Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000

Use the following information to answer the following question(s).

Delta Inc. is considering the purchase of a new machine which is expected to increase sales by $10,000 in addition to increasing non-depreciation expenses by $3,000 annually. Due to the sales increase, Delta will need to increase working capital by $1,000 at the beginning of the project. Delta will depreciate the machine using the straight-line method over the project's five year life to a salvage value of zero. The machine's purchase price is $20,000. The firm has a marginal tax rate of 34 percent, and its required rate of return is 12 percent.

The machine's initial cash outflow is

A) $20,000.

B) $21,000.

C) $27,000.

D) $23,000.

The machine's incremental after-tax cash inflow for year 1 is

A) $6,420.

B) $7,980.

C) $8,620.

D) $5,980.

The machine's after-tax incremental cash flow in year five is

A) $6,980.

B) $5,980.

C) $7,120.

D) $8,620.

The machine's NPV is

A) $1,556.56.

B) $2,556.56.

C) $1,123.99.

D) $2,123.99.

The machine's IRR is

A) less than 0.

B) greater than 12 percent.

C) less than 12 percent.

D) equal to 12 percent.

XYZ, Inc. is considering adding a product line that would utilize floor space in their manufacturing plant which is currently used for storage. XYZ will need to rent new storage space elsewhere. The floor space would be considered a(n)

A) variable cost.

B) opportunity cost.

C) sunk cost.

D) irrelevant cash flow.

Which of the following is included in the calculation of the initial outlay for a capital investment?

A) Investment in working capital

B) A feasibility study conducted the previous year.

C) Installation

D) A and C but not B

Which of the following would decrease after-tax operating cash flows? A decrease in

A) depreciation expense.

B) interest expense.

C) incremental sales.

D) both A and C.

Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR of the project

Tinker Tools, Inc. is considering a project with the following cash flows. Calculate the MIRR of the project assuming a reinvestment rate of 8%.

   Year                Cash Flows

       0                      ($70,000)

       1                      ($55,000)

       2                       $40,000

       3                       $60,000

       4                      $100,000

Answer: 

PV Cash Outflows

                Year 0 = -$70,000

                Year 1: Calculator Steps' → N=1, i=8, FV=-55,000, solve for PV = -$50,926

                PV Outflows = -$70,000 - $50,926 = -$120,926

FV of Cash Inflows

                N=2, i=8, PV=40000, PMT =0, solve for FV = $46,656

                N=1, i=8, PV=60000, PMT =0, solve for FV = $64,800

                FV of Inflows = $46,656 +$64,800 + $100,000 = $211,456

MIRR:  N=4, PV=-$120,926,FV= $211,456 solve for i=15%

Determine the IRR on the following projects:

a.     Initial outlay of $35,000 with an after-tax cash flow at the end of the year of $5,836 for seven years

b.     Initial outlay of $350,000 with an after-tax cash flow at the end of the year of $70,000 for seven years

c.     Initial outlay of $3,500 with an after-tax cash flow at the end of the year of $1,500 for three years

Answer: 

Using a financial calculator

a.     N=7, PV=-35,000, PMT=5,836, FV= 0, solve for i=4.02%

b.     N=7, PV=-350,000, PMT=70,000, solve for i=9.2%

c.     N=7, PV=-3,500, PMT=1,500, FV= 0, solve for i=13.7%

Discuss the merits and shortcomings of using the payback period for capital budgeting decisions.

Answer:  The payback period is intuitive and easily understood even by those with no training in finance. It also provides a quick assessment of a project's risk because cash flow forecasts are likely to be more accurate for the near-term.

On the other hand, there is no clear-cut decision rule associated with this method; it does not specifically take the time value of money into account, and it ignores cash flows that occur after the payback period.

Project November requires an initial investment of $500,000. The present value of operating cash flows is $550,000. Project December requires an initial investment of $750,000. The present value of operating cash flows is $810,000.

a. Compute the profitability index for each project.

b. If the projects are mutually exclusive, does the profitability index rank them correctly?

Answer: 

a. The PI for November is 550,000/500,000 = 1.1. The PI for December is 810,000/750,000 = 1.08.

b. The PI criterion would select project November because it has the higher PI. December, however, has the higher NPV ($60,000 v. $50,000) and should be selected, so the method does not rank the projects correctly.

Black Friday Inc. has estimated the following cash flows for a project it is considering:

Period	Cash Flow
0	($150,000)
1	$70,000
2	$80,000
3	($100,0000)

a. What is the payback period for this project?

b. What is the obvious problem with using the payback method in this case?

Answer:  The payback period is exactly 2 years (70,000+80,000) = 150,000. However, the project obviously has a negative NPV at any discount rate. One major problem with the payback method is that it ignores cash flows occurring after the payback period.

