FIN 5023 FINANCIAL MANAGEMENT

EXAM 2 Sample questions – Part A worth 80 points

  1. (5) There are two mutually exclusive projects with the following cash flows:

Time 0 1 2 3 4 5 ( NPV IRR MIRR

Project A -$100m $40m $70m $40m $10m $10m (37.3 27.8 17.2

Project B -$100m $10m $20m $70m $40m $60m (42.8 22.16 18.1

The opportunity cost of capital is 10%. Calculate the NPV, IRR, MIRR and payback period for both projects. Which project should be selected?

  1. (15)Superserv Inc. intends to acquire new equipment for $10 million and has an estimated life of 5 years and a salvage value of $800K. The new equipment is expected to allow additional annual sales of $5 million over the next 5 years. The associated additional annual costs are expected to be $3 million. In addition, working capital will increase by $1.2 million at the outset. The project's cost of capital is 10%. The firm's tax rate is 40%. The annual depreciation charge on the new machine is $2 million. What is the project's NPV? ($-2.5753m)
  1. (10) Investment Timing Problem 13-2 page 480

NPV (Invest now) = $4.68m NPV (wait) = $3.21m

  1. (10)You are planning on acquiring a machine for a business that you have just started. The machine costs $35,000 and you can get a 5 year term loan at 10%; at the end of the five years, the machine is expected to have a value of $5,000. The manufacturer of the equipment is willing to lease the machine for $8,000 a year payable at the beginning of the year. If the firm leases it will acquire the machine for $5,000 at the end of 5 years. The machine will be depreciated straight-line to its salvage value over 5 years. The tax rate for your business is 35%. Should you buy or lease? (Cost of lease = $26,663.56, Cost of buying = $26,273)
  1. (5) An unlevered firm has 1000 shares outstanding and is worth $10,000. Its EBIT is $1,000. The firm decides to issue $5,000 of perpetual debt @ 4% interest rate and repurchase shares. What will be the common stock required return after the repurchase? (The firm faces a 40% tax rate and has zero costs of financial distress.) (6.857% - Note Rsu = 6%, and Vl = Vu + TD = $12,000)
  1. (15) GenCorp currently has 6%, perpetual debt and 10,000 shares outstanding. The debt accounts for 25% of firm value. The firm’s EBIT is $100,000 with zero growth. Current cost of equity is 10% and the tax rate is 40%.
  1. (5pts) What is the firm’s current total market value? ($714,285.7)
  2. (1pt) What is the firm’s current stock price? ($53.57)

The firm is considering recalling existing debt and issuing new debt at 7% which will increase the debt ratio from 25% to 40%. The new funds will be used to replace the old debt and repurchase stock. The cost of equity will increase to 11%.

c. (9pts) Outline the steps in the market price’s adjustment to the new plan. What will be the new stock price after the recapitalization? ($54.61)

  1. (5) Option valuation – Binomial model – Problems 9-6 pg 336 ($2.39)
  1. (5)Brammer Corp.'s projected capital budget is $1,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $550,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out? ($150,000)
  1. (5) The spot exchange rate for the euro is $1.25/€. The current 1 year rate are 5% in the U.S. and 6% in the eurozone. What should be the 1 year forward exchange rate for the euro? ($1.2382/€)
  1. (5) For the Cook County Company, the accounts receivable conversion period is 60 days, the accounts payable deferral period is 40 days and the inventory conversion period is 30 days. The Company produces 400 jackets at a cost of $25 a unit. What is the length of the cash conversion cycle? (50 days)

Part B. (20 points - 4 questions worth 5 points each)

Sample questions:

  1. Firms often use IRR and payback period as secondary criteria for making capital budgeting decisions. Provide an economic justification for this use.
  2. What is a necessary condition for a firm to earn positive NPV on its projects? Give some real world examples of firms which are very profitable and your understanding of the reason for their success.
  3. What are the reasons why leasing may be advantageous to a lessee? Explain.
  4. In financial distress firms may make sub-optimal investment decisions. Explain the rationale behind this statement.
  5. What are the direct and indirect costs of bankruptcy? Give examples of firms with high and low bankruptcy costs and explain.
  6. “Stockholders need not be concerned with bankruptcy costs, since they will be borne by bondholders.” Comment. (Assume that the firm declares bankruptcy when the value of assets is less than the value of obligations to bondholders. Thus, in bankruptcy, equity has zero value.)
  7. Give examples of industries with (i) high financial leverage and (ii) low financial leverage. Can you justify these capital structures?
  8. “Stock prices fall when firms issue new shares because of dilution of existing shareholders’ position.” Comment.
  9. "A firm should not pay dividend if it can reinvest the money in new projects at a profitable rate. Otherwise, shareholders will lose the value of the foregone projects." Comment.
  10. “Stockholders prefer a safe dividend rather than a risky capital gain.” Comment.
  11. “Stock prices react positively to dividend increases. This shows that investors prefer more dividends.” Comment.
  12. Discuss the information asymmetry explanation for the use of convertible debt.