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Exam 3 Fall 2003 FINC 4531 Your Name ______________________
Instructions:
- The part of the exam is closed book and closed notes. No scrap paper is allowed; use the back of the exam if necessary.
- Partial points are based on readily observable evidence that you know at least part of the solution concept. The more evidence presented (and the clearer the evidence), the better the chance for partial points. In other words, SHOW ALL WORK!
- Multiple Choice are worth 3 points each. True False are worth 2 point each. Short answer questions are worth 4 points each. Problems are worth the number of points listed in the question.
- The goal of the a firm’s managers is generally presumed to be to maximize the value of the firm’s stock. a. True b. False
- (6 points) The overall process of capital budgeting can be broken down into five steps as a project moves from idea to reality. Name these five steps. Describe which step you think is most important.
Most important = Why?
- (4 points) Match the Capital Budgeting method with the assumed reinvestment rate (answers may be used more than once). a. Net Present Value ______________ b. Internal Rate of Return _____________ c. Payback Period _______________ d. Profitability Index _____________
a. Internal Rate of Return b. Cost of Capital c. Return on Investment d. Return on Equity e. None of the above.
- What is the best Capital Budgeting Decision Rule? Why?
- You have a choice between 2 mutually exclusive investments. If both projects have positive NPVs at your required return of 14%, which investment should you choose? A B Year Cash Flow Cash Flow 0 -$50,000 -$100, 1 +$10,000 +$20, 2 +$30,000 +$60, 3 +$50,000 +$100,
a. Project B because it has a higher NPV. b. Project A because it has a smaller initial investment. c. Either one, they are both good investments. d. You cannot choose because the internal rates of return are the same. e. Not enough information to choose between the two projects.
Consider the following possible problems that arise in using alternative capital budgeting decision rules, such as IRR or NPV, etc. Then, in the next three problems, choose the problems associated with the technique identified.
I. Ignores time value of money II. Ignores the more distant flows III. May give ambiguous results, e.g., multiple answers IV. May not correctly distinguish among mutually exclusive projects
- What are the problems associated with IRR? a. II only. b. III only. c. III and IV only. d. I, II and III only. e. none of the above
- What are the problems associated with NPV? a. II only. b. III only. c. III and IV only. d. I, II and III only. e. none of the above
- What are the problems associated with Payback Period? a. II only. b. III only. c. III and IV only. d. I, II and III only. e. none of the above
- Soft capital rationing refers to the rationing imposed externally by limited funds for borrowing from outside sources. a. True b. False
- When an estimate excludes inflation, it is said to be stated in __________. A. real terms B. risky terms C. nominal terms D.safe terms E. none of the above
- Which of the following is considered the most important responsibility of the financial managers of a corporation? a. liquidity management b. operations management c. capital budgeting d. capital structure e. dividend policy
- In plain English (i.e., as if you explaining this to a marketing major), explain what it means to say “the PI equals 1.52.”
Exam 3 Fall 2003 FINC 4531 Your Name ______________________
Instructions:
The part of the exam is open book and open notes.
Point values are listed with the question.
Show your work in order to have the possibility of partial credit.
(12 points) The following series of cash flows occur for t = 0, 1, 2, 3, 4, 5, and 6, respectively: -$285,500, $108,500, $108,500, $108,500, $68,500, $68,500, and $108,500. The appropriate risk-adjusted discount rate is 8%.
What is the NPV?
What is the IRR?
What is the payback period?
What is the Profitability Index?
- (6 points) Consider the projects shown below. If you were hard capital rationed to $100 for the initial investment, which project(s) should you choose?
Project: A B C D E F G H I Initial Cost: 15 20 25 30 35 30 35 10 15 NPV: 2.0 3.5 3.6 3.2 2.8 3.8 4.2 .7.
- (20 points) International Plastics, Inc. (IP) currently produces molded plastics with an injection-molding unit it purchased several years ago. The unit, which originally cost $500, currently has a book value of $250. IP is considering replacing the existing unit with a newer, more efficient one. The new unit will cost $ and will require an additional $50 for delivery and installation. The new unit will also require IP to increase its inventory levels by $40. The new molding unit will be depreciated on a straight-line basis over 5 years to a zero balance. IP could sell the existing unit for $375 today, while the existing unit would be worthless in 5 years. If IP purchases the new unit, annual revenues are expected to increase by $100 (due to increased processing capacity), and the annual operating costs (exclusive of depreciation) are expected to decrease by $20. Annual revenues and operating costs are expected to remain constant at this new level over the 5-year life of the project. After 5 years, the new unit will be completely depreciated and is expected to be sold for $70. Assume that the existing unit is being depreciated at a rate of $50 per year. The firm's tax rate is 40% and its weighted average cost of capital (WACC) is 13%. Management classifies projects as low risk, average risk, or high risk. Depending on the project’s risk, the firm adjusts the cost of capital (up or down) by 2%. This project will be financed with bank debt estimated with a pre-tax cost of 10%. Since this is a new technology, management feels that this is a high-risk project.
(Fill in the blanks for 2 points) At a discount rate of _________% the NPV of this project is $___________. For 18 points show how the previous two answers are correct.
Two friends are considering opening a driving range for golfers. Because of the popularity of golf, they estimate that they could rent 20,000 buckets at $3 a bucket in the first year, and that rentals will grow by 750 buckets a year thereafter. The price will remain at $3 per bucket for the life of the project. Equipment, listed below, is 5-year MACRS and is expected to have a salvage value of 10% of cost after 6 years. Expenditures for balls and buckets are $3,000 for year 1. The cost of replacing balls and buckets will grow at 5% per year (e.g. $3150 in year 2). Net working capital needs are $3,000 to start. The relevant tax rate is 15 percent. The required rate of return is 15 percent. The Equipment Requirements are; a Ball Dispensing Machine at 2,000, a Tractor and Accessories at 8,000, a Ball Pickup Machine at 8,000, for a Total or 18,000. The Operating Costs per Year are; Land Lease at 12,000, Water at 1,500, Electricity at 3,000, Seed & Fertilizer at 2,000, Labor (Salaried) at 30,000, Gasoline at 1,500, Maintenance at 1,000, Insurance at 1,000, Miscellaneous at 1,000, for a Total of 53,000.00. The friends will finance the 18,000 in equipment with a bank loan that has a 6% interest rate. The loan is to be repaid when the project ends in 6 years. In addition, at the end of year 3, the company will begin to pay a total dividend to your friends of $2,000 and this amount will increase by $1,000 per year until the project ends.
Evaluate the project for 6 years. Should your friends proceed with the project?