The director of capital budgeting of South Park Development Corporation is evaluating a project that will cost $200,000

The director of capital budgeting of South Park Development Corporation is evaluating a project that will cost $200,000; it is expected to last for 10 years and produce after-tax cash flows, including depreciation, of $44,503 per year. If the firm's cost of capital is 14% and its tax rate is 40%, what is the project's IRR?

A) 8%

B) 14%

C) 18%

D) -5%

The owner of a small construction business has asked you to evaluate the purchase of a new front end loader. You have determined that this investment has a large, positive, NPV, but are afraid that your client will not understand the method. A good alternative method in this circumstance might be

A) the payback method.

B) the profitability index.

C) the internal rate of return.

D) the modified internal rate of return.

Whenever the IRR on a project equals that project's required rate of return

A) the NPV equals 0.

B) The NPV equals the initial investment.

C) The profitability index equals 0.

D) The NPV equals 1.

Aroma Candles, Inc. is evaluating a project with the following cash flows. Calculate the IRR of the project. (Round to the nearest whole percentage.)

Year    Cash Flows

0            ($120,000)

1              $30,000

2              $70,000

3              $90,000

A) 18%

B) 23%

C) 28%

D) 33%

Aroma Candles, Inc. is evaluating a project with the following cash flows. The project involves a new product that will not affect the sales of any other project. Which two methods would always lead to the same accept/reject decision for this project, regardless of the discount rate.

Year    Cash Flows

0            ($120,000)

1              $30,000

2              $70,000

3              $90,000

A) Payback and Discounted Payback

B) NPV and Payback

C) NPV and IRR

D) Discounted Payback and IRR

Which of the following is considered to be a deficiency of the IRR?

A) It fails to properly rank capital projects.

B) It could produce more than one rate of return.

C) It fails to utilize the time value of money.

D) It is not useful in accounting for risk in capital budgeting.

Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows

Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. At the end of the third year, equipment will be sold producing additional cash flow of $10,000. Assuming a discount rate of 10%, which of the following is the correct equation to solve for the IRR of the project?

A) $40,000 = $35,000(1.12)1 + $35,000(1.12)2 + $45,000(1.12)3 

B) $40,000 = $35,000(1 + IRR)1 + $35,000(1 + IRR)2 + $45,000(1 + IRR)3 

C) $40,000 = $35,000/(1.12)IRR + $35,000/(1.12)IRR + $45,000/(1.12)IRR 

D) $40,000 = $35,000/(1 + IRR) + $35,000/(1.IRR) + $45,000/(1 + IRR)

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the firm $100,000 today, and the firm's cost of capital is 10%. Assume cash flows occur evenly during the year.

A) 5.23 years

B) 4.26 years

C) 4.35 years

D) 3.72 years

Below are the expected after-tax cash flows for Projects Y and Z. Both projects have an initial cash outlay of $20,000 and a required rate of return of 17%.

                        Project Y       Project Z

Year 1            $12,000         $10,000

Year 2             $8,000           $10,000

Year 3             $6,000                 0

Year 4             $2,000                 0

Year 5             $2,000                 0

Discounted payback periods for projects Y and Z are

A) 1.64 and 1.71 years.

B) 3.14 years and never.

C) 2 years and 2 years.

D) 5 years and never.

You are considering investing in a project with the following year-end after-tax cash flows:

Year 1: $5,000

Year 2: $3,200

Year 3: $7,800

If the initial outlay for the project is $12,113, compute the project's IRR.

A) 14%

B) 10%

C) 32%

D) 24%

WKW, Inc. is analyzing a project that requires an initial investment of $10,000, followed by cash inflows of $1,000 in Year 1, $4,000 in Year 2, and $15,000 in Year 3. The cost of capital is 10%. What is the profitability index of the project?

A) 1.04

B) 1.55

C) 1.78

D) 1.97

Frazier Fudge has a project with an initial outlay of $40,000, followed by three years of annual incremental cash flows of $35,000. At the end of the third year, equipment will be sold producing additional cash flow of $10,000. Assuming a cost of capital of 10%, calculate the MIRR of the project.

A) 46.5%

B) 51.3%

C) 62.9%

D) 74.7%

BCD's $1,000 par value bonds currently sell for $798.50. The coupon rate is 10%, paid semiannually.

Compare and contrast current yield and yield to maturity.

Answer:  The current yield is a measure of the one-year return on a bond if purchased today. The current yield is calculated by taking a bond's annual coupon payment and dividing by its market price. Yield to maturity measures the return on a bond if it is held to maturity. The yield to maturity is that discount rate that would make the present value of the expected future cash flows exactly equal to the market price at time of calculation. In an efficient market, the yield to maturity will reflect the market rate of interest and required return of bondholders.

