Managerial Finance 2 - Final Exam Chapters 4-6

The internal rate of return is the discount rate that makes the PV of a project's cash inflows equal to zero. True or false

False

A financial analyst can use the equivalent annual cash-flow approach to determine the year in which an existing machine can be profitably replaced with a new machine. True or false

True

A large percentage of the total value of a growth stock comes from the present value of its growth opportunities. True or false

True

When calculating cash flows, one should consider them on an incremental basis. True or false

True

When evaluating mutually exclusive projects with positive NPV but different life spans, the proper technique to employ is the equivalent annual cash-flow approach. True or false

True

A project's "book value" represents, essentially, the market valuation of the project. True or false

False

A project's internal rate of return depends on its level of risk. True or false

False

Your firm expects to receive a cash flow in two years of $10,816 in nominal terms. If the real rate of interest is 2 percent and the inflation rate is 4 percent, what is the real cash flow for year 2? A. $11,236 B. $10,000 C. $10,816 D. $9,246

B. $10,000 Explanation: Real cash flow = $10,816/(1.04^2) = $10,000

Analysts often value companies by forecasting a series of cash flows and then estimating a horizon value. Suppose a firm forecasts a project's net cash flows ($millions) in years 1 through 4 as $120, $130, $135, and $137, respectively. If the project ends at the end of the fourth year, what is the horizon value of the project? Assume that the company had a historical growth rate of 3 percent and has a discount rate of 10 percent. A. $1.96 B. $4.87 C. $1.37 D. $0.00

D. $0.00 Explanation: If the project terminates, there is no horizon value.

A piece of capital equipment costing $400,000 today has no (zero) salvage value at the end of five years. If straight-line depreciation is used, what is the book value of the equipment at the end of three years? A. $240,000 B. $120,000 C. $80,000 D. $160,000

D. $160,000 Explanation: Annual depreciation = $400,000/5 = $80,000 Depreciation for three years = $240,000 Book value = $400,000 - $240,000 = $160,000

Given the following data for Project M, calculate the NPV of the project. Cash inflow in nominal terms: C0 = -100, C1 = 75, C2 = 60 Real discount rate: 5% Nominal discount rate: 10% A. $35.00 B. $22.65 C. 25.85 D. $17.77

D. $17.77 Explanation: NPV = -100 + 75/1.1 + 60/(1.1^2) = $17.77

A financial analyst should include interest and dividend payments when calculating a project's cash flows. True or false

False

A stock's price is based on the expected present value, at the market capitalization rate, of all the stock's future earnings. True or false

False

Decommissioning and clean-up costs for any project are always insignificant and should typically be ignored. True or false

False

The cost of equity capital equals the dividend yield minus the growth rate in dividends for a constant dividend growth stock. True or false

False

Most large U.S. corporations keep two separate sets of books, one for stockholders and one for the Internal Revenue Service. True or false

True

Sunk costs are bygones (i.e., they are unaffected by the decision to accept or reject a project). They should therefore be ignored. True or false

True

(Excel problem) Compute the present value of $4,800 paid in two years using the following discount rates: 8 percent, in the first year and 7 percent in the second year. Future value (in cell D7): $4,800 Number of years (in cell D8): 2 Interest rate first year (in cell D9): 8% Interest rate second year (in cell D10): 7%

Value two years from today: $4,800 Value one year from today: $4,485.98 Present value: $4,153.69 Explanation: Value two years from today (in cell D16): =D7 Value one year from today (in cell D17): =PV(D10,1,0,D7) Present value (in cell D18): =-PV(D9,1,0,D17)

Company X is expected to pay an end-of-year dividend of $5 a share. After the dividend, its stock is expected to sell at $110. If the market capitalization rate is 8%, what is the current stock price?

$106.48 Explanation: P0 = (DIV1+ P1) / (1 + r) P0= ($5 + $110) / 1.08 = $106.48

Company Z's earnings and dividends per share are expected to grow indefinitely by 4% a year. Assume next year's dividend per share is $11 and next year's EPS is $10. The market capitalization rate is 9%. If Company Z were to distribute all of its earnings, it could maintain a level dividend stream of $10 a share. How much is the market actually paying per share for growth opportunities?

$108.89 Explanation: P0 = DIV1 / (r − g) P0 = $11 / (0.09 − 0.04) = $220.00 P0 = EPS1 / r + PVGO PVGO = ($220.00 − $10) / 0.09 = $108.89

Company Z-prime's earnings and dividends per share are expected to grow by 3% a year. Its growth will stop after year 4. In year 5 and afterward, it will pay out all earnings as dividends. Assume next year's dividend is $5, the market capitalization rate is 9% and next year's EPS is $12. What is Z-prime's stock price?

$120.00 Explanation: P4 = EPS5 / r P4 = [EPS1 × (1 + g1)^3 × (1 + g2)] / r P4 = [$12 × (1 + 0.03)^3 × (1 + 0)] / 0.09 = $145.70 Note that $12 is the EPS for year 1. The 3 percent growth rate stops after year 4, so the exponent for the first growth rate must be 3, (Year 4 − Year 1). There is no growth in year 5. P0 = ($5 / 1.09) + ([$5 × 1.03] / 1.09^2) + ([$5 × 1.03^2] / 1.09^3) + ([$5 × 1.03^3] / 1.09^4) + ($145.70 / 1.09^4) = $120.00

If depreciation is $600,000 and the marginal tax rate is 21 percent, then the tax shield due to depreciation is A. $126,000 B. the answer cannot be determined from the information given C. $390,000 D. $600,000

A. $126,000 Explanation: Tax shield effect = ($600,000)(0.21) = $126,000

Given the following data for Project M, calculate the NPV of the project. Cash flow in real terms: C0 = -200; C1 = 150; C2 = 120 Real discount rate: 5% Nominal discount rate: 10% A. $51.70 B. $45.21 C. $70.00 D. $35.54

A. $51.70 Explanation: NPV = -200 + 150/1.05 + 120/(1.05^2) = $51.70

A project requires an investment of $900 today. It can generate sales of $1,100 per year forever. Costs are $600 for the first year and will increase by 20 percent per year. (Assume all sales and costs occur at year-end [i.e., costs are $600 @ t = 1].) The project can be terminated at any time without cost. Ignore taxes and calculate the NPV of the project at a 12 percent discount rate. A. $57.51 B. $100.00 C. $65.00 D. it cannot be calculated as g > r

A. $57.51 Explanation: NPV = -900 + (1,100 - 600)/1.12 + (1,100 - (600 × 1.2))/(1.12^2) + (1,100 - 600 (1.2^2))/(1.12)^3 + (1,100 - 600 (1.2^3))/(1.12^4) = $57.51 (The project is stopped when costs > revenues.)

OM Construction Company must choose between two types of cranes. Crane A costs $600,000, will last for five years, and will require $60,000 in maintenance each year. Crane B costs $750,000, will last for seven years, and will require $30,000 in maintenance each year. Maintenance costs for cranes A and B occur at the end of each year. The appropriate discount rate is 12 percent per year. Which machine should OM Construction purchase? A. Crane B, because EAC is $194,336 B. Crane A, because its PV is $816,286 (i.e., less than the PV of Project B) C. The answer cannot be calculated because the revenues for the project are not given. D. Crane A, because EAC is $226,444

A. Crane B, because EAC is $194,336 Explanation: Crane A annuity factor = (1/.12) × (1 - (1/(1.12^5))) = 3.6048 Crane B annuity factor = (1/.12) × (1 - (1/(1.12^7))) = 4.5638. Costs: PV (A) = $600,000 + $60,000 (3.6048) = $816,286; EAC = $816,286/(3.6048) = $226,444 PV(B) = $750,000 + $30,000 (4.5638) = $886,913; EAC = $886,913/(4.5638) = $194,336.45 (Accept the project with least annual cost.)

