FINAL EXAM Corporate Finance Exam |LATEST VERSION |NEW UPDATE |GUARANTEED PASS|2024-2025, Exams of Finance

Download FINAL EXAM Corporate Finance Exam |LATEST VERSION |NEW UPDATE |GUARANTEED PASS|2024-2025 and more Exams Finance in PDF only on Docsity! FINAL EXAM Corporate Finance |LATEST VERSION |NEW UPDATE |GUARANTEED PASS|2024-2025 |BEST STUDYING MATERIAL WITH 100+ QUESTIONS Which of the following projects most likely has the lowest cost of capital? A. Construction of a new steel factory B. Investment in latest-technology, high-end television production C. Construction of a luxury resort D. Investment in a gold-mining operation - CORRECT ANS-D. Investment in a gold-mining operation An analyst computes a beta coefficient with a low standard of error. That implies that: A. this particular beta is more reliable than most. B. this particular beta has little meaning. C. too few observations were used to compute this particular beta. D. this stock responds less to market changes than most stocks. - CORRECT ANS-A. this particular beta is more reliable than most T/F The company cost of capital is the correct discount rate for any project undertaken by the company. - CORRECT ANS-F T/F An analyst should evaluate each project at its own opportunity cost of capital. The true cost of capital depends on the particular use of that capital. - CORRECT ANS-T T/F - CORRECT ANS-T T/F Projects with great amounts of diversifiable risk should generally have higher company costs of capital. - CORRECT ANS-F T/F Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity instead of market values. The resulting WACC estimates will generally be too high. - CORRECT ANS-F T/F If one uses a long-term risk-free rate for the CAPM, instead of a short-term risk-free rate, then one will generate a flatter security market line - CORRECT ANS-T T/F The cost of capital is always less than or equal to the cost of equity - CORRECT ANS-T T/F A pure play is a comparable firm that specializes in on activity - CORRECT ANS-T T/F Companies with high ratios of fixed costs to project values tend to have high betas - CORRECT ANS-T T/F A sensible way for a manager to account for overoptimistic cash-flow forecasts is to adjust the discount rate - CORRECT ANS-F T/F A manager who adjusts discount rates by using a "fudge factor" is more likely to penalize short- term projects as opposed to long-term projects - CORRECT ANS-F T/F In general, one should use higher discount rates for long-term projects - CORRECT ANS-F Discounted cash-flow (DCF) analysis generally: I) assumes that firms hold assets passively when it invests in a project; II) considers opportunities to expand a project if the project is successful; III) considers opportunities to abandon a project if the project is a failure A. I only B. II only C. II and III only D. I, II, and III - CORRECT ANS-A. I only Most firm's capital investment proposals originate from: A. senior management. B. planning staff, corporate finance department. C. the board of directors. D. divisional management. - CORRECT ANS-D. divisional management Generally, post-audits are conducted for large projects: A project has an initial investment of 100. You have come up with the following estimates of the project's cash flows: Revenues: pessimistic = 15; most likely = 20; optimistic = 25; Costs: pessimistic = 10; most likely = 8; optimistic = 5. Suppose the cash flows are perpetuities and the cost of capital is 10%. What does sensitivity analysis of NPV (no taxes) show? (Answers appear in order: [Pessimistic, Most likely, Optimistic}\].) A. -50, 20, +100. B. -100, -50, +80. C. -50, +50, +70. D. +5, +11, +18. - CORRECT ANS-A. -50, 20, +100 Pessimistic NPV = [(15 - 10)/0.10] - 100 = -50; Most Likely NPV = [(20 - 8)/0.10] - 100 = +20; Optimistic NPV = [(25 - 5)/0.10] - 100 = +100 You are given the following data for year 1: Revenues = 100, fixed costs = 30; total variable costs = 50; depreciation = $10; tax rate = 30%. Calculate the after-tax cash flow for the project for year 1. A. $17 B. $13 C. $10 D. $7 - CORRECT ANS-A. $17 EBT = (100 - 30 - 50 - 10) = 10; T = 10(0.3) = 3; CF1 = 10 - 3 + 10 = 17. