University of Guelph
School of Management and Economics
DEPARTMENT OF ECONOMICS
ECON*3560: Theory of Finance
Instructor: N. Bower
SAMPLE PROBLEMS MIDTERM 2
1.
The Gryphon Corporation has an income of $1,000,000 from operations after all
operating costs, but before (a) interest charges of $300,000, (b) dividends of $200,000 to
be paid, and (c) income taxes. If Gryphon pays taxes of 40 percent on all taxable income,
what will be its income tax bill?
2.
Identify and explain two shortcomings of the internal rate of return method of investment
evaluation.
3.
A firm is choosing between two mutually exclusive projects with the following cash
flows:
Year
Project A
Project B
0
-$10,000
-$30,000
1
0
$15,000
2
0
$15,000
3
$20,000
$15,000
The firm has a required rate of return of 10 percent.
a.
b.
c.
Compute the net present values for the two projects.
Compute either the profitability index or the internal rate of return for the two
projects.
Which project should be accepted? Why?
4.
A decision tree shows a 30% probability of $2 million in returns and a 70% chance of $1
million in returns. What is the maximum you would invest today in this project if the
cash in-flow occurs one year in the future and the discount rate is 10%?
5.
Dime a Dozen Diamonds makes synthetic diamonds by treating carbon Each diamond can
be sold for $100. The materials cost for a standard diamond is $30. The fixed costs
incurred each year for factory upkeep and administrative expenses are $200,000. The
machinery costs $1 million and is depreciated straight-line over 10 years to a salvage
value of zero. The tax rate is 35 percent, the project has a 10 year life, and the discount
rate is 12%.
a.
b.
c.
If the sales are 7,000 diamonds each year, what is the annual cash flow?
What is the net present value for the project?
What is the NPV break-even level of sales?
6.
The Mighty Mop Corporation is considering a new project that requires an initial
investment of $600,000. This cost will be depreciated straight-line to zero over the
project’s eight-year life. The project is expected to generate sales revenues of $700,000
each year with variable costs of $400,000. Fixed costs will be $100,000 per year. Mighty
Mop has a marginal tax rate of 40% and a discount rate of 12%.
a.
b.
c.
d.
7.
a.
b.
c.
Calculate the annual cash flow for the project.
Find the net present value for the project. Should Mighty Mop accept or reject
the project?
The proposed project is replacing an existing machine that is expected to generate
cash flows of $25,000 for each of the next 3 years before it fails. Should Mighty
Mop replace the existing machine? Show why or why not.
Suppose the project is being built on land owned by Mighty Mop that was
purchased 5 years ago for $120,000, but that could be sold today for $170,000.
What is the NPV now? How does this affect the decision in (b)?
TA&A Corporation’s stock has a beta of 1.4. Treasury bills yield 5% and the
market portfolio offers an expected return of 14%. Find the required return on
TA&A’s stock.
TA&A stock currently sells for $20. It is expected to pay a dividend of $1 a year
from now and sell for $23 at year-end. Find the expected return on the stock and
determine if it is over- or under-valued.
Suppose the $20 price for the stock is correct and there are 30,000 shares
outstanding. TA&A also has $200,000 of debt with a yield to maturity of 9%.
The firm is in the 35% marginal tax bracket. Find the proportions of debt and
equity and the weighted average cost of capital (WACC).