MBA 8230 Corporation Finance (Part II) Practice Final Exam #2

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1 MBA 8230 Corporation Finance (Part II) Practice Final Exam #2 1. Which of the following input factors, if increased, would result in a decrease in the value of a call option? a. the volatility of the company's stock b. the current price of the stock c. the time to maturity of the option d. the risk-free rate of interest e. the exercise price of the option 2. Which of the following statements is most correct? a. An advantage of traditional DCF cash flow analysis is its ability to automatically reflect option value. b. Options in the capital budgeting sense are the right, but not the obligation, to take some action in the future. c. Capital budgeting options must always have a positive option value. d. Both B and C are correct. e. All of the above are correct. 3. Which of the following statements is most correct? a. A managerial option is an opportunity to respond to changing circumstances, giving managers the opportunity to influence a project's outcome. b. An abandonment option allows a firm to quit a project if operating cash flows turn out to be less than expected. c. A firm would be more likely to accept a project if there is an embedded option in the project. d. Both A and C are correct. e. All of the above are correct. (USE THE INFORMATION BELOW TO ANSWER THE FOLLOWING 2 QUESTIONS) Expected Standard Return Deviation Beta Stock A 20% 14% 1.5 Stock B 25% 18% 2.0 The correlation coefficient between Stock A and Stock B is Assume that both Stock A and Stock B are in equilibrium (i.e., for both stocks, the expected rate of return is equal to the required rate of return) and that the expected return on the market is 15 percent. 4. According to the information given above, what is the risk-free rate of interest? a. 5 percent b. 7 percent c. 8 percent d. 10 percent

2 e. Not enough information provided to answer this question. 5. What is the beta of a portfolio comprised of 30 percent of Stock A, 50 percent of Stock B, and 20 percent of the risk-free security? a b c d e. Not enough information provided to answer this question. 6. Moltron, Inc. has a beta of The risk-free rate is 4 percent and the expected rate of return on the market portfolio is 13.5 percent. Using the CAPM, Moltron s expected return on equity is: a. 4.0 percent b. 9.2 percent c percent d percent e percent 7. Given the following distribution of returns, compute Stock W s standard deviation: State of Economy Probability Stock W Return Recession.35 10% Average growth.50 20% Boom.15 30% a. 0.00% b. 2.37% c. 6.78% d. 7.07% e. 8.41% 8. A portfolio has 60% of its funds invested in Security A and 40% of its funds invested in Security B. Security A has a standard deviation of 18. Security B has a standard deviation of 20. The securities have a coefficient of correlation of 0.4. Which of the following values is closest to portfolio standard deviation? a. 9.4% b. 12.6% c. 14.7% d. 15.8% e. 18.8%

3 9. Stock A has a beta of 1.2 and Stock B has a beta of 0.8. Which of the following statements must be true about these securities? a. When held in isolation, Stock A has greater risk than Stock B. b. Stock B would be a more desirable addition to a portfolio than Stock A. c. The standard deviation of Stock A will be greater than that on Stock B. d. The required return on Stock A will be greater than that on Stock B. e. The required return on Stock B will be greater than that on Stock A. 10. Which of the following statements is not correct? a. Under normal conditions, we cannot say whether the CAPM approach to estimating a firm's cost of retained earnings gives a better estimate than the DCF approach. b. The risk premium used in the bond-yield-plus-risk-premium method is not the same as the one used in the CAPM method. c. The CAPM approach cannot be used to estimate a firm's cost of internally generated equity only of externally generated equity. d. In practice, the DCF method and the CAPM method usually produce different estimates for rs. e. The CAPM method probably should not be used in isolation (i.e. alone) to estimate a firm's cost of retained earnings equity. USE THE INFORMATION BELOW TO ANSWER THE FOLLOWING 3 QUESTIONS Southeastern Electric has a target capital structure that calls for 40% debt, 10% preferred stock, and 50% common equity. The company s current after-tax cost of debt is 5%, and it can sell as much debt as it wishes at this rate. The company s preferred stock currently sells for $45 a share and pays a dividend of $5 per share; however, the company will net only $40 per share from the sale of new preferred stock. Southeastern Electric s common stock currently sells for $50 per share. The company recently paid a dividend of $1 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10% per year. 11. What is the company s cost of equity (that is, r s ) to be used in the determination of Southeastern s weighted average cost of capital? a. 10.0% b. 12.5% c. 15.5% d. 16.5% e. 18.0% 12. What is the company s cost of preferred stock equity (that is, r p ) to be used in the determination of Southeastern s weighted average cost of capital? a. 10.0% b. 12.5% c. 15.5% d. 16.5% e. 18.0%

