Corporate Finance Overview 1. Outdoor Living needs $14.6 million to finance updates and additions to its production equipment. The underwriters estimate that the firm could sell additional shares of stock at $23.50 a share with an underwriting spread of 7.75 percent. This would be a firm-commitment underwriting. The estimated issue costs are $368,000. How many shares of stock will Outdoor Living need to sell to finance this project? (Round up to the next whole share.) A. 588,917 shares B. 690,446 shares C. 686,299 shares D. 552,311 shares A firm has sales of $3,340, net income of $274, net fixed assets of $2,600, and current assets of $920. The firm has $430 in inventory. What's the common-size statement value of inventory? A. 44.16 percent B. 12.22 percent C. 16.54 percent D. 13.36 percent 3. If a firm has $8,750 in earnings before interest and taxes, $725 in depreciation expense, and $3,062 in taxes, what's the firm's operating cash flow? A. $8,750 B. $6,413 C. $4,963 D. $5,688 4. Your firm has total assets of $4,900, fixed assets of $3,200, long-term debt of $2,900, and short-term debt of $1,400. What's the amount of net working capital? A. $600 B. $1,700 C. $300 D. $1,800 5. Determining the correct offering price is the most difficult thing an underwriter must do for an IPO. If we look at the historical data of various IPOs's offering prices and closing prices, we find that most IPO's are A. overpriced on average, but only if there was excitement preceding the IPO. B. overpriced on average. C. neither overpriced nor underpriced on average. D. underpriced on average. 6. Shareholders's equity can best be described as A. a firm's financial leverage. B. representing the residual value of a firm. C. decreasing whenever new shares of stock are issued. D. including patents, preferred stock, and common stock. 7. If a firm has a notes payable balance of $42,400 at the end of 2014, and $30,100 at the end of 2015, which of the following statements about accounts payable is correct? A. Notes payable decreased by $12,300 and represented a use of cash. B. Notes payable decreased by $12,300 and represented a source of cash. C. Notes payable increased by $12,300 and represented a source of cash. D. Notes payable increased by $12,300 and represented a use of cash. 8. The stock of Cleaner Homes is currently selling for $16.90 a share. The company has decided to raise funds through a rights offering wherein every shareholder will receive one right for each share of stock they own. The new shares being offered are priced at $14 plus four rights. What's the value of one right? A. $0.25 B. $0.47 C. $0.66 D. $0.58 9. M&C Merchants is offering $2.5 million of new securities to the general public. Which SEC regulation governs this offering? A. Regulation A B. Regulation C C. Regulation G D. Regulation R 10. A.K. Stevenson wants to raise $10.2 million through a rights offering. The subscription price is set at $16 a share. Currently, the company has 1.7 million shares outstanding with a current market price of $25 a share. Shareholders will receive one right for each share of stock they currently own. How many rights will be needed to purchase one new share of stock in this offering? A. 2.67 rights B. 2.82 rights C. 2.75 rights D. 2.40 rights 11. Suppose that a corporation has a taxable income of $325,000. Using the following table, what's the firm's average tax rate? A. 39 percent B. 33.846 percent C. 35 percent D. 30.516 percent 12. Cash flow to stockholders is defined as A. dividend payments less net new equity raised. B. operating cash flow minus the cash flow to creditors. C. the change in total equity over the past year. D. the total amount of interest and dividends paid during the past year. 13. How is return on equity measured? A. Net income / Total shares outstanding B. Sales / Total equity C. Net income / Total equity D. Net income / Total assets 14. Which of the following functions should be the responsibility of the controller rather than the treasurer? A. Customer credit approval B. Equipment purchase analysis C. Income tax returns D. Payment to a vendor 15. JL Enterprises has 75,000 shares of stock outstanding, with a book value of $900,000 and a market value of $1,320,000. The firm is considering a project that requires the purchase of $130,000 in fixed assets and has a net present value of $7,500. The project would be all-equity financed through the sale of shares. What will the new book value per share be after the project is implemented? A. $15.60 B. $14.23 C. $13.70 D. $12.50 16. On a common-size balance sheet, all accounts for the current year are expressed as a percentage of A. the base year sales. B. total assets for the base year. C. total equity for the base year. D. total assets for the current year. 17. What's the most likely reason a firm would decide to go public? A. To increase the total liability of the firm B. As an exit strategy for venture capital investors C. As an inexpensive way to raise new capital D. To increase the value of the firm 18. In corporate finance, the term dilution is used to A. determine the loss in existing shareholder value. B. determine when cash flows can be distributed to shareholders as dividends. C. discuss the effects of liquidity, solvency, and bankruptcy. D. determine when and how to go public. 19. Bonner Automotive has shareholders's equity of $218,700. The firm owes a total of $141,000, of which 40 percent is payable within the next year. The firm has net fixed assets of $209,800. What's the amount of the net working capital? A. $93,500 B. $56,500 C. $125,600 D. $149,900 20. A firm has assets of $75,000 and owners's equity of $44,000. What's the balance of the firm's liabilities? A. $27,000 B. $75,000 C. $31,000 D. $119,000 Future Cash Flow Valuation 1. What's the primary reason that the stock market is more volatile than the bond market? A. Bonds are less susceptible to interest rate changes. B. More reporting requirements are placed on the bond markets. C. Stock value isn't based on cash flows but rather the underlying investment. D. Bond markets have more certain cash flows than stocks, and bonds eventually mature, whereas stocks never mature. 2. Would you expect to pay a higher interest rate for an unsecured loan for $2,000 or a secured loan for the same amount? A. The secured loan would be at a higher rate. B. The rate for each loan would vary based on inflation. C. The unsecured loan would be at a higher rate. D. The rate for both would be about the same on average. 