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Solutions for BioCom, Inc. Minicase
$20.00BioCom was founded in 1993, when several scientists and engineers at a large fiber-optic-cable company began to see that optical fiber for the telecommunications industry was becoming a cheap commodity. They decided to start their own firm, which would specialize in cutting-edge applications for research in the life sciences and medical instruments. BioCom is now one of the leading firms in its niche field. BioCom’s management attributes the firm’s success to its ability to stay one step ahead of the market’s fast-changing technological needs. Almost as important is BioCom’s ability to select high-value-added projects and avoid commercial disasters.
Over lunch, BioCom’s director of research and development (R&D) mentioned to the CFO that one of his best young scientists had recently left the company because his line manager had rejected his project. Although not a pattern, R&D had experienced similar losses in the past. The two executives discussed the problem and agreed that if the R&D people understood the selection process better, they might come up with more commercially viable projects and understand the project’s financial implications. The CFO has asked his assistant, Jane Donato, to prepare a retreat for the R&D department to explain the company’s project selection procedures. Jane is encouraged by the thought that this group will have no trouble in following the math.
BioCom’s standard capital request form includes a narrative description of the project and the customer need that the company must fulfill. If the request originates with R&D, it then goes to the marketing department for a preliminary sales forecast and then to the production manager and cost analysts for cost estimates. If a proposal shows promise after these steps, it goes to the CFO, who has a staff member enter the data into a spreadsheet template. The template computes payback, discounted payback, net present value, internal rate of return, and modified internal rate of return. BioCom uses net present value as its primary decision criterion, but company executives believe that the other statistics provide some useful additional perspectives.
To explain BioCom’s capital budgeting techniques, Jane has decided to present the cash flows from two recent proposals: the nano test tube project and the microsurgery kit project. All figures are in thousands of dollars:
Time of Cash Flow
Nano Test Tubes
Microsurgery Kit
Investment
-$11,000
-$11,000
Year 1
2,000
4,000
Year 2
3,000
4,000
Year 3
4,000
4,000
Year 4
5,000
4,000
Year 5
7,000
4,000
Help Jane answer the following questions.
Questions:
Compute the payback period for each project.
- Explain the rationale behind the payback method.
- State and explain the decision rule for the payback method.
- Explain how the payback method would be used to rank mutually exclusive projects.
- Comment on the advantages and shortcomings of this method.
Compute the discounted payback period for each project using a discount rate of 10%.
- Explain the rationale behind the discounted payback method.
- Comment on the advantages and shortcomings of this method.
Compute the net present value (NPV) for each project. BioCom uses a discount rate of 9% for projects of average risk.
- Explain the rationale behind the NPV method.
- State and explain the decision rule behind the NPV method.
- Explain how the NPV method would be used to rank mutually exclusive projects.
- Comment on the advantages and shortcomings of this method.
- Without performing any calculations, explain what happens to NPV if the discount rate is adjusted upward for projects of higher risk or downward for projects of lower risk.
Compute the internal rate of return (IRR) for each project.
- Explain the rationale behind the IRR method.
- State and explain the decision rule behind the IRR method. Assume a hurdle rate of 9%.
- Explain how the IRR method would be used to rank mutually exclusive projects.
- Comment on the advantages and shortcomings of this method.
Compute the modified internal rate of return (MIRR) for each project.
- Explain the rationale behind the MIRR method.
- State and explain the decision rule behind the MIRR method. Assume a hurdle rate of 9%.
- Explain how the MIRR method would be used to choose between mutually exclusive projects.
- Explain how this method corrects for some of the problems inherent in the IRR method.
Explain to the R & D staff why BioCom uses the NPV method as its primary project selection criterion.
Challenge question. Construct NPV profiles for both projects using discount rates of 1% through 15% at one percentage point intervals. At approximately what discount rate does the Nano test tube project become superior to the micro surgery kits? This problem is best solved using an electronic spreadsheet.
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Solutions to Chapter 9 Problems
$30.00- Payback period. Given the cash flow of four projects, A, B, C, and D, and using the payback period decision model, which projects do you accept and which projects do you reject with a four-year cutoff period for recapturing the initial cash outflow? For payback period calculations, assume that the cash flow is equally distributed over the year.
Cash flow A B C D Cost $40,000 $25,000 $45,000 $120,000 Cash flow Year 1 $ 4,000 $ 5,000 $20,000 $ 75,000 Cash flow Year 2 $ 6,000 $ 5,000 $12,000 $ 25,000 Cash flow Year 3 $ 9,000 $ 5,000 $26,000 $ 20,000 Cash flow Year 4 $ 14,000 $ 5,000 $9,000 $ 15,000 Cash flow Year 5 $ 16,000 $ 5,000 $13,000 $ 0 Cash flow Year 6 $ 20,000 $ 5,000 $18,000 $ 0 - Payback period. What are the payback periods of Projects E, F, G and H? Assume all the cash flows are evenly spread throughout the year. If the cutoff period is three years, which projects do you accept?
- Discounted payback period. Given the following four projects and their cash flows, calculate the discounted payback period with a 5% discount rate, 10% discount rate, and 20% discount rate. What do you notice about the payback period as the discount rate rises? Explain this relationship.
- Discounted payback period. Becker Inc. uses discounted payback period for projects under $25,000 and has a cut off period of 4 years for these small value projects. Two projects, R and S, are under consideration. The anticipated cash flows for these two projects are listed below. If Becker Incorporated uses an 8% discount rate on these projects, are they accepted or rejected? If it uses 12% discount rate? A 16% discount rate? Why is it necessary to only look at the first four years of the projects’ cash flows?
- Comparing payback period and discounted payback period. Hydes Inc. is debating using payback period versus discounted payback period for small-dollar projects. The company’s information officer has submitted a new computer project with a $16,000 cost. The cash flow will be $4,000 each year for the next five years. The cutoff period used by the company is four years. The information officer states that it doesn’t matter which model the company uses for the decision; the project is clearly acceptable. Demonstrate for the information officer that the selection of the model does matter.
- Comparing payback period and discounted payback period. Nielsen Inc. is switching from the payback period to the discounted payback period for small-dollar projects. The cutoff period will remain at three years. Given the following four projects’ cash flows and using a 10% discount rate, determine which projects it would have accepted under the payback period and which it will now reject under the discounted payback period.
- Net present value. Garth Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $320,000
Cash flow year one: $ 55,000
Cash flow year two: $ 75,000
Cash flow year three: $120,000
Cash flow year four: $180,000
- Using a 10% discount rate for this project and the NPV model, determine whether this
project should be accepted or rejected.
- Should it be accepted or rejected using a 12% discount rate?
- Net present value. Lepton Industries has a project with the following projected cash flows:
Initial Cost: $510,000
Cash flow year one: $135,000
Cash flow year two: $240,000
Cash flow year three: $185,000
Cash flow year four: $135,000
- Using an 8% discount rate for this project and the NPV model, determine whether this
project should be accepted or rejected.
- Should it be accepted or rejected using a 14% discount rate?
- Should it be accepted or rejected using a 20% discount rate?
- Net present value. Quark Industries has four potential projects, all with an initial cost of $2,000,000. The capital budget for the year will allow Quark Industries to accept only one of the four projects. Given the discount rates and the future cash flows of each project, determine which project Quark should accept.
- Net present value. Lepton Industries has four potential projects, all with an initial cost of $1,500,000. The capital budget for the year will allow Lepton to accept only one of the four projects. Given the discount rates and the future cash flows of each project, determine which project Lepton should accept.
