M I M E 310 E N G I N E E R I N G E C O N O M Y Class Test #2 Thursday, 15 November, 2007 90 minutes PRINT your family name / initial and record your student ID number in the spaces provided below. FAMILY NAME / INITIAL S O L U T I O N S STUDENT ID # This test consists of 18 multiple-choice questions, and two problems requiring ing a full solution. The multiple-choice question are worth a total of 80 points. There are no penalties for incorrect answers. The problems are worth a total of 20 points. MULTIPLE-CHOICE QUESTIONS Circle the correct answer on this test paper and record it on the computer answer sheet. Multiple-choice Statements Circle the correct answer on this paper and record it on the computer answer sheet. (3 points each for a total of 15) Note: There are no penalties for incorrect answers. 1. Holmes Aircraft recently announced an increase in its net income, yet its cash flow declined relative to last year. Which one of the following reasons could explain this? A) The company s interest expense increased. B) The company s depreciation expenses decreased. 47% C) The company s operating income decreased. D) All of the statements above are possible reasons. E) None of the statements above are possible reasons. 2. In the micro-economic theory of the business firm, profits per period are maximised at the production rate at which: A) Marginal cost equals marginal revenue. B) Average cost is minimised. 24% C) Marginal cost is minimised. D) Marginal cost equals unit selling price E) Both statements A and D are correct. Proportion of correct answers 1
3. Which capital investment evaluation technique is described by the following characteristics? (1) Easy to understand and communicate; (2) May result in multiple answers; (3) May lead to incorrect decisions when applied to mutually exclusive investment projects. A) Net present value B) Internal rate of return 59% C) Accounting rate of return D) Payback period E) Discounted payback period 4. When projects are mutually exclusive, A) they can only be accepted if capital funds are limited. B) the selection of one project excludes the selection of all other projects. 86% C) the selection of one project is not affected by either the selection or rejection of another. D) the present value ratio should be used to rank the projects. E) the firm can decide to proceed with as many projects as possible. 5. An increase in the financial leverage of a firm as a result of an increase in long-term debt the potential reward to common shareholders while the risk of financial distress or bankruptcy. A) decreases; decreasing B) increases; decreasing 47% C) increases; increasing D) decreases; increasing E) does not affect; increasing Problems with Multiple-choice Answers Circle the correct answer on this paper and record it on the computer answer sheet. (5 points each for a total of 65) Note: There are no penalties for incorrect answers. 6. Coolidge Cola is forecasting the income statement shown below for the coming year. Sales $30 000 000 Operating costs excluding depreciation 20 000 000 EBITDA $10 000 000 Depreciation 5 000 000 Operating income (EBIT) $ 5 000 000 Interest expense 2 000 000 Taxable income (EBT) $ 3 000 000 Taxes @ 40% 1 200 000 Net income $ 1 800 000 31% If Coolidge s depreciation expense was $8 000 000 instead of $5 000 000, and no capital expenditures are planned, what would be the company s cash flow? A) $2 000 000 B) $4 000 000 C) $6 800 000 D) $8 000 000 E) $9 800 000 With depreciation of $8 mil., EBIT=$2 mil. and EBT=0. Thus, net income is 0 \ CF = 0 + 8 mil. = $8 mil. 2
