The Price of the Stocks of the Market - Assignment Example

?Finance Part one: Multiple choice questions please place the letter of the correct answer in the corresponding box on the answer sheet that follows these questions. Questions 1- 28 are worth 1.5 points each. 1. Zinger Corporation has declared a stockdividend that pays one share of stock for every 20 shares owned. After the stock dividend (all other things remaining unchanged) the earning per share will: a) Remain the same b) Increase by 5 percent c) Increase by 20 percent d) Decrease by 5 percent e) There is not enough information given here to be able to answer this question. 2. A firm that uses RADR to evaluate investment projects would be most likely to apply the highest risk-adjusted discount rate to which of the following projects? a) The overhaul and repair of a large piece of machinery that it has been using for five years. b) An investment in a new piece of machinery to produce new products to be sold in China. c) An investment in a fleet of trucks to be used for delivery of its products. d) An investment in a new machine that will be used to improve the production process for one of its more successful products it has been producing for about 7 years. 3. A corporate bond with ten years to maturity pays $45 interest semi-annually. If the current market rate of interest on bonds in the same risk class is 9 percent; this bond will be selling for: a) Much less than $1000 b) Much more than $1000 c) Approximately $1000 d) There is not enough information here to be able to determine the answer to this question. 4. You have just calculated the NPV on an investment. It is a negative ($3.33). The IRR on this investment is: a) Equal to the cost of capital b) Higher than the cost of capital c) Lower than the cost of capital d) There is not enough information here to be able to figure out the answer to this question. 5. A firm has daily remittances (collections) of two million dollars and can earn 9 percent on investments of surplus cash. The maximum this firm should pay for a cash management system that will reduce collection time by three days is: a) $5,400,000 b) $1,800,000 c) $540,000 d) $180,000 e) $3,000,000 6. Which of the following courses of action in regard to financing working capital would be taken by a firm, wishing to take moderate risk and earn a moderate profit? a) Long-term financing and a relatively low level of liquid current assets. b) Long-term financing and a relatively high level of liquid current assets. c) Short-term financing and a relatively low level of liquid current assets. d) None of the above represents a position of moderate risk and moderate profits. 7. A firm does not maintain a single, exact, debt/equity ratio at all times because: a) It will want to sell debt when interest rates are low and sell common stock when stock prices are high. b) It will want to take advantage of timing its fund rising in order to minimize the cost of capital over time. c) The “market” allows some leeway in the debt/equity ratio before it begins to penalize the firm with higher required rates of return. d) All of the above help explain why a firm does not maintain a single, exact debt/equity ratio at all times. 8. The relationship between the price of a bond and market interest rates: a) Is a positively correlated linear relationship b) Is an inverse relationship c) Cannot be determined d) Cannot be determined without more information than is presented here. 9. The closer the correlation coefficient between two investment projects is to (-1), the greater is the a) Risk of the “portfolio” when the two projects are combined b) Risk reduction on the “portfolio” when the two projects are combined c) Return on the “portfolio” when the two projects are combined. d) Variation on the “portfolio” returns as compared to the returns on the individual projects. 10. When comparing three investment projects, if the expected cash flows from one project have a higher standard deviation than the cash flows of the other two, which of the following statements is correct? a) It has a higher level of risk than the other two b) It may have a higher level of risk than the other two c) It has a higher expected value d) None of the statements above is correct. 