- NPV unequal lives. Grady Enterprises is looking at two project opportunities for a parcel of land that the company currently owns. The first project is a restaurant, and the second project is a sports facility. The projected cash flow of the restaurant is an initial cost of $1,500,000 with cash flows over the next six years of $200,000 (Year one), $250,000 (Year two), $300,000 (Years three through five), and $1,750,000 in Year six, when Grady plans on selling the restaurant. The sports facility has the following cash outflow: initial cost of $2,400,000 with cash flows over the next three years of $400,000 (Years one to three) and $3,000,000 in Year four, when Grady plans on selling the facility. If the appropriate discount rate for the restaurant is 11% and the appropriate discount rate for the sports facility is 13%, using NPV, determine which project Grady should choose for the parcel of land. Adjust the NPV for unequal lives with the equivalent annual annuity. Does the decision change?
- NPV unequal lives. Singing Fish Fine Foods has $2,000,000 for capital investments this year and is considering two potential projects for the funds. Project one is updating the deli section of the store for additional food service. The estimated annual after-tax cash flow of this project is $600,000 per year for the next five years. Project two is updating the wine section of the store. Estimated annual after-tax cash flow for this project is $530,000 for the next six years. If the appropriate discount rate for the deli expansion is 9.5% and the appropriate discount rate for the wine section is 9.0%, using NPV, determine which project Singing Fish should choose for the parcel of land. Adjust the NPV for unequal lives with the equivalent annual annuity. Does the decision change?
- Internal rate of return and modified internal rate of return. What are the IRRs and MIRRs of the four projects for Quark Industries in Problem 9?
- Internal rate of return and modified internal rate of return. What are the IRRs and MIRRs of the four projects for Lepton Industries in Problem 10?
- MIRR unequal lives. What is the MIRR for Grady Enterprises in Problem 11? What is the MIRR when you adjust for the unequal lives? Does the adjusted MIRR for unequal lives change the decision based on MIRR? Hint: Take all cash flows to the same ending period as the longest project.
Year Restaurant Sports Facility 0 -1500000 -2400000 1 200000 400000 2 250000 400000 3 300000 400000 4 300000 3000000 5 300000 6 1750000 Disc. Rate 11% 13% - MIRR unequal lives. What is the MIRR for Singing Fish Fine Foods in Problem 12? What is the MIRR when you adjust for the unequal lives? Does the adjusted MIRR for unequal lives change the decision based on MIRR? Hint: Take all cash flows to the same ending period as the longest project.
Year Deli Section Wine Section 0 -2000000 -2000000 1 600000 530000 2 600000 530000 3 600000 530000 4 600000 530000 5 600000 530000 6 530000 Disc. Rate 9.5% 9% - Comparing NPV and IRR. Chandler and Joey were having a discussion about which financial model to use for their new business. Chandler supports NPV and Joey supports IRR. The discussion starts to get heated when Ross steps in and states, “Gentlemen, it doesn’t matter which method we choose, they give the same answer on all projects.” Is Ross correct? Under what conditions will IRR and NPV be consistent when accepting or rejecting projects?
- Comparing NPR and IRR. Monica and Rachel are having a discussion about IRR and NPV as a decision model for Monica’s new restaurant. Monica wants to use IRR because it gives a very simple and intuitive answer. Rachel states that IRR can cause errors, unlike NPV. Is Rachel correct? Show one type of error can be made with IRR and not with NPV.
- Profitability index. Given the discount rates and the future cash flows of each project, which projects should they accept using profitability index?
- Profitability index. Given the discount rates and the future cash flow of each project listed, use the PI to determine which projects the company should accept.
- Comparing all methods. Given the following after-tax cash flows on a new toy for Tyler’s Toys, find the project’s payback period, NPV, and IRR. The appropriate discount rate for the project is 12%. If the cutoff period is six years for major projects, determine whether management will accept or reject the project under the three different decision models.
Year 0 cash outflow: $10,400,000
Years 1 to 4 cash inflow: $2,600,000 each year
Year 5 cash outflow: $1,200,000
Years 6 to 8 cash inflow: $750,000 each year
- Comparing all methods. Risky Business is looking at a project with the estimated cash flows as follows:
Initial Investment at start of project: $3,600,000
Cash Flow at end of Year 1: $500,000
Cash Flow at end of Years 2 through 6: $625,000 each year
Cash Flow at end of Year 7 through 9: $530,000 each year
Cash Flow at end of Year 10: $385,000
Risky Business wants to know payback period, NPV, IRR, MIRR, and PI of this project. The appropriate discount rate for the project is 14%. If the cutoff period is six years for major projects, determine whether management at Risky Business will accept or reject the project under the five different decision models.
- NPV profile of a project. Given the following cash flows of Project L-2, draw the NPV profile. Hint: use a discount rate of zero for one intercept (y-axis) and solve for the IRR for the other intercept (x-axis).
Cash flows: Year 0 = -$250,000
Year 1 = $45,000
Year 2 = $75,000
Year 3 = $115,000
Year 4 = $135,000
- NPVprofile of two mutually exclusive projects. Moulton Industries has two potential projects for the coming year, Project B-12 and Project F-4. The two projects are mutually exclusive. The cash flows are listed below. Draw the NPV profile of each project and determine the cross-over rate of the two projects. If the appropriate hurdle rate is 10% for both projects which project, does Moulton Industries choose?
Additional Files:
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Credit scoring as a risk assessment tool in the insurance industry
$30.00is someone’s credit rating indicative of their insurance risk.? I9s it good public policy to allow insurers to use it?
Needs to be 10 pages single spaced!
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Economics Risk Assignment
$5.00Assuming the opportunity interest rate is 8%, what is the present value of the second alternative mentioned above?
Which of the two alternatives should be chosen and why?
How would your decision change if the opportunity interest rate is 12%? If the interest rate was 12% INSTEAD OF 8%.
Provide a description of a scenario where this kind of decision between two types of payment streams applies in the “real-world” business setting.
Describe and calculate Project A’s expected net present value (ENPV) and standard deviation (SD), assuming the discount rate (or risk-free interest rate) to be 8%. What is the decision rule in terms of ENPV? What will be San Diego LLC’s decision regarding this project? Describe your answer.
The company is also considering another three-year project, Project B, which has an ENPV of $32 million and standard deviation of $10.5 million. Project A and B are mutually exclusive. Which of the two projects would you prefer if you do not consider the risk factor? Explain.
Describe the coefficient of variation (CV) and the standard deviation (SD) in connection with risk attitudes and decision making. If you now also consider
your risk-aversion attitude, as the CEO of the San Diego LLC will you make a different decision between Project A and Project B? Why or why not?
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Answers to Chapter 7: Introduction to Risk, Return, and the Opportunity Cost of Capital
