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MGF 301 Study Guide Test 2 This packet contains 0 Material from all the chapters for Test 2 0 Tips and solutions to answer questions 0 Explanations to the Sample Test given based on review class 0 Another set of questions from a different Sample Test with complete answers Remember 0 It is a closed book exam 0 Bring your stationery and calculator 0 GO THROUGH ALL THE ASSIGNMENTS because the material covered will be similar The ones in RED BOLD or are important Good luck Bunny Trouble Chapter 10 Rate of Return and Risk Formula for Calculating Rate of Return Rate of Return TF1 P0 Div P0 Capital Gain Dividend Percentage Return Initial Share Price 0 These are all very simple and straightforward calculations P1 is the price ofthe stock NOW and P0 is the price at the time you bought the stock 0 Dividends are the total you earn throughout the period of holding the stock Note some stocks may not pay back dividends and that is okay There are other instances which apply the same techniques One of them is calculating Percentage Capital Gain or calculating Dividends 31 Percent age Capital Gain Init3911231 lStharClIiCe Dividend Yield Iiquotldquot d Yield Initial Share Price It is actually extracted from the initial formula Just that in percentage capital gain the dividend is not taken into account In Dividend Yield only the dividends are taken into account Don t get confused and make sure you know which formula to be used Real Rate of Return is the usual formula we did in Test 1 1 nominal ror 1 in ation rate 1 real ror Nominal ROR is most likely an answer which we have to calculate given a set of numbers We can also use this formula to calculate the in ation rate given the real ROR Measuring Risk To measure risk we can use expected return mean variance and standard deviation The standard deviation is usually the most common factor used to indicate risk Example You are interested in buying a stock that has a price of 42 You have projected that next year there is a 10 probability the stock will equal 4 a 20 probability the stock will equal 36 a 30 probability the stock will equal 46 a 30 probability the stock will equal 65 and a 10 probability the stock will equal 90 Answer the following showing all work a what is the expected return on the stock if you buy today and sell next year b what is the expected standard deviation of the stock You can use basic calculations to do this question Exnmplle int 54 quotIFD 994942 42 uet1ust9 39i39i39IiIii F fmull j T is ihe ini cil price P q we bnughi ih9 39 39 sincks int mwsm 4 ll 9 2 L 2 II I Em iquot Wquot W A mi mi i P quot R ihe piuiabiiriiy for 4 19 9949 995 Eh 36 211 1429 299 443 39 952 296 593 311 5429 1943 299 111 11429 I 1143 Add up all ihe Pr Espwe39amm values in his cnlumm To gei ihese 9uues yum musi 91ili139r11i ihe expecied value ircim ihe Aciuul Reiurn FIlEil39 ihe iirsri cine ii will he 9043 1331 1D2 39I39lienI square ilie VUIUES Risk and Diversi cation E3 949994 Return 1R 9 E9 3 9 9 9 E9 P13 9949 1 1943 1194 1429 1995 219 952 999 929 5429 1293 399 11429 9119 912 vmume 2139 Srtaniiihrd Deviamion1 5293 0139 Take ihe values from ihe previnzius column and muliiiply wiih iis probub39iiiiy I5233 vu unce Sum nf all values of ihis cnlumn in ihe above irnws Square rooi of 0 Diversi cation is when you buy many different stocks and they stocks cancel out the risks of one another hence lowering your risk in total 0 Unique risk is the firm specific risk All companies have unique risk Risk calculated based on the company s products and competitors Unique risk can be diversified by a company if the company buys its competitors hence canceling out the total risk 0 Market risk is systematic risk 0 Cannot be diversified 0 Usually represented by the Beta value Chapter ll Portfolio When you buy multiple stocks everything is combined into your portfolio The easiest way to calculate portfolio rate of return is to calculate the TOTAL value in hand and subtract the TOTAL value you got it for Example refer Assignment 3 One year ago you purchased 1000 shares of stock A for 25 per share and 2000 shares of stock B for 10 per share Stock A paid a dividend of 1 per share and is currently selling for 12 Stock B did not pay a dividend and is currently selling for 750 If the inflation rate during the year was 15 answer the following showing all work a Calculate the actual retarn also called percentage return on your combined portfolio over the last year Slack inlicll vcllua 125 quot llW i 25H139 Slack B lr39illlIIl WEIIUE Sal 239 U rt2 39 39 Cumranl Slack Value ll 239l 000 Sll 2000 ClIl39ll39E 39l39 Slack B Value 150 239 39El ll 5U39ElU Slack A dlilufida tlzs Sill ll l39 Slack B ria clhtidands lake cllvldnds lnla as ccaunl i l39lU l 39il raliumn 11200 11500 25mwm2nann