Corporate Finance A Focused Approach 4th Edition by Ehrhardt – Test Bank
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Sample Test
[1]. (3.1) Ratio
analysis
F
K
Answer: a EASY
[1]. (3.2) Liquidity
ratios F
K
Answer: a EASY
[1]. (3.2) Liquidity
ratios F
K
Answer: a EASY
[1]. (3.2) Current
ratio
F
K
Answer: b EASY
[1]. (3.3) Asset
management ratios F
K
Answer: a EASY
[1]. (3.3) Inventory
turnover ratio F
K
Answer: b EASY
[1]. (3.4) Debt management
ratios F
K
Answer: a EASY
[1]. (3.4) TIE
ratio
F
K
Answer: a EASY
[1]. (3.5) Profitability
ratios F
K
Answer: a EASY
[1]. (3.6) Market value
ratios F
K
Answer: a EASY
[1]. (3.7) Trend
analysis
F
K
Answer: a EASY
[1]. (3.10) Balance sheet changes
F
K
Answer: a EASY
Many of the ratios show sales over some past period such as the
last 12 months divided by an asset such as inventories as of a specific
date. Assets like inventories vary at different times of the year for a
seasonal business, thus leading to big changes in the ratio.
[1]. (3.10) Limitations of
ratio analysis F
K
Answer: a EASY
[1]. (3.5) Basic earning
power ratio F
K Answer: b EASY/MEDIUM
BEP = EBIT/Assets. This is before the
effects of leverage (interest) and taxes, so the statement is false.
[1]. (3.3) Inventory
turnover ratio F
K
Answer: a MEDIUM
A high current ratio is consistent with a lot of
inventory. A low inventory turnover is also consistent with a lot of
inventory. If the CR exceeds industry norms and the turnover is below the
norms, then the firm has more inventory than most other firms, given its
sales. It could just be carrying a lot of good inventory, but it might
also have a normal amount of “good” inventory plus some “bad” inventory that
has not been written off. So the statement is true.
[1]. (3.3) Fixed assets
turnover F
K
Answer: b MEDIUM
The FA turnover is Sales/FA, and it gives an indication of how
effectively the firm utilizes its FA. The proportion of FA to TA is not
relevant to this usage.
[1]. (3.5)
ROA
F K
Answer: b MEDIUM
EBIT = Sales revenues – Operating costs
Net income = EBIT – Interest – Taxes = (EBIT – Interest) ´ (1 –
T)
ROA = Net income after taxes/Assets
Two firms could have identical EBITs but very different amounts
of interest, different tax rates, and different assets, and thus very different
ROAs.
[1]. (3.8) Du Pont
equation F
K
Answer: b MEDIUM
Think about the Du Pont equation: ROE = PM ´ TATO ´ Equity
multiplier. Similar financing policies will lead to similar Equity
multipliers. Moreover, competition in the capital markets will cause ROEs
to be similar, because otherwise capital would flow to industries with high
ROEs and drive returns down toward the average, given similar risks. To
have similar ROEs, firms with relatively high PMs must have
relatively low TATOs, and vice versa. Therefore, the
statement is false.
[1]. (3.2) Liquidity
ratios F
K
Answer: b HARD
This question can be answered by thinking carefully about the
ratios:
Demonstration that
the CR = C +
A/R + Inv A > B
QR = C +
A/R B
> A
first sentence is
true:
CL
CL
A: 1
+ 1 + 3
1.67 1
+ 1
0.67
QR(B) >
QR(A)
3
3
B:
1
+ 1 + 1
1.50 1
+ 1
1.00
2
2
Demonstration that
the CR = C +
A/R + Inv A > B
QR = C + A/R B
> A
second
sentence
CL
CL
is
false:
A: 1
+ 1 + 1
1.0 1
+ 1
0.67
QR(B) <
QR(A)
3
3
B:
1
+ 1 + 4
1.5 1
+ 1
0.50
4
4
The key is inventory, which is in the CR but not in the
QR. The firm with more inventory can have the higher CR but the lower QR.
[1]. (3.2) Liquidity
ratios F
K
Answer: b HARD
Firm A has the higher inventory turnover, so given the same
sales, it must have less inventory. Thus, since the two firms have the
same CR, then A must have the higher QR, not the lower one. Therefore,
the statement is false.
[1]. (3.4) TIE
ratio
F
K
Answer: a HARD
TIE = EBIT/Interest = (Sales – Op cost)/(Debt ´ Interest
rate). If we know the op. costs, the amount of debt, and the interest
rate, then we can solve for the sales level required to achieve the target TIE.
[1]. (3.5) BEP and
ROE
F
K
Answer: a HARD
The easiest way to think about this is to realize that you can borrow
at a cost of 10% and invest the proceeds to earn 11%, you’ll earn a
surplus. If you were previously earning an ROE of 10%, then after raising
and investing additional funds, your income will be higher, your equity will be
the same, and thus your ROE will increase. Similarly, if a firm earns
more on assets than the interest rate, there will be a surplus after paying
interest on the debt that will go to the equity, thus increasing the ROE. So,
if BEP > rd, then the firm can increase its expected ROE by using more debt
leverage.
The answer can also be seen by working out an example. The
one below shows that leverage increases ROE if BEP > rd, but
it could be varied to show no difference in ROE if interest rates and BEP are
the same, and a reduction in ROE if the interest rate exceeds the BEP.
