Your
firm spends $473,000 per year in regular maintenance of its equipment. Due to
the economic downturn, the firm considers forgoing these maintenance expenses
for the next 3 years. If it does so, it expects it will need to spend $1.9
million in year 4 replacing failed equipment. What is the IRR of the decision
to forgo maintenance of the equipment?

The
IRR of the decision is 15.94%

The
IRR of the decision is 14.18%

The IRR of the decision is 15.32%.

The
IRR of the decision is 18.36%

Your
firm spends $473,000 per year in regular maintenance of its equipment. Due to
the economic downturn, the firm considers forgoing these maintenance expenses
for the next 3 years. If it does so, it expects it will need to spend $1.9
million in year 4 replacing failed equipment. Does the IRR rule work for this
decision?

Only
if the replacement cost is below $2 million.

No.

Yes.

The
last four years of returns for a stock are as follows:

Year
1

Year
2

Year
3

Year
4

-3.9%

+27.6%

+11.5%

+3.8%

Note:
Notice that the average return and standard deviation must be entered in
percentage format. The variance must be entered in decimal format.
What is the
average annual rate? (Round to two decimal places.)

The
average return is 10.15%.

The
average return is 10.25%.

The
average return is 10.05%.

The average return is 9.95%.

In
mid-2009, Rite Ad had CCC-rated, 20-year bonds outstanding with a yield to
maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%.
Suppose the mark risk premium is 5% and you believe Rite Aid’s bonds have a
beta of 0.38. If the expected loss rate of these bonds in the event of default
is 58%. What annual probability of default would be consistent with the yield
to maturity of these bonds in mid-2009?

The
required return for this investment is 4.90%. The annual probability of default
is 23.38%.

The
required return for this investment is 4.90%. The annual probability of default
is 20.38%.

The
required return for this investment is 4.90%. The annual probability of default
is 22.38%.

The required return for this investment is 4.90%. The annual
probability of default is 21.38%.

Weston
Enterprises is an all-equity firm with two divisions. The soft drink division
has an asset beta of 0.54, expects to generate free cash flow of $66 million
this year, and anticipated a 3% perpetual growth rate. The individual chemicals
division has an asset beta of 1.15, expects to generate free cash flow of $71
million this year, and anticipates a 4% perpetual growth rate. Suppose the risk
free rate is 2% and the market premium is 5%. Estimate Weston’s current cost of
capital.

Weston’s
current cost of capital is 4.70%.

Weston’s
current cost of capital is 3.70%.

Weston’s current cost of capital is 5.70%.

Weston’s
current cost of capital is 2.70%.

Consider
an investment with the following returns over four years:

Year

1

2

3

4

Return

15%

7%

9%

11%

Which
is a better measure of the investment’s past performance? If the investment’s
returns are independent and identically distributed, which is a better measure
of the investment’s expected return next year?

Arithmetic
average is a better measure of the investment’s past performance while CAGR is
a better measure of the investment’s expected return next year.

CAGR is a better measure of the investment’s past performance while
arithmetic average is a better measure of the investment’s expected return next
year.

Pisa
Pizza, a seller of frozen pizza, is considering introducing a healthier version
of its pizza that will be low in cholesterol and contain no trans fats. The
firm expects that sales of the new pizza will be $15 million per year. While
many of these sales will be to new customers, Pisa Pizza estimates that 27%
will come from customers who switch to the new, healthier pizza instead of
buying the original version. Assume customers will spend the same amount on
either version. What level of incremental sales is associated with introducing
the new pizza?

The
incremental sales are $3 million.

The
incremental sales are $9 million.

The
incremental sales are $15 million.

The incremental sales are $11 million.

You
need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you
only have the following data available regarding past returns:

Year

Risk-free
Return

Market
Return

XYZ
Return

2007

4%

6%

8%

2008

1%

-43%

-50%

Estimate
XYZ’s historical alpha.

XYZ’s historical alpha is 1.1%.

XYZ’s
historical alpha is 1.6%.

XYZ’s
historical alpha is 1.9%.

XYZ’s
historical alpha is 1.3%.

The
figure below shows the one-year return distribution of Startup, Inc.

Probability

40%

20%

20%

10%

10%

Return

-100%

-75%

-50%

-30%

1,000%

Calculate
the standard deviation of the return.

The standard deviation is 324%.

The
standard deviation is 330%.

The
standard deviation is 328%.

The standard deviation is 326%.