41% 7. Brooks operating income (EBIT) is $500 000. The company s tax rate is 40 percent and its operating cash flow (i.e. EBIT less income taxes on EBIT and plus depreciation) is $450 000. The company s interest expenses are $100 000. Assuming that depreciation is the only non-cash item in the firm s financial statements and no capital expenditures were incurred, what is the company s cash flow? A) $390 000 B) $550 000 C) $600 000 D) $950 000 E) $1 050 000 EBT: 500 000-100 000 = 400 000 \ Net income: 400 000 (1-0.4) = 240 000 Operating CF: 500 000 (1-0.4) + Depreciation = 450 000 \ Depreciation: 450 000-300 000 = 150 000 CF: 240 000 + 150 000 = $390 000 67% 8. An investment of $3000 today will generate cash flows over a period of 20 years. The project s internal rate of return is 10 percent. The projected cash flows in years 1, 2, and 3 are $100, $200, and $300, respectively. If all equal, what are the projected annual cash flows in years 4 through 20? A) $285.41 B) $313.96 C) $379.89 D) $417.87 E) $459.66 Use the following information to answer questions 9 to 12. Ozark Industries total annual cost (TC) function is: If the project s IRR is 10%, then NPV @10% = 0 PV of known CFs -3000 + 100 / (1.1) + 200 / (1.1) 2 + 300 / (1.1) 3 = -2518.40 \ PV of CF 4 to CF 20 : 2518.40 Move this value to t=3 2518.40 (1.1) 3 = 3352 Convert to annuity: 3352 (A/P,10%,17) = $417.87 TC = FC + 50 R - 5 R 2 + 0.5 R 3 in which TC and FC, the annual fixed costs, are expressed in thousands of dollars per year and R, the annual production rate, is expressed in thousands of units per year. 86% 9. Given that at an annual production rate of 4000 units, the total annual production costs are $252 000, what are the annual fixed costs (FC in the function)? A) $100 000 B) $100 C) -$100 000 D) $2000 E) None of the choices given above TC: FC + 50 (4) - 5 (4 2 ) + 0.5 (4 3 ) = 252 FC + 200-80 + 32 = 252 \ FC = 100 Thus, annual fixed costs are $100 000. 10. At an annual production rate of 5000 units, the average variable cost is: A) $300 B) $37.50 VC: 50 (5) - 5 (5 2 ) + 0.5 (5 3 ) 83% C) $500 250-125 + 62.5 = 187.5 D) $375 \ vc = 187.5 / 5 = $37.50 E) None of the choices given above 3
11. The annual production rate at which the marginal cost is minimised is: 68% A) 3750 B) 3333 MC: 50-10 R + 1.5 R 2 MC minimised at dmc/dr = 0-10 + 3 R = 0 C) 5000 i.e. at R=3.333 D) 4000 Thus, annual production rate is 3333 E) None of the choices given above 12. Given a constant selling price of $66 per unit, at what annual production rate is Ozark s annual before-tax profit maximised? A) 1333 Annual BT profit maximised at rate at which B) 3750 MC=MR. C) 8000 50-10 R + 1.5 R 2 = 66 65% 1.5 R D) 3333 2-10 R - 16 = 0 (1.5 R + 2) (R - 8) = 0 E) None of the choices given above \ R 1 = -1.333 and R 2 = 8 13. Athey Airlines is considering two mutually exclusive projects, Project Jet and Project Prop. The projects have the following cash flows (in millions of dollars): Year Project Jet Project Prop Time 0-4.0? 1 2.0 1.7 2 3.0 3.2 3 5.0 5.8 89% The crossover rate of the projects NPV profiles is 9 percent. Consequently, when the discount rate is 9 percent, the projects have the same NPV. What is Project Prop s cash flow at t=0? A) -$4.221 million B) -$3.494 million C) -$8.732 million D) -$4.511 million E) +$4.000 million NPV Jet @ 9%: Enter CFs in CF worksheet and CPT NPV 4.221 PV Prop of +CFs: Enter +CFs in CF worksheet and CPT NPV 8.732 CF 0 for project Prop: 4.221-8.732 = -$4.511 14. Whitney Cranes Inc. has the following independent investment opportunities for the coming year: Project Initial Investment Annual Cash Inflows Life (years) IRR (%) A $10 000 $11 800 1 B 5 000 3 075 2 15 C 12 000 5 696 3 D 3000 1 009 4 13 Given that the firm has a cost of capital of 12 percent, the IRRs for Projects A and C are, respectively: 4
