MBA 8622page - 1 -Practice Final Exam (Spring 1998)
MBA 8622: Practice Final Exam (Spring 1998)
1. The primary goal of a financial manager of a publicly held corporation
should be to:
a. Minimize the risk to the shareholders.
b. Maximize the wealth of the firm s owners.
c. Maximize earnings per share.
d. Maximize the growth in annual sales revenue.
e. None of the above.
2. The Security Market Line (SML) relates risk to return, for a given set of
financial market conditions. If the general level of risk aversion among investors
suddenly decreases (all else constant), which of the following changes would
be most likely to occur?
a. The market risk premium would increase.
b. The beta of the market portfolio would decrease.
c. The SML would shift upward, but the slope of the SML would remain
unchanged.
d. The required return on the market portfolio (kM) would increase.
e. None of the indicated changes would be likely to occur.
3. Given the following distribution of returns, compute Stock W s standard
deviation:
State of Economy Probability Stock W Return
Recession .35 10%
Average growth .50 20%
Boom .15 30%
a. 0.00%
b. 2.37%
c. 6.78%
d. 7.07%
e. 8.41%
4. Moltron, Inc. has a beta of 0.80. The risk-free rate is 4 percent and the
expected rate of return on the market portfolio is 13.5 percent. Using the
CAPM, Moltron s expected return on equity is:
a. 4.0 percent
b. 9.2 percent
c. 10.8 percent
d. 11.6 percent
e. 14.8 percent
5. Fairlon, Inc., an all-equity firm, is considering the formation of a new division
which will increase the assets of the firm by 100% (for example, from
$1,000,000 to $2,000,000). Fairlon currently has a required rate of return of
16%, U.S. Treasury bonds yield 4%, and the return on the market portfolio
14%. If Fairlon wants to reduce its required rate of return to 14%, what is the
maximum beta coefficient the new division could have?
a. 0.8
b. 0.9
c. 1.0
d. 1.2
e. 1.4
6. Which of the statements below is most correct assuming a positive interest
rate and positive payments. Assume that all else is constant.
a. the present value of an annuity due is less than the present value of an
ordinary annuity.
b. the higher the interest rate, the higher the present value of an annuity.
c. the higher the interest rate, the higher is the present value of a single lump
sum which will be received in the future.
d. the lower the interest rate, the lower the present value of an annuity.
e. the future value of an annuity due is higher than the future value of an
ordinary annuity .
7. Carol James is considering the purchase of a car. She wants to buy the new
beetle which will cost her $ 17,600, all features included. She expects to be
able to get a loan for the entire amount for 5.9 percent, with monthly payments
over three years. How much money will she still owe on the loan at the end of
one year?
a. $ 6,572.15
b. $ 12,075.03
c. $ 17,151.90
d. $ 12,059.24
e. $ 11,733.33
8. Wachovia Bank is offering a CD that pays 5.5 percent interest compounded
annually, while South Trust Bank offers a CD that pays interest compounded
quarterly. What is the nominal annual rate that South Trust would have to offer
in order for you to be indifferent between the two investments?
a. 5.61 percent
b. 1.34 percent
c. 5.39 percent
d. 1.40 percent
e. Insufficient information
9. Elizabeth Carson has just won a lottery. She has two alternatives.
Alternative I is that she receives ten equal annual installments of $100,000
each, with the first installment being received today. Alternative II is for her to
receive a single lump sum today and nothing later. If her personal discount rate
is 12.3 percent, what should be the least amount paid by Alternative II for her
to choose that alternative?
a. $ 558,150.68
b. $ 100,000.00
c. $ 626,803.21
d. $1,000,000.00
e. $ 589,498.15
10. Which of the following is not true about bonds? In all of the statements,
assume other things are held constant.
a. Price sensitivity, that is, the change in price due to a given change in the
required rate of return, increases as a bond's maturity increases.
b. For a given bond of any maturity, a given percentage point increase in the
interest rate (kd) causes a larger dollar capital loss than the capital gain
stemming from an identical decrease in the interest rate.
c. When the yield to maturity on a bond is equal to the coupon rate, the price
of the bond will be equal to par value, regardless of whether the bond pays
coupon interest annually or semi-annually and regardless of the bond s
remaining term to maturity.
d. From a borrower's point of view, interest paid on bonds is tax-deductible.
e. A 20-year zero-coupon bond has less reinvestment rate risk than a 20-year
coupon bond.
