Types of Questions for Quiz 2

Section 1: Exercises on WACC

Question 1. Consider the following information:

Scrumptious Cookies, a national banking franchise has decided to professionalize its project
evaluation. Previously, franchise locations had been selected on an ad hoc basis with mixed
results. The managing director has decided that Net Present Value is the best method for the
analysis.

You have been given the task of determining the WACC after tax of the firm. You are
told that the firm has used the following securities to finance its operations.
 Four hundred thousand (400,000) ordinary shares, issued at a par value of $1.50. The beta
of Scrumptious Cookies is 1.5, the risk-free rate is currently 4% per annum, and the
expected return on the market is 10% per annum. Scrumptious Cookies is expected to pay
a dividend of 10 cents per share next year, and has an expected growth rate of 8% per
annum.

 An overdraft of $300,000. The current interest rate on the overdraft is 9.5% per annum
with interest calculated on a monthly basis.

 Debentures with four years to maturity. The debentures offer a coupon of 8% per annum,
paid half yearly, (the coupon is calculated on the face value). The face value of the
debentures is $300,000, and the current market interest rate for these securities is 10% per
annum, calculated half yearly.

 A zero-coupon bond with face value of $150,000, the current market value of the zero-
coupon bond is $73,790.06. Assume interest is calculated on the bond on a quarterly basis.
The bond will mature in six years’ time.

 Tax is 33% per annum.

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Question 2. Consider the following information:
Extract of the Balance Sheet as at 30 June 2021:
Issued Capital $ Million
6,000,000 Ordinary shares of $1 fully paid 6.0
3,000,000 8% Preference Shares of $1.00 fully paid 4.0
Current Liabilities and
Provisions
Bank Overdraft: 5.0
Trade Creditors: 5.0
Unsecured Notes: 8.0
Non-Current Liabilities
Debentures: 12.0
Term Loans: 10.0
Mortgage: 24.0
You also have the following additional information available to you:
1. Term loans have a current interest rate of 6% p.a., but were negotiated at an
interest rate of 9% p.a. and are repayable in full in four years’ time. Servicing
the term loans consists of regular twice a year interest payments with the
principal repaid at maturity.
2. Unsecured notes will mature in five months and will not be replaced. They are
short-term sources of funds not typical of the firm. They have a current interest
rate of 5.5% p.a.
3. Debentures have a coupon interest rate of 10% p.a. and could be re-issued at
the present time at an interest rate of 8.0% p.a. The debentures will be redeemed
at their face value in four years’ time.
4. The mortgage loan is repayable in six years’ time and its current interest rate
is 7.0% p.a. It was negotiated at 12% p.a.
5. The company’s preference shares are currently trading at $2.50. The
company’s ordinary shares are trading at $4.00.
6. Scully Ltd. has a beta of 1.4, the risk-free rate of return is 6.5% p.a, and the
average market return is 9.5% p.a.
7. The current interest rate on the bank overdraft is 6% per annum and the
average market return is 9.5% per annum.
8. The current interest rate on the bank overdraft is 6% per annum.
9. Interest on all debt securities is paid twice yearly and the corporate tax rate is
33 percent.
Required:
(2a) Identify the various items that need to be included in the capital base to
calculate the WACC.
(2b) Calculate the market value of the various items identified in (a), the
value of the firm and the relative weight of each item in the firm’s capital
structure.
(2c) Calculate the required after-tax effective rate of return of each item
identified in (a).
(2d) Calculate the WACC.
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3. A company has $5 million in debt outstanding with a coupon rate of 12%. Currently,
the yield to maturity (YTM) on these bonds is 14%. If the firm's tax rate is 40%, what is
the company's after-tax cost of debt?
A. 5.6%.
B. 8.4%.
C. 14.0%.

4. The cost of preferred stock is equal to:

A. the preferred stock dividend divided by its par value.
B. [(1 - tax rate) times the preferred stock dividend] divided by price.
C. the preferred stock dividend divided by its market price.

5. A company's $100, 8% preferred is currently selling for $85. What is the company's
cost of preferred equity?
A. 8.0%.
B. 9.4%.
C. 10.8%.

6. The expected dividend is $2.50 for a share of stock priced at $25. What is the cost of
equity if the long-term growth in dividends is projected to be 8%?
A. 15%.
B. 16%.
C. 18%.

7. An analyst gathered the following data about a company:

Capital structure Required rate of return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn
on its investments?
A. 13.0%.
B. 14.2%.
C. 18.0%.

