Midterm Exam Name
CORPORATE VALUATION
Spring 2004
Multiple Choice -- Circle the letter of the BEST answer (3 points each)
1. Which of the following statements is most correct about a stock which has a beta of 1.2?
a. If the stock’s beta doubles, its expected return will double.
b. If expected inflation increases 3%, the stock’s expected return will increase by 3%.
c. If the market’s risk premium increases by 3%, then the stocks expected return will increase by 3%.
d. All of the above are true.
e. None of the above are true.
2. Project A has twice as much risk as the firm as a whole. The firm’s cost of capital is 12% and the risk-free rate is 5%. The firm can borrow long-term debt at 8%. The appropriate risk-adjusted discount rate for Project A is:
a. 10%
b. 13%
c. 16%
d. 19%
e. None of the above
3. Which of the following statements is NOT true?
a. If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.
b. If IRR = k (cost of capital), then NPV = 0.
c. The NPV can be negative if the IRR is positive.
d. The NPV method is not affected by the multiple IRR problem.
e. All of the above statements are true.
4. Which of the following statements is NOT correct?
a. Sunk costs should be incorporated into capital budgeting decisions.
b. Opportunity costs should be incorporated into capital budgeting decisions.
c. Sales cannibalization effects should be considered in the capital budgeting decision.
d. All of the above are correct.
e. None of the above are correct.
5. Which of the following would increase the NPV of a project?
a. A shift from MACRS to straight-line depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three years.
c. A decrease in the discount rate due to a decrease in overall interest rates.
d. The sale of the old machine in a replacement decision at a loss relative to book value rather than at a gain.
e. None of the above would increase the NPV of a project.
6. As a general rule, the capital structure that
a. maximizes expected EPS also maximizes the price per share of common stock.
b. minimizes the interest rate on debt also maximizes the expected EPS.
c. minimizes the required rate of return on equity also maximizes the stock price.
d. maximizes the price per share of common stock also minimizes the weighted average cost of capital at any given volume of financing.
e. None of the above.
7. Which of the following statements is most accurate?
a. Beta measures systematic risk, but if a firm's stockholders are not well diversified, beta may not accurately measure the firm's total risk to the stockholders.
b. If the calculated beta underestimates the firm's true investment risk, then the CAPM method will overstate ks.
c. The Discounted Cash Flow method of estimating the cost of equity (the Gordon, or Dividend Valuation, model) can be used even if the growth component, g, is not constant during the analysis period.
d. An advantage shared by both the Discounted Cash Flow and CAPM methods of estimating the cost of equity capital is that they yield precise estimates and require little or no judgment.
e. All of the above statements are accurate.
8. Diversification of risk
a. is the elimination of unsystematic risk
b. is the elimination of systematic risk
c. is more effective for positively correlated assets than for negatively correlated assets
d. is unnecessary since only non-diversifiable risk is relevant
e. none of the above
9. When establishing the cash flows of a project for capital budgeting purposes
a. depreciation should be ignored because it is not cash
b. increased receivable and inventory requirements must also be considered
c. total cash flows of the firm must be known
d. taxes can be ignored until after the Internal Rate of Return has been determined
e. none of the above is true
10. The NPV of a project utilizing a market value weighted average cost of capital
a. is the same as the NPV of the project using book value weights.
b. yields a proportionally positive NPV for lenders as well as stockholders.
c. is the same as the NPV for stockholders when debt financing cash inflows and outflows are explicitly considered in the analysis.
d. is always zero.
e. none of the above.
11. Today's Express-News business section quotes the yield on an inflation-indexed bond (principal is adjusted semi-annually for changes in the Consumer Price Index) that matures in January of 2010 as 1.04% while a non-indexed bond maturing at the same time is priced to yield a 3.25% rate of return. What is the market expectation of the average annual rate of inflation over this time period? (5 points)
2.19%
12. You're confronted with the following capital investment project:
Year Net Cash Flow
0 120,000
1 200,000
2 (400,000)
A. Because of the high risk associated with the project, you will require a 20% rate of return, while the firm's average cost of capital is only 10%. Calculate the following:
(i) Net Present Value (3 points)
(ii) Internal Rate of Return (3 points)
(iii) Net Terminal Value (as discussed in the handout) (4 points)
NPV = $8,888
IRR = 17.36%
NTV = $(34,800)
B. Assume that the Net Present Value is $10,000; the Internal Rate of Return is 14%; and the Net Terminal Value is $(25,000). Briefly, explain why Net Present Value indicates that this non-normal project should be accepted while the other two methods indicate that it should be rejected. (5 points)
13. You are considering replacing the extrusion machine that molds the plastic shells for the MP3 players your company produces. Next year's sales are currently projected to be $1,500,000 but the new machine is expected to result in an increase in sales to $1,800,000. In any event, sales are anticipated to grow at a 10% rate in following years. The new machine is priced at $1,000,000. Cost of goods sold are 60% of sales. The life of the new machine is anticipated to be 3 years at which time it will be salvaged for $400,000 and it will be depreciated using the MACRS method (20%, 32%, 19.2%, 11.52%, 11.52%, 5.76%). The old machine originally cost $1,000,000 two years ago and is being depreciated using the same MACRS method. Its remaining expected useful life is 3 more years at which time it is anticipated that it could be scrapped for $200,000; however, if it is sold now you expect to receive $450,000 for it. The new machine will require an additional $250,000 of working capital initially, all of which will be recovered in the third year. Since the amount of risk associated with the machine is the same as the company as a whole, you plan to use a weighted average cost of capital of 12% to evaluate the proposed project. The firm is in the 40% tax bracket. Should the new machine be purchased? (25 points)
Year 0 Year 1 Year 2 Year 3
Net Cash Flows (788,000) 75,200 161,120 580,000
14. The Knucklehead Company has the following balance sheet:
L-T Debt (8%) $ 3,000
Common Stock ($1 par) 400
Retained Earnings 2,600
Total Assets $ 6,000 Tot. Liab. & Equity $ 6,000
No dividend is paid on the common stock. The stock is currently selling for $12 per share and its historical beta is estimated to be 1.2 using daily price data. The current market rate of interest on the debt is 9% and the current debt will mature in 10 years. Knucklehead has a 40% tax rate. The expected return on the market is 10% and the risk-free rate is 4%.
A. What is the market value of the debt? What is the market value of the Equity? (5 points)
Debt = $2,807
Equity = $4,800
B. What is the WACC for Knucklehead? (5 points)
9.06%
C. Knucklehead plans to recapitalize by issuing $1,000 worth of additional ten-year debt paying a coupon rate of interest of 10%, the projected market rate of interest on all of its debt following the financial restructuring. The proceeds of the debt issue will be used to repurchase common stock of the company at a $15.00 tender price, the expected market price of the stock following the repurchase. What will be the new WACC after the recapitalization? (15 points)
New value of Old Debt = $2,631
New Beta = 1.275
New WACC = 9.27%