Tax Depreciation

4.1 Understand tax depreciation procedures and the effect of depreciation on the firm's cash flows.

1) Depreciation deductions, like any other business expenses, reduce the income that a firm reports on its income statement.
Answer: TRUE
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) Non-cash charges are expenses that involve an actual outlay of cash during the period but are not deducted on the income statement.
Answer: FALSE
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) Under the basic MACRS procedures, the depreciable value of an asset is its full
cost, including outlays for installation.
Answer: TRUE
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) Business firms are permitted to systematically charge a portion of the market value of fixed assets as depreciation against annual revenues.
Answer: FALSE
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills
5) Given a financial manager's preference for faster receipt of cash flows, a longer depreciable life is preferred to a shorter one.
Answer: FALSE
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) For tax purposes, using MACRS recovery periods, assets in the first four property classes are depreciated by the double-declining balance method using the half-year convention and switching to straight line when advantageous.
Answer: TRUE
Diff: 1
Topic: Depreciation Methods
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) The MACRS depreciation method requires use of the half-year convention. Assets are assumed to be acquired in the middle of the year and only one-half of the first year's depreciation is recovered in the first year.
Answer: TRUE
Diff: 1
Topic: Depreciation Methods
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) Allocation of the historic costs of fixed assets against the annual revenue they generate is called ________.
A) arbitraging
B) securitization
C) depreciation
D) amortization
Answer: C
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
9) The Modified Accelerated Cost Recovery System (MACRS) is a depreciation method used for ________ purposes.
A) tax
B) financial reporting
C) budget
D) cost accounting
Answer: A
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

10) A corporation ________.
A) must use the straight-line depreciation method for tax purposes and double declining depreciation method financial reporting purposes
B) can use straight-line depreciation method for tax purposes and MACRS depreciation method financial reporting purposes
C) can use different depreciation methods for tax and financial reporting purposes
D) must use different depreciation method for tax purposes, but strictly mandated depreciation methods for financial reporting purposes
Answer: C
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

11) The depreciable value of an asset, under MACRS, is the ________.
A) current cost
B) current cost minus salvage value
C) the original cost plus installation
D) the original cost plus installation costs, minus salvage value
Answer: C
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

MACRS RATE
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
15
19
18
14
4
7
12
12
12
5

12
9
9
6

5
9
8
7

9
7
8

4
6
9

6
10

6
11

4 12) Under MACRS, an asset which originally cost $10,000 is being depreciated using a 5-year normal recovery period. What is the depreciation expense in year 3?
A) $1,900
B) $1,200
C) $1,500
D) $2,100
Answer: A
Diff: 2
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) Under MACRS, an asset which originally cost $100,000 is being depreciated using a 10-year normal recovery period. The depreciation expense in year 5 is ________.
A) $10,000
B) $12,000
C) $21,000
D) $ 9,000
Answer: D
Diff: 2
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
14) Under MACRS, an asset which originally cost $100,000 is being depreciated using a 10-year normal recovery period. The depreciation expense in year 11 is ________.
A) $3,000
B) $4,000
C) $0
D) $6,000
Answer: B
Diff: 2
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

15) Given a financial manager's preference for faster receipt of cash flows, ________.
A) a longer depreciable life is preferred to a shorter one
B) a shorter depreciable life is preferred to a longer one
C) the manager is not concerned with depreciable life, because depreciation is a noncash expense
D) the manager is not concerned with depreciable life, because once purchased, depreciation is considered a sunk cost
Answer: B
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

16) In general, ________.
A) a longer depreciable life is preferred, because it will result in a faster receipt of cash flows
B) a shorter depreciable life is preferred, because it will result in a faster receipt of cash flows
C) a shorter depreciable life is preferred, because management can then purchase new assets, as the old assets are written off
D) a longer depreciable life is preferred, because management can postpone purchasing new assets, since the old assets still have a useful life
Answer: B
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
17) The depreciable value of an asset, under MACRS, is ________.
A) the full cost excluding installation costs
B) the full cost minus salvage value
C) the full cost including installation costs
D) the full cost including installation costs adjusted for the salvage value
Answer: C
Diff: 1
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

MACRS RATE
Recovery year
3 years
5 years
7 years
10 years
1
33%
20%
14%
10%
2
45
32
25
18
3
15
19
18
14
4
7
12
12
12
5

12
9
9
6

5
9
8
7

9
7
8

4
6
9

6
10

6
11

4 18) Under MACRS, an asset which originally cost $100,000, incurred installation costs of $10,000, and has an estimated salvage value of $25,000, is being depreciated using a 5-year normal recovery period.
What is the depreciation expense in year 1?
A) $15,000
B) $12,750
C) $11,250
D) $22,000
Answer: D
Diff: 2
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills
19) Darling Paper Container, Inc. purchased several machines at a total cost of $300,000. The installation cost for this equipment was $25,000. The firm plans to depreciate the equipment using the MACRS 5-year normal recovery period. Prepare a depreciation schedule showing the depreciation expense for each year.
Answer: Depreciation Schedule

Diff: 2
Topic: Depreciation
Learning Obj.: LG 1
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4.2 Discuss the firm's statement of cash flows, operating cash flow, and free cash flow.

1) In the statement of cash flows, the cash flows from financing activities result from debt and equity financing transactions; including incurrence and repayment of debt, cash inflow from the sale of stock, and cash outflows to repurchase stock or pay cash
dividends.
Answer: TRUE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

2) Free cash flow (FCF) is the cash flow a firm generates from its normal operations; calculated as EBIT minus taxes plus depreciation.
Answer: FALSE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) A firm's operating cash flow (OCF) is the cash flow it generates from its normal operations: producing and selling its output of goods or services.
Answer: TRUE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills
4) The net fixed asset investment (NFAI) is defined as the change in net fixed assets plus depreciation.
Answer: TRUE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) The net current asset investment (NCAI) is defined as the change in current assets minus the change in sum of the accounts payable and accruals.
Answer: TRUE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) A firm's free cash flow (FCF) represents the amount of cash flow available to investors (stockholders and bondholders) after the firm has met all operating needs and after having paid for net fixed asset investments and net current asset investments.
Answer: TRUE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) A firm's free cash flow (FCF) equals the sum of operating cash flows, financing cash flows, and investing cash flows.
Answer: FALSE
Diff: 1
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) Operating cash flow (OCF) is equal to a firm's net operating profits after taxes minus all non-cash charges.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills
9) In the statement of cash flows, cash flows from operating activities are cash flows directly related to purchase and sale of fixed assets.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

10) Depreciation is considered to be an outflow of cash.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) The statement of cash flows allows the financial manager and other interested parties to analyze a firm's past and possibly future profitability.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

12) To assess whether any developments have occurred that are contrary to a company's financial policies, the financial manager should pay special attention to both the major categories of cash flow and the individual items of cash inflow and outflow.
Answer: TRUE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) It would be correct to define operating cash flow (OCF) as net operating profit after taxes plus depreciation.
Answer: TRUE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
14) Operating cash flow (OCF) is calculated by deducting depreciation from net operating profit after taxes.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

15) Net operating profit after taxes (NOPAT) represents a firm's earnings before interest and after taxes.
Answer: TRUE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) Net operating profit after taxes (NOPAT) represents a firm's earnings after deducting both interest and taxes.
Answer: FALSE
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

17) A firm's operating cash flow (OCF) is defined as ________.
A) gross profit minus operating expenses
B) gross profit minus depreciation
C) EBIT times one minus the tax rate plus depreciation
D) EBIT plus depreciation
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
18) Which of the following is an example of noncash charges?
A) depreciation
B) accruals
C) interest expense
D) dividends paid
Answer: A
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

19) Which of the following is a source of cash flows?
A) increase in marketable securities
B) increase in accounts payable
C) decrease in notes payable
D) repurchase of stock
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

20) ________ is a noncash charge.
A) Labor expense
B) Depreciation
C) Salaries
D) Rent
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

21) In the statement of cash flows, retained earnings are handled through the adjustment of ________.
A) "Revenue" and "Cost" accounts
B) "Current Assets" and "Current Liabilities" accounts
C) "Depreciation" and "Purchases" accounts
D) "Net Profits After Taxes" and "Dividends Paid" accounts
Answer: D
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
22) The cash flows from operating activities section of the statement of cash flows includes ________.
A) principal received
B) cost of raw materials
C) dividends paid
D) stock repurchases
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

23) The cash flows from operating activities section of the statement of cash flows includes ________.
A) labor expense
B) proceeds from the sale of fixed assets
C) principal paid
D) dividends paid
Answer: A
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

24) The cash flows from financing activities section of the statement of cash flows includes ________.
A) labour expense
B) cost of raw materials
C) purchase of long-term assets
D) dividends paid
Answer: D
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
25) The three categories of a firm's statement of cash flows are ________.
A) cash flow from operating activities, cash flow from investment activities, and cash flow from noncash activities
B) cash flow from operating activities, cash flow from noncash activities, and cash flow from financing activities
C) cash flow from equity activities, cash flow from investment activities, and cash flow from financing activities
D) cash flow from operating activities, cash flow from investment activities, and cash flow from financing activities
Answer: D
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

26) Which of the following is a cash inflow?
A) a decrease in accounts payable
B) a decrease in accounts receivable
C) an increase in dividend payment
D) a decrease in accrued liabilities
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

27) Which of the following is a cash outflow?
A) an increase in accounts payable
B) a decrease in notes receivable
C) an increase in accounts receivable
D) an increase in accrued liabilities
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
28) Which of the following line items of the statement of cash flows must be obtained from the income statement ?
A) accruals in current liabilities
B) interest expenses
C) accounts receivable
D) cash dividends paid on both preferred and common stocks
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

29) Cash flows directly related to production and sale of a firm's products and services are called ________.
A) cash flow from operating activities
B) cash flow from investment activities
C) cash flow from financing activities
D) cash flow from equity activities
Answer: A
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

30) Cash flows associated with the purchase and sale of fixed assets and business interests are called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) equity activities
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
31) Cash flows that result from debt and equity financing transactions, including incurrence and repayment of debt, cash inflows from the sale of stock, and cash outflows to pay cash dividends or repurchase stock are called cash flow from ________.
A) operating activities
B) investment activities
C) financing activities
D) miscellaneous activities
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
Table 4.1

True Sandpaper Co.
Balance Sheets
For the Years Ended 2014 and 2015

32) The largest single source of funds for the firm in 2015 is ________. (See Table 4.1)
A) an increase in net profits after taxes
B) an increase in notes payable
C) an increase in long-term debt
D) an increase in inventory
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

33) Common stock dividends paid in 2015 amounted to ________. (See Table 4.1)
A) $100
B) $50
C) $600
D) $150
Answer: B
Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
34) The firm may have increased long-term debts to finance ________. (See Table 4.1)
A) an increase in net fixed assets
B) an increase in current assets
C) accounts receivable payments
D) an increase in dividends
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

35) The firm ________ fixed assets worth ________. (See Table 4.1)
A) purchased; $0
B) purchased; $200
C) sold; $0
D) sold; $200
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

36) The firm's cash flow from operating activities is ________. (See Table 4.1)
A) $50
B) $350
C) $150
D) $200
Answer: A
Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

37) The depreciation expense for 2015 is ________. (See Table 4.1)
A) $0
B) $200
C) $50
D) $1,000
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
38) A corporation sold a fixed asset for $100,000. This is ________.
A) an investment cash flow and a source of funds
B) an operating cash flow and a source of funds
C) an operating cash flow and a use of funds
D) an investment cash flow and a use of funds
Answer: A
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

39) A corporation raises $500,000 in long-term debt to acquire additional plant capacity. This is considered as ________.
A) an investment cash flow
B) a financing cash flow
C) a financing cash flow and investment cash flow, respectively
D) a financing cash flow and operating cash flow, respectively
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

40) Which of the following is a cash flow from financing activities?
A) purchase of a long-term asset
B) decrease in accounts payable
C) increase in accounts payable
D) repurchasing stock
Answer: D
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

41) Which of the following represents a cash flow from operating activities?
A) dividends paid
B) increase or decrease in current liabilities
C) increase or decrease in fixed assets
D) repurchasing stock
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
42) For the year ended December 31, 2014, a corporation had cash flow from operating activities of -$10,000, cash flow from investment activities of $4,000, and cash flow from financing activities of $9,000.
The statement of cash flows would show a ________.
A) net decrease of $3,000 in cash and marketable securities
B) net decrease of $5,000 in cash and marketable securities
C) net increase of $3,000 in cash and marketable securities
D) net increase of $5,000 in cash and marketable securities
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

43) For the year ended December 31, 2014, a corporation had cash flow from operating activities of $20,000, cash flow from investment activities of -$15,000, and cash flow from financing activities of -$10,000. The statement of cash flows would show a ________.
A) net increase of $5,000 in cash and marketable securities
B) net decrease of $5,000 in cash and marketable securities
C) net decrease of $15,000 in cash and marketable securities
D) net increase of $25,000 in cash and marketable securities
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic
Skills

44) For the year ended December 31, 2014, a corporation had cash flow from operating activities of $12,000, cash flow from investment activities of - $10,000, and cash flow from financing activities of $4,000. The statement of cash flows would show a ________.
A) net decrease of $18,000 in cash and marketable securities
B) net decrease of $6,000 in cash and marketable securities
C) net increase of $6,000 in cash and marketable securities
D) net increase of $2,000 in cash and marketable securities
Answer: C
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
45) A firm has just ended the calendar year making a sale in the amount of $200,000 of merchandise purchased during the year at a total cost of $150,500. Although the firm paid in full for the merchandise during the year, it has yet to collect at year end from the customer. One possible problem this firm may face is ________.
A) low profitability
B) insolvency
C) inability to receive credit
D) high leverage
Answer: B
Diff: 1
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

46) Calculate net operating profit after taxes (NOPAT) if a firm has sales of $1,000,000, operating profit (EBIT) of $100,000, interest expense of $50,000, and a tax rate of 30%.
A) $35,000
B) $700,000
C) $70,000
D) $45,000
Answer: C
Diff: 2
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

47) Calculate a firm's free cash flow if it has net operating profit after taxes of $60,000, depreciation expense of $10,000, net fixed asset investment requirement of $40,000, a net current asset requirement of $30,000 and a tax rate of 30%.
A) $0
B) $30,000
C) -$30,000
D) $60,000
Answer: A
Diff: 2
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
48) NICO Corporation had net fixed assets of $2,000,000 at the end of 2015 and $1,800,000 at the end of 2014. In addition, the firm had a depreciation expense of $200,000 during 2015 and $180,000 during 2014. Using this information, NICO's net fixed asset investment for 2015 was ________.
A) $20,000
B) $0
C) $380,000
D) $400,000
Answer: D
Diff: 2
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

49) NICO Corporation had net current assets of $2,000,000 at the end of 2015 and $1,800,000 at the end of 2014. In addition, NICO had net spontaneous current liabilities of $1,000,000 in 2015 and $1,500,000 in 2014. Using this information, NICO's net current asset investment for 2014 was ________.
A) $700,000
B) -$300,000
C) $300,000
D) -$700,000
Answer: B
Diff: 2
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

50) During 2015, NICO Corporation had EBIT of $100,000, a change in net fixed assets of $400,000, an increase in net current assets of $100,000, an increase in spontaneous current liabilities of $400,000, a depreciation expense of $50,000, and a tax rate of 30%. Based on this information, NICO's free cash flow is ________.
A) -$630,000
B) -$50,000
C) $650,000
D) -$30,000
Answer: D
Diff: 2
Topic: Free Cash Flow
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
51) Given the financial data for New Electronic World, Inc. (NEW), compute the following measures of cash flows for the NEW for the year ended December 31, 2015.
(a) Operating cash flow
(b) Free cash flow

For the year ended December 31,

Answer:
(a) OCF = EBIT - Taxes + Depreciation OCF = $30,000 - $8,000 + $3,000 = $25,000
(b) FCF = OCF - Net fixed asset investment (NFAI) - Net current asset investment (NCAI) NFAI = Change in net fixed assets + Depreciation = ($24,000 -$ 22,000) + 3,000 = $5,000 NCAI = Change in current assets - change in (Accounts payable + Accruals) = ($99,000 - $87,000) - ($32,000 - $26,000) = $6,000 FCF = $35,000 - $5,000 - $6,000 = $14,000
Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
52) Identify each expense or revenue as a cash flow from operating activities (O), a cash flow from investment activities (I), or a cash flow from financing activities (F).
Administrative expenses
Rent payment
Interest on a note payable
Sale of equipment
Dividend payment
Stock repurchase
Sale of finished goods
Labor expense
Sale of a bond issue
Repayment of a long-term debt
Selling expenses
Depreciation expense
Sale of common stock
Purchase of fixed assets
Answer:

Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
53) Calculate the change in the key balance sheet accounts between 2014 and 2015 and classify each as a source (S), a use (U), or neither (N), and indicate which type of cash flow it is: an operating cash flow (O), and investment cash flow (I) or a financing cash flow (F). ABC Corp. Balance Sheet Changes and Classification of Key Accounts between 2014 and 2015

Answer: ABC Corp. Balance Sheet Changes and Classification of Key Accounts between 2014 and 2015

Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
Table 4.2

Magna Fax, Inc.
Balance Sheet
For the Years Ended December 31, 2014 and 2015

54) The credit manager at First National Bank has just received the income statement and balance sheet for Magna Fax, Inc. for the year ended December 31,2015. (See Table 4.2.) The bank requires the firm to report its earnings performance and financial position quarterly as a condition of a loan agreement. The bank's credit manager must prepare two key financial statements based on the information sent by Magna Fax, Inc. This will be passed on to the commercial loan officer assigned to this account, so that he may review the financial condition of the firm.
(a) Prepare a statement of retained earnings for the year ended December 31, 2015.
(b) Prepare a summary of cash inflows and cash outflows for the year ended December 31, 2015.
(c) Prepare a statement of cash flows for the year ended December 31, 2015, organized by cash flow from operating activities, cash flow from investment activities, and cash flow from financing activities.
Answer:
(a) Magna Fax, Inc. Statement of Retained Earnings For the Year Ended December 31, 2015

(b) Magna Fax, Inc. Statement of Cash Flows For the Year Ended December 31, 2015

(c) Magna Fax, Inc. Statement of Cash Flows For the Year Ended December 31, 2015

Diff: 2
Topic: Developing the Statement of Cash Flows
Learning Obj.: LG 2
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
4.3 Understand the financial planning process, including long-term (strategic) financial plans and short-term (operating) financial plans.

