Finacial Analysis and Management

FINACIAL ANALYSIS AND MANAGEMENT
SAMPLE QUESTIONS AND ANSWERS
Capital budgeting Techniques
Question 8
Your aunt places $13,000 into an account earning an interest rate of 7% per year. After 5 years the
account will be valued at $18,233.17. Which of the following statements is correct?
A) The present value is $13,000, the time period is 7 years, the present value is $18,233.17, and the
interest rate is 5%.
B) The future value is $13,000, the time period is 5 years, the principal is $18,233.17, and the interest
rate is 7%.
C) The principal is $13,000, the time period is 5 years, the future value is $18,233.17, and the interest
rate is 7%.
D) The principal is $13,000, the time period is 7 years, the future value is $18,233.17, and the interest
rate is 5%.
Answer: C
Question 9
An investment of $100 today is worth $116.64 at the end of two years if it earns an annual interest rate of
8%. How much interest is earned in the first year and how much in the second year of this investment?
A) The interest earned in year one is $8.32 and the interest earned in year two is $8.32.
B) The interest earned in year one is $8.00 and the interest earned in year two is $8.64.
C) The interest earned in year one is $8.64 and the interest earned in year two is $8.00.
D) There is not enough information to solve this problem.
Answer: B
Comment: FV = PV*(1 + r)n = $100*(1.08)1 - $100 = $8.00 and
$108(1.08)1 - $100 = $8.64
Advanced Aspects of Capital Budgeting 1

Question 10
Discounted payback period. Given the following four projects and their cash flows, calculate the
discounted payback period with a 5% discount rate, 10% discount rate, and 20% discount rate. What do
you notice about the payback period as the discount rate rises? Explain this relationship.
Cash Flow A B C D
Cost $10,000 $25,000 $45,000 $100,000
Cash Flow Year 1 $ 4,000 $ 2,000 $10,000 $ 40,000
Cash Flow Year 2 $ 4,000 $ 8,000 $15,000 $ 30,000
Cash Flow Year 3 $ 4,000 $14,000 $20,000 $ 20,000
Cash Flow Year 4 $ 4,000 $20,000 $20,000 $ 10,000
Cash Flow Year 5 $ 4,000 $26,000 $15,000 $ 10,000
Cash Flow Year 6 $ 4,000 $32,000 $10,000 $ 0
258 Brooks • Financial Management: Core Concepts
©2010 Pearson Education, Inc. Publishing as Prentice Hall
Answer: Solution at 5% discount rate
Project A:
PV Cash flow year one—$4,000/1.05 $3,809.52
PV Cash flow year two—$4,000/1.052 $3,628.12
PV Cash flow year three—$4,000/1.053 $3,455.35
PV Cash flow year four—$4,000/1.054 $3,290.81
PV Cash flow year five—$4,000/1.055 $3,134.10
PV Cash flow year six—$4,000/1.056 $2,984.86
Discounted Payback Period: $10,000 $3,809.52 $3,628.12 $3,455.35 $892.99 and fully recovered
Discounted Payback Period is 3 years
Project B:
Discounted Payback Period: $25,000 $1,904.76 $7,256.24 $12,093.73 $16,454.05 $12,708.78

and fully recovered Discounted Payback Period is 4 years.
Project C:
Discounted Payback Period: $45,000 $9,523.81 $13,605.44 $17,276.75 $16,454.05 $11,860.05

Chapter 9 Capital Budgeting Decision Models 259
Project D:

PV Cash flow year six—$0/1.056 $0
Discounted Payback Period: $100,000 $38,095.24 $27,210.88 $17,276.75 $8,227.02

$7,835.26 $1,354.84 and NEVER fully recovered Discounted Payback Period is 5 years.
Solution at 10% discount rate
Project A:
Discounted Payback Period: $10,000 $3,636.36 $3,305.79 $3,005.26 $2,732.05 $2,679.46 and
fully recovered Discounted Payback Period is 4 years.
Project B:
Discounted Payback Period: $25,000 $1,818.18 $6,611.57 $10,518.41 $13,660.27 $7,608.43

Project C:
Discounted Payback Period: $45,000 $9,090.91 $12,396.69 $15,026.20 $13,660.27 $5174.07

Project D:
Discounted Payback Period: $100,000 $36,363.64 $24,793.39 $15,026.30 $6,830.13 $6,209.21

$10,777.33 and never recovered Initial cash outflow is never recovered.
Solution at 20% discount rate
Project A:

