Series 86 Practice Exam 3 questions and
answers with solutions
A cinema chain has determined that 50,000 buckets of popcorn can be sold per week at a price
of $4 per bucket. At a price of $3.50 per bucket, 70,000 buckets can be sold. This situation is
best described as:
A) Supply inelasticity
B) Demand inelasticity
C) Supply elasticity
D) Demand elasticity - ANSWER Elastic demand is a situation where demand is price sensitive. In
this case, a 13.3% reduction in price, created a 33% increase in demand.
A broker-dealer has been approached by a client who wants to sell his company. The firm has
determined that, prior to the sale, it should improve its total enterprise value to EBITDA (TEV /
EBITDA). Which of the following choices would be MOST helpful to achieve this result?
A) Change the method of depreciation in order to reduce the company's taxes.
B) Slow sales growth by closing stores.
C) Reduce administrative costs by outsourcing certain human resources functions.
D) Change the inventory method from FIFO to LIFO. - ANSWER In order to improve its TEV /
EBITDA, the company can focus on its EBITDA growth strategy (increase revenue and decrease
costs). Of the choices listed, reducing administrative costs by outsourcing certain human
resources functions could accomplish this goal. Other methods include general business
expansion and growth through acquisitions, as well as other types of cost reductions and
restructuring (e.g., selling off a losing business unit). Slowing revenue or sales growth by closing
stores would not help. In addition, changing the method of depreciation in order to reduce the
company's taxes would have no effect on EBITDA since it's a pre-tax number. Changing the
inventory method from FIFO to LIFO would increase (not decrease) expenses since a rising price
environment should be assumed. During an inflationary period, LIFO would show a lower
operating profit.
,A company that uses GAAP will include which of the following choices as expense items?
A) Stock option expenses
B) Capitalized software development costs
C) Amortization of goodwill
D) Capitalized interest expenses - ANSWER Stock option expenses are required to be reported as
an expense item. Research and development expenses are also reported as expense items.
Capitalized development costs are not recorded as expenses in the accounting period in which
they're paid. Goodwill doesn't have a pre-determined life and is not amortized.
In an M&A transaction, which of the following factors is MOST important in determining the
long-term value created by a potential acquisition to the acquiring company?
A) A positive change in operating margin of the combined companies
B) Whether the acquisition is accretive to EPS
C) The growth rate of the combined companies
D) Whether the acquisition will increase its return on invested capital - ANSWER This question is
asking for the most important factor. The acquiring company should look to the return on
invested capital, and whether the acquisition will provide returns that cover the cost of invested
capital. If this is accomplished, the expectation would be reflected in improvements such as
earnings per share and operating margins. The acquisition being accretive to EPS is important in
the short term but, in the long term, it is return on invested capital (ROIC).
The EXM Corporation has a debt-to-equity ratio of 50% and a beta of 1.1. The cost of debt is
8.50% and the company has a marginal tax rate of 20%. If the risk-free rate of return is 5% and
the expected return of the market is 12%, what is the company WACC?
A) 9.75%
, B) 10.75%
C) 11.91%
D) 21.2 - ANSWER If the debt-to-equity ratio is 50%, the company's capital structure is 1/3 debt
and 2/3 equity. Based upon the information given, we need to calculate the cost of retained
earnings financing using the CAPM method. We need to add the risk-free rate plus the
difference between the expected return of the market and risk-free rate of return multiplied by
the beta.
.05 + (.12 - .05) x 1.1 = .127.67 equity x .127 = .0851 (cost of equity)
The after-tax cost of debt is calculated by taking the pretax cost of debt and multiplying by the
complement of the marginal tax rate.
.085 x (1.00 - .20) = .068.33 debt x .068 = .0224 (cost of debt)
WACC = .0851 + .0224 = .1075 or 10.75%
Use the information in the table to answer the question.
Sales Net Income Forward P/E Multiple Range Expected-Growth-Rate
$280MM $30 MM 18.00 - 24.00 9%
What is the implied equity value range for this company??
A) $588,600,000 to $784,800,000
B) $540,000,000 to $720,000,000
C) $308,600,000 to $504,800,000
D) $1,350,000,000 to $6,000,000,000 - ANSWER If given the P/E ratio and an estimate of net
income, you can calculate the implied equity value. In order to answer this question we need to
determine the implied equity value range using the forward P/E and the expected growth rate.
