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# Section I: This section comprises 30 MC questions. Each question is worth 2 points.

## Choose the closest

possible alternative.
1. Ten years ago, you invested \$85,000 in Apples stock. Today, you can sell Apples stock for
\$484,050. What has been the average annual rate of return on your investment?
a. 4.7%
b. 47%
c. 50%
d. 19%
e. 13%

Answer: d

2. You want to start a food-truck business. It is expected to generate after-tax cash flows of \$40,000
per year in the years 1 through 4 and \$50,000 per year in the years 5 through 8. If you discount these
cash flows at an annual rate of 10%, what is the present value of your expected cash flows?
a. \$285,288
b. \$235,048
c. \$167,943
d. \$828,230
Answer: b
3. You have \$42,180.53 in a brokerage account, and you plan to deposit an additional \$5,000 at
the end of every future year until your account totals \$250,000. You expect to earn 12%
annually on the account. How many years will it take to reach your goal?
a. 9
b. 10
c. 11
d. 12
Answer: c

4. Which is greater, the present value of a \$1,000 five-year ordinary annuity discounted at 10%, or the
present value of a \$1,000 five-year annuity due discounted at 10%?
a.
b.
c.
d.

## The ordinary annuity is worth more with a present value of \$3,790.79.

The annuity due is worth more with a present value of \$4,169.87.
The ordinary annuity is worth more with a present value of \$4,169.87.
The annuity due is worth more with a present value of \$4,586.85.

Answer: b
5. You have just turned 25 and may now spend a portion of the trust fund your parents established for
you. The terms of the trust fund allow you to withdraw 60 beginning-of-the-year cash flows of
\$100,000 each. An investment firm has offered to pay you cash for all of the fund today. If the rate
they use to discount the cash flows is 16% per year, what is their offer price today for your pension
fund?
a. \$4,605,750,853
b. \$6,000,000.00

c. \$624,915.20
d. \$724,901.63
Answer: d
6. Your firm intends to finance the purchase of a new construction crane. The cost is \$1,500,000. What
is the size of the annual ordinary annuity payment if the loan is amortized over a ten-year period at a
rate of 8.50%?
a. \$228,611.56
b. \$127,500
c. \$3,391,475.16
d. There is not enough information to answer this question.
Answer: a
7. You invest \$15,000 today, compounded monthly, with an annual percentage rate (APR) of 8.25%.
What amount of interest will you earn in one year?
a. \$1,723.23
b. \$1,285.38
c. \$1,298.98
d. \$1,295.38
Answer: b
8. What is the EAR if the APR is 10.52% and compounding is daily (assume 365 days in one year)?
a. Slightly above 11.09%
b. Slightly above 10.09%
c. Over 11.25%
d. Slightly below 11.09%
Answer: a
9. Assume you just bought a new home and now have a mortgage on the home. The amount of the
principal is \$200,000 and the Annual Percentage Rate is 4.75%, compounded monthly. You have to
make monthly payments (at the end of each month) which are spread out over 25 years. What is the
loan payment every month?
a. \$1,157.63
b. \$1,140.23
c. \$1,225.36
d. \$1,206.58
Answer: b
10. You want to buy a zerocoupon bond for your fixedincome portfolio. How much should you pay for a
zerocoupon bond with 20 years to maturity and a face value of \$1000 if the yield to maturity is 15%?
a. \$55.42
b. \$1000
c. \$16,366.54
d. \$61.10

Answer: a

11. MacroMedia Inc. \$1,000 par value bonds are selling for \$1,265. Which of the following statements
is/are TRUE?

Statement 1: The coupon rate is greater than the yield to maturity.
Statement 2: The bonds are selling at a premium to the par value.

a. Only Statement 1.
b. Both Statement 1 and 2.
c. Only Statement 2.
d. Neither Statement 1 nor Statement 2.

