FACULTAD DE CIENCIAS EMPRESARIALES Y ECONÓMICAS

PERÍODO ACADÉMICO: 2019-1

DOCENTE RESPONSABLE: ENRIQUE MANUEL OCHOA GARCÍA, CFA

GESTIÓN DE INVERSIONES I
CUARTA PRÁCTICA CALIFICADA
SOLUCIONARIO

Question 1 - #127347

Paying a cash dividend is most likely to result in:

A) an increase in liquidity ratios.

B) an increase in financial leverage ratios.
C) the same impact on liquidity and leverage ratios as a stock dividend.
Your answer: A was incorrect. The correct answer was B) an increase in financial leverage
ratios.

A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets,
reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such
as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash
dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.

This question tested from Session 11, Reading 39, LOS a.

Question 2 - #97611

A board of directors is most likely to protect the shareholders’ interests when:

A) the board requires that management attend all meetings.

B) the board includes representatives from the firm’s key customers and suppliers.
C) one individual can be identified as the leading board member from outside the firm.
Your answer: A was incorrect. The correct answer was C) one individual can be identified as the
leading board member from outside the firm.

Especially in cases where the chairman of the board is closely aligned with the firm,
independent board members are more able to protect shareholders’ interests when they have a
leading or primary independent member. The board should meet regularly outside the presence
of management. Board members who represent the firm’s customers and suppliers may have
interests that conflict with those of shareholders.

This question tested from Session 11, Reading 41, LOS b.

Question 3 - #87170

The following information reflects the projected operating results for Opstalan, a catalog printer.

 Sales of $5.0 million.

 Variable Costs at 40% of sales.
 Fixed Costs of $1.0 million.
  Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current
yield is 8.0%).
 Tax Rate of 0.0%.

Opstalan’s degree of total leverage (DTL) is closest to:

A) 2.58.
B) 1.41.
C) 1.59.
Your answer: A was incorrect. The correct answer was C) 1.59.

First, calculate the operating results:

Opstalan Annual Operating Results

Sales $5,000,000
Variable Costs1 2,000,000
3,000,000
Fixed Costs 1,000,000
EBIT 2,000,000
Interest Expense2 105,000
1,895,000
1Variable costs = 0.40 × 5,000,000
2Interest Expense = 0.07 × 1,500,000

Second, calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) =
3,000,000 / 2,000,000 = 1.50

Third, calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.

Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.

This question tested from Session 11, Reading 38, LOS b.

Question 4 - #97396

In order to more accurately estimate the cost of equity for a company situated in a developing
market, an analyst should:

use the yield on the sovereign debt of the developing country instead of the risk free
A)
rate when using the capital asset pricing model (CAPM).
add a country risk premium to the risk-free rate when using the capital asset pricing
B)
model (CAPM).
add a country risk premium to the market risk premium when using the capital asset
C)
pricing model (CAPM).
Your answer: A was incorrect. The correct answer was C) add a country risk premium to the
market risk premium when using the capital asset pricing model (CAPM).

In order to reflect the increased risk when investing in a developing country, a country risk
premium is added to the market risk premium when using the CAPM.

This question tested from Session 11, Reading 37, LOS j.

Question 5 - #96607

The marginal cost of capital is:

A) tied solely to the specific source of financing.

B) the cost of the last dollar raised by the firm.
C) equal to the firm's weighted cost of funds.
Your answer: A was incorrect. The correct answer was B) the cost of the last dollar raised by
the firm.

The “marginal” cost refers to the last dollar of financing acquired by the firm assuming funds are
raised in the same proportion as the target capital structure. It is a percentage value based on
both the returns required by the last bondholders and stockholders to provide capital to the firm.
Regardless of whether the funding came from bondholders or stockholders, both debt and
equity are needed to fund projects.

This question tested from Session 11, Reading 37, LOS d.

Question 6 - #97208

Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is
$1,000, and the current market price of the bonds is $965. Deighton also has 6 million common
shares outstanding, with a book value of $35 per share and a market price of $28 per share. At
a recent board of directors meeting, Deighton board members decided not to change the
company’s capital structure in a material way for the future. To calculate the weighted average
cost of Deighton’s capital, what weights should be assigned to debt and to equity?