11. When it comes to financing assets, an aggressive firm will utilize more________ and maintain __________ liquidity than a conservative firm. a) Short-term debt; higher b) Long-term debt: lower c) Long-term debt; higher d) Short-term debt; lower e) None of these are correct 12. The use of simulation models allow a financial manager to: a) Reduce the standard deviations of the expected cash flows on investment projects. b) Test the possible impact of changes in the variables that are associated with the investment c) Eliminate most of the risk or uncertainty involved in making investment decisions d) None of the above 13. If a firm is not constrained by capital rationing, it should accept all investment proposals that: a) That provides returns greater than the cost of equity (retained earnings). b) That provides returns greater than the cost of debt. c) That provides returns greater than the cost of capital. d) None of these 14. When figuring out the WACOC, which of the following is used in the calculation of the after- tax cost of debt? a) The investor’s required rate of return on previously issued common stock. b) The nominal or stated rate of interest on existing debt. c) The current Yield to Maturity on similar debt. d) None of these 15. The “efficient frontier” indicates: a) Alternatives with neutral combinations of risk and return. b) Alternatives with no risk. c) Alternatives with the highest possible returns. d) Alternatives with the best combinations of risk and return possible. 16. The WACOC for the Jones and Bones Company is currently 12 percent. The company is considering a new investment project but must sell new debt to finance it. Debt represents 25 percent of the capital structure. If the after tax cost of debt rises from 6 percent to 8 percent on this new debt issue and all other things remain constant, what will the new marginal cost of capital be? a) 14.00% b) 12.50% c) 8.00% d) There is not enough information given here to answer this question. 17. The primary consideration in a decision to extend credit to a new group of customers should be: a) Return on sales b) Inventory turnover c) Sales forecasts for new customers d) The credit ratings of the new customers being considered e) None of these 18. For a given firm, holding all other factors constant, ordering costs per unit, of items purchased for inventory a) Increase in proportion to increases in inventory. b) Decline as average inventory increases. c) Are considered part of carrying costs d) Average about $1.00 per unit. 19. Which of the following is likely to result in a relatively low dividend payout ratio for a firm? a) The firm is mature....has been around for a long time. b) The firm has very easy access to the capital markets. c) The firm has a large number of good investment opportunities. 20. Risk exposure due to heavy short-term borrowing can be compensated for by a) carrying highly liquid assets b) carrying illiquid assets c) carrying longer term, more profitable current assets d) carrying more receivables to increase cash flow 21. Normally, permanent current assets should be financed by a) long term funds b) short term funds c) owner’s equity d) internally generated funds 22. Cost savings from JIT inventory management include(s) a) reduced overhead costs b) lower inventory financing costs c) greater productivity d) all of these 23. Generally, a stock split will a) Increase the total value of stockholder’s equity b) decrease the total value of stockholder's equity c) change the total value of stockholder's equity but the direction of the change cannot be determined without knowing the price of the stock. d) not affect the value of stockholder's equity 24. When an investment banking firm acts as an underwriter a) It gives a firm commitment to purchase the securities from the corporation at a set price b) the company suffers a decline in earnings after taxes c) sells the stock at the market price d) it will sell as many shares of the securities as possible and return the rest to the company unsold 25. In regard to stock dividends, most stockholders would prefer a) High dividends when earnings are high and lower dividends when earnings are low b) that 90-95 percent of earnings are paid out in dividends c) Regular, stable cash dividends d) stock dividends because they are tax free 26. Assume you require an IRR of 13% to accept a project. If the project will yield cash flows of $10,000 per year for six years, what is the maximum amount you should be willing to invest in the project to get the 13% return you require? a) Less than $25,000 b) More than $25,000 but less than $30,000 c) More than $30,000 but less than $35,000 d) More than $35,000 27. The first consideration in a cash management program is a) maximization of profit b) to minimize the "float" on disbursements c) maximization of liquidity d) synchronization of cash inflows and outflows e) none of these 28. The use of simulation models allows a financial manager to a) reduce the standard deviations of the expected cash flows on investment projects b) test the possible impact of changes in the variables associated with investment projects c) eliminate the risk or uncertainty involved in making investment project decisions d) none of the above Questions 29 - 36 are associated with the problems below and are worth 5 points each. Please show your work in the space provided below the questions and be sure to put your answer on the answer sheet. The Zingo company expects to generate the following cash flows from a $1,000,000 investment. Year Net Cash Inflows 1 $100,000 2 400,000 3 500,000 4 300,000 5 100,000 29. If the