FIN 540 Final Exam 2 - Question and Answers (VERIFIED)

1. A central question that must be addressed in bankruptcy proceedings is whether the firm's inability to meet scheduled interest payments results from a temporary cash flow problem or from a potentially permanent problem caused by falling asset values. 2. Which of the following statements is most CORRECT? 3. Bankruptcy laws have been used to help reach settlements in major product liability lawsuits. By using financial projections to show that contingent claims against the company jeopardize its existence, agreements are reached, partially satisfying claimants, and allowing the firm to continue operating. 4. What would be the priority of the claims as to the distribution of assets in a liquidation under Chapter 7 of the Bankruptcy Act? 1 is the highest claim, 5 is the lowest. (1) Trustees' costs to administer and operate the firm; (2) Common stockholders; (3) General, or unsecured, creditors; (4) Secured creditors, who have a claim to the proceeds from the sale of specific property pledged to secure a loan; (5) Taxes due to federal and state governments. 5. The basic doctrine of fairness under bankruptcy provisions states that claims must be recognized in the order of their legal and contractual priority. 6. Even if a firm's cash flow projections indicate that it will soon be unable to meet its interest payments, a bankruptcy case cannot begin until the firm actually defaults on a scheduled payment. 7. Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true about these securities? (Assume market equilibrium.) 8. Which of the following is NOT a potential problem with beta and its estimation? 9. Which of the following statements is CORRECT? 10. You hold a portfolio consisting of a $5,000 investment in each of 20 different stocks. The portfolio beta is equal to 1.12. You have decided to sell a coal mining stock (b = 1.00) at $5,000 net and use the proceeds to buy a like amount of a mineral rights company stock (b = 2.00). What is the new beta of the portfolio? 11. Your mother's well-diversified portfolio has an expected return of 12.0% and a beta of 1.20. She is in the process of buying 100 shares of Safety Corp. at $10 a share and adding it to her portfolio. Safety has an expected return of 15.0% and a beta of 2.00. The total value of your current portfolio is $9,000. What will the expected return and beta on the portfolio be after the purchase of the Safety stock? 12. Suppose that (1) investors expect a 4.0% rate of inflation in the future, (2) the real risk-free rate is 3.0%, (3) the market risk premium is 5.0%, (4) Talcott Inc.'s beta is 1.00, and (5) its realized rate of return has averaged 15.0% over the last 5 years. Calculate the required rate of return for Talcot Inc. 13. Which of the following will NOT increase the value of a real option? 14. Whether to invest in a project today or to postpone the decision until next year is a decision facing the CEO of the Aaron Co. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Aaron decides to wait. Which of the following statements best describes the issues that Aaron faces when considering this investment timing option? 15. Ashgate Enterprises uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects' sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation? 16. Which one of the following is an example of a "flexibility" option? 17. The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%. If Garner-Wagner goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of ?$6 million at t = 5. Garner-Wagner does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity? 18. The executives of Garner-Wagner Inc. are considering a project that has an up-front cost of $3 million and is expected to produce a cash flow of $500,000 at the end of each of the next 5 years. The project's cost of capital is 10%. Based on the above data, what is the project's net present value? 19. The collection process, although sometimes difficult, is also expensive in terms of out-of-pocket expenses. 20. Credit standards refer to the financial strength and importance of a potential customer to the firm required in order to qualify for credit. 21. Which of the following is not correct for a firm with seasonal sales and customers who all pay promptly at the end of 30 days? 22. Which of the following statements is most correct? 23. The collection process, although sometimes difficult, is a fairly inexpensive component of doing business. 24. Reese Brothers Publishers Inc (RBP) expects to have sales this year of $15 million under its current credit policy. The present terms are net 30; the days sales outstanding (DSO) is 60 days; and the bad debt loss percentage is 5 percent. Since RBP wants to improve its profitability, the treasurer has proposed that the credit period be shortened to 15 days. This change would reduce expected sales by $500,000, but it would also shorten the DSO on the remaining sales to 30 days. Expected bad debt losses on the remaining sales would fall to 3 percent. The variable cost percentage is 60 percent, and the cost of capital is 15 percent. What would be the incremental cost of carrying receivables if this change were made? 25. Which of the following is true of the Baumol model? Note that the optimal cash transfer amount is C*. 26. Humphrey's Housing has been practicing cash management for some time by using the Baumol model for determining cash balances. Some time ago, the model called for an average balance (C*/2) of $500; at that time, the rate on marketable securities was 4 percent. A rapid increase in interest rates has driven the interest rate up to 9 percent. What is the appropriate average cash balance now? 27. The Duckett Group is trying to determine its optimal average cash balance. The firm has determined that it will need $5,000,000 net new cash during the coming year. The fixed transaction cost of converting securities to cash is $50, and the firm earns 10 percent on its marketable securities investments. According to the Baumol model, what should be Duckett's average cash balance? 28. For some firms, holding highly liquid marketable securities is a substitute for holding cash because a marketable securities portfolio can accomplish the same objective as cash. 29. Suppose Stanley's Office Supply purchases 50,000 boxes of pens every year. Ordering costs are $100 per order and carrying costs are $0.40 per box. Moreover, management has determined that the EOQ is 5,000 boxes. The vendor now offers a quantity discount of $0.20 per box if the company buys pens in order sizes of 10,000 boxes. Determine the before-tax benefit or loss of accepting the quantity discount. (Assume the carrying cost remains at $0.40 per box whether or not the discount is taken.) 30. The cash balances of most firms consist of transactions, compensating, precautionary, and speculative balances. We can produce a total desired cash balance by calculating the amount needed for each purpose and then summing them together. 31. Which of the following statements about pension plan portfolio performance is incorrect? 32. Under a defined contribution plan, employees agree to contribute some percentage of their salaries, up to 20 percent, to the firm's pension fund. 33. From a pure cost standpoint, a firm with a defined contribution plan would be more likely to hire older workers than a firm with a defined benefit plan. 34. Which of the following statements about pension plans if any, is incorrect? 35. Kumar Consulting operates several stock investment portfolios that are used by firms for investment of pension plan assets. Last year, one portfolio had a realized return of 12.6 percent and a beta coefficient of 1.15. The average T-bond rate was 7 percent and the realized rate of return on the S&P 500 was 12 percent. What was the portfolio's alpha? 36. Which of the following statements about a not-for-profit firm's fund capital is most correct? 37. Which of the following statements about project risk analysis in not-for-profit firms is incorrect? 38. Which of the following statements about a not-for-profit firm's sources of capital is most correct? 39. Which of the following statements about municipal bond financing is most correct? 40. Which of the following statements about a not-for-profit firm's ownership is most correct?