Capital Markets
Exam Solutions
Course Introduction
This course offers an in-depth exploration of capital markets, examining their structure, functioning, and role within the global financial system. Students will study various financial instruments traded in capital markets such as stocks, bonds, and derivatives, and consider the principals and participants involved. The coursework covers market regulation, risk management, valuation techniques, and the interplay between primary and secondary markets. Through case studies and practical examples, students gain a comprehensive understanding of how capital markets facilitate the allocation of resources, support economic growth, and influence financial stability.
Recommended Textbook
Corporate Finance Core Principles and Applications 4th Edition by Sheldon M. Ross
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Page 2
Chapter 1: Introduction to Corporate Finance
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Q1) Which one of the following statements concerning a sole proprietorship is correct?
A)The life of the firm is limited to the life span of the owner.
B)The owner can generally raise large sums of capital quite easily.
C)A formal charter is required to form a new proprietorship.
D)The company must pay separate taxes from those paid by the owner.
E)The legal costs to form a sole proprietorship are quite substantial.
Answer: A
Q2) Explain why financial managers are more concerned with cash flows than with accounting profits.
Answer: To create value,firms need to create more cash inflows than cash outflows.The excess cash flows can be used to grow the firm,or return funds to bondholders and stockholders.To avoid financial distress,or the inability to pay debts in a timely manner,firms also need cash.
Accounting profits are affected by GAAP.Sales and related costs are recorded when sales are realized,not when cash is affected.Thus,a firm with profits may not have sufficient cash to meet its needs.
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Chapter 2: Financial Statements and Cash Flow
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Q1) _____ refers to a firm's interest payments minus any net new borrowing.
A)Operating cash flow
B)Distributable cash flow
C)Net working capital
D)Cash flow to equity investors
E)Cash flow to creditors
Answer: E
Q2) Interpret,in words,what cash flow of the firm,or CF(A),represents by discussing operating cash flow,changes in net working capital,and additions to fixed assets.
Answer: Operating cash flow is the cash flow a firm generates from its day-to-day operations.In other words,it is the cash inflow generated as a result of putting the firm's assets to work.Changes in net working capital and fixed assets represent investments a firm makes in these assets.That is,a firm typically takes some of the cash flow it generates from using assets and reinvests it in new assets.Cash flow of the firm,then,is the cash flow a firm generates by employing its assets,net of any acquisitions.
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Chapter 3: Financial Statements Analysis and Financial Models
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Q1) Juno's has sales of $389,000,a tax rate of 34 percent,a dividend payout ratio of 45 percent,and a profit margin of 6 percent.What is the addition to retained earnings?
A)$10,503.00
B)$12,837.00
C)$141,207.00
D)$8,472.42
E)$15,913.64
Answer: B
Q2) The sustainable rate of growth can be increased by:
A)decreasing the equity multiplier.
B)increasing the profit margin.
C)decreasing the debt-equity ratio.
D)increasing the dividend payout ratio.
E)increasing the capital intensity ratio.
Answer: B
Q3) Identify the three parts of the DuPont identity and specify what each part measures.
Answer: ROE = Profit margin (Operating efficiency)× Total asset turnover (Asset use efficiency)× Equity multiplier (Financial leverage).
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Chapter 4: Discounted Cash Flow Valuation
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Q1) The interest rate expressed as if it were compounded once per year is called the:
A)periodic interest rate.
B)compound interest rate.
C)stated annual rate.
D)daily interest rate.
E)effective annual rate.
Q2) Countrywide Oil has a well that will produce an annual cash flow of $36,900 next year.The cash flow is expected to increase by 2 percent per year indefinitely.What is this well worth today if the discount rate is 17 percent?
A)$246,000.00
B)$424,350.00
C)$194,210.53
D)$212,802.77
E)$221,400.00
Q3) There are three factors that affect the present value of an annuity.Explain what these three factors are and discuss how an increase in each will impact the present value of the annuity.
Q4) What circumstances are required for an APR to equal an EAR?
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Chapter 5: Interest Rates and Bond Valuation
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Q1) The bonds issued by North & South bear a coupon rate of 7.5 percent,payable semiannually.The bonds mature in 6.5 years,sell at par,and have a $1,000 face value.What is the yield to maturity?
A)7.59%
B)7.86%
C)7.50%
D)7.42%
E)15.00%
Q2) The term structure of interest rates reflects the:
A)pure time value of money for various lengths of time.
B)actual risk premium being paid for corporate bonds of varying maturities.
C)pure inflation adjustment applied to bonds of various maturities.
D)interest rate risk premium applicable to bonds of varying maturities.
