Business Finance
Examination Three
Fall 2002
Name ______________
Select the best answer to each of the following questions and mark your selection on the exam.
Also, record your answer on the answer sheet on the back of the exam. Detach the answer sheet
when you finish. Exam keys will be posted after the exam is completed. Your score will be
based on your answers on the exam and not on the answer sheet.
3 points per question
1.
The Net Present Value method of project evaluation is preferred over the Internal Rate of
Return method because the Net Present Value method:
a.
b.
c.
d.
e.
2.
The use of accelerated depreciation techniques (rather than straight-line depreciation)
increases the NPV of a proposed investment because:
a.
b.
c.
d.
3.
Accelerated depreciation techniques allow a larger portion of the initial cost of
the proposed investment to be depreciated.
Accelerated depreciation techniques require higher initial cash outflows and
therefore create greater total returns on the proposed investment.
Accelerated depreciation techniques significantly increase the size of the
expected cash flows of the project.
Accelerated depreciation techniques shift the cash flows forward in the project’s
life and increases the present value of these cash flows.
The internal rate of return (IRR) for a project is the discount rate at which:
a.
b.
c.
d.
e.
4.
Includes all the cash flows in its decision where IRR does not.
Assumes that the intermediate cash flows are reinvested at the required rate of
return where the IRR assumes reinvestment at the IRR.
Considers all of the project’s cash flows where the IRR does not.
Considers the timing of the cash flows where the Internal Rate of Return does
not.
Considers the risk of the project where the Internal Rate of Return does not.
the project's net present value is positive.
the net present value of the project is equal to zero.
the project's expected net cash flows generate positive net present values.
the net present value of the project is equal to the required rate of return.
the required rate of return is equal to the internal rate of return.
__________________ is the evaluation technique designed to identify the factors that
most influence the NPV of a proposed investment. Also, the technique assesses the
impact of small changes of these factors on the NPV of a project.
a.
b.
c.
d.
e.
Factor Analysis
Monte Carlo simulation
Scenario Analysis
Net Present Value
Sensitivity Analysis
5. Which of the following would increase the NPV of the project being considered (all other
things held constant)?
a.
b.
c.
d.
e.
6.
The modified internal rate of return (MIRR) is an improvement over the internal rate of
return (IRR) as a financial analysis technique because:
a.
b.
c.
d.
e.
7.
b.
c.
d.
The cost of the project analysis completed in the previous tax year and specific to
the new product.
The use of factory floor space which i s unused but available for production for
any product.
Revenues from the existing product that would be lost as a result of some
customers switching to the new product.
Shipping and installation costs associated with preparing the machine to be used
to produce the new product.
Which of the following should NOT be considered in the initial period (time=0) of a
proposed replacement decision?
a.
b.
c.
d.
e.
9.
the IRR assumes reinvestment of intermediate cash flows at the firm's required
rate of return where MIRR assumes reinvestment at the MIRR of the project.
the IRR assumes a constant level of risk though out the life of the project where
MIRR assumes the project's risk changes over its life.
the IRR assumes that the cash flows are constant though out the life of the project
where MIRR assumes the project's cash flows are not constant.
the MIRR can be adjusted to reflect the relative size of two or more projects
where IRR cannot be adjusted for size.
the MIRR assumes reinvestment of intermediate cash flows at the firm's required
rate of return where IRR assumes reinvestment at the IRR of the project.
Which of the following is not considered as a relevant concern in determining
incremental cash flows for a new product?
a.
8.
An increase in the initial cost of the project.
An increase in the required rate of return on the project.
An increase in the revenues generated by the project.
The use of straight-line depreciation on the asset rather than the MACRS method.
An increase in the operating costs associated with the project.
The book value of the machine to be replaced.
Required increases in inventories and working capital.
The market value of the machine to be replaced.
Tax implications on the sale of the new machine.
An investment tax credit.
A net present value profile represents a project's net present value:
a.
b.
c.
d.
e.
relative to the NPV of other projects.
over time.
at all interest rates.
at various net cash flows.
with no initial cash outflow.
10.
A significant weakness of the Payback evaluation technique is:
a.
b.
c.
d.
e.
It is difficult to compute.
It may give an incorrect investment decision for mutually exclusive projects.
It assumes reinvestment at the required rate of return.
It does not consider all the relevant cash flows of the project.
It may generate multiple rates of return for a project’s cash flows.
10 points
11.
IT&M, Inc., a large conglomerate, has decided to acquire another firm. Analysts are
forecasting that there will be a period (2 years) of extraordinary growth (40%) followed
by another 2 years of unusual growth (20%), and that finally the previous growth pattern
of 5% annually will resume. If the last dividend was $2 per share and the required return
is 18%, what should the market price be today?
a.
b.
c.
d.
$50.61
$42.38
$41.14
$45.61
e.
f.
g.
h.
$34.48
$30.89
$31.57
$33.61
10 points
12.
Union Paper's stock is currently in equilibrium selling at $60 per share. The firm has
been experiencing a 5% annual growth rate. Earnings per share (E0) were $8.00 and the
dividend payout ratio is 40%. The risk-free rate is 3% and the market risk premium is
9%. If systematic risk increases by 50%, all other factors remaining constant, the stock
price will decrease by:
a.
b.
c.
d.
