Financial Theory and Policy Part 2

1. Sample Questions Which of the following statements is correct? (c) a. One of the advantages of the corporate form of organization is that it avoids double taxation. b. It is easier to transfer one’s ownership interest in a partnership than in a corporation. c. One of the disadvantages of a sole proprietorship is that the proprietor is exposed to unlimited liability. d. One of the advantages of a corporation from a social standpoint is that every stockholder has equal voting rights, i.e., “one person, one vote.” e. Corporations of all types are subject to the corporate income tax. (You should concentrate on corporations) 2. Which of the following statements is correct? (e) a. The proper goal of the financial manager should be to maximize the firm’s expected cash flows, because this will add the most wealth to each of the individual shareholders of the firm. b. The financial manager should seek that combination of assets, liabilities, and capital that will generate the largest expected projected after-tax income over the relevant time horizon. c. The riskiness inherent in a firm’s earnings per share (EPS) depends on the characteristics of the projects the firm selects, which means it depends upon the firm’s assets, but EPS does not depend on the manner in which those assets are financed. 1 d. Large, publicly-owned firms like AT&T and GM, are controlled by their management teams. Ownership is generally widely dispersed, hence managers have great freedom in how they manage the firm. Managers may operate in stockholders’ best interests, but they may also operate in their own personal best interests. As long as managers stay within the law, there are no effective tools that can be used to motivate them to take actions that are in the stockholders’ best interests. e. The proper goal of the financial manager should be to maximize shareholders’ wealth even though potential conflicts of interest may exist between stockholders and managers. (The goal of a corporation is to maximize shareholders’ wealth or firm value) 3. Sims Inc. earned $1.00 per share in 2002. Five years later, in 2007, it earned $2.00. What was the growth rate in Sims' earnings per share over the 5-year period? (b) a. 15.82% b. 14.87% c. 13.61% d. 12.28% (PV = -1.00, FV = 2, N = 5, PMT = 0, solve for I/YR) 4. e. 11.17% Your sister turned 30 today, and she is planning to save $3,000 per year for retirement, with the first deposit to be made one year from today. She will invest in a mutual fund, which she expects to provide a return of 10% per year. She plans to retire 35 years from today when she turns 65, and she expects to live for 30 years after retirement, to age 95. Under these assumptions, how much can she spend each year after she retires? Her first withdrawal will be made at the end of her first retirement year. (d) a. $78,976 b. $91,110 c. $88,513 d. $86,250 e. $83,049 (Step 1: PMT = -3,000, I/YR = 10% (enter 10), N = 35, PV = 0, solve for FV = 813,073.11; Step 2: PV = -813,073.11, FV = 0, N = 30, I/YR = 10%, solve for PMT) 5. Companies generate income from their "regular" operations and from things like interest on securities they hold, which is called non-operating income. Mitel Metals recently reported $9,000 of sales, $6,000 of operating costs excluding depreciation, and $1,500 of depreciation. The company had no amortization charges and no nonoperating income. It had issued $4,000 of bonds that carry a 7% interest rate, and its federal-plus-state income tax rate was 40%. What was the firm's operating income, or EBIT? (e) a. $1,100 b. $1,200 c. $1,300 d. $1,400 e. $1,500 (Sales – operating cost – depreciation and amortization = EBIT) 2 6. Temple Square Inc. reported that its retained earnings for 2009 were $490,000. In its 2010 financial statements, it reported $60,000 of net income, and it ended 2010 with $510,000 of retained earnings. How much were paid out as cash dividends to shareholders during 2010? (e) a. $20,000 b. $25,000 c. $30,000 d. $35,000 e. $40,000 (R/E in 2010 = 510,000 – 490,000 = 20,000, so cash dividend = 60,000 – 20,000 = 40,000) 7. Collins Inc's latest net income was $1 million, and it had 200,000 shares outstanding. The company wants to pay out 40% of its income. What dividend per share should the company declare? (e) a. $1.60 b. $1.70 c. $1.80 d. $1.90 e. $2.00 (1,000,000*40% = 400,000 dividend, DPS = 4000,000 / 200,000 = $2 per share) 8. Approximately how long