a5nlm t2nwmw Curranl prlc a A Inllll Frlc a Portfolio Betas In portfolios Betas still exist because diversification only cancels out UNIQUE risk MARKET risk is not diversifiable Each stock has its own Beta Values To calculate combined portfolios you must take the AVERAGE of all your stock betas CAPM Theory which states that risk premium Beta Market risk premium Use the following formulas for any CAPM questions M arket risk premium r r m f Risk premium on any asset r rf Expected Return rf Brm rf So in conclusion Rrt39B r11139rf Where rm is the risk premium and If is the risk free rate usually given in the test B is the beta for the company In a discussion in class the And risk free rate is discussed as Very low almost close to zero useful in some questions refer to sample Test paper later on Capital Budgeting I Used to make decisions on which project should a company invest in to maximize profits 0 Methods 0 Payback period 0 NPV net present value 0 Internal Rate of Return IRR 39 NPV is usually favored because it takes into account the time value of money Payback Period 0 Calculates the amount of years needed to cover the initial investment of the project For example A company will accept a project if it pays back within 2 years The initial investment is 2000 Every year the project earns 1000 What is the payback period 2000 ll ll 0 This shows that the project is acceptable because it takes 2 years to pay it off However payback period is not a good analysis because It any profit after the payback period is not calculated A project could earn much more by the 3 year or so but it is not considered when making a decision Net Present Value Formula for Net Present Value INITIAL INVESTMENT all PVs of the cash ow Suppose PPI invests 4 million today ie Co 4000000 on a new project that is expected to last for 15 years The project is expected to generate annual cash ows of C1 500000 C2 300000 C3 300000 The discount rate is 9 009 To calculate NPV Step 1 Bring all cash ows to TIME PERIOD 0 Step 2 Sum all the cash ows Hum IJ tiny es imenl Hows en aauuaioun 394 U smuanena 5 up a 5 1 a5 rr1ir1m1 W 45B39 5 aanaioaa S A E I I gEg E 39 3 V p 3 assumes neinam3 23l ii 39539539 2 assumes NIFV Ilnxresimnir IPVI of II csh flows 4ao479s5a4i Internal Rate of Return IRR discount rate where NPV 0 Therefore you can manipulate the NPV formula to find the IRR Example formula 0 3503000 160001 16000 2 4660003 1 IRR 1 IRR 1IRR This is basically the NPV formula where We do not know the IRR The most efficient Way to solve this is by using trial and error method To accept a project IRR percentage must be MORE than the discount rate CASH FLOWS The most important part of this chapter is to know how to calculate cash flows Things to take note of O Investment money is the investment cash flow and must be a negative value 0 Working capital is usually given 0 Sales revenue and expenses are given too I Depreciation each year TOTAL INVESTMENT the number of years assets will be present in the company 0 Cash flow from operations PROFIT AFTER TAX Depreciation for that particular year 0 Operational cash flow is basically REVENUE ALL EXPENSES 0 Change in working capital Working capital from previous year Working capital of the current year calculated 0 Total cash flow Investment cash flow Operational cash flow Example from Assignment BMT has developed a new product It can go into production for an initial investment of 1500000 The equipment will be depreciated using straight line depreciation over 4 years to a value of zero The firm believes that net working capital at each date will equal 10 percent of next year s forecast sales The firm estimates that variable costs are equal to 50 of sales and fixed costs are 250000 per year Sales forecasts in dollars are below The project will come to an end after 4 years when the product becomes obsolete The firm s tax rate is 35 percent and the required return on capital is 9 percent Calculate the NPV Year 0 1 2 3 4 Sales forecast in 0 1800000 2000000 2300000 2100000 Teaquot quot1 1 23 iiihe 1ne1guIi39ve 1F1 iiUE1 Aquot Fiiiwu 3553quoti5 el39iinveslme1n1 P o p n pis G t m spein1di39ing meiney In CF invest in xed ao 0 01 buy m5eI5 E Working 1Iapita W1n1rki n 1ap1ita 1010001 200000 230000 131011 1 211000 gt 12010101 Change In w1n1r1zln 1laIi1ta 101000 20000 3 I 10 bj inveet in wk eap1ita 100001 11 1D11e1ratin1ne Re1ve1nue1s 0 180000 1100000 2000000 uiaria1 Guists 1010000 1200000 Fixed Gnets 25010001 25010001 De1pr ciLati1u n a menu e um T1 T Ff39EEi l9E 3 Pmtax pml t 1 Preiux preiili Tiat F39I390 111Ell1quot1e1iquot39i39IZ1X IIe1prre ci11quotriien Pm t after tax Gash Ilnrw frem 1n1pe1reti1u1ns D1 Pameet araluati1o1n T0ta p1r1I1je39t i39Q 139Sh 1Iu39w 1 0010001 41 G EF from iiw esirmenir werkfing ep i139ell eperuiinnei iii