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Final Exam FIN 304 Instructions: Please read and work on each of the problems below. Once you have worked out the answers to the problems go into blackboard to turn in your assignments. Use the information below to answer questions 1-3. Fine Press is considering replacing the existing press with a more efficient press. The new press costs $55,000 and requires $5,000 in installation costs. The old press was purchased 2 years ago for an installed cost of $35,000 and can be sold for $20,000 net of any removal costs today. Both presses are depreciated under the MACRS 5-year recovery schedule. The firm is in 40 percent marginal tax rate. 1) Calculate the book value of the existing press being replaced. A) $17,800 B) $16,800 C) $18,800 D) $19,800 2) Calculate the tax effect from the sale of the existing asset. A) $3,280 B) $4,280 C) $1,280 D) $2,280 3) Calculate the initial investment of the new asset. A) $41,280 B) $52,810 C) $31,820 D) $50,000 Use the information below to answer questions 4-9 Cuda Marine Engines, Inc. must develop the relevant cash flows for a replacement capital investment proposal. The proposed asset costs $50,000 and has installation costs of $3,000. The asset will be depreciated using a five-year recovery schedule. The existing equipment, which originally cost $25,000 and will be sold for $10,000, has been depreciated using an MACRS five-year recovery schedule and three years of depreciation has already been taken. The new equipment is expected to result in incremental before-tax earnings before depreciation, interest and taxes (EBIDT) of $15,000 per year. The firm has a 40 percent tax rate. 4) The cash flow pattern for the capital investment proposal is ________. A) a mixed stream and conventional. B) a mixed stream and non-conventional. C) an annuity and conventional. D) an annuity and non-conventional. 1 5) The book value of the existing asset is ________. A) $7,250 B) $15,000 C) $21,250 D) $25,000 6) The tax effect on the sale of the existing asset results in ________. A) $800 tax benefit. B) $1,000 tax liability. C) $1,100 tax liability. D) $6,000 tax liability. 7) The incremental depreciation expense for year 1 (for the new asset) is ________. A) $2,250 B) $10,600 C) $10,000 D) $7,950 8) The incremental depreciation expense for year 5 (for the new asset) is ________. A) $2,250 B) $5,110 C) $7,950 D) $6,360 9) The annual incremental after-tax cash flow from operations for year 1 (for the new equipment) is ________. A) $13,950 B) $16,600 C) $13,240 D) $30,000 2 Use the information below to answer questions 10 and 11. A firm must choose from six capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $800,000; the firm's cost of capital is 16 percent. Project IRR NPV 1 Initial Investment $100,000 17% $95,000 2 $410,000 18% $21,000 3 $230,000 16% $55,000 4 $200,000 12% -$5,000 5 $150,000 19% $46,000 6 $400,000 15% $70,000 7 $250,000 12% -$10,000 10) Using the internal rate of return approach to ranking projects, which projects should the firm accept (in what order)? A) 1, 2, and 5 B) 5,2 and 1 C) 1,2 and 3 D) 2,1 and 3 11) Using the net present value approach to ranking projects, which projects should the firm accept (in what order)? A) 6, 3, and 5 B) 3,5 and 2 C) 1,6 and 3 D) 6,3 and 1 3 Use the information below to answer questions 12-17 Nuff Folding Box Company, Inc. is considering purchasing a new gluing machine. The gluing machine costs $50,000 and requires installation costs of $2,500. This outlay would be partially offset by the sale of an existing gluer. The existing gluer originally cost $10,000 and is four years old. It is being depreciated under MACRS using a five-year recovery schedule and can currently be sold for $15,000. The existing gluer has a remaining useful life of five years. If held until year 5, the existing machine's market value would be zero. Over its five-year life, the new machine should reduce operating costs (excluding depreciation) by $17,000 (it's EBIDT) per year compared to the old machine. Training costs of employees who will operate the new machine will be a one-time cost of $5,000 which should be included in the initial outlay. The new machine will be depreciated under MACRS using a five-year recovery period. The firm has a 12 percent cost of capital and a 40 percent tax on ordinary income and capital gains. 