Firm A
Firm B
Assets
100%
Assets
100%
Debt
60%
Debt
0%
Equity
40%
Equity
100%
BEP 15%
BEP 15%
Interest rate, rd
10%
Interest rate, rd
10%
Tax
rate
40%
Tax
rate
40%
EBIT = BEP´
Assets
15.0
EBIT = BEP ´
Assets
15.0
Interest
6.0
Interest
0
Taxable
income
9.0
Taxable income
15.0
Taxes
3.6
Taxes
6.0
NI
5.4
NI
9.0
ROE 13.50%
ROE 9.00%
[1]. (3.8) Equity
multiplier F
K
Answer: a HARD
Equity multiplier = Assets/Equity = 3.0, so Assets/Equity =
1/3.0 = 0.333.
By definition, Equity/Assets + Debt/Assets = 1.00, so
0.333 + Debt/Assets = 1.0.
Therefore, Debt/Assets = 1.0 – 0.333 = 0.667. Thus, the
statement is true.
[1]. (3.10) Limitations of
ratio analysis F
K
Answer: b HARD
The key here is to recognize that if the CR is greater than 1.0,
then a given increase in both current assets and current liabilities would lead
to a decrease in the CR. The reverse would hold if the initial CR were
less than 1.0. Here the initial CR is greater than 1.0, so borrowing on a
short-term basis to build the cash account would lower the CR. For
example:
Original
New
CA/CL
Plus $1
CA/CL Old
CR New CR
3/2
1/1
4/3
1.50
1.33 CR falls
if initial CR is greater than 1.0
2/3
1/1
3/4
0.67
0.75 CR rises
if initial CR is less than 1.0
[1]. (3.10) Limitations of
ratio analysis F
K
Answer: b HARD
The key here is to recognize that if the CR is less than
1.0, then a given reduction in both current assets and current liabilities
would lead to a decrease in the CR. The reverse would hold if
the initial CR were greater than 1.0. In the question, the initial CR is
less than 1.0, so using cash to reduce current liabilities would lower the CR.
If the CR were greater than 1.0, the statement would have been true.
Here’s an illustration:
Original
New
CA/CL
Less $1
CA/CL Old
CR New CR
2/3
-1/-1
1/2
0.67
0.50 CR falls
if initial CR is less than 1.0
3/2
-1/-1
2/1
1.5
2.0 CR
rises if initial CR is greater than 1.0
[1]. (3.2) Current
ratio C
K
Answer: d EASY
[1]. (3.2) Current
ratio C
K
Answer: c EASY
[1]. (3.2) Current
ratio C
K
Answer: d EASY
[1]. (3.3)
Inventories
C
K
Answer: c EASY
[1]. (3.6) Financial
statement analysis C
K
Answer: e EASY
[1]. (3.6) Market value
ratios C
K
Answer: d EASY
[1]. (3.10) Window
dressing C
K
Answer: b EASY
[1]. (Comp: 3.2,3.4-3.6)
Miscellaneous ratios C
K
Answer: a EASY
[1]. (Comp: 3.2,3.3,3.5)
Miscellaneous ratios C
K
Answer: b EASY
[1]. (Comp: 3.3-3.5)
Miscellaneous ratios C
K
Answer: a EASY
[1]. (Comp: 3.2-3.5)
Miscellaneous ratios C
K
Answer: e EASY
[1]. (Comp: 3.2,3.4)
Miscellaneous ratios C
K
Answer: c EASY
[1]. (Comp: 3.4,3.5,3.8)
Effects of leverage C
K
Answer: b EASY
[1]. (3.2) Quick
ratio
C
K
Answer: a EASY/MEDIUM
[1]. (3.2) Current
ratio C
K
Answer: b MEDIUM
a would leave the CR unchanged.
b would indeed reduce the CR.
c is false, given that the initial CR > 1.0.
d is false, given that the initial CR > 1.0.
e is false, given that the initial CR > 1.0.
Original
New
CA/CL
Minus .5
CA/CL Old
CR New CR
1.9/1
0/0.5
1.9/1.5
1.90
1.27 CR falls
if initial CR is greater than 1.0
[1]. (3.3) Accounts
receivable C
K
Answer: e MEDIUM
[1]. (3.4) Leverage
effects; debt management C
K Answer: c
MEDIUM
a is false, because the TIE also depends on the interest rate
and EBIT.
b is false, because interest affects the profit margin.
c is correct, because the more interest the lower the profits,
hence the lower the profit margin.
d is simply incorrect.
e is incorrect. The reverse is true.
[1]. (3.6) Market value
ratios C
K
Answer: b MEDIUM
No reason for a to be true.
b must be true, as EPS and P will be the same.
No reason for c to be true.
Wrong, because high risk and low growth lead to low P/Es.
No reason for e to be true.
[1]. (3.8) Du Pont
analysis
C
K
Answer: a MEDIUM
PM ´
TATO ´
Eq mult.
=
ROE
Old
9%
1.0
1.666667
15%
New
10%
0.9
2.5
23%
We see that a is true, thus b must be false.
We can also see that c, d, and e are all false.
[1]. (3.8) Du Pont analysis
C
K
Answer: a MEDIUM
Thinking through the Du Pont equation, we can see that if the
firm’s PM and Equity multiplier are below the industry average, the only way
its ROE can exceed the industry average is if its equity multiplier exceeds the
industry average. The following data illustrate this point:
ROE
=
PM ´
TATO ´
Eq mult.