$15.00Multiple Choice Questions
1. Which of the following portfolios have the least risk?
A) A portfolio of Treasury bills
B) A portfolio of long term United States Government bonds
C) Standard and Poor’s composite index
D) Portfolio of common stocks of small firms
2. What has been the average nominal rate of interest on Treasury bills over the past seventy-five years?
A) Less than 1%
B) Between 1% and 2%
C) Between 2% and 3%
D) Between 3% and 4%
3. What has been the average real rate of interest on Treasury bills over the past seventy-five years?
A) Less than 1%
B) Between 1% and 2%
C) Between 2% and 3%
D) Between 3% and 4%
4. Standard and Poor’s 500 Index is a:
A) Portfolio of common stocks
B) Portfolio of corporate bonds
C) Portfolio of government bonds
D) A and B above
5. Long-term government bonds have:
A) Interest rate risk
B) Default risk
C) Market risk
D) None of the above
6. One dollar invested in the S&P index in 1926 would have grown in nominal value by the end of year 2000 to:
A) $6402.2
B) $2586.5
C) $64.1
D) $16.6
7. One dollar invested in the S&P index in 1926 would have grown in real value by the end of year 2000 to:
A) $659.6
B) $266.5
C) $6.6
D) $5.0
8. What has been the average risk premium on common stocks between 1926 and 2000?
A) 13.4%
B) 9.1%
C) 2.2%
D) 1.9%
9. What has been the average annual rate of return (normal value) for small common stocks between 1926 and 2000?
A) 17.3%
B) 13.0%
C) 6.0%
D) 3.9%
10. Which portfolio had the highest average annual (real) return between 1926 and 2000?
A) Small firm common stocks
B) Common stocks
C) Government bonds
D) Treasury bills
11. Which portfolio has had the lowest average annual nominal rate of return during the 1926-2000 period?
A) Small firm common stocks
B) Common stocks
C) Government bonds
D) Treasury bills
12. What has been the average risk premium on small-firm common stocks between 1926 and 2000?
A) More than 10%
B) Between 8% and 10%
C) Between 2% and 5%
D) Less than 2%
13. Which portfolio has had the highest average risk premium during the period 1926-2000?
A) Small firm common stocks
B) Common stocks
C) Government bonds
D) Treasury bills
14. Standard error measures:
A) Nominal annual rate of return on a portfolio
B) Risk of a portfolio
C) Reliability of an estimate
D) Real annual rate of return on a portfolio
15. Standard error is estimated as:
A) Average annual rate of return divided by the square root of the number of observations
B) Standard deviation of returns divided by the square root of the number of observations
C) Variance divided by the number of observations
D) None of the above
16. If the standard deviation is 13.4% and the number of observations is 10, what is the standard error?
A) 4.23 %
B) 2.4%
C) 0.47%
D) None of the above
17. Spill Oil Company’s stocks had -8%, 12% and 26% rates of return during the last three years respectively; calculate the average rate of return for the stock.
A) 10% per year
B) 8% per year
C) 12% per year
D) None of the above
18. If the average annual rate of return for common stocks is 13%, and treasury bills is 3.8%, what is the average market risk premium?
A) 13%
B) 3.8%
C) 9.2%
D) None of the above
19. The discount rate for safe projects is the:
A) Market rate of return
B) Risk-free rate
C) Market risk premium
D) None of the above
20. The discount rate for a project with a risk the same as the market risk is the:
A) Market rate of return
B) Risk-free rate
C) Market risk premium
D) None of the above
21. Mega Corporation has the following returns for the past three years: 8%, 16% and 24%. Calculate the variance of the return and the standard deviation of the returns.
A) 64 and 8%
B) 128 and 11.3%
C) 43 and 6.5%
D) None of the above
22. Macro Corporation has had the following returns for the past three years, -20%, 10%, 40%. Calculate the standard deviation of the returns.
A) 10%
B) 30%
C) 60%
D) None of the above
23. Micro Corporation has had returns of –5%, 15% and 20% for the past three years. Calculate the standard deviation of the returns.
A) 10%
B) 22.9%
C) 30%
D) None of the above
24. What has been the standard deviation of returns of common stocks during the period between 1926 and 2000?
A) 20.2%
B) 33.4%
C) 8.7%
D) 9.4%
25. Which portfolio had the highest standard deviation during the period between 1926 and 2000?
A) Small firm common stocks
B) Common stocks
C) Government bonds
D) Treasury bills
26. The standard deviation of the UK market during the period from 1996 through 2001 was:
A) 24.1%
B) 20.7%
C) 14.5%
D) None of the above
27. The portion of the risk that can be eliminated by diversification is called:
A) Unique risk
B) Market risk
C) Interest rate risk
D) Default risk28. The unique risk is also called the:
A) Unsystematic risk
B) Diversifiable risk
C) Firm specific risk
D) Residual risk
E) All of the above
29. Stock A has an expected return of 10% per year and stock B has an expected return of 20%. If 55% of the funds are invested in stock B, what is the expected return on the portfolio of stock A and stock B?
A) 10%
B) 20%
C) 15.5%
D) None of the above
30. As the number of stocks in a portfolio is increased:
A) Unique risk decreases and approaches to zero
B) Market risk decrease
C) Unique risk decreases and becomes equal to market risk
D) total risk approaches to zero
31. Stock X has a standard deviation of return of 10%. Stock Y has a standard deviation of return of 20%. The correlation coefficient between stocks is 0.5. If you invest 60% of the funds in stock X and 40% in stock Y, what is the standard deviation of a portfolio?
A) 10%
B) 20%
C) 12.2%
D) 22%
E) None of the above
32. Stock M and Stock N have had returns for the past three years of –12%. 10%, 32% and 6%, 15%, 24% respectively. Calculate the covariance between the two securities.
A) +198
B) –198
C) +132
D) None of the above
33. Stock P and stock Q have had annual returns of -10%, 12%, 28% and 8%, 13%, 24% respectively. Calculate the covariance of return between the securities.
A) 149
B) –149
C) 100
D) None of the above
34. If the covariance between stock A and stock B is 100, the standard deviation of stock A is 10% and that of stock B is 20%, calculate the correlation coefficient between the two securities.
A) +0.5
B) +1.0
C) –0.5
D) None of the above
35. If the correlation coefficient between stock C and stock D is +1.0% and the standard deviation of return for stock C is 15% and that for stock D is 30%, calculate the covariance between stock C and stock D.
A) +45
B) +450
C) –45
D) None of the above
36. The range of values that correlation coefficients can take can be:
A) –1 to +1
B) zero to +1
C) –infinity to +infinity
D) zero to +infinity
37. For a two-stock portfolio, the maximum reduction in risk occurs when the correlation coefficient between the two stocks is:
A) +1
B) 0
C) –0.5
D) –1
38. The “beta” is a measure of:
A) Unique risk
B) Market risk
C) Total risk
D) None of the above
39. The variance or standard deviation is a measure of:
A) Total risk
B) Unique risk
C) Market risk
D) None of the above
40. The beta of market portfolio is:
A) 0
B) +0.5
C) +1.0
D) –1.0
41. The beta of a risk-free portfolio is:
A) 0
B) +0.5
C) +1.0
D) –1.0
42. If the standard deviation of returns of the market is 20% and the beta of a well-diversified portfolio is 1.5, calculate the standard deviation of the portfolio:
A) 10%
B) 20%
C) 30%
D) 40%
E) none of the above
43. The correlation coefficient between stock A and the market portfolio is +0.6. The standard deviation of return of the stock is 30% and that of the market portfolio is 20%. Calculate the beta of the stock.
A) 0.9
B) 1.0
C) 1.1
D) 0.6
44. The correlation coefficient between stock B and the market portfolio is 0.8. The standard deviation of the stock B is 35% and that of the market is 20%. Calculate the beta of the stock.
A) 1.0
B) 1.4
C) 0.8
D) 0.7
45. Historical nominal return for stock A is –8%, +10% and +22%. The nominal return for the market portfolio is +6%, +18% and 24%. Calculate the beta for stock A.
A) 1.64
B) 0.61
C) 1.0
D) None of the above
46. The three year annual return for stock B comes out to be 0%, 10% and 26%. Three year annual returns for the market portfolios are +6%, 18%, 24%. Calculate the beta for the stock.
A) 1.36
B) 0.74
C) 0
D) None of the aboveTrue/False Questions
T F 47. Treasury bills have provided the lowest average return between 1926-1997.
T F 48. Risk premium is the difference between the security return and the Treasury bill return.
T F 49. The standard statistical measures of spread are variance and standard deviation.
T F 50. Diversification reduces risk because prices of different securities do not move exactly together.
T F 51. The risk that cannot be eliminated by diversification is called market risk.
T F 52. The risk that cannot be eliminated by diversification is called unique risk.
T F 53. The average beta of all stocks is zero.
T F 54. A portfolio with a beta of zero offers an expected return of zero.
