MBA Financial Management and Markets Exam 4 Spring 2010

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1 MBA Financial Management and Markets Exam 4 Spring 2010 Directions: The following 33 questions are designed to test your knowledge of cost of capital, CAPM, cash flow estimation, NPV, IRR, Modified IRR, and payback methodologies in applying financial theories to business decisions. Please choose the best possible answer from the responses provided to each question. Your completed exam will be due at the start of class on March 29, True/False Indicate whether the statement is true or false. 1. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. 2. The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. 3. Conflicts between two mutually exclusive projects, where the NPV method chooses one project but the IRR method chooses the other, should generally be resolved in favor of the project with the higher NPV. 4. One advantage of the payback method for evaluating potential investments is that it provides some information about a project's liquidity and risk. 5. Extending projects with different lives to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives. 6. If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. 7. Any cash flow that can be classified as incremental to a particular project is relevant in a capital budgeting analysis. 8. In cash flow estimation, the existence of externalities must be taken into account if those externalities have any effects on the firm's cash flows. 9. The primary advantage of accelerated depreciation over straight-line depreciation is that, while the total amount of depreciation and thus tax savings is unchanged, charges are taken sooner. This means that the firm gets the benefits of the tax savings sooner, which increases their present value. Multiple Choice Identify the choice that best completes the statement or answers the question. 10. Which of the following statements is CORRECT? a. An NPV profile graph shows how a project's payback varies as the cost of capital changes. b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. c. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. d. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital. e. We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV.

2 11. 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 NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project's NPV is greater than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPVs of relatively risky projects should be found using relatively low WACCs. 12. Which of the following statements is CORRECT? a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not. b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more likely to be appropriate. c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order. 13. Humboldt Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? WACC: 9.00% Year: Cash flows: $1,000 $300 $300 $300 $300 $300 a. $ b. $ c. $ d. $ e. $ Tucker Corp. 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 negative, in which case it will be rejected. Year: Cash flows: $1,000 $450 $450 $450 a % therefore, Tucker should reject the project b % c % d % e % 15. Wachowicz Inc. is considering two average-risk alternative ways of producing its patented polo shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2 years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years. The company has a contract that requires it to produce the shirts for 4 years, but the patent will expire after 4 years, so the shirts will not be produced after the 4 th year. Inflation is expected to be zero during the next 4 years. If cash inflows occur at the end of each year, and if the cost of capital is 10%, by what amount will the better project increase the firm's value?

3 a. $ b. $1, c. $1, d. $1, e. $1, Van Auken Inc. is considering a project that has the following cash flows: Year Cash Flow 0 $1, The company's WACC is 10%. What are the project's payback, internal rate of return, and net present value? a. Payback = 2.4; IRR = 10.00%; NPV = $600. b. Payback = 2.4; IRR = 21.22%; NPV = $260. c. Payback = 2.6; IRR = 21.22%; NPV = $300. d. Payback = 2.6; IRR = 21.22%; NPV = $260. e. Payback = 2.6; IRR = 24.12%; NPV = $ ZumBahlen Inc. is considering the following mutually exclusive projects: Project A Project B Year Cash Flow Cash Flow 0 $5,000 $5, , , , , At what cost of capital will the net present value of the two projects be the same? (That is, what is the "crossover" rate?) a % b % c % d % e % 18. Anderson Associates is considering two mutually exclusive projects that have the following cash flows: Project A Project B Year Cash Flow Cash Flow 0 $10,000 $8, ,000 7, ,000 1, ,000 1, ,000 1,000 At what cost of capital do the two projects have the same net present value? (That is, what is the crossover rate?) a %

4 b % c % d % e % 19. Rivoli Roofing is considering mutually exclusive Projects A and B, which have the following cash flows: Project A Project B Year Cash Flow Cash Flow 0 $200 $ At what cost of capital would the two projects have the same net present value (NPV)? a. 6.22% b. 7.11% c. 8.45% d. 9.32% e % 20. Bey Bikes is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 10.00% Year: Cash flows: $1,000 $525 $485 $445 $405 a years b years c years d years e years 21. Pinkerton Truck Rental is considering two mutually exclusive engine development projects. The RPX design has an expected life of 4 years and projected cash inflows are $3.6 million at the end of each of the first 2 years and $1.8 million in each of the next 2 years. The RPB design is more flexible and has an 8-year life. The projected end-of-year flows from the RPB design are $2.4 million in each of the first two years and $2.0 million in each of the next six years. Both projects require an initial investment of $5.4 million, and Pinkerton's cost of capital is 12%. Frequent changes in engine technology make engine development risky, but Pinkerton feels that the basic designs can be refined and modified. Thus, Pinkerton often assumes that continuous replacements can be made as a project's life ends. What is the net present value (on an 8-year extended basis) of the project with the most value to the company? a. $3.976 million b. $4.325 million c. $5.085 million d. $5.211 million e. $5.861 million 22. Sorenson Stores is considering a project that has the following cash flows: Year Cash Flow

