Exam 3 Practice Problems, FINAN303 Principles of Finance, Spring 2018

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1 Exam 3 Practice Problems, FINAN303 Principles of Finance, Spring 2018 ***These problems are representative of the types of problems you will encounter on the final exam. This set, however, is not exhaustive.*** PART I: General Multiple Choice 1. SomeComp is considering a project that has the following cash flow data. What is the project's IRR? Cash flows -$1200 $475 $575 $675 a % b % c % d % e % 2. Awesome Manufacturing Company is considering a project that has the following cash flow data. What is the project's payback? Cash flows -$875 $365 $385 $350 a years b years c years d years e years 3. T&T Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. The WACC (the required cost of capital) is 9%. 4 Cash flows -$1,200 $290 $330 $360 $460 a. $ b. $ c. $-3.85 d. $18.64 e. $ True/False: Assuming frictionless markets, the discount rate for the asset investment decision does not depend on the source of funds, but the use to which the funds are put. a. True b. False

2 5. CCC is considering a project that has the following cash flow data. What is the project's MIRR assuming its WACC is 11%? Cash flows -$1,200 $480 $570 $590 a % b % c % d % e % 6. Brown Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? The WACC (required cost of capital) is 9%. Cash flows -$1,250 $580 $560 $470 a. $ b. $ c. $ d. $ e. $ You are considering an investment in Facebook s (FB) equity. You think there is a 65% chance that FB will maintain its market dominance over the next year and generate a 16% return on its equity. However, you think there is a 35% chance that FB will lose a significant market share thus generating a 4% loss on its equity. What is your expected return for an investment in FB s equity? a. 9.00% b. 9.25% c % d % e % 8. Using the set-up of potential return outcomes for an investment in Facebook s equity (problem above), what is the expected risk in this set-up as measured by the investment standard deviation? a. 7.81% b. 8.75% c. 8.95% d. 9.54% e. 9.96% 9. Which of the following levels of risk, as measured by the standard deviation of returns, represents the riskiest investment? a. 5.50% b. 4.12% c. 7.00% d. 5.25%

3 10. You were hired as a consultant to Vetex Inc., whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The before-tax cost of debt is 8.00%, the firm is in a 35% tax bracket, the cost of preferred is 9.50%, and the cost of retained earnings is 12.75%. The firm will not be issuing any new stock. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.78% e % 11. D.H. & Sons is considering a project that has the following cash flow data. What is the project's payback? 4 5 Cash flows -$1100 $310 $320 $320 $400 $430 a years b years c years d years e years 12. D.H. & Sons is considering a project that has the following cash flow data. What is the project's discounted payback? WACC: 10.00% 4 5 Cash flows -$1100 $310 $320 $320 $400 $430 a years b years c years d years e years 13. Which of the following statements is CORRECT? a. The component costs of debt is higher than the component cost of equity for most firms. b. WACC calculations should be based on the before-tax costs of all the individual capital components. c. Floatation costs associated with issuing new common stock normally reduce the WACC. d. If a company s tax rate decreases, then, all else equal, its weighted average cost of capital will increase.

4 14. Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. 15. A 10-year bond with a face value of $1,000 and an annual coupon rate of 7% (paid semi-annually) is selling for $ If the corporate federal-plus-state tax rate is 35%, what is the issuing firm s aftertax cost of debt? a. 4.72% b. 5.46% c. 6.21% d. 6.80% e. 7.23% 16. Poplar Inc. is expected to pay a $2.75 dividend at year end (D 1 = $2.75), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $42.50 a share. The before-tax cost of debt is 9.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company s WACC if all the equity used is from retained earnings? a. 7.87% b. 8.36% c. 8.67% d. 9.15% e. 9.59% 17. R&R Corp. plans to issue 8-year bonds with a par value of $1,000 and an 8% coupon paid quarterly. The price of the bond is $ If Reynolds is in the 30 percent tax bracket, what is their after-tax cost of debt? a. 7.79% b. 8.12% c. 9.86% d % e % 18. Covenant Transportation is selling $10 million of $1000 par bonds with a coupon rate of 8 percent paid annually. The yield to maturity on these bonds is 10 percent. If the firm's tax rate is 35 percent, what is after-tax cost of debt (in percentage) to Hunt? a. 5.20% b. 6.50% c. 7.25% d. 8.00% e %