T F 55. Beta of a well-diversified portfolio is equal to the value weighted average beta of the securities included in the portfolio.Short Answer Questions
56. Define the term risk premium.
57. Briefly explain the term “variance” of the returns.
58. Briefly explain how diversification reduces risk.
59. In the formula for calculating the variance of N- asset portfolio, how many covariance and variance terms are there?
60. Discuss the importance of “beta” as a measure of risk.
61. Briefly explain how “beta” of a stock is estimated.
62. What is the statistical definition of “beta”?
63. Briefly explain the difference between beta as a measure of risk and variance as a measure of risk.
64. Briefly explain how individual securities affect portfolio risk.
65. What is the beta of a portfolio with a large number of randomly selected stocks?
66. How can individual investors diversify? -
Answers to Chapter 6: Making Investment Decisions with the Net Present Value Rule
$30.00Multiple Choice Questions
1. Preferably, cash flows for a project are estimated as:
A) Cash flows before taxes
B) Cash flows after taxes
C) Earnings before taxes
D) Earnings after taxes
2. Important points to remember while estimating cash flows of projects are:
A) only cash flow is relevant
B) always estimate cash flows on an incremental basis
C) be consistent in the treatment of inflation
D) all of the above
E) none of the above
3. Net Working Capital is the:
A) Difference between short-term assets and short term liabilities
B) Difference between long-term assets and long term liabilities
C) Difference between long-term assets and short term liabilities
D) None of the above
4. Net Working Capital should be considered in project cash flows because:
A) They are sunk costs
B) Firms must invest cash in short-term assets to produce finished goods
C) Firms need positive NPV projects for investment
D) None of the above
5. Investment in net working capital is not depreciated because:
A) it is not a cash flow
B) it is a sunk cost
C) it is recovered during or at the end of the project and is not a depreciating asset
D) all of the above
6. The principal short-term assets are:
A) Cash
B) Accounts receivable
C) Inventories
D) All of the above
7. Investment in inventories includes investment in:
A) Raw material
B) Work-in-progress
C) Finished goods
D) All of the above
8. The cost of a resource that may be relevant to an investment decision even when no cash changes hand is called a (an):
A) sunk cost
B) working capital
C) opportunity cost
D) none of the above
9. The following cash flows should be treated as incremental flows when deciding whether to go ahead with an electric car except:
A) The consequent deduction in sales of the company’s existing gasoline models
B) The expenditure on new plants and equipment
C) The value of tools that can be transferred from the company’s existing plants
D) Interest payment on debt
10. Which of the following cash flows should be treated as incremental flows when deciding whether to go ahead with an electric car?
A) The cost of research and development undertaken for developing the electric car in the past three years
B) The annual depreciation charge
C) The reduction in taxes resulting from the depreciation charges
D) Dividend payments
11. Money that a firm has already spent or committed to spend regardless of whether a project is taken is called:
A) Sunk cost
B) Opportunity cost
C) Fixed cost
D) None of the above
12. The value of a previously purchased machine expected to be used by a proposed project is an example of:
A) Sunk cost
B) Opportunity cost
C) Fixed cost
D) None of the above
13. A firm owns a building with a book value of $150,000 and a market value of $250,000. If the building is utilized for a project, then the opportunity cost ignoring taxes is:
A) $100,000
B) $150,000
C) $250,000
D) None of the above
14. A firm has a general purpose machine which has a book value of $400,000 and is sold for $600,000 in the market. If the tax rate is 30%, what is the opportunity cost of using the machine in a project?
A) $500,000
B) $600,000
C) $540,000
D) None of the above
15. A reduction in the sales of existing products caused by the introduction of a new product is an example of:
A) sunk cost
B) opportunity cost
C) incidental effects
D) none of the above
16. The real rate of interest is 2% and the inflation is 5%. What is the nominal rate of interest?
A) 3%
B) 4%
C) 7.1%
D) 1%
17. A cash flow received in two years is expected to be $11,236. If the real rate of interest is 4% and the inflation rate is 6%, what is the real cash flow for year-2?
A) $11,236
B) $10,388
C) $10,000
D) $9,246
18. The real interest rate is 2% and the inflation rate is 4%. What is the nominal interest rate?
A) 3%
B) 4%
C) 6.08%
D) 2%
19. If the nominal interest rate is 6.5% and the inflation rate is 3%, what is the real interest rate?
A) 3.4%
B) 9.5%
C) 4%
D) None of the above
20. Proper treatment of inflation in the NPV calculation involves:
A) Discounting nominal cash flows using the nominal discount rate
B) Discounting real cash flows using the real discount rate
C) Discounting nominal cash flows using the real discount rates
D) A and B
21. Real cash flow occurring in year-2 is 50,000. If the inflation rate is 10% per year, calculate nominal cash flow for year-2.
A) 60,500
B) 50,000
C) 55,000
D) None of the above
22. The NPV value obtained by discounting nominal cash flows using the nominal discount rate is:
A) The same as the NPV value obtained by discounting real cash flows using the real discount rate
B) The same as the NPV value obtained by discounting real cash flows using the nominal discount rate
C) The same as the NPV value obtained by discounting nominal cash flows using the real discount rate
D) None of the above
23. A capital equipment costing $100,000 today has no (zero) salvage value at the end of 5 years. If straight-line depreciation is used, what is the book value of the equipment at the end of three years?
A) $110,000
B) $80,000
C) $60,000
D) $40,000
24. Capital equipment costing $200,000 today has 50,000 salvage value at the end of 5 years. If the straight line depreciation method is used, what is the book value of the equipment at the end of two years?
A) $200,000
B) $170,000
C) $140,000
D) $50,000
25. For project A in year – 2, inventories increase by $10,000 and accounts payable by $4,000. Calculate the increase or decrease in net working capital for year-2.
A) Increases by $14,000
B) Decreases by $14,000
C) Increases by $6,000
D) Decreases by $6,000
E) None of the above
26. For project X, year – 5 inventories increase by $5,000, accounts receivables by $3,000 and accounts payables by $2,000. Calculate the increase or decrease in working capital for year-5.
A) Increases by $6,000
B) Decreases by $6,000
C) Increases by $8,000
D) Decreases by $7,000
27. If the depreciation amount is $100,000 and the marginal tax rate is 30%, then the tax shield due to depreciation is:
A) $333,333
B) $100,000
C) $30,000
D) None of the above
28. If the depreciation amount is 600,000 and the marginal tax rate is 30%, then the tax shield due to depreciation is:
A) $180,000
B) $600,000
C) $210,000
D) None of the above
Use the following to answer questions 29-30:You own 100 acres of timberland, with young timber worth $20,000 if logged today. This represents 500 cords of wood at $40 per cord. After logging, the land can be sold today for $10,000 ($100 per acre). The opportunity cost of capital is 10%. You have made the following estimates:
(i) The price of a cord of wood will increase by 5% per year.
(ii) The price of land will increase by 3% per year.
(iii) The yearly growth rate of the cords of wood on your land are: years 1-2: 15%; years 3-4: 10%; years 5-8: 5%; years thereafter: 2%.29. The present value of the optimal decision is approximately:
A) $30,000
B) $32,800
C) $34,250
D) $33,830
30. The optimal decision is to sell after:
A) 8 years
B) 5 years
C) 4 years
D) 3 years
31. You have been asked to evaluate a project with infinite life. Sales and costs are projected to be $1000 and $500 respectively. There is no depreciation and the tax rate is 30%. The real required rate of return is 10%. The inflation rate is 4% and is expected to be 4% forever. Sales and costs will increase at the rate of inflation. If the project costs $3000, what is the NPV?
A) $365.38
B) $1629.62
C) $500.00
D) None of the above
32. A project costs $100 today. It has sales of $100 per year forever. Costs will be $50 the first year and increase by 19% per year. Ignoring taxes calculate the NPV of the project at the discount rate of 10%.
