Q4 Review - Spring 2008

savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/q4_-_review_-_spring_2008.htm

1.

The largest number of firms is partnerships.

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2.

One major advantage of incorporating is permanence.

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3.

If a firm needs additional equity financing through the retention of earnings, it may be advantageous to
incorporate.

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4.

The corporate income tax rates increase as earnings increase.

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5.

If a corporation operates at a loss, the loss is initially carried forward to offset future income.

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6.

Corporate losses are carried back to offset income for up to three prior years.

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7.

The straight-line total revenue function suggests the firm may sell additional output without having to lower
the price of the product.

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8.

If a firm has a large amount of operating leverage, that suggests its earnings may be volatile.

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9.

A recession will cause earnings to fall more rapidly for more highly financially leveraged firms.

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10.

Since high use of financial leverage is associated with less risk, higher financial leverage may also result in
higher stock prices.

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11.

If a company calls a bond and retires it, the use of financial leverage is reduced.

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12.

The weighted cost of capital includes the cost of debt and the cost of equity.

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13.

If the firm issues debentures instead of preferred stock to raise additional funds, the cost of capital rises.

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14.

If the cost of capital exceeds the internal rate of return, the firm should not make the investment.

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15.

If two investments are mutually exclusive, the firm cannot make both investments.

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16.

A high cost of capital favors investments with large initial cash inflows.

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17.

If two investments are not mutually exclusive, the firm can make only one of them.

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18.

Analyzing an investment from a stand-alone perspective avoids considering portfolio effects.

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19.

A higher standard deviation for an investment's cash inflows is associated with greater risk.

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20.

If an investment is riskier, using a higher beta coefficient to analyze the alternative reduces the
investment's internal rate of return.

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Multiple Choice
Identify the choice that best completes the statement or answers the question.

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21.

Owners in which of the following forms of business have unlimited liability?

a.

LLCs

b.

corporations

c.

sole proprietorships

d.

limited partnerships

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22.

Corporate losses
a.

offset other losses from prior years

b.

are carried forward to future years

c.

are carried forward three years and then carried back

d.

are carried back three years and then carried forward

ANSWER:

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23.

To determine the break-even level of output, management must know

1.

fixed costs of operation

2.

per unit variable costs of output

3.

total sales

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

all three

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24.

A union contract suggests that labor costs may be

a.

variable

b.

fixed

c.

a non-cash expense

d.

undetermined

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25.

Business risk refers to

1.

use of accelerated depreciation

2.

the risk inherent in the nature of the business

3.

the sources of the firm's finances

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

only 2

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26.

The payback period is not concerned with

a.

earnings

b.

cash inflows

c.

the cost of an investment

d.

selecting investments

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27.

The lower the debt ratio,

a.

the higher is the use of financial leverage

b.

the lower is the use of financial leverage

c.

the lower are the firm's total assets

d.

the higher are the firm's total assets

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28.

Higher fixed costs are associated with

1.

higher operating leverage

2.

lower operating leverage

3.

increased risk

4.

lower risk

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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29.

Operating leverage
a.

is affected by the demand for the product

b.

results from use of fixed instead of variable costs

c.

is the result of using debt financing

d.

is associated with less risk and more certainty

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30.

A firm does not obtain financial leverage by

a.

issuing bonds

b.

borrowing from a bank

c.

issuing preferred stock

d.

issuing common stock

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31.

The greater the usage of financial leverage, the larger is the variability of
a.

revenues

b.

gross profits

c.

operating earnings

d.

net earnings

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32.

The effective cost of debt depends on

1.

the firm's total assets

2.

the firm's tax rate

3.

the stated interest rate

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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33.

Debt financing
1.

increases stockholders' return more than an equal dollar amount of preferred stock

2.

increases stockholders' return less than an equal dollar amount of preferred stock

3.

is less risky to the investor than preferred stock

4.

is more risky to the investor than preferred stock

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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34.

The cost of equity

1.

is less than the cost of debt

2.

is greater than the cost of debt

3.

depends on the riskiness of the firm

4.

depends on the firm's current ratio

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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35.