5 19. Davidson Electric is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. The WACC (the required discount rate is 9.00%) 4 Cash flows -$1,150 $360 $360 $360 $360 a. $16.30 b. $19.47 c. $23.85 d. $28.64 e. $ Comprehensive Consulting is considering a project that has the following cash flow data. What is the project's IRR? Cash flows -$1,200 $480 $470 $490 a. 7.70% b. 8.78% c. 9.13% d. 9.67% e % 21. Tottenham is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 11.00% Cash flows -$1500 $900 $750 $600 a years b years c years d years e years 22. Which of the following statements is CORRECT? a. The shorter a project s payback period, the less desirable the project is normally considered to be by this criterion. b. If a project s payback is positive, then the project should be accepted because it must have a positive NPV. c. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. d. One drawback of the payback criterion is that this method does not consider the time value of money. e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

6 23. Tellus Contracting is considering a project that will yield the following cash flows. What is the project s payback? Cash flows -$1000 $365 $385 $350 a years b years c years d years 24. Davis systems is considering a project with the following cash flow and WACC data. What is the project s NPV when the firm s WACC is 9%? 4 Cash flows -$1,200 $290 $430 $560 $460 a. $ b. $ c. $ d. $ Using the cash flow data from the previous problem, what is the project s IRR? a % b % c % d % 26. Investors require a return on stock of 12% for Attel Manufacturing. If the risk-free rate is 3% and the expected market return is 8%, what is Attel s beta? a. 1.2 b. 1.5 c. 1.8 d John owns 100 shares of ABC stock. Which one of the following terms is used to refer to the return that John and the other shareholders require on their investment? a. Cost of equity b. Cost of debt c. Weighted average costs of capital d. Idiosyncratic costs e. Systematic costs

7 28. Based on the following, what is the firm s after-tax cost of debt? Bond price: $895 Par value: $1000 Coupon rate: 8% annually paid semi-annually Maturity: 9 years Tax rate: 40% a. 4.89% b. 5.87% c. 6.01% d. 9.78% e % 29. You are faced with an investment that pays 12% with 70% probability and -2% with 30% probability over the next year. What is the investment s expected return? a. 5.0% b. 6.7% c. 7.2% d. 7.8% 30. As a manager, you are faced with the following two mutually exclusive projects. Assuming that your cost of capital is 11%, which project(s), if any, would you choose? (Use NPV method) Cash Flows Time Project A Project B 0-24,000-24, ,000 7, ,000 9, ,000 18,000 a. Neither A nor B b. Project A only c. Project B only d. Both A and B 31. Which of the following would decrease the after-tax cost of debt for a firm? a. An increase in the firm s beta b. An increase in the firm s tax rate c. An increase in the market risk premium d. An increase in the firm s yield on its debt e. None of the above 32. What is the component cost of common stock if the current stock price is $33.55 and the dividend in one-year is expected to be $2.50? a. 7.45% b. 8.13% c. 9.07% d % a. None of the above

8 33. When considering independent asset investment projects, the project with the lower NPV should be rejected even if it is positive. a. True b. False 34. Tellus Contracting is considering a project that will yield the following cash flows. What is the project s MIRR if the firm s WACC is 10%? 4 Cash flows -$1,200 $290 $430 $560 $460 a % b % c % d % 35. A firm determines that if it launches product B, then the sales of product A will suffer. In a capital budgeting context, this is referred to as which of the following? a. An incremental cash flow b. A sunk cost c. An opportunity costs d. An externality e. None of the above 36. So long as the correlation coefficient between two assets is less than 1, there is some diversification related benefit to holding the two assets together in a portfolio. a. True b. False 37. Which of the following are relevant cash flows in a capital budgeting context? I. Opportunity costs II. Interest expenses III. Incremental cash flows IV. Dividends V. Externalities a. I, III, and V only b. III and IV only c. I, II, and III only d. I, II, and IV only e. All of them are considered relevant cash flows

