FRL 3000 Midterm #2

A proposed new investment has projected sales of $585,000. Variable costs are 44 percent of sales, and fixed costs are $187,000; depreciation is $51,000. Prepare a pro forma income statement assuming a tax rate of 21 percent. What is the projected net income? (Input all amounts as positive values.) Sales: Variable Costs: Fixed Costs: Depreciation: EBT: Taxes: Net Income:

Proforma Income Statement Sales: $585,000 Less: Variable Costs $257400 Less: Fixed Costs $187,000 Gross profit $140,600 Less: Depreciation $51,000 EBT: $89,600 Less: Tax @ 21% $18,816 Projected Net Income: $70,784

Allison just received the semiannual payment of $35 on a bond she owns. Which term refers to this payment? A. Coupon B. Face Value C. Discount D. Call Premium E. Yield

A

Net present value: A. is the best method of analyzing mutually exclusive projects. B. is less useful than the internal rate of return when comparing different-sized projects. C. is the easiest method of evaluation for non-financial managers. D. cannot be applied when comparing mutually exclusive projects. E. is very similar in its methodology to the average accounting return.

A

Suppose you buy a 7 percent coupon, 20-year bond today when it's first issued. If interest rates suddenly rise to 15 percent, what happens to the value of your bond? A. The price of the bond will fall. B. The price of the bond will rise.

A

The difference between a company's future cash flows if it accepts a project and the company's future cash flows if it does not accept the project is referred to as the project's: A. incremental cash flows. B. internal cash flows. C. external cash flows. D. erosion effects. E. financing cash flows.

A

Which one of the following premiums is compensation for the possibility that a bond issuer may not pay a bond's interest or principal payments as expected? A. Default risk B. Taxability C. Liquidity D. Inflation E. Interest rate risk

A

A project has an initial cost of $7,900 and cash inflows of $2,100, $3,140, $3,800, and $4,500 a year over the next four years, respectively. What is the payback period? A. 2.70 years B. 3.28 years C. 3.36 years D. 3.70 years E. 2.28 years

A Payback = 2 + ($7,900 − 2,100 − 3,140)/$3,800 Payback = 2.70 years

A discount bond's coupon rate is equal to the annual interest divided by the: A. call price. B. current price. C. face value. D. clean price. E. dirty price.

C

Hi-Tek is a young start-up company that is currently retaining all of its earnings. The company plans to pay a $2 per share dividend in Year 7 and increase that dividend by 2.2 percent per year thereafter. What is the current share price if the required return is 16 percent? A. $5.95 B. $6.62 C. $8.59 D. $14.29 E. $11.78

A P6 = $2/(.16 − .022) P6 = $14.49 P0 = $14.49/1.16^6 P0 = $5.95

Fill in the missing numbers for the following income statement. Sales = $747,300 Costs = $582,600 Depreciation = $89,00 EBIT = Taxes @ 22% = Net Income = A. OCF = Net Income + Depreciation B. Depreciation Tax Shield = Depreciation * TaxRate

A. OCF = Net Income + Depreciation B. Depreciation Tax Shield = Depreciation*TaxRate

A project's cash flow is equal to the project's operating cash flow: A. plus the project's depreciation expense minus both the project's taxes and capital spending. B. minus both the project's change in net working capital and capital spending. C. minus the project's change in net working capital plus all of the depreciation expenses. D. plus the project's depreciation expenses minus the project's taxes. E. minus the project's taxes.

B

Boston Free Press has a dividend policy whereby the firm pays a constant annual dividend of $2.40 per share of common stock. The firm has 1,000 shares of stock outstanding. The company: A. must always show a current liability of $2,400 for dividends payable. B. must still declare each dividend before it becomes an actual company liability. C. is obligated to pay $2.40 per share each year in perpetuity. D. will be declared in default if it does not pay at least $2.40 per share per year on a timely basis. E. incurs a liability that must be paid at a later date should the company miss paying an annual dividend payment.

B

Interest Rate Risk is the risk that arises for bond owners from fluctuating interest rates. All other things being equal, the _______ the coupon rate, the _________ the interest rate risk. A. Lower, lower B. Lower, greater C. Higher, lower D. Higher, greater

B

Recently, you discovered a convertible, callable bond with a semiannual coupon of 5 percent. If you purchase this bond you will have the right to: A. force the issuer to repurchase the bond prior to maturity. B. convert the bond into equity shares. C. defer all taxable income until the bond matures. D. convert the bond into a perpetuity paying 5 percent. E. have the principal amount adjusted for inflation.

