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Review
On Cost of capital
1. The company cost of capital for a firm with a 65/35 debt/equity split, 8% cost of debt, 15% cost of
equity, and a 35% tax rate would be:
A. 7.02%
B. 9.12%
C. 10.45%
D. 13.80%
0.65x 8% + 0.35 x 15% = 10.45%
2. The company cost of capital, after tax, for a firm with a 65/35 debt/equity split, 8% cost of debt, 15%
cost of equity, and a 35% tax rate would be:
A. 7.02%
B. 8.63%
C. 10.80%
D. 13.80%
0.65x (1-35%) x 8% + 0.35 x 15% = 8.63%
3. Why is debt financing said to include a tax shield for the company?
A. Taxes are reduced by the amount of the debt.
B. Taxes are reduced by the amount of the interest.
C. Taxable income is reduced by the amount of the debt.
D. Taxable income is reduced by the amount of the interest.
4. What is the pretax cost of debt for a firm in the 35% tax bracket that has a 10% after-tax cost of debt?
A. 5.85%
B. 12.15%
C. 15.38%
D. 25.71%
after-tax cost of debt = pretax cost x (1 - tax rate)
10% = pretax cost x .65
15.38% = pretax cost of debt
5. How much is added to a firm's weighted average cost of capital for 45% debt financing with a required rate of
return of 10% and a tax rate of 35%?
A. 1.29%
B. 2.93%
C. 3.50%
D. 4.50%

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Component cost of debt = .45 x (1 - .35).10
= .45 x (.65 x .10)
= .45 x .065
= 2.925%
6. What is the WACC for a firm with 50% debt and 50% equity that pays 12% on its debt, 20% on its equity,
and has a 40% tax rate?
A. 9.6%
B. 12.0%
C. 13.6%
D. 16.0%
WACC = (.5 x (.12 x .6)) + (.5 x .2)
= 3.6% + 10% = 13.60%
7. Company X has 2 million shares of common stock outstanding at a book value of $2 per share. The stock
trades for $3.00 per share. It also has $2 million in face value of debt that trades at 90% of par. What is its ratio
of debt to value for WACC purposes?
A. 15.38%
B. 28.6%
C. 31.0%
D. 33.3%
2 million shares x $3.00 = $6,000,000
$2 million debt x 90% = $1,800,000
Total value = $7,800,000
$1.2 million/$7.8 million = 15.38%

On Capital budgeting
1. Capital budgeting analysis focuses on cash flow as opposed to profits.
TRUE
2. Accurate capital budgeting analysis depends on total cash flows as opposed to incremental cash flows (i.e.,
the difference between cash flow with project and cash flow without project).
FALSE
3. Sunk costs influence capital budgeting decisions only when the sunk costs exceed future cash inflows.
FALSE
4. Opportunity costs are evaluated for investment decisions at their historical (that is, book) cost.
FALSE
5. The method of financing a project affects the determination of its cash flows for capital budgeting purposes.
FALSE

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7. If a project permits a reduction in the level of working capital, this reduction is assumed to increase cash
flows.
TRUE
8. An asset in the MACRS 5-year class life will have depreciation expense in six different years.
TRUE
9. The present value of the total depreciation tax shield will be higher when an asset uses MACRS than when
depreciated straight-line.
TRUE
13. Sunk costs remain the same whether or not you accept the project.
TRUE
14. Sunk costs do not affect project NPV.
TRUE
15. Investments in working capital, just like investments in plant and equipment, result in cash inflows.
FALSE
17. Discounting real cash flows at a nominal rate is a serious mistake.
TRUE
18. Suppose you finance a project partly with debt, you should neither subtract the debt proceeds from the
required investment, nor would you recognize the interest and principal payments on the debt as cash outflows.
TRUE
19. When you finance a project partly with debt, you should still view the project as if it were all equity-
financed, treating all cash outflows required for the project as coming from stockholders, and all cash inflows as
going to them.
TRUE
20. As a project comes to its end, there is a disinvestment in working capital, which also generates positive cash
flow as inventories are sold off and accounts receivable are collected.
TRUE
22. Cash flow from operations = (revenues - cash expenses) x (1 - tax rate) + (depreciation x tax rate).
TRUE


Multiple Choice Questions

23. Corporate income statements are designed primarily to show:
A. cash flows during a period.
B. account balances at the end of a period.
C. performance during a period.
D. market values of assets and liabilities.

