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Problem Sets
CCBU 517 Corporate Financial Management
Fall, 2014

Show your work. In the instances where I ask you to use Excel, be sure to show the
arguments in your formula. Even if you use a financial calculator to answer the
questions, please show the formula that you used to solve the problem and the key steps
you took to solve it. Also, be neat and organized when presenting your work.


1. What is the objective of the firm?

2. Why is this a good objective?

3. What are Free Cash Flows? How are Free Cash flows calculated?

4. Why do we want to measure value based on future expected free cash flows and not just current free
cash flows?

5. What are the 5 uses of Free Cash Flows?

6. What are 3 ways that managers can increase the value of their firm?

7. What is the Principal/Agent Problem in relation to the structure of a corporation?

8. What are 3 ways that the Principal/Agent problem can be minimized in a company through corporate
governance? Note: Take a look at Chapter 13 Section 2 on Corporate Governance. This will provide
you with some ideas on this question.

9. Explain how mortgages get securitized today? Contrast that with how mortgages were sold to
home-buyers in the 1950s. Who bore the risk of mortgage default in the 1950s? Who bears the risk
today in a world of securitizized mortgages?

10. What are 10 reasons behind the financial meltdown from 6 years ago?

11. What are 4 features of the Dodd-Frank bill that was passed in 2010 that are designed to help prevent
the next financial crisis?


1. You are given the Balance Sheet and Income Statement for Acme Corp in the embedded spreadsheet.

Chapter 2 Homework

a) Create a Statement of Cash Flows for Acme from this information.
b) Demonstrate that the Net Operating Capital in 2013 is the same number as Investor Supplied
funds in 2013?
c) What is Free Cash Flows (FCF) for 2013?
d) Calculate the uses of Free Cash Flows (FCF) in 2013 and show that the sum of them equals the
total in your answer above.
e) What is the Return on Invested Capital (ROIC) for 2013?
f) What is the Economic Value Added (EVA) for 2013
g) What is the Market Value Added (MVA) in 2013?
h) How much Federal tax did Acme pay in 2013?

2. A company experienced a decline in net operating profit after taxes (NOPAT). Which of the following
can help explain this decline? Note: there is only one answer.

a. Sales revenues increased
b. Dividends increase
c. Interest expense increased.

Taxes increased

3. All else being equal, which of the following would cause a decrease in net operating working capital?
Note: There can be more than one answer.

a. Notes Payable increases.
b. Long-Term Debt increases.
c. Accounts Payables decrease.
d. Accounts Receivables decrease.
e. Inventories increase

4. The CFO of a company suggests should it issue $300 million worth of common stock and use the
proceeds to reduce some of the company's outstanding debt. Assume that the company adopts this
policy, and that total assets and operating income (EBIT) remain the same. The company's tax rate
will also remain the same. Which of the following will occur:

a. The company's net income will increase.
b. The company's taxable income will fall.
c. The company will pay less in taxes.
d. All of the answers above are correct.


5. Which of the following best describes free cash flow? Note: there is only one answer.

a. Free cash flow is the amount of cash flow available for distribution to shareholders after
all necessary investments in operating capital have been made.

Free cash flow is the net change in the cash account on the balance sheet.
Free cash flow is the amount of cash flow available for distribution to all investors after all
necessary investments in operating capital have been made.
d. Free cash flow is equal to net income plus depreciation.

6. As measured in dollars, what would be the EVA of a firm if it was earning just normal profits?

7. A company recently reported that its dividends per share were $4.00 (Dividends / Number of shares).
The company pays out 50% of its Net Income in dividends. The company has 1,500,000 shares of
stock outstanding. The company's interest expense was 10% on $10M of debt. The corporate tax rate
is 40 percent. What was the company's operating income (EBIT)?
a. $1,980,000
b. $17,780,000
c. $21,000,000

8. Given the information in the previous question and assuming that the company has annual depreciation
of $500K and gross investments of $1M, what is the firms free cash flow for the year?

9. A company has sales of $12.5M, operating expenses of $9.25M and a ROS of 11%. Its WACC is
10% and it's EVA is $500K. Assume a tax rate of 40%.

a) What is the Interest Expense for this company?
b) What is the Net Operating Capital for this company?