If the capital asset pricing model is used, the cost of equity depends on
1.

the firm's earnings growth rate

2.

the firm's beta

3.

the return on the market

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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36.

The optimal capital structure involves

a.

maximizing the cost of all funds

b.

minimizing the cost of all funds

c.

using no financial leverage

d.

minimizing the weighted average of the cost of funds

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37.

The effective cost of debt is reduced because

a.

interest is a tax-deductible expense

b.

interest is not a tax deducible expense

c.

interest is paid before preferred dividends

d.

interest is paid after common stock dividends

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38.

The marginal cost of capital

a.

is the firm's cost of debt and equity finance

b.

is constant given an optimal capital structure

c.

declines as flotation costs alter equity financing

d.

refers to the cost of additional financing

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39.

The net present value method considers

1.

the timing of the cash inflows from an investment

2.

the cost of an investment

3.

the firm's cost of capital

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

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40.

The internal rate of return will be higher if

a.

the cost of capital is lower

b.

the cost of capital is higher

c.

the cost of the investment is lower

d.

the cost of the investment is higher

ANSWER:

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41.

A firm should not make an investment if

1.

its net present value is positive

2.

its net present value is negative

3.

the internal rate of return exceeds the cost of capital

4.

the internal rate of return is less than the cost of capital

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

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42.

An increase in the cost of capital will

a.

increase an investment's internal rate of return

b.

decrease an investment's internal rate of return

c.

increase an investment's net present value

d.

decrease an investment's net present value

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43.

If the internal rates of return of two mutually exclusive investments exceed the firm's cost of capital, the
firm should
a.

make both investments

b.

make neither investment

c.

make the investment with the lower internal rate of return

d.

make the investment with the higher internal rate of return

ANSWER:

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44.

The internal rate of return and net present value methods of capital budgeting assume the cash flows are
reinvested at
a.

the cost of capital

b.

the internal rate of return

c.

the cost of capital for IRR and the internal rate of return for NPV

d.

the cost of capital for NPV and the internal rate of return for IRR

ANSWER:

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45.

NPV may be preferred to IRR because

a.

IRR makes the more conservative assumption concerning reinvestment

b.

NPV makes the more conservative assumption concerning reinvestment

c.

IRR excludes salvage value

d.

NPV includes salvage value

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46.

A firm should not make an investment if the internal rate of return is

a.

greater than the cost of capital

b.

less than the cost of capital

c.

greater than the interest rate

d.

less than the interest rate

ANSWER:

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47.

A stand-alone perspective for capital budgeting suggests

a.

an investment has no risk

b.

cash flows are independent of the firm's other investments

c.

portfolio effects are ignored

d.

the investment has a low beta

ANSWER:

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48.

The lack of correlation between an investment's return and the firm's other investments suggests
a.

the investment has little risk

b.

portfolio effects may exist

c.

the investment's beta coefficient is low

d.

the investment's net present value is negative

ANSWER:

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49.

Small standard deviations for cash inflows

a.

reduces an investment's net present value

b.

increases an investment's internal rate of return

c.

increases the firm's cost of capital

d.

implies more certainty

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50.

The use of certainty equivalents means

a.

the investment's cash inflows are certain

b.

an investment's cash inflows are expressed as if they were certain

c.

the cost of capital is known

d.

the probability of occurrence is certain

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Problem

51.

Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings
of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?

RESPONSE:

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ANSWER:
a.

for $1,000: ($1,000)0.15 = $150

b.

for $10,000: ($10,000)0.15 = $1,500

c.

for $100,000: ($50,000).15 + (25,000).25 +

25,000(.34) = $22,250

d.

for $1,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(235,000).39 + (665,000).34 = $340,000

e.

for $10,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(335,000).39 + (665,000).34 + (9,000,000)x.34 =
$3,400,000

POINTS:

-- / 1

REF:

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52.

The price of a product is $1 a unit. A firm can produce this good with variable costs of $0.50 per unit and
total fixed costs of $100.
a.

What is the break-even level of output?

b.

What is the break-even level of output if fixed costs increase to $180 and variable costs decline to
$0.40 per unit?

