Sample problems Exam 3 - questions PDF

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Important: this is not a study guide! Below, you can see sample of problems that appeared in previous BA 323 exams in this course. During the actual exam, students must show their calculations for problems with *.

Question 1 Which one of the following statements is most likely correct according to risk-return-reward relation and CAPM for a financial security? (similar to session 11, slide 33) A.

The lower the total volatility of returns, the greater the risk premium.

B.

The greater the total beta of returns, the greater the risk premium.

C.

The greater the total variance of returns, the greater the risk premium.

D.

The risk premium is unrelated to the average rate of return.

E.

The risk premium is not affected by the variance of returns.

Question 2 A project has some credit sales. Which item in cash flows calculation would absorb the credit channel? (similar to Quizizz in class) A.

Sales

B.

Project discount factor

C.

Capital investment

D.

Net salvage

E.

Net working capital

Question 3 For which case(s), is the profitability index (or Benefit-Cost ratio) calculation a necessary method for project(s) selection?

(similar to session 8 slide 46) I.

When the project has the option to abandon

II.

When we face two repeatable mutually exclusive projects with different lives

III.

When the IRR method implies contradicting results

IV.

When there is limited resources available to run all the projects

A.

IV only

B.

III and VI only

C.

IV, and III only

D.

I, II, and IV only

E.

I and II only

Question 4 Ceteris paribus, which one of the following measures change if the systematic risk of a project changes? I. Net Present Value II. Discounted payback period III. Profitability Index IV. Payback Period V. Average accounting return

A.

I and III only

B.

II and IV only

C.

I, II and III only

D.

II, and V only

E.

IV, and V only

Accounting methods are not sensitive to TVM, and risk

Question 5 Your project analysis shows capital investment of $1,000,000 and IRR of 8% as your base case. One of your scenarios shows capital investment of $500,000 with IRR of 10% in economic downturn. Your CEO points out a confusing observation: the project has lower return on investment (IRR) in your normal scenario (8%800,000). What action should you take? (similar to session 8 slide 37)

A.

Your analysis result is not valid and it needs revision because NPV cannot go down while IRR increases.

B.

Your analysis result is not valid. You will revise it and get back to your manager because IRR drops from the law of decreasing marginal return on decreasing capital during the economic collapse.

C.

Your analysis result is still valid and it is normal; the project is less risky with larger size and lower return on investment during the normal case.

D.

Your analysis result is still valid because the project becomes less risky during the economic collapse with lower Profitability Index (the law of decreasing marginal return on decreasing capital).

E.

Your analysis result is still valid and it is normal because the project becomes larger during the economic collapse with much higher risk.

Question 6 Which one of the following information are directly used in practice to calculate the cost of equity for a company (hint: the last slide in the last lecture)?

I. Weighted average cost of capital (WACC) II. Gordon growth model III. CAPM IV. Company rating V. Average WACC for comparable companies

A.

I and V only

B.

II and IV only

C.

I, and II only

D.

III and II only

E.

I, III, and V only

See the last slide in the last lecture

Question 7 You are aware that your neighbor trades stocks based on confidential information he overhears at his workplace. This information is not available to the general public. This neighbor continually mentions to you about the fact that these trades make lots of profit. Given this, you would tend to argue that the financial markets are …… form efficient at best. I.

Weak

II.

Semi-strong

III.

Strong

A.

I and II only

B.

III and II only

C.

I, and III only

D.

III only

E.

I, II, and III

Question 8 Based on M & M and CAPM, the required return for a project in a firm depends on: A.

the project's unsystematic risk.

B.

the firm's level of systematic risk.

C.

the relative weights of the debt and equity used to finance the firm.

D.

the firm's cost of equity.

E.

the firm's cost of debt.

Question 9 * A project that costs $25,000 today will generate cash flows of $8,000 per year for seven years. What is the project's payback period? (similar to Assignment 3) A.

3

B.

3.1

C.

7

D.

-7

E.

1

PB= 25- 8 – 8 – 8 – 1=0  PB period=25/8=3.125

Question 10 * A firm with some debt currently has 16% WACC. Risk-free rate is 6%. Market risk premium is 9%. What do you expect the firm's equity beta be, if the firm had no debt?

(similar to Quizizz in class) A.

3

B.

0.89

C.

1

D.

1.1

E.

-1

16% Cost of capital with debt ≈ Cost of capital without debt=16%=6% + beta 9% Beta=10% / 9% = 1.1

Question 11 * What would be the best answer about the total volatility (TV) and beta of a portfolio made of 40% stock A and 60% stock B based on the next information? Stock A B (similar to Quizizz in class) A.

TV=16%, Beta=1.6

B.

TV≤1.6, Beta=16%

C.

TV≥16%, Beta≤1.6

D.

TV=1.6, Beta=16%

E.

