Applied Corporate Finance
Final Test Solutions
Course Introduction
Applied Corporate Finance explores the practical aspects of financial decision-making within corporations, focusing on the techniques and tools used by managers to maximize firm value. The course covers topics such as capital budgeting, capital structure, risk management, corporate governance, and valuation methods. Through case studies and real-world examples, students learn how to analyze financial statements, assess investment opportunities, manage funding sources, and develop strategies to optimize the financial performance and competitive position of organizations.
Recommended Textbook
Corporate Finance 3rd Edition by Jonathan Berk
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Chapter 1: The Corporation
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Q1) If you buy shares of Coca-Cola on the secondary market:
A) Coca-Cola receives the money because the company has issued new shares.
B) you buy the shares from another investor who decided to sell the shares.
C) you buy the shares from the New York Stock Exchange.
D) you buy the shares from the Federal Reserve.
Answer: B
Q2) Which of the following organization forms for a business does NOT avoid double taxation?
A) Limited partnership
B) "C" corporation
C) "S" corporation
D) Limited liability company
Answer: B
Q3) The Principal-Agent Problem arises:
A) because managers have little incentive to work in the interest of shareholders when this means working against their own self-interest.
B) because of the separation of ownership and control in a corporation.
C) Both A and B
D) None of the above
Answer: C
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Chapter 2: Introduction to Financial Statement Analysis
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Q1) Assuming that Luther has no convertible bonds outstanding, then for the year ending December 31, 2009 Luther's diluted earnings per share are closest to:
A) $1.01
B) $1.04
C) $1.28
D) $1.33
Answer: A
Q2) Dustin's Donuts experienced a decrease in the value of the trademark of a company it acquired two years ago. This reduction in value results in:
A) an impairment charge.
B) depreciation expense.
C) an operating expense.
D) goodwill.
Answer: A
Q3) What are the four financial statements that all public companies must produce?
Answer: 1. Balance Sheet
2. Income Statement
3. Statement of Cash Flows
4. Statement of Stockholder's Equity
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Page 4
Chapter 3: Financial Decision Making and the Law of One
Price
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Sample Questions
Q1) A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a Large Fry. Assuming that there is a competitive market for McDonald's food items, at what price must a Big Mac value meal sell to insure the absence of an arbitrage opportunity and uphold the law of one price?
A) $4.08
B) $4.38
C) $5.47
D) $5.77
Answer: C
Q2) If the interest rate is 7%, the NPV of alternative #3 is closest to:
A) $350,000
B) $357,196
C) $370,561
D) $401,121
Answer: B
Q3) The price per share of the ETF in a normal market is:
Answer: Value of ETF = 2 × 121.57 + 3 × 36.59 + 3 × 3.15 = $362.36
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Chapter 4: The Time Value of Money
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Q1) Henry Rearden is saving for retirement and has determined that to live comfortably he must save $3 million by his 65 birthday. Henry just turned 30 today, and he has decided that starting today and continuing on every birthday up to and including his 65th birthday, he will deposit the same amount into an individual retirement account (IRA). If Henry can earn 8% on his IRA, then the amount he must set aside each year to make sure that he will have $3 million in his account on his 65th birthday is closest to:
A) $16,035
B) $17,410
C) $83,335
D) $85,715
Q2) Since your first birthday, your grandparents have been depositing $1000 into a savings account on every one of your birthdays. The account pays 4% interest annually. Immediately after your grandparents make the deposit on your 18th birthday, the amount of money in your savings account will be closest to:
A) $25,645
B) $36,465
C) $12,659
D) $18,000
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Chapter 5: Interest Rates
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Q1) What is the effective after-tax rate of each instrument, expressed as an EAR?
Q2) Which alternative offers you the lowest effective rate of return?
A) Investment A
B) Investment B
C) Investment C
D) Investment D
Q3) Hugh Akston took out a 30-year mortgage with an EAR of 5.9%. If Hugh borrowed $300,000 to buy his home, then his monthly payment will be closest to:
A) $835
B) $1,750
C) $1,780
D) $10,240
Q4) The effective annual rate on your firm's borrowings is closest to:
A) 6.00%
B) 6.14%
C) 6.25%
D) 6.30%
Q5) Should you purchase the delivery truck or lease it? Why?
