FINA 6320.794 Exam 3 Review

• FINA
• Year 4

FINA 6320.794 Exam 3 Review

Welcome to Exam 3 Review for FINA 6320.794 

Let's do amazing on this exam!!

- Prof Lizzy

In practical scenarios, which two investment appraisal methods are most commonly utilized by managers?

1. Net Present Value & Profitability Index
2. Net Present Value & Payback
3. Net Present Value & Internal Rate of Return
4. Payback & Internal Rate of Return

In practical scenarios, which two investment appraisal methods are most commonly utilized by managers? 

In practice, managers most frequently use Net Present Value (NPV) and Internal Rate of Return (IRR) as investment criteria. These methods consider the time value of money and provide reliable measures of profitability. NPV calculates the net value added by an investment today, while IRR represents the rate of return that equates present value with the initial investment. Other criteria like payback period or average accounting return may be simpler but lack this time-value consideration.

A bond has a par value of $1,000, a current yield of 8.15 percent, and semiannual coupon payments. The bond is quoted at 103.51. What is the coupon rate of the bond?

Formula for CR: (Annual Coupon Payment / Par Value of Bond) x 100%

1. 9.36%
2. 8.44%
3. 8.28%
4. 9.47%

If you sell a bond with a coupon of 5 percent to a dealer when the market rate is 6 percent which one of the following prices will you receive?

1. Call Price
2. Bid Price
3. Asked Price
4. Bid-Asked Price

If you sell a bond with a coupon of 5 percent to a dealer when the market rate is 6 percent which one of the following prices will you receive? 

Bid Price: correct because it is the price at which the dealer is willing to buy the bond from you. The bid price is typically lower than the asked price, which is the price at which the dealer would sell the bond.

POD has a project with the following cash flows:
Year Cash Flows
0 −$ 285,000
1 45,300
2 162,800
3 127,900
The required return is 8.1 percent. What is the profitability index for this project?
**Formula for Profitability Index: PV of Future Cash Flows / Initial Investment

1. 1.096
2. .950
3. 1.206
4. 1.316

Protective Covenants...

1. Only in government-issued bond indentures
2. Only apply to privately issued bonds are a feature found
3. Are primarily designed to protect bondholders
4. Only apply to bonds that have a deferred call provision

Protective Covenants...

C - protective covenants are primarily designed to protect bondholders. Correct because these covenants are legally binding clauses within a bond agreement that impose certain restrictions or requirements on the issuer. Their purpose is to safeguard the bondholders’ interests by ensuring the issuer maintains a certain level of financial stability and adheres to specific practices that will not jeopardize the bond’s value. 

A bond that pays interest semiannually has a price of $981.45 and a semiannual
coupon payment of $28.50. If the par value is $1,000, what is the current yield?

Formula for Current Yield: Annual Coupon Payments / Price
HINT*: Multiply something by 2

1. 5.81%
2. 5.70%
3. 5.76%
4. 5.52%

Bonds issued by the U.S. government...

1. Generally have higher coupons than comparable bonds issued by a corporation
2. Are considered to be free of interest rate risk
3. Pay interest that is exempt from federal income taxes
4. Are considered to be free of default risk

Bonds issued by the U.S. government...

D - Are considered to be free of default risk: correct because the U.S. government bonds are considered to have virtually no risk of default because they are backed by the “full faith and credit” of the U.S. government, which has the power to tax and print money. This makes them one of the safest investment securities available 

A municipal bond has a YTM of 4.23 percent while the YTM of a comparable taxable bond is 6.58 percent. What is the tax rate that will make an investor indifferent between the municipal bond and the taxable bond?

Formula TEY: Yield on Tax-Free Bond / 1 - Tax Rate

HINT*: Rearrange Formula (you want to find tax rate)

1. 40.82%
2. 35.71%
3. 42.38%
4. 36.52%

When evaluating two mutually exclusive projects the final decision on which project is choose ultimately depends upon which one of the following?