E)nominal interest rates applicable to coupon bonds of varying maturities.
Q3) Interest rate risk increases with:
A)both increases in time to maturity and coupon rates.
B)increases in time to maturity and decreases in coupon rates.
C)increases in coupon rates and decreases in market rates.
D)decreases in market rates and increases in time to maturity.
E)both decreases in coupon rates and market rates.
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Chapter 6: Stock Valuation
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Sample Questions
Q1) Which one of the following statements concerning dealers and brokers in the financial markets is correct?
A)A broker never assumes ownership of the securities being traded.
B)A dealer pays the ask price when purchasing securities.
C)A broker earns income in the form of a bid-ask spread.
D)A dealer in market securities arranges sales between buyers and sellers for a fee.
E)A broker deals solely in the primary market.
Q2) The EV/EBITDA ratio has an advantage over the PE ratio in situations where comparisons are being made of firms that vary based on their:
A)method of depreciation.
B)rate of growth.
C)degree of leverage.
D)level of cash.
E)sales level.
Q3) Identify at least five features of preferred stock that are similar to bond features.
Q4) Contrast some of the features of preferred stock versus common stock.
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Chapter 7: Net Present Value and Other Investment Rules
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Q1) Which one of these statements is correct given a project with conventional cash flows?
A)The project will have multiple IRRs.
B)The discounted payback period will be equal to or less than the life of the project.
C)The project's AAR will exceed its IRR.
D)The NPV is positive at the required rate of return.
E)The PI may be greater than,equal to,or less than one.
Q2) Project A has an initial cost of $16,400 and cash flows of $5,100,$6,800,and $6,900 for Years 1 to 3,respectively.Project B has an initial cost of $21,200 and cash flows of $8,300,$7,900,and $7,700 for Years 1 to 3,respectively.What is the incremental IRR?
A)2.89%
B)4.07%
C)5.91%
D)6.75%
E)7.90%
Q3) What are the limitations of the IRR rule? Given these limitations,why is IRR so commonly used?
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Chapter 8: Making Capital Investment Decisions
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Q1) Which one of the following is an example of an incremental cash flow for Project A?
A)The insurance on a building the company currently owns that will house the operations for Project A
B)The property taxes on a currently owned warehouse that has been sitting idle but is going to be utilized by Project A
C)The cost of the test marketing to ascertain whether or not Project A is feasible
D)The rental cost of some new machinery that will be acquired for Project A
E)The contractual annual salary of the company president
Q2) All else equal,a project's operating cash flow will increase when the:
A)net working capital requirement increases.
B)sales projections are lowered.
C)interest expense is lowered.
D)depreciation expense increases.
E)earnings before interest and taxes decreases.
Q3) Should financing costs be included as an incremental cash flow in capital budgeting analysis?
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Chapter 9: Risk Analysis, Real Options, and Capital Budgeting
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Q1) To determine the lowest net present value that is likely to occur given a range of values for all of the relevant variables,a firm should conduct which type of analysis?
A)Sensitivity
B)Scenario
C)Present value break-even
D)Financial break-even
E)Cash flow break-even
Q2) The accounting break-even production quantity for a project is 6,425 units.The fixed costs are $51,600 and the contribution margin is $9.What is the projected depreciation expense?
A)$3,600
B)$5,050
C)$6,225
D)$7,053
E)$7,143
Q3) Roger created a basic decision tree for a proposed project and has also developed an overall required rate of return for the project.What might be some of the shortcomings of using Roger's tree for making an accept/reject decision on the project?
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Chapter 10: Risk and Return Lessons From Market History
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Q1) You are comparing the returns on two portfolios for a 10-year period.Portfolio I has a lower dispersion of returns and a higher average rate of return than Portfolio II.Given this,what do you know with certainty?
A)Portfolio I has a lower standard deviation than Portfolio II.
B)Portfolio I consists of more dividend-paying stocks than Portfolio II.
C)Portfolio II has less total risk than Portfolio I.
D)Portfolio I will outperform Portfolio II over the next 10 years.
E)Portfolio II consists of more individual stocks than Portfolio I.
Q2) A stock had annual returns of 8 percent,-2 percent,4 percent,and 20 percent over the past four years.What is the standard deviation of these returns?
A)16.33%
B)16.09%
C)7.10%
D)9.29%
E)7.99%
Q3) What is the difference between an arithmetic and a geometric average? Is one preferred over the other?
Q4) What does market history tell us about the future performance of various securities?
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Chapter 11: Return and Risk: the Capital Asset Pricing Model
Capm
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Sample Questions
Q1) The portfolio expected return considers which of the following factors?
