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Business Finance 3120 Exam 3
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Most corporations measure the value of a project in terms of which of the following?
Present Value
Tanner is choosing between two investment options. He can invest $500 now and get guaranteed $550 in one year, or invest $500 now and get guaranteed $531.40 back later today. The risk-free rate is 3.5%. Which investment should Tanner prefer?
Tanner should be indifferent between the two investments, since both are equivalent to the same amount of cash today.
A firm has an opportunity to invest $95,000 today that will yield $109,250 in one year. If interest rates are 4%, what is the net present value of this investment?
$10,048
Martin is offered an investment where for $4000 today, he will receive $4240 in one year. He decides to borrow $4,000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?
6%
Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6,000 from the bank to make this investment. What is the maximum interest rate the bank needs to offer on the loan if Martin is at least to break even on this investment?
3%
Peter has a business opportunity that requires him to invest $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?
Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan.
Peter has a business opportunity that requires him to investment $10,000 today, and receive $12,000 in one year. He can either use $10,000 that he already has for this investment or borrow the money from his bank at an interest rate of 10%. However, the $10,000 he has right now is needed for urgent repairs to his home, repairs that will cost at least $15,000 if he delays them for a year. What is the best alternative for Peter out of the following choices?
Yes, since he can borrow the $10,000 from a bank, repair his home, invest $10,000 in the business opportunity, which, since it has a NPV > 0 will mean he will still come out ahead after repaying the loan
An auto-parts company is deciding whether to sponsor a racing team for a cost of $1 million. The sponsorship would last for three years and is expected to increase cash flows by $570,000 per year. If the discount rate is 6.9%, what will be the change in the value of the company if it chooses to go ahead with the sponsorship?
$498,597
The owner of a hair salon spends $1,000,000 to renovate its premises, estimating that this will increase her cash flow by $220,000 per year. She constructs the above graph, which shows the net present value as a function of the discount rate. At what dollar value should the NPV profile cross the vertical axis?
The vertical axis crossing point cannot be calculated since the cash inflows are in perpetuity.
According to Graham and Harvey's 2001 survey, the most popular decision rules for capital budgeting used by CFOs are
IRR, NPV, Payback period
Which of the following is NOT a limitation of the payback rule?
It is difficult to calculate.
If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?
Project B
A lottery winner can take $6 million now or be paid $600,000 at the end of each of the next 16 years. The winner calculates the internal rate of return of taking the money at the end of each year and, estimating that the discount rate across this period will be 4%, decides to take the money at the end of each year. Was her decision correct?
Yes, because it agrees with the Net Present Value rule.
Mary is in contract negotiations with a publishing house for her new novel. She has two options. She may be paid $100,000 up front, and receive royalties that are expected to total $26,000 at the end of each of the next five years. Alternatively, she can receive $200,000 up front and no royalties. Which of the following investment rules would indicate that she should take the former deal, give a discount rate of 8%
Rule 1 only -- The Net Present Value
An investor is considering a project that will generate $900,000 per year for four years. In addition to upfront costs, at the completion of the project at the end of the fifth year there will be shut-down costs of $400,000. If the cost of capital is 4.4%, based on the MIRR, at what upfront costs does this project cease to be worthwhile?
$2.91 million
Which of the following is NOT a valid method of modifying cash flows to produce a MIRR?
Turn multiple negative cash flows into a single negative cash flow by summing all negative cash flows over the project's lifetime.
Two mutually exclusive investment opportunities require an initial investment of $7 million. Investment A pays $2.0 million per year in perpetuity, while investment B pays $1.4 million in the first year, with cash flows increasing by 4% per year after that. At what cost of capital would an investor regard both opportunities as being equivalent?
13%
A company buys a color printer that will cost $16,000 to buy, and last 5 years. It is assumed that it will require servicing costing $500 each year. What is the equivalent annual annuity of this deal, given a cost of capital of 8%?
-$4,507
A lawn maintenance company compares two ride-on mowers--the Excelsior, which has an expected working-life of six years, and the Grassassinator, which has a working life of four years. After examining the equivalent annual annuities of each mower, the company decides to purchase the Excelsior. Which of the following, if true, would most likely to make them change that decision?
The mower is only expected to be needed for three years
A print shop has contracted to print a number of jobs within 24 hours. Any jobs not completely printed within this time will result in a penalty, as shown in the table above. However too many jobs have been accepted, and not all can be printed, Which jobs should be printed in the next 24 hours?