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3 = 100,000. If the discount rate changes from 12% to 15%, what is the CHANGE in the NPV of the project (approximately)? A. 12,750 increase B. 12,750 decrease C. 14,240 increase D. 14,240 decrease - CORRECT ANS-B. 12,750 decrease NPV at 12% = 135,400, NPV at 15% = 122,650. Change = 122,650 - 135, 410 = -12,750 You calculate the following estimates of project cash flows: Pessimistic investment = 100, Pessimistic Revenues = 30, Pessimistic costs = 20; Most likely investment = 80, most likely revenues = 40, most likely costs = 15; optimistic investment = 60, optimistic revenues = 50, optimistic costs = 10. The revenues and costs occur in perpetuity, as opposed to the initial investment. The cost of capital is 8%. What does a sensitivity analysis of NPV (without taxes) show? (answers appear in order: Pessimistic, most likely, optimistic.) A. 25.00, +232.50, +440.00 B. -100.00, +500.00, +800.00 C. -90.00, -55.00, -20.00 In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain. Meanwhile, working capital of $10,000 is recouped in year 3. A project requires and initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t=0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e., t=1, t=2, and t=3.) The equipment depreciates using straight-line depreciation and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the project. A. $3,840. B. $8,443. C. $-2,735. D. $7,342. - CORRECT ANS-B. $8,443 Initial investment = 90,000 + 10,000 = 100,000; CF0 = -100,000; CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600; CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 59,600. In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain. Meanwhile, working capital of $10,000 is recouped in year 3. Feedback: NPV = -100,000 + 42,600/(1.15) + 42,600/(1.15^2) + 59,600/(1.15^3) = 8,443. A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 12%. Calculate the NPV of the project: A. $14,418. B. $8,443. C. $-2,735. D. $12,873. - CORRECT ANS-A. $14,418 Initial investment = 90,000 + 10,000 = 100,000; CF0 = -100,000; CF1 and CF2: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 = 42,600; CF3: (120,000 - 72,000 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 59,600. In year 3, note that the equipment is sold for $10,000 but generates a taxable capital gain. Meanwhile, working capital of $10,000 is recouped in year 3. NPV = -100,000 + 42,600/(1.12) + 42,600/(1.12^2) + 59,600/(1.12^3) = 14,418 A project requires an initial investment in equipment of $90,000 and then requires an initial investment in working capital of $10,000 (at t = 0). You expect the project to produce sales revenue of $120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for $10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. What is the NPV of the project if the revenues were higher by 10% and the costs were 65% of the revenues? A. $8,443 B. $964 C. $5,566 D. $4,840 - CORRECT ANS-C. $5,566 Initial investment = 90,000 + 10,000 = 100,000; CF0 = -100,000; CF1 and CF2: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 = 41,340; CF3: (132,000 - 85,800 - 30,000)(1 - 0.3) + 30,000 + (10,000)(1 - 0.3) + 10,000 = 58,340. In year 3, note that the equipment is sold for $10,000 but is taxable. NPV = -100,000 + 41,340/(1.15) + 41,340/(1.15^2) + 58,340/(1.15^3) = 5,566 C. It looks at different but consistent combinations of variables. D. Each of these statements describes scenario analysis correctly. - CORRECT ANS-C. it looks at different but consistent combinations of variables The Financial Calculator Company proposes to invest $12 million in a new calculator-making plant. Fixed costs are $3 million per year. A financial calculator costs $10 per unit to manufacture and sells for $30 per unit. If the plant lasts for four years and the cost of capital is 20%, what is the break-even level (i.e., NPV = 0) of annual sales? (Assume that revenues and costs occur at the end of each year. Assume no taxes.) Round to the nearest 1,000 units. A. 150,000 units B. 342,000 units C. 382,000 units D. 300,000 units - CORRECT ANS-C. 382,000 units First, find the annual cash flow that justifies a $12 million investment using the equivalent annual cost (EAC) method. The 4-year annuity factor @ 20% equals 2.5887346. EAC = 12/2.5887346 = $4,635,469 million. The plant must net this amount of cash flow each year. Given $3M of annual fixed costs, let X = the annual sales rate: X (30 - 10) -3,000,000 = 4,635,469; X = 7,635,469/20 = 381,773.45 or approximately 382,000 units The Solar Calculator Company proposes to invest $5 million in a new calculator-making plant. Fixed costs are $2 million per year. A solar calculator costs $5 per unit to manufacture and sells for $20 per unit. If the plant lasts for three years and the cost of capital is 12%, what is the break-even level (i.e., NPV = 0) of annual sales? (Assume that revenues and costs occur at the end of each year. Assume no taxes.) Round to the nearest 1,000 units. A. 133,000 units B. 272,000 units C. 228,000 units D. 244,000 units - CORRECT ANS-B. 272,000 units First, find the annual cash flow that justifies a $5 million investment using the equivalent annual cost (EAC) method. The 3-year