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MOS 2310A: Finance

Practice Questions (Midterm)

ALL Sections Instructor: Danny L. Morrison, M.B.A CPA, CMA

Multiple-choice [2.5 marks x 40]

1. Which of the following statements best describes firm organization? a. It is generally more expensive to form a proprietorship than a corporation because, with a

proprietorship, extensive legal documents are required. b. One disadvantage of operating a business as a sole proprietorship is that the firm is

subject to double taxation, at both the firm level and the owner level. c. One advantage of forming a corporation is that equity investors are usually exposed to

less liability than in a regular partnership. d. If a regular partnership goes bankrupt, each partner is exposed to liabilities only up to the

amount of his or her investment in the business.

2. You recently sold 100 shares of your new company, XYZ Corporation, to your brother at a family reunion. At the reunion your brother gave you a cheque for the shares and you gave your brother the share certificates. Which of the following statements best describes this transaction? a. This is an example of an exchange of physical assets. b. This is an example of a primary market transaction. c. This is an example of a direct transfer of capital. d. This is an example of a money market transaction.

3. One drawback of switching from a partnership to the corporate form of organization is the following: a. It subjects the firm to additional regulations. b. It makes it more difficult for the firm to raise additional capital. c. It makes the firm’s investors subject to greater potential personal liabilities. d. It makes it more difficult for the firm’s investors to transfer their ownership interests.

4. Which of the following statements is most accurate in regarding corporations? a. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority

of businesses are organized as corporations. b. Due to legal considerations related to ownership transfers and limited liability, most

business is conducted by corporations in spite of large corporations’ often less favourable tax treatment.

c. Large corporations are taxed more favourably than sole proprietorships. d. Corporate stockholders are exposed to unlimited liability.

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5. Which of the following investments will have the HIGHEST FUTURE VALUE at the end of 10 years? Assume that the effective annual rate for all investments is the same. a. Investment A pays $250 at the beginning of every year for the next 10 years (a total of 10

payments). b. Investment B pays $125 at the end of every 6-month period for the next 10 years (a total

of 20 payments). c. Investment C pays $125 at the beginning of every 6-month period for the next 10 years (a

total of 20 payments). d. Investment D pays $2,500 at the end of 10 years (a total of one payment).

6. Suppose you have $1,500 and plan to purchase a 5-year certificate of deposit (CD) that pays 3.5% interest, compounded annually. How much will you have when the CD matures? a. $1,781.53 b. $1,870.61 c. $1,964.14 d. $2,062.34

7. Last year Toto Corporation’s sales were $225 million. If sales grow at 6% per year, how large (in millions) will they be 5 years later? a. $271.74 b. $286.05 c. $301.10 d. $316.16

8. Suppose a Government of Canada bond promises to pay $1,000 five years from now. If the going interest rate on 5-year government bonds is 5.5%, how much is the bond worth today? a. $765.13 b. $803.39 c. $843.56 d. $885.74

9. A bond that is issued by a Korean company in Canada that is denominated in Canadian dollars is an example of which of the following? a. a domestic bond b. a global bond c. a foreign bond d. a euro bond

10. Under normal conditions, which of the following would be most likely to increase the coupon rate required to enable a bond to be issued at par? a. adding additional restrictive covenants that limit management’s actions b. adding a call provision c. the rating agencies change the bond’s rating from Baa to Aaa d. adding a sinking fund

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11. Assume that all interest rates in the economy decline from 10% to 9%. Which of the following bonds would have the LARGEST percentage increase in price? a. an 8-year bond with a 9% coupon b. a 1-year bond with a 15% coupon c. a 3-year bond with a 10% coupon d. a 10-year zero coupon bond

12. A 10-year corporate bond has an annual coupon of 9%. The bond is currently selling at par ($1,000). Which of the following statements is INCORRECT? a. The bond’s expected capital gains yield is positive. b. The bond’s yield to maturity is 9%. c. The bond’s current yield is 9%. d. The bond’s current yield exceeds its capital gains yield.

13. Which of the following statements best describes bond yields? a. A zero coupon bond’s current yield is equal to its yield to maturity. b. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at par. c. All else equal, if a bond’s yield to maturity increases, its price will fall. d. If a bond’s yield to maturity exceeds its coupon rate, the bond will sell at a premium over

par.

14. You are considering two bonds. Bond A has a 9% annual coupon while Bond B has a 6% annual coupon. Both bonds have a 7% yield to maturity, and the YTM is expected to remain constant. Which of the following statements is correct? a. The price of Bond B will decrease over time, but the price of Bond A will increase over

time. b. The prices of both bonds will remain unchanged. c. The price of Bond A will decrease over time, but the price of Bond B will increase over

time. d. The prices of both bonds will increase over time, but the price of Bond A will increase by

more.

15. If the yield-to-maturity is 5.5%, what is the price of a 15-year, zero-coupon bond with a par value of $1,000? a. $413.35 b. $429.48 c. $447.93 d. $469.72.

