VERSION 1

MIME 310 ENGINEERING ECONOMY

Class Test #2 – Thursday, 10 November, 2005 – 90 minutes

Record your family name / initial and student ID

number in the spaces provided below.
FAMILY NAME / INITIAL S O L U T I O N S

STUDENT ID #

This test consists of 16 multiple-

multiple-choice questions, and three problems with sub-
sub-
questions requir
requiring a full solution. Multiple-choice questions 1 to 10 are worth 6
points each and multiple-choice questions 11 to 16 are worth 2 points each.
There are no penalties for incorrect answers. The problems are worth a total of
28 points.

MULTIPLE-CHOICE QUESTIONS
Circle the correct answer on this test paper and
record it on the computer answer sheet.

1. Consider the following information for a company supplying a competitive market:

• At zero output, the total production costs are $6.
• Each unit is sold for $9.
• The marginal costs for units 1 through 3 are, $6, $4 and $2, respectively.
• There are no taxes.

At a sales level of two units, the company’s profit is:

A) $2
At a sales level of 2 units, TC = 6 + 6 + 4 = 16
B) $5 TR = 2 (9) = 18
C) $8
∴ TP = 18 - 16 = $2
D) $18

2. If the average cost is $7 at a production rate of 4000 units per period and $8 at a rate of
4500 units, the incremental cost between rates of 4000 and 4500 units per period is:
A) $8 TC at 4000 units: 4000 (7) = 28 000
B) $16 TC at 4500 units: 4500 (8) = 36 000
C) $500
D) $8000 ∴ IC between 4000 and 4500 units: 36 000 - 28 000 / (4500 - 4000) = $16

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 VERSION 1

3. A firm has common stock with a market price of $55 per share and an expected dividend
of $2.81 per share at the end of the coming year. The dividends paid on the stock over
the past five years are as follows:

Year Dividend ($)

-5 2.00
-4 2.14
-3 2.29
-2 2.45
-1 2.62

The cost of the firm's existing common equity is:

A) 12.1 %
Historical growth rate: 2.00 (1+g)4 = 2.62 → g=6.98 %
B) 12.4 %
Expected growth rate: 2.81 / 2.62 = 1.0725 → g=7.25 %
C) 15.4 % Combined growth rate: 2.00 (1+g)4 = 2.81 → g=7.04 %
D) 4.1 % Ke: 2.81 / 55 + 0.0725 = 12.36 % (with expected growth rate)
E) 5.1 % Also acceptable: 2.81 / 55 + 0.070 = 12.11 % (assuming differences in g due to round-off)

4. A firm has determined the cost of each of its sources of capital along with its optimal capi-
tal structure expressed as target market value proportions:

Target Market Proportion After-tax Cost

Source of capital
(%) (%)
Long-term debt 40 6
Preferred equity 10 11
Common equity 50 15

The weighted-average cost of capital is:

A) 11 %
B) 15 % WACC: 6 (0.4) + 11 (0.1) + 15 (0.5) = 11.0 %
C) 10.7 %
D) 6 %

5. Five years ago, a firm’s issued 12-year bonds with a face value of $1000 and a coupon
rate of 8 percent paid semi-annually. Issuing expenses amounted to $50 on an after-tax
basis. The bonds now have a market value of $1106. Using a corporate tax rate of 36
percent, the cost of existing debt to the firm is:
A) 5.2 % Semi-annual after-tax interest payment: 1000 (0.08) / 2 (1 - 0.36) = 25.60
B) 8.9 % With N=14, PV= -1106, PMT=25.60 and FV=1000, CPT I/Y → 1.70 %
C) 3.4 %
D) 6.1 % Convert to an effective annual rate: (1 + 0.017)2 - 1 = 3.43 %

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 VERSION 1

6. A project that requires an initial investment of $100 000 has a useful life of 4 years and no
salvage value. The net after-tax income in each of these 4 years is $15 000, $20 000,
$20 000 and $25 000, respectively. The project’s accounting rate of return is:
A) 20 %
Average net income: (15 000 + 20 000 + 20 000 + 25 000) / 4 = 20 000
B) 40 %
Average investment: 100 000 / 2 = 50 000
C) 80 % ARR: 20 000 / 50 000 = 40 %
D) 160 %
E) Cannot determine the project’s accounting rate of return without a discount rate.

7. A firm is considering the five independent capital budgeting proposals outlined below. All
proposals have the same life, and the firm has a cost of capital of 15 percent and a budget
of $1 000 000.

Initial
NPV @ 15%
Project Investment
($)
($)
1 200 000 15 000
2 300 000 85 000
3 900 000 120 000
4 750 000 160 000
5 500 000 60 000

Which project(s) should the firm undertake?

