final 4 fundamentals of corporate finance, 4th edition brealey

Name ________________________ Section _____ ID # __________________
Prof. King’s section C & Prof. Alagurajah’s sections A and D)
AK/ADMS 3530 Final Exam
Summer 2007
August 14th. 7 -10 pm

Type A Exam
50 Multiple Choice Questions (Total of 164 marks) made up a follows
32 Calculation Questions (4 marks each for a total of 128 marks)
18 Conceptual Questions (2 marks each for a total of 36 marks)
Choose the response which best answers each question. Circle your answers
below, and fill in your answers on the bubble sheet. Only the bubble sheet is
used to determine your exam score. BE SURE TO BLACKEN THE BUBBLES
CORRESPONDING TO YOUR STUDENT NUMBER.
Please note the following points:
1) Please use your time efficiently and start with the questions that you are most
comfortable with first.
2) Read the exam questions carefully;
3) Choose the answers that are closest to yours, because of possible rounding;
4) Keep at least 2 decimal places in your calculations and final answers, and at
least4 decimal places for interest rates;
5) Interest rates are annual unless otherwise stated;
6) Bonds pay semi-annual coupons unless otherwise stated;
7) Bonds have a par value (or face value) of $1,000; and
8) You may use the back of the exam paper as your scrap paper.
Good Luck.


32 Calculation Questions (4 marks each)
1. The common stock of Robin's Tools sells for $24.50. The firm's beta is 1.2, the riskfree rate is 4%, and the return on the market portfolio is 12%. Next year's dividend is
expected to be $1.50. Assuming that dividend growth is expected to remain constant

for Robin’s Tools over the foreseeable future, what is the firm's anticipated dividend
growth rate?
A)
B)
C)
D)
E)

6.65%
7.48%
9.15%
13.6%
15.0%

Solution: B
r = 4% + 1.2 x (12% - 4%) = 13.6% and
$24.50 = $1.50 / (13.6% - g)
Leads to g = 7.48%
2. What is the yield to maturity on a 10-year zero-coupon bond with a $1,000 face value
selling at $742?
A)
B)
C)
D)
E)

3.03%
7.42%
13.48%
34.78

42.37%

Solution: A
YTM = (1000/742) 1/10 -1 = .03029 or 3.03%


3. Consider the following monthly cash flows (see the diagram below):

Today

X

Z

X

Z

X

Z

1

2

3

4

19

20

Cash flows of an amount X are made for months 1, 3, 5, …, 17 and 19 (the ten oddnumbered months) and cash flows of an amount Z are made for months 2, 4, 6, …, 18
and 20 (the ten even-numbered months). The APR is 6% and is compounded on a
monthly basis. What is the present value of these cash flows today if X = $2,000 and
Z = - $700?
A) 12,311
B) 12,406
C) 25,569
D) 25,664
E) 32,955
Solution: B
The monthly interest rate is 0.5% but since the X’s cash flows are made every two
months, we need to calculate the 2-months equivalent interest rate:
I2m = r = (1 + 0.5%) 2 − 1 = 1.0025%
The present value of the Z’s cash flows is given by:
Using your calculator:
I2m = 1.0025%, n=10, PMT = -700, FV=0, COMP PV
PVz0 = -$6629.02 at t=0 (Since fist payment begins at t=2 and “i" is calculated for every
2 month period, and last payment is at t=20)
And the present value of the X’s is given by:
Since X begins at t=1, using your calculator for a regular annuity will give PV at t =-1:
I2m = 1.0025%, n=10, PMT = 2000, FV=0, COMP PV
PVx--1 = -$18,940.07 at t= -1 (Since fist payment begins at t=1 and “i" is calculated for
every 2 month period, and last payment is at t=19, you are really calculating PV of an
annuity at t= -1)
To adjust for PVx at t=0-> 18,940.07 x (1.005)1 = $19,034.77
The total present value (Z + X) is equal to:

