<>FIN3320
Sample Exam #3

1.         Heino Inc. hired you as a consultant to help them estimate their cost of capital.  You have been provided with the following data:  rRF = 5.0%; RPM = 5.0%; and b = 1.1.  Based on the CAPM approach, what is the cost of equity from retained earnings?

A.  10.50%

b.   10.71%

c.   10.88%

d.   11.03%

e.   11.14%

rs = 5% + (5%)*1.1 = 10.50%

2.  P. Daves Inc. hired you as a consultant to help them estimate their cost of equity.  The yield on the firm’s bonds is 6.5%, and Daves' investment bankers believe that the cost of equity can be estimated using a risk premium of 4.0%. What is an estimate of Daves' cost of equity from retained earnings?

a.   9.77%

b.   10.02%

c.   10.19%

d.   10.33%

E.  10.50%

6.5% + 4% = 10.5%

3.  You were recently hired by Hemmings Media, Inc., to estimate their cost of capital.  You were provided with the following data: D1 = \$2.50; P0 = \$60; g = 7% (constant); and F = 5%.  What is the cost of equity raised by selling new common stock?

a.   11.02%

b.   11.20%

C.  11.39%

d.   11.58%

e.   11.74%

2.50/(60* 95%) + 7% = 11.39%

4.  For a typical firm, which of the following is correct?  All rates are after taxes, and assume the firm operates at its target capital structure.

a.   rd > re > rs > WACC.

b.   rs > re > rd > WACC.

c.   WACC > re > rs > rd.

D.  re > rs > WACC > rd.

e.   WACC > rd > rs > re.

5.  Maese Sisters Inc has been paying out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity.  Its target capital structure consists of common stock, preferred stock, and debt.  Which of the following events would reduce the WACC?

a.   The flotation costs associated with issuing new common stock increase.

B.  The market risk premium declines.

c.   The company’s beta increases.

d.   Expected inflation increases.

e.   The flotation costs associated with issuing preferred stock increase.

6.  Which of the following statements is CORRECT?

a.   In the WACC calculation, we must adjust the cost of preferred stock (the market yield) because 70% of the dividends received by corporate investors are excluded from their taxable income.

b.   We should use historical measures of the component costs from prior financings when estimating a company’s WACC for capital budgeting purposes.

c.   The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.

d.   The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of debt interest.

E.  The cost of retained earnings is the rate of return stockholders require on a firm’s common stock.

7.  If a typical U.S. company uses the same cost of capital to evaluate all projects, the firm will most likely become

A.  Riskier over time, and its intrinsic value will not be maximized.

b.   Riskier over time, but its intrinsic value will be maximized.

c.   Less risky over time, and its intrinsic value will not be maximized.

d.   Less risky over time, and its intrinsic value will be maximized.

e.   There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.

8.  Blanchford Enterprises 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 less than the WACC (and even negative), in which case it will be rejected.

Year:         0               1                2               3

Cash flows:-\$1,000     \$450          \$450          \$450

a.   16.20%

B.  16.65%

c.   17.10%

d.   17.55%

e.   18.00%

n = 3; PV = -1000; PMT = 450; FV = 0:  Solve for i = 16.6487%

9.  Tapley Dental Associates is considering a project that has the following cash flow data.  What is the project's payback?

Year:                     0                     1               2               3               4                 5

Cash flows:        -\$1,000        \$300          \$310          \$320          \$330          \$340

a.   2.11 years

b.   2.50 years

c.   2.71 years

d.   3.05 years

E.  3.21 years       Accumulate cash inflows until you get to 1000

10.  Richards Enterprises is considering a project that has the following cash flow and WACC data.  What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC = 10%

Year:                     0                 1               2                  3               4                 5

Cash flows:        -\$1,000      \$400          \$395          \$390          \$385          \$380

a.   \$478.74

B.  \$482.01   (Use the cash flow entries on your calculator with a rate of 10%)

c.   \$495.05

d.   \$507.98

e.   \$517.93

11.  Which of the following statements is CORRECT?

a.   The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

b.   The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

c.   The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

D.  The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

e.   The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

12.  Which of the following statements is CORRECT?

a.   One defect of the IRR method is that it does not take account of cash flows over a project’s full life.

b.   One defect of the IRR method is that it does not take account of the time value of money.

c.   One defect of the IRR method is that it does consider the time value of money.

d.   One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until some time in the future.

E.  One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

13.  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 regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.

b.   A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting to find the IRR.

c.   If a project’s IRR is less than the WACC, then its NPV will be positive.

