1: Multiple Choice
(30 questions; 30 marks). Select the best alternative for each of the
When analyzing two mutually exclusive capital budgeting projects, the
NPV and IRR capital budgeting methods can result in different ranking
decisions. On a NPV profile (a chart showing the NPV at different
discount rates) of these two projects, the cross-over rate is the
point at which:
a) the market risk premium equals the
asset risk premium.
b) the IRR and NPV for a single
project are equal.
c) the IRR for two projects are equal.
d) the NPV for two projects are equal.
e) none of the above.
Lan Electronics is considering expanding into another line of
business. There are five potential business opportunities available.
Each line of business has the same expected return. The betas of the
various business lines are provided below. Which of the expansion
alternatives would be the best choice for Lan Electronics?
copper mines, 1.63 d) toy manufacturing, 0.79
b) machinery construction, 1.00 e)
janitorial services, 0.95
c) natural gas exploration, 1.75
LH Enterprises borrowed $44 million in the Eurocurrency market 8
months ago at an interest rate of LIBOR plus 111. The LIBOR at that
time was 2.83%. The loan is repayable today. How much does LH
$44,000,000 d) $45,733,600
$45,245,200 e) $45,155,733
Which of the following is not a source of financing (capital) for a
assets d) bonds
common shares e) all of the above are sources
c) preferred shares
Parrish Corp is evaluating a capital budgeting project that has an
initial cost of $850 million. The company’s cost of capital is
13.8% and the NPV of the project is +$26,352. This means that:
the project generates a return of $26,352 to Parrish Corp.
the project return of $26,352 is not sufficient given the project’s
cost of $850 million.
the project’s expected return is less than 13.8%.
the project’s expected return is greater than 13.8%.
the project is not acceptable.
The IRR for a capital budgeting project is:
a) based on the market risk premium.
b) equivalent to the firm’s cost of
c) the discount rate that makes the
firm’s cost of capital equal to zero.
d) the discount rate that makes the
project’s NPV equal to zero.
e) the point where the project’s NPV
profile intersects with the firm’s cost of capital.
The interest expense for a company is equal to its operating income
(EBIT). The company’s tax rate is 40%. The company’s
times-interest earned ratio is equal to:
2 d) 1.20
1 e) none of the above.
The cost of capital is the:
a) cost of raising a marginal dollar
b) cost of the liabilities and equity
on the firm’s balance sheet.
c) cost of the funds used to acquire
the new assets that appear on the firm’s balance sheet.
d) cost of the assets that appear on
the firm’s balance sheet in the OCS weights.
e) cost of raising a marginal dollar
of financing in the OCS weights.
If inventory decreases on a balance sheet, how would this be treated
on a statement of cash flows?
a) It would be a use of cash, since
the firm is buying inventory and using cash.
b) It would be a source of cash, since
the firm is selling inventory.
c) It would be a use of cash, since
the firm is selling inventory it purchased with cash.
d) It would be a source of cash, since
the firm is buying inventory that it can resell for cash.
e) There would be no impact.
Consider the following statements regarding the retained earnings
1) Retained earnings reflects the sum
of the firm’s net income over its life less all cash dividends
2) Retained earnings is the link
between the income statement and the balance sheet.
3) Usually, retained earnings changes
every fiscal year.
4) Retained earnings represents funds
that are currently available for financing purposes.
of the above statements are correct? a) 1 and 2, only. b) 3 and
4, only. c) 2, 3, and 4, only. d) 1, 2, and 3, only. e) 1, 2, 3, and
Winn Shopping Centers is planning to use long-term debt to finance
the expansion of their business. For capital budgeting purposes,
which of the following should be recognized as part of the cash
a) the after-tax interest payments,
but not the principal repayments.
b) the principal repayments, but not
the after-tax interest payments.
c) neither the after-tax interest
payments, nor the principal repayments.
d) both the after-tax interest
payments, and the principal repayments.
Which of the following is not a financial intermediary in the
a) Chartered banks.
b) Life insurance companies.
c) Government of Canada.
d) Pension Plans.
e) All of the above are financial
Lambe Enterprises is evaluating five capital budgeting projects. The
firm has unlimited funds. Projects 1 and 2 are independent and
Projects 3, 4 and 5 are mutually exclusive. The projects are listed
below with their expected returns.
A ranking of the projects on the basis
of their returns from the best to the worst according to their
acceptability to the firm would be:
a) 4, 5, 1, 2, and 3.
b) 4, 1, and 2.
c) 3, 2, 1, 5, and 4.
d) 4, 5, 1, and 3.
e) none of the projects are
A company’s accounts receivable turnover ratio is decreasing, the
company’s average collection period (ACP):
a) is increasing
b) is decreasing
c) could be moving in either
d) there is no impact.
