Midterm Exam

Name
CORPORATE VALUATION
Spring 2008

Multiple Choice -- Circle the letter of the BEST answer (3 points each)
1. Which of the following statements is MOST correct about a stock which has a beta of 1.2?
a. If the stocks beta doubles, its expected return will double.
b. If expected inflation increases 3%, the stocks expected return will increase by 3%.
c. If the markets risk premium increases by 3%, then the stocks expected return will
increase by 3%.
d. All of the above are true.
e. None of the above is true.
2. Project A has twice as much risk as the firm as a whole. The firms cost of capital is 12% and
the risk-free rate is 5%. The firm can borrow long-term debt at 8%. The appropriate riskadjusted discount rate for Project A is:
a.
b.
c.
d.
e.

10%
13%
16%
19%
None of the above

3. Which of the following statements is NOT true?

a. If the multiple IRR problem does not exist, any independent project acceptable by the
NPV method will also be acceptable by the IRR method.
b. If IRR = k (cost of capital), then NPV = 0.
c. The NPV can be negative if the IRR is positive.
d. The NPV method is not affected by the multiple IRR problem.
e. All of the above statements are true.
4. Which of the following statements is NOT correct?
a.
b.
c.
d.
e.

Sunk costs should be incorporated into capital budgeting decisions.

Opportunity costs should be incorporated into capital budgeting decisions.
Sales cannibalization effects should be considered in the capital budgeting decision.
All of the above are correct.
None of the above is correct.

5. Which of the following would increase the NPV of a project?

a. A shift from MACRS to straight-line depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three
years.
c. A decrease in the discount rate due to a decrease in overall interest rates.
d. The sale of the old machine in a replacement decision at a loss relative to book value
rather than at a gain.
e. None of the above would increase the NPV of a project.
6. As a general rule, the capital structure that
a.
b.
c.
d.

maximizes expected EPS also maximizes the price per share of common stock.
minimizes the interest rate on debt also maximizes the expected EPS.
minimizes the required rate of return on equity also maximizes the stock price.
maximizes the price per share of common stock also minimizes the weighted
average cost of capital at any given volume of financing.
e. None of the above.

7. Which of the following statements is most accurate?

a. Beta measures systematic risk, but if a firm's stockholders are not well diversified,
beta may not accurately measure the firm's total risk to the stockholders.
b. If the calculated beta underestimates the firm's true investment risk, then the CAPM
method will overstate ks.
c. The Discounted Cash Flow method of estimating the cost of equity (the Gordon, or
Dividend Valuation, model) can be used even if the growth component, g, is not constant
during the analysis period.
d. An advantage shared by both the Discounted Cash Flow and CAPM methods of
estimating the cost of equity capital is that they yield precise estimates and require little or
no judgment.
e. All of the above statements are accurate.
8. Diversification of risk
a.
b.
c.
d.
e.

is the elimination of unsystematic risk

is the elimination of systematic risk
is more effective for positively correlated assets than for negatively correlated assets
is unnecessary since only non-diversifiable risk is relevant
none of the above

9. When establishing the cash flows of a project for capital budgeting purposes
a.
b.
c.
d.
e.

depreciation should be ignored because it is not cash

increased receivable and inventory requirements must also be considered
total cash flows of the firm must be known
taxes can be ignored until after the Internal Rate of Return has been determined
none of the above is true

10. The text unlevers the observed beta of a firm as an estimate of the weighted average cost of
capital of the firm. In so doing, the text assumes that
a. the after-tax average cost of debt is independent of capital structure
b. the after-tax average cost of capital is independent of capital structure
c. leverage does not affect the risk of the firm
d. all of the above
e. none of the above
11. Today's Wall Street Journal quotes the yield on an inflation-indexed bond (principal is
adjusted semi-annually for changes in the Consumer Price Index) that matures in January of
2015 as 1.21% while a non-indexed bond maturing at the same time is priced to yield a
3.45% rate of return. What is the market expectation of the average annual rate of inflation
over this time period? (5 points)

2.213%

12. Your company's stock is currently selling for $65 per share. The dividends paid for the stock
over the past few years have been the following:
Date

Dividend

Feb 21, 2002

Feb 21, 2003
Feb 21, 2004
Feb 21, 2005
Feb 21, 2006
Feb 21, 2007
Feb 21, 2008

$ 3.00
3.15
3.15
3.48
3.60
3.75
4.02

If investors expect dividends to grow at approximately the same rate in the future as they
have in the past, what is their required rate of return? (10 points)

Growth rate = 5%
Required rate of return = 11.49%

13. You are considering replacing the orbital welding machine that attaches piping parts in the
product your company produces. The current welding machine has been plagued with
breakdowns which interrupt the work flow and cause stock-outs. Consequently, the profit
margin is being eroded by excessive start-up costs, lost sales, unused manpower and loss of
goodwill. A new welding machine has just come out on the market that is expected to be
much more efficient as well as welding a stronger joint that will lessen returns of product by
consumers. The marketing department estimates that the increase in the quality of the
product will cause sales to rise from an estimated $1,500,000 to $1,950,000 per year. The
production manager has estimated that the reduction in work force and fewer product returns
will increase the operating profit margin from 25% to 35%. The new machine costs $600,000
and will be depreciated over its three-year useful life using the MACRS schedule (33%, 45%,
15%, 7%) for 3-year assets. The new machine is expected to be worth $175,000 after three
years. The old welding machine was purchased two years ago for $350,000 and is also
being depreciated using the 3-year MACRS schedule. Although the old machine is
anticipated to have a salvage value of $40,000 three years from now, it can be sold today for
$130,000. The new machine will require an additional $60,000 of investment in working
capital initially, but this additional working capital will be recovered at the end of the third year.
The firm is in the 40% tax bracket and estimates its average cost of capital to be 10%.
Should the new machine be purchased? (20 points)

Net Cash Flows

NPV @ 10% = $187,295

Year 0

Year 1

Year 2

Year 3

$(551,200)

242,700

282,700

378,300

14. The Maxwell Company has the following balance sheet:

Total Assets

$ 4,000

L-T Debt (6%)

Common Stock ($1 par)
Retained Earnings

$ 2,000
400
1,600

Tot. Liab. & Equity

$ 4,000

No dividend is paid on the common stock. The stock is currently selling for $11 per share
and its historical beta is estimated to be 1.1 using daily price data. The current market rate
of interest on the debt is 6% and the current debt will mature in 10 years. Maxwell has a
40% tax rate. The expected return on the market is 10% and the risk-free rate is 3%.
A. What is the market value of the debt? What is the market value of the equity?
(5 points)
Value of debt =

$2,000

Value of equity = $4,400

B. What is the WACC for Maxwell? (5 points)
WACC = 8.48%

C. Maxwell plans to recapitalize by issuing $1,000 worth of additional ten-year debt paying
a coupon rate of interest of 7%, the estimated market rate of interest on all of its debt
following the financial restructuring. The proceeds of the debt issue will be used to
repurchase common stock of the company at a $12.50 tender price, the expected
market price of the stock following the repurchase. What will be the new WACC after
the recapitalization? (15 points)
Unlevered Beta = 0.864
New levered Beta = 1.24
New WACC = 8.55%

15. The theory of capital structure has undergone an evolutionary change over the years
beginning with Modigliani and Miller's original proposition (Figure 1). Describe the change in
thought about financial structure as depicted by the three diagrams below. (10 points)
%

ks

ks

ka

ka

kd

ka

kd

kd

D/E
Figure 1

ks

D/E
Figure 2

D/E
Figure 3