# Multiple choice / short answer questions

See the attached file for proper formatting.

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1. Which of the following statements about interest rate and reinvestment rate risk is correct?

Variable, or floating rate, securities have a high degree of interest rate (price) risk.

Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.

Price risk can be eliminated by purchasing zero coupon bonds.

Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.

All of the statements above are correct.

2. Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 35 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual cost of its non-free trade credit? (Assume a 365-day year.)

17.2%

23.6%

26.1%

37.2%

50.6%

3. Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will be the nominal annual cost of trade credit if your company pays on the 35th day after receiving the invoice? (Assume a 365-day year.)

30%

304%

3%

87%

156%

4. Which of the following statements is most correct?

If new debt is used to refund old debt, the correct discount rate to use in discounting cash flows is the before-tax cost of new debt.

The key benefit associated with refunding debt is the reduction in the firm's debt ratio and creation of reserve borrowing capacity.

The mechanics of analyzing the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not as clear because it requires a forecast of future interest rates.

If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still claim the entire interest savings by locking in a low coupon rate when the rates are low, even though it refunds the debt after rates rise.

If a firm is considering refunding and interest rates rise, this would tend to lower the expected price of the new bonds which will make them cheaper to the firm and increase the expected interest savings.

5. Which of the following statements is most correct?

One of the key steps in the development of pro forma financial statements is to identify those assets and liabilities which increase spontaneously with net income.

The first, and most critical, step in constructing a set of pro forma financial statements is establishing the sales forecast.

Pro forma financial statements as discussed in the text are used primarily to assess a firm's historical performance.

The capital intensity ratio reflects how rapidly a firm turns over its assets and is the reciprocal of the fixed assets turnover ratio.

The percentage of sales method produces accurate results when fixed assets are lumpy and when economies of scale are present.

6. Which of the following statements is most correct?

Inherent in the AFN formula is the assumption that each asset item must increase in direct proportion to sales increases and that spontaneous liability accounts also grow at the same rate as sales.

If a firm has positive growth in its assets, but has no increase in retained earnings, AFN for the firm must be positive.

Using the AFN formula, if a firm increases its dividend payout ratio in anticipation of higher earnings, but sales actually decrease, the firm will automatically experience an increase in additional funds needed.

Higher sales usually require higher asset levels. Some of the increase in assets can be supported by spontaneous increases in accounts payable and accruals, and by increases in certain current asset accounts and retained earnings.

Dividend policy does not affect requirements for external capital under the AFN formula method.

7. The post-audit is used to

Improve cash flow forecasts.

Stimulate management to improve operations and bring results into line with forecasts.

Eliminate potentially profitable but risky projects.

All of the answers above are correct.

Answers a and b are correct.

8. Braun Industries is considering an investment project which has the following cash flows: Year Cash Flow 0 -$1,000 1 400 2 300 3 500 4 400 The company's WACC is 10 percent. What is the project's payback, internal rate of return, and net present value?

Payback = 2.4, IRR = 10.00%, NPV = $600.

Payback = 2.4, IRR = 21.22%, NPV = $260.

Payback = 2.6, IRR = 21.22%, NPV = $300.

Payback = 2.6, IRR = 21.22%, NPV = $260.

Payback = 2.6, IRR = 24.12%, NPV = $300.

9. Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, and its growth rate is a constant 6 percent. What is its cost of common stock, rs?

5.0%

5.3%

11.0%

11.3%

11.6%

10. An analyst has collected the following information regarding Christopher Co.: ? The company's capital structure is 70 percent equity, 30 percent debt. ? The yield to maturity on the company's bonds is 9 percent. ? The company's year-end dividend is forecasted to be $0.80 a share. ? The company expects that its dividend will grow at a constant rate of 9 percent a year. ? The company's stock price is $25. ? The company's tax rate is 40 percent. ? The company anticipates that it will need to raise new common stock this year. Its investment bankers anticipate that the total flotation cost will equal 10 percent of the amount issued. Assume the company accounts for flotation costs by adjusting the cost of capital. Given this information, calculate the company's WACC.

10.41%

12.56%

10.78%

13.55%

9.29%

#### Solution Preview

Please see attached Excel file for proper formatting.

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1. Which of the following statements about interest rate and reinvestment rate risk is correct?

Variable, or floating rate, securities have a high degree of interest rate (price) risk.

Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.

Price risk can be eliminated by purchasing zero coupon bonds.

Reinvestment rate risk can be eliminated by purchasing variable, or floating, rate bonds.

All of the statements above are correct.

Answer:

Price risk occurs because fixed-rate debt securities lose value when interest rates rise, while reinvestment rate risk is the risk of earning less than expected when interest payments or debt principal are reinvested.

Variable, or floating rate, securities do not have a high degree of interest rate (price) risk as the interest payments received from the floating rate securities change with changes in interest rates

Zero coupon bonds have a high price risk

Reinvestment rate risk can not be eliminated by purchasing variable, or floating, rate bonds as the interest payments have to be reinvested at the prevailing interest rates.

2. Dixie Tours Inc. buys on terms of 2/15, net 30 days. It does not take discounts, and it typically pays 35 days after the invoice date. Net purchases amount to $720,000 per year. What is the nominal annual cost of its non-free trade credit? (Assume a 365-day year.)

17.2%

23.6%

26.1%

37.2%

50.6%

Answer: 37.2%

Terms

Discount= 2%

Discount period= 15 days

Period after which amount is paid= 35 days

Assume the payment is for $100.00

During the first 15 days you obtain a free ride on the seller's credit

If you do not take the cash discount, in effect you are borrowing the difference between the total amount billed

$100.and the amount of the cash discount $2. which, of course is $98.

Per period cost of loan

= dollar cash discount/dollar amount of loan= $2./ $98. = 2.04%

No of periods= 365 days/ (35days - 15days )= 18.25 periods

Nominal annual cost= 37.2% = 2.04%x18.25

3. Your company has been offered credit terms on its purchases of 4/30, net 90 days. What will be the nominal annual cost of trade credit if your company pays on the 35th day after receiving the invoice? (Assume a 365-day year.)

30%

304%

3%

87%

156%

Answer: 304%

Terms

Discount= 4%

Discount period= 30 days

Period after which amount is paid= 35 days

Assume the payment is for $100.00

During the first 30 days you obtain a free ride on the seller's credit

If you do not take the cash discount, in effect you are borrowing the difference between the total amount billed

$100.and the amount of the cash discount $4. which, of course is $96.

Per period cost of loan

= dollar cash discount/dollar amount of loan= $4./ $96. = 4.17%

No of periods= 365 days/ (35days - 30days) = 73 periods

Nominal annual cost = 304% = 4.17%x73

4. Which of the following statements is most correct?

If new debt is used to refund old debt, the correct discount rate to use in discounting cash flows is the before-tax cost of new debt.

The key benefit associated with refunding debt is the reduction in the firm's debt ratio and ...

#### Solution Summary

Answers to Multiple choice / short answer questions