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Chapter 6: Valuing Bonds
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Q1) The discount rate that sets the present value of the promised bond payments equal to the current market price of the bond is called:
A) the current yield.
B) the yield to maturity.
C) the zero coupon yield.
D) the discount yield.
Q2) The credit spread of the BBB corporate bond is closest to:
A) 1.0%
B) 5.6%
C) 1.6%
D) 0.8%
Q3) Assuming the appropriate YTM on the Sisyphean bond is 7.5%, then the price that this bond trades for will be closest to:
A) $1,045
B) $691
C) $1,000
D) $957
Q4) Compute the yield to maturity for each of the five zero-coupon bonds.
Q5) Plot the zero-coupon yield curve (for the first five years).
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Chapter 7: Investment Decision Rules
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Q1) Assume that projects Alpha and Beta are mutually exclusive. Which of the following statements is true regarding the investment decision tools' suitability for deciding between projects Alpha & Beta?
A) The incremental IRR should not be used since the projects have different lives.
B) The incremental IRR should not be used since the projects have different discount rates
C) The incremental IRR should not be used since the projects have different cash flow patterns.
D) Both the NPV and incremental IRR approaches are appropriate to solve this problem.
Q2) The internal rate of return (IRR) for project Beta is closest to:
A) 25.0%
B) 22.7%
C) 24.5%
D) 22.2%
Q3) If the discount rate for project A is 16%, then what is the NPV for project A?
Q4) If your new strip mall will have 16,000 square feet of retail space available to be leased, to which businesses should you lease and why?
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Chapter 8: Fundamentals of Capital Budgeting
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Q1) Epiphany is worried about the reliability of the sales forecast. How sensitive is the project's NPV to a 10% change in sales.
Q2) Your firm is considering building a new office complex. Your firm already owns land suitable for the new complex. The current book value of the land is $100,000, however a commercial real estate again has informed you that an outside buyer is interested in purchasing this land and would be willing to pay $650,000 for it. When calculating the NPV of your new office complex, ignoring taxes, the appropriate incremental cash flow for the use of this land is:
A) $650,000
B) $0
C) $100,000
D) $750,000
Q3) The incremental EBIT in the first year for the Sisyphean Corporation's project is closest to:
A) $18,000
B) $8,000
C) $11,700
D) $5,200
Q4) How does scenario analysis differ from sensitivity analysis?
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Chapter 9: Valuing Stocks
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Q1) If you want to value a firm that consistently pays out its earnings as dividends, the simplest model for you to use is the:
A) enterprise value model.
B) total payout model.
C) dividend discount model.
D) discounted free cash flow model.
Q2) The enterprise value of CCM corporation is closest to:
A) $396 million
B) $290 million
C) $382 million
D) $350 million
Q3) Which of the following statements is FALSE?
A) Estimating dividends, especially for the distant future, is difficult.
B) A firm can only pay out its earnings to investors or reinvest their earnings.
C) Successful young firms often have high initial earnings growth rates.
D) According to the constant dividend growth model, the value of the firm depends on the current dividend level, divided by the equity cost of capital plus the growth rate.
Q4) What are some common multiples used to value stocks?
Q5) Calculate the enterprise value for DM Corporation.
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Chapter 10: Capital Markets and the Pricing of Risk
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Q1) If the expected return on the market is 11% and the expected return of investing in Merck is 10.35%, then the risk-free rate must be:
A) 3.0%
B) 4.0%
C) 4.5%
D) 5.0%
Q2) Which of the following statements is FALSE?
A) Beta measures the sensitivity of a security to market wide risk factors.
B) Volatility measures total risk, while beta measures only systematic risk.
C) The beta is the expected percentage change in the excess return of the market portfolio for a 1% change in the excess return of a security.
D) Utilities tend to be stable and highly regulated, and thus are insensitive to fluctuations in the overall market.
Q3) What is the expected payoff for Little Cure's ten drugs?
A) $500 million
B) $100 million
C) $1 billion
D) $0
Q4) Which pharmaceutical company faces less risk?
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Chapter 11: Optimal Portfolio Choice and the Capital Asset
Pricing Model
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Q1) The expected return on the alternative investment having the highest possible expected return while having the same volatility as Google is closest to?
