53. A firm has a capital structure of 40% debt and 60% equity. The firm has bonds outstanding with a face
value of $20 million. The bonds pay, on average, a 8% annual coupon and have an average maturity
length of 7 years. The market value of the bonds is 110% of face value and the tax rate facing the firm
is 40%. The firm has common stock with a beta of 1.25. The risk free rate on Treasury bonds is 2%,
while the market risk premium is 8%. A project requires an investment of $10,000 today and will pay
$2,500 annually for six years. What is the NPV of the project?
a.
$825
b.
$1,320
c.
$1,460
d.
$1,540
54. Which statement is FALSE regarding WACC and its components?
a.
The cost of debt is usually less than the cost of equity.
b.
The WACC should be used as the discount rate for all projects that the firm considers.
c.
For an all-equity firm, the cost of equity equals the WACC.
d.
The WACC may increase if the firm seeks external financing for a project.
55. Which statement is true about a firm that earns ZERO economic profit?
a.
The firm is competing in a non-competitive environment.
b.
The market must have high entry barriers to other firms.
c.
The NPV of projects the firm considers equals zero.
d.
The accounting income for projects equals zero.
56. A project’s discount rate
a.
must be lower than the cost of funds for the firm’s current list of projects.
b.
must be high enough to compensate investors for the project’s risk.
c.
must be higher than the cost of funds for the firm’s current list of projects.
d.
none of the above.
57. Nalcoa Corp. is financing a project that is in the same industry as its current portfolio of projects. If
Nalcoa has a beta of 1.5 and the expected market risk premium is 8% while the risk-free rate is 5%
then what is the weighted average cost of capital for Nalcoa if it is, and plans to continue to be an all
equity financed firm?
a.
9.5%
b.
13.0%
c.
17.0%
d.
there is not enough information to calculate the WACC
58. Operating leverage measures
a.
the effect of variable costs on the responsiveness of the firm’s earnings before interest and
taxes to changes in the level of sales.
b.
the effect of fixed operating costs on the responsiveness of the firm’s earnings before
interest and taxes to changes in the level of gross income.
c.
the effect of fixed operating costs on the responsiveness of the firm’s earnings before
interest and taxes to changes in the level of sales.
d.
none of the above.
59. Purple Bell Butter Company increased its sales by $2,000 over that of the previous years’s figure of
$50,000. Consequently, Purple Bell’s earnings before interest and taxes increased from $3,000 to
$3,300 during the same period. Calculate Purple Bell’s operating leverage.
a.
25
b.
4
c.
2.5
d.
none of the above
60. A high degree of operating leverage suggests that
a.
a small percentage increase in sales leads to a large percentage increase in earnings before
interest and taxes.
b.
a small percentage increase in sales leads to an identical percentage increase in earnings
before interest and taxes.
c.
a large percentage increase in sales leads to a small percentage increase in earnings before
interest and taxes.
d.
none of the above.
61. Which of the following industries would you expect to have the highest degree of operating leverage?
a.
financial consulting
b.
investment banking
c.
electrical utility
d.
internet publishing
62. A firm’s weighted average cost of capital is
a.
the cost of capital applicable to all new forms of capital that the firm may raise in the
future.
b.
the simple weighted average of the current required rates of return on debt and equity.
c.
the higher of either equity or debt capital that the firm is currently utilizing in its capital
structure.
d.
none of the above.
63. Which of the following is not required for a firm to utilize its current weighted average cost of capital
to evaluate a future project?
a.
the firm will not alter its capital structure
b.
the future project is very similar to the firm’s existing assets
c.
the future project has an expected life that is similar to its existing project lives
d.
neither a nor b is required
64. CapCo has a capital structure that is composed of $10 million of debt and $30 million of common
equity. If CapCo is in the 30% marginal tax rate, what is its WACC if the yield to investors on CapCo
debt is 8% and the cost of CapCo common equity is 12%?
a.
8.3%
b.