A) $11.62
B) $65.00
C) $100.00
D) Cannot be calculated as g > r
33. A project requires an initial investment of $200,000 and is expected to produce a cash flow before taxes of 120,000 per year for two years. [i.e. cash flows will occur at t = 1 and t = 2]. The corporate tax rate is 30%. The assets will be depreciated using MACRS – 3 year schedule: t=1, 33.33%; t = 2: 44.45%; t = 3: 14.81%; t = 4: 7.4%. The company’s tax situation is such that it can make use of all applicable tax shields. The opportunity cost of capital is 12%. Assume that the asset can be sold for book value. Calculate the NPV of the project at the end of two years. (approximately)
A) $16,510
B) $19,571
C) $47,035
D) None of the above
34. The IRR for the project in the previous question is: (approximately)
A) 12%
B) 10%
C) 17.8%
D) None of the above
35. OM Construction Company must choose between two types of cranes. Crane A costs $600,000, will last for 5 years, and will require $60,000 in maintenance each year. Crane B costs $750,000 and will last for seven years and will require $30,000 in maintenance each year. Maintenance costs for cranes A and B are incurred at the end of each year. The appropriate discount rate is 12% per year. Which machine should OM Construction purchase?
A) Crane A as EAC is $226,444
B) Crane B as EAC is $194,336
C) Crane A as the PV is $816,286
D) Cannot be calculated as the revenues for the project are not given
36. The projects have the following NPVs and project lives.Project NPV Life
Project A $5,000 4 years
Project B $7,000 7 yearsIf the cost of capital is 12%, which project would you accept?
A) A
B) B
C) Both A and B
D) Reject both A and B
37. Two machines, A and B, which perform the same functions, have the following costs and lives.Which machine would you choose? The two machines are mutually exclusive and the cost of capital is 15%.
A) Machine A as the EAC is $1789.89
B) Machine B as the EAC is $1922.88
C) Don’t buy either machine
True/False QuestionsT F 38. When calculating cash flows, it is important to consider all incidental effects.
T F 39. Sunk costs are unaffected by the decision to accept or reject and should be ignored.
T F 40. Opportunity costs should not be included as they are missed opportunities.
T F 41. By undertaking the analysis in real terms, the financial manager avoids having to forecast inflation.
T F 42. Do not forget to include interest and dividend payments when calculating the project’s cash flow.
T F 43. Depreciation acts as a tax shield in reducing the taxes.
T F 44. An investment should be postponed as long as the opportunity cost of capital is less than the growth rate of the value of the project.
T F 45. The rule for comparing machines with different lines is to select the machine with the lowest equivalent annual cost (EAC).
T F 46. You should replace a machine when the EAC of continuing to operate it exceeds the EAC of the next machine.
T F 47. You should always replace all old machines with new ones.Short Answer Questions
48. Define the term cash flow for a project.
49. What are some of the important points to remember while estimating the cash flows of a project?
50. Briefly discuss how taxes are taken into consideration in other countries like Japan.
51. What are some of the additional factors that have to be considered while estimating cash flows in other countries and currencies:
52. How do you compare projects with different lives?
53. Briefly explain how the decision to replace an existing machine is made?
54. Briefly explain the term ” project interactions”
55. Explain the idea behind the optimal timing of investment.
56. Briefly explain how peak demand can be met economically. -
Solutions to Chapter 5: Why Net Present Value Leads to Better Investment Decisions than Other Criteria
$8.00Multiple Choice Questions
1. The following measures are used by firms when making capital budgeting decisions except:
A) Payback period
B) Internal rate of return
C) Net present value
D) P/E ratio
2. Which of the following investment rules does not use the time value of the money concept?
A) The payback period
B) Internal rate of return
C) Net present value
D) All of the above use the time value concept
3. Suppose a firm has a $500 million in excess cash. It could:
A) Invest the funds in projects with positive NPVs
B) Pay high dividends to the shareholders
C) Buy another firm
D) All of the above
4. Which of the following investment rules has value additivity property?
A) The payback period method
B) The internal rate of return method
C) The book rate of return method
D) Net present value method
E) All of the above have value additivity property
5. If the net present value of project A is +$80, and of project B is +$60, then the net present value of the combined project is:
A) +$80
B) +$60
C) +$140
D) None of the above
6. If the NPV of project A is +$100, and that of project B is -$50 and that of project C is +$20, what is the NPV of the combined project?
A) $100
B) -$50
C) $120
D) $70
7. You are given a job to make a decision on project X, which is composed of three independent projects A, B, and C which have NPVs of +$50, -$20 and +$100, respectively. How would you go about making the decision about whether to accept or reject the project?
A) Accept the firm’s joint project as it has a positive NPV
B) Reject the joint project
C) Break up the project into its components: accept A and C and reject B
D) None of the above
8. If the NPV of project A is +$50 and that of project B is -$60, than the NPV of the combined project is:
A) +$50
B) +$60
C) -$10
D) None of the above.
9. The net present value of a project depends upon:
A) forecasted cash flows and opportunity cost of capital
B) manager’s tastes and preferences
C) company’s choice of accounting method
D) all of the above
10. The payback period rule:
A) Varies the cut-off point with the interest rate
B) Determines a cut-off point so that all projects accepted by the NPV rule will be accepted by the payback period rule.
C) Requires an arbitrary choice of a cut-off point
D) Both A and C
11. The payback period rule accepts all projects for which the payback period is:
A) Greater than the cut-off value
B) Less than the cut-off value
C) Is positive
D) An integer
12. Which of the following investment rules may not use all possible cash flows in its calculations?
A) Payback period.
B) NPV
C) IRR
D) All of the above
13. Given the following cash flows for project A: C0 = -2000, C1 = +500 , C2 = +1500 and C3 = +5000, calculate the payback period.
A) One year
B) 2 years
C) 3 years
D) None of the above
14. The main advantage of the payback rule is:
A) Adjustment for uncertainty of early cash flows
B) It is simple to use
C) Does not discount cash flows
D) Both A and C
15. Which of the following statements regarding the discounted payback period rule is true?
A) The discounted payback rule uses the time value of money concept.
B) The discounted payback rule is better than the NPV rule
C) The discounted payback rule considers all cash flows
D) The discounted payback rule exhibits the value additive property
16. The following are disadvantages of using the payback rule except:
A) The payback rule ignores all cash flow after the cutoff date
B) The payback rule does not use the time value of money
C) The payback period is easy to calculate and use
D) The payback rule does not have the value additive property
17. Given the following cash flows for project Z: C0 = -2,000, C1 = 600, C2 = 2160 and C3 = 6000, calculate the discounted payback period for the project at a discount rate of 20%.
A) One year
B) 2 years
C) 3 years
D) None of the above
18. Given the following cash flows for Project M: C0 = -2,000, C1 = +500, C2 = +1,500, C3 = +1455, calculate the IRR for the project.
A) 10%
B) 18%
C) 28%
D) None of the above
19. The quickest way to calculate the IRR of a project is by:
A) Trial and error method
B) Using the graphical method
C) Using a financial calculator
D) Guessing the IRR
20. If an investment project (normal project) has an IRR equal to the cost of capital , the NPV for that project is:
A) Positive
B) Negative
C) Zero
D) Unable to be determined
21. Project Y-File has the following cash flows: C0 = +2000, C1 = -1,200, and C2 = -1,500. If the IRR of the project is 21.65% and if the cost of capital is 15%, you would:
A) Accept the project
B) Reject the project
22. Project Y-File has the following cash flows: C0 = +2000, C1 = -1,200, and C2 = -1,200. If the IRR of the project is 13.1% and if the cost of capital is 15%, you would:
A) Accept the project
B) Reject the project
23. The IRR is defined as:
A) The discount rate that makes the NPV equal to zero
B) The difference between the cost of capital and the present value of the cash flows
C) The discount rate used in the NPV method
D) The discount rate used in the discounted payback period method
24. The following are some of the shortcomings of the IRR method except:
A) IRR is conceptually easy to communicate
B) Projects can have multiple IRRs
C) IRR method cannot distinguish between a borrowing project and a lending project
D) It is very cumbersome to evaluate mutually exclusive projects using the IRR method
25. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the IRR for the project.