10. Corporations face the following tax schedule:

Taxable Income Tax on Base Rate
$ 0 - $ 50,000 0 15%
$ 50,000 - $ 75,000 7,500 25%
$ 75,000 - $100,000 13,750 34%
$100,000 - $335,000 22,250 39%

A company has $85,000 of taxable income from its operations.
a. What is the tax liability of this company?
b. What is the average tax rate for this company?



1. Other things held constant, which of the following will not affect the quick ratio? (Assume that
current assets equal current liabilities.)
a. Fixed assets are sold for cash which is put into the cash account on the balance sheet.
b. Cash is used to purchase inventories.
c. Cash is used to pay off accounts payable.
d. Accounts receivable are collected and the funds put into the Cash account.
e. Long-term debt is issued to pay off a short-term bank loan.

2. Company R and Company S each have the same operating income (EBIT) and basic earning power
(BEP) ratio. Company S, however, has a lower times-interest-earned (TIE) ratio. Which of the
following statements is most correct?

a. Company S has a higher ROA.
b. Company S has a higher net income.
c. Company S has a higher interest expense.
d. Statements a. and b. are correct.
e. Statements a., b., and c. are correct.

3. Which of the following actions will increase a company's Basic Earning Power (BEP)? There is one
correct answer.

a. Reduce interest payments by reducing/restructuring debt.
b. Managing inventories better to reduce their inventory holdings.
c. Reduced tax rates.
d. Adjusting the capital structure to more debt and less equity.
e. Reduce sales but operating expenses and depreciation remain the

4. Which of the following alternatives could potentially result in a net increase in a company's free cash
flow for the current year?
a. Reducing the days-sales-outstanding ratio. Additional cash generated would be put into
the Cash account on the Balance Sheet.
b. Decreasing the accounts payable balance.
c. Reductions in investments in plant and equipment.

5. Which of the following could result in an improvement in the Return on Equity (ROE) of a company?
Note: There can be more than one correct answer.

a. The company is able to finance its debt with a lower interest rate than before.
b. The company decides to buy back stock (reducing the number of shares outstanding)
by issuing more debt.
c. Sales decline due to a slump in the economy. Assume there is no change in operating
d. Energy costs increase as gas prices rise thereby increasing operating expenses.


6. Suppose a company has a Total Asset Turnover = 2.00, BEP = 9%, TIE = 3.0, a tax rate of 40% and
Total Assets = $1,000. What is the companys ROS?

a. 1.8%
b. 2.0%
c. 2.8%
d. 5.0%

7. Suppose you have the following information about a firm. Assume a 40% tax rate.

Total Asset Turnover (TAT) 2.00
BEP 9.0%
TIE 3.00
Assets $1,000
Common Equity $500

Using the DuPont formula, determine the ROE. Show all 3 terms of the DuPont formula in your

a. 6.2%
b. 7.2%
c. 12.5%

8. A company uses only common equity capital (zero debt). Its sales last year were $1M, its net
income was $100K and its ROE was 9%. Stockholders recently voted in a new management team
that has promised to lower costs and increase the ROE to 12%. What profit margin would the
company need in order to achieve the 12% ROE target, holding everything else constant?

9. A company has the following financial metrics.

Sales $1,200
Debt Ratio 0.5
Total Asset Turnover 2.0
Fixed Asset Turnover 3.0
Inventory Turnover 12.0

Current Assets / Current Liabilities 1.5
Cash/Current Assets 20%
Accounts Receivable / Accounts Payable 80%
Notes Payable / Current Liabilities 20%

Given this information, complete the following Balance Sheet.

Assets Liabilities
Cash ?
Accounts receivable ? Accounts payable ?
Inventory ? Notes payable ?
Current Assets ? Current Liabilities ?

Plant & Equipment ?

Long-Term Debt
Common Equity & Retained Earnings
Total Assets ?

Total Liabilities & Shareholder Equity ?

10. Last year a company had sales of $500K, operating costs of $400K and year-end assets of $250K.
The debt/total assets ratio was 30%, the interest rate on the debt was 5% and the firms tax rate
was 40%. Now suppose the firm had used a 55% debt ratio instead of a 30% ratio. Assume that
sales and total assets would not be affected and that the interest rate and tax rate remained the
same as before. By how many percentage points would ROE change in response to the change in
the capital structure?

