Final Exam Review
S.I. Fin 301
4/30/08
**This practice exam is meant to cover the information since exam 3.**
Chapter 10 Material: The Cost of Capital
1. What is the formula for the weighted average cost of capital?
WACC= wdrd(1-T) + wprp + wcrs
W’s refer to the firms capital structure weightsàfor now they are given
R’s refer to the cost of each component
rd(1-T)= component cost of debtà want it after tax. YTM is common measure of rd
2. A 12 year, 15% semi annual coupon bond sells for $1,586.54 What is the cost of rd?
N= (12 x 2)= 24
I/Y= ?
PV= -1,586.54
PMT= (.15/2)(1000)= 75
FV= 1000
CPT I/Y= 3.751 *2 (b/c semi annual, so have to convert to annual)= 7.501%
3. A company’s current outstanding bonds have 10% coupon and 12% YTM. Their marginal tax rate is 35%. What is the after tax cost of debt?
12(1-0.35)= 7.8%
rd(1-T)
4. If a company’s preferred stock sells at a price of $45.00 a share and pays a dividend of $6.50, what is the cost of preferred stock?
(rp)= Dp/Pp
= 6.50/45
= 14.44%
5. Which of the following is used to calculate the common cost of equity rs?
a. CAPM: rs= rrf + (rm-rrf)b
b. DCF: rs= (D1/P0) + g
c. Own Bond Yield Plus Risk Premium: rs= rd + RP
d. All of the above can be used.
6. The risk free rate is 6%, the market risk premium is 9% and the beta is 1.45. What is the common cost of equity using the CAPM?
rs= rrf + (rm-rrf)b
rs= 6 + (9)(1.45)
= 19.05%
7. A company just paid a dividend of 3.50, and their stock is currently selling at $35.50 per share. It is expected to have a constant growth rate of 5%. What is the common cost of equity using the DCF approach?
D1= D0(1+g)
= 3.5(1.05)
= 3.675
DCF: rs= (D1/P0) + g
= (3.675/35.50) + 0.05
= 15.35%
8. A company’s common stock is currently trading for $50 per share and it is expected to pay a dividend of $4.55 at the end of the year. The constant growth rate is 5.75%. If they wanted to issue new stock, and would have flotation cost of 10%, what would the cost of equity of the new stock be?
rs= (D1/[P0(1-F)] + g)
= (4.55/ [50(1-0.10)] + 0.0575)
= 15.86%
9. A company has a target capital structure of 35% debt, and 65% common equity, with no preferred stock. Its before tax cost of debt is 10% and its marginal tax rate is 35%. The current stock price is $32.50 and they just paid a dividend of $3.00. It is expected to grow at a constant rate of 6.5%. What is the cost of common equity and the WACC?
D1= D0(1 + g)
= 3(1.065)
= 3.195
rs= (D1/P0) + g
= (3.195/32.50) + .065
= 16.33%
WACC= wdrd(1-T) + wprp + wcrs
= (0.35)(10%)(1-.35) + 0 + (0.65)(16.33%)
= 2.275 + 0 + 10.6145
= 12.8895%
10. Which of the following factors influence a company’s composite WACC?
a. Market conditions
b. The firms capital structure and dividend policy
c. The firms investment policy
d. All of the above
Chapter 11 Material: Capital Budgeting
1. What is the recipe for capital budgeting?
a. Estimate Cash Flows
b. Assess Riskiness of Cash Flows
c. Determine Appropriate Cost of Capital
d. Find NPV and or IRR (PB, DPB, MIRR, etc)
e. Accept if NPV>0 and or IRR > WACC.
2. Which of the following are types of projects that have cash flows that are unaffected by each other and therefore, more than one can be accepted at a time?
a. Mutually exclusive projects
b. Independent projects
c. Dependent projects
d. Accepted projects
3. A major airline purchased a fleet of jets to run its business operations. The initial cost was $50,000,000. This cost was followed by a steady inflow of revenue generated from ticket sales amounting to $15,000,000 each year for 5 years. The jets then all had to be repaired and updated resulting in a cost of $25,000,000. This is an example of a ______cash flow stream.
a. Normal
b. Non normal
c. Strange
d. Negative
e. Positive
Use the following information for #4-7
4. Project W costs $35,000 and has expected cash inflows of $12,000 a year for 5 years. It has a weighted average cost of capital of 10%. What is the projects NPV? Should you accept or reject the project based on NPV?
