Exam 4 – Finance 3320 May 10, 2011 Spring 2011

Fourth Examination – Finance 3320 – Spring 2011 (Moore)

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Clearly Fill in the appropriate bubble on the Scantron form for each of the following questions.
Choose the BEST response. There is only one answer per question.

1. Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained
earnings. This same situation is expected to persist in the future. The company uses the CAPM to
calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and
debt. Which of the following events would REDUCE its WACC?
a. The market risk premium declines.
b. The flotation costs associated with issuing new common stock increase.
c. The company’s beta increases.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.

2. Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is
10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s
projects are equally risky, as are all of Division B's projects. However, the projects of Division A are
less risky than those of Division B. Which of the following projects should the firm accept?

a. A Division B project with a 13% return.

b. A Division B project with a 12% return.
c. A Division A project with an 11% return.
d. A Division A project with a 9% return.
e. A Division B project with an 11% return.

3. Which of the following statements is CORRECT?

a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred
stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained
earnings, rs.
c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common
equity, re.
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower
than the after-tax cost of debt.

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Exam 4 – Finance 3320 May 10, 2011 Spring 2011
e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-
tax cost of its debt will fall.

4. Which of the following statements is CORRECT?

a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than
equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company
does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk,
then the company is likely to reject some safe projects that it actually should accept and to accept
some risky projects that it should reject.
d. Because no flotation costs are required to obtain capital as retained earnings, the cost of retained
earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.

5. A company’s perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual
dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of
the issue price. What is the firm's cost of preferred stock?
a. 7.81%
b. 8.22%
c. 8.65%
d. 9.10%
e. 9.56%

6. You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15%
preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%,
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. 9.83%
e. 10.12%

7. TechFin has a target capital structure of 50% debt, 15% preferred, and 35% common equity. The before-
tax cost of debt is 8.70%, the cost of preferred is 10.50%, the cost of equity from retained earnings is
14.70% and the cost of equity from newly issued common stock is 17.40%. What is its WACC if the
Tax rate is assumed 30% and no additional stock needs to be issued?
a. 9.765%
b. 10.220%
c. 10.675%
d. 11.070%
e. 11.980%

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8. TechFin has a target capital structure of 65% debt, 5% preferred, and 30% common equity. The after-tax
cost of debt is 6.09%, the cost of preferred is 10.50%, the cost of equity from retained earnings is
14.70% and the cost of equity from newly issued common stock is 17.40%. If TechFin raises a
combined $240 million of equity to finance a project, how much new debt was also issued (millions)?
a. $40
b. $280
c. $520
d. $560
e. $800

9. Which of the following statements is CORRECT?

a. The MIRR and NPV decision criteria can never conflict.
b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.
c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a
generally more reasonable reinvestment rate assumption.
d. The higher the WACC, the shorter the discounted payback period.
e. The MIRR method assumes that cash flows are reinvested at the crossover rate.

10. Which of the following statements is CORRECT?

a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full
life whereas IRR does not.
b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at
the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is
generally more appropriate.
c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a
project’s full life whereas MIRR does not.
d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the
MIRR is based on undiscounted cash flows.
e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these
two methods always rank mutually exclusive projects in the same order.

11. You are provided the following information regarding cost of capital and project cash flows (5 years):
 NPV = - $6,543.21
 WACC = 9.87%
 Beta = 1.52
 MIRR = 7.65%
 Debt to Equity ratio = 1.23

Which of the following statements must be CORRECT?

a. The required rate of return on equity must be less than 9.87%
b. The project should be accepted because of the leverage ratio.
c. The internal rate of return (IRR) must be greater than 9.87%.
d. The internal rate of return (IRR) must be strictly between WACC and MIRR.
e. The internal rate of return (IRR) must be strictly less than MIRR.

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12. Which of the following statements is CORRECT? Assume that the project being considered has normal
cash flows, with one outflow followed by a series of inflows.
a. A project’s NPV is generally found by compounding the cash inflows at the WACC to find the
terminal value (TV), then discounting the TV at the IRR to find its PV.
b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
c. If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be less than zero.
e. The NPVs of relatively risky projects should be found using relatively low WACCs.

13. Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the
project's discounted payback period?