RESPONSE:
ANSWER:
a.

break-even level of output:

$100/($1 - $0.50) = 200 units

b.

break-even level of output:

$180/($1 - $0.40) = 300 units

POINTS:

-- / 1

REF:

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53.

You want to start a firm whose output you believe you can sell for $25 per unit. The operation will require
fixed costs of $10,000, and the variable costs are expected to be $18 a unit. What will be the break-even
level of output?

RESPONSE:
ANSWER:

Break-even level of output:

$100,000/($25 - 18) = 14,286 units

POINTS:

-- / 1

REF:

54.

Which of the following $1,000 investments would the payback method select?
Cash flows:
Year

$200

$250

$400

250

250

350

300

250

200

350

250

150

400

250

100

RESPONSE:
ANSWER:

Payback for A is approximately 3.5 years

Payback for B is 4 years
Payback for C is 3.3 years
Since C recoups the $1,000 cost the fastest, it will be selected.

POINTS:

-- / 1

REF:

55.

(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales

$200

Expenses

$185

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Tax rate

33% of earnings

a.

What are earnings if the owners invest the $100?

b.

If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?

c.

What is the return on the owners' investment in each case? Why do the returns differ?

d.

If expenses rise to $194, what will be the returns in each case?

e.

In which case did the returns decline more?

f.

What generalization can you draw form the above?

RESPONSE:
ANSWER:
a.

and b.

Sales

no financial

with financial

leverage

leverage

$200

$200

185

185

Expenses
EBIT

15

15

Interest

EBT

15

11

Taxes
Net earnings

5
$

10

3.63
$

7.37

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c.

Return on equity

$10/$100 = 10%

$7.37/$60 = 12.28%

The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)

d.

Sales

no financial

with financial

leverage

leverage

$200

$200

194

194

Expenses

POINTS:

EBIT

Interest

EBT

Taxes

0.66

Net earnings

Return on equity

$4/$100 = 4%

1.34

$1.34/$60 = 2.23%

e.

The return on equity fell more for the firm that was financially leveraged.

f.

The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.

-- / 1

REF:

56.

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56.
a.

Given the following schedules,

cost of

cost of

debt/assets s

debt

equity

0%

7%

14%

10

14

20

14

30

14

40

16

50

10

18

60

12

20

What is firm's cost of capital at the various combinations of debt and equity?

b.

What is the firm's optimal capital structure? Construct a balance sheet showing that combination
of debt and equity financing.

Balance Sheet for Firm as of XX/XX/XX

Assets

$100

Debt
Equity
$100

c.

If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their
required rate of return if the firm uses its optimal combination of debt and equity financing?

d.

If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if
the cost of new shares is one percentage point higher at the firm's optimal capital structure?

e.

If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital
structure if the firm needs $2,000,000?

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RESPONSE:
ANSWER:
a.

Determination of cost of capital:

= weight cost of debt + weight cost of equity

= .0(.07) + 1(.14) = 14.00%
= .1(.07) + .9(.14) = 13.30
= .2(.07) + .8(.14) = 12.60
= .3(.08) + .7(.14) = 12.20
= .4(.08) + .6(.16) = 12.80
= .5(.10) + .5(.18) = 14.00
= .6(.12) + .4(.20) = 15.20

b.

The optimal capital structure is 30% debt and 70% equity.

The balance sheet is

Balance Sheet for Firm as of XX/XX/XX

Assets

$100

Liabilities
Equity

$ 30
70
$100

c.

If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the
stockholders will not receive their required return of 14%. With 30% debt
financing, $2.40 must go to creditors ($30 .08 = $2.40), which leaves $7.60
for stockholders ($10 - 2.40). Since the stockholders have invested $70, they
earn a return of 10.86% ($7.60/$70).

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For the stockholders to earn their required return, the firm must earn at 12.2%.
Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80)
so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 =
14%).

d.

If the cost of new equity rises to 15 percent, the cost of capital at the optimal
capital structure becomes:
.3(.08) + .7(.15) = 12.90.

e.

If the firm has retained earnings of $1,500,000, the breakpoint in the marginal
cost of capital schedule is
$1,500,000/.7 = $2,142,857.