11. Assuming g will remain constant, the dividend yield is a good measure of
the required return on a common stock under which of the following
circumstances?
a. g > 0.
b. g = 0.
c. g < 0.
d. Under no circumstances.
e. Answers a and b are both correct.
12. Renfroe Incorporated has 12 percent coupon bonds (coupon interest is
paid semi-annually) outstanding that have 24 years remaining to maturity.
These bonds have a par value of $1,000 and a current yield to maturity of 6.5
percent. Compute the current price of these Renfroe Incorporated bonds.
a. $1,804.98
b. $1,000.00
c. $1,659.91
d. $ 926.82
e. $1,663.88
14. Niven Rings Inc. just paid a regular dividend of $1.50 per share. The
regular dividend is expected to grow at a rate of 10 percent per year for the
next three years, at a rate of 7 percent per year for the next two years, and
after that at a rate of 4 percent per year forever. In addition to the regular
dividend, Niven Rings is expected to pay a special dividend of $5.00 at the
end of year 2. (NOTE: A special dividend is a one time only payment that will
not recur. It is not considered in calculating the amount of future dividends).
The appropriate discount rate is 14 percent per year. What is the price of the
stock?
a. $19.02
b. $21.67
c. $22.43
d. $22.86
e. $24.36
15. Hard Hat Construction's stock is currently selling at an equilibrium price of
$30 per share. The firm s long run growth rate is expected to remain equal to 6
percent per year, forever. Last year's earnings per share, E0, were $4.00, and
the dividend payout ratio is 40 percent. The risk-free rate is 8 percent, and the
market risk premium is 5 percent. If systematic risk (beta) increases by 50
percent, and all other factors remain constant, by how much will the stock
price change? (Hint: Use four decimal places in your calculations.)
a. ($ 7.31)
b. $ 7.14
c. ($15.00)
d. ($15.22)
e. $22.63
16. The Jackson Company wants to purchase an asset costing $6 million. The
firm just reported a net income (NI0) of $10 million; its payout ratio is 10
percent; and the firm has 1 million shares of stock outstanding. Jackson's
market value capital structure, shown below, is considered to be optimal
(assume that there is no short-term debt):
Long-term Debt $18,900,000
Equity 12,600,000
Total Capital $31,500,000
Jackson expects its earnings (and therefore its dividends) to continue to grow
at their historical rate of 4 percent per year for the indefinite future. The current
risk free rate is 5 percent and the expected return on the market portfolio is 16
percent. Jackson's cost of debt (kd) is 8 percent and the firm's tax rate is 40
percent. Calculate Jackson's weighted average cost of capital.
a. 7.78 percent.
b. 9.23 percent.
c. 12.15 percent.
d. 14.72 percent.
e. 18.99 percent.
17. Martin Corporation's common stock is currently selling for $50 per share.
The current dividend is $2.00 per share. If dividends are expected to grow at
6 percent per year, what is the firm's cost of retained earnings?
a. 10.71%
b. 11.38%
c. 10.24%
d. 9.31%
e. There is no cost because retained earnings are free.
19. Two projects being considered are mutually exclusive and have the
following projected cash flows:
Year Project A Project B
0 ($50,000) ($50,000)
1 15,625 0
2 15,625 0
3 15,625 0
4 15,625 0
5 15,625 99,500
If the required rate of return on these projects is 10 percent, which would be
chosen and why?
a. Project B because of higher NPV.
b. Project B because of higher IRR.
c. Project A because of higher NPV.
d. Project A because of higher IRR.
e. Neither, because both have IRRs less than the cost of capital.
20. The present value of the expected net cash inflows for a project will most
likely exceed the present value of the expected net profit after tax for the same
project because:
a. Income is reduced by taxes paid, but cash flow is not.
b. There is a greater probability of realizing the projected cash flow than the
forecasted income.
c. Income is reduced by dividends paid, but cash flow is not.
d. Income is reduced by depreciation charges, but cash flow is not.
e. Cash flow reflects any change in net working capital, but sales do not.
