Finance Study
Shannon's Irish Cookware is implementing a project that will initially increase accounts payable by $4,000, increase inventory by $2,300, and decrease accounts receivable by $1,500. All net working capital will be recouped when the project terminates. What is the cash flow related to the net working capital for the last year of the project?
-3,200 Net working capital recovery = −$4,000 + 2,300 − 1,500 = −$3,200
Which one of the following represents the amount of compensation an investor should expect to receive for accepting the unsystematic risk associated with an individual security?
0
Iron Works International is considering a project that will produce annual cash flows of $37,500, $46,200, $56,900, and $22,400 over the next four years, respectively. What is the internal rate of return if the project has an initial cost of $113,500?
0 = −$113,500 + $37,500/(1 + IRR) + $46,200/(1 + IRR)2 + $56,900/(1 + IRR)3 + $22,400/(1 + IRR)4 IRR = .1690, or 16.90%
Your company has a project available with the following cash flows: YearCash Flow 0 −$82,500 1 20,800 2 23,600 3 29,400 4 25,300 5 18,400 If the required return is 12 percent, should the project be accepted based on the IRR?
0 = −$82,500 + $20,800/(1 + IRR) + $23,600/(1 + IRR)2 + $29,400/(1 + IRR)3 + $25,300/(1 + IRR)4 + $18,400/(1 + IRR)5 IRR = .1313, or 13.13% Because the IRR is greater than the required return, accept the project.
Cirice Corp. is considering opening a branch in another state. The operating cash flow will be $181,400 a year. The project will require new equipment costing $568,000 that would be depreciated on a straight-line basis to zero over the 4-year life of the project. The equipment will have a market value of $161,000 at the end of the project. The project requires an initial investment of $37,000 in net working capital, which will be recovered at the end of the project. The tax rate is 34 percent. What is the project's IRR?
14.61 IRR = 0 = −$568,000 − 37,000 + $181,400(PVIFAIRR,4) + [$37,000 + (1 − .34)($161,000)]/(1 + IRR)4IRR = 14.61%
You own a house that you rent for $1,100 per month. The maintenance expenses on the house average $200 per month. The house cost $219,000 when you purchased it 4 years ago. A recent appraisal on the house valued it at $241,000. If you sell the house you will incur $19,280 in real estate fees. The annual property taxes are $2,500. You are deciding whether to sell the house or convert it for your own use as a professional office. What value should you place on this house when analyzing the option of using it as a professional office?
221,720 Opportunity cost = $241,000 − 19,280Opportunity cost = $221,720
Ferry Boat Corporation has the following financial information: Net fixed assets: Book value: $2,500, Market value: $3,000 Net working capital: $700 Current accounts liquidated: $1,500 ABC Corporation has $900 in long-term debt. What is the book value of equity?
2300
Ferry Boat Corporation has the following financial information: Net fixed assets: Book value: $2,500, Market value: $3,000 Net working capital: $700 Current accounts liquidated: $1,500 ABC Corporation has $900 in long-term debt. What is the market value of equity?
3600
Your firm has net income of $301 on total sales of $1,220. Costs are $680 and depreciation is $110. The tax rate is 30 percent. The firm does not have interest expenses. What is the operating cash flow?
411 EBIT = $1,220 - 680 - 110 = $430 (Sales - Costs - Depreciation) Taxes = .30 × $430 = $129 (Tax rate × EBIT) OCF = $430 + 110 - 129 = $411 (EBIT + Depreciation - Taxes)
A new project has an initial cost of $235,000. The equipment will be depreciated on a straight-line basis to a zero book value over the five-year life of the project. The projected net income each year is $13,100, $17,700, $19,880, $15,000, and $11,600, respectively. What is the average accounting return?
AAR = [$13,100 + 17,700 + 19,880 + 15,000+ 11,600)/5]/[$235,000 + 0)/2] AAR = .1315, or 13.15%
Mountain Frost is considering a new project with an initial cost of $175,000. The equipment will be depreciated on a straight-line basis to a zero book value over the four-year life of the project. The projected net income for each year is $19,300, $20,300, $24,500, and $16,300, respectively. What is the average accounting return?
AAR = [$19,300 + 20,300 + 24,500 + 16,300)/4]/[$175,000 + 0)/2] AAR = .2297, or 22.97%
A new project has an initial cost of $193,000. The equipment will be depreciated on a straight-line basis to a book value of $79,000 at the end of the four-year life of the project. The projected net income each year is $16,000, $18,450, $24,100, and $15,900, respectively. What is the average accounting return?