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25. If the adoption of a new product will reduce the sales of an existing product, then the:
A. new product should not be undertaken.
B. old product should be abandoned.
C. incremental benefits of the new product may be over-estimated.
D. incremental benefits of the new product may be under-estimated.

26. The value of a proposed capital budgeting project depends upon the:
A. total cash flows produced.
B. incremental cash flows produced.
C. accounting profits produced.
D. increase in total sales produced.

27. The rationale for not including sunk costs in capital budgeting decisions is that they:
A. are usually small in magnitude.
B. revert at the end of the investment.
C. have no incremental effect.
D. reduce the estimated NPV.

28. If a project's cash flows exceed the project's incremental cash flows, it is likely that the:
A. project interacts with other aspects of the firm.
B. project must have high depreciation expense.
C. opportunity cost of capital must be high.
D. project will have a negative NPV.

29. When is it appropriate to include sunk costs in the evaluation of a project?
A. Include sunk costs when they are relatively large.
B. Include sunk costs if it improves the project's NPV.
C. Include sunk costs if they are considered to be overhead costs.
D. It is never appropriate to include sunk costs.

30. A cost should be considered sunk when it:
A. is fully depreciated.
B. produces no additional sales revenues.
C. has no effect on future flows.
D. is replaced by costs that are not yet sunk.

31. The opportunity cost of an asset:
A. should be depreciated annually.
B. can differ depending on market conditions.
C. is typically ignored in capital budgeting.
D. is important only for parcels of land.

32. Which of the following is least likely to influence the opportunity cost of an asset?
A. Its current market value.
B. Alternative uses for the asset.
C. The current demand for the asset.
D. Its current book value.

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42. How much will a firm need in cash flow before tax and interest to satisfy debtholders and equityholders if:
the tax rate is 40%, there is $10 million in common stock requiring a 12% return, and $6 million in bonds
requiring an 8% return?
A. $1,392,000
B. $1,488,000
C. $2,480,000
D. $2,800,000

47. What would you estimate to be the required rate of return for equity investors if a stock sells for $40 and
will pay a $4.40 dividend that is expected to grow at a constant rate of 5%?
A. 7.6%
B. 12.0%
C. 12.6%
D. 16.0%

55. Debt financing is made up of explicit and implicit costs which refer to:
A. a higher required ROE and the interest rate bondholders demand, respectively.
B. the interest rate bondholders demand and a higher required ROE, respectively.
C. the costs of equity and debt, respectively.
D. the costs of issuing bonds and the interest rate bondholders demand, respectively.
52. An implicit cost of increasing the proportion of debt in a firm's capital structure is that:
A. the firm's asset beta will increase.
B. equityholders will demand a higher rate of return.
C. the tax shield will not apply to the added debt.
D. the equity-to-value ratio will decrease.

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60. If a firm has twice as much equity as debt in its capital structure, then the firm has:
A. 75.0% debt.
B. 66.7% equity.
C. 40.0% debt.
D. 33.3% equity.
Let x = % of debt
Then 2x = % of equity
And 3x = 100% x = 33.3%
Equity = 66.7%
61. If a firm has three times as much equity as debt in its capital structure, then the firm has:
A. 25.0% debt.
B. 66.7% equity.
C. 40.0% debt.
D. 33.3% equity.
Let x = % of debt
Then 3x = % of equity
And 4x = 100% x = 25.0%
Equity = 75.0%
71. What proportion of a firm is equity financed if the WACC is 14%, the after-tax cost of debt is 7.0%, the tax
rate is 35%, and the required return on equity is 18%?
A. 54.00%
B. 63.64%
C. 70.26%
D. 77.78%
14% = (1 - x)(7%) + (x)18%
14% = 7% - (x)7% + (x)18%
7% = (x)11%
63.64% = x
77. What is the WACC for a firm with 40% debt, 20% preferred stock and 40% equity if the respective costs for
these components are 6% after-tax, 12% after-tax, and 18% before-tax? The firm's tax rate is 35%.
A. 9.48%
B. 11.16%
C. 12.00%
D. 15.60%
WACC = (.4 x .06) + (.2 x .12) + (.4 x .18)
= .024 + .024 + .072
= 12.0%