PV = $19,034.77 − $6,629.02 = $12,405.75


4. TD Bank’s earnings and dividends are expected to grow at a rate of 10% during the
next 2 years, at 8% in the third year, and at a constant rate of 6% thereafter. If last
dividend paid was $2.00 and the required rate of return on its common stock is 12%.
How much should you pay today for one share of TD Bank?
A) $19.31
B) $24.66
C) $38.62
D) $51.93
E) $55.41
Solution: C
DIV0 = $2.00
DIV1 = $2.20
DIV2 = $2.42
DIV3 = $2.6136
DIV4 = $2.7704 Æ P3 = DIV4 /(r-g) = 2.7704/.12-.06) = $46.1736
P0 = DIV1 /(1 + r) + DIV2/(1+r )^2 + DIV3/(1 + r)^3 + P3/(1 + r)^3
= 2.20/(1.12) + 2.42/ (1.12)^2 + 2.6136/ (1.12)^3 + 47.1736/(1.12)^3 = $38.62
5. Atkinson Co. will finance its expansion through additional bond sales. Its current
outstanding bonds are selling for $919.71. These have a 6% coupon rate, pay
interest semi-annually and will mature in 12 years. What must the coupon rate of the
new bonds be in order to sell the issue at par, if they will also mature in 12 years and
pay semi-annual coupons?
A)
B)
C)
D)

E)

3.00%
3.50%
6.00%
7.00%
8.00%

Solution D):
Need to find YTM of old bonds -> this must be coupon rate of new bonds if new bonds
are to sell at par ($1000).
Using your calculator:
PV = -919.71, PMT = 30, n = 12x2 = 24, FV= $1000, COMP “i”
I= 3.50%
=> YTMold = 3.50% x 2 = 7.00%
=> coupon of new bonds = 7.00%


6. What is the minimum cash flow that could be received at the end of year two to make
the following project "acceptable"? Initial cost = $100,000; cash flow at end of year one
= $35,000, cash flow at the end of year three = $52,250; opportunity cost of capital = 8%.
A)
B)
C)
D)
E)

$20,917
$22,640
$25,727

$26,727
$30,229

Solution: E
Project is acceptable when NPV is equal to or greater than 0.
For a 0 NPV, PV of CFs must be equal to the initial investment.
i.e. 100,000 = 35,000/ (1.08) + X/(1.08^)2 + 52,250/(1.08)^)3
solve for X to get: X = $30,229
7. A proposed nuclear power plant will cost $22 million to build and then will produce
cash flows of $3 million at the end of each year for 15 years. At the end of year 15, it
must be decommissioned (closed) at a cost of $9 million. If the discount rate is 9%,
should the plant be built?
A) Yes, because the NPV is positive
B) Yes, because the IRR is positive
C) Yes, because both NPV and IRR are positive
D) No, because the NPV is negative
E) No, because the cash flows sign change over the project’s life.
Solution: D
NPV = −22 + 3 × annuity factor(r, 15 years) − 9/(1 + r)15
When r = 9%, NPV = −288,777
IRR = 8.74 % (which is less than the discount rate)
8. A firm is considering the following project.. Its opportunity cost of capital is 9%
Time
Cash Flow

0
-4500

1
+2000

2
0

3
+3200

4
+2600

What is the payback and discounted payback, respectively, of the project?
A) 2.00 years; 3.00 years
B) 3.00 years; 4.00 years
C) 1.78 years; 4.00 years
D) 2.78 years; 3.11 years
E) 3.78 years; 4.11 years
Solution: D: 2.78 years for simple payback, 3.11 years for discounted payback


9. Below are the cash flows for two for two mutually exclusive projects. The projects’
discount rate is 10%.
Project C0
A
-18
B
-50

C1
10
25

C2
10
25

C3
10
25

Which of the following statements is/are true?
A) Project A should be chosen because it has the higher NPV.
B) Project A should be chosen because it has the higher IRR.
C) If funds are limited, Project B should be chosen because it has the higher profitability
index.
D) If the firm has unlimited funds, both projects should be chosen.
E) None of the above statements is true.
Detailed Solution E:
NPVA = –18 + 10 × annuity factor(10%, 3 periods) =
$ 6.87
NPVB =
–50 + 25 × annuity factor(10%, 3 periods) = $12.17
Thus Project B has the higher NPV if the discount rate is 10%.
Project A has the higher profitability index.
Project
A
B

PV
24.87
62.17

Invest
ment
18
50

NPV
6.87
12.17

Profitability Index
(= NPV/Investment)
0.38
0.24

A firm with a limited amount of funds available should choose Project A since it has a
higher profitability index of 0.38, i.e., a higher “bang for the buck.”
For a firm with unlimited funds, the possibilities are:
i.

