Instructor:
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***Suggested Solutions***
REMARKS:
The purpose of this Exam is to help you reflect on the lectures and to apply
the tools we have learnt to real life examples
The problems are to be answered in the space provided for them in this
booklet.
Clearly show ALL your working and encircle the final answer.
Neatness will be greatly appreciated
This Exam consists of two parts (24 questions) on a total of 11 pages,
including cover page.
Part I
MULTIPLE CHOICE QUESTIONS (5 POINTS EACH)
Show ALL CALCULATIONS. Answers without supporting calculations will be
deemed a guess and will not receive any credit.
1.
You are considering opening a new plant. The plant will cost $100 million
upfront and will take one year to build. After that, it is expected to
produce net cash flows of $30 million at the end of every year of
production. The cash flows are expected to last forever. Should you make
the investment if your opportunity cost is 8%?
a.
b.
c.
d.
Answer:
Solution:
r
30
NPV (
)(1.08) 1 100 $247,222,222
0.08
NPV
2.
Answer: c
Solution:
The correct answer is c. Sunk costs should be excluded from the analysis, and
interest expense is incorporated in the WACC and not the cash flows.
3.
Annual
Net Income ($)
50,000
60,000
70,000
60,000
Annual
Depreciation Rate
0.33
0.45
0.15
0.07
$153,840
$159,071
$162,409
$168,604
Answer:
d
Solution:
Step 1: Calculate depreciation:
Dep 1 = 100,000(0.33) = 33,000.
Dep 2 = 100,000(0.45) = 45,000.
Dep 3 = 100,000(0.15) = 15,000.
Dep 4 = 100,000(0.07) = 7,000.
Step 2: Calculate cash flows:
CF 0 = Initial Investment + Initial Increase in NWC
= 100,000 + 5,000 = 105,000.
CF
= Net Income + Depreciation
CF 1 = 50,000 + 33,000 = 83,000.
CF 2 = 60,000 + 45,000 = 105,000.
CF 3 = 70,000 + 15,000 = 85,000.
CF 4 = Net Income + Depreciation + Recovered NWC + Salvage Value
= 60,000 + 7,000 + 5,000 + 15,000 = 87,000.
Step 3: Calculate NPV:
Use CF key on calculator. Enter cash flows shown above. Enter I/YR = 12%.
Solve for NPV = $168,603.89.
NPV
CIFt
(1 r )
t 1
NPV 83,000(1.12)
t 0
COFt
(1 r ) t
4.
Answer:
Solution:
$2,927,716.00
$3,000,000.00
-$ 72,283.55
$2,807,228.00
-$3,072,283.55
c
Step 1:
1 (1 .10) 10
PVA 500,000
.10
PVA CF
PVA $3,072,283.55
Step 2:
5
5.
A tenant wants to lease a building for $48,000 per year. She signs a fiveyear rental agreement that states that she will pay $24,000 every six months
for the next five years. Which of the following is the timeline for her rental
payments, assuming she makes the first payment immediately?
a)
Date
(years)
Cash Flows
$48
(thousands)
b)
Date
(years)
$48
$48
$48
$48
$48
1/2
1 1/2 2
2 1/2 3
3 1/2 4
4 1/2 5
Cash Flows
-$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 0
(thousands)
c)
Date
(years)
Cash Flows
$24
(thousands)
d)
Date
(years)
3 1/2 4
4 1/2 5
$24
$24
$24
$24
$24
$24
$24
$24
Cash Flows
-$48
(thousands)
Answer:
6.
-$48
-$48
-$48
-$48
-$48
$24
$24
A bank offers a home buyer a 25-year loan at 8% per year. If the home
buyer borrows $120,000 from the bank, how much must be repaid every
year?
a.
$9,845.89
b.
$10,786.66
c.
$7,896.45
d.
$11,241.45
Answer:
Solution:
d
1 (1 r ) n
PVA PMT
1 (1 .08) 25
.08
120,000 PMT
PMT $11,241.45
6
7.
Suppose you could borrow using either a credit card that charges 1.5
percent per month or a bank loan with a 18 percent quoted interest rate that
is compounded daily. Which should you choose?
a.
b.
c.
d.
e.
Answer:
Solution:
APR m
) 1
m
Credit card loan :
EAR (1
0.18 365
) 1 0.19716 19.72%
365
Thus, the bank loan a little more than the credit card loan
EAR (1
8.
The future value of a lump sum at the end of five years is $1,000. The
nominal interest rate is 10 percent and interest is compounded
semiannually. Which of the following statements is most correct?
a.
b.
c.
d.
e.
Answer:
d
Statements b and c are correct; therefore, statement d is the correct choice. The
present value is smaller if interest is compounded monthly rather than
semiannually.
9.
