GUIDE – PRACTICAL PART

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CLASS 1 AND CLASS 2

1) A corporation may incur agency costs because:

A) managers may not attempt to maximize the value of the firm to shareholders.
B) shareholders incur monitoring costs.
C) of the separation of ownership and management.
D) all of the responses are correct.

2) The following groups are some of the claimants to a firm's income stream:
A) shareholders and bondholders only.
B) shareholders, bondholders, and employees only.
C) shareholders, bondholders, employees, and management only.
D) shareholders, bondholders, employees, management, and government.

3) Mr. Free has $100 in income this year and will have zero income next year. The
market interest rate is 10 percent per year. If Mr. Free consumes $30 this year and
invests the rest in the market, what will be available for his consumption next year?
A) $50
B) $55
C) $77
D) $100

4) Mr. Bird has $100 in income this year and will have zero income next year. The
market interest rate is 10 percent per year. Mr. Bird also has an investment
opportunity in which he can invest $50 today and receive $80 next year. Suppose
Mr. Bird consumes $30 this year and invests in the project. How much will be
available for his consumption next year?
A) $80
B) $82
C) $100
D) $102
5) Mr. Dell has $100 in income this year and will have zero income next year. The
expected return from investing in the stock market is 10 percent a year. Mr. Dell also
has an investment opportunity—having the same risk as the market in which he can
invest $50 this year and receive $80 next year. Suppose Mr. Dell consumes $50 this
year and invests in the project. What is the NPV of the investment opportunity?
A) $0
B) $5
C) $22.73
D) none of the options

6) Ms. Delgado has $60,000 in income this year and will have $40,000 next year. The
market interest rate is 10 percent per year. Suppose Ms. Delgado consumes $80,000
this year. How much will be available for her consumption next year?
A) $18,000
B) $30,000
C) $60,000
D) $70,000

7) Ms. Newcastle has $60,000 in income this year and will have $40,000 next year.
The market interest rate is 10 percent per year. Suppose Ms. Newcastle wishes to
consume $62,000 next year. How much will she be able to consume this year?
A) $19,000
B) $40,000
C) $60,000
D) $70,000

8) Mr. Cobb has an income of $40,000 this year and will have $60,000 next year. He
can invest in a project that costs $30,000 this year, which generates an income of
$36,000 next year. The market interest rate is 10 percent. What will be available for
his consumption next year if Mr. Cobb invests in the project and consumes $50,000
this year?
A) $40,000
B) $52,000
C) $60,000
D) $62,000

SHORT ANSWER. Write the word or phrase that best completes each statement
or answers the question.
9) Briefly explain the term limited liability.
10) Briefly explain the advantages of a corporation as a form of business organization.

11) Briefly explain the sequence of cash flows between financial markets and the firm.

12) Briefly explain the functions of financial markets.

13) Briefly discuss the role of financial managers.

14) Briefly explain the term agency costs as related to a corporation.

15) Briefly discuss principal-agent problems as related to a corporation.

16) Explain why “maximization of shareholders' wealth” is the appropriate ultimate,

long-term goal of the firm.

17) Briefly explain some of the institutional arrangements that ensure that managers
work toward increasing the value of a firm.

18) Briefly explain how individuals can adjust their current and future consumption
according to their preferences.

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MULTIPLE CHOICE - Choose the one alternative that best completes the
statement or answers the question.
1) The dividend yield reported on finance.yahoo.com is calculated as follows:
A) (dividend/year-high stock price).
B) (dividend/year-low stock price).
C) (dividend/closing stock price).
D) (dividends/earnings).

