# 38. the average annual return on small-company stocks was about _____

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38. The average annual return on small-company stocks was about _____ percent greater than the average annual return on large-company stocks over the period 1926-2007.

A. 3

B. 5

C. 7

D. 9

E. 11

39. To convince investors to accept greater volatility, you must:

A. decrease the risk premium.

B. increase the risk premium.

C. decrease the real return.

D. decrease the risk-free rate.

E. increase the risk-free rate.

40. According to Jeremy Siegel, the real return on stocks over the long-term has averaged about:

A. 6.8 percent

B. 8.7 percent

C. 10.4 percent

D. 12.3 percent

E. 14.8 percent

41. Which of the following statements are correct?

I. The SML approach is dependent upon a reliable measure of a firm’s unsystematic risk.

II. The SML approach can be applied to firms that retain all of their earnings.

III. The SML approach assumes a firm’s future risks are similar to its past risks.

IV. The SML approach assumes the reward-to-risk ratio is constant.

A. I and III only

B. II and IV only

C. III and IV only

D. I, II, and III only

E. II, III, and IV only

42. The capital structure weights used in computing the weighted average cost of capital:

A. are based on the book values of total debt and total equity.

B. are based on the market value of the firm’s debt and equity securities.

C. are computed using the book value of the long-term debt and the book value of equity.

D. remain constant over time unless the firm issues new securities.

E. are restricted to the firm’s debt and common stock.

43. Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to:

A. receive less project funding if its line of business is riskier than that of the other divisions.

B. avoid risky projects so it can receive more project funding.

C. become less risky over time based on the projects that are accepted.

D. have equal probability of receiving funding as compared to the other divisions.

E. prefer higher risk projects over lower risk projects.

44. Phil’s is a sit-down restaurant that specializes in home-cooked meals. Theresa’s is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil’s currently has a WACC of 14 percent while Theresa’s WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months?

A. Phil’s only

B. Theresa’s only

C. both Phil’s and Theresa’s

D. neither Phil’s nor Theresa’s

E. cannot be determined from the information provided

45. The pre-tax cost of debt:

A. is based on the current yield to maturity of the firm’s outstanding bonds.

B. is equal to the coupon rate on the latest bonds issued by a firm.

C. is equivalent to the average current yield on all of a firm’s outstanding bonds.

D. is based on the original yield to maturity on the latest bonds issued by a firm.

E. has to be estimated as it cannot be directly observed in the market.

46. Which one of the following statements related to the SML approach to equity valuation is correct? Assume the firm uses debt in its capital structure.

A. This model considers a firm’s rate of growth.

B. The model applies only to non-dividend paying firms.

C. The model is dependent upon a reliable estimate of the market risk premium.

D. The model generally produces the same cost of equity as the dividend growth model.

E. This approach generally produces a cost of equity that equals the firm’s overall cost of capital.

47. The cost of equity for a firm:

A. tends to remain static for firms with increasing levels of risk.

B. increases as the unsystematic risk of the firm increases.

C. ignores the firm’s risks when that cost is based on the dividend growth model.

D. equals the risk-free rate plus the market risk premium.

E. equals the firm’s pretax weighted average cost of capital.

48. Scholastic Toys is considering developing and distributing a new board game for children. The project is similar in risk to the firm’s current operations. The firm maintains a debt-equity ratio of 0.40 and retains all profits to fund the firm’s rapid growth. How should the firm determine its cost of equity?

A. by adding the market risk premium to the aftertax cost of debt

B. by multiplying the market risk premium by (1 – 0.40)

C. by using the dividend growth model

D. by using the capital asset pricing model

E. by averaging the costs based on the dividend growth model and the capital asset pricing model

49. When a manager develops a cost of capital for a specific project based on the cost of capital for another firm which has a similar line of business as the project, the manager is utilizing the _____ approach.

A. subjective risk

B. pure play

C. divisional cost of capital

D. capital adjustment

E. security market line

50. Applying the discounted payback decision rule to all projects may cause:

A. some positive net present value projects to be rejected.

B. the most liquid projects to be rejected in favor of the less liquid projects.

C. projects to be incorrectly accepted due to ignoring the time value of money.

D. a firm to become more long-term focused.

E. some projects to be accepted which would otherwise be rejected under the payback rule.

51. The current dividend yield on Clayton’s Metals common stock is 2.5 percent. The company just paid a $1.48 annual dividend and announced plans to pay $1.54 next year. The dividend growth rate is expected to remain constant at the current level. What is the required rate of return on this stock?

A. 6.55 percent

B. 6.82 percent

C. 7.08 percent

D. 7.39 percent

E. 7.75 percent

52. Winter Time Adventures is going to pay an annual dividend of $2.86 a share on its common stock next year. This year, the company paid a dividend of $2.75 a share. The company adheres to a constant rate of growth dividend policy. What will one share of this common stock be worth five years from now if the applicable discount rate is 11.7 percent?