A) 21.6%
B) 19.6%
C) 23.4%
D) 35.0%
Q2) Consider a portfolio consisting of only Microsoft and Wal-Mart stock. Calculate the volatility of such a portfolio when the weight on Microsoft stock is 0%, 25%, 50%, 75%, and 100%
Q3) Suppose over the next year Ball has a return of 12.5%, Lowes has a return of 20%, and Abbott Labs has a return of -10%. The weight on Abbott Labs in your portfolio after one year is closest to:
A) -10.0%
B) 43.5%
C) 45.0%
D) 50.0%
Q4) Calculate the variance on a portfolio that is made up of equal investments in Stock Y and Stock Z stock .
Q5) Calculate the covariance between Stock Y's and Stock Z's returns .
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Chapter 12: Estimating the Cost of Capital
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Q1) The e<sub>i</sub> in the regression
A) measures the market risk in returns.
B) measures the deviation from the best fitting line and is zero on average.
C) measures the sensitivity of the security to market risk.
D) measures the historical performance of the security relative to the expected return predicted by the SML.
Q2) Which of the following statements is FALSE?
A) There may be reasons to exclude certain historical data as anomalous when estimating beta.
B) Many practitioners use adjusted betas, which are calculated by averaging the estimated beta with 1.0.
C) The beta estimated we obtain from linear regression can be very sensitive to outliers, which are returns of unusually small magnitude.
D) If we use very old data to when estimating beta, they data may be unrepresentative of the current market risk of the security.
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Chapter 13: Investor Behavior and Capital Market Efficiency
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Q1) The expected alpha for Taggart Transcontinental is closest to:
A) -3.00%
B) -1.00%
C) 1.00%
D) 3.00%
Q2) The market value for Chihuahua is closest to:
A) $10.0 million
B) $12.5 million
C) $12.0 million
D) $15 million
Q3) The tendency of uninformed individuals to overestimate the precision of their knowledge is known as:
A) overconfidence bias.
B) herd behavior.
C) familiarity bias.
D) disposition bias.
Q4) What does the existence of a positive alpha investment strategy imply?
Q5) Explain why the market portfolio proxy may not be efficient.
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Chapter 14: Capital Structure in a Perfect Market
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Q1) Which of the following statements is FALSE?
A) Holding cash has the opposite effect of leverage on risk and return.
B) We use the market value of the firm's net debt when computing its WACC and unlevered beta to measure the cost of capital and market risk of the firm's business assets.
C) Since the WACC does not change with the use of leverage, the value of the firm's free cash flow evaluated using the WACC does not change, and so the enterprise value of the firm does not depend on its financing choices.
D) Even if the firm's capital structure is more complex, the WACC is calculated by computing the weighted average cost of only the firm's debt and equity.
Q2) Suppose that to raise the funds for the initial investment the firm borrows $45,000 at the risk free rate and issues new equity to cover the remainder. In this situation, calculate the value of the firm's levered equity from the project. What is the cost of capital for the firm's levered equity?
Q3) Show mathematically that the stock price of Rockwood does not depend on whether they issue new stock or borrow to fund their expansion.
Q4) What is the conservation of value principle?
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Chapter 15: Debt and Taxes
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Q1) The present value of LCMS' interest tax shield is closest to:
A) $45.5 million
B) $20.0 million
C) $24.5 million
D) $35.0 million
Q2) Assume that investors in Google pay a 15% tax rate on income from equity and a 35% tax rate on interest income. If Google were to issue sufficient debt to reduce its taxes by $1 billion per year permanently, then the effective tax advantage of this debt would be closest to:
A) 10%
B) 15%
C) 25%
D) 30%
Q3) Rosewood's net income is closest to:
A) $450 million
B) $180 million
C) $290 million
D) $95 million
Q4) If Flagstaff currently maintains a .8 debt to equity ratio, then calculate the value of Flagstaff's interest tax shield.
Page 17
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Chapter 16: Financial Distress, Managerial Incentives, and Information
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Q1) The value of Luther with leverage is closest to:
A) $315 million
B) $340 million
C) $205 million
D) $300 million
Q2) Assuming your cost of capital is 6 percent, based on the present value of your expected wage you should:
A) accept Rearden's offer since the PV of your expected wage would be approximately $6,000 higher.
