Review for Exam 3. Instructions: Please read carefully

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1 Review for Exam 3 Instructions: Please read carefully The exam will have 25 multiple choice questions and 5 work problems. You are not responsible for any topics that are not covered in the lecture note slides (lecture 9, 10). Questions in the multiple choice section will be either concept or calculation questions. The calculation questions will be similar to those in the homework and review. However, the concept questions will be related to any topic we have covered in the class. The concept questions in the review are only some sample questions. You should NOT study only topics in the review. For the work problems, you need to solve the problems without knowing the possible answers. The questions will be similar to those in the homework and the review except that the possible solutions are not given. You can bring a formula sheet to the exam. Final Exams for Classes Meeting Tue. at 6:30pm o Tuesday, December 22 6:30 PM - 9:30 PM

2 1. Assume the U.S. government was to decide to increase its budget deficit. This will cause to increase. A) interest rates B) the output of the economy C) both a and b D) neither a nor b 2. A big increase in government spending is an example of. A) a demand shock B) a supply shock C) an unsurprising shock D) none of the above 3. If you expect a larger interest rate increase than other market participants do, you would A) buy long-term bonds B) buy short-term bonds C) buy long-term government bonds only D) buy short-term government bonds only 4. Which of the following would not be considered a supply shock? A) a change in the price of imported oil B) frost damage to the orange crop C) a change in the level of education of the average worker D) an increase in the level of government spending 5. A trough is. A) a transition from an expansion in the business cycle to the start of a contraction B) a transition from a contraction in the business cycle to the start of an expansion C) only something used by farmers to feed pigs and is not a term in investments D) none of the above 6. The stage of the business cycle would be a good time to invest in firms engaged in natural resource extraction and processing such as minerals and petroleum. A) Peak B) Contraction C) Trough D) Expansion

3 7. the ratio of the number of people classified as unemployed to the total labor force. A) The capacity utilization rate is B) The participation rate is C) The unemployment rate is D) None of the above are 8. An analyst starts by examining the broad economic environment and then considers the implications of the outside environment on the industry in which the firm operates. Finally, the firm's position within the industry is examined. This is called analysis. A) bottom-up B) outside-inside C) top-down D) upside-down 9. is defined as the present value of all cash proceeds to the investor in the stock. A) dividend payout ratio B) intrinsic value C) market capitalization rate D) plow-back ratio 10. are analysts who use information concerning current and prospective profitability of a company to assess its fair market value. A) credit analysts B) fundamental analysts C) systems analysts D) technical analysts 11. You wish to earn a return of 10% on each of two stocks, A and B. Each of the stocks is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends is 6% for stock A and 5% for stock B. Using the constant growth DDM, the intrinsic value of stock A. A) will be higher than the intrinsic value of stock B B) will be the same as the intrinsic value of stock B C) will be less than the intrinsic value of stock B D) more information is necessary to Answer this question

4 12. The market capitalization rate on the stock of Aberdeen Wholesale Company is 10%. Its expected ROE is 12% and its expected EPS is $5.00. If the firm's plowback ratio is 40%, its P/E ratio will be. A) 8.33 B) C) D) Rose Hill Trading Company is expected to have EPS in the upcoming year of $6.00. The expected ROE is 18.0%. An appropriate required return on the stock is 14%. If the firm has a plowback ratio of 60%, its growth rate of dividends should be. A) 2.5% B) 4.0% C) 8.4% D) 10.8% 14. Grott and Perrin, Inc. has expected earnings of $3 per share for next year. The firm's ROE is 20% and its earnings retention ratio is 70%. If the firm's market capitalization rate is 15%, what is the present value of its growth opportunities? A) $20 B) $70 C) $90 D) $ Cache Creek Manufacturing Company is expected to pay a dividend of $4.20 in the upcoming year. Dividends are expected to grow at the rate of 8% per year. The riskfree rate of return is 4% and the expected return on the market portfolio is 14%. Investors use the CAPM to compute the market capitalization rate on the stock, and the constant growth DDM to determine the intrinsic value of the stock. The stock is trading in the market today at $ Using the constant growth DDM and the CAPM, the beta of the stock is. A) 1.4 B) 0.9 C) 0.8 D) 0.5

