Financial Cases Final

Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of$900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500,$300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative,and a 10 percent cost of capital. Inflation is zero. What is the project's NPV? a. $ 6.24 b. $ 7.89 c. $ 8.87 d. $ 9.15 e. $10.41

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You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastic goods:plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the Vice-President of Finance. This is a position with high visibility and the opportunity for rapid advancement,providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. Following are balance sheets and some information about CGT. Assets Current assets $ 38,000,000 Net plant, property, and equipment $101,000,000 $ 38,000,000 + $ 101,000,000 = Total Assets $139,000,000 Liabilities and Equity Accounts payable $ 10,000,000 Accruals $ 9,000,000 $ 10,000,000 + $ 9,000,000 Current liabilities $ 19,000,000 Long term debt (40,000 bonds, $1,000 face value) $ 40,000,000 $ 19,000,000 + $ 40,000,000 Total liabilities $ 59,000,000 Common Stock 10,000,000 shares) $ 30,000,000 Retained Earnings $ 50,000,000 $ 30,000,000 + $ 50,000,000 Total shareholders equity $ 80,000,000 Total liabilities and shareholders equity $139,000,000 You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $889.50 per bond. These bonds have a 7.25 percent annual coupon rate, with semi-annual payments. The bonds mature in twenty years. The beta for your company is approximately equal to 1.1. The yield on a 6-month Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5percent. The expected return on the stock market is 11.5 percent, but the stock market has had an average annual return of 14.5 percent during the past five years. CGT is in the 40 percent tax bracket. 37. What is best estimate for the after-tax cost of debt for CGT? a. 2.52% b. 4.20% c. 4.35% d. 5.04% e. 5.37%

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You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastic goods:plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the Vice-President of Finance. This is a position with high visibility and the opportunity for rapid advancement,providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. Following are balance sheets and some information about CGT. Assets Current assets $ 38,000,000 Net plant, property, and equipment $101,000,000 $ 38,000,000 + $ 101,000,000 = Total Assets $139,000,000 Liabilities and Equity Accounts payable $ 10,000,000 Accruals $ 9,000,000 $ 10,000,000 + $ 9,000,000 Current liabilities $ 19,000,000 Long term debt (40,000 bonds, $1,000 face value) $ 40,000,000 $ 19,000,000 + $ 40,000,000 Total liabilities $ 59,000,000 Common Stock 10,000,000 shares) $ 30,000,000 Retained Earnings $ 50,000,000 $ 30,000,000 + $ 50,000,000 Total shareholders equity $ 80,000,000 Total liabilities and shareholders equity $139,000,000 You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $889.50 per bond. These bonds have a 7.25 percent annual coupon rate, with semi-annual payments. The bonds mature in twenty years. The beta for your company is approximately equal to 1.1. The yield on a 6-month Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5percent. The expected return on the stock market is 11.5 percent, but the stock market has had an average annual return of 14.5 percent during the past five years. CGT is in the 40 percent tax bracket. What is the best estimate of the WACC for CGT? a. 8.65% b. 8.92% c. 9.18% d. 9.75% e. 9.83%

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Which of the following statements is most correct? a. The AFN formula method assumes that the balance sheet ratios of assets and liabilities to sales (A*/S0 and L*/S0) remain constant over time, while the percentage of sales method does not. b. When assets are added in large, discrete units as a company grows, then the assumption of constant ratios and steady growth rates is most appropriate. c. Temporary excess capacity can be characteristic of a firm that adds lumpy assets as it grows or one that experiences cyclical changes. d. For a firm that has lumpy assets, small increases in sales can be accommodated without expanding fixed assets, even when the firm is at capacity. e. The graphical relationship between assets and sales where economies of scale are present is always linear.

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A corporate bond which matures in 12 years, pays a 9 percent annual coupon, has a face value of $1,000, anda yield to maturity of 7.5 percent. The bond can first be called four years from now. The call price is $1,050. What is the bond's yield to call? a. 6.73% b. 7.10% c. 7.50% d. 11.86% e. 13.45%

N: 12, PMT: 1000 * 9% = 90, FV: 1000, RATE: 7.5 ..... PV = $1,114.39 .....N: 4, PMT: 1000 * 9% = 90, FV: 1050, RATE: __ ..... PV = $1,062.85 .....

