Final Quiz Review

savannahstate.edu/misc/dowlingw/3155/Practice%20Exams/quiz_3_review.htm

1.

Which of the following bonds is supported by collateral?

a.

unsecured bonds

b.

income bonds

c.

equipment trust certificates

d.

debentures

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

2.

Interest is exempt from federal income taxation on

a.

equipment trust certificates

b.

zero coupon bonds

c.

federal bonds such as savings bonds

d.

state of Florida bonds

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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3.

If a company fails to meet the terms of the indenture, it is

a.

bankrupt

b.

in default

c.

profitable

d.

in registration

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

4.

Debt instruments subject their owners to risk from

1.

loss of purchasing power

2.

higher credit ratings

3.

default

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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5.

If interest rates decline after a bond is issued,

a.

the bond's coupon is decreased

b.

the bond's price falls

c.

the yield to maturity will exceed the current yield

d.

the current yield will exceed the yield to maturity

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

6.

Which of the following bonds is supported by collateral?

a.

convertible bonds

b.

income bonds

c.

equipment trust certificates

d.

debentures

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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7.

A convertible bond's value as stock depends on the

1.

current rate of interest

2.

number of shares into which is convertible

3.

price of the stock

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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8.

The price of a convertible bond is often

1.

greater than its value as stock

2.

less than its value as stock

3.

greater than its value as debt

4.

less than its value as debt

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

9.

The value of a convertible bond as stock depends in part upon

a.

interest rates

b.

the maturity date

c.

the exercise price

d.

the call penalty

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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10.

Realized returns by mutual funds

a.

tend to outperform the market

b.

are usually retained to finance growth

c.

exceed realized losses

d.

are generally distributed

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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11.

Costs associated with investing in mutual funds include

1.

management fees

2.

taxes on unrealized profits

3.

brokerage commissions when the investor sells the shares

4.

load charges

a.

1 and 3

b.

1 and 4

c.

2 and 3

d.

2 and 4

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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12.

The shares of mutual funds are bought

a.

in the secondary markets

b.

from closed-end investment companies

c.

from commercial banks

d.

from the mutual fund

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

13.

No load mutual funds

a.

have no selling fees

b.

pay no cash dividends

c.

have no administrative expenses

d.

have a fixed portfolio

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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14.

Owners in which of the following forms of business have unlimited liability?

a.

LLCs

b.

corporations

c.

sole proprietorships

d.

limited partnerships

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

15.

Variable costs
a.

are greater than fixed costs

b.

are greater than total costs

c.

are paid after fixed costs

d.

change with the level of output

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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16.

A union contract suggests that labor costs may be

a.

variable

b.

fixed

c.

a non-cash expense

d.

undetermined

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

17.

Retained earnings
a.

have no cost

b.

are the firm's cheapest source of funds

c.

have a cost that equals the cost of capital

d.

are cheaper than the cost of new common stock

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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18.

The optimal capital structure involves

a.

maximizing the cost of all funds

b.

minimizing the cost of all funds

c.

using no financial leverage

d.

minimizing the weighted average of the cost of funds

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

19.

Preferred stock increases common stockholders' return

a.

more than an equal dollar amount of debt

b.

less than an equal dollar amount of debt

c.

more than an equal dollar amount of retained earnings

d.

less than an equal dollar amount of retained earnings

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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20.

The marginal cost of capital

a.

is the firm's cost of debt and equity finance

b.

is constant given an optimal capital structure

c.

declines as flotation costs alter equity financing

d.

refers to the cost of additional financing

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

21.

The internal rate of return will be higher if

a.

the cost of capital is lower

b.

the cost of capital is higher

c.

the cost of the investment is lower

d.

the cost of the investment is higher

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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22.

The net present value will be larger if

a.

the cost of capital is higher

b.

there is no salvage value

c.

the cost of the investment is lower

d.

the firm uses straight-line depreciation

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

23.

Risk may be incorporated into capital budgeting by

1.

increasing an investment's internal rate of return by a risk premium

2.

adjusting the cash flows by the probability of occurrence

3.

increasing the cost of capital by a risk premium

a.

1 and 2

b.

1 and 3

c.

2 and 3

d.

1, 2, and 3

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

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24.