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16. The Morrissey Company’s bonds mature in 7 years, have a par value of $1,000, and make an annual coupon payment of $70. The market interest rate for the bonds is 8.5%. What is the bond’s price? a. $923.22 b. $946.30 c. $969.96 d. $994.21

17. What happens to portfolios that cannot be dominated? a. They lie on the efficient frontier. b. They are minimum risk portfolios. c. They have low correlations. d. They have maximum expected returns.

18. What does an asset having a negative beta value imply?

a. non-existence because negative beta assets are theoretically impossible b. a necessary component to get a fully diversified portfolio c. a risk-reducing property when added to a portfolio d. the higher expected return of this asset

19. Consider the following information for three stocks, A, B, and C, and portfolios of these stocks. The stocks’ returns are positively but not perfectly positively correlated with one another, i.e., the correlation coefficients are all between 0 and 1. Expected Standard Stock Return Deviation Beta Stock A 10% 20% 1.0 Stock B 10 10 1.0 Stock C 12 12 1.4 Portfolio AB has half of its funds invested in Stock A and half in Stock B. Portfolio ABC has one third of its funds invested in each of the three stocks. The risk-free rate is 5%, and the market is in equilibrium, so required returns equal expected returns. Which of the following statements is correct? a. Portfolio AB has a standard deviation of 20%. b. Portfolio AB’s coefficient of variation is greater than 2.0. c. Portfolio AB’s required return is greater than the required return on Stock A. d. Portfolio ABC’s expected return is 10.67%.

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20. Stock A has an expected return of 12%, a beta of 1.2, and a standard deviation of 20%. Stock B also has a beta of 1.2, an expected return of 10%, and a standard deviation of 15%. Portfolio AB has $900,000 invested in Stock A and $300,000 invested in Stock B. The correlation between the two stocks’ returns is zero (that is, rA,B = 0). Which of the following statements is correct? a. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is

overvalued. b. The stocks are not in equilibrium based on the CAPM; if A is valued correctly, then B is

undervalued. c. Portfolio AB’s expected return is 11.0%. d. Portfolio AB’s beta is less than 1.2.

21. Stocks A and B each have an expected return of 12%, a beta of 1.2, and a standard deviation

of 25%. The returns on the two stocks have a correlation of 0.6. Portfolio P has 50% in Stock A and 50% in Stock B. Which of the following statements is correct? a. Portfolio P has a beta that is greater than 1.2. b. Portfolio P has a standard deviation that is greater than 25%. c. Portfolio P has a standard deviation that is less than 25%. d. Portfolio P has a beta that is less than 1.2.

22. Which of the following statements is correct? (Assume that the risk-free rate is a constant.) a. If the market risk premium increases by 1%, then the required return will increase for

stocks that have a beta greater than 1.0, but it will decrease for stocks that have a beta less than 1.0.

b. The effect of a change in the market risk premium depends on the slope of the yield curve.

c. If the market risk premium increases by 1%, then the required return on all stocks will rise by 1%.

d. If the market risk premium increases by 1%, then the required return will increase by 1% for a stock that has a beta of 1.0.

23. Assume that the risk-free rate is 5%. Which of the following statements is correct?

a. If a stock has a negative beta, its required return under the CAPM would be less than 5%. b. If a stock’s beta doubled, its required return under the CAPM would also double. c. If a stock’s beta were less than 1.0, its required return under the CAPM would less than

5%. d. If a stock’s beta were 1.0, its required return under the CAPM would be 5%.

24. Currently, the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is correct? a. An index fund with beta = 1.0 should have a required return of 11%. b. An index fund with beta = 1.0 should have a required return less than 11%. c. If a stock’s beta doubles, its required return must also double. d. An index fund with beta = 1.0 should have a required return greater than 11%.

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25. Ripken Iron Works believes the following probability distribution exists for its stock. What is the coefficient of variation on the company’s stock? State of the Economy Probability of State

Occurring Stock’s Expected

Return

Boom 0.25 25% Normal 0.50 15% Recession 0.25 5% a. 0.4360 b. 0.4714 c. 0.5068 d. 0.5448

26. Yonan Corporation’s stock had a required return of 11.50% last year, when the risk-free rate was 5.50% and the market risk premium was 4.75%. Now suppose there is a shift in investor risk aversion, and the market risk premium increases by 2%. The risk-free rate and Yonan’s beta remain unchanged. What is Yonan’s new required return? (Hint: First calculate the beta, then find the required return.) a. 14.03% b. 14.38% c. 14.74% d. 15.10%

27. The real risk-free rate is 2%, the expected inflation rate is 3.00%, the market risk premium is 4.70%, and Kohers Enterprises has a beta of 1.10. What is the required rate of return on Kohers’ stock? a. 9.43% b. 9.67% c. 9.92% d. 10.17%

28. Why is the preemptive right important to shareholders? a. It allows managers to buy additional shares below the current market price.

b. It results in higher dividends per share.

c. It is included in every article of incorporation.

d. It protects the current shareholders against a dilution of their ownership interests.

