PRINCIPLES OF FINANCIAL MANAGEMENT

BUS 302A: PRINCIPLES OF FINANCIAL MANAGEMENT

Midterm: by July 23, Thursday 11:59 pm CST, 2015

Instructor: Dr. Leo Bin

 

NOTES: Please see my requirements posted along with the exam link on Blackboard. If you do not follow them, you will be subject to credit deductions, or zero credit, or even a grade of F. The due date is this Thursday, be careful!

 

PART I: 20 multiple-choice questions, 2 points for each, up to 40 points in total.

(For this part, you do NOT need to show me any solution steps; just pick the one answer that you consider the “closest”, and type the chosen answer number into your Excel sheet such as 1. F; 2. G;… No need to copy any question statements into the Excel, either.)

 

1. By the history record for U.S. capital market, ________ had the smallest average annual return, and ________ had the greatest standard deviation (total risk) of returns.

a. Large company stocks; Small company stocks.

b. Small company stocks; Large company stocks.

c. Large company stocks; Treasury bills.

d. Treasury bills; Small company stocks.

e. Governmental bonds; Corporate bonds.

 

2. Star Wars Group just paid a dividend of $1.50 per share on its stock. The dividends are expected to grow at a constant rate of 10% per year, indefinitely. If investors require 15% annual return on this stock, the current stock price shall be ________.

1. 1. $30
   2. $33
   3. $35
   4. $40
   5. $43

3. Based on the previous information from Q2, seven years from now the stock price of Star Wars Group shall be ________.

1. 1. $52.32
   2. $58.46
   3. $64.31
   4. $72.50
   5. $77.95

4. Cardassia Corp. will pay a dividend of $2.00 per share on its stock for the next year. The dividends are expected to grow at a constant rate of 15% per year, indefinitely. If investors expect and require 10% annual return on this stock, the current stock price shall be ________.

a. -$44

b. -$40

c. $40

d. $44

e. None of the above.

 

5. One investment opportunity should be rejected if its NPV is ________ and its IRR is ________.

a. Positive; Positive.

b. Positive; Greater than the required return.

c. Negative; Negative.

d. Negative; Smaller than the required return.

e. Negative; Greater than the required return.

 

6. The IRR and NPV rules always lead to identical decisions if:

a. The project’s cash flows are conventional.

b. The projects are mutually exclusive.

c. The projects are independent.

d. Both (a) and (b).

e. Both (a) and (c).

 

7. Darth Vader, Inc. is looking at setting up a new manufacturing plant in Death Star to produce TIE fighters. The company bought some land a decade ago for $40 billion. The land was appraised recently for $30 billion. Darth Vader wants to build the new plant on this land; the plant will cost $50 billion to build, and the site requires $3 billion worth of grading before it is suitable for construction. What should be the proper “incremental cash flow” amount to use as the initial investment (CF0)?

a. $43 billion.

b. $60 billion.

c. $63 billion.

d. $83 billion.

e. $93 billion.

 

Questions 8-12 refer to the following information.

The above are two mutually exclusive investment projects for Rebel Alliance. The Alliance requires getting their invested amount fully paid back within 5 years. The Alliance’s cost of capital (i.e., the required return on investment) is 6% annually.

 

8. Based on the Payback rule, what project(s) should the Alliance accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

9. Based on the NPV rule, what project(s) should the Alliance accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

10. Based on the IRR rule, what project(s) should the Alliance accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

11. Based on your answers to Q8-10, what project(s) should the Alliance accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

12. At what discount rate would the Alliance be indifferent between the two projects?

a. 4%.

b. 5%.

c. 6%.

d. 7%

e. 8%.

 

Questions 13-16 refer to the following information.

There are two independent investment projects for the Galactic Empire. Project A (build TIE Fighters) costs the Empire $300,000 to set up, and it will provide annual cash inflows of $70,000 for 7 years. Project B (build Death Star) costs the Empire $1,000,000 to set up, and it will provide annual cash inflows of $255,000 for 6 years. The Empire’s cost of capital (i.e., the required return on investment) is 10% annually, and the Empire requires the initial investments in those projects be fully paid back within 4 years, or it will be running out of money by then.

 

13. Based on the NPV rule, what project(s) should the Empire accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

14. Based on the IRR rule, what project(s) should the Empire accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

15. Based on the Payback rule, what project(s) should the Empire accept?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

16. Based on your answers to Q13-15, what project(s) should the Empire finally choose?

a. Project A only.

b. Project B only.

c. Both Projects A and B.

d. Neither Project A or B.

 

17. The capital assets pricing model (CAPM) tells us that in an efficient and fair capital market, the expected return on an asset only depends on its:

a. Total risk.

b. Systematic risk.

c. Unsystematic risk.

d. No risk.

 

18. The CAPM shows that the expected return for a particular asset depends on the following factors except:

a. Market risk premium.

b. The pure time value of money.

c. The amount of unsystematic risk.

d. The amount of systematic risk.

 

19. Obi-Wan’s common stock has a beta of 1.4. If the risk-free rate is 3 percent and the market risk premium is 15 percent, what is Obi-Wan’s cost of equity?

a. 16.80%.

b. 19.80%.

c. 21.00%.

d. 24.00%.

