Final Exam Intro Finance

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 (NPV) of this investment?

$109,250 / (1+0.04)=$105,048.077; $105,048.077 - $95,000 = $10,048

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?

$125,000 + $100,000 - $90,000 = $135,000

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 (NPV) of the project?

$360 million Compute present value of the cash flows at WACC and subtract investment costs as well as issuance costs. PV project cash inflows = $ 45 million / (0.09 - 0.03 ) = $ 750 million; cash outflows = $380 million + $ 10 million = $ 390 million; NPV = $ 750 million - $ 390 million = $360 million

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?

$49,000.00 Effective after-tax interest expense = Interest expense × (1 - Tax Rate) Effective after-tax interest expense = $70,000 × (1 - 0.3 ) = $49,000.00

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 Compute present value of the cash flows at WACC and subtract investment costs as well as issuance costs. PV project cash inflows = $ 50 million / (0.09 - 0.04) = $ 1000 million; Cash outflows = $420 million + $ 20 million = $ 440 million; NPV = $ 1000 million - $ 440 million = $560 million

Martin is offered an investment where for $4000 today, he will receive $4240 in one year. He decides to borrow $4000 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?

($4240-$4000)/4000 =6%

Martin is offered an investment where for $6000 today, he will receive $6180 in one year. He decides to borrow $6000 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?

($6180-$6000)/6000 =3%

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?

-7+2.0 /r=-7+1/(r-0.04); r=13%

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 Weight in debt equals market value of debt divided by market value of debt plus equity. Similarly, weight in equity is market value of equity divided by market value of debt plus equity. Weight in equity = $ 4 billion / ($4 + $ 19.8 ) billion = 0.168 ; Weight in debt = $ 19.8 billion / ($ 4 + $ 19.8 ) billion = 0.832

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% Cost of equity is the next period dividend divided by the price plus the growth rate in dividends. Costofequity=(Div1/PE)+g =($4.50×1.08)/$100+0.08=0.1286=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% Apply the CAPM equation. Costofequity=0.04+(1.6 ×0.07)=0.152=15.2%

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 Market Value Debt = $24 million × 120% = $28.8 million Market Value Equity = 2 million × $20 = $40 million Total Market Value = $68.8 million Weight of debt = $28.8 million / $68.8 million = 41.86 % Weight of equity = $40 million / $68.8 million = 58.14%

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 (PV) 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 Net present value = -Investment + Present Value of (Revenues × (1 - proportion of costs)) Net present value = -$1.5 million + ($ 2 million × (1 - 0.5 )) / 0.14 = $5.6 million

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% rwacc=rEE%+rD (1-Tc)D%+rpfdP% rwacc=0.25 ×0.13 +0.65 ×0.08 ×(1-0.4)+0.1×0.09 =0.0727=7.27%

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% Current yield = coupon / price; 0.07 = coupon / 95; hence, coupon = 0.07 × 95 = 6.65; yield to maturity = pretax cost of debt; using a financial calculator, -95 PV, 100 FV, 6.65 PMT, 10 N, CPT I = 7.37%

Assume the market value of Fords' equity, preferred stock and debt are $6 billion, $3 billion, and $13 billion, respectively. Ford has a beta of1.7, the market risk premium is8%, 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% Cost of equity is the next period dividend divided by the price plus the growth rate in dividends. Cost of debt is the yield to maturity times one minus the tax rate. WACC is the weight of debt times cost of debt plus weight of equity times cost of equity. Cost of equity = 0.03 + 1.7 × 0.08 = 0.166 ; Costofdebt=0.095 ×(1-0.35)=0.06175; Cost of preferred stock = $ 2.50 / $ 30 = 0.08333333 ; WACC=$6 billion×0.166 /$22billion+$3 billion×0.08333333 /$22billion+$13 billion×0.06175 / 22 = 0.09313 or 9.31%

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% Cost of debt = rate on bank debt Cost of equity = Risk-free rate + Beta × Market risk premium Weight of equity = Outstanding equity / (Outstanding equity + Debt) Weight of debt = 1- Weight of equity. rwacc=rEE%+rD (1-Tc)D% Cost of equity = 0.04 + 1 × 0.08 = 0.12 or 12% Weightofequity=12/(12+4)=0.75 or75% Weightofdebt=1-0.75 =0.25 or25% WACC=0.75 ×0.12+0.25 ×0.04×(1-0.3)=9.70%

37) Year0 Year1 Year2 Year3 Year4 Year5 Depreciation Rate 20.00% 32.00% 19.20% 11.52% 11.52% 5.76% 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%

Accumulated depreciation = $40,000 × 0.712 = $28,480 ; book value = $40,000 - $28,480 = $11,520 ; capital gain = $21,000 - $11,520 = $9480 ; tax owed = 0.4 × $9480 = $3792; after-tax cash flow = $21,000 - $3792 = $17,208

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 the firm's marginal tax rate is 35 %?

Annualdepreciation=$300,000 /4=$75,000. Free Cash Flow ($1,300,000 - $700,000 - $75,000 ) × (1 - 0.35 ) + $75,000 = $416,250

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?

Bring all negative cash flows to time 0; thus,PVshut-downcost=-400,000 /(1+0.044)5=-$322,520.63; FV positive cash flows at time 5 = $ 4,013,810.7; PV of positive cash flows at time 0 = $3,139,085; NPV at 4.4% = 2.91 million

Which of the following statements is FALSE?