1) Strategic financial plans are planned long-term financial actions and the anticipated financial impact of those actions.
Answer: TRUE
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) A financial planning process begins with short-term, or operating, plans and budgets that in turn guide the formulation of long-term, or strategic, financial plans.
Answer: FALSE
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) Operating financial plans are planned short-term financial actions and the anticipated financial impact of those actions.
Answer: TRUE
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) Generally, firms that are subject to high degrees of operating uncertainty, relatively short production cycles, or both, tend to use shorter planning horizons.
Answer: TRUE
Diff: 1
Topic: Long-Term (Strategic) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) The sales forecast and various forms of operating and financial data are the key outputs of the short-run (operating) financial planning.
Answer: FALSE
Diff: 1
Topic: Short-Term (Operating) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
6) The financial planning process begins with ________ financial plans that in turn guide the formation of ________ plans and budgets.
A) short-term; long-term
B) short-term; short-term
C) long-term; long-term
D) long-term; short-term
Answer: D
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

7) Short-term financial plans and long-term financial plans generally cover periods ranging from ________ years and ________ years, respectively.
A) one to two; two to ten
B) five to ten; ten to twenty
C) zero to one; five to ten
D) one to ten; ten to fifteen
Answer: A
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

8) The key aspects of a financial planning process are ________.
A) cash planning and investment planning
B) operations planning and investment planning
C) investment planning and profit planning
D) cash planning and profit planning
Answer: D
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

9) Pro forma financial statements are used for ________.
A) cash budgeting
B) preparing financial statements
C) profit planning
D) auditing
Answer: C
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills
10) Which of the following would be the least likely to utilize a cash budget?
A) top management
B) middle management
C) public investors
D) lenders
Answer: C
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

11) The primary purpose in preparing pro forma financial statements is ________.
A) for cash planning
B) to ensure the ability to pay dividends
C) to reduce risk
D) for profit planning
Answer: D
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-02
Question Status: Revised
AACSB Tag: Analytic Skills

12) ________ consider proposed fixed-asset outlays, research and development activities, marketing and product development actions, capital structure, and major sources of financing.
A) Short-term financial plans
B) Long-term financial plans
C) Pro forma statements
D) Cash budgeting
Answer: B
Diff: 1
Topic: Financial Planning Process
Learning Obj.: LG 3
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) ________ generally reflect(s) the anticipated financial impact of planned long-term actions.
A) A cash budget
B) Strategic financial plans
C) Operating financial plans
D) A pro forma income statement
Answer: B
Diff: 1
Topic: Long-Term (Strategic) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-02
Question Status: Previous Edition
AACSB Tag: Analytic Skills
14) In general, firms that are subject to a high degree of ________, relatively short production cycles, or both, tend to use shorter planning horizons.
A) profitability
B) financial certainty
C) operating uncertainty
D) financial planning
Answer: C
Diff: 1
Topic: Long-Term (Strategic) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) The key outputs of the short-term financial planning process are the ________.
A) cash budget, pro forma income statement, and pro forma balance sheet
B) sales forecast and capital assets journal
C) sales forecast and schedule of changes in working capital
D) income statement, balance sheet, and source and use statement
Answer: A
Diff: 1
Topic: Short-Term (Operating) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

16) Key inputs to short-term financial planning are ________.
A) cash flow statements and income statement
B) pro forma financial statements
C) sales forecasts, and operating and financial data
D) leverage analysis and pro forma income statement
Answer: C
Diff: 1
Topic: Short-Term (Operating) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

17) Once sales are forecasted, ________ must be generated to estimate required raw materials.
A) a production plan
B) a cash budget
C) an operating budget
D) a pro forma statement
Answer: A
Diff: 1
Topic: Short-Term (Operating) Financial Plans
Learning Obj.: LG 3
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills
4.4 Discuss the cash-planning process and the preparation, evaluation, and use of the cash budget.

1) The more seasonal and uncertain a firm's cash flows, the greater the number of intervals and the shorter time intervals.
Answer: TRUE
Diff: 1
Topic: Cash Planning: Cash Budgets
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) An internal sales forecast is based on the relationships that can be observed between a firm's sales and certain key economic indicators such as the gross domestic product, new housing starts, or disposable personal income.
Answer: FALSE
Diff: 1
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) The ________ is a financial projection of a firm's short-term cash surpluses or shortages.
A) operating financial plan
B) cash budget
C) strategic financial journal
D) capital assets journal
Answer: B
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) The primary purpose in preparing a cash budget is ________.
A) to evaluate the intrinsic value of a financial assets
B) to estimate a firm's short-term cash requirements
C) for risk analysis
D) to estimate sales
Answer: B
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
5) Cash budget is a statement of a firm's planned inflows and outflows of cash that is used to estimate its long-term cash requirement.
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) Cash planning involves the preparation of a firm's cash budget. Without adequate cash—regardless of the level of profits—any firm could fail.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) Cash budgets and pro forma statements are useful not only for internal financial planning but also are routinely required by the Internal Revenue Service (IRS).
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) A cash budget gives the financial manager a clear view of the timing of a firm's expected profitability over a given period.
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) Since depreciation and other noncash charges represent a scheduled write-off of an earlier cash outflow, they should not be included in the cash budget.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills
10) In cash budgeting, the impact of depreciation is reflected in a reduction in tax payments.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) In cash budgeting, other cash receipts are cash receipts expected to result from sources other than sales.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

12) A firm's net cash flow is the mathematical difference between the firm's beginning cash and its cash disbursements in each period.
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) The excess cash balance is the amount available for investment by a firm if the desired minimum cash balance is less than the period's ending cash.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

14) The required total financing figures in the cash budget refer to the monthly changes in borrowing.
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills
15) If the net cash flow is less than the minimum cash balance, financing is required.
Answer: FALSE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) If the ending cash is greater than the minimum cash balance, excess cash exists.
Answer: TRUE
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

17) Using simulations, a firm can determine the amount of financing needed to protect it adequately against a cash shortage.
Answer: TRUE
Diff: 1
Topic: Coping with Uncertainty in the Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) As the typical cash budget shows cash flows only on a monthly basis, the information provided by the cash budget is not necessarily adequate for ensuring solvency.
Answer: TRUE
Diff: 1
Topic: Cash Flow within the Month
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

19) As the typical cash budget shows cash flows on a monthly basis, the information provided by the cash budget is adequate for ensuring solvency.
Answer: FALSE
Diff: 1
Topic: Cash Flow within the Month
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
20) An external sales forecast is based on ________.
A) the relationships between a firm's sales and certain key economic indicators such as GDP and consumer confidence
B) a buildup, or consensus of sales forecasts through a firm's own sales channels
C) the prediction of a firm's sales over a given period through the analysis of the sales trends of its competitors.
D) developing the pro forma income statement to forecast sales and then express the various income statement items as percentage of projected sales
Answer: A
Diff: 1
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: New
AACSB Tag: Analytic Skills

21) An internal forecast is based on ________.
A) a buildup, or consensus, of sales forecasts through a firm's own sales channels, adjusted for additional factors such as production capabilities
B) the relationships between a firm's sales and certain economic indicators
C) the prediction of a firm's sales over a given period through surveys sent to financial analysts
D) developing the pro forma income statement to forecast sales and then express the various income statement items as percentage of projected sales
Answer: A
Diff: 1
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: New
AACSB Tag: Analytic Skills

22) A firm's final sales forecast is usually a function of ________.
A) its net income
B) the salesperson's estimates of demand
C) internal and external factors in combination
D) its accounts receivable
Answer: C
Diff: 1
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
23) The key input to the short-term financial planning process is ________.
A) the audit report
B) the pro forma balance sheet
C) the sales forecast
D) the pro forma income statement
Answer: C
Diff: 1
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

24) A firm has projected sales in May, June, and July of $100, $200, and $300, respectively. The firm makes 20 percent of sales for cash and collects the balance one month following the sale. The firm's total cash receipts in July is ________.
A) $220
B) $200
C) $180
D) $140
Answer: A
Diff: 2
Topic: The Sales Forecast
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

25) In preparing a cash budget, the ________ seasonal and uncertain a firm's cash flows, the ________ the number of budgeting intervals it should use.
A) more; greater
B) more; fewer
C) less; greater
D) less; fewer
Answer: A
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

26) The key input to any cash budget is ________.
A) the sales forecast
B) the production plan
C) the pro forma balance sheet
D) the current tax laws
Answer: A
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
27) Of the following components of a cash budget, generally the easiest to estimate would be the ________.
A) cash sales
B) cash receipts
C) cash disbursements
D) month-to-month short-term borrowing
Answer: C
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

28) Cash disbursements include ________.
A) amortization expense
B) rent payments
C) depreciation expense
D) depletion
Answer: B
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

29) A projected excess cash balance for the month may be ________.
A) financed with short-term securities
B) financed with long-term securities
C) invested in marketable securities
D) invested in long-term securities
Answer: C
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

30) If a firm expects short-term cash surpluses, it can plan ________.
A) long-term investments
B) short-term borrowing
C) short-term investments
D) leverage decisions
Answer: C
Diff: 1
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
31) A firm has actual sales in November of $1,000 and projected sales in December and January of $3,000 and $4,000, respectively. The firm makes 10 percent of its sales for cash, collects 40 percent of its sales one month following the sale, and collects the balance two months following the sale. The firm's total cash receipts in November is ________.
A) $1,000
B) $100
C) $700
D) $400
Answer: B
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

32) A firm has actual sales in November of $1,000 and projected sales in December and January of $3,000 and $4,000, respectively. The firm makes 10 percent of its sales for cash, collects 40 percent of its sales one month following the sale, and collects the balance two months following the sale. The firm's total expected cash receipts in January is ________.
A) $700
B) $2,100
C) $1,900
D) $300
Answer: B
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

33) In April, a firm had an ending cash balance of $35,000. In May, the firm had total cash receipts of $40,000 and total cash disbursements of $50,000. The minimum cash balance required by the firm is $25,000. At the end of May, the firm had ________.
A) an excess cash balance of $25,000
B) an excess cash balance of $0
C) required financing of $10,000
D) required financing of $25,000
Answer: B
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
34) In October, a firm had an ending cash balance of $35,000. In November, the firm had a net cash flow of $40,000. The minimum cash balance required by the firm is $25,000. At the end of November, the firm had ________.
A) an excess cash balance of $50,000
B) an excess cash balance of $75,000
C) required total financing of $15,000
D) required total financing of $5,000
Answer: A
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

35) In the month of August, a firm had total cash receipts of $10,000, total cash disbursements of $8,000, depreciation expense of $1,000, a minimum cash balance of $3,000, and a beginning cash balance of $500. The ending cash balance for August totals ________.
A) $1,500
B) $5,500
C) $2,500
D) $3,500
Answer: C
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

36) In the month of August, a firm had total cash receipts of $10,000, total cash disbursements of $8,000, depreciation expense of $1,000, a minimum cash balance of $3,000, and a beginning cash balance of $500. At the end of August, the firm ________.
A) required total financing of $500
B) had an excess cash balance of $5,500
C) had an excess cash balance of $500
D) required total financing of $2,500
Answer: A
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
37) Which of the following represents a way of coping with uncertainty in a cash budget?
A) careful estimation of cash budgets outputs
B) developing a pro forma income statement to forecast sales and then express the various income statement items as percentage of projected sales
C) always using the prior year's data for estimates of the future
D) using scenario analysis, or "what if" approach, to analyze cash flows under a variety of circumstances
Answer: D
Diff: 1
Topic: Coping with Uncertainty in the Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

38) One way a firm can reduce the amount of cash it needs in any month is to ________.
A) slow down the payment of receivables
B) delay the payment of wages
C) accrue taxes
D) speed up payment of accounts payable
Answer: B
Diff: 1
Topic: Cash Flow within the Month
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills
39) Gerry Jacobs, a financial analyst for Best Value Supermarkets, has prepared the following sales and cash disbursement estimates for the period August through December of the current year.

Ninety percent of sales are for cash, the remaining 10 percent are collected one month later. All disbursements are on a cash basis. The firm wishes to maintain a minimum cash balance of $50. The beginning cash balance in September is $25. Prepare a cash budget for the months of October, November, and December, noting any needed financing or excess cash available.
Answer:

Best Value Supermarkets should arrange for a line of credit for at least $235 during the four month period.
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
40) Terrel Manufacturing expects stable sales through the summer months of June, July, and August of $500,000 per month. The firm will make purchases of $350,000 per month during these months. Wages and salaries are estimated at $60,000 per month plus 7 percent of sales. The firm must make a principal and interest payment on an outstanding loan in June of $100,000. The firm plans a purchase of a fixed asset costing $75,000 in July. The second quarter tax payment of $20,000 is also due in June. All sales are for cash.
(a) Construct a cash budget for June, July, and August, assuming the firm has a beginning cash balance of $100,000 in June.
(b) The sales projections may not be accurate due to the lack of experience by a newly-hired sales manager. If the sales manager believes the most optimistic and pessimistic estimates of sales are $600,000 and $400,000, respectively, what are the monthly net cash flows and required financing or excess cash balances?
Answer:

If the most pessimistic sales figure ($400,000) materializes, the financial manager should expect a financing requirement of $209,000 and should arrange for a line of credit to cover the firm's cash deficit. However, if the most optimistic estimate materializes, the financial manager will need to arrange for investing a total of $349,000 over the three month period.
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
41) In the preparation of a quarterly cash budget, the following revenue and cost information have been compiled. Prepare and evaluate a cash budget for the months of October, November, and December based on the information shown below.

∙ The firm collects 60 percent of sales for cash and 40 percent of its sales one month later.
∙ Interest income of $50,000 on marketable securities will be received in December.
∙ The firm pays cash for 40 percent of its purchases.
∙ The firm pays for 60 percent of its purchases the following month.
∙ Salaries and wages amount to 15 percent of the preceding month's sales.
∙ Sales commissions amount to 2 percent of the preceding month's sales.
∙ Lease payments of $100,000 must be made each month.
∙ A principal and interest payment on an outstanding loan is due in December of $150,000.
∙ The firm pays dividends of $50,000 at the end of the quarter.
∙ Fixed assets costing $600,000 will be purchased in December.
∙ Depreciation expense each month of $45,000.
∙ The firm has a beginning cash balance in October of $100,000 and maintains a minimum cash balance of $200,000.
Answer:

The firm has excess cash during the three month period and can invest the excess cash in marketable securities.
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
42) Harry's House of Hamburgers (HHH) wants to prepare a cash budget for months of September through December. Using the following information, prepare the cash budget schedule and interpret the results.
∙ Sales were $50,000 in June and $60,000 in July. Sales have been forecasted to be $65,000, $72,000, $63,000, $59,000, and $56,000 for months of August, September, October, November, and December, respectively. In the past, 10 percent of sales were on cash basis, and the collection were 50 percent in the first month, 30 percent in the second month, and 10 percent in the third month following the sales.
∙ Every four months (three times a year) $500 of dividends from investments are expected. The first dividend payment was received in January.
∙ Purchases are 60 percent of sales, 15 percent of which are paid in cash, 65 percent are paid one month later, and the rest is paid two months after purchase.
∙ $8,000 dividends are paid twice a year (in March and September).
∙ The monthly rent is $2,000.
∙ Taxes are $6,500 payable in December.
∙ A new hamburger press will be purchased in October for $2,300.
∙ $1,500 interest will be paid in November.
∙ $1,000 loan payments are paid every month.
∙ Wages and salaries are $1,000 plus 5 percent of sales in each month.
∙ August's ending cash balance is $3,000.
∙ HHH would like to maintain a minimum cash balance of $10,000.
Answer: Cash Budget

No financing required. The company may invest the excess cash in marketable securities.
Diff: 2
Topic: Preparing The Cash Budget
Learning Obj.: LG 4
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
4.5 Explain the simplified procedures used to prepare and evaluate the pro forma income statement and the pro forma balance sheet.