will it take to double your money if the interest rate is 12% compounded annually? (d) a. 12 years b. 10 years c. 8 years d. 6 years e. None of the above (PV = -1, FV = 2, I/YR = 12% (enter 12), PMT = 0, solve for N) 9. Which of the following statements is correct? (e) a. If you purchase 100 shares of Disney stock from your brother-in-law, this is an example of a primary market transaction. b. If Disney issues additional shares of common stock through an investment banker, this would be a secondary market transaction. c. The NYSE is an example of an over-the-counter market. d. Only institutions, and not individuals, can engage in the derivatives markets. e. As they are generally defined, money market transactions involve debt securities with maturities of less than one year. (You need to know the definitions of different financial markets) 10. Suppose you have a daughter who just turned 8. You would like to set up an education account for her. You plan to save each year in next 10 years and the first investment will be made in one year. The money in the education account earns 12%, compounded annually. It is expected that your daughter needs $20,000 per year for 4 years to finish her college. The first withdraw will take place when she turns 18 (ordinary annuity or annuity due?). How much should you save each year in next 10 years? (d) a. b. c. d. e. $8,000.00 $5,454.45 $4,356.34 $3,877.01 $3,233.05 3 (First, it is an annuity due problem for the daughter. Step 1: PMT = 20,000, N = 4, FV = 0, I/YR = 12% (enter 12), solve for PV = -60,746.99, then multiply that by (1 + 12%) to get -68,036.63. Second, it is an ordinary problem for the father. Step 2: FV = 68,036.63, PV = 0, I/YR = 12% (enter 12), N = 10, solve for PMT) 11. Capital markets are markets for (e) a. short-term debts. b. consumer automobile loans. c. corporate stocks. d. long-term bonds. e. Both c and d are correct. (Capital markets are markets for long-term debt and stocks while money markets are markets for short-term debt) 12. All of the following represent cash outflows to a firm except (a) a. Depreciation. b. Interest payments. c. Dividends. d. Purchase of plant and equipment. e. Taxes. (Only depreciation is not a cash outflow) 13. What will be the present value of the following uneven cash flows if the interest rate is 8%? (b) 100 200 200 200 200 -------------------------------------------------0 1 2 3 4 5 a. 650.25 b. 705.95 c. 805.50 d. 855.90 e. None of the above (Use CF functions. CF0 = 0, press enter, press arrow done, C01 = 100, press enter, press arrow done, F01 = 1, press arrow down, C02 = 200, press enter, press arrow done, F02 = 4, press enter, press arrow done, press NPV, I/YR = 8% (enter 8), press enter, press arrow done, and press CPT) 14. ABC’s return on equity (ROE) is 15%. If sales were $10 million, the debt ratio was 40%, and total liabilities were $5 million, what would be ABC’s return on assets (ROA)? (c) a. 15% b. 10% c. 9% d. 8% e. 7% (ROE = ROA*EM. If debt ratio is 40%, then equity ratio is 60% and EM is 5/3) 4 15. If you buy a condominium for $200,000 and the terms are 10% down, the balance of $180,000 to be paid off over 15 years at a 6% rate of interest on the unpaid balance, what is your annual payment? (a) a. 18,533.30 b. 19,976.23 c. 20,143.56 d. 21,367.12 e. 22,102.31 (PV = 180,000, N = 15, I/YR = 6% (enter 6), FV = 0, solve for PMT) 16. In the above question, what is your monthly payment? (b) a. 1,456.89 b. 1,518.94 c. 1,606.25 d. 1,664.67 e. 1,734.29 (PV = 180,000, N = 180 (180 monthly payments), I/YR = 0.5% per month (enter 0.5), FV = 0, solve for PMT) 17. You are considering investing in either XYZ bonds that yield 6% or state of California municipal bonds that yield 4.0%. What should be your marginal tax rate such that you will be indifferent between these two investments based on after tax returns (ignore the risk)? (c) a. 28.00% b. 31.00% c. 33.33% d. 36.66% e. 38.00% (4% = 6%*(1-T), solve for T = 33.33%. You are indifferent if two investments provide the same after-tax returns) 18. Loan amortization schedule Amount borrowed: $100,000 Years: 5 Rate: 6% compounded annually PMT: -$23,739.64 (PV = 100,000, N = 5, I/YR = 6%, FV = 0, solve for PMT) Year 1 2 3 4 5 Beginning Amount (1) $100,000.00 82,260.36 63,456.34 43,524.08 22,395.89 Payment (2) $23,739.64 23,739.64 23,739.64 23,739.64 23,739.64 Interest (3) $6,000.00 4,935.62 3,807.38 2,611.44 1,343.75 Repayment of Principal (4) $17,739.64 