A) 14.5%
B) 18.6%
C) 23.4%
D) 20.2%
26. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the MIRR (modified internal rate of return) for the project if the cost of capital is 15%.
A) 14.5%
B) 18.6%
C) 23.4%
D) 20.2%
27. Valentine Company is considering investing in a new project. The project will need an initial investment of $1,200,000 and will generate $600,000 (after-tax) cash flows for three years. Calculate the NPV for the project if the cost of capital is 15%.
A) $169,935
B) $129,211
C) $600,000
D) $125,846
28. A project will have only one internal rate of return if:
A) The net present value is positive
B) The net present value is negative
C) There is a one fifth change in the cash flows
D) The cash flows decline over the life of the project
29. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the IRR approximately.
A) 14.6
B) 16.4
C) 22.1
D) 17.3
30. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the MIRR for the project if the cost of capital is 12% APR.
A) 15.3%
B) 17.3%
C) 23.8%
D) 22.1%
31. Elephant company is investing in a giant crane. It is expected to cost 2.2 million in initial investment and it is expected to generate an end of year cash flow of 1.0 million each year for three years. Calculate the NPV at 12% (approximately).
A) 2.4 million
B) 0.20 million
C) 0.80 million
D) 0.40 million
32. Given the following cash flow for project A: C0 = -2000, C1 = +500, C2 = +1500 and C3 = +5000, calculate the NPV of the project using a 15% discount rate.
A) $5000
B) $2857
C) $3201
D) $2352
33. Profitability index is the ratio of:
A) Present value of cash flow to initial investment
B) Net present value cash flow to initial investment
C) Net present value of cash flow to IRR
D) Present value of cash flow to IRR
34. Benefit-cost ratio is defined as the ratio of:
A) Present value of cash flow to initial investment
B) Net present value cash flow to initial investment
C) Net present value of cash flow to IRR
D) Present value of cash flow to IRR
35. Profitability index is useful under:
A) Capital rationing
B) Mutually exclusive projects
C) Non-normal projects
D) None of the above
36. The following table gives the available projects for a firm. If the firm has a limit of 210 million to invest, what is the maximum NPV the company can obtain?
A) 200
B) 307
C) 283
D) None of the above
37. The firm has only twenty million to invest. What is the maximum NPV that the company can obtain?
A) 3.5
B) 4.5
C) 4.0
D) None of the above
38. The profitability index can be used for ranking projects under:
A) Soft capital rationing
B) Hard capital rationing
C) Capital rationing at t = 0
D) Both A and BTrue/False Questions
T F 39. Present values have value additivity property.
T F 40. The payback rule gives equal weight to all cash flows before the payback date and zero weight to subsequent cash flows.
T F 41. The discounted payback rule calculates the payback period and then discounts it at the opportunity cost of capital.
T F 42. The internal rate of return is the discount rate that makes the PV of a project equal to zero.
T F 43. The IRR rule states that firms should accept any project offering an internal rate of return in excess of the cost of capital.
T F 44. In case of a loan project, one should accept the project if the IRR is less than the cost of capital.
T F 45. MIRRs have the value additivity property and IRRs do not.
T F 46. Soft rationing may be used to control managerial behavior.Essay Questions
47. Briefly explain the value additivity property.
48. Discuss some of the advantages of using the payback method.
49. Discuss some of the disadvantages of the payback rule.
50. What are some of the advantages of using the IRR method?
51. What are some of the disadvantages of using the IRR method?
52. In what way is the modified internal rate of return (MIRR) method better than the IRR method?
53. Briefly discuss capital rationing.
54. Briefly explain how linear programming is useful for solving capital rationing problems.
55. Briefly explain the term “soft rationing”Answers to Chapter 6: Making Investment Decisions with the Net Present Value Rule
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Answers to Chapter 4: The Value of Common Stocks
$20.00Multiple Choice Questions
1. If the Vol. 100s is reported as 10,233 in the Wall Street Journal quotation, then the trading volume for that day of trading is:
A) 10,233 shares
B) 102,330 shares
C) 1,023,300 shares
D) 10,233,000 shares2. The dividend yield reported as Yld. % in The Wall Street Journal quotation is calculated as follows:
A) (dividends / hi)
B) (dividends / lo)
C) (dividends / close)
D) None of the above3. The Wall Street Journal quotation for a company has the following values: Div: 2.28, PE: 19, Close: 75.30. Calculate the dividend pay out ratio for the company.
A) 58%
B) 12%
C) 75%
D) None of the above
4. If the Wall Street Journal Quotation for a company has the following values close: 26.00; Net chg: =+1.00; then the closing price for the stock for the previous trading day was?
A) $26
B) $25
C) $27
D) None of the above.
5. The value of a common stock today depends on:
A) Number of shares outstanding and the number of shareholders
B) The Wall Street analysts
C) The expected future dividends and the discount rate
D) Present value of the future earnings per share
6. Super Computer Company’s stock is selling for $100 per share today. It is expected that this stock will pay a dividend of 5 dollars per share, and then be sold for $120 per share at the end of one year. Calculate the expected rate of return for the shareholders.
A) 20%
B) 25%
C) 10%
D) 15%
7. PC Company stockholders expect to receive a year-end dividend of $10 per share and then be sold for $122 dollars per share. If the required rate of return for the stock is 20%, what is the current value of the stock?
A) $100
B) $122
C) $132
D) $110
8. Macrohard Company expects to pay a dividend of $6 per share at the end of year one, $8 per share at the end of year two and then be sold for $136 per share. If the required rate on the stock is 20%, what is the current value of the stock?
A) $100
B) $105
C) $110
D) $1209. The constant dividend growth formula P0 = D1/(r-g) assumes:
A) The dividends are growing at a constant rate g forever.
B) r > g
C) g is never negative.
D) Both A and B
10. Casino Co. is expected to pay a dividend of $6 per share at the end of year one and these dividends are expected to grow at a constant rate of 8% per year forever. If the required rate of return on the stock is 20%, what is current value of the stock today?
A) $30
B) $50
C) $100
D) $54
11. WorldTour Co. has just now paid a dividend of $6 per share (Do), the dividends are expected to grow at a constant rate of 5% per year forever. If the required rate of return on the stock is 15%, what is the current value on stock, after paying the dividend?
A) $63
B) $56
C) $40
D) $48
12. The required rate of return or the market capitalization rate is estimated as follows:
A) Dividend yield + expected rate of growth in dividends
B) Dividend yield – expected rate of growth in dividends
C) Dividend yield / expected rate of growth in dividends
D) (Dividend yield) * (expected rate of growth in dividends)
13. Mcom Co. is expected to pay a dividend of $4 per share at the end of year one and the dividends are expected to grow at a constant rate of 4% forever. If the current price of the stock is $25 per share calculated the required rate of return or the market capitalization rate for the firms’ stock.
A) 4%
B) 16%
C) 20%
D) None of the above.
14. Dividend growth rate for a stable firm can be estimated as:
A) Plow back rate * the return on equity (ROE)
B) Plow back rate / the return on equity (ROE)
C) Plow back rate +the return on equity (ROE)
D) Plow back rate – the return on equity (ROE)
15. MJ Co. pays out 60% of its earnings as dividends. Its return on equity is 20%. What is the stable dividend growth rate for the firm?
A) 3%
B) 5%
C) 8%
D) 12%
16. Michigan Motor Company is currently paying a dividend of $1.50 per year. The dividends are expected to grow at a rate of 20% for the next three years and then a constant rate of 6 % thereafter. What is the expected dividend per share in year 5?17. Great Lakes Co. is currently paying a dividend of $2.20 per share. The dividends are expected to grow at 25% per year for the next four years and then grow 5% per year thereafter. Calculate the expected dividend in year 6.