1) Development of pro forma financial statements helps a financial manager to project the amount of external financing required to support a given level of sales as well as overall financial performance of the firm in the coming year.
Answer: TRUE
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

2) Since the percentage-of-sales method assumes that all the form's costs and expenses are variable, it tends to understate profits when sales are increasing and overstate profits when sales are decreasing.
Answer: TRUE
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

3) In the development of pro forma statements, a firm that requires external funds means that its projected level of cash is in excess of its needs and that funds would therefore be available for repaying debt, repurchasing stock, or increasing the dividend to stockholders.
Answer: FALSE
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

4) The primary purpose in preparing pro forma financial statements is ________.
A) for cash planning
B) to ensure the ability to pay dividends
C) for risk analysis
D) for profit planning
Answer: D
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
5) ________ are projected financial statements.
A) Pro forma statements
B) Statements of retained earnings
C) Cash budgets
D) Cash flow statements
Answer: A
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

6) The key inputs for preparing pro forma income statements using the simplified approaches are the ________.
A) sales forecast for the preceding year and financial statements for the coming year
B) sales forecast for the coming year and the cash budget for the preceding year
C) sales forecast for the coming year and financial statements for the preceding year
D) cash budget for the coming year and sales forecast for the preceding year
Answer: C
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

7) In the next planning period, a firm plans to change its policy of all cash sales and initiate a credit policy requiring payment within 30 days. The statements that will be directly affected immediately are the ________.
A) pro forma income statement, balance sheet, and cash budget
B) pro forma balance sheet and cash budget
C) cash budget and statement of retained earnings
D) pro forma income statement and pro forma balance sheet
Answer: B
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
8) A firm plans to retire outstanding bonds in the next planning period. Which of the following gets affected?
A) pro forma income statement and pro forma balance sheet
B) previous year income statement and previous year balance sheet
C) previous year income statement and statement of retained earnings
D) pro forma income statement and proxy statement
Answer: A
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

9) A firm plans to depreciate a five year asset in the next planning period. The statements that will be directly affected are the ________.
A) pro forma income statement, pro forma balance sheet, and cash budget
B) pro forma balance sheet, cash budget, and statement of retained earnings
C) cash budget and pro forma balance sheet
D) pro forma income statement and pro forma balance sheet
Answer: D
Diff: 1
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

10) In a period of rising sales, utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial statements will tend to ________.
A) overstate costs and overstate profits
B) overstate costs and understate profits
C) understate costs and overstate profits
D) understate costs and understate profits
Answer: B
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
11) The percentage-of-sales method of preparing pro forma income statements assumes that ________.
A) sales are fixed
B) all costs inversely vary with sales
C) all costs are independent
D) all costs are variable
Answer: D
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

12) The percent-of-sales method of developing a pro forma income statement forecasts sales and other line items as a ________.
A) percentage of projected sales
B) percentage of average sales over a period
C) percentage of projected total assets
D) percentage of average total assets over a period
Answer: A
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) The best way to adjust for the presence of fixed costs when using the simplified approach for pro forma income statement preparation is ________.
A) to proportionately vary the fixed costs with the change in sales
B) to adjust for projected fixed-asset outlays
C) to disproportionately vary the costs with the change in sales
D) to break the firm's historical costs into fixed and variable components
Answer: D
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
14) The percent-of-sales method to prepare a pro forma income statement assumes a firm has no fixed costs. Therefore, the use of the past cost and expense ratios generally tends to ________ profits when sales are increasing.
A) accurately predict
B) overstate
C) understate
D) have no effect on
Answer: C
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) For firms with high fixed costs, the percent-of-sales approach for preparing a pro forma income statement tends to ________.
A) overestimate profits when sales are increasing
B) underestimate profits when sales are increasing
C) underestimate profits when assets are increasing
D) overestimate profits when assets are increasing
Answer: B
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

16) In a period of rising sales utilizing past cost and expense ratios (percent-of-sales method), when preparing pro forma financial statements and planning financing, will tend to ________.
A) understate retained earnings and understate the additional financing needed
B) overstate retained earnings and overstate the additional financing needed
C) understate retained earnings and overstate the financing needed
D) overstate retained earnings and understate the financing needed
Answer: C
Diff: 1
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
17) Under the judgmental approach for developing a pro forma balance sheet, the "plug" figure required to bring the statement into balance may be called the ________.
A) cash balance
B) retained earnings
C) external financing required
D) accounts receivable
Answer: C
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

18) The ________ method of developing a pro forma balance sheet estimates values of certain balance sheet accounts while external financing is used as a balancing, or plug, figure.
A) percent-of-sales
B) accrual
C) judgmental
D) cash
Answer: C
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

19) A firm has prepared the coming year's pro forma balance sheet resulting in a plug figure in a preliminary statement—called the external financing required—of $230,000. The firm should prepare to ________.
A) repurchase common stock totaling $230,000
B) arrange for a loan of $230,000
C) do nothing; the balance sheet balances
D) invest in marketable securities totaling $230,000
Answer: B
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
20) A firm has prepared the coming year's pro forma balance sheet resulting in a plug figure in a preliminary statement—called the external financing required—of negative $250,000. The firm may prepare to ________.
A) sell common stock totaling $250,000
B) arrange for a loan of $250,000
C) do nothing; the balance sheet balances
D) invest in marketable securities totaling $250,000
Answer: D
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

Table 4.3

The financial analyst for Sportif, Inc. has compiled sales and disbursement estimates for the coming months of January through May. Historically, 75 percent of sales are for cash with the remaining 25 percent collected in the following month. The ending cash balance in January is $3,000.

21) The total cash receipts for April are ________. (See Table 4.3)
A) $5,000
B) $7,500
C) $9,250
D) $10,000
Answer: D
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

22) The net cash flow for February is ________. (See Table 4.3)
A) -$1,250
B) -$1,000
C) $5,750
D) $750
Answer: A
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
23) The firm has a negative net cash flow in the month(s) of ________. (See Table 4.3)
A) January, February, and March
B) February and March
C) January and February
D) February
Answer: C
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Analytic Skills

24) The ending cash balance for March is ________. (See Table 4.3)
A) $250
B) $6,750
C) $2,500
D) $500
Answer: B
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

25) The ending cash balance for February is ________. (See Table 4.3)
A) $750
B) $1,750
C) $2,500
D) -$1,000
Answer: B
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

26) At the end of May, the firm has an ending cash balance of ________. (See Table 4.3)
A) $9,000
B) $16,750
C) $14,250
D) $12,000
Answer: B
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
27) The firm has a total financing requirement of ________ for the period from February through May. (See Table 4.3)
A) $ 0
B) $1,750
C) $1,250
D) $ 750
Answer: A
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

28) If a pro forma balance sheet dated at the end of May was prepared from the information presented, the marketable securities would total ________. (See Table 4.3)
A) $9,000
B) $9,500
C) $12,000
D) $16,750
Answer: D
Diff: 2
Topic: Profit Planning: Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
Table 4.4

Use the percent-of-sales method to prepare a pro forma income statement for the year ended December 31, 2015, for Hennesaw Lumber, Inc.

Hennesaw Lumber, Inc. estimates that its sales in 2000 will be $4,500,000. Interest expense is to remain unchanged at $105,000 and the firm plans to pay cash dividends of $150,000 during 2015. Hennesaw Lumber, Inc.'s income statement for the year ended December 31, 2014 is shown below. From your preparation of the pro forma income statement, answer the following multiple choice questions.

29) The pro forma net profits after taxes for 2015 are ________. (See Table 4.4)
A) $202,500
B) $207,000
C) $52,500
D) $57,000
Answer: B
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

30) The pro forma cost of goods sold for 2015 is ________. (See Table 4.4)
A) $3,500,000
B) $3,750,000
C) $3,825,000
D) $4,000,000
Answer: C
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
31) The pro forma operating expenses for 2015 are ________. (See Table 4.4)
A) $150,000
B) $200,000
C) $210,000
D) $225,000
Answer: D
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

32) The pro forma accumulated retained earnings account on the balance sheet is projected to be ________. (See Table 4.4)
A) $62,500
B) $52,500
C) $57,000
D) $67,000
Answer: C
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
Table 4.5

A financial manager at General Talc Mines has gathered the financial data essential to prepare a pro forma balance sheet for cash and profit planning purposes for the coming year ended December 31, 2015. Using the percent-of-sales method and the following financial data, prepare the pro forma balance sheet in order to answer the following multiple choice questions.
(a) The firm estimates sales of $1,000,000.
(b) The firm maintains a cash balance of $25,000.
(c) Accounts receivable represents 15 percent of sales.
(d) Inventory represents 35 percent of sales.
(e) A new piece of mining equipment costing $150,000 will be purchased in 2010. Total depreciation for 2010 will be $75,000.
(f) Accounts payable represents 10 percent of sales.
(g) There will be no change in notes payable, accruals, and common stock.
(h) The firm plans to retire a long term note of $100,000.
(i) Dividends of $45,000 will be paid in 2015.
(j) The firm predicts a 4 percent net profit margin.

Balance Sheet
General Talc Mines
December 31, 2014

33) The pro forma total current assets amount is ________. (See Table 4.5)
A) $470,900
B) $500,000
C) $525,000
D) $575,000
Answer: C
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

34) The pro forma net fixed assets amount is ________. (See Table 4.5)
A) $500,000
B) $575,000
C) $600,000
D) $650,000
Answer: B
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

35) The pro forma current liabilities amount is ________. (See Table 4.5)
A) $400,000
B) $450,000
C) $475,000
D) $500,000
Answer: D
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

36) The pro forma total liabilities amount is ________. (See Table 4.5)
A) $500,000
B) $550,000
C) $700,000
D) $650,000
Answer: B
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
37) The pro forma accumulated retained earnings amount is ________. (See Table 4.5)
A) $90,000
B) $175,000
C) $140,000
D) $130,000
Answer: D
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

38) The external financing required in 2015 will be ________. (See Table 4.5)
A) $230,000
B) $240,000
C) $0
D) $195,000
Answer: B
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

39) General Talc Mines may prepare to ________. (See Table 4.5)
A) arrange for a loan equal to the external funds requirement
B) eliminate the dividend to cover the needed financing
C) cancel the retirement of the long term note to cover the needed financing
D) repurchase common stock equal to the external funds requirement
Answer: A
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

40) The external funds requirement results primarily from ________. (See Table 4.5)
A) the payment of dividends
B) the retirement of debt and purchase of new fixed assets
C) low profit margin
D) high cost of sales
Answer: B
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
41) If General Talc Mines cannot raise the external financing required through traditional credit channels, the firm may ________. (See Table 4.5)
A) increase sales
B) purchase additional fixed assets to raise productivity
C) sell common stock
D) factor accounts receivable
Answer: C
Diff: 1
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
42) Income Statement Huddleston Manufacturing Company For the Year Ended December 31, 2015

Huddleston Manufacturing estimates its sales in 2016 will be $3 million. Interest expense is expected to remain unchanged at $70,000, and the firm plans to pay cash dividends of $140,000 during 2016. Use the percent-of-sales method to prepare a pro forma income statement for the year ended December 31, 2016, based on the 2015 income statement shown above.
Answer: Pro Forma Income Statement Huddleston Manufacturing Company For the Year Ended December 31, 2016

Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

43) Calculate the amount of accounts receivable assuming that a pro forma balance sheet dated at the end of May was prepared from the information presented. (See Table 4.3)
Answer: $2,500.
Diff: 2
Topic: Preparing The Pro Forma Balance Sheet
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
Table 4.6

Income Statement
Ace Manufacturing, Inc.
For the Year Ended December 31, 2015

44) Ace Manufacturing, Inc., is preparing pro forma financial statements for 2016. The firm utilized the percent-of-sales method to estimate costs for the next year. Sales in 2015 were $2 million and are expected to increase to $2.4 million in 2016. The firm has a 40 percent tax rate.
(a) Given the 2015 income statement in Table 4.6, estimate net profit and retained earnings for 2016.
(b) If $200,000 of the cost of goods sold and $40,000 of selling expense are fixed costs; and the interest expense and dividends are not expected to change, what is he dollar effect on net income and retained earnings? What is the significance of this effect?
Answer:
(a)
Pro forma income statement: December 31, 2016

(b)

Net profit after tax is understated by $38,400 and retained earnings by $58,400, using the percent-of-sales method. In planning the addition of assets (current or fixed) and the financing of those assets, the straight percent-of-sales method understates net profit and retained earnings. This, therefore, overstates additional financing needed to add those assets. The judgmental approach allows the firm to obtain a more accurate estimate of the line of credit or long-term financing that will be necessary in the next planning period.
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
Table 4.7

The income statement and balance sheet for the ZZZ Mattress Co. for the year ended December 31, 2015 follow.

Balance Sheet
ZZZ Mattress Company
December 31, 2015

45) The ZZZ Mattress Co. has been requested by the 1st National Bank, a major creditor, to prepare a pro forma balance sheet for the year ending, December 31, 2016. Using the percent-of-sales method and the following financial data, prepare the pro forma income statement and balance sheet and discuss the resulting external financing required. (See Table 4.7)
∙ 2016 sales are estimated at $330,000.
∙ Accounts receivable represent 20 percent of sales.
∙ A minimum cash balance of $1,650 is maintained.
∙ Inventory represents 32 percent of sales.
∙ Fixed-asset outlays in 2006 are $20,000. Total depreciation expense for 2016 will be $15,000.
∙ Accounts payable represents 15 percent of sales.
∙ Notes payable and accruals will remain the same.
∙ No long-term debt will be retired in 2016.
∙ No common stock will be repurchased in 2016.
∙ The firm will pay dividends equal to 50 percent of its earnings after taxes.
Answer:

Balance Sheet ZZZ Mattress Company December 31, 2016

A 10 percent growth rate in sales cannot be supported by the firm's internally generated funds. A larger line of credit or a request for a long-term loan for the additional $8,390 is necessary to finance operations.
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
Table 4.8

Balance Sheet
Wirl Wind Company

46) The Wirl-Wind Company of America is trying to plan for the next year. Using the current income statement and balance sheet given in Table 4.8, and the additional information provided, prepare the company's pro forma statements.
∙ Sales are projected to increase by 15 percent.
∙ Total of $75,000 in dividend will be paid.
∙ A minimum cash balance of $650,000 is desired.
∙ A new asset for $50,000 will be purchased.
∙ Depreciation expense for next year is $50,000.
∙ Marketable securities will remain the same.
∙ Accounts receivable, inventory, accounts payable, notes payable, and accruals will increase by 15 percent.
∙ $30,000 new issue of bond will be sold.
∙ No new stock will be issued.
Answer:

The Wirl Wind Company of America will have an excess cash of $156,474 which can be used to pay debt.
Diff: 2
Topic: Preparing The Pro Forma Income Statement
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
4.6 Evaluate the simplified approaches to pro forma financial statement preparation and the common uses of pro forma statements.

1) One basic weakness of the simplified pro forma approaches lies in the assumption that certain variables, such as cash, accounts receivable, and inventories, can be forced to take on certain "desired" values.
Answer: TRUE
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 6
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

2) One basic weakness of the simplified pro forma approaches lies in the assumption that the firm's past financial condition is an accurate indicator of its future.
Answer: TRUE
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 6
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

3) A weakness of the percent-of-sales method of preparing a pro forma income statement is ________.
A) that it forecasts income and then expresses the various income statement items as percentages of projected income.
B) the assumption that the firm faces linear total revenue and total operating cost functions
C) the assumption that the firm's past financial condition is an accurate predictor of its future
D) the difficulty faced in calculation and preparation of such statements
Answer: C
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 6
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

4) Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial statements will tend to ________.
A) understate profits when sales are decreasing
B) understate profits when sales are increasing
C) overstate profits when sales are increasing
D) neither understate nor overstate profits
Answer: B
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
5) Utilizing past cost and expense ratios (percent-of-sales method) when preparing pro forma financial statements will tend to ________.
A) understate profits when sales are decreasing and overstate profits when sales are increasing
B) understate profits, no matter what the change in sales, as long as fixed costs are present
C) understate profits when sales are increasing and overstate profits when sales are decreasing
D) overstate profits, no matter what the change in sales, as long as fixed costs are present
Answer: C
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 5
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

6) The weakness of the judgmental approach to preparing a pro forma balance sheet is ________.
A) the assumption that the values of certain accounts can be forced to take on desired levels
B) the assumption that the firm faces linear total revenue and total operating cost functions
C) the assumption that the firm's past financial condition is an accurate predictor of its future
D) ease of calculation and preparation
Answer: A
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 6
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills

7) If transportation costs were a huge portion of a firm's expenses and the firm expected gas prices to increase greatly in the next year, then in preparing its pro forma income statement the firm should ________.
A) use the percentage of transportation costs from last year's sales
B) decrease the percentage of transportation costs from the percentage of last year's sales
C) increase the percentage of transportation costs from the percentage of last year's sales
D) double the percentage of transportation costs from the percentage of last year's sales
Answer: C
Diff: 1
Topic: Evaluation of Pro Forma Statements
Learning Obj.: LG 6
Learning Outcome: F-25
Question Status: Revised
AACSB Tag: Analytic Skills
Principles of Managerial Finance, 14e (Gitman/Zutter)
Chapter 5 Time Value of Money

5.1 Discuss the role of time value in finance, the use of computational tools, and the basic patterns of cash flow.

1) Since individuals are always confronted with opportunities to earn positive rates of return on their funds, the timing of cash flows does not have any significant economic consequences.
Answer: FALSE
Diff: 1
Topic: Role of Time Value in Finance
Learning Obj.: LG 1
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) Time value of money is based on the belief that a dollar that will be received at some future date is worth more than a dollar today.
Answer: FALSE
Diff: 1
Topic: Role of Time Value in Finance
Learning Obj.: LG 1
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5.2 Understand the concepts of future value and present value, their calculation for single amounts, and the relationship between them.

1) For a given positive interest rate, the future value of $100 increases with the passage of time. Thus, the longer the period of time, the greater the future value.
Answer: TRUE
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) Future value is the value of a future amount at the present time, found by applying compound interest over a specified period of time.
Answer: FALSE
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
3) The greater the interest rate and the longer the period of time, the higher the present value.
Answer: FALSE
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) Everything else being equal, the higher the interest rate, the higher the future value.
Answer: TRUE
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) Future value increases with increases in the interest rate or the period of time funds are left on deposit.
Answer: TRUE
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) Everything else being equal, the higher the discount rate, the higher the present value.
Answer: FALSE
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) Everything else being equal, the longer the period of time, the lower the present value.
Answer: TRUE
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
8) ________ is the amount earned on a deposit that has become the part of the principal at the end of a specified time period.
A) Discount interest
B) Compound interest
C) Primary interest
D) Future value
Answer: B
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

9) The future value of $100 received today and deposited at 6 percent for four years is ________.
A) $126
B) $ 79
C) $124
D) $116
Answer: A
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

10) The future value of $200 received today and deposited at 8 percent for three years is ________.
A) $248
B) $252
C) $158
D) $200
Answer: B
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) The present value of $100 to be received 10 years from today, assuming an opportunity cost of 9 percent, is ________.
A) $236
B) $699
C) $ 42
D) $ 75
Answer: C
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
12) The amount of money that would have to be invested today at a given interest rate over a specified period in order to equal a future amount is called ________.
A) future value
B) present value
C) future value of an annuity
D) compounded value
Answer: B
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) The present value of $200 to be received 10 years from today, assuming an opportunity cost of 10 percent, is ________.
A) $ 50
B) $200
C) $518
D) $ 77
Answer: D
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

14) The future value of a dollar ________ as the interest rate increases and ________ the further in the future an initial deposit is to be received.
A) decreases; decreases
B) decreases; increases
C) increases; increases
D) increases; decreases
Answer: C
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) The annual rate of return is referred to as the ________.
A) discount rate
B) marginal rate
C) risk-free rate
D) marginal cost
Answer: A
Diff: 1
Topic: Basic Time Value Concepts
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
16) If you expect to retire in 30 years, live on $50,000 per year and expect the inflation to average 3% over the next 30 years, what amount of annual income will you need to live at the same comfort level in 30 years?
A) $121,363
B) $$95,000
C) $20,599
D) $51,500
Answer: A
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

17) Calculate the future value of $4,600 received today if it is deposited at 9 percent for three years.
Answer: FV = PV (1+ r)n = $4,600(1.09)3 = $5,957
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

18) Calculate the present value of $89,000 to be received in 15 years, assuming an opportunity cost of 14 percent.
Answer: PV = 89,000(1.14)-15 = $12,469
Diff: 1
Topic: Present Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

19) Aunt Tillie has deposited $33,000 today in an account which will earn 10 percent annually. She plans to leave the funds in this account for seven years earning interest. If the goal of this deposit is to cover a future obligation of $65,000, what recommendation would you make to Aunt Tillie?
Answer: FV = 33,000(1.1)7 = $64,308
Aunt Tillie will only have $64,308 at the end of seven years under the stated arrangement. She must find an account with a higher interest rate or deposit a larger sum today.
The amount Aunt Tillie should invest today to receive $65,000 after 7 years, PV = 65,000 / (1.1)7 = $33,355.28
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
20) China Manufacturing Agents, Inc. is preparing a five-year plan. Today, sales are $1,000,000. If the growth rate in sales is projected to be 10 percent over the next five years, what will the dollar amount of sales be in year five?
Answer: FV = 1,000,000(1.1)5 = $1,610,510
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

21) Colin has inherited $6,000 from the death of Grandma Anna. He would like to use this money to buy his mom Hayley a new scooter costing $7,000, two years from now. Will Colin have enough money to buy the gift if he deposits his money in an account paying 8 percent compounded semiannually?
Answer: n = 2, m = 2, r = 8%
FV = 6,000(1+.08/2)2 × 2 = 6000(1.04)4 = $7,019
Yes, Colin will have enough money to buy the scooter.
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

22) Dan and Jia are newlyweds and have just purchased a condominium for $70,000. Since the condo is very small, they hope to move into a single-family house in 5 years. How much will their condo worth in 5 years if inflation is expected to be 8 percent?
Answer: PV = $70,000, r = 8%, n = 5
FV = 70,000(1.08)5 = $102,853.
Diff: 1
Topic: Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
23) Congratulations! You have just won the lottery! However, the lottery bureau has just informed you that you can take your winnings in one of two ways. Choice X pays $1,000,000. Choice Y pays $1,750,000 at the end of five years from now. Using a discount rate of 5 percent, based on present values, which would you choose? Using the same discount rate of 5 percent, based on future values, which would you choose? What do your results suggest as a general rule for approaching such problems? (Make your choices based purely on the time value of money.)
Answer: The PV of X = $1,000,000; The PV of Y = $1,371,000; The FV of X = $1,276,000; The FV of Y = $1,500,000. Based on both present values and future values, B is the better choice. Finding present values and future values are simply reverse processes of one another, and that choosing between two lump sums based on PV will always give the same result as choosing between the same two lump sums based on FV.
Diff: 1
Topic: Present Value and Future Value
Learning Obj.: LG 2
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

5.3 Find the future value and the present value of both an ordinary annuity and an annuity due, and find the present value of a perpetuity.