I.The amount of money currently invested in each individual security
II.Various levels of economic activity
III.The performance of each stock given various economic scenarios
IV.The probability of various states of the economy occurring
A)I and III only
B)II and IV only
C)I,III,and IV only
D)II,III,and IV only
E)I,II,III,and IV only
Q2) Assume you are looking at a security market line graph.Where would an overpriced stock with a beta of .98 plot on that graph?
A)To the right of the market and below the security market line
B)To the left of the market and below the security market line
C)To the right of the market and above the security market line
D)To the left of the market and above the security market line
E)To the right of the market on the security market line
Q3) Securities with zero or negative correlations are desired by many investors for their portfolio holdings.How might you go about identifying such securities?
Page 13
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Chapter 12: Risk, Cost of Capital, and Valuation
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Q1) The Red Hen currently has a debt-to-equity ratio of .45,its cost of equity is 13.6 percent,and its beta is 1.49.The pretax cost of debt is 7.8 percent,the tax rate is 35 percent,and the risk-free rate is 3.1 percent.The firm's target debt-to-equity ratio is .5.What discount rate should be assigned to a new project the firm is considering if the project is equally as risky as the overall firm and will be financed solely with debt?
A)7.80%
B)9.76%
C)5.07%
D)9.34%
E)10.76%
Q2) The cost of equity for Ryan Corporation is 15.43 percent.The expected return on the market is 13.81 percent,the risk-free rate is 3.7 percent,and the tax rate is 35 percent.What is the equity beta?
A).92
B).86
C).94
D)1.07
E)1.16
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Page 14
Chapter 13: Efficient Capital Markets and Behavioral Challenges
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Q1) ALLGO announced at Time t that it was acquiring DoLittle Industries.There were no other announcements affecting these firms.ALLGO's stock had daily returns of -.2,+.1,-.5,-.1,+.1 for Time <sub>t - 2</sub> to Time <sub>t + 2</sub>,respectively.The daily returns on the market were -.1,+.2,+.1,-.2,and +.2 for Time <sub>t - 2</sub> to Time <sub>t + 2</sub>,respectively.What is the cumulative abnormal return for these five days?
A)-.7
B)-.8
C)-.5
D)-.10
E)-.3
Q2) Which one of these serial coefficient values is most consistent with weak form market efficiency?
A)-1
B)-.5
C)0
D)+.5
E)+1
Q3) Explain why in an efficient market investments have an expected net present value (NPV)of zero.
Page 15
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Chapter 14: Capital Structure: Basic Concepts
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Q1) When comparing levered versus unlevered capital structures,leverage works to increase EPS for high levels of EBIT because interest payments on the debt:
A)vary with EBIT levels.
B)stay fixed,leaving more income to be distributed over fewer shares.
C)stay fixed,leaving less income to be distributed over fewer shares.
D)stay fixed,leaving less income to be distributed over more shares.
E)stay fixed,leaving more income to be distributed over more shares.
Q2) Financial leverage impacts the performance of a firm by:
A)increasing the volatility of the firm's EBIT.
B)decreasing the volatility of the firm's EBIT.
C)decreasing the volatility of the firm's net income.
D)increasing the volatility of the firm's net income
E)lowering the firm's level of risk.
Q3) Which one of these best supports the argument that leverage increases shareholder risk?
A)EPS is directly related to EBIT.
B)Individuals employ homemade leverage.
C)EPS variability increases when leverage is used.
D)Firm values rise with leverage in the presence of taxes.
E)The number of shares outstanding tends to decrease when leverage is used.
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Chapter 15: Capital Structure: Limits to the Use of Debt
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Q1) The Window Store will have a value of $163,000 if the economy does well this coming year and a value of $142,000 if the economy does poorly.The probability of a good economy is 55 percent.The firm owes its bondholders $54,000.The firm will only operate for one more year.What is the value of this firm to its shareholders?
A)$98,500
B)$99,550
C)$100,450
D)$153,550
E)$154,450
Q2) Explain a Section 363 bankruptcy and identify its primary benefit over a traditional bankruptcy.
Q3) A firm is technically insolvent when:
A)the value of its stock declines by more than 50 percent in any given 12-month period.
B)the value of the firm's assets is less than the value of the firm's liabilities.
C)it files the legal forms petitioning for bankruptcy protection.
D)it is unable to meet its financial obligations.
E)it has a negative net worth on its balance sheet.
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Chapter 16: Dividends and Other Payouts
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Q1) Newtown stock is currently trading at $64 a share.The firm feels that its primary clientele of small retail investors can afford to spend between $3,000 and $3,500 to purchase a round lot of 100 shares.If excess funds are limited,the firm should consider a:
A)special dividend.