9 38. As a manager, you are faced with the following two independent projects. Assuming that your cost of capital is 11%, which project(s), if any, would you choose? (Use NPV method) Cash Flows Time Project A Project B 0-500, , ,000 75, , , , , , ,000 a. Neither A nor B b. Project A only c. Project B only d. Both A and B 39. Davidson Inc. is considering investing in a project that will require an initial investment of $100,000 and will produce after tax cash flows of $28,000 per year for five years. Assuming Davidson s WACC is 8%, what is the project s net present value (round to the nearest dollar)? a. $11,313 b. $11,796 c. $12,345 d. $12, Tattersall Clothiers plans to issue 6-year bonds with a par value of $1000 and an 8% coupon paid quarterly. Based on current market conditions, they expect that these bonds will sell for $1070. Given this information, what is Tattersall s expected, after-tax cost of debt assuming they are in a 30% tax bracket? a. 4.72% b. 5.61% c. 6.57% d. 8.23% 41. The DuPont ratio separates ROE into three components. Using the DuPont method and assuming turnover and profit margin are held constant, decreasing the leverage (amount of debt) of the firm would affect the ROE in which way? a. Decrease ROE b. Increase ROE c. Remain unchanged d. The DuPont ratio does not consider leverage 42. A $1000 par bond pays a $20 coupon payment per quarter. What is the bond s coupon rate? a. $20 b. $80 c. 2% d. 8%

10 43. Commercial banks have an average equity multiplier of If their average ROA of is roughly 1.2%, what is the average ROE for commercial banks? a % b % c % d % 44. If markets rate decrease from 6% to 5%, what is the percent change in the price of a 5-year, $1000 par, zero-coupon bond? a. Decrease 4.85% b. Decrease 5.21% c. Increase 4.85% d. Increase 5.21% 45. A bank advertises that it pays 6.9% per year, compounded daily on its savings accounts. What is the effective annual rate (EAR) paid by the bank? Assume 365 days in a year. a. 7.01% b. 7.14% c. 7.89% d. 8.14% e. 8.51% 46. A common-size income statement sheet helps financial managers determine: a. Which customers are paying on a timely basis. b. If costs are increasing faster or slower than sales c. If changes are occurring in a firm s asset composition (asset mix). d. If a firm is generating more or less sales per dollar of assets than in prior years. e. The rate at which the firm s dividends are changing. 47. An increase in a profitable firm s depreciation expense would affect the firm in which of the following ways? a. Reduce taxes b. Increase net income c. Increase net fixed assets d. Decrease net working capital e. Increasing depreciation expense would have no effect 48. What is the price of a stock if the required return is 11% and the most recent dividend amount (which is paid annually) is $1.75? a. $14.65 b. $14.89 c. $15.32 d. $15.91

11 49. Which of the following actions is most likely to directly decrease cash as shown on a firm s balance sheet? b. The firm sells some of its plant and equipment at book value. c. The firm makes a large profit for the year. d. Managers cut the dividends paid by the firm. e. The firm repurchases $2 million of its common stock. 50. The present value of an investment is $18,633. The investment pays $5,000 in year one, $8,000 in year two, and some amount in year three. If the discount rate used to value the investment is 8%, what is the amount of the cash flow in year three (round to the nearest dollar)? a. $8,750 b. $9,000 c. $9,250 d. $9, If a firm manager wanted to know how well the firm could meet its short-term obligations, they would examine the firm s: a. Activity ratios b. Efficiency ratios c. Profitability ratios d. Liquidity ratios e. None of the above 52. You estimate the following free-cash flow data for MAGA Inc. (in millions). The firm s long-term growth will be 4% per year after year three and the firm s required return on equity is 9%. MAGA has $106 million in total debt and preferred stock and 10 million shares outstanding. Using the corporate valuation model, what is the intrinsic price of one share of MAGA? (Round at the end) Free Cash flows -$5 $10 $15 a. $14.16 b. $14.54 c. $14.87 d. $15.03 e. $Not enough information

12 Answer Key 1. D 2. D 3. A 4. A 5. D 6. C 7. A 8. D 9. C 10. D 11. A 12. E 13. D 14. A 15. C 16. D 17. B 18. B 19. A 20. D 21. B 22. D 23. D 24. C 25. B 26. C 27. A 28. C 29. D 30. C 31. B 32. A 33. B 34. C 35. D 36. A 37. A 38. A 39. B 40. A 41. A 42. D 43. A 44. C 45. B 46. B 47. A 48. D 49. E 50. B 51. D 52. D

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