ROA
Firm
30%
9%
2.0
1.67
18%
Industry
25%
10%
1
2.50
10%
The above demonstrates that a is correct, and that makes d and e
incorrect.
Now consider the following:
NI/Assets = NI/Sales × Sales/Assets
ROA = PM × TATO
If its ROA were equal to the industry average, then with its low
debt ratio (hence low equity multiplier) its ROE would also be below the
industry average. So b is incorrect. With its debt ratio below the
industry average, its interest charges should also be low, which would increase
its TIE ratio, making c incorrect.
[1]. (3.8) Du Pont
analysis
C
K
Answer: d MEDIUM
Rule out all answers except d because they are false.
Alternative answer explanation using the Du Pont equation:
ROE = PM ´ TATO ´ Eq mult.
ROE = NI/S ´ S/TA ´ TA/Equity
The first two terms are the same, but HD has higher equity
multiplier, hence higher ROE.
[1]. (Comp: 3.4,3.5)
Financial statement analysis C K Answer:
c MEDIUM
a is false because reducing debt will lower interest, raise
income, and thus raise ROA.
b is false for the above reason.
c is true for the above reason.
d is false.
The TIE will increase, not decrease.
[1]. (Comp: 3.3-3.5)
Financial statement analysis C K Answer:
e MEDIUM
1. Sales
fluctuations would have more effects on the DSO and S/Inventory ratios.
2. ROE =
ROA ´ Equity multiplier, so more debt, higher ROE for given ROA.
3. DSO =
Receivables/Sales per day. With sales constant, an increase in DSO would mean
an increase in receivables, hence a decline, not a rise, in the TATO.
4. An
increase in the DSO might increase or decrease ROE, depending on how it
affected sales and costs.
5. ore
debt would mean more interest, hence a lower NI, given a constant EBIT. This
would lower the profit margin = NI/Sales.
[1]. (Comp: 3.4,3.5,3.8)
Financial statement analysis C K Answer: d MEDIUM
More debt would mean more interest, hence a lower NI, given a
constant EBIT, so d is correct. Also, we can rule out a and e, and HD
would also have the higher multiplier, which rules out b. And with more
interest, HD would have to pay less taxes, not more.
[1]. (Comp: 3.2,3.3) Cash
flows C
K
Answer: c MEDIUM
1. Lengthening
depreciable lives would lower depreciation, increase taxable income and taxes,
and thus lower cash flow.
2. Paying
down accounts payable would use cash and thus reduce cash flow.
3. Reducing
the DSO would require collecting receivables faster, which would indeed
increase cash flow.
4. Decreasing
accruals would lower cash flow.
5. Reducing
inventory turnover would mean increasing inventories, which would use cash.
[1]. (Comp: 3.4,3.5,3.8)
Leverage, taxes, and ratios C K Answer: a MEDIUM
Under the stated conditions, HD would have more interest
charges, thus lower taxable income and taxes. Thus, a is correct.
All of the other statements are incorrect.
[1]. (Comp: 3.4,3.5,3.8)
Leverage, taxes, and ratios C K Answer: e MEDIUM
HD has higher interest charges. Basic earning power equals
EBIT/Assets, and since assets are equal, EBIT
must also be equal. TIE = EBIT/Interest. Therefore,
HD’s higher interest charges means that its TIE must be lower. Thus, e is
correct. All of the other statements are incorrect.
[1]. (3.2) Current
ratio
C
K
Answer: a MEDIUM/HARD
The key here is to recognize that if the CR is less than 1.0,
then a given increase in both current assets and
current liabilities would lead to an increase in the CR.
The reverse would hold if the initial CR were greater than 1.0. Here the initial
CR is less than 1.0, so borrowing on a short-term basis to build inventories
would increase the CR. For example:
Original
New
CA/CL
Plus $1
CA/CL Old
CR New CR
1/2
1/1
2/3
0.50
0.67 CR rises
if initial CR is less than 1.0
All of the other statements are incorrect, although b, c, and d
would be correct if the initial CR had been >1.0.
[1]. (3.2) Current
ratio C
K
Answer: b MEDIUM/HARD
The key here is to recognize that if the CR is less than 1.0,
then a given increase to both current assets and current liabilities will
increase the CR, while the reverse will hold if the initial CR is greater than
1.0. Thus, the transaction would make Risco look stronger but Safeco look
weaker. Here’s an illustration:
Original
New
CA/CL Plus
$10 CA/CL Old
CR New CR
Safeco
20/10
10/10
30/20
2.00
1.50 CR falls because initial CR is greater than 1.0
Original
New
CA/CL Plus
$10 CA/CL Old
CR New CR
Risco
10/20
10/10
20/30
0.50
0.67 CR rises because initial CR is less than 1.0
All of the statements except b are incorrect.
[1]. (Comp: 3.4,3.5)
Effects of financial leverage C K Answer: e MEDIUM/HARD
The companies have the same EBIT and assets, hence the same BEP
ratio. If the interest rate is less than the BEP, then using more debt
will raise the ROE. Therefore, statement e is correct. The others are all
incorrect.