The internal rate of return will be higher if

a.

the cost of capital is lower

b.

the cost of the investment is higher

c.

the cost of the investment is lower

d.

the cost of capital is higher

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

25.

A firm should not make an investment if the internal rate of return is

a.

greater than the cost of capital

b.

less than the cost of capital

c.

greater than the interest rate

d.

less than the interest rate

ANSWER:

POINTS:

0/1

FEEDBACK:
REF:

Problem

26.

A bond has the following terms:

principal amount

$1,000

semi-annual interest

$50

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maturity

10 years

a.

What is the bond's price if comparable debt yields 12%?

b.

What would be the price if comparable debt yields 12% and the bond matures after five years?

c.

What are the current yields and yields to maturity in a. and b.?

d.

What would be the bond's price in a. and b. if interest rates declined to 8%?

e.

What are the current yields and yield to maturity in d.?

f.

What two generalizations may be drawn from the above price changes?

RESPONSE:
ANSWER:
a.

P = interest(PV of an annuity at 6% for 20 periods)

+ principal (PV of $1 at 6% for 20 years)
= $50(11.470) + $1,000(.312) = $885

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

PV = -885.)

b.

P = $50(7.360) + $1,000(.558) = $926

(PV = ?; I = 6; N = 10; PMT = 50, and FV = 1000.

PV = -926.)

c.

Current yield

Yield to maturity

in a:
$100/$885 =
11.3%

12%

in b:
$100/$926 =
10.8%

12%

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Notice that the yield to maturity is the yield on the comparable debt. Students
may confirm this by calculating the yield to maturity.

d.

Price at 4% for 20 periods:

P = $50(13.590) + $1,000(.456) = $1,136

(PV = ?; I = 4; N = 20; PMT = 50, and FV = 1000.

PV = -1136.)

Price at 4% for 10 periods:

P = $50(8.111) + $1,000(.676) = $1,082

(PV = ?; I = 4; N = 10; PMT = 50, and FV = 1000.

PV = -1081.)

e.

f.

POINTS:

Current yields

Yield to maturity

a:
$100/$1,136
= 8.8%

8%

b:
$100/$1,082
= 9.2%

8%

(1)

The inverse relationship between bond prices and current interest

rates: when interest rates fall (12% to 8%), the price of the bond rises.

(2)

The longer the term of the bond (ten versus five years), the greater is
the price fluctuation.

-- / 1

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27.

REF:
You purchase a bond for $875. It pays $80 a year (i.e., the semiannual coupon is 4 percent), and the bond
matures after ten years. What is the yield to maturity?

RESPONSE:
ANSWER:

The yield to maturity equates the present value of the interest payments and principal
repayment. In this problem, that rate is 10%:
($40)(12.462) + ($1,000)(0.377) = $875.48.
(PV = -875; I = ?; N = 20; PMT = 40, and FV = 1000, I = 5 per period or 10 annually.)

POINTS:

-- / 1

REF:

28.

Determine the current market prices of the following $1,000 bonds if the comparable rate is 10 percent
and answer the following questions.
XY 5 1/4 percent (interest paid annually) for 20 years
AB 14 percent (interest paid annually) for 20 years
a.

Which bond has a current yield that exceeds the yield to maturity?

b.

Which bond may you expect to be called? Why?

c.

If CD, Inc. has a bond with a 5 1/4 percent coupon and a maturity of 20 years but which was lower
rated, what would be its price relative to the XY, Inc bond? Explain.

RESPONSE:

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ANSWER:

Price of the XY, Inc. bond:

(PV = ?; I = 10; N = 20; PMT = 52.50, and FV = 1000, PV = -596.)
Price of the AB, Inc. bond:
(PV = ?; I = 10; N = 20; PMT = 140, and FV = 1000, PV = -1341.)
The current yields are

POINTS:

a.

The current yield of the AB, Inc. bond exceeds the yield to maturity (10.25%
versus 10%) because the current yield does not consider the loss of the
premium the investors will suffer over the lifetime of the bond.

b.

There is no reason to expect the firm to call the XY bond, because the firm
could repurchase the bonds at a discount. The AB bond, however, may be
called. Current interest rates are lower (10% versus the 14% coupon on that
bond), so the firm could refund the debt. (The instructor should ask what
impact the expectation of such refunding may have on the price of the bond.)

c.

