FINANCE : 19 QUESTIONS MOSTLY ASKED IN EXAMINATIONS.

21.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Project the annual free cash flows (FCF) of buying the chains.

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The annual free cash flows for years 1 to 10 of buying the chains is $-482,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-485,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-486,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-489,940.

22.The last four years of returns for a stock are as follows:

 

Year 1 Year 2 Year 3 Year 4
-3.9% +27.6% +11.5% +3.8%

 

Note: Notice that the average return and standard deviation must be entered in percentage format. The variance must be entered in decimal format. What is the standard deviation of the stock’s returns? (Round to two decimal places.)

The standard deviation is 13.99%.

The standard deviation is 14.79%.

The standard deviation is 14.99%.

The standard deviation is 13.79%.

23.You are considering a safe investment opportunity that requires a $920 investment today, and will pay $690 two years from now and another $640 five years from now. If you are choosing between this investment and putting your money in a safe bank account that pays an EAR of 5% per year for any horizon, can you make the decision by simply comparing this EAR with the IRR of the investment? Explain.

No, because the timing of the cashflows are different.

Yes, you can always compare IRRs of riskless projects, and an investment in the back is riskless.

No, this is like comparing the IRR of two projects.

Yes, because the EAR is the same at all horizons, so the two “projects” have the same riskiness, scale, and timing.

24.You are considering a safe investment opportunity that requires a $920 investment today, and will pay $690 two years from now and another $640 five years from now. What is the IRR of this investment?

The IRR of this investment is 8.65%.

The IRR of this investment is 6.92%.

The IRR of this investment is 22.29%.

The IRR of this investment is 11.74%.

25.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the FCF in years 1 through 9 of producing the chains.

The FCF in years 1 through 9 of producing the chains is $-338,950.

The FCF in years 1 through 9 of producing the chains is $-336,950.

The FCF in years 1 through 9 of producing the chains is $-342,950.

The FCF in years 1 through 9 of producing the chains is $-339,950.

26.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the NVP of producing the chains from the FCF.

The NVP of producing the chains from the FCF is $-3,007,692.

The NVP of producing the chains from the FCF is $-2,007,692.

The NVP of producing the chains from the FCF is $-4,007,692.

The NVP of producing the chains from the FCF is $-1,007,692.

27.IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business:

 

Debt outstanding (book value, AA-rated) $392.4 million
Number of shares of common stock 77.2 million
Stock price per share $14.67
Book value of equity per share $5.55
Beta of equity 1.32

 

What assumptions do you need to make? (Select all the choices that apply.)

Assume comparable assets have same risk as project.

Assume debt is risk-free and market value = book value.

Assume comparable assets have same cost.

Assume debt is risk-free and market value > book value.

28.IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business:

 

Debt outstanding (book value, AA-rated) $392.4 million
Number of shares of common stock 77.2 million
Stock price per share $14.67
Book value of equity per share $5.55
Beta of equity 1.32

 

What is your estimate of the project’s beta?

The project beta is 1.98.

The project beta is 0.98.

The project beta is 2.98.

The project beta is 1.48.

29.Your firm spends $473,000 per year in regular maintenance of its equipment. Due to the economic downturn, the firm considers forgoing these maintenance expenses for the next 3 years. If it does so, it expects it will need to spend $1.9 million in year 4 replacing failed equipment. For what costs of capital (COC) is forgoing maintenance a good idea?

For costs of capital that are less than the replacement costs.

For costs of capital that are greater than the NPV.

For costs of capital that are less than the IRR.

For costs of capital that are greater than the IRR.

30.In mid-2009, Rite Ad had CCC-rated, 20-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%. Suppose the mark risk premium is 5% and you believe Rite Aid’s bonds have a beta of 0.38. If the expected loss rate of these bonds in the event of default is 58%. In mid-2012, Rite Aid’s bonds a had a yield of 8.2%, while similar maturity Treasuries had a yield of 0.8%. What probability of default would you estimate now?

The probability of default will be 10.48%.

The probability of default will be 8.48%.

The probability of default will be 11.48%.

The probability of default will be 9.48%.

31.Bay Properties is considering starting a commercial real estate division. It has prepared the following four-year forecast of free cash flows for this division:

 

  Year 1 Year 2 Year 3 Year 4
Free cash flow $-122,000 $-9,000 $100,000 $219,000

 

Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this division is 17%, what is the continuation value in year 4 for cash flows after year 4?

The continuation value is $1,611,214.

The continuation value is $1,601,214.

The continuation value is $611,214.

The continuation value is $1,621,214.

32.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the difference between the net present values of buying the chains and producing the chains.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $431,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $331,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $131,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $231,128.

33.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Should you make the investment?

Yes, because the project will generate cash flows forever.

No, because the NVP is not greater than the initial costs.

Yes, because the NVP is positive.

No, because the NVP is less than zero.

34.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the FCF in year 10 of producing the chains.

The FCF in year 10 of producing the chains is $-182,613.

The FCF in year 10 of producing the chains is $-282,813.

The FCF in year 10 of producing the chains is $-182,813.

The FCF in year 10 of producing the chains is $-282,613.

35.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the initial FCF of producing the chains.

The initial FCF of producing the chains is $-335,000.

The initial FCF of producing the chains is $-339,000.

The initial FCF of producing the chains is $-340,000.

The initial FCF of producing the chains is $-330,000.

36.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Use the IRR to determine the maximum deviation allowable in the cost of capital estimate to make the investment.

The maximum deviation allowable in the cost of capital is 28.65%.

The maximum deviation allowable in the cost of capital is 21.60%.

The maximum deviation allowable in the cost of capital is 24.70%.

The maximum deviation allowable in the cost of capital is 18.45%.

37.The figure below shows the one-year return distribution of Startup, Inc.

 

Probability 40% 20% 20% 10% 10%
Return -100% -75% -50% -30% 1,000%

 

Calculate the expected return.

The expected return is 30.0%.

The expected return is 31.2%.

The expected return is 32.0%.

The expected return is 30.7%.

38.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Calculate the IRR.

The IRR of the project is 30.60%.

The IRR of the project is 28.80%.

The IRR of the project is 33.70%.

The IRR of the project is 31.80%.

39.Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $15 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 27% will come from customers who switch to the new, healthier pizza instead of buying the original version. Suppose that 39% of customers who switch from Pisa Pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case?

The incremental sales are $11 million.

The incremental sales are $8 million.

The incremental sales are $6 million.

The incremental sales are $13 million.

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