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86. According to CAPM estimates, what is the cost of equity for a firm with beta of 1.5 when the risk-free
interest rate is 6% and the expected return on the market portfolio is 15%?
A. 19.5%
B. 21.0%
C. 22.5%
D. 24.0%
Expected return on stock = 6% + 1.5(15% - 6%)
= 6 + 13.5
= 19.5%
87. What return on equity do investors seem to expect for a firm with a $55 share price, an expected dividend of
$5.50, a beta of .9 and a constant growth rate of 5.5%?
A. 9.00%
B. 10.00%
C. 13.95%
D. 15.50%

91. Find the required rate of return for equity investors of a firm with a beta of 1.3 when the risk free rate is 5%,
the market risk premium is 5%, and the return on the market is 10%.
A. 11.5%
B. 13.0%
C. 16.5%
D. 18.0%
CAPM: r
r
= 0.05 + 1.30(0.10 - 0.05) = 11.5%
92. Plasti-tech Inc. is financed 60% with equity and 40% with debt. Currently, its debt has a before-tax interest
rate of 12%. Plasti-tech's common stock trades at $15 per share and its most recent dividend was $1.00. Future
dividends are expected grow by 4%. If the tax rate is 34%, what is Plasti-tech's WACC?
A. 7.39%
B. 9.57%
C. 9.73%
D. 11.20%
r
e
= ((1(1 + 0.04))/$15) + 0.04
= 10.93%
WACC = 0.4[0.12(1 - 0.34)] + 0.6(0.1093)
= .0317 + .0656
= 9.73%

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93. The capital structure for the CR Corporation is the following: bonds $5,500, and common stock $11,000. If
CR has an after-tax cost of debt of 6%, and a 16% cost of common stock, what is its WACC?
A. 9.33%
B. 12.67%
C. 13.33%
D. 14.67%
WACC = [(5,500/16,500) x (0.06)] + [(11,000/16,500) x (0.16)]
= .02 + .10667
= 12.67%
33. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
34. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
35. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock
36. The sensitivity of a stock's returns to the returns on a market portfolio is referred to as the:
A. stock's market risk premium.
B. stock's beta.
C. market portfolio's systematic risk.
D. stock's unique risk.
37. When the overall market is up by 10%, an investor with a portfolio of defensive stocks will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
38. When the overall market experiences a decline of 8%, an investor with a portfolio of aggressive stocks will
probably experience:
A. negative portfolio returns of less than 8%.
B. negative portfolio returns of greater than 8%.
C. positive portfolio returns of less than 8%.
D. positive portfolio returns of greater than 8%.

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39. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.
40. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
41. The line plotted to fit observations of a stock's returns versus the market's returns determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
42. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2% then its
beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.
43. If the slope of the line measuring a stock's historic returns against the market's historic returns is positive,
then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.
44. If the line measuring a stock's historic returns against the market's historic returns has a slope greater than
1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.

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45. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a month where the
market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.
33. Macro events only are reflected in the performance of the market portfolio because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
34. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
35. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock.
36. The sensitivity of a stock's returns to the returns on a market portfolio is referred to as the:
A. stock's market risk premium.
B. stock's beta.
C. market portfolio's systematic risk.
D. stock's unique risk.
37. When the overall market is up by 10%, an investor with a portfolio of defensive stocks will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
38. When the overall market experiences a decline of 8%, an investor with a portfolio of aggressive stocks will
probably experience:
A. negative portfolio returns of less than 8%.
B. negative portfolio returns of greater than 8%.
C. positive portfolio returns of less than 8%.
D. positive portfolio returns of greater than 8%.

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39. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.
40. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
41. The line plotted to fit observations of a stock's returns versus the market's returns determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
42. If a stock consistently goes down (up) by 1.6% when the market portfolio goes down (up) by 1.2% then its
beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.

43. If the slope of the line measuring a stock's historic returns against the market's historic returns is positive,
then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.

44. If the line measuring a stock's historic returns against the market's historic returns has a slope greater than
1.0, then the:
A. stock is currently underpriced.
B. market risk premium is increasing.
C. stock has a significant amount of unique risk.
D. stock has a beta exceeding 1.0.

