1

Instructor:

College of Business & Finance

The MBA Program
Financial Management (FINC 501)
Mid-Term Examination
Winter 2013
Dr. Wajeeh Elali

Student Name:
Student ID:
***Suggested Solutions***
REMARKS:
The purpose of this Exam is to help you reflect on the lectures and to apply
the tools we have learnt to real life examples
The problems are to be answered in the space provided for them in this
booklet.
Clearly show ALL your working and encircle the final answer.
Neatness will be greatly appreciated
This Exam consists of two parts (24 questions) on a total of 11 pages,
including cover page.

Part I
MULTIPLE CHOICE QUESTIONS (5 POINTS EACH)
Show ALL CALCULATIONS. Answers without supporting calculations will be
deemed a guess and will not receive any credit.
1.

You are considering opening a new plant. The plant will cost $100 million
upfront and will take one year to build. After that, it is expected to
produce net cash flows of $30 million at the end of every year of
production. The cash flows are expected to last forever. Should you make
the investment if your opportunity cost is 8%?
a.
b.
c.
d.

Answer:
Solution:

Yes, since NPV= $247.22 million

No, since NPV= -$117.37 million
Yes, since NPV= $165.98 million
cannot be determined
a

NPV PV (CIF ) PV (COF )

CIF
(1 r ) 1 COF

r
30
NPV (
)(1.08) 1 100 $247,222,222
0.08
NPV

2.

A company is considering a new project. The companys CFO plans to

calculate the projects NPV by discounting the relevant cash flows (which
include the initial up-front costs, the operating cash flows, and the terminal
cash flows) at the companys cost of capital (COC). Which of the following
factors should the CFO include when estimating the relevant cash flows?
a.
b.
c.
d.
e.

Any sunk costs associated with the project.

Any interest expenses associated with the project.
Any opportunity costs associated with the project.
Statements b and c are correct.
All of the statements above are correct.

Answer: c
Solution:
The correct answer is c. Sunk costs should be excluded from the analysis, and
interest expense is incorporated in the WACC and not the cash flows.

3.

Noora Corp. is faced with an investment project. The following information is

associated with this project:
Year
1
2
3
4

Annual
Net Income ($)
50,000
60,000
70,000
60,000

Annual
Depreciation Rate
0.33
0.45
0.15
0.07

The project involves an initial investment of $100,000 in equipment that has

an estimated salvage value of $15,000. In addition, the company expects an
initial increase in net operating working capital (NWC) of $5,000 that will be
recovered in Year 4. The cost of capital (COC) for the project is 12 percent.
What is the projects net present value (NPV)? (Round your final answer to
the nearest whole dollar.)
a.
b.
c.
d.

$153,840
$159,071
$162,409
$168,604

Answer:
d
Solution:
Step 1: Calculate depreciation:
Dep 1 = 100,000(0.33) = 33,000.
Dep 2 = 100,000(0.45) = 45,000.
Dep 3 = 100,000(0.15) = 15,000.
Dep 4 = 100,000(0.07) = 7,000.
Step 2: Calculate cash flows:
CF 0 = Initial Investment + Initial Increase in NWC
= 100,000 + 5,000 = 105,000.
CF
= Net Income + Depreciation
CF 1 = 50,000 + 33,000 = 83,000.
CF 2 = 60,000 + 45,000 = 105,000.
CF 3 = 70,000 + 15,000 = 85,000.
CF 4 = Net Income + Depreciation + Recovered NWC + Salvage Value
= 60,000 + 7,000 + 5,000 + 15,000 = 87,000.
Step 3: Calculate NPV:
Use CF key on calculator. Enter cash flows shown above. Enter I/YR = 12%.
Solve for NPV = $168,603.89.

NPV

CIFt

(1 r )
t 1

NPV 83,000(1.12)

t 0

COFt
(1 r ) t

105(1.12) 2 85,000(1.12) 3 87,000(1.12) 4 105,000

NPV 273,603.89 105,000 $168,603.89 $168,604

4.

