ÇANKAYA UNIVERSITY
MAN 305 BUSINESS FINANCE
MIDTERM EXAM II
28 December 2012
NAME:
DEPT:
SURNAME:
ID:
Question 1 (20 p)
Calculate the NPV for the following capital budgeting proposal: $100,000 initial cost, to be depreciated
straight-line over five years to an expected salvage value of $5,000, 35% tax rate, $45,000 additional annual
revenues, $15,000 additional annual expense, 11% cost of capital.
Answer
Year 0
-100,000
Cost
Revenues
- Expenses
- Dep'n
= Pretax
Profit
Taxes
Profit
Salvage Value
Tax effect
Cash Flows
-100,000
 1
NPV = $26,150 

1
Year 1
Year 2
Year 3
Year 4
Year 5
45,000
- 15,000
- 19,000
45,000
- 15,000
- 19,000
45,000
- 15,000
- 19,000
45,000
- 15,000
- 19,000
45,000
- 15,000
- 19,000
11,000
3,850
7,150
11,000
3,850
7,150
11,000
3,850
7,150
11,000
3,850
7,150
11,000
3,850
7,150
5,000
0
26,150
26,150
26,150
26,150
31,150

4
.11 .11(1.11) 
= 26,150 [9.07091 – 5.98846] +
+
$31,150
(1.11) 5
31,150
1.68506
= 26,150 [3.10245] + 18,485 – 100,000
= 81,129.07 + 18,459 – 100,000
= -$385,93
Reject the project
- 100,000
- 100,000
Question 2 (15 p)
An investor was expecting a 18% return on his portfolio with beta of 1.25 before the market risk premium
decreased from
8% to 6%. Based on this change, what return will now be expected on the portfolio?
Answer:
Old: 18% = rf + 1.25(8%)
= rf + 10.0%
8.0% = rf
New: Expected return = 8.0% + 1.25(6%)
= 8.0% + 7.5%
= 15.5%
Question 3 (10 p)
Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a before-tax interest rate
of 12%. Plasti-tech's common stock trades at $15 per share and its most recent dividend was $1.00. Future
dividends are expected grow by 4%. If the tax rate is 34%, what is Plasti-tech's WACC?
re = 1/$15 + 0.04
= 10.67%
WACC = 0.4[0.12(1 - 0.34)] + 0.6(0.1067)
= .0317 + .064
= 9.57%
Question 4 (10 p)
You have two types of common stocks, and their rates of returns in 3 different economical conditions
are given below. Which one would you invest? Stock A or Stock B?
Scenario
Probability
Return on A
Return on B
Recession
25%
-4%
9%
Normal
40%
8%
4%
Boom
35%
20%
-4%
Stock A:
Expected return = (.25 x –4%) + (.40 x 8%) + (.35 x 20%) = 9.2%
Stock B:
Expected return = (.25 x 9%) + (.40 x 4%) + (.35 x -4%) = 2.45%
Stock A will be better alternative to invest
Question 5 (15 p)
Calculate the nominal return, real return, and real risk premium for the following common stock
investment:
Purchase price
$60.00 per share
Dividend
$3.50 per year
Sales price
$73.00 per share
Treasury bill yield
8.5%
Inflation rate
7.5%
Hint: Risk premium = real return - real return on Treasury bills
Answer:
capital gain  dividend
Nominal return =
initial share price
=
$73  60   $3.50
$60
13  3.50
60
16.50
=
60
= 27.5%
=
Real return =
=
1.275
-1
1.075
1  nominal rate
-1
1  inflation rate
= 18.6%
Risk premium = real return less real return on Treasury bills
 1.085

= 18.6% - 
1 
 1.075

= 18.6% - .93%
= 17.67% in real terms.
Note: The problem did not specify whether the risk premium should be calculated in
nominal or real terms, so either answer would be accepted.
Question 6 (10 p) (optional, solve this question instead of 5 multiple choice questions)
What is the WACC for a firm with 40% debt, 20% preferred stock and 40% equity if the respective
costs for these components are 9.23% before-tax, 12% after-tax, and 18% before-tax? The
firm's tax rate is 35%.
WACC = (.4 x (1-35%) x .0923) + (.2 x .12) + (.4 x .18)
= .024 + .024 + .072
= 12.0%
Question 7 (2 p each)
Which of the following descriptions is representative of scenario analysis?
A) One variable at a time is allowed to change.
B) It isolates the unknowns that belong in the model.
C) Different combinations of variables are analyzed.
D) It represents the "top-down" approach.
Answer: C
Using a computer model to repeatedly vary the combination of project variables in order to compare
NPVs is called:
A) Scenario analysis
B) Sensitivity analysis
C) NPV break-even analysis
D) Simulation analysis
Answer: D
When management selects production technologies that include a high proportion of fixed costs,
they:
A) decrease their DOL.
B) increase their DOL.
C) decrease their NPV-break even level of sales.
D) reduce the NPV of their cash flows.
Answer: B
Real rates of return are typically less than nominal rates of return due to:
A) inflation.
B) capital gains.
C) dividend payments.
D) depreciation.
Answer: A
In a year in which common stocks offered an average return of 18%, Treasury bonds offered 10% and
Treasury bills offered 7%, the risk premium for common stocks was:
A) 1%
B) 3%
C) 8%
D) 11%
Answer: D
A tax shield is equal to the reduction in:
A) tax liability resulting from a deductible expense.
B) taxable income resulting from a deductible expense.
C) cash flow from an expense.
D) net income.
Answer: A
When the overall market is up by 10%, an investor with a portfolio of defensive stocks will probably
have:
A) negative portfolio returns less than 10%.
B) negative portfolio returns greater than 10%.
C) positive portfolio returns less than 10%.
D) positive portfolio returns greater than 10%.
Answer: C
A stock with a beta greater than 1.0 would be termed:
A) an aggressive stock, expected to increase more than the market increases.
B) a defensive stock, expected to decrease more than the market increases.
C) an aggressive stock, expected to decrease more than the market increases.
D) a defensive stock, expected to increase more than the market decreases.
Answer: A
Stock returns can be explained by the stock's _________ and the stock's __________.
A) beta; unique risk.
B) beta; market risk.
C) unique risk; firm-specific risk.
D) aggressive risk; defensive risk.
Answer: A
Investment projects that plot above the security market line would be considered to have:
A) a positive NPV.
B) a negative NPV.
C) a zero NPV.
D) an excessively high discount rate.
Answer: A
The slope of the regression line that exhibits the past relationship between a stock's return and the
market's return is the:
A) security market line.
B) stock's beta.
C) market risk premium.
D) stock's unique risk.
Answer: B
Which of the following statements is incorrect concerning the equity component of the WACC?
A) The value of retained earnings is not included.
B) Market values should be used in the calculations.
C) Preferred equity has a separate component.
D) There is a tax shield such as with debt.
Answer: D
In a year in which common stocks offered an average return of 18%, Treasury bonds offered
10% and Treasury bills offered 7%, the risk premium for common stocks was:
A) 1%
B) 3%
C) 8%
D) 11%
Answer:D
The appropriate opportunity cost of capital is the return that investors give up on alternative
investments with:
A) the same risk.
B) the risk-free return.
C) the expected return on the S&P 500 index.
D) the normal, common stock risk premium.
Answer: A
An estimation of the opportunity cost of capital for projects that have an "average" level of risk is the
rate of return on:
A) Treasury bills.
B) the market portfolio.
C) the market portfolio minus the rate of return on Treasury bills.
D) Treasury bonds plus a maturity premium.
Answer: B