Debt Equity
A) 48.85% 51.15%
B) 56.55% 43.45%
C) 53.46% 46.54%
Your answer: A was incorrect. The correct answer was C)
53.46% 46.54%

In order to calculate the weighted average cost of capital (WACC), market value weights should
be used.

For the bonds = 200,000 × $965 = $193,000,000

For the stocks = 6,000,000 × $28 = $168,000,000
$361,000,000

The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%

The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%

This question tested from Session 11, Reading 37, LOS c.

Question 7 - #96547

Which of the following statements about independent projects is least accurate?

 A) If the internal rate of return is less than the cost of capital, reject the project.
The net present value indicates how much the value of the firm will change if the
B)
project is accepted.
The internal rate of return and net present value methods can yield different
C)
accept/reject decisions for independent projects.
Your answer: A was incorrect. The correct answer was C) The internal rate of return and net
present value methods can yield different accept/reject decisions for independent projects.

For independent projects the IRR and NPV give the same accept/reject decision. For mutually
exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.

This question tested from Session 11, Reading 36, LOS e.

Question 8 - #87172

What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor
wants to avoid receiving a dividend and thereby avoid paying tax on the distribution, if the date
of record is Thursday, October 31?

A) Monday, October 28.

B) Thursday, October 24.
C) Tuesday, October 29.
Your answer: A was incorrect. The correct answer was C) Tuesday, October 29.

The ex-dividend date is now two business days prior to the date of record. Counting back two
business days identifies Tuesday, October 29 as the date when the shares can be purchased
without the dividend.

This question tested from Session 11, Reading 39, LOS b.

Question 9 - #96542

Apple Industries, a firm with unlimited funds, is evaluating five projects. Projects A and B are
independent and Projects C, D, and E are mutually exclusive. The projects are listed with their
rate of return and NPV. Assume that the applicable discount rate is 10%.

Project Status Rate of Return Net Present Value

A Independent 14% $10,500
B Independent 12% $13,400
C Mutually Exclusive 11% $16,000
D Mutually Exclusive 15% $14,000
E Mutually Exclusive 12% $11,500

Rank the projects the firm should select.

A) Project A, Project B, and Project C.

B) All projects should be selected.
C) Project A, Project B, and Project D.
Your answer: A was correct!

When it comes to independent projects, financial managers should select all with positive NPVs,
resulting in inclusion of Project A and Project B. Remember that projects with positive NPVs will
increase the value of the firm. Among mutually exclusive projects, financial managers would
select the one with the highest NPV, in this case Project C. Although all projects have positive
NPVs, only one of the latter three can be chosen. If the selection were based upon the internal
rate of return, Project D would be chosen instead of Project C. This shows why NPV is the
superior decision criteria because Project C is the investment that will cause the greatest
increase to the value of the firm.

This question tested from Session 11, Reading 36, LOS e.

Question 10 - #100683

Degen Company is considering a project in the commercial printing business. Its debt currently
has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins
Inc., a publicly traded firm that operates only in the commercial printing business, has a
marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free
rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use
in evaluating Degen’s project is closest to:

A) 8.9%.
B) 8.6%.
C) 9.2%.
Your answer: A was incorrect. The correct answer was B) 8.6%.

Hodgkins’ asset beta:

We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of
1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.

Equity beta for the project:

βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932

Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%

Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 =
43.5%.

The appropriate WACC for the project is therefore:

0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.

This question tested from Session 11, Reading 37, LOS i.

Question 11 - #97549

Which of the following firms is most likely to have a board of directors that considers the best
interest of all shareholders?

Firms that assign a single vote to each share, and firms with different classes of
A)
common equity with supermajority rights given to one class.
 Firms that assign a single vote to each share, but not firms with different classes of
B)
common equity with supermajority rights given to one class.
Neither firms with different classes of common equity with supermajority rights
C)
given to one class, nor firms that assign a single vote to each share.
Your answer: A was incorrect. The correct answer was B) Firms that assign a single vote to
each share, but not firms with different classes of common equity with supermajority rights given
to one class.

Firms that assign one vote to each share are more likely to have a board that considers the best
interest of all shareholders. Firms with dual classes of common equity where supermajority
rights are given to one class are likely to have boards that focus on the interests of the
supermajority shareholders.

This question tested from Session 11, Reading 41, LOS g.