10.4%
c.
11.0%
d.
none of the above
65. WidgetMaker has discovered that its fixed costs are $100,000 per month. If WidgetMaker sells its
widgets for $35 per unit based upon a cost of $15 per unit to manufacture (variable costs) then how
many widgets per year must WidgetMaker sell in order to break-even?
a.
5,000
b.
34,286
c.
60,000
d.
None of the above
66. WidgetMaker has discovered that its fixed costs are $100,000 per month. If WidgetMaker sells its
widgets for $35 per unit based upon a cost of $15 per unit to manufacture (variable costs) then what
dollar sales per year must WidgetMaker sell in order to break-even?
a.
$175,000
b.
$1,200,000
c.
$2,100,000
d.
none of the above
67. If a company decides to change one input at a time in its net present value analysis, in order to measure
the NPV impact of such a change then the firm is performing
a.
a Monte Carlo simulation.
b.
scenario analysis.
c.
a sensitivity analysis.
d.
none of the above
68. A firm prefers to assume a probability distribution concerning each of the major inputs for the net
present value of a project and then randomly draw those inputs over and over again until a distribution
is generated for the net present value of an entire project. The firm is performing
a.
a Monte Carlo analysis on its projects.
b.
sensitivity analysis on its projects.
c.
a scenario analysis on its projects.
d.
none of the above.
69. You are given the opportunity to play a game of high stakes gambling. The game begins by you paying
an entry fee of $35,000,000 followed by a fair coin toss. If the coin toss is “heads” then you have an
80% probability of receiving a perpetuity of $10,000,000 per year and a 20% probability of receiving a
perpetuity of $1,000,000 per year. Assume that the proper discount rate for the perpetual cash flow is
10%. If the coin toss is “tails”you can continue to play but you will lose $50,000,000 with certainty.
Alternatively, you can make a make an opt-out payment of $10,000,000 after a “tail” to prevent you
from going down such a costly path. What is the present value of playing such a game?
a.
$1,000,000
b.
-$1,000,000
c.
-$39,000,000
d.
none of the above
70. The right but not the obligation to produce oil from one of your existing oil wells can be described as
a.
a real option.
b.
a stock option.
c.
an interest rate option.
d.
a future.
71. You are the owner of a natural gas well that can produce exactly (at today’s prices) $1,000,000 worth
of gas per year for exactly 5 years. You also know (with certainty) that the correct discount rate for
these revenues is 10%. An oil and gas production firm offers you $5,000,000 today for the natural gas
well. What is the implied value of the real option to not produce or not to produce natural gas?
a.
$0
b.
$604,607
c.
$1,209,213
d.
$2,418,426
72. The going rate for paying a CEO in the widget industry is $1,000,000 per year. You find that the CEO
of MasterWidgets has a contract that pays him $1,200,000 per year for five years if he cannot work for
any other firm (for any reason during the contractual period). What is the value of a real option for a
CEO to not work for a firm other than MasterWidgets? Assume a discount rate of 10%.
a.
$181,818
b.
$200,000
c.
$758,157
d.
$1,000,000
73. You are a professional football running back who is eligible to be a free agent. You are offered a
two-year contract to play for your current team for $3,000,000. If you accept that contract, the firm
retains your rights and you will not be able to play for another team at the conclusion of the contract.
Otherwise, you can play for you current team for two years at a price of $2,000,000 but you have the
ability to play for any team at the expiration of this agreement. What is the value of the option to pay
for any team you like after two years? Assume a discount rate of 5%.
a.
$5,578,231
b.
$3,718,821
c.
$1,859,410
d.
none of the above
74. You are considering the purchase of a business that produces net cash flows of $350,000 per year in
perpetuity. In a perfectly competitive market, what should be the asking price for the business if the
firm’s cost of capital is 15%?
a.
$350,000
b.
$3,050,000
c.