B) accept Rearden's offer since the PV of your expected wage would be approximately $8,000 lower.
C) accept Rearden's offer since the PV of your expected wage would be approximately $8,000 higher.
D) accept Wyatt's offer since the PV of your expected wage would be approximately $6,000 higher.
Q3) Suppose that MI has zero-coupon debt with a $140 million face value due next year.
Calculate the value of levered equity, the value of debt, and the total value of MI with leverage.
Q4) List five general categories of indirect costs associated with bankruptcy.
Page 18
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Chapter 17: Payout Policy
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Q1) Which of the following statements is FALSE?
A) In perfect capital markets, holding fixed the investment policy of a firm, the firm's choice of dividend policy is irrelevant and does not affect the initial share price.
B) In a perfect capital market, when a dividend is paid, the share price drops by the amount of the dividend when the stock begins to trade ex-dividend.
C) In perfect capital markets, an open market share repurchase has no effect on the stock price, and the stock price is the same as the ex-dividend price if a dividend were paid instead.
D) In perfect capital markets, investors are indifferent between the firm distributing funds via dividends or share repurchases. By reinvesting dividends or selling shares, they can replicate either payout method on their own.
Q2) The price per share of Iota if they use the $200 million to expand is closest to:
A) $13.75
B) $16.50
C) $19.00
D) $16.80
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19
Chapter 18: Capital Budgeting and Valuation With Leverage
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Q1) Rose's unlevered cost of capital is closest to:
A) 8.0%
B) 7.5%
C) 7.0%
D) 9.0%
Q2) Which of the following is NOT one of the simplifying assumptions made for the three main methods of capital budgeting?
A) The firm pays out all earnings as dividends.
B) The project has average risk.
C) Corporate taxes are the only market imperfection.
D) The firm's debt-equity ratio is constant.
Q3) The Free Cash Flow to Equity (FCFE) for the acquisition in year 0 is closest to:
A) $5 million
B) $100 million
C) -$100 million
D) -$50 million
Q4) Suppose that to fund this new project, Aardvark borrows $150 with the principal to be paid in three equal installments at the end each year. Calculate the The levered value of Aardvark's new project.
Q5) Calculate the NPV for Iota's new project.
Page 20
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Chapter 19: Valuation and Financial Modeling: a Case Study
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Q1) Based upon the average EV/Sales ratio of the comparable firms, Ideko's target economic value is closest to:
A) $191 million
B) $155 million
C) $165 million
D) $157 million
Q2) The amount of the increase in net working capital for Ideko in 2007 is closest to:
A) $4,090
B) $4,685
C) $3,665
D) $5,230
Q3) With the proper changes it is believed that Ideko's credit policies will allow for an account receivables days of 60. The forecasted accounts receivable for Ideko in 2006 is closest to:
A) $19,690
B) $16,970
C) 22,710
D) $14,525
Q4) What is the purpose of the sensitivity analysis?
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Chapter 20: Financial Options
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Q1) In describing Galt's debt as a put option, the strike price of the put option is:
A) $200 million
B) $300 million
C) $500 million
D) $700 million
Q2) KD Industries stock is currently trading at $32 per share. Consider a put option on KD stock with a strike price of $30. The intrinsic value of this put option is:
A) $0
B) -$2
C) $2
D) $30
Q3) How many of the January 2009 call options are in the money?
A) 2
B) 4
C) 1
D) 3
Q4) Describe the conditions when it would be optimal to exercise an American Call and an American Put option prior to their expiration.
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Chapter 21: Option Valuation
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Q1) Which of the following statements is FALSE?
A) In both the Binomial and Black-Scholes Pricing Models, we need to know the risk neutral probability of each possible future stock price to calculate the option price.
B) In the real world, investors are risk averse. Thus, the expected return of a typical stock includes a positive risk premium to compensate investors for risk.
C) Because no assumption on the risk preferences of investors is necessary to calculate the option price using either the Binomial Model or the Black-Scholes formula, the models must work for any set of preferences, including risk-neutral investors.
D) If all market participants were risk neutral, then all financial assets (including options) would have the same cost of capital-the risk free rate of interest.