If the projects are independent projects, then the firm should choose both
projects.

ii.

However, if the projects are mutually exclusive(!), then Project B
should be selected. It has the higher NPV.


10. Sequel Catering is considering a second store that has an up-front cost of $X. The

project will generate a positive cash flow of $65,000 a year. Assume that these cash flows
are paid at the end of each year and that the project will last for 20 years. Sequel uses a 9%
annual discount rate. The project has a 12 percent IRR. What is the project's NPV?
A)
B)
C)
D)
E)

$107,842
$485,514
$593,355
$638,517
$656,789

Solution: A
Step 1:

Step 2:

Calculate the value of the up-front cost $X by solving for NPV, at a 12
percent IRR:
CF0 = 0; CF1 = 65,000; n = 20; and i = 12.
Then solve for NPV = $485,513.84, which is equal to the up-front cost of
$X.
Calculate the net present value of the project at its cost of capital of 9
percent:
CF0= -485,513.84; CF1 = 65,000; n = 20; and i = 9.
Then solve for NPV = $107,841.63

11. What is the amount of operating cash flow for a firm with $500,000 profit before tax,
$100,000 depreciation expense, and a 35% corporate tax rate?
A) $260,000
B) $325,000
C) $360,000
D) $425,000
E) $445,000
Profit before tax
$500,000
-Taxes @ 35%
-$175,000
Net profit equals
$325,000
+ depreciation
+$100,000
Cash flow from operations $425,000


12.An investment today of $25,000 promises to return $10,000 annually for the next three
years. What is the approximate real rate of return on this investment if inflation averages
6 percent annually during the 3 years?
A) 3.5 %
B) 9.7 %
C) 14.0 %
D) 20.0 %
E) 21.4 %
Solving with financial calculator, the IRR = 9.701%.
Then, 1.09701/1.06 = 1.0349 or approx 3.5% real return.

13. At what discount rate would you be indifferent between accepting or rejecting a

project which costs $6,000 today with annual cash flows of $1,200 for the next nine
years?
A) 13.50%
B) 13.60%
C) 13.70%
D) 13.80%
E) 13.96%
Calculate the IRR; the point at which the NPV of the project equals “0”
(indifference point). Using your calculator IRR = 13.70%.


14.A project anticipates net cash flows of $10,000 at the end of year one, this amount will
grow at a 5 percent rate of inflation over the subsequent four years. Calculate the real
present value of this five-year cash stream if the firm employs a nominal discount rate of
15 percent.
A) $33,522
B) $38,377
C) $43,294
D) $55,000
E) $59,234
The 9.52% is the real discount rate = (1.15/1.05) – 1.
 1

1
−

5
.0952 .0952(1.09 52) 
= $38,377.02
Present Value = $10,000 

15.What is the NPV of a project that costs $100,000, provides $23,000 in after-tax cash
flows annually for six years, requires a $5,000 increase in net working capital today
(which you recoup in yr 6), and depreciate the asset at 30 percent declining balance over
six years and sold at zero salvage value? The discount rate is 14 percent. The tax rate is
40 percent. (assume the half year rule applies).
A) -$23,460


B) 12,315.37
C) $13,283
D) $44,866
E) $46,785
NPV= -105,000+ PV of 23,000/(1.14)^6 + PVCCATS + 5000/1.14^6
= -105,000 + 89,438.35 + 25,598.09 +2277.93
= 12,315.37
where PVCCATS = [(.4)(.3)(100,000)/.14+.30][1.07/1.14] = 25,598.09


16. Consider the following example of Fairways Driving Range. Rental income is
expected to be 20,000 buckets a year at $3 per bucket. Equipment costs are $20,000,
depreciated straight-line over 5 years with no salvage value. Variable costs are 10% of
rentals and fixed costs are $45,000 per year. Assume no increase in working capital nor
any additional capital outlays. The required return is 15% and the tax rate is 15%. What
is the NPV?
A) -$11,526
B) -$9,582
C) $7,654
D) $9,3259
E) $11,214