$2,333,333
d.
none of the above
75. You are a gold producer and have noticed that the value of your business may increase even though
the price of gold falls. Your explanation for this phenomenon is
a.
that the relationship between the value of future cash flows and interest rates is positive.
b.
that increased risk may increase the real option value of the firm.
c.
that cheaper gold prices are good for the economy and that must be good for the firm.
d.
none of the above
76. You are an aerospace defense contractor and you routinely work projects for the U.S. Department of
Defense that generate cash flows that by themselves, do not cover the cost of capital for the firm. One
reason for this may be
a.
because you can make up negative NPV projects by taking on more volume.
b.
because the projects have an implicit option to work on non-defense related projects at a
lower direct research cost than projects without defense related work.
c.
because there is a taxable exemption from doing patriotic work.
d.
none of the above.
77. You are considering the purchase of production volume of 100,000 widgets per year. You can
purchase either a single 100,000 widget per year machine that costs $1,000,000 or first buy a 50,000
per year machine and then if sales volume permits, purchase another machine later. If widget
production volume costs the same per unit to produce, what should the cost of the 50,000 per year
machine be (to you) if there is a real option to expand production?
a.
less than $500,000
b.
$500,000
c.
greater than $500,000
d.
it is impossible to tell from the information given
78. You are about to embark on a project that has an equal 50% probability of generating a $10,000
windfall or a loss of $4,000. However, an insurance company comes to you saying they will sell you
an indemnification policy for the event that you incur the $4,000 loss. If the insurance company is
basing their charge for the policy on real option analysis, what will they charge you for the policy?
a.
$1,000
b.
$2,000
c.
$4,000
d.
none of the above
79. Lunar Surf Boards has annual fixed costs of $5,000 with a variable cost of $10 per unit and a sales
price of $20 per unit. Lunar expects to sell 1,000 units this year without much trouble. However, Lunar
is concerned about the scenario that variable costs will increase 10% this year. If that happens, what
will be Lunar’s earnings before interest and taxes?
a.
$6,000
b.
$5,000
c.
$4,000
d.
none of the above
80. Jupitor Surf Boards has annual fixed costs of $5,000 with a variable cost of $10 per unit and a sales
price of $20 per unit. Jupitor expects to sell 1,000 units this year without much trouble. However,
Jupitor is concerned about the scenario that all costs will increase 10% this year. If that happens, what
will be Jupitor’s earnings before interest and taxes?
a.
$6,000
b.
$5000
c.
$4,000
d.
$3,500
81. The discount rate used to evaluate a firm’s projects should:
a.
reflect the opportunity costs of investing in either the firm’s project or a similar project
b.
be high enough to compensate investors for the risk of the project
c.
be the same across all the firm’s projects
d.
Both (a) and (b) are true
e.
All of the above
82. Financial leverage:
a.
results when a firm finances a portion of its assets with debt
b.
can enhance a firm’s earnings if sales increase
c.
can impact the beta of the firm’s stock
d.
All of the above
e.
Only (a) and (b) are true
83. Which of the following statements is true?
a.
Using the same WACC to discount all a firm’s potential investments is a sound financial
practice.
b.
When a firm has debt in its capital structure, the cost of equity is the appropriate discount
rate to use in NPV calculations.
c.
If an investment being evaluated has higher risk than the firm’s current set of projects, the
firm’s WACC is the appropriate discount rate to use.
d.
Statements (a) and (b) are true
e.
All of the above statements are false.
84. Taxes impact the WACC calculation because:
a.
Dividends paid on common stock are tax deductible.
b.
Dividends paid on preferred stock are tax deductible.
c.
Interest paid on debt is tax deductible.
d.
Both (a) and (c) are true.
e.
All of the above
85. Which of the following statements is true?
a.
When conducting sensitivity analysis all variables except one are held constant.
b.
When conducting sensitivity analysis a ‘base-case’ set of assumptions must be established.
c.