You are considering the purchase of one of two machines required in your production process. Machine A has a life of two years. Machine A costs $50 initially and then $70 per year in maintenance. Machine B has an initial cost of $90. It requires $40 in maintenance for each year of its three-year life. Either machine must be replaced at the end of its life. Which is the better machine for the firm? The discount rate is 15 percent and the tax rate is zero. A. Machine B, because EAC for machine B is $79.42 B. Machine B, because PV of costs for machine B is $181.33 C. Machine A, because PV of costs for machine A is $163.80 D. Machine A, because EAC for machine A is $100.76

A. Machine B, because EAC for machine B is $79.42 Explanation: Machine A annuity factor = (1/.15) × (1 - (1/(1.15^2))) = 1.6257 Machine B annuity factor = (1/.15) (1 - (1/(1.15^3))) = 2.2832 Costs: PV(A) = 50 + 70 (1.6257) = 163.80; EAC = 163.80/(1.6257) = 100.76 PV(B) = 90 + 40 (2.2832) = 181.33; EAC = 181.33/2.2832 = 79.42 (Accept the project with least annual cost.)

Preferably, a financial analyst estimates cash flows for a project as A. cash flows after taxes B. cash flows before taxes C. accounting profits before taxes D. accounting profits after taxes

A. cash flows after taxes

Indicate whether the following statements are true or false. A. Project cash flows should take account of interest paid on any borrowing undertaken to finance the project. B. In the U.S., income reported to the tax authorities must equal income reported to shareholders. C. Accelerated depreciation reduces near-term project cash flows and therefore reduces project NPV.

A. false B. false C. false Explanation: A. Financing and investment decisions are kept separate. B. One set of books is kept for stockholders using straight-line depreciation. Another set of books is kept for tax purposes using accelerated depreciation. C. Depreciation does not directly affect cash flows. However, an increase in depreciation in the earlier years will increase the present value of the depreciation tax shield and thus increase the NPV of the project.

Working capital is a frequent source of errors in estimating project cash flows. These errors include A. forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting that working capital is recovered at the end of the project. B. forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting to depreciate working capital. C. forgetting that working capital may change during the life of the project, forgetting that working capital is recovered at the end of the project, and forgetting to depreciate working capital. D. forgetting about working capital entirely and forgetting that working capital may change during the life of the project.

A. forgetting about working capital entirely, forgetting that working capital may change during the life of the project, and forgetting that working capital is recovered at the end of the project.

For project Z, year 5 inventories increase by $6,000; accounts receivable by $4,000; and accounts payable by $3,000. Calculate the increase or decrease in working capital for year 5. A. increases by $7,000 B. decreases by $7,000 C. decreases by $1,000 D. increases by $1,000

A. increases by $7,000 Explanation: Change in working capital = $6,000 + $4,000 - $3,000 = +$7,000

For the case of an electric car project, the following costs should be treated as incremental costs when deciding whether to go ahead with the project except A. interest payments on debt incurred to finance the project. B. the consequent reduction in sales of the company's existing gasoline models (i.e., incidental effects). C. the value of tools that will be transferred to the project from the company's existing plants instead of being sold. D. the expenditure on new plants and equipment.

A. interest payments on debt incurred to finance the project.

The net present value of a project depends upon the A. project's cash flows and opportunity cost of capital. B. company's choice of accounting method. C. company's profitability index. D. manager's tastes and preferences.

A. project's cash flows and opportunity cost of capital.

Investment in inventories includes investment in A. raw material, work-in-progress, and finished goods B. raw material only C. finished goods only D. raw material and work-in-progress

A. raw material, work-in-progress, and finished goods

Suppose that a project has a depreciable investment of $600,000 and falls under the following MACRS year 5 class depreciation schedule: year 1: 20 percent; year 2: 32 percent; year 3: 19.2 percent; year 4: 11.5 percent; year 5: 11.5 percent; and year 6: 5.8 percent. Calculate depreciation for year 2. A. $115,200 B. $192,000 C. $96,000 D. $120,000

B. $192,000 Explanation: Depreciation for year 2 = ($600,000)(0.32) = $192,000

A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years (i.e., cash flows will occur at t = 1 and t = 2). The corporate tax rate is 21 percent. The assets will depreciate using the MACRS 3-year schedule: (t = 1, 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can use all applicable tax shields. The opportunity cost of capital is 12 percent. Assume that the asset can sell for book value at the end of the project. Calculate the NPV of the project (approximately). A. $5,721 B. $22,735 C. $22,463 D. $19,315

B. $22,735 Explanation: Book value at the end of year 2 = (0.15 + 0.07) × $200,000 = $44,000 Year 1 cash flow: ($120,000 × (1 - 0.21)) + ($200,000 × 0.33 × 0.21) = $108,660 Year 2 cash flow: ($120,000 × (1 - 0.21)) + ($200,000 × 0.45 × 0.21) + $44,000 = $157,700 -$200,000 + ($108,660/1.12) + (($157,700)/(1.12^2)) = $22,735

A firm has a general-purpose machine, which has a book value of $300,000 and is worth $500,000 in the market. If the tax rate is 21 percent, what is the opportunity cost of using the machine in a project? A. $300,000 B. $458,000 C. $500,000 D. $200,000

B. $458,000 Explanation: The firm could sell the machine, which would generate a taxable capital gain of ($500,000 - $300,000) = $200,000. The opportunity cost of using the machine equals the market value of the machine less its tax impact: $500,000 - $200,000 × 0.21 = $458,000.

Two machines, A and B, which perform the same functions, have the following costs and lives. Machine A: PV costs = $6,000; life = 5 Machine B: PV costs = $8,000; life = 7 Which machine would you choose? The two machines are mutually exclusive and the cost of capital is 15 percent. A. Machine A, because it has lower PV costs B. Machine A, because the EAC is $1,789.89 C. Machine B, because the EAC is $1,922.88 D. Machine B, because it has longer life

B. Machine A, because the EAC is $1,789.89 Explanation: EAC(A) = 6,000/3.35215 = 1,789.89 EAC(B) = 8,000/4.1604 = 1,922.88 Using a financial calculator: EAC(A) = PV = 6,000; I = 15; FV = 0; & N = 5; Compute: PMT = -1,789.89 EAC(B) = PV = 8,000; I = 15; FV = 0; & N = 7; Compute: PMT = -1,922.88

The important point(s) to remember while estimating the cash flows of a project A. are cash flow is relevant and always estimate cash flows on an incremental basis. B. are cash flow is relevant, always estimate cash flows on an incremental basis, and be consistent in the treatment of inflation. C. is that only cash flow is relevant. D. are to always estimate cash flows on an incremental basis and to be consistent in the treatment of inflation.

B. are cash flow is relevant, always estimate cash flows on an incremental basis, and be consistent in the treatment of inflation.

If the discount rate is stated in nominal terms, then in order to calculate the NPV in a consistent manner, the project requires that A. accounting income be used B. cash flows be estimated in nominal terms C. cash flows be estimated ignoring inflation D. cash flows be estimated in real terms

B. cash flows be estimated in nominal terms

The principle short-term assets are A. accounts payable only B. cash, accounts receivable, and inventories C. cash and accounts payable only D. cash only

B. cash, accounts receivable, and inventories

For project A in year 2, inventories increase by $12,000 and accounts payable increase by $2,000. Accounts receivable remain the same. Calculate the increase or decrease in net working capital for year 2. A. increases by $14,000 B. increases by $10,000 C. decreases by $14,000 D. decreases by $10,000

B. increases by $10,000 Explanation: Working capital = $12,000 - $2,000 = +$10,000

The NPV value obtained by discounting nominal cash flows using the nominal discount rate is the same as the NPV value obtained by discounting A. real cash flows using the nominal discount rate and nominal cash flows using the real discount rate. B. real cash flows using the real discount rate only. C. real cash flows using the nominal discount rate only. D. nominal cash flows using the real discount rate only.