Question 12 - #96560

Compared to the prior year, Chart Industries has reported that its operating cycle has remained
relatively stable while its cash conversion cycle has decreased. The most likely explanation for
this is that the firm:

A) is relying more on its suppliers for short-term liquidity.

B) has improved its inventory turnover.
C) is paying its bills for raw materials more rapidly.
Your answer: A was correct!

The cash conversion cycle is its operating cycle minus its average days payables outstanding.
Therefore, the firm’s average days payables must have increased, a clear indication that the
firm is relying more heavily on credit from its suppliers. Improved inventory turnover would tend
to increase both the operating and cash conversion cycles. Relaxed credit policies would tend
to increase the firm’s operating cycle as receivables turnover would tend to decrease.

This question tested from Session 11, Reading 40, LOS c.

Question 13 - #98110

Given the following information about capital structure, compute the WACC. The marginal tax
rate is 40%.

Type of Percent of Before-Tax

Capital Capital Structure Component Cost
Bonds 40% 7.5%
Preferred Stock 5% 11.0%
Common Stock 55% 15.0%
A) 13.3%.
B) 7.1%.
C) 10.6%.
Your answer: A was incorrect. The correct answer was C) 10.6%.

WACC = (W d)(Kd (1 − t)) + (W ps)(Kps) + (W ce)(Ks)

WACC = 0.4(7.5%)(1 − 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.

This question tested from Session 11, Reading 37, LOS a.

Question 14 - #87171

Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and
development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans
an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs
to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of
operating leverage at the new projected sales level?

A) 3.75.
B) 4.20.
C) 3.50.
Your answer: A was correct!

Sales = $100,000,000

VC of 25% of sales = 25,000,000

FC of 40,000,000 + 15,000,000 = 55,000,000

DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75

This question tested from Session 11, Reading 38, LOS b.

Question 15 - #96566

An appropriate cash management strategy for a company that has a seasonally high need for
cash prior to the holiday shopping season would least likely include:

A) allowing short-term securities to mature without reinvestment.

B) borrowing funds though a bank line of credit.
investing in U.S. Treasury notes at other times of the year because they are highly
C)
liquid.
Your answer: A was incorrect. The correct answer was C) investing in U.S. Treasury notes at
other times of the year because they are highly liquid.

Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than
those of securities suitable for cash management. Allowing short-term securities to mature
without reinvesting the cash generated would be one way to meet seasonal cash needs. Short-
term bank borrowing or issuing commercial paper that can be paid off when holiday sales
generate cash would be appropriate strategies for dealing with a predictable short-term need for
cash.

This question tested from Session 11, Reading 40, LOS d.

Question 16 - #97272

The after-tax cost of preferred stock is always:

A) equal to the before-tax cost of preferred stock.

B) less than the before-tax cost of preferred stock.
 C) higher than the cost of common shares.
Your answer: A was correct!

The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because
preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher
than the cost of debt, but less than the cost of common shares.

This question tested from Session 11, Reading 37, LOS g.

Question 17 - #96571

A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and
promises to return the following irregular payments:

Year 1: $100,000
Year 2: $82,000
Year 3: $76,000
Year 4: $111,000
Year 5: $142,000
If the required rate of return for the firm is 8%, what is the net present value of the investment?
(You’ll need to use your financial calculator.)
A) $99,860.
B) $64,582.
C) $86,133.
Your answer: A was incorrect. The correct answer was B) $64,582.

In order to determine the net present value of the investment, given the required rate of return;
we can discount each cash flow to its present value, sum the present value, and subtract the
required investment.

Year Cash Flow PV of Cash flow at 8%

0 -336,875.00 -336,875.00
1 100,000.00 92,592.59
2 82,000.00 70,301.78
3 76,000.00 60,331.25
4 111,000.00 81,588.31
5 142,000.00 96,642.81
Net Present Value 64,581.74

This question tested from Session 11, Reading 36, LOS d.

Question 18 - #96602

An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results
to the industry averages:

Financial Ratio Iridescent Carpeting Industry Average

Current Ratio 2.3x 1.8x
Net Profit Margin 22% 24%
Return on Equity 17% 20%
Total Debt / Total Capital 35% 56%
Times Interest Earned 4.7x 4.1x
Based on the above data, which of the following can the analyst conclude? Iridescent
Carpeting:

A) has better short-term liquidity than its competitors.

B) has stronger profitability than its competitors.
C) is most likely a younger company than its competitors.
Your answer: A was correct!

