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1 Midterm exam financiering/finance <Front page>

2 Question 1 An agency problem can be alleviated by: A) requiring all organizations to be sole proprietorships. B) compensating managers in such a way that acting in the best interest of shareholders is also in the best interest of managers. C) asking managers to take on more risk than they are comfortable taking. D) A and B. Answer: D Question 2 Which of the following are subject to double taxation? A) Corporation B) Partnership C) Sole proprietorship D) A and B Answer: A Use the table for the question(s) below. Consider the following balance sheet: Luther Corporation Consolidated Balance Sheet December 31, 2009 and 2008 (in $ millions) Assets Liabilities and Shareholders' Equity Current Assets Current Liabilities Inventories Accounts payable Accounts receivable Notes payable / short-term debt Cash Current maturities of long-term debt Other current assets Other current liabilities Total current assets Total current liabilities Non-Current Assets Non-Current Liabilities Land Long-term debt Buildings Capital lease obligations Equipment Total Debt Less accumulated depreciation (56.1) (52.5) Deferred taxes Net property, plant, and equipment Other long-term liabilities Total non-current Goodwill liabilities Other long-term assets Total liabilities Total non-current assets Shareholders' Equity

3 Total Assets Total liabilities and Shareholders' Equity Question 3 What is Luther's net working capital in 2008? A) $12 million B) $27 million C) $39 million D) $63.6 million Answer: A Explanation: A) NWC = current assets - current liabilities = = $12 million Section: 2.3 Balance Sheet Analysis Question 4 11) If in 2009 Luther has 10.2 million shares outstanding and these shares are trading at $16 per share, then what is Luther's Enterprise Value? A) -$63.3 million B) $353.1 million C) $389.7 million D) $516.9 million Explanation: Total Debt = (notes payable (10.5) + current maturities of long-term debt (39.9) + long-term debt (239.7) = million Total Equity = 10.2 $16 = 163.2, C) Enterprise value = MVE + Debt - Cash = 10.2 $ = Section: 2.3 Balance Sheet Analysis Use the table for the question(s) below. Consider the following income statement and other information: Luther Corporation Consolidated Income Statement Year ended December 31 (in $ millions) Sales revenue Cost of sales (500.2) (481.9) Gross profit Selling, general, and administrative expenses (40.5) (39.0) Research and development (24.6) (22.8) Depreciation and amortization (3.6) (3.3) Operating income

4 Other income Earnings before interest and taxes (EBIT) Interest income (expense) (25.1) (15.8) Pre-tax income Taxes (5.5) (5.3) Net income Price per share $16 $15 Shares outstanding (millions) Share options outstanding (millions) Shareholders' Equity Total Liabilities and Shareholders' Equity Question 5 Luther's EBIT coverage ratio for the year ending December 31, 2008 is closest to: A) 1.64 B) 1.78 C) 1.98 D) 2.19 Explanation: C) EBIT Coverage ratio = EBIT / (Interest Expense) = 31.3/15.8 = Section: 2.5 Income Statement Analysis Week 2 Question 6 A project with discount rate 10% per year generates the following cash flows at the end of each year. Year 1 Year 2 Year 3 Year 5-10 Cash flow $20 $20 $0 $20 Year 5-10 considers the years 5, 6, 7, 8, 9 and 10. What is the present value of the cash flows of this project? A) Less than $100 B) Between $100 and $115 C) Between $115 and $130 D) More than $130 Answer: B Explanation: Calculate PV of annuity and subtract PV of year 3 cash flow. PV annuity = 20 x (1/0.10) x [1-1/(1.10)^10] = $122,89 PV year 3 = 20/1.1^3 = $15,02 PV = = $107 Question 7

5 Consider a risk-free bond with a market price of $114 and the following cash flows. Year 1 Year 2 Cash flow $12 $112 Where year 1 is one year from now and year 2, is two years from now. The risk free interest rate is 3% per year. Which statement is true? A) There is no arbitrage opportunity. B) There is an arbitrage opportunity and you can exploit this by selling the bond and saving at the bank at the risk free interest rate. C) There is an arbitrage opportunity and you can exploit this by buying the bond and borrow from the bank against the risk free interest rate. D) This is a normal market. Explanation: PV bond = 12/1, /(1,03)^2 = 117,22. So bond price is too low so buy bond and fund it with a loan (borrow from the bank). Question 8 Which of the following loans has the highest effective annual rate? 1. A loan with 5% APR and quarterly compounding 2. A loan with 7% APR with yearly compounding 3. A loan with a 0.6% effective rate per month 4. A loan with 6% EAR A) Loan 1 B) Loan 2 C) Loan 3 D) Loan 4 Loan 1: EAR = (1+5%/4)^4-1=5,1% Loan 2: EAR = 7% Loan 3: EAR = (1+0.06%)^12-1=7.4% Loan 4: EAR = 6% Question 9 Consider the information about a project below. Year 0 Year 1 Year 2 Year 3 Cash flow -$100 $30 $40 $50 Term 1 Year 2 Years 3 Years 4 Years Rate (EAR) 4.0% 4.5% 5.0% 5.5% What is the net present value of this project? A) Less than $0 B) Between $0 and $5 C) Between $5 and $10 D) More than $10