18,804.02 19,932.26 21,128.20 22,395.89 Ending Balance (5) $82,260.36 63,456.34 43,524.08 22,395.89 0.00 Interest (3) = Beginning Amount (1)*6% Repayment of Principal (4) = Payment (2) – Interest (3) Ending Balance (5) = Beginning Amount (1) – Repayment of Principal (4) 5 For the next three questions, suppose the following holds: You are given the following information about ABC Company for 2010: Sales = $600,000 (+600,000) Cost of goods sold = $200,000 (-200,000) Operating expenses = $100,000 (-100,000) Depreciation expenses = $6,000 (-6,000) Dividend income = $20,000 (+6,000, since 70% is tax-exempt) Common stock dividend paid = $35,000 (irrelevant, should not be included) Interest income = $20,000 (+20,000) Interest paid = $40,000 (-40,000) Capital gains = $30,000 (+30,000, no short-term or long-term difference) Capital loss carried forward from 2009 = $20,000 (-20,000 to offset capital gains) Corporate Income $ 050,000 $ 50,000 75,000 $ 75,000 - 100,000 $ 100,000 - 335,000 $ 335,000 - 10,000,000 $10,000,000 - 15,000,000 $15,000,000 - 18,333,333 Over $18,333,333 19. Corporate Tax Rates Base $ 0 7,500 13,750 22,250 113,900 3,400,000 5,150,000 6,416,667 What is taxable income for ABC in 2010? Tax Rate 15% 25% 34% 39% 34% 35% 38% 35% Average Rate 15.0% 18.3% 22.3% 34.0% 34.0% 34.3% 35.0% 35.0% (c) a. $355,000 b. $310,000 c. $290,000 d. $276,000 e. $250,000 (See the detailed calculations above) 20. How much in taxes should ABC pay in 2010? a. $ 96,350 b. $114,580 c. $104,150 d. $ 90,890 e. $ 80,750 (22,250 + (290,000 – 100,000)*(0.39) = 96,350) 6 (a) 21. What are the marginal and average tax rates for the company in 2010? (b) a. 34%, 32.45% b. 39%, 33.22% c. 39%, 35.23% d. 34%, 30.23% e. 39%, 34.00% (Marginal is 39% and average is 96,350 / 290,000 = 33.22%) For the next three questions, suppose the following holds: The projected taxable income for ABC to be formed in 2008 is indicated in the following table. The tax rate for ABC is 40%. Year Taxable income 2008 ($5,000,000) 2009 4,000,000 2010 4,000,000 2011 (2,000,000) 22. What would be the tax liability for ABC in year 2009? (b) a. There would be no taxes due and there would be $5,000,000 loss to carry forward. b. There would be no taxes due and there would be $1,000,000 loss to carry forward. c. There would be no taxes due and there would be no loss to carry forward. d. There would be a tax liability of $1,000,000. e. There would be a tax liability of $400,000. (No taxes due in 2009 for ABC since the loss of 5 million from 2008 can be used to offset 4 million of income in 2009. In addition, ABC will have 1 million of loss to carry forward to 2010) 23. What would be the tax liability for ABC in year 2010? (e) a. There would be no taxes due and there would be $3,000,000 loss to carry back. b. There would be no taxes due and there would be $1,000,000 loss to carry back. c. There would be no taxes due and there would be no loss to carry forward. d. There would be a tax liability of $3,000,000. e. There would be a tax liability of $1,200,000. (ABC has a taxable income of 3 million and needs to pay 1.2 million of taxes since the loss of 1 million carried forward from 2009 can only offset 1 million of income in 2010) 7 24. What is the tax liability for ABC in year 2011? (a) a. There would be no taxes due and there would be $2,000,000 loss to carry back for a refund of $800,000. b. There would be no taxes due and there would be $1,000,000 loss to carry back for a refund of $400,000. c. There would be no taxes due and there would be no loss to carry back. d. There would be a tax liability of $1,000,000. e. There would be a tax liability of $400,000. (No taxes due for ABC in 2011. In addition, the firm can carry 2 million of loss in 2011 back to 2010 to offset 2 million of taxable income to get a refund of 800,000) 25. Travis Corp.'s bonds currently sell for $1,050. They have an 8% annual coupon rate (payable semiannually) and a 20-year maturity, but they can be called in 5 years at $1,120. Assume that no costs other than the call premium would be incurred to call and refund the bonds, and also assume that the yield curve is horizontal, with rates expected to remain at current levels on into the future. Under these conditions, what is yield to call (YTC)? (e) a. 7.51% b. 7.71% c. 8.04% d. 8.37% e. 8.71% (PV = -1,050, PMT = 40, N = 10, FV = 1,120, solve for I/YR = 4.356%, YTC = 4.356%*2) 26. If the expectations theory of the term structure of interest