8. A company is planning a $50 million expansion. The expansion is to be financed by

selling $20 million in new debt and $30 million in new common stock. The before-tax
required return on debt is 9% and 14% for equity. If the company is in the 40% tax
bracket, the company's marginal cost of capital is closest to:
A. 7.2%.
B. 10.6%.
C. 12.0%.

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Use the following data to answer Questions 9 through 12.
 The company has a target capital structure of 40% debt and 60% equity. Bonds
with face value of $1,000 pay a 10% coupon (semiannual), mature in 20 years,
and sell for $849.54 with a yield to maturity of 12%.
 The company stock beta is 1.2.
 Risk-free rate is 10%, and market risk premium is 5%.
 The company is a constant-growth firm that just paid a dividend of $2, sells for
$27per share, and has a growth rate of 8%.
 The company's marginal tax rate is 40%.

9. The company's after-tax cost of debt is:

A. 7.2%.
B. 8.0%.
C. 9.1 %.

10. The company's cost of equity using the capital asset pricing model (CAPM)
approach is:
A. 16.0%.
B. 16.6%.
C. 16.9%.

11. The company's cost of equity using the dividend discount model is:
A. 15.4%.
B. 16.0%.
C. 16.6%.

12. The company's weighted average cost of capital (using the cost of equity from CAPM)
is closest to:
A. 12.5%.
B. 13.0%.
C.13.5%.

13. What happens to a company's weighted average cost of capital (WACC) if the firm's
corporate tax rate increases and if the Federal Reserve causes an increase in the risk-free
rate, respectively? (Consider the events independently and assume a beta of less than
one.)

Tax rate increase Increase in risk-free rate

A. Decrease WACC Increase WACC
B. Decrease WACC Decrease WACC
C. Increase WACC Increase WACC

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14. Given the following information on a company’s capital structure, what is the
company’s weighted average cost of capital? The marginal tax rate is 40%.
Type of Capital Percentage of capital Before-tax component cost
structure
Bonds 40% 7.5%
Preferred stock 5% 11%
Common stock 55% 15%

A. 10%.
B. 10.6%
C. 11.8%.

15. Mahmoud Kamal is an analyst with Walmart, a major U.S., based discount
retailer. Walmart is considering opening new stores in Brazil and wants to estimate
its cost of equity capital for this investment. Mahmoud has found that:
 The yield on a Brazil government 10-year U.S. dollar-denominated bond is
7.2%.
 A 10-year U.S. Treasury bond has a yield of 4.9%.
 The annualized standard deviation of the Bovespa Stock Exchange Index in the
most recent year is 24%.
 The annualized standard deviation of Brazil Government 10-year U.S. dollar-
denominated bond in the most recent year is 18%.
 The appropriate beta to use for the project is 1.3.
 The market risk premium is 6%.
 The risk-free interest rate is 4.5%.

Which of the following choices is closest to the appropriate country risk premium for
Brazil and the cost of equity that Mahmoud should use in his analysis?

Country risk premium for Cost of equity for project

Brazil
A. 2.5% 15.6%
B. 2.5% 16.3%
C. 3.1% 16.3%

You are given: Country Risk Premium = sovereign yield spread*(annualized standard
deviation of equity index of developing country/annualized standard deviation of
sovereign bond market in terms of the developed country). You are given:

ke = rf + (e(rm)-rf+CRP)*beta

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16. Tesla Industries currently has assets on its balance sheet of $200 million financed
with 70% equity and 30% debt. The executive management team at Tesla is
considering a major expansion that would require raising additional capital. Sarah
Daw, the CFO of Tesla, has put together the following schedule for the costs of debt
and equity:
Amount of new debt After-tax cost of Amount of new Cost of equity
(in millions) debt equity (in millions)
$0 to $49 4% $0 to $99 7%
$50 to $99 4.2% $100 to $199 8%
$100 to $149 4.5% $200 to $299 9%

In a presentation to Tesla’s board of Directors, Sarah makes the following statements:

Statement 1: if we maintain our target capital structure of 70% equity and 30% debt,
the breakpoint at which our cost of equity will increase to 8% is $185 million in new
capital.
Statement 2: If we want to finance total assets of $450 million, our marginal cost of
capital will increase to 7.56%.
Are Sarah’s statements 1 and 2 most likely correct or incorrect?