B. real cash flows using the real discount rate only.

Net working capital is best represented as A. short-term assets only B. short-term assets and short-term liabilities C. long-term assets and long-term liabilities D. long-term assets and short-term assets

B. short-term assets and short-term liabilities

Money that a firm has already spent, or committed to spend regardless of whether a project is taken, is called a(n) A. opportunity cost B. sunk cost C. fixed cost D. incremental cost

B. sunk cost

Capital equipment costing $250,000 today has $50,000 salvage value at the end of five years. If the straight-line depreciation method is used, what is the book value of the equipment at the end of two years? A. $200,000 B. $150,000 C. $170,000 D. $140,000

C. $170,000 Explanation: Annual depreciation = ($250,000 - $50,000)/5 = $40,000 Book value at the end of two years = $250,000 - $80,000 = $170,000

The current market value of a previously purchased machine proposed for use in a project is an example of a(n) A. sunk cost B. fixed cost C. opportunity cost D. inventoriable cost

C. opportunity cost

A firm owns a building with a book value of $150,000 and a market value of $250,000. If the firm uses the building for a project, then its opportunity cost, ignoring taxes, is A. $400,000 B. $100,000 C. $150,000 D. $250,000

D. $250,000

If a Wall Street Journal quotation for a company has the values Close = 55.14 and Net change = +1.04, then what was the closing price for the stock for the previous trading day? A. $55.66 B. $53.02 C. $56.18 D. $54.10

D. $54.10 Explanation: Previous closing = Today's closing - net chg. = 55.14 - 1.04 = $54.10

A project requires an initial investment of $200,000 and expects to produce a cash flow before taxes of $120,000 per year for two years (i.e., cash flows will occur at t = 1 and t = 2). The corporate tax rate is 21 percent. The assets will depreciate using the MACRS year 3 schedule: (t = 1: 33%); (t = 2: 45%); (t = 3: 15%); (t = 4: 7%). The company's tax situation is such that it can use all applicable tax shields. The opportunity cost of capital is 11 percent. Assume that the asset can sell for book value at the end of the project. Calculate the approximate IRR for the project. A. 14.06 percent B. 11.00 percent C. 12.00 percent D. 20.02 percent

D. 20.02 percent Explanation: Year 1 cash flow: (120,000 × (1 - 0.21)) + (200,000 × 0.33 × 0.21) = 108,660 Year 2 cash flow: (120,000 × (1 - 0.21)) + (200,000 × 0.45 × 0.21) + 44,000 = 157,700 0 = -200,000 + (108,660/(1 + IRR)) + (157,700/((1 + IRR)^2)) = 20.02%

The real interest rate is 3 percent and the inflation rate is 5 percent. What is the nominal interest rate? A. 5.00 percent B. 2.00 percent C. 3.00 percent D. 8.15 percent

D. 8.15 percent Explanation: 1 + nominal rate = (1 + real rate) (1 + inflation rate) = (1.03)(1.05) = (1.0815). Nominal rate = 0.0815 = 8.15%

Two mutually exclusive projects have the following positive NPVs and project lives. Project A: NPV = $5,000; life = 3 years Project B: NPV = $6,500; life = 5 years If the cost of capital were 15 percent, which project would you accept? A. Project B, because it has higher EAC B. Project A, because its NPV can be earned more quickly C. Project B, because it has higher NPV D. Project A, because it has higher EAC

D. Project A, because it has higher EAC Explanation: EAC(A) = 5,000/2.2832 = 2,189.88 (Accept the project with higher EAC.) EAC(B) = 6,500/3.35216 = 1,939.05 Using a financial calculator: EAC(A) = PV = 5,000; I = 15; FV = 0; & N = 3; Compute: PMT = -2,189.88 EAC(B) = PV = 6,500; I = 15; FV = 0; & N = 5; Compute: PMT = -1,939.05

For the case of an electric car project, which of the following costs or cash flows should be categorized as incremental when analyzing whether to invest in the project? A. The annual depreciation charge B. Dividend payments C. The cost of research and development undertaken for developing the electric car during the past three years D. Tax savings resulting from the depreciation charges

D. Tax savings resulting from the depreciation charges

Which of the following countries allows firms to keep two separate sets of books, one for the stockholders and one for the tax authorities like the Internal Revenue Service? A. none of these options are correct B. United States, Japan, and France C. United States and Japan D. United States only

D. United States only

When Honda develops a new engine, the incidental effects might include the following: A. demand for replacement parts and profits from the sale of repair services. B. demand for replacement parts only. C. demand for replacement parts and offer modified or improved versions of the new engine for other uses. D. demand for replacement parts, profits from the sale of repair services, and offer modified or improved versions of the new engine for other uses.

D. demand for replacement parts, profits from the sale of repair services, and offer modified or improved versions of the new engine for other uses.

A reduction in the sales of existing products caused by the introduction of a new product is an example of A. sunk costs B. opportunity costs C. allocated overhead costs D. incidental effects

D. incidental effects

When a firm has the opportunity to add a project that will utilize excess factory capacity (that is currently not being used), which costs should be used to help determine if the added project should be undertaken? A. allocated overhead costs B. sunk costs C. average costs D. incremental costs

D. incremental costs

Accountants do not depreciate investment in net working capital because A. it is a sunk cost B. it is not a cash flow C. working capital appears on the balance sheet, not the income statement D. it is recovered during or at the end of project; thus it is not a depreciating asset

D. it is recovered during or at the end of project; thus it is not a depreciating asset

An analyst wishes to determine the value of resources used by a proposed project. Which values should the analyst use to approximate opportunity costs? A. accounting values plus an inflation adjustment B. book values C. historical values D. market values

D. market values

The equivalent annual cash-flow technique is primarily used whenever the lives of two different projects are the same. True or false

False

Marsha Jones has bought a used Mercedes horse transporter for her Connecticut estate. It cost $35,000. The object is to save on horse transporter rentals. Marsha had been renting a transporter every other week for $200 per day plus $1.00 per mile. Most of the trips are 80 or 100 miles in total. Marsha usually gives Joe Laminitis, the driver, a $40 tip. With the new transporter she will only have to pay for diesel fuel and maintenance, at about $0.45 per mile. Insurance costs for Marsha's transporter are $1,200 per year. The transporter will probably be worth $15,000 (in real terms) after eight years, when Marsha's horse Spike, will be ready to retire. Assume a nominal discount rate of 9% and a 3% forecasted inflation rate. Marsha's transporter is a personal outlay, not a business or financial investment, so taxes can be ignored. Calculate the NPV of the investment. (round your answer to the nearest whole dollar amount)

NPV = $14,088 Explanation: Rreal = (1 + Rnominal) / (1 + inflation rate) − 1 Rreal = (1 + 0.09) / (1 + 0.03) − 1 = 0.0583, or 5.83% Given the one-day rental every two weeks: Rental savings = [$200 + ($1 × 90) + $40] × (52 / 2) = $8,580 Mileage cost = ($0.45 × 90) × (52 / 2) = $1,053 NPV(5.83%) = $14,098.79, or $14,099

Mr. Art Deco will be paid $100,000 one year hence. This is a nominal flow, which he discounts at an 8% nominal discount rate: PV = $100,000 / 1.08 = $92,593 The inflation rate is 4%. Calculate the PV of Mr. Deco's payment using the equivalent real cash flow and real discount rate.

Real cash flow = $96,154 Real discount rate = 3.846% Present value = $92,593 Explanation: Real cash flow = $100,000 / (1 + 0.04) = $96,154 r = (1 + 0.08) / (1 + 0.04) - 1 = 0.03846, or 3.846% PV = $96,154 / (1 + 0.03846) = $92,593

All securities in an equivalent risk class are priced to offer the same expected return. True or false

True

Depreciation expense acts as a tax shield in reducing taxes. True or false

True

The discounted payback method discounts cash flows at the opportunity cost of capital and then calculates the payback period. True or false

True

The payback rule ignores all cash flows after the cut-off date. True or false

True

Working capital is needed for additional investment within a project and should be included within cash-flow estimates. True or false

True

You should replace a machine when the EAC of continuing to operate it exceeds the EAC of the new machine. True or false

True

Excel problem: Annual dividends of AT&T Corp (T) grew from $0.93 in 2000 to $1.54 in 2012. What was the annual growth rate? Beginning dividend (in cell D6): $0.93 Ending dividend (in cell D7): $1.54 Interval (in years) (in cell D8): 12

4.29% Explanation: (In cell D15, type as follow) =RATE(D9,,-D7,D8) *Do not hard code values

Company Y does not plow back any earnings and is expected to produce a level dividend stream of $5 a share. If the current stock price is $40, what is the market capitalization rate?