11. You are given the following information: Stockholders' equity (booked equity) = $1,250;
price/earnings ratio = 5; shares outstanding = 25; market/book for equity ratio = 1.5. Calculate the
market price of a share of the company's stock.

a. $33.33
b. $75.00
c. $100.00
d. $166.67

12. A company has the following data for the current year:

Sales $950
Opex Exp+Depre $400
Debt Ratio (Debt/Assets) 50%
Debt $3,500
Tax Rate 40%
Interest Rate on Debt 6%

Sales will grow 20% next year. Operating expenses & Depreciation will grow 10%. And as a result of
the sales growth, assets will grow at 10% but the same Debt/Asset ratio will be maintained.

a) What is the ROA, ROS and Total Asset Turnover for the current year?
b) As a result of the sales change, what will be the revised ROA, ROS and Total Asset Turnover?

13. A company has 100,000 shares of common stock outstanding. The company's stock price = $27
per share and its P/E is 10. What are the earnings (Net Income) of this company?

14. Your company had the following balance sheet and income statement information for 2013:

The industry average for DSO is 20 days. You think you can change your collections
procedures so that you can achieve that average. The result of your efforts is that this is
expected to generate additional cash for you since your collections will be accelerated.

You plan on buying tax-exempt securities which pays 6% interest annually. The interest
payments you receive are interest income to your company and are added to your net income
from operations. Because these are tax exempt, they boost your net income on a dollar-for-
dollar basis. What will your profit margin be after the change in your collections procedure is
reflected in the income statement?

15. A firm has $1M in debt and pays 6% annual interest on that debt, has sales of $2 million, a tax rate
of 40 percent, and a net profit margin (ROS) of 10%. What is the firm's times-interest-earned


1. You deposit $1,700 in a savings account that pays 1.5 percent interest, compounded annually. How
much will your account be worth in 25 years? Show the formula and the compounding factor you
used to calculate your answer.

2. You can earn 4 percent interest, compounded annually. How much must you deposit today to
withdraw $5,500 in 5 years? Make sure you show the formula and the present value factor you used
to calculate your answer.
Balance Sheet:

Assets Liabilities
Cash $300 Accruals $0
A/R $800 Accounts Payable $0
Inventories $2,500 Notes Payable $0
Current Assets $3,600
Current Liabilities

Debt $2,500
Net Fixed Assets $3,900 Equity $5,000
Total Assets $7,500 Total Liabilities $7,500

Income Statement:
Sales $8,500
Cost of goods sold $6,000
EBIT $2,500
Interest (10%) $250
EBT $2,250
Taxes (40%) $900
Net Income $1,350

3. Suppose you invested $10,000 in stocks 35 years ago. If your account is now worth $36,500, what
annual rate of return did your stocks earn? Show the formula and calculations used to determine
your answer.

4. You are currently investing your money in a bank account which has a nominal annual rate of 1%
compounded annually. If you invest $10,000 today, how many years will it take for your account to
grow to $20,000? Solve the problem algebraically.
a. 35 years
b. 70 years
c. 140 years

5. What is the future value of a 15-year ordinary annuity with annual payments of $200, evaluated at a 3
percent interest rate? Show the formula used and the annuity factor you used to calculate your answer.

6. What is the present value of a 5-year ordinary annuity with annual payments of $250, evaluated at a 5
percent interest rate? Show the formula and discounting factor used to calculate your answer.

7. Suppose that instead of an ordinary annuity, this was an annuity due. What would be the present value
of this annuity?

8. If a 5-year ordinary annuity has a present value of $1,500, and the interest rate is 2 percent, what is the
amount of each annuity payment? Show your formula and interest factor.

9. You have the opportunity to buy a perpetuity which pays $1,000 annually. Your required rate of return
on this investment is 2 percent. What is the highest price would you be willing to pay for this

10. You are given the following end-of-year cash flows. Assuming a 7% interest rate, what is the present
value of these cash flows? Solve this algebraically.

Year 1 Year 2 Year 3 Year 4
$4,000 $4,000 $4,500 $4,800

11. Which of the following investments would provide an investor the highest effective annual return?
a. An investment which has a 8.6 percent nominal rate with daily compounding.
b. An investment which has a 8.9 percent nominal rate with monthly compounding.
c. An investment which has a 9.5 percent nominal rate with quarterly compounding.
d. An investment which has a 9.6 percent nominal rate with semi-annual compounding.

12. Suppose we have a 10-year ordinary annuity that has a present value of $1,000 and an nominal annual
interest rate is 9.5 percent. If interest is compounded quarterly, what is the value of the quarterly

a. $37.50
b. $39.00
c. $52.45

13. You borrow $300,000 at a 6.00% interest rate. You make annual payments (at the end of the year) for
20 years.

a. What is your annual payment?
b. How much interest did you pay in year 10?
c. How much principal will you pay in year 5?
d. What is the total amount of interest you will pay?
e. Demonstrate that your loan is fully paid up at the end of year 20.