BCD's $1,000 par value bonds currently sell for $798.50. The coupon rate is 10%, paid semiannually. If the bonds have five years before maturity, what is the yield to maturity or expected rate of return?

Answer:  N=10, PV=-798.50, PMT=50, FV=1000, solve for i=8.00 semi-annual rate, 8.00% × 2 = 16%

If you are willing to pay $1,392.05 for a 15-year, $1,000 par value bond that pays 10% interest semiannually, what is your expected rate of return?

Answer:  N=30, PV=-1,392.05, PMT=50, FV=1000, solve for i=2.99 semi-annual rate, 2.99 % × 2 = 6%

DAH, Inc. has issued a 12% bond that is to mature in nine years. The bond had a $1,000 par value, and interest is due to be paid semiannually. If your required rate of return is 10%, what price would you be willing to pay for the bond?

Answer: 

N=18, i=5, PMT=60, FV=1000, solve for PV=.-1116.90

Price = $1,116.90

The market price of a 20-year, $1,000 bond that pays 9% interest semiannually is $774.31. What is the bond's yield to maturity?

Answer:   N=40, PV=-774.31, PMT=45, FV=1000, solve for i=6.00 semi-annual rate, 6.00 × 2 = 6%

Calculate the value of a bond that is expected to mature in 13 years with a $1,000 face value. The interest coupon rate is 8%, and the required rate of return is 10%. Interest is paid annually.

Answer: 

N=13, i=5, PMT=80, FV=1000, solve for PV=.-1116.90

Price = $1,116.90

Garvin, Inc.'s bonds have a par value of $1,000. The bonds pay semiannual interest of $40 and mature in five years.

a.     How much would you pay for Garvin bonds if your required rate of return is 10%?

b.     How much would you pay if your required rate of return is 8%?

Answer: 

a.     N=10, i=5, PMT=40, FV=1000, solve for PV=-922.78

        Price = $922.78

b.     Price = $1,000

Given the following information, determine the market value of EAO Company bonds.

Par value                        $1,000

Coupon rate                    10%

Years to maturity              6

Market rate                       8%

Interest paid           semiannually

Answer: 

N=12, i=4, PMT=50, FV=1000, solve for PV=-1093.85

Price = $1,093.85

Mango Company bonds pay a semiannual coupon rate of 6.4%. They have eight years to maturity and face value

Mango Company bonds pay a semiannual coupon rate of 6.4%. They have eight years to maturity and face value, or par, of $1,000. Compute the value of Mango bonds if investors' required rate of return is 5%.

A) $1,090.48

B) $883.66

C) $1,006.83

D) $950.00

As interest rates, and consequently investors' required rates of return, change over time, the ________ of outstanding bonds will also change.

A) maturity date

B) coupon interest payment

C) par value

D) price

Terminator Bug Company bonds have a 14% coupon rate. Interest is paid semiannually. The bonds have a par value of $1,000 and will mature 10 years from now. Compute the value of Terminator bonds if investors' required rate of return is 12%.

A) $1,114.70

B) $1,149.39

C) $894.06

D) $1,000.00

Brookline, Inc. just sold an issue of 30-year bonds for $1,107.20. Investors require a rate of return on these bonds of 7.75%. The bonds pay interest semiannually. What is the coupon rate of the bonds?

A) 7.750%

B) 11.072%

C) 9.375%

D) 8.675%

Applebee sold an issue of 30-year, $1,000 par value bonds to the public. The coupon rate of 8.75% is payable annually. It is now five years later, and the current market rate of interest is 7.25%. What is the current market price (intrinsic value) of the bonds? Round off to the nearest $1.

A) $715

B) $1,171

C) $1,225

D) $697

Six years ago, Colt, Inc. sold an issue of 30-year, $1,000 par value bonds. The coupon rate of 5.25% is payable annually. Investors presently require a rate of return of 8.375%. What is the current market price (intrinsic value) of the bonds? Round off to the nearest $1.

A) $1,050

B) $932

C) $681

D) $1,111

Blue's Chips Inc. has a $1,000 par value bond that is currently selling for $1,300. It has an annual coupon rate of 7%, paid semiannually, and has nine years remaining until maturity. What is the annual yield to maturity on the bond? (Round to the nearest whole percentage.)

A) 3.15%

B) 1.57%

C) 3.12%

D) 6.24%

You are considering the purchase of Hytec bonds that were issued 14 years ago. When the bonds were originally sold, they had a 30-year maturity and a 14.375% coupon interest rate that is payable semiannually. The bond is currently selling for $1,508.72. What is the yield to maturity on the bonds?

A) 8.50%

B) 14.38%

C) 11.11%

D) 7.67%

Aurand, Inc. has outstanding bonds with an 8% annual coupon rate paid semiannually. The bonds have a par value of $1,000, a current price of $904, and will mature in 14 years. What is the annual yield to maturity on the bond?

