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1 BUS 438 (Durham). Fall 2016. Exam 1. Multiple choice (3 pts each) 1. If shareholders are unhappy with a CEO’s performance, they are most likely to: (a) buy more shares in an effort to gain control of the firm. (b) file a shareholder resolution. (c) replace the CEO through a grassroots shareholder uprising. (d) Solution: sell their shares. 2. An investment is said to be liquid if the investment: (a) has large day to day fluctuations in price. (b) has a large bid-ask spread. (c) Solution: can easily be converted into cash. (d) is traded on a stock exchange. 3. If you buy shares of Coca-Cola on the secondary market: (a) Coca-Cola receives the money because the company has issued new shares. (b) Solution: you buy the shares from another investor who decided to sell the shares. (c) you buy the shares from the New York Stock Exchange. (d) you buy the shares from the Federal Reserve. 4. Accounts payable is a: (a) long-term liability. (b) current asset. (c) long-term asset. (d) Solution: current liability. 5. Financial leverage refers to the: (a) Solution: use of debt in a firm’s capital structure. (b) ratio of retained earnings to shareholders’ equity. (c) ratio of paid-in surplus to shareholders’ equity. (d) ratio of sales to total assets. (e) ratio of current assets to long-term assets. 6. Which of the following best describes free cash flow? (a) Solution: Free cash flow is the amount of cash flow available for distribution to all investors after all necessary investments in operating capital have been made. (b) Free cash flow is the amount of cash flow available for distribution to shareholders after all necessary investments in operating capital have been made. (c) Free cash flow is the net change in the cash account on the balance sheet. (d) Free cash flow is equal to net income plus depreciation. (e) Free cash flow is equal to the cash flow from non-taxable transactions. 7. Company J and Company K each recently reported the same earnings per share (EPS). Company J’s stock, however, trades at a higher price. Which of the following statements is most correct? (a) (b) (c) (d) (e) Solution: Company J must have a higher P/E ratio. Company J must have a higher market to book ratio. Company J must be riskier. Company J must have fewer growth opportunities. All of the statements above are correct. 8. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. For both projects, the cash flows are conventional (i.e., all positive except for the initial cost) and the appropriate discount rate is 12 percent. Which of the following statements is most correct? (a) (b) (c) (d) (e) Solution: Both projects have a positive net present value (NPV). Project A must have a higher NPV than Project B. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A. Statements a and b are correct. Statements a, b, and c are correct. 9. Your _____ tax rate is the amount of tax payable on the next taxable dollar you earn. (a) (b) (c) (d) (e) mean residual total average Solution: marginal 10. The CFO of Mulroney Brothers has suggested that the company should issue $300 million worth of common stock and use the proceeds to reduce some of the company’s outstanding debt. Assume that the company adopts this policy, and that total assets and operating income (EBIT) remain the same. The company’s tax rate will also remain the same. Which of the following will occur: (a) (b) (c) (d) (e) Solution: The company’s net income will increase. The company’s taxable income will fall. The company will pay less in taxes. All of the answers above are correct. Answers b and c are correct. 11. Net capital spending: (a) is equal to ending fixed assets minus beginning fixed assets. (b) Solution: is equal to zero if the decrease in the fixed assets account is equal to the depreciation expense. (c) reflects the net changes in total assets over a stated period of time. (d) is equivalent to the cash flow from assets minus the operating cash flow minus the change in net working capital. (e) is equal to the change in the inventory balance for the period. 12. The annual annuity stream of payments with the same present value as a project’s costs is called the project’s _______ cost. (a) (b) (c) (d) (e) incremental sunk opportunity erosion Solution: equivalent annual 2 Problems 1. (12 points) Use the financial statements below to answer the following questions. Arrow Corporation Consolidated Balance Sheet December 31, 2014 (in $ millions) Liabilities and Assets Stockholders’ Equity Current Assets Current Liabilities Cash 63.6 Accounts payable Accounts receivable 55.5 Notes payable Inventories 45.9 Current maturities of long-term debt Other current assets 6.0 Other current liabilities Total current assets 171.0 Total current liabilities Long-Term Assets Long-Term Liabilities Land 66.6 Long-term debt Buildings 109.5 Equipment 119.1 Less accumulated depreciation (56.1) Deferred taxes Net property, plant, and equipment 239.1 Other long-term liabilities Goodwill 60.0 Total long-term liabilities Other long-term assets 63.0 Total liabilities Total long-term assets 362.1 Stockholders’ Equity Total Assets 533.1 Total liabilities and Stockholders’ Equity Arrow Corporation Consolidated Income Statement Year ended December 31 (in $ millions) Total sales 610.1 Cost of sales (500.2) Gross profit 109.9 Selling, general, and administrative expenses (40.5) Research and development (24.6) Depreciation and amortization (3.6) Operating income 41.2 Other income 0.0 EBIT 41.2 Interest income (expense) (25.1) Pre-tax income 16.1 Taxes (5.5) Net income 10.6 Dividends Paid 5.1 Price per Share Shares outstanding (millions) Stock options outstanding (millions) Stockholders’ Equity (Book) Total Liabilities and Stockholders’ Equity (Book) 3 $16 10.2 0.3 126.6 533.1 87.6 10.5 39.9 6.0 144.0 239.7 22.8 0.0 262.5 406.5 126.6 533.1 What is Arrow’s: (a) EPS (earnings per share) (b) Enterprise value (c) Market-to-book (d) Total asset turnover (e) ROE (return on equity) (f) ROA (return on assets) Solution: (a) EPS (earnings per share) NI / # shares outstanding = 10.6 / 10.2 = $1.039 (b) Enterprise value Market cap + LTD + Current maturities of LTD + NP cash = 163.2 + 239.7 + 39.9 + 10.5 63.6 = $389.7 M (c) Market-to-book 163.2 / 126.6 = 1.289 (d) Total asset turnover Sales / assets = 610.1 / 533.1 = 1.14 (e) ROE (return on equity) NI / Equity = 10.6 / 126.6 = 8.37% (f) ROA (return on assets) (NI + Interest) / assets = (10.6 + 25.1) / 533.1 = 6.70% 4 2. (8 points) Use the annual cash flows below to answer following questions. Year Cash flow Year Cash flow 0 -8000 10 400 1 200 11 400 2 200 12 400 3 200 13 400 4 300 14 400 5 300 15 500 6 300 16 500 7 300 17 500 8 300 18 500 9 300 19 -1000 (a) What is the NPV (using a discount rate of 10%)? Solution: -5624 (b) What is the IRR? Solution: IRR is not useful because of nonconventional cash flows. (c) What is the MIRR (using a discount rate of 10%)? Solution: CF(17) = 500 + 500/1.10 - 1000/1.10^2 = 128 MIRR = -3.54% (d) What is the profitability index? Solution: -5624 / 8000 = -70.3% 3. (8 points) Dave will receive cash flows of $100 per month beginning five years from today and continuing every year thereafter forever. Using a discount rate of 6%, what is the present value of those cash flows? Solution: P(59) = 100/0.005 = 20,000 P(0) = P(59) / 1.0005^59 = 14,902 5 4. (8 points) NJH Corp. is evaluating a new piece of machinery. The machine has an initial cost of $1000 and operating costs of $300 per year. It is to be depreciated over 7 years using the straight-line method. The machine has a useful life of 5 years. At the end of that time it has no salvage value. The tax rate is 35% and the appropriate discount rate is 12%. What is the machines equivalent annual cost (EAC)? Solution: OCF = -300 * 0.65 + 1000/7*0.35 = -145 ATSV = 2/7*1000*0.35 = 100 0 1 2 3 4 5 OCF -145 -145 -145 -145 -145 ChNWC NCS -1000 100 ============================================ -1000 -145 -145 -145 -145 -45 NPV = -1465.95 For EAC, use PV=-1465.95, n=5, FV=0, i=12, and solve for PMT. You should get 406.67. 5. (8 points) You have decided to refinance your mortgage. You plan to borrow whatever is outstanding on your current mortgage. The current monthly payment is $2356 and you have made every payment on time. The original term of the mortgage was 30 years and the mortgage is exactly four years and eight months old. You have just made your monthly payment. The mortgage interest rate is 6.375%. How much do you owe on the mortgage today? Solution: n=304, FV=0, PMT=2356, R=6.375/12, solve to get PV=354,900 6 6. (12 points) JRM Inc. is evaluating a new project to produce filing cabinets. The machinery required for this project will cost $2.5 million and be depreciated using the straight-line method over 10 years. The filing cabinets will sell for $120 each and JRM expects to sell 8000 per year. Variable costs will be $40 per unit and fixed costs will be $200,000 per year. JRM has spent $300,000 in consulting fees to assess the market demand for this product. The project will run for 6 years. At the end of year 6, JRM expects to be able to sell the machinery required for this project for $300,000. The project will require an increase of $100,000 in NWC at the start of the project. This NWC will be recovered at the end of year 6. The cost of capital for this project is 12% and JRM’s tax rate is 40%. (a) What is the NPV of this project? (b) What is the IRR? Solution: All values in $1000’s EndBV = 1000 BTSV = 300 ATSV = BTSV*(1-T) + EndBV*T = 300 * .6 + 1,000 * .4 = 580 Depr = 2500/10 = 250 OCF = (Q*(P-VC) - FC) * (1-T) + Depr*T = (8000*(120-40) - 200)*0.6 + 250*0.4 = 364 0 1 ... 6 OCF 364 ... 364 ChNWC -100 100 NCS -2500 580 ================================== FCF -2600 364 ... 1044 NPV(R=.12) = -$758,938 IRR = 2.41% 7