Gulf Products is considering a new project that develops a new laundry

detergent, WOW. The company has estimated that the projects NPV is $3
million, but this does not consider that the new laundry detergent will
reduce the revenues received on its existing laundry detergent products.
Specifically, the company estimates that if it develops WOW the company
will lose $500,000 in after-tax cash flows during each of the next 10 years
because of the cannibalization of its existing products. Gulfs cost of
capital is 10 percent. What is the net present value (NPV) of undertaking
WOW after considering externalities?
a.
b.
c.
d.
e.

Answer:
Solution:

$2,927,716.00
$3,000,000.00
-$ 72,283.55
$2,807,228.00
-$3,072,283.55
c

Step 1:

Calculate the NPV of the negative externalities due to the

cannibalization of existing projects:
Enter the following input data in the calculator:
CF0 = 0; CF1-10 = -500,000; I = 10; and then solve for NPV = $3,072,283.55.
1 (1 r ) n

1 (1 .10) 10
PVA 500,000

.10

PVA CF

PVA $3,072,283.55

Step 2:

Recalculate the new projects NPV after considering externalities:

Adjusted NPV= +$3,000,000 - $3,072,283.55 = -$72,283.55.

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5.

A tenant wants to lease a building for $48,000 per year. She signs a fiveyear rental agreement that states that she will pay $24,000 every six months
for the next five years. Which of the following is the timeline for her rental
payments, assuming she makes the first payment immediately?
a)
Date
(years)

Cash Flows
$48
(thousands)
b)
Date
(years)

$48

$48

$48

$48

$48

1/2

1 1/2 2

2 1/2 3

3 1/2 4

4 1/2 5

Cash Flows
-$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 0
(thousands)
c)
Date
(years)

Cash Flows
$24
(thousands)
d)
Date
(years)

3 1/2 4

4 1/2 5

$24

$24

$24

$24

$24

$24

$24

$24

Cash Flows
-$48
(thousands)

Answer:
6.

-$48

-$48

-$48

-$48

-$48

$24

$24

A bank offers a home buyer a 25-year loan at 8% per year. If the home
buyer borrows $120,000 from the bank, how much must be repaid every
year?
a.
$9,845.89
b.
$10,786.66
c.
$7,896.45
d.
$11,241.45

Answer:
Solution:

d
1 (1 r ) n

PVA PMT

1 (1 .08) 25

.08

120,000 PMT

PMT $11,241.45

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7.

Suppose you could borrow using either a credit card that charges 1.5
percent per month or a bank loan with a 18 percent quoted interest rate that
is compounded daily. Which should you choose?
a.
b.
c.
d.
e.

Answer:
Solution:

the bank loan

the credit card loan
neither a nor b would be chosen
can not tell from the information given
both a and b
b

APR m
) 1
m
Credit card loan :
EAR (1

APR ( rate per period ) * (# of periods )

APR (.015) * (12) 0.18 or 18%
0.18 12
) 1 (1.015)12 1 0.195618 19.56%
12
Bank loan :
EAR (1

0.18 365
) 1 0.19716 19.72%
365
Thus, the bank loan a little more than the credit card loan
EAR (1

8.

The future value of a lump sum at the end of five years is $1,000. The
nominal interest rate is 10 percent and interest is compounded
semiannually. Which of the following statements is most correct?
a.
b.
c.
d.
e.

The present value of the $1,000 is greater if interest is compounded

monthly rather than semiannually.
The effective annual rate is greater than 10 percent.
The periodic interest rate is 5 percent.
Statements b and c are correct.
All of the statements above are correct.

Answer:
d
Statements b and c are correct; therefore, statement d is the correct choice. The
present value is smaller if interest is compounded monthly rather than
semiannually.
9.

You are offered an investment opportunity that costs you $28,000, has a net
present value (NPV) of $2278, lasts for three years, has interest rate of 10%,
and produces the following cash flows:

The missing cash flow from year 2 is closest to:

a.
b.
c.
d.