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29. What annual payment would you have to receive in order to earn a 7.5% rate of return on a

perpetuity that has a cost of $1,250? a. $89.06 b. $93.75 c. $98.44 d. $103.36

30. Merchants Bank offers to lend you $30,000 at a nominal rate of 6.0%, simple interest, with interest paid quarterly. Gold Coast Bank offers to lend you the $30,000, but it will charge 7.0%, simple interest, with interest paid at the end of the year. What’s the DIFFERENCE in the effective annual rates charged by the two banks? a. 1.49% b. 1.24% c. 1.04% d. 0.86%

31. A stock is expected to pay a dividend of $0.75 at the end of the year. The required rate of return is rs = 12.5%, and the expected constant growth rate is g = 8.5%. What is its current price? a. $17.82

b. $18.28

c. $18.75

d. $19.22

32. If D1 = $1.75, g (which is constant) = 4.5%, and P0 = $46, what is the stock’s expected dividend yield for the coming year? a. 3.26%

b. 3.43%

c. 3.61%

d. 3.80%

33. The Zumwalt Company is expected to pay a dividend of $2.25 per share at the end of the year, and that dividend is expected to grow at a constant rate of 5.00% per year in the future. The company’s beta is 1.15, the market risk premium is 5.50%, and the risk-free rate is 4.00%. What is the company’s current stock price? a. $42.25

b. $43.31

c. $44.39

d. $45.50

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34. The Isberg Company just paid a dividend of $0.80 per share, and that dividend is expected to grow at a constant rate of 6.00% per year in the future. The company’s beta is 1.25, the market risk premium is 5.00%, and the risk-free rate is 4.00%. What is the company’s current stock price? a. $19.95

b. $20.45

c. $20.96

d. $21.49

35. Schnusenberg Corporation just paid a dividend of $0.65 per share, and that dividend is expected to grow at a constant rate of 7.00% per year in the future. The company’s beta is 0.95, the required return on the market is 10.50%, and the risk-free rate is 5.00%. What is the company’s current stock price? a. $21.57

b. $22.11

c. $22.66

d. $23.22

36. You must estimate the intrinsic value of Tsetseko Technologies’ stock. Tsetseko’s end-of-year free cash flow (FCF) is expected to be $17.50 million, and it is expected to grow at a constant rate of 7.00% a year thereafter. The company’s WACC is 10.00%. Tsetseko has $125.00 million of long-term debt plus preferred stock, and there are 15.00 million shares of common stock outstanding. What is Tsetseko’s estimated intrinsic value per share of common stock? a. $28.16

b. $29.33

c. $30.56

d. $31.78

37. The Wei Company’s last dividend was $1.75. The dividend growth rate is expected to be constant at 1.50% for 2 years, after which dividends are expected to grow at a rate of 8.00% forever. Wei’s required return (rs) is 12.00%. What is Wei’s current share price? a. $41.83

b. $43.08

c. $44.38

d. $45.71

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38. Prock Petroleum’s stock has a required return of 13%, and the stock sells for $50 per share. The firm just paid a dividend of $1.00, and the dividend is expected to grow by 30% per year for the next 4 years, so D4 = $1.00(1.30)4 = $2.8561. After t = 4, the dividend is expected to grow at a constant rate of X% per year forever. What is the stock’s expected constant growth rate after t = 4, i.e., what is X? a. 7.46%

b. 7.85%

c. 8.26%

d. 8.70%

39. If the stock market is semistrong efficient, which of the following statements is correct? a. All stocks should have the same expected returns; however, they may have different

realized returns.

b. Investors can outperform the market if they have access to information that has not yet

been publicly revealed.

c. In equilibrium, stocks and bonds should have the same expected returns.

d. All stocks should have the same expected return.

40. For a stock to be in equilibrium, that is, for there to be no consistent pressure for its price to depart from its current level, what must occur? a. The expected future return must be less than the most recent past realized return.

b. The past realized return must be equal to the expected return during the same period.

c. The required return must equal the realized return in all periods.

d. The expected future returns must be equal to the required return.

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Equations

€

PV (1+ I)N + FVN = 0

€

PV (1+ I)N + PMT (1+ I)N

I−1I

⎡

⎣ ⎢

⎤

⎦ ⎥ + FV = 0

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Question Answer 1. C 2. C 3. A 4. B 5. A 6. A 7. C 8. A 9. C 10. B 11. D 12. A 13. C 14. C 15. C 16. A 17. A 18. C 19. D 20. A 21. C 22. D 23. A 24. A 25. B 26. A 27. D 28. D 29. B 30. D 31. C 32. D 33. A 34. A 35. A 36. C 37. A 38. D 39. B 40. D