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BU393: Financial Management II

Winter 2011

Midterm Exam – Solutions

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Multiple Choice Questions Instructions: Choose the most correct answer for each of the following multiple choice questions. Indicate your choice by CLEARLY CIRCLING the letter that corresponds to your answer. There is only ONE best answer to each of these questions. No points will be awarded if ambiguous or multiple selections are made. Each question is worth 2 points. [Correct choice in bold red font] 1. An investment project is most likely to be accepted by the payback period rule and not

accepted by the NPV rule if: (a) the project has a very large initial investment with moderate positive cash flows over a

very long period of time. (b) the project has a very large negative cash flow at the termination of the project. (c) the project has a life smaller than the minimum payback period acceptable. (d) all projects approved by the payback period rule will be accepted by the NPV rule. (e) the payback period rule and the NPV rule cannot be used to evaluate the same type of

projects. 2. If independent projects A and B have the same IRR, which of the following is always true?

(a) If kA = kB, then NPVA = NPVB (b) If kA = kB, then PIA = PIB (c) If kA < kB, then NPVA > NPVB (d) If kA > kB, then NPVA > NPVB (e) None of the above.

3. For mutually exclusive projects, which of the following is always true about the NPV, IRR,

and PI decision rules? (a) All three give the same ranking of the projects. (b) IRR and PI give the same ranking of the projects. (c) NPV and incremental IRR give the same ranking of the projects. (d) Both (b) and (c). (e) None of the above.

4. IRR and NPV criteria always give the same conclusion when projects are______. These two

criteria may give different conclusions when projects are_______, and the underlying cause of such conflicts is that______. (a) independent; mutually exclusive; IRR ignores the scales of investment projects

while NPV correctly considers the sizes of projects. (b) mutually exclusive; under capital constraint; IRR ignores the scales of investment

projects while NPV correctly considers the sizes of projects. (c) independent; mutually exclusive; IRR assumes reinvestment at the internal rate of

return while NPV assumes reinvestment at the firm’s cost of capital. (d) mutually exclusive; independent; IRR assumes reinvestment at the internal rate of

return while NPV assumes reinvestment at the current market rate of return. (e) independent; under no capital constraint; IRR assumes reinvestment at the internal rate

of return while NPV assumes reinvestment at the firm’s cost of capital.

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5. Which of the following decision rule(s) is (are) incorrect?

I. If IIRR > k, prefer the bigger investment project (or the “challenger”); but accept the

bigger project only if its IRR < k. II. If IIRR < k, prefer the smaller investment project (or the “incumbent”); but accept the

smaller project only if its IRR < k. III. If IPI > 1, prefer the larger investment project; but accept the larger project only if its PI

> 1. IV. For a financing project, accept project only if NPV < 0.

(a) Statements I, II & III (b) Statements I & II (c) Statements II & IV (d) Statement II, III & IV (e) Statement I, II & IV

6. Projects X and Y are 5-year investment projects with positive cash flows at the end of each

of the five years following the initial investment. When discount rate is 3%, NPVX = $80 and NPVY = $40. When discount rate is 8%, NPVX = $20 and NPVY = $30. Which of the following statement is true? (a) IRRX > IRRY (b) IRRX = IRRY (c) IRRX < IRRY (d) It is possible that one or both IRR’s do not exist. (e) Impossible to say based on information provided.

7. A traditional investment project (with initial negative cash flow followed by positive future

cash flows) has a PI of 1.16. The initial investment in the project is $1 million. What is the NPV of the project? (a) $2.26M (b) $1.16M (c) $0.16M (d) $0 (e) None of the above

8. Which of the following statement(s) is (are) false?

I. A sunk cost remains the same whether or not you accept the project and therefore

should not be considered when evaluating a project. II. Overhead costs (like salaries of current employees) should be considered because they

represent incremental cash flows that are incurred by the firm. III. One has the flexibility to mix and match real and nominal cash flows while evaluating a

project.

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(a) Statements I & II (b) Statements I & III (c) Statements II & III (d) Statement II only (e) Statement III only

9. Financing costs are excluded as cash flows in NPV calculations because:

(a) There are multiple ways to obtain financing and choosing one particular method for including financing costs would almost certainly be wrong.

(b) Financing costs are not included in cash flow statements and therefore do not belong in NPV calculations.

(c) Discount rates implicitly include financing costs; consequently it is not correct to include financing costs as cash flows.