Revenues
Variable costs
Fixed costs
Depreciation
EBIT
Taxes (15%)
Net income

$60,000
6,000
45,000
4,000
$5,000
750
$4,250

Thus, cash flow is $5,000 + 4,000 – 750 = $8,250. At 15%, the five-year
annuity factor is 3.352, so NPV based upon expected cash flows is:
NPV = – $20,000 + ($8,250 × 3.352) = $7,654

17.What is the break-even level of revenues for a firm with $6 million in sales, variable
costs of $3.9 million, fixed costs of $1.2 million, and depreciation of $1 million?
A) $3,428,571
B) $6,100,000
C) $6,285,700
D) $6,557,377
E) $7,563,454
$3.9 million
Variable costs = $6.0 million = 65%
$2,200,000

Break-even level of revenues = (1 − .65)

= $6,285,714


18. What is the maximum percentage of variable costs in relation to sales that a firm
could experience and still (accounting) break even with $5 million revenue, $1million
fixed costs and $500,000 depreciation?
A) 30%
B) 60%
C) 70%
D) 80%
E) 90%
Accounting break-even revenue = fixed costs (including depreciation) / profit
margin. So $5 million revenue = ($1 million + $500,000) / profit margin
profit margin = $1.5 million / $5 million = 0.3
The percentage of variable costs = 1 – 0.3 = 0.7 = 70%.

19. A firm with $600,000 fixed costs and $200,000 depreciation is expected to produce
$225,000 in pretax profits. What is its Degree of Operating Leverage (DOL)?
A) 3.56
B) 3.67
C) 4.56
D) 4.67
E) 5.13
Accounting break-even revenue = 1 + [fixed costs (including depreciation)/pretax
profits] = 1 + $(600,000 + 200,000)/$225,000 = 4.56.


20.If pretax profits decrease by 13.8 percent when the DOL is 3.8, then the decrease in

sales is:
A) 0.28 percent
B) 2.75 percent
C) 3.63 percent
D) 10.00 percent
E) 13.36 percent
%∆ in profits
DOL = %∆ in sales
− 13.8%
x
3.8 =
; 3.8X = –13.8%

X = 3.63% therefore sales decreased by 3.63%

21.What is the approximate variance of returns if over the past three years an investment
returned 8.0%, -12.0%, and 15.0%? (please use “n” as your divisor)
A) 31
B) 131
C) 182
D) 961
E) 1018
8 − 12 + 15
3
Mean =

= 3.67%

(8 − 3.67 )2 + (− 12 − 3.67 )2 + (15 − 3.67 )2

Variance =

3

18.75 + 245.55 + 128.37
3
=

= 130.89

22. What should be the beta of stock C if an investor wishes to achieve a portfolio beta of
1 in the following equally weighted portfolio: stock A (beta = 0.9), stock B (beta = 1.1),
and stock C?
A) 0.93
B) 1.00
C) 1.08
D) 1.15
E) 1.21
Portfolio Beta = 1/3 * 0.9 + 1/3 *1.1 + 1/3 * Beta “C” = 1
Therefore Beta “C” = 1 – 1/3 *09. – 1/3 * 1.1 – 3 = 1


23. You are provided with the following information about two perfectly negatively
correlated stocks in a portfolio. What is the standard deviation of the portfolio return?

A)
B)
C)
D)
E)

Stock

σ

Weight

C
D

13%
27%

0.43
0.57

4.46%
9.80%
16.37%
20.98%
22.25

σ P = x12σ 12 + x 22σ 22 + 2 x1 x 2 ρ1, 2σ 1σ 2
= 0.43 2 × 0.13 2 + 0.57 2 × 0.27 2 + 2 × 0.43 × 0.57 × (−1) × 0.13 × 0.27
= 0.009604 = 0.098 = 9.80%
24. What is the correlation of stocks A and B’s returns if their standard deviations are
10%
and 17%, respectively, and the covariance of A and B’s returns is 0.00765?
A) -0.25
B) 0.45

C) 0.77
D) 1
E) 1.27

ρ A, B =

Cov(rA , rB )