B

The length of time a firm must wait to recoup the money it has invested in a project is called the: A. internal return period. B. payback period. C. profitability period. D. discounted cash period. E. valuation period.

B

U. S. Treasury bonds: A. are highly illiquid. B. are quoted as a percentage of par. C. are quoted at the dirty price. D. pay interest that is federally tax-exempt. E. must be held until maturity.

B

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: A. accepted because the payback period is less than the required time period. B. accepted because the profitability index is greater than 1. C. accepted because the profitability index is negative. D. rejected because the internal rate of return is negative. E. rejected because the net present value is positive.

B

Which one of the following bonds is the least sensitive to interest rate risk? A. 3-year; 4 percent coupon B. 3-year; 6 percent coupon C. 5-year; 6 percent coupon D. 7-year; 6 percent coupon E. 7-year; 4 percent coupon

B

A project has an initial cost of $31,300 and a three-year life. The company uses straight-line depreciation to a book value of zero over the life of the project. The projected net income from the project is $1,750, $2,100, and $1,700 a year for the next three years, respectively. What is the average accounting return? A. 12.79 percent B. 11.82 percent C. 10.35 percent D. 11.69 percent E. 10.14 percent

B Average Accounting Return AAR = [($1,750 + 2,100 + 1,700)/3]/[($31,300 + 0)/2] AAR = .1182, or 11.82%

You just purchased $218,000 of equipment that is classified as five-year MACRS property. The MACRS rates are .2, .32, .192, .1152, .1152, and .0576 for Years 1 to 6, respectively. What will be the book value of this equipment at the end of three years assuming no bonus depreciation is taken? A. $58,467 B. $62,784 C. $159,533 D. $67,670 E. $155,216

Book value3 = $218,000(1 − .2 − .32 − .192) Book value3 = $62,784

A bond's principal is repaid on the ____ date. A. Coupon B. Yield C. Maturity D. Dirty E. Clean

C

A project's average net income divided by its average book value is referred to as the project's average: A. net present value B. internal rate of return C. accounting return D. profitability index E. payback period

C

If a firm accepts Project A it will not be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be: A. independent B. interdependent C. mutually exclusive D. economically scaled E. operationally distinct

C

Isaac has analyzed two mutually exclusive projects that have 3-year lives. Project A has an NPV of $81,406, a payback period of 2.48 years, and an AAR of 9.31 percent. Project B has an NPV of $82,909, a payback period of 2.57 years, and an AAR of 9.22 percent. The required return for Project A is 11.5 percent while it is 12 percent for Project B. Both projects have a required AAR of 9.25 percent. Isaac must make a recommendation and justify it in 15 words or less. What should his recommendation be? A. Accept both projects because both NPVs are positive B. Accept Project A because it has the shortest payback period C. Accept Project B and reject Project A based on the NPVs D. Accept Project A and reject Project B based on their AARs E. Accept Project A because it has the lower required return

C

Kelley's Baskets makes handmade baskets and is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project? A. Storing supplies in the same space currently used for materials storage B. Utilizing the basket manager to oversee wreath production C. Hiring additional employees to handle the increased workload should the firm accept the wreath project D. Researching the market to determine if wreath sales might be profitable before deciding to proceed E. Planning on lower interest expense by assuming the proceeds of the wreath sales will be used to reduce the firm's currently outstanding debt

C

Municipal bonds: A. are totally risk free. B. generally have higher coupon rates than corporate bonds. C. pay interest that is federally tax free. D. are rarely callable. E. are free of default risk.

C

National Trucking has paid an annual dividend of $1 per share on its common stock for the past 15 years and is expected to continue paying a dollar a share long into the future. Given this, one share of the firm's stock is: A. basically worthless as it offers no growth potential. B. equal in value to the present value of $1 paid one year from today. C. priced the same as a $1 perpetuity. D. valued at an assumed growth rate of 1 percent. E. worth $1 a share in the current market.