An investor is forming a portfolio by investing $50,000 in stock A which has a beta of 1.50, and $25,000 instock B which has a beta of 0.90. The return on the market is equal to 6 percent and Treasury bonds have ayield of 4 percent. What is the required rate of return on the investor's portfolio? a. 6.6% b. 6.8% c. 5.8% d. 7.0% e. None of the answers above is correct.

a. 6.6%

If interest rates fall from 8 percent to 7 percent, which of the following bonds will have the largest percentage increase in its value? a. A 10-year zero coupon bond. b. A 10-year bond with a 10 percent semiannual coupon. c. A 10-year bond with a 10 percent annual coupon. d. A 5-year zero coupon bond. e. A 5-year bond with a 12 percent annual coupon.

a. A 10-year zero coupon bond.

If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most likely become: a. Riskier over time, and its value will decline. b. Riskier over time, and its value will rise. c. Less risky over time, and its value will rise. d. Less risky over time, and its value will decline. e. There is no reason to expect its risk position or value to change over time as a result of its use of a single discount rate.

a. Riskier over time, and its value will decline.

Which of the following statements is most correct? a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component which makes up the firm's target capital structure. b. The weighted average cost of capital is calculated on a before-tax basis. c. An increase in the risk-free rate is likely to increase the marginal costs of both debt and equity financing. d. Answers a and c are correct. e. All of the answers above are correct.

a. The weighted average cost of capital for a given capital budget level is a weighted average of the marginal cost of each relevant capital component which makes up the firm's target capital structure.

A firm with a low bond rating faces a more severe penalty when the Security Market Line (SML) is relatively steep than when it is not so steep. a. True b. False

a. True

Any cash flow that can be classified as incremental is relevant in a capital budgeting project analysis. a. True b. False

a. True

If the required rate of return on a bond is greater than its coupon interest rate (and rd remains above the coupon rate), the market value of that bond will always be below its par value until the bond matures, at which time its market value will equal its par value. (Accrued interest between interest payment dates should not be considered when answering this question.) a. True b. False

a. True

In capital budgeting analyses, it is possible that NPV and IRR will both involve an assumption of reinvestment of the project's cash flows at the same rate. a. True b. False

a. True

Since the market return represents the return on an average stock, that return carries risk with it. As a result,there exists a market risk premium which is the amount over and above the risk-free rate that is required to compensate an investor for assuming an average amount of risk. a. True b. False

a. True

The motivation for floating rate bonds arose out of the costly experience of the early 1980s when inflation pushed interest rates to very high levels causing sharp declines in the prices of long-term bonds. a. True b. False

a. True

The trade-off theory tells us that the capital structure decision involves a tradeoff between the costs of debt financing and the benefits of debt financing. a. True b. False

a. True

There is an inverse relationship between bond ratings and the required return on a bond. The required return islowest for AAA-rated bonds, and required returns increase as the ratings get lower. a. True b. False

a. True

When a corporation's shares are owned by a few individuals who are associated with the firm's management,we say that the stock is "closely held." a. True b. False

a. True

You are given the following data: (1) The risk-free rate is 5 percent. (2) The required return on the market is 8 percent. (3) The expected growth rate for the firm is 4 percent. (4) The last dividend paid was $0.80 per share. (5) Beta is 1.3. Now assume the following changes occur: (1) The inflation premium drops by 1 percent. (2) An increased degree of risk aversion causes the required return on the market to go to 10 percent after adjusting for the changed inflation premium.(3) The expected growth rate increases to 6 percent. (4) Beta rises to 1.5.What will be the change in price per share, assuming the stock was in equilibrium before the changes? a. +$12.11 b. -$ 4.87 c. +$ 6.28 d. -$16.97 e. +$ 2.78

b. -$ 4.87 Rrf) Before Change: 5%, After Change: 5%-1%=4% - Rrf - inflation premium Market Return) Before Change: 8%, After Change: 10% Beta) Before Change: 1.3, After Change: 1.5 Req. Ret on stock) Before Change: 8.9%, After Change: 13% - rrf+b*(market ret-rrf) : both Growth Rate) Before Change: 4%, After Change: 6% Last Dividend) Before Change: 0.80, After Change: $0.80 Stock Price) Before Change: $16.98, After Change: $12.11 - dividend*(1+growth rate)?(req. ret. - growth rate) : both Change in Price) after changes - before changes = -$4.87