WACC: 10.00%
Year 0 1 2 3 4
Cash flows -$950 $525 $485 $445 $405

a. 1.61 years
b. 1.79 years
c. 1.88 years
d. 2.22 years
e. 2.44 years

14. Ingram Electric Products is considering a project that has the following cash flow and WACC data.
What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even
negative), in which case it will be rejected.

WACC: 11.00%
Year 0 1 2 3
Cash flows -$800 $350 $350 $350

a. 8.86%
b. 9.84%
c. 10.94%
d. 12.15%
e. 13.50%

15. Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the
project's payback period?

WACC: 10.00%
Year 0 1 2 3 4
Cash flows -$950 $525 $485 $445 $405

a. 1.61 years
b. 1.79 years
c. 1.88 years
d. 2.22 years
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e. 2.44 years

16. Barry Company is considering a project that has the following cash flow and WACC data. What is the
project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected.

WACC: 12.00%
Year 0 1 2 3 4 5
Cash flows -$1,100 $400 $390 $380 $370 $360
a. $250.15
b. $277.94
c. $305.73
d. $336.31
e. $369.94

17. When evaluating a new project, firms should include in the projected cash flows all of the following
EXCEPT:

a. Changes in net working capital attributable to the project.

b. Previous expenditures associated with a market test to determine the feasibility of the project,
provided those costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product, provided that decline is directly attributable to this
project.
e. The salvage value of assets used for the project that will be recovered at the end of the project’s life.

18. Thomson Media is considering some new equipment whose data are shown below. The equipment has a
4-year tax life and would be fully depreciated by the straight-line method over 4 years, but it would have
a positive pre-tax salvage value at the end of Year 4, when the project would be closed down. Also,
some new working capital would be required, but it would be recovered at the end of the project's life.
Revenues and other operating costs are expected to be constant over the project's 4-year life.

WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Cost of Last Year’s Project Feasibility Study $25,000
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%

Compute the decision-relevant Year 4 after-tax cash flows. (ALL cash flows in year 4)
a. $35,375
b. $38,625
c. $45,375
d. $48,625
e. $50,375

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19. Thomson Media is considering some new equipment whose data are shown below. The equipment has a
4-year tax life and would be fully depreciated by the straight-line method over 4 years, but it would have
a positive pre-tax salvage value at the end of Year 4, when the project would be closed down. Also,
some new working capital would be required, but it would be recovered at the end of the project's life.
Revenues and other operating costs are expected to be constant over the project's 4-year life.

WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Cost of Last Year’s Project Feasibility Study $25,000
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%

Compute the decision-relevant Time 0 initial after-tax cash outflows.

a. $25,000
b. $70,000
c. $80,000
d. $95,000
e. $105,000

20. Thomson Media is considering some new equipment whose data are shown below. The equipment has a
4-year tax life and would be fully depreciated by the straight-line method over 4 years, but it would have
a positive pre-tax salvage value at the end of Year 4, when the project would be closed down. Also,
some new working capital would be required, but it would be recovered at the end of the project's life.
Revenues and other operating costs are expected to be constant over the project's 4-year life.

WACC 10.0%
Net investment in fixed assets (depreciable basis) $70,000
Required new working capital $10,000
Cost of Last Year’s Project Feasibility Study $25,000
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $30,000
Expected pretax salvage value $5,000
Tax rate 35.0%

Compute the decision-relevant Year 2 after-tax cash flows.

a. $27,125
b. $29,250
c. $33,575
d. $35,375
e. $46,750

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21. Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The
machine has a tax life of 5 years, and it can be depreciated according to the following rates. The firm
expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is
40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

Year Depreciation Rate

1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06
a. $8,878
b. $9,345
c. $9,837
d. $10,355
e. $10,900

22. Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of
$10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and
$7,900 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax
cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 8%. Use the
replacement chain approach to determine the NPV of the most profitable project.

a. $4,242
b. $4,246
c. $4,286
d. $4,325
e. $4,433

23. Foley Systems is considering a new investment whose data are shown below. The equipment would be
depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and
would require some additional working capital that would be recovered at the end of the project's life.
Revenues and other operating costs are expected to be constant over the project's life. What is the
project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)