C

Round Dot Inns is preparing a bond offering with a coupon rate of 6 percent, paid semiannually, and a face value of $1,000. The bonds will mature in 10 years and will be sold at par. Given this, which one of the following statements is correct? A. The bonds will become discount bonds if the market rate of interest declines. B. The bonds will pay 10 interest payments of $60 each. C. The bonds will sell at a premium if the market rate is 5.5 percent. D. The bonds will initially sell for $1,030 each. E. The final payment will be in the amount of $1,060.

C

The price sensitivity of a bond increases in response to a change in the market rate of interest as the: A. coupon rate increases. B. time to maturity decreases. C. coupon rate decreases and the time to maturity increases. D. time to maturity and coupon rate both decrease. E. coupon rate and time to maturity both increase.

C

The stream of customer orders coming in to the NYSE trading floor is called the: A. paper trail B. trading volume C. order flow D. bid-ask spread E. commission trail

C

Which of the following are advantages of the payback method of project analysis? A. Considers time value of money, liquidity bias B. Liquidity bias, arbitrary cutoff point C. Liquidity bias, ease of use D. Ignores time value of money, ease of use E. Ease of use, arbitrary cutoff point

C

Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach? A. Providing both ketchup and mustard for customers' use B. Repairing the roof of the hot dog stand because of water damage C. Selling fewer hot dogs because hamburgers were added to the menu D. Offering french fries but not onion rings E. Losing sales due to bad weather

C

Which one of the following costs was incurred in the past and cannot be recouped? A. Incremental B. Side C. Sunk D. Opportunity E. Erosion

C

Which one of the following risk premiums compensates for the inability to easily resell a bond prior to maturity? A. Default risk B. Taxability C. Liquidity D. Inflation E. Interest rate risk

C

Which one of the following statements related to the internal rate of return (IRR) is correct? A. The IRR yields the same accept and reject decisions as the net present value method given mutually exclusive projects. B. A project with an IRR equal to the required return would reduce the value of a firm if accepted. C. The IRR is equal to the required return when the net present value is equal to zero. D. Financing type projects should be accepted if the IRR exceeds the required return. E. The average accounting return is a better method of analysis than the IRR from a financial point of view.

C

Is the yield to maturity on a bond the same thing as the required return? Is YTM the same thing as the coupon rate? Suppose today a 10 percent coupon bond sells at par. Two years from now, the required return on the same bond is 8 percent. What is the coupon rate on the bond?

Coupon Rate = 10% YTM = 8 % The yield to maturity is the required rate of return on a bond expressed as a nominal annual interest rate. For noncallable bonds, the yield to maturity and required rate of return are interchangeable terms. Unlike YTM and required return, the coupon rate is not a return used as the interest rate in bond cash flow valuation, but is a fixed percentage of par over the life of the bond used to set the coupon payment amount. For the example given, the coupon rate on the bond is still 10 percent, and the YTM is 8 percent.

A forward PE is based on: A. the last four quarterly dividend payments B. the last dividend payment multiplied by 2 C. historical earnings D. estimated future earnings E. industry averages

D

DLQ Inc. bonds mature in 12 years and have a coupon rate of 6 percent. If the market rate of interest increases, then the: A. coupon rate will also increase. B. current yield will decrease. C. yield to maturity will be less than the coupon rate. D. market price of the bond will decrease. E. coupon payment will increase.

D

Interest Rate Risk is the risk that arises for bond owners from fluctuating interest rates. All other things being equal, the _______ the time to maturity, the _________ the interest rate risk. A. Shorter, lower B. Shorter, greater C. Longer, lower D. Longer, greater

D

The Fisher effect primarily emphasizes the effects of _____ on an investor's rate of return. A. default B. market movements C. interest rate changes D. inflation E. the time to maturity

D

The internal rate of return is defined as the: A. maximum rate of return a firm expects to earn on a project. B. rate of return a project will generate if the project is financed solely with internal funds. C. discount rate that equates the net cash inflows of a project to zero. D. discount rate which causes the net present value of a project to equal zero. E. discount rate that causes the profitability index for a project to equal zero.

D

The present value of an investment's future cash flows divided by the initial cost of the investment is called the: A. net present value. B. internal rate of return. C. average accounting return. D. profitability index. E. profile period.

D

Treasury bonds are: A. issued by any governmental agency in the U.S. B. issued only on the first day of each fiscal year by the U.S. Department of Treasury. C. bonds that offer the best tax benefits of any bonds currently available. D. generally issued as semiannual coupon bonds. E. totally risk free.