A) 15.80%

B) 10.47%

C) 9.24%

D) 7.90%

E) 4.62%

The Blackburn Group has recently issued 20-year, unsecured bonds rated BB by Moody's

The Blackburn Group has recently issued 20-year, unsecured bonds rated BB by Moody's. These bonds yield 443 basis points above the U.S. Treasury yield of 2.76%.  The yield to maturity on these bonds is

A) 4.43%.

B) 7.19%.

C) 12.23%.

D) mortgage bonds.

Colby & Company bonds pay semiannual interest of $50. They mature in 15 years and have a par value of $1,000. The market rate of interest is 8%. The market value of Colby bonds is (round to the nearest dollar)

A) $1,173.

B) $743.

C) $1,000.

D) $827.

Caldwell, Inc. sold an issue of 30-year, $1,000 par value bonds to the public. The bonds carry a 10.85% coupon rate and pay interest semiannually. It is now 12 years later. The current market rate of interest on the Caldwell bonds is 8.45%. What is the current market price (intrinsic value) of the bonds? Round off to the nearest $1.

A) $751

B) $1,177

C) $1,220

D) $976

The yield to maturity on a bond

A) is fixed in the indenture.

B) is lower for higher-risk bonds.

C) is the required return on the bond.

D) is generally equal to the coupon interest rate.

All of the following affect the value of a bond EXCEPT

A) investors' required rate of return.

B) the recorded value of the firm's assets.

C) the coupon rate of interest.

D) the maturity date of the bond.

A $1,000 par value 10-year bond with a 10% coupon rate recently sold for $900. The yield to maturity

A) is 10%.

B) is greater than 10%.

C) is less than 10%.

D) cannot be determined.

Sterling Corp. bonds pay 10% annual interest and are selling at 97. The market rate of interest

A) is less than 10%.

B) is greater than 10%.

C) equals 10%.

D) cannot be determined.

Tanzlin Manufacturing's common stock has a beta of 1.5. If the expected risk-free return is 2%

Tanzlin Manufacturing's common stock has a beta of 1.5. If the expected risk-free return is 2% and the expected return on the market is 14%, what is the expected return on the stock?

A) 13.5%

B) 21.0%

C) 16.8%

D) 20.0%

Given the capital asset pricing model, a security with a beta of 1.5 should return ________, if the risk-free rate is 3% and the market return is 11%.

A) 16.5%

B) 14.0%

C) 14.5%

D) 15.0%

The security market line (SML) relates risk to return, for a given set of market conditions. If expected inflation increases, which of the following would most likely occur?

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

The security market line (SML) relates risk to return, for a given set of market conditions. If risk aversion increases, which of the following would most likely occur?

A) The market risk premium would increase.

B) Beta would increase.

C) The slope of the SML would increase.

D) The SML line would shift up.

The Elvis Alive Corporation, makers of Elvis memorabilia, has a beta of 2.35. The return on the market portfolio is 12%, and the risk-free rate is 2.5%. According to CAPM, what is the risk premium on a stock with a beta of 1.0?

A) 12.00%

B) 22.33%

C) 9.5%

D) 14.5%

Bell Weather, Inc. has a beta of 1.25. The return on the market portfolio is 12.5%, and the risk-free rate is 5%. According to CAPM, what is the required return on this stock?

A) 20.62%

B) 9.37%

C) 14.37%

D) 15.62%

Susan Bright will get returns of 18%, -20.3%, -14%, 17.6%, and 8.3% in the next five years on her investment in CoffeeTown, Inc

Use the following information to answer the following question(s).

Susan Bright will get returns of 18%, -20.3%, -14%, 17.6%, and 8.3% in the next five years on her investment in CoffeeTown, Inc. stock, which she purchases for $73,419.66 today.

What is the arithmetic average return on her stock if she sells it five years from today?

A) 1.92%

B) 3.98%

C) 6.47%

D) 7.11%

What is the geometric average return on her stock if she sells it five years from today?

A) -2.33%

B) .59%

C) 3.67%

D) 4.88%

How much will Susan's stock be worth if she sells it five years from today?

A) $71,423.85

B) $73,419.66

C) $75,628.75

D) $80,333.40

Arithmetic average rate of return takes compounding into effect.

Answer:  FALSE

An investor who wishes to hold a stock for five years will be most interested in geometric average rather than in the arithmetic average return.

Answer:  TRUE

If an investor holds earns 10% on her investment in the first year and loses 10% the next year, she will have neither a gain nor a loss.

Answer:  FALSE

If an investor holds a stock for three years, the value at the end of three years will always be the initial cost of the stock times (1 + arithmetic average return) to the third power.

Answer:  FALSE