REVIW TEST 2 by M L Poloskey These are some questions that I wrote for another text, that you can use for practice. Note: Not all topics in our current text are covered here! 1. Using the following information from Capstone Corporation, what price would CAPM predict that this company’s stock will trade for 1 year from today, if you assume a risk free rate of 3% and a market risk premium of 8%? Beta: .65 Current Price: $64.61 Estimated Forward Annual Dividend: $1.92 2. How are covariance and correlation different? 3. Calculate the beta of this portfolio and use the capital asset pricing model (CAPM) to determine its expected rate of return. The market expected rate of return is 15%, and the risk-free rate is 7%. Stock Investment Beta A $ 200,000 1.50 B 300,000 .65 C 500,000 1.25 4. What would you recommend to an investor who is considering an investment which, according to its beta, plots below the security market line (SML)? 5. Why does an investor want a diversified portfolio? Can an investor eliminate all risk? 6. Testco Corp. is considering adding a new product line. The cost of the factory and equipment to produce this product is $1,780,000, and the company expects increased cash flows from the sale of this product to be $450,000 for each of the next eight years. If the company uses a discount rate of 12 percent, what is the net present value of this project? What is the internal rate of return of this project? 7. Flowers Unlimited is considering purchasing an additional delivery truck. The cost of the new truck will be $42,000. Cost savings are expected to be $12,800 for the next two years and $8,900 for the following two years and $5,000 for the last 3 years of the truck’s useful life. What is the payback period for this project? What is the discounted payback period for this project assuming a discount rate of 10 percent?8. What is the average accounting rate of return (ARR) on equipment that will initially cost $1.2 million and will result in pretax cost savings of $380,000 for the next three years and then $280,000 for the following three years. The machinery will be depreciated to a salvage value of 0 over 6 years using the straight-line method. The company’s tax rate is 32 percent and the firm’s acceptance decision on any project is based on an ARR of 20% percent. Should this machinery be purchased? 9. If a project has a positive NPV what do we know about that project’s IRR? 10. Which of the following are relevant cash flows in the evaluation of a proposed capital budgeting project to produce a new product? a. Decrease in the cash flows of a substitute product b. Alternative of leasing an existing building that will be used for manufacturing this product c. The cost of a new machine to produce this product d. Salvage value of the new machine at the end of its useful life e. Increase in net working capital at the beginning of the project’s life f. Cost to develop a product prototype last year 11. A division of Blakewell Manufacturing is considering purchasing an auto insert machine to load computer components on mother boards for $1,500,000. The machine will have annual operating costs of $50,000 and save the company $370,000 in labor costs each year. The machine will have a useful life of 10 years. For tax purposes, straight-line depreciation will be used with an estimated salvage value of $300,000 (which will be the market value at that time). The discount rate is 12% and the corporate tax rate is 32%. What is the NPV of this proposal? 12. After examining a potential project’s NPV analysis, the manager advises that the initial fixed capital outlay be increased by $480,000. The initial fixed capital outlay is fully depreciated straight-line over a twelve year life. The tax rate is 35 percent and the required rate of return is 10 percent. No other changes are made to the analysis. What is the effect on the project NPV? 13. Central Embroidery needs to purchase a new monogram machine and is considering two options. The first machine costs $100,000 and is expected to last 5 years, and the second machine costs $160,000 and is expected to last 8 years. Assume that the opportunity cost of capital is 8 percent. Which machine should Central Embroidery purchase? 14. You have inherited an apple orchard and want to sell it in the next four years. An expert in this type of valuation has estimated the after-tax cash flow you would receive as follows: $1,000,000 if sold in one year; $1,300,000 if sold in two years; $1,500,000 if sold inthree years; and $1,600,000 if sold in four years. Your opportunity cost of capital is 10 percent. When should you sell the orchard? 15. Howard Electric & Telecomm groups its product and service offerings into the following divisions. What is the beta of Howard Electric & Telecomm? Division Beta MV of Assets Building & Construction 1.5 $250,000,000 Power .8 $325,000,000 Telecommunications 2.3 $675,000,000 16. Is preferred stock classified as debt or equity? 17. Burnes, Inc. is a mature firm that is growing at a constant rate of 5.5 percent per year. The firm’s last dividend was $1.50. If the required rate of return is 12 percent, what is the market value of this stock assuming dividend growth equals the growth rate of the firm? 18. Abacus Corp. will pay dividends of $2.25, $2.95 and $3.15 for the next three years. After three years, the firm will grow at a constant rate of 4 percent. If the required rate of return is 14.5 percent, what is the current value of the