Based on the data provided, the analyst can conclude that Iridescent Carpeting has weaker
profitability than its competitors based on the net profit margin and return on equity. The analyst
can also conclude that the company has less financial leverage (risk) than the industry average
based on the total debt / total capital and the times interest earned ratios. The analyst can
conclude that the company has better short-term liquidity than the industry average (i.e., its
competitors) based on the current ratio.

This question tested from Session 11, Reading 40, LOS b.

Question 19 - #97617

Which of the following activities would least likely be an example of good corporate
governance?

The board has decided to eliminate finders’ fees for its members for any potential
A)
acquisitions that are brought to management’s attention.
B) Management is allowed to act independently of board of directors.
C) The board of directors has decided to conduct a self-assessment.
Your answer: A was incorrect. The correct answer was B) Management is allowed to act
independently of board of directors.

The board of directors should be allowed to act independently of management. Management

should not be allowed to act independently from the board.

This question tested from Session 11, Reading 41, LOS a.

Question 20 - #97569

The most likely outcome of adopting a golden parachute, poison pill, or greenmail is a:

negative impact on the stock price and a greater possibility for a successful
A)
takeover bid.
reduced possibility for a successful takeover bid and a negative impact on the stock
B)
price.
reduced possibility for a successful takeover bid and a positive impact on the stock
C)
price.
Your answer: A was incorrect. The correct answer was B) reduced possibility for a successful
takeover bid and a negative impact on the stock price.

Adopting a golden parachute, poison pill, or greenmail are all take-over defenses used to
frustrate an acquisition attempt. The barriers created by such defenses are likely to decrease
the value of the stock.

This question tested from Session 11, Reading 41, LOS g.

Question 21 - #87166

The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer,
wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s
expected operating performance is as follows:

 Sales of $500,000.
 Variable Costs at 60% of sales.
 Fixed Costs of $120,000.
 Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A) reduce variable expenses by 30%.

B) increase variable expenses by 30%.
C) reduce variable expenses by 38.5%.
Your answer: A was correct!

To obtain this result, we need to calculate the current variable costs, determine the variable
costs that will result in a DTL ratio of 2.00, and calculate the percentage change.

Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000

Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:

(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)

results in:

Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:

VC = (300,000 − 210,000) / 300,000 = 0.30, or 30%.

This question tested from Session 11, Reading 38, LOS b.

Question 22 - #96781

Which of the following statements about the role of the marginal cost of capital in determining
the net present value of a project is most accurate? The marginal cost of capital should be used
to discount the cash flows:

A) of all projects the firm is considering.

B) for potential projects that have a level of risk near that of the firm’s average project.
C) if the firm’s capital structure is expected to change during the project’s life.
Your answer: A was incorrect. The correct answer was B) for potential projects that have a level
of risk near that of the firm’s average project.
Net present values of projects with the average risk for the firm should be determined using the
firm’s marginal cost of capital. The discount rate should be adjusted for projects with above-
average or below-average risk. Using the marginal cost of capital assumes the firm’s capital
structure does not change over the life of the project.

This question tested from Session 11, Reading 37, LOS e.

Question 23 - #87103

The share price of Winnipeg Auto Unlimited is $5 per share. There are 50 million shares
outstanding, and Winnipeg has a book value of $900 million. What is the book value per share
(BVPS) after the share repurchase of $10 million?

A) $21.24.
B) $18.54.
C) $14.76.
Your answer: A was incorrect. The correct answer was B) $18.54.

The share buyback is $10 million / $5 per share = 2,000,000 shares.

Remaining shares: 50 million − 2 million = 48 million shares.

Winnipeg Auto Unlimited’s current BVPS = $900 million / 50 million = $18.

Book value after repurchase: $900 million − $10 million = $890 million.
BVPS = $890 million / 48.0 million = $18.54.
BVPS increased by $0.54.

Book value per share (BVPS) increased because the share price is less than the original BVPS.
If the share prices were more than the original BVPS, then the BVPS after the repurchase
would have decreased.

This question tested from Session 11, Reading 39, LOS e.

Question 24 - #96604

Which of the following firms is most likely to use a discounted cash flow technique as its primary
capital budgeting tool?