3. Gee-Gee's is going to pay an annual dividend of $2.05 a share on its common stock next year. This year, the company paid a dividend of $2 a share. The company adheres to a constant rate of growth dividend policy. What will one share of this common stock be worth five years from now if the applicable discount rate is 10.9 percent? A. $28.30 B. $26.28 C. $26.94 D. $27.61 4. Which of the following will produce the lowest present value interest factor? A. 6 percent interest for 10 years B. 8 percent interest for 10 years C. 6 percent interest for 5 years D. 8 percent interest for 5 years 5. Amortized loans must have which one of these characteristics? A. Increasing payments over the life of the loan B. Equal interest payments over the life of the loan C. Either equal or unequal principal payments over the life of the loan D. One lump sum principal payment 6. You just received a $5,000 gift from your grandmother. You decide to save this money so that you can gift it to your grandchildren 50 years from now. How much additional money will you have to gift to your grandchildren if you can earn an average of 7½ percent instead of just 7 percent on your savings? A. $39,464.79 B. $39,318.09 C. $37,811.99 D. $38,663.60 7. Your car dealer is willing to lease you a new car for $190 a month for 36 months. Payments are due on the first day of each month, starting with the day you sign the lease contract. If your cost of money is 6½ percent, what's the current value of the lease? A. $10,331.03 B. $9,197.74 C. $7,203.14 D. $6,232.80 8. Oil Wells offers 6½-percent coupon bonds with semiannual payments and a yield to maturity of 6.94 percent. The bonds mature in seven years. What's the market price per bond if the face value is $1,000? A. $989.70 B. $913.48 C. $975.93 D. $902.60 9. Today, you deposit $1,500 into an account that pays six-percent interest annually. How much will you have in the account after five years? (Round your answer to the nearest dollar.) A. $2,097 B. $1,894 C. $2,007 D. $1,950 10. On an investment of $3,000, you'll earn 10-percent interest per year compounded semiannually. What's the future value of this investment after two years? (Round your answer to the nearest dollar.) A. $3,600 B. $3,630 C. $3,647 D. $6,600 11. New Homes has a bond issue with a coupon rate of 5½ percent that matures in 8½ years. The bonds have a par value of $1,000 and a market price of $972. Interest is paid semiannually. What's the yield to maturity? A. 6.42 percent B. 6.36 percent C. 5.92 percent D. 5.74 percent 12. While researching construction loans, you discover you can take out a Bank of America fiveyear, $200,000 loan with eight-percent interest compounded annually, or a Chase Bank loan with the same terms—except that the eight-percent interest is compounded semiannually. You know you won't be able to make any payments on the loan until you sell the building at the end of year five. Which loan will result in the lowest interest expense? A. The Chase Bank loan B. The Bank of America loan C. It isn't possible to determine the interest expense of these loans with the information provided. D. It doesn't make any difference; the interest expense will be the same. 13. Three Corners Markets paid an annual dividend of $1.37 a share last month. Today, the company announced that future dividends will be increasing by 2.8 percent annually. If you require a return of 11.6 percent, how much are you willing to pay to purchase one share of this stock today? A. $18.23 B. $15.57 C. $16.67 D. $16.00 14. Suppose that you buy a $2,000 bond with a 10-percent annual coupon, payable semiannually on January 1st and July 1st. On both January 1st and July 1st, the bondholder will receive $100 for a total annual interest payment of $200 ($100 + $100). Based on the principal and accrued interest only, how much would you expect to pay to purchase this bond on April 1st? A. $2,100 B. $2,050 C. $2,000 D. $2,200 15. Roy's Welding common stock sells for $48.96 a share and pays an annual dividend that increases by 2½ percent annually. The market rate of return on this stock is 14.6 percent. What's the amount of the last dividend paid? A. $4.80 B. $5.86 C. $4.98 D. $5.78 16. You want to invest money for three years in an account that pays nine-percent interest annually. How much would you need to invest today to reach a future goal of $12,000? (Round your answer to the nearest dollar.) A. $10,984 B. $11,432 C. $10,100 D. $9,266 17. MBM estimates its expansion cost at $18.63 million and wants it fully funded upfront. Management has decided to save $1.1 million a quarter for this purpose. The firm earns 6¼ percent, compounded quarterly, on its savings. How long does the firm have to wait before expanding its operations? A. 3.09 years B. 4.91 years C. 3.79 years D. 4.82 years 18. You need some money today. Your friend agrees to loan you the money if you make payments of $30 a month for the next six months. In keeping with his reputation, he requires that the first payment be paid today. He also charges you two-percent interest per month. How much money are you borrowing? A. $164.09 B. $168.22 C. $171.40 D. $170.68 19. Assume that a corporation wants to borrow $100,000 by issuing one hundred 10-year, $1,000 bonds. The interest rate required for similar bonds from similar corporations is 11 percent. Coupon payments will be made annually. What's the annual coupon payment for each bond? A. $11,000 B. $110 C. $1,100 D. $100,000 20. The interest rate most commonly quoted by a lender is referred to as the A. effective annual rate. B. simple rate. C. annual percentage rate. D. compound rate. Exam: 500302RR - Capital Budgeting When you have completed your exam and reviewed your answers, click Submit Exam. Answers will not be recorded until you hit Submit Exam. If you need to exit before completing the exam, click Cancel Exam. Questions 1 to 20: Select the best answer to each question. Note that a question and its answers may be split across a page break, so be sure that you have seen the entire question and all the answers before choosing an answer. 