1. A stock is expected to pay a year-end dividend of $2.00, i.e., D1 = $2.00. The dividend is expected to decline at a rate of 5% a year forever (g = -5%). If the company’s expected and required rate of return is 15%, which of the following statements is CORRECT?
a. The company’s current stock price is $20.
b. The company’s dividend yield 5 years from now is expected to be 10%.
c. The constant growth model cannot be used because the growth rate is negative.
d. The company’s expected capital gains yield is 5%.
e. The company’s stock price next year is expected to be $9.50.
2. A share of common stock has just paid a dividend of $2.00. If the expected long-run growth rate for this stock is 4.0%, and if investors’ required rate of return is 10.5%, what is the stock’s intrinsic value?
3. E. M. Roussakis Inc.’s stock currently sells for $40 per share. The stock’s dividend is projected to increase at a constant rate of 4% per year. The required rate of return on the stock, rs, is 15.50%. What is Roussakis’ expected price 5 years from now?
4. Carter’s preferred stock pays a dividend of $1.75 per quarter. If the price of the stock is $60.00, what is its nominal (not effective) annual expected rate of return?
5. Schnusenberg Corporation just paid a dividend of $1.25 per share, and that dividend is expected to grow at a constant rate of 7.00% per year in the future. The company’s beta is 1.25, the required return on the market is 10.50%, and the risk-free rate is 4.00%. What is the intrinsic value for Schnusenberg’s stock?
6. Rentz RVs Inc. (RRV) is presently enjoying relatively high growth because of a surge in the demand for recreational vehicles. Management expects earnings and dividends to grow at a rate of 30% for the next 4 years, after which high gas prices will probably reduce the growth rate in earnings and dividends to zero, i.e., g = 0. The company’s last dividend, D0, was $1.25. RRV’s beta is 1.20, the market risk premium is 5.50%, and the risk-free rate is 3.00%. What is the intrinsic value of RRV’s common stock?
7. Using the information on Rentz RVs Inc. from problem 6, what is the dividend yield expected for the next year?
8. The Wei Company’s last paid dividend was $2.75. The dividend growth rate is expected to be constant at 2.50% for 2 years, after which dividends are expected to grow at a rate of 8.00% forever. Wei’s required return (rs) is 15.00%. What is the intrinsic value of Wei’s stock?
9. Using the information on Wei Company from problem 8, what should be the price of Wei’s stock at the end of Year 5?
10. You are an analyst studying Beranek Technologies, which was founded 10 years ago. It has been profitable for the last 5 years, but it has needed all of its earnings to support growth and thus has never paid a dividend. Management has indicated that it plans to pay a $0.50 dividend 3 years from today, then to increase it at a relatively rapid rate for 2 years with 50% dividend growth in year 4 and 25% dividend growth in year 5, and then to increase its dividend at a constant growth rate of 6.00% per year thereafter. Assuming a required return of 15.00%, what is your estimate of the intrinsic value of Beranek’s stock?
11. Schalheim Sisters Inc. has always paid out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reduce its WACC?
a. The market risk premium declines.
b. The flotation costs associated with issuing new common stock increase.
c. The company’s beta increases.
d. Expected inflation increases.
e. The flotation costs associated with issuing preferred stock increase.
12. Hettenhouse Company’s (HC) perpetual preferred stock sells for $105.50 per share, and it pays a $9.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. HC’s marginal tax rate is 30%. What is the company’s cost of preferred stock for use in calculating the WACC?
13. Scanlon Inc.’s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: the risk–free rate of return is 4.00%; the market risk premium is 6.00%; and Scanlon’s beta is 0.95. Based on the CAPM approach, what is the cost of equity from retained earnings?
14. Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $1.80; P0 = $45.50; and g = 7.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?
15. P. Lange Inc. hired your consulting firm to help them estimate the cost of equity. The yield on Lange’s bonds is 7.25%, and your firm’s economists believe that the cost of equity can be estimated using a risk premium of 3.50% over a firm’s own cost of debt. What is an estimate of Lange’s cost of equity from retained earnings?
16. In their most recent fiscal year, XYZ, Inc. had net income of $15 million and total common equity of $200 million. Also, XYZ, Inc. pays out 40% of its earnings as dividends. Using the Retention Growth Model, what is your best estimate of XYZ’s expected growth rate?
17. Several years ago the Pettijohn Company sold a $1,000 par value, noncallable bond that now has 15 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $950, and the company’s tax rate is 35%. To issue new bonds, Pettijohn would incur 3% flotation costs. What is the component cost of debt for use in the WACC calculation?
18. LePage Co. expects to earn $2.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $22.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. What would be the cost of equity from new common stock?
19. You were hired as a consultant to Quigley Company, whose target capital structure is 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 12.50%, and the tax rate is 34%. The firm will not be issuing any new stock. What is Quigley’s WACC?
20. Roxie Epoxy’s balance sheet shows a total of $50 million long-term debt with a coupon rate of 8.00% and a yield to maturity of 7.00%. This debt currently has a market value of $55 million. The balance sheet also shows that that the company has 20 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $8.50 per share; stockholders’ required return, rs, is 12.00%; and the firm’s tax rate is 35%. Based on market value weights, and assuming the firm is currently at its target capital structure, what WACC should Roxie use to evaluate capital budgeting projects?
21. Projects C and D are mutually exclusive and have normal cash flows with an initial outflow followed by a series of positive cash inflows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?
a. Project D has a higher IRR.
b. Project D is probably larger in scale than Project C.
c. Project C probably has a faster payback.
d. Project C has a higher IRR.
e. The crossover rate between the two projects is below 12%.