Solve for this using the appropriate annuity formula and Excel table.

CHAPTER 6 Risk and Return

1. Stock A has a beta of 1.5 and Stock B has a beta of .9. Which one of the following statements is
correct? Note: There is only one correct answer.

a. The required return on Stock A will be greater than Stock B.
b. The slope of the SML for Stock A is steeper than Stock B.
c. Stock B is riskier than the entire market.
d. The required return on Stock B will be greater than Stock A.

a. D
2. A risk-averse investor is considering two possible assets to be held on a standalone basis. The possible
returns and related probabilities (i.e. the probability distributions) for each assets are as follows:

Asset X Asset Y
Prob r Prob r
5% -5% 5% -2%
15% 5% 15% 4%
25% 6% 20% 4%
25% 7% 25% 9%
30% 12% 35% 11%

Considering both its return and risk, which asset is preferred? Why?

3. Given the returns and probabilities for assets X and Y below, which asset would be preferred if you
were interested in minimizing your relative risk?

Asset X Asset Y
Prob r Prob r
5% -2% 5% 2%
15% 5% 15% 4%
25% 6% 20% 7%
25% 7% 25% 9%
30% 12% 35% 14%

4. You are a risk-averse investor. Suppose two stocks had the following historical returns

Stock A Stock B
Year 1 10% 10%
Year 2 11% 7%
Year 3 9% 12%
Year 4 13% 10%
Year 5 7% 12%

Further suppose you have 3 investment options a) hold only Stock A, b) hold only Stock B or c) hold a
portfolio consisting of 50% of each stock. Which would you choose? Why?

5. Which of the following statements are correct?
a. If you add enough randomly selected stocks to a portfolio, you can completely eliminate
all the risk from the portfolio.
b. Diversifiable (or company-specific or unsystematic) risk can be reduced by forming a
large portfolio, but even highly diversified portfolios will still be subject to market (or
systematic) risk.
c. Only if the portfolio beta is greater than 1 will unsystematic risk be reduced by adding
stocks to a portfolio.

6. Suppose the correlation coefficient between two stocks is equal to +1. Can you reduce your risk by
creating a portfolio that consists of these two stocks? Explain your reasoning.

7. Suppose two investments yield the same fixed return as measured in dollars, say, $100. But the return
to one security has certainty (such as a US Treasury obligation) and the return to the other is uncertain
(such as a junk bond which may default). And further suppose that, for the moment, the price of each
security is $1,000 and the percentage return of each is 10%. This situation cannot persist as investors
buy and sell these bonds in response in response to the perceived risk differences. What would be a
possible equilibrium price and return for each security?

a. Treasury Security: Price = $800, r = 16.67%
Junk Bond: Price = $1,200, r = 8.33%
b. Treasury Security: Price = $1,500, r = 6.67%
Junk Bond: Price = $850, r = 11.8%
c. Treasury Security: Price = $1,200, r = 20%
Junk Bond: Price = $750, r = 12%

8. Stock A and Stock B each have an expected return of 15 percent, a standard deviation of 20 percent,
and a beta of 1.2. The returns of the two stocks are not perfectly correlated as the correlation
coefficient is 0.6. You have put together a portfolio which is 50 percent Stock A and 50 percent
Stock B. Which of the following statements is correct? Note: There is only one correct answer.

a. The portfolio's expected return is greater than 15 percent.
b. The portfolio's beta is less than 1.2.
c. The portfolio's standard deviation is greater than 20 percent.
d. None of the statements are correct.

9. The required rate of return on the stock using the Security Market Line formula is 8% when the
required return on an average stock in the market (r
) is 10 percent. The risk-free rate is 2%.

What will be the percentage change in the return to this stock if r
increases by 10 percent? (Note:
Not 10 percentage points but 10%. So, for example, if r
=10%, 1.1 x 10% = 11%.) Note that the
risk-free rate is unchanged.

