INDIANA UNIVERSITY NORTHWEST
Division of Business and Economics
F301 Financial Management
Fall 2000
Professor William Nelson
TEST 3 1. In capital budgeting and cost of capital analyses, the firm should always consider retained earnings as the first source of capital, since this is a free source of funding to the firm. a. True b. False 2. You are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. Thus, the appropriate marginal cost of capital for the current year is the after-tax cost of debt.

Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins= beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm=s policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find k_s.

3. What is Rollins' component cost of debt?

a. 10.0% b. 9.1% c. 8.6% d. 8.0% e. 7.2

4. What is Rollins' cost of preferred stock?

a. 10.0% b. 11.0% c. 12.0% d. 12.6% e. 13.2%

5. What is Rollins' cost of retained earnings using the CAPM approach?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

6. What is the firm's cost of retained earnings using the DCF approach?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

7. What is Rollins' WACC?

a. 13.6% b. 14.1% c. 16.0% d. 16.6% e. 16.9%

8. The internal rate of return is that discount rate which equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

a. True b. False

9. The NPV and IRR methods, when used to evaluate an independent project, will lead to different accept/reject decisions unless the IRR is greater than the cost of capital.

a. True b. False

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10 percent. Assume cash flows occur evenly during the year, 1/365th each day.

10. What is the payback period for this investment?

a. 5.23 years b. 4.86 years c. 4.00 years d. 6.12 years e. 4.35 years 11. What is the NPV for this investment? a. $135,984 b. $ 18,023 c. $219,045 d. $ 51,138 e. $ 92,146 12. Alyeska Salmon Inc., a large salmon canning firm operating out of Valdez, Alaska, has a new automated production line project it is considering. The project has a cost of $275,000 and is expected to provide after-tax annual cash flows of $73,306 for eight years. The firm's management is uncomfortable with the IRR reinvestment assumption and prefers the modified IRR approach. You have calculated a cost of capital for the firm of 12 percent. What is the project's MIRR? a. 15.0% b. 14.0% c. 12.0% d. 16.0% e. 17.0% 13. As the capital budgeting director for Chapel Hill Coffins Company, you are evaluating construction of a new plant. The plant has a net cost of $5 million in Year 0 (today), and it will provide net cash inflows of $1 million at the end of Year 1, $1.5 million at the end of Year 2, and $2 million at the end of Years 3 through 5. Within what range is the plant's IRR? a. 14 - 15% b. 15 - 16% c. 16 - 17% d. 17 - 18% e. 18 - 19% 14. When calculating the cash flows for a project, you should include interest payments. a. True b. False 15. Suppose a firm is considering production of a new product whose projected sales include sales that will be taken away from another product the firm also produces. The lost sales on the existing product are a sunk cost and are not a relevant cost to the new product. a. True b. False 16. Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer models. Each will require a net investment of $5,000. The cash flow figures for each project are shown below: Period Project A Project B

1 $2,000 $3,000

2 2,500 2,600

3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model A is of average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of capital when evaluating a high-risk project. The cost of capital used for average risk projects is 12 percent. Which of the following statements regarding the NPVs for Models A and B is most correct?

a. NPV_a = $380; NPV_b = $1,815

b. NPV_a = $197; NPV_b = $1,590

c. NPV_a = $380; NPV_b = $1,590

d. NPV_a = $5,380; NPV_b = $6,590

e. None of the above statements is correct.

The president of Real Time Inc. has asked you to evaluate the proposed acquisition of a new computer. The computer=s price is $40,000, and it fall into the MACRS 3-year class. Purchase of the computer would require an increase in net working capital of $2,000. The computer would increase the firm=s before-tax revenues by $20,000 per year but would also increase operating costs by $5,000 per year. The computer is expected to be used for 3 years and then be sold for $25,000. The firm=s marginal tax rate is 40 percent, and the project=s cost of capital is 14 percent.