2) A Wall Street Journal quotation for a company has the following values: Dividend
payout: $1.12, PE: 18.3, Close: $37.22. Calculate the approximate dividend payout
ratio for the company.
A) 18 percent
B) 35 percent
C) 45 percent
D) 55 percent
3) Super Computer Company's stock is selling for $100 per share today. It is expected
that–at the end of one year–it will pay a dividend of $6 per share and then be sold
for $114 per share. Calculate the expected rate of return for the shareholders.
A) 20 percent
B) 15 percent
C) 10 percent
D) 25 percent

4) <p>Casino Incorporated expects to pay a dividend of $3 per share at the end of

year 1 ( ) and these dividends are expected to grow at a constant rate of 6
percent per year forever. If the required rate of return on the stock is 18 percent,
what is the current value of the stock today?</p>
A) $100
B) $25
C) $54
D) $50

5) <p>The constant dividend growth formula assumes:</p>

A) that dividends grow at a constant rate g, forever only.
B) r > g only.
C) that dividends grow at a constant rate g, forever, and r > g only.
D) g is never negative only.

6) MJ Company pays out 60 percent of its earnings as dividends. Its return on equity
is 15 percent. What is the stable dividend growth rate for the firm?
A) 9 percent
B) 5 percent
C) 6 percent
D) 15 percent

7) R&D Technology Corporation just paid a dividend of $0.50 per share. Analysts
expect its dividend to grow at 24 percent per year for the next two years and then 8
percent per year thereafter. If the required rate of return in the stock is 16 percent,
calculate the current value of the stock.
A) $1.11
B) $7.71
C) $8.82
D) $10.38
8) Ocean Company just paid a dividend of $2 per share out of earnings of $4 per
share. If the book value per share is $25, what is the expected growth rate in
dividends (g)?
A) 16 percent
B) 12 percent
C) 8 percent
D) 4 percent

9) Company X has a P/E ratio of 10 and a stock price of $50 per share. Calculate
earnings per share of the company.
A) $5 per share
B) $6 per share
C) $10 per share
D) $0.20 per share

10) Summer Company expects to pay a dividend of $4.00 per share—one year from
now—out of earnings of $7.50 per share. If the required rate of return on the stock
is 15 percent and its dividends are growing at a constant rate of 10 percent per
year, calculate the present value of growth opportunities for the stock (PVGO).
A) $80
B) $30
C) $50
D) $26

11) Parcel Corporation expects to pay a dividend of $5 per share next year, and the
dividend payout ratio is 50 percent. If dividends are expected to grow at a constant
rate of 8 percent forever, and the required rate of return on the stock is 13 percent,
calculate the present value of growth opportunities.
A) $100.00
B) $76.92
C) $23.08
D) $69.54

12) The following are measures used by firms when making capital budgeting
decisions except:
A) payback period.
B) internal rate of return.
C) P/E ratio.
D) net present value.
13) The survey of CFOs indicates that the NPV method is always, or almost always,
used for evaluating investment projects by approximately:
A) 12 percent of firms.
B) 20 percent of firms.
C) 57 percent of firms.
D) 75 percent of firms.

14) You are given a job to make a decision on project X, which is composed of three
independent projects A, B, and C that have NPVs of $70, −$40 and $100,
respectively. How would you go about making the decision about whether to
accept or reject the project?
A) Accept project X as it has a positive NPV.
B) Reject project X.
C) Break up the project into its components: Accept A and C, but reject B.
D) Break up the project into its components: Accept C.

15) The payback period rule:

A) varies the cut-off point with the interest rate.
B) determines a cut-off point so that all projects accepted by the NPV rule will
be accepted by the payback period rule.
C) requires an arbitrary choice of a cut-off point.
D) varies the cut-off point with the interest rate and requires an arbitrary choice
of a cut-off point.

16) The payback period rule accepts all projects for which the payback period is:
A) greater than the cut-off value.
B) less than the cut-off value.
C) positive.
D) an integer.

17) The cost of a new machine is $250,000. The machine has a five-year life and no
salvage value. If the cash flow each year is equal to 25 percent of the cost of the
machine, calculate the payback period for the project.
A) 2.0 years
B) 2.5 years
C) 3.0 years
D) 4.0 years
18) If an investment project (normal project) has an IRR equal to the cost of capital,
the NPV for that project is:
A) positive.
B) negative.
C) zero.
D) unable to be determined.

19) <p>If the cash flows for Project M are ; ; ; and

, calculate the IRR for the project.</p>
A) 23 percent
B) 21 percent
C) 19 percent
D) 17 percent

20) <p>Project X has the following cash flows: , , and

. If the IRR of the project is 25 percent and if the cost of capital is
18 percent, you would:</p>
A) accept the project.
B) reject the project.
C) show indifference towards the project
D) not be able to make a decision based on the information provided.