A. $43.45

B. $43.87

C. $44.15

D. $45.19

E. $47.00

53. Combined Communications is a new firm in a rapidly growing industry. The company is planning on increasing its annual dividend by 15 percent a year for the next 4 years and then decreasing the growth rate to 3.5 percent per year. The company just paid its annual dividend in the amount of $0.20 per share. What is the current value of one share of this stock if the required rate of return is 15.5 percent?

A. $1.82

B. $2.04

C. $2.49

D. $2.71

E. $3.05

54. Yesteryear Productions pays no dividend at the present time. The company plans to start paying an annual dividend in the amount of $0.40 a share for two years commencing four years from today. After that time, the company plans on paying a constant $0.75 a share annual dividend indefinitely. How much are you willing to pay to buy a share of this stock today if your required return is 11.6 percent?

A. $3.78

B. $4.22

C. $4.37

D. $4.71

E. $4.98

55. Beatrice Markets is expecting a period of intense growth and has decided to retain more of its earnings to help finance that growth. As a result, it is going to reduce its annual dividend by 30 percent a year for the next 2 years. After that, it will maintain a constant dividend of $2.50 a share. Last year, the company paid $3.60 as the annual dividend per share. What is the market value of this stock if the required rate of return is 14.5 percent?

A. $14.63

B. $16.70

C. $18.08

D. $19.61

E. $21.23

56. You are considering the following two mutually exclusive projects. The required rate of return is 14.6 percent for project A and 13.8 percent for project B. Which project should you accept and why?

A. project A; because it has the higher required rate of return

B. project A; because its NPV is about $4,900 more than the NPV of project B

C. project B; because it has the largest total cash inflow

D. project B; because it has the largest cash inflow in year one

E. project B; because it has the lower required return

57. You are considering two mutually exclusive projects with the following cash flows. Which project(s) should you accept if the discount rate is 8.5 percent? What if the discount rate is 13 percent?

A. accept project A as it always has the higher NPV

B. accept project B as it always has the higher NPV

C. accept A at 8.5 percent and B at 13 percent

D. accept B at 8.5 percent and A at 13 percent

E. accept B at 8.5 percent and neither at 13 percent

58. You are considering two independent projects with the following cash flows. The required return for both projects is 16 percent. Given this information, which one of the following statements is correct?

A. You should accept Project A and reject Project B based on their respective NPVs.

B. You should accept Project B and reject Project A based on their respective NPVs.

C. You should accept Project A and reject Project B based on their respective IRRs.

D. You should accept Project B and reject Project A based on their respective IRRs.

E. You should accept both projects based on both the NPV and IRR decision rules.

59. Cool Water Drinks is considering a proposed project with the following cash flows. Should this project be accepted based on the combined approach to the modified internal rate of return if both the discount rate and the reinvestment rate are 12.6 percent? Why or why not?

A. Yes; The MIRR is 8.81 percent.

B. Yes; The MIRR is 9.23 percent.

C. No; The MIRR is 8.81 percent.

D. No; The MIRR is 9.06 percent.

E. No; The MIRR is 9.23 percent.

60. You would like to invest in the following project.

Sis, your boss, insists that only projects returning at least $1.06 in today’s dollars for every $1 invested can be accepted. She also insists on applying a 14 percent discount rate to all cash flows. Based on these criteria, you should:

A. accept the project because the PI is 0.90.

B. accept the project because the PI is 1.04.

C. accept the project because the PI is 1.11.

D. reject the project because the PI is 0.90.

E. reject the project because the PI is 0.96.

61. Cool Comfort currently sells 300 Class A spas, 450 Class C spas, and 200 deluxe model spas each year. The firm is considering adding a mid-class spa and expects that if it does it can sell 375 of them. However, if the new spa is added, Class A sales are expected to decline to 225 units while the Class C sales are expected to decline to 200. The sales of the deluxe model will not be affected. Class A spas sell for an average of $12,000 each. Class C spas are priced at $6,000 and the deluxe model sells for $17,000 each. The new mid-range spa will sell for $8,000. What is the value of the erosion?

A. $600,000

B. $1,200,000

C. $1,800,000

D. $2,400,000

E. $3,900,000

62. Crafter’s Supply purchased some fixed assets 2 years ago at a cost of $38,700. It no longer needs these assets so it is going to sell them today for $25,000. The assets are classified as 5-year property for MACRS. What is the net cash flow from this sale if the firm’s tax rate is 30 percent?

A. $13,122.20

B. $18,576.00

C. $20,843.68

D. $23,072.80

E. $25,211.09

63. You own some equipment that you purchased 4 years ago at a cost of $216,000. The equipment is 5-year property for MACRS. You are considering selling the equipment today for $75,500. Which one of the following statements is correct if your tax rate is 35 percent?

A. The tax due on the sale is $26,425.

B. The book value today is $178,675.20.

C. The accumulated depreciation to date is $37,324.80.

D. The taxable amount on the sale is $37,324.80.

E. The aftertax salvage value is $62,138.68.

64. Jasper Metals is considering installing a new molding machine which is expected to produce operating cash flows of $73,000 a year for 7 years. At the beginning of the project, inventory will decrease by $16,000, accounts receivables will increase by $21,000, and accounts payable will increase by $15,000. All net working capital will be recovered at the end of the project. The initial cost of the molding machine is $249,000. The equipment will be depreciated straight-line to a zero book value over the life of the project. The equipment will be salvaged at the end of the project creating a $48,000 aftertax cash flow. At the end of the project, net working capital will return to its normal level. What is the net present value of this project given a required return of 14.5 percent?