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45. What is the most logical explanation for a +2.0% return on a stock with a beta of 1.0 in a month where the
market returned +1.0%?
A. The stock is aggressive.
B. The market is undervalued.
C. Favorable firm-specific news was reported.
D. The beta is incorrect.
Question 1 (15 points)
Tarans Manufacturing is developing the incremental cash flows associated with the proposed replacement of
an existing stamping machine with a new, technologically advanced one. Given the following costs related to
the proposed project, explain whether each would be treated as a sunk cost or an opportunity cost in developing
the incremental cash flows associated with the proposed replacement decision. Briefly discuss the cash flow
effect of sunk costs and opportunity costs.
a. Tarans would be able to use the same dies and other tools, which had a book value of $40,000, on the new
stamping machine as it used on the old one.
b. Tarans would be able to link the new machine to its existing computer system in order to control its
operations. The old stamping machine did not have a computer control system. The firms excess computer
capacity could be leased to an other firm for an annual fee of $17,000.
c. Tarans would have to obtain additional floor space to accommodate the larger new stamping machine. The
space that would be used is currently being leased to another company for $10,000 per year.
d. Tarans would retain an existing overhead crane, which it had planned to sell for its $180,000 market value.
Although the crane was not needed with the old stamping machine, it would be used to position raw
materials on the new stamping machine.

Answer
a. sunk cost => no cash flow effect
b. opportunity cost, since excess computer capacity could be for other use and could generate revenues =>
negative cash flow effect
c. opportunity cost, since the current space is generating revenues => negative cash flow effect
d. opportunity cost, since the existing crane could be sold for a certain amount of money => negative cash flow
effect

Question 2 (15points)
Assume that the assumptions underlying the Capital Asset Pricing Model (CAPM) hold. Suppose the
following is known about stocks Apple and Blueberry:

Covariance with
Stock Apple Blueberry Expected return, E[ri]
Apple 0.25 -0.10 4%
Blueberry -0.10 0.25 6%
The expected return on the Market portfolio is 7%, the risk-free rate is 2%. The variance of the return on the
Market portfolio is equal to Var(RM) = 0.075 which is also the variance of the return on this portfolio.


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Suppose currently you have all your money on a bank account, and consider investing this money in a
portfolio consisting of 50% of Apple stock and 50% of Blueberry stock.

a. Calculate: i) the expected return on this portfolio, and ii) the beta of this portfolio.

Answer:
i) Expected return: 0.5 (4%) + 0.5 (6%) = 5%

ii) Beta; the risk-free rate and the expected return on the market portfolio give the SML; using this equation
we find a beta of 0.4 for stock Apple and a beta of 0.8 for stock Blueberry. The beta of the portfolio is equal
to: 0.5 (0.4) + 0.5 (0.8) = 0.6. (Alternatively you can directly plug in the SML the expected return of 5%).



Your friend advices you to invest in the market portfolio instead of the portfolio P consisting of 50% of stock
Apple and 50% of stock Blueberry.

b. Would you follow your friends advice? Explain why or why not?



Problem 2 (20 points): The market value of ABC share is $20, the number of stock outstanding is 4 million and
total value of the companys debt is $60 million. The company estimates that the beta of its stock is 1.8 and that
the market risk premium is 15 percent. The Treasury bill rate is 5%.

1. What is the required rate of return on ABC stock?
2. What is the beta of companys existing portfolio of assets? The debt is perceived as risky as the market.
3. Calculate the WACC of the company assuming a tax rate of 35%
4. Estimate the discount rate for an expansion of the companys present business.
5. Suppose the company uses more debt for the expansion, will require rate of return on the companys stock
be lower or higher than the one found in the first question? Why?

Answers:
a. r = r
f
+ |(r
m
r
f
) r = 5% + (1.8 15%) = 32%
b. Weighted average beta = (6/14 1) + (8/14 1.8) = 1.46
Answer
Your friend is right. You should follow his/her advice. Even though the systematic risk of the portfolio P
(beta) is low, the non-systematic is quite high and for a non-diversified portfolio of only 2 stocks the non-
systematic risk is very relevant. The non-systematic part becomes irrelevant only when an investor diversifies
his portfolio by investing in many different assets. In that case the non-systematic risk becomes small to
insignificant. In fact, by following your friends advice of investing in the market portfolio, you will have a
higher return at 7% at the same level of risk of the proposed portfolio (Var(RM) = Var(RP) = 0.075).

