JUN18L1CFI/C01

Question 1
Alton Technologies is planning to set up a new plant in a foreign country. The company has the following
capital structure:
Capital Structure Required Rate of Return
45% common stock 8%
35% debt 7%
20% preferred stock 9%
The company’s directors have estimated the cost of the investment to be $55 million and plan to finance $33
million by issuing common stock and $22 million by issuing debt. Given that the company’s marginal tax rate
is 40%, its weighted average cost of capital is closest to:
a)
a) 20.10%
b)
b) 7.60%
c)
c) 6.48%
Percentage of equity in the capital structure = 33 / 55 = 60%
Percentage of debt in the capital structure = 22 / 55 = 40%
WACC = (0.6 × 0.08) + (0.4 × 0.07 × 0.6) = 6.48%

Question 2
Fonte Inc. wants to use the profitability index method for analyzing any future investments. Which of the
following statements will most likely discourage Fonte from using the profitability index for making capital
budgeting decisions?
I. It does not indicate the magnitude of projects' cash flows when projects of different values are
compared.
II. It does not account the different risks associated with projects.
III. The readability of rankings given by the profitability index is not the same as that of the NPV.

a)
a) I and II only.
b)
b) I and III only.
c)
c) I, II, and III.
The profitability index takes into account the varying risks attached with different investments by using a
different discount rate for different investments. The readability of rankings given by the profitability index is
inferior to that of the NPV, as the profitability index is a ratio whereas the NPV gives absolute dollar amounts.

Question 3
Malcolm Technologies’ directors are considering the purchase of a subsidiary for $90 million. The present
value of the future after-tax cash flows associated with the subsidiary is estimated to be $120 million. This is
new information and is independent of other expectations regarding the company. The company has 3 million
shares outstanding at the market price of $50. If the company goes ahead with the purchase, the market price
of the company’s stock will be closest to:
a) $60
b) $55
c) $40
NPV of the new project = 120 – 90 = $30 million
Company value before the purchase = 3 million × 50 = $150 million
Company value after the purchase = 150 + 30 = $180 million
Price / share after the purchase = 180 / 3 = $60

Question 4
An analyst using the CAPM to estimate a company's cost of equity has gathered the following:
 Risk-free rate = 3.5 percent
 Expected return on the market = 8.0 percent
 Company's common stock beta = 0.8
 Marginal tax rate for the company = 30 percent
The analyst's estimate of the cost of equity will be closest to:
 a) 5.0 percent.
b) 7.1 percent.
c) 9.9 percent.
The calculation is as follows:
E(Ri) = Rf+βi[E(RM)−Rf] = 0.035+0.8(0.08−0.035) = 71percent

Question 5
Jurer Industries is considering expanding its products to include a new product. The cost of the expansion is
150 million yen. The expansion will cause after-tax cash flows to rise by 28 million yen for the next 10 years.
The required rate of return is 7 percent. What is the project's NPV?
NPV (in million yen)? IRR?
A. 37.8 10.5%
B. 46.7 13.3%
C. 60.4 17.6%
a) Row A
b) Row B
c) Row C
The NPV is calculated using your financial calculator:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, NPV 7 ENTER ↓CPT = 46.66
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, 7 i, f NPV = 46.66
These show that the approximate NPV is 46.7 million yen.
Next, we find the IRR using our calculators again:
TI BAII+: CF 150 +/- ENTER, ↓28 ENTER, ↓10 ENTER, IRR CPT = 13.32
HP12C: 150 CHS g CF0, 28 g CFj, 10 g Nj, f IRR = 13.32
The IRR is approximately of 13.3 percent.

Question 6
A company has a target capital structure of 20 percent debt and 80 percent equity. The company has
determined the following with respect to raising capital:
Costs of Debt and Equity Schedule
Amount of New Debt (in After-Tax Cost of Amount of New Equity (in Cost of
millions) Debt millions) Equity
new debt < $10 4.0 percent new equity < $40 8.0 percent
$10 < new debt < $25 5.0 percent $40 < new equity < $80 10.0 percent
$25 < new debt 5.5 percent $80 < new equity 11.0 percent
The third debt break point is closest to:
a) $50 million in new debt capital being raised.
b) $125 million in new debt capital being raised.
c) $125 million in new total capital being raised.
The calculation of the third debt break point is:
Debt break point 2 = $25 million/0.2 debt weight = $125 million
If the company raises $125 million in new capital, 20 percent or $25 million will come from debt and the
remaining $100 million, or 80 percent, will come from equity.

Question 7
Dagg Corporation is a medium-sized company, and Venso Corporation is a large player; both companies
operate in the same industry. The financials of the two companies are given below. Based on this information,
the weighted average cost of capital (WACC) of Dagg, as compared to Venso, is most likely:
Dagg Venso
Equity (in $ millions) 40 87
Debt (in $ millions) 55 120
Marginal tax rates 45% 40%
Current yield 6.0% 6.8%
 Dagg Venso
IRR of existing debt 8% 7.5%
Required rate of return on company's equity 11% 11%
a) higher because of a higher IRR on its debt.
b) higher because of a lower current yield on its debt.
c) lower because of its higher marginal tax rate.
The overall WACC of Dagg is less than that of Venso, because Dagg has a higher marginal tax rate.

Question 8
If the project’s NPV is negative, which of the following is most likely?
a) The cost of capital is greater than the project’s IRR.
b) The cost of capital is less than the project’s IRR.
c) The cost of capital is equal to the project’s IRR.
When IRR is lower than the cost of capital, the project’s NPV will be negative.

Question 9
Dolphin Inc. has a return on equity of 15%. Its next year’s dividend is forecasted to be $1.52 per share and the
current stock price is $43. Given that the company’s cost of equity is 16%, its earnings retention rate is closest
to:
a) 15.50%
b) 83.10%
c) 60.43%
0.16 = (1.52 / 43) + Dividend growth rate
Dividend growth rate = 12.4651%
0.124651 = Retention rate × 0.15
Retention rate = 83.10%

Question 10
A project's cash flows are given as follows. What is its payback and discounted payback if the discount rate is
10%?
Year 0 1 2 3 4 5 6
Cash flows −$25,000 $6,000 $8,000 $7,500 $6,500 $7,800 $9,300
a) Payback period = 3.46 years; discounted payback period = 4.59 years
b) Payback period = 3.54 years; discounted payback period = 4.41 years
c) Payback period = 3.54 years; discounted payback period = 4.59 years

Year 0 1 2 3 4 5 6
Cash flows –25,000 6,000 8,000 7,500 6,500 7,800 9,300
Cumulative CF –25,000 –19,000 –11,000 –3,500 3,000
Discounted cash flow –25,000 5,455 6,612 5,635 4,440 4,843 5,250
Cumulative discounted CF –25,000 –19,545.5 –12,933.9 –7,299.02 –2,859.44 1,983.75
PB = 3 + (3,500 / 6,500) = 3.54 years
DPB = 4 + (2,859.44 / 4,843) = 4.59 years