A. $77,211.20

B. $79,418.80

C. $82,336.01

D. $84,049.74

E. $87,925.54

65. Precise Machinery is analyzing a proposed project. The company expects to sell 2,100 units, give or take 5 percent. The expected variable cost per unit is $260 and the expected fixed costs are $589,000. Cost estimates are considered accurate within a plus or minus 4 percent range. The depreciation expense is $129,000. The sales price is estimated at $750 per unit, plus or minus 2 percent. What is the sales revenue under the worst case scenario?

A. $1,686,825

B. $1,496,250

C. $1,466,325

D. $1,543,500

E. $1,620,675

66. Miller Mfg. is analyzing a proposed project. The company expects to sell 8,000 units, plus or minus 2 percent. The expected variable cost per unit is $11 and the expected fixed costs are $287,000. The fixed and variable cost estimates are considered accurate within a plus or minus 5 percent range. The depreciation expense is $68,000. The tax rate is 32 percent. The sales price is estimated at $64 a unit, give or take 3 percent. What is the operating cash flow under the best case scenario?

A. $144,150

B. $148,475

C. $107,146

D. $168,630

E. $174,220

67. Last year, you purchased 500 shares of Analog Devices, Inc. stock for $11.16 a share. You have received a total of $120 in dividends and $7,190 from selling the shares. What is your capital gains yield on this stock?

A. 26.70 percent

B. 26.73 percent

C. 28.85 percent

D. 29.13 percent

E. 31.02 percent

68. Last year, you purchased a stock at a price of $47.10 a share. Over the course of the year, you received $2.40 per share in dividends while inflation averaged 3.4 percent. Today, you sold your shares for $49.50 a share. What is your approximate real rate of return on this investment?

A. 6.30 percent

B. 6.79 percent

C. 7.18 percent

D. 9.69 percent

E. 10.19 percent

69. A stock had returns of 11 percent, -18 percent, -21 percent, 5 percent, and 34 percent over the past five years. What is the standard deviation of these returns?

A. 18.74 percent

B. 20.21 percent

C. 20.68 percent

D. 22.60 percent

E. 23.49 percent

70. A stock had annual returns of 3.6 percent, -8.7 percent, 5.6 percent, and 11.1 percent over the past four years. Which one of the following best describes the probability that this stock will produce a return of 20 percent or more in a single year?

A. less than 0.1 percent

B. less than 0.5 percent but greater than 0.1 percent

C. less than 1.0 percent but greater the 0.5 percent

D. less than 2.5 percent but greater than 1.0 percent

E. less than 5 percent but greater than 2.5 percent

71. The Shoe Outlet has paid annual dividends of $0.65, $0.70, $0.72, and $0.75 per share over the last four years, respectively. The stock is currently selling for $26 a share. What is this firm’s cost of equity?

A. 7.56 percent

B. 7.93 percent

C. 10.38 percent

D. 10.53 percent

E. 11.79 percent

72. Highway Express has paid annual dividends of $1.16, $1.20, $1.25, $1.10, and $0.95 over the past five years respectively. What is the average dividend growth rate?

A. -4.51 percent

B. -3.60 percent

C. 2.28 percent

D. 2.47 percent

E. 4.39 percent

73. Electronics Galore has 950,000 shares of common stock outstanding at a market price of $38 a share. The company also has 40,000 bonds outstanding that are quoted at 106 percent of face value. What weight should be given to the debt when the firm computes its weighted average cost of capital?

A. 42 percent

B. 46 percent

C. 50 percent

D. 54 percent

E. 58 percent

74. Wayco Industrial Supply has a pre-tax cost of debt of 7.6 percent, a cost of equity of 14.3 percent, and a cost of preferred stock of 8.5 percent. The firm has 220,000 shares of common stock outstanding at a market price of $27 a share. There are 25,000 shares of preferred stock outstanding at a market price of $41 a share. The bond issue has a face value of $550,000 and a market quote of 101.2. The company’s tax rate is 37 percent. What is the firm’s weighted average cost of capital?

A. 10.18 percent

B. 10.84 percent

C. 11.32 percent

D. 12.60 percent

E. 12.81 percent

75. Travis & Sons has a capital structure which is based on 40 percent debt, 5 percent preferred stock, and 55 percent common stock. The pre-tax cost of debt is 7.5 percent, the cost of preferred is 9 percent, and the cost of common stock is 13 percent. The company’s tax rate is 39 percent. The company is considering a project that is equally as risky as the overall firm. This project has initial costs of $325,000 and annual cash inflows of $87,000, $279,000, and $116,000 over the next three years, respectively. What is the projected net present value of this project?

A. $68,211.04

B. $68,879.97

C. $69,361.08

D. $74,208.18

E. $76,011.23