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Second Midterm Exam
MBAC 6060
Fall 2005
Please Read This: This exam will serve as the answer sheet. There are 4 full problems
on this exam and some have different points so look over the entire exam before you
start. You have about an hour and twenty minutes. Enjoy. If you have questions, ask!
(1) (25 points) Ralph Inc. is evaluating an investment project. Ralph will invest $2
Million in a new commercial construction project and he expects to receive perpetual
cash flow, beginning one year from now, in the amount of $475,000 each year. The
appropriate annual discount rate is 25%.
(a) What is the payback period for this project? Ralph believes that for a project of this
size if he gets his money back in 4 ½ years or sooner he will make money. Will the
project be accepted using the payback period rule?
(b) What is the profitability index of this project?
(c) What is the NPV of the project?
(d) What is the IRR of the project?
(e) What is the discounted payback period for this project?
(2) (25 points) Your firm is evaluating a project and wants you to develop an estimate
of the appropriate discount rate to use as a cost of capital. You have identified 3 firms
you predict will have the same underlying business risk of your project. Relevant
information for these firms is provided in the table below. Your firm plans a debt to
equity ratio of 0.8 for the project, your firm’s marginal tax rate is 30%, and your firm can
issue risk free debt. The current risk free rate is 4% and the market portfolio’s expected
risk premium is 7%. What discount rate is appropriate for your project?
Firm
Equity Beta
Debt to Equity Ratio Marginal Tax Rate
1
1.6
0.75
30%
2
1.7
1.0
38%
3
1.8
1.10
35%
**Note: all of these firms have risk free debt outstanding.
(3) (25 points) Ralph Enterprises is evaluating two mutually exclusive projects. The
appropriate discount rate for both is 10% (just because it is always 10%). The expected
cash flow streams of the two projects (1 and 2 for lack of creativity) are shown below.
Project
T=0
T=1
T=2
T=3
T=4
#1
-$10,000
$6,000
$6,000
#2
-$10,000
$3,400
$3,400
$3,400
$3,400
(a) What is the IRR of project 1? What is the IRR of project 2? Can we tell, based on
this information which project should be taken?
(b) What is the NPV of project 1? What is the NPV of project 2? Can we tell, based on
this information which project should be taken?
(c) Which project should the firm take and why?
(4) (25 points) Presented below are the returns to two individual assets (asset 1 and
asset 2) and the market portfolio for the last several years.
Year
1998
1999
2000
2001
2002
2003
2004
Asset 1
0.19
0.19
0.03
0.02
0.22
0.25
0.09
Asset 2
0.25
0.05
0.01
0.11
0.15
0.08
-0.07
Market Portfolio
0.14
0.06
0.03
0.05
0.11
0.07
-0.07
(a) Find the sample variances and standard deviations of the returns for the two assets.
What type of risk do these statistics measure for these assets?
(b) Estimate the beta of each asset. What type of risk does this statistic measure for these
assets?
(c) If the risk free rate is 2% and the sample average from the table above is a reasonable
representation of the market’s expectation for the return on the market portfolio write
down the equation for the security market line. Using the information calculated in part
(b) what is the expected return for each of these assets?