$24.26
$29.02
$33.97
$39.09
e.
f.
g.
h.
$65.45
$53.38
$57.78
$16.95
10 points
13.
The chief financial officer of Portland Oil has given you the assignment of determining
the firm's marginal cost of capital. The present capital structure which is considered
optimal, is:
Book Value Market Value
Debt
$120 million $ 100 million
Preferred Stock
20 million
40 million
Common Equity 160 million
260 million
Total
$ 300 million $ 400 million
The anticipated financing opportunities are these: Debt can be issued with a 20 percent
before-tax cost. Preferred stock will be $100 par, carry a dividend of 25 percent, and can
be sold to net the firm $90 per share. Common equity has a beta of 1.2, the return on the
market is 15 percent, and the risk-free rate is 3 percent. If the firm's tax rate is 40 percent,
what is its marginal cost of capital?
a.
b.
c.
d.
14.8 percent
17.1 percent
13.3 percent
25.4 percent
e.
f.
g.
h.
18.5 percent
23.3 percent
20.2 percent
21.1 percent
6 points
14.
If the required rate of return is 15 percent, what is the net present value of the project
described below:
COST OF NEW EQUIPMENT $500,000
LIFE OF EQUIPMENT
10 YEARS
SALVAGE VALUE
$ 50,000
ANNUAL NET CASH FLOW
$100,000
a.
b.
c.
d.
$
$
$
$
65,022
81,121
14,236
13,735
e.
f.
g.
h.
$ 11,008
$194,168
$114,457
$133,734
12 points (6 points per section)
15.
Projects C has the following net cash flows:
Year
Project
0
-$25,000
1
12,000
2
17,000
3
1,000
4
500
A.
If the required rate of return is 12 percent, what is the net present value for
the project?
a.
b.
c.
d.
B.
$ 1,535.57
$ 35.57
$ 1,061.73
$ 2,558.06
e.
f.
g.
h.
$ 1,003.47
$ 1,920.81
$ 296.12
$ 2,656.33
What is the Internal Rate of Return for the project?
a.
19.9 percent
e.
13.9 percent
b.
18.4 percent
f.
12.8 percent
c.
14.6 percent
g.
10.9 percent
d.
17.5 percent
h.
10.0 percent
10 points
16.
M&M Inc., is considering the purchase of a new machine that will reduce manufacturing
costs by $60,000 annually. M&M will use the straight-line method to depreciate the
machine, and it expects to sell the machine at the end of its 5-year life for $5,000. The
firm expects to be able to reduce working capital by $10,000 when the machine is
installed. The firm's marginal tax rate is 40% and it uses a 15% cost of capital to evaluate
projects of this nature. If the machine costs $150,000, what is the NPV of the project's
cash flows?
a.
b.
c.
d.
$ 22,048
$ 23,546
$ 17,077
$ 20,429
e.
f.
g.
h.
$ 46,650
$ 15,643
$ 40,262
$ 53,456
12 points
17.
PC, Inc., has a stamping machine which is 5 years old and which is expected to last
another 10 years. It has a book value of $55,000 and is being depreciated by the straightline method to $5,000 salvage vale. Tri-State Industries has demonstrated a new machine
with an expected useful life of 10 years (scrap value $20,000) that should save PC
$50,000 a year in labor and maintenance costs. If PC's cost of capital is 8%, should the
replacement be made? PC's tax rate is 40%, and the new machine will cost $200,000.
The market value of the old machine is $10,000 and a $10,000 increase in working
capital will be needed to support the new machine.
a.
b.
c.
d.
$ 65,775
$ 56,511
$ 75,800
$ 68,930
e.
f.
g.
h.
$ 55,594
$ 60,840
$ 62,076
$ 50,840
Formula Sheet
Exam Three
------------
NPV = -C0 + 
NCFt
(1+k)t

NCFt
-C0 =  -----------(1+IRR)t
Kre = Rf + B(Rm - Rf) = (D0 (1 + g)/P0) + g
NPV
EAA = --------------PVIFA
PI =
C0 + NPV
----------------C0
EPS = (EBIT-I)(1-TR)
shares
Kne = (D0 (1 + g)/(P0(1 - F)) + g
NOPAT = EBIT(1-TR)
Ka = wdkd(1-tr) + wpkp + weke
Kp = D/P
Operating Cash Flow = NOPAT + Depreciation
DPS = EPS x payout ratio
Free Cash Flow = NOPAT – Net Investment in Operating Capital
BPre = Retained Earnings / % of capital structure which is equity
BPd = “Up to” / % of capital structure which is debt
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
____
____
____
____
____
____
____
____
____
____
3 pts
3 pts
3 pts
3 pts
3 pts
3 pts
3 pts
3 pts
3 pts
3 pts
11. ______ 10 pts
12. ______ 10 pts
13. ______ 10 pts
14. ______ 6 pts
15 A._____ 6 pts
B._____ 6 pts
16. ______ 8 pts
17. ______ 12 pts