The cost of capital from $0 - $2,142,857 is 12.2%.

The cost of capital above $2,142,857 is 12.9%.

The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is
$142,857 at 12.2 percent and $1,857,143 at 12.7 percent.
POINTS:

-- / 1

REF:

57.

Given the following information:

a.

interest rate

8%

tax rate

30%

dividend

$ 1

price of the common stock

$50

growth rate of dividends

7%

debt ratio

40%

Determine the firm's cost of capital.

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b.

If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of
capital?

c.

If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock
falls to $30, what is the cost of capital? Why is this cost different?

RESPONSE:

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ANSWER:
a.

Cost of debt: .08(1 - .3) = .056 = 5.6%

Cost of equity: $1(1 + .07)/$50 + .07 = 9.1%
Cost of capital:
weights

costs

.4

.056

.0224

.6

.091

.0546
.0770 = 7.7%

b.

The cost of debt and equity are unchanged. Only the weights are changed.
Cost of capital:
weights

costs

.5

.056

.0280

.5

.091

.0455
.0735 = 7.35%

c.

Both the cost of debt and equity are changed.

Cost of capital:
weights

costs

.6

.063

.0378

.4

.106

.0424
.0802 = 8.02%

The cost of capital changes as any of the components are changed. As the
firm initially substitutes cheaper debt financing, the cost of capital declines
(7.7% to 7.35%). However, as the firm uses more debt financing and
becomes more financial leveraged, it becomes riskier, and the cost of capital
rises (7.35% to 8.02%).

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POINTS:

-- / 1

REF:

58.

Fill in the table using the following information.

Assets required for operation: $2,000
Case A

- firm uses only equity financing

Case B

- firm uses 30% debt with a 10% interest rate and 70% equity

Case C

- firm uses 50% debt with a 12% interest rate and 50% equity

Debt outstanding

300

300

300

Stockholders' equity
Earnings before
interest and taxes
Interest expense
Earnings before taxes
Taxes (40% of earnings)
Net earnings
Return on stockholders'
investment

What happens to the rate of return on the stockholders' investment as the amount of debt increases? Why
did the rate of interest increase in case C?

RESPONSE:

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ANSWER:
A

$ 600

$1,000

Debt outstanding

Stockholders' equity

2,000

1,400

1,000

Earnings before

300

300

300

Interest expense

60

120

Earnings before taxes

300

240

180

Taxes (40% of earnings)

120

96

72

Net earnings

$ 180

$ 144

$ 108

Return on stockholders'

9%

10.3%

10.8%

interest and taxes

investment

The rate of return to stockholders rises because the after tax cost of debt in B is .1(1 .4) = 6%. The after tax cost of debt in C is .12(1 - .4) = 7.2%. These costs are less
than the 9 percent the firm earns after taxes on its assets ($180/$2,000). The interest
rate increases because the firm becomes riskier when it uses more financial leverage.

POINTS:
59.

-- / 1

The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
REF: its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
exhausts
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.

What is the firm's cost of capital if it uses only retained earnings?

b.

What is the firm's cost of capital if it uses new equity?

c.

How much total financing may the firm have before the marginal cost of capital rises?

RESPONSE:

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ANSWER:
a.

The cost of capital using retained earnings:

(.35)(.08) + (.65)(.14) = 11.9%

b.

The cost of capital using new equity:

(.35)(.08) + (.65)(.149) = 12.485%

Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.

c.

The break-point in the marginal cost of capital schedule:

$23,678/.65 = $36,428

The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However, after
$36,428 of total financing, the retained earnings are exhausted, and the firm
must start using more expensive new equity.

POINTS:

-- / 1

REF:

60.

An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to
the net present value and internal rate of return methods of capital budgeting, should the firm make this
investment if its cost of capital is (a) 10% or (b) 14%?

