Final Exam Corporate Finance FINC 650 1. Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting? a. b. c. d. e. Long-term debt. Common stock. Short-term debt used to finance seasonal current assets. Preferred stock. All of the above are considered capital components for WACC and capital budgeting purposes.

2. A company has a capital structure which consists of 50 percent debt and 50 percent equity. Which of the following statements is most correct? a. b. c. d. The cost of equity financing is greater than the cost of debt financing. The WACC exceeds the cost of equity financing. The WACC is calculated on a before-tax basis. The WACC represents the cost of capital based on historical averages. In that sense, it does not represent the marginal cost of capital. e. The cost of retained earnings exceeds the cost of issuing new common stock.

Order now3. Which of the following statements is most correct? a. Preferred stock does not involve any adjustment for flotation cost since the dividend and price are fixed. b. The cost of debt used in calculating the WACC is an average of the after-tax cost of new debt and of outstanding debt. c. The opportunity cost principle implies that if the firm cannot invest retained earnings and earn at least rs, it should pay these funds to its stockholders and let them invest directly in other assets that do provide this return. d. The cost of common stock, rs, is usually less than the cost of preferred stock. 4. Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct? a. b. c. d. e. All else equal, a project ‘s IRR increases as the cost of capital declines. All else equal, a project ‘s NPV increases as the cost of capital declines. All else equal, a project ‘s MIRR is unaffected by changes in the cost of capital. Answers a and b are correct. Answers b and c are correct.

5. Which of the following statements is most correct? a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk free rate while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider the inflation premium. e. The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback period. 6. Project A and B both have normal cash flows. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct? a. Both projects have a positive net present value (NPV). b. Project A must have a higher NPV than Project B. c. If the cost of capital were less than 12 percent, Project B would have a higher IRR than Project A. d. Statements a and c are correct. e. Statements a, b, and c are correct. 7. Which of the following statements is most correct? a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the project must have a positive NPV. b. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher NPV. c. The modified internal rate of return (MIRR) can never exceed the IRR. d. Answers a and c are correct. e. None of the answers above is correct. 8. Which of the following is not an incremental cash flow that results from the decision to accept a project? a. b. c. d. e. Changes in working capital. Shipping and installation costs. Sunk costs. Opportunity costs. Cannibalization of existing products.

9. Risk in a project which has only negative cash flows can best be adjusted for by a. b. c. d. e. Ignoring it. Adjusting the discount rate upward for increasing risk. Adjusting the discount rate downward for increasing risk. Picking a risk factor equal to the average discount rate. Reducing the NPV by 10 percent for risky projects.

10. 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, if prices are expected to increase, the calculated NPV would a. b. c. d. e. Be correct. Be biased downward. Be biased upward. Possibly have a bias, but it could be upward or downward. More information is needed; otherwise, we can make no reasonable statement.

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 $450 2 $450 3 $450

Cash flows:-$1,000 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: 5 0 1 2 3 4

Cash flows: $300 $310 a. 2.11 years b. 2.50 years c. 2.71 years d. 3.05 years E. 3.21 years

-$1,000 $320

$330

$340

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: 5 Cash flows: -$1,000 $400 $395 $390 $385 $380 0 1 2 3 4

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. 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 Cash flows 0 -$850 1 $300 2 $320 3 $340 4 $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 Depreciation $11,000 $4,000

Other operating costs Tax rate

$6,000 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 Depreciation Other operating costs Interest expense Tax rate $33,000 $10,000 $17,000 $4,000 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 = 1.3829 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.

Show your work for problems and label your answers.

1. (12 points) Flagstaff Manufacturing’s (FM) only debt is represented by 800,000 bonds with a market price per bond of $1,050. It has 20 million shares of common stock outstanding with a market price of $50 per share, and no preferred stock. a. Calculate the market value of long-term debt and common equity, and the percentage of capital obtained from each source. $ % Debt 840M .4565 ComSt 1,000M .5435 Total 1,840M b. The bonds have a coupon rate of 7% and based on the market price of the bonds, the yield to maturity is 6%. FM has a 40% tax rate. Calculate the after-tax cost of debt financing. ATrd = 6 (.6) = 3.6%

The market price of common stock is $50. The firm paid a dividend of $2.00 per share of common stock in the fiscal year that just ended. Dividends are expected to increase at an annual rate of 5%. The stock’s beta is 0.70. The risk-free rate is 5% and the expected return on the market is 11%. c. Calculate the required return on common stock using CAPM. rs = 5 + .70(6) = 9.2%

d. FM does not plan to sell any additional shares of common stock this year and anticipates adding $20 million to retained earnings this year. Use the market value weights and your answers above to calculate the weighted average cost of capital (WACC). WACC = .4565 (3.6) + .5435 (9.2) = 6.64%

3. (10 points) Acme Chemical is considering two mutually exclusive machines: Machine X has a cost of $60,000 and provides after-tax cash flows of $42,000 per year for 2 years. It has a required return of 10%. Project Y has a cost of $100,000, provides after-tax cash flows of $40,000 per year for 4 years and has a required return of 12%. Machine prices and cash flows are expected to remain constant in the foreseeable future. Evaluate the two machines and make a decision: which should Acme purchase and why? Show your analysis, including any necessary calculations and make it clear what your decision is based on. Over a common 4-year life, the replacement chain NPVs are: X = $23,548 Y = $21,494 The equivalent annual annuities are: X = $7,429 Y = $7,077 Project X should be chosen: it has higher RCNPV and higher EAA.

4. (10 points) The cash flows associated with a project under consideration are shown below. The required return is 10%. Year 0 1 2 3 CF (1,000) 500 400 200

a. Calculate the NPV of the project. NPV = -$64.61

b. Calculate the IRR of the project IRR = 5.73%

c. Calculate the MIRR of the project. MIRR = 7.58%

5. (20 points) Replacement project. Existing machine was purchased 1 years ago at a cost of $20,000. For tax purposes, it is being depreciated straight line at $4,000 annually. It can be sold now for 12,000 or used for 4 more years at which time it will be sold for an estimated $2,500. It provides revenue of $15,000 annually and has cash costs of $4,200 annually. A replacement machine can be purchased now for $26,000. It would be used for 4 years, and depreciated using straight line at $6,500 annually. It will result in total sales revenue of $20,000 annually, but because of its increased efficiency its cash expense would remain at $4,200 annually. It is expected to have a salvage value of $4,400 in 4 years. The new machine would require additional inventories of $800, and accounts payable would increase by $500. The tax rate is 40% and the required rate of return is 10%. a. Calculate the incremental initial cash flow associated with acquiring the replacement machine (i.e., CF0). Price of new -ATSV of old, if sold now Increase in net WC Initial investment 26,000 -13,600 300 12,700

The initial investment is a negative cash flow.