MGMT 130 Winter 2010
Midterm Answer Key
1. The answer is (a): Choose the 8% compounded annually rate because it has the higher
effective annual rate. Since option A is compounded annually, the EAR is exactly 8%.
For option B, EAR is
2
2
0775
.
0
1
+
-1, or 7.90%.
2. The answer is (a). Quoted rates may differ in their actual value depending upon how
frequently they are compounded. None of the other answers makes sense.
3. The answer is (b). Debt ratings (also called credit ratings) are specifically designed to
measure credit risk, or the risk of the issuer defaulting on their payments. Interest rate
risk and callable risk depend upon factors not related to the issuer and are not
incorporated in the credit rating.
4. The answer is (b), false. A project with conventional cash flows (a negative up front
payment, followed by only positive cash flows) can only have one IRR. Projects with
unconventional
cash flows can have multiple IRRs.
5. The answer is (a), true. IRR and profitability index do not take into account the scale of
a project. They can lead you to choose a smaller project with a higher rate of profitability
over larger project with a greater absolute amount of profitability.
6. The answer is (b), false. Since funds are limited, we want to invest in the combination
of projects that delivers the maximum NPV. Analyzing by IRR will not necessarily
provide us with this result.
7. The answer is (d), the long time period to maturity. Short-term government bonds are
considered risk-free, but long term government bonds have duration risk and can lose
value as interest rates change.
8. The answer is (e), small company stocks. We have seen that they have historically had
the most volatile returns.
9. The answer is (b). ROE = profit margins x total asset turnover x assets-to-total equity
ratio.
10. The answer is (e). ROA is net income divided by total assets. ROE is net income
divided by total equity. The company is profitable, so net income must be positive. Total
assets is total equity + total debt. Since a company cannot have negative debt, total assets
must be greater than or equal to total equity. Therefore ROA must be less than or equal to

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*Sign up*ROE. (If income was negative, then ROE would be a bigger negative number than ROA.
This illustrates the effect of leverage.)
11. The answer is (c), the corporate BB rated 30 year coupon bond. Coupon bonds always
have lower duration than equivalent maturity discount bonds. And due to their higher
coupons, a corporate bond will have lower duration than a US Treasury.
12. The answer is (b), No. Even though earnings and dividends have grown, that does not
mean that the project contributed positive NPV to the shareholders. The fact that earnings
and dividends have grown indicates that the acquisition has generated good cash flows.
But the value to the shareholders also depends upon the price paid for the acquisition.

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