A bicycle
manufacturer currently produces 356,000 units a year and expects output levels
to remain steady in the future. It buys chains from an outside supplier at a
price of $2.10 a chain. The plant manager believes that it would be cheaper to
make these chains rather than buy them. Direct in-house production costs are
estimated to be only $1.50 per chain. The necessary machinery would cost
$290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000, but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $21,750. If the company pays tax at
a rate of 35% and the opportunity cost of capital is 15%, what is the net
present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?

Compute
the NPV of buying the chains from the FCF.

The
NPV of buying the chains from the FCF is $-438,850.

The
NPV of buying the chains from the FCF is $-438,820.

The
NPV of buying the chains from the FCF is $-1,438,820.

The NPV of buying the chains from the FCF is $-2,438,820.

Consider
an investment with the following returns over four years:

Year

1

2

3

4

Return

15%

7%

9%

11%

What
is the average annual return of the investment over the four years?

The
average annual return is 1.50%.

The
average annual return is 0.50%.

The average annual return is 10.50%.

The
average annual return is 5.50%.

Bay Properties
is considering starting a commercial real estate division. It has prepared the
following four-year forecast of free cash flows for this division:

Year
1

Year
2

Year
3

Year
4

Free
cash flow

$-122,000

$-9,000

$100,000

$219,000

Assume
cash flows after year 4 will grow at 3% per year, forever. If the cost of
capital for this division is 17%, what is the value today of this division?

The
value today is $528,283.

The value today is $928,283.

The
value today is $228,283.

The
value today is $728,283.

You
need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you
only have the following data available regarding past returns:

Year

Risk-free
Return

Market
Return

XYZ
Return

2007

4%

6%

8%

2008

1%

-43%

-50%

Would
you base your estimate of XYZ’s equity cost of capital on historical return or
expected return?

Expected return because the CAPM provides a better estimate of
expected returns.

Historical
return because the average past returns provides a better estimate of expected
returns.

You
need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you
only have the following data available regarding past returns:

Year

Risk-free
Return

Market
Return

XYZ
Return

2007

4%

6%

8%

2008

1%

-43%

-50%

Compute
the market’s and XYZ’s excess returns for each year. Estimate XYZ’s beta.

The market’s excess return for 2007 is 2%. The market’s excess
return for 2008 is -44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess
return for 208 is -51%. XYZ’s beta is 1.20.

The
market’s excess return for 2007 is 2%. The market’s excess return for 2008 is
-44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 2008 is -51%.
XYZ’s beta is 1.40.

The
market’s excess return for 2007 is 2%. The market’s excess return for 2008 is
-44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 2008 is -51%.
XYZ’s beta is 1.10.

The
market’s excess return for 2007 is 2%. The market’s excess return for 2008 is
-44%. XYZ’s excess return for 2007 is 4%. XYZ’s excess return for 208 is -51%. XYZ’s
beta is 1.30.

The
last four years of returns for a stock are as follows:

Year
1

Year
2

Year
3

Year
4

-3.9%

+27.6%

+11.5%

+3.8%

Note:
Notice that the average return and standard deviation must be entered in
percentage format. The variance must be entered in decimal format.
What is the
variance of the stock’s returns? (Round to five decimal places.)

The
variance of the returns is 0.01602.

The
variance of the returns is 0.01702.

The
variance of the returns is 0.01902.

The variance of the returns is 0.01802.

Consider
an investment with the following returns over four years:

Year

1

2

3

4

Return

15%

7%

9%

11%

What
is the compound annual growth rate (CAGR) for this investment over the four
years?

The compound annual growth rate is 10.46%.

The
compound annual growth rate is 10.36%.

The
compound annual growth rate is 10.26%.

The
compound annual growth rate is 10.16%.

Weston
Enterprises is an all-equity firm with two divisions. The soft drink division
has an asset beta of 0.54, expects to generate free cash flow of $66 million
this year, and anticipated a 3% perpetual growth rate. The individual chemicals
division has an asset beta of 1.15, expects to generate free cash flow of $71
million this year, and anticipates a 4% perpetual growth rate. Suppose the risk-free
rate is 2% and the market premium is 5%. Estimate Weston’s current equity beta.

Weston’s current equity beta is 0.74.

Weston’s
current equity beta is 0.66.

Weston’s
current equity beta is 0.79.

Weston’s
current equity beta is 0.70.

You
are considering opening a new plant. The plant will cost $100.3 million
upfront. After that, it is expected to produce profits of $31.9 million at the
end of every year. The cash flows are expected to last forever. Calculate the
NPV of this investment opportunity if your cost of capital is 7.1%.

