Midterm Exam 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.Which of the following would be considered an advantage of the sole proprietorship form of
organization?
A) Wide access to capital markets
B) Unlimited liability
C) A pool of expertise
D) Profits taxed once
E) None of the above

D)

3.One common reason for partnerships to convert to a corporate form of organization is that the
partnership:
A) faces rapidly growing financing requirements.
B) wishes to avoid double taxation of profits.
C) has issued all of its allotted shares.
D) agreement expires after ten years of use.
E) None of the above

A)

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 wealth of the firm’s stock holders
D) Maximize the value of the firm with both bond and stock holders
E) None of the above
 Answer: C

Financial managers are to maximize the wealth of shareholders.

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. When the management of a business is conducted by individuals other than the

owners, the business is more likely to be a:
A) corporation.
B) sole proprietorship.
C) partnership.
D) general partner.
E) None of the above
A)
8. “Double taxation” refers to:
A) all partners paying equal taxes on profits.
B) corporations paying taxes on both dividends and retained earnings.
C) paying taxes on profits at the corporate level and dividends at the personal
level.
D) the fact that marginal tax rates are doubled for corporations.
E) None of the above

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 have a service division in India
C) Repurchasing shares of common stock
D) Issuing debt in the form of long-term bonds
 E) None of the above

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 not traded in the financial market.
D) products or services are available to the public.
E) None of the above

Answer: E

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) None of the above.

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 use internal cash flows to fulfill their needs
C) cannot be profitable.
D) have insufficient funds to fulfill their needs.
E) none of the above.

Answer: B

14. The expected rate of return for one period investment project with a positive investment cost
at time zero, and the cash flows as C0 and C1, respectively, at time zero and period one ,
is:
A) (C1 –C0)/C0
B) (C1+C0)/C0
C) (-C1-C0)/C0
D) (C1-C0)/(-C0)
E) None of the above

Answer: C

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 present value of the following cash flows at a discount rate of 12%?

t = -1 t=0 t=1
-$25,000 $100 $25,000

A) 0
B) -$4,772.73
C) $4,772,73
D) $5,778.57
E) none of the above

Answer: E
PV= -25000*1.12+100+ 25000/1.12 =-$ 5,578.57

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 at the year of your retirement. The interest rate is
10%)?
A) $545,455
B) $1,500,000.
C) $660,000
D) None of the above

Answer: C
Fund =60000+600000=$660,000

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 10%?
A) $65.0
B) $72.1
C) $59.1
D) $55.1
E) None of the above

Answer : E

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 = 65/1.1^3 =$48.84

19.15 years ago, you invested some money in the financial market, which was 2.5
times its present value at time zero. If the rate of return is the same for every year, what
is the annual rate of return ?
A) 5.9%
B) 6.3%
C) 7.3%
D) 4.3%
E) none of the above
E)
Rate of return = (1/2.5)^(1/15)-1 = -5.9%

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 interest payment in the second payment?
A) $1,950
B) $ 7,249
C) $1,508
D) $1,222
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

Answer: C

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 decrease.
C) coupon payments increase.
D) maturity date is extended.
E) none of the above

Answer: B

24. How much would an investor expect to pay for a $1,000 par value bond with a 9%
annual coupon that matures in 20 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 current market price of the
bond.
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 10%.
C) The bond’s current market 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 8%?
A) 6%
B) 7%
C) 8%
D) 9%
E) None of the above
 Answer: C

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 $1,000 for a three-year bond with
a 9% coupon rate and sells the bond one year later for $980?
A) 5%
B) 6%
C) 7%
D) 8%
E) none of the above

Answer: C

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 P0/E0 ratio is now 13.5 when earnings E0 is now $3 , what is the stock’s
current price P0 ?
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 $10 in annual dividends next year sells now for $100 and has an
expected return of 15%. What might investors expect to pay for the stock one
year from now?
A) $182.00
B) $186.00
C) $115.00
D) $105.00
E) None of the above

Answer: D .

Div1  P1  Po
Expected return =
Po
$10  P1 $100
15% =
$100
$105 = P1

34.How much should you pay for a share of stock one year from now that offers a
constant dividend growth rate of 10%, has a discount rate of 16%, and pays a
dividend of $3 per share now?
A) $42.00
B) $55.00
C) $45.45
D) $50.00
E) none of the above

Answer: E

P1=DIV2/(r-g)=3*1.1*1.1/0.06=$60.5

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

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

Answer: B

36.What should be the current price for a common stock paying a constant of $3.50
annual dividends per share if 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 $33, earnings of $5 per
share now, a discount rate of 20% , and a rate of return on equity of 25% ?
A) 0.3
B) 0.4
C) 0.5
D) 0.6
E) None of the above

B)

38.What is the expected constant growth rate of dividends for a stock that is priced at
$60.5 per share one year from now, now paying a dividend of $5 per share,
and has a required return of 20%?
A) 13%
B) 12%
C) 11%
D) 10%
E) none of the above

Answer: D
By using the dividend growth model, P1 =div2/(r-g), we have
$60.5 = $5*(1+g)*(1+g)/(.2 – g).
g = 0.1=10%

39.If the (current) dividend yield is 5% and the stock price is $25, what will the year four
dividend be if dividends grow at a constant 6%?
A) $1.33
B) $1.40
C) $1.49
D) $1.67
E) none of the above
 Answer: C
Dividend yield is Div1/P0, which is 5%. So
Div1=.05 x 25 = 1.25
then, Div4 = div1*(1+g)3=1.25 x (1.06)3 = $1.49

40.What would be the current price of a stock when dividends are expected to grow at a
25% rate for next year, then grow at a constant rate of 5% every year, if the stock’s
required return is 10% and the dividend is now $3.2?
A) $80
B) $68
C) $75
D) $72.62
E) None of the above

Answer: A

The idea to solve this problem is to assume that you hold the stock for one year and sell
the stock at the end of year 1. After year 1, 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 1, which is P1=Div2/(r-
g), where r=10% and g =5%.

Then the current stock price is the present value of one dividends received in the next
year, and the stock price at year 1.

P0 = 4/1.1 + (4.2/0.05)/1.1 =$80