21) Music Company is considering investing in a new project. The project will need an
initial investment of $2,400,000 and will generate $1,200,000 (after-tax) cash
flows for three years. Calculate the NPV for the project if the cost of capital is 15
percent.
A) $169, 935
B) $1,200,000
C) $339,870
D) $125,846

22) Muscle Company is investing in a giant crane. It is expected to cost $6.5 million in
initial investment, and it is expected to generate an end-of-year cash flow of $3.0
million each year for three years. Calculate the IRR.
A) 14.6 percent
B) 16.4 percent
C) 18.2 percent
D) 22.1 percent
23) <p>If the cash flows for project A are , ; ; and
, calculate the NPV of the project using a 15 percent discount rate.
A) $5,000
B) $2,352
C) $3,201
D) $1,857

24) The following table gives the available projects (in $millions) for a firm.
A B C D E F G

5.0 4.0 5.0 1.0 2.0 7.0 8.0 Initial investment

1.5 −0.5 1.0 0.5 0.5 1.0 1.0 NPV
The firm has only $20 million to invest. What is the maximum NPV that the
company can obtain?
A) 3.5
B) 4.0
C) 4.5
D) 5.0

25) The benefit-cost ratio is defined as the ratio of:

A) net present value cash flows to initial investment.
B) present value of cash flows to initial investment.
C) net present value of cash flows to IRR.
D) present value of cash flows to IRR.

26) Preferably, a financial analyst estimates cash flows for a project as:
A) cash flows before taxes.
B) cash flows after taxes.
C) accounting profits before taxes.
D) accounting profits after taxes.

27) The cost of a resource that may be relevant to an investment decision even when
no cash changes hand is called a(n):
A) sunk cost.
B) opportunity cost.
C) depreciation cost.
D) average cost.
28) Net working capital is best represented as:
A) short-term assets only.
B) short-term assets and short-term liabilities.
C) long-term assets and short-term assets.
D) long-term assets and long-term liabilities.

29) The principal short-term assets are:

A) cash only.
B) cash and accounts payable only.
C) cash, accounts receivable, and inventories.
D) accounts payable only.

30) For the case of an electric car project, which of the following costs or cash flows
should be categorized as incremental when analyzing whether to invest in the
project?
A) The cost of research and development undertaken for developing the electric
car during the past three years
B) The annual depreciation charge
C) Tax savings resulting from the depreciation charges
D) Dividend payments

31) An analyst wishes to determine the value of resources used by a proposed project.
Which values should the analyst use to approximate opportunity costs?
A) Book values
B) Market values
C) Historical values
D) Accounting values plus an inflation adjustment

32) If the nominal interest rate is 7.5 percent and the inflation rate is 4.0 percent, what
is the real interest rate?
A) 4.0 percent
B) 9.5 percent
C) 3.4 percent
D) 11.5 percent
33) The real rate of interest is 3 percent and inflation is 4 percent. What is the nominal
rate of interest?
A) 3.00 percent
B) 1.00 percent
C) 7.12 percent
D) −1.00 percent

34) The NPV value obtained by discounting nominal cash flows using the nominal
discount rate is the same as the NPV value obtained by discounting:
A) real cash flows using the real discount rate only.
B) real cash flows using the nominal discount rate only.
C) nominal cash flows using the real discount rate only.
D) real cash flows using the nominal discount rate and nominal cash flows
using the real discount rate.

35) A piece of capital equipment costing $400,000 today has no salvage value at the
end of five years. If straight-line depreciation is used, what is the book value of the
equipment at the end of three years?
A) $120,000
B) $80,000
C) $160,000
D) $240,000

36) If depreciation is $600,000 and the marginal tax rate is 21 percent, then the tax
shield due to depreciation is:
A) $126,000.
B) $600,000.
C) $390,000.
D) The answer cannot be determined from the information given.