12.5% Explanation: r = DIV1 / P0 r = $5 / $40 = 0.125, or 12.5%

(Excel problem) What annual rate of return is earned on a $5,000 investment when it grows it $10,750 in six years? Present value (in cell D7): $5,000 Future value (in cell D8): $10,750 Number of periods (in cell D9): 6

13.61% Explanation: Type as followed in cell D15 =RATE(D9,,-D7,D8) *Do not hard code values.

Company Z's earnings and dividends per share are expected to grow indefinitely by 5% a year. If next year's dividend is $10 and the market capitalization rate is 8%, what is the current stock price?

$333.33 Explanation: P0 = DIV1 / (r − g) P0 = $10 / (0.08 − 0.05) = $333.33

Compost Science Inc. (CSI) is in the business of converting Boston's sewage sludge into fertilizer. The business is not in itself very profitable. However, to induce CSI to remain in business, the Metropolitan District Commission (MDC) has agreed to pay whatever amount is necessary to yield CSI a 12% book return on equity. At the end of the year, CSI is expected to pay a $5 dividend. It has been reinvesting 30% of earnings and growing at 3% a year. A-1. Suppose CSI continues on this growth trend. What is the expected long-run rate of return from purchasing the stock at $100? A-2. What part of the $100 price is attributable to the present value of growth opportunities? B. Now the MDC announces a plan for CSI to treat Cambridge sewage. CSI's plant will, therefore, be expanded gradually over five years. This means that CSI will have to reinvest 60% of its earnings for five years. Starting in year 6, however, it will again be able to pay out 70% of earnings. What will be CSI's stock price once this announcement is made and its consequences for CSI are known?

A-1. 8% A-2. $10.75 B. $109.38 Explanation: A-1. r = DIV1 / P0 + g r = $5 / $100 + 0.03 = 0.08, or 8% A-2. EPS1 = DIV1 / (1 − reinvestment rate) EPS1 = $5 / (1 − 0.3) = $7.14 P0 = EPS1 / r + PVGO PVGO = P0 − EPS1 / r PVGO = $100 − $7.14 / 0.08 = $10.71 B. DIV1 will decrease to: 0.4 × $7.14 = $3. By plowing back 60% of earnings, CSI will grow by 7.20% per year for five years before returning to its long-run growth rate of 3%. The dividend will be 40% of earnings for Years 1-5 and 70% of earnings in Year 6 and beyond. Year 1: EPS = $7.14; DIV = $2.86 Year 2: EPS = $7.66; DIV = $3.06 Year 3: EPS = $8.21; DIV = $3.28 Year 4: EPS = $8.80; DIV = $3.52 Year 5: EPS = $9.43; DIV = $3.77 Year 6: EPS = $10.11; DIV = $7.08 P5 = DIV6 / (r − g) P5 = $7.08 / (0.08 − 0.03) = $141.57 P0 = ($2.86 / 1.08) + ($3.06 / 1.082^) + ($3.28 / 1.08^3) + ($3.52 / 1.08^4) + ($3.77 / 1.08^5) + ($141.57 / 1.08^5) = $109.38

Consider the following three stocks: Stock A is expected to provide a dividend of $10.30 a share forever. Stock B is expected to pay a dividend of $5.30 next year. Thereafter, dividend growth is expected to be 3.00% a year forever. Stock C is expected to pay a dividend of $5.30 next year. Thereafter, dividend growth is expected to be 19.00% a year for five years (i.e., years 2 through 6) and zero thereafter. A-1. If the market capitalization rate for each stock is 9.00%, what is the stock price for each of the stocks? A-2. Which stock is the most valuable? B-1. If the market capitalization rate for each stock is 6.00%, what is the stock price for each of the stocks? B-2. Which stock is the most valuable?

A-1. Stock A = $114.44 Stock B = $88.33 Stock C = $120.64 A-2. Stock C B-1. Stock A = $171.67 Stock B = $176.67 Stock C = $189.63 B-2. Stock C Explanation: A-1. P0 Stock A = $10.30 / 0.09 = $114.44 P0 Stock B = $5.30 / (0.09 − 0.03) = $88.33 P0 Stock C = ($5.30 / 1.09) + ([$5.30 × 1.19] / 1.09^2) + ([$5.30 × 1.19^2] / 1.09^3) + ([$5.30 × 1.19^3] / 1.09^4) + ([$5.30 × 1.19^4] / 1.09^5) + ([$5.30 × 1.19^5] / 1.09^6) + {([$5.30 × 1.19^5 × (1 + 0)] / 0.09) / 1.09^6} = $120.54 A-2. At a 9% capitalization rate, Stock C has the largest present value. B-1. Using the same formulas as above with a 6% capitalization rate, the values are: P0 Stock A = $10.30 / 0.06 = $171.67 P0 Stock B = $5.30 / (0.06 − 0.03) = $176.67 P0 Stock C = ($5.30 / 1.06) + ([$5.30 × 1.19] / 1.06^2) + ([$5.30 × 1.19^2] / 1.06^3) + ([$5.30 × 1.19^3] / 1.06^4) + ([$5.30 × 1.19^4] / 1.06^5) + ([$5.30 × 1.19^5] / 1.06^6) + {([$5.30 × 1.19^5 × (1 + 0)] / 0.06) / 1.06^6} = $189.45 B-2. At a 6% capitalization rate, Stock C has the largest present value.

If the cash flows for project A are C0 = -3,000, C1 = +500; C2 = +1,500; and C3 = +5,000, calculate the NPV of the project using a 15 percent discount rate. A. $1,857 B. $2,352 C. $3,201 D. $5,000

A. $1,857 Explanation: NPV = -3,000 + (500/1.15) + (1,500/1.15^2) + (5,000/1.15^3) = 1,857

Ottocell Motor Company just paid a dividend of $1.40. Analysts expect its dividend to grow at a rate of 10 percent next year, 8 percent for the following two years, and then a constant rate of 5 percent thereafter. What is the expected dividend per share at the end of year 5? A. $1.98 B. $0.99 C. $2.08 D. $1.80

A. $1.98 Explanation: D5 = (1.40) × (1.10) × (1.08^2) × (1.05^2) = 1.98

Here is a small part of the order book for Mesquite Foods: BID: Price: 103.0, Size: 100 Price: 102.5, Size: 200 Price: 101.0, Size 400 Price 99.8, Size 300 ASK: Price: 103.5, Size, 200 Price 103.8, Size 200 Price 104.0, Size 300 Price 104.5, Size 400 A. Georgina Sloberg submits a market order to sell 100 shares. What price will she receive? B. Norman Pilbarra submits a market order to buy 400 shares. What is the maximum price that he will pay? C. Carlos Ramirez submits a limit bid order at 105. Will it execute immediately?

A. $103.0 B. $103.8 C. Yes Explanation: C. Yes, if Carlos seeks to buy by placing a $105 buy limit order, it will execute since prices are already below the $105 limit.

The In-Tech Co. just paid a dividend of $1 per share. Analysts expect its dividend to grow at 25 percent per year for the next three years and then 5 percent per year thereafter. If the required rate of return on the stock is 18 percent, what is the current value of the stock? A. $12.97 B. $11.93 C. $15.20 D. $15.78

A. $12.97 Explanation: P = (1.25/1.18) + (1.5625/1.18^2) + (1.9531/1.18^3) + (2.0508/(0.18 - 0.05))/(1.18^3) = 12.97

Pharmecology just paid an annual dividend of $1.35 per share. It's a mature company, but future EPS and dividends are expected to grow with inflation, which is forecasted at 2.75% per year. The nominal cost of capital is 9.5%. A. What is Pharmecology's current stock price? B. What would be Pharmecology's current stock price using forecasted real dividends and a real discount rate?