AAR = [($16,000 + 18,450 + 24,100 + 15,900)/4]/[($193,000 +79,000)/2] AAR = .1369, or 13.69%
According to the video, which of the following are disadvantages of the Average Accounting Return (AAR)?
All of the above are disadvantages. Time value of money is ignored, an arbitrary benchmark cutoff rate is established, and market values are not considered.
All of the following are disadvantages of the Payback Period, except:
All of the items are disadvantages except that The method incorporates the time value of money.
Guerilla Radio Broadcasting has a project available with the following cash flows: YearCash Flow 0 −$17,200 1 7,100 2 8,400 3 3,100 4 2,700 What is the payback period?
Amount short after 2 years = $17,200 − 7,100 − 8,400 Amount short after 2 years = $1,700 Payback period = 2 + $1,700/$3,100 Payback period = 2.55 years
What is the payback period?
Amount short after 2 years = $17,200 − 7,100 − 8,400Amount short after 2 years = $1,700Payback period = 2 + $1,700/$3,10Payback period = 2.55 years
A project with an initial cost of $24,450 is expected to generate cash flows of $5,800, $7,900, $8,700, $7,600, and $6,600 over each of the next five years, respectively. What is the project's payback period?
Amount short after 3 years = $24,450 − 5,800 − 7,900 − 8,700 Amount short after 3 years = $2,050 Payback period = 3 + $2,050/$7,600 Payback period = 3.27 years
Power Manufacturing has equipment that it purchased 6 years ago for $1,900,000. The equipment was used for a project that was intended to last for 8 years and was being depreciated over the life of the project. However, due to low demand, the project is being shut down. The equipment was depreciated using the straight-line method and can be sold for $270,000 today. The company's tax rate is 35 percent. What is the aftertax salvage value of the equipment?
Annual depreciation = $1,900,000/8 Annual depreciation = $237,500 Book value = $1,900,000 − 6($237,500) Book value = $475,000 Tax refund (due) = ($475,000 − 270,000)(.35) Tax refund (due) = $71,750 Aftertax salvage value = $270,000 + 71,750 Aftertax salvage value = $341,750
The ABC Corporation has the following information. How much is the Cash Flow to Creditors? ABC Corporation Earnings before interest & taxes $1,588 Depreciation 130 Beginning net fixed assets 1,650 Interest paid 150 Net new equity raised 450 Net new borrowing 110 Taxes 424
Cash Flow to Creditors = Interest Paid - Net New Borrowing Cash Flow to Creditors = $150 − 110 Cash Flow to Creditors = $40
A 4-year project has an annual operating cash flow of $56,000. At the beginning of the project, $4,700 in net working capital was required, which will be recovered at the end of the project. The firm also spent $23,300 on equipment to start the project. This equipment will have a book value of $5,020 at the end of the project, but can be sold for $5,940. The tax rate is 34 percent. What is the Year 4 cash flow?
Cash flow = $56,000 + 4,700 + 5,940 + .34($5,020 − 5,940)Cash flow = $66,327
Cash flow from assets equals:
Cash flow from assets = cash flow to creditors + cash flow to stockholders
At the beginning of the year, a firm has current assets of $319 and current liabilities of $223. At the end of the year, the current assets are $475 and the current liabilities are $263. What is the change in net working capital?
Change in net working capital = ($475 - 263) - ($319 - 223) = $116
The net present value of an investment represents the difference between the investment's:
Cost and its market value
Hoodoo Voodoo Co. has total assets of $65,550, net working capital of $19,975, owners' equity of $31,995, and long-term debt of $23,105. What is the company's current assets?
Current liabilities = $65,550 − 31,995 − 23,105 = $10,450 Current assets = $19,975 + 10,450 = $30,425
The risk-free rate is 2.4 percent and the market expected return is 12.1 percent. What is the expected return of a stock that has a beta of .88?
E(R) = .024 + .88(.121 − .024)E(R) = .1094, or 10.94%
The stock of Big Joe's has a beta of 1.48 and an expected return of 12.50 percent. The risk-free rate of return is 5 percent. What is the expected return on the market?
E(R) = .125 = .050 + 1.48[E(RM) − .050] .075 = 1.48[E(RM) − .050]E(RM) = .1007, or 10.07%
If the economy booms, Meyer&Co. stock will have a return of 20.9 percent. If the economy goes into a recession, the stock will have a loss of 13.2 percent. The probability of a boom is 62 percent while the probability of a recession is 38 percent. What is the standard deviation of the returns on the stock?