annuity factor @ 12% equals 2.40183127. EAC = 5,000,000/2.40183127 = 2,081,745 million. The plant must net this amount of cash flow each year. Given $2M of annual fixed costs, let X = the annual sales rate: (X) (20 - 5) - 2,000,000 = 2,081,745; X = (4,081,745/15) = 272,117 units or about 272,000 units Firms often calculate a project's break-even sales using book earnings. However, break-even sales based on NPV is generally: A. higher than the one calculated using book earnings. B. lower than the one calculated using book earnings. C. equal to the one calculated using book earnings. D. not related to the one calculated using book earnings. - CORRECT ANS-A. higher than the one calculated using book earnings The accounting break-even point occurs when: A. the total revenue line cuts the fixed cost line. A. 133,334 units B. 272,117 units C. 244,444 units D. 466,666 units - CORRECT ANS-C. 244,444 units Fixed costs and depreciation equal $2M and $1.67M per year, respectively. Let X = the annual sales rate. Given a price of $20 and variable cost of $5, X = (2,000,000 + 1,666,667)/(20 - 5) = 244,444 units. The Taj Mahal Tour Company proposes to invest $3 million in a new tour package project. Fixed costs are $1 million per year. The tour package costs the company $500 to produce and can be sold at $1500 per package to tourists. This tour package will last for the next five years. If the cost of capital is 20%, what is the NPV break-even number of tourists per year? (Ignore taxes. Round to the nearest 1,000.) A. 1,000 B. 2,000 C. 3,000 D. 4,000 - CORRECT ANS-B. 2,000 First, find the annual cash flow that justifies a $3 million investment using the equivalent annual cost (EAC) method. The 5-year annuity factor @ 20% equals 2.9906. EAC = $3 million/2.9906 = $1.00 million. The tour must net this amount of cash flow each year. Given $1M of annual fixed costs, let X = the annual sales rate: (X) × (1500 - 500) - 1,000,000 = 1,000,000. X (1000) = 2,000,000; X = 2,000,000/1000 = 2000 The Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $0.5 million per year. The equipment will last for five years. The manufacturing cost per hammer is $1 and each hammer sells for $6. The cost of capital is 20%. Calculate the break-even (i.e., NPV = 0) sales volume per year. (Ignore taxes. Round to the nearest 1,000.) A. 500,000 units B. 600,000 units C. 450,000 units D. 550,000 units - CORRECT ANS-A. 500,000 units First, find the annual cash flow that justifies a $6 million investment using the equivalent annual cost (EAC) method. The 5-year annuity factor @ 20% equals 2.9906. EAC = 6/2.9906 = 2 million. The equipment must net this amount of cash flow each year. Given $0.5M of annual fixed costs, let X = the annual sales rate: X (6 - 1) - 500,000 = 2,000,000; X = 2,500,000/5 = 500,000 units Hammer Company proposes to invest $6 million in a new type of hammer-making equipment. The fixed costs are $1.0 million per year. The equipment will last for five years. The manufacturing cost per hammer is $1 and each hammer sells for $6. The cost of capital is 20%. Calculate the break-even (i.e., NPV = 0) sales volume per year. (Ignore taxes. Round to the nearest 1,000.) A. 500,000 units B. 550,000 units C. 600,000 units B. I, II, and III only C. II, III, and IV only D. I, II, III, and IV - CORRECT ANS-D. I, II, III, and IV After completing a project analysis, an analyst should rely on which tool to make a final recommendation on the project? A. sensitivity analysis B. break-even analysis C. decision trees D. NPV - CORRECT ANS-D. NPV Which of the following outputs is likely to be most useful and easy to interpret? The output shows the distribution(s) of the project's: A. sales. B. internal rate of return. C. cash flows. D. profits. - CORRECT ANS-C. cash flows Generally, Monte Carlo models, for project analysis, use which device to generate simulations? A. pair of dice B. roulette wheel C. computer D. pack of cards - CORRECT ANS-C. computer Monte Carlo simulation is likely to be most useful: A. for very complex projects. B. for projects of moderate complexity. C. for very simple projects. D. regardless of the project's complexity. - CORRECT ANS-A. for very complex projects C. options to expand. D. options to abandon. - CORRECT ANS-A. stock options Petroleum Inc. (PI) controls off-shore oil leases. It is considering the construction of a deep-sea oil rig at a cost of $500 million. The price of oil is $100/bbl. and extraction costs are $50/bbl. PI expects costs to remain constant. The rig will produce an estimated 1,200,000 bbl. per year forever. The risk-free rate is 10% per year, which is also the cost of capital. (Ignore taxes). Suppose that oil