A. $20.55 B. $20.54 Explanation: A. P0 = [DIV0 × (1 + g)] / (r − g) P0 = [$1.35 × (1 + 0.0275)] / (0.095 − 0.0275) = $20.55 B. r = (1 + R) / (1 + h) − 1 r = (1 + 0.095) / (1 + 0.0275) − 1 = 0.0657, or 6.57% In real terms, g equals 0, so DIV1 equals DIV0. P0 = DIV0 / r P0 = $1.35 / 0.0657 = $20.55

The forecasted earnings and dividends for Growth-Tech are as follows: Year 1: Book equity = 10.00 EPS = 2.50 ROE = 0.25 Payout ratio = 0.20 DIV = 0.50 Growth rate of dividends (%) = -- Year 2: Book equity = 12.00 EPS = 3.00 ROE = 0.25 Payout ratio = 0.20 DIV = 0.60 Growth rate of dividends (%) = 20 Year 3: Book equity = 14.40 EPS = 2.30 ROE = 0.16 Payout ratio = 0.50 DIV = 1.15 Growth rate of dividends (%) = 92 Year 4: Book equity: 15.55 EPS = 2.48 ROE = 0.16 Payout ratio = 0.50 DIV = 1.24 Growth rate of dividends (%) = 8 The opportunity cost of capital is r = 0.12. The growth rate in year 4 remains constant thereafter. A. Calculate the value of Growth-Tech stock. B. What part of the stock value reflects the discounted value of P3, the price forecasted for year 3? C. What part of P3 reflects the present value of growth opportunities (PVGO) after year 3? D. Suppose that competition will catch up with Growth-Tech by year 4, so that it can earn only its cost of capital on any investments made in year 4 or subsequently. What is Growth-Tech stock worth now under this assumption? (Make additional assumptions if necessary.)

A. $23.81 B.$22.07 C. $10.33 D. $16.46 Explanation: A. P0 = Div1 / (1 + r) + Div2 / (1 + r)^2 + Div3 / (1 + r)^3+ (Div4 / (r − g)) / (1 + r)^3 P0 = ($0.50 / 1.12) + ($0.60 / 1.12^2) + ($1.15 / 1.12^3) + ([$1.24 / (0.12 − 0.08)] / 1.12^3) = $23.81 B. The horizon value P3 contributes: P0 = [$1.24 / (0.12 − 0.08)] / 1.12^3 = $22.07 C. Without PVGO, P3 would equal earnings for year 4 capitalized at 12%, so PVGO3 is valued as: PVGO3 = [DIV4 / (r − g)] − EPS4 / r PVGO3 = [$1.24 / (0.12 − 0.08)] − $2.48 / 0.12 = $10.33 D. The PVGO of $10.33 is lost at Year 3. Therefore, the current stock price of $23.81 will decrease by the present value of PVGO: P0 No-growth = P0 − PVGO3 / (1 + r)^3 P0 No-growth = $23.81 − $10.33 / 1.12^3 = $16.45

Phoenix Corp. faltered in the recent recession but is recovering. Free cash flow has grown rapidly. Forecasts made in 2019 are as follows (in millions): 2020: Net income = 1.0 Investment = 1.0 Free cash flow = 0 2021: Net income = 2.8 Investment = 1.8 Free cash flow = 1.0 2022: Net income = 4.8 Investment = 2.0 Free cash flow = 2.8 2023: Net income = 5.3 Investment = 2.2 Free cash flow = 3.1 2024: Net income = 5.6 Investment = 2.2 Free cash flow = 3.4 Phoenix's recovery will be complete by 2024, and there will be no further growth in net income or free cash flow. A. Calculate the PV of free cash flow, assuming a cost of equity of 10%. B. Assume that Phoenix has 14 million shares outstanding. What is the price per share? C. Confirm that the expected rate of return on Phoenix stock is exactly 10% in each of the years from 2020 to 2024.

A. $28.27 B. $2.02 C. 2020: PV = $31.10, rate of return = 10.00% 2021: PV = $33.21, rate of return = 10.00% 2022: PV = $33.73, rate of return = 10.00% 2023: PV = $34.00, rate of return = 10.00% 2024: $34.00, rate of return = 10.00% Explanation: A. PV2019 = ($0 / 1.10) + ($1 / 1.10^2) + ($2.8 / 1.10^3) + ($3.1 / 1.10^4) + ($3.4 / 1.10^5) + ($34 / 1.10^5) = $28.27 million B. Assuming no debt, the share price would be: Price per share2019 = $28.27 / 14 = $2.02 C. The PV of the cash flows at various points in time are as follows: PV2020 = ($1.0 / 1.10) + ($2.8 / 1.10^2) + ($3.1 / 1.10^3) + ($3.4 / 1.10^4) + ($34 / 1.10^4) = $31.09 PV2021 = ($2.8 / 1.10) + ($3.1 / 1.10^2) + ($3.4 / 1.10^3) + ($34 / 1.10^3) = $33.20 PV2022 = ($3.1 / 1.10) + ($3.4 / 1.10^2) + ($34 / 1.10^2) = $33.73 PV2023 = $3.4 / 0.10 = $34.00 PV2024 = $3.4 / 0.10 = $34.00 Using the formula, r0 = (DIV1 + P1 − P0) / P0, the annual rates of return are: Rate of return2020 = ($0 + 31.09 − 28.27) / $28.27 = 0.10 or 10.00% Rate of return2021 = ($1.0 + 33.20 − 31.09) / $31.09 = 0.10 or 10.00% Rate of return2022 = ($2.8 + 33.73 − 33.20) / $33.20 = 0.10 or 10.00% Rate of return2023 = ($3.1 + 34.00 − 33.73) / $33.73 = 0.10 or 10.00% Rate of return2024 = ($3.4 + 34.00 − 34.00) / $34.00 = 0.10 or 10.00%

Summer Co. expects to pay a dividend of $4.00 per share—one year from now—out of earnings of $7.50 per share. If the required rate of return on the stock is 15 percent and its dividends are growing at a constant rate of 10 percent per year, calculate the present value of growth opportunities for the stock (PVGO). A. $30 B. $50 C. $26 D. $80

A. $30 Explanation: No growth value = 7.5/0.15 = 50; P0 = 4.00/(0.15 - 0.10) = 80; PVGO = 80 - 50 = 30

World-Tour Co. has just now paid a dividend of $2.83 per share (Div0); its dividends are expected to grow at a constant rate of 6 percent per year forever. If the required rate of return on the stock is 16 percent, what is the current value of the stock, after paying the dividend? A. $30 B. $56 C. $70 D. $48

A. $30 Explanation: P0 = (2.83 × 1.06)/(0.16 - 0.06) = 30

Mexican Motors' market cap is 300 billion pesos. Next year's free cash flow is 9.6 billion pesos. Security analysts are forecasting that free cash flow will grow by 8.60% per year for the next five years. A. Assume that the 8.60% growth rate is expected to continue forever. What rate of return are investors expecting? B-1. Mexican Motors has generally earned about 14% on book equity (ROE = 14%) and reinvested 50% of earnings. The remaining 50% of earnings has gone to free cash flow. Suppose the company maintains the same ROE and investment rate for the long run. What will be the growth rate of earnings? B-2. What would be the rate of return?

A. 11.80% B-1. 7.0% B-2. 10.20% Explanation: A. r = DIV1 / P0 + g r = 9.6 / 300 + 0.086 = 0.1180, or 11.80% B-1. g = ROE × (1 - reinvestment rate) g = 0.14 × (1 - 0.50) = 0.07, or 7.0% B-2. r = DIV1 / P0 + g r = 9.6 / 300 + 0.07 = 0.1020, or 10.20%

Super Computer Company's stock is selling for $100 per share today. It is expected that-at the end of one year-it will pay a dividend of $6 per share and then be sold for $114 per share. Calculate the expected rate of return for the shareholders. A. 20 percent B. 10 percent C. 15 percent D. 25 percent

A. 20 percent Explanation: r = (114 + 6 - 100)/100 = 20%

If the cash flows for Project M are C0 = -1,000; C1 = +200; C2 = +700; and C3 = +698, calculate the IRR for the project. A. 23 percent B. 21 percent C. 19 percent D. 17 percent

A. 23 percent Explanation: -1,000 + [200/(1 + IRR)] + [700/(1 + IRR)^2] + [698/(1 + IRR)^3] = 0; IRR = 23%. In Excel: In , arrange cash flows in order starting with -1,000 in cell A1 and ending with +698 in cell A4, then "= IRR(A1:A4)".