4 13. What is Southeastern s weighted average cost of capital? a. 12.5% b. 8.3% c. 10.5% d. 11.9% e. 14.1% 14. If a firm increases the debt in its capital structure, then all else equal, which of the following statements is true? a. Both business and financial risk increase b. Business risk increases but financial risk remains the same c. Business risk remains the same but financial risk increases d. Business risk decreases, but financial risk remains the same e. Business risk remains the same but financial risk decreases 15. Chunky Fried Chicken is trying to determine its WACC at the optimal capital structure. The firm now has only debt and equity, and estimates that it will continue to use only debt and equity in the future also. It has determined that the optimal capital structure is given by a debt-to-equity ratio of 0.5. At this ratio, its pre-tax cost of debt is 6%. It has estimated that if it had no debt, then its beta would be 1.2. Assume the risk-free rate is 2% and the market risk premium is 7%. Assume the firm s tax rate is 40%. Based on this information, what is the WACC at the optimal capital structure? a. 9.81% b % c. 7.00% d. 8.26% e % 16. Restown, Inc. has an optimal capital structure of 50 percent debt and 50 percent equity. The firm s weighted average cost of capital is 14.2%. All else constant, if the risk-free interest rate increases, due to higher expected inflation, Restown s WACC would: a. increase b. decrease c. either increase or decrease depending on the magnitude of the increase in the risk-free rate. The greater the increase in the risk-free rate, the more likely that WACC would increase. d. either increase or decrease depending on the magnitude of the increase in the risk-free rate. The greater the increase in the risk-free rate, the more likely that WACC would decrease. e. There is no relationship between the risk-free interest rate and Restown s WACC. 17. Suppose the firm's Weighted Average Cost of Capital (WACC) is stated in nominal terms, but the project's cash flows are expressed in real dollars. In this situation, the calculated NPV normally would a. be correct. b. be biased downward. c. be biased upward. d. possibly have a bias, but it could be upward or downward. e. More information is needed; otherwise, we can make no reasonable statement.

5 USE THE INFORMATION BELOW TO ANSWER THE FOLLOWING 3 QUESTIONS Pooh Industries is contemplating replacing a piece of existing equipment with a more efficient model. The old equipment was purchased 2 years ago for $330,000. It is being depreciated using the straight-line method to salvage value of $30,000 over an original life of 10 years. Pooh could sell the existing equipment today for $255,000. The new equipment would cost $800,000 and would be depreciated over an expected life of 8 years to a zero salvage value using the straight-line method. Pooh forecasts that the new machine would reduce operating expenses by $170,000 per year. The firm's marginal tax rate is 40% and its hurdle rate is 15%. The new machine would require additional net working capital (aka motor oil) of $60,000 when it is purchased and another $60,000 at the beginning of year 5. All the working additional net working capital would be returned at the end of the 8th year. Should Pooh make the replacement? 18. What is the net initial cash outlay of this replacement project. a. $ b. $ c. $ d. $ e. $ 19. What is the net operating cash flow in Year 1 for this replacement project? a. $ b. $ c. $ d. $ e. $ 20. What is the final year non-operating cash flow for this replacement project? a. $ b. $ c. $ d. $ e. $ 21. Which of the following statements is most correct? a. Since debt financing raises the firm's financial risk, raising a company s debt ratio will always increase the company s WACC. b. Since debt financing is cheaper than equity financing, raising a company s debt ratio will always reduce the company s WACC. c. Increasing a company s debt ratio will typically reduce the marginal cost of both debt and equity financing; however, it still may raise the company s WACC. d. Statements a and c are correct. e. None of the statements above is correct.

6 22. Ridgefield Enterprises has total assets of $300 million. The company currently has no debt in its capital structure. The company s basic earning power is 15 percent. The company is contemplating a recapitalization where it will issue debt at 10 percent and use the proceeds to buy back shares of the company s common stock. If the company proceeds with the recapitalization, its operating income, total assets, and tax rate will remain the same. Which of the following will occur as a result of the recapitalization? a. The company s ROA will decline. b. The company s ROE will increase. c. The company s basic earning power will decline. d. Answers a and b are correct. e. All of the above answers are correct. 23. Which of the following events is likely to encourage a company to raise its target debt ratio? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company s operating leverage. d. Statements a and c are correct. e. All of the statements above are correct. 24. Which of the following would increase the likelihood that a company would increase its debt ratio in its capital structure? a. An increase in costs incurred when filing for bankruptcy. b. An increase in the corporate tax rate. c. An increase in the personal tax rate. d. A decrease in the firm s business risk. e. Statements b and d are correct. 25. Volga Publishing is considering a proposed increase in its debt ratio, which will also increase the company s interest expense. The plan would involve the company issuing new bonds and using the proceeds to buy back shares of its common stock. The company s CFO expects that the plan will not change the company s total assets or operating income. However, the company s CFO does estimate that it will increase the company s earnings per share (EPS). Assuming the CFO s estimates are correct, which of the following statements is most correct? a. Since the proposed plan increases Volga s financial risk, the company s stock price still might fall even though its EPS is expected to increase. b. If the plan reduces the company s WACC, the company s stock price is also likely to decline. c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. d. Statements a and b are correct. e. Statements a and c are correct.