firm’s cost of capital is 10%, The NPV on this investment would be: a) $1,063,800 b) $1,400, 000 c) $63,800 d) $3,791,000 Working: Year Net Cash Inflows Rate 0 $ (1,000,000.00) 10% 1 $ 100,000.00   2 $ 400,000.00   3 $ 500,000.00   4 $ 300,000.00   5 $ 100,000.00   NPV $ 64,141.17   30. The IRR on this investment is: a) Between 11 and 12 percent b) Between 12 and 13 percent c) Between 14 and 15 percent d) The IRR on this investment cannot be determined without additional information Workings: Year Net Cash Inflows Rate 0 $ (1,000,000.00) 10% 1 $ 100,000.00   2 $ 400,000.00   3 $ 500,000.00   4 $ 300,000.00   5 $ 100,000.00   IRR 12.5%   The Lincoln Limousine Company has $1000 par value bonds outstanding that pay 9% interest annually. The bonds mature in 20 years. 31. If the present yield to maturity on bonds in this risk class is 7%, the current market price of the Lincoln bonds will be: a) $258 b) $953.46 c) $1211.46 d) $1000 e) None of these Workings: PV=$90*PVIFA (7%, 20yrs) +$1000*PVIF (7%, 20yrs) PV= $90*10.5940+$1000*0.2584 PV=$953.46+$258.4 PV=$1211.86 32. If the present yield to maturity on bonds in this risk class is 12%, the current market price of the Lincoln bonds will be: a) $776.21 b) $1000 c) $632.25 d) $1800 e) None of these Workings: PV=$90*PVIFA (12%, 20yrs) +$1000*PVIF (12%, 20yrs) PV= $90*7.4694+$1000*0.1037 PV=$672.246+$103.7 PV=$775.946 33. Global Technology's Capital Structure is as follows: Debt - 35%, Preferred Stock - 15%, Common Equity - 50%. The after tax cost of debt is 6.5%, the cost of preferred stock is 10%, and the cost of common equity (in the form of retained earnings) is 13.5%. Global's Weighted Average Cost of Capital is: a) 105.25% b) 30% c) 8.4275% d) 10.525% e) Global's WACOC cannot be determined without more information than is presented here. Workings: WACC=Weke+Wpkp+Wdkd (1-t) WACC= 0.50*13.5%+0.15*10%+0.35*6.5% WACC=6.75+1.5+2.275 WACC=10.525% The Lawrence Corporation is a restaurant supply company that sells furniture, glassware, and cooking utensils primarily to large restaurant chains. The firm is considering expanding its sales to independent restaurants. Although the order sizes will be considerably smaller, the marketing vice president believes Lawrence can charge higher prices that will help compensate for the smaller orders. and she believes the firm will be able to increase sales by $1,200,000. But, since many of these smaller restaurants present higher credit risks than the larger chains, the financial vice president estimates that 12% of the accounts will be uncollectible and he is arguing against this change in strategy. The cost of producing and marketing the products is estimated to be 75% of sales. Collection costs on delinquent accounts runs 5% of sales. Lawrence's tax rate is 30%. 34. If the company enters the new market and the forecasts are all correct, its incremental net income (after taxes) will be: a) 144,000 b) 90,000 c) 67,200 d) 28,800 35. If Lawrence has a receivables turnover ratio of 8 times and an inventory turnover ratio of 10 times, how much will the firm have to invest in new receivables and inventory to support the new sales to the smaller restaurants? a) 150,000 b) 60,000 c) 270,000 d) 135,600 e) none of these 36. If Lawrence requires a minimum return on investment in assets of 19%, should the firm take on these new customers or, is the financial vice president correct is his assessment of the situation. Do some calculations and choose the correct response below. a) The financial vice president is correct. It makes no sense to enter this market knowing that 12% of the accounts will be uncollectible. b) Of course the firm should enter this market. The return on investment is almost 25% and that exceeds the 19% return on investment the company requires. c) The financial vice president is right about not entering the market but his reason for not doing so is incorrect. The firm should not enter the market because the return on investment is only 5.6% and that is way below the 19% the firm requires. Essay/discussion questions. Please choose two (2) of the questions below. Do not answer more than two questions Your answers should be complete and concise, but should only answer the questions as it is asked. Please do not fill a page with extra “stuff” that the question does not call for. (9 points each) 1. “If stock markets are efficient, it is very difficult for investors to select portfolios of common stocks that can outperform the market in general.” Discuss clearly and concisely, what is meant by an efficient market, and why this quote from our text is probably very much on target. 