Engineering Economy Practice Exam

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1 Engineering Economy Practice Exam

2 1. In the Canadian tax system, the sale of an asset in a particular asset class can simultaneously trigger a depreciation recapture and a loss on disposal. A) T B) F 2. For given demand and supply schedules, the market equilibrium is always in a price interval in which demand is elastic because the total consumer expenditure in this price range decreases. A) T B) F 3. When using the equivalent annual value criterion to compare equipment alternatives, it is assumed that continuous replacements are made for as long as the service of such equipment is required. A) T B) F

3 4. A capital gain occurs when a depreciable asset is sold for more than its undepreciated balance at the time of sale, but for less than its purchase price. A) T B) F 5. In the Canadian tax system, assets belonging to a particular class depreciated by the declining-balance method are grouped into one common pool and depreciated together. A) T B) F 6. The discounted payback period is superior to the payback period because it considers the cash flows that occur beyond the discounted capital recovery period. A) T B) F

4 7. When using an integrated company basis of taxation in project evaluation, any excess of operating expenses and tax allowances over a project's revenue in a particular year is assumed to be fully absorbed by other taxable corporate income of the company. A) T B) F 8. A change in supply to higher quantity levels is reflected by a vertical upward shift of the supply curve. A) T B) F 9. The law of diminishing marginal returns states that decreasing amounts of output will inevitably be obtained from successive additions of equal amounts of variable input in a system where fixed resources have achieved their optimum efficiency. A) T B) F

5 10. When using the capital tax factor on a capital expenditure, it is assumed that depreciation allowances generated by that capital expenditure can be fully absorbed (i.e. there is enough net income before allowances and taxes) in the year in which they are claimed. A) T B) F 11. Assume that a project requires additions to working capital in each year of its life, all to be recovered at the end along with the initial input. In this case, the present value at the beginning of the project s life (i.e. time 0) of the recovered working capital will exceed the total outlays of working capital. A) T B) F 12. Any regular bond with any maturity period will have a market value equal to its face value if the coupon rate is the same as the going market rate (expressed as a nominal rate with the same compounding interval as that of the bond). A) T B) F

6 13. Cash flows that result from debt and equity financing transactions, including incurrence and repayment of debt, cash inflows from the sale of stock, and cash outflows to pay dividends or repurchase stock are called: A) financing flows. B) operating flows. C) investment flows. D) monetary flows. E) none of the choices listed above.

7 14. The half-year rule in the Canadian tax system was probably implemented to: A) discourage firms from acquiring depreciable assets at year-end to take advantage of the fact that a full-year s depreciation could be claimed on those assets. B) encourage the purchase of depreciable assets later in the year. C) satisfy political lobbyists. D) increase corporate tax savings resulting from the CCA. E) none of the choices listed above.

8 15. Which one of the following is not tax-deductible? A) Capital cost allowances B) Interest charges C) Preferred dividends D) Issuing expenses on securities E) Operating costs 16. When using the internal rate of return criterion to compare projects, it is assumed that cash flows can be reinvested at the: A) cost of raising funds through equity sources (i.e. issuing shares) B) cost of capital C) internal rate of return D) prevailing interest rate E) all of the choices listed above

9 17. Which one of the following ratios would be most helpful in assessing a company's liquidity? A) time-interest-earned ratio B) current ratio C) price to earnings ratio D) total asset turnover ratio E) accounts receivable turnover ratio 18. Liquidity and activity ratios rely most heavily on entries taken from the: A) income statement B) balance sheet C) statement of cash flow D) statement of earned surplus E) all of the financial statements listed above

10 19. If a negative pool balance occurs as a result of the disposal of an asset in the Canadian tax system, then a firm: A) can claim the balance as a tax deductible expense B) must add that balance (as a positive amount) to its taxable income C) should sell all of the assets in that pool D) can calculate the CCA for the year using the negative balance E) can use the negative balance as a loss for tax purposes in subsequent years

11 The table below reports the average annual copper prices over the period, along with the Gross Domestic Product implicit price index for the same period. Year Copper Price (U.S. $/lb) GDP Implicit Price Index (1986=100)

12 20. Determine the 1992 copper price in constant money of the year (135.1 / 123.4) = $ What was the average annual compound rate of inflation over the period? Year Copper Price (U.S. $/lb) GDP Implicit Price Index (1986=100) (135.1 / 118.5) = 1.32%

13 22. What was the real average annual compound rate of change in the copper price over the period? Copper price of 1990 in constant money of year 2000: (135.1 / 118.5) = (0.890 / 1.405) = -4.46% Year Copper Price (U.S. $/lb) GDP Implicit Price Index (1986=100) If the base year of the implicit price index series is changed from 1986 to 1996, determine the revised index for the year (135.1 / 129.1) (100) = 104.6

14 Use the financial statements below to answer questions 13 to 17. BJL Incorporated Income Statement for 1999 ( $) Net sales 1384 Less: Cost of goods sold 605 Less: Depreciation 180 Earnings before interest and taxes 599 Less: Interest on long-term debt 80 Taxable income 519 Less: Income taxes 156 Net income 363 Addition to retained earnings 254 Dividends paid 109

15 BJL Incorporated Balance Sheets at 12/31/98 and 12/31/99 ( $) Cash Accounts payable Accounts receivable Notes payable Inventory Total Total Long-term debt Shareholders equity Net fixed assets Common stock Retained earnings Total Total Assets Total Liab. & S.E Note: The long-term debt consists of bonds with a face value of $1000 each. Additional bonds with the same face value were issued on the first day of 1999.

