## FIN 385 Week 8 Final Exam Page 1 TCOs 9 Using the security market

FIN 385 Week 8 – Final Exam

Final Exam – Page 1

1. (TCOs 1, 8, 9) Using the security market line formula rather than the dividend discount formula, determine the expected return on a firm’s common stock when:
(a) beta = 1.0;
(b) the risk-free rate is 4%; and
(c) marketplace interest rates have hovered around 9%. (Points : 20)

2. (TCOs 1, 5 ,6) Calculate the appropriate selling price of a 30-year 5% coupon, \$100 corporate bond that was purchased five years ago. Marketplace interest rates are averaging 8%. (Points : 20)

3. (TCO 6) Calculate the five ratios for the following company info.
Income Statement Balance Sheet
Revenue 10,000 Assets Liab. + OE

EBIT \$2,000 cash \$10,000 a/p \$2,000

Interest \$500 A/R \$1,000 Bonds payable \$50,000

Earnings B4 Tax \$1,500 Equip \$25,000 equity \$84,000

EAT (at 40%) \$900 Bldg \$100,000

Total \$136,000 \$136,000
– return on sales
– ROA
– ROE
– fixed asset turnover
– times interest earned
(Points : 20)

4. (TCO 2) Given the data below, calculate the expected return, variance, and standard deviation of the following company.
In a recessionary economy, which is expected to occur with a 30% probability, the expected returns would be -5%.
In an expanding economy with an expected probability of occurrence of 20%, the expected return would be 20%.
In a normal economy expected to occur 50% of the time, the expected return would be 5%.
(Points : 20)

5. (TCO 9) As percentage of debt on the balance sheet increases, financial leverage increases, which makes EPS increase. If this is the case, why don’t all firms try to end up with very high debt? (Points : 20)

6. (TCO 7) What would be the expected change to a 30-year bond’s market price or value if its YTM increases to 9.4%? Its YTM is now 9%, it has an 8% annual coupon, \$1,000 face value, it is currently priced at \$897.26, and its duration is eight years. (Points : 20)

7. (TCO 9) What are M&M Propositions with and without taxes all about? Please explain, and you must use your own words to earn credit. (Points : 20)

8. (TCO 6) A \$1,000 face value bond was issued at par 20 years ago with a 6% coupon paid semiannually. The bond now has eight years remaining to maturity and similar debt obligations are yielding 12%.
• Compute the current price of the bond.
• Assuming that the bond is sold at its current price, what is the capital gain or loss from the original purchase?
• Now assume that the price of the bond returns to par. What is the percentage capital gain or loss for the new owner?
• Please explain why the percentage gain is different from the percentage loss.
(Points : 22)

9. (TCO 6) What is the interest rate needed on a \$1,000 face value, 6% coupon corporate bond to make it equivalent in terms of return to one whose interest rate is tax free? Assume the corporate tax rate is 30%. (Points : 10)

Final Exam – Page 2

1. (TCO 1) Which of the following is true about fixed-income securities? (Points : 6)
They are usually found on the income statement.
They are always found on the left side of the balance sheet.
They are usually shown on the right side of the balance sheet.
None of the above

2. (TCO 2) The concept of risk versus return _______. (Points : 6)
is all about investors’ expectation of higher risk deserving higher returns
means that most investors require 2 times the change in return for a given change in risk
refers to most of us being risk-loving
None of the above

3. (TCO 5) Which of the following is true? (Points : 6)
YTM is the same as a bond’s coupon yield in all cases.
YTM reflects the total return to a bondholder, taking time value of money into account.
Yield to call is of interest to companies issuing redeemable bonds only.
None of the above

4. (TCO 9) Financial leverage _______. (Points : 6)
is affected by numerous factors including how much debt versus equity there is in the firm
is primarily affected by sales levels
is never good if it’s too high
None of the above

5. (TCO 9) Which of the following is true about a firm’s WACC? (Points : 6)
The lower the better
It is what the firm uses as its discount rate
Reflects the various expected returns of various suppliers of capital to the firm
All of the above

6. (TCO 7) What can be said about the optimal capital structure of a firm? (Points : 6)
The point at which added tax savings from debt just equals cost of bankruptcy
Point where financial leverage = 1
The point where a firm’s WACC is maximized

7. (TCO 3) Which of the following are not part of the overall offering, buying, and selling process for corporate bonds? (Points : 6)
IPO process, investment bankers, and secondary markets
Shelf registration, the SEC, and the Federal Reserve
Direct search markets, brokered markets, and dealer markets
Bonds could be declared as semiannual or annual interest payments
None of the above

8. (TCO 9) What is the concept behind M&M Principle 1 in a world of no taxes? (Points : 6)
The higher the corporate tax rate, the higher the firm value.
If there are no taxes, the value of the firm is unaffected by capital structure.
Capital structure is primarily determined by a firm’s WACC.
None of the above

9. (TCO 6) Which of the following is true about the yield curve? (Points : 6)
The normal yield curve is downward sloping to the right.
The normal yield curve is upward sloping to the right due solely to inflation expectations.
The normal yield curve is upward sloping to the right because of several factors.
None of the above

10. (TCO 4) Which of the following would be a good indicator of the bond market? (Points : 6)
Lehman Brothers Index
S&P 500
CBOE
None of the above

11. (TCO 8) Who would normally be required to create a portfolio investment policy? (Points : 6)
Pension fund managers
Large insurance companies
All of the above

12. (TCOs 1, 8) Corporate bonds, T-bonds, and preferred stock are all examples of which of the following? (Points : 6)
Investment options for an investor seeking low risk
Investment options for an investor seeking high return for the high risk he or she is taking
Fixed-income securities
None of the above

13. (TCO 6) Portfolio diversification attempts to ______. (Points : 6)
maximize the investor’s return
minimize risk per unit of return
minimize the risk
None of the above

14. (TCO 5) What is the normal yield curve shape? (Points : 6)
Humped in the middle
Downward sloping to the right
Upward sloping to the right
None of the above

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