E(R) = .62(.209) + .38(-.132)E(R) = .0794, or 7.94% σ2 = .38(−.132 - .0794)2 + .62(.209 - .0794)2σ2 = .027396 σ = .0273961/2σ = .1655, or 16.55%
The economy has been very volatile lately. There is a 40% chance of recession and a 60% chance of a boom. Stock A would have a return of −15% if there was a recession but, a 40% return in a boom economy. What is the expected return for Stock A?
E(RA) = .40 × − .15 + .60 × .40 E(RA) = − .06 + .24 E(RA) = .18 E(RA) = 18%
Disturbed, Inc., had the following operating results for the past year: sales = $22,600; depreciation = $1,340; interest expense = $1,080; costs = $16,505. The tax rate for the year was 35 percent. What was the company's operating cash flow?
EBIT = $22,600 − 16,505 − 1,340 = $4,755 EBT = $4,755 − 1,080 = $3,675 Taxes = $3,675(.35) = $1,286 OCF = $4,755 + 1,340 − 1,286 = $4,809
Expected return is the return on a _______ asset expected in the future.
Expected return is the return on a risky asset expected in the future
All of the following are commonly cited reasons for using the Internal Rate of Return, except:
Multiple IRR's create confusion and are commonly associated with non-conventional cash flows are would not be a reason for using the Internal Rate of Return.
What does mutually exclusive mean?
Mutually Exclusive means we must make a choice between projects and that we can only accept one project.
Which one of the following indicates that a project is expected to create value for its owners?
NPV
Using the method of your choice, calculate the Net Present Value of the following cash flows. Assume that the required return on this project is 15%. Compare to the $150 estimated cost:
NPV = -$150 + ($152 + $76) = $78
A project with an initial investment of $440,900 will generate equal annual cash flows over its 11-year life. The project has a required return of 8.2 percent. What is the minimum annual cash flow required to accept the project?
NPV = 0 = −$440,900 + C(PVIFA8.2%, 11) C = $62,360.23
A company. has a project available with the following cash flows: Year Cash Flow 0 −$31,670 1 13,110 2 14,740 3 20,920 4 12,080 If the required return for the project is 9.7 percent, what is the project's NPV?
NPV = −$31,670 + $13,110/(1 + .097) + $14,740/(1 + .097) 2 + $20,920/(1 + .097)3 + $12,080/(1 + .097)4 NPV = $16,717.55
Rossdale Flowers has a new greenhouse project with an initial cost of $316,500 that is expected to generate cash flows of $48,100 for 8 years and a cash flow of $63,500 in Year 9. If the required return is 8.6 percent, what is the project's NPV?
NPV = −$316,500 + $48,100(PVIFA8.60%, 8) + $63,500/(1 + .086)9 NPV = −$16,050.25
You are examining a company's balance sheet and find that it has total assets of $21,156, a cash balance of $2,424, inventory of $5,169, current liabilities of $6,341 and accounts receivable of $2,935. What is the company's net working capital?
NWC = Current assets − Current liabilitiesNWC = ($2,424 + 2,935 + 5,169) − 6,341NWC = $4,187
Which one of the following is generally considered to be the best form of analysis if you have to select a single method to analyze a variety of investment opportunities?
Net Present Value
What is the Net Working Capital for Capella Corporation?
Net Working Capital = Current Assets − Current Liabilities Net Working Capital = $300 − $110 = $190
Teddy's Pillows had beginning net fixed assets of $465 and ending net fixed assets of $538. Assets valued at $313 were sold during the year. Depreciation was $30. What is the amount of net capital spending?
Net capital spending = $538 (ending net fixed assets) + 30 (Depreciation) - 465 (beginning net fixed assets)Net capital spending = $103
Micro, Inc., started the year with net fixed assets of $75,175. At the end of the year, there was $96,525 in the same account, and the company's income statement showed depreciation expense of $13,175 for the year. What was the company's net capital spending for the year?
Net capital spending = $96,525 − 75,175 + 13,175 = $34,525
What are non-conventional cash flows?.
Non-conventional cash flows are defined as a combination of cash outflows, followed by inflows, and returning to outflows. This commonly occurs because companies will invest a small amount into a project, monitor the inflows, and then anticipate investing additional funds later assuming the project is successful.
Cori's Dog House is considering the installation of a new computerized pressure cooker for hot dogs. The cooker will increase sales by $7,800 per year and will cut annual operating costs by $13,900. The system will cost $54,700 to purchase and install. This system is expected to have a 6-year life and will be depreciated to zero using straight-line depreciation and have no salvage value. The tax rate is 40 percent and the required return is 11.4 percent. What is the NPV of purchasing the pressure cooker?
