Review for Final--Corporation Finance
(1) A machine that costs $58,874 has the following cash inflows: Year 1=$10,000, Year 2 = $20,000, Year 3 = $30,000, and Year 4 = $40,000 The firm's cost of capital is 12%. (a) What is the payback period? [2.96 years] (b) What is the discounted payback period? [3.5 years](c) Solve for the NPV. [$12,773] (d) Calculate the IRR [20%]
(2) A machine that costs $4,271 has the following cash inflows: Year 1 = $1000, Year 2 = $2,000, Year 3 = 3,000. The firm’s cost of capital 12%. (a) What is the payback period? [2.42 years] (b) What is the discounted payback period? [ 2.84 years] (c) Solve for the NPV [ $352] (d) Solve for the NTV in year 3 [ $ 493] (e) Calculate the IRR [16%] (f) What is the profitability index? [ 1.082]
(3) Using the profitability index, which of the following projects would you choose if: (a) you have unlimited funds [all except G and H] (b) you have only $200,000 and you may invest in parts of projects [ A, B, 2/3 of C; NPV = $88,000] (c) you have $200,000 and cannot invest in parts of projects [ A, C, E].
Project |
Initial outlay |
NPV |
|---|---|---|
| A | $120,000 | $60,000 |
| B | 40,000 | 16,000 |
| C | 60,000 | 18,000 |
| D | 80,000 | 16,000 |
| E | 20,000 | 2,000 |
| F | 160,000 | 8,000 |
| G | 120,000 | 0 |
| H | 100,000 |
-5,000 |
(4) You are considering two mutually exclusive projects, A and B. Project A costs $89,760 and will return $40,000 in year 1, $35,300 in year 2, and $30,200 in year 3. Project B costs $53,530 and will return $25,000 in year 1, $22,000 in year 2, and $18,000 in year 3. Plot the NPV profiles and determine at which interest rate the crossover rate occurs [ 6%] (b) which project would you invest in if your cost of capital were 5%? [A] (c) which project would you invest in if your cost of capital were 8% [B] [The IRR for A is 9% and for B it is 11%.]
(5) A firm uses the adjusting the discount rate approach to adjust for risk. What is the expected NPV of the following project if the "riskless" cost of capital is 10% and projects with moderate risk are discounted by 12%, projects with high risk by 14%, and very high risk by 18%? The following project has been rated as moderate risk. Calculate the NPV. [-$336]
Cost=$12,600
YEAR ONE |
YEAR TWO |
||
|---|---|---|---|
Cash inflow |
Probability |
Cash inflow |
Probability |
| $10,000 | .30 | $10,000 | .40 |
| 8,000 | .60 | 8,000 | .20 |
| 4,000 | .10 | 2,000 | .30 |
| 0 | .10 | ||
(6) A firm uses the certainty equivalent approach to adjust for risk. What is the expected NPV of the following project if the certainty equivalent is .7 for the expected returns of both years and the cost of capital is 9%? [$545]
Cost=$8,000
YEAR ONE |
YEAR TWO |
||
|---|---|---|---|
Cash inflow |
Probability |
Cash inflow |
Probability |
| $8,000 | .30 | $10,000 | .30 |
| 6,000 | .20 | 8,000 | .60 |
| 4,000 | .50 | 6,000 | .10 |
(7) The Imbeciles Assoseation of Americka (IAA) is interested in determining their cost of capital. Compute the after tax cost of each of the following: Assume that the corporate tax rate is 35%. bond:
(a) An IAA 20-year bond with an 8% coupon and interest paid semi-annually. Investors paid $1,000 per bond but the underwriter received $172 per bond for flotation costs. [6.5%]
(b) IAA preferred stock paying a dividend of $4. The public paid $25 per share but flotation costs were $2 per share. [17.4%]
(c) IAA common stock is issued at a price of 65. Flotation costs were 6% of the market price and dividends will be $3.00 in one year and are expected to grow at a rate of 4% per year. [8.9%]
(d) The cost of retained earnings at IAA [8.6%]
(8) What is the weighted cost of capital for the IAA Corporation? It consists of 50% debt, 30% preferred, and 20% common. The cost of debt =12%, cost of preferred=14%, and the cost of common=16%. [13.4%]
(9) What is the cost of not taking a cash discount if the terms are 2.5/10 net 60: [18.72%]
(10) [You may not be responsible for calculation of the standard deviation. Check with me in class.] What is the expected return and standard deviation of a portfolio that is invested 50% in Stock A and 50% in Stock B? [13.6% and .8%]
State |
Prob (state) |
Exp.Returns-A | Exp.Returns-B |
|---|---|---|---|
Prosperity |
.80 |
20% |
8% |
Recession |
.20 |
6% |
18% |
(11) Using CAPM, what return should be required for IAA stock. Its beta is 1.20, the risk-free rate (T-bills) is 6% and the rate of return on the market portfolio (S&P 500) is 20%? [22.8%]
(12) The Schmendrick Technology Company has sales this year of $360,000, total variable cost of $210,000, and fixed cost of $100,000. What is its breakeven point in sales? [$240,000]
(13) The Schlemiel Consulting Company had sales this year of $880,000, total variable cost= $90,000, and fixed cost=$500,000. Calculate the degree of operating leverage at the current sales level of $880,000. [2.72]
Some terms that you should know:
Risk premium, efficient markets hypothesis, (3 form of market efficiency): strong form efficient, semistrong efficient, weak form efficient, dominance principle, diversification, total risk, systematic risk, unsystematic risk, beta of stock, CAPM, optimal capital structure, net income approach vs. net operating income (EBIT) approach, Modigliani and Miller, breakeven point, operating leverage.
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(C)1998 copyright Dr. H. H. Friedman