Q2) The Black-Scholes value of a one-year European put option on Taggart stock with a strike price of $50 is closest to:
A) $1.45
B) $3.15
C) $4.75
D) $9.50
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Chapter 22: Real Options
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Q1) Which of the following statements is FALSE?
A) It is tempting to use the Black-Scholes formula to value future growth options, but often there are good reasons why this formula might not price these options correctly.
B) When a firm has a real option to invest in the future it is known as a growth option.
C) Because growth options have value, they contribute to the value of any firm that has future possible investment opportunities.
D) Future growth opportunities can be thought of as a collection of real put options on potential projects.
Q2) Assuming that this project will provide Rearden with perpetual annual cash flows of $65,000, the NPV of investing in the project next year is closest to:
A) -281,000
B) +46,000
C) +83,000
D) +143,000
E) +238,000
Q3) Do out-of-the-money real options have value?
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Chapter 23: Raising Equity Capital
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Q1) Which of the following statements is FALSE?
A) SEO rights offers have lower costs than cash offers.
B) The decision to raise financing externally usually implies that a firm plans to pursue an investment opportunity.
C) Although not as costly as IPOs, seasoned offerings are still expensive.
D) Researchers have found that, on average, the market greets the news of an SEO with a price increase.
Q2) Which of the following is NOT one of the four characteristics of IPOs that puzzle financial economists?
A) On average, IPOs appear to be underpriced.
B) The long-run performance of a newly public company (three to five years from the date of issue) is superior to the overall market return.
C) The number of issues is highly cyclical.
D) The costs of the IPO are very high, and it is unclear why firms willingly incur such high costs.
Q3) What will the proceeds from the IPO be if Luther is selling 1.1 million shares?
Q4) What will the offer price of these shares be if Luther is selling 800,000 shares?
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Chapter 24: Debt Financing
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Q1) Which of the following statements is FALSE?
A) Mortgage-backed securities, such as GNMAs, are pass-through securities. That is, each security is backed by an underlying portfolio or pool of mortgages.
B) The Government National Mortgage Association (GNMA, or "Ginnie Mae") is an example of an enterprise; the Student Loan Marketing Association ("Sallie Mae") is an example of a government-sponsored agency.
C) Sovereign debt is debt issued by national governments.
D) Agency securities are issued by agencies of the U.S. government or by U.S. government sponsored enterprises.
Q2) Galt Industries has just issued a callable, $1000 par value, five-year, 6% coupon bond with semiannual coupon payments. The bond can be called at par in three years or anytime thereafter on a coupon payment date. If the bond is currently trading for $978.94, then its yield to maturity is closest to:
A) 3.4%
B) 6.0%
C) 6.5%
D) 6.8%
Q3) What is the Yield to Call (YTC) on this bond?
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Chapter 25: Leasing
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Q1) Assuming that Rearden's annual lease payments are $1.2 million, then the amount of the savings in year 0 from leasing is closest to:
A) $3.8 million
B) $3.9 million
C) $4.0 million
D) $4.2 million
Q2) Assuming that Rearden's annual lease payments are $1.2 million, then Rearden Metal should:
A) lease the furnace since the amount saved in year zero from leasing is greater than the amount of the lease equivalent loan.
B) buy the furnace since the amount saved in year zero from leasing is greater than the amount of the lease equivalent loan.
C) lease the furnace since the amount saved in year zero from leasing is less than the amount of the lease equivalent loan.
D) buy the furnace since the amount saved in year zero from leasing is less than the amount of the lease equivalent loan.
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Chapter 26: Working Capital Management
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Q1) Which of the following money market investments is short-term debt issued by a bank with a minimum denomination of $100,000?
A) Treasury Bill
B) Banker's Acceptance
C) Repurchase Agreement
D) Commercial Paper
E) Certificates of Deposit (CD)
Q2) Luther's Accounts Payable days is closest to:
A) 39 days
B) 32 days
C) 59 days
D) 42 days
Q3) The percentage of Wyatt's receivables that are more than 30 days past due is closest to:
A) 20.1%
B) 32.1%
C) 38.3%
D) 42.2%
Q4) What is a compensating balance?
Q5) Describe "just-in-time" inventory management.