The following table gives the available projects (in $millions) for a firm. Initial investment A: 5.0 NPV A: 1.5 Initial investment B: 4.0 NPV B: -0.5 Initial investment C: 5.0 NPV C: 1.0 Initial investment D: 1.0 NPV D: 0.5 Initial investment E: 2.0 NPV E: 0.5 Initial investment F: 7.0 NPV F: 1.0 Initial investment G: 8.0 NPV G: 1.0 The firm has only $20 million to invest. What is the maximum NPV that the company can obtain? A. 4.5 B. 4.0 C. 3.5 D. 5.0

A. 4.5 Explanation: A + C + D + E + F = 4.5; Total investment = 5 + 5 + 1 + 2 + 7 = $20 million

Ocean Co. just paid a dividend of $2 per share out of earnings of $4 per share. If the book value per share is $25, what is the expected growth rate in dividends (g)? A. 8 percent B. 16 percent C. 12 percent D. 4 percent

A. 8 percent Explanation: Sustainable growth = ROE ? plowback ratio; Payout ratio = 50%; Plowback ratio = 50%; g = (1 - 0.5)(4/25) = 0.08, or 8%

Assume Boeing has about 10.3 billion shares outstanding and the stock price is $37.10. Also, assume the P/E ratio is about 18.3. Calculate the approximate market capitalization for GE. A. $103 billion B. $382 billion C. $188 billion D. $679 billion Explanation Market capitalization = (10.3)(37.10) = $382.13 billion.

B. $382 billion Explanation: Market capitalization = (10.3)(37.10) = $382.13 billion

Consider three investors: A. Mr. Single invests for one year. B. Ms. Double invests for two years. C. Mrs. Triple invests for three years. Company Z's earnings and dividends per share are expected to grow indefinitely by 5% a year, the next year's dividend is $10 and the market capitalization rate is 8%. Assume each invests in company Z. What is the expected rate of return for each of these investors?

A. 8% B. 8% C. 8% Explanation: DIV1 = $10 DIV2 = DIV1 × (1 + g) = $10 × 1.05 = $10.50 DIV3 = DIV2 × (1 + g) = $10.50 × 1.05 = $11.03 P0 = DIV1 / (r − g) = $10 / (0.08 − 0.05) = $333.33 P1 = P0 × (1 + g) = $333.33 × 1.05 = $350.00 P2 = P1 × (1 + g) = $350.00 × 1.05 = $367.50 P3 = P2 × (1 + g) = $367.50 × 1.05 = $385.88 r1 = (DIV1 + P1 − P0) / P0 = ($10.00 + 350.00 − 333.33) / $333.33 = 0.08, or 8% r2 = (DIV2 + P2 − P1) / P1 = ($10.50 + 367.50 − 350.00) / $350.00 = 0.08, or 8% r3 = (DIV3 + P3 − P2) / P2 = ($11.03 + 385.88 − 367.50) / $367.50 = 0.08, or 8% Since the rate of return each year is 8%, each investor should expect to earn 8%.

Which of the following formulas regarding the earnings-to-price ratio is true? A. EPS/P0 = r[1 - PVGO/P0] B. EPS/P0 = r[1 + PVGO/P0] C. EPS/P0 = [1 + r + PVGO/P0)]/r D. EPS/P0 = [r + PVGO/P0]

A. EPS/P0 = r[1 - PVGO/P0]

Indicate whether the following statements are true or false: A. The bid price is always greater than the ask price. B. An investor who wants to sell his stock immediately should enter a limit order. C. The sale of shares by a large investor usually takes place in the primary market. D. Electronic Communications Network refers to the automated ticker tape on the New York Stock Exchange.

A. False B. False C. False D. False Explanation: A. The ask is the higher price, at which traders are willing to sell to you. If you wish to sell a share of stock, you will receive the lower bid price, at which traders are willing to buy the share from you. B. This investor should enter a market order. C. Most investors sell their shares in the secondary market. If the investor was a private equity investor, perhaps they would sell into the primary market, but this is less common. D. Electronic communication networks (ECNs) are another means of trading shares of stock.

Here are forecasts for next year for two stocks: Stock A: ROE: 15% EPS: $2.00 DPS: $1.00 Stock B: ROE: 10% EPS: $1.50 DPS: $1.00 A. What are the dividend payout ratios for each firm? B. What are the expected dividend growth rates for each stock? Assume dividend has a steady growth for both stocks. C. If investors require a return of 15% on each stock, what are their values?

A. Stock A: 50% Stock B: 67% B. Stock A: 7.5% Stock B: 3.3% C. Stock A: $13.33 Stock B: $8.55 Explanation: A. Stock A: Payout ratio = Dividends / Earnings = $1.00 / $2.00 = 50% Stock B: Payout ratio = Dividends / Earnings = $1.00 / $1.50 = 67% B. Stock A: Growth rate = plowback ratio × ROE = (1 − 50%) × 15% = 7.5% Stock B: Growth rate = plowback ratio × ROE = (1 − 67%) × 10% = 3.3% C. Stock A: PVA = DIV1 / (r − g) = $1.00 / (0.15 − 0.075) = $13.33 Stock B: PVB = DIV1 / (r − g) = $1.00 / (0.15 − 0.033) = $8.55

Indicate whether the following statements are true or false. A. All stocks in an equivalent-risk class are priced to offer the same expected rate of return. B. The value of a share equals the PV of future dividends per share. C. The value of a share equals the PV of earnings per share assuming the firm does not grow, plus the NPV of future growth opportunities.

A. True B. True C. True Explanation: A. Particularly market risk. C. The expected return is equal to the yearly dividend divided by the share price. If the firm does not grow and all earnings are paid out as dividends, then the expected return is also equal to the EPS/share price. Therefore, P0 = DIV1/r = EPS1/r. We must still account for the present value of the growth opportunities, however, so P0 = EPS1/r + PVGO.

Company Q's current return on equity (ROE) is 14%. It pays out 50 percent of earnings as cash dividends (payout ratio = 0.50). Current book value per share is $60. Book value per share will grow as Q reinvests earnings. Assume that the ROE and payout ratio stay constant for the next four years. After that, competition forces ROE down to 11.5% and the payout ratio increases to 0.90. The cost of capital is 11.5%. A. What are Q's EPS and dividends in years 1, 2, 3, 4, and 5? B. What is Q's stock worth per share?

A. Year 1: EPS = $8.99, dividend = $4.49 Year 2: EPS = $9.62, dividend = $4.81 Year 3: EPS = $10.29, dividend = $5.15 Year 4: EPS = $11.01, dividend = $5.51 Year 5: EPS = $11.14, dividend = $10.02 B. $77.83 Explanation: A. Payout ratio = 0.50 gYears 1-4 = 0.50 × 0.14 = 0.07 EPS0 = $8.40; DIV0 = $8.40 × 0.50 = $4.20 gYear 5 and later: (1 - 0.90) × 0.115 = 0.011, or 1.15% EPS1 = $8.40 × 1.07 = $8.99; DIV1 = $8.99 × 0.50 = $4.49 EPS2 = $8.40 × 1.07^2 = $9.62; DIV2 = $9.62 × 0.50 = $4.81 EPS3 = $8.40 × 1.07^3 = $10.29; DIV3 = $10.29 × 0.50 = $5.15 EPS4 = $8.40 × 1.07^4 = $11.01; DIV4 = $11.01 × 0.50 = $5.51 EPS5 = $8.40 × 1.07^4 × 1.012 = $11.14; DIV5 = $11.14 × 0.90 = $10.02 B. PH = [DIV5 × (1 + g2)] / (r − g2) PH = ($10.02 × 1.0115) / (0.115 − 0.0115) = $97.96 P0 = DIV1 / (1 + r) + DIV2 / (1 + r)^2 + DIV3 / (1 + r)^3+ DIV4 / (1 + r)^4 + DIV5 / (1 + r)^5 + PH / (1 + r)^5 P0 = ($4.49 / 1.115) + ($4.81 / 1.115^2) + ($5.15 / 1.115^3) + ($5.51 / 1.115^4) + ($10.02 / 1.115^5) + ($97.96 / 1.115^5) = $77.83 *The last term in the above calculation is dependent on the payout ratio and the growth rate after year 4.

The payback period rule accepts all projects for which the payback period is A. less than the cut-off value. B. greater than the cut-off value. C. positive. D. an integer.

