Name Fall 2012 Test 2 Student No TEST 2 MGF 301 Corporation Finance Fall 2012 Please sign name in box Please tear off the answer sheet and answer all of the following questions on the answer sheet Note Total Points 100 Multiple Choice 4 points each unless otherwise indicated 1 The following arise out of a new project X implemented by YT Inc Which of the following does not represent a cash flow that should be taken into account for capital budgeting purposes a allocation of pre existing sunk cost overhead expenses to project X b an increase in sales of a related YT Inc product caused by project X c a decrease in income taxes paid to the government because of expenses of project X d all of the above should be taken into account 2 Jon is conducting a capital budgeting analysis using NPV for a major expansion of his company He is concerned because there is a lot of uncertainty about what the market conditions will be for his product the next few years Jon has decided to decrease all of his revenue estimates so that they are worst case scenarios Is this the correct way to handle uncertainty in an NPV analysis a Yes NPV analysis requires the use of worst case scenario cash flows b No because increased uncertainty is accounted for in an NPV analysis through a higher discount rate c No no adjustment should be made to cash flows because uncertainty about outcomes is not important to capital budgeting decisions d It doesn t matter what cash flows Jon uses as he will get the same NPV 3 In which of the following investments is an investor expected to earn the most over a 40 year period A E r 1 and 100 2 and 10 B E r 0 and 25 C E r Explain your answer 6 points Choice A is the only one with a positive expected return So if you project out for 40 years the most likely result is that Choice A will increase while B will stay the same and C will go down 4 Mark each statement about capital budgeting as true or false 2 points each T a The IRR method can be used even if cash flows continue in perpetuity F b The payback method is not used as often as NPV because many do not realize that payback is preferred to NPV Name Fall 2012 Test 2 Student No F c The time value of money is an important consideration in each of the NPV payback not payback and IRR methods of capital budgeting 5 AGG Inc s earnings are very dependent on the economy They have high earnings when the economy is booming and large losses in recessions Which is true about the company a an investor in the company can diversify some of the company s overall risk b the company has low market risk c the company has a equal to 1 d the company has no unique risk because it is so dependent on the economy 6 You are analyzing the stock of a Hollywood movie studio You find that the company has a high standard deviation of stock returns which means it has high overall risk But when you calculate beta you find 8 Is it possible to have high overall risk and low market risk Explain 6 points Overall risk Market risk Firm specific risk If a company has high firm specific risk it can have high overall risk even if its overall risk is low A movie studio has high firm specific risk because major movies can be big hits or big losses This type of risk can be easily diversified by owning other stocks so it turns out that movie studios have below average market risk even though they have high overall risk 7 If the Neptune Company has 1 3 the E RM 11 and RF 2 what is the E R of Neptune under CAPM 6 points E r 02 1 3 11 02 137 or 13 7 8 An investment project costs 250 in time 0 and has the following payouts C1 75 C2 125 C3 100 and C4 100 The cost of capital for the firm is 13 Which of the following is the formula for NPV a 250 75 1 13 125 1 132 100 1 133 100 1 134 b 250 75 1 13 125 1 132 100 1 133 100 1 134 c 0 250 75 1 r 125 1 r 2 100 1 r 3 100 1 r 4 and solve for r d 250 1 13 75 1 132 125 1 133 100 1 134 100 1 135 9 If 5 for company JKL and the market was down by 20 last year which of the following is the most likely actual return earned by investors in JKL last year a 10 b 10 c 20 d 0 10 The cash flows for a project are as follows initial cost of 4 000 000 C1 500 000 C2 800 000 C3 1 200 000 C4 2 000 000 C5 3 000 000 If the company uses the payback method with a four year payback should they accept the project Explain 6 points 2 Name Fall 2012 Test 2 Student No After four years the company will have received 500 000 800 000 1 200 000 2 000 000 3 500 000 As this is less than the initial 4 000 000 investment the project should be rejected under the payback method 11 A proposed investment will cost 1 000 000 in year 0 It will have a life of 5 years and the cost will be depreciated using straight line to a zero salvage value The company expects revenues of 700 000 in time 1 and 800 000 in time 2 The variable cost is 40 of revenues and the fixed costs will be 100 000 Working capital is 10 of next year s revenues If taxes are 35 what is the incremental cash flow for year 1 Show your calculations 8 points Change in working capital 80 000 70 000 10 000 Cash flow from working capital 10 000 Depreciation 1 000 000 5 200 000 Pre tax cash flow from operations 700 000 700 000 40 100 000 200 000 120 000 After tax cash flow 120 000 120 000 35 78 000 Cash flow from operations 78 000 200 000 278 000 Overall cash flow 278 000 10 000 268 000 12 Assuming you have the per unit data for question 11 if you calculate the accounting breakeven and the economic breakeven which will require the sale of more units a the accounting breakeven because Generally Accepted Accounting Principles GAAP are conservative b both give the same breakeven c the economic breakeven because the depreciation calculation under the accounting breakeven is too low if the time value of money is considered d none of the above is true 13 If investors in the market are expecting that quarterly earnings of BCJ will be 35 above last year s earnings draw a graph indicating …