A) 1 and 4 Present value ratios Using high PVRs as a guide,
B) 1, 2 and 5
C) 3 1: 15 000 / 200 000 = 0.075 Start with 2 @ $300 000 and add 5
D) 4 2: 85 000 / 300 000 = 0.283 @ $500 000 → Total NPV= $145 000
E) All projects 3: 120 000 / 900 000 = 0.133 Start with 4 @ $750 000 and add 1
4: 160 000 / 750 000 = 0.213 @ $200 000 → Total NPV= $175 000
5: 60 000 / 500 000 = 0.120
Use the information below to answer questions 8 and 9.

A firm is considering two mutually exclusive projects with cash flows as follows:

Year Project A Project B

Time 0 -40 000 -90 000
1 20 000 40 000
2 20 000 40 000
3 20 000 80 000

8. If the firm requires a payback period of two years, they should:

A) accept project A and reject B. Payback periods
B) reject project A and accept B.
C) accept both projects. A: 40 000 / 20 000 = 2 years
D) reject both projects. B: 2 + 10 000 / 80 000 = 2.125 years

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 VERSION 1

9. The new financial analyst does not like the payback period criterion and determines that
the firm's required rate of return is 15 percent. His recommendation would be to:
A) reject project B and accept A. Net present values @ 15 %
B) accept both projects.
C) accept project B and reject A. A: -40 000 + 20 000 (P/A,15%,3) = $5665
D) reject both projects. B: -90 000 + 40 000 (P/A,15%,2) + 80 000 (P/F,15%,3) = $27 630

10. A firm is evaluating two independent projects using the internal rate of return. Project X
has an initial investment of $80 000 and cash inflows of $25 000 over the following five
years. Project Z has an initial investment of $120 000 and cash inflows of $40 000 over
the following four years. The firm should:
A) reject both projects if their cost of capital is 12%.
B) accept both projects if their cost of capital is 15%.
C) accept only X if their cost of capital is 15%. Internal rates of return
D) accept only Z if their cost of capital is 15%.
X: With N=5, PV= -80 and PMT=25, CPT I/Y → 17.0 %
Z: With N=4, PV= -120 and PMT=40, CPT I/Y → 12.6%
True or False Statements – 2 points each for a total of 12

11. The discounted payback period is superior to the payback period because it considers the
cash flows beyond the time required to recover the discounted initial investment.

A) True B) False

12. Whatever the discount rate used, a project that has a discounted payback period equal to
its productive life has a net present value equal to zero.

A) True B) False

13. The best way to account for issuing expenses associated with debt and equity is to add
their relative cost (i.e. expressed as a percentage) to the WACC.

A) True B) False

14. When using the equivalent annual value criterion to compare equipment alterna-
tives, it is assumed that continuous replacements are made for as long as the ser-
vice of such equipment is required.

A) True B) False

15 Funds acquired by the firm through retaining earnings have no cost because there are no
associated dividend nor interest payments, but capital raised by selling new stock or issu-
ing bonds does have a cost.

A) True B) False

16 The discount rate used in the calculation of the benefit-cost ratio for governmental or pub-
lic projects is often referred to as the social discount rate.

A) True B) False

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 VERSION 1

FULL-SOLUTION PROBLEMS
For full marks, record the complete solution on the
lines provided and the answer in the box.

17. A manufacturing company is planning to add a new item to its production line. The plant's
capacity for this product is 15 000 units per year. The annual fixed cost of the new process is
$3.1 million and the variable costs are $350 per unit for any amount produced up to a level of
10 000 per year, and $300 per unit for that part of the production that exceeds 10 000 units per
year. The selling price set by the firm is $600 per unit. (Hint: draw the revenue and cost func-
tions at the bottom of this page)

Determine the break-even production rate. (8 points)

____________________________________________________________________________
Contribution margin on the first 10 000 units sold: 600 - 350 = 250 VERSION 1
Contribution margin on units sold above 10 000: 600 - 300 = 300
____________________________________________________________________________
Fixed costs recovered on first 10 000 units sold: 10 000 (250) = 2 500 000
____________________________________________________________________________
Remaining fixed costs to be recovered from units sold above 10 000: 3.1 - 2.5 = 0.6 mil.

____________________________________________________________________________
Units to be sold above 10 000 to recover the remaining fixed costs: 600 000 / 300 = 2000

∴ The break even rate is 12 000 units.