You are offered an investment opportunity that costs you $28,000, has a net
present value (NPV) of $2278, lasts for three years, has interest rate of 10%,
and produces the following cash flows:
$13,000
$12,500
$10,000
$12,000
Answer:
Solution:
d
n
NPV
t 1
n
CIFt
COFt
t
t
(1 r )
t 0 (1 r )
10.
The timeline shown below best describes the cash flow of which of the
following people?
Date
0
(years)
Cash
Flows
$1000
$1000
$1000
$1000
a.
b.
c.
d.
-$3500
Dina, who loans a friend $3500, which friend then pays back the loan
in four annual installments of $1000
Zina, who borrows $3500, and then pays back the loan in four annual
payments of $1000
Tara, who borrows $3500, and then receives an annual payment of
$1000
Sara, who puts down $3500 to buy a car, and then makes annual
payments of $1000
Answer:
a
11.
Which of the following statements is most correct?
8
a.
The present value of an annuity due will exceed the present value of
an ordinary annuity (assuming all else equal).
The future value of an annuity due will exceed the future value of an
ordinary annuity (assuming all else equal).
The nominal interest rate will always be greater than or equal to the
effective annual interest rate.
Statements a and b are correct.
All of the statements above are correct.
b.
c.
d.
e.
Answer:
d
Statements a and b are correct; therefore, statement d is the correct choice. The
nominal interest rate will be less than the effective rate when the number of
periods per year is greater than one.
12.
If you deposit $300 at the beginning of each year for three years in a savings
account that pays 6 percent interest per year, how much will you have at the
end of three years?
a.
b.
c.
d.
$900.00
$1,315.25
$1,012.38
$1,304.83
Answer:
Solution:
c
(1 k ) n 1
(1 r )
k
FVA PMT
(1 .06) 3 1
(1 .06) $1,012.38
.06
FVA $300
13.
Answer:
Solution:
9
Statement (a) is true; projects with IRRs greater than the cost of capital will have
a positive NPV. Statement (b) is false because you know nothing about the
relative magnitudes of the projects. Statement (c) is false because the IRR is
independent of the cost of capital. Therefore, the correct choice is statement (a).
14.
Cash Flow
$325
400
550
?
750
800
$1,187
$ 600
$1,157
$ 655
$1,267
c
15.
A firm with a cost of capital (COC) of 15% is evaluating four capital projects.
The internal rates of return (IRR) are as follows:
Project
IRR
10
1
16%
2
13%
3
17%
4
14%
The firm should
a. Accept project 4 and 1, and reject 2 and 3.
b. Accept project 4, 1, and 3, and reject 2
c. Accept project 3, and reject 1, 2, and 3.
d. Accept project 3, and 1, and reject 2 and 4.
Answer: d
Solution:
If IRR > COC accept
If IRR < COC reject
16.
Zina recently purchased a new automobile for $32,000. She made a $7,000
down payment and financed the balance over 48 months using a loan with a
12 percent annual nominal rate of interest. What are her monthly payments?
a.
b.
c.
d.
Answer:
Solution:
$512.98
$577.87
$658.35
$688.98
c
m 12
r
12%
1% per month
m 12month
1 (1 r / m) n*m
PVA PMT
r/m
PVA
25,000
25,000
PMT
$658.35 / month
n*m
48
37.97395949
1 (1 r / m)
1 (1 .12 / 12)
r/m
.12 / 12
17.
11
Answer:
d
Solution:
Alternative (d) is correct; the other alternatives are incorrect. Looking at
responses (a) through (d), you should realize the choice with the greatest
frequency of compounding will give you the highest EAR. This is alternative (d).
The EAR of each of the alternatives is shown below.
APR m
) 1 ;
where m # of times per year int erest is compounded
m
.08 12
EAR NBB (1
) 1 8.30%
12
.0825 1
EARCNN (1
) 1 8.25%
1
.08 4
EAR RBC (1
) 1 8.24%
4
.08 365
EARCIBC (1
) 1 8.328%
365
EAR (1
18.
To save money for a new house, you want to begin contributing money to a
brokerage account. Your plan is to make 10 contributions to the brokerage
account. Each contribution will be for $1,500. The contributions will come at
the beginning of each of the next 10 years. The first contribution will be
made at t = 0 and the final contribution will be made at t = 9. Assume that the
brokerage account pays a 9 percent return with quarterly compounding.
How much money do you expect to have in the brokerage account nine
years from now (t = 9)?
a.
b.
c.
d.
e.
$23,127.49
$25,140.65
$25,280.27
$21,627.49
$19,785.76
Answer:
a
Solution:
First, convert the 9 percent return with quarterly compounding to an effective rate
of 9.308332%. With a financial calculator, NOM% = 9; P/YR = 4; EFF% =
9.308332%. (Dont forget to change P/YR = 4 back to P/YR = 1.) Then calculate
the FV of all but the final payment. BEGIN MODE (1 P/YR) N = 9; I/YR =
9.308332; PV = 0; PMT = 1500; and solve for FV = $21,627.49. You must then
add the $1,500 at t = 9 to find the answer, $23,127.49.
