MIDTERM 1 (sample)                                         

1 a)   Mr. Sabri will receive the following 5-year cashflow stream: $328 at time 1, and the size of future payments will grow at 3% each year.  If the expected inflation rate is 3% per year, what are Mr. Sabri’s real cashflows each year?

b) Nusrat Inc.’s new project will generate real cashflows of $8,000 each year for 4 years, starting at time 1.  Expected inflation rates today are 2.5% a year for the first two years and 4% a year thereafter. The nominal interest rate is constant at 8%.  Compute the present value of these cashflows in real terms.

(10 points)

2 a)   Rumi and Shams Investments have found an investment where they will invest $600 today, and get back $610.10 at the end of 2 months.  What is the effective annual rate they will earn?

b) An ordinary annuity will pay $600 each month for three years.  If the discount rate is 8% per year, compounded quarterly, what is the present value of the annuity?

(10 points)

3 a)   The We Dig Deeper Detective Agency had earnings per share last year of $1.20, and they paid a dividend last year of 42c.   They have a constant payout ratio, and a constant ROE of 14%.  Their required return is 10% per year.

         i) What is the stock price today?

         ii) How much of this is PVGO?

b) Describe in words how you would go about computing PVGO for a non-constant growth stock.  Make sure you explain everything fully.

(15 points)

4)      You need to choose between these two mutually exclusive projects using IRR alone.      

  Project                C₀                          C₁                     C₂                     C₃  

            A                -130,000                   44,000              88,000             50,000   

            B                  -80,000                  -74,500            158,000             50,000

a) Which project will you pick if the required return is 10%?

b) What would the required return have to be in order for you to pick the other project? (One example is enough.)

(15 points)

5.      A four year project requires a capital investment of $150,000.  The assets will be classified as 3-year assets under IRS rules, and depreciated at the following rates: first year 33.33%, second year 44.45%, third year 14.81%, fourth year 7.41%.  The expected salvage value at the end of 4 years is $22,000.  Projected operating data for each year is as follows:

                                           (1)                (2)                    (3)                    (4)

Sales (units)                    50,000          70,000             75,000            80,000

Sale price/unit                          6                   6.25                 6.40                6.50

Variable cost/unit                      5.20             5.25                 5.30               5.35

Fixed costs                      20,000          21,000             22,250            23,500

Allocated overheads          4,000            4,400               4,800              5,200

Incremental overheads      2,500            3,000               3,300              3,600

Interest Charges                3,000            3,500               4,000              4,500

The project requires working capital of $6,000 for the first year.  Working capital requirements will increase by 12% each subsequent year.  The firm will also use an existing piece of land for the project.  This was purchased 2 years ago for $20,000; it’s value today is $25,000.  The firm has a tax rate of 35%.  Compute the project’s net cashflows today (time 0) and for the last year.

(15 points)

6.      Biggio Brothers is deciding when to replace an existing machine, which has a useful life of 3 years left.  The real net cash flows the machine will generate are as follows:

                          Year         Net Cash Flow      

                         First                   5,000

                         Second              2,500

                         Third                  1,250

A replacement machine with the same production capacity would cost $50,000 today and will produce real net cash flows of $18,000 each year over its 4-year life.

a) If the real required return is 9% p.a., when should the existing machine be replaced?  (Be specific.  Say either “time x” or “beginning of year x” or “end of year x”.)

b) What assumptions are you making to answer this question?

(15 points)

7.      In a bold diversification move, the Kreamy Kold Kustard Ko. got into the snow shovel business some years ago.  They have 2 existing machines to manufacture snow shovels.    The production capacity of each machine is 30,000 shovels/year.  In fall/winter the machines produce at 100% of capacity (and produce 15,000 each).  In spring/summer, they produce at 45% of capacity.  The machines have an indefinite life, and an operating cost of $5 per shovel.  New machines are available that would cost $150,000, have the same production capacity, an indefinite life and an operating cost of $4.20 per unit.  If the required return is 6%, should you replace any of the old machines with new ones today?

(15 points)

8)      Mark the following statements with a T or an F to indicate whether they are true or false (no explanations required):                                                                                                                                        (20 points)

a)      In the context of a corporation the term “agency problem” refers to the fact that managers will act in the interests of stockholders only instead of balancing the interests of all the stakeholders in the firm (including bondholders, employees, customers, suppliers, etc).

b)      If you have a capital market in which you can lend but not borrow, you can compute a FV of a time 0 cashflow, but you cannot compute a PV today for a future cashflow.

c)   Computing stock price as the present value of just the future dividends ignores the fact that stockholders receive part of their return through capital gains.

d)   Holding other things constant, a company with valuable growth opportunities (i.e. positive PVGO) will have a high P/E ratio.

e)   If a company whose required return is10% has future investment opportunities each year with an NPV equal to 8% of the investment, their stock would be considered a growth stock.

f)       When you are considering just a single project, and the project has non-conventional cash flows, the investment decision can be made using IRR alone, if we reverse the IRR rule to make it: "Accept when IRR is less than required return."

g)      If short term and long-term interest rates are not equal, investment decisions cannot be made using IRR alone.

h)      If working capital is a fixed proportion of revenue, and revenues and costs increase at the inflation rate, nominal cashflows will grow at the inflation rate and real cashflows will be constant.

i)       When there is capital rationing, and following the Profitability Index rule does not fully utilize the budget, we look for the best combination that fully utilizes the budget.

j)       A project’s cashflows can increase simply because of inflation; only when capital budgeting is done with real cashflows do we get a reliable assessment of a project’s worth.