Job C, Job B, and Job E
You are opening up a brand new retails strip mall. You presently have more potential retail outlets wanting to locate in your mall than you have space available. What is the most appropriate tool to use if you are trying to determine the optimal allocation of your retail space?
Profitability Index
The profitability index for project B is closest to
0.15
Which of the following best describes the Net Present Value rule?
Take any investment opportunity where the net present value is not negative; turn down any opportunity when it is negative.
Which of the following decision rules might best be used as a supplement to net present value by a firm that favors liquidity?
payback period
The ultimate goal of the capital budgeting process is to
determine the effect of the decision to accept or reject a project on the firm's cash flows
Which of the following best defines incremental earnings?
the amount by which a firm's earnings are expected to change as a result of an investment decision
Which of the following best describes why the predicted incremental earnings arising from a given decision are not sufficient in and of themselves to determine whether that decision is worthwhile?
These earnings are not actual cash flows.
A small manufacturer that makes clothespins and other household products buys new injection molding equipment for a cost of $500,000. This will allow the manufacturer to make more clothespins in the same amount of time with an estimated increase in sales of 25%. If the manufacturer currently makes 75 tons of clothespins per year, which sell at $18,000 per ton, what will be the increase in revenue next year form the new equipment?
$337,500
Which of the following would you NOT consider when making a capital budgeting decision?
the cost of a marketing study completed last year
Which of the following adjustments should NOT be made when computing free cash flow from incremental earnings?
subtracting depreciating expenses from taxable earnings
The balance sheet for a small firm is shown above. All amounts are in thousands. What is this firm's Net Working Capital?
$46 thousand
A garage is installing a new "bubble-wash" car wash. It will promote the car wash as a fun activity for the family, and it is expected that the novelty of this approach will boost sales in the medium term. If the cost of capital is 10%, what is the net present value of this project?
$150,548
The Sisyphean Company is considering a new project that will have an annual depreciation expense of $3.6 million. If Sisyphean's marginal corporate tax rate is 35% and its average corporate tax rate is 30%, then what is the value of the depreciation tax shield on the company's new project?
$1,260,000
A firm is considering changing their credit terms. It is estimated that this change would result in sales increasing by $1,600,000. This in turn would cause inventory to increase by $125,000, accounts receivable to increase by $100,000, and accounts payable to increase by $90,000. What is the firm's expected change in net working capital?
$135,000
A firm is considering a new project that will generate cash revenue of $1,300,000 and cash expenses of $700,000 per year for five years. The equipment necessary for the project will cost $300,000 and will be depreciated straight line over four years. What is the expected free cash flow in the second year of the project if a firm's marginal tax rate is 35%?
$416,250
An insurance office owns a large building downtown. The sixth floor of this building currently houses its entire Human Resources Department. After carrying out a survey to see whether the sixth floor could be
rented and for what price, the company must decide whether to split the Human Resources Department between currently unoccupied spaces on several floors and rent out the entire sixth floor or to leave things as they currently are. Which of the following should NOT be considered when deciding whether to rent out the sixth floor?
the cost of the research into the feasibility of renting the sixth floor
A bakery invests $40,000 in a light delivery truck. This was depreciated using the five-year MACRS schedule shown above. If the company sold it immediately after the end of year 2 for $21,000, what would be the after-tax cash flow from the sale of this asset, given a tax rate of 40%?
$17,208
A firm is considering the purchase of a new machine for $325,000. The firm is unsure if it should use the 3-Year MACRS schedule or straight-line depreciation over three years. What is the difference in the book value after three years if the firm uses MACRS instead of straight-line depreciation?
$0
Panjandrum Industries, a manufacturer of industrial piping, is evaluating whether it should expand into the sale of plastic fittings for home garden sprinkler systems. It has made the above estimates of free cash flows resulting from such a decision. There are some concerns that estimates of manufacturing expenses may be low, due to the rising cost of raw materials. What is the break-even point for manufacturing expenses, if all other estimates are correct and the cost of capital is 9%?
