SAMPLE QUESTIONS
Part I: Capital Budgeting Questions.
____a____1) Which of the following does NOT impact the market risk of a project?
a) The degree to which the project provides diversification for the firm
(given the firm’s other projects)
b) The cyclicality of the project’s cash flows
c) The fixed operating costs associated with the project.
d) In fact, all of the above impact market risk of a project
For the following capital budgeting questions, note that a tax rate give in the question
does not necessarily mean that the cash flows in the question are subject to taxes, when
valued on an after-tax basis.
In the answers, an OUTFLOW is indicated by a negative number. An INFLOW is
indicated by a positive number.
____c____2) You are conducting a capital budgeting analysis. You expect that, at the end
of year 1, cash will increase by $10,000, Account Receivable will increase by $5,000,
Accounts Payable will increase by $15,000 and Inventory will increase by $20,000. What
is the (after-tax) cash flow associated with these changes, to occur at the end of year 1?
The corporate tax rate is 30%.
a)
b)
c)
d)
e)
f)
-14,000
+14,000
-20,000
+ 20,000
0 (No cash flow)
None of the above
_____b_____3) You are asked to determine the after tax cash flow associated with the
sale of a sprocket machine at the end of year 2 for $100,000. The initial cost of the
sprocket machine is $1,000,000. The sprocket machine is being depreciated down to $0
using a MACRS depreciation schedule for three year assets, as given below:
Year
% of value
1
33%
2
45%
3
15%
4
7%
The corporate tax rate is 40%
a) 100,000
b) 148,000
c) 60,000
d) 52,000
e) None of these
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____d_______4) Which of the following statements is/are FALSE regarding capital
budgeting?
a) You need to consider the potential for inflation when estimating future
revenues and future expenses
b) Some firms discount cash flows known with certainty by the riskless discount
rate, instead of their WACC
c) The creation of brand loyalty is a source of positive NPV
d) In fact, none of the above statements is false
_____b______5) You are considering the purchase of home in a neighborhood adjacent
to Miami U, with the purpose of obtaining rental income from students. What is the best,
most reliable way to value this property?
a) Estimate future rental income over the life of the property, along with
expected future expenses. Factor in an allowance for inflation, costs
associated with future repairs, taxes, and the future demand for rental
property. Discount the after tax cash flows over the life of the property by the
appropriate discount rate to determine the price you should offer for the
property.
b) Average recent sales prices of similar homes in the same neighborhood.
c) Obtain after-tax cash flows associated with this property over the past five
years. Obtain inflation estimates for the future. Increase the after tax cash
flows by the inflation rate, and discount them at your cost of capital.
d) None of the above are reasonable methods to value this property.
Part II: REAL OPTIONS
_____d_____6) Which of the following is not a type of real option?
a) Abandonment or early sale option
b) Option to convert a production line to a new product
c) Option to delay start of project
d) In fact, all of the above are types of real options
e) In fact, none of the above is a type of real option
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7) You are considering a project to open Homer’s Doughnut Shop in a new strip mall.
You estimate the following cash flows will occur:
Event
apartments built next to strip mall
no apartments built next to strip mall
prob
0.4
0.6
NPV of
project
(t=0)
12000
-15000
If you wait a year to open Homer’s Doughnut shop, you will know, with certainty,
whether the apartments will be built on the adjacent piece of land or not, before you need
to make the decision to invest in the shop, or not. However, the cost of the doughnut shop
lease will go up if the apartments are built and you wait a year to invest. The NPVs of the
investment if you wait a year & invest become:
Event
apartments built next to strip mall
no apartments built next to strip mall
prob
0.4
0.6
NPV
(t=1)
8000
-15000
NPV
(t=0)
7273
-13636
i) What is the NPV of the decision to invest NOW?_____-4,200___________ (Write
actual answer on line) (4 pts)
ii) What is the NPV of the decision to wait a year to invest, given that you have the
option not to invest at that time?__2,909.2____________ (Write actual answer on line) (6
pts)
_____b_______iii) What should the investor do? (3 pts)
a) Invest NOW
.
b) Wait a year to invest
c) Don’t invest NOW or LATER
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PART III: CML AND SML
____b______8) Assume point “e” denotes the 1-month t-bill rate. To obtain a position along line
segment ea, you must engage in:
a)
b)
c)
d)
e)
Borrow at the riskless rate and invest in any portfolio along the efficient frontier
Lend at the riskless rate and invest in portfolio a only
Borrow at the riskless rate and invest in portfolio a only
Either a or c
In fact, an investor can not obtain a position along line segment ea, since one can not
truly borrow at the risk free rate.
____c______9) The standard deviation plotted on the x-axis represents
a) The standard deviation of dividends for a stock or portfolio
b) The standard deviation of stock (or portfolio) price
c) The standard deviation of stock (or portfolio) returns
d) The standard deviation of stock (or portfolio) beta
e) None of the above
_____b____10) Point "d" on the diagram represents:
a) Any portfolio purchased on margin, with a rate on borrowings equal to "e"
b) Portfolio "a" purchased on margin, with a rate on borrowings equal to "e", and relatively
more borrowed money than used to obtain portfolio “c”
c) Any portfolio of stocks where the beta > 1
d) In fact, it is impossible to obtain investments at point “d”, even if borrowing is possible at
rate “e”.
e) None of the above are true statements about point “d”.
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______c_____11) The slope of the expected SML is equal to:
a) beta
b) expected return on the market
c) expected market risk premium
d) expected return on the individual security
e) Risk-free rate
PART III: Capital Structure
12) A firm produces EBIT of $20,000 in perpetuity. Assume that corporate taxes are
40%, and that there are no personal taxes.
____80000_______ i) What is the value of this firm, if the required rate of
return on equity is 15%, and the firm is an unlevered firm (Vu)? (2 pts) (write answer on
the line)
____96000________ii) What is the value of this same firm, if instead of being
unlevered, we assume that the firm has $40,000 in debt (market value)? (3 pts)
_____56000_______iii) For the above firm in ii, what is the market value of its
equity?
Solution Choices for questions 13-14 (3 pts each)
a) All equity would be optimal
b) All debt would be optimal
c) Capital Structure would be irrelevant (You’d observe random debt ratios)
Which capital structure would be optimal under the following assumptions?
__b____13) Assume corporate tax rate = 20%, the personal tax rate on debt and equity
earnings are both equal to 0, and there are no bankruptcy costs.
___c____14) No corporate taxes, no personal taxes, and no bankruptcy costs.
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