CF0= -35,000
CF1= 12,000
F= 5
NPV
I= 10
Enter, down
NPV CPT= $10,489.44 You should accept the project b/c the NPV is > 0.
5. What is the IRR for project W? Should you accept or reject the project based on IRR?
IRR CPT= 21.15%
Accept because the IRR > WACC
6. What is the payback period for project W?
Student Version:
Make timeline
Professional Version:
NPV, down, down, down
PB CPT= 2.92 years
7. What is the discounted payback for project W?
Student Version
Make timeline then discount cash flows
Professional Version
NPV, down, down, down, down
DPB CPT= 3.63 years
8. If you are dealing with mutually exclusive projects, what method of evaluation should you use, and why?
a. IRR because it gives better results.
b. NPV because in the case that there is a cross over point, and the WACC is less than the cross over point, the NPV and IRR will give conflicting results, and NPV has the more realistic reinvestment rate assumption.
c. IRR because in the case that there is a cross over point, and the WACC is less than the corss over point, the NPV and IRR will give conflicting results, and IRR has the more realistic reinvestment rate assumption.
d. NPV or MIRR because in the case that there is a cross over point, and the WACC is less than the cross over point, the NPV and IRR will give conflicting results, and NPV has the more realistic reinvestment rate assumption, also MIRR assumes that the incremental cash flows are reinvested at the WACC, much like NPV.
e. Payback period, because it is the easiest method and it gives the clearest picture of what kind of return projects will yield.
9. What is the MIRR?
The modified internal rate of return. It assumes that CF’s are reinvested at the WACC so it eliminates the problem of conflicting results for NPV/IRR.
10. A project costs 60,000 and has cash inflows of 15,000 each year for ten years. It has a weighted average cost of capital of 11%. What is the projects MIRR?
Student Version:
N= 10
I/Y=11
PV=0
PMT= 15000
CPT FV=$250,830.13
N=10
I/Y=?
PV= -60,000
PMT= 0
FV= $250,830.13
CPT I/Y= 15.38%
Professional Version:
CFo=-60,000
Enter, down
CF1= 15,000
Enter, down
F1= 10
IRR
RI= 11
Enter, down
MOD= CPT= 15.38
Chapter 12: Cash Flow Estimation and Risk Analysis
1. Match the terms in the column on the left with the definition in the column on the right.
A. Sunk Cost (3) / 1. When a new project reduces cash flows that the firm would otherwise have had. A negative impact.B. Incremental Cash Flow (5) / 2. The effect on the firm or the environment that is not reflected in the project’s cash flows. Can be positive or negative.
C. Opportunity Cost (4) / 3. A cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.
D. Externality (2) / 4. The return on the best alternative use of an asset. The highest return that will not be earned if funds are invested in a particular project.
E. Cannibalization Effect (1) / 5. A cash flow that will occur only if the firm takes on a project.
2. ______risk is the risk an asset would have if it were the only asset the firm had, and if investors owned only one stock. Measured by the variability of the asset’s expected returns.
a. Stand-alone risk
b. Corporate Risk- risk not considering the effects of stock holders diversification; measured by a project’s effect on uncertainty about the firms future earnings
c. Market Risk- the part of a projects’ risk that cannot be eliminated by diversification; it is measured by the project’s beta coefficient.
3. Match the types of analysis with their appropriate definition.
A. Sensitivity Analysis (5) / 1. An analysis in which all of the input variables are set at their most likely valuesB. Scenario Analysis (4) / 2. An analysis in which all of the variables are set at their worst reasonably forecasted values.
C. Base-Case Scenario (1) / 3. An analysis in which all of the input variables are set at their best reasonably forecasted values.