Discounted Payback Period: $10,000 $3,333.33 $2,777.78 $2,314.81 $1,929.01 $354.93 and
fully recovered Discounted Payback Period is 4 years.
Project B:
Discounted Payback Period: $25,000 $1,666.67 $5,555.56 $8,101.85 $9,645.06 $10,448.82

$10,417.96 and fully recovered
Discounted Payback Period is 5 years.
Project C:
Discounted Payback Period: $45,000 $8,333.33 $10,416.67 $11,574.07 $9,645.06 $6,028.16

$997.29 and fully recovered Discounted Payback Period is 5 years.
Project D:
Discounted Payback Period: $100,000 $33,333.33 $20,833.33 $11,574.07 $4,822.53

$4,018.78 $25,417.95 and initial cost is never recovered Discounted Payback Period is infinity.
As the discount rate increases, the discounted payback period also increases. The reason
is that the future dollars are worth less in present value as the discount rate increases,
requiring more future dollars to recover the present value of the outlay.
Question 11
Net present value. Quark Industries has a project with the following projected cash flows:
Initial Cost, Year 0: $240,000
Cash flow year one: $ 25,000
Cash flow year two: $ 75,000
Cash flow year three: $150,000
Cash flow year four: $150,000
a. Using a 10% discount rate for this project and the NPV model, determine whether this
project should be accepted or rejected.
b. Should it be accepted or rejected using a 15% discount rate?
c. Should it be accepted or rejected using a 20% discount rate?
Answers:
a. NPV $240,000 $25,000/1.10 $75,000/1.102 $150,000/1.103 $150,000/1.104
NPV $240,000 $22,727.27 $61,983.47 $112,697.22 $102,452.02
NPV $59,859.98, and accept the project.
b. NPV $240,000 $25,000/1.15 $75,000/1.152 $150,000/1.153 $150,000/1.154
NPV $240,000 $21,739.13 $56,710.76 $98,627.43 $85,762.99
NPV $22,840.31, and accept the project.
c. NPV $240,000 $25,000/1.20 $75,000/1.202 $150,000/1.203 $150,000/1.204
NPV $240,000 $20,833.33 $52,083.33 $86,805.56 $72,337.96
NPV $7,939.82, and reject the project.
Advanced Aspects of Capital Budgeting 2
Question 12
Profitability Index. Given the discount rates and the future cash flows of each project, which
projects should they accept using profitability index?
Cash Flow Project U Project V Project W Project X
Year 0 $2,000,000 $2,500,000 $2,400,000 $1,750,000
Year 1 $ 500,000 $ 600,000 $1,000,000 $ 300,000
Year 2 $ 500,000 $ 600,000 $ 800,000 $ 500,000
Year 3 $ 500,000 $ 600,000 $ 600,000 $ 700,000
Year 4 $ 500,000 $ 600,000 $ 400,000 $ 900,000
Year 5 $ 500,000 $ 600,000 $ 200,000 $1,100,000
Discount rate 6% 9% 15% 22%
Answer: Find the present value of benefits and divide by the present value of the costs for each
project.
Project U’s PV Benefits $500,000/1.05 $500,000/1.052 $500,000/1.053 $500,000/1.054
$500,000/1.055
Project U’s PV Benefits $471,698.1 $444,998.2 $419,809.60 $396,046.8$373,629.1

$2,106,182
Project U’s PV Costs $2,000,000
Project U’s PI $2,106,182/$2,000,000 1.053; accept project.
Project V’s PV Benefits $600,000/1.09 $600,000/1.092 $600,000/1.093 $600,000/1.094

$600,000/1.095
Project V’s PV Benefits $2,000,000 $550,458.72 $505,008.00 $463,331.09 $425,055.13

$389,958.83 $2,333,790.77
Project V’s PV Costs $2,500,000
Project V’s PI $2,333,790.77/$ 2,500,000 0.9335; reject project.
Project W’s PV Benefits $1,000,000/1.15 $800,000/1.152 $600,000/1.153 $400,000/1.154

$200,000/1.155
Project W’s PV Benefits $869,565.22 $604,914.93 $394,509.74 $228,701.30 $99,435.34

$2,197,126.53
Project W’s PV Costs $2,400,000
Project W’s PI $2,197,126.53/$2,400,000 0.9155; reject project.
Project X’s PV Benefits $2,000,000 $300,000/1.22 $500,000/1.222 $700,000/1.223

$900,000/1.224 $1,100,000/1.225
Project X’s PV Benefits $2,000,000 $245,901.64 $335,931.20 $385,494.82 $406,259.18

$406,999.18 $1,780,586.02
Project X’s PV Cost $1,750,000
Project X’s PI $1,780,586.02/$1,750,000 1.0175; accept project.