ρ A, B =

0.00765
= 0.45
0.1 × 0.17

σ Aσ B


25. Given the following information, what is WBM Corporation's WACC?
Common Stock: 1 million shares outstanding, $40 per share, $20 par value, beta = 1.3
Bonds: 10,000 bonds outstanding, $1,000 face value each, 8% annual coupon, 22 years to
maturity, market price = $1,101.23 per bond. Semi-annual coupon payments.
Market risk premium = 8.6%, risk-free rate = 4.5%, marginal tax rate = 34%
A) 9.90%
B) 12.19%
C) 13.30%
D) 14.00%
E) 15.46%
The Market Value of debt is D = 10,000 x $1,101.23 = $11,012,300.
The market value of common shares is E = 1 million x $40 = $40 million.
So the total market value of the firm is V = D + E = $51,012,300.

requity = 0.045 + 1.3x(0.086) = 15.68 %,
rdebt = 7.078% (YTM as calculated by a financial calculator)
The weights are: D/V = $11,012,300 / $51,012,300 = 0.2159, E/V = 0.7841.
WACC = (D/V) x (1 – TC) × rdebt + (E/V) x requity
= 0.2159 x (1 - 0.34) x 0.0708 + 0.7841 x 0.1568 = 13.30%.

26. Where will the following two projects plot in relation to the security market line
(SML) if the risk-free rate is 6% and the market risk premium is 9%? Which project
should be undertaken?
Project Beta IRR
I
2.0 25%
II
1.1 15%
A) Project I plots above the SML and should be accepted; Project II plots below
the SML and should be rejected.
B) Project I plots above the SML and should be rejected; Project II plots below
14 the SML and should be accepted.
C) Project I plots below the SML and should be accepted; Project II plots above
the SML and should be rejected.
D) Project I plots below the SML and should be rejected; Project II plots above
the SML and should be accepted.
E) None of the above
Project I: expected return = 0.06 + 2 × 0.09 = 0. 24 < IRR of 0.25.
Project I plots above the SML and should be accepted.
Project II: expected return = 0.06 + 1.1 × 0.09 = 0. 159 > IRR of 0.15.
Project II plots below the SML and should be rejected.


27.A project is determined to have equal probability of generating $1 million annually or

$500,000 annually, for each of four years. The initial outlay is $2 million. The expected
return on Treasury bills is 6 percent and the market risk premium is 8 percent. What isthe
highest project beta that will justify acceptance of the project?
A) 0.0
B) 1.00
C) 1.56
D) 2.31
E) 2.49
Expected cash flow = (1 million x .5) + (500,000 x .5)= 750,000
1 − (1 + i )−4 


i

$2 million = 750,000 

18.45% = I (Re)
Using CAPM Re = Rf + B (Rm – Rf). Solving for Beta we get 1.56.

28. Stone Industries is expected to pay a dividend of $2.10 per share in one year. This
dividend, along with the firm's earnings, is expected to grow at a rate of 5% forever. The
current market price for a share of Stone’s common stock is $38.62. If the T-bill return is
4% and the market risk premium is 6%, then what is the beta of Stone’s common stock?
A) 0.67
B) 1.07
C) 1.17
D) 1.20
E) 1.32
DIV1
$2.1

⇒ $38.62 =
⇒ r = 10.44%.
r−g
r − 5%
By the CAPM, r = r f + β (rm − r f ) ⇒ 10.44% = 4% + β × 6% ⇒ β = 1.07

By the DDM, P0 =


29. Consider the following information for Alex Computers. Total book value of the
firm’s equity is $10 million; book value per share is $20. The stock sells for a price of
$30 per share. The firms’ beta is 1.5 and the market risk premium is 7.33% and the riskfree rate is 4%. The firm’s bonds have a par value of $5 million and sell at a price of
110% of par. The yield to maturity on the bonds is 9% and the firm’s tax rate is 40%.
What is the firm’s WACC?
A)
B)
C)
D)
E)

8.03%
9.00%
11.59%
12.42%
13.39%

Solution: D
Security

Market value

Explanation

Debt
Equity

$ 5.5 million
$15.0 million

1.10 × par value of $5 million
$30 per share × 500,000 shares*

Total

$20.5 million

*Number of shares = Error!= 500,000
WACC = Error!× rdebt + Error!× requity
= Error!× (1 – .4) × 9% + Error!× 15% = 12.42%

