long-term financing to finance all fixed and current assets.

Incorrect. The firm will actually find a decrease in its risk profile, as there is less interest rate and refinancing risks.

16. Correct Which of the following statements is correct for an aggressive financing policy for a firm relative to a former conservative policy?Your answer: The firm will see an increase in its expected profits.

Correct.

17. Incorrect How can a firm provide a margin of safety if it cannot borrow on short notice to meet its needs?Your answer: Shorten the maturity schedule of financingThe correct answer: Lengthening the maturity schedule of financing

Incorrect. However, lengthening the maturity schedule of financing would help

provide a margin of safety.

18. Incorrect Risk, as it relates to working capital, means that there is jeopardy to the firm for not maintaining sufficient current assets to __________.Your answer: support the proper level of sales and take prompt payment discountsThe correct answer: meet its cash obligations as they occur and support the proper level of sales

Incorrect. The first part of the answer is correct, but not the second.

19. Incorrect If a company moves from a "conservative" working capital policy to an "aggressive" policy, it should expect __________.Your answer: expected profitability to increase, whereas risk would decreaseThe correct answer: liquidity to decrease, whereas expected profitability would increase

Incorrect. Expected profitability would increase, but so would risk.

20. Incorrect To financial analysts, "net working capital" means the same thing as __________.Your answer: fixed assetsThe correct answer: current assets minus current liabilities.

Incorrect. Financial analysts use the term "working capital" when referring to the dollar difference between current assets and current liabilities.

1. Correct From a financial analyst's viewpoint, "gross working capital" simply refers to current assets.Your answer: TRUECorrect

2. Incorrect The optimal level of working capital is that which provides a 2:1 ratio of current assets to current liabilities.Your answer: TRUEThe correct answer: FALSE

Incorrect. Based on our stated objective for the firm, the optimal level of working capital (holding everything else equal) is that which ultimately maximizes shareholder wealth, not a fixed ratio.

3. Incorrect The level of current assets to maintain and how to finance current assets are interdependent.Your answer: FALSEThe correct answer: TRUE

These two items are considered jointly. A firm that follows a conservative policy (high levels of current assets) should be in a better position to utilize short-term borrowing than a firm that maintains aggressively low levels of current assets.

4. Correct The hedging approach to financing involves matching maturities of financing with specific assets.Your answer: TRUE

Correct.

5. Correct In general, long-term debt costs less than short-term debt.Your answer: FALSE

Correct.

1.   Hoskins Hiking Boot Company is trying to devise an appropriate working capital policy. Their most recent balance sheet is as follows:

BALANCE SHEET, DECEMBER 31, 2001 (in thousands)

ASSETS LIABILIIES AND OWNER'S EQUITY

Cash $30 Accounts payable $35Accounts receivable 50 Notes payable 10Inventories 30 Accruals 5Current Assets 110 Current liabilities 50

Net fixed assets 150Mortgage loan (at 13%)

80

Common equity 130Total liabilities &

Total assets $260 Owner's equity $260You know that net profits in 2001 were $28,000.

a. What is Hoskin's current level of working capital? b. What percentage of total assets is invested in working capital? c. Calculate Hoskins' return on investment. d. Suppose the firm reduces cash, accounts receivable, and inventory by

10% and uses the proceeds to pay off some of its accounts payable. Now, assuming all other items remain the same, answer a, b, and c above using these new figures

2. Devise a financing plan, assuming that your objective is to use a maturity matching policy for Hoskins Hiking Boot Company. The firm has had the following quantity of fixed and current assets over the past five years:

EndingDate

Fixed Assets(millions)

Current Assets(millions)

6/1999 $100 $ 8012/1999 100 1006/2000 110 90

CHAPTR 3

1. Correct In proper capital budgeting analysis we evaluate incremental __________ cash flows.Your answer: operating

Correct.

2. Correct The estimated benefits from a capital budgeting project are expected as cash flows rather than income flows because __________.Your answer: it is cash, not accounting income, that is central to the firm's capital budgeting decision

Correct.

3. Incorrect What is the depreciable basis?Your answer: It is the cost of capital (both debt and equity) that can be depreciated and the cost spread over multiple years of the project.The correct answer: It is the fully installed cost of an asset that taxing authorities allow to be written off for tax purposes.

