Practice Questions

Questions from the Textbook:

Ehrhardt and Brigham, 12th edition, Chapter 8, page 308, Problems

section, question 8-3, 8-5, 8-6, 8-7, 8-19. Answers are provided at the
end of the textbook.

Multiple Choice Questions:

1. An increase in a firm’s expected growth rate would normally cause its

required rate of return to

a. Increase.
b. Decrease.
c. Fluctuate less than before.
d. Remain constant.
e. Possibly increase, possibly decrease, or possibly have no effect.

Answer: e

2. If in the opinion of a given investor a stock’s expected return exceeds

its required return, this suggests that

a. The investor thinks the stock is experiencing supernormal growth.

b. The investor thinks the stock should be sold.
c. The investor thinks the stock is a good buy.
d. The investor thinks management is probably not trying to maximize the
price per share.

Answer: c

3. Stock A has a required return of 10% and a price of $25, and its
dividend is expected to grow at a constant rate of 7% per year. Stock B
has a required return of 12% and a price of $40, and its dividend is
expected to grow at a constant rate of 9% per year. Which of the
following statements is CORRECT?

a. If the stock market were efficient, these two stocks would have the same
price.
b. The two stocks have the same dividend yield.
c. If the stock market were efficient, these two stocks would have the same
expected return.
d. The two stocks have the same expected capital gains yield.

Answer: b

4. Stocks A and B have the same price, but Stock A has the higher required
rate of return. Which of the following statements is CORRECT?

a. If Stock A has a lower dividend yield than Stock B, its expected capital
gains yield must be higher than Stock B’s.
b. Stock B must have a higher dividend yield than Stock A.
c. Stock A must have a higher dividend yield than Stock B.
d. If Stock A has a higher dividend yield than Stock B, its expected
capital gains yield must be lower than Stock B’s.
e. Stock A must have both a higher dividend yield and a higher capital

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 gains yield than Stock B.

Answer: a

5. Stocks X and Y sell at the same price. Stock X has a required return of
12% while Y's required return is 10%. Stock X’s dividend is expected to
grow at a constant rate of 6% a year, while Stock Y’s dividend is
expected to grow at a constant rate of 4%. If the market is in
equilibrium so that expected returns equal required returns, which of
the following statements is CORRECT?

a. Stock X has a higher dividend yield than Stock Y.

b. Stock Y has a higher dividend yield than Stock X.
c. One year from now, Stock X’s price is expected to be higher than Stock
Y’s price.
d. Stock X has the higher expected year-end dividend.
e. Stock Y has a higher capital gains yield.

Answer: c

6. Stock X is expected to pay a dividend of $3.00 at the end of the year,

i.e., D1 = $3.00, and that dividend is expected to grow at a constant rate
of 6% a year. The stock currently trades at a price of $50 a share.
Assume that the stock is in equilibrium, that is, the stock’s price equals
its intrinsic value. Which of the following statements is CORRECT?

a. The stock’s required return is 10%.

b. The stock’s expected dividend yield and growth rate are equal.
c. The stock’s expected dividend yield is 5%.
d. The stock’s expected capital gains yield is 5%.
e. The stock’s expected price 10 years from now is $100.00.

Answer: b

7. Stock A has a beta of 1.1 and Stock B's beta is 0.9. The market risk
premium is 6%, and the risk-free rate is 6.3%. Both stocks have a
constant dividend growth rate of 7%. If the market is in equilibrium,
which of the following statements is CORRECT?

a. Stock A must have a higher stock price than Stock B.

b. Stock A must have a higher dividend yield than Stock B.
c. Stock B’s dividend yield equals its expected dividend growth rate.
d. Stock B must have the higher required return.
e. Stock B could have the higher expected return.

Answer: b

8. Which of the following statements is CORRECT?

a. Preferred stockholders have a priority to income but not to liquidation

proceeds over bondholders in the event of bankruptcy.
b. The preferred stock of a given firm is generally less risky to investors
than the same firm’s common stock.
c. Corporations cannot buy the preferred stocks of other corporations.
d. Preferred dividends are not generally cumulative.

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 e. A big advantage of preferred stock is that dividends on preferred stocks
are tax deductible by the issuing corporation.