10. Assume that the risk-free rate, r
, is 6 percent and the market risk premium, (r
- r
), is 5 percent.
Assume that required returns are based on the CAPM (Security Market Line formula). Your $1
million portfolio consists of $700,000 invested in a stock that has a beta of 1.2 and $300,000 invested
in a stock that has a beta of 0.8. Which of the following statements is correct? (Note: There is only 1
correct answer.)
a. The portfolio's required return is less than 11 percent.
b. If the risk-free rate remains unchanged but the market risk premium increases by 2
percentage points (from 5% to 7%), the required return on your portfolio will increase by
more than 2 percentage points.
c. If the market risk premium remains unchanged but expected inflation increases by 2
percentage points, the required return on your portfolio will increase by more than 2
percentage points.
d. If the stock market is efficient, your portfolio's expected return should equal the expected
return on the market, which is 11 percent.

11. What condition holds when a stock is in equilibrium -
a. The expected future return equals the current return.
b. The expected return equals the required return.
c. Beta = 1.

Note: there is only one correct answer.

12. If markets are semi-strong efficient, can the average investor successfully pick individual stocks?
Explain your reasoning.


1. Will an unsecured bond (i.e. a bond with no asset as collateral) have a higher or lower yield-to-
maturity than a mortgage-backed bond? Explain your reasoning.

2. The Yield Curve is generally positively sloped Treasury bills have a lower yield than Treasury
bonds. What explains the unusual situation when a Treasury bill has a higher yield-to-maturity than a
20-year Treasury bond?

3. Which of the following statements is correct? (Note: There can be more than one correct answer.)

All else equal, short-term bonds have less reinvestment risk than long-term bonds.
All else equal, long-term bonds have a greater maturity risk premium than short-term bonds.
c. Corporate securities have a smaller inflation premium than a similar Treasury security.
d. All bonds have the same liquidity risk premium.
e. All bonds have the same default risk premium
f. All of the above answers are false.

4. Suppose the U.S. Federal Government defaults on paying the interest on its debt obligations. What do
you think will happen to yields on Federal Government debt obligations? Explain your reasoning.

5. Assume interest rates on 10-year federal government and 10-year corporate bonds were as follows:

US Treasury bond = 7.72% Corporate A-Rated Bonds = 9.64%
Corporate AAA-Rated Bonds = 8.72% Corporate BBB-Rated Bonds = 10.18%

The differences in rates among these issues were caused primarily by -
a. Tax effects.
b. Default risk differences.
c. Maturity risk differences.
d. Inflation differences.
e. Answers b and d are correct.

6. You would like to minimize your interest rate risk (maturity risk) and your default risk. Which of the
possible bonds listed below best satisfies your requirements?
a. AAA bond with 10 years to maturity.
b. BBB perpetual bond.
c. BBB bond with 10 years to maturity.
d. AAA bond with 5 years to maturity.
e. AA bond with 5 years to maturity.
f. 90-day Treasury Bill

7. You noticed in the financial pages of the local newspaper that you can buy a $1,000 par value bond for
$950. The annual coupon rate is 10 percent and there are 4 years to maturity. If the required return on
this investment is 11 percent, should you make the purchase?

8. Consider a $1,000 par value bond with a 5 percent annual coupon. The bond pays interest annually.
There are 7 years remaining until maturity. What is the current yield on the bond assuming that the
required return on the bond is 9 percent?
a. 9.00%
b. 6.26%
c. 4.78%

9. A bond has a par value = $1,000. The annual required rate of return on this bond is currently 7 percent,
and interest is paid semi-annually. The bond matures in 5 years and its current market value is
$1041.58. What is the semi-annual coupon payment?

a. $35
b. $40
c. $80

10. The current yield-to-maturity on a 10-year corporate bond is 7%. You are given the following
information on this bond.

r* = real risk-free rate on Treasury & corporate bonds = .5%
Maturity risk premium = 1%
Inflation premium = 2%
Liquidity premium = .5%

What is the default risk premium for this bond?

11. A 20-year bond has a par value of $1,000 with a coupon return of 8.5% and a yield-to-maturity
(YTM) of 11%. What is the price of this bond? Provide your answer using the NPV, PV and Price
functions in Excel.


1. A share of common stock has just paid an annual dividend of $ 3.50 (D
). If the expected dividend
growth rate for this stock is 3 percent (g) and investors require a 10 percent rate of return (r
). What is
the price of the stock?

a. $36.05
b. $50.00
c. $51.50

2. Given the information in the previous question, what would be the expected share price in period 2

3. What is the dividend yield on this stock in period 0?

4. What is the expected rate of return on this stock? Show your answer by considering the dividend yield
and capital gains yield.