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c.
(

+
(

=
equity C debt
r
V
E
) T 1 ( r
V
D
WACC
= [0.43 20% (1 0.35)] + [0.57 32%] = 23.86%

d. If the company plans to expand its present business, then the WACC is a reasonable estimate of the
discount rate since the risk of the proposed project is similar to the risk of the existing projects. Use
a discount rate of 23.86%.

e. It will be higher because of the implicit cost of equity incurred by the companys issuing more
debt

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1. As the opportunity cost of capital decreases, the net present value of a project increases.
a. TRUE b. FALSE
2. The IRR is the rate of return on the cash flows of the investment, also known as the opportunity cost of
capital.
a. TRUE b. FALSE
3. When calculating IRR with a trial and error process, discount rates should be raised when NPV is
positive.
a. TRUE b. FALSE
4. Both the NPV and the internal rate of return methods recognize that the timing of cash flows affects
project value.
a. TRUE b. FALSE
5. When choosing among mutually exclusive projects, the choice is easy using the NPV rule. As long as at
least one project has positive NPV, simply choose the project with the highest NPV.
a. TRUE b. FALSE
6. Which of the following statements is correct for a project with a positive NPV?
A. IRR exceeds the cost of capital.
B. Accepting the project has an indeterminate effect on shareholders.
C. The discount rate exceeds the cost of capital.
D. The profitability index equals one.
7. What is the NPV of a project that costs $100,000 and returns $50,000 annually for three years if the
opportunity cost of capital is 14%?
A. $3,397.57
B. $4,473.44
C. $16,085.00
D. $35,000.00
8. What is the approximate maximum amount that a firm should consider paying for a project that will
return $15,000 annually for 5 years if the opportunity cost is 10%?
A. $33,520
B. $56,860
C. $62,540
D. $75,000
9. If the opportunity cost of capital for a project exceeds the project's IRR, then the project has a(n):
A. positive NPV.
B. negative NPV.
C. acceptable payback period.
D. positive profitability index.

10. If the IRR for a project is 15%, then the project's NPV would be:
A. negative at a discount rate of 10%.
B. positive at a discount rate of 20%.
C. negative at a discount rate of 20%.
D. positive at a discount rate of 15%.
11. When mutually exclusive projects have different lives, the project which should be selected will have
the:
A. highest IRR.
B. longest life.
C. lowest equivalent annual cost.
D. highest NPV, discounted at the opportunity cost of capital.

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12. Which mutually exclusive project would you select, if both are priced at $1,000 and your discount rate is
15%; Project A with three annual cash flows of $1,000, or Project B, with three years of zero cash flow
followed by three years of $1,500 annually?
A. Project A.
B. Project B.
C. You are indifferent since the NPVs are equal.
D. Neither project should be selected.
13. The profitability index for a project costing $40,000 and returning $15,000 annually for four years at an
opportunity cost of capital of 12% is:
A. 0.139
B. 0.320
C. 0.500
D. 0.861
14. What is the net effect on a firm's working capital if a new project requires: $30,000 increase in
inventory, $10,000 increase in accounts receivable, $35,000 increase in machinery, and a $20,000
increase in accounts payable?
A. -$5,000
B. +$10,000
C. +$20,000
D. +$55,000
15. If a project is expected to increase inventory by $17,000, increase accounts payable by $10,000, and
decrease accounts receivable by $1,000, what effect does working capital have during the life of the
project?
A. Increases investment by $4,000.
B. Increases investment by $5,000.
C. Increases investment by $6,000.
D. Working capital has no effect during the life of the project.
16. Changes in net working capital can occur at:
A. the beginning of a project.
B. the end of a project.
C. any time during the life of a project.
D. the beginning of any accounting period.
17. What is the undiscounted cash flow in the final year of an investment, assuming: $10,000 after-tax cash
flows from operations, the fully depreciated machine is sold for $1,000, the project had required $2,000
in additional working capital, and a 35% tax rate?
A. $8,450
B. $12,600
C. $12,650
D. $14,000
18. At current prices and a 13% cost of capital, a project's NPV is $100,000. By what minimum amount
must the initial cost of the project decrease (revenues will be unchanged) before you would prefer to
wait two years before investing?
A. $21,685
B. $26,000
C. $27,690
D. $29,380
19. $100,000 x (1.13)
2
= $127,690
Therefore, the cost must decrease by a minimum of $27,690 (which would increase NPV by an
equivalent amount) before we would wait the two years to invest.