$1.66 million
An exploration of the effect of changing multiple parameters on net present value is called
scenario anaylsis
An analysis that breaks the net present value calculation into its component assumptions and shows how the net present value varies as one of the underlying assumptions changes is called
sensitivity analyiss
Jim owns a farm that he wants to sell. He learns that a highway will be built near the farm in the future, giving access to the farmland from a nearby city and thus making the land attractive to housing developers. Expecting the net present value of the sale to be greater after the highway is built, he decides not to sell at this time. What real option is Jim taking?
option to delay
A manufacturer of peripheral devices for PCs decides to try and capture some of the PC gaming market by creating gaming versions of its traditional peripheral devices. It decides to start with a gaming version of its
standard keyboard, increasing the number of macro keys, adding a small LCD screen to display game data, and giving the user the ability to backlight keys in different colors. If this device is a success, the manufacturer plans to release gaming versions of its trackballs and other peripherals. What option is the manufacturer gaining by the release of the new keyboard?
option to expand
Which of the following statements regarding real options is NOT correct?
real options enhance the forecast of a project's expected future cash flows by incorporating, at the start of the project, the effect of decisions that will be made at a later date
The book value of a firm's equity is $100 million and its market value of equity is $200 million. The face value of its debt is $50 million and its market value of debt is $60 million. What is the market value of assets of the firm?
$260 million
Assume Lavender Corporation has a market value of $4 billion of equity and a market value of $19.8 billion of debt. What are the weights in equity and debt that are used for calculating the WACC?
0.168, 0.832
A firm incurs $70,000 in interest expenses each year. If the tax rate of the firm is 30%, what is the effective after-tax interest rate expense for the firm?
$49,000
Assume JUP has debt with a book value of $24 million, trading at 120% of par value. The firm has book equity of $28 million, and 2 million shares trading at $20 per share. What weights should JUP use in
calculating its WACC?
41.86% for debt, 58.14% for equity
Assume IBM just paid a dividend of $4.50 and expects these dividends to grow at 8% a year. The price of IBM is $100 per share. What is IBM's cost of equity capital?
12.86%
Your estimate of the market risk premium is 7%. The risk-free rate of return is 4% and General Motors has a beta of 1.6 . What is General Motors' cost of equity capital?
15.2%
The outstanding debt of Berstin Corp. has ten years to maturity, a current yield of 7%, and a price of $95. What is the pretax cost of debt if the tax rate is 30%.
7.37%
SIROM Scientific Solutions has $12 million of outstanding equity and $4 million of bank debt. The bank debt costs 4% per year. The estimated equity beta is 1. If the market risk premium is 8% and the risk-free rate is
4%, compute the weighted average cost of capital if the firm's tax rate is 30%.
9.70%
The after-tax cost of debt ________ the before-tax cost of debt for a firm that has a positive marginal tax rate
is always less than
Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13 billion, respectively. Ford has a beta of 1.7, the market risk premium is 8%, and the risk-free rate of interest is 3%. Ford's preferred stock pays a dividend of $2.50 each year and trades at a price of $30 per share. Ford's debt
trades with a yield to maturity of 9.5 %. What is Ford's weighted average cost of capital if its tax rate is 35%?
9.31%
Assume Ford Motor Company is discussing new ways to recapitalize the firm and raise additional capital. Its current capital structure has a 25% weight in equity, 10% in preferred stock, and 65% in debt. The cost of equity capital is 13%, the cost of preferred stock is 9%, and the pretax cost of debt is 8%. What is the weighted average cost of capital for Ford if its marginal tax rate is 40%?
7.27%
Holding everything else constant, an increase in cash _______ a firm's net debt.
will decrease
SAP Inc. received a $1.5 million grant under its Small Business Innovation program. SAP invested the grant money and developed a system to remove metal contaminants from storm water in shipyards. The firm
estimates that each shipyard spends $500,000 a year on storm water clean-up efforts. If SAP is able to sign up and retain four shipyards in the first year onwards, what is the present value of the project (net of investment) if the cost of capital for SAP is 14% per year? Assume a cost of operations and other costs for SAP equal 50% of revenue
$5.64 million
Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $50 million each year, and expects these to grow at 4% each year. The upfront project costs are $420 million and Ford's
weighted average cost of capital is 9%. If the issuance costs for external finances are $20 million, what is the net present value (NPV) of the project?
$560 million
Assume Ford Motors expects a new hybrid-engine project to produce incremental cash flows of $45 million each year, and expects these to grow at 3% each year. The upfront project costs are $380 million and Ford's weighted average cost of capital is 9%. If the issuance costs for external finances are $10 million, what is the net present value of the project?
$360 million
Which of the following statements is FALSE?
external equity is less expensive than retained earnings
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