17. What is the net investment required at t = 0? a. -$42,000 b. -$40,000 c. -$38,600 d. -$37,600 e. -$36,600 18. What is the operating cash flow in Year 2? a. $ 9,000 b. $10,240 c. $11,687 d. $13,453 e. $16,200 19. What is the total value of the terminal year non-operating cash flows at the end of Year 3? a. $18,120 b. $19,000 c. $21,000 d. $25,000 e. $27,000 20. A small manufacturer is considering two alternative machines. Machine A costs $1 million, has an expected life of 5 years, and generates after-tax cash flows of $350,000 per year. At the end of 5 years, the salvage value of the original machine is zero, but the company will be able to purchase another Machine A at a cost of $1.2 million. The second Machine A will generate after-tax cash flows of $375,000 a year for another 5 years at which time its salvage value will again be zero. Alternatively, the company can buy Machine B at a cost of $1.5 million today. Machine B will produce after-tax cash flows of $400,000 a year for ten years, and after ten years it will have an after-tax salvage value of $100,000. Assume that the cost of capital is 12 percent. If the company chooses the machine which adds the most value to the firm, by how much will the company's value increase? a. $347,802.00 b. $451,775.21 c. $633,481.19 d. $792,286.54 e. $811,357.66

INDIANA UNIVERSITY NORTHWEST
Division of Business and Economics
F301 Financial Management
Fall 1997
Test 3
ANSWER KEY FOR TEST

1. b

Retained earnings

2. b

Cost of capital

3. e. 7.2%

Cost of debt

Since the bond sells at par of $1,000, its YTM and coupon rate (12 percent) are

equal. Thus, the before-tax cost of debt to Rollins is 12.0 percent. The after-tax

cost of debt equals.

k d,After-tax = 12.0%(1 - 0.40) = 7.2%.

Financial calculator solution:

Inputs: N = 40; PV = -1,000; PMT = 60; FV = 1,000;

Output: I = 6.0% - k d/2 .

k d = 6.0% x 2 = 12%.

k d (1 - T) = 12.0%(0.6) = 7.2%.

4. d. 12.6%

Cost of preferred stock

Cost of preferred stock: k ps = $12/$100(0.95) = 12.6%.

5. c. 16.0%

Cost of equity: CAPM

Cost of retained earnings (CAPM approach):

k s = 10% + 1.2(5%) = 16.0%.

6. c. 16.0%

Cost of equity: DCF

Cost of retained earnings (DCF approach):

^ $2.00(1.08)

k s = k s = + 8% = 16.0%.

$27

7. a. 13.6%

Wacc=.2(.12)(1-.4)+.2(12.6)+.6(.16) = .136

8. a

IRR

9. b

NPV versus IRR

10. b. 4.86 years

Payback period

Using the even cash flow distribution assumption, the project will

completely recover initial investment after 30/35 = 0.86 of Year 5:

Payback = 4 + = 4.86 years.

11. d. $ 51,138

NPV

Tabular solution:

NPV = $30,000(PVIFA % , ) + $35,000(PVIFA % , )(PVIF % , )

+ $40,000(PVIF % , ) - $150,000

= $30,000(3.1699) + $35,000(3.7908)(0.6830)

+ $40,000(0.3855) - $150,000 = $51,136.07 $51,136.

Financial calculator solution: (In thousands)

Inputs: CF = - 150; CF = 30; N j = 4; CF = 35; N j = 5; CF = 40;

I = 10.

Output: NPV = $51.13824 = $51,138.24 $51,138.

12. d. 16.0%

Modified IRR

Tabular solution:

TV = $73,306(FVIFA % , ) = $73,306(12.300) = $901,663.80

901,663.80

$275,000 =

(1 + MIRR)

0.30499 =

(1 + MIRR)

(1 + MIRR) = (FVIF IRR, ) = 3.27869.

Look in table: Periods = 8, i = 16%. MIRR = 16%.

Alternate method

3.27869 = 1 + MIRR

MIRR = 16%.

Financial calculator solution:

TV Inputs: N = 8; I = 12; PMT = 73,306. Output: FV = -$901,641.31.

MIRR Inputs: N = 8; PV = -275,000; FV = 901,641.31. Output: I = 16%.