D. Worst-Case Scenario (2) / 4. A risk analysis technique in which “bad” and “good” sets of financial circumstances are compared with a most likely or base case situation.
E. Best Case Scenario (3) / 5. A risk analysis technique in which key variables are changed one at a time and the resulting changes in NPV are observed.
4. A company is considering an expansion. The necessary equipment would be purchased for $8 million, and it would also require an additional $4 million investment in working capital. The tax rate is 35%.
a. What is the initial investment outlay?
Initial investment outlay is the amount of money that has to be spent at the beginning of the project.
Equipment Cost…………………..8,000,000
+Working Capital…………………4,000,000
Initial Investment Outlay…….$12,000,000
b. The company spent and expensed $65,000 on research related to the project 6 months ago. Would this change your answer in part A?
No, the $65k that was spent 6 months ago is a sunk cost and therefore does not need to be added in as part of the initial investment outlay.
c. The company plans to use an existing, but not currently used building for the project. The building could be sold for $2.5 million after tax. Does this affect your answer in part a?
Yes because this is an opportunity cost. If the project is not done, then the company would have revenue of $2.5 million. Therefore it should be added onto the initial investment outlay for a total of $14.5 million.
5. A company has the following information about a project
Sales Revenue / $12 MillionOperating Costs (excluding dep’r) / $6 Million
Depreciation / $2 Million
Interest Expense / $1.5 Million
The company has a 35% tax rate and the WACC is 10%.
a. What is the projects operating cash flow for year one? (t=1)
Sales 12,000,000
-Operating Costs 6,000,000
-Depreciation 2,000,000
= Operating income before taxes 4,000,000
-Tax Expense (35%) 1,400,000
= Operating income after taxes 2,600,000
+ Depreciation 2,000,000
= Operating Cash Flow 4,600,000
b. If this project would cannibalize other parts of the company by $2 million of cash flow before taxes per year, how would this change your answer to part A?
If the project is cannibalizing other areas of the company, then that money has to be taken away from the operating cash flow of the project. However, everything we do in this class is after tax, so the $2 million needs to be reduced from the operating cash flow after tax.
4,600,000- (2,000,000(1-0.35))=
3,300,000 is the new operating cash flow.
6. A company is in the final year of a project. The equipment oringially cost $45,000,000, but 75% of it has depreciated. They used equipment can be sold today for $12,000,000, and its tax rate is 35%. What is the equipments after tax net salvage value?
Equipment’s original cost $45,000,000
Depreciation (75) 33,750,000
Book Value 11,250,000
Gain on Sale: 12,000,000 – 11,250,000= 750,000
Tax on Gain: $750,000(0.35)= 262,500
After Tax Net Salvage Value: 12,000,000-262,500= $11,737,500
7. You must evaluate a proposed project for the R & D department. The base price for the new equipment is $140,000, and it would cost another $25,000 to modify the equipment for special needs of the firm. The equipment falls into the MACRS 3-year class system and would be sold after 3 years for $60,000. The applicable depreciation rates are 33,45,15, and 7% . The equipment would require an $8,000 increase in working capital. The project would have no effect on revenues, but it should save the firm $60,000 per year before tax labor costs. The firms’ marginal federal plus state tax rate is 35%.
a. What is the net cost of the project, aka the Year 0 project cash flow?
Base Price $140,000
Modification 25,000
Increase in Working Capital 8,000
Cash Outlay $173,000
b. What are the net operating cash flows in years one, two and three?
Year One / Year Two / Year ThreeAfter Tax Savings / (60,000(1-0.35)
=39,000 / =39,000 / =39,000
Depreciation Tax Savings / + 19057.50 / + 25,987.50 / + 8662.50
Net Operating Cash Flow / =$58,057.50 / = $64,987.50 / = $47,662.50
*Depreciable basis= 140,000 + 25,000= 165,000
*Depreciation per year= 165,000(.33) & 165,000(.45) & 165,000(.15)
54,450 74,250 24,750
*Depreciation Tax savings=54,450(0.35) 74,250(0.35) 24,750(0.35)
c. What is the terminal cash flow?