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Sample midterm 1

1. Businesses can be organized as


A) sole proprietorships
B) partnerships
C) corporations
D) any of the above
E) None of the above

Answer: D

2. Generally, a corporation is owned by the:


A) Managers
B) Board of Directors
C) Shareholders
D) All of the above.

Answer: C

Shareholders are owners.

3. Limited liability is an important feature of:


A) Sole proprietorships
B) Partnerships
C) Corporations
D) All of the above

Answer: C

4. A firm's investment decision is also called the:


A) Financing decision
B) Capital budgeting decision
C) Liquidity decision
D) None of the above

Answer: B

5. The goal of a financial manager is to:


A) Maximize sales
B) Maximize profits
C) Maximize the value of the shareholders
D) Maximize the value of the firm with both bond and stock holders
Answer: C
( Many of you chose D)

This is because shareholders are the owners and managers are hired by them.

6. Which of the following is the function of a financial market


A) provide liquidity
B) risk management
C) efficient allocation of money
D) provide information.
E) all of the above

Answer: E

7. One common reason for partnerships to convert to a corporate form of


organization is that the partnership:
A) faces rapidly growing marketing requirements.
B) wishes to avoid taxation of profits.
C) has issued all of its allotted shares.
D) agreement expires after ten years of use.
E) faces rapidly growing capital needs

Answer: E .

This is the reason for the firm to go public to raise capital.

8. Unlimited liability is faced by the owners of:


A) corporations.
B) partnerships and corporations.
C) sole proprietorships and partnerships.
D) all forms of business organization.

Answer: C .

9. A board of directors is elected as a representative of the corporation’s:


A) top management.
B) stakeholders.
C) shareholders.
D) customers.
E) bond and stock holders

Answer: C

10. Which of the following would be considered a capital budgeting decision?


A) Planning to issue common stock rather than issuing preferred stock
B) A decision to expand into a new line of products, at a cost of $5 million
C) Repurchasing shares of common stock
D) Issuing debt in the form of long-term bonds

Answer: B

11. Corporations are referred to as public companies when their:


A) shareholders have no tax liability.
B) shares are held by the federal or state government.
C) stock is widely traded.
D) products or services are available to the public.

Answer: C .

12. Which of the following statements best distinguishes the difference between real
and financial assets?
A) Real assets have less value than financial assets.
B) Real assets are tangible; financial assets are not.
C) Financial assets represent the voting power on real assets.
D) Financial assets claim to cash flows that are generated by real assets.
E) Financial assets appreciate in value; real assets depreciate in value.

Answer: D

13. Corporations that do not issue more financial securities such as stock or debt
obligations:
A) will not be able to increase sales.
B) may have internal cash flows to fulfill their needs
C) cannot be profitable.
D) generate insufficient funds to fulfill their needs.
E) do not face taxation of their profits.

Answer: B
To finance good projects, firms can also use internal cash flows.

14. The net present value formula for one period is:
A) NPV = PV cash flows/initial investment
B) NPV = C0/C1
C) NPV = C0+[C1/(1 + r)]
D) Any of the above
E) None of the above

Answer: C
This is the NPV formula for a project which produces one piece of
cash flow in the next period.

15. The managers of a firm are supposed to

A) take all projects with positive NPVs


B) take all projects with NPVs greater than the discount rate
C) take all projects with NPVs greater than present value of cash flow
D) All of the above
E) None of the above

Answer: A

16. What is the net present value of the following cash flows at a discount rate on 12%?

t = 0 t = 1 t= 2 t= 3
-2 5 0 ,0 0 0 1 0 0 ,0 0 0 1 5 0 ,0 0 0 2 0 0 ,0 0 0

A) $101,221
B) $200,000
C) $142,208
D) None of the above

Answer: A
NPV = -250,000 + (100,000/1.12) + (150,000/(1.12^2)) + 200,000/(1.12^3) = 101,221

17. You would like to have enough money saved to receive a perpetuity, with the first
payment being $60,000, after retirement so that you and your family can lead a good life.
How much would you need to save in your retirement fund to achieve this goal (assume
that the perpetuity payments start one year from the date of your retirement. The interest
rate is 10%)?
A) $7,500,000
B) $1,500,000
C) $600,000
D) None of the above

Answer: C
After your retirement, you will receive a standard perpetuity.

PV = 60,000/0.1 = 600,000

18. Three yeas from now, if the economy is good, you will receive $100; if the
economy is bad, you will receive $50. If the probability for the good economy is 30% and
the economy has only two states three years from now: good and bad, what is the
present value of this expected payment if the discount rate is 3.5%?
A) $65.00
B) $72.07
C) $59.48
D) None of the above
E) Any of the above
Answer : D

First calculate C3, which is the expected cash flows at period three.