1) An annuity due is an amount that occur at the beginning of each period.
Answer: TRUE
Diff: 1
Topic: Annuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) An ordinary annuity is an annuity in which cash flows occur at the beginning of each period.
Answer: FALSE
Diff: 1
Topic: Annuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) The future value of an annuity due is always greater than the future value of an otherwise identical ordinary annuity for interest rates greater than zero.
Answer: TRUE
Diff: 2
Topic: Annuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Dynamics of the Global Economy
4) Which of the following is true of annuities?
A) An ordinary annuity is an equal payment paid or received at the beginning of each period.
B) An annuity due is a payment paid or received at the beginning of each period that increases by an equal amount each period.
C) An annuity due is an equal stream of cash flows is paid or received at the beginning of each period.
D) An ordinary annuity is an equal payment paid or received at the end of each period that increases by an equal amount each period.
Answer: C
Diff: 1
Topic: Annuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

5) The present value of a $25,000 perpetuity at a 14 percent discount rate is ________.
A) $178,571
B) $285,000
C) $350,000
D) $219,298
Answer: A
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) An annuity with an infinite life is called a(n) ________.
A) perpetuity
B) primia
C) option
D) deep discount
Answer: A
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
7) The present value of a $20,000 perpetuity at a 7 percent discount rate is ________.
A) $186,915
B) $285,714
C) $140,000
D) $325,000
Answer: B
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) A(n) ________ is an annuity with an infinite life making continual annual payments.
A) amortized loan
B) principal
C) perpetuity
D) APR
Answer: C
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

9) Bill plans to fund his individual retirement account (IRA) with the maximum contribution of $2,000 at the end of each year for the next 20 years. If Bill can earn 12 percent on his contributions, how much will he have at the end of the twentieth year?
A) $19,292
B) $14,938
C) $40,000
D) $144,104
Answer: D
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
10) Dan plans to fund his individual retirement account (IRA) with the maximum contribution of $2,000 at the end of each year for the next 10 years. If Dan can earn 10 percent on his contributions, how much will he have at the end of the tenth year?
A) $12,290
B) $20,000
C) $31,874
D) $51,880
Answer: C
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

11) In comparing an ordinary annuity and an annuity due, which of the following is true?
A) The future value of an annuity due is always greater than the future value of an otherwise identical ordinary annuity.
B) The future value of an ordinary annuity is always greater than the future value of an otherwise identical annuity due.
C) The future value of an annuity due is always less than the future value of an otherwise identical ordinary annuity, since one less payment is received with an annuity due.
D) All things being equal, one would prefer to receive an ordinary annuity compared to an annuity due.
Answer: A
Diff: 1
Topic: Future Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

12) The future value of a $2,000 annuity due deposited at 8 percent compounded annually for each of the next 10 years is ________.
A) $28,974
B) $31,291
C) $14,494
D) $13,420
Answer: B
Diff: 2
Topic: Future Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
13) The future value of a $10,000 annuity due deposited at 12 percent compounded annually for each of the next 5 years is ________.
A) $36,050
B) $63,530
C) $40,376
D) $71,152
Answer: D
Diff: 2
Topic: Future Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

14) The future value of an ordinary annuity of $1,000 each year for 10 years, deposited at 3 percent, is ________.
A) $11,808.
B) $11,464.
C) $ 8,530.
D) $10,000.
Answer: B
Diff: 2
Topic: Future Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) The future value of an ordinary annuity of $2,000 each year for 10 years, deposited at 12 percent, is ________.
A) $35,098
B) $20,000
C) $39,310
D) $11,300
Answer: A
Diff: 2
Topic: Future Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
16) A college received a contribution to its endowment fund of $2 million. It can never touch the principal, but can use the earnings. At an assumed interest rate of 9.5 percent, how much can the college earn to help its operations each year?
A) $95,000
B) $19,000
C) $190,000
D) $18,000
Answer: C
Diff: 2
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

17) If the present value of a perpetual income stream is increasing, the discount rate must be ________.
A) increasing
B) decreasing
C) changing unpredictably
D) increasing proportionally
Answer: B
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

18) The present value of an ordinary annuity of $350 each year for five years, assuming an opportunity cost of 4 percent, is ________.
A) $288
B) $1,896
C) $1,750
D) $1,558
Answer: D
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
19) The present value of an ordinary annuity of $2,350 each year for eight years, assuming an opportunity cost of 11 percent, is ________.
A) $ 1,020
B) $27,869
C) $18,800
D) $12,093
Answer: D
Diff: 2
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

20) A generous benefactor to a local ballet plans to make a one-time endowment that would provide the ballet with $150,000 per year into perpetuity. The rate of interest is expected to be 5 percent for all future time periods. How large must the endowment be?
A) $ 300,000
B) $3,000,000
C) $ 750,000
D) $1,428,571
Answer: B
Diff: 2
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

21) A generous philanthropist plans to make a one-time endowment to a renowned heart research center which would provide the facility with $250,000 per year into perpetuity. The rate of interest is expected to be 8 percent for all future time periods. How large must the endowment be?
A) $2,314,814
B) $2,000,000
C) $3,125,000
D) $3,000,000
Answer: C
Diff: 3
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
22) Mary will receive $12,000 per year for the next 10 years as royalty for her work on a finance book. What is the present value of her royalty income if the opportunity cost is 12 percent?
A) $120,000
B) $ 67,800
C) $ 38,640
D) $ 72,560
Answer: B
Diff: 2
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

23) To pay for her college education, Gina is saving $2,000 at the beginning of each year for the next eight years in a bank account paying 12 percent interest. How much will Gina have in that account at the end of 8th year?
A) $16,000
B) $17,920
C) $24,600
D) $27,552
Answer: D
Diff: 2
Topic: Future Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

24) James plans to fund his individual retirement account, beginning today, with 20 annual deposits of $2,000, which he will continue for the next 20 years. If he can earn an annual compound rate of 8 percent on his deposits, the amount in the account upon retirement will be ________.
A) $19,636
B) $91,524
C) $98,846
D) $21,207
Answer: C
Diff: 2
Topic: Future Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
25) You have been offered a project paying $300 at the beginning of each year for the next 20 years. What is the maximum amount of money you would invest in this project if you expect 9 percent rate of return to your investment?
A) $ 2,738
B) $ 2,985
C) $15,347
D) $ 6,000
Answer: B
Diff: 2
Topic: Present Value of an Annuity Due
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

26) Calculate the present value of a $10,000 perpetuity at a 6 percent discount rate.
Answer: PV = 10,000/0.06 = $166,667
Diff: 1
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

27) Calculate the future value of an annuity of $5,000 each year for eight years, deposited at 6 percent.
Answer: FV = CF[(1 + r)n - 1] / r = $5,000[(1.06)8 - 1] / 0.06 = $49,487.34
Diff: 2
Topic: Future Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

28) Calculate the present value of an annuity of $3,900 each year for four years, assuming an opportunity cost of 10 percent.
Answer: PV = (3,900/0.1)[1-(1/(1.1)4)] = $12,363
Diff: 2
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

29) Dottie has decided to set up an account that will pay her granddaughter (Lexi) $5,000 a year indefinitely. How much should Dottie deposit in an account paying 8 percent annual interest?
Answer: PV = 5,000/0.08 = $62,500
Diff: 2
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
30) A wealthy industrialist wishes to establish a $2,000,000 trust fund which will provide income for his grandchild into perpetuity. He stipulates in the trust agreement that the principal may not be distributed. The grandchild may only receive the interest earned. If the interest rate earned on the trust is expected to be at least 7 percent in all future periods, how much income will the grandchild receive each year?
Answer: $2,000,000 × 0.07 = $140,000
Diff: 2
Topic: Perpetuities
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

31) Nico establishes a seven-year, 8 percent loan with a bank requiring annual end-of-year payments of $960.43. Calculate the original principal amount.
Answer: PVA = (960.43/0.08)[1-(1/(1.08)7)] = $5,000
Diff: 2
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

32) A lottery administrator has just completed the state's most recent $50 million lottery. Receipts from lottery sales were $50 million and the payout will be $5 million at the end of each year for 10 years. The expenses of running the lottery were $800,000. The state can earn an annual compound rate of 8 percent on any funds invested.
(a) Calculate the gross profit to the state from this lottery.
(b) Calculate the net profit to the state from this lottery (no taxes).
Answer:

Diff: 3
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
33) Jia has just won a $20 million lottery, which will pay her $1 million at the end of each year for 20 years. An investor has offered her $10 million for this annuity. She estimates that she can earn 10 percent interest, compounded annually, on any amounts she invests. She asks your advice on whether to accept or reject the offer. What will you tell her? (Ignore Taxes)
Answer: P = ($1,000,000/0.1) × [1-(1/(1.1)20] = $8,514,000
$10,000,000 > $8,514,000 Accept the offer.
Diff: 3
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

34) Mr. Jackson has been awarded a bonus for his outstanding work. His employer offers him a choice of a lump-sum of $5,000 today, or an annuity of $1,250 a year for the next five years. Which option should Mr. Jackson choose if his opportunity cost is 9 percent?
Answer: PVA = ($1,250/0.09) × [1-1/(1.09)5] = $4,862.06
Mr. Jackson should choose a lump-sum of $5,000 today.
Diff: 3
Topic: Present Value of an Annuity
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

35) In their meeting with their advisor, Mr. and Mrs. O'Rourke concluded that they would need $40,000 per year during their retirement years in order to live comfortably. They will retire 10 years from now and expect a 20-year retirement period. How much should Mr. and Mrs. O'Rourke deposit now in a bank account paying 9 percent to reach financial happiness during retirement?
Answer: The amount of money required at the beginning of the retirement period is: n = 20, i = 9%
PVA = (CF/r) × [1-1/(1+r)n] = (40,000/.09) × [1-1/(1.09)20]= $365,142 n = 10, i = 9%
PV = 365,142(1.09)-10 = $154,239.85
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
36) Nico is 30 years old and will retire at age 65. He will receive retirement benefits, but the benefits are not going to be enough to make a comfortable retirement life for him. Nico has estimated that an additional $25,000 a year over his retirement benefits will allow him to have a satisfactory life. How much should Nico deposit today in an account paying 6 percent interest to meet his goal? Assume Nico will have 15 years of retirement.
Answer: PMT = $25,000, n = 15, r = 6%
PV(65) = (25,000/.06) × [1-1/(1.06)15] = $242,806
FV = $242,806, n = 35, r = 6%
P(30) = 242,800(1.06)-35 = 242,800(0.130) = $31,590
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

37) You have been given a choice between two retirement policies as described below.
Policy A: You will receive equal annual payments of $10,000 beginning 35 years from now for 10 years.
Policy B: You will receive one lump-sum of $100,000 in 40 years from now.
Which policy would you choose? Assume rate of interest is 6 percent.
Answer: Policy A: present value of the annuity at the beginning of the 35 years from now:
PVA = (10,000/0.06) × [1-1/(1.06)10] = $73,600
Policy B: present value of the lump-sum at the beginning of the 35 years from now:
PV = 100,000(1.06)-5 = $74,726
I will choose policy B.
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
38) Ashley is planning to attend college when she graduates from high school 7 years from now. She anticipates that she will need $10,000 at the beginning of each of the four college years to pay for tuition and fees, and have some spending money. Ashley has made an arrangement with her father to do the household chores if her dad deposits $3,500 at the end of each year for the next 7 years in a bank account paying 8 percent interest. Will there be enough money in the account for Ashley to pay for her college expenses? Assume the rate of interest stays at 8 percent during the college years.
Answer: At the beginning of the first year of college:
PV = 10,000 + (10,000/0.08) × [1-1/(1.08)3]
= 10,000 + 25,770.96 = $35,770.96
PMT = $3,500, r= 8%, n = 7
FVA = 3,500{[(1.08)7-1]/0.08} = 3,500(8.923) = $31,230
Ashley will need $4,541 (= $35,770.96 -$ 31,230) additional money to pay for her college education.
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 3
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

5.4 Calculate both the future value and the present value of a mixed stream of cash flows.

1) $100 is received at the beginning of year 1, $200 is received at the beginning of year 2, and $300 is received at the beginning of year 3. If these cash flows are deposited at 12 percent, their combined future value at the end of year 3 is ________.
A) $1,536
B) $ 672
C) $ 727
D) $1,245
Answer: C
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) $1,200 is received at the beginning of year 1, $2,200 is received at the beginning of year 2, and $3,300 is received at the beginning of year 3. If these cash flows are deposited at 12 percent, their combined future value at the end of year 3 is ________.
A) $ 6,700
B) $17,072
C) $12,510
D) $ 8,142
Answer: D
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
3) Find the future value at the end of year 3 of the following stream of cash flows received at the end of each year, assuming the firm can earn 17 percent on its investments.

A) $20,724
B) $20,127
C) $23,550
D) $23,350
Answer: B
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) Find the future value at the end of year 3 of the following stream of cash flows received at the end of each year, assuming the firm can earn 8 percent on its investments.

A) $45,000
B) $53,396
C) $47,944
D) $56,690
Answer: C
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
5) The present value of $1,000 received at the end of year 1, $1,200 received at the end of year 2, and $1,300 received at the end of year 3, assuming an opportunity cost of 7 percent, is ________.
A) $2,500
B) $3,044
C) $6,516
D) $2,856
Answer: B
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

6) The present value of $100 received at the end of year 1, $200 received at the end of year 2, and $300 received at the end of year 3, assuming an opportunity cost of 13 percent, is ________.
A) $ 453
B) $ 416
C) $1,181
D) $ 500
Answer: A
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) Find the present value of the following stream of a firm's cash flows, assuming that the firm's opportunity cost is 14 percent.

A) $121,256
B) $ 69,000
C) $ 60,513
D) $ 51,903
Answer: D
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
8) Find the present value of the following stream of a firm's cash flows, assuming that the firm's opportunity cost is 25 percent.

A) $27,168
B) $35,200
C) $34,074
D) $32,281
Answer: A
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

9) Find the present value of the following stream of a firm's cash flows, assuming that the firm's opportunity cost is 9 percent.

A) $ 13,252
B) $141,588
C) $ 10,972
D) $ 79,345
Answer: D
Diff: 3
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
10) Find the present value of the following stream of a firm's cash flows, assuming that the firm's opportunity cost is 14 percent.

A) $131,068
B) $ 19,830
C) $ 14,850
D) $120,820
Answer: A
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

11) During her four years at college, Hayley received the following amounts of money at the end of each year from her grandmother. She deposited her money in a savings account paying 6 percent rate of interest. How much money will Hayley have on graduation day?

Answer: Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
12) You have provided your friend with a service worth $8,500. Your friend offers you the following cash flow instead of paying $8,500 today. Should you accept his offer if your opportunity cost is 8 percent?

Answer:

Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) Calculate the present value of $5,800 received at the end of year 1, $6,400 received at the end of year 2, and $8,700 at the end of year 3, assuming an opportunity cost of 13 percent.
Answer: PV = 5,800(1.13)-1 + 6,400(1.13)-2 + 8,700(1.13)-3 = $16,174.42
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

14) Calculate the present value of $800 received at the beginning of year 1, $400 received at the beginning of year 2, and $700 received at the beginning of year 3, assuming an opportunity cost of 9 percent.
Answer: PV = 800 + 400(1.09) + 700(1.09)2 = $1,756.15
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
15) Calculate the combined future value at the end of year 3 of $1,000 received at the end of year 1, $3,000 received at the end of year 2, and $5,000 received at the end of year 3, all sums deposited at 5 percent.
Answer: FV = 1000(1.05)2 + 3000(1.05) + 5000 = $9,252
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) You are considering the purchase of new equipment for your company and you have narrowed down the possibilities to two models which perform equally well. However, the method of paying for the two models is different. Model A requires $5,000 per year payment for the next five years. Model B requires the following payment schedule. Which model should you buy if your opportunity cost is 8 percent?

Answer: Model A: PV = (CF/i) × [1-1/(1+r)n] = (5,000/.08) × [1-1/(1.08)5] = $19,963.55

Buy Model A.
Diff: 2
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
17) Last Christmas, Danny received an annual bonus of $1,500. These annual bonuses are expected to grow by 5 percent for the next 5 years. How much will Danny have at the end of the fifth year if he invests his Christmas bonuses (including the most recent bonus) in a project paying 8 percent per year?
Answer:

Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) Calculate the present value of the following stream of cash flows, assuming that the firm's opportunity cost is 15 percent.

Answer: PV = (12,000/.15) × [1-1/(1.15)7] + {(14,000/.15) × [1-1/(1.15)3]} × (1.15)-7 = $61,942
Diff: 1
Topic: Mixed Streams
Learning Obj.: LG 4
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5.5 Understand the effect that compounding interest more frequently than annually has on future value and on the effective annual rate of interest.