D

Which one of the following costs was incurred in the past and cannot be recouped? A. Salvage Value B. Wasted Value C. Sunk Cost D. Opportunity Cost E. Erosion

D

Which one of the following rights is never directly granted to all shareholders of a publicly held corporation? A. Electing the board of directors B. Receiving a distribution of company profits C. Voting either for or against a proposed merger or acquisition D. Determining the amount of the dividend to be paid per share E. Having first chance to purchase any new equity shares that may be offered

D

Which one of the following should not be included in the analysis of a new product? A. Increase in accounts payable for inventory purchases of the new product B. Reduction in sales for a current product once the new product is introduced C. Market value of a machine owned by the firm which will be used to produce the new product D. Money already spent for research and development of the new product E. Increase in accounts receivable needed to finance sales of the new product

D

You own one share of a cumulative preferred stock that pays quarterly dividends. The firm has recently suffered some financial setbacks and has failed to pay the last two dividends. However, new funding has been arranged and the firm intends to restore all dividends, both common and preferred, this quarter. As a preferred shareholder, you should expect to receive the equivalent of ____ quarter(s) of dividends when the next dividend is paid. A. 0 B. 1 C. 2 D. 3 E. either 1, 2, or 3

D

Currently, a firm has an EPS of $2.08 and a benchmark PE of 12.7. Earnings are expected to grow by 3.8 percent annually. What is the estimated current stock price? A. $27.42 B. $27.09 C. $26.08 D. $26.42 E. $28.13

D P0 = $2.08(12.7) P0 = $26.42

Jensen Shipping currently has an EPS of $2.31, a benchmark PE of 13.5, and an earnings growth rate of 2.3 percent. What is the target share price 4 years from now? A. $27.32 B. $31.15 C. $38.47 D. $34.15 E. $29.42

D P4 = $2.31(1.023^4)(13.5) P4 = $34.15

AOK preferred stock pays an annual dividend of $6.50. What is the current price of this stock at a discount rate of 8.9 percent? A. $57.85 B. $65.48 C. $78.25 D. $73.03 E. $67.50

D Stock price = dividend / rate $6.5 / (0.089) = $73.03

Eglon Mills has a new Year 2020 project with an initial equipment cost of $368,000 and a project life of 10 years. The firm generally uses straight-line depreciation to a zero book value over the project's life. If the firm opts instead to use the bonus depreciation method, what is the depreciation tax shield amount for Year 2020 at a tax rate of 21 percent? A. $77,280 B. $38,640 C. $7,280 D. $3,864 E. $15,456

Depreciation tax shield = .21($368,000) Depreciation tax shield = $77,280

A "fallen angel" is a bond that has moved from: A. being publicly traded to being privately traded. B. being a long-term obligation to being a short-term obligation. C. being a premium bond to being a discount bond. D. senior status to junior status for liquidation purposes. E. investment grade to speculative grade.

E

A person on the floor of the NYSE who executes buy and sell orders on behalf of customers is called a(n): A. designated market maker. B. dealer. C. specialist. D. supplemental liquidity provider. E. floor broker

E

A project has a net present value of zero. Which one of the following best describes this project? A. The project has a zero percent rate of return. B. The project requires no initial cash investment. C. The project has no cash flows. D. The summation of all of the project's cash flows is zero. E. The project's cash inflows equal its cash outflows in current dollar terms.

E

An agent who maintains an inventory from which he or she buys and sells securities is called a: A. broker. B. trader. C. capitalist. D. principal. E. dealer.

E

GL Plastics spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost? A. Opportunity B. Fixed C. Incremental D. Erosion E. Sunk

E

Which one of the following statements is correct? A. Stocks can only be assigned one dividend growth rate. B. Preferred stocks generally have variable growth rates. C. Dividend growth rates must be either zero or positive. D. All stocks can be valued using the dividend discount models. E. Stocks can have negative growth rates.

E

Which one of the following types of stock is defined by the fact that it receives no preferential treatment in respect to either dividends or bankruptcy proceedings? A. Dual Class B. Cumulative C. Non-cumulative D. Preferred E. Common

E

Which one of these equations applies to a bond that currently has a market price that exceeds par value? A. Market value < Face value B. Yield to maturity = Current yield C. Market value = Face value D. Current yield > Coupon rate E. Yield to maturity < Coupon rate

E

Which one of these statements related to preferred stock is correct? A. Preferred shareholders normally receive one vote per share of stock owned. B. Preferred shareholders determine the outcome of any election that involves a proxy fight. C. Preferred shareholders are considered to be the residual owners of a corporation. D. Preferred stock normally has a stated liquidating value of $1,000 per share. E. Cumulative preferred shares are more valuable than comparable noncumulative shares.