5. The last dividend paid by a company was $3.00 (D
=$3.00). The dividend next year is expected to be
$3.50 (D
=$3.50) and the dividend two years out is expected to be $4.00 (D
=$4.00). After that, the
dividend growth rate is expected to be 4 percent forever. The company's stockholders require a rate of
return on equity (r
) of 12 percent. What is the current price of the stock?
a. $47.76
b. $75.90
c. $75.90

6. A company has decided to undertake a large capital project. And there is a need for additional funds.
The financial manager plans to issue preferred stock with a perpetual annual dividend of $4.00 per
share. If the required return on this stock is currently 6 percent, what should be the price of the stock?
a. $45.33
b. $66.66
c. $67.66

7. The most recent dividend of a company was $2.50 per share (i.e., D
= $2.50). The dividend is
expected to grow at a rate of 4 percent per year. The risk-free rate is 1 percent and the return on the
market is 8 percent. If the company's beta is 1.1, what is the price of the stock today? Note: You need
to use the CAPM and constant dividend growth model to solve this.

8. A stock is currently selling for $30 a share. The stock is expected to pay a $1 dividend at the end of the
year (D
= $1). The stock's dividend is expected to grow at a constant rate of 2 percent a year forever.
The risk-free rate (r
) is 1 percent and the market risk premium (r
- r
) is 5 percent. What is the
beta for this stock?
a. .866
b. 1.06
c. 1.62

9. You are given the following data:

(1) The FCF = $200,000.
(2) It is expected to grow 2% per year.
(3) The WACC is 9%
(4) The company has a capital structure of 30% debt and 70% equity.
(5) The company has 100,000 shares outstanding.

What is the stock price?

10. A company has a current stock price of $47. This company is planning to pay a dividend of $2.50 per
share two years from now, (i.e., D
= $2.50). The company is planning to pay the same dividend each
of the following 2 years (D
= $2.50 and D
= $2.50) and will then increase the dividend to $3.00 for
the subsequent 2 years (i.e., D
and D
). After that time the dividends will grow at a constant rate of 5
percent per year. If the required return on the company's common stock is 10 percent per year, what is
expected dividend at the end of year 1 (D
a. $1.80
b. $2.45
c. $2.50

11. A company has 1.1M subscribers to its service. The Price/100K Subscribers ratio is $4.50. Using a
market-multiple analysis, what is the price of a share of stock for this company?

d. $4.50
e. $45.50
f. $49.50

12. A company has a stock price of $30.00 per share (P
= $30.00). The dividend per share in the current
period is $2.00 (D
= $2.00). The expected capital gains yield or long-run growth rate (g) for the
company is a constant 1.5 percent (g=1.5%). What is the company's capital gains yield and dividend

a. Capital gains yield = 1.5%; Dividend yield = 6.76%.
b. Capital gains yield = 6.76%; Dividend yield = 1.5%.
c.. Capital gains yield = 1.5%; Dividend yield = 6.66%.


1. Why do we use the after-tax cost of debt but the before-tax cost of equity when calculating our

2. Some people argue that retained earnings are free money because a company does not have to pay
fees to investment bankers when it issues new stock. Therefore, the firm doesnt have to worry about
the return on the projects that it invests in with these funds. Evaluate the validity of that statement.

3. Which of the following is not considered a capital component for the purpose of calculating the
weighted average cost of capital as it applies to capital budgeting?
a. Long-term debt.
b. Common stock.
c. Receivables
d. Preferred stock
e. Notes Payable
f. All of the above are considered capital components for WACC and capital budgeting

4. For a typical firm with a given capital structure of debt and common equity, which of the following is
a. r
> r
b. r
> r
c. r
> WACC > r
d. WACC > r
> r

5. A company's capital structure consists of common stock and debt. Which of the following events will
reduce the company's WACC?

a. An increase in the market risk premium.
b. An increase in the risk-free rate.
c. An increase in the tax rate.
d. An increase in expected inflation.
e. An increase in the companys beta.
f. An increase in the projected dividend growth rate.

6. If a company uses the same discount rate to evaluate all its projects, the firm will most likely become -
a. Riskier over time
b. Less risky over time
c. There is no reason to expect its risk position or value to change over time as a result of its
use of a single discount rate.