1) The nominal (stated) annual rate is the rate of interest actually paid or earned.
Answer: FALSE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
2) The nominal and effective rates are equivalent for annual compounding.
Answer: TRUE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) The effective annual rate increases with increasing compounding frequency.
Answer: TRUE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) The annual percentage rate (APR) is the nominal rate of interest, found by multiplying the periodic rate by the number of periods in one year.
Answer: TRUE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) The annual percentage yield (APY) is the effective rate of interest that must be disclosed to customers by banks on their savings products as a result of "truth in savings laws."
Answer: TRUE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) The effective rate of interest is the contractual rate of interest charged by a lender or promised by a borrower.
Answer: FALSE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
7) The effective rate of interest differs from the nominal rate of interest in that it reflects the impact of compounding frequency.
Answer: TRUE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) For any interest rate and for any period of time, the more frequently interest is compounded, the greater the amount of money that has to be invested today in order to accumulate a given future amount.
Answer: FALSE
Diff: 2
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

9) The effective rate of interest and compounding frequency are inversely related.
Answer: FALSE
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

10) The rate of interest agreed upon contractually charged by a lender or promised by a borrower is the ________ interest rate.
A) effective
B) nominal
C) discounted
D) continuous
Answer: B
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
11) The rate of interest actually paid or earned, also called the annual percentage rate (APR), is the ________ interest rate.
A) effective
B) nominal
C) discounted
D) continuous
Answer: A
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

12) The future value of $200 received today and deposited at 8 percent compounded semiannually for three years is ________.
A) $380
B) $158
C) $253
D) $252
Answer: C
Diff: 2
Topic: Future Value
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) The future value of $100 received today and deposited in an account for four years paying semiannual interest of 6 percent is ________.
A) $450
B) $127
C) $889
D) $134
Answer: B
Diff: 2
Topic: Future Value
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
14) The future value of $200 received today and deposited for three years in an account which pays semiannual interest of 8 percent is ________.
A) $253.00
B) $252.00
C) $158.00
D) $134.66
Answer: A
Diff: 2
Topic: Future Value
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) The future value of an annuity of $1,000 each quarter for 10 years, deposited at 12 percent compounded quarterly is ________.
A) $17,549
B) $75,401
C) $93,049
D) $11,200
Answer: B
Diff: 2
Topic: Future Value of an Annuity
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) What is the highest effective rate attainable with a 12 percent nominal rate?
A) 12.00%
B) 12.55%
C) 12.75%
D) 12.95%
Answer: C
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
17) Gina has planned to start her college education four years from now. To pay for her college education, she has decided to save $1,000 a quarter for the next four years in a bank account paying 12 percent interest. How much will she have at the end of the fourth year?
A) $ 1,574
B) $19,116
C) $20,157
D) $16,000
Answer: C
Diff: 2
Topic: Future Value of an Annuity
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) How much would Sophie have in her account at the end of 10 years if she deposit $2,000 into the account today if she earned 8 percent interest and interest is compounded continuously?
A) $4,317
B) $4,134
C) $4,451
D) $4,521
Answer: C
Diff: 1
Topic: Continuous Compounding
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

19) Assume Julian has a choice between two deposit accounts. Account A has an annual percentage rate of 7.55 percent but with interest compounded monthly. Account B has an annual percentage rate of 7.45 percent with interest compounded continuously. Which account provides the highest effective annual return?
A) Account A
B) Account B
C) Both provide the same effective annual return
D) We don't have sufficient information to make a choice
Answer: A
Diff: 2
Topic: Continuous Compounding and Effective Annual Rate
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
20) Calculate the future value of $6,490 received today and deposited for five years in an account which pays interest of 14 percent compounded semiannually.
Answer: FV = 6,490{[(1.14/2)5×2 - 1]/.14/2} = 6,490{[(1.07)10 - 1]/.07} = $12,766
Diff: 1
Topic: Future Value
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

21) Calculate the future value of $10,000 received today and deposited for six years in an account which pays interest of 12 percent compounded quarterly.
Answer: FV = 10,000{[(1.12/4)6×4 - 1]/.12/4} = 10,000{[(1.03)24 - 1]/.03} = $20,328
Diff: 1
Topic: Future Value
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

22) Jeanne has just graduated from high school and has received an award for $5,000. She would like to deposit the money in an interest earning account until she graduates from college (i.e., four years from now). In her search for the highest interest earning account, she has narrowed the list down to the following two accounts: 1) bank A pays 9 percent interest compounded annually, and 2) bank B pays 8 percent interest compounded semiannually. Which is the better offer, and how much will Jeanne have upon graduation from college?
Answer: Bank A: n = 4, r = 9%, m = 1
FV = 5,000{[(1.09)4 - 1]/.09} = $7,057
Bank B: n = 4, r = 8%, m = 2
FV = 5,000{[1.04)8 - 1]/.04} = $6,842
Jeanne should deposit her money in Bank A and she will have $7,057 upon her graduation from college.
Diff: 3
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
23) Assume you have a choice between two deposit accounts. Account X has an annual percentage rate of 12.25 percent but with interest compounded monthly. Account Y has an annual percentage rate of 12.20 percent with interest compounded continuously. Which account provides the highest effective annual return?
Answer: Account X
EAR = [1 + - 1 = 12.96%
Account Y
EAR = - 1 = 12.75%
Choose X
Diff: 2
Topic: Continuous Compounding and Effective Annual Rate
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

24) Nico is the new assistant branch manager of a larger Florida-based bank and the branch manager has asked him a question to test his knowledge. The question he asked is which rate should the bank advertise on monthly-compounded loans, the nominal annual percentage rate or the effective annual percentage rate? Which rate should the bank advertise on quarterly-compounded savings accounts? Explain. As a consumer, which would you prefer to see and why?
Answer: A bank would rather advertise the annual percentage rate on loans since this rate appears to be lower and the effective annual rate. With respect to savings accounts, the bank would advertise the effective rate since this rate will be higher than the annual percentage rate(APR). As a consumer, the effective rate is the more important rate since it represents the rate actually paid or earned.
Diff: 1
Topic: Nominal and Effective Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5.6 Describe the procedures involved in (1) determining deposits needed to accumulate a future sum, (2) loan amortization, (3) finding interest or growth rates, and (4) finding an unknown number of periods.

1) In general, with an amortized loan, the payment amount remains constant over the life of the loan, the principal portion of each payment grows over the life of the loan, and the interest portion of each payment declines over the life of the loan.
Answer: TRUE
Diff: 1
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
2) In general, with an amortized loan, the payment amount remains constant over the life of the loan, the principal portion of each payment declines over the life of the loan, and the interest portion of each payment grows over the life of the loan.
Answer: FALSE
Diff: 1
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) In general, with an amortized loan, the payment amount remains constant over the life of the loan, both the principal portion of and the interest portion declines over the life of the loan.
Answer: FALSE
Diff: 1
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

4) In general, with an amortized loan, the payment amount grows over the life of the loan, the principal portion of each payment grows over the life of the loan, and the interest portion declines over the life of the loan.
Answer: FALSE
Diff: 1
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) When computing an interest or growth rate, the rate will increase with an increase in future value, holding present value and the number of periods constant.
Answer: TRUE
Diff: 1
Topic: Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) When computing an interest or growth rate, the rate will decrease with an increase in future value, holding present value and the number of periods constant.
Answer: FALSE
Diff: 1
Topic: Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
7) When computing an interest or growth rate, the rate will increase with a decrease in future value, holding present value and the number of periods constant.
Answer: FALSE
Diff: 1
Topic: Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

8) When computing the number of deposits needed to accumulate to a future sum, it will take longer if the interest rate decreases, holding the future value and deposit size constant.
Answer: TRUE
Diff: 1
Topic: Deposits Needed to Accumulate a Future Sum
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) When computing the number of deposits needed to accumulate a future sum, it will take longer if the interest rates are higher, holding the future value and deposit size constant.
Answer: FALSE
Diff: 1
Topic: Deposits Needed to Accumulate a Future Sum
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

10) The time value concept/calculation used in amortizing a loan is ________.
A) future value of a dollar
B) future value of an annuity
C) present value of a dollar
D) present value of an annuity
Answer: D
Diff: 1
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
11) If a United States Savings bond can be purchased for $29.50 and has a maturity value of $100 at the end of 25 years, what is the annual rate of return on the bond?
A) 5 percent
B) 6 percent
C) 7 percent
D) 8 percent
Answer: A
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

12) If a United States Savings bond can be purchased for $14.60 and has a maturity value at the end of 25 years of $100, what is the annual rate of return on the bond?
A) 6 percent
B) 7 percent
C) 8 percent
D) 9 percent
Answer: C
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) Janice would like to send her parents on a cruise for their 25th wedding anniversary. She has priced the cruise at $15,000, and she has 5 years to accumulate this money. How much must Janice deposit annually in an account paying 10 percent interest in order to have enough money to send her parents on the cruise?
A) $1,862
B) $2,457
C) $3,000
D) $2,234
Answer: B
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
14) Adam borrows $4,500 at 12 percent annually compounded interest to be repaid in four equal annual installments. The actual end-of-year payment is ________.
A) $ 942
B) $1,125
C) $1,482
D) $2,641
Answer: C
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) Jia borrows $50,000 at 10 percent annually compounded interest to be repaid in four equal annual installments. The actual end-of-year loan payment is ________.
A) $10,774
B) $12,500
C) $14,340
D) $15,773
Answer: D
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) Nico makes annual end-of-year payments of $5,043.71 on a four-year loan with an interest rate of 13 percent. The original principal amount was ________.
A) $24,450
B) $15,000
C) $3,100
D) $20,175
Answer: B
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
17) Hayley makes annual end-of-year payments of $6,260.96 on a five-year loan with an 8 percent interest rate. The original principal amount was ________.
A) $31,000
B) $30,000
C) $25,000
D) $20,000
Answer: C
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) Ashley owns stock in a company which has consistently paid a growing dividend over the last five years. The first year Ashley owned the stock, she received $1.71 per share and in the fifth year, she received $2.89 per share. What is the growth rate of the dividends over the last five years?
A) 7 percent
B) 11 percent
C) 12 percent
D) 5 percent
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

19) Julian was given a gold coin originally purchased for $1 by his great-grandfather 50 years ago. Today the coin is worth $450. The rate of return realized on the sale of this coin is approximately equal to ________.
A) 7.5%
B) 13%
C) 9%
D) 18%
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
20) Alexis owns stock in a company which has consistently paid a growing dividend over the last 10 years. The first year Alexis owned the stock, she received $4.50 per share and in the 10th year, she received $4.92 per share. What is the growth rate of the dividends over the last 10 years?
A) 15 percent
B) 14.8 percent
C) 12.2 percent
D) 9.3 percent
Answer: D
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

21) The rate of return earned on an investment of $50,000 today that guarantees an annuity of $10,489 for six years is approximately ________.
A) 5%
B) 7%
C) 10%
D) 12%
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

22) What is the rate of return on an investment of $16,278 if the company expects to receive $3,000 per year for the next 10 years?
A) 18 percent
B) 13 percent
C) 8 percent
D) 3 percent
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
23) What is the rate of return on an investment of $124,090 if the company expects to receive $10,000 per year for the next 30 years?
A) 7 percent
B) 4 percent
C) 6 percent
D) 5.5 percent
Answer: A
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

24) A local brokerage firm is offering a zero-coupon certificate of deposit for $10,000. At maturity, three years from now, the investor will receive $14,000. What is the rate of return on this investment?
A) 14 percent
B) 13 percent
C) 12 percent
D) 11 percent
Answer: C
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

25) A local bank is offering a zero-coupon certificate of deposit for $25,000. At maturity, three years from now, the investor will receive $32,000. What is the rate of return on this investment?
A) 3 percent
B) 6 percent
C) 9 percent
D) 12 percent
Answer: C
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
26) A ski chalet at Peak n' Peak now costs $250,000. Inflation is expected to cause this price to increase at 5 percent per year over the next 10 years before Chris and Julie retire from successful investment banking careers. How large an equal annual end-of-year deposit must be made into an account paying an annual rate of interest of 13 percent in order to buy the ski chalet upon retirement?
A) $ 8,333
B) $13,572
C) $25,005
D) $22,109
Answer: D
Diff: 2
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

27) A beach house in Southern California now costs $350,000. Inflation is expected to cause this price to increase at 5 percent per year over the next 20 years before Eric and Karinna retire from successful careers in commercial art. How large an equal annual end-of-year deposit must be made into an account paying an annual rate of interest of 13 percent in order to buy the beach house upon retirement?
A) $11,472
B) $4,323
C) $79,977
D) $17,350
Answer: A
Diff: 2
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

28) Xiao Xin is planning to accumulate $40,000 by the end of 5 years by making 5 equal annual deposits. If she plans to make her first deposit today and can earn an annual compound rate of 9 percent on her investment, how much must each deposit be in order to accumulate the $40,000?
A) $ 6,132
B) $ 6,684
C) $23,844
D) $ 9,434
Answer: B
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
29) Zheng Sen wishes to accumulate $1 million by the end of 20 years by making equal annual end-of-year deposits over the next 20 years. If Zheng Sen can earn 10 percent on his investments, how much must he deposit at the end of each year?
A) $ 14,900
B) $ 50,000
C) $117,453
D) $ 17,460
Answer: D
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

30) Xiao Li wishes to accumulate $50,000 by the end of 10 years by making equal annual end-of-year deposits over the next 10 years. If Xiao Li can earn 5 percent on her investments, how much must she deposit at the end of each year?
A) $3,975
B) $6,475
C) $5,000
D) $4,513
Answer: A
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

31) Dorothy borrows $10,000 from the bank. For a four-year loan, the bank requires annual end-of-year payments of $3,223.73. The annual interest rate on the loan is ________.
A) 9 percent
B) 10 percent
C) 11 percent
D) 12 percent
Answer: C
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
32) Detta borrows $20,000 from the bank. For a five-year loan, the bank requires annual end-of-year payments of $4,878.05. The annual interest rate on the loan is ________.
A) 6 percent
B) 7 percent
C) 8 percent
D) 9 percent
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

33) Thelma is planning for her son's college education to begin five years from today. She estimates the yearly tuition, books, and living expenses to be $5,000 per year for a four-year degree, assuming th expenses incur only at the end of the year. How much must Thelma deposit today, at an interest rate of 8 percent, for her son to be able to withdraw $5,000 per year for four years of college?
A) $20,000
B) $13,620
C) $39,520
D) $11,270
Answer: D
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

34) Otto is planning for his son's college education to begin ten years from today. He estimates the end-of-the-year tuition, books, and living expenses to be $10,000 per year for a four-year degree. How much must Otto deposit today, at an interest rate of 12 percent, for his son to be able to withdraw $10,000 per year for four years of college?
A) $12,880
B) $ 9,780
C) $40,000
D) $18,950
Answer: B
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
35) Aunt Tilly borrows $3,500 from the bank at 12 percent annually compounded interest to be repaid in four equal annual installments. The interest paid in the first year is ________.
A) $ 152
B) $ 277
C) $ 420
D) $1,152
Answer: C
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

36) Danny Joe borrows $10,500 from the bank at 11 percent annually compounded interest to be repaid in six equal annual installments. The interest paid in the first year is ________.
A) $1,155
B) $2,481
C) $ 144
D) $1,327
Answer: A
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

37) Rita borrows $4,500 from the bank at 9 percent annually compounded interest to be repaid in three equal annual installments. The interest paid in the third year is ________.
A) $277.95
B) $405.00
C) $352.00
D) $147.00
Answer: D
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
38) Aunt Butch borrows $19,500 from the bank at 8 percent annually compounded interest to be repaid in 10 equal annual installments. The interest paid in the third year is ________.
A) $1,336.00
B) $1,560.14
C) $2,906.11
D) $1,947.10
Answer: A
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

39) Entertainer's Aid plans five annual colossal concerts, each in a different nation's capital. The concerts will raise funds for an endowment which would provide the World Wide Hunger Fund with $3,000,000 per year into perpetuity. The endowment will be given at the end of the fifth year. The rate of interest is expected to be 9 percent in all future periods. How much must Entertainer's Aid deposit each year to accumulate to the required amount?
A) $5,569,749
B) $3,333,333
C) $1,830,275
D) $8,568,980
Answer: A
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

40) A wealthy art collector has decided to endow her favorite art museum by establishing funds for an endowment which would provide the museum with $1,000,000 per year for acquisitions into perpetuity. The art collector will give the endowment upon her fiftieth birthday 10 years from today. She plans to accumulate the endowment by making annual end-of-year deposits into an account. The rate of interest is expected to be 6 percent in all future periods. How much must the art collector deposit each year to accumulate to the required amount?
A) $1,575,333
B) $ 736,000
C) $1,264,466
D) $ 943,396
Answer: C
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills
41) How long would it take for you to save an adequate amount for retirement if you deposit $40,000 per year into an account beginning today that pays 12 percent per year if you wish to have a total of $1,000,000 at retirement?
A) 12.2 years
B) 10.5 years
C) 14.8 years
D) 11.5 years
Answer: D
Diff: 2
Topic: Finding an Unknown Number of Periods
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

42) How many years would it take for Jughead to save an adequate amount for retirement if he deposits $2,000 per month into an account beginning today that pays 12 percent per year if he wishes to have a total of $1,000,000 at retirement?
A) 13 years
B) 16 years
C) 15 years
D) 12 years
Answer: C
Diff: 1
Topic: Finding an Unknown Number of Periods
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

43) How long would it take for Nico to save an adequate amount for retirement if he deposits $40,000 per year into an account beginning one year from today that pays 12 percent per year if he wishes to have a total of $1,000,000 at retirement?
A) 12.2 years
B) 15.7 years
C) 14.5 years
D) 16.5 years
Answer: A
Diff: 1
Topic: Finding an Unknown Number of Periods
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
44) What annual rate of return would Jia need to earn if she deposits $20,000 per year into an account beginning one year from today in order to have a total of $1,000,000 in 30 years?
A) 2.3%
B) 3.3%
C) 1.3%
D) 4.3%
Answer: B
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

45) What annual rate of return would Grandma Zoe need to earn if she deposits $1,000 per month into an account beginning one month from today in order to have a total of $1,000,000 in 30 years?
A) 4.55%
B) 5.28%
C) 5.98%
D) 6.23%
Answer: C
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

46) What effective annual rate of return (EAR) would Rayne need to earn if she deposits $1,000 per month into an account beginning one month from today in order to have a total of $1,000,000 in 30 years?
A) 5.98%
B) 6.55%
C) 4.87%
D) 6.14%
Answer: D
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

47) Janice borrows $25,000 from the bank at 15 percent to be repaid in 10 equal annual installments. Calculate the end-of-year payment.
Answer: Use financial calculator: PV = 25,000, I = 15, FV = 0, N = 10, CPT PMT: $4,981.30
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
48) The following table presents the Sally's Silly Service Company's net earnings for the past six years. Compute the growth rate in the company's earnings.