The NVP of this investment opportunity is $349.0 million.

The
NVP of this investment opportunity is $349.0 million.

The
NVP of this investment opportunity is $349.0 million.

The
NVP of this investment opportunity is $349.0 million.

You
need to estimate the equity cost of capital for XYZ Corp. Unfortunately, you
only have the following data available regarding past returns:

Year

Risk-free
Return

Market
Return

XYZ
Return

2007

4%

6%

8%

2008

1%

-43%

-50%

What
was XYZ’s average historical return?

XYZ’s
average historical return was -18.0%.

XYZ’s
average historical return was -15.0%.

XYZ’s average historical return was -21.0%.

XYZ’s
average historical return was -20.0%.

Weston
Enterprises is an all-equity firm with two divisions. The soft drink division
has an asset beta of 0.54, expects to generate free cash flow of $66 million
this year, and anticipated a 3% perpetual growth rate. The individual chemicals
division has an asset beta of 1.15, expects to generate free cash flow of $71
million this year, and anticipates a 4% perpetual growth rate. Suppose the
risk-free rate is 2% and the market premium is 5%. Estimate the value of each
division.

The
estimated value of the soft drink division is $70.3 million and the estimated value
of the industrial chemicals division is $76.3 million.

The estimated value of the soft drink division is $3,882.4 million
and the estimated value of the industrial chemicals division is $1,893.3
million.

The
estimated value of the soft drink division is $3,796.2 million and the
estimated value of the industrial chemicals division is $8,774.5 million.

The
estimated value of the soft drink division is $1,893.3 million and the
estimated value of the industrial chemicals division is $3,882.4 million.

A bicycle
manufacturer currently produces 356,000 units a year and expects output levels
to remain steady in the future. It buys chains from an outside supplier at a
price of $2.10 a chain. The plant manager believes that it would be cheaper to
make these chains rather than buy them. Direct in-house production costs are
estimated to be only $1.50 per chain. The necessary machinery would cost
$290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000, but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from scrapping
the machinery after 10 years are $21,750. If the company pays tax at a rate of
35% and the opportunity cost of capital is 15%, what is the net present value
of the decision to produce the chains in-house instead of purchasing them from
the supplier?

Project
the annual free cash flows (FCF) of buying the chains.

The
annual free cash flows for years 1 to 10 of buying the chains is $-482,940.

The annual free cash flows for years 1 to 10 of buying the chains is
$-485,940.

The
annual free cash flows for years 1 to 10 of buying the chains is $-486,940.

The
annual free cash flows for years 1 to 10 of buying the chains is $-489,940.

The
last four years of returns for a stock are as follows:

Year
1

Year
2

Year
3

Year
4

-3.9%

+27.6%

+11.5%

+3.8%

Note:
Notice that the average return and standard deviation must be entered in
percentage format. The variance must be entered in decimal format.
What is the
standard deviation of the stock’s returns? (Round to two decimal places.)

The
standard deviation is 13.99%.

The
standard deviation is 14.79%.

The
standard deviation is 14.99%.

The standard deviation is 13.79%.

You
are considering a safe investment opportunity that requires a $920 investment
today, and will pay $690 two years from now and another $640 five years from
now. If you are choosing between this investment and putting your money in a
safe bank account that pays an EAR of 5% per year for any horizon, can
you make the decision by simply comparing this EAR with the IRR of the
investment? Explain.

No,
because the timing of the cashflows are different.

Yes, you can always compare IRRs of riskless projects, and an
investment in the back is riskless.

No,
this is like comparing the IRR of two projects.

Yes,
because the EAR is the same at all horizons, so the two “projects”
have the same riskiness, scale, and timing.

You
are considering a safe investment opportunity that requires a $920 investment
today, and will pay $690 two years from now and another $640 five years from
now. What is the IRR of this investment?

The
IRR of this investment is 8.65%.

The
IRR of this investment is 6.92%.

The
IRR of this investment is 22.29%.

The IRR of this investment is 11.74%.

A
bicycle manufacturer currently produces 356,000 units a year and expects output
levels to remain steady in the future. It buys chains from an outside supplier
at a price of $2.10 a chain. The plant manager believes that it would be
cheaper to make these chains rather than buy them. Direct in-house production
costs are estimated to be only $1.50 per chain. The necessary machinery would
cost $290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000 but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $21,750. If the company pays tax at
a rate of 35% and the opportunity cost of capital is 15%, what is the net
present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?