16 24. What was the firm's inventory turnover ratio? A) (1.42) B) 1.42 C) 1.47 D) 1.38 E) None of the choices given above ITR = Cost of goods sold / Average inventory Use sales in the absence of cost of goods sold. Cost of goods sold: $605 million Average inventory: ( ) / 2 = $425 million ITR = 605 / 425 = 1.42

17 25. Determine the cash flow from financing activities for 1999 (in $ mil.) A) ($99) B) $50 C) $30 D) $10 E) None of the choices given above Financing activities: Dividends paid -109 Decrease in notes payable -20 Increase in long-term debt 50 Decrease in common stock -20 Total -$99 million

18 26. If the firm had 180 million shares of common stock outstanding at the end of 1999, what was the dividend per share? A) $0.50 B) $0.61 C) $1.41 D) $1.83 E) $2.02 Dividends paid: $109 million Dividend per share: 109 / 180 = $0.61

19 27. Determine the total uses of funds for 1999 (in $ mil.) [consider appropriate income statement entries and changes in all balance sheet accounts except the cash account]. A) $422 B) $623 C) $582 D) $602 E) None of the choices given above Consider only the items that contribute to a decrease in cash: Increase in accounts receivable 75 Increase in fixed assets at cost ( ) 328 Decrease in accounts payable 50 Decrease in notes payable 20 Decrease in common stock 20 Dividends paid 109 Total $602 million

20 28. Given that BJL s before-tax costs of debt and equity are 9 and 16 percent, respectively, and that it is subject to a corporate tax rate of 40 percent, the firm s after-tax cost of capital based on 1999 book values is: A) 8.4 % B) 10.8 % C) 13.0 % D) 14.0 % E) None of the choices given above 1999 Book values Bonds: 550 Equity: = 1390 Total: 1940 WACC 9% (1-0.4) (550 / 1940) + 16% (1390 / 1940) = 13.0 %

21 29. A fertilizer plant has a linear production cost function. The plant currently produces 8000 tonnes of product per month at an average cost of $15 and incurs monthly fixed costs of $ The constant unit variable cost of the plant is: A) $15 B) $4 C) $11 D) $19 E) None of the choices given above Total monthly costs: 8000 (15) = Total variable costs: = Unit variable cost: / 8000 = $11

22 30. Three years ago, you purchased an apartment building in Montreal for $ and have been renting all of its apartments. The building is a Class 3 asset subject to decliningbalance depreciation at an annual rate of 4%, and over the past three years, you have claimed the full annual depreciation allowances on the building. You now sold the building, the only Class 3 asset that you own, for $ If your income tax rate is 40%, how much taxes resulting from depreciation recapture do you owe the government? A) $ B) $ C) $ D) $ E) None of the choices given above Book value 3 (UCC): (1-0.02) (1-0.04) 2 = Taxes: ( ) (0.40) = $

23 WBM Corporation has been operating for 15 years. The company was originally financed by issuing one million common shares at a par value of $20 each. WBM s capital structure is now composed of the following: Common Equity 1 million shares outstanding, with a market price of $40 per share, an expected dividend yield (D 1 /P) of 10% this year, and an expected annual growth rate of 5.9%. Bonds bonds outstanding, with a face value of $1000 each, an annual coupon of 8%, 12 years to maturity and a market price of $1105 per bond. WBM s corporate income tax rate is 34%.

24 31. WBM s after-tax cost of common equity capital is: A) 5.9% B) 10.0% C) 15.9% D) 10.5% E) None of the choices given above. The cost of existing common equity is: K e = (D 1 / P) + g = = 15.9%

25 32. WBM s after-tax cost of debt capital is: A) 4.2% B) 6.7% C) 8.0% D) 4.4% E) None of the choices given above. The cost of existing debt is based on the market value of the bonds. It is expressed as an effective annual rate. Hence PV = -1105, FV = 1000 and N =12 PMT = 0.08 (1000) (1-0.34) = CPT I/Y 4.151%

26 33. Assuming before-tax costs of 8% and 15% for debt and equity capital, respectively, WBM s after-tax cost of capital is: A) 8.4% B) 8.9% C) 11.8% D) 12.9% E) None of the choices given above. The weights are based on market value and not on face value Market value of the bonds: (1105) = $11.05 million Market value of the shares: (40) = $40 million WACC = 8% (1-0.34) (11.05 / 51.05) + 15% (40 / 51.05) = 12.9%