94% A) 16 % and 14 % B) 18 % and 10 % C) 18 % and 20 % D) 18 % and 13 % E) 16 % and 13 % For project A: With N=1, PV= -10 000, PMT=0 and FV=11 800, CPT I/Y 18.0% (alternatively, set PMT=11 800 and FV=0) For project C: With N=3, PV= -12 000, PMT=5696 and FV=0, CPT I/Y 19.99% 15. Davis Corporation is considering two independent investment opportunities. The corporation has a policy that requires a project to recover its initial capital investment within 3 years. The corporation uses the discounted payback period to assess potential projects and utilises a discount rate of 10 percent. The cash flows for the two projects are: Year Project A Project B Time 0 -$100 000 -$80 000 1 40 000 50 000 2 40 000 20 000 3 40 000 30 000 4 30 000 0 Discounted CFs for project A: -100 000, 36 364, 33 058, 30 053 and 20 490 DCF summation: -100 000, -63 636, -30 579, -526, 19 965 DPP exceeds 3 years Discounted CFs for project B: -80 000, 45 455, 16 529, 22 539 DCF Summation: -80 000, -34 545, -18 016, 4522 DPP less than 3 years 77% In which project(s) should the company invest? A) Project A only B) Neither Project A nor Project B C) Project A and Project B D) Project B only E) Cannot determine because the projects do not have the same lives 16. Hatch Corporation s target capital structure is 40 percent debt, 50 percent common equity, and 10 percent preferred equity. Information regarding the company s cost of capital can be summarized as follows: The company s bonds have a yield to maturity of 6.88 percent and pay interest twice a year. The company s preferred stock has a market price of $42 per share and pays an annual dividend of $4 per share. The company s common stock has a market price of $28 per share, and is expected to pay a dividend of $2 per share at the end of this year. The dividend is expected to grow at a constant annual rate of 7 percent. The firm is able to use retained earnings to fund the common equity portion of its capital budget. The company s corporate tax rate is 40 percent. 44% What is the company s existing weighted-average after-tax cost of capital? A) 9.25 % Effective YTM on bonds: (1 + 0.0344) 2-1 = 7.0% B) 9.70 % K d : 7 (1-0.4) = 4.20% C) 10.03 % K p : 4 / 42 = 9.52% D) 10.59 % K e : 2 / 28 + 0.07 = 14.14% E) 11.30 % WACC: 4.20 (0.4) + 9.52 (0.1) + 14.14 (0.5) = 9.70% 5
Use the following information to answer questions 17 and 18. Byron Corporation s present capital structure, which is also its target capital structure, is 40 percent debt and 60 percent common equity. Assume that the firm has no retained earnings available. The company s earnings and dividends are growing at a constant annual rate of 5 percent, the current dividend was $2.00 per share, and the market price of its common shares is now $21.88 per unit. Byron can raise all the debt financing it needs at a before-tax cost of 14 percent. The cost associated with issuing new common shares amounts to 20 percent of the market price whereas that for issuing new debt amounts to 15 percent of par value. The firm s corporate tax rate is 40 percent. 17. What is the cost of the equity raised by selling new common shares? 53% A) 15.9 % B) 17.0 % C) 16.4 % D) 15.4 % E) 14.1 % K e : 2.00 (1.05) / {21.88 [1-0.2 (1-0.4)]} + 0.05 = 15.9% 34% 18. Byron needs $50 million for a new project. What total monetary amount does the company need to raise in debt and equity capital combined to have the required $50 million once all issuing expenses have been paid? (Note that issuing expenses are tax deductible) A) $50.000 million B) $56.054 miliion C) $60.976 million D) $54.945 million E) $56.818 million Let S represent the total amount of debt and equity to be raised. 0.4 S [1-0.15 (1-0.4)] + 0.6 S [1-0.2 (1-0.4)] = 50 mil. 0.364 S + 0.528 S = 50 S = 56.054 million 6