Cost of Capital – equity, debt, WACC
Question 13
WACC. Eric has another get-rich-quick idea, but needs funding to support it. He chooses an
all-debt funding scenario. Eric will borrow $2,000 from Wendy, who will charge him 6% on the
loan. He will also borrow $1,500 from Bebe, who will charge 8% on the loan, and $800 from
Shelly, who will charge 14% on the loan. What is the weighted average cost of capital for Eric?
Answer: Total funds borrowed $2,000 $1,500 $800 $4,300
WACC ($2,000/$4,300) 0.06 ($1,500/$4,300)
0.08 ($800/$4,300) 0.14
WACC 0.4651 0.06 0.3488 0.08 0.1860 0.14
WACC 0.0279 0.0279 0.0260 0.0819 or 8.19%
Question 14
WACC. Grey’s Pharmaceuticals has a new project that will require funding of $4 million. The
company has decided to pursue an all-debt scenario. Grey’s has made an agreement with four
lenders for the needed financing. These lenders will advance the following amounts and interest
rates:
Lender Amount Interest Rate
Stevens $1,500,000 11%
Yang $1,200,000 9%
Shepherd $1,000,000 7%
Bailey $ 300,000 8%
What is the weighted average cost of capital for the $4,000,000?

Answer: WACC ($1.5/$4) 0.11 ($1.2/$4) 0.09 ($1/$4) 0.07 ($0.3/$4) 0.08
WACC 0.375 0.11 0.3 0.09 0.25 0.07 0.075 0.08
WACC 0.04125 0.0270 0.0175 0.0060 0.09175 9.175%
The Capital Asset Pricing Models and its Variants
Question 15
Cost of Equity: SML. Stan is expanding his business and he will sell common stock for the
needed funds. If the current risk-free rate is 4% and the expected market return is 12%, what
is the cost of equity for Stan if the beta of the stock is:
a. 0.75?
b. 0.90?
c. 1.05?
d. 1.20?
Answer: a. Using the security market line, we have
E(ri) rf [E(rm) rf] i
Cost of Equity E(ri) 0.04 (0.12 0.04) 0.75
Cost of Equity 0.04 (0.08) 0.75 0.04 0.06 0.10 or 10%
b. Using the security market line, we have
E(ri) rf [E(rm) rf] i
Cost of Equity 0.04 (0.08) 0.90 0.04 0.072 0.112 or 11.2%
c. Using the security market line, we have
E(ri) rf [E(rm) rf ] i

Cost of Equity 0.04 (0.08) 1.05 0.04 0.084 0.124 or 12.4%
d. Using the security market line, we have
E(ri) rf [E(rm) rf] i
Cost of Equity 0.04 (0.08) 1.20 0.04 0.096 0.136 or 13.6%
Question 16
Cost of Equity: SML. Stan had to delay the sale of the common stock as outlined in Problem 9
for six months. When he finally did sell the stock, the risk-free rate had fallen to 3%, but the
expected return on the market had risen to 13%. What was the effect on the cost of equity by
waiting six months, using the four different betas from Problem 9? What do you notice about
the increases in the cost of equity as beta is increased?
Answer: a. The new rate is
Cost of Equity 0.03 (0.10) 0.75 0.03 0.075 0.105 or 10.5%
and is an increase of 0.5% over the original cost of equity.
b. The new rate is
Cost of Equity E(ri) 0.03 (0.13 0.03) 0.90
Cost of Equity 0.03 (0.10) 0.90 0.03 0.09 0.12 or 12%
c. The new rate is
Cost of Equity 0.03 (0.10) 1.05 0.03 0.105 0.135 or 13.5%