27 34. Suppose that you purchase a stripped bond (i.e. a bond that pays no interest because it has been stripped of its coupons) with face value $1000 maturing in 20 years for $ If the yield to maturity on the bond remains unchanged over its life, what will be its market value five years from now? A) $ B) $ C) $ D) $ E) $1000 Yield to maturity: PV = , FV = 1000, N = 20, CPT I/Y 8.0% Market value in 5 years: (1.08) 5 = $315.24

28 35. You have to chose between two mutually exclusive projects with cash flows as shown below. If you have unlimited funds and you require a 14% return on investment, which project should you choose? Project Year Time A Cash Flow Cash Flow A) Project B, because it has a smaller initial investment. B) Project A, because it has a higher NPV. C) Either one, because they have the same life. D) Project B, because it has a higher internal rate of return. E) Project B, because it has a shorter payback period. B A - B % IRR (%) The IRRs and the incremental analysis are of course not necessary.

29 A project with a preproduction period of one year is characterized by the following time distribution of current money cash flows: Time Cash Flow (mil. $) Using a constant-money cost of capital of 12 percent and the Gross Domestic Product implicit price index series used for questions 21 to 23 (assume year-end indices), determine the net present value of this 4-year project given that it operated in years 1995 to Year Copper Price (U.S. $/lb) GDP Implicit Price Index (1986=100)

30 Time Cur. $ Cons. $ (125.6 / 127.5) (125.6 / 129.1) (125.6 / 130.7) (125.6 / 133.3) Enter CFs in CF worksheet and compute 12% NPV: $21.0 mil.

31 A project has the following specifications: Preproduction period 2 Production period 5 Preproduction capital expenditures (mil. $) Year 1 25 Year 2 40 Working capital 6 Projected annual revenues (mil. $) 60 Projected annual expenses (mil. $) 24 Projected salvage value (mil. $) 10 Depreciation: SL at 20 % per year (do not use the half-year rule) Project basis of taxation in which depreciation cannot be used to create a loss Income tax rate: 40 % Any gain (loss) on disposal of an asset is taxed (written off) in the year of disposal Determine the project s cash flow in production year 5.

32 At 20 % SL, it takes 5 years to fully depreciate a capital expenditure. Thus, under the project basis of taxation in which depreciation cannot be used to create a loss, all assets installed in preproduction years 1 and 2 will be depreciated in equal amounts ([ ] / 5 = 13) over production years 1 to 5, i.e. depreciation cannot be claimed during the preproduction period. Revenue 60.0 Operating expenses 24.0 Operating profit 36.0 Salvage value 10.0 Depreciation 13.0 Taxable Income % 13.2 Net Income 19.8 Capital expenditure 0.0 CF = = 38.8 (or ) SV TX CE RWC DEP CE RWC

33 Your firm needs a computerized line-boring machine that costs $80 000, requires $ of annual operating and maintenance expenses over its three-year life, and has a salvage value of $ The machine is a Class 10 asset qualifying for a CCA rate of 30% per year on a decliningbalance basis. The corporate income tax rate is 34% and the cost of capital is 10%. Class 10 and CCA are Canadian tax terminology. Therefore, the half-year rule applies. 1. Determine the annual after-tax operating and maintenance expenses. OTF = = 0.66 A-T OC = 0.66 (20 000) = $13 200

34 2. Determine the after-tax salvage value. CTF = 1 - [ (d t) / (d + i) ] [ (1 + i/2) / (1 + i) ] = CTF = 1 - [ (d t) / (d + i) ] = The factor with the half-year rule adjustment is used on capital expenditures. For salvage values, use the CTF without the halfyear rule adjustment, unless it is known that there are acquisitions in the year of disposal, and that these exceed the salvage value of $ (this is not the case here). A-T SV = (15 000) = $11 175

35 3. Determine the net after-tax capital expenditure (initial cost net of salvage value). Use the CTF with the half-year rule on the capital expenditure. The A-T SV must be discounted to the time of purchase (3 years at 10%). Net A-T CAPEX: (0.7566) / (1.1) 3 = $ Determine the overall equivalent annual after-tax cost of the machine. Annual A-T operating and maintenance expenses: EAV of net A-T CAPEX: (A/P,10%,3) = Overall EAV of A-T cost: = $34 163

36 At the final exam Pay attention to the terminology. Use common sense in judging the validity of your results. Record your name and code your ID and checkbits on the computer answer sheet. Record your name and ID on the exam paper. Circle your multiple choice question answers on the exam paper and code them on the computer answer sheet. Record your full-solution problem answers in the boxes. Professors Jassim and Bilodeau wish you success!!!

37 Can you find Prof. Bilodeau?

38 Who s this young gentleman?

P R A C T I C E E X A M

MIME 310 ENGINEERING ECONOMY P R A C T I C E E X A M A P R I L 2 0 0 8 If you want to maximize the benefits that you derive from this exercise, here's what you should do: Give yourself a two to three-hour