FIn504 final quiz 1

1. Which of the following is/are TRUE?

I. The net present value method assumes that cash flows are reinvested at the computed internal rate of return, whereas the internal rate of return method assumes that cash flows are reinvested at the firm’s cost of capital.
II. The payback period of an investment is defined as the number of years required for the cumulative cash flows from a project to equal the initial outlay. (Points : 3.7)

Question 2. 2.Which of the following is/are TRUE?

I. Perfectly negatively correlated describes two negatively correlated stocks that have a correlation coefficient of -1.
II. With a perfect positive correlation of returns between two securities, there will always be some proportion of the securities that will result in the complete elimination of portfolio risk.
III. Assume that capital asset pricing model holds. Then, a security whose expected return falls above the SML (security market line) indicates that the security is overvalued, whereas a security whose expected return falls below the SML indicates that the security is undervalued.
(Points : 3.7)

Question 3. 3.Which of the following is/are TRUE?

I. The systematic risk is diversifiable.
II. The efficient portfolios provide the lowest possible return for a given level of risk (i.e., for a given standard deviation).
III. With the ability to borrow and lend at the risk-free rate, there is one BEST efficient risky portfolio to hold, the tangency portfolio (identified by the tangent point of the capital market line and the efficient frontier). (Points : 3.7)

Question 4. 4.Which of the following is/are TRUE?

I. The security market line can be thought of as expressing relationships between expected required rates of return and beta.
II. The beta of the market portfolio is 0.
III. A stock with a beta of zero would be expected to have a rate of return equal to zero.
IV. On the capital market line (CML), any risk-return combination beyond the Market Portfolio (m) is obtained by borrowing money at risk-free rate and investing the borrowed amount at the tangency portfolio, m (i.e., market portfolio).
(Points : 3.7)

Question 5. 5.Which of the following is/are FALSE?

I. A firm's leveraged beta will always be greater than its unleveraged beta.
II. The larger the amount of debt in a firm's capital structure, the greater will be the firm's leveraged beta. (Points : 3.7)

Question 6. 6.Which of the following is/are FALSE?

I. The standard deviation of a portfolio of two or more securities is always equal to the weighted average of the standard deviation of each of the individual securities in the portfolio.
II. A beta value of 2.0 for a security indicates the security has greater-than-average systematic risk, and, in this case, it indicates the security is twice as risky as market.
III. A beta value of 0.5 for a security the security has below-average systematic risk, and, in this case, it indicates the security is half as risky as market. (Points : 3.7)

Question 7. 7.The expected return for Asset S is 30%, and it has a standard deviation of 12%. The expected return for Asset T is 17%, and it has a standard deviation of 7%. Which of the following is a CORRECT statement? (Points : 3.7)

Question 8. 8.Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent. Faris' tax rate is 40 percent. What will be Faris' weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent? (Points : 3.7)

Question 9. 9.The following financial information is available on Global Enterprises:

Current per share market price: $12.25
Current (t = 0) per share dividend: $2.00
Expected long-term growth rate: 9.5%

Global can issue new common stock to net the company $10.50 per share. Determine the cost of external equity capital using the dividend capitalization model approach (i.e., constant dividend growth valuation model).
(Points : 3.7)

Question 10. 10.Dunkin Industries sold a 15 year $1,000 face value bond with a 10.5 percent coupon rate. Interest is paid annually. After flotation costs, Dunkin received $920 per bond. Compute the after-tax cost of debt for these bonds if the firm's marginal tax rate is 28 percent. (Points : 3.7)

Question 11. 11.Calculate the after-tax cost of preferred stock for Marriot Hotel Corporation, which is planning to sell $200 million of $4.15 cumulative preferred stock to the public at a price of $45 per share. Flotation costs are $2.50 per share. Marriot has a marginal income tax rate of 40%. (Points : 3.7)

Question 12. 12.Wilson Electric is planning a $100 million expansion. This expansion will be financed, in part with debt issued with a coupon interest rate of 8.27%. The bonds have a 20-year maturity and a $1000 face value, and they will be sold to net Wilson Electric $996 after issue costs. Wilson Electric’s marginal tax rate is 40%.