RESPONSE:

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ANSWER:

Internal rate of return:

$10,000 = (PVAIF x%, 10y)$1,770
$10,000 = $1,770X
X = $10,000/$1,770 = 5.650
r = 12%
(PV = -10000; N= 10; I = ?; PMT = 1770, and FV = 0.
I = 12.)
Net present value at 10%:
NPV

= $1,770(PVAIF 10%, 10y)

= $1,770(6.145) - $10,000 = $10,876.65 - $10,000
= $876.65

(PV = ?; N = 10; I = 10; PMT = 1770, and FV = 0.

PV = -10876.)
Net present value at 14%:
NPV

= $1,770(PVAIF 14%, 10y)

= $1,770(5.216) - $10,000 = ($767.68)

(PV = ?; N = 14; I = 10; PMT = 1770, and FV = 0.

PV = -9233.)
At k = 10% the firm should make the investment. (NPV is positive and IRR exceeds
the firm's cost of capital.) At k = 14% the firm should not make the investment. (NPV is
negative and IRR is less than the firm's cost of capital.)

POINTS:

-- / 1

REF:

61.

A firm with the following investment opportunities has a capital budget of $10,000. According to the net
present value technique, which investment(s) should the firm make if the firm's cost of capital is 10%?
Investment

Cost
Cash inflow

$10,000

$7,000

$3,000

$12,000

$8,600

$4,000

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RESPONSE:
ANSWER:

The firm should select that combination of investments which uses the available funds
and maximizes the combined net present value.
NPVA

= $12,000(PVIF 10% 1y) - $10,000

= $12,000/(1 + .1) - 10,000
= $12,000(.909) - $10,000 = $908

NPVB

= $8,600/(1 + .1) - $7,000

= $8,600(.909) - $7,000 = $817

NPVC

= $4,000/(1 + .1) - $3,000

= $4,000(.909) - $3,000 = $636

NPVA is less than NPV B + NPV C. Therefore, select B + C over A even though A has
the highest individual NPV.

POINTS:

-- / 1

REF:

62.

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62.

A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost
of capital is 6 percent.
Year

Cash Inflow
A

$175

$1,100

175

175

175

175

175

175

175

a.

What is the internal rate of return on each investment? Which investment should the firm make?

b.

What is the net present value of each investment? Which investment should the firm make?

c.

If the cash inflows can be reinvested at 8 percent, which investment should be made?

RESPONSE:
ANSWER:
a.

Determination of the internal rates of return:

A:

$175(PVAIF x%, 8y) = $1,000

Interest factor = $1,000/$175 = 5.174
rA = approximately 8%
(PV = -1000; N = 8; I = ?; PMT = 175, and FV = 0.
I = 8.15.)

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B:

$1,100/(1 + r B) = $1,000
Interest factor = $1,000/$1,100 = .909
rB = 10%

Since the investments are mutually exclusive, the firm should select B
because it has the higher internal rate of return.

b.

Determination of the net present values:

A:

Net present value A:

$175(PVAIF 6%, 8y) - $1,000 = $175(6.210) - $1,000
= $87

B:

Net present value B:

$1,100/(1 + .06) - $1,000 = $1,100(.943) - $1,000 = $37

Since the investments are mutually exclusive, the firm should select A
because it has the higher net present value.(This contradicts part a, which
selected investment B.)

c.

If the firm is able to reinvest the annual payments of $175, the terminal value
of A is $175(10.637) = $1,861.48
(10.637 is the interest factor for the future value of an ordinary annuity at 8%
for eight years.)

If the firm selects B, it receives $1,100 in year one, which is reinvested at 8%

for seven years. The terminal value is $1,100(1.714) = $1,885.40. This is
higher than the terminal value for A, so the firm should make investment B.

POINTS:

-- / 1

REF:

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63.

A firm has three investment opportunities. Each costs $1,000, and the firm's cost of capital is 10 percent.
The cash inflow of each investment is as follows:
cash inflow

$300

500

100

300

400

200

300

200

400

300

100

500

year

a.

If the net present value method is used, which investment(s) should the firm make?

b.

What is the internal rate of return of investment A? The internal rate of return of investment B is
10.22% and 6.15% for investment C. Which investment(s) should the firm make?

c.

What is the payback period for each investment?

RESPONSE:
ANSWER:
A.