B)liquidating dividend.
C)stock split.
D)reverse stock split.
E)Dutch auction.
Q2) The market's reaction to the announcement of a change in the firm's dividend payout is likely the:
A)clientele effect.
B)information content effect.
C)efficient markets hypothesis.
D)MM Proposition I.
E)MM Proposition II.
Q3) Summarize at least four key points that are known about dividends and share repurchases.
Q4) What is the theory behind the Lintner formula and why might firms adopt the Lintner approach?
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Chapter 17: Options and Corporate Finance
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Q1) The effect on an option's value of a small change in the value of the underlying asset is called the option:
A)vega.
B)theta.
C)rho.
D)gamma.
E)delta.
Q2) A 40 put option on FKL stock expires today.The current price of the stock is $36. The put is:
A)at the money.
B)out of the money.
C)in the money.
D)funded.
E)unfunded.
Q3) What is a protective put and what does it protect?
Q4) Explain the rationale behind the statement that equity is a call option on a firm's assets.When would a shareholder allow the call to expire?
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Chapter 18: Short-Term Finance and Planning
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Q1) Which one of the following is a source of cash?
A)A decrease in inventory
B)An increase in fixed assets
C)A decrease in long-term debt
D)The payment of a cash dividend
E)An increase in accounts receivable
Q2) HM Industries has a beginning receivables balance on January 1<sup>st</sup> of $420.Sales for January through April are $340,$250,$330,and $240,respectively.The accounts receivable period is 60 days.How much did the firm collect in the month of April? Assume a 360 day year.
A)$240
B)$250
C)$330
D)$290
E)$340
Q3) Countrywide Machine Parts is considering a proposal whereby customers who pay their bills on time will receive a 2 percent rebate on their purchases.Those who pay cash will receive a 5 percent rebate.All rebates will be applied to the next order placed by the customer.Explain the impact of this proposal on the firm.
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Chapter 19: Raising Capital
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Q1) Tina researched DE Industries and decided the firm has good growth prospects.Since she knows the owners,she approached them with an offer.Her offer was $1 million in cash in exchange for 20 percent ownership in the firm.Both parties have agreed to the terms of her offer but Tina does have one remaining concern.She wants to ensure that she can maintain her proposed ownership percentage in the future.What can she do to ensure this will occur?
Q2) Which one of the following statements is correct?
A)The underwriters must approve any increase in the authorized number of shares for a firm.
B)A prospectus must be provided to all investors who purchase shares of a new equity offering.
C)The corporate CEO has the authority to authorize additional shares of stock for a new issue.
D)When issuing new securities,the first step is the distribution of the prospectus.
E)Written offers can be made for new securities during the waiting period.
Q3) Why might an eligible firm choose a Rule 415 registration of securities?
Q4) Explain how a Dutch auction operates and why a firm might choose to sell its securities in this manner.
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Chapter 20: International Corporate Finance
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Q1) What is required for absolute purchasing power parity to hold? Do you think absolute PPP can hold for a commodity sold in both North Dakota and Canada? How about Houston,Texas,and Winnipeg,Manitoba?
Q2) Describe the foreign currency and home currency approaches to capital budgeting.Which is better? Which approach would you recommend a U.S.firm use? Justify your answer.
Q3) The foreign currency approach to capital budgeting analysis:
I.is computationally easier to use than the home currency approach. II.produces the same results as the home currency approach.
III.utilizes the uncovered interest parity relationship.
IV.computes the net present value of a project in both the foreign and in the domestic currency.
A)I and III only
B)II and IV only
C)I,II,and IV only
D)II,III,and IV only
E)I,II,III,and IV
Q4) What role does triangle arbitrage play in the foreign exchange markets? What might limit the effectiveness of triangle arbitrage?
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Chapter 21: Mergers and Acquisitions Web Only
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Q1) Low's has 12,000 shares of stock outstanding at a price per share of $16.40.Bert's has 21,000 shares outstanding at a price per share of $26.50.Bert's believes it can create $41,000 of synergy if it acquires Low's in an exchange of stock.What is the value of the combined firm following the merger? Assume both firms are all-equity financed.
A)$794,300
B)$597,500
C)$753,300
D)$400,700
E)$636,800
Q2) XYZ has a market value of $287,400.ABC has a market value of $611,900.ABC believes it can create $57,000 of synergy if it acquires XYZ for $300,000 in cash.What is the value of ABC following the merger? Assume both firms are all-equity financed.
A)$656,300
B)$998,900
C)$956,300
D)$668,900
E)$368,900
Q3) Explain the pros and cons of a cash acquisition over a stock acquisition.
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