C3 = 0.3*100+0.7*50=$65
PV= C3/(1+r)3 = 65/1.0353 = $58.63

19. 10 years from now, you will receive a payment, which is 1.5 times the present
value of this payment? If the discount rate is the same for every year, what is the
annual discount rate ?
A) 8.10%
B) 8.18%
C) 7.18%
D) 4.14%
E) none of the above

Answer D.

Let the present value be $1. The future value will be $1.5. Then, we have

1=1.5/(1+r)10. Then (1+r)10=1.5. r = (1.5)1/10 -1 = 4.14%.

20. You have a car loan of $30,000 (which is called the principle) with the interest
rate of 6.5%. You decide to pay off this loan in next four years with equal
payment each year, what is the remaining principal before the last payment?
A) $7,621.03
B) $8,757.08
C) $9,523.36
D) $ 8,222.61
E) none of the above

First use the annuity formula to calculate the total payment in each period.

That is, 30000=C(1/r-1/(r.(1+r)4)), where r=0.065. So C=$8,757


Let the remaining principal be x before the last payment. Then, the interest payment in
the last period is 0.065x. Since principal + interest payment = total payment,
we have x + 0.065x =C=8757. x = 8757/(1+0.065)=$8,222.61

Answer: D.

21.The annual coupon rate of a bond equals:


A) its yield to maturity.
B) a percentage of its price.
C) the maturity value.
D) the ratio of the annual coupon payment to the par value.
E) None of the above

Answer: D

22.The face value of a bond is received by the bondholder:


A) at the time of purchase.
B) annually.
C) whenever coupon payments are made.
D) at maturity.
E) none of the above

Answer: D

23.Which of the following presents the correct relationship? As the coupon rate of a
bond decreases, the bond’s:
A) face value increases.
B) bond price tends to increase.
C) interest payments increase.
D) maturity date is extended.
E) coupon payments decrease

Answer: E

24. How much would an investor expect to pay for a $1,000 par value bond with a 9%
annual coupon that matures in 5 years if the interest rate is 9%?
A) $696.74
B) $1,075.00
C) $1,000.00
D) $1,123.01
E) None of the above

Answer: C

25.The current yield of a bond can be calculated by:


A) multiplying the price by the coupon rate.
B) dividing the price by the annual coupon payments.
C) dividing the price by the par value.
D) dividing the annual coupon payments by the price.
E) none of the above

Answer: D

26. Which of the following statements is correct for a 10% coupon bond that has a
current yield of 13%?
A) The face value of the bond has decreased.
B) The discount rate is 13%.
C) The bond’s price is smaller than the bond’s maturity value (par value).
D) The bond has few years remaining until maturity.
E) None of the above

Answer: C

27.What is the coupon rate for a bond (par value of $1,000) with three years until
maturity, a price of $1,000, and a yield to maturity of 6%?
A) 6%
B) 7%
C) 8%
D) 9%
E) None of the above

Answer: A
 1 1  $1,000
$1,000 = PMT   3  3
 .06 .06(1.06)  (1.06)
$60.00 = PMT
$60
 6% coupon rate. In fact you don’t need to calculate. Why?
1000

28.What happens to the price of a three-year bond with an 8% coupon when interest
rates change from 8% to 6%?
A) A price increase of $53.47
B) A price decrease of $51.54
C) A price decrease of $53.47
D) No change in price
E) None of the above

Answer: A
 1 1  $1,000
PV = $80   3 
 3
 .06 .06i(1.06)  (1.06)
$1,000
= $80[16.667 – 13.994] +
1.06  3
= $213.84 + $839.63
= $1,053.47

This represents a price change of $53.47, since the bond had sold for par.

29.Which of the following bonds would be considered to be of speculative-grade?


A) A Caa-rated bond.
B) An Aaa-rated bond.
C) An AAA-rated bond.
D) A Baa-rated bond.
E) None of the above

Answer: A

30.What is the rate of return for an investor who pays $1,054.47 for a three-year bond
with a 7% coupon and sells the bond one year later for $1,037.19?
A) 5.00%
B) 5.33%
C) 6.46%
D) 7.00%
E) none of the above

Answer: A
Rate of Return = ($70.00 - $17.28)/$1,054.47
= $52.72/$1,054.47
= 5%

31.According to the dividend discount model, the current value of a stock is equal to the:
A) present value of all expected future dividends.
B) sum of all future expected dividends.
C) next expected dividend, discounted to the present.
D) discounted value of all dividends growing at a constant rate.
E) none of the above