Consider the following four financial events:
an increase in cost of goods sold.2) issuing a long-term
debenture.3) a reduction in accounts receivable.4) a
reduction in the line of credit.
Which of the above financial events
represent a use of cash for a company?
1 and 3, only. d) 1, 3, and 4, only.b) 2 and 4, only. e) 1,
2, 3, and 4.c) 1 and 4, only.
The NPV and IRR methods of capital budgeting can sometimes result in
different rankings for mutually exclusive capital budgeting projects.
Consider the following statements that may explain the reasons the
different rankings can occur.
Differences can result because of
differences in the size and timing of the cash inflows for the
Differences in rankings can occur
because time value of money is not explicitly considered in one of
the capital budgeting methods.
Differences in ranking can occur
because one of the methods does not consider all of the cash flows
associated with a project.
Differences in ranking can occur due
to different re-investment rate assumptions regarding the project’s
Which of the above explanations are
a) 1 and 4, only.
b) 2 and 3, only.
c) 2, 3, and 4, only.
d) 1, 3, and 4, only.
e) 1, 2, 3, and 4.
Crowner Enterprises is evaluating two independent projects. Project
A has incremental capital cost $369,000 and is expected to have a
useful life of five years. After-tax cash inflows are expected to be
$112,700 per year. Project B has an incremental cost of $550,000 and
a useful life of four years. After-tax cash inflows are expected to
be $181,080 per year. The company has sufficient funds to invest in
both projects if required. Crowner should:
a) invest in both projects if the
company’s cost of capital is 15% or less.
b) invest in Project B only if the
company’s cost of capital is 15% or less.
c) invest in both projects if the
company’s cost of capital is 12% or less.
d) invest in Project A only if the
company’s cost of capital is 12% or less.
e) invest in neither project if the
company’s cost of capital is 12% or less.
Bond A has a coupon rate of 10% and matures in 2 years. Bond B also
has a coupon rate of 10% and matures in 22 years. Both bonds are
rated A. If yields on debt securities in the market decrease:
a) the fall in the market price of
bond A would exceed the fall in the market price of bond B.
b) the fall in the market price of
bond B would exceed the fall in the market price of bond A.
c) the rise in the market price of
bond A would exceed the rise in the market price of bond B.
d) the rise in the market price of
bond B would exceed the rise in the market price of bond A.
e) the change in the market price of
bond A would equal the change in the market price of bond B.
The type of risk depicted in the above example is , and
investors rationally demand a
a) default risk, a default risk
b) default risk, a maturity risk
c) inflation, a liquidity premium
d) interest rate risk, a maturity risk
e) reinvestment rate risk, an
What is the primary goal of financial management?
a) To increase the company’s
b) To maximize the company’s cash
c) To maximize the value of the
company’s common shares.
d) To minimize the risk of the
e) To maximize the company’s sales.
The market price of a company’s common shares will fall if any of
the following occur EXCEPT:
a) expected dividends decrease.
b) the growth rate in dividends
c) the risk of the common shares
d) the required return on the common
e) all of the above will result in the
share price falling.
When a company “goes public”, this refers to:
a) registering a prospectus with a
provincial securities commission.
b) listing common shares on one of the
organized stock exchanges for the first time.
c) registering with one of the
d) publication of the stock’s price
quotations in the financial news.
e) receiving approval from the Bank of
Canada to issue common shares the first time.
A firm’s current earnings per share are $5 and the firm has a
price/earnings ratio of 15. It is expected that the company earnings
will grow by 10% and that an “appropriate” price/earnings
ratio for the company is 14. What is the value of the firm’s
a) $75.00 per share
b) $70.00 per share
c) $82.50 per share
d) $77.00 per share
e) the company assigns a share price
independent of EPS and the P/E ratio.
On June 25, Maxwell Corp. sold 500,000 new common shares to the
public for $25 per share but, due to issue costs, Maxwell only
received $23.75 per share. Prior to the sale of the new shares, the
company had 2.5 million common shares outstanding. Income available
to common shareholders for the quarter ended June 30 is $6 million.
What is the impact on earnings per share of the new issue?
a) EPS is reduced (diluted) by $2.40
b) EPS is reduced (diluted) by $2.00
c) EPS is reduced (diluted) by $0.40
d) EPS is reduced (diluted) by $1.25
e) EPS is not affected since Maxwell
receives funds from the share issue.
A $1,000 par value treasury-bill with 98 days to maturity is sold to
yield 2.86%. What is the most you should pay for this treasury-bill?
e) none of the above
A company requires external financing of $50 million, which it is
going to raise by issuing new common shares. Where would this
a) In the primary market within the
b) In the secondary market within the
c) In the primary market of the money
d) In the secondary market of the
e) In the market associated with the
Which of the following statements about bond ratings is true?