A) $5.37
B) $2.95
C) $5.92
D) $8.39
18. Y2K Technology Corporation has just paid a dividend of $0.40 per share. The dividends are expected to grow at 30% per year for the next two years and at 5% per year thereafter. If the required rate of return in the stock is 15% (APR), calculate the current value of the stock.
A) $1.420
B) $6.33
C) $5.63
D) None of the above
19. The NetTech Co. has just paid a dividend of $1 per share. The dividends are expected to grow at 20% per year for the next three years and at the rate of 5% per year thereafter. If the required rate of return on the stock is 15%(APR), what is the current value of the stock?
A) $18.14
B) $15.20
C) $12.51
D) None of the above
20. Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25, what is the expected growth rate in dividends (g)?
A) 16%
B) 12%
C) 8%
D) 4%
21. Lake Co. has paid a dividend $2 per share out of earnings of $4 per share. If the book value per share is $25 and is currently selling for $30 per share, calculate the required rate of return on the stock. (Use the calculated g from the previous problem to answer this question.)
A) 7.2%
B) 15.2%
C) 14.7%
D) 16.6%
22. Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40, what is the expected growth rate in dividends?
A) 12.5%
B) 8%
C) 5%
D) 3%
23. Lake Co. has paid a dividend $3 per share out of earnings of $5 per share. If the book value per share is $40 and the share value is 52.50 per share, calculate the required rate of return on the stock. (Use the calculated ‘g’ from the previous problem to answer this question)
A) 11%
B) 12%
C) 5%
D) 6%
24. The growth rate in dividends can be thought of as a sum of two parts. They are:
A) ROE and the Retention Ratio.
B) Dividend yield and growth rate in dividends
C) ROA and ROE
D) Book value per share and EPS
25. The value of the stock:
A) Increases as the dividend growth rate increases
B) Increases as the required rate of return decreases
C) Increases as the required rate of return increases
D) Both A and B
26. Company X has a P/E ratio of 10 and a stock price of $50 per share. Calculate earnings per share of the company.
A) $5 per share
B) $10 per share
C) $0.20 per share
D) $6 per share
27. Companies with higher expected growth opportunities usually sell for:
A) Lower P/E ratio
B) Higher P/E ratio
C) A price that is independent of P/E ratio
D) A price that the dependent upon the payment ratio
28. Which of the following formulas regarding earnings to price ratio is true:
A) EPS/Po = r[1+(PVGO/Po]
B) EPS/Po = r[1 – (PVGO/Po)]
C) EPS/Po = [r+(PVGO/Po)]
D) EPS/Po =[r(1+(PVGO/Po)]/r
29. Woe Co. is expected to pay a dividend or $4.00 per share out of earnings of $7.50 per share. If the required rate of return on the stock is 15% and dividends are growing at a current rate of 10% per year, calculate the percent value of the growth opportunity for the stock (PVGO).
A) $80
B) $50
C) $30
D) $26
30. Parcel Corporation is expected to pay a dividend of $5 per share next year, and the dividends pay out ratio is 50%. If the dividends are expected to grow at a constant rate of 8% forever and the required rate of return on the stock is 13%, calculate the present value of the growth opportunity.
A) $23.08
B) $64.10
C) $100
D) None of the above
31. A high proportion of the value a growth stock comes from:
A) Past dividend payments
B) Past earnings
C) PVGO (Present Value of the Growth Opportunities)
D) Both A and B
32. Generally high growth stocks pay:
A) High dividends
B) Low or no dividends
C) Erratic dividends
D) Both A and C
33. The following stocks are examples of growth stocks except:
A) Wal-Mart
B) Dell Computer
C) Microsoft
D) Chubb
34. The following stocks are examples of income stocks except:
A) Exxon Mobil
B) Wal-Mart
C) Chubb
D) Kellogg
E) All of the above
35. Which of the following stocks are growth stocks?
A) Dell Computer
B) AT&T
C) Duke Power
D) Exxon
E) None of the above
36. Which of the following stocks are income stocks?
A) Duke Power
B) Dell Computer
C) Microsoft
D) Wal-Mart
E) None of the above
37. The relationship between P/E ratio and market capitalization rate can be described by the following statements:
A) EPS/Po measures r, only if PVGO = 0
B) High P/E ratios indicate low r
C) There is no reliable association between the P/E ratio and r
D) A and C above
38. Universal Air is a no growth firm and has two million shares outstanding. It is expected to earn a constant 20 million per year on its assets. If all earnings are paid out as dividends and the cost of capital is 10%, calculate the current price per share for the stock.
A) $200
B) $100
C) $150
D) $50
39. Which of the following statements regarding free cash flow is true?
A) Free cash flow is always positive
B) Free cash flow is always negative
C) Free cash flow is the net cash flow to the shareholders after paying for future investments
D) None of the above
40. Discounted cash flow formulas work for the valuation of:
A) Stocks with constant dividend growth
B) Businesses
C) Stocks with super normal dividend growth
D) All of the above
41. The value of a business is given by:
A) PV = PV(free cash flows)
B) PV = PV(free cash flows) + PV (horizon value)
C) PV(free cash flows) – PV(horizon value)
D) None of the above
42. The present value of free cash flow is $5 million and the present value of the horizon value is $10 million. Calculate the present value of the business.
A) $5 million
B) $10 million
C) $15 million
D) None of the aboveTrue/False Questions
T F 43. The New York Stock Exchange is the only stock market in the US.
T F 44. Shareholders receive cash from the firm in the form of dividends and capital gains.
T F 45. The return that is expected by investors from a common stock is often called its market capitalization rate.
T F 46. At each point in time, all securities in an equivalent-risk class are priced to offer the same expected return.
T F 47. The constant growth formula for stock valuation does not work for firms with negative growth (declining) rates in dividends.
T F 48. The market capitalization equals the dividend yield plus the growth rate in dividends for a constant dividend growth stock.
T F 49. The value of a share of common stock is equal to the discounted stream of free cash flow per share.
T F 50. The value of a share of common stock is equal to the discounted stream of earnings per share.
T F 51. There is a strong relationship between a stock’s price-earnings (P/E) ratio and its capitalization rate.
T F 52. Discounted cash flow approach can be used to value ongoing businesses.Essay Questions
53. Explain the term “primary market.”
54. Explain the term “secondary market.”
55. Briefly explain the term “market capitalization rate.”
56. Discuss the general principle in the valuation of a common stock.
57. Discuss the term “price-earnings (P/E) ratio.”
58. Discuss the problems inherent in the valuation of a business. -
Solutions For Chapter 9
$30.00Questions:
- Payback Period – Given the cash flows of the four projects, A, B, C, and D, and using the Payback Period decision model, which projects do you accept and which projects do you reject with a three year cut-off period for recapturing the initial cash outflow? Assume that the cash flows are equally distributed over the year for Payback Period calculations.
Projects A B C D Cost $10,000 $25,000 $45,000 $100,000 Cash Flow Year One $4,000 $2,000 $10,000 $40,000 Cash Flow Year Two $4,000 $8,000 $15,000 $30,000 Cash Flow Year Three $4,000 $14,000 $20,000 $20,000 Cash Flow Year Four $4,000 $20,000 $20,000 $10,000 Cash Flow year Five $4,000 $26,000 $15,000 $0 Cash Flow Year Six $4,000 $32,000 $10,000 $0 - Payback Period – What are the Payback Periods of Projects E, F, G and H? Assume all cash flows are evenly spread throughout the year. If the cut-off period is three years, which projects do you accept?