Answer: g = (FV/PV)1/n - 1, n = 5, FV = 2659, PV = 1728 g = (2659/1728)1/5 - 1 = .09 = 9%
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

49) Marc has purchased a new car for $15,000. He paid $2,500 as down payment and he paid the balance by a loan from his hometown bank. The loan is to be paid on a monthly basis for two years charging 12 percent interest. How much are the monthly payments?
Answer: PV = 15,000 - 2,500 = $12,500, r = 12%, n = 2, m = 12
Use financial calculator: PV = 12500, I = 1, n = 24, FV = 0, CPT PMT: $588.42
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

50) You have been given the opportunity to earn $20,000 five years from now if you invest $9,524 today. What will be the rate of return to your investment?
Answer: Use financial calculator: PV = -9524, FV = 20000, PMT = 0, N = 5, CPT I: 16%
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
51) Ten years ago, Tom purchased a painting for $300. The painting is now worth $1,020. Tom could have deposited $300 in a savings account paying 12 percent interest compounded annually. Which of these two options would have provided Tom with a higher return?
Answer: Using financial calculator: PV = - $300, FV = $1,020, n = 10, PMT = 0, CPT I: 13%
Painting has a higher return (13 percent) in comparison to the 12 percent rate of return from the savings account.
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

52) Find the equal annual end-of-year payment on $50,000, 15 year, and 10 percent loan.
Answer: Using financial calculator: PV = 50,000, FV = 0, N = 15, I = 10, CMP PMT: $6,573.69
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

53) A firm wishes to establish a fund which, in 10 years, will accumulate to $10,000,000. The fund will be used to repay an outstanding bond issue. The firm plans to make deposits, which will earn 12 percent, to this fund at the end of each of the 10 years prior to maturity of the bond. How large must these deposits be to accumulate to $10,000,000?
Answer: Financial Calculator: PV = 0, FV = 10000000, N = 10, I = 12, CPT PMT: $569,833.04
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

54) John borrowed $12,000 to buy a new car and expects to pay $564.87 per month for the next 2 years to pay off the loan. What is the loan's rate of interest?
Answer: Using Financial Calculator: PV = 12000, FV = 0, N = 24, PMT = -564.87, CPT I: 0.9998 × 12 = 12%
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
55) The New York Soccer Association would like to accumulate $10,000 by the end of 4 years from now to finance a big soccer weekend for its members. The Association currently has $2,500 and wishes to raise the balance by arranging annual fund-raising events. How much money should they raise at each annual fund-raising event assuming 8 percent rate of interest?
Answer: Using Financial Calculator: PV = -2500, FV = 10000, N = 4, I = 8, CPT PMT: 1464.41
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

56) Ms. Day needs $20,000 to buy her dream car. In her search for the best (low cost) loan, she has gathered the following information from three local banks. Which bank would you recommend Ms. Day borrow from?

Answer: A: Using financial calculator: PV = 20000, PMT = -8326.40, N = 3, FV = 0, CPT I = 12%
B: Using financial calculator: PV = 20000, PMT = -6309.15, N = 4, FV = 0, CPT I = 10%
C: Using financial calculator: PV = 20000, PMT = -5411.25, N = 5, FV = 0, CPT I = 11%
Ms. Day should borrow from Bank B. Bank B has the lowest rate.
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

57) A deep-discount bond can be purchased for $312 and in 20 years it will be worth $1,000. What is the rate of interest on the bond?
Answer: Using financial calculator: PV = -312, PMT = 0, N = 20, FV = 1000, CPT I = 6 percent
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

58) Timothy borrows $6,930 from the bank. For a four-year loan, the bank requires annual end-of-year payments of $2,281.86. Calculate the interest rate on the loan.
Answer: Using financial calculator: PV = 6930, PMT = -2281.86, N = 4, FV = 0, CPT I = 12%
Diff: 1
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
59) Tom is evaluating the growth rate in dividends of a company over the past 6 years. What is the annual compound growth rate if the dividends are as follows:

Answer: ($2.15/$1.38)1/5 - 1 = .0927 = 9.27%
Approximately 9 percent.
Diff: 2
Topic: Finding Interest or Growth Rates
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

60) To expand its operation, the International Tools Inc. (ITI) has applied for a $3,500,000 loan from the International Bank. According to ITI's financial manager, the company can only afford a maximum yearly loan payment of $1,000,000. The bank has offered ITI, 1) a 3-year loan with a 10 percent interest rate, 2) a 4-year loan with a 11 percent interest rate, or 3) a 5-year loan with a 12 percent interest rate.
(a) Compute the loan payment under each option.
(b) Which option should the company choose?
Answer:
(a)
1) Using financial calculator: PV = 3500000, N = 3, FV = 0, I = 10, CPT PMT = 1,407,402
2) Using financial calculator: PV = 3500000, N = 4, FV = 0, I = 11, CPT PMT = $1,128,304.32
3) Using financial calculator: PV = 3500000, N = 5, FV = 0, I = 12, CPT PMT = $ 970,873.79
(b) The company should choose option #3.
Diff: 1
Topic: Present Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
61) To buy his favorite car, Larry is planning to accumulate money by investing his Christmas bonuses for the next five years in a security which pays a 10 percent annual rate of return. The car will cost $20,000 at the end of the fifth year and Larry's Christmas bonus is $3,000 a year. Will Larry accumulate enough money to buy the car?
Answer: Using financial calculator: PV = 0, N = 5, PMT = 3000, I = 10, CPT FV = $18,315
Larry will not have enough money to buy the car. He should either invest more money or deposit his christmas bonuses in a security paying a higher rate of return.
Diff: 1
Topic: Future Value of an Annuity
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

62) Mr. & Mrs. Pribel wish to purchase a boat in 8 years when they retire. They are planning to purchase the boat using proceeds from the sale of their property which is currently worth $90,000 and its value is growing at 7 percent a year. The boat is currently worth $200,000 increasing at 5 percent per year. In addition to the value of their property, how much additional money should they deposit at the end of each year in an account paying 9 percent annual interest in order to be able to buy the boat upon retirement?
Answer: Value of the property upon retirement:
PV = $90,000, I = 7, N = 8, PMT = 0
CPT FV = $154,637
Value of the boat upon retirement:
PV = $200,000, I = 5, N = 8, PMT = 0
CPT FV = $295,491
Additional money needed upon retirement:
$295,491 - $154,637 = $140854
Amount of money needed to deposit at the end of each year:
PV = 0, FV = $140,780, N = 8, I = 9%, PMT = ?
PMT = $12,765.69
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills

63) Herbert has opened a retirement fund account which pays 7 percent interest and requires $5,000 annual deposits. Herbert will retire in 15 years and expects 10 years of retirement life. What is the maximum annual retirement benefit Herbert can get during his retirement years?
Answer: I = 7%, PMT = $5,000, N = 15, PV = 0
At the beginning of retirement:
CPT FV = $125,645
Annual retirement benefit: i = 7%, n = 10, PV = $125,645, FV = 0
CPT PMT = $17,887.96
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
64) Brian borrows $5,000 from a bank at 8 percent annually compounded interest to be repaid in five annual installments. Calculate the principal paid in the third year.
Answer: PV = 5000, I = 8, N = 3, FV = 0, CPT PMT = $1,252.19

The principal paid in the third year is $993.99.
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

65) Nancy would like to accumulate $10,000 by the end of 3 years from now to buy a sports car from her friend, Jim. She has $2,500 now and would like to save equal annual end-of-year deposits to pay for the car. How much should she deposit at the end of each year in an account paying 8 percent interest to buy the car?
Answer: Using financial calculator: PV = -2500, N = 3, I = 8, FV = 10000, CPT PMT = 2110.25
Diff: 3
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

66) To expand its operation, International Tools Inc. has applied to the International Bank for a 3-year, $3,500,000 loan. Prepare a loan amortization table assuming 10 percent rate of interest.
Answer: PV = 3500000, I = 10, N = 3, FV = 0, CPT PMT = $1,407,401.81

Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Revised
AACSB Tag: Analytic Skills
67) Ken borrows $15,000 from a bank at 10 percent annually compounded interest to be repaid in six equal installments. Calculate the interest paid in the second year.
Answer: PPV = 15000, I = 10, N = 2, FV = 0, CPT PMT = $3,444.32

The interest paid in the second year is $1,305.57.
Diff: 3
Topic: Loan Amortization
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills

68) Suzy wants to buy a house but does not want to get a loan. The average price of her dream house is $500,000 and its price is growing at 5 percent per year. How much should Suzy invest in a project at the end of each year for the next 5 years in order to accumulate enough money to buy her dream house with cash at the end of the fifth year? Assume the project pays 12 percent rate of return.
Answer: FV = 500,000(1.05)5 = $638,141
PV = 0, I = 12, N = 5, FV = 638,141, CPT PMT = $100,450
Diff: 2
Topic: Complex Time Value Problems
Learning Obj.: LG 6
Learning Outcome: F-03
Question Status: Previous Edition
AACSB Tag: Analytic Skills
Principles of Managerial Finance, 14e (Gitman/Zutter)
Chapter 6 Interest Rates and Bond Valuation

6.1 Describe interest rate fundamentals, the term structure of interest rates, and risk premiums.

1) An interest rate or a required rate of return represents the cost of money.
Answer: TRUE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

2) Longer the maturity of a Treasury security, the smaller the interest rate risk.
Answer: FALSE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) A real rate of interest is the compensation paid by the borrower of funds to the lender.
Answer: FALSE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

4) A nominal rate of interest is equal to the sum of the real rate of interest plus the risk free rate of interest.
Answer: FALSE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

5) Risk-free rate of interest is equal to the sum of the real rate of interest plus an inflation premium.
Answer: TRUE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills
6) Nominal rate of interest is equal to the sum of the real rate of interest plus an inflation premium plus a risk premium.
Answer: TRUE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

7) The nominal rate of interest on a bond is 7% and an inflation premium of 3%. This results in a real rate of interest of 4% on the bond.
Answer: FALSE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

8) In theory, the rate of return on U.S. Treasury bills should always exceed the rate of inflation as measured by the consumer price index.
Answer: TRUE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) The nominal rate of interest is the actual rate of interest charged by the supplier of funds and paid by demander.
Answer: TRUE
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 5
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

10) The term structure of interest rates is a graphical presentation of the relationship between the maturity and rate of return.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills
11) An inverted yield curve is a downward-sloping yield curve that indicates that short-term interest rates are generally higher than long-term interest rates.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

12) A yield curve that reflects relatively similar borrowing costs for both short- and long-term loans is called a normal yield curve.
Answer: FALSE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) Upward-sloping yield curves result from higher future inflation expectations, lender preferences for shorter maturity loans, and greater supply of short-term as opposed to long-term loans relative to their respective demand.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

14) A flat yield curve means that the rates do not vary much at different maturities.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

15) A normal yield curve is upward-sloping and indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills
16) A flat yield curve indicates generally cheaper long-term borrowing costs than short-term borrowing costs.
Answer: FALSE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

17) The market segmentation theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) The liquidity preference theory suggests that the shape of the yield curve is determined by the supply and demand for funds within each maturity segment.
Answer: FALSE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

19) The liquidity preference theory suggests that short-term interest rates should be lower than long-term interest rates.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

20) The expectations theory suggests that the shape of the yield curve reflects investors expectations about future interest rates.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills
21) A downward-sloping yield curve indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
Answer: FALSE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

22) An inverted yield curve is an upward-sloping yield curve that indicates generally cheaper short-term borrowing costs than long-term borrowing costs.
Answer: FALSE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

23) The liquidity preference theory suggests that for any given issuer, long-term interest rates tend to be higher than short-term rates due to the lower liquidity and higher responsiveness to general interest rate movements of longer-term securities; this causes the yield curve to be upward-sloping.
Answer: TRUE
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 5
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

24) The components of risk premium includes business risk, financial risk, interest rate risk, liquidity risk, and tax risk.
Answer: TRUE
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

25) The reason for a difference in the yield between a Aaa corporate bond and an otherwise identical Baa bond is the risk premium; other things being equal.
Answer: TRUE
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills
26) The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called maturity risk.
Answer: FALSE
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

27) The possibility that the issuer of a bond will not pay the contractual interest or principal payments as scheduled is called default risk.
Answer: TRUE
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

28) ________ rate of interest creates equilibrium between the supply of savings and the demand for investment funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
Answer: B
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

29) Generally, an increase in risk will result in ________.
A) a lower required return or interest rate
B) a higher required return or interest rate
C) a higher return on investment
D) a lower return on investment
Answer: B
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills
30) Nominal rate of interest is equal to ________.
A) the real rate plus an inflationary expectation
B) the real rate plus a risk premium
C) the risk-free rate plus an inflationary expectation
D) the risk-free rate plus a risk premium
Answer: D
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

31) The ________ rate is typically the nominal rate of interest on a three-month U.S. Treasury bill.
A) expected
B) real
C) risk-free
D) premium
Answer: C
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

32) Nico Nelson, a management trainee at a large New York-based bank, is trying to estimate the real rate of return expected by investors. He notes that the 3-month T-bill currently yields 3 percent and has decided to use the consumer price index as a proxy for expected inflation. What is the estimated real rate of interest if the CPI is currently 2 percent?
A) 5%
B) 1%
C) 3%
D) 2%
Answer: B
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills
33) The inflation risk premium on a bond is 2 percent, the U.S. T-bill rate is 5 percent, the maturity risk premium on the bond is 3 percent, the default risk premium on the bond is 2 percent, and the liquidity risk premium on the bond is 1 percent. Calculate its nominal rate of return.
A) 16%
B) 13%
C) 11%
D) 9%
Answer: B
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

34) Nico invested an amount a year ago and calculated his return on investment. He found that his purchasing power had increased by 15 percent as a result of his investment. If inflation during the year was 4 percent, then Nico's ________.
A) real return on investment is more than 15 percent
B) nominal return on investment is more than 15 percent
C) nominal return on investment is less than 11 percent
D) real return on investment is equal to 4 percent
Answer: B
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

35) ________ rate of interest is the actual rate charged by the supplier and paid by the demander of funds.
A) Nominal
B) Real
C) Risk-free
D) Inflationary
Answer: A
Diff: 1
Topic: Interest Rate Fundamentals
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills
36) The ________ is the compound annual rate of interest earned on a debt security purchased on a given date and held to maturity.
A) risk premium
B) yield curve
C) risk-free rate
D) yield to maturity
Answer: D
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

37) A(n) ________ is a graphic depiction between the maturity and rate of return for bonds with similar risks.
A) yield curve
B) supply function
C) risk-return profile
D) aggregate demand curve
Answer: A
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

38) A(n) ________ yield curve reflects higher expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
Answer: A
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

39) A(n) ________ yield curve reflects lower expected future rates of interest.
A) upward-sloping
B) flat
C) downward-sloping
D) linear
Answer: C
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills
40) The term structure of interest rates is the relationship between ________.
A) the present value of principal and coupon rate of the bonds
B) the general expectation of inflation and nominal rate of return for bonds
C) the general expectation of inflation and real rate of return for bonds
D) the maturity and rate of return for bonds with similar level of risk
Answer: D
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

41) A downward-sloping yield curve that indicates generally cheaper long-term borrowing costs than short-term borrowing costs is called ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) linear yield curve
Answer: B
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

42) An upward-sloping yield curve that indicates cheaper short-term borrowing costs than long-term borrowing costs is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal yield curve
Answer: A
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

43) A yield curve that reflects relatively similar borrowing costs for both short-term and long-term loans is called as ________.
A) normal yield curve
B) inverted yield curve
C) flat yield curve
D) lognormal curve
Answer: C
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills
44) The theory suggesting that for any given issuer, long-term interest rates tends to be higher than short-term rates is called ________.
A) expectation hypothesis
B) liquidity preference theory
C) market segmentation theory
D) interest parity theory
Answer: B
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

45) The yield curve in an economic period where higher future inflation is expected would be ________.
A) upward-sloping
B) flat
C) downward-sloping
D) lognormal
Answer: A
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

46) The yield curve in an economic period where lower future inflation is expected would be ________.
A) upward-sloping
B) flat
C) downward-sloping
D) exponential
Answer: C
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

47) Which of the following explains the general shape of the yield curve of a bond?
A) Expectations theory
B) Perfect market theory
C) Capital asset pricing theory
D) Securities market theory
Answer: A
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills
48) Assume the following returns and yields: U.S. T-bill = 8%, 5-year U.S. T-note = 7%, IBM common stock = 15%, IBM AAA Corporate Bond = 12% and 10-year U.S. T-bond = 6%. Based on this information, the shape of the yield curve is ________.
A) upward sloping
B) downward sloping
C) flat
D) normal
Answer: B
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

49) ________ mainly explains the tendency for the yield curve to be upward sloping.
A) Expectations theory
B) Liquidity preference theory
C) Market segmentation theory
D) Investor perception theory
Answer: B
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

50) Which of the following affects the slope of yield curve?
A) tax rates
B) dividend policy
C) selection of accounting standards
D) liquidity preferences
Answer: D
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills
51) Which of the following is true of risk premium?
A) T-bills have a have a higher risk premium than that of Treasury bonds.
B) The government bonds have a higher risk premium than that of corporate bonds.
C) The speculative corporate issues have a lower risk premium than that of the higher rated corporate issues.
D) The lower-rated corporate issues have a higher risk premium than that of the higher rated corporate issues.
Answer: D
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: New
AACSB Tag: Reflective Thinking Skills

52) Draw a graph of a typical Treasury yield curve and discuss why it usually takes that shape.
Answer: The student should draw a normal, upward-sloping yield curve as shown in the text. Factors impacting the shape of the yield curve are the risk free rate, the inflation premium, and the interest rate risk premium.
Diff: 1
Topic: Term Structure of Interest Rates
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

53) Explain liquidity, default risk, and maturity risk premiums.
Answer: Liquidity problems exist in thinly traded bonds, default risk is the likelihood the corporation will default on its bond obligations, and the maturity risk reflects the fact that longer-term bonds possess greater interest rate risk and sensitivity than shorter term bonds. If any of these exists, investors will demand compensation for the risk by demanding a yield premium to own the bonds.
Diff: 1
Topic: Risk Premiums
Learning Obj.: LG 1
Learning Outcome: F-05
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6.2 Review the legal aspects of bond financing and bond cost.