Alternate method:

Inputs: CF = 0; CF = 73,306; N j = 8; I = 12. Output: NFV =

$901,641.31.

Inputs: CF = -275,000; CF = 0; N j = 7; CF = 901,641.31.

Output: IRR = 16.0% = MIRR.

13. e. 18 - 19%

IRR of uneven CF stream

Time line: ( In millions )

0 IRR = ? 1 2 3 4 5 years

-5 1 1 2 2 2

Financial calculator solution: (In millions)

Inputs: CF = -5; CF = 1.0; CF = 1.5; CF = 2.0; N j = 3.

Output: IRR% = 18.37%.

14. b

Relevant cash flows

15. b

Sunk costs

16. c. NPV A = $380; NPV B = $1,590

Risk-adjusted NPV

Time lines:

Project A

0 1 2 3 Periods

k = 12%

CFs A -5,000 2,000 2,500 2,250

NPV A = ?

Project B

0 1 2 3 Periods

k = 14%

CFs B -5,000 3,000 2,600 2,900

NPV B = ?

Project A: k Average risk = 12%.

Project B: k High risk = 12% + 2% = 14%.

Tabular solution:

NPV A = $2,000(PVIF % , ) + $2,500(PVIF % , ) + $2,250(PVIF % , ) -

$5,000

= $2,000(0.8929) + $2,500(0.7972) + $2,250(0.7118) - $5,000

= $380.35 $380.

NPV B = $3,000(PVIF % , ) + $2,600(PVIF % ) + $2,900(PVIF % , )

- $5,000

= $3,000(0.8772) + $2,600(0.7695) + $2,900(0.6750) - $5,000

= $1,589.80 $1,590.

Financial calculator solution:

A : Inputs: CF = -5,000; CF = 2,000; CF = 2,500; CF = 2,250;

I = 12%

Output: NPV = $380.20 $380.

B : Inputs: CF = -5,000; CF = 3,000; CF = 2,600; CF = 2,900;

I = 14%

Output: NPV = $1,589.61 $1,590.

17. a. -$42,000

New project investment

Initial investment:

Cost ($40,000)

Change in NWC (2,000 )

($42,000)

Operating cash flow:

18. e. $16,200

Operating cash flow

Depreciation schedule:

Depreciable basis = $40,000.

MACRS Depreciable Annual

Year Percent Basis Depreciation

1 0.33 $40,000 $13,200

2 0.45 40,000 18,000

3 0.15 40,000 6,000

4 0.07 40,000 2,800

$40,000

Operating cash flows:

Year 1 2 3

1) Increase in revenues $20,000 $20,000 $20,000

2) Increase in costs (5,000) (5,000) (5,000)

3) Before-tax change in

earnings 15,000 15,000 15,000

4) After-tax change in

earnings (line 3 x 0.60) 9,000 9,000 9,000

5) Depreciation 13,200 18,000 6,000

6) Tax savings deprec.

(line 6 x 0.40) 5,280 7,200 2,400

7) Net Operating CFs

(line 4 + 6) $14,280 $16,200 $11,400

19. a. $18,120

Non-operating cash flows

Additional Year 3 cash flows:

Salvage value $25,000

Tax on Salvage value (8,880) *

Recovery of NWC 2,000

$18,120

* (Market value - Book value)(Tax rate)

($25,000 - $2,800)(0.40) = $8,800.

20. d. $792,286.54

Replacement chain

Machine A (Time line in thousands):

0 1 2 3 4
-1,000 350 350 375 375

-1,200

-850

With a financial calculator input the following:

CF = -1,000,000

CF 1-4 = 350,000

CF 5 = -850,000

CF 6-10 = 375,000

I = 12%

Solve for NPV A = $347,802.

Machine B (Time line in thousands):

0 1 2 3
-1,500 400 400 400

100

500

CF = -1,500,000

CF 1-9 = 400,000

CF = 500,000

I = 12%

Solve for NPV B = $792,286.54.

Last Updated: 19 January 1999
http://www.iun.edu/~busnw/bill/f31f97t3.html
Comments: Dr. William Nelson
Copyright 1999, The Trustees of Indiana University