Midterm exam financiering/finance
<Front page>
Question 1
An agency problem can be alleviated by:
A) requiring all organizations to be sole proprietorships.
B) compensating managers in such a way that acting in the best interest of shareholders is also
in the best interest of managers.
C) asking managers to take on more risk than they are comfortable taking.
D) A and B.
Answer: D
Question 2
Which of the following are subject to double taxation?
A) Corporation
B) Partnership
C) Sole proprietorship
D) A and B
Answer: A
Use the table for the question(s) below.
Consider the following balance sheet:
Luther Corporation
Consolidated Balance Sheet
December 31, 2009 and 2008 (in $ millions)
Assets
Current Assets
Inventories
2009
2008
45.9
42.9
Accounts receivable
55.5
39.6
Cash
63.6 58.5
Other current assets
6.0
3.0
Total current assets 171.0 144.0
Non-Current Assets
Land
Buildings
Equipment
Less accumulated
depreciation
Net property, plant, and
equipment
66.6
109.5
119.1
62.1
91.5
99.6
Liabilities and
Shareholders' Equity
2009 2008
Current Liabilities
Accounts payable
87.6 73.5
Notes payable /
short-term debt
10.5
9.6
Current maturities of
long-term debt
39.9 36.9
Other current liabilities
6.0 12.0
Total current liabilities 144.0 132.0
Non-Current Liabilities
Long-term debt
239.7 168.9
Capital lease obligations
----Total Debt
239.7 168.9
(56.1) (52.5)
Deferred taxes
239.1 200.7
Other long-term liabilities
----Total non-current
liabilities 262.5 191.1
Total liabilities
406.5 323.1
Shareholders' Equity
126.6 63.6
Goodwill
60.0
-Other long-term assets
63.0 42.0
Total non-current assets 362.1 242.7
22.8
22.2
Total Assets
533.1 386.7
Total liabilities and
Shareholders' Equity
533.1 386.7
Question 3
What is Luther's net working capital in 2008?
A) $12 million
B) $27 million
C) $39 million
D) $63.6 million
Answer: A
Explanation: A) NWC = current assets - current liabilities = 144 - 132 = $12 million
Section: 2.3 Balance Sheet Analysis
Question 4
11) If in 2009 Luther has 10.2 million shares outstanding and these shares are trading at $16
per share, then what is Luther's Enterprise Value?
A) -$63.3 million
B) $353.1 million
C) $389.7 million
D) $516.9 million
Answer: C
Explanation:
Total Debt = (notes payable (10.5) + current maturities of long-term debt (39.9) + long-term
debt (239.7) = 290.1 million
Total Equity = 10.2 × $16 = 163.2,
C) Enterprise value = MVE + Debt - Cash = 10.2 × $16 + 290.1 - 63.6 = 389.7
Section: 2.3 Balance Sheet Analysis
Use the table for the question(s) below.
Consider the following income statement and other information:
Luther Corporation
Consolidated Income Statement
Year ended December 31 (in $ millions)
2009
2008
Sales revenue
610.1
578.3
Cost of sales
(500.2)
(481.9)
Gross profit
109.9
96.4
Selling, general, and
administrative expenses
(40.5)
(39.0)
Research and development
(24.6)
(22.8)
Depreciation and amortization
(3.6)
(3.3)
Operating income
41.2
31.3
Other income
Earnings before interest and taxes
(EBIT)
Interest income (expense)
Pre-tax income
Taxes
Net income
Price per share
Shares outstanding (millions)
Share options outstanding (millions)
Shareholders' Equity
Total Liabilities and Shareholders'
Equity
---
---
41.2
(25.1)
16.1
(5.5)
10.6
31.3
(15.8)
15.5
(5.3)
10.2
$16
10.2
0.3
$15
8.0
0.2
126.6
63.6
533.1
386.7
Question 5
Luther's EBIT coverage ratio for the year ending December 31, 2008 is closest to:
A) 1.64
B) 1.78
C) 1.98
D) 2.19
Answer: C
Explanation: C) EBIT Coverage ratio = EBIT / (Interest Expense) = 31.3/15.8 = 1.981
Section: 2.5 Income Statement Analysis
Week 2
Question 6
A project with discount rate 10% per year generates the following cash flows at the end of
each year.
Year 1
Year 2
Year 3 Year 5-10
Cash flow
$20
$20
$0
$20
Year 5-10 considers the years 5, 6, 7, 8, 9 and 10.
What is the present value of the cash flows of this project?
A) Less than $100
B) Between $100 and $115
C) Between $115 and $130
D) More than $130
Answer: B
Explanation: Calculate PV of annuity and subtract PV of year 3 cash flow.
PV annuity = 20 x (1/0.10) x [1- 1/(1.10)^10] = $122,89
PV year 3 = 20/1.1^3 = $15,02
PV = 122 – 15 = $107
Question 7
Consider a risk-free bond with a market price of $114 and the following cash flows.
Year 1
Year 2
Cash flow
$12
$112
Where year 1 is one year from now and year 2, is two years from now. The risk free interest
rate is 3% per year. Which statement is true?
A) There is no arbitrage opportunity.
B) There is an arbitrage opportunity and you can exploit this by selling the bond and saving at
the bank at the risk free interest rate.
C) There is an arbitrage opportunity and you can exploit this by buying the bond and borrow
from the bank against the risk free interest rate.
D) This is a normal market.
Answer: C
Explanation: PV bond = 12/1,03 + 112/(1,03)^2 = 117,22. So bond price is too low so buy
bond and fund it with a loan (borrow from the bank).
Question 8
Which of the following loans has the highest effective annual rate?