Answer: A

32.If a stock’s P/E ratio is 13.5 at a time when earnings are $3 per year, what is the
stock’s current price?
A) $4.50
B) $18.00
C) $22.22
D) $40.50
E) None of the above

Answer: D
P/E = 13.5
Then P = 13.5 x $3
Price = $40.50

33. A stock paying $5 in annual dividends sells now for $100 and has an expected return
of 20%. What might investors expect to pay for the stock one year from now?
A) $182.00
B) $186.00
C) $115.00
D) $110.00
E) None of the above

Answer: C .
Div1  P1  Po
Expected return =
Po
$5  P1 $100
20% =
$100
$115 = P1

34.How much should you pay for a share of stock that offers a constant dividend growth
rate of 10%, has a discount rate of 16%, and pays a dividend of $3 next year?
A) $42.00
B) $45.00
C) $45.45
D) $50.00
E) none of the above

Answer: D

P0=C1/(r-g)=3/0.06=$50

35.The price of a stock will likely increase if:


A) the investment horizon decreases.
B) the growth rate of dividends increases.
C) the discount rate increases.
D) dividends are discounted back to the present.
E) none of the above

Answer: B

36.What should be the price for a common stock paying $3.50 annually in dividends if
the growth rate is zero and the discount rate is 8%?
A) $22.86
B) $28.00
C) $42.00
D) $43.75
E) None of the above

Answer: D
Div 3.50
Po =   $43.75
r .08
37.What is the plowback ratio for a stock with current price of $30, earnings of $5 per
share next year, a discount rate of 20% , and a rate of return on equity of 25% ?
A) 0.5
B) 0.2
C) 0.4
D) 0.1
E) None of the above

The idea to solve this problem is that you suppose that the plow-back ratio is the ratio in
each choice, then you use the dividend growth model ( P0 = Div1/(r-g) ) to
calculate the current stock price. If the calculated stock price is the same as
the given stock price of $30, then that choice is the answer.

For example, suppose that the plow-back ratio is 0.5 in choice A. Then the dividend
growth rate g = plow-back ratio * the rate of return on equity (ROE)
=0.5*0.25=12.5%. Div1 =earnings1 * payout ratio =5*(1-plow-back
ratio)=$2.5. P0 =Div1/(r-g)=2.5/(0.2-0.125)=$33.3, which is not the same as
$30. So choice A is not the answer. Then use the above procedure to test
choice B and you will find out P0=4/(0.2-0.5)=$26.7 < $30. So Choice B is
not the answer. For choice C,
g= 0.4*0.25=10%; P0=Div1/(r-g)=0.6*5/0.1=$30. So choice C is the answer.

38.What is the expected constant growth rate of dividends for a stock currently priced at
$50, that is expected to pay a dividend of $5 next year, and has a required return
of 20%?
A) 13%
B) 10%
C) 11%
D) 12%
E) none of the above

Answer: B
By using the dividend growth model, P0 =div1/(r-g), we have
$50 = $5/(.2 – g).
g = 0.1=10%

39.If the (current) dividend yield is 5% and the stock price is $25, what will the year
three dividend be if dividends grow at a constant 6%?
A) $1.33
B) $1.40
C) $1.58
D) $1.67
E) none of the above

Answer: B
Dividend yield is Div1/P0, which is 5%. So
Div1=.05 x 25 = 1.25
then, Div3 = div1*(1+g)2=1.25 x (1.06)2 = $1.4045

40.What would be the current price of a stock when dividends are expected to grow at a
25% rate for three years, then grow at a constant rate of 5%, if the stock’s required
return is 13% and next year’s dividend will be $4.00?
A) $61.60
B) $62.08
C) $68.62
D) $79.44
E) None of the above

Answer: C

The idea to solve this problem is to assume that you hold the stock for three years and
sell the stock at the end of year 3. After year 3, the dividends have a constant
growth rate of 5%. By observing this constant growth rate of dividends, you can
use the dividend growth model to calculate the stock price at year 3, which is
P3=Div4/(r-g), where r=13% and g =5%.

Then the current stock price is the present value of three dividends received in each
year in the next three years, and the stock price at year 3.

$4.00 $4.00(1.25) $4.00(1.25)2 $4.00(1.25)2 (1.05)


  
Po = (1.13) (1.13)2 (1.13) 3 .13 .05
(1.13)3
$5.00 $6.25 6.56
 
= 3.54 + 1.2769 1.4429 .08
1.4429
= 3.54 + 3.92 + 4.33 + 56.83
= $68.62