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FNCE 3010
Practice
Exam 3
Name: S013
1.
A company is considering an expansion project. The company’s CFO plans to calculate
the project’s NPV by discounting the relevant cash flows (which include the initial upfront costs, the operating cash flows, and the terminal cash flows) at the company’s cost
of capital (WACC). Which of the following factors should the CFO include when
estimating the relevant cash flows?
a.
Any sunk costs associated with the project.
b.
Any interest expenses associated with the project.
c.
Any opportunity costs associated with the project.
d.
Answers b and c are correct.
e.
All of the answers above are correct.
2.
Other things held constant, which of the following would increase the NPV of a project
being considered?
a.
A shift from MACRS to straight-line depreciation.
b.
Making the initial investment in the first year rather than spreading it over the first
3 years.
c.
A decrease in the discount rate associated with the project.
d.
The sale of the old machine in a replacement decision at a capital loss rather than
at book value
e.
An increase in required working capital.
3.
Which of the following statements is correct?
a.
An asset that is sold for less than book value at the end of a project’s life will
generate a loss for the firm and will cause an actual cash outflow attributable to
the project.
b.
Only incremental cash flows are relevant in project analysis and the proper
incremental cash flows are the reported accounting profits because they form the
true basis for investor and managerial decisions.
c.
It is unrealistic to expect that increases in net working capital that are required at
the start of the expansion project are simply recovered at the project’s completion.
Thus, these cash flows are included only at the start of a project.
d.
Equipment sold for more than its book value at the end of a project’s life will
increase income and, despite increasing taxes, will generate a greater cash flow
than if the same asset is sold at book value.
e.
All of the statements above are false.
4.
Suppose the firm’s WACC is stated in nominal terms, but the project’s expected cash
flows are expressed in real dollars. In this situation, other things held constant, the
calculated NPV 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.
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5.
Given the following information, what is the required cash outflow associated with the
acquisition of a new machine; that is, in a project analysis, what is the cash outflow at
t = 0?
Purchase price of new machine
Installation charge
Market value of old machine
Book value of old machine
Inventory decrease if new machine is installed
Accounts payable increase if new machine is installed
Tax rate
Cost of capital
a.
b.
c.
d.
e.
6.
$8,000
2,000
2,000
1,000
1,000
500
35%
15%
-$ 8,980.
-$ 6,460.
-$ 5,200.
-$ 6,850.
-$12,020
Dumb and Dumber Development Company has two mutually exclusive investment
projects to evaluate. Assume both projects can be repeated indefinitely. The following
cash flows are associated with each project
Year
0
1
2
3
4
5
Project A
Cash Flow
-$100,000
30,000
50,000
70,000
---
Project B
Cash Flow
-$70,000
30,000
30,000
30,000
30,000
10,000
The project types are equally risky and the firm’s cost of capital is 12 percent. What is
the EAA of the higher valued project? (Round your final answer to the nearest whole
dollar.)
a.
b.
c.
d.
e.
$6,857.
$7,433.
$11,325.
$16,470.
None of the above.
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(The following information applies to the next four problems.)
The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a
new computer. The computer’s price is $40,000, and it falls into the MACRS 3-year
class. Purchase of the computer would require an increase in net working capital of
$2,000. The computer would increase the firm’s before-tax revenues by $20,000 per year
but would also increase the operating costs by $5,000 per year. The computer is expected
to be used for 3 years and then sold for $25,000. The firm’s marginal tax rate is 40
percent, and the projects cost of capital is 14 percent. Applicable MACRS rates are 33%,
45%, 15%, 7%
7.
What is the investment required at t = 0?
a.
-$42,000.
b.
-$40,000.
c.
-$38,600.
d.
-$37,600.
e.
-$36,600.
8.
What is the operating cash flow in Year 2?
a.
$ 9,000
b.
$10,240
c.
$11,687
d.
$13,453
e.
$16,200
9.
What is the total value of the terminal year non-operating cash flows at the end of Year
3?
a.
$18,120.
b.
$19,000.
c.
$21,000.
d.
$25,000.
e.
$27,000.
10.
What is the project’s NPV?
a.
$2,622.
b.
$2,803.
c.
$2.917.
d.
$5,712.
e.
$6,438.
11.
A firm is considering the purchase of an asset whose risk is greater than the current risk
of the firm, based on any method for assessing risk. In evaluating this asset, the decision
maker should
a.
Increase the IRR of the asset to reflect the greater risk.
b.
Increase the NPV of the asset to reflect the greater risk..
c.
Reject the asset, since its acceptance would increase the risk of the firm.
d.
Ignore the risk differential if the asset to be accepted would comprise only a small
fraction of the total assets of the firm.
e.
Increase the cost of capital used to evaluate the project to reflect the higher risk of
the project.
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12.
Arizona Rock, an all-equity firm, currently has a beta of 1.25, a risk-free rate of seven
percent, and the return on the market is 14 percent. Suppose the firm sells 10 percent of
its assets (beta of 1.25) and purchases the same proportion of new assets with a Beta f
1.1. What will be the firm's new overall required rate of return? What rate of return must
the new assets produce?
a.
