Midterm Exam

Name

CORPORATE VALUATION Spring 2010 Multiple Choice -- Circle the letter of the BEST answer (3 points each) 1. Consider a project with positive future cash flows. As the discount rate is increased, the a. b. c. d. e. IRR remains constant while the NPV rises IRR decreases while NPV remains constant IRR remains constant while NPV decreases payback period lengthens none of the above

2. In theory, the decision maker should view the firm's systematic risk as being of primary importance. The firm's unsystematic risk is also important because a. b. c. d. e. it may affect the debt capacity and net income of the firm it affects the firm's creditworthiness it affects the job stability of the manager all of the above none of the above

3. Which of the following statement completions is NOT true? For a profitable firm, using MACRS accelerated depreciation rather than straight-line depreciation results in a. b. c. d. higher depreciation charges in the early years of an asset's life larger cash flows in the earlier years larger total profits from the project over the project's life smaller accounting profits in the early years (assuming the same depreciation method is used for both financial and tax purposes) e. All of the above statements are true. 4. Which of the following is NOT true about the Net Present Value (NPV) of a project? a. It assumes that the cash flows are reinvested at the discount rate b. It tells you the increase in the value of the firm that will occur by accepting the project. c. If the NPV is greater than zero, then the IRR is greater than the required rate of return when cash outflows precede cash inflows. d. It doesn't indicate how efficiently funds have been invested. e. All of the above are true. 5. A project with a Net Present Value of zero when discounted at the weighted average cost of capital a. provides lenders their required rates of return and principal, but only returns principal to stockholders b. returns principal only to both lenders and stockholders c. provides lenders their required rates of return and principal, but returns neither to stockholders d. has an Internal Rate of Return that is greater than the weighted average cost of capital e. none of the above 6. Methods of estimating a firm's cost of equity include a. b. c. d. e. the Gordon Dividend Model using industry data rather than specific firm data the Capital Asset Pricing Model all of the above none of the above

7. The use of past returns as an estimate of expected future returns relies upon

a. the assumption that history always repeats itself b. the past being observable, while the future cannot be observed c. rational expectations and the assumption that investor errors in forecasting future performance are not systematically wrong over time d. the cost of capital remaining constant over time e. none of the above 8. Which of the following capital budgeting evaluation techniques is generally accepted to be the most consistent with the concept of maximizing shareholder wealth? a. b. c. d. e. payback net present value internal rate of return profitability index (benefit-cost ratio) none of the above are consistent with shareholder wealth maximization

9. The optimal debt ratio a. utilizes debt to increase stockholder wealth to the point where the advantage of financial leverage is just offset by the increased riskiness to stockholders b. uses as much debt as possible to take advantage of the tax-deductibility of interest payments c. maximizes the weighted average cost of capital d. maximizes the availability of capital e. none of the above 10. Inflation, recession and high interest rates are economic events which are characterized as a. b. c. d. e. company specific risk that can be diversified away systematic risk that can be diversified away unsystematic risk that can be diversified away market risk none of the above

11. You have applied for a $1 million equipment loan from your bank. The loan repayment will consist of five equal payments at the end of each of the next five years, with each payment being part interest and part principal. The bank has agreed to loan you the money over a fiveyear period at an 8% rate of interest if you (1) pay a loan origination fee of $25,000; (2) pay bank fees of $24,000 per year; and (3) pay the legal fees of $5,000 to have a clear title to the equipment at the end of the loan period. What is the effective rate of interest on this loan? (10 points)

12.7%

12. This question was on material not being covered in Spring 2011.

13. Your construction company needs to purchase an additional frontloader for moving dirt and loading trucks. The CAT-10 model costs $100,000 but your foreman is pushing for the larger, more expensive Komatsu Groundhog that costs $150,000. Both models fall under the MACRS 5-year asset category for depreciation purposes (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%). You insist that the more expensive machine pay for itself within three years, and will assume that both models will have a resale value of 45% of purchase cost at the end of three years for purposes of making a comparison. The foreman insists that the larger Groundhog will complete projects faster and allow you to take on $250,000 in additional jobs each year. As a consequence, of the additional work, however, salaries and transportation costs will increase by $210,000 per year and insurance will be approximately $8,000 per year more. In addition, the increased amount of work will require $20,000 in working capital initially (in the form of increased accounts receivable and inventories), all of which will be recovered at the end of the third year. You are in the 40% tax bracket and your cost of capital is 15%. Should you buy the larger Komatsu Groundhog? (20 points)

Year 0 Net Cash Flows $(70,000)

Year 1 $ 23,200

Year 2 $ 25,600

Year 3 $ 62,300

14. Tektonic Enterprises has the following balance sheet: L-T Debt (7%) Common Stock ($4 par) Retained Earnings Total Assets $ 5,000Tot. Liab. & Equity $2,000 2,000 1,000 $5,000

No dividend is paid on the common stock. Its historical beta has been 1.2 and the stock is currently selling for $12.00 per share. The current market rate of interest on the debt is 5% and the current debt will mature in 10 years. Tektonic has a 40% tax rate. The expected return on the market is 9% and the risk-free rate is 3%. A. What is the market value of the debt? What is the market value of the Equity? (5 points) Debt = $ 2,309 Equity = $ 6,000

B.

What is the WACC for Tektonic? (5 points)

8.2%

C.

Tektonic Enterprises is going to issue $1,000 worth of new debt (at a 7% coupon rate of interest) to finance a repurchase of common stock in order to avoid a hostile takeover. The market rate of interest on the outstanding bonds is expected to rise to 7% since the probability of default will increase. The market price per share of common stock is expected to rise to $12.50 per share as a result of the repurchase. What will be the new WACC after the new debt is issued and the $1,000 of stock repurchased? (15 points)

Unlevered Beta = 0.975 New WACC = 8.44%