5 16. Westsyde Tool Company is expected to pay a dividend of $2.00 in the upcoming year. The risk-free rate of return is 6% and the expected return on the market portfolio is 12%. Analysts expect the price of Westsyde Tool Company shares to be $29 a year from now. The beta of Westsyde Tool Company's stock is Using a one-period valuation model, the intrinsic value of Westsyde Tool Company stock today is. A) $24.29 B) $27.39 C) $31.13 D) $ Ace Frisbee Corporation produces a good that is very mature in their product life cycles. Ace Frisbee Corporation is expected to pay a dividend in year 1 of $3.00, a dividend in year 2 of $2.00, and a dividend in year 3 of $1.00. After year 3, dividends are expected to decline at the rate of 2% per year. An appropriate required return for the stock is 8%. Using the multistage DDM, the stock should be worth today. A) $13.06 B) $13.38 C) $18.25 D) $ A firm is expected to produce $3.00 per share in earnings next year. If the firm plans to plow back 30% of those earnings at a reinvestment rate of 25%, what will be the expected growth in dividends? A) 7.50% B) 15.0% C) 25.0% D) 30.0% 19. Next year's earnings are estimated to be $5.00. The company plans to reinvest 20% of its earnings at 15%. If the cost of equity is 9%, what is the present value of growth opportunities? A) $9.09 B) $10.10 C) $11.11 D) $12,21

6 20. Janet Ludlow s firm requires all its analysts to use a two-stage DDM and the CAPM to value stocks. Using these measures, Ludlow has valued QuickBrush Company at $63 per share. She now must value SmileWhite Corporation. a. Calculate the required rate of return for SmileWhite using the information in the following table: (K) b. Ludlow estimates the following EPS and dividend growth rates for SmileWhite: (K) Estimate the intrinsic value of SmileWhite using the table above, and the twostage DDM. Dividends per share in 2007 were $ Which of the following balance sheet items is not considered an asset? A) inventory B) accounts receivable C) accrued taxes D) All of the above are assets 22. A firm has a ROE of 20% and a market-to-book ratio of Its P/E ratio is. A) 8.40 B) C) D) 47.60

7 Use the following to answer questions 32-41: The financial statements of Shuswap Lake Manufacturing Company are given below. Note: The common shares are trading in the stock market for $160 each. 23. The firm's current ratio for 2005 is. A) 0.90 B) 1.44 C) 1.89 D) 2.80

8 24. The firm's leverage ratio for 2004 is. A) 0.90 B) 1.56 C) 1.89 D) The firm's fixed asset turnover ratio for 2005 is. Please keep in mind that when a ratio involves both income statement and balance sheet numbers, the balance sheet numbers for the beginning and end of the year must be averaged. A) 3.39 B) 3.60 C) 6.00 D) The firm's asset turnover ratio for 2005 is. Please keep in mind that when a ratio involves both income statement and balance sheet numbers, the balance sheet numbers for the beginning and end of the year must be averaged. A) 0.90 B) 1.56 C) 1.92 D) The net income of the company is $970. Taxes payable decrease by $120, depreciation is $85, and fixed assets are sold for $90. If the firm's inventories also decline by $65, what is the total change in cash for the firm for all activities? A) Increase of $970 B) Increase of $1090 C) Decrease of $970 D) Decrease of $ A firm has an ROE of 3%, a debt/equity ratio of 0.5, a tax rate of 40%, and the interest rate on its debt is 10%. Its ROA is. A) 4% B) 6% C) 6.67% D) 7.50% 29. A firm purchases goods on credit worth $150. The same firm pays off $100 in old credit purchases. An investment is made via the purchase of a new facility and equity is issued in the amount of $300 to pay for the purchase. What is the change in net cash provided by operations? A) $50 increase B) $100 increase C) $150 increase D) $250 increase

9 30. What ratio will definitely increase when a firm increases its annual sales with no corresponding increase in assets? A) Asset turnover B) Current ratio C) Liquidity ratio D) Quick ratio 31. Alumbat Corporation has $800,000 of debt outstanding, and it pays an interest rate of 10 percent annually on its bank loan. Alumbat's annual sales are $3,200,000; its average tax rate is 40 percent; and its net profit margin on sales is 6 percent. If the company does not maintain a TIE ratio of at least 4 times, its bank will refuse to renew its loan, and bankruptcy will result. What is Alumbat's current TIE ratio? a. 2.4 b. 3.4 c. 3.6 d. 4.0 e. 5.0

10 32. If the economy is growing, firms with high operating leverage will experience. A. higher increases in profits than firms with low operating leverage. B. similar increases in profits as firms with low operating leverage. C. smaller increases in profits than firms with low operating leverage. D. no change in profits A firm in an industry that is very sensitive to the business cycle will likely have a stock beta. A. greater than 1.0 B. equal to 1.0 C. less than 1.0 but greater than 0.0 D. equal to or less than 0.0 E. There is no relationship between beta and sensitivity to the business cycle. 34. A firm in the early stages of the industry life cycle will likely have. A. high market penetration. B. high risk. C. rapid growth D. A and C E. B and C 35. Assume the U.S. government was to decide to decrease the budget deficit. This action will most likely cause to decrease A. interest rates B. government borrowing C. unemployment D. both A and B 36. are analysts who use information concerning current and prospective profitability of a firms to assess the firm's fair market value. A. Credit analysts B. Fundamental analysts C. Systems analysts D. Technical analysts E. Specialists 37. The is defined as the present value of all cash proceeds to the investor in the stock. A. dividend payout ratio B. intrinsic value C. market capitalization rate D. plowback ratio