37) If depreciation is $100,000 and the marginal tax rate is 21 percent, then the tax
shield due to depreciation is:
A) $21,000.
B) $100,000.
C) $65,000.
D) The answer cannot be determined from the information given.
38) Your boss asked you to evaluate a project with an infinite life. Sales and costs
project to $1,000 and $500 per year, respectively. (Assume sales and costs occur at
the end of the year [i.e., profit of $500 at the end of year one].) There is no
depreciation and the tax rate is 21 percent. The real required rate of return is 10
percent. The inflation rate is 4 percent and is expected to be 4 percent forever.
Sales and costs will increase at the rate of inflation. If the project costs $3,000,
what is the NPV?
A) $950.00
B) $1,629.62
C) $365.38
D) $472.22
Answer Key
Test name: MCQ 4-5-6

1) C
2) D
PE ratio = price per share ÷ earnings per share; Earnings per share = ($37.22) ÷ 18.3 =
2.03; Dividend payout = $1.12 ÷ 2.03 = 0.55 = 55%.

3) A
r = ($114 + $6 − $100) ÷ $100 = 20%.

4) B

>
5) C
6) C
g = (1 − 0.60) × 15% = 6%.

7) C

8) C
Sustainable growth = ROE × plowback ratio; Payout ratio = 50%; Plowback ratio =
50%; g = (1 − 0.5)($4 ÷ $25) = 0.08, or 8%.

9) A
EPS = $50 ÷ 10 = $5.

10) B

No growth value = $7.5 ÷ 0.15 = $50; ; PVGO = $80 − $50 =

$30.

11) C
EPS = ($5 ÷ 0.5) = $10; No growth value = $10 ÷ 0.13 = $76.92; Growth value = $5 ÷
(0.13 − 0.08) = $100; PVGO = $100 − $76.92 = $23.08.

12) C
13) D
14) C
 15) C
16) B
17) D
Cash flow each year = 0.25 × $250,000 = $62,500; Payback period = 4.0 years.

18) C
19) A
−1,000 + [200 ÷ (1 + IRR)] + [700 ÷ (1 + IRR)^2] + [698 ÷ (1 + IRR)^3] = 0; IRR =
23%.
In Excel: Arrange cash flows in order starting with −1,000 in cell A1 and ending with
+698 in cell A4, then "= IRR(A1:A4)".

20) B
This is a loan project (i.e., borrowing) with IRR greater than the cost of capital.
Therefore, reject it.

21) C
NPV = −$2,400,000 + $1,200,000 ÷ 1.15 + $1,200,000 ÷ (1.15^2) + $1,200,000 ÷
(1.15^3) = $339,870.

22) C
0 = −$6.5 + $3 ÷ (1 + IRR) + $3 ÷ (1 + IRR)2raise to the power of 2 + $3 ÷ (1 +
IRR)3raise to the power of 3;
IRR = 18.2% (by trial and error).
In Excel, arrange cash flows in order starting with −$6.5 in cell A1 and $3 in cells A2
through A4, then "= IRR(A1:A4)".

23) D
NPV = −3,000 + (500 ÷ 1.15) + (1,500 ÷ 1.15^2) + (5,000 ÷ 1.15^3) = 1,857.

24) C
A + C + D + E + F = 4.5; Total investment = 5 + 5 + 1 + 2 + 7 = $20 million.

25) B

26) B
27) B
28) B
29) C
30) C
31) B
32) C
1 + real rate = (1 + nominal rate) ÷ (1 + inflation rate) = 1.075 ÷ 1.04 = 1.0337;
real rate = 3.4%.

33) C
1 + nominal rate = 1.03 × 1.04 = 1.0712; nominal rate = 7.12%.

34) A
35) C
Annual depreciation = $400,000 ÷ 5 = $80,000.
Depreciation for three years = $240,000.
Book value = $400,000 − $240,000 = $160,000.

36) A
Tax shield effect = ($600,000)(0.21) = $126,000

37) A
Tax shield effect = ($100,000)(0.21) = $21,000.

38) A
Easiest to consider real cash flows: NPV = −3,000 + (1,000 − 500) × 0.79 ÷ 0.10 =
$950.00.