[1]. (3.3) Total assets
turnover C
K
Answer: d EASY
Sales
$52,000
Total
assets
$22,000
TATO 2.36
[1]. (3.4) Debt ratio:
find the debt, given the D/A ratio C K Answer: b EASY
Total assets
$410,000
Target debt
ratio
40%
Debt to achieve target ratio = amount borrowed $164,000
[1]. (3.4) Times interest
earned C
K
Answer: e EASY
Sales
$435,000
Operating
costs
362,500
Operating income
(EBIT)
72,500
Interest
charges
$ 12,500
TIE
ratio 5.80
[1]. (3.5) Profit margin
on sales C
K
Answer: c EASY
Sales
$320,000
Net
income
$23,000
Profit
margin 7.19%
[1]. (3.5) Return on total
assets (ROA) C
K
Answer: a EASY
Total assets
$315,000
Net
income
$22,750
ROA 7.22%
[1]. (3.5) Basic earning
power (BEP) C
K
Answer: c EASY
Total
assets
$305,000
EBIT
$62,500
BEP 20.49%
[1]. (3.5) Return on
equity (ROE) C
K
Answer: d EASY
Common
equity
$305,000
Net
income
$60,000
ROE 19.67%
[1]. (3.5) Return on
equity (ROE): finding net income C K Answer: e
EASY
Assets =
equity
$475,000
Target
ROE
13.5%
Required net
income $64,125
[1]. (3.6) Price/Earnings
ratio (P/E) C
K
Answer: b EASY
Stock
price
$33.50
EPS
$2.30
P/E 14.57
[1]. (3.6) Price/Earnings
ratio (P/E) C
K
Answer: a EASY
Stock price
$33.50
Book value per
share
$25.00
M/B
ratio 1.34
[1]. (3.8) Du Pont
equation: basic calculation C
K Answer:
c EASY
Profit
margin
5.25%
TATO
1.50
Equity
multiplier
1.80
ROE 14.18%
[1]. (3.4) Debt
ratio
C K Answer:
a EASY/MEDIUM
Total
assets
$625,000
Present
debt
$185,000
Target debt
ratio
55%
Target amount of
debt
$343,750
Change in amount of debt
outstanding $158,750
[1]. (3.6) EPS, DPS, and
payout C
K Answer: d
EASY/MEDIUM
Net
income
$1,250,000
Shares
outstanding
225,000
Payout
ratio
45%
EPS
$5.56
DPS $2.50
[1]. (3.3) Effect of
lowering the DSO on net income C K Answer: e
MEDIUM
Rate of return on cash
generated
8.0%
Sales
$100,000
A/R
$11,500
Days in
year
365
Sales/day
$273.97
Company
DSO
42.0
Industry
DSO
27.0
Excess
DSO
15.0
Cash flow from reducing the
DSO
$4,102.74
Alternative calculation:
A/R at industry
DSO
$7,397.26
Change in
A/R
$4,102.74
Additional Net Income $328.22
[1]. (3.3) Days sales
outstanding (DSO) C
K
Answer: b MEDIUM
Credit
period
45
Sales
$425,000
Sales/Day
$1,164
Receivables
$60,000
DSO
51.53
Credit period – DSO = Days early (+) or late
(–) 6.53
[1]. (3.3) DSO: days of free
credit C
K
Answer: d MEDIUM
Sales
$395,000
Sales/Day
$1,082
Receivables
$42,500
DSO
39.27
Credit
period
30
Credit period – DSO = Days
late 9.27
[1]. (3.3) Total assets
turnover ratio (TATO) C
K Answer: c MEDIUM
Sales
$415,000
Total
assets
$355,000
Target
TATO
2.40
Target assets = Sales / Target
TATO
$172,917
Asset reduction
$182,083
[1]. (3.4) Max debt ratio
consistent with given TIE ratio C K Answer: e MEDIUM
Assets
$565,000
Sales
$452,800
Operating
costs
354,300
Operating income
(EBIT)
$ 98,500
TIE
4.00
Maximum interest expense =
EBIT/TIE
$24,625
Interest
rate
7.50%
Max. debt = Max interest/Interest
rate
$328,333
Maximum debt ratio =
Debt/Assets 58.11%
[1]. (3.4) EBITDA
coverage
C
K
Answer: b MEDIUM
EBITDA
$390,000
Interest
charges
$9,500
Repayment of
principal
$26,000
Lease
payments
$17,400
Total financial
charges
$52,900
Funds avail for fin charges (EBITDA + Lease
pmts)
$407,400
EBITDA
coverage 7.70
[1]. (3.5) Profit margin
and ROE C
K
Answer: a MEDIUM
Total assets =
equity
$312,900
Sales
$620,000
Net
income
$24,655
Target
ROE
15.00%
Net income req’d to achieve target
ROE
$46,935
Profit margin needed to achieve target
ROE 7.57%
[1]. (3.5) Effect of
reducing costs on the ROE C
K Answer: d MEDIUM
Assets
$197,500
Debt
ratio
37.5%
Debt
$74,063
Equity
$123,438
Sales
$307,500
Old net
income
$19,575
New net
income
$33,000
New
ROE
26.734%
Old
ROE
15.858%
Increase in
ROE 10.88%
[1]. (3.6) EPS, book
value, and debt ratio C
K Answer: e MEDIUM
EPS
$3.50
BVPS
$22.75
Shares
outstanding
215,000
Debt
ratio
46.0%
Total
equity
$4,891,250
Total
assets
$9,057,870
Total
debt $4,166,620
[1]. (3.8) Du Pont
equation: basic calculation C
K Answer: a MEDIUM
Sales
$315,000
Assets
$210,000
Net
income
$17,832
Debt
ratio
42.5%
Debt
$89,250
Equity
$120,750
Profit
margin
5.66%
TATO
1.50
Equity
multiplier
1.74
ROE 14.77%