d. The new rate is
Cost of Equity 0.03 (0.10) 1.20 0.03 0.12 0.15 or 15%
The increases are growing but growing at a constant rate of 0.3% as you raise the beta
by 0.15 units or a ratio of 2% over the change in the beta.
Source of Finance 2
Question 17
What is the difference between an angel investor and a venture capitalist? What event do these
investors want to see happen? Why?
Angel investors are lenders who provide funding for new, high-risk ideas. The term does not refer to
a well-defined set of lenders but rather is a generic term applied to individuals or groups that seek to
support new start-up business ventures. As such, an angel financier is usually a wealthy individual.
Like angel investors, venture capitalists are not a well-defined group of lenders, but rather a general
term applied to groups or institutions that provide funding at a level higher (larger loans) than that of
most angel investors. Both these lenders want to see a liquidity event where they are repaid their
initial investment plus a large profit.
Question 18
What is the role of an investment bank in selling stock?
The investment bank becomes a partner of the company as it guides the company through the selling
process. As part of its role as a partner in the process, an investment bank is required to perform due
diligence in making sure that all information released during the process is accurate and that all
material information has been released. Failing to perform this due-diligence task puts the investment
bank and the company at risk for litigation after the sale of the stock.
Question 19
Equity value in a levered firm. Air America has an annual EBIT of $1,000,000, and the WACC
in the unlevered firm is 20%. The current tax rate is 35%. Air America will have the same
EBIT forever. If the company sells debt for $2,500,000 with a cost of debt of 20%, what is the
value of equity in the unlevered and in the levered firm? What is the value of debt in the
levered firm? What is the government’s value in the unlevered firm and in the levered firm?
Answer:
Present Value of Cash Flow EBIT/WACC ($1,000,000/0.20) $5,000,000
VE $5,000,000(1 0.35) $3,250,000
VL VE (D TC)
$3,250,000 ($2,500,000 0.35) $4,125,000
i.e., (E D): $1,625,000 $2,500,000)
Government’s value:
Unlevered: $5,000,000 0.35 $1,750,000
Levered: ($5,000,000 $2,500,000) 0.35 $2,500,000 0.35 $875,000
Question 20
A company is considering diversifying with a project in a new industry.The company’s capital structure is
60% debt and 40% equity and will not change. The debt is 9% debentures, redeemable at par (£100) after
10 years with a current market value of £90. Any new debt will have the same cost which is currently
8%.Tax rate is 30% and its ordinary shares are currently trading at 445 pence. The equity beta is 1.21.
The systematic risk of the debt may be assumed to be zero. The risk free rate is 5.75% and market return
11%.The estimated equity beta of a company in the same industry as the business is 1.5 and its capital
gearing is 35% equity and 65% debt.
Required:
1. Calculate a project-specific discount rate.
2. Discuss the problems that may be encountered in using CAPM.
3. Explain briefly the order companies prefer to raise finance in.

Answers
1. Obtain a project specific beta value by using the beta of a similar company. This beta needs to be
adjusted to remove the similar company’s financial risk and then regeared it to take into account the
companys financial risk.
Ungear to remove similar company’s financial risk
βassets = βequity * E/[E+D(1-t)]
= 1.5 x 35/[35+65(1-.3) = 0.652
Regear for the companys financial risk
0.652 = βe x 40/[40+60(1-.30)]
βe = 0.652/0.48780 = 1.3366
Re = 5.75% + (11-5.75%)1.337 = 12.77%
WACC = [12.77% x 40%) + ( 8%x 60%) = 9.9%
2. The discount rate has been calculated using the capital asset pricing model.
The CAPM produces a required return based on the expected return of the market, the risk-free interest
rate and the variability of project returns relative to the market returns (beta).
Its main advantage when used for investment appraisal is that it produces a discount rate which is based
on the systematic risk of the individual investment. Systematic risk is the market risk which cannot be
diversified away. It can be used to compare projects of all different risk classes and is therefore superior
to an NPV approach which uses only one discount rate for all projects, regardless of their risk.
Practical problems
 Problems in estimating – it is hard to estimate returns on projects under different economic

environments, market returns under different economic environments and the probabilities of the
various environments
 Single period model – the CAPM is really just a single period model. Few investment projects
last for one year only and to extend the use of the return estimated from the model to more than
one time period would require both project performance relative to the market and the economic
environment to be reasonably stable.
 Complications over time – in theory it should be possible to apply the CAPM for each time
period, thus arriving at successive discount rates, one for each year of the project’s life. In
practice, this would exacerbate the estimation problems mentioned above and also make the
discounting process much more cumbersome.
 Risk-free rate – it may be hard to determine the risk-free rate of return. Government securities are
usually taken to be risk-free but the return on these securities varies according to their term to
maturity.
 Beta formula – there are also problems with using the geared and ungeared beta formula for
calculating a firm’s equity beta from data about other firms. It is difficult to identify other firms
with identical operating characteristics and there may be differences in beta values between firms
caused by different cost structures or size differences between firms.
3. Firms will prefer retained earnings to any other source of finance, and then will choose debt and last
of all equity. Businesses will try to match investment opportunities with internal finance provided
this does not mean excessive changes in dividend payout ratios. If there is a deficiency of internal
funds, external finance will be issued starting with debt. Establishing an ideal debt-equity mix will be
problematic, since internal equity funds will be the first source of finance that businesses choose, and
external equity funds the last.