A large, publicly held European firm that has managers with no formal business
A)
education.
A small, privately held European firm that has managers with no formal business
B)
education.
C) A large, publicly held U.S. firm where managers hold MBA degrees.
Your answer: A was incorrect. The correct answer was C) A large, publicly held U.S. firm where
managers hold MBA degrees.

Companies that favor discounted cash flow capital budgeting techniques such as NPV and IRR
over payback period or other non-DCF capital budgeting techniques tend to have the following
characteristics:

 Location: European firms tend to favor payback period.

 Size: Smaller firms tend to favor payback period.
 Ownership: Private firms tend to favor payback period.
 Management education: The more highly educated a firm’s management, the more
likely it is to use a DCF capital budgeting technique as its primary tool.

This question tested from Session 11, Reading 36, LOS f.

Question 25 - #97494

A firm is planning a $25 million expansion project. The project will be financed with $10
million in debt and $15 million in equity stock (equal to the company's current capital
structure). The before-tax required return on debt is 10% and 15% for equity. If the
company is in the 35% tax bracket, what cost of capital should the firm use to determine
the project's net present value (NPV)?

A) 12.5%.
B) 9.6%.
C) 11.6%.

Your answer: A was incorrect. The correct answer was C) 11.6%.

WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)

WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%

This question tested from Session 11, Reading 37, LOS a.

Question 26 - #87165

If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm
uses no debt, then what is its degree of operating leverage?

A) 4.7.
B) 4.2.
C) 5.0.

Your answer: A was incorrect. The correct answer was C) 5.0.

Upon first glance, it appears there is not enough information to complete the problem.
However when one realizes DTL = (DOL)(DFL) it is possible to complete this problem.

DTL = %∆EPS/%∆Sales = 5

DFL = EBIT/(EBIT-I) = 1.

(DOL)(1) =5

DOL= 5.

This question tested from Session 11, Reading 38, LOS b.

Question 27 - #134988

The CFO of Axis Manufacturing is evaluating the introduction of a new product. The
costs of a recently completed marketing study for the new product and the possible
increase in the sales of a related product made by Axis are best described
(respectively) as:

A) sunk cost; externality.

B) opportunity cost; externality.
C) externality; cannibalization.

Your answer: A was correct!

The study is a sunk cost, and the possible increase in sales of a related product is an
example of a positive externality.

This question tested from Session 11, Reading 36, LOS b.

Question 28 - #97615

During a recent luncheon, Angus Rahamut and Dan Riding became engaged in a
discussion of issues related to corporate governance. Neither of these individuals is an
expert in the field of corporate governance and either of them may have made an
inaccurate statement. Which of the following is most likely to be an inaccurate
statement?

“In order to avoid conflicts of interest, board members should seek

A)
management approval prior to hiring external advisors.”
“Board members must have the experience and qualifications necessary for
B) them to be able to make decisions independently from the firm’s
management.”
“To be independent, a board member must not have any material
C)
relationship with the firm’s executive management or their families.”

Your answer: A was correct!

Ideally, independent board members can hire external consultants without

management’s approval. This enables the board to obtain advice on specialized issues
that is not biased by the interests of management.

This question tested from Session 11, Reading 41, LOS a.

Question 29 - #97584

Which of the following might be an undesirable trait of a member of the board of

directors?

A) Lack of legal or regulatory problems as a result of working with other firms.

B) Experience with the technologies, products, and services the firm offers.
C) Service on the board for more than 10 years.
Your answer: A was incorrect. The correct answer was C) Service on the board for
more than 10 years.

Service on the board for more than 10 years may indicate knowledge and experience,
but may result in a member becoming too close to management.

This question tested from Session 11, Reading 41, LOS d.

Question 30 - #97511

A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume
annual payments). The bonds trade at a price of $92 per $100 par in the open market.
The firm’s marginal tax rate is 35%. What is the after-tax component cost of debt to be
used in the weighted average cost of capital (WACC) calculations?

A) 6.02%.
B) 9.26%.
C) 5.40%.

Your answer: A was correct!

If the bonds are trading at $92 per $100 par, the required yield is 9.26% (N = 10; PV = –
92; FV = 100; PMT = 8; CPT I/Y = 9.26). The equivalent after-tax cost of this financing
is: 9.26% (1 – 0.35) = 6.02%.

This question tested from Session 11, Reading 37, LOS h.