1. If a project has a net present value equal to zero, then A. a decrease in the project's initial cost will cause the project to have a negative NPV. B. the project's PI must also be equal to zero. C. the project earns a return exactly equal to the discount rate. D. the total of the cash inflows must equal the initial cost of the project. 2. A new project will cause a $2,200 increase in sales, a $1,045 increase in costs, a $440 increase in depreciation, and a $243 increase in taxes. Using the bottom-up approach, what's the change to OCF? A. $342 B. $472 C. $1,155 D. $912 3. An app startup currently has one million per year in cash flows from its garden-themed SIMS game. The firm is looking at developing a new pet-theme SIMS game. In preliminary projections, the CFO believes that the new project can generate an additional one million in new cash flows per year. He argues that the two products could bring in a total of two million in cash flows per year. After evaluating his prediction, you conclude that cash flows are likely to be A. more than two million because of capital spending. B. less than two million because of erosion. C. less than two million because of opportunity costs. D. more than two million because of sunk costs. 4. You're working on a bid to build two apartment buildings a year for the next three years. This project requires the purchase of $1,089,000 of equipment that will be depreciated using straight-line depreciation to a zero book value over the project's life. The equipment can be sold at the end of the project for $815,000. You'll also need $280,000 in net working capital over the life of the project. The fixed costs will be $528,000 a year, and the variable costs will be $1,640,000 per building. Your required rate of return is 18 percent for this project, and your tax rate is 35 percent. What's the minimal amount, rounded to the nearest $100, you should bid per building? A. $2,116,200 B. $2,780,600 C. $4,233,000 D. $4,489,500 5. G & L Plastic Molders spent $1,200 last week repairing a machine. This week, the company is trying to decide if the machine could be better utilized if they assigned it to a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost? A. Fixed B. Incremental C. Sunk D. Opportunity 6. A disadvantage of the discounted payback period method when compared to NPV is that it A. may accept negative NPV projects. B. may reject economically viable projects (positive NPV projects). C. completely ignores the time value of money. D. is more difficult to understand. 7. What's an example of a variable cost? A. Rent B. Depreciation C. Administrative costs D. Cost of goods sold 8. Precise Machinery is analyzing a proposed project. The company expects to sell 2,340 units, give or take five percent. The expected variable cost per unit is $260, and the expected fixed costs are $589,000. Cost estimates are considered accurate within a plus or minus four-percent range. The depreciation expense is $129,000. The sales price is estimated at $750 per unit, give or take two percent. What's the amount of the total costs per unit under the worst-case scenario? A. $638.23 B. $545.96 C. $551.62 D. $638.23 9. A project requires an initial investment of $1,000 and will pay only one payment of $1,160 in one year. Assuming a firm's required rate of return is 15 percent, should the firm accept the project according to the IRR rule? Why or why not? A. The firm should be indifferent toward the decision. B. Yes, the IRR is greater than the required rate of return. C. There isn't enough information to determine if the project should be accepted or rejected. D. No, the IRR is less than the required rate of return. 10. Which of the following will decrease the net present value of a project? A. Decreasing the required discount rate B. Increasing the amount of the final cash inflow C. Increasing the value of each project's discounted cash inflows D. Increasing the project's initial cost at time zero 11. Why is it important to find changes of net working capital (NWC) in developing cash flows? A. Changes in NWC indicate capital expenditures (such as purchase of equipment). They must be subtracted from cash inflows (measured by other cash flow). B. Changes in NWC indicate cash outflows (measured by change in NWC) must be subtracted from cash inflows (measured by operating cash flow). C. Changes in NWC have important tax implications (a tax shield), so they must be multiplied by 1 minus the tax rate to find total cash flow. D. Changes of NWC are unimportant. 12. The Coffee Express has computed its fixed costs to be $.48 for every cup of coffee it sells, given annual sales of 145,000 cups. The sales price is $1.29 per cup, while the variable cost per cup is $.07. How many cups of coffee must it sell to break even on a cash basis? A. 67,630 B. 57,049 C. 23,910 D. 46,472 13. Net present value is based on many estimates and forecasts. What can be done to compensate for the uncertainty of these future variables? A. Nothing B. Sensitivity and scenario analysis C. Decreasing the discount rate D. Using IRR instead 14. Sensitivity analysis determines the A. degree to which the net present value reacts to changes in a single variable. B. net present value range that can be realized from a proposed project. C. degree to which a project relies on its fixed costs. D. ideal ratio of variable costs to fixed costs for profit maximization. 15. A project requires an initial investment of $10,000 and will pay only one payment of $12,000 in one year. What's the IRR? A. $12,000 B. 12 percent C. $2,000 D. 20 percent 16. Which of the following best describes the concept of erosion? A. Change in net working capital related to implementing a new project B. The cash flows of a new project that come at the expense of a firm's existing cash flows C. The alternative that's forfeited when a fixed asset is used by a project D. Expenses that have already been incurred and can't be recovered 17. A project will require $498,000 for fixed assets and $58,000 for net working capital. The fixed assets will be depreciated straight-line to a zero book value over the five-year life of the project. At the end of the project, the fixed assets will be worthless. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $875,000 and costs of $640,000. The tax rate is 35 percent, and the required rate of return is 15 percent. What's the amount of the annual operating cash flow? A. $117,320 B. $187,610 C. $105,000 D. $147,820 18. A project requires an initial investment of $45,400 today. The present value of the cash inflows likely to result from this initial investment is $45,300. Should the firm proceed with the investment? Why or why not? A. Yes, because the NPV is positive. B. Yes, because the NPV is negative. C. No, because the NPV is positive. D. No, because the NPV is negative. 19. Suppose you're considering making an investment in one of two firms. Firm A has fixed costs that account for 50 percent of total costs, and variable costs account for 50 percent of total costs. Firm B has fixed costs that account for 80 percent of total costs, and variable costs account for 20 percent of total costs. Assuming everything else is equal and that you're risk adverse, which firm would you invest in and why? A. Firm A because it's less risky B. There isn't enough information. C. Firm B because it's less risky D. It doesn't matter because both firms have a similar amount of risk. 20. Assume a project has a sales quantity of 8,600 units plus or minus five percent and a sales price of $69 a unit plus or minus one percent. The expected variable cost per unit is $11 plus or minus three percent, and the expected fixed costs are $290,000 plus or minus two percent. The depreciation expense is $68,000. The tax rate is 34 percent. What's the operating cash flow under the best-case scenario? A. $168,470.15 B. $187,295.40 C. $175,705.93 D. $164,208.11 End of exam Exam: 500304RR - Cost of Capital and Financial Policy When you have completed your exam and reviewed your answers, click Submit Exam. Answers will not be recorded until you hit Submit Exam. If you need to exit before completing the exam, click Cancel Exam. Questions 1 to 20: Select the best answer to each question. Note that a question and its answers may be split across a page break, so be sure that you have seen the entire question and all the answers before choosing an answer. 1. What are the two risk components that determine a firm's cost of equity? A. Management risk and financial structure risk B. Financial structure risk and interest rate risk C. The risk inherent in a firm's operations, plus financial structure risk D. Interest rate risk and the risk inherent in a firm's operations 2. The interest tax shield is a key reason why A. the value of an unlevered firm is equal to the value of a levered firm. B. firms prefer equity financing over debt financing. C. the net cost of debt to a firm is generally less than the cost of equity. D. the cost of debt is equal to the cost of equity for a levered firm. 3. When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should A. increase the initial project cost by multiplying that cost by 1.068. B. add 6.8 percent to the firm's WACC to determine the discount rate for the project. C. increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 – .068). D. increase the initial project cost by dividing that cost by (1 – .068). 4. Hanover Tech is currently an all-equity firm that has 320,000 shares of stock outstanding with a market price of $19 a share. The current cost of equity is 15.4 percent, and the tax rate is 34 percent. The firm is considering adding $1.2 million of debt with a coupon rate of 8 percent to its capital structure. The debt will be sold at par value. What's the levered value of the equity? A. $6.708 million B. $5.209 million C. $6.512 million D. $5.288 million 5. Deep Mining and Precious Metals are separate firms that are both considering a silver exploration project. Deep Mining is in the actual mining business and has an aftertax cost of capital of 16.7 percent. Precious Metals is in the precious gem retail business and has an aftertax cost of capital of 12.6 percent. The project under consideration has initial costs of $755,000 and anticipated annual cash inflows of $152,000 a year for 10 years. Which firm(s), if either, should accept this project? A. Deep Mining only B. Both Deep Mining and Precious Metals C. Neither Deep Mining nor Precious Metals D. Precious Metals only 6. Western Wear is considering a project that requires an initial investment of $260,000. The firm maintains a debt-equity ratio of .40, has a flotation cost of debt of 8 percent, and a flotation cost of equity of 10½ percent. The firm has sufficient internally generated equity to cover the equity portion of this project. What's the initial cost of the project including the flotation costs? A. $297,747 B. $272,005 C. $281,406 D. $266,082 7. D. L. Tuckers has $48,000 of debt outstanding that's selling at par and has a coupon rate of 6.75 percent. The tax rate is 35 percent. What's the present value of the tax shield? A. $2,106 B. $16,200 C. $16,800 D. $3,240 8. Which cost is an indirect cost of bankruptcy to the firm? A. Administrative costs associated with the bankruptcy B. Administrative costs not associated with the bankruptcy C. Legal costs associated with the bankruptcy D. Loss of sales from people not wanting to buy a product from a bankrupt company 9. The unlevered cost of capital refers to the cost of capital for A. a corporate shareholder. B. a governmental entity. C. a privately owned entity. D. an all-equity firm. 10. The cost of preferred stock can be calculated by A. using the risk-free rate and adding a risk premium. B. discounting five future predicted dividends and a future predicted preferred stock price. C. dividing the annual dividend by the price of the preferred stock. D. dividing the price of the preferred stock by the dividend. 11. Which of the following is true about a firm with no equity financing? A. The return on equity = cost of debt B. The return on equity = WACC C. The cost of debt = WACC D. The after-tax cost of debt = WACC 12. What does the pecking order theory postulate? A. The optimal capital structure is a highly leveraged firm because of the tax shield. B. The optimal capital structure is dependent upon the effective tax rate. C. The optimal capital structure is the point at which the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. D. There's no optimal debt-equity ratio; instead, a firm's capital structure is determined by its need for external financing. 