FULL-SOLUTION PROBLEMS For full marks, show a complete solution on the lines provided and record your answer in the box. 19. A firm with a required return on investment of 15 percent must choose the optimal combination of independent projects from those listed in the table below. Project Initial Investment (t=0) ($) NPV @ 15% ($) A 250 000 10 000 B 300 000 85 000 C 900 000 89 500 D 750 000 180 000 E 700 000 46 000 19.1 Rank the projects in decreasing order of desirability based on the present value ratio or the profitability index. (4 points) PVR = NPV / Initial Investment PVRs: 0.040, 0.283, 0.099, 0.240 and 0.066 PI = PVR + 1 PIs: 1.040, 1.283, 1.099, 1.240 and 1.066 \ ranking: B, D, C, E and A ANSWER Most desirable B, D, C, E, A Least desirable 19.2 Given that the firm has a capital budget of $1 000 000, which projects should be selected to optimise its portfolio? (6 points) Start with B and add A for NPV=95 000, or add E for NPV=131 000 Start with D and add A for NPV=190 000 Start with C for NPV=89 500 Start with E and add A for NPV=56 000, or add B for NPV=131 000 Start with A and add B for NPV=95 000, or add D for NPV=190 000, or add E for NPV=56 000 ANSWER Projects D and A 7
20. A provincial government is considering the construction of a dam to control seasonal floods. Two plans are available. Benefit and cost estimates associated with these plans are as follows: Plan A Plan B Initial investment assume at t=0 ($) 200 000 420 000 Average annual agricultural benefits ($) 16 000 33 000 Annual recreational benefits ($) 1 500 4 000 Annual operating expenses ($) 3 500 7 000 B - A -220 000 17 000 2 500-3 500 Using the benefit-cost ratio criterion and a social discount rate of 7 percent, negligible salvage values for both plans, and a study period of 60 years, which plan is preferable? (10 points) VERSION 1 For mutually exclusive projects, an incremental approach must be used with the BCR. PV of costs: -220 000 + 3500 (P/A,7%,60) = 220 000 + 49 137 = 269 137 PV of benefits: (17 000 + 2500) (P/A,7%,60) = 273 764 BCR: 273 764 / 269 137 = 1.017 As BCR above unity, Plan B is preferable. VERSION 2 B - A For mutually exclusive projects, an incremental approach must be used with the BCR. -220 000 PV of costs: -220 000 + 3500 (P/A,7%,60) = 220 000 + 49 137 = 269 137 16 000 PV of benefits: (16 000 + 2500) (P/A,7%,60) = 259 725 BCR: 259 725 / 269 137 = 0.965 2 500 As BCR below unity, Plan A is preferable. -3 500 ANSWER Plan B This is the last page of the test paper. 8
Answer Key for Version 2 1. C 2. E 3. C 4. D 5. B 6. A 7. C 8. B 9. B 10. D 11. D 12. D 13. A 14. D 15. A 16. E 17. E 18. D Test Question References in the Class Notes, PP Class slides and PP Tutorial slides 1. PP Chapter 2, p. 6, Chapter 6, p. 6 2. PP Chapter 4, p. 32 3. PP Chapter 6, pp. 37, 44-56 4. PP Chapter 6, p. 49, Class Test 2 W04, question 18 5. PP Chapter 5, pp. 47-52 6. PP Chapter 6, p. 6, PP Tutorial 6, pp. 2-3 7. PP Chapter 6, p. 6, PP Tutorial 6, pp. 2-3 8. PP Chapter 6, pp. 37, and TVM functions from Chapter 3 9. PP Chapter 4, pp. 18-21, 26-32 10. PP Chapter 4, pp. 18-21, 26-32 11. PP Chapter 4, pp. 18-21, 26-32 12. PP Chapter 4, pp. 18-21, 26-32, PP Tutorial 4, p. 4 13. PP Chapter 6, pp. 37, 54-55, and TVM functions from Chapter 3 14. PP Chapter 6, pp. 37-40 15. PP Chapter 6, pp. 21-22, PP Tutorial 6, p. 5 16. PP Chapter 5, pp. 57-59, PP Tutorial 5, pp. 11-13 17. PP Chapter 5, pp. 42-43, PP Tutorial 5, pp. 9-10 18. PP Tutorial 5, p. 14, PP Practice Test 2, question 19, Class Test 2 F04, question 15 19. PP Practice Test 2, question 17 20. PP Chapter 6, p. 56, PP Tutorial 6, pp. 13-14 9