15.645%; 15.645%.
b.
15.75%; 14.7%.
c.
15.645%:14.7%.
d.
15.75%; 15.645%.
e.
14.75%: 15.75%.
13.
In theory, the decision maker should view market risk as being of primary importance.
However, within-firm, or corporate, risk is relevant to a firm’s
a.
Well-diversified stockholders, because it may affect debt capacity and operating
income.
b.
Management, because it affects job stability.
c.
Creditors, because it affects the firm’s credit worthiness.
d.
All of the answers above are correct.
e.
Only answers a and c are correct.
14.
The Oneonta Chemical Company is evaluating two mutually exclusive pollution control
systems. Since the company’s revenue stream will not be affected by the choice of
control systems, the projects are being evaluated by finding the PV of each set of costs.
The firm’s required rate of return is 13 percent, and it adds or subtracts 3 percentage
points to adjust for project risk difference. System A is judged to be a high-risk project
(it might end up costing much more to operate than is expected). System A’s riskadjusted cost of capital is
a.
b.
c.
d.
e.
15.
10% percent; this might seem illogical at first, but it correctly adjusts for risk
where outflows, rather than inflows, are being discounted.
13 percent; the firm’s cost of capital should not be adjusted when evaluating
outflow only projects.
16 percent; since A is more risky, its cash flows should be discounted at a higher
rate, because this correctly penalizes the project for its high risk.
Somewhere between 10 percent and 16 percent, with the answer depending on the
riskiness of the relevant inflows.
Indeterminate, or, more accurately, irrelevant, because for such projects we would
simply select the process that meets the requirements with the lowest required
investment.
Which of the following are not real options?
a.
The option to expand production if the product is successful.
b.
The option to buy additional shares of stock if the stock price goes up.
c.
The option to expand into a new geographic region.
d.
The option to abandon a project.
e.
The option to switch sources of fuel used in an industrial furnace.
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16.
Interstate Transport has a target capital structure of 50 percent debt and 50 percent
common equity. The firm is considering a new independent project which has an IRR of
13 percent and which is not related to transportation. However, a pure play proxy firm
has been identified that is exclusively engaged in the new line of business. The proxy
firm has a beta of 1.38. Both firms have a marginal tax rate of 40 percent, and
Interstate’s before-tax cost of debt is 12 percent. The risk-free rate is 10 percent, and the
market risk premium is 5 %. The firm should
a.
Reject the project; its IRR is less than the firm’s required rate of return on the
project of 16.9 percent.
b.
Accept the project; its IRR is greater than the firm’s required rate of return on the
project of 12.05 percent.
c.
Reject the project; its IRR is only 13 percent.
d.
Accept the project; its IRR exceeds the risk-free rate and the before-tax cost of
debt.
e.
Be indifferent between accepting or rejecting; the firm’s required rate of return on
the project equals its expected return.
17.
OMIT A company is forecasting an increase in sales and is using the AFN model to
forecast the additional capital that they need to raise. Which of the following factors are
likely to increase the additional funds needed (AFN)?
a.
The company has a lot of excess capacity.
b.
The company has a high dividend payout ratio.
c.
The company has a lot of spontaneous liabilities that increase as sales increase.
d.
The company has a high profit margin.
e.
All of the answers above are correct.
18.
Kenny Corporation recently reported the following income statement for 1998 (numbers
are in millions of dollars):
Sales
Total operating costs
EBIT
Interest
Earnings before tax (EBY)
Taxes (40%)
Net income available to common shareholders
$7,000
3,000
$4,000
200
$3,800
1,520
$2,280
The company forecasts that its sales will increase by 10% in 1999 and its operating costs
will increase in proportion to sales. The company’s interest expense is expected to
remain at $200 million, and the tax rate will remain at 40 percent. The company plans to
pay out 50 percent of its net income as dividends, the other 50 percent will be additions to
retained earnings. What is the forecasted addition to retained earnings for 1999?
a.
b.
c.
d.
e.
$1,140.
$1,260.
$1,440
$1,790.
$1,810.
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19.
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.
(The following data are required for the next three problems.)
The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of
perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before
interest and taxes (EBIT) are $100,000, and it is a zero growth company. AJC’s current
cost of equity is 10 percent, and its tax rate is 40 percent. The firm has 10,000 shares of
common stock outstanding.
20.
What is AJC’s current total market value?
a.
$500,000
b.
$528,000
c.
$700,000
d.
$728,000
e.
$800,000
21.
What is AJC’s current stock price?
a.
$50.00
b.
$52.00
c.
$52.80
d.
$59.27
e.
$60.36
22.
Independent of # 20 and 21 above, the firm is considering recalling the 6 percent debt and
issuing $400,000 of new debt. The new funds would be used to replace the old debt and
to repurchase stock. It is estimated that the increase in riskiness resulting from the
leverage increase would cause the required rate of return on debt to rise to 7 percent,
while the required rate of return on equity would increase to 11 percent. If this plan were
carried out, what would be AJC’s new stock price, based on the 10,000 shares
outstanding after the buyback.
a.
$50.00
b.
$52.00
c.
$52.80
d.
$59.27
e.
$60.36
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