Midterm_Answer_Key - MGMT 130 Winter 2010 Midterm Answer...

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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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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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Midterm_Answer_Key - MGMT 130 Winter 2010 Midterm Answer...

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