A1.The Difference Between the Present Value of an Investment and Its Cost Is The

Midterm 2

Business Finance, Spring 2007

Instructor: Nina Baranchuk

a1.The difference between the present value of an investment and its cost is the:

a.net present value.

b.internal rate of return.

c.payback period.

d.profitability index.

e.discounted payback period.

d2.The discounted payback rule states that you should accept projects:

a.which have a discounted payback period that is greater than some pre-specified period of time.

b.if the discounted payback is positive and rejected if it is negative.

c.only if the discounted payback period equals some pre-specified period of time.

d.if the discounted payback period is less than some pre-specified period of time.

e.only if the discounted payback period is equal to zero.

d3.The most valuable investment given up if an alternative investment is chosen is a(n):

a.salvage value expense.

b.net working capital expense.

c.sunk cost.

d.opportunity cost.

e.erosion cost.

b4.The stock valuation model that determines the current stock price by dividing the next annual dividend amount by the excess of the discount rate less the dividend growth rate is called the _____ model.

a.zero growth

b.dividend growth

c.capital pricing

d.earnings capitalization

e.discounted dividend

d5.The price a dealer is willing to accept for selling a security to an investor is called the:

a.equilibrium price.

b.auction price.

c.bid price.

d.ask price.

e.bid-ask spread.

a6.Wine and Roses, Inc. offers a 7 percent coupon bond with semiannual payments and a yield to maturity of 7.73 percent. The bonds mature in 9 years. What is the market price of a $1,000 face value bond?

a.$953.28

b.$953.88

c.$1,108.16

d.$1,401.26

e.$1,401.86

The bond valuation formula is: B = C(1-1/((1+r)^t))/r + F/((1+r)^t)

In this case, the (semiannual) coupon is C = 0.07*1000/2 = $35; the face value is F = 1000; the (semiannual) discount rate is r = 0.0773/2; and the number of (semiannual) periods is t = 9*2.

a7.The nominal rate of return on the bonds of Stu’s Boats is 8.75 percent. The real rate of return is 3.4 percent. What is the rate of inflation?

a.5.17 percent

b.5.28 percent

c.5.35 percent

d.5.43 percent

e.5.49 percent

Fisher effect: (1+R) = (1+r)(1+h)

Here, R = 0.0875 and r = 0.034.

c8.Leslie’s Unique Clothing Stores offers a common stock that pays an annual dividend

of $2.00 a share. The company has promised to maintain a constant dividend. How

much are you willing to pay for one share of this stock if you want to earn 12 percent

return on your equity investments?

a.$10.00

b.$13.33

c.$16.67

d.$18.88

e.$20.00

Dividend growth model: P = D(1+g)/(R-g)

Here, D = 2, g = 0, and R = 0.12.

d9.Which of the following are elements of the internal rate of return method of analysis?

I.the timing of the cash flows

II.the cutoff point after which any future cash flows are ignored

III.the rate designated as the minimum acceptable rate for a project to be accepted

IV.the initial cost of an investment

a.I and II only

b.III and IV only

c.I, II, and III only

d.I, III, and IV only

e.II, III, and IV only

d10.You own a house that you rent for $1,200 a month. The maintenance expenses on

the house average $200 a month. The house cost $89,000 when you purchased it

several years ago. A recent appraisal on the house valued it at $210,000. The annual

property taxes are $5,000. If you sell the house you will incur $20,000 in expenses.

You are deciding whether to sell the house or convert it for your own use as a

professional office. What value should you place on this house when analyzing the option of using it as a professional office?

a.$89,000

b.$120,000

c.$185,000

d.$190,000

e.$210,000

The value you should place on the house is the opportunity cost of selling the house. If you sell the house, you get $210,000, but you have to pay $20,000 in expenses. Thus, the opportunity cost is $210,000-$20,000 = $190,000.

b11.What is the net present value of a project with the following cash flows and a required

return of 12 percent?

YearCash Flow

0 -$28,900

1 $12,450

2 $19,630

3 $ 2,750

a.-$287.22

b.-$177.62

c.$177.62

d.$204.36

e.$287.22

NPV = -$28,900 + $12,450/(1+0.12) + $19,630/((1+0.12)^2) + $2,750/((1+0.12)^3).

d12.Sun Lee’s Furniture just purchased some fixed assets classified as 5-year property for

MACRS. The assets cost $24,000. What is the amount of the depreciation expense for

the third year?

MACRS 5-year property

YearRate

120.00%

232.00%

319.20%

411.52%

511.52%

6 5.76%

a.$2,304

b.$2,507

c.$2,765

d.$4,608

e.$4,800

Depreciation expense is $24,000*0.192

Use this information to answer questions 13 through 65.

You are working on a bid to build three playgrounds a year for the next two years. This project requires the purchase of $48,000 of equipment which will be depreciated using straight-line depreciation to a zero book value over the two years. The equipment can be sold at the end of the project for $30,000. You will also need $10,000 in net working capital over the life of the project. The fixed costs will be $15,000 a year and the variable costs will be $65,000 per playground. Your required rate of return is 12 percent for this project and your tax rate is 35 percent.

a13. What is the after tax salvage value?

a.$19,500

b.$29,500

c.$30,000

d.$40,000

e.$10,500

After tax salvage = Salvage – tax rate * (Salvage – book value). Here, Salvage is $30,000, tax rate is 0.35, and book value at the end of the project is 0.

b14. What will be your OCF if you charge the minimal amount per playground?

a.$16,863

b.$20,403

c.$34,483

d.$48,234

e.$51,774

OCF is found using the same method as for finding the equivalent annual cost: the present value of the investment into the project is

Initial Investment – present value of after tax salvage and recovered net working capital

here, initial investment is 48,000 + 10,000 = 58,000; after tax salvage is 19,500; net working capital recovered at the end of the project is 10,000. Thus, the present value of the total investment into the project is

58,000 – (19,500+10,000)/((1+0.12)^2)

OCF generated by the project has to at least cover this investment (in present value terms, of course). Otherwise, the project is not worth undertaking. Thus, we must have

OCF(1-1/((1+0.12)^2))/0.12 = 58,000 – (19,500+10,000)/((1+0.12)^2).

From the above, find that OCF is $20,403.

a15.What is the minimal amount (rounded to the nearest $500) that you should bid per playground?

a.$76,000

b.$78,000

c.$78,500

d.$84,500

e.$85,000

From OCF, obtained for the previous question, we can back out Sales as follows:

OCF = Sales – Costs – Taxes

= Sales – Costs – tax rate * (Sales – Costs – Depreciation)

In this problem, Costs = Fixed Costs + Variable Costs = 15,000+3*65,000 = 210,000; Depreciation is 48,000/2 = 24,000; tax rate = 0.35; and OCF = $20,403. Thus,

$20,403 = Sales – 210,000 – 0.35*(Sales – 210,000 – 24,000)

= 0.65(Sales – 210,000) + 8,400

Thus, Sales = (20,403 – 8,400)/0.65 +210,000 = 228,466.2

Since you need to build three playgrounds, you should charge at least 228,466.2 = 76,155.4 per playground. Or, rounded to the nearest $500, you should charge $76,000 per playground.