13. Key Motors has a cost of equity of 11.29 percent and an unlevered cost of capital of 10.4 percent. The company has $22,000 in debt that's selling at par value. The levered value of the firm is $64,000, and the tax rate is 34 percent. What's the pretax cost of debt? A. 7.82 percent B. 5.73 percent C. 6.18 percent D. 6.59 percent 14. A higher debt level usually equates to a A. smaller tax shield and increased financial risk. B. smaller tax shield and decreased financial risk. C. larger tax shield and decreased financial risk. D. larger tax shield but increased financial risk. 15. Stock in Country Road Industries has a beta of 1.46. The market risk premium is 7½ percent, while Tbills are currently yielding 2½ percent. Country Road's last dividend was $1.55 per share, and dividends are expected to grow at an annual rate of 4½ percent indefinitely. The stock sells for $26 a share. What's the estimated cost of equity using the average return of the CAPM and the dividend discount model? A. 11.50 percent B. 11.38 percent C. 14.06 percent D. 12.09 percent 16. According to the static tradeoff theory, what's the optimal capital structure? A. A firm should have equal parts equity and debt. B. A firm should borrow up to the point at which the tax benefit from an extra dollar is equal to zero. C. A firm should borrow up to the point at which the interest is equal to the total tax expense. D. A firm should borrow up to the point at which the tax benefit from an extra dollar in debt is exactly equal to the cost that comes from the increased probability of financial distress. 17. SLG Corp. is an all-equity firm with a weighted average cost of capital of 9.68 percent. The current market value of the equity is $27½ million, and the tax rate is 35 percent. What is EBIT? A. $1,730,300 B. $2,821,194 C. $6,180,000 D. $4,095,385 18. River Walk Tours is expected to have an EBIT of $354,000 next year. Depreciation, the increase in net working capital, and capital spending, are expected to be $24,000, $2,000, and $33,000, respectively. All are expected to grow at 7 percent per year for three years. After year four, the adjusted cash flow from assets is expected to grow at 3.2 percent indefinitely. The company's WACC is 9.2 percent, and the tax rate is 34 percent. What's the terminal value of the firm's cash flows? A. $3,711,052 B. $4,008,051 C. $3,992,419 D. $4,691,189 19. A firm has issued too much debt and is considering a seasoned offering (issuing more stock) to raise money to pay off a good portion of its debt. This is considered A. bankruptcy. B. illegal. C. restructuring. D. liquidating. 20. Dee's Toys has a target debt-equity ratio of .55. Its WACC is 12.4 percent, and the tax rate is 34 percent. What's the cost of equity if the aftertax cost of debt is 5½ percent? A. 15.84 percent B. 14.79 percent C. 16.20 percent D. 15.75 percent End of exam Exam: 500303RR - Risk and Return When you have completed your exam and reviewed your answers, click Submit Exam. Answers will not be recorded until you hit Submit Exam. If you need to exit before completing the exam, click Cancel Exam. Questions 1 to 20: Select the best answer to each question. Note that a question and its answers may be split across a page break, so be sure that you have seen the entire question and all the answers before choosing an answer. 1. How many diverse securities are required to eliminate the majority of the diversifiable risk from a portfolio? A. 5 B. 10 C. 15 D. 25 2. Leo purchased a stock for $47.10 a share, received a $1.74 dividend per share, and sold the shares for $50.10 a share. During the time he owned the stock, inflation averaged 3.1 percent. What's his approximate real rate of return on this investment? A. 6.96 percent B. 6.30 percent C. 7.18 percent D. 9.69 percent 3. The real rate of return on a stock is approximately equal to the nominal rate of return A. divided by (1 – inflation rate). B. plus the inflation rate. C. divided by (1 + inflation rate). D. minus the inflation rate. 4. The primary purpose of portfolio diversification is to A. eliminate asset-specific risk. B. lower both returns and risks. C. eliminate systematic risk. D. increase returns and risks. 5. The primary purpose of Blume's formula is to A. project future rates of return. B. compute an accurate historical rate of return. C. determine the actual real rate of return. D. consider compounding when estimating a rate of return. 6. The intercept point of the security market line is the rate of return that corresponds to A. the market rate. B. the risk-free rate. C. the market risk premium. D. a return of zero. 7. A stock has a beta of 1.2 and an expected return of 17 percent. A risk-free asset currently earns 5.1 percent. The beta of a portfolio comprised of these two assets is 0.85. What percentage of the portfolio is invested in the stock? A. 71 percent B. 77 percent C. 92 percent D. 81 percent 8. The common stock of United Industries has a beta of 1.34 and an expected return of 14.29 percent. The risk-free rate of return is 3.7 percent. What's the expected market risk premium? A. 10.63 percent B. 7.90 percent C. 11.22 percent D. 7.02 percent 9. The expected return on JK stock is 15.78 percent, while the expected return on the market is 11.34 percent. The stock's beta is 1.51. What's the risk-free rate of return? A. 2.63 percent B. 2.31 percent C. 2.22 percent D. 2.42 percent 10. Assume you invest in a portfolio of U. S. Treasury bills and that the portfolio will earn a rate of return similar to the average return on U.S. Treasury bills for the period 1926–2013. What rate of return should you expect to earn? A. Less than two percent B. More than five percent C. Between two and three percent D. Between three and four percent 11. According to CAPM, the amount of reward an investor receives for bearing the risk of an individual security depends on the A. market risk premium and the amount of systematic risk inherent in the security. B. beta of the security and the market rate of return. C. amount of total risk assumed and the market risk premium. D. risk-free rate, the market rate of return, and the standard deviation of the security. 12. West Wind Tours stock is currently selling for $48 a share. The stock has a dividend yield of 3.2 percent. How much dividend income will you receive per year if you purchase 200 shares of this stock? A. $362.00 B. $36.20 C. $24.96 D. $307.20 13. You have a portfolio consisting solely of stock A and stock B. The portfolio has an expected return of 9.8 percent. Stock A has an expected return of 11.4 percent, while stock B is expected to return 6.4 percent. What's the portfolio weight of stock A? A. 81 percent B. 68 percent C. 59 percent D. 74 percent 14. Last year, U.S. Treasury bills returned two percent, while your investment in large-company stocks earned an average of five percent. The difference between these two rates of return is the A. geometric return. B. standard deviation. C. variance. D. risk premium. 