____________________________________________________________________________

____________________________________________________________________________
Contribution margin on the first 10 000 units sold: 600 - 350 = 250 VERSION 2
Contribution margin on units sold above 10 000: 600 - 320 = 280
____________________________________________________________________________
Fixed costs recovered on first 10 000 units sold: 10 000 (250) = 2 500 000
____________________________________________________________________________
Remaining fixed costs to be recovered from units sold above 10 000: 3.2 - 2.5 = 0.7 mil.

____________________________________________________________________________
Units to be sold above 10 000 to recover the remaining fixed costs: 700 000 / 280 = 2500

∴ The break even rate is 12 500 units.

____________________________________________________________________________

____________________________________________________________________________

ANSWER 12 000 units

TR
$
TC

B/E

10 000 RATE

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 VERSION 1

18. The following information is available concerning General Talc Mines’.

Balance Sheet
General Talc Mines Limited
31 December, 2003

Current Assets Current Liabilities

Cash 25 000 Accounts payable 80 000
Accounts receivable 120 000 Notes payable 350 000
Inventories 300 000 Accruals 50 000
Total 445 000 Total 480 000

Net Fixed Assets 500 000 Long-term Debt (par=$1000) 150 000

Common Shares (par=$20) 180 000

Retained Earnings 135 000
Total Assets $945 000 Total Liab. & Shar. Equity $945 000

Before-tax cost Market Price

Source of capital
(%) ($)
Long-term debt 9 980 per bond
Common equity 16 50 per share

Corporate tax rate: 36 %

18.1 Using book values as weights, determine the weighted-average cost of capital. (6
points)

____________________________________________________________________________

____________________________________________________________________________
VERSION 1 (for VERSION 2, see 18.2)
Equity book value: 180 000 + 135 000 = 315 000
____________________________________________________________________________
Long-term debt book value: 150 000
____________________________________________________________________________
Weights: Equity 315 / (315 + 150) = 0.6774
Debt 150 / (315 + 150) = 0.3226
____________________________________________________________________________
WACC: 16 (0.6774) + 9 (1 - 0.36) (0.3226) = 12.7 %
____________________________________________________________________________

____________________________________________________________________________

____________________________________________________________________________

ANSWER 12.7 %

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 VERSION 1

18.2 Using market values as weights, determine the weighted-average cost of capital. (6
points)

____________________________________________________________________________

____________________________________________________________________________
VERSION 1 (for VERSION 2, see 18.1)
# of common shares: 180 000 / 20 = 9000
____________________________________________________________________________
# of bonds: 150 000 / 1000 = 150
____________________________________________________________________________
Equity market value: 9000 (50) = 450 000
Long-term debt market value: 150 (980) = 147 000
____________________________________________________________________________
Weights: Equity 450 / (450 + 147) = 0.7538
Debt 147 / (450 + 147) = 0.2462
____________________________________________________________________________
WACC: 16 (0.7538) + 9 (1 - 0.36) (0.2462) = 13.5 %
____________________________________________________________________________

____________________________________________________________________________

ANSWER 13.5 %

9. Due to expanding business activities, a construction company is planning to add a truck to

its existing fleet. The company’s is considering the purchase of a truck that costs $95 000, has
a useful life of three years, and operating and maintenance costs of $20 000, $25 000 and
$30 000 in years 1, 2 and 3, respectively. The truck has a salvage value of $35 000. If the
company’s cost of capital is 12 percent, what minimum annual benefit must the truck generate
to justify its purchase? (8 points)

____________________________________________________________________________
PV of overall costs: VERSION 1
____________________________________________________________________________
95 000 - 30 000 (P/F,12%,3) + 20 000 (P/F, 12%,1) +
25 000 (P/F, 12%,2) + 30 000 (P/F, 12%,3) = 129 228
____________________________________________________________________________
EA costs: 129 228 (A/P,12%,3) = 53 804
∴ The minimum annual benefit must equal the equivalent annual costs, i.e. $53 804.
____________________________________________________________________________

____________________________________________________________________________
PV of overall costs: VERSION 2
____________________________________________________________________________
100 000 - 40 000 (P/F,12%,3) + 20 000 (P/F, 12%,1) +
25 000 (P/F, 12%,2) + 30 000 (P/F, 12%,3) = 130 669
____________________________________________________________________________
EA costs: 130 669 (A/P,12%,3) = 54 404
∴ The minimum annual benefit must equal the equivalent annual costs, i.e. $54 404.
____________________________________________________________________________

____________________________________________________________________________

ANSWER $53 804

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 VERSION 1

Answer Key for Version 2

1. D
2. D
3. D or E
4. C
5. B
6. C
7. D
8. B
9. A
10. A
11. A
12. B
13. B
14. B
15. A
16. A