prices are uncertain and are equally likely to be $120/bbl. or $80/bbl. next year. Suppose that PI has the option to postpone the project by one year. Calculate the value of the real option to postpone the project for one year. A. +$30 million B. +$50 million C. +$54 million D. +$70 million - CORRECT ANS-C. +$54 million Easiest to do computations in $M. NPV today = -500 + (1.2) × ((0.5 × 120 + 0.5 × 80) - 50)/0.10 = +100; NPV(at t = 1, oil price = $120/bbl.) = -500 + (1.2)(120 - 50)/0.10 = +340; NPV(at t = 1, oil price = $80/bbl.) = -500 + (1.2)(80 - 50)/0.10 = -140 (reject so NPV = 0); NPV(at t = 1, oil price = $80/bbl.) = 0; Expected NPV(at t = 0) = ((0.5)(0) + (0.5)(340))/1.10 = 154.5; Value of the option to wait = 154 - 100 = $54 million Which of the following does NOT represent an option to expand a project? A. A firm leases more office space than it forecasts it will need. B. A company engages in test marketing for a new product. C. Your university builds an administrators' parking garage having more parking spaces than administrators. D. A dry cleaner purchases equipment that can be readily sold to other dry cleaners. - CORRECT ANS-D. a dry cleaner purchases equipment that can be readily sold to other dry cleaners Which of the following does NOT represent an option to abandon a project? A. Your friend builds a custom-made home. B. You enroll in five classes, planning to drop one class before the semester ends. C. A dry cleaner purchases equipment that can be readily sold to other dry cleaners. D. You purchase a fully refundable airplane ticket. - CORRECT ANS-A. your friend builds a custom- made home You are planning to produce a new action figure called "Hillary". However, you are very uncertain about the demand for the product. If it is a hit, you will have net cash flows of $50 million per year for three years (starting next year, i.e., at t = 1). If it fails, you will only have net cash flows of $10 million per year for two years (also starting next year). There is an equal chance that it will be a hit or failure (probability = 50%). You will not know whether it is a hit or a failure until after the first year's cash flows are in, i.e., at t = 1. You have to spend $80 million immediately for equipment and the rights to produce the figure. If the discount rate is 10%, calculate Hillary's NPV. A. -9.15 C. +23.14 D. 0 - CORRECT ANS-C. +23.14 1) Calculate the NPV of the project without an abandonment option. Calculate the PV of cash inflows. The 3-year annuity factor at 10% equals 2.48685. The 2-year annuity factor at 10% equals 1.73554. PV(Success) = 50 (2.48685) = 124.3426; PV(Failure) = 10 (1.73554) = 17.3554; NPV = -80 + (124.3426)(0.5) + (17.3554)(0.5) = -9.15. 2) Calculate the NPV of the project with an abandonment option. Calculate the PV of cash inflows. The 3-year annuity factor at 10% equals 2.48685. NPV with abandonment option: PV(success) = 50(2.48685) = 124.3426; PV(Failure) = 10/1.1 + 60/1.1 = 63.6364 (assuming that the equipment will be sold if the action figure is a failure); NPV = -80 + (124.3426)(0.5) + (63.6364)(0.5) = +13.99. 3) Value of the abandonment option = NPV (with the option) - NPV (without the option) = 13.99 - (-9.15) = 23.14 The following options associated with a project increase managerial flexibility: I) option to expand; II) option to abandon; III) production options; IV) timing options A. I only B. II only C. I, II, III, and IV D. IV only - CORRECT ANS-C. I, II, III, and IV The Consumer-Mart Company is going to introduce a new consumer product. If brought to market without research about consumer tastes the firm believes that there is a 60% chance that the product will be successful. If successful, the project has a NPV = $500,000. If the product is a failure (40%) and withdrawn from the market, then NPV = -$100,000. A consumer survey will cost $60,000 and delay the introduction by one year. With a survey, there is an 80% chance of consumer acceptance, in which case the NPV = $500,000. If, on the other hand the product is a failure (20%) and withdrawn from the market, then NPV = -$100,000. The discount rate is 10%. By how much does the marketing survey change the expected net present value of the project? A. increases the NPV by $25,455 B. decreases the NPV by $5950 C. increases the NPV by $8955 D. decreases the NPV by $25,455 - CORRECT ANS-A. increases the NPV by $25,455 No survey: Expected NPV = 500,000 (0.6) - 100,000 (0.4) = +260,000. With the survey: Expected NPV = -60,000 + [(500,000)(0.8) - (100,000)(0.2)]/(1.10) = +285,455. Increase in NPV by the survey = 285,455 - 260,000 = 25,455 T/F Expansion options generally show as an asset on a corporation's