Preferred stock will cost Wilson Electric 12% after tax. Wilson Electric’s common stock pays a dividend of $2 per share. The current market price per share is $25, and new share can be sold to net $24 per share. Wilson Electric’s dividends are expected to increase at an annual rate of 5% for the foreseeable future. Wilson Electric expects to have $20 million of retained earnings available to finance the expansion.

Wilson Electric’s target capital structure is as follows:

Debt 25%
Preferred Stock 10%
Common Equity 65%

Calculate the weighted average cost of capital that is appropriate to use in evaluating this expansion program.
(Points : 3.7)

Question 13. 13.The net present value of a project is normally distributed with an expected value of $1,258,900 and a standard deviation of $960,850. Determine the probability that the project will have a net present value of less than zero. (Points : 3.7)

Question 14. 14.The stock of Milton, Inc., is expected to return 22% annually with a standard deviation of 8%. The stock of Eaton, Inc., is expected to return 24% annually with a standard deviation of 12%. The beta of the Milton stock is 1.50, and the beta of the Eaton stock is 2.2. The risk-free rate of return is expected to be 3%, but the return on the market portfolio is 14%.
Based on the Security Market Line (SML), what are the required rates of return for Milton and Eaton respectively given the current market situation? (Points : 3.7)

Question 15. 15.Continued from Question 14, which one is a better buy in the current market? (Points : 3.7)

Question 16. 16.An investor plans to invest 75 percent of her funds in the common stock of Mickey Company and 25 percent in Mini Company. The expected return on Mickey is 16 percent and the expected return on Mini is 12 percent. The standard deviation of returns for Mickey is 20 percent and for Mini is 15 percent. The correlation between the returns for Mickey and Mini is -0.4 (negative 0.4). Determine the standard deviation of returns for this investor's portfolio. (Points : 3.7)

Question 17. 17.Seattle Best Company common stock is currently selling for $40 per share. Security analysts at Goldman Sachs have assigned the following probability distribution to the price of (and rate of return on) Seattle Best stock one year from now:

Price Rate of Return Probability
$35 -12.5% 0.55
$45 12.5% 0.30
$55 +37.5% 0.13
$65 +62.5% 0.02
Assuming that Seattle Best is not expected to pay any dividends during the coming year, determine the expected rate of return on Seattle Best Stock. (Points : 3.7)

Question 18. 18.Technico plans to start a new product division that will have a capital structure of 60 percent debt and 40 percent equity. The levered beta for this division has been estimated to be 2.10. What will be Technico's weighted cost of capital for this new division if the after-tax cost of debt is 16 percent, the risk-free rate is 3 percent, and the market risk premium is 10 percent? (Points : 3.7)

Question 19. 19.Husky Inc. is considering a capital expansion project. The initial investment of undertaking this project is $114,500. This expansion project will last for five years. The net operating cash flows from the expansion project at the end of year 1, 2, 3, 4 and 5 are estimated to be $19,850, $24,780, $33,960, $51,236 and $55,780 respectively.

Husky has a capital structure consisting of 20% debt and 80% equity. The after-tax cost of debt is 16% and the cost of equity is 18.5%.

What is Husky’s weighted average cost of capital (WACC)? (Points : 3.7)

Question 20. 20.Continued from Question 19, based on Husky’s weighted average cost of capital calculated, what is the NPV of undertaking this expansion project? That is, what is the NPV if the weighted average cost of capital is used as the discount rate? Shall Husky undertake the investment project? (Points : 3.7)

Question 21. 21.Continued from Question 19, based on Husky’s weighted average cost of capital calculated, what is the profitability index (PI)of undertaking this project? That is, what is the profitability index if the weighted average cost of capital is used as the discount rate? Shall Husky undertake the investment project? (Points : 3.7)

Question 22. 22.Continued from Question 19, what is the internal rate of return (IRR) if Husky undertakes this project? Based on the IRR, shall Husky undertake this investment project assuming the weighted average cost of capital (calculated in Question 19) is the appropriate discount rate for the capital budgeting problems considered. (Points : 3.7)

Question 23. 23.Continued from Question 19, what is the modified internal rate of return if Husky undertakes this project. Assuming that the positive cash inflow from undertaking this project will be reinvested at the weighted average cost of capital calculated in Question 19. (Points : 3.7)