WACC 10.0%
Net investment in fixed assets (basis) $75,000
Required new working capital $15,000
Straight-line deprec. rate 33.333%
Sales revenues, each year $75,000
Operating costs (excl. deprec.), each year $25,000
Tax rate 35.0%

a. $23,852
b. $25,045
c. $26,297
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Exam 4 – Finance 3320 May 10, 2011 Spring 2011
d. $27,612
e. $28,993
24. Which of the following statements concerning risk management is NOT CORRECT?
a. Risk management can reduce the volatility of cash flows, and this decreases the probability of
bankruptcy.
b. Risk management makes sense for firms directly engaged in activities that involve commodities
whose values can be hedged, and it doesn't make much sense for most other firms.
c. Companies with volatile earnings pay more taxes than more stable companies due to the treatment of
tax credits and the rules governing corporate loss carry-forwards and carry-backs. Therefore, our tax
system encourages risk management to stabilize earnings.
d. Risk management can reduce the likelihood of low cash flows, and therefore reduce the probability
of financial distress.
e. Risk management involves identifying events that could have adverse financial consequences and
then taking actions to prevent and/or to minimize the damage caused by these events.

25. Which of the following statements is the most CORRECT?

a. One advantage of forward contracts is that they are default free.
b. Futures contracts generally trade on an organized exchange and are marked to market daily.
c. Goods are never delivered with forward contracts, but are almost always delivered with futures.
d. Forward contracts are generally standardized instruments, whereas futures contracts are generally
tailor-made for the 2 parties of the contract.
e. Essentially there are no differences between forward and futures contracts, except that forward
contracts are used only for financial assets while futures contracts are used only for commodities.

Use the Option Quote information on the last page of this exam to answer the next two questions (26-27)

Basic information for questions 26 and 27.

Assume that it is 3:15 in the afternoon on May 9, 2011 and that you can transact at the quoted option prices for
Google. You believe that Google shares are going to change by at least $100 during the next 9 months and
decide to take an option position in Google. You write 3 January 2012 Call contracts with a strike price of $450
and write 3 January 2012 Put contracts with a $650 strike price.

26. Given the above information, how much money do you spend or receive when you open the option
position on May 9, 2011?
a. Spend $703.80
b. Receive $703.80
c. Receive $23,460.00
d. Spend $70,380.00
e. Receive $70,380.00

27. Assume that Google’s stock price is $648.33 at the close of business on January 20, 2012 and that your
positions are closed either with the options expiring or being exercised. Without considering the cost
or revenue from the options in May 2011, how much do you receive/spend on January 20, 2012 if the
optional exercise/expiration of the options is made? If a person exercising the call option, he/she will
buy at the strike price and sell at the current stock price of $648.33. Likewise, the person exercising the
put option will sell at the strike price and buy shares to deliver at $648.33. Otherwise, the options expire
unexercised.
a. $501.00 spent
b. $501.00 received
c. $59,499.00 spent
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Exam 4 – Finance 3320 May 10, 2011 Spring 2011
d. $60,000.00 received
e. $60,000.00 spent

Use the following information for questions (28-30)

You operate Burgers and Belts, a chain of hamburger and leather good stands located on Interstate 40 between
Albuquerque, NM and Tulsa, OK. Your main cost is the live cattle you turn into hamburger, belts and boots.
The volatility of beef prices has impacted your profits the past 3 years. In June of 2010 your forecast using
220,000 pounds of Beef during July of 2011 and you used Live Cattle futures contracts that expire at the end of
June 2011 to guarantee your supply of beef when the futures price for this contract was 92.05 (92.05 cents per
pound).

A Live Cattle (LC) futures contract on the Chicago Mercantile Exchange covers 40,000 pounds of live steer
(beef cows) and is quoted in cents per pound. The closest delivery point for Burgers and Belts is Amarillo, TX.
Margin requirements are $1,620 (US dollars) per futures contract.

28. Which is the optimal futures position assuming you desire the maximum insurance on your hamburger
beef needs without over-hedging your budgeted requirements?

a. Short 5 Contracts
b. Short 6 Contracts
c. Long 5.5 Contracts
d. Long 5 Contracts
e. Long 6 Contracts

29. How much margin must you deposit or receive when you open the futures position?

a. Deposit $1,620
b. Deposit $8,100
c. Deposit $8,910
d. Deposit $9,720
e. Deposit $40,000

30. Assume that at expiration, the June 2011 Live Cattle futures contract is quoted at 110.775 cents per
pound and that you close out your position by netting at this price. What is your gain or loss on the
Futures contract position when you close?

a. $44,940.00 loss
b. $37,450.00 loss
c. $44,940.00 gain
d. $41,195.00 gain
e. $37,450.00 gain

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