Compute
the FCF in years 1 through 9 of producing the chains.

The
FCF in years 1 through 9 of producing the chains is $-338,950.

The
FCF in years 1 through 9 of producing the chains is $-336,950.

The FCF in years 1 through 9 of producing the chains is $-342,950.

The
FCF in years 1 through 9 of producing the chains is $-339,950.

A
bicycle manufacturer currently produces 356,000 units a year and expects output
levels to remain steady in the future. It buys chains from an outside supplier
at a price of $2.10 a chain. The plant manager believes that it would be
cheaper to make these chains rather than buy them. Direct in-house production
costs are estimated to be only $1.50 per chain. The necessary machinery would
cost $290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000 but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $21,750. If the company pays tax at
a rate of 35% and the opportunity cost of capital is 15%, what is the net
present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?

Compute
the NVP of producing the chains from the FCF.

The
NVP of producing the chains from the FCF is $-3,007,692.

The NVP of producing the chains from the FCF is $-2,007,692.

The
NVP of producing the chains from the FCF is $-4,007,692.

The
NVP of producing the chains from the FCF is $-1,007,692.

IDX
Tech is looking to expand its investment in advanced security systems. The
project will be financed with equity. You are trying to assess the value of the
investment, and must estimate its cost of capital. You find the following data
for a publicly traded firm in the same line of business:

Debt
outstanding (book value, AA-rated)

$392.4
million

Number
of shares of common stock

77.2
million

Stock
price per share

$14.67

Book
value of equity per share

$5.55

Beta
of equity

1.32

What
assumptions do you need to make? (Select all the choices that apply.)

Assume
comparable assets have same risk as project.

Assume debt is risk-free and market value = book value.

Assume
comparable assets have same cost.

Assume
debt is risk-free and market value > book value.

IDX
Tech is looking to expand its investment in advanced security systems. The
project will be financed with equity. You are trying to assess the value of the
investment, and must estimate its cost of capital. You find the following data
for a publicly traded firm in the same line of business:

Debt
outstanding (book value, AA-rated)

$392.4
million

Number
of shares of common stock

77.2
million

Stock
price per share

$14.67

Book
value of equity per share

$5.55

Beta
of equity

1.32

What
is your estimate of the project’s beta?

The
project beta is 1.98.

The project beta is 0.98.

The
project beta is 2.98.

The
project beta is 1.48.

Your
firm spends $473,000 per year in regular maintenance of its equipment. Due to
the economic downturn, the firm considers forgoing these maintenance expenses
for the next 3 years. If it does so, it expects it will need to spend $1.9
million in year 4 replacing failed equipment. For what costs of capital (COC)
is forgoing maintenance a good idea?

For
costs of capital that are less than the replacement costs.

For
costs of capital that are greater than the NPV.

For
costs of capital that are less than the IRR.

For costs of capital that are greater than the IRR.

In
mid-2009, Rite Ad had CCC-rated, 20-year bonds outstanding with a yield to
maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%.
Suppose the mark risk premium is 5% and you believe Rite Aid’s bonds have a
beta of 0.38. If the expected loss rate of these bonds in the event of default is 58%. In mid-2012, Rite Aid’s bonds a had a
yield of 8.2%, while similar maturity Treasuries had a yield of 0.8%. What
probability of default would you estimate now?

The
probability of default will be 10.48%.

The
probability of default will be 8.48%.

The probability of default will be 11.48%.

The
probability of default will be 9.48%.

Bay
Properties is considering starting a commercial real estate division. It has
prepared the following four-year forecast of free cash flows for this division:

Year
1

Year
2

Year
3

Year
4

Free
cash flow

$-122,000

$-9,000

$100,000

$219,000

Assume
cash flows after year 4 will grow at 3% per year, forever. If the cost of
capital for this division is 17%, what is the continuation value in year 4 for
cash flows after year 4?

The continuation value is $1,611,214.

The
continuation value is $1,601,214.

The
continuation value is $611,214.

The
continuation value is $1,621,214.

A
bicycle manufacturer currently produces 356,000 units a year and expects output
levels to remain steady in the future. It buys chains from an outside supplier
at a price of $2.10 a chain. The plant manager believes that it would be
cheaper to make these chains rather than buy them. Direct in-house production
costs are estimated to be only $1.50 per chain. The necessary machinery would
cost $290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000 but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $21,750. If the company pays tax at
a rate of 35% and the opportunity cost of capital is 15%, what is the net
present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?

Compute
the difference between the net present values of buying the chains and producing
the chains.

