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

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1 MIME 310 ENGINEERING ECONOMY P R A C T I C E E X A M A P R I L 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 period to complete the exam Don't do the exam with friends; pretend that you're in a real examination room, sitting right in front of an invigilator. Don't lose precious time trying to find the solutions or answers in the notes, solutions to the problem exercises or tutorial problems. When finished, attend the review on Thursday, 10 April, at 16:00 in 304 ENGMC to check your answers, or look up the solutions on WebCT after the review. Congratulate yourself on the good score, and be assured that you have maximised the benefits derived from this exercise.

2 PART 1. True or False Statements Circle the correct answer on this paper and record it on the computer answer sheet. (1.5 points each for a total of 18) Note: There are no penalties for incorrect answers. 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. 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. 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. 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. 5. In the Canadian tax system, assets belonging to the same class depreciated by the declining-balance method are grouped into pools and depreciated together. 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. 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 absorbed by other taxable corporate income of the company. 8. A change in supply to higher levels is reflected by a vertical upward shift of the supply curve. 9. The law of diminishing marginal returns states that decreasing amounts of output are inevitably obtained from successive additions of equal amounts of variable input in a system where fixed resources have achieved their optimum efficiency. 10. When using the capital tax factor on a capital expenditure, it is assumed that the depreciation allowances can be fully absorbed (i.e. there is enough net income before allowances and taxes) in the year in which they are claimed. 1

3 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. 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). PART 2. Financial Statements with Multiple-choice Answers Circle the correct answer on this paper and record it on the computer answer sheet. (2 points each for a total of 10) Note: There are no penalties for incorrect answers. Use the following information to answer questions 13 to 17. BJL, Inc. Income Statement for 1999 (in millions of $) 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: Taxes 156 Net income 363 Addition to retained earnings 254 Dividends paid 109 BJL, Inc. 12/31/98 and 12/31/99 Balance Sheets (in millions of $) Cash Accounts payable Accounts receivable Notes payable Inventory Total Total Long-term debt Net fixed assets Shareholders equity Common stock Retained earnings Total Total Assets $2 446 $2 660 Total Liab. & S.E. $2 446 $2 660 Note: Each bond has a face value of $1000 and the additional bonds were issued on the first day of

4 13. What was the firm's inventory turnover ratio for 1999? A) (1.42) B) 1.42 C) 1.47 D) Determine the cash flow from financing activities for 1999 (in $ mil.) [consider appropriate income statement entries and changes in all balance sheet accounts except the cash account]. A) ($99) B) $50 C) $30 D) $ If the firm had 180 million shares of common stock outstanding at the end of 1999, what was the dividend per common share? A) $0.50 B) $0.61 C) $1.41 D) $1.83 E) $ 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) $ 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 % PART 3. Problems with Multiple-choice Answers Circle the correct answer on this paper and record it on the computer answer sheet. (3 points each for a total of 21) Note: There are no penalties for incorrect answers. 18. 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: 3

5 A) $15 B) $4 C) $11 D) $ 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) $ Use the following information to answer questions 20 to 22. 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 Bonds 1 million shares outstanding with a market value of $40 per share, an expected dividend yield (D 1 /P) of 10% this year, and an expected annual dividend growth rate of 5.9% bonds outstanding with a face value of $1000 each, an 8% annual coupon, 12 years to maturity and a market price of $1105 per bond. WBM s corporate income tax rate is 34%. 20. WBM s after-tax cost of existing common equity capital Is: A) 5.9 % B) 10.0 % C) 15.9 % D) 10.5 %. 21. WBM s after-tax cost of existing debt capital is: A) 4.2 % B) 6.7 % C) 8.0 % D) 4.4 %. 4

6 22. Assuming before-tax costs of 8% and 15% for debt and equity capital, respectively, WBM s cost of capital is: A) 8.4 % B) 8.9 % C) 11.8 % D) 12.9 %. 23. 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, what will be the market value of the bond five years from now? A) $ B) $ C) $ D) $ E) $ You have to choose 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 A B Year Cash Flow Cash Flow Time 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. PART 4. Multiple-choice Statements Circle the correct answer on this paper and record it on the computer answer sheet. (2 points each for a total of 14) Note: There are no penalties for incorrect answers. 25. Which one of the following statements illustrates an elastic demand curve? A) A price elasticity measure of zero. B) A 10 % increase in price causes a 20 % decrease in quantity demanded. C) A price elasticity measure of 1.0. D) A price elasticity measure of 0.2. E) A 10 % increase in price causes a 5 % decrease in quantity demanded. 5

7 26. 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. 27. 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 28. 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 29. 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 30. 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 31. If a negative pool balance occurs as a result of the disposal of an asset depreciated by the declining-balance method in the Canadian tax system, then a firm A) can claim the balance as a tax deductible expense B) must add the 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 6

8 PART 5. Problems Requiring Full Solutions 1. The table below reports the average annual current money 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) What is the 1992 copper price expressed in constant money of the year 2000? (2 points) 1.2 What was the average annual compound rate of inflation over the period? (2 points) 1.3 What was the real average annual compound rate of change in the copper price over the period? (4 points) 1.4 If the base year of the implicit price index series is changed from 1986 to 1996, determine the revised index for the year (2 points) 2. 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 given in question 1 above (assume year-end), determine the net present value of this 4-year project given that it operated in years 1995 to (10 points) 7

9 3. A project has the following specifications: Preproduction period (yrs) 2 Production period (yrs) 5 Preproduction investment (mil. $) Capital expenditure incurred over year 1 25 Capital expenditure incurred over year 2 40 Working capital 6 Projected annual revenues (mil. $) 60 Projected annual operating expenses (mil. $) 24 Projected salvage value (mil. $) 10 For tax purposes, capital expenditures are to be depreciated by the straight-line method at a rate of 20 percent per year (do not use the half-year rule). Assume an integrated company basis of taxation in which: i) a depreciation allowance resulting from a capital expenditure can be claimed in the year in which the expenditure is incurred; ii) depreciation allowances are fully absorbed by other company income. The corporate income tax rate is 40 percent. Any gain (or loss) on the disposal of assets is taxable (or deductible) in the year of disposal. Complete the table below, expressing all monetary values in millions of dollars. For full marks, show how all your values are obtained. (6 marks) SHOW WORK BELOW Cash Flow Calculation Production Year 5 Revenue - Operating expenses Operating profit - Depreciation allowance Taxable income - 40 % Net income Capital expenditure Salvage value Return of working capital Cash Flow 8

10 4. 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 30% per year on a declining-balance basis. The corporate income tax rate is 34% and the cost of capital is 10%. 4.1 Determine the annual after-tax operating and maintenance expenses. (2 points) 4.2 Determine the after-tax salvage value. (2 points) 4.3 Determine the net after-tax capital expenditure (initial cost net of salvage value). (3 points) 4.4 Determine the overall equivalent annual after-tax cost of the machine. (3 points) 9