21. Michigan Mattress Company is considering the purchase of land and the
construction
of a new plant. The land, which would be bought immediately (at t = 0), has a
cost of $100,000 and the building, which would be erected at the end of the
first year (t = 1), would cost $500,000. It is estimated that the firm's after-tax
cash flow will be increased by $90,000 starting at the end of the second year,
and that this incremental flow would increase at a 10 percent rate annually over
the next 10 years. What is the approximate payback period?
a. 2 years
b. 4 years
c. 6 years
d. 8 years
e. 10 years
22. Two of your classmates are evaluating a project with the following net cash
flows:
Year Cash Flow
0 ($ 10,000)
1 $100,000
2 ($100,000)
One classmate says that the project has an IRR of between 12 and 13%. The
other classmate calculates an IRR of just under 800%, but fears his calculator's
battery is low and may have caused an error. You agree to settle the dispute
by analyzing the project cash flows. Which statement best describes the IRR
for this project?
a. There is a single IRR of approximately 12.7 percent.
b. This project has no IRR, because the NPV profile does not cross the X
axis.
c. This project has two imaginary IRRs.
d. There are an infinite number of IRRs between 12.5 percent and 790 percent
that can define the IRR for this project.
e. There are multiple IRRs of approximately 12.7 percent and 787 percent.
USE THE FOLLOWING INFORMATION TO ANSWER THE NEXT
THREE QUESTIONS
Topsider Inc. is considering the purchase of a new leather-cutting machine to
replace an existing machine that has a book value of $3,000 and can be sold
for $1,500. The old machine is being depreciated on a straight-line basis, and
its estimated salvage value 3 years from now is zero. The new machine will
reduce costs (before taxes) by $7,000 per year. The new machine has a
3-year life, it costs $14,200, and it can be sold for an expected $2,000 at the
end of the third year. Our tax accountant has told Topsider that the new
machine would be depreciated using the following depreciation schedule; Year
1 @ 33%, Year 2 @ 45%, Year 3 @ 15%, and Year 4 @ 7% Assuming a
40 percent tax rate and a cost of capital of 16 percent, answer the following
three questions:
23. For this project, Topsider s cash flows in Year 0 for this project are
closest to:
a. -$14,000
b. -$13,000
c. -$12,000
d. -$11,000
e. -$10,000
24. For this project, Topsider s cash flows in Year 2 for this project are
closest to:
a. $2,000
b. $3,000
c. $4,000
d. $5,000
e. $6,000
25. For this project, Topsider s cash flows in Year 3 for this project are
closest to:
a. $2,000
b. $3,000
c. $4,000
d. $5,000
e. $6,000
Answer Key to Practice Final Exam Spring 1998
1. B 2. E 3. C 4. D
5. A Currently beta (b) = 1.2 from: 16 = 4 + b (14 - 4).
For k to equal 14, b must decrease to 1. The beta of a portfolio of assets is
the weighted average of the betas that make up that portfolio. This firm will
have two divisions, each with a beta. The beta of the existing division is 1.2
(since the current required rate of return is 16%). With the addition of the new
division, the firm will have two divisions (each with a separate beta) that are
equally weighted in size.
Thus, for the answer solve: (.5)(1.2) + (.5)(b-new) = 1; and beta of the new
division = .8.
6. E. 7. B 8. C 9. C 10. B 11.B 12. E
14.D
15. A First solve for current k = D1/P0 + g = (4.00)(.40)(1.06)/30 + .06 =
.1165 or 11.65%.
Then find current beta from: 11.65 = 8% + b (5%); b = .73.
Next increase beta by 50% : .73(1.50) = 1.095.
Now solve for new k = 8% + (1.095)(5%) = 13.475%.
Finally, solve for new price = P0 = (1.60)(1.06)/ (.13475-.06) = 22.68.
Reduction in price = 30 - 22.68.
16. A Want to solve: K = (D/A)(kd)(1-T) + (S/A)(ks)
where, D/A = (18.9/31.5), S/A = (12.6/31.5), kd = 8%, and (1-T) = .6.
To get ks, must either solve the CAPM equation of the DCF equation. Since
we do not have a beta, we cannot solve the CAPM equation. The DCF
equation is:
k = D1/P0 + g. Here, D0 = (Net income x Dividend payout ratio) divided by
the number of shares outstanding = (10,000,000)(.1)/1,000,000 = 1.00 and
D1 = D0(1+g) = 1.00(1.04) = $1.04.
P0 can be found from the market value of equity and the number of shares
outstanding. Specifically, P0 = Market value of equity divided by the number
of shares outstanding = 12,600,000/1,000,000 = 12.60.
g = 4% = .04. Thus, ks = 1.04/12.60 + .04.
Plug this into the above equation to solve for WACC.
17. C Solve k = D0(1+g)/P0 + g; k = 2.00(1.06)/50 + .06 = .1024 =
10.24%.
19. A 20. D 21. C 22. E 23. C 24. E25. E