Projects E F G H Cost $40,000 $250,000 $75,000 $100,000 Cash Flow Year One $10,000 $40,000 $20,000 $30,000 Cash Flow Year Two $10,000 $120,000 $35,000 $30,000 Cash Flow Year Three $10,000 $200,000 $40,000 $30,000 Cash Flow Year Four $10,000 $200,000 $40,000 $20,000 Cash Flow year Five $10,000 $200,000 $35,000 $10,000 Cash Flow Year Six $10,000 $200,000 $20,000 $0 - Discounted Payback Period – Given the following four projects and their cash flows, calculate the discounted payback period with a 5% discount rate, 10% discount rate, and 20% discount rate. What do you notice about the payback period as the discount rate rises? Explain this relationship.
Projects A B C D Cost $10,000 $25,000 $45,000 $100,000 Cash Flow Year One $4,000 $2,000 $10,000 $40,000 Cash Flow Year Two $4,000 $8,000 $15,000 $30,000 Cash Flow Year Three $4,000 $14,000 $20,000 $20,000 Cash Flow Year Four $4,000 $20,000 $20,000 $10,000 Cash Flow year Five $4,000 $26,000 $15,000 $10,000 Cash Flow Year Six $4,000 $32,000 $10,000 $0 - Discounted Payback Period – Graham Incorporated uses discounted payback period for projects under $25,000 and has a cut off period of 4 years for these small value projects. Two projects, R and S are under consideration. The anticipated cash flows for these two projects are listed below. If Graham Incorporated uses an 8% discount rate on these projects are they accepted or rejected? If they use 12% discount rate? If they use a 16% discount rate? Why is it necessary to only look at the first four years of the projects’ cash flows?
Cash Flows Project R Project S Initial Cost $24,000 $18,000 Cash flow year one $6,000 $9,000 Cash flow year two $8,000 $6,000 Cash flow year three $10,000 $6,000 Cash flow year four $12,000 $3,000 - Comparing Payback Period and Discounted Payback Period – Mathew Incorporated is debating using Payback Period versus Discounted Payback Period for small dollar projects. The Information Officer has submitted a new computer project of $15,000 cost. The cash flows will be $5,000 each year for the next five years. The cut-off period used by Mathew Incorporated is three years. The Information Officer states it doesn’t matter what model the company uses for the decision, it is clearly an acceptable project. Demonstrate for the IO that the selection of the model does matter!
- Comparing Payback Period and Discounted Payback Period – Neilsen Incorporated is switching from Payback Period to Discounted Payback Period for small dollar projects. The cut-off period will remain at 3 years. Given the following four projects cash flows and using a 10% discount rate, which projects that would have been accepted under Payback Period will now be rejected under Discounted Payback Period?
Cash Flows
Project One
Project Two
Project Three Project Four Initial cost $10,000 $15,000 $8,000 $18,000 Year One $4,000 $7,000 $3,000 $10,000 Year Two $4,000 $5,500 $3,500 $11,000 Year Three $4,000 $4,000 $4,000 $0 - Net Present Value – Swanson Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $240,000
Cash flow year one: $25,000
Cash flow year two: $75,000
Cash flow year three: $150,000
Cash flow year four: $150,000
- Using a 10% discount rate for this project and the NPV model should this project be accepted or rejected?
- Using a 15% discount rate?
- Using a 20% discount rate?
- Net Present Value – Campbell Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $468,000
Cash flow year one: $135,000
Cash flow year two: $240,000
Cash flow year three: $185,000
Cash flow year four: $135,000
- Using an 8% discount rate for this project and the NPV model should this project be accepted or rejected?
- Using a 14% discount rate?
- Using a 20% discount rate?
- Net Present Value – Swanson Industries has four potential projects all with an initial cost of $2,000,000. The capital budget for the year will only allow Swanson industries to accept one of the four projects. Given the discount rates and the future cash flows of each project, which project should they accept?
Cash Flows Project M Project N Project O Project P Year one $500,000 $600,000 $1,000,000 $300,000 Year two $500,000 $600,000 $800,000 $500,000 Year three $500,000 $600,000 $600,000 $700,000 Year four $500,000 $600,000 $400,000 $900,000 Year five $500,000 $600,000 $200,000 $1,100,000 Discount Rate 6% 9% 15% 22% - Net Present Value – Campbell Industries has four potential projects all with an initial cost of $1,500,000. The capital budget for the year will only allow Swanson industries to accept one of the four projects. Given the discount rates and the future cash flows of each project, which project should they accept?
Cash Flows Project Q Project R Project S Project T Year one $350,000 $400,000 $700,000 $200,000 Year two $350,000 $400,000 $600,000 $400,000 Year three $350,000 $400,000 $500,000 $600,000 Year four $350,000 $400,000 $400,000 $800,000 Year five $350,000 $400,000 $300,000 $1,000,000 Discount Rate 4% 8% 13% 18% - Internal Rate of Return – What are the IRRs of the four projects for Swanson Industries in problem #9?
- Internal Rate of Return — Internal Rate of Return – What are the IRRs of the four projects for Campbell Industries in problem #10?
- Comparing NPV and IRR – Chandler and Joey were having a discussion about which financial model to use for their new business. Chandler supports NPV and Joey supports IRR. The discussion starts to get heated when Ross steps in and states, “gentlemen, it doesn’t matter which method we choose, they give the same answer on all projects.” Is Ross right? Under what conditions will IRR and NPV be consistent when accepting or rejecting projects?
- Comparing NPR and IRR – Monica and Rachel are having a discussion about IRR and NPV as a decision model for Monica’s new restaurant. Monica wants to use IRR because it gives a very simple and intuitive answer. Rachel states that there can be errors made with IRR that are not made with NPV. Is Rachel right? Show one type of error can be made with IRR and not with NPV?
- Profitability Index — Given the discount rates and the future cash flows of each project, which projects should they accept using profitability index?
Cash Flows Project U Project V Project W Project X Year zero -$2,000,000 -$2,500,000 -$2,400,000 -$1,750,000 Year one $500,000 $600,000 $1,000,000 $300,000 Year two $500,000 $600,000 $800,000 $500,000 Year three $500,000 $600,000 $600,000 $700,000 Year four $500,000 $600,000 $400,000 $900,000 Year five $500,000 $600,000 $200,000 $1,100,000 Discount Rate 6% 9% 15% 22% - Profitability Index — Given the discount rates and the future cash flows of each project, which projects should they accept using profitability index?
Cash Flows Project A Project B Project C Project D Year zero -$1,500,000 -$1,500,000 -$2,000,000 -$2,000,000 Year one $350,000 $400,000 $700,000 $200,000 Year two $350,000 $400,000 $600,000 $400,000 Year three $350,000 $400,000 $500,000 $600,000 Year four $350,000 $400,000 $400,000 $800,000 Year five $350,000 $400,000 $300,000 $1,000,000 Discount Rate 4% 8% 13% 18% - Comparing All Methods — Given the following After Tax Cash Flows for Tyler’s Tinkering Toys on a new toy find the Payback Period, NPV, and Profitability Index of this project. The appropriate discount rate for the project is 12%. If the cut-off period is six years for major projects, determine if the project is accepted or rejected under the four different decision models.
Year 0 cash outflow: $10,400,000
Years 1 to 4 cash inflow: $2,600,000 each year
Year 5 cash outflow: $1,200,000
Years 6 – 8 cash inflow: $750,000 each year
- Comparing All Methods — Tom’s Risky Business is looking at a project with the estimated cash flows as follows:
Initial Investment at start of project: $3,600,000
Cash Flow at end of Year 1: $500,000
Cash Flow at end of Years 2 through 6: $625,000 each year
Cash Flow at end of Year 7 through 9: $530,000 each year
Cash Flow at end of Year 10: $385,000
Risky Business wants to know the Payback Period, NPV, and Profitability Index of this project. The appropriate discount rate for the project is 14%. If the cut-off period is six years for major projects, determine if the project is accepted or rejected under the four different decision models.