balance sheet - CORRECT ANS- F T/F Postaudits are conducted before the start of projects - CORRECT ANS-F T/F Most firms keep track of the progress of projects by conducting post-audits shortly after the projects have begun to operate - CORRECT ANS-T T/F Projects with higher fixed costs have lower break-even points - CORRECT ANS-F T/F The break-even point in terms of NPV is usually lower than the break-even point on an accounting basis - CORRECT ANS-F T/F A. $2.42 million B. $10.82 million C. $6.21 million D. $2.82 million - CORRECT ANS-C. $6.21 million NPV = -50 + 5/1.1 + 5/(1.1^2) + 5/(1.1^3) + 5/(1.1)^4 + 65/(1.1^5) = +6.21 A new grocery store requires $50 million in initial investment. You estimate that the store will generate $5 million of after-tax cash flow each year for five years. At the end of five years, it can be sold for $55 million. What is the NPV of the project at a discount rate of 10%? A. $2.4 million B. $5.0 million C. $3.1 million D. $0.0 million - CORRECT ANS-C. $3.1 million NPV = -50 + 5/1.1 + 5/(1.1^2) + 5/(1.1^3) + 5/(1.1 ^4) + 60/(1.1^5) = +3.1 A rental property is providing an acceptable market rate of return of 13%. You expect next year's rent to be $1.0 million and that rent is expected to grow at 3% per year forever. What is the current value of the property? A. $7.7 million B. $10.0 million C. $33.3 million D. $50.0 million - CORRECT ANS-B. $10.0 million Value = 1.0/(0.13 - 0.03) = $10M A building is appraised at $1 million. This estimate is based on forecasted net rent of $100,000 per year discounted at a 10% cost of capital [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently uninhabitable. It will take one year and $250,000 of work (spent at the end of the year) to bring it into rentable condition. How much would you be willing to pay for the building today? A. $1,000,000 B. $681,818 C. $750,000 D. $909,090 - CORRECT ANS-B. $681,818 Price: (1,000,000 - 250,000)/(1.1) = $681,818 USGOLD Company has an opportunity to invest in a gold mine. The initial investment is $250 million. Analysts estimate that the mine will produce 100,000 ounces of gold per year for the next 10 years. The extraction cost of gold is $150 per ounce and is expected to remain at that level. The current price of gold is $600 per ounce and is expected to increase 4% per year for the next 10 years. What is the NPV of the project at a discount rate of 10%? (Ignore taxes.) A. -$3.8 million B. B. $521.64 million C. $690.86 million D. $3,000.00 million - CORRECT ANS-A. $600 million Current value = (0.2)(5)(600) = 600 million Goldsmith Labs recovers gold from printed circuit boards. It has developed new equipment for this purpose. You have the following data. 1) The equipment costs $250,000. 2) It costs $200,000 per year to operate. 3) It has an economic life of five years and is depreciated using the straight-line method. 4) It will recover 300 ounces of gold per year. 5) The current price of gold is $900 per ounce and is expected to increase at a rate of 4% per year for the foreseeable future. 6) The tax rate is 30%. 7) The cost of capital is 8%. What is the NPV of installing this equipment? A. $430,400 B. $520,510 C. $470,400 D. $195,911 - CORRECT ANS-D. $195,000 To find NPV: subtract equipment cost; add in PV of depreciation tax effect; add in after-tax PV of revenue from gold recovery; and subtract PV of after-tax costs of operation. = -250,000 + [PV of (0.3)(50,000) for five years at 8%] + (5)(900)(300)(1 - 0.3) - PV of (1 - 0.3)(200,000) for five years at 8%; = -250,000 + 59,890 + 945,000 - 558,979; = 195,911 The formula P0 = Pt/((1 + r)^t) applies to assets that: I) pay no dividends; II) are traded in a competitive market; III) cost nothing to hold A. I only B. I and II only C. I, II, and III D. II and III only - CORRECT ANS-C. I, II, and III Investing in gold is like investing in: I) a stock that pays quarterly dividends; II) a stock that pays annual dividends; III) Treasury bonds; IV) a stock that pays no dividends A. I only B. II only C. I, II, and III only D. IV only - CORRECT ANS-D. IV only If you use future prices to estimate the cash flows of a project, which discount rate should you use? If you use futures prices to estimate the cash flows of a project, which discount rate should you use? I) the cost of capital for the firm; II) the cost of capital for the project; III) the risk-free rate I only B. II only C. I and II only D. I, II, and III - CORRECT ANS-C. I and II only Economic rents are returns that: A. exceed the opportunity cost of capital. B. equal the opportunity cost of the capital. C. are less than the opportunity cost of capital. D. are not related to the opportunity cost