5 0 CF 0 =? 1 $2, , , ,500 The project has a payback of 2.5 years, and the firm's cost of capital is 12%. What is the project's NPV? a. $ b. $ c. $1, d. $2, e. $3, Which of the following statements is CORRECT? a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV. e. A good example of a sunk cost is a situation where a retailer opens a new store, and that leads to a decline in sales of some of the firm's existing stores. 24. A company is considering a new project. The CFO plans to calculate the project's NPV by 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 one 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. 25. You work for Athens Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 operating cash flow? Sales revenues $15,000 Depreciation $4,000 Other operating costs $6,000 Tax rate 35.0% a. $7,250 b. $7,431 c. $7,617 d. $7,807 e. $8,003

6 26. Zeta Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's operating cash flow for Year 1? Equipment cost (depreciable basis) $75,000 Straight-line depreciation rate 33.33% Sales revenues, each year $60,000 Operating costs excl. depr'n $25,000 Tax rate 35.0% a. $29,196 b. $29,945 c. $30,712 d. $31,500 e. $32, Your company, Q4 Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the MACRS rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year operating life. What is the project's operating cash flow during Year 4? Equipment cost (depreciable basis) $70,000 Sales revenues, each year $50,000 Operating costs excl. depr'n $25,000 Tax rate 35.0% a. $16,213 b. $17,067 c. $17,965 d. $18,863 e. $19, California Hideaways is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have zero salvage value. No new working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) WACC 10.0% Net investment cost (depreciable basis) $65,000 Straight-line depr'n rate % Sales revenues, each year $60,000 Operating costs excl. depr'n, each year $25,000 Tax rate 35.0% a. $8,499 b. $8,946 c. $9,417 d. $9,913 e. $10,434

7 29. Moore & Moore (MM) is considering the purchase of a new machine for $50,000, installed. MM will use the MACRS accelerated method to depreciate the machine, which is classified as 5-year property (see the following MACRS table for depreciation rates). MM expects to sell the machine at the end of its 4-year operating life for $10,000. If MM's marginal tax rate is 40%, what will the after-tax cash flow be when it disposes of the machine at the end of Year 4? Ownership Year Depreciation Rate 1 20% a. $7,656 b. $8,059 c. $8,484 d. $8,930 e. $9, Dumpe Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price will increase with inflation. Fixed costs will also be constant, but variable costs will rise with inflation. The project should last for 3 years, and there will be no salvage value. This is just one project for the firm, so any losses can be used to offset gains on other firm projects. What is the project's expected NPV? WACC 10.0% Net investment cost (depreciable basis) $100,000 Units sold 40,000 Average price per unit, Year 1 $25.00 Fixed op. cost excl. depr'n (constant) $150,000 Variable op. cost/unit, Year 1 $20.20 Annual depreciation rate 33.33% Expected inflation 5.00% Tax rate 40.0% a. $8,536 b. $8,985 c. $9,458 d. $9,931 e. $10, You were recently hired by Nast Media Inc. to estimate its cost of capital. You were provided with the following data: D 1 = $2.00; P 0 = $55.00; g = 8.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a % b % c % d % e %

8 32. Schadler Systems is expected to pay a $3.50 dividend at year end (D 1 = $3.50), the dividend is expected to grow at a constant rate of 6.50% a year, and the common stock currently sells for $62.50 a share. The before-tax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 40% debt and 60% common equity. What is the company's WACC if all equity is from retained earnings? a. 8.35% b. 8.70% c. 9.06% d. 9.42% e. 9.80% 33. A small manufacturer is considering two alternative machines. Machine A costs $1.0 million, has an expected life of 5 years, and generates after-tax cash flows of $350,000 per year. At the end of 5 years, the salvage value of the machine is zero, but the company will be able to purchase another Machine A at a cost of $1.2 million. The second Machine A will generate after-tax cash flows of $375,000 a year for another 5 years, at which time its salvage value will again be zero. Alternatively, the company can buy Machine B at a cost of $1.5 million today. Machine B will produce after-tax cash flows of $400,000 a year for 10 years, after which it will have an after-tax salvage value of $100,000. Assume that the cost of capital is 12%. If the company chooses the machine that adds the most value to the firm, by how much will the company's value increase? a. $347, b. $451, c. $633, d. $792, e. $841,357.66

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