9. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. A) True B) False 10. If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? A) It is impossible to tell without knowing the coupon rates of the bonds. B) The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium. C) The yields on the two securities would be equal. D) It is impossible to tell without knowing the relative risks of the two securities. E) The yield on a 10-year bond would be less than that on a 1-year bill. 11. Which of the following statements is CORRECT? A) An NPV profile graph shows how a projects payback varies as the cost of capital changes. B) The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. C) An NPV profile graph is designed to give decision makers an idea about how a projects risk varies with its life. D) We cannot draw a projects NPV profile unless we know the appropriate WACC for use in evaluating the projects NPV. E) An NPV profile graph is designed to give decision makers an idea about how a projects contribution to the firms value varies with the cost of capital. 12. Stocks A and B have the same price and are in equilibrium, but Stock A has the higher required rate of return. Which of the following statements is CORRECT? A) Stock B must have a higher dividend yield than Stock A. B) If Stock A has a lower dividend yield than Stock B, its expected capital gains yield must be higher than Stock Bs. C) Stock A must have a higher dividend yield than Stock B. D) Stock A must have both a higher dividend yield and a higher capital gains yield than Stock B. E) If Stock A has a higher dividend yield than Stock B, its expected capital gains yield must be lower than Stock Bs. 13. Which of the following statements is CORRECT? A) A sinking fund provision makes a bond more risky to investors at the time of issuance. B) Sinking fund provisions never require companies to retire their debt; they only establish targets for the company to reduce its debt over time. C) If interest rates increase after a company has issued bonds with a sinking fund, the company will be less likely to buy bonds on the open market to meet its sinking fund obligation and more likely to call them in at the sinking fund call price. D) Most sinking funds require the issuer to provide funds to a trustee, who holds the money so that it will be available to pay off bondholders when the bonds mature. E) Sinking fund provisions sometimes turn out to adversely affect bondholders, and this is most likely to occur if interest rates decline after the bond was issued. 14. Which of the following events would make it more likely that a company would call its outstanding callable bonds? A) The company's financial situation deteriorates significantly. B) Market interest rates decline sharply. C) Market interest rates rise sharply. D) The companys bonds are downgraded. E) Inflation increases significantly. 15. Stock A has an expected return of 10% and a standard deviation of 20%. Stock B has an expected return of 13% and a standard deviation of 30%. The risk-free rate is 5% and the market risk premium, rM rRF, is 6%. Assume that the market is in equilibrium. Portfolio AB has 50% invested in Stock A and 50% invested in Stock B. The returns of Stock A and Stock B are independent of one another, i.e., the correlation coefficient between them is zero. Which of the following statements is CORRECT? A) Since the two stocks have zero correlation, Portfolio AB is riskless. B) Portfolio AB's standard deviation is 25%. C) Portfolio AB's required return is 11%. D) Stock B's beta is 1.0000. E) Stock A's beta is 0.8333. 16. Which of the following bonds has the greatest interest rate price risk? A) A 10-year, $1,000 face value, 10% coupon bond with annual interest payments. B) All 10-year bonds have the same price risk since they have the same maturity. C) A 10-year $100 annuity. D) A 10-year, $1,000 face value, 10% coupon bond with semiannual interest payments. E) A 10-year, $1,000 face value, zero coupon bond. 17. Which of the following factors would be most likely to lead to an increase in nominal interest rates? A) There is a decrease in expected inflation. B) The Federal Reserve decides to try to stimulate the economy. C) The economy falls into a recession. D) A new technology like the Internet has just been introduced, and it increases investment opportunities. E) Households reduce their consumption and increase their savings. 18. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 10.5%, and the expected constant growth rate is g = 6.4%. What is the stock's current price? A) $18.75 B) $19.22 C) $17.84 D) $18.29 E) $17.39 19. Which of the following statements is CORRECT? A) The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects. B) If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. C) Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. D) The percentage difference between the MIRR and the IRR is equal to the projects WACC. E) For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. 20. The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T). A) True B) False 21. The preemptive right is important to shareholders because it A) is included in every corporate charter. B) protects bondholders, and thus enables the firm to issue debt with a relatively low interest rate. C) will result in higher dividends per share. D) protects the current shareholders against a dilution of their ownership interests. E) allows managers to buy additional shares below the current market price. 22. The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. A) True B) False 23. Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method? A) Ignores cash flows beyond the payback period. B) Does not directly account for the time value of money. C) Lacks an objective, market-determined benchmark for making decisions. D) Does not take account of differences in size among projects. E) Does not provide any indication regarding a projects liquidity or risk. 24. Assume that you hold a well-diversified portfolio that has an expected return of 11.0% and a beta of 1.20. You are in the process of buying 1,000 shares of Alpha Corp at $10 a share and adding it to your portfolio. Alpha has an expected return of 13.0% and a beta of 1.50. The total value of your current portfolio is $90,000. What will the expected return and beta on the portfolio be after the purchase of the Alpha stock? A) 10.64%; 1.17 B) 12.97%; 1.42 C) 11.76%; 1.29 D) 12.35%; 1.36 E) 11.20%; 1.23 25. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. A) True B) False 26. Suppose the real risk-free rate is 3.00%, the average expected future inflation rate is 2.25%, and a maturity risk premium of 0.10% per year to maturity applies, i.e., MRP = 0.10%(t), where t is the years to maturity. What rate of return would you expect on a 1-year Treasury security, assuming the pure expectations theory is NOT valid? Disregard cross-product terms, i.e., if averaging is required, use the arithmetic average. A) 5.62% B) 5.08% C) 5.90% D) 6.19% E) 5.35% 27. Which of the following statements is CORRECT? A) Portfolio diversification reduces the variability of returns (as measured by the standard deviation) of each individual stock held in a portfolio. B) A security's beta measures its non-diversifiable, or market, risk relative to that of an average stock. C) If an investor buys enough stocks, he or she can, through diversification, eliminate all of the diversifiable risk inherent in owning stocks. Therefore, if a portfolio contained all publicly traded stocks, it would be essentially riskless. D) A stock's beta is less relevant as a measure of risk to an investor with a well-diversified portfolio than to an investor who holds only that one stock. E) The required return on a firm's common stock is, in theory, determined solely by its market risk. If the market risk is known, and if that risk is expected to remain constant, then no other information is required to specify the firm's required return. 28. Which of the following statements is CORRECT? A) The expected return on a corporate bond must be greater than its promised return if the probability of default is greater than zero. B) A companys bond rating is affected by its financial ratios but not by provisions in its indenture. C) All else equal, senior debt has more default risk than subordinated debt. D) Under Chapter 11 of the Bankruptcy Act, the assets of a firm that declares bankruptcy must be liquidated, and the sale proceeds must be used to pay off claims against it according to the priority of the claims as spelled out in the Act. E) All else equal, secured debt is more risky than unsecured debt. 29. Junk bonds are high-risk, high-yield debt instruments. They are often used to finance leveraged buyouts and mergers, and to provide financing to companies of questionable financial strength. A) True B) False 30. Stocks X and Y have the following data. Assuming the stock market is efficient and the stocks are in equilibrium, which of the following statements is CORRECT? X Y Price $30 $30 Expected growth (constant) 6% 4% Required return 12% 10% A) Stock Y has a higher capital gains yield. B) One year from now, Stock Xs price is expected to be higher than Stock Ys price. C) Stock X has a higher dividend yield than Stock Y. D) Stock Y has a higher dividend yield than Stock X. E) Stock X has the higher expected year-end dividend.

31. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is CORRECT?

Answer

a. If the bonds yield to maturity declines, the bond will sell at a discount.

b. The bonds current yield is above 9%.

c. The bonds current yield is less than its expected capital gains yield.

d. The bonds yield to maturity is above 9%.

e. The bonds expected capital gains yield is zero.

32. A 10-year Treasury bond has an 8% coupon, and an 8-year Treasury bond has a 10% coupon. Neither is callable, and both have the same yield to maturity. If the yield to maturity of both bonds increases by the same amount, which of the following statements would be CORRECT

Answer

a. One bond's price would increase, while the other bonds price would decrease.

b. The prices of both bonds would increase by the same amount.

c. The prices of both bonds will decrease by the same amount.

d. The prices of the two bonds would remain constant.

e. Both bonds would decline in price, but the 10-year bond would have the greater percentage decline in price

33. Which of the following statements is CORRECT

Answer

a. A debenture is a secured bond that is backed by some or all of the firms assets.

b. Convertible bonds generally have lower coupon rates than non-convertible bonds of similar default risk because they offer the possibility of capital gains.

c. Senior debt is debt that has been more recently issued, and in bankruptcy it is paid off after junior debt because the junior debt was issued first.

d. A company's subordinated debt has less default risk than its senior debt.

e. Junk bonds typically provide a lower yield to maturity than investment-grade bonds.

34. Which of the following statements is CORRECT?

Answer

a. Income bonds must pay interest only if the company earns the interest. Thus, these securities cannot bankrupt a company prior to their maturity, and this makes them safer to the issuing corporation than "regular" bonds.

b. A firm with a sinking fund that gives it the choice of calling the required bonds at par or buying the bonds in the open market would generally choose the open market purchase if the coupon rate exceeded the going interest rate.

c. Other things held constant, a callable bond should have a lower yield to maturity than a noncallable bond.

d. One disadvantage of zero coupon bonds is that the issuing firm cannot realize any tax savings from the use of debt until the bonds mature.

e. Once a firm declares bankruptcy, it must be liquidated by the trustee, who uses the proceeds to pay bondholders, unpaid wages, taxes, and legal fees

35 A company is planning to raise $1,000,000 to finance a new plant. Which of the following statements is CORRECT

Answer

a. If debt is used to raise the million dollars, the cost of the debt would be higher if the debt were in the form of a mortgage bond rather than an unsecured term loan.

b. The company would be especially eager to have a call provision included in the indenture if its management thinks that interest rates are almost certain to rise in the foreseeable future.

c. If debt is used to raise the million dollars, the cost of the debt would be lower if the debt were in the form of a fixed-rate bond rather than a floating-rate bond.

d. If two classes of debt are used (with one senior and the other subordinated to all other debt), the subordinated debt will carry a lower interest rate.

e. If debt is used to raise the million dollars, but $500,000 is raised as first mortgage bonds on the new plant and $500,000 as debentures, the interest rate on the first mortgage bonds would be lower than it would be if the entire $1 million were raised by selling first mortgage bonds.

.

36. Taussig Corp.'s bonds currently sell for $840. They have a 6.35% annual coupon rate and a 20-year maturity, but they can be called in 5 years at $1,067.50. 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 rate of return should an investor expect to earn if he or she purchases these bonds?

Answer

a. 7.98%

b. 8.69%

c. 7.74%

d. 9.81%

e. 6.94%