of capital. - CORRECT ANS-A. exceed the opportunity cost of capital Long-lasting competitive advantages include: I) patents; II) brand names; III) economies of scale A. I only B. II only C. I and II only D. I, II, and III - CORRECT ANS-D. I, II, and III Long-lasting competitive advantages include: I) proprietary technology; II) protected markets with high barriers to entry for other firms; III) strategic assets that competitors cannot easily duplicate A. I only B. II only C. I and II only D. I, II, and III - CORRECT ANS-D. I, II, and III Which of the following is an example of a strategic asset? A. trucks B. diesel engines C. railroad containers D. Your marketing staff alerts you that the new project may "cannibalize" sales (i.e., reduce sales) of existing product to a greater extent. - CORRECT ANS-B. a key competitor releases earning results, and its stock price drops by 25% in response The NPV of a project can be thought of as the present value of its: A. economic rents. B. profits. C. revenues. D. salvage value. - CORRECT ANS-A. economic rents A positive NPV forecast for a new project is reliable only if it is based on: A. forecasts of cash flows. B. Michael Porter's theories. C. identifiable sources of economic rents. D. results from Monte Carlo analysis. - CORRECT ANS-C. identifiable sources of economic rents You inherited a run-down house in Chicago. There is an active market in properties of this type, and similar properties currently sell for $100,000. If rented, the property can deliver cash returns of $12,000 per year forever. If the appropriate discount rate is 15%, how much is the house worth? A. $80,000 B. $100,000 C. $150,000 D. $180,000 - CORRECT ANS-B. $100,000 You inherited 100 acres of Iowa farmland. There is an active market in this type of land, and similar properties currently sell for $10,000 per acre. If planted with corn, you expect that the land will deliver net cash flows of $800 per acre forever. If the discount rate is 10%, how much is the land worth per acre?You inherited 100 acres of Iowa farmland. There is an active market in this type of land, and similar properties currently sell for $10,000 per acre. If planted with corn, you expect that the land will deliver net cash flows of $800 per acre forever. If the discount rate is 10%, how much is the land worth per acre? A. $10,000 B. $8,000 C. $18,000 D. $12,000 PV = 800/0.1 = 8,000; Market value = 10,000; Land value = market value. - CORRECT ANS-A. $10,000 PV = 800/0.1 = 8,000; Market value = 10,000; Land value = market value. B. +$210,648 C. +$250,000 D. -$150,000 - CORRECT ANS-B. +$210,648 Determine market price per gallon, assuming the old plant is a zero-NPV investment. Old plant NPV: 500,000 + (100,000 (P - 2))/(0.2) = 0; P - 2 = 1; P = $3; New plant NPV: -500,000 + [(100,000(3.0 - 1.0))/1.2] + [(100,000(3.0 - 1.0))/(1.2^2)] + [(100,000(3.0 - 1.0))/1.2^3] + [500,000/(1.2^3)] = $210,648. The new plant delivers three years of economic rents and is worth $500K at year 3 due to its infinite life (i.e., it does not depreciate) The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000-gallon capacity plant costs $500,000 to build and has an indefinite life, with no salvage value. The cost of capital is 20% (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology? A. +$500,000 B. +$210,648 C. +$299,061 D. -$220,000 - CORRECT ANS-C. +$299,06 Mine market price per gallon, assuming the old plant is a zero-NPV investment. Old plant NPV: -500,000 + (100,000 (P - 2))/(0.2) = 0; P - 2 = 1; P = $3/per gallon; New plant NPV: -500,000 + [(100,000(3 - 1)/1.2)] + [(100,000(3 - 1)/(1.2^2))] + [(100,000(3 - 1)/1.2^3)] + [(100,000(3 - 1)/(1.2)^4)] + [(100,000(3 - 1)/(1.2^5)] + (500,000/1.2^5) = $299,061. The new plant delivers five years of economic rents and is worth $500K at year 5 due to its infinite life (i.e., it does not depreciate) The annual demand (in millions) for baseballs is given by the equation: Demand = 10 × (4 - price). If the price of baseballs is $1.50, what is the annual demand for baseballs? A. 10 million B. 15 million C. 20 million D. 25 million - CORRECT ANS-D. 25 million Demand = 10 × (4 - 1.50) = 25 million The annual demand (in millions) for golf balls is given by the equation: Demand = 6 × (5 - price). If the price of a golf ball is $3, what is the annual demand for golf balls? A. 8 million B. 12 million C. 15 million D. 18 million - CORRECT ANS-B. 12 million Demand = 6 × (5 - 3) = 12 million Allen Technology Company is currently valued at $400 million. It is proposing a new plant with a net present value of $200 million. However, the new plant will reduce the value of one of its existing plants by $50 