$13,000
$12,500
$10,000
$12,000

Answer:
Solution:

d
n

NPV
t 1

n
CIFt
COFt

t
t
(1 r )
t 0 (1 r )

2,278 10,000(1 .10) 1 CIF2 (1 .10) 2 15,000(1 .10) 3 28,000

CIF2 $12,000

10.

The timeline shown below best describes the cash flow of which of the
following people?
Date
0
(years)

Cash
Flows

$1000

$1000

$1000

$1000

a.
b.
c.
d.

-$3500

Dina, who loans a friend $3500, which friend then pays back the loan
in four annual installments of $1000
Zina, who borrows $3500, and then pays back the loan in four annual
payments of $1000
Tara, who borrows $3500, and then receives an annual payment of
$1000
Sara, who puts down $3500 to buy a car, and then makes annual
payments of $1000

Answer:
a
11.
Which of the following statements is most correct?

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a.

The present value of an annuity due will exceed the present value of
an ordinary annuity (assuming all else equal).
The future value of an annuity due will exceed the future value of an
ordinary annuity (assuming all else equal).
The nominal interest rate will always be greater than or equal to the
effective annual interest rate.
Statements a and b are correct.
All of the statements above are correct.

b.
c.
d.
e.

Answer:
d
Statements a and b are correct; therefore, statement d is the correct choice. The
nominal interest rate will be less than the effective rate when the number of
periods per year is greater than one.
12.

If you deposit $300 at the beginning of each year for three years in a savings
account that pays 6 percent interest per year, how much will you have at the
end of three years?
a.
b.
c.
d.

$900.00
$1,315.25
$1,012.38
$1,304.83

Answer:
Solution:

c
(1 k ) n 1
(1 r )
k

FVA PMT

(1 .06) 3 1
(1 .06) $1,012.38
.06

FVA $300

13.

Project A has an internal rate of return (IRR) of 15 percent. Project B has

an IRR of 14 percent. Both projects have a cost of capital of 12 percent.
Which of the following statements is most correct?
a. Both projects have a positive net present value (NPV).
b. Project A must have a higher NPV than Project B.
c. If the cost of capital were less than 12 percent, Project B would have a
higher IRR than Project A.
d. Statements a and c are correct.
e. All of the statements above are correct

Answer:
Solution:

9
Statement (a) is true; projects with IRRs greater than the cost of capital will have
a positive NPV. Statement (b) is false because you know nothing about the
relative magnitudes of the projects. Statement (c) is false because the IRR is
independent of the cost of capital. Therefore, the correct choice is statement (a).
14.

Sara recently invested $2,566.70 in a project that is promising to return 12

percent per year. The cash flows are expected to be as follows:
End of Year
1
2
3
4
5
6

Cash Flow
$325
400
550
?
750
800

What is the cash flow at the end of the 4th year?

a.
b.
c.
d.
e.
Answer:
Solution:

$1,187
$ 600
$1,157
$ 655
$1,267
c

Find the present value of each of the cash flows:

PV of CF1 = $325/1.12 = $290.18. PV of CF 2 = $400/(1.12)2 = $318.88.
PV of CF3 = $550/(1.12)3 = $391.48. PV of CF5 = $750/(1.12)5 = $425.57. PV of
CF6 = $800/(1.12)6 = $405.30. Summing these values you obtain $1,831.41. The
present value of CF4 must then be $2,566.70 - $1,831.41 = $735.29. The value of
CF4 is ($735.29)(1.12)4 = $1,157.
PV FV (1 r ) n
2,566.70 325(1.12) 1 400(1.12) 2 550(1.12) 3 CF4 (1.12) 4 750(1.12) 5 800(1.12) 6
735.289839 0.635518(CF4 )
CF4 $1,156.992 $1,157

15.

A firm with a cost of capital (COC) of 15% is evaluating four capital projects.
The internal rates of return (IRR) are as follows:
Project

IRR

10
1
16%
2
13%
3
17%
4
14%
The firm should
a. Accept project 4 and 1, and reject 2 and 3.
b. Accept project 4, 1, and 3, and reject 2
c. Accept project 3, and reject 1, 2, and 3.
d. Accept project 3, and 1, and reject 2 and 4.
Answer: d
Solution:
If IRR > COC accept
If IRR < COC reject
16.