2. From time to time, corporations may declare stock dividends; stock splits, or engage in stock repurchases. a) Explain how they work and why a corporation might do any of them. b) What is the impact of each of the actions on the wealth of the stockholders i.e., does it increase, decrease, or remain the same as a result of the actions. Explain why each of the actions has the impact that it does. 3. Present a concise, complete, and very logical argument supporting the contention that the residual theory of dividends is incomplete i.e., that investors are not indifferent between cash dividends and the future benefits to be derived from retained earnings even though retained earnings may be able to be invested at a rate of return equal to or perhaps even greater than the stockholder’s required rates of return. Answers of MCQ: 1. (e) There is not enough information given here to be able to answer this question. 2. (d) An investment in a new machine that will be used to improve the production process for one of its more successful products it has been producing for about 7 years. 3. (b) much more than $1000. 4. (c) Lower than the cost of capital (If NPV < 0, then IRR < Cost of Capital). 5. (a) $5,400,000 ($2,000,000*3*9/100). 6. (b) Long-term financing and a relatively high level of liquid current assets. 7. (d) All of the above help explain why a firm does not maintain a single, exact debt/equity ratio at all times. 8. (b) relationship between the price of a bond and market interest rates. 9. (a) Risk of the “portfolio” when the two projects are combined. 10. (a) It has a higher level of risk than the other two. 11. (a) Short-term debt; higher. 12. (c) Eliminate most of the risk or uncertainty involved in making investment decisions. 13. (d) None of these. 14. (d) None of these. 15. (d) Alternatives with the best combinations of risk and return possible. 16. (b) 12.50%. 17. (d) The credit ratings of the new customers being considered. 18. (b) Decline as average inventory increases. 19. (a) The firm is mature....has been around for a long time. 20. (a) carrying highly liquid assets. 21. (d) internally generated funds. 22. (d) all of these. 23. (c) change the total value of stockholder's equity but the direction of the change cannot be determined without knowing the price of the stock. 24. (a) It gives a firm commitment to purchase the securities from the corporation at a set price. 25. (c) Regular, stable cash dividends. 26. (d) More than $35,000. 27. (a) maximization of profit. 28. (c) eliminate the risk or uncertainty involved in making investment project decisions 29. (c) $63,800. 30. (b) Between 12 and 13 percent. 31. (c) $1211.46. 32. (a) $776.21. 33. (d) 10.525%. 34. (d) 28,800. 35. (e) none of these. 36. (c) The financial vice president is right about not entering the market but his reason for not doing so is incorrect. The firm should not enter the market because the return on investment is only 5.6% and that is way below the 19% the firm requires. Answers on Essay/discussion questions 1. The price of the stocks of the market is usually affected by the efficiency that the market projects over a particular period of time. Thus to understand the movement of the price in the market and gain larger profits at reduced risk the model of Efficient Market Hypothesis was created. As per the model the security prices should equal to the value of the securities investment at an investment value where the security’s future cash flow can be detected easily by capable and knowledgeable analysts. With the availability of any new information related to a company the stock prices immediate movement projects the new scenario of the market. However, in an efficient market the real prices of the stock get reflected with the change in the information of the market in the company. Generally the movement in the prices of stock depends on the demand supply theory. When a substantial group in the market tends towards purchasing of the shares in the market the prices of the stocks tend to push up. But when the bulk investors concentrate on selling their stock the prices which were once high tend to fall rapidly. This is known as the demand pull and cost push concept of the market which is very much applicable for the price movement of the stock. In a perfect market the information and the transaction are costless, which implies that the participants of the market have full information and can react without incurring cost. Efficiency of the market is distinguished between three forms: weak-form, semi-strong form and strong form. However, to balance the information that is made available to the investors of the market the semi-strong form of market hypothesis is generally applied. The information that is made available to the investors through the efficient market stock prices prevents the investors from earning excess return without incurring the transaction cost. Thus it is rightly said that it is very difficult to select stocks in an efficient market that will outperform the market in general because the costless information is readily available to all the investors. There lies no way in which one can make some extra earning from the rest of the investors in the market. On the other hand, if the assumption made