STEP 1. The expected net income is $32,700,000 ($30 MM x 1.09).
answers with solutions
A cinema chain has determined that 50,000 buckets of popcorn can be sold per week at a price
of $4 per bucket. At a price of $3.50 per bucket, 70,000 buckets can be sold. This situation is
best described as:
A) Supply inelasticity
B) Demand inelasticity
C) Supply elasticity
D) Demand elasticity - ANSWER Elastic demand is a situation where demand is price sensitive. In
this case, a 13.3% reduction in price, created a 33% increase in demand.
A broker-dealer has been approached by a client who wants to sell his company. The firm has
determined that, prior to the sale, it should improve its total enterprise value to EBITDA (TEV /
EBITDA). Which of the following choices would be MOST helpful to achieve this result?
A) Change the method of depreciation in order to reduce the company's taxes.
B) Slow sales growth by closing stores.
C) Reduce administrative costs by outsourcing certain human resources functions.
D) Change the inventory method from FIFO to LIFO. - ANSWER In order to improve its TEV /
EBITDA, the company can focus on its EBITDA growth strategy (increase revenue and decrease
costs). Of the choices listed, reducing administrative costs by outsourcing certain human
resources functions could accomplish this goal. Other methods include general business
expansion and growth through acquisitions, as well as other types of cost reductions and
restructuring (e.g., selling off a losing business unit). Slowing revenue or sales growth by closing
stores would not help. In addition, changing the method of depreciation in order to reduce the
company's taxes would have no effect on EBITDA since it's a pre-tax number. Changing the
inventory method from FIFO to LIFO would increase (not decrease) expenses since a rising price
environment should be assumed. During an inflationary period, LIFO would show a lower
operating profit.
,A company that uses GAAP will include which of the following choices as expense items?
A) Stock option expenses
B) Capitalized software development costs
C) Amortization of goodwill
D) Capitalized interest expenses - ANSWER Stock option expenses are required to be reported as
an expense item. Research and development expenses are also reported as expense items.
Capitalized development costs are not recorded as expenses in the accounting period in which
they're paid. Goodwill doesn't have a pre-determined life and is not amortized.
In an M&A transaction, which of the following factors is MOST important in determining the
long-term value created by a potential acquisition to the acquiring company?
A) A positive change in operating margin of the combined companies
B) Whether the acquisition is accretive to EPS
C) The growth rate of the combined companies
D) Whether the acquisition will increase its return on invested capital - ANSWER This question is
asking for the most important factor. The acquiring company should look to the return on
invested capital, and whether the acquisition will provide returns that cover the cost of invested
capital. If this is accomplished, the expectation would be reflected in improvements such as
earnings per share and operating margins. The acquisition being accretive to EPS is important in
the short term but, in the long term, it is return on invested capital (ROIC).
The EXM Corporation has a debt-to-equity ratio of 50% and a beta of 1.1. The cost of debt is
8.50% and the company has a marginal tax rate of 20%. If the risk-free rate of return is 5% and
the expected return of the market is 12%, what is the company WACC?
A) 9.75%
, B) 10.75%
C) 11.91%
D) 21.2 - ANSWER If the debt-to-equity ratio is 50%, the company's capital structure is 1/3 debt
and 2/3 equity. Based upon the information given, we need to calculate the cost of retained
earnings financing using the CAPM method. We need to add the risk-free rate plus the
difference between the expected return of the market and risk-free rate of return multiplied by
the beta.
.05 + (.12 - .05) x 1.1 = .127.67 equity x .127 = .0851 (cost of equity)
The after-tax cost of debt is calculated by taking the pretax cost of debt and multiplying by the
complement of the marginal tax rate.
.085 x (1.00 - .20) = .068.33 debt x .068 = .0224 (cost of debt)
WACC = .0851 + .0224 = .1075 or 10.75%
Use the information in the table to answer the question.
Sales Net Income Forward P/E Multiple Range Expected-Growth-Rate
$280MM $30 MM 18.00 - 24.00 9%
What is the implied equity value range for this company??
A) $588,600,000 to $784,800,000
B) $540,000,000 to $720,000,000
C) $308,600,000 to $504,800,000
D) $1,350,000,000 to $6,000,000,000 - ANSWER If given the P/E ratio and an estimate of net
income, you can calculate the implied equity value. In order to answer this question we need to
determine the implied equity value range using the forward P/E and the expected growth rate.
STEP 1. The expected net income is $32,700,000 ($30 MM x 1.09).
