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Mock Exam Solution

Uploaded by

su13092004
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© © All Rights Reserved
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BANKING ACADEMY FINAL EXAM

INTERNATIONAL SCHOOL OF Corporate Finance – No.3


BUSINESS Time allowance: 90’

Apply to: City U Program

Date of exam: …………………………… Date of approval:……………… ……..

Signature of censor 1:……………… Signature of censor 2:…………………

(Note: Students are allowed to use the materials during the exam)

PART I – 60 points (Multiple choice questions)

Each question is worth 5 points. Only one answer per question is accepted (no partial
credit). There is no penalty for wrong answers.

# According to the pecking-order theory, a firm’s leverage ratio is determined by


A) the firm’s financing needs.
B) equating the tax benefit of debt to the financial distress costs of debt.
C) the value of the tax benefit of debt.
D) the market rate of interest.

# The MM theory with taxes implies that firms should issue maximum debt. In practice,
this does not occur because:
A) bankruptcy is a disadvantage to debt.
B) debt is more risky than equity.
C) the weighted average cost of capital is inversely related to the debt-equity ratio.
D) the weighted average cost of capital is directly related to the debt-equity ratio

# Companies will generally have a ____ beta if their:


A) high; sales are highly dependent on the market cycle
B) low; stock price is relatively low.
C) high; sales are growing at a steady rate of increase.
D) high; sales are high compared to other firms in their industry

# The net working capital of a firm will decrease if there is


A) a decrease in accounts receivable.
B) an increase in inventory.
C) a decrease in accounts payable.
D) an increase in the checking account balance.

# Of the following choices, which one is an example of erosion and should be included in
a capital project analysis?
A) The anticipated loss of current sales when a new product is launched.
B) The expected decline in sales as the market for a product becomes saturated.
C) The reduction in sales that occurs when a competitor introduces a new product.
D) The sudden loss of sales due to a major employer in your community implementing
massive layoffs

# Woodard Pools is evaluating a project which will increase annual sales by $50,000 and
costs by $30,000. The project has an initial asset cost of $150,000 that will be
depreciated straight-line to a zero book value over the 10-year life of the project. Ignore
bonus depreciation. The applicable tax rate is 25 percent. What is the annual operating
cash flow for this project?
A) $18,750
B) $15,500
C) $21,350
D) $17,900

# A project is expected to create operating cash flows of $26,500 a year for four years.
The fixed assets required for the project cost $62,000 and will be worthless at the end of
the project. An additional $3,000 of net working capital will be required throughout the
life of the project. What is the project's net present value if the required rate of return is
12 percent?
A) $17,396.31
B) $14,028.18
C) $15,306.09
D) $19,208.11

# A project is expected to produce cash flows of $140,000, $225,000, and $200,000 over
the next three years, respectively. After three years, the project will be worthless. What
is the net present value of this project if the applicable discount rate is 10.1 percent and
the initial cost is $522,765?
A) −$60,141
B) $46,262
C) −$9,595
D) $51,317

# Vyshali is evaluating an investment costing $55,000 that has cash flows of $35,000 in
Year 2, $36,000 in Year 3, and −$5,000 in Year 4. Her employer requires a rate of
return of 8 percent and has a required discounted payback period of three years.
Should this project be accepted? Why?
A) No; The NPV indicates rejection as does discounted payback when all cash flows are
considered.
B) Yes; The project pays back on a discounted basis within the assigned time period and also
produces a positive NPV.
C) Yes; The discounted payback requirement is met and other methods of analysis are less
desirable.
D) No; Although the project earns more than 8 percent, there is no situation where the project
can pay back on a discounted basis within three years.
# Jaime is evaluating two independent projects. Project A costs $74,600 and has
projected cash flows of $18,700, $46,300, and $12,200 for Years 1 to 3, respectively.
Project B costs $70,000 and has cash flows of $10,600, $15,800, and $67,900 for Years 1
to 3, respectively. Jaime assigns a discount rate of 10 percent to Project A and 12
percent to Project B. Which project or projects, if either, should he accept based on the
profitability index rule?
A) Accept Project B and reject Project A.
B) Reject both projects..
C) Accept Project A and reject Project B.
D) Accept both projects.

PART II – 40 points

Calculate the WACC


The cost of equity is with CAPM: 0.03 + 1.1 x(0.08-0.03) = 0.085 (5 marks)
Debt = 40*($1,000)
Debt = $40,000 (5 marks)

Common stock = 8,000*($20)


Common stock = $160,000 (5 marks)

Total debt and equity = $40,000 + 160,000


Total debt and equity = $200,000

WACC = ($160,000/$200,000)(.085) + ($40,000/$200,000)(.052)(1 − .20)


WACC = .0763, or 7.63% (5 marks)
It is an incremental cash flow analysis of the change in cash flows from the existing machine
to the new machine, assuming the new machine is purchased. In this type of analysis, the
initial cash outlay would be the cost of the new machine, the increased NWC, and the cash
inflow (including any applicable taxes) of selling the old machine. In this case, the initial cash
flow under this method would be:
Tax on selling the old machine = (4500000-4000000)*0.2 = 100000
Purchase new machine –$8,000,000
Net working capital –250,000
Sell old machine 4,000,000
Taxes on old machine -100,000
Total –$4350000
(5 marks)
The cash flows from purchasing the new machine would be the saved operating expenses.
We would also need to include the change in depreciation. The old machine has a
depreciation of $1 million per year, and the new machine has depreciation of $2 million per
year, so the increased depreciation will be $1 million per year. The pro forma income
statement and operating cash flow under this approach will be:

Operating expense savings $2,000,000


Depreciation 1,000,000
EBT $1,000,000
Taxes 200,000
Net income $800,000
OCF $1,800,000
(5 marks)
The NPV under this method is:
NPV = –$4,350,000 + $1,800,000(PVIFA7.63%,4) + $250,000/1.07634
NPV = $1,847,557.78(5 marks)

And the IRR is:


0 = –$4,350,000 + $1,800,000 (PVIFAIRR,4) + $250,000/(1 + IRR)4
Using a spreadsheet or financial calculator, we find the IRR is: IRR = 25.04%(5 marks)

So, this analysis tells us the company should purchase the new machine.

PART III – 10 points (Short essay)

What should be the primary goal of the financial manager of a corporation? Explain
why this is appropriate.

The appropriate goal is to maximize the current value of the outstanding stock. This goal
focuses on enhancing the returns to the current stockholders who are the owners of the firm.
Other goals, such as maximizing sales or earnings, focus too narrowly on accounting profits
and ignore the importance of market values in managerial finance.

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