Intermediate Finace – Exam III
Multiple choice and short answer. (3 points each)
1. Calculate the replacement chain NPV for Project QRT given a common life of 6
years and the following cash flows: (i.e. Assume that this project must be done
twice to compare to another 6 year project.) The cost of capital is 12%.
Year
CF
0
-25,000
1
16,000
2
10,000
3
5,000
4
5
6
Show your work.
2. The equivalent annual annuity is used to:
a. compare projects with unequal lives.
b. decide if a project should be abandoned before completion.
c. decide whether to purchase an annuity with funds instead of selecting a
project.
d. compare projects with nonnormal cash flows.
e. compare projects with conflicting NPV and IRR recommendations.
3. When using the certainty equivalent method for computing NPV:
a. adjust the company’s cost of capital to reflect project risk
b. multiply the division’s cost of capital by a certainty equivalent factor
c. adjust the cash flows for risk and discount at the risk-free rate
d. calculate the standard deviation of the cash flows and then the CV
e. you are always assuming that the project is riskier than the average project
of the firm.
4. The project risk is often measured when the market risk of a project is difficult to
estimate because:
a. project risk is more important to the diversified investor
b. project risk and market risk are highly correlated
c. too many managers prefer lower levels of debt compared to stockholders
d. some projects have positive project risk and negative market risk
e. only total risk matters
5. Sensitivity analysis:
a. computes different IRRs with various scenarios
b. computes the NPVs for three different scenarios
c. varies all the input variables at once
d. changes one input variable at a time and computes a new NPV
e. computes the CV of three different scenarios
6. Norris Communications has fixed costs of $400,000. Their total variable costs are
$100,000 and their price per unit is $3.60. If the company sells 50,000 units, what
is their break-even quantity?
a. 111,111 units
b. 50,000 units
c. 200,000 units
d. 125,000 units
e. 250,000 units
7. Due to intense competition, a firm has a high level of volatility in the selling price
of their product. (i.e. they have little control over sales price) This will:
a. increase the firm’s financial risk.
b. decrease the firm’s financial risk.
c. increase the firm’s business risk.
d. decrease the firm’s business risk.
8. Business risk is the:
a. standard deviation of the ROE of an unlevered firm
b. variance of the income of an unlevered firm
c. stand-alone risk of the firm
d. standard deviation of the ROE
e. risk included in the levered beta
9. According to the signaling theory:
a. managers are reluctant to issue debt because stockholders don’t want to
share profits
b. when a company issues debt they are pessimistic about the company’s
future
c. stock prices fall when a company issues debt due to asymmetric
information
d. companies prefer to issue debt because the payments are fixed and debt
reduces business risk
e. company’s issue stock when they anticipate losses and want to share those
losses with new stockholders
Problems and essays.
1. Pure-play problem. Jones Ravioli Company wants to branch out into pastry
production. Their current beta is 1.2 and debt comprises 20% of their capital
structure (so 80% is equity). The proxy company – Elegant Pastries – is a
publicly owned company that produces pastries. Elegant Pastries has a beta of 1.5
and their capital structure is 40% debt and 60% equity. The risk-free rate is 6%,
the market return is 14%, and both firms have a tax rate of 40%. Calculate the
cost of capital at which this new project’s cash flows should be discounted. Jones
Ravioli Company’s cost of debt is 12%. (Hamada’s equation is Bu = BL/(1+(1t)(D/E).)
Give 2 examples of when pure-play cannot be used to determine the risk-adjusted
discount rate.
What kind of risk does pure-play measure? How does a company cope with this type of
risk if pure-play cannot be used?
2. Decision tree analysis. Joseph Rodriguez is considering building an indoor
soccer/athletic field complex. The first step is to conduct a study at a cost of
$200,000 to determine if the demand exists for such a center. There is a 20%
chance the study will determine that there is no demand and the project will not
be undertaken. There is an 80% chance that the project has sustainable demand
and will be undertaken. The year after the marketing study (year 1), the building
will be built for $2,000,000. In year 2, the complex has a 50% chance of earning
$1,000,000 and a 50% chance of earning $500,000. If the complex earns
$1,000,000 there is a 60% chance that a competitor will build a complex nearby
and the third year’s cash flow will only be $400,000. If the competitor doesn’t
build a complex, the cash flow will be $1,500,000. Rodriguez plans on selling the
complex at the end of the third year. If the income is $400,000, he will be able to
sell it for $2,000,000. If the income is $1,500,000, he will be able to sell it for
$4,000,000. The firm’s cost of capital is 12%. What is the expected NPV of this
project? Draw the decision tree. Do NOT calculate the standard deviation.
If one calculates standard deviation and CV, what type of risk is being measured?
3. Compute the optimal level of debt for ABC Corp. Their EBIT is $500,000 and their
cost of equity with no leverage is 15%. Their tax rate is 40%. The present value of
expected future financial distress costs is $400,000.
Debt
0
$250,000
500,000
750,000
1,000,000
Probability of Fin’l Distress
0
10%
20%
50%
90%
Show all computations including the Vu computation.
Why is a 0% level of debt rarely optimal for a firm?
Essay 1. Even in the same industry, some firms have different levels of debt. Explain 5
reasons a firm’s actual debt level may differ from other firms in the same industry and
from the optimal level as computed by the trade-off theory. These other factors influence
the optimal level of debt.
(5 points extra credit) Short essay 2. Explain the relationship between the optimal level
of debt and a firm’s cost of capital. Show 2 graphs that relate the D/V ratio to value of
the firm and a firm’s cost of capital.