The
net present value of producing the chains in-house instead of purchasing them
from the supplier is $431,128.

The net present value of producing the chains in-house instead of
purchasing them from the supplier is $331,128.

The
net present value of producing the chains in-house instead of purchasing them
from the supplier is $131,128.

The
net present value of producing the chains in-house instead of purchasing them
from the supplier is $231,128.

You
are considering opening a new plant. The plant will cost $100.3 million
upfront. After that, it is expected to produce profits of $31.9 million at the
end of every year. The cash flows are expected to last forever. Should you make
the investment?

Yes,
because the project will generate cash flows forever.

No,
because the NVP is not greater than the initial costs.

Yes, because the NVP is positive.

No,
because the NVP is less than zero.

A
bicycle manufacturer currently produces 356,000 units a year and expects output
levels to remain steady in the future. It buys chains from an outside supplier
at a price of $2.10 a chain. The plant manager believes that it would be
cheaper to make these chains rather than buy them. Direct in-house production
costs are estimated to be only $1.50 per chain. The necessary machinery would
cost $290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require additional
working capital of $40,000, but argues that this sum can be ignored since it is
recoverable at the end of the 10 years. Expected proceeds from scrapping the
machinery after 10 years are $21,750. If the company pays tax at a rate of 35%
and the opportunity cost of capital is 15%, what is the net present value of
the decision to produce the chains in-house instead of purchasing them from the
supplier?

Compute
the FCF in year 10 of producing the chains.

The
FCF in year 10 of producing the chains is $-182,613.

The
FCF in year 10 of producing the chains is $-282,813.

The FCF in year 10 of producing the chains is $-182,813.

The
FCF in year 10 of producing the chains is $-282,613.

A
bicycle manufacturer currently produces 356,000 units a year and expects output
levels to remain steady in the future. It buys chains from an outside supplier
at a price of $2.10 a chain. The plant manager believes that it would be
cheaper to make these chains rather than buy them. Direct in-house production
costs are estimated to be only $1.50 per chain. The necessary machinery would
cost $290,000 and would be obsolete after 10 years. This investment could be
depreciated to zero for tax purposed using a 10-year straight-line depreciation
schedule. The plant manager estimates that the operation would require
additional working capital of $40,000, but argues that this sum can be ignored
since it is recoverable at the end of the 10 years. Expected proceeds from
scrapping the machinery after 10 years are $21,750. If the company pays tax at
a rate of 35% and the opportunity cost of capital is 15%, what is the net
present value of the decision to produce the chains in-house instead of
purchasing them from the supplier?

Compute
the initial FCF of producing the chains.

The
initial FCF of producing the chains is $-335,000.

The
initial FCF of producing the chains is $-339,000.

The
initial FCF of producing the chains is $-340,000.

The initial FCF of producing the chains is $-330,000.

You
are considering opening a new plant. The plant will cost $100.3 million
upfront. After that, it is expected to produce profits of $31.9 million at the
end of every year. The cash flows are expected to last forever. Use the IRR to
determine the maximum deviation allowable in the cost of capital estimate to make
the investment.

The
maximum deviation allowable in the cost of capital is 28.65%.

The
maximum deviation allowable in the cost of capital is 21.60%.

The maximum deviation allowable in the cost of capital is 24.70%.

The
maximum deviation allowable in the cost of capital is 18.45%.

The
figure below shows the one-year return distribution of Startup, Inc.

Probability

40%

20%

20%

10%

10%

Return

-100%

-75%

-50%

-30%

1,000%

Calculate
the expected return.

The
expected return is 30.0%.

The
expected return is 31.2%.

The expected return is 32.0%.

The
expected return is 30.7%.

You
are considering opening a new plant. The plant will cost $100.3 million
upfront. After that, it is expected to produce profits of $31.9 million at the
end of every year. The cash flows are expected to last forever. Calculate the
IRR.

The
IRR of the project is 30.60%.

The
IRR of the project is 28.80%.

The
IRR of the project is 33.70%.

The IRR of the project is 31.80%.

Pisa
Pizza, a seller of frozen pizza, is considering introducing a healthier version
of its pizza that will be low in cholesterol and contain no trans fats. The
firm expects that sales of the new pizza will be $15 million per year. While
many of these sales will be to new customers, Pisa Pizza estimates that 27%
will come from customers who switch to the new, healthier pizza instead of
buying the original version. Suppose that 39% of customers who switch from Pisa
Pizza to its healthier pizza will switch to another brand if