Statement 1 Statement 2
A. Incorrect Incorrect
B. Correct Correct
C. Incorrect Correct

17. Hilton is considering a project that requires a $180,000 cash outlay and is
expected to produce cash flows of $50,000 per year for the next five years. Hilton’s
tax rate is 25%, and the before-tax cost of debt is 8%. The current share price for
Hilton’s stock is $56 and the expected dividend next year is $2.80 per share. Hilton’s
expected growth rate is 5%. Assume that Hilton finances the project with 60% equity
and 40% debt, and the flotation cost for equity is 4%. The appropriate discount rate is
the weighted average cost of capital (WACC). Which of the following choices is
closest to the dollar amount of flotation costs and the NPV for the project, assuming
that flotation costs are accounted for properly?

Dollar amount of NPV of project

flotation costs
A. $4,320 $13,228
B. $4,320 $17,548
C. $7,200 $17,548

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18. Shaddy Company has a debt-to-equity ratio of 2.0. Shaddy is evaluating the cost of
equity for a project in the same line of business as Etisalat Company and will use the pure-
play method with Etisalat Company as the comparable firm. Etisalat Company has a beta of
1.2 and a debt-to-equity ratio of 1.6. The project beta most likely:
A. could be great or less than Shaddy Company’s beta.
B. will be less than Shaddy Company’s beta.
C. will be greater than Shaddy Company’s beta.

Additional information: The pure play approach or pure play method is a method for
estimating the cost of capital for a proposed new project or product line. It involves
examining other companies, which are pure plays in the proposed line of business and
inferring a cost of capital based on their capital structures (e.g. Debt-to-Equity ratio) and
betas. The project beta calculated using the pure-play method is nor necessarily related in
a predictable way to the beta of the firm that is performing the project.

Section 2: Exercises on Stock Valuation

19. Which of the following firms would most likely be appropriately valued
using the constant growth DDM?
A. An auto manufacturer.
B. A biotechnology firm in existence for two years.
C. A producer of bread and snack foods.
(CHOOSE THE CORRECT ANSWER)

20. Which of the following is least likely a rationale for using price
multiples?
A. The fundamental P/E ratio is insensitive to its inputs.
B. Price multiples are easily calculated.
C. The use of forward values in the divisor provides an incorporation of the
future.
(CHOOSE THE CORRECT ANSWER)

21. Which of the following firms would most appropriately be valued using
an asset based model?
A. A paper firm located in a country that is experiencing high inflation.
B. A software firm that invests heavily in research and development and
frequently introduces new products.
C. An energy exploration firm in financial distress that owns drilling rights for
offshore areas.
(CHOOSE THE CORRECT ANSWER)

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22. Assume that a stock is expected to pay dividends at the end of Year 1
and Year 2 of $1.25 and $1.56, respectively. Dividends are expected to grow
at a 5% rate thereafter. Assuming that ke is 11.6%, the value of the stock is
closest to:
A. $22.30.
B. $23.42.
C. $24.55.
(CHOOSE THE CLOSEST ANSWER)

23. An analyst feels that Procter's earnings and dividends will grow at 25%
for two years, after which growth will fall to a constant rate of 6%. If the
projected discount rate is 10%, and Procter's most recently paid dividend
was $0.85, the value of Procter's stock using the multistage dividend
discount model is closest to:
A. $31.15.
B. $33.54.
C. $36.65.
(CHOOSE THE CLOSEST ANSWER)

24. A firm has an expected dividend payout ratio of 60% and an expected
future growth rate of 9%. What should the firm's fundamental price-to-
earnings (P/E) ratio be if the required rate of return on stocks of this type is
15%?
A. 5.0x.
B. 7.5x.
C. 10.0x.
(CHOOSE THE CLOSEST ANSWER)

25. An analyst estimates a value of $45 for a stock with a market price of
$50. The analyst is most likely to conclude that a stock is overvalued if:
A. few analysts follow the stock and the analyst has less confidence in his model
inputs.
B. few analysts follow the stock and the analyst is confident in his model inputs.
C. many analysts follow the stock and the analyst is confident in his model
inputs.
(CHOOSE THE CORRECT ANSWER)

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26. What would an investor be willing to pay for a share of preferred stock
that pays an annual $7 dividend if the required return is 8.00%?
A. $77.50.
B. $87.50.
C. $90.32.
(CHOOSE THE CLOSEST ANSWER)

27. The constant growth model requires which of the following?

A. g > k.
B. g < k.
C. g ≠ k.

28. What is the intrinsic value of a company's stock if dividends are

expected to grow at 5.23%, the most recent dividend was $1, and investors'
required rate of return for this stock is 10%?
A. $20.00.
B. $21.00.
C. $22.05.
(CHOOSE THE CLOSEST ANSWER)