Zina recently purchased a new automobile for $32,000. She made a $7,000
down payment and financed the balance over 48 months using a loan with a
12 percent annual nominal rate of interest. What are her monthly payments?
a.
b.
c.
d.

Answer:
Solution:

$512.98
$577.87
$658.35
$688.98
c

PV0 $32,000 $7,000 $25,000

m 12
r
12%

1% per month
m 12month
1 (1 r / m) n*m
PVA PMT

r/m

PVA
25,000
25,000
PMT

$658.35 / month
n*m
48
37.97395949
1 (1 r / m)

1 (1 .12 / 12)

r/m
.12 / 12

rate per period

17.

You are interested in investing your money in a bank account. Which of

the following banks provides you with the highest effective rate of interest?
a.
b.
c.
d.

Bank NBB; 8.00% with monthly compounding.

Bank CNN; 8.25% with annual compounding.
Bank RBC; 8.00% with quarterly compounding.
Bank CIBS; 8.00% with daily (365-day) compounding.

11

Answer:
d
Solution:
Alternative (d) is correct; the other alternatives are incorrect. Looking at
responses (a) through (d), you should realize the choice with the greatest
frequency of compounding will give you the highest EAR. This is alternative (d).
The EAR of each of the alternatives is shown below.
APR m
) 1 ;
where m # of times per year int erest is compounded
m
.08 12
EAR NBB (1
) 1 8.30%
12
.0825 1
EARCNN (1
) 1 8.25%
1
.08 4
EAR RBC (1
) 1 8.24%
4
.08 365
EARCIBC (1
) 1 8.328%
365
EAR (1

18.

To save money for a new house, you want to begin contributing money to a
brokerage account. Your plan is to make 10 contributions to the brokerage
account. Each contribution will be for $1,500. The contributions will come at
the beginning of each of the next 10 years. The first contribution will be
made at t = 0 and the final contribution will be made at t = 9. Assume that the
brokerage account pays a 9 percent return with quarterly compounding.
How much money do you expect to have in the brokerage account nine
years from now (t = 9)?
a.
b.
c.
d.
e.

$23,127.49
$25,140.65
$25,280.27
$21,627.49
$19,785.76

Answer:
a
Solution:
First, convert the 9 percent return with quarterly compounding to an effective rate
of 9.308332%. With a financial calculator, NOM% = 9; P/YR = 4; EFF% =
9.308332%. (Dont forget to change P/YR = 4 back to P/YR = 1.) Then calculate
the FV of all but the final payment. BEGIN MODE (1 P/YR) N = 9; I/YR =
9.308332; PV = 0; PMT = 1500; and solve for FV = $21,627.49. You must then
add the $1,500 at t = 9 to find the answer, $23,127.49.

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.09 4
) 1 9.308332%
4
(1 r ) n 1
PMT
(1 r )
r

EAR (1
FVAdue

(1 .09308332) 9 1
(1 .09308332) $21,627.48931
.09308332

Total Expected Money 1,500 21,627.48931 $23,127.48931

FVAdue 1,500

19.

You have just arranged a $15,000 loan from your bank at an annual rate of
10%. The loan calls for annual payments of $1,000 over the next 14 years,
and a final payment at the end of year 15. How big will the final payment
(balloon) be?
a.
b.
c.
d.

Answer:
Solution

$28,986
$29,098
$31,886
$31,946
c

PV ( Loan)

14

PMTt

(1 k )
t 1

PMT15 (1 k ) 15

1 (1 .10) 14
15
PMT15 (1 .10)
.10

15,000 1,000

15,000 7,366.68745 0.239392 PMT15

PMT15 $31,886

20.

West Island Industries is considering a project which has the following cash
flows:
Year
0
1
2
3
4

Cash Flow
?
$2,000
3,000
3,000
1,500

The project has a payback period of 2.5 years. The firms cost of capital is 12
percent. What is the projects net present value?
a. $577.68
b. $676.74
c. $823.81

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d. $977.56
e. None of the above, the answer is $______________.
Answer:
e
Solution:
Initial Investment=$2,000+3,000+(3,000/2)=$6,500
NPV 6,500

2,000
3,000
3,000
1,500

$765.91
1
2
3
(1.12)
(1.12)
(1.12)
(1.12) 4

Part II
Problems

Q1.