12
.09 4
) 1 9.308332%
4
(1 r ) n 1
PMT
(1 r )
r
EAR (1
FVAdue
(1 .09308332) 9 1
(1 .09308332) $21,627.48931
.09308332
19.
You have just arranged a $15,000 loan from your bank at an annual rate of
10%. The loan calls for annual payments of $1,000 over the next 14 years,
and a final payment at the end of year 15. How big will the final payment
(balloon) be?
a.
b.
c.
d.
Answer:
Solution
$28,986
$29,098
$31,886
$31,946
c
PV ( Loan)
14
PMTt
(1 k )
t 1
PMT15 (1 k ) 15
1 (1 .10) 14
15
PMT15 (1 .10)
.10
15,000 1,000
20.
West Island Industries is considering a project which has the following cash
flows:
Year
0
1
2
3
4
Cash Flow
?
$2,000
3,000
3,000
1,500
The project has a payback period of 2.5 years. The firms cost of capital is 12
percent. What is the projects net present value?
a. $577.68
b. $676.74
c. $823.81
13
d. $977.56
e. None of the above, the answer is $______________.
Answer:
e
Solution:
Initial Investment=$2,000+3,000+(3,000/2)=$6,500
NPV 6,500
2,000
3,000
3,000
1,500
$765.91
1
2
3
(1.12)
(1.12)
(1.12)
(1.12) 4
Part II
Problems
Q1.
You are running a hot Internet company. Analysts predict that its earnings will grow at 30%
per year for the next five years. After that, as competition increases, earnings growth is
expected to slow to 2% per year and continue at that level forever. Your company has just
announced earnings of $1,000,000. What is the present value of all future earnings if the
interest rate is 8%? (Assume all cash flows occur at the end of the year.)
Solution:
Timeline:
0
1(1.3)
(1.3)2
(1.3)3
(1.3)4
(1.3)5
(1.3)5(1.02)
(1.3)5(1.02)2
1
0.08 0.3
1.08
1.3
Now we calculate the PV of (2). The value at date 5 of the growing perpetuity is
PV5
1.3 5 1.02
0.08 0.02
63.12
1.08 5
$42.96 million.
Adding the present value of (1) and (2) together gives the PV value of future earnings:
$9.02 $42.96 $51.98 million.
14
Q2.
Suppose you invest $2000 today and receive $10,000 in five years.
a.
b. Suppose another investment opportunity also requires $2000 upfront, but pays an equal
amount at the end of each year for the next five years. If this investment has the same
IRR as the first one, what is the amount you will receive each year?
Solution:
Solution part a
Timeline
0
-2000
10,000
2000
1/ 5
So IRR
1 =37.97%.
Solution part b
Timeline
0
-2000
X solves
2000
X
IRR
so
X
2000 IRR
1
1
5
(1
IRR
)
= $949.27
Q3.
You are shopping for a car and read the following advertisement in the newspaper: Own a
new Spitfire! No money down. Four annual payments of just $10,000. You have shopped
around and know that you can buy a Spitfire for cash for $32,500. What is the interest rate
the dealer is advertising (what is the IRR of the loan in the advertisement)? Assume that you
must make the annual payments at the end of each year.
Solution:
15
Timeline:
0
32,500
10,000
10,000
10,000
10,000
10, 000
r
1 r
4
Setting the NPV of the cash flow stream equal to zero and solving for r gives the IRR:
NPV 0 32, 500
10, 000
r
1-
10, 000
1 r
4
32, 500
1 r
4
To find r we either need to guess or use the annuity calculator. You can check and see that r =
8.85581% solves this equation. So the IRR is 8.86%.
Q4.
You have just purchased a home and taken out a $500,000 mortgage. The mortgage has a 30year term with monthly payments and an APR of 6%.
a.
How much will you pay in interest, and how much will you pay in principal, during the
first year?
b. How much will you pay in interest, and how much will you pay in principal, during the
20th year (i.e., between 19 and 20 years from now)?
Solution:
a.
500, 000
$2997.75
1
1
APR of 6% = 0.5% per month. Payment =
.
.005
1.005360
Total annual payments = 2997.75 12 = $35,973.
Loan balance at the end of 1 year = $2997.75
1
1
1
$493,860 .
.005
1.005348
Therefore, 500,000 493,860 = $6140 in principal repaid in first year, and 35,973 6140 =
$29833 in interest paid in first year.
b.
1
1
1
$289,162 .
.005
1.005132
1
1
1
$270, 018 .
.005
1.005120
16
Therefore, 289,162 270,018 = $19,144 in principal repaid, and $35,973 19,144 = $16,829
in interest repaid.
Good Luck!