Consider a $1,000 par value bond with a 7 percent annual coupon. The bond pays interest annually. There are 9 years remaining until maturity. What is the current yield on the bond assuming that the required return on the bond is 10 percent? a. 10.00% b. 8.46% c. 7.00% d. 8.52% e. 8.37%

b. 8.46% coupon = 0.07*1000 = 70 Current Price: =-PV(0.1, 9, 70, 1000, 0) = 827.23 Current Yield: =70/827.23 = 8.46%

Your company's stock sells for $50 per share, its last dividend (D0) was $2.00, and its growth rate is a constant 5 percent. What is the cost of common stock, rs? a. 9.0% b. 9.2% c. 9.6% d. 9.8% e. 10.0%

b. 9.2% D0 = $2, P0 = $50, g = 0.05 r = g + [ D0 * ( 1 + g ) / P0 ] r = 0.05 + [(2 * 1.05) / 50] = 0.092 or 9.2%

You have developed the following data on three stocks: Stock A B C Standard Deviation A: 0.15 B: 0.25 C: 0.20 Beta A: 0.79 B: 0.61 C: 1.29 If you are a risk minimizer, you should choose Stock _______ if it is to be held in isolation and Stock _______ if it is to be held as part of a well-diversified portfolio. a. A; A b. A; B c. B; A d. C; A e. C; B

b. A; B

Assume a project has normal cash flows (that is, the initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct? a. All else equal, a project's IRR increases as the cost of capital declines. b. All else equal, a project's NPV increases as the cost of capital declines. c. All else equal, a project's MIRR is unaffected by changes in the cost of capital. d. Answers a and b are correct. e. Answers b and c are correct.

b. All else equal, a project's NPV increases as the cost of capital declines.

28. You have collected the following information regarding Companies C and D: The two companies have the same total assets. The two companies have the same operating income (EBIT). The two companies have the same tax rate. Company C has a higher debt ratio and a higher interest expense than Company D. Company C has a lower profit margin than Company D.Based on this information, which of the following statements is most correct? a. Company C must have a higher level of sales. b. Company C must have a lower ROE. c. Company C must have a higher times-interest-earned (TIE) ratio. d. Company C must have a lower ROA. e. Company C must have a higher basic earning power (BEP) ratio.

b. Company C must have a lower ROE.

A 20-year original maturity bond with 1 year left to maturity has more interest rate risk than a 10-year original maturity bond with 1 year left to maturity. (Assume that the bonds have equal default risk and equal couponrates.) a. True b. False

b. False

Since ROA measures the firm's effective utilization of assets (without considering how these assets are financed), two firms with the same EBIT must have the same ROA. a. True b. False

b. False

The realized portfolio return is the weighted average of the relative weights of securities in the portfolio multiplied by their respective expected returns. a. True b. False

b. False

To determine the amount of additional funds needed, you may subtract the expected increase in liabilities (a source of funds) from the sum of the expected increases in retained earnings and assets (both uses of funds). a. True b. False

b. False

You are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt.Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt. a. True b. False

b. False

Which of the following statements is correct? a. Because discounted payback takes account of the cost of capital, a project's discounted payback is normally shorter than its regular payback. b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found. c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV profiles, a NPV/IRR conflict will not occur. d. If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile. e. If the cost of capital is relatively high, this will favor larger, longer-term projects over smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over longer periods.

b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found.

Which of the following statements is most correct? a. The slope of the security market line is beta. b. The slope of the security market line is the market risk premium, (rM - rRF). c. If you double a company's beta its required return more than doubles. d. Statements a and c are correct. e. Statements b and c are correct.

b. The slope of the security market line is the market risk premium, (rM - rRF).

Which of the following statements is most correct? a. One of the ways in which firms can mitigate or reduce agency problems between bondholders and stockholders is by increasing the amount of debt in the capital structure. b. The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated. c. Managerial compensation can be structured to reduce agency problems between stockholders and managers. d. Statements b and c are correct. e. All of the statements above are correct.

b. The threat of takeover is one way in which the agency problem between stockholders and managers can be alleviated.