[1]. (3.8) Du Pont eqn:
effect of reducing assets on ROE C K Answer: b MEDIUM
Old
New
Sales
$205,000
$205,000
Original
assets
$127,500
Reduction in
assets
$
21,000
New
assets
$106,500
TATO
1.61
1.92
Profit
margin
5.30%
5.30%
Equity
multiplier
1.20
1.20
ROE
10.23%
12.24%
Change in
ROE
2.02%
[1].(3.8) Du Pont eqn: effect of reducing
costs on ROE C K Answer: c MEDIUM
Old
New
Sales
$195,000
$195,000
Original net income
$
10,549
$ 10,549
Increase in net
income
$0 $
5,250
New net
income
$ 10,549
$ 15,799
Profit
margin
5.41%
8.10%
TATO
1.33
1.33
Equity
multiplier
1.75
1.75
ROE
12.59%
18.86%
Change in
ROE
6.27%
[1]. (3.8) Du Pont
equation: changing the debt ratio C K Answer: a MEDIUM
Assets
$195,000
Old debt
ratio
32%
Old
debt
$62,400
Old
equity
$132,600
New debt
ratio
48%
New
debt
$93,600
New
Equity
$101,400
Net
income
$18,775
New
ROE
18.52%
Old
ROE
14.16%
Increase in
ROE 4.36%
[1]. (Comp: 3.3-3.5) Asset
reduction: turnover and ROE C K Answer: c MEDIUM
Old
New
Assets
$205,000
$152,500
Sales
$303,500
$303,500
Net income
$18,250
$18,250
Debt
ratio
41.00%
41.00%
Debt
$84,050
$62,525
Equity
$120,950
$89,975
ROE
15.089%
20.283%
Increase in
ROE 5.19%
[1]. (3.3) DSO and its
effect on net income C
K Answer: b HARD
Sales
$280,000
Net income
$21,000
Actual current
ratio
4.20
Target current
ratio
2.70
ORIGINAL BALANCE SHEET
Cash
$14,000
Accounts
payable
$42,000
Receivables
$70,000
Other current
liabilities
$28,000
Inventories
$210,000
Long-term debt
$70,000
Net fixed
assets $126,000
Common
equity $280,000
Total
assets $420,000
Total liab. and
equity $420,000
NI/Equity =
ROE:
7.50%
Inv. at target
CR
$105,000
Reduction in inv & equity
$105,000 = inventories and common equity decrease by this
amount
New common
equity
$175,000
New
ROE
12.00%
Δ
ROE 4.50%
[1]. (Comp: 3.4,3.5) ROE
changing with debt ratio C K
Answer: d HARD
Old
New
Interest
rate
8.2%
8.2%
Tax
rate
37%
37%
Assets
$195,000
$195,000
Debt
ratio
27%
45%
Debt
$52,650
$87,750
Equity
$142,350
$107,250
Sales
$303,225
$303,225
Operating
costs $267,500 $267,500
EBIT
$35,725
$35,725
Interest
paid $4,317 $7,196
Taxable
income
$31,408
$28,530
Taxes $11,621 $10,556
Net
income $19,787 $17,974
ROE
13.90%
16.76%
Change in
ROE 2.86%
[1]. (Comp: 3.4,3.5)
Maximum debt constrained by TIE C K Answer:
a HARD
Answer: Work down the Plan A column, find the Max Debt, then use
it to complete Plan B and the ROEs.
Plan A
Plan B
Interest
rate
8.80%
8.80%
Tax rate
35%
35%
Assets
$200,000
$200,000
Debt ratio
25%
Debt
$50,000
$100,071
Equity
$150,000
$99,929
Sales
$301,770
$301,770
Constant
Operating
costs
$266,545
$266,545
Constant
EBIT
$35,225
$35,225
Constant
Interest $4,400
$8,806
Taxable
income
$30,825
$26,419
Taxes $10,789
$9,247
Net
income $20,036 $17,172
ROE
13.36%
17.18%
TIE
8.01
Minimum
TIE
4.00
Interest consistent with
minimum TIE = EBIT/Min
TIE
$8,806
Max debt = Interest/interest rate
$100,071
Change in
ROE 3.83%
[1]. (3.2) Calculating
ratios given financial stmts C K Answer: d MEDIUM
Current ratio = Current assets/Current liabilities = 1.33
[1]. (3.2) Calculating
ratios given financial stmts C K Answer: b MEDIUM
Quick ratio = (CA – Inventory)/CL = 0.61
[1]. (3.3) Calculating
ratios given financial stmts C K Answer: e MEDIUM
DSO = Accounts receivable/(Sales/360) = 59.14
[1]. (3.3) Calculating
ratios given financial stmts C K Answer: c MEDIUM
Total assets turnover ratio = Sales/Total assets = 1.40
[1]. (3.3) Calculating
ratios given financial stmts C K Answer: a MEDIUM
Inventory turnover ratio = Sales/Inventory = 4.38
[1]. (3.4) Calculating
ratios given financial stmts C K Answer: d MEDIUM
TIE = EBIT/Interest charges = 2.66
[1]. (3.4) Calculating
ratios given financial stmts C K Answer: c MEDIUM
EBITDA covg =(EBITDA + lease)/(Int + principal + lease) = 3.64
[1]. (3.4) Calculating
ratios given financial stmts C K Answer: e MEDIUM
Debt ratio = Total debt/Total assets = 70.0%
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: a MEDIUM
ROA = Net income/Total assets = 2.70%
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: b MEDIUM
ROE = Net income/Common equity = 8.99%
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: c MEDIUM