D.  A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.

e.   If a project’s IRR is positive, then its NPV must also be positive.

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14.  Malholtra Inc. is considering a project that has the following cash flow and WACC data.  What is the project's MIRR?  Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC:   10.00%

Year              0                1            2            3            4

Cash flows      -\$850     \$300     \$320     \$340     \$360

a. 14.08%

B. 15.65%

c. 17.21%

d. 18.94%

e. 20.83%

15.  You work for Alpha Inc., and you must estimate the Year 1 operating net cash flow for a proposed project with the following data.  What is the Year 1 operating cash flow?

Sales                                                     \$11,000

Depreciation                                           \$4,000

Other operating costs                              \$6,000

Tax rate                                                       35%

A.  \$4,650

b.   \$4,800

c.   \$4,950

d.   \$5,100

e.   \$5,250

You earn \$650 after tax and add back depreciation to get \$4650

16.  As a member of Gamma Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data.  What is the Year 1 operating cash flow?

Sales                                                     \$33,000

Depreciation                                         \$10,000

Other operating costs                            \$17,000

Interest expense                                      \$4,000

Tax rate                                                      35%

a.   \$ 9,500

b.   \$10,600

c.   \$11,700

d.   \$12,800

E.  \$13,900

\$33000-27000= 6000* (1-.35) + 10000 = \$13900

17.  Big Air Services is now in the final year of a project.  The equipment originally cost \$20 million, of which 75% has been depreciated.  Big Air can sell the used equipment today for \$6 million, and its tax rate is 40%.  What is the equipment’s after-tax net salvage value?

a.   \$5,500,000

B.  \$5,600,000

c.   \$5,700,000

d.   \$5,800,000

e.   \$5,900,000

Book Value = \$5 M; Taxable Gain on Sale = \$1M; Tax on Gain – 400,000

Total After Tax Salvage = \$5,600,000

18.  Which of the following is NOT a cash flow that should be included in the analysis of a project?

a.   Changes in net operating working capital.

b.   Shipping and installation costs.

c.   Cannibalization effects.

d.   Opportunity costs.

E.  Sunk costs that have been expensed for tax purposes.

19.  Which of the following statements is CORRECT?

A.  Using MACRS depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but would affect the timing of the cash flows and thus the NPV.

b.   Under current laws and regulations, corporations must use straight line depreciation for all assets whose lives are 10 years or longer.

c.   Corporations must use the same depreciation method (e.g., straight line or MACRS) for stockholder reporting and tax purposes.

d.   Since depreciation is not a cash expense, it has no affect on cash flows and thus no affect on capital budgeting decisions.

e.   Under MACRS depreciation rules, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers the projected NPV.

20.  A company is considering a new project. The CFO plans to calculate the project’s NPV by first 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 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.

21.  Millman Electronics will produce 60,000 stereos next year.  Variable costs will equal 50% of sales, while fixed costs will total \$120,000.  At what price must each stereo be sold for the company to achieve an EBIT of \$95,000?

a.   \$6.57

b.   \$6.87

C.  \$7.17

d.   \$7.47

e.   \$7.77

60,000X – 30,000X – 120,000 = 95,000

30,000X = 215,000

X = \$7.1667

22.  Brandi Co. has an unlevered beta of 1.10.  The firm currently has no debt, but is considering changing its capital structure to be 30% debt and 70% equity.  If its corporate tax rate is 40%, what is Brandi's levered beta?

a.   1.2549

B.  1.3829

c.   1.5764

d.   1.6235

e.   1.7458

Levered Beta = Unlevered Beta [1+(1-t)D/E] = 1.3829

23.  If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium.

a. The expected return on the stock is 5% a year.

b. The stock’s dividend yield is 5%.

c. The price of the stock is expected to decline in the future.

d. The stock’s required return must be equal to or less than 5%.

E. The stock’s price one year from now is expected to be 5% above the current price.

<>24.  The firm’s target capital structure is consistent with which of the following?

a.   Maximum earnings per share (EPS).

b.   Minimum cost of debt (rd).

c.   Highest bond rating.

d.   Minimum cost of equity (rs).

E.  Minimum weighted average cost of capital (WACC).

<>25.  Which of the following statements is correct?

A.  The capital structure that maximizes stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

b.   The capital structure that maximizes stock price is also the capital structure that maximizes earnings per share.

c.   The capital structure that maximizes stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio.

d.   Increasing a company’s debt ratio will typically reduce the marginal costs of both debt and equity financing; however, it still may raise the company’s WACC.

e.   If Congress were to pass legislation that increases the personal tax rate, but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.