30. Evan Sports Inc. has two issues of debt outstanding. One is a 9% coupon bond with
a face value of $20 million, a maturity of 10 years, and a yield to maturity of 10%. The
second bond issue has a maturity of 15 years, and a coupon rate of 10%. The face value


of the second issue is $25 million and the issue sells for 92.8% of par. Both bonds pay
coupons annually. The firm’s tax rate is 35%. What is Evan Sports Inc.’s after-tax cost
of debt?
A)
B)

C)
D)
E)

3.69%
6.86%
10.00%
10.55%
11.25%

Solution: B
The 9% coupon bond has a yield to maturity of 10% and sells for 93.86% of face value:
Using your calculator:
n = 10, i = 10%, PMT = 90, FV = 1000, compute PV = $938.55
The market value of the first issue is therefore
9386 × $20 million = $18.77 million
The 10% coupon bond sells for 92.8% of par value, and has a yield to maturity of 11.0%:
n = 15, PV = (−)928, PMT = 100, FV = 1000, compute i = 11.00%
The market value of the issue is .928 × $25 million = $23.20 million
The weighted average before-tax cost of debt is therefore
Error!× 10% + Error!× 11% = 10.55%
The after-tax cost of debt is (1 – .35) × 10.55% = 6.86%

31. What is the after-tax cost of 6% preferred stock that has a par value of $20, a total
book value of $20 million, sells for $15 per share in the market, and the firm’s tax rate is
40%?
A)
B)
C)
D)

E)

3.60%
4.80%
6.00%
8.00%
8.85%

Solution: D
Annual dividend:
= 6% x 20 = $1.20 per share annual dividend
After-tax cost of preferred =required rate of return = $1.20/15 = 8.00%.
Taxes have no impact on the cost of preferred stock!
32. Cocoa Industries has a cost of equity of 12% and a cost of debt of 8%.
If the target debt/equity ratio is 60%, and the tax rate is 35%, what is Cocoa's
weighted average cost of capital (WACC)?


A)
B)
C)
D)
E)

8.00%
9.45%
10.50%
11.25%
12.00%

Solution: B
If Equity = $100, then Debt = $60 and V = $160
Weight of equity = 100/160 = .625 Weight of debt = 60/160 =.375
WACC = .625 x 12% + (.375 x .08) x (1-.35) = 9.45%
18 Conceptual Questions (2 marks each)

33. Stock prices are said to follow a “random walk,” which means that if a stock’s price
decreased during the past week, then
A) this week’s price will reverse last week’s loss and go up.
B) this week’s price will continue last week’s decline.
C) this week’s price will remain constant until new information is released.
D) this week’s price will change in either direction with equal likelihood.
E) Only technical analysts can determine this week’s price.
Solution: D
34. What happens when a bond's expected cash flows are discounted at a rate lower than
the bond's coupon rate?
A) The price of the bond increases.
B) The coupon rate of the bond increases.
C) The par value of the bond decreases.
D) The coupon payments will be adjusted to the new discount rate.
E) The maturity of the bond will be increased
Solution: A
35. The book value of a firm's equity is determined by:
A) multiplying current share price by number of shares outstanding.
B) multiplying share price of any new equity issue by number of shares outstanding.
C) the difference between the book values of assets and liabilities.
D) the book value of firm's assets divided by shares outstanding.
E) the market value of it’s debt
Solution: C
36. A firm is considering the purchase of an asset whose risk is greater than the current

risk of the firm, based on any method for assessing risk. In evaluating this asset, the
decision maker should
A) Increase the IRR of the asset to reflect the greater risk.


B) Increase the NPV of the asset to reflect the greater risk.
C) Reject the asset, since its acceptance would increase the firm’s risk.
D) Increase the cost of capital used to evaluate the project to reflect the
project’s higher risk.
E) multiply the firm’s WACC by the firm’s beta to compute a new riskadjusted discount rate
Solution: D
37. Which of the following statements concerning IRR is false;
A) IRR cannot rank mutually exclusive projects.
B) In certain situations, projects with higher IRRs may have lower NPV’s.
C) IRR cannot be used for projects with downward-sloping NPV profiles.
D) IRR is defined as the discount rate at which project NPV equals zero
E) The IRR investment rule is to accept the project if the IRR is greater than the
opportunity cost of capital.
Solution C: see text p.228 IRR cannot be used for projects with upward-sloping NPV
profile
38. A project's payback period is determined to be four years. If it is later discovered that
additional cash flows will be generated in years five and six, then:
A) the project's payback period will be reduced.
B) the project's payback period will be increased.
C) the project's payback period will be unchanged.
D) the discount rate must be known to determine whether the payback period changes.
E) add these cash flows to the payback calculation
Solution: C

