1
BUS 438 (Durham). Spring 2017. Exam 1.
Multiple choice (3 pts each)
1. Net capital spending:
(a) is equal to ending fixed assets minus beginning fixed assets.
(b) Solution: is equal to zero if the decrease in the fixed assets account is equal to the depreciation expense.
(c) reflects the net change in total assets over a stated period of time.
(d) is equivalent to the free cash flow minus the operating cash flow plus the change in net working capital.
(e) is equal to the change in the inventory balance for the period.
2. Last year Aldrin Co. had negative operating cash flow, yet the amount of cash on its balance sheet increased.
What could explain this?
(a) Aldrin issued long-term debt.
(b) Aldrin repurchased some of its common stock.
(c) Aldrin sold some of its assets.
(d) Statements a and b are correct.
(e) Solution: Statements a and c are correct.
3. Which of the following alternatives could potentially result in a net increase in a company’s free cash flow (cash
flow from assets) for the current year?
(a) Solution: Reducing the accounts receivable balance.
(b) Increasing the number of years over which fixed assets are depreciated.
(c) Reducing the accounts payable balance.
(d) All of the answers above are correct.
(e) Answers a and b are correct.
4. Which of the following is NOT an advantage of a sole proprietorship?
(a) Single taxation
(b) Ease of setup
(c) Solution: Limited liability
(d) No separation of ownership and control
5. Accounts payable is a:
(a) long-term liability.
(b) current asset.
(c) long-term asset.
(d) Solution: current liability.
6. Stennett Corp.’s CFO has proposed that the company issue new debt and use the proceeds to buy back common
stock. Which of the following are likely to occur if this proposal is adopted? (Assume that the proposal would
have no effect on the company’s operating earnings.)
(a) Return on assets (ROA) will decline.
(b) The equity multiplier will decrease.
(c) Solution: Taxes paid will decline.
(d) None of the statements above is correct.
(e) Statements a and c are correct.
7. Which of the following statements is most correct?
(a) If a company increases its current liabilities by $1000 and simultaneously increases its inventories by
$1000, its current ratio must rise.
(b) If a company increases its current liabilities by $1000 and simultaneously increases its inventories by
$1000, its quick ratio must fall.
(c) A company’s quick ratio can never exceed its current ratio.
(d) Solution: Answers b and c are correct.
(e) None of the answers above is correct.
8. A project has an up-front cost of $100,000. The project has conventional cash flows. The project’s WACC is
12 percent and its net present value is $10,000. Which of the following statements is most correct?
(a) The project should be rejected since its return is less than the WACC.
(b) Solution: The project’s internal rate of return is greater than 12 percent.
(c) The project’s modified internal rate of return is less than 12 percent.
(d) All of the above answers are correct.
(e) None of the above answers is correct.
9. Assume a project has conventional cash flows. Which of the following statements is most correct?
(a) All else equal, a project’s IRR increases as the cost of capital declines.
(b) Solution: All else equal, a project’s NPV increases as the cost of capital declines.
(c) All else equal, a project’s MIRR is unaffected by changes in the cost of capital.
(d) Answers a and b are correct.
(e) Answers b and c are correct.
10. The annual annuity stream of payments with the same present value as a project’s costs is called the project’s
_______ cost.
(a) incremental
(b) sunk
(c) opportunity
(d) erosion
(e) Solution: equivalent annual
2
11. A Treasury yield curve is defined as the plotting of the yields on Treasury securities relative to:
(a) market interest rates.
(b) comparable corporate bond yields.
(c) the risk-free rate.
(d) inflation.
(e) Solution: maturity.
12. Today, February 21, you want to buy a bond with a quoted price of 100.42. The bond pays interest on
September 1 and March 1. The price you will pay to purchase this bond is equal to the:
(a) clean price.
(b) muddy price.
(c) Solution: dirty price.
(d) par value price.
(e) bid price.
3
Problems
1. (12 points) Use the financial statements below to answer the following questions.