l3l3lItCLlIl3I39i39E irhe N1P uiquot yreu musi BRING B QCiK each Cl ll h ew vnllue ire irime perierdl Q ilquot1en sum ll ei irhe values up 0 Depreciation is calculated by dividing 1500000 by 4 years Differences between accounting profit and economic profit 0 Economic profit usually take into account the following o Depreciation 0 Time value of money 0 Economic profit is a more realistic assessment of the company 0 For breakeven when taking the economic profit the company needs to sell more units to breakeven as compared to taking the accounting profit Equivalent Annual Annuitv PV The formula for EAA method is EAA Annuity Given 2 machines select the lower cost machine using equivalent annual annuity method Capital cost is 6 Machine F costs more but lasts longer Machine G Costs less but does not last as long Co st Time period 1 2 3 0 Machine F 15 4 4 4 Machine G 10 6 6 machine spoiled Step 1 Bring back each year to time period 0 to find PV Step 2 Find the annuity using the formula Step 3 Divide the PV by Annuity 1r fPl 39j 1 l11 C C E jr11139I1J Erie11 il11nrtrrity C 1151 Flatt 5quot1fPl 39 Net 39E IESETii39 iquot li rf1ltrE 1 39I39 t JZ IE petquot petn nril 11quot 39 EE E ii391l3IE39 cf ae11 sac1Es Calculating Present Values don t forget the negative signs 5 U m 392 Pericld EaChm F1 5110 W 51 merited lmh achunle G 1nu u 1 3 1 2 2 3 SUM sum 21uu Calculating the EAA Fur Mc1ir1e1F c1 at225s 1 j1 s1 1951 Use the same formula for Machine G and you will get 114544 You will see that Machine F is the better machine Market Efficiency Theory 0 Weak form the market is based on past occurrences I Semi strong the market is based on Strong market based The market is usually semi strong when there is a reaction after a piece of news is announced 0 Ifthere is a reaction the reaction is announced such as price increase it means that it is not consistent with semi strong and that the company is doing some INSIDER trading before releasing the information out I For the semi strong theory there could be NO reaction when ANALYSTS HAVE ALREADY EXPECTED THE PRICE to increase decrease 0 Whenever you see an increase in price and it falls down to its initial closing price of the previous day it is consistent with the semi strong theory only when at some point of the day another piece of information is revealed to bring the price down Sample Test 2 11 part 1 The following arise out of a new project X implemented by YT Inc Which of the following does not represent a cash flow that should be taken into account for capital budgeting purposes a a decrease in income taxes paid to the government because of expenses of project X b increase in electricity usage because of new machinery c an increase in sales of a related YT Inc product caused by project X d all of the above should be taken into account All need to be taken account because they are part of operational cash flows where revenue and expenses must be taken into account Lower taxes paid will decrease expenses Increase in electricity increases expenses Increase in sales increases the revenue A point to note is that all expenses and revenue is because of Project X If there are increase because of another Project Y or something it should not be taken account We don t count stuff like salary of the president because he will still be paid with or without the project 2 Jon is conducting a capital budgeting analysis using NPV for a major expansion of his company He is concerned because there is a lot of uncertainty about what the market conditions will be for his product the next few years Jon has decided to use his best estimate for the revenue even though there is a lot of uncertainty Is this the correct way to handle uncertainty in an NPV analysis a No he should use worst case estimates for cash flows if there is a lot of uncertainty b No NPV analysis requires the use of best case scenario cash flows c Yes because increased uncertainty is accounted for in an NPV analysis through a higher discount rate d It doesn t matter what cash ows Jon uses as he will get the same NPV NPV involves the usage of discount rate hence it is the best choice 3 In which of the following investments is an investor expected to earn the most over a 40 year period A Er 1 and o 100 B Er 0 and o 25 C Er 2 and 6 10 Explain your answer 6 points Choice B is expected to earn 0 over the long run and Choice C is expected to lose money so Choice A has the highest expected return 10000 will grow to 10000 1012quot under A Through the expectation that we will earn a little bit every time we invest C is not an option because it has a negative expected rate of return Standard deviation sort of counts the risk involves The lower the standard deviation the lower the risks This means that it takes longer for you to lose money However in the long run the