Answer: b

9. 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 the current stock price?

a. $17.82
b. $18.28
c. $18.75
d. $19.22
e. $19.70

Answer: c

10. Ewert Enterprises' stock currently sells for $30.50 per share. The
stock’s dividend is projected to increase at a constant rate of 4.50%
per year. The required rate of return on the stock, rs, is 10.00%. What
is Ewert's expected price 3 years from today?

a. $31.61
b. $32.43
c. $33.26
d. $34.11
e. $34.81

Answer: e

11. WWW Servers just paid a dividend of D0 = $1.00. Analysts expect the
company's dividend to grow by 30% this year, by 10% in Year 2, and at a
constant rate of 5% in Year 3 and thereafter. The required return on
WWW's stock is 9.00%. What is the best estimate of the stock’s current
intrinsic value?

a. $31.50
b. $32.31
c. $33.14
d. $33.99
e. $34.84

Answer: d

12. Rentz RVs Inc. (RRV) is presently enjoying relatively high growth because
of a surge in the demand for recreational vehicles. Management expects
earnings and dividends to grow at a rate of 25% for the next 4 years, after
which high gas prices will probably reduce the growth rate in earnings and
dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25.
RRV’s beta is 1.20, the market risk premium is 5.50%, and the risk-free
rate is 3.00%. What is the current price of the common stock?

a. $26.77
b. $27.89
c. $29.05

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 d. $30.21
e. $31.42

Answer: c

STATEMENT OF CASH FLOWS

Net income before preferred dividends $ 117.50

OPERATING ACTIVITIES
Non-cash adjustments
Depreciation $ 100.00
Due to changes in working capital
Increases in A/R $ (60.00)
Increases in inventories $ (200.00)
Increases in A/P $ 30.00
Increase in Accruals $ 10.00
Net cash provided by operating activities
LONG TERM INVESTING ACTIVITIES
Cash used to acquire fixed assets $ (230.00)
FINANCING ACTIVITIES
Sale of short-term assets $ 65.00
Increase in notes payable $ 50.00
Incresae in bonds outstanding $ 174.00
Payment of preferred and common dividends $ (61.50)
Net cash provided from financing activities $

Summary
Net change in cash
Cash at beginning year $ 15.00
Cash at end of year $ 10.00

13.) According to the table above, net cash provided from

operating activities is
a. -2.50
b. 2.50
c. 250.00
d. -5.00

14.) According to the table above, net cash provided from

financing activities is
a. 230.00
b. 227.50
c. -227.50
d. -230.00

15.) According to the table above, net change in cash is

a. 5.00
b. -5.00
c. 10.00
d. -10.00

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 16.) From Brigham and Ehrhardt, Chapter 5, page 193, problems sections
questions, 5-1, 5-2, 5-7, 5-21. Answers are provided in appendix B.
The command to use for finding yield to maturity is =yield
17) One of the basic relationships in interest rate theory is that,
other things held constant, for a given change in the required
rate of return, the the time to maturity, the
the change in price.

a. longer; smaller.
b. shorter; larger.
c. longer; greater.
d. shorter; smaller.
e. Answers c and d are correct.
Answer: e

18.) Which of the following statements is most correct?

a. All else equal, if a bond’s yield to maturity increases, its

price will fall.
b. All else equal, if a bond’s yield to maturity increases, its
current yield will fall.
c. If a bond’s yield to maturity exceeds the coupon rate, the
bond will sell at a premium over par.
d. All of the answers above are correct.
e. None of the answers above is correct
Answer: a

19.) A 10-year corporate bond has an annual coupon payment of 9 percent. The bond is
currently selling at par ($1,000). Which of the following statements is most
correct?

a. The bond’s yield to maturity is 9 percent.

b. The bond’s current yield is 9 percent.
c. If the bond’s yield to maturity remains constant, the bond’s price will remain
at par.
d. Both answers a and c are correct.
e. All of the answers above are correct
Answer: e

20.) Which of the following statements is most correct?

a. Junk bonds typically have a lower yield to maturity relative to investment

grade bonds.
b. A debenture is a secured bond which is backed by some or all of the firm’s
fixed assets.
c. Subordinated debt has less default risk than senior debt.
d. All of the statements above are correct.
e. None of the statements above is correct.
Answer: e

21.) Which of the following are likely to occur if Congress passes

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 legislation which forces Carter Manufacturing to depreciate their
equipment over a longer time period:

a. The company’s physical stock of assets would increase.

b. The company’s reported net income would decline.
c. The company’s cash position would decline.
d. All of the answers above are correct.
e. Answers b and c are correct.
Answer: c

22.) Coolidge Cola is forecasting the following income statement:

Sales $30,000,000
Operating costs excluding depreciation 20,000,000
Depreciation 5,000,000
Operating income (EBIT) $ 5,000,000
Interest expense 2,000,000
Taxable income (EBT) $ 3,000,000
Taxes (40%) 1,200,000
Net income $ 1,800,000

Assume that, with the exception of depreciation, all other non-

cash revenues and expenses sum to zero.

Congress is considering a proposal which will allow companies to

depreciate their equipment at a faster rate. If this provision
were put in place, Coolidge’s depreciation expense would be
$8,000,000 (instead of $5,000,000). This proposal would have no
effect on the economic value of the company’s equipment, nor
would it affect the company’s tax rate, which would remain at 40
percent. If this proposal were to be implemented, what would be
the company’s net cash flow?

a. $2,000,000
b. $4,000,000
c. $6,800,000
d. $8,000,000
e. $9,800,000

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