1) Coupon interest rate on a bond represents the percentage of the bond's par value that will be paid annually, typically in two equal semiannual payments, as interest.
Answer: TRUE
Diff: 1
Topic: Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
2) Restrictive covenants are contractual clauses in long-term debt agreements that place certain operating and financial constraints on the borrower.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) Standard debt provisions specify certain record keeping and general business practices that must be ensured by the bond issuer.
Answer: FALSE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

4) A trustee is a paid party representing the bond issuer in the bond indenture.
Answer: FALSE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) Restrictive covenants, coupled with standard debt provisions, help the lender to monitor the borrower's activities to ensure efficient use of funds.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

6) The restrictive debt covenant that imposes fixed assets is to guarantee fixed-payment obligations by maintaining a specified level of fixed assets.
Answer: FALSE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
7) In a bond indenture, subordination is the stipulation that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) The bond indenture identifies any collateral pledged against a bond and specifies how it is to be maintained.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

9) To carry out systematic retirement of bonds, a corporation makes semiannual or annual payments that are used to retire bonds by purchasing them in the marketplace.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

10) Subordination means that subsequent creditors agree to wait until all claims of the senior debt are satisfied.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

11) Restrictive covenants place operating and financial constraints on the borrower.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
12) In a bond indenture, the term "security interest" refers to the fact that most firms that issue bonds are required to establish sinking fund provisions to protect bondholders.
Answer: FALSE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) In a bond indenture, the term "security interest" refers to collateral pledged against the bond.
Answer: TRUE
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

14) Longer the maturity, higher is the cost of a bond.
Answer: TRUE
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

15) The lower a bond's default risk, the higher is the interest rate.
Answer: FALSE
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

16) The legal contract setting forth the terms and provisions of a corporate bond is a(n) ________.
A) indenture
B) debenture
C) loan document
D) promissory note
Answer: A
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
17) A debt instrument indicating that a corporation has borrowed a certain amount of money and promises to repay it in the future under clearly defined terms is called a(n) ________.
A) common stock
B) corporate bond
C) indenture
D) preferred stock
Answer: B
Diff: 1
Topic: Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

18) A(n) ________ is a paid individual, corporation, or a commercial bank trust department that acts as a third party to a bond indenture.
A) trustee
B) investment banker
C) bond issuer
D) bond rating agency
Answer: A
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

19) A ________ is a restrictive provision in a bond indenture, providing for the systematic retirement of the bonds prior to their maturity.
A) redemption clause
B) sinking-fund requirement
C) conversion feature
D) subordination clause
Answer: B
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
20) Bond indentures include restrictive covenants.These provisions protect the bondholders against ________.
A) increase in inflation rate
B) increase in borrower's risk
C) decrease in liquidity risk
D) maturity risk
Answer: B
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

21) Which of the following is a restrictive covenant?
A) to maintain satisfactory accounting records
B) to pay the taxes due
C) to supply audited financial statements
D) to impose fixed asset restrictions
Answer: D
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

22) The purpose of the debt covenant that requires maintaining a minimum level of net working capital is to ________.
A) protect the lender by controlling the risk and marketability of the borrower's security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm
Answer: C
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
23) The purpose of the debt covenant that prohibits borrowers from entering into certain types of leases is to ________.
A) protect the lender by controlling the risk and marketability of the borrower's security investments alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) limit the annual cash dividends paid by the firm
Answer: B
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

24) The purpose of the restrictive debt covenant that imposes fixed assets restrictions is to ________.
A) protect the lender by controlling the risk and marketability of the borrower's security investment alternatives
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) prevent the firm from liquidation and ensure its ability to repay the debt
Answer: D
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

25) The purpose of the restrictive debt covenant that prohibits the sale of accounts receivable is to ________.
A) assure the lender that additional borrowing is constrained
B) limit the amount of fixed-payment obligations
C) limit the realization of current assets to cash
D) limit the payment of annual cash dividends
Answer: C
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
26) The purpose of the restrictive debt covenant that requires that subsequent borrowing be subordinated to the original loan is to ________.
A) maintain a minimum level of liquidity
B) limit the amount of fixed-payment obligations
C) ensure a long-run cash shortage does not cause an inability to meet current obligations
D) protect the original lender in the priority of claims during liquidation
Answer: D
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

27) ________ means that subsequent creditors agree to wait until all claims of the are senior debt satisfied before having their claims satisfied.
A) Security interest
B) Subordination
C) Sinking fund requirement
D) Bond indenture
Answer: B
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

28) The purpose of the restrictive debt covenant that limits the distribution of profits to shareholders is to ________.
A) assure the lender that additional borrowing is constrained or may be subordinated to the original loan
B) limit the amount of fixed-payment obligations
C) ensure a cash shortage does not cause an inability to meet current obligations
D) avoid default of payments to bondholders
Answer: D
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
29) An example of a standard debt provision is to ________.
A) limit the corporation's annual cash dividend payments
B) pay taxes and other liabilities when due
C) restrict the corporation from disposing of fixed assets
D) maintain a minimum level of liquidity
Answer: B
Diff: 1
Topic: Legal Aspects of Corporate Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

30) The cost of a long-term debt generally ________ that of a short-term debt.
A) is less than
B) is equal to
C) is greater than
D) is less than or equal to
Answer: C
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

31) Which of the following affects the cost of a bond?
A) maturity of a bond
B) dividend policy
C) fixed assets purchased from the proceeds of bond issue
D) money market regulations
Answer: A
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

32) To compensate for the uncertainty of future interest rates and the fact that the longer the term of a loan the higher the probability that the borrower will default, the lender typically ________.
A) charges a higher interest rate on long-term loans
B) reserves the right to change the terms of the loan at any time
C) includes excessively restrictive debt provisions
D) reserves the right to demand immediate payment at any time
Answer: A
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
33) The size of a loan and its issuance costs (as a percentage of the amount borrowed) are ________.
A) not related
B) inversely related
C) independent
D) perfectly positively correlated
Answer: B
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

34) The ________ in the capital market is the basis for determining a bond's coupon interest rate.
A) cost of money
B) weighted average cost of capital
C) bond's face value
D) average coupon interest rate
Answer: A
Diff: 1
Topic: Cost of Bonds to the Issuer
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

6.3 Discuss the general features, yields, prices, ratings, popular types, and international issues of corporate bonds.

1) A call premium is the amount by which the call price exceeds the market price of the bond.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) Stock purchase warrants are instruments that give their holder the right to purchase a certain number of shares of the firm's common stock at the market price over a certain period of time.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Revised
AACSB Tag: Analytic Skills
3) A call feature is a feature included in all corporate bonds and allows the issuer to repurchase bonds at the market price prior to maturity.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) Bondholders will convert their convertible bonds into shares of stock only when the conversion price is greater than the market price of the stock.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) To sell a callable bond, the issuer must pay a higher interest rate than on an otherwise equivalent noncallable bond.
Answer: TRUE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) The conversion feature of a bond is a feature that is included in all corporate bond issues that gives the issuer the opportunity to repurchase bonds at a stated price prior to maturity.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) A call feature in a bond allows bondholders to change each bond into a stated number of shares of common stock.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
8) A conversion feature in a bond allows bondholders to change each bond into a stated number of shares of common stock.
Answer: TRUE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) The call option in a bond has a greater chance of being exercised (to the detriment of the bondholder) if market interest rates have fallen since the bond was issued.
Answer: TRUE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

10) A call feature in a bond allows the issuer the opportunity to repurchase bonds at a stated price prior to maturity, and this option has a greater chance of being exercised (to the benefit of the bondholder) if market interest rates have fallen since the bond was issued.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) A conversion feature in a bond has a greater chance of being exercised (to the detriment of the bondholder) if market interest rates have risen since the bond was issued.
Answer: FALSE
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

12) IBM stock will experience greater trading activity (in terms of the number of shares traded on a given day) compared to IBM bonds.
Answer: TRUE
Diff: 1
Topic: Bond Prices
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
13) A company's bonds will experience more trading activity (in terms of the number of bonds traded on a given day) compared to its stock.
Answer: FALSE
Diff: 1
Topic: Bond Prices
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

14) High-quality (high-rated) bonds provide lower returns than lower-quality (low-rated) bonds.
Answer: TRUE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) There is an inverse relationship between the quality or rating of a bond and the rate of return it must provide bondholders.
Answer: TRUE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

16) Any bond rated Aaa through Caa according to Moody's, would be considered investment grade debt.
Answer: FALSE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

17) An A rated bond should provide investors with a higher yield than an otherwise identical B rated bond.
Answer: FALSE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
18) Any Ba rated bond or lower would be considered speculative or "junk."
Answer: TRUE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

19) As a bond approaches maturity, the price of the bond will approach its par value until, the bond is worth its face value at maturity.
Answer: TRUE
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills

20) Debentures such as convertible bonds are unsecured bonds that only the most creditworthy firms can issue.
Answer: TRUE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Revised
AACSB Tag: Analytic Skills

21) Putable bonds give the bondholders an option to sell the bond at a price higher than par value by the amount of one year interest payment when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt.
Answer: FALSE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

22) Since a putable bond gives its holder the right to "put the bond" at specified times or because of specified actions by the issuing firm, the bond's yield would be lower than that of an otherwise equivalent non-putable bond.
Answer: TRUE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
23) With subordinated debentures, payment of interest by a firm is required only when earnings are available.
Answer: FALSE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

24) Since the issuer of zero (or low) coupon bonds can annually deduct the current year's interest accrual without having to actually pay the interest until the bond matures (or is called), its cash flow each year is increased by the amount of the tax shield provided by the interest deduction.
Answer: TRUE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

25) The market price of a callable bond will not generally exceed its call price, except in the case of a convertible bond.
Answer: TRUE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

26) Floating-rate bonds are bonds that can be redeemed at par at the option of their holder either at specific date after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt.
Answer: FALSE
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

27) A bond issued by an American company that is denominated in Swiss Francs and sold in Switzerland would be an example of a foreign bond.
Answer: TRUE
Diff: 1
Topic: International Bond Issues
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
28) A foreign bond is a bond issued by a foreign corporation or government and is denominated in the investor's home currency and sold in the investor's home market.
Answer: TRUE
Diff: 1
Topic: International Bond Issues
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

29) A Eurobond is a bond issued by an international borrower and sold to investors in countries with currencies other than the country in which the bond is denominated.
Answer: TRUE
Diff: 1
Topic: International Bond Issues
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

30) A Eurobond bond is a bond denominated in Euros.
Answer: FALSE
Diff: 1
Topic: International Bond Issues
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

31) The ________ feature permits the issuer to repurchase bonds at a stated price prior to maturity.
A) call
B) conversion
C) put
D) swap
Answer: A
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
32) The ________ feature allows bondholders to change each bond into stated number of shares of stock.
A) call
B) conversion
C) put
D) swap
Answer: B
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Previous Edition
AACSB Tag: Analytic Skills

33) ________ allow bondholders to purchase a certain number of shares of the firm's common stock at a specified price over a certain period of time.
A) Call options
B) Stock purchase warrants
C) Debentures
D) Put options
Answer: B
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

34) A ________ give bondholders the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time.
A) stock purchase warrant
B) call feature
C) swap
D) conversion feature
Answer: A
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
35) Stock purchase warrants are instruments that give their holders ________.
A) the obligation to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time
B) the right to purchase a certain number of shares of the issuer's common stock at a specified price over a certain period of time
C) the obligation to sell a certain number of shares of the issuer's preferred stock at a specified price over a certain period of time
D) the right to sell a certain number of shares of the issuer's preferred stock at a specified price over a certain period of time
Answer: B
Diff: 1
Topic: General Features of a Bond Issue
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

36) A $1,000, 8% bond sells for 980. $1,000 is called the ________.
A) current value
B) market value
C) par value
D) auction value
Answer: C
Diff: 1
Topic: Bond Yields
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

37) The current yield on a bond is measured by ________.
A) the annual interest payment divided by the current price
B) the annual interest payment divided by the par value
C) the annual interest payment divided by the maturity value
D) the annual interest payment divided by the yield to maturity
Answer: A
Diff: 1
Topic: Bond Yields
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
38) A bond rated Aaa according to Moody's, is considered ________.
A) a high grade bond
B) a prime quality bond
C) an upper medium grade bond
D) a medium grade bond
Answer: B
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

39) The riskiness of publicly traded bond issues is rated by independent agencies. According to Moody's rating system, an Aaa bond and a Caa bond are ________ and ________ respectively.
A) speculative; investment grade
B) prime quality; medium grade
C) prime quality; speculative
D) medium grade; lowest grade
Answer: C
Diff: 1
Topic: Bond Ratings
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

40) A(n) ________ gives purchasers inflation protection.
A) zero-coupon bond
B) junk bond
C) floating rate bond
D) income bond
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

41) ________ is used to finance "rolling stock"—airplanes,trucks,boats,railroad cars.
A) Income bonds
B) Equipment trust certificates
C) Collateral trust bonds
D) Subordinated debentures
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
42) Deeply discounted bond that pays no coupon interest is a ________.
A) junk bond
B) floating rate bond
C) zero coupon bond
D) subordinated debenture
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

43) Stated interest rate under ________ is adjusted periodically within stated limits in response to changes in specified money market or capital market rates.
A) junk bonds
B) floating rate bonds
C) extendible notes
D) putable bonds
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

44) ________ are popular vehicle used to finance mergers and takeovers.
A) Income bonds
B) Junk bonds
C) Floating rate bonds
D) Convertible debentures
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

45) A(n) ________ is secured by real estate.
A) income bond
B) debenture
C) mortgage bond
D) subordinated debenture
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
46) A(n) ________ is issued with no or very low coupon and sells significantly below its par value.
A) income bond
B) zero or low coupon bond
C) mortgage bond
D) subordinated debenture
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

47) On ________, the stated interest rate is adjusted periodically within stated limits in response to changes in specified money or capital market rates.
A) a floating rate bond
B) a zero coupon bond
C) a mortgage bond
D) an equipment trust certificate
Answer: A
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

48) ________ are commonly issued in the reorganization of a failed or failing firm.
A) Floating rate bonds
B) Income bonds
C) Mortgage bonds
D) Equipment trust certificates
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

49) ________ bonds are characterized by interest payments that are required only when earnings are available.
A) Floating rate
B) Income
C) Mortgage
D) Junk
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
50) ________ are debt rated Ba or lower by Moody's or BB or lower by Standard & Poor's and are commonly used by rapidly growing firms to obtain growth capital, most often to finance mergers and takeovers.
A) Subordinated debentures
B) Mortgage bonds
C) Junk bonds
D) Equipment trust certificates
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

51) Convertible bonds are normally ________.
A) debentures
B) income bonds
C) zero coupon bonds
D) mortgage bonds
Answer: A
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-20
Question Status: Previous Edition
AACSB Tag: Analytic Skills

52) A debenture is ________.
A) a bond secured by specific assets that any firm can issue
B) a secured bond that is secured by unspecified assets
C) a secured bond issued by startup firms
D) an unsecured bond that only creditworthy firms can issue
Answer: D
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

53) ________ are secured by stock and/or bonds that are owned by the issuer.
A) Mortgage bonds
B) Equipment trust certificates
C) Collateral trust bonds
D) Subordinated debentures
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
54) ________ have a short maturities, typically one to five years, and which can be renewed for a similar period at the option of their holders.
A) Floating rate bonds
B) Extendible notes
C) Putable bonds
D) Junk bonds
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

55) Payment of interest required only when earnings are made available from which to make a payment is characteristic of a(n) ________.
A) floating rate bond
B) income bond
C) mortgage bond
D) equipment trust certificate
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

56) A putable bond gives the bondholder ________.
A) the right to sell the bond back to the corporation at a discount
B) the right to sell the bond back to the corporation at a stated premium
C) the right to redeem the bond back to the corporation at the current market value
D) the right to redeem the bond back to the corporation at par
Answer: D
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

57) A significant portion of the return on a zero coupon bond is in the form of ________.
A) interest and gain in value
B) interest
C) gain in value
D) tax reduction
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
58) When issuing a(n) ________ the issuer can annually deduct the current year's interest accrual without having to actually pay the interest until the bond matures.
A) junk bond
B) zero coupon bond
C) floating rate bond
D) extendible note
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

59) High-risk, high-yield junk bonds have declined in popularity over time due to ________.
A) the decline in mergers and takeovers, which these bonds were used to finance
B) the declining need of growth capital
C) the stabilizing of interest rates
D) a number of major defaults on these bonds
Answer: D
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

60) ________ are claims that are not satisfied until those of the creditors holding certain (senior) debts have been fully satisfied.
A) Convertible debentures
B) Subordinated debentures
C) Mortgage bonds
D) Collateral trust bonds
Answer: B
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
61) Bonds that can be redeemed at par at the option of their holders either at specific date after the date of issue and every 1 to 5 years thereafter or when and if the firm takes specified actions such as being acquired, acquiring another company, or issuing a large amount of additional debt are called ________.
A) zero coupon bonds
B) junk bonds
C) floating-rate bonds
D) putable bonds
Answer: D
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

62) The decision to refund a callable bond ________.
A) should be made only if interest rates have increased
B) is a net working capital decision
C) is a capital budgeting decision
D) is an investing decision
Answer: C
Diff: 1
Topic: Common Types of Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

63) A foreign bond is issued by a(n) ________.
A) foreign corporation or government and is denominated in the investor's home currency and sold in the investor's home market
B) corporation or government and is denominated in the investor's foreign currency and sold in the foreign market
C) international borrower and sold to investors in countries with currencies other than the local currency
D) international borrower and sold to investors in countries with currencies in which the bond is denominated
Answer: A
Diff: 1
Topic: International Bond Issues
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
Table 6.1

Assume the below information to answer the following question(s).

64) Based on the table 6.1, on this trading day, the number of Ford bonds which changed hands was ________.
A) 5,100
B) 51,000
C) 510,000
D) 5,100,000
Answer: D
Diff: 1
Topic: Corporate Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

65) Based on the Table 6.1, assume this bond's face value is $1,000. What is the bond's current market price?
A) $65.00
B) $655.00
C) $650.00
D) $6,550.00
Answer: B
Diff: 1
Topic: Corporate Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

66) Based on the Table 6.1, what is the last yield for this bond?
A) 11.0%
B) 14.2%
C) 16.8%
D) 18.9%
Answer: C
Diff: 1
Topic: Corporate Bonds
Learning Obj.: LG 3
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
6.4 Understand the key inputs and basic model used in the bond valuation process.

