Practice Questions:

Q#1: Lion Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit
produced, and its product sells for $4.00 per unit. What is the company's break-even
point, i.e., at what unit sales volume would income equal costs?

Answer: 391,667

Q#2: Your uncle is considering investing in a new company that will produce high quality
stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the
variable cost per unit is estimated to be $75.00; and fixed costs are estimated at
$1,200,000. What sales volume would be required to break even, i.e., to have EBIT =
zero?

Answer: 32,000

Q#3: Assume that you and your brother plan to open a business that will make and sell a
newly designed type of sandal. Two robotic machines are available to make the
sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of
which machine is used. The fixed and variable costs associated with the two machines
are shown below. What is the difference between the break-even points for Machines
A and B? (Hint: Find BEB - BEA)

Machine A Machine B
Price per pair (P) $20.00 $20.00
Fixed costs (F) $25,000 $100,000
Variable cost/unit (V) $7.00 $4.00

Answer: 4,327

Q#4: You work for the CEO of a new company that plans to manufacture and sell a new
product, a watch that has an embedded TV set and a magnifying glass crystal. The
issue now is how to finance the company, with only equity or with a mix of debt and
equity. Expected operating income is $400,000. Other data for the firm are shown
below. How much higher or lower will the firm's expected ROE be if it uses some debt
rather than all equity, i.e., what is ROEL - ROEU?

0% Debt, U 60% Debt, L

Oper. income (EBIT) $400,000 $400,000
Required investment $2,500,000 $2,500,000
% Debt 0.0% 60.0%
$ of Debt $0.00 $1,500,000
$ of Common equity $2,500,000 $1,000,000
Interest rate NA 10.00%
Tax rate 35% 35%

Answer: 5.85%

Q#5: A group of venture investors is considering putting money into Lemma Books, which
wants to produce a new reader for electronic books. The variable cost per unit is
estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed
costs are estimated at $750,000. The investors will put up the funds if the project is
likely to have an operating income of $500,000 or more. What sales volume would be
required in order to meet the minimum profit goal? (Hint: Use the break-even formula,
but include the required profit in the numerator.)

Answer: 5,000
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Q#6: Momin Company's bonds mature in 8 years, have a par value of $1,000, and make an
annual coupon interest payment of $65. The market requires an interest rate of 8.2%
on these bonds. What is the bond's price?

Answer: $903.04

Q#7: Aalam Enterprises’ non-callable bonds currently sell for $1,120. They have a 15-year
maturity, an annual coupon of $85, and a par value of $1,000. What is their yield to
maturity?

Answer: 7.17%

Q#8: David Inc.'s bonds currently sell for $1,040 and have a par value of $1,000. They pay
a $65 annual coupon and have a 15-year maturity, but they can be called in 5 years at
$1,100. What is their yield to maturity (YTM)?

Answer: 6.09%

Q#9: Minhal Inc.'s bonds currently sell for $1,250. They pay a $90 annual coupon, have a
25-year maturity, and a $1,000 par value, but they can be called in 5 years at $1,050.
Assume that no costs other than the call premium would be incurred to call and refund
the bonds, and also assume that the yield curve is horizontal, with rates expected to
remain at current levels on into the future. What is the difference between this bond's
YTM and its YTC?

Answer: 2.62%

Q#10: In order to accurately assess the capital structure of a firm, it is necessary to convert its
balance sheet figures from historical book values to market values. KPMG
Corporation's balance sheet (book values) as of today is as follows:

Long-term debt (bonds, at par) $23,500,000

Preferred stock 2,000,000
Common stock ($10 par) 10,000,000
Retained earnings 4,000,000
Total debt and equity $39,500,000

The bonds have a 7.0% coupon rate, payable semiannually, and a par value of $1,000.
They mature exactly 10 years from today. The yield to maturity is 11%, so the bonds
now sell below par. What is the current market value of the firm's debt?

Answer: $17,883,320

Q#11: If D1 = $1.25, g (which is constant) = 5.5%, and P0 = $44, what is the stock’s expected
total return for the coming year?

Answer: 8.34%

Q#12: Zil Corporation’s free cash flow during the just-ended year (t = 0) was $150 million,
and its FCF is expected to grow at a constant rate of 5.0% in the future. If the weighted
average cost of capital is 12.5%, what is the firm’s total corporate value, in millions?

Answer: $2,100

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Q#13: The Family Company is expected to pay a dividend of D1 = $1.25 per share at the end
of the year, and that dividend is expected to grow at a constant rate of 6.00% per year
in the future. The company's beta is 1.15, the market risk premium is 5.50%, and the
risk-free rate is 4.00%. What is the company's current stock price?

Answer: $28.90

Q#14: Bilal Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50
annual dividend. If the company were to sell a new preferred issue, it would incur a
flotation cost of 4.00% of the price paid by investors. What is the company's cost of
preferred stock for use in calculating the WACC?

Answer: 9.08%

Q#15: Onion Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is
the firm's cost of equity from retained earnings based on the CAPM?

Answer: 11.30%

Q#16: You were hired as a consultant to Mono 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?

Answer: 9.26%

Q#17: Weaver Chocolate Co. received dividend of $3.50, its expected constant dividend
growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New
stock can be sold to the public at the current price, but a flotation cost of 5% would be
incurred. What would be the cost of equity from new common stock?

Answer: 18%

Q#18: Saher Trucking’s balance sheet shows a total of non-callable $45 million long-term
debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently
has a market value of $50 million. The balance sheet also shows that the company has
10 million shares of common stock, and the book value of the common equity (common
stock plus retained earnings) is $65 million. The current stock price is $22.50 per share;
stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO
thinks the WACC should be based on market value weights, but the president thinks
book weights are more appropriate. What is the difference between these two WACCs?

Answer: 2.36%

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