Managerial Finance

Homework II – Managerial Economics – Fall 2011 Each question is worth 1 point. 1. A call provision gives bondholders the right to demand, or “call for,” repayment of a bond. Typically, calls are exercised if interest rates rise, because when rates rise the bondholder can get the principal amount back and reinvest it elsewhere at higher rates a. True b. False 2. Sinking funds are devices used to force companies to retire bonds on a scheduled basis prior to their maturity.

Many bond indentures allow the company to acquire bonds for a sinking fund by either purchasing bonds in the market or selecting the bonds to be acquired by a lottery administered by the trustee through a call at face value c. True d. False 3. The market value of any real or financial asset, including stocks, bonds, or art work purchased in hope of selling it at a profit, may be estimated by determining future cash flows and then discounting them back to the present e. True f. False . As a general rule, a company’s debentures have higher required interest rates than its mortgage bonds because mortgage bonds are backed by specific assets while debentures are unsecured. g. True h. False 5. A bond has a $1,000 par value, makes annual interest payments of $100, has 5 years to maturity, cannot be called, and is not expected to default. The bond should sell at a premium if interest rates are below 10% and at a discount if interest rates are greater than 10%. i. True j. False 6.

You have funds that you want to invest in bonds, and you just noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for $800. The coupon rate is 10% (with annual payments), and there are 10 years before the bond will mature and pay off its $1,000 par value. You should buy the bond if your required return on bonds with this risk is 12%. k. True l. False 7. “Restrictive covenants” are designed primarily to protect bondholders by constraining the actions of managers. Such covenants are spelled out in bond indentures. . True n. False 8. Any change in its beta is likely to affect the required rate of return on a stock, which implies that a change in beta will likely have an impact on the stock’s price, other things held constant. o. True p. False 9. If an investor buys enough stocks, he or she can, through diversification, eliminate all of the market risk inherent in owning stocks, but as a general rule it will not be possible to eliminate all diversifiable risk. q. True r. False 10. Even if the correlation between the returns on two securities is +1. , if the securities are combined in the correct proportions, the resulting 2-asset portfolio will have less risk than either security held alone. s. True t. False 11. The distributions of rates of return for Companies AA and BB are given below: State of theProbability of EconomyThis State OccurringAABB Boom0. 230%-10% Normal0. 610%5% Recession0. 2-5%50% We can conclude from the above information that any rational, risk-averse investor would be better off adding Security AA to a well-diversified portfolio over Security BB u. True v. False 12. Risk aversion” implies that investors require higher expected returns on riskier than on less risky securities w. True x. False 13. An individual stock’s diversifiable risk, which is measured by its beta, can be lowered by adding more stocks to the portfolio in which the stock is held. y. True z. False 14. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. {. True |. False 15. Tom O’Brien has a 2-stock portfolio with a total value of $100,000. $37,500 is invested in Stock A with a beta of 0. 5 and the remainder is invested in Stock B with a beta of 1. 42. What is his portfolio’s beta? a. 1. 17 b. 1. 23 c. 1. 29 d. 1. 35 e. 1. 42 16. Moerdyk Company’s stock has a beta of 1. 40, the risk-free rate is 4. 25%, and the market risk premium is 5. 50%. What is the firm’s required rate of return? a. 11. 36% b. 11. 65% c. 11. 95% d. 12. 25% e. 12. 55% 17. Choudhary Corp believes the following probability distribution exists for its stock. What is the coefficient of variation on the company’s stock? ProbabilityStock’s State ofof StateExpected the EconomyOccurringReturn

Boom0. 4525% Normal0. 5015% Recession0. 055% a. 0. 2839 b. 0. 3069 c. 0. 3299 d. 0. 3547 e. 0. 3813 18. A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms }. True ~. False 19. Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don’t want to relinquish voting control. . True ?. False 20.

Preferred stock is a hybrid–a sort of cross between a common stock and a bond–in the sense that it pays dividends that normally increase annually like a stock but its payments are contractually guaranteed like interest on a bond ?. True ?. False 21. Huang Company’s last dividend was $1. 25. The dividend growth rate is expected to be constant at 15% for 3 years, after which dividends are expected to grow at a rate of 6% forever. If the firm’s required return (rs) is 11%, what is its current stock price? a. $30. 57 b. $31. 52 c. $32. 49 d. $33. 50 e. $34. 50 22. The Ramirez Company’s last dividend was $1. 5. Its dividend growth rate is expected to be constant at 25% for 2 years, after which dividends are expected to grow at a rate of 6% forever. Its required return (rs) is 12%. What is the best estimate of the current stock price? a. $41. 58 b. $42. 64 c. $43. 71 d. $44. 80 e. $45. 92 23. Goode Inc. ‘s stock has a required rate of return of 11. 50%, and it sells for $25. 00 per share. Goode’s dividend is expected to grow at a constant rate of 7. 00%. What was the last dividend, D0? a. $0. 95 b. $1. 05 c. $1. 16 d. $1. 27 e. $1. 40 24. The Isberg Company just paid a dividend of $0. 5 per share, and that dividend is expected to grow at a constant rate of 5. 50% per year in the future. The company’s beta is 1. 15, the market risk premium is 5. 00%, and the risk-free rate is 4. 00%. What is the company’s current stock price, P0? a. $18. 62 b. $19. 08 c. $19. 56 d. $20. 05 e. $20. 55 25. Molen Inc. has an outstanding issue of perpetual preferred stock with an annual dividend of $7. 50 per share. If the required return on this preferred stock is 6. 5%, at what price should the preferred stock sell? a. $104. 27 b. $106. 95 c. $109. 69 d. $112. 50 e. $115. 38