Scenario analysis is a more complex form of sensitivity analysis.
d.
both (a) and (b) are true
e.
all of the above are true
86. Which of the following describes a visual representation of the sequential choices that managers face
over time with regard to a particular investment?
a.
Sensitivity analysis
b.
Monte Carlo simulation
c.
Decision tree
d.
Scenario analysis
e.
Breakeven analysis
87. One major flaw in decision trees is that:
a.
the risk of many investments changes as one moves from one point in the decision tree to
another.
b.
Establishing the base case scenario requires many iterations.
c.
The necessary computing power to run a decision tree is expensive.
d.
all of the above
e.
none of the above
88. The right to invest additional resources in investments that enjoy early success is known as a(n):
a.
expansion option
b.
abandonment option
c.
follow-on investment option
d.
flexibility option
89. The option to withdraw resources from projects that fail to live up to short-run expectations is know as
a(n):
a.
expansion option
b.
abandonment option
c.
follow-on investment option
d.
flexibility option
90. The option to make additional investments should earlier investments prove to be successful is known
as a(n):
a.
expansion option
b.
abandonment option
c.
follow-on investment option
d.
flexibility option
91. Options that offer a firm the ability to adapt to changes in inputs, outputs and maintaining excess
production capacity are known as:
a.
expansion options
b.
abandonment options
c.
follow-on investment options
d.
flexibility options
92. Which of the following statements is true?
a.
More risk leads to higher option values.
b.
More risk leads to lower option values.
c.
Options are characterized by equal payoffs.
d.
All of the above statements are true.
e.
None of the above statements is true.
93. If any project is to have a positive NPV, advocates of that project:
a.
need only crunch the numbers to determine if it will be successful.
b.
should be able to articulate a project’s competitive advantage prior to crunching the
numbers.
c.
should insert their own personal optimistic biases into the cash flow estimates.
d.
should show that the present value of the outflows must exceed the present value of the
inflows.
94. Consider the following: the market value of Louis stock is $15 a share (with 5,000,000 shares
outstanding and the next annual dividend is expected to be $1.25), the bonds are currently selling for
$920 (semi-annual coupon payments of $30; maturing in 20 years; 200,000 bonds in the market), the
preferred stock currently is $25 per share (paying dividends of $3 in perpetuity, 100,000 shares
outstanding); if the tax rate is 40%, what is the firm’s WACC?
a.
6.81%
b.
7.26%
c.
9.07%
d.
7.81%
95. Consider the following: the market value of Roxy stock is $17 a share (with 3,000,000 shares
outstanding and the next annual dividend is expected to be $1.00), the bonds are currently selling for
$1020 (semi-annual coupon payments of $25; maturing in 20 years; 20,000 bonds in the market), the
preferred stock currently is $30 per share (paying dividends of $3 in perpetuity, 100,000 shares
outstanding); if the tax rate is 40%, what is the firm’s WACC?
a.
5.76%
b.
5.23%
c.
5.88%
d.
6.91%
96. Consider the following: the market value of Emma stock is $40 a share (with 2,000,000 shares
outstanding and the next annual dividend is expected to be $3.50), the bonds are currently selling for
$1080 (semi-annual coupon payments of $25; maturing in 20 years; 10,000 bonds in the market), the
preferred stock currently is $40 per share (paying dividends of $3 in perpetuity, 100,000 shares
outstanding); if the tax rate is 40%, what is the firm’s WACC?
a.
8.20%
b.
6.88%
c.
8.00%
d.
8.75%
97. Consider the following: the market value of Luke-I-am–your-father stock is $60 a share (with
2,000,000 shares outstanding and the next annual dividend is expected to be $1.50), the bonds are
currently selling for $1050 (semi-annual coupon payments of $45; maturing in 20 years; 10,000
bonds in the market), the preferred stock currently is $10 per share (paying dividends of $.50 in
perpetuity, 100,000 shares outstanding); if the tax rate is 40%, what is the firm’s WACC?
a.
2.50%
b.
3.00%
c.
5.33%
d.
2.73%