 

20. Yoda Co.’s most recent dividend was $1.50 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely. The stock sells for $30 per share. What is Yoda’s cost of equity?

a. 10.00%

b. 10.25%.

c. 11.00%.

d. 11.25%.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

PART B: Problem-solving Questions, up to 60 points in total.

(For this part, you MUST present sufficient solution steps, and MUST apply specific Excel functions =NPV(…), =IRR(…), =YIELD(…) whenever applicable. Otherwise, you will not receive credit for your answers.)

 

Mini-Case One

Ferengi, Inc. is subject to an applicable corporate tax rate of 35 percent, and the weighted average cost of capital (WACC) of 12.5 percent. There is no specific time constraint on investment project payback requirements.

 

Q1: Ferengi is currently contemplating two capital investment plans. Plan A: the upgrade of an information system with an installed cost of $2,400,000. The upgrade system will be depreciated straight-line to zero over the project’s five-year life, at the end of which the system will be worth $400,000 at the market. The system upgrade will not affect sales, but will save the firm $700,000 per year in pretax operating costs; and the upgrade will increase the working efficiency and reduce net working capital by $300,000 at the beginning year.

 

What is the NPV of Plan A? What is the IRR of Plan A? Should Ferengi accept or reject Plan A? (12 points)

 

 

 

Q2: Instead of Plan A, Ferengi can alternatively choose Plan B: allocate the $2,400,000 capital budget to develop a new product line. The new product line will be depreciated straight-line to zero over the project’s ten-year life, at the end of which the system will be worth $100,000. The new product line will not only add the firm $830,000 per year in sales, but also add $200,000 per year in pretax operating costs; and the new project line requires an initial investment in net working capital of $300,000 at the beginning year.

 

What would be the NPV of Plan B? What would be the IRR of Plan B? If these two plans are mutually exclusive, shall Ferengi finally choose Plan A or B? (12 points)

 

 

 

 

 

 

 

Mini-Case Two

Given the following information for Bajor Co.:

 

Debt: Bajor’s long-term debt capital consists of bonds with 6.250 percent coupon rate (semiannual coupon payments), 9 years time to maturity, and current price of 106.61 percent of its par value.

 

Preferred stock: Bajor has not issued any preferred stocks.

 

Common stock (equity):

• Bajor’s equity capital consists of common stocks with the most recent annual dividend of $0.92 per share, and a current stock price of $14 per share.

• According to online data sources, Bajor’s long-term dividend growth (e.g., for 5-Year average) g = 4.5% per year.

• The “risk-free” Treasury bill return is 3.8%; the market expected return for the stock market on average is 12.3%; and Bajor’s systematic risk (Beta) is 0.71.

Taxes: The applicable federal-plus-state corporate tax rate for Bajor is 40 percent.

 

Capital weight:Bajor’s “Market Capitalization” amounts to $18.23 billion, and “Total Debt” amounts to $14.44 billion. You can use such data to estimate the capital weights for equity and debt, respectively (We and Wd).

 

Time constraint:For any investment projects, Bajor are required by her investors to recover its initial cost within no more than 6 years.

 

Q1: What is Bajor’s pretax cost of debt Rd, cost of equity Re, and WACC, respectively? (Hint: For the best estimate of cost of equity Re, you shall apply both CAPM and Dividend Growth Model and then average the two estimates.)(12 pts)

 

Q2: There are three investment projects available to Bajor:

Project A costs $12 million today and then provides after-tax net cash inflow of $2.50 million per year for the next 7 years.

Project B costs $18 million today and then provides after-tax net cash inflow of $3.30 million per year for the next 8 years.

Project C costs $30 million today and then provides after-tax net cash inflow of $4.25 million per year for the next 10 years.

 

If Projects A, B & C are mutually exclusive, which project(s) should Bajor accept?(You must apply NPV, IRR and Payback rules)(8 pts)

 

Q3: If the aforementioned Projects A, B & C are independent, which project(s) should Bajor accept? (You must apply NPV, IRR and Payback rules)(4 pts)

 

 

Mini-Case Three

We are given that Microthin’s stock price was $21 in May 2011, $29 in May 2012, $27 in May 2013, $20 in May 2014, and $26 in May 2015. It also pays annual dividends varying from 2011 through 2015.

Let’s assume you do the following transactions:

a) In May 2011: buy 30,000 Microthin shares;

b) In May 2012: collect the dividends ($0.39 per share) on your shares, and then sell 10,000 shares;

c) In May 2013: collect the dividends ($0.43 per share) on your remaining shares, and then buy another 15,000 shares;

d) In May 2014: collect the dividends ($0.50 per share) on your remaining shares, and then sell another 10,000 shares.

e) In May 2015: collect the dividends ($0.52 per share) on your remaining shares, and then sell all your remaining shares.

 

Q1: What should be the IRR during your “May 2011 – May 2015″ period for your Microthin stock investment?(4 pts)

 

 

Q2: Also given are Microthin stock Beta value = 1.25, the updated long-term average return of US stock market index = 11.53%, and the updated long-term average return of US “risk-free” T-bill = 3.53%. What shall be the required return on Microthin stock (using CAPM)?(4 pts)

 

 

Q3: Based on your answers to Q1 and Q2, is your Microthin stock investment over the “May 2011 – May 2015” period good or bad (using NPV and IRR rules)? (4 pts)

 

 

PS: Additional bonus quiz regarding ETS finance field test sample questions will be available via another “Assignments” link, and will have another separate due date (by Monday).