BEP = EBIT/Total assets = 6.65%
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: d MEDIUM
Profit margin = Net income/Sales = 1.93%
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: b MEDIUM
DPS = Common dividends paid/Shares outstanding = $2.91
[1]. (3.5) Calculating
ratios given financial stmts C K Answer: e MEDIUM
CFPS = (Net income + Depreciation)/Shares outstanding = $12.35
[1]. (3.6) Calculating
ratios given financial stmts C K Answer: c MEDIUM
EPS = Net income/common shares outstanding = $6.47
[1]. (3.6) Calculating
ratios given financial stmts C K Answer: a MEDIUM
P/E ratio = Price per share/Earnings per share = 12.0
[1]. (3.6) Calculating
ratios given financial stmts C K Answer: d MEDIUM
BVPS = Common equity/Shares outstanding = $72.00
[1]. (3.6) Calculating
ratios given financial stmts C K Answer: e MEDIUM
Market/book ratio (M/B) = Price per share/BVPS = 1.08
[1]. (3.8) Calculating
ratios given financial stmts C K Answer: a MEDIUM
Equity multiplier = Total assets/Common equity = 3.33
[1]. (5.2) Issuing
bonds F G
Answer: a EASY
[1]. (5.2) Call provision
F
G
Answer: b EASY
[1]. (5.2) Sinking fund
F
G
Answer: a EASY
[1]. (5.2) Zero coupon
bond F
G
Answer: b EASY
[1]. (5.2) Floating-rate
debt F
G
Answer: a EASY
[1]. (5.3) Discounted cash
flows F
G
Answer: a EASY
[1]. (5.3) Bond prices and
interest rates F G
Answer: a EASY
[1]. (5.11) Mortgage
bond F
G
Answer: a EASY
[1]. (5.11) Debt coupon
rate F
G
Answer: a EASY
[1]. (5.11) Bond ratings
and required returns F G
Answer: a EASY
[1]. (5.13) Interest rate
risk F
G
Answer: b EASY
[1]. (5.13) Interest rate
risk F
G
Answer: b EASY
[1]. (5.15) Junk
bond
F
G
Answer: a EASY
[1]. (5.2) Callable
bonds F
G
Answer: b MEDIUM
The callable bond will be called if rates fall far enough below
the coupon rate, but it will not be called otherwise. Thus, the call provision
can only harm bondholders. Therefore, callable bonds sell at higher
yields than noncallable bonds, regardless of the slope of the yield
curve.
[1]. (5.2) Income
bond F
G
Answer: b MEDIUM
[1]. (5.2) Sinking
fund F
G
Answer: b MEDIUM
The sinking fund would give Bond SF a lower average maturity,
and it would also lower its risk. Therefore, Bond SF should have a lower,
not a higher, yield.
[1]. (5.2) Floating-rate
debt F
G
Answer: b MEDIUM
Floating rates can benefit issuers if rates decline, so a
company that thinks rates are likely to fall would want to issue such bonds.
[1]. (5.3) Bond premiums
and discounts F
G
Answer: a MEDIUM
[1]. (5.3) Bond value–annual
payment F
G
Answer: a MEDIUM
The bonds expected return (YTM) is 13.81%, which exceeds the 12%
required return, so buy the bond.
[1]. (5.4) Bond
value
F
G
Answer: a MEDIUM
[1]. (5.11) Restrictive
covenants F
G
Answer: a MEDIUM
[1]. (5.13) Prices and
interest rates F
G
Answer: a MEDIUM
The reason for this is that more of the cash flows of a
low-coupon bond comes late in the bond’s life (as the maturity payment), and
later cash flows are impacted most heavily by changing market rates.
[1]. (5.4) Interest
rates
C
G
Answer: a EASY
[1]. (5.4) Callable
bond
C
G
Answer: c EASY
[1]. (Comp: 5.3,5.6) Bond
concepts C
G
Answer: d EASY
[1]. (Comp: 5.6,5.11,5.16)
Bonds, default risk C
G Answer: a
EASY
[1]. (5.2) Call
provision
C G Answer:
d EASY/MEDIUM
[1]. (5.3) Bond coupon
rate C
G Answer:
b EASY/MEDIUM
[1]. (5.13) Interest rate
risk C
G Answer:
e EASY/MEDIUM
[1]. (5.13) Interest rate
risk C
G Answer:
d EASY/MEDIUM
[1]. (5.13) Interest rate
risk C
G Answer:
b EASY/MEDIUM
[1]. (5.13) Interest rate
risk C
G Answer:
e EASY/MEDIUM
[1]. (5.2) Sinking
funds
C
G
Answer: a MEDIUM
[1]. (5.2) Convertible,
callable bonds C
G
Answer: b MEDIUM
[1]. (5.3) Bond
concepts
C
G
Answer: d MEDIUM
Note that Bond B sells at par, so the required return on all
these bonds is 10%. B’s price will remain constant; A will sell initially
at a discount and will rise, and C will sell initially at a premium and will
decline. Note too that since it has larger cash flows from its higher
coupons, Bond C would be less sensitive to interest rate changes, i.e., it has
less interest rate risk. Perhaps it has less default risk.
