Student ID 9.220 Corporation Finance Mid-term Examination JI I.

Multinle Choice Section;

N. Bhattacharyyd T. Demarin/ G. Jacoby/ R. Scott March i&2000 7:00 p.m. - 9:00 p.m. Total: 80 marks

Each of the following questions or statements is followed by several suggested answers or completions. Select the best alternative and place the corresponding letter on the accompanying computerized answer sheet. (Value: 10 x 2 = 20 marks) 1.
Consider the following cash flows

Year
It is true that

0 -4

25

2 -25

a)
b)
C

d & 4

the project has more than two IRRs. the unique IRR for these cash flows is 25%. there is a unique IRR for these cash flows, but it cannot be determined. there could be as many as two IRRs for these cash flows. we need to draw an NPV profile and therefore cannot say anything about the nature of IRR without a spreadsheet programme.

2.

A company is considering 5 mutually exclusive projects. In considering these projects, the firm knows
a)

b 0
4 4 4

these cannot be financing projects. the acceptance of one project precludes the acceptance of any of the other four projects. the acceptance of one project is not affected by either the acceptance or rejection of another,, the IRR method should always be used. it may accept as many of the five projects it wishes as long as they have positive NPVS.

3.

You are going to choose between two mutually exclusive investments. Both investments cost $80,000 but investment A pays $35,000 per year for 4 years and investment B pays $30,000 per year for 5 years. Assume these cash inflows occur at the end of each year. If your required rate of return is 13%, you should choose ti wy aq,)BG 5-b A because it pays back sooner. 4 -pjQ Rc 1 uiq* A because its IRR exceeds 13%. b) A because it has a higher IRR. ry PV,: 2s, a 6iqy d B because its IRR. exceeds 13%. 3&2g- pr\ 1. d) B because it has a higher NPV. e) 0 John Bishop, a private contractor, has an opportunity for a recycling pickup contract with the city over the next 5 years. The contract calls for the city to pay John $250,000 at the start of the contract and nothing for the remainder of the contract. John estimates that his expenses will be $70,000 at the end of each of the 5 years. If John uses IRR to evaluate his opportunities, he would only accept this contract if the discount rate (hurdle rate) is

4.

a 0 b) 4 d) e)

greater than 12.37624 146%. less than 12.37624146%. greater than 17.190612%. less than 17.190612%. none of the above.

9.220 Corporation Finance Mid-term Examination II 5.

N. Bhattacharyya/T. DemarinlG. Jacobyl R. Scott March 16,200O 7:00 p.m. - 930 p.m. Total: 80 marks

When using NPV and IRR to evaluate projects for investment, it is true that a) 0 b) 4 d) d 1RR always reaches the same decision as NPV when the initial investment outlays of an independent project are followed by a series of cash inflows. an independent project that has initial cash inflows followed by one or more cash outflows should be accepted when the projects IRR is greater than the discount rate. a project that has a number of changes in the direction of its cash flows should always be accepted when the projects IRR is greater than the discount rate. when a project has an NPV = 0, IRR cannot be calculated. with mutually exclusive projects, the project with the highest IRR will always have the greatest NPV.

6.

A retirement annuity will pay nominal cash flows of $75,000 per year for 25 years. The expected inflation rate is 4% per year. The expected growth rate in the annuitys J& cash flows is

a)
b) d d e d 7.

96.153846 15% per year 96.0% per year. 4.0% per year. -3.72453208% per year. -3.846 15385% per year.

3- +q -1 \
\A

\-

A firm investing in a IO-year project purchases equipment for $1,000,000. This equipment is placed in a CCA Class with a rate of 20%. Assume that the company uses its maximum CCA claim in each of years 1 and 2, and that the company is subject to a corporate tax rate of 35%. The maximum CCA tax shield available to the company in year 3 is ~Lbeb&& cc/+ .g&QA y-e g;y OOQ qG&:, 0~ $35,000. tGp,30Y $50,400. $63,000. c) $144,000. $20 1,600. 4 When computing the NPV of a project, each of the following should be treated as an incremental cash-flow exceot

8.

4
a
C

d) e)

a reduction in sales of the companys other products. research and development costs incurred and paid prior to the start of the project. the resale value of plant and equipment at the end of the projects life. the salary and medical costs of production employees added to the payroll as a result of the project. the expenditure on plant and equipment.

9.