(d) The question is wrong because some projects do include financing costs, i.e., the financing projects.

(e) All of the above. 10. A project calls for an initial investment of $200 and is expected to yield real cash flows of

$110 and $121 in the next two years. The nominal discount rate is 12.20% and inflation is 2%. What is the NPV of the project? (a) –$11.50 (b) –$5.84 (c) $0 (d) $24.14 (e) None of the above

11. A firm purchases a new asset for $30,000 and sells an old asset for $32,000. The old asset

was purchased six years ago for $25,000. CCA rate is 30%. What is the CCA amount for the year after the purchase and sale activity? (a) –$600 (b) –$300 (c) $300 (d) $750 (e) $1,500

12. An asset was purchased five years ago and sold today, thereby terminating the asset pool.

Which of the following tax outcomes will never occur? (a) There is capital gains. (b) There is CCA recapture, but no capital gains. (c) There is capital gains, but no CCA recapture. (d) There is simultaneously capital gains as well as CCA recapture. (e) None of the above.

13. Which of the following is true about capital cost allowance (CCA)?

(a) CCA by itself is not an actual cash expense, but higher CCA rate often decreases project NPV.

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(b) CCA by itself is not an actual cash expense, but higher CCA rate often increases project NPV.

(c) CCA is an actual cash expense, and higher CCA rate often decreases project NPV. (d) CCA is an actual cash expense, and higher CCA rate often increases project NPV. (e) None of the above.

14. Project A has a life of 4 years and Project B has a life of 5 years. In order to compare the two

projects based on replacement chain methodology, you need to compute the NPV’s of the two projects over a time span of: (a) 1 year (b) 20 years (c) 40 years (d) either (b) or (c) (e) any of (a), (b) or (c)

15. The interest tax shield has no value for a firm when

I. the firm doesn’t pay corporate taxes.

II. the debt-equity ratio is exactly equal to 1. III. the firm has no debt. IV. the firm incurs operating losses. (a) Statements I & III only (b) Statements II & IV only (c) Statement I, III & IV only (d) Statement II, III & IV only (e) Statement I, II & IV only

16. Which of the following relationships is almost always true?

(a) kps < ke (b) WACCretained earnings < WACCnew equity (c) ke > kps > kd > ki (d) WACCfirms with no debt > WACCfirms with some debt (e) All of the above

17. A firm with both equity and debt currently has a WACC of 16.25%. It undertakes a 2:1 stock

split whereby the number of outstanding shares double and the price per share halves. The post-split WACC will most likely be: (a) smaller than 16.25% because stock prices are lower. (b) greater than 16.25% because number of shares double. (c) greater than 16.25% because stock splits improve the stock liquidity. (d) smaller than 16.25% because stock splits improve the stock liquidity. (e) impossible to say.

18. When a firm undertakes a new project which is very large in scale, the post-project WACC is

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typically higher than the pre-project WACC. Which of the following is not a valid reason that explains this phenomenon? (a) The firm’s retained earnings may not be sufficient to finance the new project. (b) The firm may need to resort to more expensive forms of financing, say, new equity. (c) The investors demand higher required rates of return. (d) IRR of a project is a function of the scale of the project, hence larger projects have

higher hurdle rates. (e) Cost of equity is likely to be higher because of the large volume of equity financing.

19. You will most likely use the pure-play approach to compute WACC for which of the

following projects? (a) Ford purchases three emission-purifiers from the sole government-approved vendor to

meet mandatory pollution control regulations. (b) Ford buys out a local vendor of car parts. (c) Ford expands the capacity of its Mustang assembly plant in its Detroit headquarters. (d) Ford launches the production of a new car model to be assembled in Mexico. (e) None of the above.

20. A long-term maturity bond with annual coupon rate of 8% is trading at 105% of the par

value. What can you say about the pre-tax cost of debt of this bond? (a) YTM > 8% (b) YTM = 8% (c) YTM < 8% (d) Insufficient information to answer (e) None of the above

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Numerical Problems

21. (9 points) Trustworthy Warehouse is evaluating between two industrial vacuum-cum-steam cleaners – ExcelModel and ProModel – to be used for maintenance operations. ExcelModel costs $20,000 to purchase and $3,000 per year to operate. It lasts for 7 years and has no salvage value. ProModel costs $10,000 to purchase and $5,000 per year to operate. It lasts for 5 years and has no salvage value. Purchasing and operating costs are not expected to change in future. All cash flows are quoted after-tax. Due to certain unique circumstances, the firm is not eligible for CCA tax shields. The firm’s weighted average cost of capital is 10%. Assuming that each cleaner is replaced when its useful life is over, which model will you recommend? No salvage, no tax implications, no change in NWC.