22. Frye Foods is considering a project that has the following cash flow data. What is the
Year: 0 1 2 3 4 5
Cash flows: -$1,200 $325 $325 $325 $325 $325
23. Van Auken Inc. is considering a project that has the following cash flows:
Year Cash Flow
The company’s WACC is 10%. What is the project’s ordinary payback?
24. Babcock Inc. is considering a project that has the following cash flow and WACC data.
What is the project’s NPV?
Year: 0 1 2 3
Cash flows: -$950 $500 $300 $400
25. Garvin Enterprises is considering a project that has the following cash flow and WACC
data. What is the project’s discounted payback?
Year: 0 1 2 3
Cash flows: -$1,000 $500 $500 $500
26. Hindelang Inc. is considering a project that has the following cash flow and WACC data.
What is the project’s MIRR?
Year: 0 1 2 3 4
Cash flows: -$900 $300 $320 $340 $360
27. Hogwarts Inc. is considering a project with the following cash flows:
Initial cash outlay = $2,500,000
After–tax net operating cash flows for years 1 to 4 = $750,000 per year
Additional after–tax terminal cash flow at the end of year 4 = $400,000
Compute the profitability index of this project if Hogwarts’ WACC is 12%.
28. Anderson Associates is considering two mutually exclusive projects that have the following cash
Project A Project B
Year Cash Flow Cash Flow
0 -$10,000 -$8,000
1 1,000 7,000
2 2,000 3,000
3 6,000 1,000
4 8,000 1,000
At what cost of capital do the two projects have the same net present value? (That is, what is the crossover rate?)
29. Walker & Campsey wants to invest in a new computer system, and management has narrowed the choice to Systems A and B.
System A requires an up-front cost of $100,000, after which it generates positive after-tax cash flows of $60,000 at the end of each of the next 2 years. The system could be replaced every 2 years, and the cash inflows and outflows would remain the same.
System B also requires an up-front cost of $100,000, after which it would generate positive after-tax cash flows of $48,000 at the end of each of the next 3 years. System B can be replaced every 3 years, but each time the system is replaced, both the cash outflows and cash inflows would increase by 10%.
The company needs a computer system for 6 years, after which the current owners plan to retire and liquidate the firm. The company’s cost of capital is 14%. What is the NPV (on a 6-year extended basis) of the system that adds the most value?
30. Using the information from problem 29 on Walker & Campsey, what is the equivalent annual annuity (EAA) for System A?
31. When evaluating a new project, firms should include in the projected cash flows all of the
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project provided those costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product provided that decline is directly attributable to this project.
e. The salvage value of assets used for the project at the end of the project’s life.
32. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following numbers:
Project X Project Y
Expected NPV $350,000 $350,000
NPV)sStandard deviation ( $100,000 $150,000
Project beta (vs. market) 1.4 0.8
Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.
Which of the following statements is CORRECT?
a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has less market risk than Project Y.
33. Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12
C High 11
D Low 9
E Low 6
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.
34. Which of the following statements is CORRECT?
a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
c. Corporations must use MACRS depreciation for both stockholder reporting and tax purposes.
d. Using MACRS depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.
e. Using MACRS depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project’s forecasted NPV.
35. Which of the following does NOT have incremental cash flow effects and thus should NOT be considered in capital budgeting decisions?
a. A firm has a parcel of land that can be used for a new plant site, be sold, or be used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million of costs for shipping and installing the new machinery will be required.
d. A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered if the new project is rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
36. You work for Athens Inc., and you must estimate the Year 1 operating cash flow for a project with the following data. What is the Year 1 after-tax net operating cash flow?
Sales revenues $15,000
Cash operating costs $6,000
Tax rate 34.0%
37. Fool Proof Software is considering a new project whose data are shown below. The equipment that will be used has a 3-year class life, and will be depreciated by the MACRS depreciation system. Revenues and Cash operating costs are expected to be constant over the project’s 10-year life. What is the Year 1 after-tax net operating cash flow?
Equipment cost (depreciable basis) $75,000
Sales revenues, each year $60,000
Cash operating costs $25,000
Tax rate 35.0%
38. Bing Services is now in the final year of a project. The equipment originally cost $20,000, of which 75% has been depreciated. Bing can sell the used equipment today for $6,000, and its tax rate is 35%. What is the equipment’s net after-tax salvage value for use in a capital budgeting analysis?
39. Thomson Media is considering investing in some new equipment whose data are shown below. The equipment has a 3-year class life and will be depreciated by the MACRS depreciation system, and it will have a positive pre-tax salvage value at the end of Year 3, when the project will be closed down. Also, some new working capital will be required, but it will be recovered at the end of the project’s life. Revenues and cash operating costs are expected to be constant over the project’s 3-year life. What is the project’s NPV?
Net investment in fixed assets (depreciable basis) $60,000
Required new working capital $10,000
Sales revenues, each year $75,000
Operating costs excl. depr’n, each year $30,000
Expected pretax salvage value $7,000
Tax rate 35.0%
40. A project’s base case or most likely NPV is $50,000, and assume its probability of occurrence is
60%. Assume the best case scenario NPV is 40% higher than the base case and assume the worst
scenario NPV is 30% lower than the base case. Both the best case scenario and the worst case scenario
have a 20% probability of occurrence. Find the project’s coefficient of variation.