Question 31 - #97026

BPM Ltd. has the following capital structure: 40% debt and 60% equity. The cost of
retained earnings is 13%, and the cost of new common stock is 16%. BPM will not have
any retained earnings available in the upcoming year. Its before tax cost of debt is 8%,
and its corporate tax rate is 40%. BPM is considering between two mutually exclusive
projects that have the following cash flows:

Today Year 1 Year 2 Year 3

Project A Cost = 100 million + 50 million + 30 million + 50 million
Project B Cost = 150 million + 50 million + 60 million + 80 million

Which project should BPM choose?

A) Project A since its net present value (NPV) is +$5.01 million.

B) Project A since its NPV is $16 million.
C) Project B since its NPV is $22 million.

Your answer: A was correct!

Use the Marginal cost of capital (= WACCnew equity) as the discount rate to calculate NPV.

WACCnew equity = (wd × (kd × (1 - T))) + (W ce × Ke)

= [0.4 × 0.08 × (1 - 0.4)] + [0.6 × 0.16] = 11.52%

NPV of project A = -100 + 50 / (1.1152) + 30 / (1.11522) + 50 / (1.11523) = +5.01

NPV of project B = -150 + 50 / (1.1152) + 60 / (1.11522) + 80 / (1.11523) = +0.76

This question tested from Session 11, Reading 37, LOS k.

Question 32 - #96553

Which of the following projects would most likely have multiple internal rates of return
(IRRs)? The cost of capital for all projects is 10.0%.

Cash Flows South East West

CF0 -15,000 -12,000 -8,000
CF1 10,000 7,000 4,000
CF2 -1,000 2,000 0
CF3 15,000 2,000 6,000
A) Projects East and West.
Projects South and
B)
West.
C) Project South only.

Your answer: A was incorrect. The correct answer was C) Project South only.

The multiple IRR problem occurs if a project has an unconventional cash flow pattern,
that is, the sign of the cash flows changes more than once (from negative to positive to
negative, or vice-versa). Only Project South has this cash flow pattern. Neither the zero
cash flow for Project West nor the likely negative net present value for Project East
would result in multiple IRRs.

This question tested from Session 11, Reading 36, LOS e.

Question 33 - #97587

The expected annual dividend one year from today is $2.50 for a share of stock priced
at $25. What is the cost of equity if the constant long-term growth in dividends is
projected to be 8%?

A) 18%.
B) 19%.
C) 15%.

Your answer: A was correct!

Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.

This question tested from Session 11, Reading 37, LOS h.

Question 34 - #131569

Yields on firms’ investments in short-term securities for comparison purposes are best
stated as:

A)
.

B)
.

C)
.

Your answer: A was incorrect. The correct answer was B)

The yields on investments in short-term securities should be stated as bond equivalent

yields (BEYs), and returns on portfolios of these securities should be stated as a

weighted average of BEYs. The BEY, which is holding period yield × ,

allows fixed-income securities whose payments are not annual to be compared with
securities with annual yields.

This question tested from Session 11, Reading 40, LOS e.

Question 35 - #97496

A firm is considering a $200,000 project that will last 3 years and has the following
financial data:

 Annual after-tax cash flows are expected to be $90,000.

 Target debt/equity ratio is 0.4.
 Cost of equity is 14%.
 Cost of debt is 7%.
 Tax rate is 34%.

Determine the project's payback period and net present value (NPV).

Payback Period NPV

A) 2.43 years $18,716
B) 2.22 years $18,716
C) 2.22 years $21,872

Your answer: A was incorrect. The correct answer was B)

2.22 years $18,716

Payback Period

$200,000 / $90,000 = 2.22 years

NPV Method

First, calculate the weights for debt and equity

wd + we = 1
we = 1 − wd
wd / we = 0.40
wd = 0.40 × (1 − wd)
wd = 0.40 − 0.40wd
1.40wd = 0.40
wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14)
= 0.0132 + 0.100 = 0.1132

Third, calculate the PV of the project cash flows

90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $218,716 − $200,000 = $18,716

This question tested from Session 11, Reading 36, LOS d.

Question 36 - #96638

Which of the following statements about NPV and IRR is NOT correct?

A) The IRR can be positive even if the NPV is negative.

B) When the IRR is equal to the cost of capital, the NPV equals zero.
C) The NPV will be positive if the IRR is less than the cost of capital.