1. Initial Cost of Each Project
2. Total Cash Inflows of Each Project
3. Net Present Value
4. Timing of Cash Inflows

When evaluating two mutually exclusive projects the final decision on which project is choose ultimately depends upon which one of the following? 

C - Net Present Value (NPV) is the correct because when evaluating two mutually exclusive projects it accounts for the time value of money, providing a measure of the value added by the project in today’s dollars. It considers all cash inflows and outflows over the project’s life and discounts them back to their present value. 

An investment had a nominal return of 9.7 percent last year. The inflation rate
was 2.7 percent. What was the real return on the investment?

Formula for R = ( 1 + Nominal Rate / 1 + Inflation Rate) - 1

1. 7.57%
2. 6.38%
3. 9.52%
4. 6.82%

Which one of the following statements related to the internal rate of return (IRR) is correct?

1. The IRR is equal to the required return when the net present value is equal to zero
2. The IRR does not always yield the same accept and reject decisions as the NPV method for mutually exclusive projects
3. A project with an IRR equal to the required return would not necessarily reduce the value of a firm if accepted
4. The average accounting return is not necessarily a better method of analysis than the IRR from a financial point of view.

Which one of the following statements related to the internal rate of return (IRR) is correct? 

A - The IRR is equal to the required return when the net present value is equal to zero.

This is because the IRR is the discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. If the IRR is exactly equal to the required return, it means the project is expected to generate a return just sufficient to cover the cost of capital, and the NPV would be zero, indicating that the project neither adds nor subtracts value from the firm.

Living Colour Company has a project available with the following cash flows:
Year Cash Flow : 0 −$ 33,310
1 8,300
2 10,010
3 14,330
4 16,050
5 11,000
If the required return for the project is 9 percent, what is the project's NPV?
NPV = Y0 + Y1 / (1 + R) + Y2 / (1 + R)^2 + Y3 / (1 + R) ^ 3 + Y4 / (1 + R) ^ 4 + Y5 / (1 + R)^ 5

1. $13,340.98
2. $12,314.75
3. $14,074.01
4. $26,380.00

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be:

1. Rejected because the net present value is positive
2. Accepted because the profitability index is negative
3. Rejected because the internal rate of return is negative
4. Accepted because the profitability index is greater than 1.

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: 

D - Accepted because the profitability index is greater than 1: correct because when the present value of the cash inflows exceeds the initial cost of a project, the Profitability Index (PI) is greater than 1. The PI is calculated by dividing the present value of future cash inflows by the initial investment. A PI greater than 1 indicates that the NPV is positive, and the project is expected to generate more value than it costs, which is a sign that the project should be accepted. 

Municipal bond has a coupon rate of 6.04 percent and a YTM of 5.67 percent. If an investor has a marginal tax rate of 39 percent, what is equivalent pretax yield on a taxable bond?

TEY = Tax- Free Yield / (1 - Marginal Tax Rate)

1. 6.49%
2. 9.30%
3. 6.24%
4. 9.60%

Today, Hannah paid a total of $1,176, including accrued interest, to purchase a 20-year bond that has 6 years left until maturity. This is referred to as the

1. Dirty Price
2. Clean Price
3. Call Price
4. Spread Price

Today, Hannah paid a total of $1,176, including accrued interest, to purchase a 20-year bond that has 6 years left until maturity. This is referred to as the

A - Dirty price is correct in this context because it refers to the price of a bond that includes accrued interest in addition to the bond’s face value. When Hannah paid $1,176 for the bond, this amount covered not only the current market value of the bond but also the interest that has accumulated since the last coupon payment was made.

Filter Corporation has a project available with the following cash flows:
Year Cash Flow
0 −$ 16,000
1 5,800
2 7,100
3 6,100
4 4,900
What is the project's IRR?
Formula: 0 = Y0 + Y1 / (1 + IRR) + Y2 / (1 + IRR)^2 + Y3 / (1 + IRR)^3 + Y4/(1 + IRR)^4

1. 20.93%
2. 18.84%
3. 20.41%
4. 19.62%

Which one of the following statements is false concerning the term structure of interest rates?