1. A loan with 5% APR and quarterly compounding
2. A loan with 7% APR with yearly compounding
3. A loan with a 0.6% effective rate per month
4. A loan with 6% EAR
A) Loan 1
B) Loan 2
C) Loan 3
D) Loan 4
Answer: C
Loan 1: EAR = (1+5%/4)^4-1=5,1%
Loan 2: EAR = 7%
Loan 3: EAR = (1+0.06%)^12-1=7.4%
Loan 4: EAR = 6%
Question 9
Consider the information about a project below.
Cash flow
Term
Rate (EAR)
Year 0
-$100
1 Year
4.0%
Year 1
$30
2 Years
4.5%
Year 2
$40
3 Years
5.0%
What is the net present value of this project?
A) Less than $0
B) Between $0 and $5
C) Between $5 and $10
D) More than $10
Year 3
$50
4 Years
5.5%
Answer C.
Explanation: PV = -100 + 30/1,04 + 40/1,045^2 + 50/1,055^3 = $8,67
Question 10
You are thinking about buying a house for $200,000 with a 30-year annuity loan that has
equal monthly payments. These payments include interest and ensure that the loan will be
repaid in full in year 30. If the effective interest rate for this loan is 0.5% per month and the
maximum monthly amount you are able to pay is $1300, can you afford the loan?
A) Yes, since the value of these monthly payments required by the bank is higher than
$200,000
B) Yes, since the monthly payment required by the bank will be lower than $1300
C) No, since the value of these monthly payments required by the bank is less than $200,000
D) No, since the monthly payment required by the bank is higher than $1300
Answer: B
PV annuity = 200.000 = C x *(1/0,005)*(1- 1/(1,005)^360) = C x 166.792 -> C = 200.000 /
166.792 = $1199 per month.
Question 11
When considering inflation in capital budgeting, one should include inflation if:
A) the rate of inflation in the economy is positive.
B) the project has uncertain cash flows.
C) the discount rate used is a real rate of interest.
D) None of the above.
Answer: D
Question 12
You are considering the following project. It will provide you $350,000 today, however you
will have to make an investment of $1,400,000 in ten years. Given the riskiness of the
investment opportunity, your cost of capital is 15%. Which of the following statements is
correct.
A) Accept, because NPV is positive. The IRR equals approximately 0,1487. The IRR rule
and NPV rule conflict.
B) Reject, because NPV is negative, The IRR equals approximately 0,1487. The IRR rule
and NPV rule do not conflict.
C) Accept, because NPV is positive. The IRR equals approximately 0,1587. The IRR rule
and NPV rule do not conflict.
D) Reject because NPV is negative, The IRR equals approximately 0,1587. The IRR rule
and NPV rule do not conflict.
Answer: A
Explanation: Accept, because NPV is positive, NPV =350-1400/(1.15^10)=3.941. The IRR
equals approximately 0,1487. The IRR rule and NPV rule conflict. NPV =350-1400/(1.15^10).
IRR=(1400/350)^(1/10) -1
Question 13
Consider five projects with the following cash flows (in millions), where year 1 is one year
from now (t=0).
Project
A
B
C
D
E
T=0
-10
-20
-30
-30
-50
Year 1
5
15
2
33
25
Year 2
8
9
40
2
35
The discount rate is 5% per year. Suppose your firm has a total capital budget of $60 million
which projects should be undertaken?
A) Project A, B and D
B) Project A and E
C) Project A, B and C
D) All expect one: D
Answer: C
Explanation: The PI(profitability index) selects projects A, B and C. These are also the optimal
projects to undertake as the budget is used fully used.
Project
A
B
C
D
E
t=0
-10
-20
-30
-30
-50
t=1
5
15
2
33
25
t=2
8
9
40
2
35
NPV
2,018141
2,44898
8,185941
3,24263
5,555556
PI
0,201814
0,122449
0,272865
0,108088
0,111111
Question 14
Assume the following for the next question.
 Accepting project X will increase gross profit by $25,000 in both year 1 and year 2.
 Funding cost of project X (interest payments) is 1,000 per year
 To increase consumer awareness of project X, the firm will spend $9,000 in the first
year.
 The R&D costs of project are $14,000 and should be paid upfront. Note that the firm
should expense R&D costs as incurred to comply with the financial standards.
 Production of project X will require an upfront investment of $25,000 . For tax purposes
we need to assume that the equipment has a two-year life and that the firm uses straightline depreciation for the new equipment.
 Net working capital each year is 20% of gross profit.
 Income tax is 50%.
 Revenues and costs are paid at the end of the year.
The free cash flow of project X in year 1 is closest to?
A) $18,750
B) $9,250
C) $1,750
D) $8,750
Answer: B
Explanation
Year
Incremental Earnings
Gross profit
Selling, General and Administrative
Research and Development
Depreciation
EBIT
Income Tax at 50%
Unlevered net income
Free Cash Flow
Plus: Depreciation
Less: Capital Expenditure
Less: Increases in NWC
Free Cash Flow
0
1
2
25000
(9000)
25000
3
(14000)
(12500) (12500)
(14000)
3500
12500
7000 (1750) (6250)
(7000)
1750
6250
12500
12500
(5000)
9250
0
18750
(25000)
(32000)
5000
5000
Question 15
Which of the following statements is false?
A) We can use scenario analysis to evaluate alternative pricing strategies for our project.
B) Scenario analysis considers the effect on NPV of changing multiple project parameters.
C) The difference between the IRR of a project and the cost of capital tells you how much
error in the cost of capital it would take to change the investment decision.
D) Scenario analysis breaks the NPV calculation into its component assumptions and show
how the NPV varies as each one of the underlying assumptions change.
Answer: D