longer you play the more you lose Because B has zero expected returns the investor will break even in the long run A is the best choice because it is the only one which has a positive expected rate of return even if the standard deviation shows that it has high risks If we have to calculate the expected returns remember professor said that the question won t be exactly the same It could be calculations too Calculation lpercentage4quot To the power of 40 because it is in time 40 A l00l4quot THIS SHOWS THAT A HAS THE HIGHEST VALUE B 104 C 1 002 In terms of calculation 4 Mark each statement about capital budgeting as true or false 2 points each Ta If a company accepts a project with a positive NPV the value of the company increases by the NPV Tb The IRR decision rule will give the same answer as the NPV decision rule for projects where none of the aws with IRR are present Fc The payback method is not used as often as NPV because it is more difficult to calculate payback C is false because it is extremely easy to calculate payback 5 AGG Inc s earnings are very dependent on the economy They have high earnings when the economy is booming and large losses in recessions Which is E true about the company a the company has a B greater than 1 b the company has no unique risk c an investor in the company can diversify some of the company s overall risk d the company has high market risk Beta captures the market risk If you have a higher Beta usually more than 1 then they have a higher risk that is dependent on the market Example is automotive companies because not many will buy cars when there is a recession The company actually has high market risk too they mean the same in this question As for choice C investors can cancel out some risks by purchasing a few stocks at the same time to hope that returns from one stock will be able to cover losses from another stock All companies has 2 types of risk a Market risk risk you cannot get rid of Beta only calculates the market risk b Unique risk firm specific risk where all firms HAVE unique risk related to their products in comparison to the competitors All companies have products and competitors The way you can diversify this risk is by buying two competitor companies 6 You are analyzing the stock of a Hollywood movie studio You find that the company has a high standard deviation of stock returns which means it has high overall risk But when you calculate beta you find 3 8 Is it possible to have high overall risk and low market risk Explain 6 points Yes because a company39s overall risk is made up of rm specific risk and market risk Beta measures only the market risk of the company Movie studios have high rm speci c risk because their individual movies are big hits or misses But much of this risk can be diversi ed away leaving a beta lower than the market beta of 1 7 Using estimates for ERm and Rf based on our discussions in class as to what is reasonable if the Neptune Company has 3 11 what is an appropriate estimate for the Er next year under CAPM 6 points Show your estimates and calculation Appropriate estimates in today39s market are Rf 1 and ERm 9 If B 11 then an appropriate estimate for Er 01 110901 098 For this question the reasonable expected return is close to 7 So your answer be close to 76 to 8 In the discussion in class it is said that the risk free rate is usually very low close to zero Hence whatever number you choose for risk free rate make sure that you add 75 to 8 to get the ERm Because expected return ERm Rf 8 An investment project costs 250 in time 0 and has the following payouts C1 75 C2 125 C3 100 and C4 100 The cost of capital for the firm is 13 Which of the following is the formula for NPV a 250 75113 1251132 1001133 1001134 13 250 75113 1251132 1001133 1001134 c 0 250 7511 125112 100113 10011 and solve for r d 250113 751132 1251133 1001134 1001135 This question is very straightforward All you need to do is plug into the NPV formula Just be careful of the information given The 4 quot year there is a negative cash flow That is the difference between the choices of A and B 9 Sensitivity analysis is useful to NPV calculations because a It shows which individual assumptions are the most crucial b It shows how bad things will be if several bad events occur at the same time c It shows where there are mistakes in the calculation d None of the above B is scenario analysis Analysis does not show mistakes in calculation 10 The cash ows for a project are as follows initial cost of 2000000 C1 200000 C 800000 C3 1200000 C4 2000000 C5 3000000 If the company uses the payback method with a three year payback should they accept the project Explain 6 points After three years the cash received is 200000 800000 1200000 1800000 which is less than the 2000000 initial cost so the project