39. What is the net effect on a project’s NPV if a capital asset has salvage value at the

end of a project’s life (versus no salvage value, everything else being equal)?
A) The project’s NPV will increase.
B) The project’s NPV will decrease.


C) The project’s NPV will be unchanged.
D) We do not have enough information to calculate the net effect.
E) It depends if the project has multiple IRR’s.
Solution D:
Salvage Value inpacts NPV two ways:
(i) It increases NPV by adding the discounted salvage value to the project’s cash flows
(ii) It decreases NPV as it decreases the PVCCATS calculation.
Thus we need more information to assess the net effect.
40. Which of the following statements regarding discounted cash flow analysis is false?
A) Discount incremental profits
B) Include all indirect effects (both good and bad)
C) Ignore sunk costs
D) Include opportunity costs
E) Recognize the investment in net working capital
Solution A:
41. Which if the following statements regarding working capital is true?
A) The project’s cash flow each year is influenced by the absolute level of working
capital
B) An increase in inventories is an example of a negative cash flow.
C) An increase in accounts payable is an example of a positive cash flow.
D) Both statements (b) and (c) are true.
E) All of the above statements are true.
Solution: D
42. All else the same, if a firm revises its production process to use more variable labour
cost and less machinery cost, the firm will have:

I. An increased depreciation expense
II. A decreased accounting break-even.
III. An increased degree of operating leverage.
IV. None of the above
A) I only
B) II only
C) III only
D) IV only
E) II and III only
Ans: B


43.Which of the following is (are) true concerning the accounting break-even point?
I. The net income is zero.
II. The net present value is zero.
III. The operating cash flow is zero.
IV. The internal rate of return is zero.
A) I only
B) I and IV only
C) II only
D) III only
E) II and IV only
Ans: B

44. All else the same, if you decrease fixed costs, which of the following will also ecline?
I. Operating leverage
II. Accounting break-even
III. Operating cash flow
IV. Cash flow break-even
A) I and II only

B) II and IV only
C) I, II, and III only
D) I, II, and IV only
E) I, II, III, and IV
Ans: D

45. Averaging the deviations from the mean for a portfolio of securities will:
A) compute the standard deviation.
B) compute the variance.
C) equal zero.
D) equal the number of securities in the portfolio.
E) equal the Beta
Ans: C

46. Which of the following are included in the market prices if the market is semi-strong
efficient?
I. All historical information
II. All insider information
III. All public information


IV. All information of any kind
A) I only
B) III only
C) I and III only
D) I, II, and III only
E) I, II, III, and IV
Ans: C

47. The slope of the security market line equals:

A) one.
B) beta.
C) beta * (Rm – Rf)
D) the market risk premium.
E) the expected return on the market portfolio.
Ans: D

48. Why is debt financing said to include a tax shield for the company?
A) Taxes are reduced by the amount of the debt.
B) Taxes are reduced by the amount of the interest.
C) Taxable income is reduced by the amount of the debt.
D) Tax expenses is Debt * (1 – Tax Rate)
E) Taxable income is reduced by the amount of the interest.
Ans: E

49. If a company’s WACC is less than the required return on equity, then the firm:
A) has debt in its capital structure.
B) is perceived to be less risky than most firms.
C) must have convertible debt.
D) cannot be using any debt.
E) is efficiently priced and lies on the SML.
Solution: A
50. The cost of capital in a firm that has both debt and equity __________.
A) Is equal to the cost of debt or equity, depending on which type of financing the firm
uses more of.
B) Is equal to the rate of return as calculated by CAPM.
C) Is what a firm must earn on a project to compensate investors for the use of their
funds.

D) Will be the equity cost or the debt cost, which ever is higher.
E) Will be the equity cost or the debt cost, which ever is lower.
Solution: C