million. What is the value of the company if it invests in the new plant? Scrap value exceeds year 1 value, so scrap it at the end of year 1 The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300, year 2: +$43,300, and year 3 = +$58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year is $66,700, would you scrap the plant at the end of year 1? A. yes B. no C. depends on the net present value D. need more information - CORRECT ANS-B. no (You can check the competitiveness assumption by calculating that the NPV of a new plant is approximately zero.) Year 1 value: 43,300/1.2 + 58,300/1.2^2 = $76,569. lScrap value is less than the year 1 value, so do not scrap it at the end of year 1 The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300, year 2: +$$43,300, and year 3 = +$58,300. (Assume no taxes.) If the discount rate is 20%, what is the value of the plant at the end of year 2? Round to the nearest $100. A. $48,600 B. $38,520 C. -$51,600 D. zero - CORRECT ANS-A. $48,600 (You can check the competitiveness assumption by calculating that the NPV of a new plant is approximately zero.) Year 2 year-end value = 58,300/1.2 = 48,600 The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300, year 2: +$43,300, and year 3 = +$58,300. (Assume no taxes.) If the salvage value at the end of year 2 is $40,000, would you scrap the plant at the end of year 2? A. yes B. no C. don't know D. need more information - CORRECT ANS-B. no (You can check the competitiveness assumption by calculating that the NPV of a new plant is approximately zero.) Year 2 year-end value = 58,300/1.2 = 48,600. The salvage value is less than the plant's operational value, so do not scrap it at the end of year 2 A strategy of deliberately slowing down the rate of introduction of new products by well- established and technologically advanced firms is best described as: A. a good strategy that maximizes economic rents. B. a dangerous strategy as it provides opportunities for other firms to introduce new products. C. a good strategy because firms only have a limited number of good projects. D. a zero-NPV strategy. - CORRECT ANS-B. a dangerous strategy as it provides opportunities for other firms to introduce new products T/F The NPV of an investment is the discounted value of the economic rents that it is expected to produce - CORRECT ANS-T T/F In order to generate a positive NPV project, a firm must have an economic advantage over its competitors - CORRECT ANS-T T/F The cash forecasts for a positive NPV project is more reliable if the managers of the firm can identify the economic rents associated with the project - CORRECT ANS-T T/F According to Michael Porter, managers can secure a competitive advantage for their firms within in their industry in three ways. They are: by cost leadership, by product differentiation, and by focusing on a particular market niche - CORRECT ANS-T T/F While evaluating a project, an analyst should consider its effect upon the sales of the firm's existing products. - CORRECT ANS-T T/F A firm that expects long-run economic rents from a particular project is likely ignoring the effects of competition. - CORRECT ANS-T T/F Sometimes, the gains from new technology are completely offset by the losses on existing plants - CORRECT ANS-T T/F The total NPV of a new plant is equal to the NPV of the new plant plus the change in the present value of existing plants due to the impact of the new plant - CORRECT ANS-T T/F In a competitive market, most firms can earn high economic rents - CORRECT ANS-F T/F Increasing market share is typically a successful strategy to create economic rents in a competitive market - CORRECT ANS-F T/F Price cutting in a competitive market will usually not lead to the creation of economic rents - CORRECT ANS-T In the principle-agent framework, the ultimate principals are: I) managers; II) board of directors; III) shareholders; IV) governments A. I and II only B. IV only C. III only D. I, II, and III only - CORRECT ANS-C. III only The following are agency problems in capital budgeting except: A. empire building. B. entrenching investments. C. avoiding risks. D. accepting all positive NPV projects. - CORRECT ANS-D. accepting all positive NPV projects The following are agency problems associated with capital budgeting except: A. reduced effort. B. II only C. III only D. I and II only - CORRECT ANS-C. III only The following actions by managers are examples of over-investment: I) entrenching investments; II) empire building; III) investing beyond the point where NPV falls to zero A. I only B. II only C. I and II only D. I, II, and III - CORRECT ANS-D. I, II, and II Managers on a fixed salary often