Assume that the average firm in your company's industry is expected to grow at a constant rate of 5 percent,and its dividend yield is 4 percent. Your company is about as risky as the average firm in the industry, but it has just developed a line of innovative new products which leads you to expect that its earnings and dividends will grow at a rate of 40 percent (D1 = D0(1 + g) = D0(1.40)) this year and 25 percent the following year, afterwhich growth should match the 5 percent industry average rate. The last dividend paid (D0) was $2. What is the value per share of your firm's stock? a. $ 42.60 b. $ 82.84 c. $ 91.88 d. $101.15 e. $110.37

c. $ 91.88

Stock X, Stock Y, and the market have had the following returns over the past four years. Year : Market 1 : 11% 2 : 7% 3 : 17% 4 : -3% X : Y 10% : 12% 4% : -3% 12% : 21% -2% : -5% The risk-free rate is 7 percent. The market risk premium is 5 percent. What is the required rate of return for a portfolio which consists of $14,000 invested in Stock X and $6,000 invested in Stock Y? a. 9.94% b. 10.68% c. 11.58% d. 12.41% e. 13.67%

c. 11.58% Beta X : = slope ( of x values, of market values ) = .75 Beta Y : = slope ( of y values, of market values ) = 1.33 Value Stock X (14000) + Value Stock Y (6000) = 20000 Portfolio X, Value 1400: Weight : = 14000 / 20000 = .70 Portfolio Y, Value 6000: Weight : = 6000 / 20000 = .30 Portfolio's Beta : = sumproduct ( Weigh X : Weight Y, Beta X : Beta Y ) = 0.92 Req. Rate of Ret for Portfolio : = Rfr + portfolio's beta * MRP Req. Rate of Ret for Portfolio : = .07 + .92 * .05 = 11.58%

Oakdale Furniture Inc. has a beta coefficient of 0.7 and a required rate of return of 15%. The market risk premium is currently 5%. If the inflation premium increases by 2% points, and Oakdale acquires new assets which increase its beta by 50%, what will be Oakdale's new required rate of return? a. 13.50% b. 22.80% c. 18.75% d. 15.25% e. 17.00%

c. 18.75%

Project A has an internal rate of return of 18 percent, while Project B has an internal rate of return of 16 percent. However, if the company's cost of capital (WACC) is 12 percent, Project B has a higher net present value. Which of the following statements is most correct? a. The crossover rate for the two projects is less than 12 percent. b. Assuming the timing of the two projects is the same, Project A is probably of larger scale than Project B. c. Assuming that the two projects have the same scale, Project A probably has a faster payback than Project B. d. Answers a and b are correct.e. Answers b and c are correct.

c. Assuming that the two projects have the same scale, Project A probably has a faster payback than Project B.

Which of the following statements is most correct? a. Using cash to purchase inventories will increase a company's quick ratio and reduce its current ratio. b. Using cash to purchase inventories will reduce a company's quick ratio and increase its current ratio. c. If a company's total assets turnover ratio exceeds the industry average, and yet its fixed assets turnover ratio is below the industry average, this suggests that the company has excessive current assets (more than the industry average). d. Answers b and c are correct. e. None of the answers above is correct.

c. If a company's total assets turnover ratio exceeds the industry average, and yet its fixed assets turnover ratio is below the industry average, this suggests that the company has excessive current assets (more than the industry average).

Stock A has a beta of 1.2 and a standard deviation of 20 percent. Stock B has a beta of 0.8 and a standard deviation of 25 percent. Portfolio P is a $200,000 portfolio consisting of $100,000 invested in Stock A and$100,000 invested in Stock B. Which of the following statements is most correct? (Assume that the required return is determined by the Security Market Line.) a. Stock B has a higher required rate of return than stock A. b. Portfolio P has a standard deviation of 22.5 percent. c. Portfolio P has a beta equal to 1.0. d. Statements a and b are correct. e. Statements a and c are correct.

c. Portfolio P has a beta equal to 1.0.

Which of the following is not considered a capital component for the purpose of calculating the weighted average cost of capital as it applies to capital budgeting? a. Long-term debt. b. Common stock. c. Short-term debt used to finance seasonal current assets. d. Preferred stock. e. All of the above are considered capital components for WACC and capital budgeting purposes.

c. Short-term debt used to finance seasonal current assets.

Which of the following is not a cash flow that results from the decision to accept a project? a. Changes in working capital. b. Shipping and installation costs. c. Sunk costs. d. Opportunity costs. e. Externalities.

c. Sunk costs.