29. Next year's dividend is expected to be $2.14, g = 7%, and k = 12%.

What is the stock's intrinsic value?
A. $28.57.
B. $40.00.
C. $42.80.
(CHOOSE THE CLOSEST ANSWER)

30. The XX Company paid a $1 dividend in the most recent period. The
company is expecting dividends to grow at a 6% rate into the future. What
is the value of this stock if an investor requires a 15.54% rate of return on
stocks of this risk class?
A. $10.60.
B. $11.11.
C. $11.78.
(CHOOSE THE CLOSEST ANSWER)

31. An analyst estimates that a stock will pay a $1 dividend next year and
that it will sell for $32 at year-end. If the required rate of return is 12%,
what is the value of the stock?
A. $23.31.
B. $26.95.
C. $29.46.
(CHOOSE THE CLOSEST ANSWER)

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 Section 3: Investment Decision Rules

Use the information for the question 32 below.

The Sisyphean Company is planning on investing in a new project. This will involve the
purchase of some new machinery costing $450,000. The Sisyphean Company expects
cash inflows from this project as detailed below:

Year One Year Two Year Three Year Four

$200,000 $0 $225,000 $225,000

The appropriate discount rate for this project is 5%.

32) The NPV for this project is closest to:

A) $116,270
B) $102,420
C) $105,864
D) $119,947

Use the table for the questions 33 and 34 below.

Consider the following two projects:

In ,000$
Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount
Project C/F C/F C/F C/F C/F C/F C/F C/F Rate
Alpha -79 20 25 30 35 40 N/A N/A 15%
Beta -80 25 25 25 25 25 25 18 16%

33) The NPV for project alpha is closest to (in ,000$):

A) $20.96
B) $16.92
C) $24.01
D) $14.41

34) The NPV for project beta is closest to (in ,000$):

A) $17.85
B) $17.92
C) $18.48
D) $19.26

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Use the information for the question 35 below.

Larry the Cucumber has been offered $14 million to star in the lead role of the next
three Larry Boy adventure movies. If Larry takes this offer, he will have to forgo acting
in other Veggie movies that would pay him $6 million at the end of each of the next three
years. Assume Larry's personal cost of capital is 10% per year.

35) The NPV of Larry's three movie Larry Boy offer is closest to:
A) 921,111
B) 1,027,033
C) 1,097,027
D) 1,116,478

Use the following information to answer the question 36 below.

Rearden Metals is considering opening a strip mining operation to provide some of the
raw materials needed in producing Rearden metal. The initial purchase of the land and
the associated costs of opening up mining operations will cost $90 million today. The
mine is expected to generate $16 million worth of ore per year for the next 12 years. At
the end of the 12th year Rearden will need to spend $20 million to restore the land to its
original pristine nature appearance.

36) The payback period for Rearden's mining operation is closest to:
A) 4.90 years
B) 5.25 years
C) 5.62 years
D) 6.2 years

37) Which of the following statements is false?

A) The payback investment rule is based on the notion that an opportunity that pays back its
initial investments quickly is a good idea.
B) A NPV will always exist for an investment opportunity.
C) An IRR will always exist for an investment opportunity.
D) In general, there can be as many IRRs as the number of times the project's cash flows
change sign over time.

38) Which of the following statements is false?

A) The payback rule is useful in cases where the cost of making an incorrect decision might
not be large enough to justify the time required for calculating the NPV.
B) For most investment opportunities expenses occur initially and cash is received later.
C) The payback rule is reliable because it considers the time value of money and depends on
the cost of capital.
D) Fifty percent of firms surveyed reported using the payback rule for making decisions.

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39) Assuming that your capital is constrained, which investment tool should you use to
determine the correct investment decisions?
A) Profitability Index
B) Incremental IRR
C) NPV
D) IRR

Use the table for the questions 40 and 41 below.

Consider the following two projects:

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Discount
Project C/F C/F C/F C/F C/F C/F C/F C/F Rate
Alpha -80 25 25 25 25 25 25 25 16%
Beta -79 20 25 30 35 40 N/A N/A 15%

40) The payback period for project Alpha is closest to:

A) 2.9 years
B) 3.1 years
C) 2.6 years
D) 3.2 years

41) The payback period for project Beta is closest to:

A) 3.2 years
B) 2.9 years
C) 3.1 years
D) 2.6 years

Use the table for the questions 42 and 43 below.