Answer: b

12. Benson Biometrics Inc., has outstanding \$1,000 face value 9% coupon bonds that make semiannual
payments, and have 14 years remaining to maturity. If the current price for these bonds is \$950.25,
what is the (annualized) yield to maturity?
a. 9.74%
b. 9.00%
c. 9.38%
d. 9.66%

Answer: d

13. Five years ago Bacon Signs Inc. issued twentyfiveyear 8% annual coupon bonds with a \$1,000 face
value each. Since then, interest rates in general have fallen and the yield to maturity on the Bacon
bonds is now 6%. Given this information, what is the price today for a Bacon Signs bond?
a. \$914.41
b. \$1,201.54
c. \$1,229.40
d. \$1,000

Answer: c

14. If Re denotes the required return on equity, g denotes the constant growth rate of dividends, and Dt
denotes the dividend in year t, the price of a stock at year 4 can be expressed as:
a. D0 / (Re + g).
b. D0 (1 + Re)5.
c. D1 (1 + Re)5.
d. D4/(Re g).
e. D5/(Re g).

Answer: e

15. A portfolio contains four assets. Asset 1 has a beta of 0.8 and comprises 30% of the portfolio.
Asset 2 has a beta of 1.1 and comprises 25% of the portfolio. Asset 3 has a beta of 1.5 and
comprises 25% of the portfolio. Asset 4 has a beta of 1.6 and comprises the remaining 20% of
the portfolio. If the riskless rate is expected to be 3% and the market risk premium is 6%, what
is the beta of the portfolio?
a. 0.80

b. 1.10
c. 1.19
d. 1.21

e. 1.40

Answer: d
16. You have \$10,000 to invest in a stock portfolio. Your choices are Stock X with an expected return of
13% and stock Y with an expected return of 10%. If your goal is to create a portfolio with an
expected return of 11.8%, how much money will you invest in Stock X?
a. \$11,000
b. \$ 9,000
c. \$ 8,000
d. \$ 6,000
e. \$ 3,000
Answer: d
17. Which one of the following is the slope of the security market line?
a. Riskfree rate
b. Market risk premium
c. Beta coefficient
d. Risk premium on an individual asset
e. Market rate of return
Answer: b
18. Which of the following statements is CORRECT?

a. An investor can eliminate virtually all systematic risk if he or she holds a very large and
well diversified portfolio of stocks.
b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent
in the portfolio.
c. Once a portfolio has about 40 stocks, adding additional stocks will reduce its risk by a
large amount.
d. An investor can eliminate virtually all diversifiable risk if he or she holds a very large,
welldiversified portfolio of stocks.
Answer: d

19. You find a certain stock that had returns of 14%, 27%, 19%, 21% and 20.5% for the last five
years. What is the (sample) standard deviation of the stock's returns?
a. 11.67%
b. 12.90%
c. 14.14%
d. 20.59%
Answer: d
20. Suppose the riskfree rate is 5%, the expected market return is 10% and the required rate of
return on Apples stock is 12%. What would be the beta of Apples stock?

a. 1
b. 1.4
c. 0.7
d. Cannot compute it since the market risk premium is not known.

Answer: b
21. As CFO of Young Turks Inc., you have the responsibility of selecting which projects your
company will invest in the coming fiscal year. Your total available budget for investment is
\$70,000. If you can choose from among the following 4 projects, which combination of
projects should you choose?

Project
Cost of Project
NPV of Project

a.
b.
c.
d.

10000

2200

15000

3750

23000

5400

30000

6100

A, B and C
A, B and D
B, C, and D
A, C and D

Answer: c

22. Geronimo, Inc. is considering a project that has an initial outlay of \$220,000. The respective
future cash inflows from its fouryear project for years 1 through 4 are: \$50,000, \$60,000,
\$70,000 and \$80,000. Geronimo uses the net present value method and has a discount rate of
11%. Will Geronimo accept the project?
a. Geronimo accepts the project because the NPV is greater than \$10,000.00.
b. Geronimo rejects the project because the NPV is about \$22,375.73.
c. Geronimo rejects the project because the NPV is about \$12,375.60.
d. Geronimo rejects the project because the NPV is about \$2,375.60.