A. less than the cut-off value.

The profitability index is the ratio of the A. net present value of cash flows to investment. B. net present value of cash flows to IRR. C. present value of cash flows to IRR. D. future value of cash flows to investment.

A. net present value of cash flows to investment.

CK Company stockholders expect to receive a year-end dividend of $5 per share and then immediately sell their shares for $115 dollars per share. If the required rate of return for the stock is 20 percent, what is the current value of the stock? A. $122 B. $100 C. $132 D. $110 Explanation P = (115 + 5)/1.20 = 100.

B. $100 Explanation: P = (115 + 5)/1.20 = 100

Deluxe Company expects to pay a dividend of $2 per share at the end of year 1, $3 per share at the end of year 2, and then be sold for $32 per share at the end of year 2. If the required rate of return on the stock is 15 percent, what is the current value of the stock? A. $32.00 B. $28.20 C. $29.18 D. $32.17

B. $28.20 Explanation: P0 = (2/1.15) + [(3 + 32)/(1.15^2)] = $28.20

Michigan Co. just paid a dividend of $2 per share. Analysts expect future dividends to grow at 20 percent per year for the next four years and then grow at 6 percent per year thereafter. Calculate the expected dividend in year 5. A. $4.15 B. $4.40 C. $2.95 D. $3.81

B. $4.40 Explanation: Div5 = (2.00) × (1.20^4) × (1.06) = 4.40

Seven-Seas Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40.00 and its market price is $52.50 per share, calculate the required rate of return on the stock. A. 5 percent B. 11 percent C. 6 percent D. 12 percent

B. 11 percent Explanation: g = (1 - 0.6) (5/40) = .05, or 5%; r = [(3 ? 1.05)/52.50] + 0.05 = 0.11 = 11%

Driscoll Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the IRR for the project. A. 14.5 percent B. 23.4 percent C. 20.2 percent D. 18.6 percent

B. 23.4 percent Explanation: -2,400,000 + [1,200,000/(1 + IRR)] + [1,200,000/(1 + IRR)^2] + [1,200,000/(1 + IRR)^3] = 0; IRR = 23.4%. In Excel, arrange cash flows in order starting with -2,400,000 in cell A1 and 1,200,000 in cells A2 through A4, then "= IRR(A1:A4)".

MJ Co. pays out 60 percent of its earnings as dividends. Its return on equity is 15 percent. What is the stable dividend growth rate for the firm? A. 5 percent B. 6 percent C. 15 percent D. 9 percent

B. 6 percent Explanation: g = (1 - 0.60) ? 15 = 6

If the cash flows for project A are C0 = −1,000; C1 = +600; C2 = +400; and C3= +1,500, calculate the payback period. A. Three years B. Two years C. One year D. Cannot be determined

B. Two years Explanation: Initial investment: 1,000 = CF1 + CF2 = 600 + 400; payback period = 2 years.

Project X has the following cash flows: C0 = +2,000, C1 = -1,150, and C2 = -1,150. If the IRR of the project is 9.85 percent and if the cost of capital is 12.00 percent, you would A. reject the project B. accept the project.

B. accept the project. Explanation: This is a loan project (i.e., borrowing) with IRR less than the cost of capital. Therefore, accept it.

Generally, high growth stocks pay A. erratic dividends. B. low or no dividends. C. high, steadily growing dividends. D. decreasing dividends.

B. low or no dividends.

Project X has the following cash flows: C0 = +2,000, C1 = -1,300, and C2 = -1,500. If the IRR of the project is 25 percent and if the cost of capital is 18 percent, you would A. accept the project. B. reject the project.

B. reject the project. Explanation: This is a loan project (i.e., borrowing) with IRR greater than the cost of capital. Therefore, reject it.

Casino Inc. expects to pay a dividend of $3 per share at the end of year 1 (Div1) and these dividends are expected to grow at a constant rate of 6 percent per year forever. If the required rate of return on the stock is 18 percent, what is the current value of the stock today? A. $100 B. $54 C. $25 D. $50

C. $25 Explanation: P0 = Div1/(r − g) = (3/(0.18 − 0.06)) = 25

Music Company is considering investing in a new project. The project will need an initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15 percent. A. $169, 935 B. $1,200,000 C. $339,870 D. $125,846

C. $339,870 Explanation: NPV = -2,400,000 + [(1,200,000)/(1.15)] + [(1,200,000/(1.15)^2] + [1,200,000/(1.15)^3] = 339,870

The dividend yield reported on finance.yahoo.com is calculated as follows: A. (dividend/year-high stock price). B. (dividends/earnings). C. (dividend/closing stock price). D. (dividend/year-low stock price).

C. (dividend/closing stock price).

What is the profitability index of an investment with cash flows in years 0 thru 4 of -340, 120, 130, 153, and 166, respectively, and a discount rate of 16 percent? A. .22. B. 35 C. .15 D. .42

C. .15 Explanation: NPV = 49.7 PI = 49.7/340 = .15.

If the cash flows for project Z are C0 = -1,000; C1 = 600; C2 = 720; and C3 = 2,000, calculate the discounted payback period for the project at a discount rate of 20 percent. A. >3 years B. 3 years C. 2 years D. 1 year

C. 2 years Explanation: 1,000 = (600/1.2) + (720/1.2^2); Discounted payback = 2 years.

A Wall Street Journal quotation for a company has the following values: Div: $1.12, PE: 18.3, Close: $37.22. Calculate the approximate dividend payout ratio for the company. A. 35 percent B. 45 percent C. 55 percent D. 18 percent

C. 55 percent Explanation: PE ratio = price per share/earnings per share; Earnings per share = (37.22)/18.3 = 2.03; Dividend payout = 1.12/2.03 = 0.55 = 55%

You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C that have NPVs of + $70, -$40 and + $100, respectively. How would you go about making the decision about whether to accept or reject the project? A. Break up the project into its components: Accept C. B. Reject project X. C. Break up the project into its components: Accept A and C, but reject B. D. Accept project X as it has a positive NPV.

C. Break up the project into its components: Accept A and C, but reject B.

The major secondary market for Boeing shares is: A. Hang Seng. B. London Stock Exchange. C. New York Stock Exchange. D. Tokyo Stock Exchange.

C. New York Stock Exchange.

A high proportion of the value of a growth stock typically comes from A. past dividend payments and past earnings. B. past dividend payments. C. PVGO (present value of growth opportunities). D. past earnings.

C. PVGO (present value of growth opportunities).

Which of the following investment rules may not use all possible cash flows in its calculations? A. IRR B. NPV C. Payback period D. Profitability index

C. Payback period

One can use the profitability index most usefully for which situation? A. Evaluation of nonnormal projects B. When a project has unusually high cash flow uncertainty C. When capital rationing exists D. Evaluation of exceptionally long-term projects

C. When capital rationing exists

The main advantage of the payback rule is that it A. does not discount cash flows. B. adjusts for uncertainty of early cash flows. C. is simple to use. D. better accounts for salvage costs at the end of a project.

C. is simple to use.

One can estimate the dividend growth rate for a stable firm as A. plow-back rate/the return on equity (ROE). B. plow-back rate - the return on equity (ROE). C. plow-back rate × the return on equity (ROE). D. plow-back rate + the return on equity (ROE).

C. plow-back rate × the return on equity (ROE).

If the sign of the cash flows for a project changes two times, then the project likely has A. one IRR. B. three IRRs. C. two IRRs. D. four IRRs.

C. two IRRs.

If an investment project (normal project) has an IRR equal to the cost of capital, the NPV for that project is A. positive. B. negative. C. zero. D. unable to be determined.