rates is correct, and if the other term structure theories are invalid, and we observe a downward sloping yield curve, which of the following is a true statement? (c) a. b. c. d. Investors expect short-term rates to be constant over time. Investors expect short-term rates to increase in the future. Investors expect short-term rates to decrease in the future. It is impossible to say unless we know whether investors require a positive or negative maturity risk premium. e. The maturity risk premium must be positive. (If a yield curve is downward sloping, it implies that the short-term rates in the future will be lower) For the next three questions, suppose the following holds: k* = real risk-free rate = 2% Constant inflation premium = 3% Maturity risk premium = (t-1)*0.1%, t is the number of years till maturity Default risk premium = 1% Liquidity premium = 1% Assume that XYZ corporate bonds are not liquid in the market and the expected rate of inflation is a constant. 8 27. What should be the nominal risk-free rate for 3-month T-bills? a. 4% b. 5% c. 6% d. 7% (2% + 3% = 5% since MRP = DRP = LP = 0 for T-bills) 28. e. 8% What should be the rate on a 20 year T-bond? a. 5.0% b. 5.9% c. 6.9% d. 7.9% e. 8.9% (2% + 3% + (20 - 1)*0.1% = 6.9% since DRP = LP = 0 for T-bonds) 29. (b) (c) What should be the rate on a 20 year XYZ bond? a. 5.0% b. 5.9% c. 6.9% d. 7.9% e. 8.9% (e) (2% + 3% + (20 - 1)*0.1% + 1% + 1% since it is a corporate bond and it is not liquid) 30. A 4.5% coupon bond issued by the State of Pennsylvania sells for $1,000 and thus provides a 4.5% yield to maturity. What coupon rate on a Synthetic Chemical Company bond that also sells at its $1,000 par value would cause the two bonds to provide the same after-tax return to an investor in the 28% tax bracket? (a) a. 6.25% b. 6.50% c. 6.75% d. 7.00% (X*(1 - 28%) = 4.5%, solve for X = 6.25%) e. 4.50% For the next two questions, suppose the following holds: Suppose the annual yield on a 2-year T-bond is 6%, while that on a 1-year T-bond is 5%. The real risk-free rate (r*) is 3%, and the maturity risk premium is zero. 31. Using the expectation theory, what should be the interest rate on a 1-year T-bond during the second year (or the forward rate between year 1 and year 2)? (c) a. 9% b. 8% (2*6% - 5% = 7%) 32. c. 7% d. 6% What are the expected inflation rates in year1 and year 2? e. 5% (a) a. 2%, 4% b. 2%, 6% c. 4%, 2% d. 2%, 2% e. none of the above (5% = 3% + IP1, so IP1 = 2% = inf1; 6% = 3% + IP2, so IP2 = 3% = (inf1 + inf2) / 2; since inf1 = 2%, so inf2 = 4%) 9 For the next two questions, suppose the following holds: ABC Corporation is trying to choose among three alternative investments shown below: (1) Tax-free municipal bonds with a return of 5% (2) XYZ corporation bonds with a return of 8% (3) CFI corporation preferred stock with a dividend yield of 6% The company’s tax rate is 40%. Assume the company chooses the best alternative based on the after tax return (hint: 70% of dividend received by a corporation is tax exempt). 33. What is the after tax return for ABC if it chooses CFI preferred stock? (c) a. 3.60% b. 5.00% c. 5.28% d. 6.00% e. None of the above (6% - 6%*30%*40% = 5.28% since only 30% of dividend is taxable and the tax rate is 40%) 34. Which alternative should the company choose? (c) a. Tax-free municipal bonds b. XYZ corporate bonds c. CFI preferred stock d. All of them e. None of them (CFI provides the highest after tax return, compared with 5% from municipal bonds or 8%*(1 - 0.4) = 4.8% from XYZ bonds) For the next two questions, suppose the following holds: You just purchased a 20-year bond that pays $50 in interest each six months. You plan to hold this bond for only 10 years, at which time you will sell it in the marketplace. The required rate of return for this bond is believed to be 12%. 