Answer: b

23. Diesel Inc. is currently considering a six-year project that has an initial outlay or cost of \$60,000.
The future cash inflows from its project for years 1 through 6 are constant at \$20,000 per year.
Diesel has a discount rate of 12%. Because of concerns about funds being short to finance all good
projects, Diesel wants to compute the profitability index (PI) for each project. What is the PI for
Diesel's current project?
a.
b.
c.
d.

About 1.47
About 1.17
About 1.27
About 1.37

Answer: d
24. Dice, Inc. is considering a very risky five-year project that has an initial outlay or cost of \$70,000.
The future cash inflows from its project for years 1, 2, 3, 4, and 5 are constant at \$35,000 each year.

Dice uses the internal rate of return method to evaluate projects. Will Dice accept the project if its
required rate of return (hurdle rate) is 40.00%?
a. Dice will probably reject this project because its IRR is 39.74%, which is below its hurdle
rate.
b. Dice will probably accept this project because its IRR is about 41.04%, which is above its
hurdle rate.
c. Dice will accept this project because its IRR is 41.50%.
d. Dice will accept this project because its IRR is over 45.50%.
Answer: b
25. Which of the following statements about Net Present Value (NPV) and Internal Rate of Return
(IRR) is/are FALSE?
Statement 1: A unique IRR always exists for any cash flow pattern.
Statement 2: When we are choosing between two mutually exclusive projects, NPV and IRR
always give the same decision on which project to choose.
a. Only Statement 1
b. Only Statement 2
c. Both Statements 1 and 2
d. Neither Statement is false
Answer: c

26. The EBIT of a company is \$20,000, depreciation is \$5,000, taxes are \$3,000 and interest
expenses are \$2000. What is the operating cash flow (OCF)?

a. \$25,000
b. \$22,000
c. \$14,000
d. \$25,000
Answer: b

27. You are a financial analyst for Hittle Company. The expected net cash flows for Projects X and
Y are as follows:
Year
Project X
Project Y
0

\$10,000

\$10,000

6,500

3,500

3,000

3,500

3,000

3,500

1,000

3,500

The payback periods for projects X and Y are:
a. 2.17 years and 2.86 years, respectively.
b. 3 years for both projects.
c. 4 years and 3 years, respectively.
d. 2.83 years and 2.14 years, respectively.

Answer: a
28. Bacon Signs Inc., purchases a machine for \$70,000. This machine qualifies as a five-year recovery
asset under MACRS with the fixed depreciation percentages as follows: year 1 = 20.00%; year 2 =
32.00%; year 3 = 19.20%; year 4 = 11.52%, etc. The firm has a tax rate of 40%. If the machine is
sold at the end of two years for \$50,000, what is the cash flow from disposal?
a. \$50,000
b. \$43,440
c. \$39,875
d. \$33,600
Answer: b

29. Which of the following statements about the Weighted Average Cost of Capital (WACC) is TRUE?
a. When computing the weights for different sources of capital, the book values are preferable
to the market values.
b. The cost of debt for a company is computed as the ratio of interest expense in the income
statement to the total amount of debt outstanding.
c. The effect of taxes increases the cost of debt and makes debt financing less attractive for
corporations.
d. It is appropriate to use a companys WACC as the discount rate for projects of average risk.
Answer: d
30. Your firm intends to issue new common stock. Your investment bankers have determined that the
stock should be offered at a price of \$20.00 per share and that you should anticipate paying a
dividend of \$0.75 one year from today. If you anticipate a constant growth in dividends of 3.00%
per year, what is the required rate of return for this issue of new common stock? You may assume
there are no flotation costs.
a.
b.
c.
d.

3%
6.75%
3.75%
Not enough information to compute the required rate of return.

Answer: b

Section II: This Section comprises 4 questions worth 10 points each. Please write your answers in
the answer book provided to you.
1.

A. Explain whether the following statements are true or false: (No credit will be given
without explanation)

(2+2 = 4 Points)
i. A corporations primary objective should be to maximize its market share.

Answer: FALSE. A corporations primary objective should be to maximize shareholder value (stock price).

ii. An increase in the risk free interest rate tends to increase stock prices by
increasing the required rate of return on stocks.
Answer: FALSE. An increase in the risk free interest rate increases the required rate of return on stocks.
Hence the future cash flows are discounted at a higher rate, which decreases stock prices. (Other
explanations, such as those based on Gordon Growth model, also get full credit. In the GGM, the required
rate of return is in the denominator. As it increases, stock prices decline.)

