MBA 6223 Finance Exam 2

A firm expects to pay dividends of $2/share in upcoming year. Dividends will grow by 25% the following year. Dividend growth will then be a constant 4% per year. If the required return on the stock is 11%, what is the current share price? **How would you solve?**

1) Cash at year 1 is $2, Cash at year 2 is $2+25%=$2.50 2) Calculate horizon value by taking your cash at the year before the horizon (year 2) and multiplying by 1+growth rate. Divide by required return minus growth rate. ((2.50(1.04))/(.11-.04) 3) Take the NPV. =NPV(rate,CF1,CF2+Horizon) ***Don't forget to add your horizon value at the end of the formula***

Don't forget when calculating Vu or VL (D+E), denominator is

1+ return rate; because have to discount back to year 0

How do you calculate NPV of a project to incorporate investment at year 0?

=NPV(CFY1, CFY2, CFY3...)+CFY0 <-- investment at year 0 is added outside the formula

How do you calculate NPV with supernormal growth/a horizon value?

=NPV(rate,CF1,CF2,CF...+Horizon value)

Which of the following is NOT a way that a firm can increase a dividend? A. By increasing its retention rate B. By decreasing its shares outstanding C. By increasing its earnings D. By increasing its dividend payout rate E. Neither C nor D are ways that a firm can increase its dividend

A. By increasing its retention rate

Operating leverage

Change in Earnings before interest and taxes (EBIT) caused by a change in quantity sold; higher proportion of fixed costs relative to variable costs, the greater the operating leverage

What does low IRR and high NPV mean?

Could mean that pace of return is slow, but project may be adding a great deal of overall value to company.

Luther Industries has 25 million shares outstanding trading at $18/share. In addition, Luther has $150 million in outstanding debt. Suppose Luther's equity cost of capital is 13%, its debt cost of capital is 7% and the corporate tax rate is 40%. Luther's after-tax cost of debt is... **How would you solve?**

Debt cost of capital (7%) * (1-T) = 4.2%

If bankruptcy occurs does debt go up or down?

Down. Debt-holders will receive less because of the bankruptcy.

True or False: With perfect capital markets, a firm's WACC is dependent on its capital structure and is equal to its equity cost of capital only the firm it is unlevered.

FALSE

True or false: When securities are fairly priced, the original shareholders of a firm pay the future value of the costs associated with bankruptcy and financial distress.

FALSE

How do you calculate a payback period?

Find the first year start to have positive cash flows. To find the fraction between the last negative and the first positive year, take the last negative year plus the negative cumulative value for that year, divided by the positive cashflow of the first positive year. =2+-20,000/16,000

How do you know how many IRRs a project will have?

How many sign changes are in the cash flows of the project (positive to a negative/negative to positive)

Reviewing a positive NPV project that has a conventional cash flow pattern (initial investment is cash outflow, followed by cash inflows in all future periods). If all cash flows of the project were to double, the:

IRR would stay the same and the NPV would increase

What is IRR?

Internal Rate of Return; discount rate that makes the NPV of all cashflows = 0

How do you find the EAA of a project?

It is the PMT calculation in the TVM equation.

The more fixed costs you have the ________________ (more/less) operating leverage you have.

More

How do you calculate ROE (return on equity)?

Net income/Equity (net income being revenue or earnings after taxes and after interest, and equity being cost of debt [revenue * %cost of debt provided])

Will a firm without leverage have distress costs/bankruptcy costs?

No, because can't have bankruptcy if you don't have leverage.

On July 1, 2008 just after a dividend payment, you purchased 200 shares of stock at a price of $114.62/share. The company paid annual dividends of $3.75 on June 30 of each year. On June 30, 2011, just after receiving the dividend payment, you sell the stock for $119.45. What annual return did you earn? **How would you solve this?**

TVM equation with n=3, PV=-114.62, PMT=3.75 and FV 119.45. I/Y=4.6%

What is a firm's optimal capital structure?

That capital structure which minimizes the firm's WACC. It will be the structure with the lowest WACC%.

How much debt does a firm want to carry?

The level of debt that maximizes tax shield benefits while minimizing the relative distress costs

Operating breakeven

The output quantity at which EBIT = 0; OR Q=FC/P-VC; P-VC is our margin

What is the finance rate and the reinvestment rate in the MIRR formula?

They're the same for our purposes. Also the same as WACC.

When distress costs are included in a project, which is greater, value of leveraged firm, or value of unleveraged firm?

Unleveraged firm

Always approve a project that has positive NPV?

Usually, but not if the financing for the firm can't come from debt financing and has to come from the shareholders. If the financing needed from shareholders is greater than the return rate, shareholders are going to refuse the project.

How do you determine which project has the highest expected payoff?

Weight(payoff)+weight(payoff)

Is deciding whether or not a newly invented product should be produced a capital budgeting decision?

YES; capital budgeting is a planning process used to determine whether an organization's long term investments such as new machinery, replacement of machinery, new plants, new products, and research development projects are worth the funding of cash

A project has a payback period of one year, a negative NPV and a positive IRR. Is this possible?

Yes

Can a firm with leverage have distress costs/bankruptcy costs?

Yes, because if project fails and is leveraged, will default

Tallant Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Expected NPV X $500,000 Y $500,000 Standard deviation (σNPV) X $200,000 Y $250,000 Project beta (vs. market) X 1.4 Y 0.8 Which of the following statements is CORRECT? a. Project X has more market risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has the same level of corporate risk as Project Y. d. Project X has more stand-alone risk than Project Y. e. Project X has less market risk than Project Y.

a. Project X has more market risk than Project Y.

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? a. Cannibalization effects. b. Sunk costs that have been expensed for tax purposes. c. Shipping and installation costs. d. Changes in net working capital. e. Opportunity costs.

b. Sunk costs that have been expensed for tax purposes.

Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of operations. b. The constant growth model takes into consideration the capital gains investors expect to earn on a stock. c. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. d. The value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. e. If a company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%.

b. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

Consider projects S and L. Both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same cost of capital, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT? a. Project S must have a higher NPV than Project L. b. If the cost of capital increases, each project's IRR will decrease. c. If Projects S and L have the same NPV at the current cost of capital, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the cost of capital used to evaluate the projects declined. d. If the cost of capital falls, each project's IRR will increase. e. If Project S has a positive NPV, Project L must also have a positive NPV.

c. If Projects S and L have the same NPV at the current cost of capital, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the cost of capital used to evaluate the projects declined.

Which of the following statements is CORRECT? a. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life. b. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. c. If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. d. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. e. If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

c. If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.

Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become riskier over time, but its intrinsic value will be maximized. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become less risky over time, and this will maximize its intrinsic value.

c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. If a project's IRR is positive, then its NPV must also be positive. b. A project's regular IRR is found by compounding the initial cost at the cost of capital to find the terminal value (TV), then discounting the TV at the cost of capital. c. If a project's IRR is smaller than the cost of capital, then its NPV will be positive. d. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. e. A project's regular IRR is found by compounding the cash inflows at the cost of capital to find the present value (PV), then discounting the TV to find the IRR.

d. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost.

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's MIRR is unaffected by changes in the cost of capital. b. A project's regular payback increases as the cost of capital declines. c. A project's discounted payback increases as the cost of capital declines. d. A project's IRR increases as the cost of capital declines. e. A project's NPV increases as the cost of capital declines.

e. A project's NPV increases as the cost of capital declines.

How do you find total value with leverage?

equal to D + E