C) External equity is less expensive than retained earnings

Revenues Cost of Goods Sold Gross Profit Selling, General and Admin Depreciation EBIT Income tax (35%) Incremental Earnings Year 0 280,000 Year 1 140,000 70,000 70,000 6400 75,000 -11,400 3990 Year 2 440,000 220,000 220,000 6400 75,000 138,600 -48,510 Year 3 440,000 220,000 220,000 6400 75,000 138,600 -48,510 90,090 -5,000 Year 4 350,000 175,000 175,000 6400 75,000 93,600 -32,760 60,840 -5,000 Capital Purchases Changes to NWC -7410 90,090 -5,000 -5,000 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 (NPV) of this project?

CF1 = -7410 + 75,000 + 5,000 = 72,590 ; CF2 and 3 = 90,090 + 75,000 + 5,000 = 170,090 ; CF4 = 60,840 + 75,000 + 5,000 = 140,840 ; Using a financial calculator, CF0 = -280,000, CF1 = 72,590 , CF2 = 170,090 , CF3 = 170,090 , CF4 = 140,840 ; calculating NPV at 10 % = $150,548 .

Balance Sheet Assets Current Assets Cash Accounts receivable Inventories Total current assets Long-Term Assets Net property, plant, and equipment Total long-term assets Total Assets $ 47 23 16 86 164 164 250 Liabilities Current Liabilities Accounts payable Total current liabilities Long-Term Liabilities Long-term debt Total long-term liabilities Total Liabilities Stockholders' Equity Total Liabilities and Stockholders' Equity $ 40 40 170 170 210 40 250 The balance sheet for a small firm is shown above. All amounts are in thousands of dollars. What is this firm's Net Working Capital?

Current assets - current liabilities = $86 - $40 = $46 thousand

Year 0 Year 1 Year 2 Year 3 Depreciation Rate 33.33% 44.45% 14.81% 7.41% MACRS 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?

Explanation: At the end of three years, both will be completely depreciated, thus $0 - $0 = 0

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?

Here we need to use the marginal tax rate. So, depreciation tax shield = $3.6 million × 0.35 = $1.26 million

According to Graham and Harvey's 2001 survey (Figure 8.2 in the text), the most popular decision rules for capital budgeting used by CFOs are ________.

IRR, NPV, Payback period

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 from the new equipment?

Incremental revenue = 25 % × 75 × $18,000 = $337,500

Which of the following is NOT a limitation of the payback rule?

It is difficult to calculate.

Outstanding Job Hours to Print Job JobA 6 JobB 9 JobC 12 JobD 16 JobE 2 Penalty for not completing job in 24 hours -$120 -$200 -$360 -$400 -$50

JobC,JobB,andJobE

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?

Market value of debt plus market value of equity gives market value of assets. $200 + $60 = $260 million

18) 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 %

NPV = -$17,996 equivalent annual annuity = -$4507

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?

NPV=-1,000,000+570,000 /(1+0.069)+570,000 /(1+0.069)^2+ 570,000 /(1+0.069)^3 = $498,597

Consider the following two projects: Year 0 Year 1 Year 2 Year 3 Year 4 Discount CashFlow CashFlow CashFlow CashFlow CashFlow Rate A -100 40 50 60 N/A 0.16 B -73 30 30 30 30 0.16

PI = NPV / Investment (or resources consumed) NPV = -73 + 30 / (1 + 0.16 ) 1 + 30 / (1 + 0.16 ) 2 + 30 / (1 + 0.16 ) 3 + 30 / (1 + 0.16 ) 4 = 10.9454191 So, PI = 10.9454191 / 73 = 0.1499

If WiseGuy Inc. uses payback period rule to choose projects, which of the projects (Project A or Project B) will rank highest?

Project B

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.

An analysis that breaks the net present value (NPV) calculation into its component assumptions and shows how the net present value (NPV) varies as one of the underlying assumptions changes is called

Sensitivity analysis

Which of the following best describes the Net Present Value rule?

Take any investment opportunity where the net present value (NPV) is not negative; turn down any opportunity when it is negative.

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 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 be most likely to make them change that decision?

The mower is only expected to be needed for three years

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

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.

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 (all quantities in millions of dollars). 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%?

Using a financial calculator, CF0 = -6 , CF1 = 1.93 , F1 = 10; calculate NPV at 9 % equals 6.38608 ; using TVM keys, PV = 6.38608 , N = 10, I = 9 ; calculate PMT = 0.99508 . Pre -tax manufacturing expenses = 0.99508 / 0.6 = $1.66 million

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, given a discount rate of 8%? Rule I: The Net Present Value rule Rule II: The Payback Rule with a payback period of two years Rule III: The internal rate of return (IRR) Rule

Using a financial calculator, enter CF0 = 100,000, CF1 = 26,000, F1 = 5; calculate NPV for I = 8 = $203,810, which is greater than $200,000. D) Rule I only

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 (IRR) 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?

Using a financial calculator, enter PMT = 600,000, N = 16, I = 4%; calculate PV = $6,991,377, which is greater than $6,000,000. Yes, because it agrees with the Net Present Value rule.

7) 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

6) 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.

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

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

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 (NPV) 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 decision rules might best be used as a supplement to net present value (NPV) by a firm that favors liquidity?

payback period

Most corporations measure the value of a project in terms of which of the following?

present value (PV)

You are opening up a brand new retail 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

An exploration of the effect of changing multiple project parameters on net present value (NPV) is called

scenario analysis

Which of the following adjustments should NOT be made when computing free cash flow from incremental earnings?

subtracting depreciation expenses from taxable earnings

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 would you NOT consider when making a capital budgeting decision?

the cost of a marketing study completed last year

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

Holding everything else constant, an increase in cash ________ a firm's net debt.

will decrease