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20. A new project requires an increase in both current assets and current liabilities of $125,000 each. What
is the overall impact on net working capital investment?
A. An increase of zero.
B. An increase of $125,000.
C. An increase of $250,000.
D. An increase of $62,500, when averaged over the life of the project.
21. An investment today of $25,000 promises to return $10,000 annually for the next three years. What is
the approximate real rate of return on this investment if inflation averages 6% annually during the
period?
A. 3.5%
B. 9.7%
C. 14.0%
D. 20.0%

22. What is the NPV of a project that costs $100,000, provides $23,000 in cash flows annually for six years,
requires a $5,000 increase in net working capital, and depreciates the asset straight line over six years
while ignoring the half-year convention? The discount rate is 14%.
A. -$15,561
B. -$13,283
C. $13,283
D. $15,561

23. New projects or products can have an indirect effect on the firm as well as direct effect. Which of the
following appears to be an indirect effect of launching a new product?
A. Additional working capital is required.
B. Sales force will need to be increased.
C. Sales of our similar product will decline.
D. Additional machinery must be purchased.
24. Which of the following is not accurate in depicting cash flows from operations?
A. (revenues - expenses)(1 - tax rate) + (depreciation x tax rate)
B. (revenues - expenses - taxes paid)
C. (net profit + depreciation)
D. (revenues - cash expenses - taxes paid)
25. A bank can purchase an ATM (automated teller machine) for $110,000 that has an estimated life of 6
years. Maintenance over that period will begin at $2,500 annually and increase at a 10% rate. If the
ATM is purchased the bank will not be required to hire one additional (human) teller. Including fringe
benefits, the teller costs $18,000 per year, and this amount is expected to increase 5% annually. If the
bank's cost of capital is 10%, which alternative should be selected?
26. What is the approximate standard deviation of returns if over the past four years an investment returned
8.0%, -12.0%, -12% and 15.0%?
A. 9.26%
B. 10.26%
C. 11.26%
D. 12.01%
27. The variance of a stock's returns can be calculated as the:
A. average value of deviations from the mean.
B. average value of squared deviations from the mean.
C. square root of average value of deviations from the mean.
D. sum of the deviations from the mean.

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28. You are considering the purchase of new equipment. Your analysis includes the evaluation of two
machines which have differing initial and ongoing costs and differing lives. Whichever machine is
purchased will be replaced at the end of its useful life. You should select the machine which has the:
a. longest life.
b. highest annual operating cost.
c. lowest annual operating cost.
d. highest equivalent annual cost.
e. lowest equivalent annual cost.
29. The book value of equipment will:
a. remain constant over the life of the equipment.
b. vary in response to changes in the market value.
c. decrease at a constant rate when MACRS depreciation is used.
d. increase over the taxable life of an asset.
e. decrease slower under straight-line depreciation than under MACRS.
30. A project's operating cash flow will increase when:
a. the tax rate increases.
b. sales decrease.
c. interest expense decreases.
d. depreciation expense increases.
e. earnings before interest and taxes decreases.
31. Justin's Manufacturing purchased a lot in Lake City ten years ago at a cost of $790,000. Today, that lot
has a market value of $1.2 million. At the time of the purchase, the company spent $100,000 to grade
the lot and another $20,000 to build a small garage on the lot to house additional equipment. The
company now wants to build a new facility on the site. The building cost is estimated at $1.7 million.
What amount should be used as the initial cash flow for this project?
a. $2,490,000
b. $2,610,000
c. $2,900,000
d. $3,020,000
e. $3,690,000
32. John's Surf Shop has sales of $620,000 and a profit margin of 8 percent. The annual depreciation
expense is $50,000. What is the amount of the operating cash flow if the company has no long-term
debt?
a. $45,600
b. $49,600
c. $53,600
d. $95,600
e. $99,600

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33. You own some equipment which you purchased three years ago at a cost of $155,000. The equipment is
5-year property for MACRS. You are considering selling the equipment today for $41,500. Which one
of the following statements is correct if your tax rate is 34 percent?


a. The tax due on the sale is $2,072.40.
b. The book value today is $74,400.
c. The book value today is $60,600.
d. The taxable amount on the sale is $44,640.
e. You will receive a tax refund of $1,067.60 as a result of this sale.