ExcelModel: ( ) ( )( )7$3,000 1 1.10

$20,000 $34,6050.10

NPV−− −

= − + = − [2 points]

( ) 7

$34,605 $7,1081 1.10

0.10

EANPV −−= = −

−

[2 points]

ProModel: ( ) ( )( )5$5,000 1 1.10

$10,000 28,9540.10

NPV−− −

= − + = − [2 points]

( ) 5

$28,954 $7,6381 1.10

0.10

EANPV −−= = −

−

[2 points]

The equivalent cost per year is $7,108 for ExcelModel and $7,638 for the ProModel. To lower costs, choose ExcelModel. [1 point]

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22. (11 points) Great Falls Refining Inc. bought Equipment M1 for $150,000 and Equipment S2 for $250,000 exactly twenty-five years ago (today is the first day of the 26th year from the point of initial purchase). Both equipments belong to the Class 8 assets with CCA rate of 20%. There was no other asset in Class 8 when these two equipments were purchased. After (exactly) 11 years of initial purchase, Equipment S2 was sold for $10,000, and Equipment M1 became the only Class 8 asset. Yesterday (at the end of 25th year), Equipment M1 was sold for $175,000. What is the current (post-sale) total tax liability of Great Falls Inc. if it has a tax rate of 32%? Equipments M1 and S2 were purchased at the beginning of year –25 (twenty-five years ago); S2 was sold at the end of year –15 (eleven years after initial purchase); M1 was sold just now.

When both M1 and S2 were purchased twenty-five years ago:

25_ $150,000 $250,000 $400,000begUCCP− = + = [1 point]

Just prior to the sale of S2 at the end of 11th year:

( ) ( )12 215_ $400,000* 1 0.1 * 1 0.2 $38,655endUCCP −− = − − = [2 points]

There is no tax implication arising from the sale of S2.

Revised UCCP following the sale of S2: [ ]14 _ $38,655 min $250,000; $10,000 $28,655 begUCCP− = − = [2 points]

Just prior to the sale of M1 yesterday after 14 years of being the sole asset in Class 8:

( )140 1_ $28,655 1 0.2 $1,260endUCCP UCCP−= = − = [2 points]

Since, for M1, SV > C > UCCP, there is capital gains as well as CCA Recapture.

Capital gains tax = 0.5 * ($175,000 – $150,000) * 0.32 = $4,000 [2 points]

CCA recapture tax = ($150,000 – $1,260) * 0.32 = $47,597 [1 point]

Total tax liability = $51,597 [1 point]

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23. (16 points) Abbott Industries currently has 5 million common shares trading at $25 each, 0.5 million preferred shares trading at $50 each, and 100,000 bonds trading at 90% of par. The bonds have a maturity of 20 years and pay semiannual coupons at 5.5%. The preferred shares pay annual dividends of $3.50 per share. The stock pays annual dividends; the recently paid dividend was $1.96 and dividends grow at a constant rate of 2%. In addition, the stock beta is 1.57, average risk free rate is 1%, and average return on market index is 7%. Abbott is considering undertaking a new project whose risk matches the risk of the firm. Retained earnings are insufficient to finance the new project. Abbott decides to issue new bonds, common stock and preferred shares with the same terms and features as the existing securities (that is, same bond maturity and coupon rate, and same dividend amounts and growth rate). The plan involves issuing 3,000 new bonds, 6,000 new preferred shares, and 280,000 new common shares. In response to the announcement that Abbott is planning to issue new securities, the prices of common shares and preferred shares drop by $1 and $2 respectively, and the prices of bonds drop by 1% of par. All new securities are issued at the lower market prices. In addition, the intermediary investment bank charges underwriting fees for issuing equity; these fees translate to $0.25 per share when all existing and new common shares are taken into account. What is the value of weighted average cost of capital (WACC) that Abbott needs to apply to evaluate the new project? Abbott’s tax rate is 28%. Capital structure of the firm (that is, relative market value proportions of the securities) and the component costs of capital need to be computed after taking into consideration the issuance of new securities. After the issuance of new securities, market value of equity = (5,000,000 + 280,000) * ($25 – $1) = $126.720M [2 points] market value of preferred stock = (500,000 + 6,000) * ($50 – $2) = $24.288M [2 points] market value of debt = (100,000 + 3,000) * (90% – 1%) * $1,000 = $91.670M [2 points] total market value of firm = $242.678M

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(PLEASE USE THIS PAGE TO CONTINUE PROBLEM 23)

Post-issuance costs of capital:

cost of preferred shares( )

$3.50 7.29%$50 $2

= =−

[2 points]

cost of debt (approx.)

