FIN 301

1. One reason why we adjust for the change in net working capital when we calculate cash flows is:

a) Because in most cases “receivables collected” is equal to “sales book” and “expenses paid” is equal to “expenses incurred”.

b) Because “sales” and “expenses” obtained from the firm’s income statements are typically not equal to “cash flows”.

c) Because we need to adjust for depreciation.

d) Because a positive change in net working capital from one year to the other reflects a cash inflow.

e) Because we need to adjust for investments in fixed assets (e.g., buildings, machines, etc.).

2. Precise Corp. is considering the acquisition of a new CNC machine. The NPV of this acquisition project is $2.5 million and the project has an IRR of 14%. To calculate those numbers, you assumed a CCA rate of 30%. It turns out that you were wrong regarding the CCA rate, and that the correct CCA rate that applies to this type of machine is 40%. What would happen to the NPV and the IRR of the project if you used in your calculations a CCA rate of 40% (instead of 30%)?

a) NPV decreases, IRR decreases

b) NPV decreases, IRR increases

c) NPV increases, IRR decreases

d) NPV increases, IRR increases

e) NPV does not change, IRR does not change

3. Energy Supply is paying out all its earnings of $3/share as dividends and will not reinvest in any new projects for the foreseeable future. You can expect the following:

a) Energy Supply’s dividends will grow at 10%.

b) Energy Supply’s dividends will not grow.

c) Energy Supply’s dividends will grow by more than the required rate of return.

d) Energy Supply’s dividends will grow at a negative growth rate.

e) Energy Supply’s earnings-per-share will grow at 10%.

4. Consider a project that requires an initial investment of $200, 000 today and will generate cash flows of $100,000 at t = 2 and $100,000 at t = 4. What is the IRR of this project?

a) IRR does not exist

b) Zero

c) Positive infinity

d) 10%

e) 100%

5. Consider two mutually exclusive projects: Project A has a profitability index of PIA = 1.4, and Project B has a profitability index of PIB = 1.2. Which of the following statements is true:

a) The NPV of Project A is greater than the NPV of Project B.

b) The NPV of Project B is negative.

c) The firm should invest in Project A.

d) The firm should invest in Project B.

e) The firm is unable to make an investment decision based on the information given.

6. Belford Co. just paid a dividend of $2 per share and dividends are expected to grow at a rate of 4% per year forever. If Belford’s current stock price is $40, what will be its share price one year from today (right after the next dividend payment)?

a) $38.00

b) $40.00

c) $41.60

d) $42.00

e) $43.60

7. Gateway Tours is choosing between two bus models. The “Old Reliable” bus model has an expected life of 7 years, an NPV of -$218,000, and an EAC (equivalent annual cost) of -$46,450. The “Short and Sweet” bus model has an NPV of -$318,000 and an expected life of 5 years. The required rate of return is 11%. You conclude:

a) The EAC of the “Old Reliable” is larger than the EAC of the “Short and Sweet”.

b) You choose the “Old Reliable” because it has the lower EAC.

c) You choose the “Short and Sweet” because it has the larger NPV.

d) To make a decision you also need to know the IRR of the two models.

e) You are indifferent between the two models.

8. Consider a firm that has two assets in its Class 10 Asset Pool. The current UCC of this asset pool is $11,000. Asset 1 was purchased 4 years ago for $10,000, and Asset 2 was acquired 3 years ago also for $10,000. If the firm sells Asset 1 and 2 for $4,000 and $6,000, respectively, and the Class 10 Asset Pool is closed, what would be the firm’s tax consequences? Assume a tax rate of 40%.

a) The firm has to pay a capital gains tax.

b) The sale of the two assets will result in a terminal loss and a final CCA tax shield of $400.

c) Due to the sale of the two assets the firm will pay additional taxes of $400.

d) There won’t be any tax consequences when the pool is closed.

e) The firm has under-depreciated the two assets and will need to pay taxes of $200.

9. Consider a project with an initial investment of -$120 (t = 0) and two cash flows of $310 (t = 1) and -$200 (t = 2).

a) The project has one (positive) IRR.

b) The project has two (positive) IRRs.

c) The project has three (positive) IRRs.

d) The NPV of this project is positive when the required rate of return is 0%.

e) The project has no IRR.

10. You are considering making a movie. The movie is expected to cost $10 million upfront (at t = 0). After that, it is expected to make $5 million in the first year (at t = 1) and $2 million in each of the following four years (at t = 2 to 5). The following statement is true:

a) If the required payback period is 2 years, you will make the movie.

b) The payback period of this investment is 4 years.

c) The payback period of this investment is 3 years.

d) The movie project has a positive NPV.

e) The movie project has a required rate of return greater than its IRR.

Use the following information to answer Multiple Choice Problems 11 to 15:

Cenex Inc. reported earnings-per-share of $4 this year. Mr. Beauford, the CEO of Cenex, pays 60% of earnings as dividends every year. Cenex has just paid its annual dividend to shareholders and will pay the next dividend in exactly one year from today. Mr. Beauford believes that based on the current payout and reinvestment policy, Cenex dividends will grow at a rate of 5% per year for the foreseeable future (i.e., forever).