(Questions 34, 35, 36, 37 are answered based on the information that follows): Johnson, Inc. is
considering a new project. The project will require $350,000 for new fixed assets, $140,000 for
additional inventory, and $45,000 for additional accounts receivable. Short-term debt is expected to
increase by $110,000 and long-term debt is expected to increase by $330,000. The project has a 7-year
life. The fixed assets will be depreciated straight-line to a zero book value over the life of the project. At
the end of the project, the fixed assets can be sold for 30 percent of their original cost. The net working
capital returns to its original level at the end of the project. The project is expected to generate annual
sales of $600,000 and costs of $400,000. The tax rate is 35 percent and the required rate of return is 12
percent.
34. What is the project's cash flow at time zero?
a. $195,000
b. $350,000
c. $425,000
d. $490,000
e. $535,000
35. What is the amount of the earnings before interest and taxes for the first year of this project?
a. $97,500
b. $130,000
c. $150,000
d. $200,000
e. $250,000
36. What is the amount of the after-tax cash flow from the sale of the fixed assets at the end of this project?
a. $0
b. $32,500
c. $36,750
d. $68,250
e. $105,000

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37. What is the cash flow recovery from net working capital at the end of this project?
a. $30,000
b. $75,000
c. $90,000
d. $185,000
e. $205,000
38. Which of the following risk types can be diversified by adding stocks to a portfolio?
A. Systematic risk
B. Unique risk
C. Default risk
D. Market risk

39. Which of the following risks is most important to a well-diversified investor in common stocks?
A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk
40. What is the approximate standard deviation of returns if over the past four years an investment returned
8.0%, -12.0%, -12% and 15.0%?
A. 9.26%
B. 10.26%
C. 11.26%
D. 12.01%

41. What is the standard deviation of return of a four-stock portfolio (each stock being equally weighted)
that produced returns of 20%, 20%, 25% and 30%?
A. 2.15%
B. 3.15%
C. 4.15%
D. 5.15%

42. The benefits of portfolio diversification are highest when the individual securities have returns that:
A. vary directly with the rest of the portfolio.
B. vary indirectly with the rest of the portfolio.
C. are less than perfectly correlated with the rest of the portfolio.
D. are countercyclical.
43. The major benefit of diversification is to:
A. increase the expected return.
B. remove negative risk assets from the portfolio.
C. reduce the portfolio's systematic risk.
D. reduce the expected risk.

44. What is the expected return on a portfolio that will decline in value by 13% in a recession, will increase
by 16% in normal times, and will increase by 23% during boom times if each scenario has equal
likelihood?
A. 8.67%
B. 13.00%
C. 13.43%
D. 17.33%

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45. A stock investor owns a diversified portfolio of 15 stocks. What will be the likely effect on portfolio
standard deviation from adding one more stock?
A. A slight increase will occur.
B. A large increase will occur.
C. A slight decrease will occur.
D. A large decrease will occur.
46. Risk factors that are expected to affect only a specific firm are referred to as:
A. market risk.
B. diversifiable risk.
C. systematic risk.
D. risk premiums.
47. Which of the following risks is most important to a well-diversified investor in common stocks?
A. Market risk
B. Unique risk
C. Total risk
D. Diversifiable risk
48. Perhaps the best way to reduce macro risk in a stock portfolio is to invest in stocks that:
A. have only unique risks.
B. have diversified away the macro risk.
C. have low exposure to business cycles.
D. pay guaranteed dividends.

49. Calculate the expected return, variance, and standard deviations for investments in either stock A or
stock B, or an equally weighted portfolio of both.


A. Standard deviations of stock A, the stock B and the portfolio are 9.22%, 5.12% and 2.1% respectively.
B. Standard deviations of stock A, the stock B and the portfolio are 5.12%, 9.22% and 2.1% respectively.
C. Standard deviations of stock A, the stock B and the portfolio are 12%, 9.2% and 2.1% respectively.