6 Answer C. Explanation: PV = /1, /1,045^2 + 50/1,055^3 = $8,67 Question 10 You are thinking about buying a house for $200,000 with a 30-year annuity loan that has equal monthly payments. These payments include interest and ensure that the loan will be repaid in full in year 30. If the effective interest rate for this loan is 0.5% per month and the maximum monthly amount you are able to pay is $1300, can you afford the loan? A) Yes, since the value of these monthly payments required by the bank is higher than $200,000 B) Yes, since the monthly payment required by the bank will be lower than $1300 C) No, since the value of these monthly payments required by the bank is less than $200,000 D) No, since the monthly payment required by the bank is higher than $1300 Answer: B PV annuity = = C x *(1/0,005)*(1-1/(1,005)^360) = C x > C = / = $1199 per month. Question 11 When considering inflation in capital budgeting, one should include inflation if: A) the rate of inflation in the economy is positive. B) the project has uncertain cash flows. C) the discount rate used is a real rate of interest. D) None of the above. Answer: D Question 12 You are considering the following project. It will provide you $350,000 today, however you will have to make an investment of $1,400,000 in ten years. Given the riskiness of the investment opportunity, your cost of capital is 15%. Which of the following statements is correct. A) Accept, because NPV is positive. The IRR equals approximately 0,1487. The IRR rule and NPV rule conflict. B) Reject, because NPV is negative, The IRR equals approximately 0,1487. The IRR rule and NPV rule do not conflict. C) Accept, because NPV is positive. The IRR equals approximately 0,1587. The IRR rule and NPV rule do not conflict. D) Reject because NPV is negative, The IRR equals approximately 0,1587. The IRR rule and NPV rule do not conflict. Answer: A Explanation: Accept, because NPV is positive, NPV = /(1.15^10)= The IRR equals approximately 0,1487. The IRR rule and NPV rule conflict. NPV = /(1.15^10). IRR=(1400/350)^(1/10) -1

7 Question 13 Consider five projects with the following cash flows (in millions), where year 1 is one year from now (t=0). Project T=0 Year 1 Year 2 A B C D E The discount rate is 5% per year. Suppose your firm has a total capital budget of $60 million which projects should be undertaken? A) Project A, B and D B) Project A and E C) Project A, B and C D) All expect one: D Explanation: The PI(profitability index) selects projects A, B and C. These are also the optimal projects to undertake as the budget is used fully used. Project t=0 t=1 t=2 NPV PI A , , B , , C , , D , , E , , Question 14 Assume the following for the next question. Accepting project X will increase gross profit by $25,000 in both year 1 and year 2. Funding cost of project X (interest payments) is 1,000 per year To increase consumer awareness of project X, the firm will spend $9,000 in the first year. The R&D costs of project are $14,000 and should be paid upfront. Note that the firm should expense R&D costs as incurred to comply with the financial standards. Production of project X will require an upfront investment of $25,000. For tax purposes we need to assume that the equipment has a two-year life and that the firm uses straightline depreciation for the new equipment. Net working capital each year is 20% of gross profit. Income tax is 50%. Revenues and costs are paid at the end of the year. The free cash flow of project X in year 1 is closest to? A) $18,750

8 Answer: B Explanation B) $9,250 C) $1,750 D) $8,750 Year Incremental Earnings Gross profit Selling, General and Administrative (9000) Research and Development (14000) Depreciation (12500) (12500) EBIT (14000) Income Tax at 50% 7000 (1750) (6250) Unlevered net income (7000) Free Cash Flow Plus: Depreciation Less: Capital Expenditure (25000) Less: Increases in NWC (5000) Free Cash Flow (32000) Question 15 Which of the following statements is false? A) We can use scenario analysis to evaluate alternative pricing strategies for our project. B) Scenario analysis considers the effect on NPV of changing multiple project parameters. C) The difference between the IRR of a project and the cost of capital tells you how much error in the cost of capital it would take to change the investment decision. D) Scenario analysis breaks the NPV calculation into its component assumptions and show how the NPV varies as each one of the underlying assumptions change. Answer: D

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