FINANCE : 20 QUESTIONS

1.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. What is the IRR of the decision to forgo maintenance of the equipment?

The IRR of the decision is 15.94%

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The IRR of the decision is 14.18%

The IRR of the decision is 15.32%.

The IRR of the decision is 18.36%

2.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. Does the IRR rule work for this decision?

Only if the replacement cost is below $2 million.

No.

Yes.

3.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 average annual rate? (Round to two decimal places.)

The average return is 10.15%.

The average return is 10.25%.

The average return is 10.05%.

The average return is 9.95%.

4.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%. What annual probability of default would be consistent with the yield to maturity of these bonds in mid-2009?

The required return for this investment is 4.90%. The annual probability of default is 23.38%.

The required return for this investment is 4.90%. The annual probability of default is 20.38%.

The required return for this investment is 4.90%. The annual probability of default is 22.38%.

The required return for this investment is 4.90%. The annual probability of default is 21.38%.

5.Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.54, expects to generate free cash flow of $66 million this year, and anticipated a 3% perpetual growth rate. The individual chemicals division has an asset beta of 1.15, expects to generate free cash flow of $71 million this year, and anticipates a 4% perpetual growth rate. Suppose the risk free rate is 2% and the market premium is 5%. Estimate Weston’s current cost of capital.

Weston’s current cost of capital is 4.70%.

Weston’s current cost of capital is 3.70%.

Weston’s current cost of capital is 5.70%.

Weston’s current cost of capital is 2.70%.

6.Consider an investment with the following returns over four years:

 

Year 1 2 3 4
Return 15% 7% 9% 11%

 

Which is a better measure of the investment’s past performance? If the investment’s returns are independent and identically distributed, which is a better measure of the investment’s expected return next year?

Arithmetic average is a better measure of the investment’s past performance while CAGR is a better measure of the investment’s expected return next year.

CAGR is a better measure of the investment’s past performance while arithmetic average is a better measure of the investment’s expected return next year.

7.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. Assume customers will spend the same amount on either version. What level of incremental sales is associated with introducing the new pizza?

The incremental sales are $3 million.

The incremental sales are $9 million.

The incremental sales are $15 million.

The incremental sales are $11 million.

8.You need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you only have the following data available regarding past returns:

 

Year Risk-free Return Market Return XYZ Return
2007 4% 6% 8%
2008 1% -43% -50%

 

Estimate XYZ’s historical alpha.

XYZ’s historical alpha is 1.1%.

XYZ’s historical alpha is 1.6%.

XYZ’s historical alpha is 1.9%.

XYZ’s historical alpha is 1.3%.

9.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 standard deviation of the return.

The standard deviation is 324%.

The standard deviation is 330%.

The standard deviation is 328%.

The standard deviation is 326%.

10.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 NPV of buying the chains from the FCF.

The NPV of buying the chains from the FCF is $-438,850.

The NPV of buying the chains from the FCF is $-438,820.

The NPV of buying the chains from the FCF is $-1,438,820.

The NPV of buying the chains from the FCF is $-2,438,820.

11.Consider an investment with the following returns over four years:

 

Year 1 2 3 4
Return 15% 7% 9% 11%

 

What is the average annual return of the investment over the four years?

The average annual return is 1.50%.

The average annual return is 0.50%.

The average annual return is 10.50%.

The average annual return is 5.50%.

12.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 value today of this division?

The value today is $528,283.

The value today is $928,283.

The value today is $228,283.

The value today is $728,283.

13.You need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you only have the following data available regarding past returns:

 

Year Risk-free Return Market Return XYZ Return
2007 4% 6% 8%
2008 1% -43% -50%

 

Would you base your estimate of XYZ’s equity cost of capital on historical return or expected return?

Expected return because the CAPM provides a better estimate of expected returns.

Historical return because the average past returns provides a better estimate of expected returns.

14.You need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you only have the following data available regarding past returns:

 

Year Risk-free Return Market Return XYZ Return
2007 4% 6% 8%
2008 1% -43% -50%

 

Compute the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.

The market’s excess return for 2007 is 2%. The market’s excess return for 2008 is -44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 208 is -51%. XYZ’s beta is 1.20.

The market’s excess return for 2007 is 2%. The market’s excess return for 2008 is -44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 2008 is -51%. XYZ’s beta is 1.40.

The market’s excess return for 2007 is 2%. The market’s excess return for 2008 is -44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 2008 is -51%. XYZ’s beta is 1.10.

The market’s excess return for 2007 is 2%. The market’s excess return for 2008 is -44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 208 is -51%. XYZ’s beta is 1.30.

15.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 variance of the stock’s returns? (Round to five decimal places.)

The variance of the returns is 0.01602.

The variance of the returns is 0.01702.

The variance of the returns is 0.01902.

The variance of the returns is 0.01802.

16.Consider an investment with the following returns over four years:

 

Year 1 2 3 4
Return 15% 7% 9% 11%

 

What is the compound annual growth rate (CAGR) for this investment over the four years?

The compound annual growth rate is 10.46%.

The compound annual growth rate is 10.36%.

The compound annual growth rate is 10.26%.

The compound annual growth rate is 10.16%.

17.Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.54, expects to generate free cash flow of $66 million this year, and anticipated a 3% perpetual growth rate. The individual chemicals division has an asset beta of 1.15, expects to generate free cash flow of $71 million this year, and anticipates a 4% perpetual growth rate. Suppose the risk-free rate is 2% and the market premium is 5%. Estimate Weston’s current equity beta.

Weston’s current equity beta is 0.74.

Weston’s current equity beta is 0.66.

Weston’s current equity beta is 0.79.

Weston’s current equity beta is 0.70.

18.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 NPV of this investment opportunity if your cost of capital is 7.1%.

The NVP of this investment opportunity is $349.0 million.

The NVP of this investment opportunity is $349.0 million.

The NVP of this investment opportunity is $349.0 million.

The NVP of this investment opportunity is $349.0 million.

19.You need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you only have the following data available regarding past returns:

 

Year Risk-free Return Market Return XYZ Return
2007 4% 6% 8%
2008 1% -43% -50%

 

What was XYZ’s average historical return?

XYZ’s average historical return was -18.0%.

XYZ’s average historical return was -15.0%.

XYZ’s average historical return was -21.0%.

XYZ’s average historical return was -20.0%.

20.Weston Enterprises is an all-equity firm with two divisions. The soft drink division has an asset beta of 0.54, expects to generate free cash flow of $66 million this year, and anticipated a 3% perpetual growth rate. The individual chemicals division has an asset beta of 1.15, expects to generate free cash flow of $71 million this year, and anticipates a 4% perpetual growth rate. Suppose the risk-free rate is 2% and the market premium is 5%. Estimate the value of each division.

The estimated value of the soft drink division is $70.3 million and the estimated value of the industrial chemicals division is $76.3 million.

The estimated value of the soft drink division is $3,882.4 million and the estimated value of the industrial chemicals division is $1,893.3 million.

The estimated value of the soft drink division is $3,796.2 million and the estimated value of the industrial chemicals division is $8,774.5 million.

The estimated value of the soft drink division is $1,893.3 million and the estimated value of the industrial chemicals division is $3,882.4 million.

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