should not be accepted because it does not pay back within three years 1 1 A proposed investment will cost 600000 in year 0 It will have a life of 4 years and the cost will be depreciated using straight line to a zero salvage value The company expects revenues of 500000 in time 1 and 600000 in time 2 The variable cost is 50 of revenues and the fixed costs will be 50000 Working capital is 10 of next year39s revenues If taxes are 35 What is the incremental cash flow for year 1 Show your calculations 10 points Change in working capital 600000 X 10 60000 year 1 and 50000 year 0 Cash flow from working capital 10000 PreTax Income 500000 250000 vc 50000 FC 150000 Depr 50000 Tax 50000 x 35 17500 Operating Cash Flow 50000 17500 32500 Combined Cash Flow 32500 150000 Depr 10000 172500 Possibility that this will come out in the test Refer above to see method on how to calculate 12 Assuming you have the per unit data for question 11 if you calculate the accounting break even and the economic breakeven which will require the sale of more units a the economic breakeven because the depreciation calculation under the accounting breakeven is too low if the time value of money is considered b the accounting breakeven because Generally Accepted Accounting Principles GAAP are conservative c both give the same breakeven d none of the above is true Economic break eVen takes time Value into consideration it is also more realistic Usually breakeven point is higher in economic compared to accounting 13 If investors in the market are expecting that quarterly earnings of BC will be 25 below last year s earnings draw a graph indicating the market reaction to the announcement by the company that its quarterly earnings tumed out to be 20 below last year s eamings Assume semi strong market efficiency 6 points This is good news because earnings did not fall as far as expected The market reaction should be a quick increase after the announcement followed by a at line Note your graph should show when the announcement occurred This should be good news because the company did not do as badly as expected 3 I I I I H I I I I 2 1l 0 ll 2 H1 day nws was reload 14 If the actual return over the last year was 72 and the dividend yield was 12 which of the following is the percentage capital gain a 6 b 84 c 6 d 84 Percentage capital gain Actual return Dividend yield This is the turnaround of the formula Actual Return Percentage Capital gain Dividend yield 15 Which of the following is not true about methods of capital budgeting a a discount rate is required to calculate IRR b NPV is generally preferred over the payback method because NPV includes discounting for the time value of money c the payback method ignores cash flows after the cutoff period d all of the above are true IRR does not take into account discount rate just cash flows IRR PVAnnuity No discount rate 16 The company is considering a new project that costs 1 million in time 0 If the cash flows from the project are 200000 per year for years 1 10 and the discount rate is 8 calculate the NPV of the project using the following annuity table 6 points time periods 9 l0 1 1 interest rate 8 6247 6710 7139 NPV 1000000 200000 X 6710 342000 Only use the annuity factor for 10 years Don t use 9 or 11 It s a trick The present value for 10 years 200000Annuity factor 6710 Then we have to add the cost of the project into the PV 17 Some analysts have argued that stock prices follow trends in public culture One example is that the stock market is said to go up throughout the first year a new President takes office and decrease throughout the last year a President serves in office Is this trend consistent with market efficiency in the semi strong form Explain your answer 6 points As the timing of when a President is elected and leaves office are known under the semi strong form of market efficiency there should not be any predictable increases or decreases in the market at the beginning of the term or at the end So this trend violates market efficiency theory in the semistrong form 18 ABC stock sells today for 30 You expect that one year from now one of four outcomes will occur with the following probabilities and prices there is a 20 chance P 15 a 50 chance P36 and a 30 chance P60 What is the expected return on the stock over the neXt year if you invest today Show your work 6 points Er 2 X 153030 5 X 363030 3 X 603030 30 Just plug in the values into the formula 19 You have purchased a portfolio of equal investments in 4 stocks XYWZ that have the following B39s Bw l BX 5 By 75 32 8 Which is true about your portfolio a The portfolio will have a beta equal to the market beta because of the diversification b The portfolio beta is the average of the individual stock betas c The portfolio does not reduce the overall risk of the