B. After graduation, you accepted a job as an analyst at KPCG with a monthly salary of
\$24000. You expect to work there for exactly five years. Further assume that you
are able to earn a nominal APR of 6.0%, compounded monthly. What is the present
value of your income from the position at KPCG?

(3 Points)

Answer: N = 5 x 12 = 60, I/Y = 6/12 = 0.5, PMT = 24,000, CPTPV = 1,241,413.46. PV = \$1,241,413.46

C. You invest \$15,000 at an annual percentage rate of 8.25% for one year. How much
extra interest would you earn on your investment with quarterly compounding as
compared to annual compounding?
(3 Points)
Answer: With annual compounding, Interest Earned =15,000 x 0.0825= \$1,237.50.
Alternatively: N = 1, I/Y = 8.25, PV = 15,000, CPTFV = 16,237.5; Interest Earned = \$16,237.6
\$15,000 = \$1,237.5
With quarterly compounding, Interest Earned = 15,000 x 1 0.08254 4 1 =\$1,276.31
Alternatively: N = 4, I/Y = 8.25/4 = 2.0625, PV = 15,000, CPTFV = \$16,276.31; Interest Earned =
\$16,276.31 \$15,000 = \$1,276.31
Thus, the difference in interest earned is \$1,276.31 \$1,237.50 = \$38.81.

2.
A. Homer Co. just paid a \$1.20 dividend. The company expects dividends to grow at
40% for each of the next 3 years before settling into a constant 10% growth rate in
year 4 and beyond. If you require 14.6% return from the company, what price
should you pay for the companys stock today?
(5 Points)

Answer:
Ke
gl
gs

0.146
0.1
0.4

Time
1
2
3
3

Dividend/Value of Company
D0*(1+gs) =
D0*(1+gs)^2 =
D0*(1+gs)^3 =
D0*((1+gs)^3)*(1+gl)/(Ke-gl)=

1.680
2.352
3.293
78.741
Value of Company today =

Present Value
1.466
1.791
2.188
52.317
57.762

B. Microsoft Inc. is considering two potential upgrades of its current operating system
Windows 8.1 Evolution and Involution. The firm can choose only one of them for
implementation in the next generation of its products (that is, they are mutually
exclusive investments). Evolution will cost \$25 million to develop whereas
Involution will cost \$20 million (these development costs will be incurred in the
current year). Both operating systems have an estimated useful life of 5 years,
during which time the cash inflows for Evolution will be \$15 million per year and
those for the Involution will be \$12.5 million per year. The cost of capital that
applies to both projects is 11%.
i. Calculate the NPV and IRR for each operating system.
(3 points)
Answer: NPV for Evolution = 25 + 15/(1+0.11) + 15/(1+0.11)^2 + + 15/(1+0.11)^5
= \$30.44 Million;
NPV for Involution = 20 + 12.5/(1+0.11) + 12.5/(1+0.11)^2 + + 12.5/(1+0.11)^5
= \$26.20 Million
IRR for Evolution = 52.80%
IRR for Involution = 55.66%

## ii. Which operating system would you recommend Microsoft to adopt?

Explain your answer.

(2 points)
Answer: Since the systems are mutually exclusive, Microsoft can choose only
one of them. When NPV and IRR have a conflict of ranking, the NPV criterion is
strongly preferred due to its more realistic assumption about the reinvestment
rate compared with IRR. Hence Microsoft should select Evolution, which has the
higher NPV.

3. Angel Inc. is considering a new investment project and has gathered the following
relevant information:
The new equipment for this project will cost \$1.65 million dollars. It will be
sold at the end of the project for \$0.5 million.
The equipment belongs to the 3 Year Asset Class under MACRS and the
depreciation rates are as follows:
i. Year 1: 33.33%
ii. Year 2: 44.45%
iii. Year 3: 14.81%
iv. Year 4: 7.41%
The project will involve an increase in net working capital of \$250,000 in the
beginning, which can be recovered at the end of the project.
The project will last for 2 years. In each year, the revenue is estimated to be
\$6 million and production costs will be 45% of revenue. In addition, there
will be a fixed cost of \$90,000 each year.
Angel Inc.s tax rate is 30%.
Angel Inc.s WACC is 12%.