C. zero.

Story Company is investing in a giant crane. It is expected to cost $6 million in initial investment, and it is expected to generate an end-of-year after-tax cash flow of $3 million each year for three years. Calculate the NPV at 12 percent. A. $2.40 million B. $0.80 million C. $0.20 million D. $1.20 million

D. $1.20 million Explanation: NPV(millions) = -6.0 + 3/1.12 + 3/(1.12^2) + 3/(1.12^3) = 1.2.

Universal Air is a no-growth firm and has two million shares outstanding. It expects to earn a constant $20 million per year on its assets. If it has no debt, all earnings are paid out as dividends, and the cost of capital is 10 percent, calculate the current price per share of the stock. A. $200 B. $50 C. $150 D. $100

D. $100 Explanation: EPS = DPS = 20,000,000/2,000,000 = $10 per share; P0 = 10/0.10 = $100/share

A company forecasts growth of 6 percent for the next five years and 3 percent thereafter. Given last year's free cash flow was $100, what is its horizon value (PV looking forward from year 4) if the company cost of capital is 8 percent? A. $0 B. $1,672 C. $2,000 D. $2,676

D. $2,676 Explanation: The future value at five years of the free cash flow is expected to equal 100 ? 1.065 = 133.82. The horizon value = 133.82/(.08 - .03) = 2,676

Parcel Corporation expects to pay a dividend of $5 per share next year, and the dividend payout ratio is 50 percent. If dividends are expected to grow at a constant rate of 8 percent forever, and the required rate of return on the stock is 13 percent, calculate the present value of growth opportunities. A. $69.54 B. $100.00 C. $76.92 D. $23.08

D. $23.08 Explanation: EPS = (5/0.5) = $10; No growth value = 10/0.13 = 76.92; Growth value = 5/(0.13 - 0.08) = 100; PVGO = 100 - 76.92 = 23.08

Company X has a P/E ratio of 10 and a stock price of $50 per share. Calculate earnings per share of the company. A. $6 per share B. $0.20 per share C. $10 per share D. $5 per share

D. $5 per share Explanation: EPS = 50/10 = $5

The real cash flow occurring in year 2 is $60,000. If the inflation rate is 5 percent per year and the real rate of interest is 2 percent per year, calculate the nominal cash flow for year 2. A. $62,424 B. $60,000 C. $63,654 D. $66,150

D. $66,150 Explanation: Nominal cash flow = (60,000)(1.05)^2 = $66,150

If the NPV of project A is + $30 and that of project B is -$60, then the NPV of the combined projects is A. +$30. B. -$1,800. C. -$60. D. -$30.

D. -$30. Explanation: NPV(A + B) = 30 - 60 = -30.

Will Co. is expected to pay a dividend of $2 per share at the end of year 1(Div1), and the dividends are expected to grow at a constant rate of 4 percent forever. If the current price of the stock is $20 per share, calculate the expected return or the cost of equity capital for the firm. A. 10 percent B. 4 percent C. 20 percent D. 14 percent

D. 14 percent Explanation: r = [(Div1/P0 ) + g] = (2/20) + 0.04 = 14%

The following table gives the available projects (in $millions) for a firm. Initial investment A: 90 NPV A: 140 Initial investment B: 20 NPV B: 70 Initial investment C: 60 NPV C: 65 Initial investment D: 50 NPV D: -10 Initial investment E: 150 NPV E: 30 Initial investment F: 40 NPV F: 32 Initial investment G: 20 NPV G: 10 If the firm has a limit of $210 million to invest, what is the maximum NPV the company can obtain? A.200 B. 283 C. 347 D. 307

D. 307 Explanation: A + B + C + F = 140 + 70 + 65 + 32 = 307; Total investment = 90 + 20 + 60 + 40 = 210.

The cost of a new machine is $250,000. The machine has a five-year life and no salvage value. If the cash flow each year is equal to 25 percent of the cost of the machine, calculate the payback period for the project. A. 2.5 years B. 2.0 years C. 3.0 years D. 4.0 years

D. 4.0 years Explanation: Cash flow each year = (0.25)(250,000) = 62,500; Payback period = 4.0 years.

Lake Co. just paid a dividend of $3 per share out of earnings of $5 per share. If its book value per share is $40, what is the expected growth rate in dividends? A. 8 percent B. 12.5 percent C. 7.5 percent D. 5 percent

D. 5 percent Explanation g = (1 - 3/5)(5/40) = .05, or 5%

Which investment analysis technique is used the least by CFOs? A. Payback B. Internal rate of return C. Net present value D. Book rate of return

D. Book rate of return

The following are some of the shortcomings of the IRR method except A. IRR cannot distinguish between a borrowing project and a lending project. B. it is very cumbersome to evaluate mutually exclusive projects using the IRR method. C. projects can have multiple IRRs. D. IRR is conceptually easy to communicate.

D. IRR is conceptually easy to communicate.

The following is an example of a dealer market: A. London Stock Exchange B. Tokyo Stock Exchange C. New York Stock Exchange D. Nasdaq

D. Nasdaq

The following are measures used by firms when making capital budgeting decisions except A. payback period. B. net present value. C. internal rate of return. D. P/E ratio.

D. P/E ratio.

Which of the following investment rules has the value additivity property? A. The payback period method B. The book rate of return method C. The internal rate of return method D. The net present value method

D. The net present value method

Which of the following investment rules does not use the time value of money concept? A. Profitability index B. Internal rate of return C. Net present value D. The payback period

D. The payback period

Suppose a firm has $100 million in excess cash. It could A. invest the funds in projects with positive NPVs B. buy another firm C. pay high dividends to the shareholders. D. do all of the options.

D. do all of the options.

The cost of a resource that may be relevant to an investment decision even when no cash changes hand is called a(n) A. depreciation cost B. average cost C. sunk cost D. opportunity cost

D. opportunity cost

The constant dividend growth formula P0 = Div1/(r − g) assumes . A. that dividends grow at a constant rate g, forever only. B. g is never negative only. C. r > g only. D. that dividends grow at a constant rate g, forever, and r > g only.

D. that dividends grow at a constant rate g, forever, and r > g only.

A project will have only one internal rate of return if A. the net present value is positive. B. the net present value is negative. C. the cash flows decline over the life of the project. D. there is a one-sign change in the cash flows.

D. there is a one-sign change in the cash flows.

One should consider net working capital (NWC) in project cash flows because A. inclusion of NWC typically increases calculated NPV B. firms need positive NPV projects for investment C. NWC represents sunk costs D. typically firms must invest cash in short-term assets to produce finished goods

D. typically firms must invest cash in short-term assets to produce finished goods

The discounted payback method calculates the payback period and then discounts the payback period at the opportunity cost of capital. True or false

False

The only payoff to the owners of common stocks is in the form of cash dividends. True or false

False

The profitability index is always less than 1. True or false

False

Excel problem: A fast-growing firm recently paid a dividend of $0.95 per share. The dividend is expected to increase at a 15 percent rate for the next three years. Afterwards, a more stable 10 percent growth rate can be assumed. If an 11 percent discount rate is appropriate for this stock, what is its value today? Latest dividend: $0.95 (cell D7) Non-constant growth rate: 15.00% (cell D8) Length of time non constant growth rate lasts for (in years): 3 (cell D9) Eventual constant growth rate: 10.00% (cell D10) Discount rate: 11.00% (cell D11)

Time period 1: dividend is $1.09 Time period 2: dividend is $1.26 Time period 3: dividend is $1.44 Time period 4: dividend is $1.59 Time period 5: dividend is $1.75 Time period 6: dividend is $1.92 Value at time 5: $192.31 Value today: $119.27 Explanation: Time period 1 dividend (in cell D18): =D7*(1+D8) Time period 2 dividend (in cell D19): =IF(C19<=$D$9,D18*(1+$D$8),D18*(1+$D$10)) Time period 3 dividend (in cell D20): =IF(C20<=$D$9,D19*(1+$D$8),D19*(1+$D$10)) Time period 4 dividend (in cell D21): =IF(C21<=$D$9,D20*(1+$D$8),D20*(1+$D$10)) Time period 5 dividend (in cell D22): =IF(C22<=$D$9,D21*(1+$D$8),D21*(1+$D$10)) Time period 6 dividend (in cell D23): =IF(C23<=$D$9,D22*(1+$D$8),D22*(1+$D$10)) Value at time 5 (in cell D24): =D23/(D11-D10) Value today (in cell D25): =NPV(D11,D18,D19,D20,D21,D22+D24)

The discounted payback method will never accept a negative-NPV project. True or false

True

The profitability index of a positive NPV project is always positive. True or false

True

The return that is expected by investors from a common stock is also called its market capitalization rate, or cost of equity capital. True or false

True