TV≤16%, Beta=1.6

Total volatility 10% 20%

Total beta 1 2

Systematic risk=Beta of portfolio= weighted average of stock betas= 40%*1+ 60%*2=1.6 Systematic risk+ diversifiable risk=Volatility of portfolio ≤ weighted average of stock volatilites

Question 12 *

You have $20,000. For your portfolio, you invested in stocks A and B, and a risk-free asset. You already invested $6,000 in stock A, which you do not change. Stock A has a beta of 2 and stock B has a beta of 0.5. At least, how much needs to be invested in risk-free asset if you want a portfolio beta matching with the market portfolio beta? (similar to Assignment 4) A. -$2,000 B. 0 C. $8000 D. $10,000 E. $20,000

Market portfolio beta=BetaPortfolio = weighted average of elements’ beta = 1 = ($6,000/$20,000)(2) + (($20,000 - $6,000 - x)/$20,000)(0.5) + (x/$20,000)(0) x = -$2,000, short-sell the risk-free asset similar to example in the class that we showed how to get negative beta. Intuitively, you have to “divest” (borrow) in risk-free asset and “invest” in assets A & B. Divesting risk-free asset= borrowing. Invest 16,000 on Asset B => 20,000=6,000 in A + 16,000 in B + -2,000 in Risk-free

Question 13 * A stock just paid a dividend of $4.33 and is expected to maintain a constant dividend growth rate of 4.3 percent indefinitely. If the current stock price is $74, what is the required return on the stock? (similar to Quiz 4) A

9.71%

B

9.64%

C

10.40%

D

10.15%

E

8.88%

Constant growth model: Dividend yield = [$4.33(1 + .043)]/$74 = .0610, or 6.10% Required return = 4.3% + 6.10% = 10.40% Note: this problem or similar problems appear before and after midterm, because it is also related to cost of equity concept

Question 14 * A project is expected to produce 20 products every year for 4 years starting from next year (t=1…4). The discount rate is 10% and the project initially costs $10. What is the minimum price for each product to charge based on NPV rule? There is no inflation. (similar to Quizizz in class) A.

1

B.

0.5

C.

0.17

D.

0.12

E.

0.16

Bidding price definition: price to make NPV=0 0=NPV= -10 + (20*X) * PVIFA(10%,4) => X= 10/(20*PVIFA(10%,4))= 0.157

Question 15 * Power Manufacturing has equipment that it purchased 6 years ago for $2,500,000. The equipment was used for a project that was intended to last for 8 years. However, due to low demand, the project is being shut down. The equipment was depreciated using the straight-line method and can be sold for $525,000 today. The company's tax rate is 35 percent. What is the aftertax salvage value of the equipment? (similar to Assignment 3) A.

$472,250

B.

$307,750

C.

$525,000

D.

$560,000

E.

$625,000

Annual depreciation = $2,500,000/8 = $312,500 Book value = $2,500,000 − 6($312,500) = $625,000 Tax refund (due) = ($625,000 − 525,000)(.35) = $35,000 Aftertax salvage value = $525,000 + 35,000 = $560,000

Question 16 * A project with an initial cost of $70,000 is expected to provide annual cash flows of $12,750 over the 9-year life of the project. If the required return is 8.9 percent, what is the project's profitability index? (similar to Quiz 5) A.

1.135

B.

1.096

C.

1.238

D.

0.808

E.

1.393

PI = [$12,750(PVIFA(8.9%, 9))]/$70,000 PI = 1.096

Question 17 * Alpha Industries is considering a project with an initial cost of $10 million. The project will produce cash inflows of $1.98 million per year for 7 years. The project has the same risk as the firm. The firm has a pretax cost of debt of 6.06 percent and a cost of equity of 11.57 percent. The debt–equity ratio is 0.75 and the tax rate is 35 percent. What is the net present value of the project? (similar to Assignment 4) A.

$731,987

B.

$395,886

C.

$633,450

D.

$203,700

E.

$603,286

WACC = (1/1.75)(11.57) + (.75/1.75)(6.06%)(1 − .35) WACC = 8.30% NPV = −$10,000,000 + $1,980,000(PVIFA(8.30%,7) NPV = $203,700

Question 18 * It took 3 weeks for you to write a project proposal. The project has NPV of -$10,000 with 25% discount rate and 10% IRR. The tax rate is 25% and project lasts 5 years. During your presentation, a senior manager points out that your income estimates are not realistic: the last year’s sales should be $200,000 higher. What will happen to the decision about the project? Hint: consider incremental cash flows principle. A.

Accept the project because NPV will be 110,000

B.

Accept the project because NPV will be 1,536

C.

Reject the project because NPV will be -465

D.

Reject the project because IRR will be 14% and lower than discount rate

E.

We cannot determine the decision and require more information

Using the incremental cash flow principle: NPVnew = Old NPV + PV(incremental cash flow)= -10,000 + 200,000 * (1 - 25%)/1.25^5 = -10,000 + 49,100 = 39,100 which is close to 1,536

Question 19*

You present a proposal to buy new machinery with NPV of $0.5 Million, discount rate of 12%, and 13% Internal Rate of Return (IRR). The market leverage (debt to asset) of your company is 20%. Your CEO notices that you underestimated the cost of equity by only 5% through a mistake. What do you expect your project’s cost of capital be, if you use the corrected cost of equity? Hint: consider any change in the elements of the cost of capital

A. 16% B. 13% C. 12% D. 0.5% E. We need more details for cost of capital calculation

Old discount rate = 20% * Kd + 80% * Ke =12% New discount rate = 20% * Kd + 80% * (Ke+5%) = Old discount rate + 4% = 16%>13% New discount rate = Old discount rate + (1-20%) * 5% = 16%...