Incorrect. It is the fully installed cost of an asset that taxing authorities allow to be written off for tax purposes.

4. Incorrect In estimating "after-tax incremental operating cash flows" for a project, you should include all of the following except __________.Your answer: changes in working capital resulting from the project, net of spontaneous changes in current liabilitiesThe correct answer: costs that have previously been incurred that are unrecoverable

Incorrect. We want to consider changes in working capital when evaluating a project.

5. Incorrect All of the following influence capital budgeting cash flows except __________.

Your answer: economic length of the projectThe correct answer: sunk costs of the project

Incorrect. The economic life of the project impacts the quantity and timing of cash flows in a project.

6. Correct The basic capital budgeting principles involved in determining relevant after-tax incremental operating cash flows require us to __________.Your answer: include opportunity costs, but ignore sunk costs

Correct.

7. Incorrect Place the following items in the proper order of completion regarding the capital budgeting process. I. Perform a postaudit for completed projects; II. Generate project proposals; III. Estimate appropriate cash flows; IV. Select value-maximizing projects; V. Evaluate projects.Your answer: II, III, IV, V, and I.The correct answer: II, III, V, IV, and I.

Incorrect. There correct order is II, III, V, IV, and I.

8. Incorrect The basic capital budgeting principles involved in determining relevant after-tax incremental operating cash flows require us to __________.Your answer: ignore both the effects of inflation and project-driven changes in working capital net of spontaneous changes in current liabilitiesThe correct answer: include effects of inflation, and include project-driven changes in working capital net of spontaneous changes in current liabilities

Incorrect. We would include effects of inflation, and include project-driven changes in working capital net of spontaneous changes in current liabilities.

9. Incorrect Interest payments, principal payments, and cash dividends are __________ the typical budgeting cash-flow analysis because they are ________ flows.Your answer: included in; financingThe correct answer: excluded from; financing

Incorrect. These items are excluded because they are financing flows.

10. Correct What is an example of a capitalized expenditure?Your answer: Installation costs necessary to use a machine that was just purchased.

Correct.

11. Correct In regards to the sale or disposal of a depreciable asset, "recapture of depreciation" is __________.

Your answer: any amount realized in excess of its depreciated (tax) book value, but less than its original depreciable basis

Correct.

12. Incorrect For a corporation, what is the maximum federal tax that applies to any gains on the sale of a depreciable asset above its depreciable basis?Your answer: 39%.The correct answer: 35%.

Incorrect. The maximum rate is 35%.

13. Correct Under the MACRS system, and employing the half-year convention, a piece of machinery falling in the 10-year property class would generally be depreciated over __________.Your answer: 11 recovery years

Correct.

14. Correct Which of the following is least likely to be part of the calculation of the terminal-year incremental net cash flow for a energy-related expansion project?Your answer: Capitalized expenditures.

Correct.

15. Incorrect HeinShmidt Wines.com is considering the purchase of a new project with a four-year life. The depreciable basis is $100,000 and requires $20,000 of additional working capital. The project will generate $87,000 of additional revenue with $50,000 of additional operating expenses for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year is expected to be $5,000. The incremental net cash flow for the first year of the project is closest to which of the four suggested answers below?Your answer: $35,862The correct answer: $35,532

Incorrect. ($87,000 - $50,000 - $33,330) × (1-.40) + $33,330 = $35,532. Note that the depreciation charge is 33.33% of $100,000.

16. Incorrect HeinShmidt Wines.com is considering the purchase of a new project with a four-year life. The depreciable basis is $100,000 and requires $20,000 of additional working capital. The project will generate $87,000 of additional revenue with $50,000 of additional operating expenses for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year is expected to be $5,000. When we

determine the project's terminal year incremental net cash flow, i.e., the flow for year 4, we apply the same step-by-step procedure for this period's cash flow as we do to those in all the interim periods. In addition, we give special recognition to a few cash flows that are connected with project termination. The adjustment (i.e., the sum of just those flows connected with project termination) that needs to be made to the incremental net cash flow for the fourth year of the project is closest to which of the four suggested answers below?Your answer: $25,000The correct answer: $23,000

Incorrect. ($5,000 - $2,000 + $20,000) = $23,000. Note that the salvage value is considered as recapturing previous depreciation and will increase taxes by 40% of the salvage value.