11 38. You wish to earn a return of 13% on each of two stocks, X and Y. Stock X is expected to pay a dividend of $3 in the upcoming year while Stock Y is expected to pay a dividend of $4 in the upcoming year. The expected growth rate of dividends for both stocks is 7%. The intrinsic value of stock X. A. cannot be calculated without knowing the market rate of return B. will be greater than the intrinsic value of stock Y C. will be the same as the intrinsic value of stock Y D. will be less than the intrinsic value of stock Y is a correct answer. 39. You are considering acquiring a common stock that you would like to hold for one year. You expect to receive both $1.25 in dividends and $32 from the sale of the stock at the end of the year. The maximum price you would pay for the stock today is if you wanted to earn a 10% return. A. $30.23 B. $24.11 C. $26.52 D. $ Old Quartz Gold Mining Company is expected to pay a dividend of $8 in the coming year. Dividends are expected to decline at the rate of 2% per year. The risk-free rate of return is 6% and the expected return on the market portfolio is 14%. The stock of Old Quartz Gold Mining Company has a beta of The intrinsic value of the stock is. A. $80.00 B C. $ D. $ The market capitalization rate on the stock of Flexsteel Company is 12%. The expected ROE is 13% and the expected EPS are $3.60. If the firm's plowback ratio is 50%, the P/E ratio will be. A B C D

12 42. J.C. Penney Company is expected to pay a dividend in year 1 of $1.65, a dividend in year 2 of $1.97, and a dividend in year 3 of $2.54. After year 3, dividends are expected to grow at the rate of 8% per year. An appropriate required return for the stock is 11%. The stock should be worth today. A. $33.00 B. $40.67 C. $77.53 D. $ The present value of growth opportunities (PVGO) is equal to I) the difference between a stock's price and its no-growth value per share. II) the stock's price III) zero if its return on equity equals the discount rate. IV) the net present value of favorable investment opportunities. A. I and IV B. II and IV C. I, III, and IV D. II, III, and IV E. III and IV 44. A firm has a (net profit / pretax profit ratio) of 0.625, a leverage ratio of 1.2, a (pretax profit / EBIT) of 0.9, an ROE of 17.82%, a current ratio of 8, and a return on sales ratio of 8%. The firm's asset turnover is. A. 0.3 B. 1.3 C. 2.3 D A firm has a (net profit/pretax profit) ratio of 0.6, a leverage ratio of 2, a (pretax profit/ebit) of 0.6, an asset turnover ratio of 2.5, a current ratio of 1.5, and a return on sales ratio of 4%. The firm's ROE is. A. 4.2% B. 5.2% C. 6.2% D. 7.2%

13 46. FOX Company has a ratio of (total debt/total assets) that is above the industry average, and a ratio of (long term debt/equity) that is below the industry average. These ratios suggest that the firm. A. utilizes assets effectively B. has too much equity in the capital structure C. has relatively high current liabilities D. has a relatively low dividend payout ratio The financial statements of Midwest Tours are given below.

14 47. Refer to the financial statements of Midwest Tours. The firm's current ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's quick ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's leverage ratio for 2007 is. A B C D E Refer to the financial statements of Midwest Tours. The firm's times interest earned ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's average collection period for 2007 is. A B C D E

15 52. Refer to the financial statements of Midwest Tours. The firm's inventory turnover ratio for 2007 is. A B C D E Refer to the financial statements of Midwest Tours. The firm's fixed asset turnover ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's asset turnover ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's return on sales ratio for 2007 is percent. A B C D Refer to the financial statements of Midwest Tours. The firm's return on equity ratio for 2007 is. A % B % C % D % E. 16.9%

16 57. Refer to the financial statements of Midwest Tours. The firm's P/E ratio for 2007 is. A B C D Refer to the financial statements of Midwest Tours. The firm's market to book value for 2007 is. A B C D The Digital Electronic Quotation System (DEQS) Corporation pays no cash dividends currently and is not expected to for the next 5 years. Its latest EPS was $10, all of which was reinvested in the company. The firm's expected ROE for the next 5 years is 20% per year, and during this time, it is expected to continue to reinvest all of its earnings. Starting 6 years from now the firm's ROE on new investment is expected to fall to 15%, and the company is expected to start paying out 40% of its earning in cash dividends, which it will continue to do forever after. DEQS's market capitalization rate is 15% per year. a. what is your estimate of DEQS's intrinsic value per share? b. Assuming its current market price is equal to its intrinsic value, what do you expect to happen to its price over the next year? The year after? c. What effect would it have on your estimate of DEQS's intrinsic value if you expected DEQS to pay out only 20% of earnings stating in year 6?