Assume for all the following questions 11 to 15 that the required rate of return on Cenex stock is 11% (EAR).

11. Given the information above, what is the stock price of Cenex Inc. today?

a) $22.9

b) $26.7

c) $28.0

d) $40.0

e) $42.0

12. Tracy Spence, an equity analyst, believes that starting next year, Cenex will pay out all earnings as dividends for the foreseeable future. Further, she believes that next year’s earnings-per-share will be $5. Based on her expectations, what would be Cenex’s stock price today?

a) $27.3

b) $40.0

c) $45.5

d) $50.0

e) $83.3

13. Ann King, the CFO of Cenex, is evaluating an expansion project. She expects that this expansion project would require an initial investment in one year (t = 1) of $2.5/share and would result in additional annual cash flows of $1.5/share over the next ten years starting in two years from now (at t = 2 to t = 11). The opportunity cost of capital for this project is 11% (EAR). By how much would the price of one Cenex share increase today if Cenex decides to undertake this project?

a) $5.7

b) $6.3

c) $8.0

d) $11.3

e) Cenex should not undertake that project because its NPV is negative.

14. Going back to the initial case, Mr. Beauford is worried that the current payout policy of paying out 60% of earnings as dividends is not the optimal choice for Cenex shareholders. He therefore hires the Payout Consulting Group. The first question the consultants ask is how big the ROE (i.e., the return on reinvested earnings) of Cenex is. Remember, Cenex dividends will grow at a rate of 5% per year for the foreseeable future.

a) 5.0%

b) 8.3%

c) 11.0%

d) 12.5%

e) 20.0%

15. The Payout Consulting Group believes that it would be in the best interest of shareholders if Mr. Beauford would decrease the payout ratio from 60% to 25%. They also evaluated the potential of future investment projects and estimate that future projects will earn 12% (i.e., Cenex’s ROE is 12%) for the foreseeable future. Based on this information, what would be the annual growth rate of Cenex’s dividends?

a) 3%

b) 9%

c) 11%

d) 12%

e) Dividends would not grow.

Use the following information to answer Multiple Choice Problems 16 to 23:

Future Electronics Corp. (FEC) is considering the purchase of an additional assembly line for their new smartphone. The new assembly line costs $1 million (at t = 0) and can be sold for $115,000 at the end of its expected 4-year operating life. The new assembly line would increase the annual output capacity from currently 750,000 to 950,000 smartphones per year (at t = 1 to t = 4). FEC estimates to earn $10 per smartphone, calculated as sales less operating expenses (not including taxes, depreciation, or adjustments for net working capital). A study conducted by an independent consulting firm estimates that FEC will be able to lower net working capital by $50,000 when the new assembly line is installed (at t = 0), and that net working capital will increase again by $50,000 at the end of the machine’s operating life (at t = 4). The fee for this study amounts to $18,000 and is due today. The new assembly line belongs to asset class 43 with a CCA rate of 30%. FEC’s required rate of return is 12%, and FEC’s corporate tax rate is 35%.

Note: You don’t need to find the present value of all cash flows. Calculate only the relevant numbers required to answer the questions below.

16. The fee payment of $18,000 for the study conducted by the consulting firm is an example of:

a) A sunk cost

b) An opportunity cost

c) A change in net working capital

d) An initial investment

e) A residual salvage

17. What is the initial cash outlay (i.e., the total cash flow at t = 0; excluding any CCA tax shields)?

a) -$617,500

b) -$950,000

c) -$968,000

d) -$1,000,000

e) -$1,050,000

18. What is the total cash flow in year 3 (at t = 3; excluding any CCA tax shields)?

a) $1,300,000

b) $1,362,475

c) $2,000,000

d) $2,018,000

e) $6,175,000

19. What is the last year’s total cash flow (at t = 4; excluding any CCA tax shields)?

a) $1,135,000

b) $1,250,000

c) $2,065,000

d) $1,465,000

e) $1,365,000

20. What is the CCA in year 2 (at t = 2)?

a) $73,500

b) $89,250

c) $150,000

d) $210,000

e) $165,000

21. What is the NPV of the project?

a) NPV = PV of total cash flows (excluding CCA TS) – PV CCA tax shields

b) NPV = PV of total cash flows (excluding CCA TS) + PV CCA tax shields

c) NPV = PV of total cash flows (excluding CCA TS)

d) NPV = PV CCA tax shields

e) NPV = PV of total cash flows (excluding CCA TS) – PV CCA tax shields + NWC

22. Suppose the consultants were wrong and net working capital increases by $100,000 when the new assembly line is installed (and will decrease by $100,000 at the end of the project). What would be the additional tax savings due to this change in net working capital requirements?

a) $0

b) $50,000

c) -$50,000

d) -$65,000

e) -$100,000

23. Suppose production needs to be halted for five days to install the new assembly line. This production stop would result in a pre-tax operating loss of $75,000 (at t = 0). How much would the NPV of the project change due to this new information?

a) $0

b) $75,000

c) -$26,250

d) -$75,000

e) -$48,750