The federal government publishes bond ratings.
b) Bonds rated “C” are
considered to be high quality bonds.
c) Bond ratings assess the firm’s
ability to make dividend payments.
d) There is an inverse relationship
between bond ratings and yields.
e) None of the above statements about
bond ratings are true.
Money market securities are:
a) long-term debt securities like
bonds and debentures.
b) common shares.
c) preferred shares.
d) short-term debt securities like
treasury-bills and bankers’ acceptances
e) all of the above are money market
In today’s newspaper, the quote on Nova Inc.’s debentures is 86.58.
What does this mean?
a) The debentures can be sold for
$86.58 of their par value.
b) The debentures can be purchased for
$86.58 per debenture certificate.
c) The debentures are trading for
86.58% of their par value.
d) Interest rates decreased between
the date of the debenture’s issue and now.
e) Two of the above.
A sinking fund:
can only be beneficial for the investor.
b) results in the gradual retirement
of a debt issue.
c) must be exercised by purchasing
debt in the open market.
d) always results in the debt being
purchased at less than par value.
e) all of the above.
2: 9 Short Answer Questions/Problems (25 marks) Please show all of
your calculations/work for the solutions.
marks) Gitman Corp’s total assets are $1.2 million, while their
total assets turnover is 2.35. Total debt is $600,000. The
company’s return on equity is 14.1%. What is the company’s
mark) What is the value of any productive asset based on (equal to)?
marks) Franklin Enterprises has just borrowed $150,000 from the TD
Bank. The interest rate on the loan is 6.25% and Franklin has
agreed to repay the loan on a monthly basis over five years.
Payments will include both principal and interest. What are
Franklin’s monthly payments?
marks) Wal-Smart Technology is considering the construction of a new
plant. The land on which the plant will be constructed was
purchased eight years ago for $835,000 but a recent appraisal
indicates that the land is currently worth $2.2 million. The plant
will cost $8.4 million to construct. Two years ago, Wal-Smart paid a
consulting company $300,000 to complete an environmental impact
study on the new plant. Many pieces of equipment will be required
for the plant. One of the pieces of equipment that will be used in
the new plant was purchased two years ago for $875,000. The
equipment was never used and depreciation was never charged on the
equipment. The piece of equipment is now worth $475,000. Based on
this data, what cost figure should Wal-Smart Technology use as the
relevant cost of the new plant?
marks) You are considering making a common equity investment in a
private company. The company’s beta is estimated to be 1.8. The
risk-free rate of return is expected to be 4.5%. Historically, the
market risk premium has been 6%. Over the coming years, the company
hopes to generate average yearly returns on equity of 16%. What is
your required rate of return on the equity investment in the
company? Should you make the investment? Explain.
marks) Ray Connolly is considering becoming an organic farmer. His
cost of capital is 12%. The incremental after-tax operating earnings
that will be generated from the organic farm are provided below.
What is the present value of this stream of operating earnings?Year
1: cash outflow of $250,000 Year 2: cash outflow of $150,000
Year 3: cash outflow of $100,000 Years 4 to 50: cash
inflow of $ 90,000 each year.
marks) During the most recent year, Epson Inc. paid common dividends
of $1.60 per share. Financial analysts following Epson expect the
company will grow their dividends by 13.8% for the next two years.
It is expected that growth will then fall to 10% and remain at that
level indefinitely. If investors require a 14% return on an
investment in the common shares of Epson, calculate the value of
Epson’s common shares today using the DVM.
mark) JetRed Manufacturing wishes to calculate the payback period
for new production equipment. The equipment will cost $435,000 and
is expected to have a life of four years. The equipment is expected
to generate the following after-tax cash flows for the four years.
What is the payback period for new production equipment?
marks) Quickware Computer’s return on equity (ROE) for the 2003
fiscal year was 10%. The company wishes to calculate their ROE for
the 2004 fiscal year using the DuPont system. The following
financial information is available. Use this data to calculate the
ROE for 2004 using the DuPont system.
income after tax
Now, explain what could have happened
to cause the change in ROE between 2003 and 2004.
3: Three Problems (55 marks) Please show all of your detailed
calculations/work for the solutions.
(15 marks) The September 30, 2004 financial statements for
Millipore Company are provided on the following page. Millipore’s
chief financial officer has asked you to prepare a proforma income
statement, balance sheet, and statement of external financing
required (EFR) for Millipore Corp for the 2005 fiscal year. The
Statement of EFR should show the total financing required, the
internal sources, and any adjustments to EFR. The following
forecasts for the 2005 fiscal year are available:
The company’s sales are forecasted
to increase by 32%.
Cost of goods sold are expected to be
70.8% of sales.
Selling and administration expenses
will increase by $80,000.
will increase by $10,000 since the company is planning to acquire
new fixed assets that will cost $628,200.
Lease Payments will remain unchanged.
Interest expense will increase by
Millipore’s tax rate is 20%.