Consider the following list of projects:

Project Investment PV(future CFs)

A 135,000 141,000
B 200,000 230,000
C 125,000 145,000
D 150,000 152,000
E 175,000 185,000
F 75,000 85,000
G 80,000 89,000
H 200,000 220,000
I 50,000 54,000

42) Assuming that your capital is constrained, which project should you invest in first?
A) Project B
B) Project C
C) Project F
D) Project G

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43) Assuming that your capital is constrained, so that you only have $600,000 available
to invest in projects, which project should you invest in and in what order?
A) CBGF
B) CBEF
C) BCFG
D) CBFG
E) CBFH

44. Alcoa is investing $400 million in new industrial equipment. The present value of the
future after-tax cash flows resulting from the equipment is $700 million. Alcoa currently
has 85.5 million shares of common stock outstanding, with a current market price of $36
per share. Assuming that this project is new information and is independent of other
expectations about the company, what is the theoretical effect of the new equipment on
Alcoa's stock price? The stock price will:
A. decrease to $36.50.
B. increase to $37.50.
C. increase to $39.50.

Use the following data to answer Questions 45 through 49.

A company is considering the purchase of a copier that costs $5,000. Assume a required
rate of return of 10 % and the following cash flow schedule:
• Year 1: $3,000.
• Year 2: $2,000.
• Year 3: $2,000.

45. What is the project's payback period?

A. 1.5 years.
B. 2.0 years.
C. 2.5 years.

46. The project's discounted payback period is closest to:

A. 1.4 years.
B. 2.0 years.
C. 2.4 years.

47. What is the project's NPV?

A. +$883.
B. -$309.
C. + $1,523.

48. The project's IRR is closest to:

A. 10%.
B. 15%.
C. 20%.

49. What is the project's profitability index (PI)?

A. 0.72.
B. 1.18.
C. 1.72.

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50. An analyst has gathered the following information about a project:
• Cost $10,000
• Annual cash inflow $4,000
• Life 4 years
• Cost of capital 12%
Which of the following statements about the project is least accurate?
A. The discounted payback period is 3.5 years.
B. The IRR of the project is 21.9%; accept the project.
C. The NPV of the project is +$2,149; accept the project.

Use the following data for Questions 51 and 53.

An analyst has gathered the following data about two projects, each with a 12%
required rate of return.
Project A Project B
Initial cost $15,000 $20,000
Life 5 years 4 years
Cash inflows $5,000/year $7,500/year

51. If the projects are independent, the company should:

A. accept both projects.
B. accept Project A and reject Project B.
C. reject Project A and accept Project B.

52. If the projects are mutually exclusive, the company should:

A. reject both projects.
B. reject Project A and accept Project B.
C. accept Project A and reject Project B.

53. The NPV profiles of two projects will intersect:

A. at the discount rate that makes their net present values equal.
B. at their internal rates of return.
C. if they have different discount rates.

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54. Compute the beta of Microsoft based on 60 monthly returns.
Use the data from the file FIN550_GROUPASSIGNMENT2_q54.xls
Send your Excel file with the computed beta with your answer sheet.

E(ri )  rf  E rm   rf  i

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 Formulae sheet

  i n*T 
1  1  n   n*T

PV  C      FV 1
  i 
 i   n 
 
 n

PV  1/(1  r * maturity in days/ 360)

E( ri )  rf  E rm   rf  i

P1  D1  P0
E(r) 
P0
FV
PV 
 i n*T
1 
 n 


Constant growth model

Po = D1/(k-g) = Earnings1 * (1-plowback ratio) / (k-g)
Constant dividend model

Po = D1 / k

i  m
i
2
 im i
2
m

m m

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 Formulae sheet
 D 
Debt to capital ratio  
 


 D  E 
 D
Debt to equity ratio  
 
 E 


  n*T 
1  1  ni   n*T
PV  C    FV 1  i 

 i   n 
 
 n

PV  1/(1  r * maturity / 360)

E(ri )  rf  E rm   rf  i

WACC  r (1 Tc)  D   E 
 d    re  
DE DE 
   
FV
PV 
 i n*T
1 
 n 


Plowback ratio = 1-(dividend payout ratio)

Dividend payout ratio = D1/E1

g = ROE * plowback ratio

Constant growth model:

Po = D1/(k-g)

Constant dividend model (perpetuity):

Po = D1 / k

V=D+E
VL=VU+P.V. of the tax savings on interest

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Quick ratio = (current assets – inventories) / current liabilities

NPV=PV of cash flows - Initial outflow

IRR = WACC when NPV = 0

PI  Total PV of Future Cash Flows

Initial Investment

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