You are considering two investments. You note that the return on investment A tends to vary quite widely from its average, and definitely more so than does investment B. Based on this fact you believe that A has a lower variance than B. A has a lower standard deviation than B. C A has a higher inflation premium than B. & A is riskier than B. A must be stock in one of the 300 largest firms while B must be stock in one of the e) smallest firms listed on the TSE. b)

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9.220 Corporation Finance Mid-term Examination II 10.

N. BhattacharyyaR. Demarin/G. Jacoby/ R. Scott March l&2000 7:OO p.m. - 9:00 p.m. Total: 80 marks

An investor would get the largest reduction in risk in a portfolio composed of two stocks if

4
b) C cb d) e)

the correlation coefficient between the two stocks was 0. the two stocks have perfect positive correlation. the two stocks have perfect negative correlation. the correlation coefficient between the two stocks was -00. the correlation coefficient between the two stocks was foe.

II. Lone Answer Section; (60 marks\ Answer each question in the space provided. Show all relevant work (i.e., formulas and substitutions). Do POT indicate which buttons were pushed on your calculator. Do not . . round anv interp,lg#ate g&&&tion$, Final dollar answers may be rounded to the nearest cent; other final answers may be rounded to 6 decimal places unless otherwise specified. 1. At the beginning of a year you invest $15,000 by buying 500 shares of Laidlaw. During the year Laidlaw paid you an annual dividend of $3.00 per share. At the end of the year, the stock was trading at $33 per share. Determine your dollar return for the year for the above investment. (2 marks) a)

b)

Determine your percentage return for the year.

(2 marks)

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9.220 Corporation Finance Mid-term Examination II

2.

N. Bhattacharyya/T. DenwinG Jacoby/ R. Scott March 16,200O 7:OO p.m. - 9:00 p.m. Total: 80 marks

You have in your portfolio 500 shares of a stock that you bought 5 years ago. Your investment advisor informs you that your effective annual return on this investment is 18%. You would like to know the returns from each individual year but your advisor has only some of the information which is provided in the table below:
Year 1 ? Year 2 ? Year 3 Year 4 Year 5

16%

-4%

l?%

Your advisor indicates that the returns from years 1 and 2 were identical to each other. Determine the returns from year 1 and 2. (4 marks)

3.

ABC Corp is considering an investment project that is expected to generate the same cash flow for each period of the projects life. Each periodic cash flow generated by the project is exactly 22.97% of the initial investment and is assumed to occur at the end of each period. Assume an effective discount rate of 10% per period. Determine the minimum number of periods (rounded to the nearest whole number) for which the project should pay cash flows in order for the project to be acceptable. (3 marks)

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9.220 Corporation Finance Mid-term Examination II 4.

N. Bhattacharyya/T. Demarin/G. Jacoby/ R. Scott March l&2000 7:00 p.m. - 9:00 p.m. Total: 80 marks

Consider the following cash-flows fro -5ci,ooo 11,000 20,000 40,000 Cash flows of project A are expressed in real terms while those of project B are expressed in nominal terms. The appropriate nominal discount rate is 15%, and the annual rate of inflation is 4%. Determine the real discount rate. (2 marks) al Year 0 1 2 3 -40,000 20,000 15,000 15,000

\.\5 \abq

- \=

\0.5369113\%

b)

Determine the NW of project A. (Show your work.) (2 mark)

Determine the NPV of project B. (No work need be shown.)$ (2 marks) Which project should be selected? (1 mark)

7sg

2-i

d)

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9.220 Corporation Finance Mid-term Examination II 5.

N. Bhattacharyya!T. Demarin/G. Jacoby/ R. Scott March 16,200O 7:00 p.m. - 9:00 p.m. Total: 80 marks

The Old Company Ltd. (TOC) is a producer of many video, audio and computer support products. Ltd. (TOO) has already invested $2.5 million dollars into research and development connected with the design and production of new super high-density digital video discs (DVDs) and is now considered a leader in the field. TOC believes that the competitive advantage to bringing this product to market now will last 6 years. The vicepresident in charge of finance has provided you with the following data and worksheet and asked you to determine, using an NPV analysis, if the project should be undertaken. She has also hinted that your future with the company hinges on a successful analysis of the project. Data Sheet: Companys tax rate = 36% Companys opportunity cost of capital = 12% Net working capital requirements of the project if it is accepted: Year 0 $700 , 000 Year 1 $800 , 000 Yea r2 $1 ,ooo,ooo Yea r 3 $1 ,ooo,ooo Year 4 $600,000 Year 5 $500,000 Year 6 $0 If they decide to go ahead, TOC will have to invest immediately an additional $9,000,000 in production equipment, but expects to be able to selI it to a competitor after the six years for $800,000. This new machinery will be placed in a 30% CCA class where there are many comparable assets. Assume that selling the asset will not deplete this CCA pool. TOC has decided to set its selling price at $100 per package of discs and has estimated the fist year market share to be 70 , 000 packages. It further believes that this market share will grow at 5% per year for each of the 6 years of competitive advantage. Operating expenses associated with the project are estimated to be $4,000,000 in the first year of the project and they are expected to grow at 5% per year as well for each of the six years of the project. Assume that these cash-flows occur at the end of each of the six years. TOC estimates that introducing these new DVDs to the market will result in a reduction in net sales (i.e., soles minus variable costs) of their existing products by $200,000 per year indefinitely. Assume that this cash- flow occurs at the end of each year. Worksheet & Supporting Calculations:

a)

What is the impact on the NPV of the project of the $2,500,000 research and development costs? (1 mark)

b)

What is the impact on the NPV of the project of the $9 million investment in new equipment? (Ignore the effect of any possible CCA tax shields and salvage.) (1 mark)

Qdwc
4

h-q

01

What is the impact on the NPV of the project of the net working capital requirements associated with the project? (3 marks)

o(30,~Osa

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,, 3.
,1,9220 Corporation Finance ?Mid-term Examination II d) N. BhattacharyyaIT. Demarin/G. Jacoby/ R. Scott March 16,200O 7:00 p.m. - 9:00 p.m. Total: 80 marks

What is the impact on the NPV of the project of the salvage of the assets at the end of year six? (Ignore the effect of any lost CCA tax shields) (2 marks)

What is the impact on the NPV of the project of the CCA tax shield associated with the use of the assets in the project? (3 marks)

What is the impact on the NPV of the project of the incremental revenues and expenses associated with the project (excluding lost sales of other products)? (3 marks)

g)

What is the impact on the NPV of the project of the decreased sales of TOCs other products? (2 marks)

h)

What is the NPV of the project & what is your recommendation? sq G 1 k q \

!!

(1 mark)

NPV = $

q9

.* . the project should be

Q, cqyLeA

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9.220 Corporation Finance Miditerm Examination II 6.

N. B hattacharyya/T., Demarin/G. Jacoby/ R. Scott March 16,200O 7:00 p.m. - 9:00 p.m. Total: 80 marks

The returns on the market and three stocks are given below for three possible states of the economy which might prevail next year: Economic condition Recession Normal Boom Probability
0.20

Estimated Estimated Estimated Estimated Market Return on Return on Return on return Stock A Stock B Stock C
6% 4%

0.50
0.30

14%
26%

?
34%

15% 4%

-10%

26% 8% -4%

a)

Determine the estimated return on stock A in normal conditions which would give an expected return for stock A of 20%. (3 marks) I.,\ , J wy\A. v&j +\A E c&y w. t &\,h ok 5hk A -\ k yyk 0-J -JJ+-~, 1L

b)

The expected return from stock B is 2%. Determine the standard deviation of stock Bs returns. (4 marks) 7; 4 0 y-J--.

The expected return from a market portfotio is 16% and from stock C is 8%. Determine the covariance between the returns of the market and those of Stock C. (5 marks) q IVQb 1-t 15

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9.220 Corporation Finance Mid-term Examination II

N. Bhattacharyya/T. Demarin/G. Jacoby/ R. Scott March 16,200O 7:00 p.m. - 9:00 p.m. Total: 80 marks

7.

Consider the following information provided for two securities. Security 1 Expected Return
.34

Standard

Deviation
.38

A portfolio comprised of security #l and security #2 is being considered. It is known that PI2 = -0.15. Determine the portfolio weights that would provide an investor with an expected a) return of 20.35%? (4 marks)

b)

Calculate the standard deviation of a portfolio composed of 30% of security I and the remainder in security 2. (4 marks)

Calculate the covariance between securities 1 and 2.

(2 marks)

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9.220 Corporation Finance Mid-term Examination II 8.

N. BhattacharyyalT. DemarinG Jacobyl R. Scott March l&2000 7:00 p.m. - 9:00 p.m. Total: 80 marks

A financial analyst predicts that during the following year the economy will be either booming or in recession (bust). The analyst further predicts the following returns for stocks A and B under both states. Use the following information to answer the question below.
Economic Return on _ State Stock A

Boom Bust

15% 5%

The analyst has calculated the expected return on Stock A to be 11%. Determine the probabilities she attaches to each state of the economy. (4 marks)

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