The company’s policy is to pay 25%
of their net income after tax as common share dividends.
The firm wishes to have a minimum
cash balance of $45,000.
The company’s goal is to have an
average collection period of 65 days, an average age of inventory of
72 days, and an average payment period of 85 days.
Accruals will increase by $5,000.
During the 2005 fiscal year, the
company is required to repay $205,000 of the principal on their
outstanding long-term debt.
Any external financing required will
be raised as follows: 60% line of credit, 40% sale of common shares.
(all on credit)
of goods sold
and admin. expense
plant and equipment
and Owners’ Equity
liabilities and equity
(15 marks) Fine Foods Catering Ltd (FFC) operates a serving-line
cafeteria in an office building in downtown Halifax, Nova Scotia.
About 1,500 people work in the office building. The cafeteria is
open 250 days a year and operates from 7:00 am until 4:00 pm. Demand
always peaks during the lunch hours. For lunch, 600 people want to
use the cafeteria, however, the serving-line facilities can only
accommodate 400 people. Therefore, each day 200 potential customers
are turned away. The owners of FFC have recently recognized that
this is resulting in a considerable loss of revenue for the
To tap the excess demand, the
cafeteria is considering expanding the current serving-line
facilities over the upcoming Christmas holidays. Expanding the
serving-line will cost $260,000. With the expansion, it is estimated
that 75% of the customers that are currently being turned away from
the cafeteria will use the cafeteria.
For the cafeteria, the current average
lunch sale is $5.40 excluding taxes. The direct cost of the average
lunch (the food sold) is 40%. This will remain the same if the
serving-line facilities are expanded. With the expanded serving-line,
an extra cook, dish washer, and cash clerk will be required. The
wages for these new employees will be $28,000, $12,500, and $21,500
per year, respectively. In addition, extra cleaning costs of $45 per
day will be incurred.
Since sales will increase with the
expanded serving-line, the cafeteria will have to invest an
additional $0.10 in food inventory for each $1.00 increase in sales.
The serving line expansion has an expected useful life of 20 years.
The salvage value of the new equipment at the end of its 20 year life
will be $25,000 and it will cost $2,500 to dismantle. The CCA rate
for the new serving-line facilities is 15%. FFC’s tax rate is 20%
while their cost of capital is 14%.
a) Should FFC expand the current
serving-line facilities in the cafeteria? Fully explain being sure to
provide a complete net present value analysis.
b) For the following question,
additional calculations are not required. If the firm’s cost of
were 12.5% and not the 14% used above,
would this change your answer? Briefly discuss.
Remember, do not make any
(25 marks) It is January 2, 2005 and the President of Byfield
Corporation has approached you with a problem. The president has
uncovered three possible independent projects that the company could
invest in. The president is wondering which of the projects the
company should select. You inform the President, based on the
knowledge gained in your corporate finance course, that she must
first determine the company’s cost of capital.
Based on this response, the President
hires you to complete the analysis. You know that after calculating
the company’s cost of capital, you can make a decision regarding
the available projects.
Byfield’s capital structure, which
is considered optimal, is as follows:
(10% coupon, due December 6, 2005)
equity ($20 stated value, 8.1% dividend rate)
shares (972,152 common shares outstanding)
If Byfield were to issue a bond, it
would have a life of 25 years. Byfield’s current bonds were issued
in 1985 for $998.25 per $1,000 of par. The bonds are now rated BBB
(low) and are currently trading for $1,011.61 per $1,000 of par.
Magna Canada, also rated BBB (low), has a bond outstanding that has
20 years to run to maturity and has a coupon rate of 11% (paid
semi-annually) This bond is currently trading for $1,238.47.
Byfield’s underwriter has informed
the company that for a bond with a 25 year maturity, the market would
require a premium 30 basis points (0.30%) more than that provided on
a 20 year bond issue with the same default risk. The new bond would
be sold for $1,002 and issue costs on a new bond issue would be 2.2%
of par. Byfield’s tax rate is 20%.
Byfield’s preferred shares are
currently trading for $18.10. If Byfield issued new preferred
shares, their underwriter has suggested that issue costs would be
2.7% of the $25 stated value of the new issue.
Byfield’s most recent earnings
available to common shareholders were $1,905,418 and the company paid
common share dividends of $369,418 or $0.38 per share. Byfield’s
common shares are currently trading for $12.22 per share. You have
been told that the company’s earnings and dividends are expected to
grow by 16% per year for the foreseeable future. For a sale of new
common shares, issue costs would be 4.83% of the current share price.
The costs and the expected returns of
the three projects Byfield is considering are presented below.
transfer colour printer
application imaging machine
a) Calculate Byfield’s cost of
capital. Which project(s) should Byfield accept? Explain.
b) In the phrase “cost of
capital,” what has a cost? Briefly explain why knowing the cost
of capital is important for a company.
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