E

You cannot attend the shareholder's meeting for Alpha United so you authorize another shareholder to vote on your behalf. What is the granting of this authority called? A. Alternative voting B. Cumulative voting C. Straight voting D. Indenture voting E. Voting by proxy

E

You are considering two mutually exclusive projects. Project A has cash flows of −$125,000, $51,400, $52,900, and $63,300 for Years 0 to 3, respectively. Project B has cash flows of −$85,000, $23,100, $28,200, and $69,800 for Years 0 to 3, respectively. Project A has a required return of 9 percent while Project B's required return is 11 percent. Should you accept or reject these mutually exclusive projects based on IRR analysis? A. Accept Project A and reject Project B B. Reject Project A and accept Project B C. Accept both projects D. Reject both projects E. You should not use IRR; use a different method of analysis

E Because these are mutually exclusive projects of differing sizes you should not apply the IRR rule.

Dog Up! Franks is looking at a new sausage system with an installed cost of $413,400. This cost will be depreciated straight-line to zero over the project's 4-year life, at the end of which the sausage system can be scrapped for $63,600. The sausage system will save the firm $127,200 per year in pretax operating costs, and the system requires an initial investment in net working capital of $29,680. If the tax rate is 21 percent and the discount rate is 8 percent, what is the NPV of this project? A. $21,399.29 B. $28,244.59 C. $-16,550.57 D. $-8,686.25 E. $20,380.27

First we will calculate the annual depreciation of the new equipment. It will be: Annual depreciation = $413,400/4 Annual depreciation = $103,350 Now, we calculate the aftertax salvage value. The aftertax salvage value is the market price minus (or plus) the taxes on the sale of the equipment, so: Aftertax salvage value = MV + (BV - MV)tc Very often the book value of the equipment is zero as it is in this case. If the book value is zero, the equation for the aftertax salvage value becomes: Aftertax salvage value = MV + (0 - MV)tc Aftertax salvage value = MV(1 - tc) We will use this equation to find the aftertax salvage value since we know the book value is zero. So, the aftertax salvage value is: Aftertax salvage value = $63,600(1 - .21) Aftertax salvage value = $50,244 Using the tax shield approach, we find the OCF for the project is: OCF = $127,200(1 - .21) + .21($103,350) OCF = $122,191.5 Now we can find the project NPV. Notice we include the NWC in the initial cash outlay. The recovery of the NWC occurs in Year 4, along with the aftertax salvage value. NPV = -$413,400 - 29,680 + $122,191.5(PVIFA8%, 4) + [($50,244 + 29,680) /1.08^4] NPV = $20,380.27

Quad Enterprises is considering a new three-year expansion project that requires an initial fixed asset investment of $2.32 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $1.735 million in annual sales, with costs of $650,000. The project requires an initial investment in net working capital of $250,000, and the fixed asset will have a market value of $180,000 at the end of the project. The tax rate is 21 percent. A. What is the project's Year 0 net cash flow? Year 1? Year 2? Year 3? B. If the required return is 12%, what is the project's NPV?

Year 0 = -$2,320,000 - 250,000 = -$2,570,000 The cash outflow at the beginning of the project will increase because of the spending on NWC. At the end of the project, the company will recover the NWC, so it will be a cash inflow. The sale of the equipment will result in a cash inflow, but we also must account for the taxes that will be paid on this sale. So, the cash flows for each year of the project will be: OCF = (Sales − Costs)(1 − TC) + TC(Depreciation) OCF = ($1,735,000 - 650,000)(1 - .21) + .21($2,320,000/3) OCF = $1,019,550 In Years 1 and 2, the only cash flow is the OCF. In Year 3, the total cash flow will include the recovery of the NWC and the aftertax salvage value, so: Year 3 = $1,019,550 + 250,000 + 180,000 + ($0 - 180,000)(.21) = $1,411,750 And the NPV of the project is: NPV = -$2,570,000 + $1,019,550(PVIFA12%,2) + ($1,411,750/1.12^3) NPV = $157,947.28