15. Suppose that you purchased 250 shares of a stock at $32 per share, ignoring all commissions. Assume the stock paid a dividend of $3.75 per share for the year. The stock price rose to $44.25 per share and was then sold at that price. What was the total dollar return? A. $937.50 B. $4,000 C. $5,750 D. $12,000 16. The average compound return earned per year over a multiyear period is called the _______ average return. A. geometric B. arithmetic C. standard D. variant 17. _______ market efficiency suggests that at a minimum, the current price of the stock reflects the stock's own past prices. A. Loose form B. Strong form C. Semistrong D. Weak form 18. With regard to the efficient markets hypothesis (EMH), which of the following answers illustrates market inefficiencies? A. Delayed reactions, overreactions, and corrections B. An immediate price jump after good news is announced C. An immediate price fall after bad news is announced D. Insider trading, corruption, and government bailouts 19. Suppose the firm, Elena, Inc., has a major lawsuit pending against it. Everyone expects the company to win the suit, but to everyone's surprise, the firm loses. As far as the firm's stock price goes, the news is likely to have a/an A. immediate and slightly negative effect. B. immediate and significantly negative effect. C. immediate and significantly positive effect. D. slow and slightly negative effect. 20. Using the following, what's the expected return for the portfolio? Portfolio Stock A Value: 2,000 Expected Return: 15 percent Stock B Value: 8,000 Expected Return: 20 percent A. 18 percent B. 17 percent C. 19 percent D. 16 percent End of exam Graded Project Corporate Finance CONTENTS INTRODUCTION 2 Part 1: El Cap Climbing Company Part 2: Mortgage Decision Part 3: Can We Upgrade? Part 4: Risky Business 2 3 5 6 GRADING CRITERIA 10 Submitting Your Project 11 © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 1 CORPORATE FINANCE INTRODUCTION The purpose of this graded project is to bring together in a practical way some important concepts you’ve learned in the course. Once you’ve completed this project, you can perform similar analyses on other organizations. Some of the work for this project will be completed in Excel. Once you’ve completed these problems in Excel, and if you’ve linked all your cells properly, you can reuse your spreadsheets, only changing the inputs. Go to your student portal and download the 500306_Project_Files. This spreadsheet contains information needed to complete the project. You’ll be submitting this Excel spreadsheet along with your project. Part 1: El Cap Climbing Company El Cap Climbing Company (ECCC) is a small startup that manufactures and sells high-quality climbing gear in Fresno, California. The founder of the company, Leah, has been incredibly successful, but hasn’t kept the company’s financial records as well as she might have. The initial investment for El Cap was provided by her friends and family, and was small. However, current operations can’t meet the demand for the product, and Leah has plans to increase both production and the number of storefronts. These plans require a large investment from both equity and debt financing. The new investors and creditors require detailed financial statements. Leah has hired you, a financial analyst, to prepare these statements and give insight into the financial position of the firm. Leah has provided information from her bank statements, bills, and receipts in an Excel spreadsheet, which is found in your downloaded project files. She explained to you that taxes are paid at a rate of 30 percent, and dividends are paid at a rate of 40 percent. (Note: You can create the statements in the same Excel spreadsheet that has the financial information. Be sure to let the instructor know if you choose to do this instead of creating them in a Word document.) Prepare the following: n An income statement for 2015 and 2016 n A balance sheet for 2015 and 2016 n Operating cash flows for the two years n Cash flows from assets in 2016 n Cash flows to creditors for 2016 n Cash flows to stockholders for 2016 © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 2 B. Answer the following: 1. How would you describe the financial position of the firm in 2016? Write a brief overview. 2. What do you think about Leah’s plans to expand? Part 2: Mortgage Decision In order to expand, El Cap Climbing Company (ECCC) is considering taking out a mortgage for a new store location, a nonresidential real property that includes land and a building. Leah is unsure if she has the cash flow to take on any more debt. She asked you to create a loan amortization schedule for the proposed mortgage loan. Then, you’ll create a chart that represents the portion of each payment that goes toward principal and interest. A. Prepare the following: n A loan amortization schedule n A chart showing the percentage of the payment applied toward the principal and interest Loan Amortization Schedule First, you’ll need to create a loan amortization schedule in the downloaded Excel spreadsheet. Create the table on the tab named “Part 2 Loan Amortization Sched.” The following table illustrates the payments and interest amounts for a fixed-rate, 30-year, $500,000 mortgage, at a five-percent interest rate. The monthly payment will be 2,684.11. Payment Number Payment Amount 5% Interest Expense Principal 0 Balance Annual Interest Expense 500,000.00 - 1 2,684.11 2,083.33 600.78 499,399.22 2 2,684.11 2,080.83 603.28 498,795.94 …break in the sequence… Totals 466,278.03 500,000.00 359 2,684.11 22.22 2,661.89 360 2,682.54 11.13 2,671.41 2,671.41 - 855.56 The table serves as an example of what you’ll create in Excel. Note that the table shows only the figures for the first and the last year of payments; you’ll need to calculate the amounts for the remaining payments, and fill them in. Once you’ve determined how each of the amounts in the table is obtained, you can use relative and absolute cell references