7. You have the following information about a company -

- A company wishes to finance its projects with 30% debt,
10% preferred stock and 60% common stock.
- The company can issue bonds at a yield to maturity of 6.5
- The cost of preferred stock is 7.5 percent.
- The company's common stock currently sells for $40 a
- The company's dividend is currently $2.10 a share (D
$2.10), and is expected to grow at a constant rate of 5
percent per year.
- Assume that there is no flotation cost on debt and
preferred stock, and no new stock will be issued.
- The company's tax rate is 40 percent.

What is the company's weighted average cost of capital (WACC)?

a. 8.23%
b. 8.73%
c. 9.79%

8. A company has a weighted average cost of capital of 11.5 percent. Its target capital structure is 55
percent equity and 45 percent debt. The company has sufficient retained earnings to fund the equity
portion of its capital budget. The before-tax cost of debt is 9 percent, and the company's tax rate is 30
percent. If the expected dividend next period (D
) and current stock price are $5 and $45,
respectively, what is the company's growth rate (g)?

a. 2.68%
b. 3.44%
c. 4.64%


1. What are three reasons why the NPV method preferred to the payback period method (not
discounted payback period) when evaluating cash flows?

2. A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of the
following independent projects should the company accept? Note: there is only one correct

a. Project A requires an up-front expenditure of $1,000,000 and generates an internal rate of return of
9.7 percent.
b. Project B has a modified internal rate of return of 9.5 percent.
c. Project C requires an initial investment of $1,000,000 and generates a net present value of -$3,200.
d. Project D has an internal rate of return of 10.2 percent.
e. Project E has a Discounted Payback Period of 24 months.
f. None of the projects above should be accepted.

3. A company has an investment opportunity which will yield the following cash flows (in thousands
of dollars). Assuming the cash flows occur evenly during the year, what is the payback period for
this investment?

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Cash Flow -$40 $5 $10 $15 $15 $15

a. 3.00 years
b. 3.33 years
c. 3.67 years
d. 4.00 years

4. What is the discounted payback period for these cash flows? Assume a WACC of 9%.

5. Given the cash flows in the previous problem and assuming a 9% WACC, calculate the NPV for
this project. Should this project be undertaken?

6. Using Excel, calculate the IRR for this stream of cash flows. Does your answer confirm the
results of the previous problem?

7. A company has a project which has the following cash flows

If the cost of capital is 10%, what is the Modified Internal Rate of Return
(MIRR)? Solve this problem algebraically (i.e. not using Excel).

a. 25.7%
b. 30.2%
c. 36.3%

8. Suppose you had the following cash flows.

0 -$1,000
1 $200
2 $250
3 $300
4 $350
5 $400

Using Excel and assuming a WACC and reinvestment rate of 6%, what is the MIRR?

a) 9.6%
b) 10.6%
c) 13.5%

9. Suppose we have a project with an upfront investment of $2,000 and positive cash flows of $100
per year for the next 100,000 years. The appropriate discount rate is 4%. Further suppose that we
are evaluating this project before the time of spreadsheets and computers. So we need to make this
calculation the old fashioned way using good ol paper and pencil. Determine the NPV of this

a. Cant be calculated because of the number of years involved.
b. -$250
c. $0
d. $500


1. A company is thinking about expanding their business by opening another shop on property they
purchased for cash 10 years ago. Which of the following items should be included in the analysis of
this endeavor? (Answer with a Yes or No.) And why?
a. The property was cleared of trees and brush 5 years ago at a cost of $5,000.
b. The new shop is expected to affect the profitability of the existing shop since some current
customers will transfer their business to the new shop. The company estimates that profits
0 -$500
1 $300
2 $300
3 $300
at the existing shop will decrease by 10 percent.
c. The company can lease the entire property to another company (that wants to grow
flowers on the lot) for $5,000 per year.
d. The company needs to purchase inventory to stock the shop prior to its opening.
e. The company must pay workers to keep the shop running.
A competitor has a shop across the street selling similar goods.
The cash outlay that you made 10 years ago for this property.

2. What is the impact on the cash flows of a project when you switch from straight-line depreciation to
MACRS accelerated depreciation? Why?