individual stocks d None of the above is true The more stocks we buy the lower the risks because the stocks cancel each other s risk out However there are still some market risks which cannot be get rid of Investors will only care about the market risk which is represented through the Beta value To calculate portfolio beta just take the average of the individual stocks Portfolio will reduce the overall risk that is the unique risk through diversification gimme Version 2 am mg 1 Plasma Inc is considering expanding production to build a new television XScreen The CEO is concerned that the new television will reduce sales of the current models Does the capital budgeting process we learned in class address the CEO s concern a Yes because the discount rate is increased to reflect the effect of lost sales b No because the sales of the other television are not an incremental cash flow c No because each product should be evaluated separately 1 None of the above is correct 2 Anthony has earned actual returns of 7 12 and 11 over a three year period on an investment During the same time period the return on the market was 10 5 12 Applying finance theory we learned in class mark the following as true or false 2 points each aT The beta of the investment is most likely less than 1 bT A negative actual return during one year means the expected return on the investment must have been gt 0 for that year cF The actual return on the market each year is the same as the expected return on the market at the beginning of each year 3 You currently own only a single stock that has 3 5 If you form a portfolio by buying another stock with 3 5 are you reducing the expected level of overall risk in your portfolio a No because the portfolio still has a 3 5 b No because all stocks have risk and you can only reduce risk by adding a bond c Yes because the second stock will cancel out some of the variation in the first stock d Yes because the portfolio will now have a 3 25 4 A publicly traded company has discovered a new battery that has double the life of any competitor39s battery The new discovery has not yet been announced to the public Two days i the company makes the public announcement one of the scientists at the company brags about the discovery to his friends and relatives If the market follows the semi strong form of market efficiency draw a graph showing the stock price of the company from the period three days before the announcement to three days after 6 points Clearly mark the days on your graph You should chart 3 days before the day of the announcement and 3 days after on the horizontal axis and the stock price on the vertical axis In the three days before there will some increase in price due to the news leaking out then the remainder of the price increase due to the announcement will happen immediately when markets open on day 0 For the three days after the announcement the stock price should remain flat 5 Mark each statement about capital budgeting as true or false 2 points each aT Scenario analysis is a useful Way to calculate how NPV will change if you change several assumptions at the same time bF NPV analysis does not require a discount rate cF If a project is accepted under the payback method that means it will also be accepted under the IRR method 6 You are interested in buying a stock that has a price of 32 You have projected that next year there is a 15 probability the stock will equal 5 a 35 probability the stock will equal 28 and a 50 probability the stock will equal 50 What is the expected return on the stock if you buy today and sell next year 6 points Er p1r1 pzrg y pnrn Er 15 x 53232 35 x 283232 5 x 503232 Er 1109 or 1109 7 A proposed investment will cost 1000000 in year 0 It will have a life of 4 years and the cost will be depreciated using straight line to a zero salvage value For year 1 the company expects sales of 45000 units at 17 each The variable cost is 10 per unit and the fixed costs will be 150000 Working capital in year 0 is 100000 and this increases to 130000 in year 1 If taxes are 35 what is the incremental cash ow for year 1 Show your calculation 8 points Change in net working capital time 1 130000 100000 30000 cash ow from net working capital time 1 30000 depreciation 10000004 250000 Cash ow from operations 45000 X 17 45000 X 10 150000 250000 85000 Assuming no tax due to the loss cf from operations 85000 250000 165000 Overall incremental cash flow year 1 165000 30000 135000 8 In question 7 will the accounting breakeven or the economic breakeven give a higher number of units Explain your answer 6 points The economic breakeven will give a higher number of units because the accounting breakeven spreads the initial cost of the project over time without considering the time value of money Hence the depreciation charge