17 Answers 1. Answer: C 2. Answer: A 3. Answer: B 4. Answer: D 5. Answer: B 6. Answer: A 7. Answer: C 8. Answer: C 9. Answer: B 10. Answer: B 11. Answer: A 12. Answer: B Difficulty: Medium P 1.40 = = E.10.12(.40) 13. Answer: D ( ) g = = 14. Answer: B 15. Answer: B 16. Answer: B 17. Answer: A V =.08 PVGO = V (.02) (.02) k = (.7).2(.7 ) β = = = = = = = 70 V 0 = Answer: A g = 0.30 x 0.25 = Answer: C (.926) (.857) + ( )(.794) =

18 g =.20 x.15 =.03. P = 4.0 / ( ) = PVGO = (5/.09) = a. k = r f + β [Ε(r M ) r f ] = 4.5% (14.5% 4.5%) = 16% b. Year Dividends 2007 $ $ = $ $ = $ $ = $ $ = $2.63 Present value of dividends paid in years 2008 to 2001: Year PV of Dividends 2008 $1.93/ = $ $2.16/ = $ $2.42/ = $1.55 Total: $4.82 D $2.63 = = k g P2010 = $37.57 PV (in 2007) of P 2010 = $37.57/( ) = $24.07 Intrinsic value of stock = $ $24.07 = $ Answer: C 22. Answer: B 23. Answer: B P E = 2.38 = ,150,000 CR = = , Answer: D 2,500,000 L = = , , Answer: A 5,000,000 FAT = = ,400, ,550, Answer: C

19 5,000,000 AT = 2,500, ,700, Answer: B cash flow = = 1090 = Answer: C 1.03 ROA = Answer: A 30. Answer: A (.10) = ANS: E TIE = EBIT/I, so find EBIT and I. Interest = $800, = $80,000. Net income = $3,200, = $192,000. Taxable income = EBT = $192,000/(1 T) = $192,000/0.6 = $320,000. EBIT = $320,000 + $80,000 = $400,000. TIE = $400,000/$80,000 = 5.0 times.

20 32. A As sales increase, firms with high operating leverage spread these fixed costs over more units and thus increase profits. 33. A Cyclical stocks are more volatile than the market in general, and thus have betas greater than E In the early stages of the industry life cycle, the firm is likely to be high in risk. 35. D decreasing the deficit lowers government borrowing, decreases the demand for funds and thus decreases the interest rates. 36. B Fundamentalists use all public information in an attempt to value stock (while hoping to identify undervalued securities). 37. B The cash flows from the stock discounted at the appropriate rate, based on the perceived riskiness of the stock, the market risk premium and the risk free rate, determine the intrinsic value of the stock. 38. D PV0 = D1/(k-g); given k and g are equal, the stock with the larger dividend will have the higher value. 39. A.10 = (32 - P ) / P;.10P = 32 - P ; 1.10P = 33.25; P = B k = 6% + [-0.25(14% - 6%)] = 4%; P = 8 / [.04 - (-.02)] = $ C

21 g = 13% X 0.5 = 6.5%;.5/( ) = C Calculations are shown in the table below. P 3 = $2.54(1.08) / ( ) = $91.44; PV of P 3 = $91.44/(1.08) 3 = $ ; P O = $ $72.59 = $ C All are correct except II - the stock's price equals the no-growth value per share plus the PVGO. 44. D 17.82% = X 0.9 X 8% X asset turnover X 1.2; asset turnover = D ROE = 0.6 X 0.6 X 4% X 2.5 X 2 = 7.2%. 46. C Total debt includes both current and long term debt; the above relationships could occur only if FOX Company has a higher than average level of current liabilities. 47. C $860,000/$660,000 = C ($860,000 - $300,000)/$660,000 = C $3,040,000/$1,520,000 = C

22 $540,000 / 160,000 = A AR Turnover = $2,500,000 / [($500,000 + $450,000)) 2] = 5.26; ACP = 365 / 5.26 = days 52. D $1,260,000/[($300,000 + $270,000)) 2] = C $2,500,000/[($2,180,000 + $2,000,000)) 2] = C $2,500,000/[($3,040,000 + $2,770,000)) 2] = B $540,000/$2,500,000 = or 21.6%. 56. C $228,000/[($1,520,000 + $1,420,000)) 2] = A EPS = $228,000/30,000 = $7.60; $36/$7.60 = C $36/[$1,520,000/30,000] = Time: E t $ $ $ $ D t $0.000 $0.000 $0.000 $ b g 20.0% 20.0% 20.0% 9.0% a. D6 $ V5 = = = $ k g

23 V5 = (1 + k) $ = 1.15 V0 = 5 5 $98.97 b. The price should rise by 15% per year until year 6: because there is no dividend, the entire return must be in capital gains. c. The payout ratio would have no effect on intrinsic value because ROE = k.

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