12) The payback period when looking at the cash flow for the new project is (hint you will need to calculate the incremental operational cash flow for the new machine and the initial outlay for the new project in number 14 first) A) 1 year. B) 2 years. C) between 3 and 4 years. D) between 4 and 5 years. 13) The tax effect of the sale of the existing asset is A) a tax liability of $2,340. B) a tax benefit of $1,500. C) a tax liability of $3,320. D) a tax liability of $5,320. 14) The initial outlay for this new project is A) $42,820. B) $40,320. C) $47,820. D) $35,140. 15) The present value of the new project's annual cash flows (after tax) is A) $ 47,820. B) $ 53,756 C) $ 70,618 D) $100,563. 16) The net present value of the new project is (hint: take the answer for number 15 and subtract the initial outlay) A) - $3,927. B) $8,445. C) $1,614. D) $5,936. 4 17) The internal rate of return for the new project is A) between 7 and 8 percent. B) Is close to 17 percent. C) is exactly 11 percent D) between 19 and 20 percent. Use the information below to answer questions 18-20 Galaxy Satellite Co. is attempting to select the best group of independent projects competing for the firm's fixed capital budget of $9,000,000. A summary of key data about the proposed projects follows. Hint, the cost of capital is already given here, you just have to know where to look for it! Project IRR A Initial Investment $2,000,000 20% PV of Inflows at 15% $3,050,000 B $6,000,000 25% $9,320,000 C $700,000 24% $1,060,000 D $5,000,000 23% $7,350,000 E $4,000,000 26% $5,320,000 18) Use the NPV approach to select the best group of projects (in the order they should be implemented). A. Choose Projects C and D, since this combination maximizes NPV at $2,710,000. B. Choose Projects B, A and C since this combination maximizes NPV at $4,730,000. C. Choose Projects B, D and E since this combination maximizes NPV at $6,990,000 D. Choose Projects B and D, since this combination maximizes NPV at $5,670,000. 19) Use the IRR approach to select the best group of projects (in the order they should be implemented). . A. Choose Projects E, C and A resulting in a combined NPV of $2,730,000 B. Choose Projects A, C and E resulting in a combined NPV of $3,730,000 C. Choose Projects E, B and C, resulting in a combined NPV of $5,000,000 D. Choose Projects C, B, and E resulting in a combined NPV of $ 5,000,000 5 20) Which projects should the firm implement? A. E, C and A since the combined NPV is the highest B. B, A and C since the combined NPV is the highest C. E, C and A since the combined NPV is the lowest D. E, B and C since the combined NPV is the highest E. C, B, and E since the combined NPV is the highest Use the information below to answer questions 21-23 A firm is considering investment in a capital project which is described below. The firm's cost of capital is 11 percent and the risk-free rate is 2 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index x (Cost of capital - Rf) - Looks familiar...hmm....maybe CAPM? Initial Investment $1,300,000 Year 1 Cash Flow $700,000 2 $700,000 3 $700,000 21) The net present value without adjusting the discount rate for risk is ________. A) Around $410,600. B) Around $310,991. C) Around $-410,600. D) Around $221,991 22) The discount rate that should be used in the net present value calculation to compensate for risk is ________. A) Around 27 percent. B) Around 16 percent. C) Around 19 percent. D) Around 25 percent. 23) The net present value of the project when adjusting for risk is ________. A) Around -$272,123. B) Around $1,572,123272. C) Around $272,123. D) Around $221,991. 6 Use the information below to answer questions 24-27 Bell Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Bell Manufacturing's overall cost of capital is 5 percent, the market return is 9 percent and the risk-free rate is 1 percent. Bell estimates that the beta for project X is 1.20 and the beta for project Y is 1.40. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + beta x (Market Return - Rf) - Looks familiar...hmm....maybe CAPM? Project X Project Y $1,500,000 $2,000,000 1 $750,000 $430,000 2 $750,000 $675,000 3 $750,000 $435,000 4 $750,000 $800,000 Initial Investment Year 24) Calculate the risk-adjusted discount rates for project X and project Y using CAPM A RADR x - Around 18% RADR y - Around 22% B RADR x - Around 25% RADR y - Around 20% C RADR x - Around 11% RADR y - Around 12% D RADR x - Around 16% RADR y -Around 17% 7 25) Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Bell select using this method? A NPVx is around $846,846 NPVy is around - $267,796 B NPVx is around - $846,846 NPVy is around $267,796 C NPVx is around $1,159,463 NPVy is around $55,700 D NPVx is around - $1,159,463 NPVy is around - $55,700 26) Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm's overall cost of capital to evaluate projects X and Y A NPVx is around $846,846 NPVy is around - $267,796 B NPVx is around - $846,846 NPVy is around $267,796 C NPVx is around $1,159,463 NPVy is around $55,700 D NPVx is around - $1,159,463 NPVy is around - $55,700 8 27) What potential biases exist in project selection if Bell Manufacturing did not adjust for the difference in risk between projects X and Y A - The danger of not accounting for differences in project risk is that potentially unacceptable low-risk projects (with positive NPVs) may be chosen over potentially acceptable high-risk projects (with negative NPVs). B -The danger of not accounting for differences in project risk is that potentially unacceptable high-risk projects (with negative NPVs) may be chosen over potentially acceptable low-risk projects (with positive NPVs). C - The danger of not accounting for similarities in project risk minimal. There is no proven correlation between discount rates and NPV value. So, using the RADR is merely a theoretical approach that is hardly put into practice. Real life impact is negligible. Use the information below to answer questions 28-32 Yong Importers, an Asian import company, is evaluating two mutually exclusive projects, A and B. The relevant cash flows for each project are given in the table below. The cost of capital for use in evaluating each of these equally risky projects is 8 percent. Project A 225,000 Project B 350,000 1 220,000 275,000 2 165,000 385,000 3 190,000 250,000 4 100,000 5 75,000 6 50,000 Initial Investment Year 28) The NPVs of projects A and B are ________. A) Around $397,207 and $406,010 respectively. B) Around $397,207 and $-55,898 respectively C) Around $427,048 and 433,163 respectively D) Around -$427,048 and 433,163 respectively 9 29) The Annualized NPV of project A is ________. A) Around $45,377 B) Around $85,922 C) Around $95,922. D) Around $92,377 30) The Annualized NPV of project B is ________. A) Around $406,082 B) Around $168,082 C) Around $397,208 D) Around $157,208 31) Which project should be chosen on the basis of the normal NPV approach? A) Project A B) Project B C) neither D) both (question 32 on next page). 10 32) Which project should be chosen using the Annualized NPV approach? A) Project A B) Project B C) neither D) both Use the information below to answer questions 33-38 A firm has determined its optimal capital structure which is composed of the following sources and target market value proportions. Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation cost of 2 percent of the face value would be required in addition to the discount of $40. Preferred Stock: The firm has determined it can issue preferred stock at $75 per share par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the stock is $3 per share. Common Stock: A firm's common stock is currently selling for $18 per share. The dividend expected to be paid at the end of the coming year is $1.74. Its dividend payments have been growing at a constant rate for the last four years. Four years ago, the dividend was $1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent. 33) The firm's before-tax cost of debt is ________. A) 7.7 percent. B) 10.6 percent. C) 11.2 percent. D) 12.7 percent. 34) The firm's after-tax cost of debt is ________. A) 3.25 percent. B) 4.6 percent. C) 8 percent. D) 8.13 percent. 35) The firm's cost of preferred stock is ________. A) 7.2 percent. B) 8.3 percent. C) 13.9 percent. D) 14.2 percent. 11 36) The firm's cost of a new issue of common stock is ________. ) A) 7 percent. B) 9.08 percent. C) 12.2 percent. D) 13.4 percent. 37) The firm's cost of retained earnings is ________. A) 10.2 percent. B) 13.9 percent. C) 11.4 percent. D) 12.9 percent. 38) The weighted average cost of capital up to the point when retained earnings are exhausted is ________. A) 7.5 percent. B) 8.65 percent. C) 9.4 percent. D) 11.73 percent. 12