You are running a hot Internet company. Analysts predict that its earnings will grow at 30%
per year for the next five years. After that, as competition increases, earnings growth is
expected to slow to 2% per year and continue at that level forever. Your company has just
announced earnings of $1,000,000. What is the present value of all future earnings if the
interest rate is 8%? (Assume all cash flows occur at the end of the year.)
Solution:
Timeline:
0

1(1.3)

(1.3)2

(1.3)3

(1.3)4

(1.3)5

(1.3)5(1.02)

(1.3)5(1.02)2

This problem consists of two parts:

(1) A growing annuity for 5 years;
(2) A growing perpetuity after 5 years.
First we find the PV of (1):
PVGA

1.3 $9.02 million.

1
0.08 0.3
1.08
1.3

Now we calculate the PV of (2). The value at date 5 of the growing perpetuity is
PV5

1.3 5 1.02
0.08 0.02

$63.12 million PV0

63.12

1.08 5

$42.96 million.

Adding the present value of (1) and (2) together gives the PV value of future earnings:
$9.02 $42.96 $51.98 million.

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Q2.

Suppose you invest $2000 today and receive $10,000 in five years.
a.

What is the IRR of this opportunity?

b. Suppose another investment opportunity also requires $2000 upfront, but pays an equal
amount at the end of each year for the next five years. If this investment has the same
IRR as the first one, what is the amount you will receive each year?
Solution:
Solution part a
Timeline
0

-2000

10,000

IRR solves 2000=10000/(1+r)

10000

2000

1/ 5

So IRR

1 =37.97%.

Solution part b
Timeline
0

-2000

X solves
2000

X
IRR

so
X

2000 IRR

1
1
5
(1

IRR
)

= $949.27

Q3.

You are shopping for a car and read the following advertisement in the newspaper: Own a
new Spitfire! No money down. Four annual payments of just $10,000. You have shopped
around and know that you can buy a Spitfire for cash for $32,500. What is the interest rate
the dealer is advertising (what is the IRR of the loan in the advertisement)? Assume that you
must make the annual payments at the end of each year.
Solution:

15

Timeline:
0

32,500

10,000

10,000

10,000

10,000

The PV of the car payments is a 4-year annuity:

PV

10, 000
r

1 r
4

Setting the NPV of the cash flow stream equal to zero and solving for r gives the IRR:
NPV 0 32, 500

10, 000
r

1-

10, 000

1 r
4

32, 500

1 r
4

To find r we either need to guess or use the annuity calculator. You can check and see that r =
8.85581% solves this equation. So the IRR is 8.86%.

Q4.

You have just purchased a home and taken out a $500,000 mortgage. The mortgage has a 30year term with monthly payments and an APR of 6%.
a.

How much will you pay in interest, and how much will you pay in principal, during the
first year?

b. How much will you pay in interest, and how much will you pay in principal, during the
20th year (i.e., between 19 and 20 years from now)?
Solution:
a.

500, 000
$2997.75
1
1
APR of 6% = 0.5% per month. Payment =
.

.005
1.005360
Total annual payments = 2997.75 12 = $35,973.
Loan balance at the end of 1 year = $2997.75

1
1
1
$493,860 .
.005
1.005348

Therefore, 500,000 493,860 = $6140 in principal repaid in first year, and 35,973 6140 =
$29833 in interest paid in first year.
b.

Loan balance in 19 years (or 360 1912 = 132 remaining pmts) is

$2997.75

1
1
1
$289,162 .
.005
1.005132

Loan balance in 20 years = $2997.75

1
1
1
$270, 018 .
.005
1.005120

16
Therefore, 289,162 270,018 = $19,144 in principal repaid, and $35,973 19,144 = $16,829
in interest repaid.

Good Luck!