A. Calculate the cash flow for Year 0 (which is the current year). (1 Point)
Answer: Cash flow for Year 0 = Cost of new equipment plus increase in net working
capital = \$1.65 million \$0.25 million = \$1.9 million.
B. Calculate the operating cash flow for Year 1 and Year 2. Show your calculations.
(4 Points)
Answer: The numbers are in millions of \$)

Revenue

ProductionCost
FixedCost

Depreciation
EBIT

Tax

NetIncome

Depreciation
OperatingCashFlow

Year1
Year2
6,000,000.00 6,000,000.00
2,700,000.00 2,700,000.00
90,000.00
90,000.00
549,945.00733,425.00
2,660,055.00 2,476,575.00
798,016.50
742,972.50
1,862,038.50 1,733,602.50
549,945.00
733,425.00
2,411,983.50 2,467,027.50

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C. Calculate the nonoperating cash flow of Year 2 generated by the sale of the
equipment and recovery of working capital.

(3 Points)
Answer: Accumulated Depreciation = (0.3333+0.4445)*1,650,000 = \$1,283,370.00
Book Value = \$1,650,000 - \$1,283,370.00= \$366,630.00
Selling Price = \$500,000
Gain on disposal of equipment = \$500,000 \$366,630.00= \$133,370.00
Tax = 0.3 x \$133,370.00 = \$40,011.00
Cash Flow from Disposal = \$500,000 \$40,011.00 = \$459,989.00
Recovery of Net Working Capital = \$250,000.00
Non-Operating Cash Flow of Year 2 = \$459,989.00 + \$250,000.00 = \$709,989.00

D. Should Angel Inc. invest in this project? Explain your answer. (2 Points)
Answer: NPV = 1,900,000.00 + (2,411,983.50)/(1.12) + (3,177,016.50)/(1.12)^2 =
2,786,255.64

4. Gap Inc. currently has 50,000 of its 10% coupon bonds outstanding (Face value
=1000). The bonds pay interest semiannually, will mature in 15 years and are
currently priced at \$1,340 per bond. The firm also has an issue of 1.5 million
preferred shares outstanding with a market price of \$21.00. The preferred shares
offer a constant annual dividend of \$2.3 forever. Gap Inc. also has 3 million shares
of common stock outstanding with a price of \$40.00 per share. The firm is expected
to pay a \$4.50 common dividend one year from today, and that dividend is expected
to increase by 5 percent per year forever. The firm is subject to a 35 percent
marginal tax rate. You have been assigned to help the CEO of the company figure
out the WACC. Assume that there are no flotation costs.

A. Compute the firms beforetax and aftertax cost of debt. (2 + 1 points)
Answer: Beforetax Cost of debt is the YTM on outstanding bonds.
N = 15x2 = 30, PV = 1340, PMT = 100/2 = 50, FV = 1000, CPT I/Y = 3.216
Before tax cost of debt = YTM = 3.216*2 = 6.432% (2 Points)
After taxcost of debt = (10.35)*6.432% = 4.181% (1 Point)
B. Compute the firms cost of preferred shares.

(2 points)
Answer: Cost of preferred shares = \$2.3/21 = 10.95%
C. Compute the firms cost of equity.

(2 points)
Answer: Cost of equity = (4.5/40) + 0.05 = 16.25%
D. Compute the firms weighted average cost of capital.
(3 Points)
Answer: Total Market Value = \$67 + \$31.5 + \$120 = \$218.5 Million
Wd = 67/218.5 = 0.307; Wps = 31.5/218.5 = 0.144; We = 120/218.5 = 0.549
WACC = 0.307*4.181% + 0.144*10.95% + 0.549*16.25% = 1.284% + 1.577% + 8.921%
= 11.782%

End of the Exam

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