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FINACIAL ANALYSIS AND MANAGEMENT

SAMPLE QUESTIONS AND ANSWERS

Capital budgeting Techniques

Advanced Aspects of Capital Budgeting 1

Cost $10,000 $25,000 $45,000 $100,000

Cash Flow Year 1 $ 4,000 $ 2,000 $10,000 $ 40,000

Cash Flow Year 2 $ 4,000 $ 8,000 $15,000 $ 30,000

Cash Flow Year 3 $ 4,000 $14,000 $20,000 $ 20,000

Cash Flow Year 4 $ 4,000 $20,000 $20,000 $ 10,000

Cash Flow Year 5 $ 4,000 $26,000 $15,000 $ 10,000

Cash Flow Year 6 $ 4,000 $32,000 $10,000 $ 0

258 Brooks • Financial Management: Core Concepts

©2010 Pearson Education, Inc. Publishing as Prentice Hall

Answer: Solution at 5% discount rate

PV Cash flow year one—$4,000/1.05 $3,809.52

PV Cash flow year two—$4,000/1.052 $3,628.12

PV Cash flow year three—$4,000/1.053 $3,455.35

PV Cash flow year four—$4,000/1.054 $3,290.81

PV Cash flow year five—$4,000/1.055 $3,134.10

PV Cash flow year six—$4,000/1.056 $2,984.86

Discounted Payback Period is 3 years

PV Cash flow year two—$8,000/1.052 $7,256.24

PV Cash flow year three—$14,000/1.053 $12,093.73

PV Cash flow year four—$20,000/1.054 $16,454.05

PV Cash flow year five—$26,000/1.055 $20,371.68

PV Cash flow year six—$32,000/1.056 $23,878.89

Discounted Payback Period: $25,000 $1,904.76 $7,256.24 $12,093.73 $16,454.05 $12,708.78

PV Cash flow year one—$10,000/1.05 $9,523.81

PV Cash flow year two—$15,000/1.052 $13,605.44

PV Cash flow year three—$20,000/1.053 $17,276.75

PV Cash flow year four—$20,000/1.054 $16,454.05

PV Cash flow year five—$15,000/1.055 $11,752.89

PV Cash flow year six—$10,000/1.056 $7,462.15

Discounted Payback Period: $45,000 $9,523.81 $13,605.44 $17,276.75 $16,454.05 $11,860.05

Chapter 9 Capital Budgeting Decision Models 259

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PV Cash flow year one—$40,000/1.05 $38,095.24

PV Cash flow year two—$30,000/1.052 $27,210.88

PV Cash flow year three—$20,000/1.053 $17,276.75

PV Cash flow year four—$10,000/1.054 $8,227.02

PV Cash flow year five—$10,000/1.055 $7,835.26

Discounted Payback Period: $100,000 $38,095.24 $27,210.88 $17,276.75 $8,227.02

Solution at 10% discount rate

PV Cash flow year one—$4,000/1.10 $3,636.36

PV Cash flow year two—$4,000/1.102 $3,305.79

PV Cash flow year three—$4,000/1.103 $3,005.26

PV Cash flow year four—$4,000/1.104 $2,732.05

PV Cash flow year five—$4,000/1.105 $2,483.69

PV Cash flow year six—$4,000/1.106 $2,257.90

PV Cash flow year one—$2,000/1.10 $1,818.18

PV Cash flow year two—$8,000/1.102 $6,611.57

PV Cash flow year three—$14,000/1.103 $10,518.41

PV Cash flow year four—$20,000/1.104 $13,660.27

PV Cash flow year five—$26,000/1.105 $16,143.95

PV Cash flow year six—$32,000/1.106 $18,063.17

Discounted Payback Period: $25,000 $1,818.18 $6,611.57 $10,518.41 $13,660.27 $7,608.43

260 Brooks • Financial Management: Core Concepts

©2010 Pearson Education, Inc. Publishing as Prentice Hall

PV Cash flow year two—$15,000/1.102 $12,396.69

PV Cash flow year three—$20,000/1.103 $15,026.30

PV Cash flow year four—$20,000/1.104 $13,660.27

PV Cash flow year five—$15,000/1.105 $9,313.82

PV Cash flow year six—$10,000/1.106 $5,644.74