OCF = ($7,800 + 13,900)(1 − .40) + .40($54,700/6)OCF = $16,667 NPV = −$54,700 + 16,667(PVIFA11.4%,6)NPV = $15,004
Outdoor Sports is considering adding a putt putt golf course to its facility. The course would cost $169,000, would be depreciated on a straight-line basis over its 5-year life, and would have a zero salvage value. The sales would be $85,000 a year, with variable costs of $27,500 and fixed costs of $12,100. In addition, the firm anticipates an additional $16,100 in revenue from its existing facilities if the putt putt course is added. The project will require $2,700 of net working capital, which is recoverable at the end of the project. What is the net present value of this project at a discount rate of 10 percent and a tax rate of 35 percent?
OCF = ($85,000 + 16,100 − 27,500 − 12,100)(1 − .35) + .35($169,000/5)OCF = $51,805 NPV = −$169,000 − 2,700 + $51,805(PVIFA10%,5) + $2,700/1.105NPV = $26,358
The ABC Corporation has the following information. How much is the Operating Cash Flow? ABC Corporation Earnings before interest & taxes $1,588 Depreciation 130 Beginning net fixed assets 1,650 Net new equity raised 450 Taxes 424
Operating Cash flow = EBIT + Depreciation − Taxes Operating Cash flow = $1,588 + 130 − 424 Operating Cash flow = $1,294
A project with an initial cost of $31,600 is expected to provide cash flows of $12,300, $12,700, $15,800, and $10,300 over the next four years, respectively. If the required return is 8.6 percent, what is the project's profitability index?
PI = [$12,300/(1 + .086) + $12,700/(1 + .086)2 + $15,800/(1 + .086)3 + $10,300/(1 + .086)4]/$31,600 PI = 1.324
POD has a project with the following cash flows: Year Cash Flows 0 −$271,000 1 146,000 2 163,500 3 128,600 The required return is 8.8 percent. What is the profitability index for this project?
PI = [$146,000/(1 + .088) + $163,500/(1 + .088)2 + $128,600/(1 + .088)3]/$271,000PI = 1.373
A project with an initial cost of $52,800 is expected to provide annual cash flows of $17,600 over the 6-year life of the project. If the required return is 8.1 percent, what is the project's profitability index?
PI = [$17,600(PVIFA8.1%, 6)]/$52,800 PI = 1.536
A project that costs $23,000 today will generate cash flows of $8,900 per year for seven years. What is the project's payback period?
Payback period = $23,000/$8,900 Payback period = 2.58 years
You have a portfolio that is 37 percent invested in Stock R, 21 percent invested in Stock S, with the remainder in Stock T. The expected return on these stocks is 9.0 percent, 10.4 percent, and 12.7 percent, respectively. What is the expected return on the portfolio?
Portfolio expected return = .37(9%) + .21(10.4%) + (1 - .37 − .21)(12.7%)Portfolio expected return = 10.85%
If risk-free investments are currently 6% and our expected return from Stock V was 14%. What is the risk premium on this investment?
Risk premium = Expected Return − Risk free rate Risk premium = 14% − 6% Risk premium = 8%
Bubbly Waters currently sells 510 Class A spas, 660 Class C spas, and 410 deluxe model spas each year. The firm is considering adding a mid-class spa and expects that if it does, it can sell 585 units per year. However, if the new spa is added, Class A sales are expected to decline to 330 units while the Class C sales are expected to increase to 685. The sales of the deluxe model will not be affected. Class A spas sell for an average of $16,100 each. Class C spas are priced at $8,100 and the deluxe models sell for $19,100 each. The new mid-range spa will sell for $10,100. What annual sales figure should you use in your analysis?
Sales = 585($10,100) + (330 − 510)($16,100) + (685 − 660)($8,100)Sales = $3,213,000
The Average Accounting Return (AAR) Rule states that a company will accept a project that has an average account return that:
The Average Accounting Rule (AAR) states that a company will accept a project that has an average account return that exceeds a pre-determined target average accounting return.
The Internal Rate of Return (IRR) represents which of the following:
The Internal Rate of Return (IRR) represents the discount rate that makes the net present value equal to zero
The Payback Period Rule states that a company will accept a project if:
The calculated payback is less than a pre-specified number of years.
All of the following are useful for understanding Profitability Index, except:
The initial investment is not included when calculating the present value of the future cash flows.
All of the following are advantages of the Profitability Index, except:
The main disadvantage with the profitability index is the you may incorrectly choose projects when considering mutually exclusive investments.