1) Valuation is the process that links risk and return to determine the worth of an asset.
Answer: TRUE
Diff: 1
Topic: Valuation Fundamentals
Learning Obj.: LG 4
Learning Outcome: F-11
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) The value of an asset depends on the historical cash flow(s) up to the present time.
Answer: FALSE
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-08
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) In the valuation process, the higher the risk, the greater is the required return.
Answer: TRUE
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-11
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) The level of risk associated with a given cash flow positively affects its value.
Answer: FALSE
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-08
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) The value of an asset is determined by discounting the expected cash flows back to its present value, using an appropriate discount rate.
Answer: TRUE
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Revised
AACSB Tag: Analytic Skills
6) The process that links risk and return in order to determine the worth of an asset is termed ________.
A) securitization
B) valuation
C) discounting
D) compounding
Answer: B
Diff: 1
Topic: Valuation Fundamentals
Learning Obj.: LG 4
Learning Outcome: F-11
Question Status: Previous Edition
AACSB Tag: Analytic Skills

7) The return expected from an asset is fully defined by its ________.
A) risk and cash flow
B) cash flow and timing
C) discount rate
D) beta
Answer: B
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-08
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) The key inputs to the valuation process include ________.
A) returns and risk
B) cash flow, cash flow timing, and risk
C) cash flows and discount rate
D) returns, discount rate, and risk
Answer: B
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) Less certain a cash flow, the ________ the risk, and ________ the present value of the cash flow.
A) lower; higher
B) lower; lower
C) higher; lower
D) higher; higher
Answer: C
Diff: 1
Topic: Key Inputs
Learning Obj.: LG 4
Learning Outcome: F-08
Question Status: Revised
AACSB Tag: Analytic Skills
10) The value of any asset is the ________.
A) sum of all future cash flows it is expected to provide over the relevant time period
B) sum of the present values of all future cash flows it is expected to provide over the relevant time period
C) present value of the sum of all future cash flows it is expected to provide over the relevant time period
D) sum of all compounded future cash flows it is expected to provide over the relevant time period
Answer: B
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Revised
AACSB Tag: Analytic Skills

11) In the basic valuation model, risk is generally incorporated into the ________.
A) cash flows
B) timing
C) discount rate
D) total value
Answer: C
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Previous Edition
AACSB Tag: Analytic Skills

12) A record collector has agreed to sell her entire collection to a historical museum in three years at a price of $100,000. The current risk-free rate is 7 percent. At what price should she value her collection today?
Answer: $100,000(1.07)-3 = $81,630
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Previous Edition
AACSB Tag: Analytic Skills

13) A corporate financial analyst must calculate the value of an asset which produces year-end annual cash flows of $0 the first year, $2,000 the second year, $3,000 the third year, and $2,500 the fourth year. Assuming a discount rate of 15 percent, what is the value of this asset?
Answer: = $0/(1.15)1 + $2,000/(1.15)2 + $3,000/(1.15)3 + $2,500/(1.15)4 = $4,914
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Previous Edition
AACSB Tag: Analytic Skills
14) What is the value of an asset which pays $200 a year for the next 5 years and can be sold for $1,500 at the end of five years from now? Assume that the opportunity cost is 10 percent.
Answer: Using Financial calculator: FV = 1500, PMT = 200, N = 5, I = 10, CPT PV = -1689.54
The value of the asset = $1,689.54.
Diff: 1
Topic: Basic Valuation Model
Learning Obj.: LG 4
Learning Outcome: F-04
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6.5 Apply the basic valuation model to bonds, and describe the impact of required return and time to maturity on bond values.

1) The value of a bond that pays semiannual interest is greater than that on an otherwise equivalent annual coupon interest paying bond.
Answer: TRUE
Diff: 1
Topic: Bond Fundamentals
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) Interest rate risk is the risk that results from the changes in interest rates and thereby impact the bond value.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-05
Question Status: Revised
AACSB Tag: Analytic Skills

3) When the required return is different from the coupon interest rate and is constant until maturity, the value of the bond will approach its par value as it nears maturity.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills

4) When a bond's required return is greater than its coupon interest rate, the bond value will be less than its par value.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
5) A bond with short maturity has less "interest rate risk" than a bond with long maturity when all other features—coupon interest rate, par value, and interest payment frequency—are the same.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

6) Duration measures the sensitivity of a bond's prices to changing interest rates.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 6
Learning Outcome: F-05
Question Status: New
AACSB Tag: Analytic Skills

7) The shorter the amount of time until a bond's maturity, the more responsive is its market value to a given change in the required return.
Answer: FALSE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

8) Increases in the basic cost of long-term funds or in risk will raise the required return on a bond.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) A bond will sell at a premium when its required return rises above its coupon interest rate.
Answer: FALSE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
10) The required return on a bond is likely to differ from the stated interest rate for either of two reasons: 1) economic conditions have changed, causing a shift in the basic cost of long-term funds, or 2) the firm's risk has changed.
Answer: TRUE
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) Corporate bonds have a ________.
A) face value of $5,000
B) market price of $1,000
C) specified coupon rate paid annually
D) par value of $1,000
Answer: D
Diff: 1
Topic: Bond Fundamentals
Learning Obj.: LG 2
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

12) Bonds are ________.
A) a series of perpetual short-term debt instruments
B) a form of equity financing that pays interest
C) long-term debt instruments used to raise large sums of money
D) a hybrid form of financing used to raise large sums of money from a diverse group of lenders
Answer: C
Diff: 1
Topic: Bond Fundamentals
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

13) A type of long-term financing used by both corporations and government entities is ________.
A) common stocks
B) bonds
C) preferred stocks
D) retained earnings
Answer: B
Diff: 1
Topic: Bond Fundamentals
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
14) The value of a bond is the present value of the ________.
A) dividends and maturity value
B) interest and dividend payments
C) maturity value
D) interest payments and maturity value
Answer: D
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

15) A firm has an issue of $1,000 par value bonds with a 12 percent stated interest rate outstanding. The issue pays interest annually and has 10 years remaining to its maturity date. If bonds of similar risk are currently earning 8 percent, the firm's bond will sell for ________ today.
A) $1,000
B) $805.20
C) $1,115.50
D) $1,268.40
Answer: D
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

16) The value of a bond is the present value of its interest payments plus ________.
A) future value of its par value
B) present value of its par value
C) its face value
D) present value of interest payment
Answer: B
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
17) Danno is trying to decide which of two bonds to buy. Bond H is a 10 percent coupon, 10-year maturity, $1,000 par, January 1, 2000 issue paying annual interest. Bond F is a 10 percent coupon, 10-year maturity, $1,000 par, January 1, 2000 issue paying semiannual interest. The market required return for each bond is 10 percent. When using present value to determine the prices of the bonds, Danno will find that ________.
A) there is no difference in price
B) the price of F is greater than H
C) the price of H is greater than F
D) he needs more information before determining the prices.
Answer: A
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

18) A firm has an issue of $1,000 par value bonds with a 9 percent stated interest rate outstanding. The issue pays interest annually and has 20 years remaining to its maturity date. If bonds of similar risk are currently earning 11 percent, the firm's bond will sell for ________ today.
A) $1,000
B) $716.67
C) $840.73
D) $1,123.33
Answer: C
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

19) Calculate the value of a $1,000 bond which has 10 years until maturity and pays quarterly interest at an annual coupon rate of 12 percent. The required return on similar-risk bonds is 20 percent.
A) $656.82
B) $835.45
C) $845.66
D) $2,201.08
Answer: A
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
20) Jia Hua Enterprises wants to issue sixty 20-year, $1,000 par value, zero-coupon bonds. If each bond is priced to yield 7 percent, how much will Jia Hua receive (ignoring issuance costs) when the bonds are first sold?
A) $11,212
B) $12,393
C) $15,505
D) $18,880
Answer: C
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

21) Zheng Corporation plans to issue new bonds to finance its expansion plans. In its efforts to price the issue, Zheng Corporation has identified a company of similar risk with an outstanding bond issue that has an 8 percent coupon rate having a maturity of ten years. This firm's bonds are currently selling for $1,091.96. If interest is paid annually for both bonds, what must the coupon rate of the new bonds be in order for the issue to sell at par?
A) 5.78%
B) 6.88%
C) 6.50%
D) 6.71%
Answer: D
Diff: 2
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

22) If the coupon rate of a bond is equal to its required rate of return, then ________.
A) the current value is not equal to par value
B) the current value is equal to par value
C) the maturity value is equal to par value
D) the current value is equal to maturity value
Answer: B
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
23) Bonds which sell at less than face value are priced at a ________, while bonds which sell at greater than face value sell at a ________.
A) par; premium
B) discount; par
C) discount; premium
D) coupon; premium
Answer: C
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

24) The price of a bond with a fixed coupon rate and the required return have a relationship that is best described as ________.
A) perfect positive correlation
B) constant
C) direct
D) inverse
Answer: D
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

25) When the required return is constant and equal to the coupon rate, the price of a bond as it approaches its maturity date will ________.
A) remain at par
B) increase
C) decrease
D) change depending on whether it is a discount or premium bond
Answer: A
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
26) Interest rate risk and the time to maturity have a relationship that is best characterized as ________.
A) constant
B) varying
C) direct
D) inverse
Answer: C
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

27) If the required return is less than the coupon rate, a bond will sell at ________.
A) par
B) a discount
C) a premium
D) book value
Answer: C
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

28) When the required return is constant but different from the coupon rate, the price of a bond as it approaches its maturity date will ________.
A) remain constant
B) increase
C) decrease
D) approach par
Answer: D
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

29) If the required return is greater than the coupon rate, a bond will sell at ________.
A) par
B) a discount
C) a premium
D) book value
Answer: B
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
30) ABC company has two bonds outstanding that are the same except for the maturity date. Bond D matures in 4 years, while Bond E matures in 7 years. If the required return changes by 5 percent, then ________.
A) bond D will have a greater change in price
B) bond E will have a greater change in price
C) the price of the bonds will be constant
D) the percentage price change for the bonds will be equal
Answer: B
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

31) Hewitt Packing Company has an issue of $1,000 par value bonds with a 14 percent annual coupon interest rate. The issue has ten years remaining to the maturity date. Bonds of similar risk are currently selling to yield a 12 percent rate of return. The current value of each Hewitt bond is ________.
A) $791.00
B) $1,000
C) $1,052.24
D) $1,113.00
Answer: D
Diff: 1
Topic: Bond Prices
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

32) A bond will sell ________ when the stated rate of interest exceeds the required rate of return, ________ when the stated rate of interest is less than the required return, and ________ when the stated rate of interest is equal to the required return.
A) at a premium; at a discount; equal to the par value
B) at a premium; equal to the par value; at a discount
C) at a discount; at a premium; equal to the par value
D) equal to the par value; at a premium; at a discount
Answer: A
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
33) If a corporate bond is issued with a coupon rate that varies directly with the required return, the price of the bond will ________.
A) equal the face value
B) be less than the face value
C) be greater than the face value
D) be greater than or less than the face value depending on how interest rates vary
Answer: A
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

Table 6.2

34) (a) Calculate the current value of Bond L. (See Table 6.2)
(b) What will happen to the value/price as the bond approaches maturity?
Answer:
a) Using Financial calculator: PMT = 90, N = 5, I = 6, FV = 1000, CPT PV = $1,126.08
(b) The bond price will decrease and come closer to par.
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

35) Calculate the current value of Bond M. (See Table 6.2)
Answer: Annual coupon interest rate = required rate of return
Therefore, current value = par value = $100.
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

36) Calculate the current value of Bond M if the time of maturity is six years. (See Table 6.2)
Answer: The bond is at par, or $100, because the annual coupon interest rate is equal to the required rate of return.
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
37) (a) Calculate the current value of Bond N. (See Table 6.2)
(b) What will happen to value/price as the bond approaches maturity?
Answer:
(a) Using financial calculator: PMT = $90, N = 17, I = 15, FV = 500, CPT PV = $590.71
(b) The bond price will decrease and come closer to par.
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

38) Hewitt Packing Company has an issue of $1,000 par value bonds with a 14 percent coupon interest rate outstanding. The issue pays interest semiannually and has 10 years remaining to its maturity date. Bonds of similar risk are currently selling to yield a 12 percent rate of return. What is the value of these Hewitt Packing Company bonds?
Answer: B: Using financial calculator: PMT = $70, N = 20, FV = 1000, I = 6, CPT PV = $1,114.70
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

39) To expand its business, the Kingston Outlet factory would like to issue a bond with par value of $1,000, coupon rate of 10 percent, and maturity of 10 years from now. What is the value of the bond if the required rate of return is 1) 8 percent, 2) 10 percent, and 3) 12 percent?
Answer: Coupon payment = 1,000 × 0.10 = $100
1) Using Financial calculator: PMT = 100, N = 10, I = 8, FV = 1000, CPT PV = $1,134.20
2) $1,000 since coupon rate and required rate of return are equal.
3) Using Financial calculator: PMT = 100, N = 10, I = 12, FV = 1000, CPT PV = $887
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

40) To finance a new line of product, the Tangshan Toys has issued a bond with a par value of $1,000, coupon rate of 8 percent, and maturity of 30 years. Compute the price of the bond if the opportunity cost is 11 percent.
Answer: Coupon payment = 1,000 × 0.08 = $80
Using financial calculator: PMT = 80, I = 11, N = 30, FV = 1000, CPT PV = $739.19
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills
41) Zhen Yi Computers has an outstanding issue of bond with a par value of $1,000, paying 12 percent coupon rate semi-annually. The bond was issued 25 years ago and has 5 years to maturity. What is the value of the bond assuming 14 percent rate of interest?
Answer: Coupon payment = 1,000 × 0.12 = $120
Semi-annual coupon payment = 120/2 = $60
Using financial calculator: PMT = 60, I = 7, N = 10, FV = 1000, CPT PV = $929.76
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

42) Tangshan Coal Inc. just issued a 10 percent, 25-year bond with a $1,000 par value that pays interest semiannually.
(a) How much can the investor expect in annual interest (in dollars)?
(b) How much can the investor expect in interest every six months (in dollars)?
(c) How much can the investor expect in par value at the end of the 25th year?
Answer:
(a) $100
(b) $50
(c) $1,000
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Reflective Thinking Skills

43) Yantai Food, Inc. has issued a bond with par value of $1,000, a coupon rate of 9 percent that is paid semi-annually, and that matures in 10 years. What is the value of the bond if the required rate of return is 12 percent?
Answer: Coupon payment = 1,000 × 0.09 = $90
Semi-annual coupon payment = 90/2 = $45
Using financial calculator: PMT = 45, I = 6, N = 20, FV = 1000, CPT PV = $827.95
Diff: 1
Topic: Basic Bond Valuation
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

44) Gong Li has recently inherited $10,000 and is considering purchasing 10 bonds of the Lucky Corporation. The bond has a par value of $1,000 with 10 percent coupon rate and will mature in 10 years. Does Gong Li have enough money to buy 10 bonds if the required rate of return is 9 percent?
Answer: No. Since the required rate of return (9%) is less than the bond's coupon rate (10%), the bond's price is greater than its par value ($1,000). Thus, the total price of 10 bonds is greater than $10,000.
Diff: 1
Topic: Bond Value Behavior
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Reflective Thinking Skills
6.6 Explain yield to maturity (YTM), its calculation, and the procedure used to value bonds that pay interest semiannually.

1) Yield to maturity (YTM) is the rate investors earn if they buy the bond at a specific price and hold it until maturity.
Answer: TRUE
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

2) The yield to maturity on a bond with a current price equal to its par or face value, will always be equal to the coupon interest rate.
Answer: TRUE
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

3) If a bond's required return always equals its coupon interest rate, the bond's value will remain at par until it matures.
Answer: TRUE
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

4) When a bond's value differs from par, its yield to maturity will differ from its coupon interest rate.
Answer: TRUE
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

5) Yield to call represents the rate of return that investors earn if they buy a callable bond at a specific price and hold it until it is called back and they receive the call price, which would be set above the bond's par value.
Answer: TRUE
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: New
AACSB Tag: Analytic Skills
6) For an investor who plans to purchase a bond maturing in one year, the primary consideration should be ________.
A) retained earnings
B) face value
C) yield to maturity
D) net income
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 5
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

7) Yield to maturity on a bond with price equal to its par value will ________.
A) be less than the coupon rate
B) be more than the coupon rate
C) always be equal to the coupon rate
D) be less than or equal to the coupon rate depending on the required return
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Revised
AACSB Tag: Analytic Skills

8) What is the current price of a $1,000 par value bond maturing in 9 years with a coupon rate of 8 percent, paid annually, that has a YTM of 9 percent?
A) $700
B) $945
C) $940
D) $1,062
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

9) What is the approximate yield to maturity for a $1,000 par value bond selling for $1,120 that matures in 6 years and pays 12 percent interest annually?
A) 8.5 percent
B) 9.3 percent
C) 12.0 percent
D) 13.2 percent
Answer: B
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
10) Tangshan Industries has issued a bond which has a $1,000 par value and a 15 percent annual coupon interest rate. The bond will mature in ten years and currently sells for $1,250. Using this information, the yield to maturity on the Tangshan Industries bond is ________.
A) 10.79 percent
B) 11.39 percent
C) 12.19 percent
D) 13.29 percent
Answer: A
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

11) What is the yield to maturity, to the nearest percent, for the following bond: current price is $908, coupon rate is 11 percent, $1,000 par value, interest paid annually, eight years to maturity?
A) 11 percent
B) 12 percent
C) 13 percent
D) 14 percent
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills

12) What is the current price of a $1,000 par value bond maturing in 12 years with a coupon rate of 14 percent, paid semiannually, that has a YTM of 13 percent?
A) $604
B) $1,090
C) $1,060
D) $1,073
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills
13) Nico Corp issued bonds bearing a coupon rate of 12 percent, pay coupons semiannually, have 3 years remaining to maturity, and are currently priced at $940 per bond. What is the yield to maturity?
A) 12.00%
B) 13.99%
C) 14.54%
D) 15.25%
Answer: C
Diff: 1
Topic: Yield to Maturity
Learning Obj.: LG 6
Learning Outcome: F-06
Question Status: Previous Edition
AACSB Tag: Analytic Skills