Your answer: A was incorrect. The correct answer was C) The NPV will be positive if
the IRR is less than the cost of capital.

This statement should read, "The NPV will be positive if the IRR is greater than the cost
of capital. The other statements are correct. The IRR can be positive (>0), but less than
the cost of capital, thus resulting in a negative NPV. One definition of the IRR is the rate
of return for which the NPV of a project is zero.

This question tested from Session 11, Reading 36, LOS e.

Question 37 - #97645
All of the following negatively affect shareholders’ proxy voting rights, EXCEPT:

preventing investors who wish to vote their shares from trading during a
A)
period prior to the annual meeting.
B) requiring attendance at the annual meeting.
C) allowing proxy voting by means other than a paper ballot.

Your answer: A was incorrect. The correct answer was C) allowing proxy voting by
means other than a paper ballot.

Allowing proxy voting by means other than a paper ballot has a positive impact on
shareholders’ proxy voting rights. Both of the remaining choices negatively affect
shareholders’ proxy voting rights.

This question tested from Session 11, Reading 41, LOS g.

Question 38 - #131567

A company’s outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At
a tax rate of 40%, the company’s after-tax cost of debt capital is closest to:

A) 4.2%.
B) 5.1%
C) 7.0%

Your answer: A was correct!

Pretax cost of debt: N = 20; FV = 1000; PV = −894; PMT = 60; CPT → I/Y = 7%

After-tax cost of debt: kd = (7%)(1−0.4) = 4.2%

This question tested from Session 11, Reading 37, LOS h.

Question 39 - #97870

A company has the following capital structure:

 Target weightings: 30% debt, 20% preferred stock, 50% common equity.
 Tax Rate: 35%.
 The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-
year maturity for a price of $1,047.46.
 A preferred stock issue that pays a dividend of $2.80 has a value of $35 per
share.
 The company’s growth rate is estimated at 6%.
 The company's common shares have a value of $40 and a dividend in year 0 of
D0 = $3.00.

The company's weighted average cost of capital is closest to:

A) 9.84%.
 B) 9.28%.
C) 10.53%.

Your answer: A was correct!

Step 1: Determine the after-tax cost of debt:

The after-tax cost of debt [kd (1 – t)] is used to compute the weighted average
cost of capital. It is the interest rate on new debt (k d) less the tax savings due to
the deductibility of interest (k dt).

Here, we are given the inputs needed to calculate k d: N = 15 × 2 = 30; PMT =

(1,000 × 0.07) / 2 = 35; FV = 1,000; PV = -1,047.46; CPT → I = 3.25, multiply
by 2 = 6.50%.

Thus, kd (1 – t) = 6.50% × (1 – 0.35) = 4.22%

Step 2: Determine the cost of preferred stock:

Preferred stock is a perpetuity that pays a fixed dividend (D ps) forever. The cost
of preferred stock (kps) = Dps / P

where: Dps = preferred dividends.

P = price

Here, kps = Dps / P = $2.80 / $35 = 0.08, or 8.0%.

Step 3: Determine the cost of common equity:

kce = (D1 / P0) + g

where: D1 = Dividend in next year

P0 = Current stock price

g = Dividend growth rate

Here, D1 = D0 × (1 + g) = $3.00 × (1 + 0.06) = $3.18.

kce = (3.18 / 40) + 0.06 = 0.1395 or 13.95%.

Step 4: Calculate WACC:

WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)

where wd, wps, and wce are the weights used for debt, preferred stock, and
common equity.

Here, WACC = (0.30 × 4.22%) + (0.20 × 8.0%) + (0.50 × 13.95%) = 9.84%.

Note: Your calculation may differ slightly, depending on whether you carry all
calculations in your calculator, or round to two decimals and then calculate.
This question tested from Session 11, Reading 37, LOS a.

Question 40 - #98181

In calculating the weighted average cost of capital (WACC), which of the following
statements is least accurate?

The cost of debt is equal to one minus the marginal tax rate multiplied by
A)
the coupon rate on outstanding debt.
Different methods for estimating the cost of common equity might produce
B)
different results.
The cost of preferred equity capital is the preferred dividend divided by the
C)
price of preferred shares.

Your answer: A was correct!

After-tax cost of debt = bond yield − tax savings = kd − kdt = kd(1 − t)

This question tested from Session 11, Reading 37, LOS a.