[1]. (5.6) Bond
yields
C
G
Answer: a MEDIUM
[1]. (5.6) Bond
yields
C
G
Answer: c MEDIUM
[1]. (5.6) Bond
yields
C G
Answer: c MEDIUM
[1]. (5.6) Bond
yields
C
G
Answer: b MEDIUM
Answers c, d, and e are clearly wrong, and answer b is clearly
correct. Answer a is also wrong, but this is not obvious to most
people. We can demonstrate that a is incorrect by using the following
example.
Par
$1,000
YTM
8.00%
Maturity
10
Price
$1,100
Payment
$94.90
Coupon
rate
9.49%
Current
yield
8.63% The current yield is greater
than 8%.
[1]. (5.6) Bond
yields
C
G
Answer: d MEDIUM
[1]. (5.4) Interest rates
and bond prices C
G
Answer: c MEDIUM
[1]. (5.4) Interest rates
and bond prices C
G
Answer: b MEDIUM
We can tell by inspection that a, c, d, and e are all
incorrect. That leaves Answer b as the only possibly correct
statement. Recognize that longer-term bonds, and ones where payments come
late (like low coupon bonds) are most sensitive to changes in interest
rates. Thus, the 10-year, 8% coupon bond should be more sensitive to a
decline in rates. You could also do some calculations to confirm that b
is correct.
[1]. (5.4) Bond yields and
prices C
G
Answer: c MEDIUM
[1]. (5.7) Interest rates
C
G
Answer: c MEDIUM
[1]. (5.13) Interest vs.
reinvestment rate risk C G
Answer: e MEDIUM
[1]. (5.13) Interest vs.
reinvestment rate risk C G
Answer: d MEDIUM
[1]. (5.14) Term structure
of interest rates C
G Answer: e MEDIUM
[1]. (Comp: 5.3-5.6) Bond
concepts C
G
Answer: a MEDIUM
[1]. (Comp: 5.3,5.6) Bond
concepts C
G
Answer: e MEDIUM
[1]. (Comp: 5.6,5.5) Bond concepts
C
G
Answer: b MEDIUM
[1]. (Comp: 5.3,5.6,5.13)
Bond concepts C
G
Answer: e MEDIUM
[1]. (Comp:
5.2,5.3,5.4,5.13) Bond concepts C
G Answer: b MEDIUM
[1]. (Comp: 5.5,5.6) Bond
concepts C
G
Answer: e MEDIUM
[1]. (Comp: 5.3-5.6) Bond
concepts C
G
Answer: a MEDIUM
[1]. (Comp: 5.4,5.13) Bond
concepts C
G
Answer: a MEDIUM
[1]. (Comp: 5.3-5.6,5.13)
Bond concepts C G
Answer: d MEDIUM
[1]. (Comp:
5.2,5.5,5.6,5.13) Bond concepts C
G Answer: c MEDIUM
[1]. (Comp: 5.3,5.6) Bond
yields C
G
Answer: d MEDIUM
[1]. (Comp: 5.3,5.6) Bond
yields C
G
Answer: e MEDIUM
[1]. (Comp:
5.7,5.9,5.13,5.14) Yield curve C
G Answer: a MEDIUM
The slope of the yield curve depends primarily on expected
inflation and the MRP. The greater the expected increase in inflation,
and the higher the MRP, the steeper the slope of the yield curve. If
inflation is expected to decline, then even if the MRP is positive, the curve
could still have a downward slope.
[1]. (Comp:
5.7,5.9,5.13,5.14) Yield curve
C G Answer: d MEDIUM
[1]. (Comp: 5.7,5.9,5.11,5.13,5.14)
Yield curve C G Answer: c
MEDIUM
[1]. (Comp:
5.7,5.9,5.11,5.13,5.14) Corporate yield curve C G Answer: a MEDIUM
[1]. (Comp: 5.3-5.6) Bond
rates and prices C
G Answer: e MEDIUM
[1]. (Comp: 5.2,5.5,5.6)
Callable
bond C
G Answer: a MEDIUM
[1]. (Comp: 5.2,5.11)
Costs of types of debt C
G Answer: b MEDIUM
On Statement b, note that if only $500,000 of 1st mortgage bonds
were secured by $1 million of property, each of those bonds would be less risky
than if there were $1 million of bonds backed by the $1 million of
property. Note too that the cost of the total $1 million of debt would be
an average of the cost of the mortgage bonds and the debentures, and that cost
could be higher, lower, or the same as if only mortgage bonds or debentures
were used.
[1]. (Comp: 5.2,5.11,5.15)
Types of debt
C G Answer: c MEDIUM
[1]. (Comp: 5.2,5.6,5.16)
Miscellaneous concepts C G Answer:
d MEDIUM
[1]. (Comp: 5.3-5.6,5.16)
Miscellaneous concepts C G Answer:
c MEDIUM
[1]. (Comp: 5.6,5.11,5.16)
Default and bankruptcy C G Answer: e
MEDIUM
[1]. (Comp: 5.3,5.6) Call
provision C
G Answer: c
MEDIUM/HARD
A bond would not be called unless the current rate was below the
YTM. The investor would get the funds, then reinvest at the new market
rate. Thus, the investor would end up earning less than the YTM, even
after receiving the call premium.
[1]. (5.6) Current yield
and yield to maturity C
G Answer: b HARD
Answer a is incorrect because a premium bond must have a
negative capital gains yield.
Answer c is incorrect because a bond selling at par must have a
current yield equal to its YTM.