1. The real rate of return has minimal, if any effect on the slope of the term structure of interest rates
2. The term structure of interest rates includes both an inflation premium and an interest rate risk premium
3. The interest rate risk premium increases as the time to maturity increases
4. The term structure of interest rates and the time to maturity are always directly related

Which one of the following statements is false concerning the term structure of interest rates?

D - The term structure of interest rates and the time to maturity are not always directly related. While they often move together, other factors like monetary policy and economic conditions can influence the relationship.

Blinding Light Company has a project available with the following cash flows:
Year Cash Flow
1 −$ 34,430
2 8,090
3 13,840
4 15,770
5 10,580
What is the project's IRR?
Formula: 0 = Y0 + Y1 / (1 + IRR) + Y2 / (1 + IRR)^2 + Y3 / (1 + IRR)^3 + Y4/(1 + IRR)^4

1. 20.78%
2. 20.26%
3. 18.70%
4. 19.48%

Which one of the following is the best example of two mutually exclusive projects?

1. Waiting until a machine finishes molding Product X before being able to mold Product Z
2. Producing both plastic forks and spoons on the same assembly line
3. Building a furniture store beside a clothing outlet in the same shopping mall
4. Promoting two products during the same television commercial

Which one of the following is the best example of two mutually exclusive projects?

The best example of two mutually exclusive projects is A - waiting until a machine finishes molding Product X before being able to mold Product Z1 because mutually exclusive projects are those where acceptance of one project precludes the acceptance of another. In other words, if you choose one project, you cannot undertake the other simultaneously.

There is a zero coupon bond that sells for $310.18 and has a par value of 1,000. The bond has 24 years to maturity. What is the yield to maturity? Assume semiannual compounding?

YTM = (( Fave Value / Current Bond Price) ^ 1/n - 1 ) x 2

1. 4.74%
2. 4.94%
3. 4.77%
4. 4.81%

Isaac has analyzed two mutually exclusive projects that have 3-year lives. Project A has an NPV of $81,406, a payback period of 2.48 years, and an AAR of 9.31 percent. Project B has an NPV of $82,909, a payback period of 2.57 years, and an AAR of 9.22 percent. The required return for Project A is 11.5 percent while it is 12 percent for Project B. Both projects have a required AAR of 9.25 percent. Isaac must make a recommendation and justify it in 15 words or less. What should his recommendation be?

1. Accept Project A because it has the shortest payback period
2. Accept Project A because it has the lower required return
3. Accept both projects because both NPVs are positive
4. Accept Project B and reject Project A based on the NPVs

Isaac has analyzed two mutually exclusive projects that have 3-year lives. Project A has an NPV of $81,406, a payback period of 2.48 years, and an AAR of 9.31 percent. Project B has an NPV of $82,909, a payback period of 2.57 years, and an AAR of 9.22 percent. The required return for Project A is 11.5 percent while it is 12 percent for Project B. Both projects have a required AAR of 9.25 percent. Isaac must make a recommendation and justify it in 15 words or less. What should his recommendation be?

D- Accept Project B and reject Project A based on the NPVs correct because the Net Present Value (NPV) is the most reliable measure for evaluating projects, especially when they are mutually exclusive. It represents the value added to the firm by undertaking the project. Not only that but Project B has a higher NPV ($82,909) compared to Project A ($81,406), which means it is expected to add more value to the firm. On the other hand,  Project A does have a shorter payback period and a slightly higher Accounting Rate of Return (AAR), these metrics are less important than NPV for long-term profitability and value creation.

The required returns and AARs are close enough that they do not outweigh the importance of the NPV difference.

ANDDDDDDD We're DONEEEEEEE