Which of the following statements is most correct? a. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but the two classes must have the same voting rights. b. An IPO occurs whenever a company buys back its stock on the open market. c. The preemptive right is a provision in the corporate charter which gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock. d. Statements a and b are correct. e. Statements a and c are correct.

c. The preemptive right is a provision in the corporate charter which gives common stockholders the right to purchase (on a pro rata basis) new issues of common stock.

A stock has an expected return of 12.25%. The beta of the stock is 1.15 and the risk-free rate is 5%. What is the market risk premium? a. 1.30% b. 6.50% c. 15.00% d. 6.30% e. 7.25%

d. 6.30% MRP = Rfr + (Exp Ret - 5% ) * Beta MRP = 5% + (12.25 - 5% ) * 1.15 = 11.30% 11.30% - 5% = 6.30%

Monte Carlo simulation: a. Can be useful for estimating a project's stand-alone risk. b. Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable. c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR. d. All of the answers above. e. Only answers a and b are correct.

d. All of the answers above.

Which of the following statements is correct? a. If a company is retiring bonds for sinking fund purposes it will buy back bonds on the open market when the coupon rate is less than the market interest rate. b. A bond sinking fund would be good for investors if interest rates have declined after issuance and the investor's bonds get called. c. Mortgage bonds have less default risk than debentures. d. Both a and c are correct. e. All of the statements above are correct.

d. Both a and c are correct.

Which of the following statements is most correct? a. Although some methods of estimating the cost of equity capital encounter severe difficulties, the CAPM is a simple and reliable model that provides great accuracy and consistency in estimating the cost of equity capital. b. The DCF model is preferred over other models to estimate the cost of equity because of the ease with which a firm's growth rate is obtained. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity is not always accurate but its advantages are that it is a standardized and objective model. d. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms. e. None of the statements above is correct.

d. Depreciation-generated funds are an additional source of capital and, in fact, represent the largest single source of funds for some firms.

Blair Company has $5 million in total assets. The company's assets are financed with $1 million of debt, and $4 million of common equity. The company's income statement is summarized below: Operating Income (EBIT): $1,000,000 Interest Expense: 100,000 Earnings before tax (EBT): $ 900,000 Taxes (40%): 360,000 Net Income: $540,000 The company wants to increase its assets by $1 million, and it plans to finance this increase by issuing $1 million in new debt. This action will double the company's interest expense, but its operating income will remain at 20 percent of its total assets, and its average tax rate will remain at 40 percent. If the company takes this action, which of the following will occur: a. The company's net income will increase. b. The company's return on assets will fall. c. The company's return on equity will remain the same. d. Statements a and b are correct. e. All of the answers above are correct.

d. Statements a and b are correct.

One of the basic relationships in interest rate theory is that, other things held constant, for a given change in the required rate of return, the ____ the time to maturity, the ____ the change in price. a. longer; smaller. b. shorter; larger. c. longer; greater. d. shorter; smaller. e. Answers c and d are correct.

e. Answers c and d are correct.

Which of the following is most correct? a. The NPV and IRR rules will always lead to the same decision in choosing between mutually exclusive projects, unless one or both of the projects are "non-normal" in the sense of having only one change of sign in the cash flow stream. b. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of capital. c. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive projects (that each have normal cash flows) when the cost of capital exceeds the crossover point (that is, the point at which the NPV profiles cross). d. The discounted payback method overcomes the problems that the payback method has with cash flows occurring after the payback period. e. None of the statements above is correct.

e. None of the statements above is correct.

Which of the following mechanisms is used to motivate managers to act in the interests of shareholders? a. Bond covenants. b. The threat of a takeover. c. Executive stock options. d. Statements a and b are correct. e. Statements b and c are correct.

e. Statements b and c are correct.

Which of the following statements is most correct? a. One of the disadvantages of choosing between mutually exclusive projects on the basis of the discounted payback method is that you might choose the project with the faster payback period but with the lower total return. b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more common in cases where project cash flows are non normal. c. When choosing between mutually exclusive projects, managers should accept all projects with IRRs greater than the weighted average cost of capital. d. All of the statements above are correct. e. Two of the statements above are correct.

e. Two of the statements above are correct. Answers a and b