Answer d is incorrect because a bond selling at below par must
have a YTM > the coupon rate.
Answer e is incorrect because a discount bond’s price must rise
over time.
That leaves Answer b as the only possibly correct answer.
Note that YTM = Cur Yld +/- Cap gains Yld., so Cur Yld = YTM +/- Cap gain
yld. The cap gains yld will be positive or negative depending on whether
the coupon rate is above or below the YTM. That means that the Cur yld
must either equal the YTM or be between the YTM and the coupon rate. d’s
correctness is also demonstrated below:
Par bond Premium Discount
Par
1000
1000
1000
Maturity
10
10
10
Coup
rate
10%
11%
9%
YTM
10.00%
10.00%
10.00%
Ann
coup
$100.00
$110.00
$90.00
Price
$1,000.00 $1,061.45
$938.55
Cur
Yield
10.00%
10.36%
9.59% Equal
to or between YTM and coupon rate.
Cap
gain
0.00%
-0.36%
0.41%
[1]. (5.6) Effect of
interest rate on bond prices C
G Answer: a HARD
We can tell by inspection that c, d, and e are all
incorrect. That leaves Answers a and b as the only possibly correct
statements. Also, recognize that longer-term bonds, and ones where
payments come late (like low coupon bonds) are most sensitive to changes in
interest rates. Thus, the 15-year, 8% coupon bond should be more
sensitive to a decline in rates. Finally, we can do some calculations to
confirm that a is the correct answer:
Current situation
Rates decline
10-year
15-year
10-year 15-year
Par
1000
1000
1000
1000
Maturity
10
15
10
15
Coup
rate
12%
8%
12%
8%
YTM
10.00%
10.00%
9.00% 9.00%
Ann
coup
120
80
120
80
Price
$1,122.89
$847.88 $1,192.53
$919.39
%
Gain
6.2%
8.4%
[1]. (5.11) Bond
indenture
C G Answer: a HARD
[1]. (5.11) Types of debt
and their relative costs C G Answer:
c HARD
The higher the percentage of mortgage bonds, the less the
collateral backing each bond, so the bonds’ risk and thus required return would
be higher. Also, the higher the percentage of mortgage bonds, the less
free assets would be backing the debentures, so their risk and required return
would also be higher. However, mortgage bonds are less risky than
debentures, so mortgage bond rates are lower than rates on debentures. We
end up with a situation where the greater the percentage of mortgage bonds, the
higher the rate on both types of bonds, but the average cost to the company
could be higher, lower, or constant. Note that we could draw a graph of
the situation, with % mortgage on the horizontal axis and rates on the vertical
axis, then the graph would look like the WACC graph in the cost of capital chapter.
[1]. (5.13) Interest rate
and reinvestment rate risk C G Answer: b
HARD
[1]. (Comp: 5.6,5.6) Bond
yields and prices C
G Answer: d HARD
[1]. (Comp: 5.2,5.4,5.13)
Bond concepts
C G Answer: e HARD
It is relatively easy to eliminate a, c, and d. When
choosing between b and e, think about the graph that shows the relationship
between a bond’s price and the going interest rate. This curve is
concave, indicating that at any interest rate, the decline in price from an
increase in rates is less than the gain in price from a similar interest rate
decline. It would be easy to confirm this statement with an example.
[1]. (5.3) Bond
valuation
C
G
Answer: a EASY
N
7
I/YR
8.5%
PMT
$70
FV
$1,000
PV $923.22
[1]. (5.3) Bond
valuation
C
G
Answer: d EASY
Coupon
rate
5.5%
PMT
$55
N
10
I/YR
7.0%
FV
$1,000
PV $894.65
[1]. (5.6) Yield to
maturity
C
G
Answer: e EASY
N
15
PV
$1,165
PMT
$95
FV
$1,000
I/YR 7.62%
[1]. (5.6) Yield to
maturity
C
G
Answer: b EASY
N
15
PV
$1,080
PMT
$10
FV
$1,000
I/YR 9.01% =
YTM
[1]. (5.6) Yield to
maturity
C G
Answer: b EASY
Coupon rate
7.25%
N
13
PV =
Price
$1,125
PMT
$72.50
FV =
Par
$1,000
I/YR 5.85% = YTM
[1]. (5.6) Yield to
call
C
G
Answer: d EASY
N
5
PV
$1,280
PMT
$135
FV
$1,050
I/YR =
YTC 7.45%
[1]. (5.6) Current
yield
C
G
Answer: a EASY
N
6
PV
$1,150
PMT
$85
FV
$1,000
Current yield
= 7.39%
[1]. (5.5) Bond valuation:
semiannual coupons C
G Answer:
a EASY
Par
value
$1,000
Coupon
rate
9.5%
Periods/year
2
Yrs to
maturity
15
N =
periods
30
Annual
rate
11.0%
Periodic
rate
5.50%
PMT/period
$47.50
FV
$1,000
PV $891.00
[1]. (5.11) Default risk
premium (DRP) C
G Answer: a
EASY
T-bond yield
6.20%
Corporate
yield
8.50%
MRP
Included in both bonds
1.30%
LP
Included in corporate
0.40%
DRP 1.90%
[1]. (5.3) Bond valuation:
annual coupons C
G Answer: e MEDIUM
Par
value
$1,000
Coupon
rate
7.5%
N
14
I/YR
5.5%
PMT
$75
FV
$1,000
PV $1,191.79
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