Question 24. 24.Kleenex is a multi-divisional utility company. Kleenex has four divisions with the following betas and proportions of the firm's total assets:

Division Beta % of Assets
Electric & Gas 1.28 25
Bus transportation 2.15 36
Real estate 0.76 15
Recreation 1.35 24

What is the firm's weighted average beta? (Points : 3.7)

Question 25. 25.Wentworth Limited, a large conglomerate firm, plans to build a new toll way. The cost (NINV) of the project is expected to be $2 billion. Net cash inflows are expected to equal $550 million per year. How many years must the firm generate this cash inflow stream for investors to earn their required 22 percent rate of return? (Points : 3.7)

Question 26. 26.An acre planted with walnut trees is estimated to be worth $1,767,950 in 50 years. If you want to realize a 28 percent rate of return on your investment, how much can you afford to invest per acre? (Ignore all taxes and assume the annual cash outlays to maintain your stand of walnut tree are nil.) (Points : 3.7)

Question 27. 27.Cranberry Manufacturing Company is considering an asset replacement project of replacing a control device. This old control device has been fully depreciated but can be sold for $4,000. The new control device, which is more automated, will cost $22,000. The new device’s installation and shipping costs will total $10,000. The new device will be depreciated on a straight-line basis over its 2-year economic life to an estimated salvage value of $0. The actual salvage value of this device at the end of 2-year period (That is, the market value of the device at the end of 2-year period) is estimated to be $3,000. If the replacement project is accepted, Cranberry will require an initial working capital investment of $3,000 (that is, adding $3,000 initially to its net working capital).

During the 1^st year of operations, Cranberry expects its annual revenue to increase from $65,500 to $85,000. After the 1^st year, revenues from the replacement are expected to increase at a rate of $2,200 a year for the remainder of the project life.

Cranberry's incremental operating costs associated with the replacement project are expected to decrease from $20,000 to $12,000 during the 1^st year and increase at a rate of $2500 for the remainder of the project life.

Cranberry expects that it will have to add about $2,000 to its net working capital in year 1, and nothing in year 2. At the end of the project, the total accumulated net working capital required by the project will be recovered.

Cranberry has a marginal tax rate of 35%. What is the initial net investment for Cranberry to undertake this replacement project?

(Points : 3.7)

Question 28. 28.Continued from Question 27, what is the net operating cash flow at the end of year 1? (Points : 3.7)

Question 29. 29.Continued from Question 27, what is the net operating cash flow at the end of year 2? (Points : 3.7)

Question 30. 30.The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The initial outlay required is $22 million. Net cash flows over the 4-year life cycle and the corresponding certainty-equivalents of the new model are as follows:

Year Net Cash Flow Certainty-equivalent Factor
1 $15 million 0.90
2 $13 million 0.75
3 $11 million 0.55
4 $ 9 million 0.30

The firm's cost of capital is 14% and the risk-free rate is 6%. Bull uses the certainty-equivalent approach in evaluating above-average risk investments such as this one. What is the project's certainty-equivalent NPV? (Points : 3.7)

Question 31. 31.Cranberry Industries, Inc. is in the process of determining its optimal capital budget for next year. The following investment projects are under consideration:

Required Expected Rate
Project Investment of Return
A $5 million 18.0%
B 5 million 15.0%
C 2 million 14.5%
D 2 million 14.0%
E 6 million 13.5%
F 3 million 13.0%
G 5 million 12.5%

The firm's marginal cost of capital schedule is as follows:

Amount of
Funds Raised Cost
$0 - $5 million 12.0%
$5 million - $10 million 12.5%
$10 million - $18 million 13.5%
Over $18 million 15.0%

(Points : 3.7)

Question 32. 32.An investor currently has all of his wealth in Treasury bills. He is considering investing 80% of his funds in General Electric, whose beta is 4.50, with the remainder left in Treasury bills. GE has an expected return of 25% and Treasury bills have an expected return of 2%. What are the investor’s portfolio beta and portfolio expected return? (Points : 3.7)

Question 33. 33.Using the profitability index, which of the following mutually exclusive projects should be accepted?
Project A: NPV = -$14,387; NINV = $38,260
Project B: NPV = $9,541; NINV = $11,500
Project C: NPV = $78,121; NINV = $99,710 (Points : 3.7)