regarding the information holds and the stock prices still react to the index inclusion, then this reaction can be due to large-scale purchases of the stock by index funds. Hence the lack of the price effect in the efficient market prevents the investors from earning more than the usual in a market that is already efficient. Again, a troubling concern for the corporate financial managers is the possibility that it may take several years for the investors to appreciate the significance of the newly obtained information of the market. Moreover, the concept of random walk being applicable in an efficient market it is difficult to predict whether the market will rise or fall. But whatever it may be the reaction of the investors is more or less the same preventing them from earning any abnormal income from the market (Palan 1-20). 2 (a) The stocks dividend are a portion of the earnings of the company which is distributed amongst the shareholders of a company as dividends, while the rest of the earnings is reinvested in the company for further growth of the company. The stock dividends are given by the corporations as an interest on the sum of money they take from the public in exchange of the stocks sold to them. The payment of the dividends of the organization is also made with the intention to avoid the transaction cost that is associated with the retained earnings of the organization. The transaction cost of the organization generally increases when the investors sell their shares too frequently. This can also be avoided or reduced by the payment of the stock dividend. When the market price of the stock increases to a point where investment in the stock of that company is discouraged by the investors, many companies believe that a wide distribution of the ownership of the company is good for their image. Thus to fall into the bracket of “trading range” and reduce the prices of the stock, concerned companies adopt the measure of stock split. In stock split the face value of the shares decreases increasing the count of the number of shares being issued in the market. However, the paid-up capital does not change due to stock split. Repurchase of share is the method through which the company provides cash to its existing shareholders to re-purchase the stocks of the organization. This helps reduce the number of available stocks with the company. The method through which repurchase of stocks is done is private negotiations, open market, repurchase 'put' rights, and two variants of self-tender repurchase: a Dutch auction and fixed price tender offer. The reduction in the number of shares of the company helps it to increase its earnings per share elevating the existing market value of the shares. 2 (b) The wealth of the stockholders of the market tends to rise in case of payment of stock dividend and share repurchases but remains the same for stock split decision taken by the firm. The reason behind the rise in the wealth of the investors in case of the payment of stock dividend is the fact that the investors tend to receive earnings from the company as long as it holds the stock of the company. This results in the income of the investor of the company rising. Moreover, the company feels proud in announcing the dividend to the shareholders of its company as it is a sign of prosperity for the company. Thus the investors remain very satisfied with that particular company preventing them from frequently trading of the stocks of the company. Hence the income optimization is justified in this case resulting in favorable outcome for the company. The process of share repurchasing is a process where the capital is provided by the company to its existing shareholders to invest in the respective company. This enhances the wealth of the shareholders of the company. The increase in the wealth of the shareholders makes them hold the shares of that company for a long period of time. This reduces the transaction cost undertaken by the company which usually occurs due to frequent trading of the stock of a particular company. However, when the company takes the decision to split the stock of the company it is with an intention to benefit the company and not the investors. Thus, the existing stocks get bifurcated into more units reducing the price of the stock. This in turn makes the stock more in demand for the investors to buy as the price which was once sky-rising has reduced. Therefore this is a measure taken by the company for its own benefit to bring the prices of the stock to a trading range. But, on the contrary, the earning per share of the company gets reduced in the long-run with the increase in the number of shares. This may tend to be harmful for the company if other measures to increase the profitability of the company are not adopted immediately. Work Cited Palan Stefan. “The Efficient Market Hypothesis and its Validity in Today’s Market”. Master Thesis, Aug. 2004. Web. 4 Aug 2012. Read More