to fill in the full 360 payments. © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 3 The following is an explanation of the columns in the table: n Payment number—The first column in the table shows the 360 payments required to pay off the mortgage loan (30 years, with 12 monthly payments per year). n Payment amount—The second column shows the monthly payment amount. n Interest—The third column shows the portion of the monthly payment that goes to interest. n Principal—The fourth column shows the portion paid toward the principal. n Balance—The fifth column shows the starting balance of $500,000, and the remaining balance each month after the principal is subtracted. n Annual interest expense—The last column provides a running total of the interest expense on the mortgage for the entire 12-month period. It’s the amount that would be reported on the financial statements. n Totals—The “Totals” under the “5% Interest Expense” and “Principal” columns show the final totals for the 30-year life of the mortgage. Mortgage Principal and Interest Chart Next, you’ll create a chart following these steps. Create the table on the tab named “Part 2 Chart.” 1. Start by selecting the Interest Expense and Principal columns. Make sure to select the column headers and values. Don’t select the Totals row. 2. Click on the Insert tab and select a “Stacked Column.” Make sure to label the x-axis (payment month) and y-axis (dollars), and include a legend for the two values (interest and principal). 3. Your final chart should be set up similar to the chart below, with the data populating the chart. (The increments don’t need to be the same). © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 4 B. Answer the following: 1. How can you describe the relationship between time and the amount paid towards principal and interest? 2. Knowing what we know about ECCC’s cash flow from Part 1, is it reasonable to believe that ECCC can take on this new debt? Part 3: Can We Upgrade? It’s now 2017, and El Cap Climbing Company (ECCC) has continued to grow. One of ECCC’s major revenue-producing products is a spring-loaded camming device called SLCD, or cams. It’s a device with a small handle (called the “trigger”) and two spring loaded “cams” on an axle. When the trigger is pulled, the cams move together, decreasing the size of the cams. It’s then inserted into a crack or pocket in the rock. When the trigger is released, the cams expand. These cams are used as anchors when “trad” rock climbing. ECCC currently has one set of cams on the market, and sales have been excellent. The cams are lighter and perform better than their competitors. However, as with any high-performance item, technology changes rapidly, and the cams are now falling behind the competition. ECCC spent $200,000 to develop a prototype for a new line of cams that has all the features of the existing cams, but are made from an even lighter and stronger 7075-T6 aluminum alloy. The company has spent a further $150,000 for a marketing study to determine the expected sales figures for the cam line. ECCC can manufacture a set of the new cams for an average of $140 each in variable costs. Fixed costs for the operation are estimated to run an additional $2.1 million per year if the new project is undertaken. The estimated sales volume is 75,000, 85,000, 80,000, 70,000, and 65,000 per year for the next five years, respectively. The unit price of the new cam set will be $240. The necessary equipment can be purchased for $10.5 million and will be depreciated on a seven-year MACRS schedule. It’s believed the value of the equipment in five years will be $1.1 million. Production of the current cam line is expected to be terminated in two years. If ECCC doesn’t introduce the new line of cams, sales will be 45,000 units and 25,000 units for the next two years, respectively. The price of the cam set is $150, with variable costs of $95 each, and fixed costs of $1.5 million per year. If ECCC does introduce the new cams, sales of the existing product will fall by 10,000 units per year, and the price of the existing sets should be lowered to $120 each. Net working capital for the cams will be 22 percent of sales and will occur with the timing of the cash flows for the year; for example, there’s no initial outlay for NWC, but changes in NWC will occur in Year 1 with the first year’s sales. ECCC has a 30-percent corporate tax rate and a required return of 10 percent. (Note: You can create the solutions in the same Excel spreadsheet that has the data report information. Be sure to let the instructor know if you choose to do this instead of creating them in a Word document.) © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 5 Leah has provided you with a data report in an Excel spreadsheet that contains information to answer the following questions: 1. What’s the payback period of the project? 2. What’s the profitability index of the project? 3. What’s the IRR of the project? 4. What’s the NPV of the project? 5. Should Leah accept the project? 6. If Leah needs to adjust the price of the product, what’s the lowest Leah could make the price of the new cam set and still have a positive NPV project (keeping all other assumptions the same)? Part 4: Risky Business Lastly, just for fun, El Cap Climbing Company (ECCC) is looking at determining their sensitivity to market fluctuations. Since ECCC isn’t publically traded and can’t look at their own stock history, they must evaluate their competitors. Black Diamond Equipment is their closest competitor, but the company doesn’t have enough trading volume to make any sound conclusions. Leah identifies Callaway Golf Company (ELY) as ECCC’s closest publicly-traded competitor. Even though ELY sells golf equipment, it too is a specialized company selling high-tech sports equipment. Finding Beta with CAPM Note: This information is also in your textbook. The CAPM is one of the most thoroughly researched models in financial economics. When beta is estimated in practice, a variation of CAPM, called the market model, is often used. To derive the market model, we start with the CAPM: E(Ri) 5 Rf 1 β[E(RM) 2 Rf ] Since CAPM is an equation, we can subtract the risk-free rate from both sides, which gives us: E(Ri) 2 Rf 5 β[E(RM) 2 Rf ] This equation is deterministic—that is, exact. In a regression, we realize that there’s some indeterminate