Sample Exam #3

1.
Heino Inc. hired you as a
consultant to help them
estimate their cost of capital. You have
been provided with the following data: r_{RF}
= 5.0%; _{M}

*A.* 10.50%

b.
10.71%

c.
10.88%

d.
11.03%

e.
11.14%

*r _{s} = 5% + (5%)*1.1 = 10.50%*

2. P. Daves
Inc. hired you as a consultant to help them estimate their cost of
equity. The yield on the firm’s bonds is
6.5%, and
Daves' investment bankers believe that the cost of equity can be
estimated
using a risk premium of 4.0%. What is an estimate of Daves' cost of
equity from
retained earnings?

a.
9.77%

b.
10.02%

c.
10.19%

d.
10.33%

*E.* 10.50%

3. You were
recently hired by Hemmings Media, Inc., to estimate their cost of
capital. You were provided with the
following data: D_{1}
= $2.50; P_{0} = $60; g = 7% (constant); and F = 5%. What is the cost of equity raised by selling
new common stock?

a.
11.02%

b.
11.20%

*C.* 11.39%

d.
11.58%

e.
11.74%

*2.50/(60* 95%) + 7% = 11.39%*

4. For a
typical firm, which of the following is correct? All
rates are after taxes, and assume the
firm operates at its target capital structure.

a.
r_{d}
> r_{e} > r_{s} > WACC.

b.
r_{s}
> r_{e} > r_{d} > WACC.

c.
WACC
> r_{e} > r_{s} > r_{d}.

*D.* r_{e}
> r_{s}
> WACC > r_{d}.

e.
WACC
> r_{d} > r_{s} > r_{e}.

5. Maese
Sisters Inc has been paying out all of its earnings as dividends, and
hence has
no retained earnings. This same situation is expected to persist in the
future.
The company uses the CAPM to calculate its cost of equity.
Its target capital structure consists of
common stock, preferred stock, and debt.
Which of the following events would __reduce__ the WACC?

a.
The
flotation costs associated with issuing new common stock increase.

*B.* The
market risk premium declines.

c.
The
company’s beta increases.

d.
Expected
inflation increases.

6. Which of the following statements is CORRECT?

a.
In the
WACC calculation, we must adjust the cost of preferred stock (the
market yield)
because 70% of the dividends received by corporate investors are
excluded from
their taxable income.

b.
We
should use historical measures of the component costs from prior
financings when
estimating a company’s WACC for capital budgeting purposes.

c.
The cost
of new equity (r_{e}) could possibly be lower than the cost of
retained
earnings (r_{s}) if the market risk premium, risk-free rate,
and the
company’s beta all decline by a sufficiently large amount.

d.
The
component cost of preferred stock is expressed as r_{p}(1 - T),
because
preferred stock dividends are treated as fixed charges, similar to the
treatment of debt interest.

*E.* The cost
of retained earnings is
the rate of return stockholders require on a firm’s common stock.

7. If a
typical

*A.* Riskier
over time, and its
intrinsic value will not be maximized.

b.
Riskier
over time, but its intrinsic value will be maximized.

c.
Less
risky over time, and its intrinsic value will not be maximized.

d.
Less
risky over time, and its intrinsic value will be maximized.

e.
There is
no reason to expect its risk position or value to change over time as a
result
of its use of a single discount rate.

8. Blanchford
Enterprises is considering a project that has the following cash flow
data. What is the project's IRR? Note that a project's projected IRR
can be less than the WACC (and even negative), in which case it will be
rejected.

__Year:
0
1
2
3 __

Cash
flows:-$1,000 $450 $450 $450

a.
16.20%

*B.* 16.65%

c.
17.10%

d.
17.55%

e.
18.00%

*n = 3; PV = -1000; PMT = 450; FV = 0:
Solve for i = 16.6487%*

9. Tapley
Dental Associates is considering a project that has the following cash
flow
data. What is the project's payback?

__Year:
0
1
2
3
4
5 __

Cash
flows: -$1,000 $300
$310
$320
$330
$340

a.
2.11
years

b.
2.50
years

c.
2.71 years

d.
3.05
years

*E.* 3.21
years *Accumulate
cash inflows until you get to 1000*

10. Richards
Enterprises is considering a project that has the following cash flow
and WACC
data. What is the project's NPV? Note
that a project's projected NPV can be negative, in which case it will
be rejected.

WACC
= 10%

__Year:
0
1
2
3
4
5 __

Cash
flows: -$1,000 $400
$395
$390
$385
$380

a.
$478.74

*B.* $482.01
*(Use
the cash flow entries on your calculator with a rate of 10%)*

c.
$495.05

d.
$507.98

e.
$517.93

11. Which of
the following statements is CORRECT?

a.
The
internal rate of return method (IRR) is generally regarded by academics
as
being the best single method for evaluating capital budgeting projects.

b.
The
payback method is generally regarded by academics as being the best
single
method for evaluating capital budgeting projects.

c.
The
discounted payback method is generally regarded by academics as being
the best
single method for evaluating capital budgeting projects.

*D.* The net
present value method
(NPV) is generally regarded by academics as being the best single
method for
evaluating capital budgeting projects.

e.
The
modified internal rate of return method (MIRR) is generally regarded by
academics as being the best single method for evaluating capital
budgeting
projects.

12. Which of
the following statements is CORRECT?

a.
One
defect of the IRR method is that it does not take account of cash flows
over a
project’s full life.

b.
One
defect of the IRR method is that it does not take account of the time
value of
money.

c.
One
defect of the IRR method is that it does consider the time value of
money.

d.
One
defect of the IRR method is that it values a dollar received today the
same as
a dollar that will not be received until some time in the future.