17. Incorrect HeinShmidt Wines.com is considering the purchase of a new project with a four-year life. The depreciable basis is $100,000 and requires $20,000 of additional working capital. The project will generate $87,000 of additional revenue with $50,000 of additional operating expenses for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year is expected to be $5,000. The initial cash outflow for the project is closest to which of the four suggested answers below?Your answer: $100,000The correct answer: $120,000

Incorrect. ($100,000 + $20,000) = $120,000.

18. Incorrect HeinShmidt Wines.com is considering the purchase of a new project with a four-year life. The depreciable basis is $100,000 and requires $20,000 of additional working capital. The project will generate $87,000 of additional revenue with $50,000 of additional operating expenses for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year is expected to be $5,000. The incremental net cash flow for the second year of the project is closest to which of the four suggested answers below?Your answer: $27,000The correct answer: $39,980

Incorrect. ($87,000 - $50,000 - $44,450) × (1 - .40) + $44,450 = $39,980. Note that the depreciation charge is 44.45% of $100,000 and we assume that the "tax loss" shields other income in the firm.

19. Incorrect Bruggerstein Auto.com is considering replacing a machine with a new machine that has a four-year life. The depreciable basis of the "new" machine is $100,000 ($80,000 cost plus $20,000 shipping and installation) and requires no additional working capital. The "old"

machine can be salvaged for $20,000 (at its current {tax} book value) today. The "new" project will not generate additional revenues, but will decrease operating expenses by $35,000 for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The "old" machine has four years of useful life remaining, only one year of tax depreciation of $5,000 remaining to be taken, and an estimated final salvage value, four years from now, of zero. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year for the "new" project is expected to be $5,000. The incremental net cash flow for the first year of the project is closest to which of the four suggested answers below?Your answer: $28,330The correct answer: $32,332

Incorrect. [ $35,000 - ($33,330 - $5,000) ] × [ 1- .40 ] + $28,330 = $32,332.

20. Incorrect Bruggerstein Auto.com is considering replacing a machine with a new machine that has a four-year life. The depreciable basis of the "new" machine is $100,000 ($80,000 cost plus $20,000 shipping and installation) and requires no additional working capital. The "old" machine can be salvaged for $20,000 (at its current {tax} book value) today. The "new" project will not generate additional revenues, but will decrease operating expenses by $35,000 for each year of the four-year project. For tax purposes, the equipment falls into the three-year property class using MACRS percentages. The "old" machine has four years of useful life remaining, only one year of tax depreciation of $5,000 remaining to be taken, and an estimated final salvage value, four years from now, of zero. The company is subject to a marginal tax rate of 40%. The salvage value at the end of the fourth year for the "new" project is expected to be $5,000. The initial cash outflow for the project is closest to which of the four suggested answers below? Your answer: $120,000The correct answer: $80,000

Incorrect. [ $80,000 + $20,000 - $20,000 + $0 ] = $80,0001. Incorrect The stream of cash flows produced by the project directly influences

the value of a capital expansion project.Your answer: FALSEThe correct answer: TRUE Incorrect. Cash flows are critical to the valuation of any project or asset.

2. Correct Capital budgeting is the process of identifying, analyzing, and selecting investment projects whose cash flows will all be received beyond one year.Your answer: TRUE

Correct.

3. Incorrect In the initial years of a project the use of an accelerated form of

depreciation, like Modified Cost Recovery System, increases taxable income relative to the use of the straight-line method.Your answer: TRUEThe correct answer: FALSE

Incorrect. An accelerated form of depreciation increases the depreciation expense in the initial years that results in lower taxable income and higher cash flows.

4. Incorrect Cash flow calculations require adding back depreciation to net income since it is a non-cash expense.Your answer: FALSEThe correct answer: TRUE

Incorrect. Depreciation is a non-cash expense. Thus we add it back in calculating cash flows since the firm expended no cash at that time.

5. Incorrect A capital investment involves making a future cash outlay in the expectation of current benefits.Your answer: TRUEThe correct answer: FALSE

Incorrect. A capital investment involves making a current cash outlay in the expectation of future benefits