error. We need to formally recognize this in the equation by adding epsilon, which represents this error: E(Ri) 2 Rf 5 β[E(RM) 2 Rf ] 1 ε © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 6 Finally, think of the above equation in a regression. Since there’s no intercept in the equation, the intercept is zero. However, when we estimate the regression equation, we can add an intercept term, which we’ll call alpha: E(Ri) 2 Rf 5 αi 1 β[E(RM) 2 Rf ] 1 ε The intercept term is known as Jensen’s alpha, and it represents the “excess” return. If CAPM holds exactly, this intercept should be zero. Think of alpha in terms of the SML: If the alpha is positive, the stock plots above the SML; if the alpha is negative, the stock plots below the SML. You’ll first create a scatter plot and then perform a regression analysis for ELY stock and the mutual fund. Then use those results to compare and analyze the results. A. Scatter Plotting and Regression Analysis Use the following steps to create the scatter plot: 1. Go to the Part 4 Stock Data tab in your Excel spreadsheet. Highlight column K–M headings, then hold down the Ctrl button and select cells K-3 through M-62. 2. Go to the INSERT tab, click on Scatter Chart, and select the first style. 3. Move the chart to the side of the data, and increase the size of the chart. Click on the Chart Title and change it to Risk Premium Analysis. © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 7 4. In the DESIGN tab, click on Quick Layout. Select the layout that gives you the y formulas and the R2. 5. Move the y formulas and the R2 to the bottom right-hand corner of the chart. Now use the following steps to create a regression analysis for ELY and for the Mutual Fund: 1. First, check to see that you have the ability to run the analysis. Go to the DATA tab in Excel, and look for the Data Analysis feature shown in the image below. If you don’t see Data Analysis, you might need to add Analysis Toolpak in Excel. For instructions on how to load the Analysis Tookpak into your version of Excel, visit https://support.office.com/en-us/article/Loadthe-Analysis-ToolPak-6a63e598-cd6d-42e3-9317-6b40ba1a66b4. Contact Microsoft Support if you have any issues with this add-in. Once you've completed all these steps, you can continue with your project. © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 8 2. Click on Data Analysis. A dialog box with a list of analysis tools will open. Select Regression from the list and click OK. 3. Next, another dialog box opens for you to select your Inputs and Output for the regression. Select the input data ranges by highlighting S&P Risk Premium numbers (x-axes range) and the number for the asset you’re comparing as the y-axes range. Output to a new worksheet (do not type a name in the text box). Select the check boxes for Labels, Confidence Level, and Residuals. Click OK. 4. Your regression analysis will open in a new worksheet. Rename the worksheet based on the premium being compared to the S&P premium, for example: “ELY Regression Analysis.” © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 9 B. Answer the following questions: 1. In this regression, Rt is the return on the stock and Rft is the risk-free rate for the same period. RMt is the return on a stock market index, such as the S&P 500 index. αi is the regression intercept, and βi is the slope (and the stock’s estimated beta). εt represents the residuals for the regression. The intercept, αi, is often called Jensen’s alpha. What does it measure? If an asset has a positive Jensen’s alpha, where would it plot with respect to the SML? Rt 2 Rft 5 αi 1 βi [RMt 2 Rft ] 1 εt 2. Is the alpha of either ELY or the mutual fund significantly more or less than zero? (Hint: The alpha is the intercept.) 3. How do you interpret the beta for the stock and the mutual fund? (Hint: The beta is next to the coefficient.) 4. Which of the two regression estimates has the highest R-squared? Is this what you would have expected? Use the scatterplot to explain why. GRADING CRITERIA Your project is worth a total of 100 points. Your instructor will use the following breakdown of points for each portion of the project to calculate your final grade: Part 1— 25 Points Total Part 2— 25 Points Total Part 3— 25 Points Total Part 4— 25 Points Total Interest: 4 points Question 1: 3 points Graph: 5 points Principal: 2 points Question 2: 5 points Balance: 3 points Question 3: 5 points Display Amounts: 6 points Operating Cash Flows: 4 points Annual interest: 4 points Question 4: 5 points Asset Cash Flows: 6 points Sub Totals: 2 points Creditor Cash Flows: 2 points Question 1: 2 points Income Statement: 6 Points Balance Sheet: 5 points Stockholder Cash Flows: 2 points Graph: 5 points Question 5: 2 points Question 6: 5 points Question 1: 4 points Question 2: 2 points Question 3 : 2 points Question 4: 6 points Question 2: 3 points © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 10 Submitting Your Project Each project is individually graded and therefore could take approximately five to seven business days to grade. Be sure to submit the Excel spreadsheet with your answers and any word documents. Follow this procedure to submit your project online: Make sure the following information is in the heading of each document: n Your name n Your email address n Your student number n Course name and number n Project number (50030600) To submit your graded project, follow these steps: 1. Go to http://www.pennfoster.edu and log in to your stu­dent portal. 2. On your student portal, click on Take an Exam. 3. In the box provided, enter the project number. The number for this project is 50030600. 4. Click on Submit. 5. On the next screen, enter your email address. (Note: This information is required for online submission.) 6. If you wish to tell your instructor anything specific regarding this project, enter it in the Comments. 7. Attach your file or files as follows: a. Click on the first Browse box. b. Locate the file you wish to attach. c. Double-click on the file. d. To attach the additional files, click on the next Browse box and repeat steps b and c. Repeat until all files are uploaded. 8. Click on Submit. Be sure to keep a backup copy of any files you submit to the school! © PENN FOSTER, INC. 2017 CORPORATE FINANCE Graded Project PAGE 11
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