*E.
*One
defect of the IRR method is that it assumes
that the cash flows to be received from a project can be reinvested at
the IRR
itself, and that assumption is often not valid.

13. Which of
the following statements is CORRECT?
Assume that the project being considered has normal cash flows,
with one
outflow followed by a series of inflows.

a.
A
project’s regular IRR is found by compounding the initial cost at the
WACC to
find the terminal value (TV), then discounting the TV at the WACC.

b.
A
project’s regular IRR is found by compounding the cash inflows at the
WACC to
find the present value (PV), then discounting to find the IRR.

c.
If a
project’s IRR is less than the WACC, then its NPV will be positive.

*D.* A
project’s IRR is the discount
rate that causes the PV of the inflows to equal the project’s cost.

e.
If a
project’s IRR is positive, then its NPV must also be positive.

14. Malholtra Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 10.00%

Year __ 0
1
2
3
4 __

Cash
flows -$850 $300
$320 $340 $360

a. 14.08%

B. 15.65%

c. 17.21%

d. 18.94%

e. 20.83%

15. You work for Alpha Inc., and you must estimate the Year 1 operating net cash flow for a proposed project with the following data. What is the Year 1 operating cash flow?

Sales $11,000

Depreciation $4,000

Other operating costs $6,000

Tax
rate
35%

*A.* $4,650

b. $4,800

c. $4,950

d. $5,100

e. $5,250

*You earn $650 after tax and add back
depreciation to get $4650*

16. As a member of Gamma Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data. What is the Year 1 operating cash flow?

Sales $33,000

Depreciation $10,000

Other operating costs $17,000

Interest expense $4,000

Tax
rate
35%

a. $ 9,500

b. $10,600

c. $11,700

d. $12,800

*E.* $13,900

*$33000-27000= 6000* (1-.35) + 10000 = $13900*

17.
Big Air
Services is now in the final year of a project.
The equipment originally cost $20 million, of which 75% has been
depreciated. Big Air can sell the used
equipment today for $6 million, and its tax rate is 40%.
What is the equipment’s after-tax net salvage
value?

a. $5,500,000

*B.* $5,600,000

c. $5,700,000

d. $5,800,000

e. $5,900,000

*Book Value = $5 M; Taxable Gain on *

*
Total
After Tax Salvage = $5,600,000*

18. Which of the following is __NOT__
a cash
flow that should be included in the analysis of a project?

a. Changes in net operating working capital.

b. Shipping and installation costs.

c. Cannibalization effects.

d.

*E.* Sunk
costs that have been expensed for tax purposes.

19. Which of the following statements is CORRECT?

A. Using MACRS depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but would affect the timing of the cash flows and thus the NPV.

b. Under current laws and regulations, corporations must use straight line depreciation for all assets whose lives are 10 years or longer.

c. Corporations must use
the same depreciation
method (e.g., straight line or MACRS) for stockholder reporting and tax
purposes.

d. Since depreciation is not a cash expense, it has no affect on cash flows and thus no affect on capital budgeting decisions.

e. Under MACRS depreciation rules, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers the projected NPV.

20. A company is considering a
new project. The
CFO plans to calculate the project’s NPV by first estimating the
relevant cash
flows for each year of the project’s life (the initial investment cost,
the
annual operating cash flows, and the terminal cash flow), then
discounting
those cash flows at the company’s WACC.
Which of the following factors should the CFO __INCLUDE IN THE
CASH
FLOWS__ when estimating the relevant cash flows?

a. All sunk costs that have been incurred relating to the project.

b. All interest expenses on debt used to help finance the project.

*C.* The
investment in working capital required to operate the project, even if
that
investment will be recovered at the end of the project’s life.

d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.

e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.

21. Millman Electronics will produce 60,000 stereos next year. Variable costs will equal 50% of sales, while fixed costs will total $120,000. At what price must each stereo be sold for the company to achieve an EBIT of $95,000?

a. $6.57

b. $6.87

*C.* $7.17

d. $7.47

e. $7.77

*60,000X – 30,000X – 120,000 = 95,000*

*
30,000X = 215,000*

*
X = $7.1667*

22. Brandi Co. has an unlevered beta of 1.10. The firm currently has no debt, but is considering changing its capital structure to be 30% debt and 70% equity. If its corporate tax rate is 40%, what is Brandi's levered beta?

a. 1.2549

*B.
* 1.3829

c. 1.5764

d. 1.6235

e. 1.7458

*Levered Beta = Unlevered Beta [1+(1-t)D/E] = 1.3829*

23. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.

a. The expected return on the stock is
5% a year.

b. The stock’s dividend yield is 5%.

c. The price of the stock is expected
to decline
in the future.

d. The stock’s required return must be equal to or less
than 5%.

E. The stock’s price one year from now is expected to be
5% above the current price.

a. Maximum earnings per share (EPS).

b. Minimum cost of debt (r_{d}).

c. Highest bond rating.

d. Minimum cost of equity
(r_{s}).

*E.* Minimum
weighted average cost of capital (WACC).

*A.* The
capital structure that maximizes stock price is also the capital
structure that
minimizes the weighted average cost of capital (WACC).

b. The capital structure that maximizes stock price is also the capital structure that maximizes earnings per share.

c. The capital structure that maximizes stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.

d. Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, it still may raise the company’s WACC.

e. If Congress were to pass legislation that increases the personal tax rate, but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.