Flash Corporation
Consolidated Balance Sheet
December 31, 2016 (in $ millions)
Liabilities and
Assets
Stockholders’ Equity
Current Assets
Current Liabilities
Cash
63.6
Accounts payable
Accounts receivable
51.5
Notes payable
Inventories
45.9
Current maturities of
long-term debt
Other current assets
6.0
Other current liabilities
Total current assets
167.0
Total current liabilities
Long-Term Assets
Long-Term Liabilities
Land
66.6
Long-term debt
Buildings
109.5
Deferred taxes
Equipment
145.1
Other long-term liabilities
Less accumulated
Total long-term liabilities
depreciation
(56.1)
Total liabilities
Net property, plant,
Stockholders’ Equity
and equipment
265.1
Total liabilities and
Goodwill
60.0
Stockholders’ Equity
Other long-term assets
63.0
Total long-term assets
388.1
Total Assets
555.1
Flash Corporation
Consolidated Income Statement
Year ended December 31, 2016 (in $ millions)
Total sales
610.1
Cost of sales
(500.2)
Gross profit
109.9
Selling, general, and
administrative expenses
(40.5)
Research and development
(24.6)
Depreciation and amortization
(3.6)
Operating income
41.2
Other income
0.0
EBIT
41.2
Interest income (expense)
(25.1)
Pre-tax income
16.1
Taxes
(5.5)
Net income
10.6
Dividends Paid
5.1
Price per Share
Shares outstanding (millions)
Stock options outstanding (millions)
4
$16
10.2
0.3
87.6
32.5
39.9
6.0
166.0
239.7
22.8
0.0
262.5
428.5
126.6
555.1
What is Flash’s:
(a) Quick ratio
(b) Operating margin
(c) P/E ratio
(d) Market capitalization
(e) Market-to-book ratio
(f) Debt-to-capital ratio
Solution:
(a) Quick ratio = (CA - Inv) / CL = (167 - 45.9)/166 = 0.73
(b) Operating margin = Operating income / Sales = 41.2 / 610.1 = 0.068
(c) P/E ratio = 16 / (10.6/10.2) = 15.40
(d) MArket cap = 16 * 10.2 = 163.2
(e) MArket-to-book = 163.2/126.6 = 1.289
(f) Debt-to-capital = debt / (debt + equity) = 239.7 + 32.5 + 39.9 / (239.7 + 32.5 + 39.9 + 126.6)
5
2. (6 points) A rich relative has bequethed you a growing perpetuity. The first payment will occur three years
from today and will be $1000. Each year after that you will receive a payment that is 6% larger than the one
before. The interest rate is 12% per year.
(a) What is the value of the bequest today?
(b) What is the value of the bequest immediately before the first payment is made?
(c) What is the value of the bequest immediately after the first payment is made?
Solution:
(a) P2 = 1000/(0.12 − 0.06) = 16, 667. P0 = P2 /1.122 = 13, 287.
(b) P3 (before payment) = P2 · 1.12 = 18, 667
(c) P3 (after payment) = 18667 − 1000 = 17, 667
3. (6 points) Consider the two following mutually exclusive projects. Project A has an initial cost of $30 million
and generates cash flows of $15 million at the end of year 1 and 20 million at the end of year 2. Project B has
an initial cost of $80 million and generates cash flows of $39 million at the end of year 1 and $52 million at the
end of year 2.
(a) What is the IRR of each project?
(b) At a discount rate of 5%, which project should the firm accept? Why?
(c) At what discount rate do these projects have the same NPV?
Solution:
(a) IRR(A) = 10.39%. IRR(B) = 8.60%.
(b) NPV(A) = 2.43 M. NPV(B) = 4.31 M. Choose B.
(c) Crossover = 7.52% (compute IRR of differences in cash flows.)
6
4. (6 points) Dave is considering the following investment opportunity. Immediately and then at the end of each
of the first three years, he must pay in $200. Beginning at the end of the fourth year, the investment begins
making annual payments that continue forever. The first cash flow is $40, and the cash flows increase by 8%
each year. Dave believes that it is appropriate to evaluate this investment using a 12% discount rate. What is
the net present value of this investment? Should Dave accept it?
Solution:
The value of the growing perpetuity at t=3 is
FV(3) = 40/(.12-.08) = 1000.
Now, discount the following cash flows at 12%:
t
CF
0
-200
1
-200
2
-200
3
(-200 + 1000 )
You should get 31.41
5. (8 points) Your firm is considering a new project that requires the purchase of a new piece of machinery costing
$800,000. The machine will be depreciated using the the 7-year MACRS schedule. At the end of the third
year, the project will be terminated and the piece of equipment sold for $300,000. The project will generate
revenues of $220,000 per year. The tax rate is 35% and discount rate is 12%.
The 7-year MACRS schedule is as follows:
0
0.1429
1
0.2449
2
0.1749
3
0.1249
4
0.0893
5
0.0893
(a) What is the book value of the machine for each of years 0-3?
(b) What is the depreciation for each of years 0-3?
(c) What is the after tax salvage value of the machine?
(d) What are the operating cash flows for each of years 0-3?
Solution:
Year
MACRS
DEPR
BV
OCF
0
0.1429
114,320
685,680
40,012
1
0.2449
195,920
489,260
211,572
2
0.1749
139,920
349,840
191,972
3
0.1249
99,920
249,920
177,972
ATSV = BTSV * 0.65 + EndBV * 0.35 = 282,474
7
6
0.0893
7
0.0445
6. (10 points) ABC Corp. is considering a new project to manufacture cell phones. ABC expects to sell the phones
for $80 each. Variable costs will be $30 per unit. There are no fixed costs. The machinery required for the
project will cost $100,000 and be depreciated over 5 years using the straight-line method. The project will run
for 5 years. At the end of the project, the machinery will have no salvage value. The cost of capital is 10% and
tax rate is 35%.
How many units must ABC sell in order to break even financially (NPV=0)?
Solution:
PV = -100,000, FV = 0, n=5, r=10, pmt = ? = 26,380 (this is the required OCF to break even).
Solve OCF = (P-VC)*Q*0.65 + Depr*0.35 for Q.
8
You should get Q=596.3.