Suppose you put half of your money in Monster Beverage and half in IBM. What would the beta of this combination be if Monster Beverage has a beta of 1.52 and Pepsi has a beta of .55?
The portfolio's beta would be: βp = (Wa × β) + (Wb × β) βp = (.50 × 1.52) + (.50 × .55) βp = .76 + .275 = 1.035
You decide to invest $20,500 in Bank of America and $14,500 in Twitter. What is the portfolio's beta? Bank of America beta: 1.27 Twitter beta: 1.96
Wa (Bank of America) = $20,500/($20,500 + $14,500) = 59% Wb (Twitter) = 1 − 59% = 41% βp = (Wa × β) + (Wb × β) βp = (.59 × 1.27) + (.41 × 1.96) βp = .7493 + .8036 = 1.553
You own 360 shares of Stock X at a price of $29 per share, 230 shares of Stock Y at a price of $52 per share, and 295 shares of Stock Z at a price of $75 per share. What is the portfolio weight of Stock Y?
Weight of Y = 230($52)/[360($29) + 230($52) + 295($75)]Weight of Y = .2686
When choosing between mutually exclusive projects, what is the best method to use?
When choosing between mutually exclusive projects, the highest NPV is always the best option.
Which one of the following portfolios will have a beta of zero?
a portfolio compressed solely of us treasury bills
Which one of the following is the best example of unsystematic risk?
a warehouse fire
Systematic risk is defined as:
any risk that affects a larger number of assets
The security market line is a positively sloped straight line that displays the relationship between expected return and ____________.
beta
CrossTown Builders is considering remodeling an old building it currently owns. The building was purchased ten years ago for $1.2 million. Over the past ten years, the firm rented out the building and used the rent to pay off the mortgage. The building is now owned free and clear and has a current market value of $1.9 million. The company is considering remodeling the building into industrial-type apartments at an estimated cost of $1.6 million. The estimated present value of the future income from these apartments is $4.1 million. Which one of the following defines the opportunity cost of the remodeling project?
current market value of the building
Which term best refers to the practice of investing in a variety of diverse assets as a means of reducing risk?
diversification
Which one of the following terms is most commonly used to describe the cash flows of a new project that are simply an offset of reduced cash flows for a current project?
erosion
Net working capital represents current assets plus current liabilities.
false
Which one of these represents systematic risk?
increase consumption created by a reduction in personal tax rates
Any changes to a firm's projected future cash flows that are caused by adding a new project are referred to as:
incremental cash flows
The systematic risk principle states that the expected return on a risky asset depends only on the asset's ___ risk.
market
Unsystematic risk can be defined by all of the following except:
market risk
When considering Net Working Capital, a project will generally need all of the following, except:
only long term assets to get the project started
Which one of the following terms refers to the best option that was foregone when a particular investment is selected?
opportunity cost
The net working capital invested in a project is generally:
recouped at the end of the project
The market value of an asset depends on:
riskiness and cash flow
Weston Steel purchased a new coal furnace six years ago at a cost of $2.2 million. Last year, the government changed the emission requirements and this furnace cannot meet those standards. Thus, the company can no longer use the furnace, nor has it been able to locate anyone willing to purchase the furnace. Given the current situation, the furnace is best described as which type of cost?
sunk
A cost that should be ignored when evaluating a project because that cost has already been incurred and cannot be recouped is referred to as a(n):
sunk cost
The risk premium for an individual security is based on which one of the following types of risk?
systematic
The amount by which a firm's tax bill is reduced as a result of the depreciation expense is referred to as the depreciation:
tax shield
Operating cash flow is defined as:
the cash that a firm generates from its normal business activities
The Capital Asset Pricing Model (CAPM) shows that the expected return for a particular asset depends on all of the following, except:
the return on risk-less asset
Thrill Rides is considering adding a new roller coaster to its amusement park. The addition is expected to increase its overall ticket sales. In particular, the company expects to sell more tickets for its current roller coaster and experience extremely high demand for its new coaster. Sales for its boat ride are expected to decline but food and beverage sales are expected to increase significantly. All of the following are side effects associated with the new roller coaster with the exception of the:
ticket sales for the new coaster
Risk-free assets have a beta of 0 and the market portfolio has a beta of 1.
true
Portfolio Beta is the ______________ average of the Betas of the investments included in the portfolio.
weighted
You have a portfolio that is invested 21 percent in Stock A, 36 percent in Stock B, and 43 percent in Stock C. The betas of the stocks are .74, 1.29, and 1.58, respectively. What is the beta of the portfolio?
βPortfolio = .21(.74) + .36(1.29) + .43(1.58)βPortfolio = 1.30