( )

( )

$1,000 $890$27.50

40$1,000 $890

2

−+

=+

= 3.20% for ½ year; 6.40% per year

alternatively, cost of debt (approx.)

( )

( )

$1,000 $890$55

20$1,000 $890

2

−+

=+

= 6.40%

after-tax cost of debt = (1 – 0.28) * 6.40% = 4.61%

cost of equity (dividend discount method) ( )( )

$1.96* 1.022% 10.42%

$25 $1 $0.25= + =

− −

cost of equity (CAPM method) = 1% + 1.57 * (7% – 1%) = 10.42%

Weighted-average cost of capital, WACC

$91.670 $24.288 $126.720*4.61% *7.29% *10.42% 7.91%$242.678 $242.678 $242.678

= + + =

[3 points]

Either approach is acceptable…

[2 points]

Either approach is acceptable…

[3 points]

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24. (24 points) PixTel Inc. is considering replacing an old machine by a new one. The current market value for the existing machine is $30,000, it was purchased six years ago for $105,000. The new machine costs $90,000. If the new machine is adopted, it will reduce before-tax maintenance cost by $20,000 per year and save before-tax labor costs by $15,000 per year for ten years. These savings in costs would occur at year-end. The new machine will be housed in space that would have otherwise been rented out for $4,000 per year. Rental payments occur at the end of each year. At the end of the tenth year, the old machine is expected to have a resale value of $4,000. PixTel expects to sell the new machine for $10,000 after 10 years. There will be other assets in the asset pool after ten years. Replacement of the old machine will require that the firm set aside $30,000 towards initial working capital. At the end of the new machine’s life, 50% of this working capital will be recovered. The new as well as the old machines qualify for a CCA rate of 20 percent. The tax rate for PixTel is 35 percent and the appropriate discount rate is 10 percent. Should PixTel replace its old machine? Assuming that the old machine is the only one in its asset class, UCCP at the point of replacement (today) ( ) ( )5$105,000* 1 0.1 * 1 0.2 $30,966= − − = . If there are other assets in the asset pool, UCCP today will be even higher. So there is no tax outcome if the old asset is sold today. Incremental initial outlay, ∆I = –$90,000 + $30,000 = –$60,000 [2 points] Total cost savings (maintenance and labor costs) per year = $20,000 + $15,000 = $35,000 Present value of incremental post-tax operating cash flows, ∆PVATOCF

( ) ( ) ( )( )101 0.35 * $35,000 * 1 1.10

$139,7890.10

−− −= = [5 points]

Opportunity costs (lost rental proceeds) per year = –$4,000 Present value of post-tax lost opportunity costs, ∆PVATLOC

( ) ( ) ( )( )101 0.35 * $4,000 * 1 1.10

$15,9760.10

−− − −= = − [4 points]

Present value of incremental working capital changes, ∆PVNWC

( )10

$15,000$30,000 $24,2171 0.10

= − + = −+

[3 points]

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(PLEASE USE THIS PAGE TO CONTINUE PROBLEM 24)

Present value of incremental CCA tax shield benefits, ∆PVCCATS

( )10$60,000*0.20*0.35 1.05 1 $6,000*0.20*0.35 $12,824

0.10 0.20 1.10 0.10 0.201.10 = − = + +

[5 points] Present value of incremental salvage value, ∆PVSV

( )( )10

$10,000 $4,000$2,313

1 0.10−

= =+

[3 points]

There are no pool termination effects since there are other assets in the asset pool. Summing up all components, ∆NPV

= ∆I + ∆PVATOCF + ∆PVATLOC + ∆PVCCATS + ∆PVSV + ∆PVNWC = –$60,000 + $139,789 – $15,976 + $12,824 + $2,313 – $24,217 = $54,733

Since ∆NPV > 0, PixTel should replace its old machine. [2 points]