Finance Final Quiz Summer 2014

1. Which of the following statements is correct?
a. If companies have fewer good investment opportunities, interest rates are likely to
increase.
b. If individuals increase their savings rate, interest rates are likely to increase.
c. If expected inflation increases, interest rates are likely to increase.
d. Interest rates on all debt securities tend to rise during recessions because recessions
increase the possibility of bankruptcy, hence the riskiness of all debt securities.
2. If 10 – year T-bonds have a yield of 6.3%, 10 – year corporate bonds yield 7.7%, and
corporate bonds have a 0.2% liquidity premium versus a zero liquidity premium for tbonds, what is the default risk premium on the corporate bond?
3. The McCurry Company's bonds mature in 12 years have a par value of $1,000 and an annual
coupon payment of $90. The market interest rate for the bonds is 12%. What is the price
of these bonds?
4. John Jacob Inc's bonds currently sell for $1,250 and have a par value of $1,000. They pay an
$80 annual coupon and have a 25-year maturity, but they can be called in 10 years at
$1,100. What is their yield to maturity (YTM)?
5. Stickle Inc's bonds currently sell for $1,275 and have a par value of $1,000. They pay an $80
annual coupon and have a 20-year maturity, but they can be called in 5 years at $1,080. What is
their yield to call (YTC)?
6. A stock just paid a dividend of $1.25. The required rate of return is rs = 14%, and the constant
growth rate is 7%. What is the current stock price?
7. Johnny Walker Inc plans to issue preferred stock with a perpetual annual dividend of $1.10 per
share and a par value of $15. If the required return on this stock is currently 10%, what should be the
stock’s market value?
8. If D1 = $2.00, g (which is constant) = 6%, and P0 = $70, what is the stock’s expected total return
for the coming year?
9. The Parker Alan Company's last dividend was $1.20. Its dividend growth rate is expected to be
constant at 20% for 3 years, after which dividends are expected to grow at a rate of 8% forever.
Connors’ required return (rs) is 12%. What is Connors’ current stock price?
10. If a stock’s expected return exceeds its required return, this suggests that
a. The stock should be sold.
b. The company is probably not trying to maximize price per share.
c. The stock is probably a good buy.
d. Dividends are not being declared.

Question 11-20
I recommend using an excel spreadsheet and first calculate your cash flows over the life time of
the Death Star. In addition, you don’t need the CAPM, but simply calculation the return for the
stock based upon the information. Each section is worth five points. I will be here early next
week for questions and can work together to finish this question, just attempt to finish as
much as possible, or at least have the problem mapped out. In addition, I can entertain some
email questions if necessary. Good luck!
The Empire is planning to create the first ever Death Star. Darth Vader, the Emperor’s right hand
man and the manager of the project, has asked you to evaluate the project. Here is some of the
information that you will need to evaluate the project. The equipment would cost around IC
100,000 (where IC is the imperial credit) plus IC 60,000 more for installation. In order to operate
the Death Star, working capital has to increase by IC 40,000 which will be recovered at the end
of the project. As the Emperor has foreseen it, the project is expected to last 4 years after which
the equipment will be destroyed by the Rebellion. However, some parts of the project will be
salvaged and sold for IC 20,000 to the Ewoks. Depreciation will be based on straight-line
method with zero salvaged value. Each planet that Darth Vader destroys will cost the empire IC
10,000 but at the same time it will bring in IC 25,000 per planet destroyed from other fearing
planets. Each year the empire plans to destroy 10 planets. The Death Star is a big-machine and
therefore will incur a fixed cost of IC 75,000 to operate each year. In order to set an example, the
Empire Department of Tax will charge a 40% tax rate on the Death Star; however they will give
tax shield for borrowing money.

To finance this project, the Empire will borrow 40% of the initial outlay from the Banking Clan
at a pre-tax rate of 12.50%. The other 60% will come by selling equity to the Separatist Group.
The selling price per share of the Empire is IC 100 and is expected to grow at the constant rate of
11.67% forever. The next dividend will be of IC 5. The lenders of the capital require high rate of
return because this is a risky project and has never been done before.
What is your recommendation of the Death Star project to Darth Vader? Show your work. If you
believe that you cannot do this analysis, Darth Vader has given you the following warning: “I
find your lack of faith disturbing.”
11. What is the initial outlay for the project? (Hint: Add increase in working capital.)
12. What is the per year depreciation expense? (Hint: Do not count the NOWC.)
13. What is the after-tax salvage value of the equipment? (Hint: Remember that the book
value of the equipment at the end of the project is zero.)
14. What are the cash flows for all 4 years? (Hint: Cash flows for year 1, 2, and 3 will be
same. For the fourth year, add the NOWC and after-tax salvage value of the equipment.)
15. What is the after tax cost of debt?
16. What is the cost of equity? (Hint: See directions for hint.)
17. Given the financing need of the Empire, what is WACC?
18. Based on WACC, what is the NPV of the project?
19. What is the IRR of the project?

20. What is your recommendation to Darth Vader? (Remember Darth Vader doesn’t like simple answer, you need to provide proper explanation)