3. A company is contemplating the replacement of its old printing machine with a new model costing
$80,000. The old machine, which originally cost $60,000, has a current book value of $30,000 versus
a current market value of $35,000. The company has corporate tax rate is 40 percent. If the company
sells the old machine at market value, what is the net after-tax outlay for the new printing machine?

a. -$40,000
b. -$46,000
c. -$47,000

4. A company is considering the introducing a new product. Annual sales are expected to be 30,000
units per year for 5 years. Each unit will sell for $4.00. No inflation is anticipated. This will require
investment in machinery of $90,000. Operating expenses are expected to be $85,000 per year. The
company will use the MACRS accelerated method to depreciate the machine, and it expects to sell the
machine at the end of its 5-year operating life for $6,000. The firm expects its net operating working
capital to increase at the beginning of the project by 3% x annual sales resulting in a cash outflow.
During the course of this project, there will be no net change to net operating working capital. But its
working capital requirements will decline by 3% x annual sales at the end of 5 years as inventories
are sold. This will result in a cash inflow. The marginal tax rate for this company is 40 percent, and
it uses a 7 percent cost of capital to evaluate projects like this. What is the NPV of this project?
Should the company go ahead with the project?

Below is the appropriate depreciation schedule.
Year Percent
1 0.20
2 0.32
3 0.19
4 0.12
5 0.11
6 0.06

5. For a +/- 10% change in its base value, is the NPV more sensitive to a change in the amount of
equipment required or the unit price? Show your answer in a sensitivity table.


6. A company is considering an investment in a new product. There are 3 stages to this project.

Stage 1: The company will invest $10,000 at t=0 for the product design and testing. The company
believes there is a 60% probability that this phase will be successful and the project will continue. If
this stage is not successful, the project will be abandoned with zero salvage value.

Stage 2: If Stage 1 is successful, the company will create a prototype in Stage 2. This will cost
$500,000 at t=1. If the prototype tests well, the company will go into production. If it does not test
well, then the company will abandon the project and the prototype will be sold for $100,000. The
company estimates that the probably of testing success is 80%. If Stage 2 is successful, the company
will go into Stage 3.

Stage 3: This would require further investments of $1,000,000 at t=2. The product will then be sold in
period t=3. (In other words, there is one period of sales.) If the economy is strong, the company
believes that its net cash flows in t=3 will be $3,000,000. If the economy is average, the net cash
flows in t=3 will be $1,500,000. The probability of a strong economy is 50% and an average economy
is 50%.

The companys WACC is 12%.

a) What is the expected NPV of this project?
b) What is the expected standard deviation of this project?
c) What is the Coefficient of Variation of this project?

Note: The easiest way to set this up is use a decision tree similar to the examples in the book.


1. A company had the following balance sheet last year:

Assets Liabilities & Equity
Cash $300 Accounts payable $2,150
Accounts receivable $500 Accrued wages $650
Inventory $1,000 Notes payable $1,000
Current Assets $1,800 Current Liabilities $3,800

Net fixed assets $27,000 Mortgage $16,800

Common stock $4,200
Retained earnings $4,000
Total assets $28,800 Total liabilities and equity $28,800

The company has just invented a product which it expects will cause sales to increase by 50% from
$10,000 to $15,000, increasing net income by $2,000 of which 50% will retain and 50% will be
distributed to shareholders as dividends. As a result of the sales increase, current assets will increase
by 50% as will current liabilities (excluding notes payable). Fixed assets will increase by 20% to
support the increased sales.

(1) Will the company need any outside funding?
(2) If it does require outside funding, how much does it need? (Assume any outside funding is done
through an increase in notes payable.)

a. No; $0. No AFN required. And no surplus
b. Yes; $3,900 in AFN
c. Yes; $4,100 in AFN
d. No; there will be a $150 surplus.

2. You are given the Income Statement and Balance Sheet for Acme in the embedded spreadsheet.

Chapter 12
Homework Problem.xlsx

Calculate the following
a. Horizon Value
b. Value of Operations
c. Share price.
d. Will the company have surplus or deficit financing requirements? How much?

Note: There are a series of assumptions that should underlie your analysis. Assume that the various
financial ratios are the same for every year as the current 2013 ratios. Assume that the sales growth
rate and the dividend growth rate is the same as their 2013/2012 values. Run your projections for 5

a) Horizon Value
i) $1,979
ii) $2,155
iii) $2,432

b) Value of Operations
i) $1,668
ii) $1,768
iii) $2,155

c) Share Price
i) $10.23
ii) $11.67
iii) $14.67

d) Financing requirements
i) Surplus. $10
ii) Deficit: $32
iii) Deficit: $27


3. If Acme improves its COGS (excluding depreciation) by 1 percentage point (e.g. from 87.2% of sales
to 86.2% of sales), what will be the new share price?