Discount the cash inflows by the cost of capital. For each investment, that is

$300 .909

$272.70

$500 .909

$ 454.50

300 .826

247.80

400 .826

330.40

300 .751

225.30

200 .751

150.20

300 .683

100 .683

204.90
$950.70

68.30
$1,003.40

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$100 .909

$ 90.90

200 .826

165.20

400 .751

300.40

500 .683

341.50
$898.00.

Since investment A is an annuity, the present value could be determined by

using the interest table for the present value of an annuity. That is, $300
3.170 = $951, which is essentially the same answer except for rounding.

Next subtract the cost from the present value to determine the net present
value:

A:

$950.70 - $1,000 = ($49.30)

B:

$1,003.40 - $1,000 = $3.40

C:

$898.00 - $1,000 = ($102.00).

Since only B has a net present value that is positive, it is the only investment
that covers the firm's cost of capital and hence is the only one that should be
selected.

b.

Internal rate of return for A:

Since investment A is an annuity, the annuity table for the present value of an
annuity may be used to solve the problem. Restated the equation is
$1,000 = $300X
X = $1,000/$300 = 3.33.

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3.33 is the interest factor for the present value of an annuity for four years.
Find this interest factor in the table to determine the internal rate of return. In
this case the internal rate of return is approximately 8 percent, which is less
than the firm's cost of capital. (The IRR is 7.7 percent using a financial
calculator.) Therefore, the investment should not be made. (This answer is
consistent with the answer given by the net present value in the previous
question.) The internal rates of return for investments B and C were given.
Only the internal rate of return of B exceeds the cost of capital; thus it is the
only investment the firm should make.

c.

The payback periods for the investments are

A

three and one-third years

two and one-half years

three and two-thirds years.

Notice that in this case the payback method gives the same ranking of
investments as the net present value. However, the payback method does not
tell if any of the investments should be made.
POINTS:

-- / 1

REF:

64.

Investments A and B are mutually exclusive and cost $2,000 each. The firm's cost of capital is 9%, and the
investments' estimated cash inflows are
cash inflow

$2,320

---

---

---

---

$2,810

year

a.

What investment(s) should the firm make according to net present value?

b.

What investment(s) should the firm make according to internal rate of return?

c.

If the firm can reinvest funds earned in year 1 at 10%, which investment(s) should the firm make?

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RESPONSE:
ANSWER:
a.

Net present value of A: $2,320/(1 + .09) - 2,000 = $128

Net present value of B: $2,810/(1 + .09) 3 - 2,000 = $170

Since the investments are mutually exclusive, the firm cannot make both and
will select B since it has the higher NPV.

b.

Internal rate of return of A: $2,000 = $2,320/(1 + r)

PVIF = .862
r = 16%

Internal rate of return of B: $2,000 = $2810/(1 + r) 3

PVIF = .712
r = 12%

Since the investments are mutually exclusive, the firm cannot make both and
will select A since it has the higher IRR.

c.

There is an obvious conflict in the rankings. The purpose of this question is to

help reconcile the conflict. If the $2,320 grow annually at 10 percent, then the
future value is

$2,320(1 + .1) 2 = $2,320(1.210) = $2,807.20.

Investment B is now clearly preferred to A because the terminal value of S is

$2,807.20, which is less than $2810.

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POINTS:

-- / 1

REF:

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65.

A risky $500,000 investment is expected to generate the following cash flows:

Year

$250,000

$266,667

$285,715.

The probability of receiving each cash inflow is 80, 75, and 70 percent, respectively. If the firm's cost of
capital is 10 percent, should the investment be made?

RESPONSE:
ANSWER:

The risk-adjusted cash inflows are

(0.80) ($250,000) = $200,000
(0.75) ($266,667) = 200,000
(0.70) ($285,715) = 200,000

The present value of the cash inflows is

$200,000(PVAIF, 10I, 3N) = $200,000(2.487) = $497,400
(FV = 0; PMT = 200000, I = 10; N = 3; PV = ?. PV = -497370.)
Since the net present value is negative [$497,400 - 500,000 =
($2,600)], the investment should not be made.
POINTS:

-- / 1

REF:

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