Page 28
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Chapter 27: Short-Term Financial Planning
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Q1) Hammond Motors is considering using a public warehouse loan as part of its short-term financing. The firm will require a loan of $2 million for three months. Interest on the loan will be 12% (APR, compounded quarterly) to be paid at the end of the quarter. The warehouse charges 1% of the face value of the loan, payable at the beginning of the quarter. The effect annual rate on this loan is closest to:
A) 9.3%
B) 11.3%
C) 15.2%
D) 17.1%
Q2) The effective annual rate for Taggart if they choose alternative #1 is closest to: A) 13.9%
B) 18.8%
C) 27.0%
D) 27.9%
Q3) Kinston Industries issued $4,000,000 in commercial paper which matures in six months and received $3,876,000. Calculate the effective annual rate that Kinston is paying.
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Chapter 28: Mergers and Acquisitions
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Q1) If Rearden offers an exchange ratio such that, at current pre-announcement share prices for both firms, the offer represents a 20% premium to buy Associated Steel, then actual premium Rearden will pay will be closest to:
A) 14.7%
B) 18.0%
C) 20.0%
D) 22.4%
Q2) Which of the following questions is FALSE?
A) Any acquirer shares received in full or partial exchange for target shares triggers an immediate tax liability for target shareholders.
B) In a friendly takeover, the target board of directors supports the merger, negotiates with potential acquirers, and agrees on a price that is ultimately put to a shareholder vote.
C) How the acquirer pays for the target affects the taxes of both the target shareholders and the combined firm.
D) If the acquirer purchases the target assets directly (rather than the target stock), then it can step up the book value of the target's assets to the purchase price.
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Chapter 29: Corporate Governance
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Q1) A board of directors is said to be captured when:
A) a majority of the directors are independent directors.
B) a majority of the directors are outside directors.
C) its monitoring duties have been compromised by connections or perceived loyalties to management.
D) when the CEO also serves as chairman of the board of directors.
Q2) While the Sarbanes-Oxley Act (SOX) contains many provisions, the overall intent of the legislation was to improve the accuracy of information given to both boards and to shareholders. SOX attempted to achieve this goal in all of the following ways EXCEPT:
A) overhauling incentives and independence in the auditing process.
B) mandating the separation of the positions of CEO and Chairman of the Board.
C) stiffening penalties for providing false information.
D) forcing companies to validate their internal financial control processes.
Q3) Describe the "stakeholder" model of corporate governance.
Q4) What is the role of takeovers in corporate governance?
Q5) What is corporate governance?
Q6) How does a pyramid structure work?
Q7) What are some of the negative effects of increasing the sensitivity of managerial pay to firm performance?
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Chapter 30: Risk Management
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Q1) Luther Industries needs to borrow $50 million in cash. Currently long-term AAA rates are 9%. Luther can borrow at 9.75% given its current credit rating. Luther is expecting interest rates to fall over the next few years, so it would prefer to borrow at the short-term rates and refinance after rates have dropped. Luther management is afraid, however, that its credit rating may fall which could greatly increase the spread the firm must pay on new borrowings. How can Luther benefit from the expected decline in future interest rates without exposure to the risk of the potential future changes to its credit ratings bring?
Q2) To protect the firm against the loss of earnings if the business operations are disrupted due to fire, accident, or some other insured peril a firm would purchase:
A) property insurance.
B) key personnel insurance.
C) business liability insurance.
D) business interruption insurance.
Q3) The duration of SFTSL's equity is closest to:
A) 6 years
B) 8 years
C) 10 years
D) 14 years
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Page 32
Chapter 31: International Corporate Finance
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Q1) Which of the following statements regarding international projects is FALSE?
A) Interest rates and costs of capital will likely be different in the foreign country as a result of the macroeconomic environment.
B) The project will most likely generate foreign currency cash flows, although the firm cares about the foreign currency value of the project.
C) Under internationally integrated capital markets, the value of an investment does not depend on the currency we use in the analysis.
D) The firm will probably face a different tax rate in the foreign country and will be subject to both foreign and domestic tax codes.
Q2) The present value of the £5 million cash inflow computed by first converting into dollars and then discounting is closest to:
A) $8,950,495
B) $8,954,615
C) $8,943,695
D) $8,961,420
Q3) What conditions cause the cash flows of a foreign project to be affected by exchange rate risk?
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