in the accounting breakeven will be too low and the accounting breakeven will occur at a point where the NPV is negative 9 If stock XYZ paid a dividend of 1 last year and the dividend yield was 2 What was the stock price at the beginning of the year a 50 b 20 c 10 C1 1 10 The estimated standard deviations for stocks A and B are ox 25 og 35 Under finance theory which stock has a higher expected return Explain 6 points Under nance theory the expected return on a stock depends only on the market risk of the stock not the overall risk CAPM says that stocks with higher betas which measures market risk will have higher returns In this example the standard deviation measures overall risk which does not directly translate into market risk Hence more information about beta is required to determine which stock has a higher expected return 11 If the Neptune Company has an expected return 12 under CAPM the expected Rm is 10 and the risk free rate is 1 What is the beta of Neptune Show your calculation 6 points ERi RF I3i ERM RF 12 01 i10 01 Bi 122 12 While markets were closed a company announced that its earnings were 20 higher than last year39s earnings When markets opened the company39s stock started trading at a level 10 i the previous day39s closing trade How can this result be explained if markets follow se1ni strong form market efficiency a it takes time for investors to realize that higher earnings are good news so the decrease will eventually turn into an increase b before the announcement investors were expecting earnings to go up more than 20 c the company has a high beta which can lead to unusual stock price changes d this result cannot be explained under semi strong form market efficiency 13 If students were asked to pick either 2 stocks or 10 stocks in a stock picking contest which of the following is 17 a the student in first place will most likely have chosen 2 stocks b the student in last place will most likely have chosen 10 stocks c if a student picks 2 stocks in the same industry there will still be some diversification d all of the above are true 14 Which of the following is not true concerning the IRR method of capital budgeting a the IRR includes cash flows after the payback method cutoff period b the IRR calculates the discount rate where NPV 0 c if you make changes to the cash ows in your capital budgeting estimates the estimated IRR will probably not change d all of the above are true 15 AGG Inc s earnings are very dependent on the economy They have high earnings when the economy is booming and big losses in recessions Which is J a the company has high market risk b the company has no unique risk c the company has a 3 greater than 1 d an investor in the company can diversify some of the company s overall risk 16 An investment project costs 1000000 in time 0 and has the following cash flows C1 250000 C2 300000 C3 400000 C4 500000 C5 600000 C5 700000 a Set up the calculation to find the discount rate where this project has NPV 0 6 points 0 1000000 2500001r 300000112 400000x113 500000114 6000001r5 700000116 Solve for r b If you use the payback method with a payback cutoff of four years which statement is true i The project should be accepted because it pays back more than the initial cost ii The cash flows in time 1 and time 2 can be ignored because they are negative iii The cash ows in time 5 and time 6 can be ignored because they are after the cutoff iv None of the above is true 17 In conducting sensitivity analysis for an NPV analysis with five key assumptions which of the following is true a All five assumptions should be varied at the same time to show the best case and WOI39St C336 SC6I1Ell39lO b If some assumptions seem too optimistic then the worst case scenario should be chosen as the correct NPV c Management should automatically reject a project where sensitivity analysis shows there is a small chance of having a negative NPV d None of the above is true 18 The company is choosing between machine A and B they are mutually exclusive and the company can only pick one The initial cost of machine A is 1000000 and it will last for 6 years before it needs to be replaced The cost of operating machine A each year is 100000 The initial cost of Machine B is 700000 and it will last for 4 years before it needs to be replaced The cost of operating machine B is 150000 in cash flow per year If the discount rate is 9 and the annuity factors are as follows Annuity factors 9 3years 4years Syears 6years 7years 2531 3240 3890 4486 5033 which machine is preferred using the equivalent annuity method Show your calculation 8 points PVA 1000000 100000 X 4486 1448600 PVB 700000 150000 x 3240 1186000 EAAA 1448600 4486 32291574 Machine A is preferred EAAB 1186000 3240 36604938
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