35. What is the annual coupon interest rate for the bond? (e) a. 5.00% b. 7.50% c. 8.50% d. 9.00% e. 10.00% ($50 in every 6 months or $100 per year, so the coupon rate is 10% since the face value is $1,000) 36. What will be the price of the bond 10 years from today? (b) a. $775.55 b. $885.30 c. $945.23 d. $1,000 e. $1,123.45 (There will be 10 years left. PMT = 50, N = 20, I/YR = 6%, FV = 1,000, solve for PV = -885.30) 10 37. Keeping other things constant, if market interest rates rise, the current yield (CY) for a bond will (b) a. decrease. b. increase. c. not change. d. All of the above are possible. e. None of the above can happen. (If market interest rates rise, bond prices will fall. As a result, CY will rise) 38. Which of the following events would make it more likely that a company would choose to call its outstanding callable bonds? (a) a. Market interest rates decline sharply. b. The company’s bonds are downgraded. c. Market interest rates rise sharply. d. Inflation increases significantly. e. The company's financial situation deteriorates significantly. (When market interest rates drop, firms tend to call their bonds) 39. Which of the following statements is correct? (e) a. Risk refers to the chance that some unfavorable event will occur, and a probability distribution is completely described by a listing of the likelihood of unfavorable events. b. Portfolio diversification reduces the variability of returns on an individual stock. c. When company-specific risk has been diversified away, the inherent risk that remains is market risk, which is constant for all stocks in the market. d. A stock with a beta of -1.0 has zero market risk if held in a 1-stock portfolio. e. The SML relates its required return to a firm’s market risk. The slope and intercept of this line cannot be controlled by the financial manager. (Refer to the concept of SML) 40. If a stock’s expected return exceeds its required return, this suggests that (d) a. The stock is experiencing supernormal growth. b. The stock should be sold. c. The company is probably not trying to maximize price per share. d. The stock is probably a good buy. e. Dividends are not being declared. (If expected return exceeds required return, the asset is undervalued to the investor) 11 41. Which of the following statements is correct, assuming that the risk-free rate is a constant. (c) a. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%. b. If the market risk premium increases by 1%, then the required return will increase for stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0. c. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0. d. The effect of a change in the market risk premium depends on the level of the risk-free rate. e. The effect of a change in the market risk premium depends on the slope of the yield curve. (Refer to the concept of CAPM) For the next three questions, suppose the following holds: Suppose securities I and J have the following probability distributions: State i ------1 2 42. Pi ---0.5 0.5 kI ---6% 18% kJ ---24% 4% What is the expected rate of return for I and for J? (b) a. 6% and 18% b. 12% and 14% c. 24% and 4% d. 6% and 24% e. 18% and 4% (0.5*6 + 0.5*18 = 12% for I, 0.5*24 + 0.5*4 = 14% for J) 43. What is the standard deviation for I and for J? a. 6% and 10% b. 6% and 12% c. 12% and 10% d. 12% and 14% e. 18% and 4% [0.5*(6-12)2 + 0.5*(18-12)2]1/2 = 6% for I [0.5*(24-14)2 + 0.5*(4-14)2]1/2 = 10% for J 12 (a) 44. Suppose 60% of your money is invested in security I and the rest in security J. What is the expected rate of return for your portfolio? (a) a. 12.8% b. 10.8% (0.6*12 + 0.4*14 = 12.8%) 45. c. 12.4% d. 13.6% e. 14.8% Stock A has a beta of 1.5 and Stock B has a beta of 0.5. Which of the following statements must be true about these securities? Assume the market is in equilibrium. (d) a. When held in isolation, Stock A has more risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. Stock A would be a more desirable addition to a portfolio than Stock B. d. The expected return on Stock A will be greater than that on Stock B. e. The expected return on Stock B will be greater than that on Stock A. (Since A carries a higher level of market risk, in equilibrium, A should earn a higher return) For the next three questions, suppose the following holds: Suppose you are the manager of a $2 million mutual fund. The fund consists of three stocks with the following investments and betas: Stock Investment Beta A $ 400,000 1.00 B 600,000 1.20 C 1,000,000 1.50 46. What is the beta of the fund? (c) a. 1.20 b. 1.23 c. 1.31 d. 1.42 e. 1.50 (Total investment is 2,000,000, so the weights are 20% in A, 30% in B, and 50% in C. Beta of the fund = (0.2)*1 + (0.3)*1.2 + (0.5)*1.5 = 1.31 47. If the expected market return is 10% and the risk-free rate is 4%, what is the fund’s required rate of return? (b) a. 10.00% b. 11.86% c. 12.35% d. 14.00% e. 14.32% (Using CAPM, fund return = 4% + (10% - 4%)*1.31 = 11.86%) 48. What is the expected risk premium for the fund? a. 10.00% b. 11.86% c. 12.35% d. 14.00% (The risk premium = (10% - 4%)*1.31 = 7.86%) 13 e. 14.32%