fall victim to the following temptations: I) reduced effort; II) needless spending on perks or private benefits; III) empire building; IV) entrenching investments; V) avoiding risks A. I, II, and V only B. I, II, and IV only C. I, II, III, and IV only D. I, II, III, IV, and V - CORRECT ANS-D. I, II, III, IV, and V Agency costs can be thought of as the loss in the value of a firm resulting from following actions by managers: I) reduced effort; II) perks or private benefits; III) empire building; IV) entrenching investments; V) avoiding risks A. I, II, and V only B. I, II, and IV only C. I, II, III, and IV only D. I, II, III, IV, and V - CORRECT ANS-D. I, II, III, IV, and V Monitoring is typically done by: I) shareholders; II) board of directors; III) independent accountants; IV) lenders A. I only B. I and II only C. I, II, and III only D. A. I only B. II only C. III only D. I, II, and III - CORRECT ANS-D. I, II, and III Since monitoring is not perfect, compensation plans should primarily provide managers incentives to: A. put a lot of thought into their work. B. work long hours. C. take actions that make stakeholders happy. D. maximize the value of the firm to the shareholders. - CORRECT ANS-D. maximize the value of the firm to the shareholders Generally, firms should attempt to base a manager's compensation on: A. the number of years of managerial experience. B. the number of hours they work. C. verifiable results. D. perks consumed. - CORRECT ANS-C. verifiable results CEO compensation is generally highest in (the): A. U.S. B. India. C. U.K. D. Germany. - CORRECT ANS-A. U.S When firms award stock options to managers as incentives, they typically set the exercise price of these options equal to the firm's: A. stock price on the day the options are granted. B. expected stock price one year from the day the options are granted. C. C. 15% D. 10% - CORRECT ANS-A. 5% (2,000/10,000) - 0.15 = 0.05 = 5% A firm has an average investment of $10,000 during the year. During the same time, the firm generates after-tax income of $2,000. Calculate the economic value added (EVA) for the firm. (The cost of capital is 15%.) A. $500 B. $1,500 C. $2,000 D. $1,000 - CORRECT ANS-A. $500 EVA = 2000 - (0.15)(10,000) = $500 A firm has an average investment of $10,000 during the year. During the same period, the firm generates after-tax income of $1,000 If the cost of capital is 15%, what is the net return on the investment? A. 15% B. -5% C. 10% D. 5% - CORRECT ANS-B. -5% Net return on investment = 1000/10000 - 0.15 = -0.05, or -5% A firm has an average investment of $10,000 during the year. During the same period, the firm generates after-tax income of $1,000. Calculate the economic value added (EVA) for the firm. (The cost of capital is 15%.) A. -$500 B. $1,500 C. $1,200 D. $1,000 - CORRECT ANS-A. -$500 EVA = 1000 - (0.15)(10,000) = -500 The term economic value added (EVA) is copyrighted by: A. Brealey-Myers. B. Brealey-Myers-Allen. C. Ross-Westerfield. D. Stern-Stewart. - CORRECT ANS-D. Stern-Stewart EP = (ROI)/(capital invested) - CORRECT ANS-A. EP = (ROI - r) x (capital invested), where r = cost of capital The following are disadvantages of using EVA as a performance measure EXCEPT: A. EVA does not measure present values. B. EVA rewards the choice of projects with quick paybacks and penalizes projects with longer payback periods. C. EVA reduces explicit monitoring by top management. D. EVA is difficult to apply to start-up ventures. - CORRECT ANS-D. EVA reduces explicit monitoring by top management The following are advantages of using EVA as a performance measure EXCEPT: A. EVA can substitute for explicit monitoring by top management. B. EVA makes the cost of capital visible to operating management, thereby reducing capital employed. C. EVA does not measure present values. D. EVA highlights business units that are underperforming their peers. - CORRECT ANS-C. EVA does not measure present values EVA is used for: I) measuring performance within the firm; II) rewarding performances within the firm; III) improving performance within the firm A. I only B. II only C. I and II only D. I, II, and III - CORRECT ANS-D. I, II, and III Which of the following actions - all else equal - will decrease a firm's EVA? A. The firm raises its prices, but ships the same amount of product. B. The firm reduces its inventory. C. The firm increases its borrowing to repurchase some of its shares. D. The firm increases its accounts receivable. - CORRECT ANS-D. The firm increases its accounts receivable Which of the following actions - all else equal - will increase a firm's EVA? A. The firm raises its prices, but ships the same amount of product.