Since the CD and XY bonds are identical with regard to interest paid and term
to maturity, the factor that differentiates them is the credit rating. The CD bond
has a lower credit rating, so its value relative to the XY bond should be less.
Such a lower price will increase the yield to the investor and presumably
would be necessary to induce the investor to purchase the riskier bond.

-- / 1

REF:
29.

An investor buys a $1,000, 20 year 7 percent (interest paid semiannually) bond at par. After five years have
passed, interest rates are 10 percent. How much did the investor lose on the purchase of the bond?

RESPONSE:
ANSWER:

Price of the bond with 15 years (30 time periods) to maturity:

(PV = ?; I = 5; N = 30; PMT = 35.50, and FV = 1000, PV = -777.10.)
Since the investor purchased the bond for $1,000, the loss is $1,000 - $776 = $224.

POINTS:

-- / 1

REF:

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30.

A firm has the following preferred stocks outstanding:

PFD A:

$40 annual dividend; $1,000 par value;

no maturity

PFD B:

$95 annual dividend; $1,000 par value;

maturity after twenty-five years

If comparable yields are 9 percent, what should be the price of each preferred stock?

RESPONSE:
ANSWER:

Price of PFD A: $40/.09 = $444

Price of PFD B: $95(9.823) + $1,000(.116) = $1,049
(9.823 is the interest factor for the present value of an annuity of $1 at 9 percent for
twenty-five years, and .116 is the interest factor for the present value of $1 at 9
percent for twenty-five years.)
(PV = ?; N = 25; I = 9; PMT = 95; and FV = 1000. PV = 1049.)
Point out the inverse relationship between interest rates and changes in the prices of
preferred stock. Stock A's price declined since the dividend yield (based on the par
value) is 4 percent. Stock B's price rose, since its yield (based on the par value) is 9.5
percent.

POINTS:

-- / 1

REF:

31.

Given the information below, answer the following questions.

A convertible bond has the following features:

a.

Principal

$1,000

Maturity date

20

years

Interest

$80

(8% coupon)

Call price

$1,050

Exercise price

$65

a share

The bond may be converted into how many shares?

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b.

If comparable non-convertible debt offered an annual yield of 12 percent, what would be the value
of this bond as debt?

c.

If the stock were selling for $52, what is the value of the bond in terms of stock?

d.

Would you expect the bond to sell for its value as debt (i.e., the value determined in b) if the price of
the stock were $52?

e.

If the price of the bond were $960, what are the premiums paid over the bond's value as stock and
its value as debt?

f.

If the price of the stock were $35, what would be the minimum price of the bond?

g.

What is the probability that the bond will be called when the price of the stock is $52?

h.

If the price of the stock rose to $73, what would happen to the price of the bond?

i.

If the price of the stock were $73, what would the investor receive if the bond were called?

RESPONSE:
ANSWER:
a.

Number of shares: $1,000/$65 = 15.385 shares

b.

Value of the bond as debt (assuming annual payments):

$80(7.470) + $1,000(.104) = $701.60

(PV = ?; N = 20; I = 12; PMT = 80, and FV = 1000.

PV = -701.22.)

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c.

Value of the bond as stock: 15.385 $52 = $800

d.

The bond would not sell for $701.60 but for at least $800, its value as stock.

e.

Premium over its value as stock: $960 - $800 = $160

Premium over its value as debt: $960 - $701.60 = $258.40

POINTS:

f.

If the price of the stock were $35, the value of the bond as stock would be $35
15,385 = $538.48. The bond would sell for at least its value as debt
($701.60).

g.

The value of the bond as stock would be $800. No one would convert the
bond if it were called; they would accept the call price instead ($1,050). Thus
there is no reason to expect the firm to call the bond.

h.

The value of the bond as stock is $73 15.385 = $1,123.11; the bond's value
would rise to at least $1,123.11.

i.

Since the bond is worth $1,123.11 in terms of stock, the holders would convert
the bond. If they did not convert the bond, they would suffer a loss as they
would receive only the call price ($1,050).

-- / 1

REF:

32.

Using the corporate tax rates given in the text (p. 345), what is the corporate income tax paid on earnings
of (a) $1,000, (b) $10,000, (c) $100,000, (d) 1,000,000, and (e) 10,000,000?

RESPONSE:

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ANSWER:
a.

for $1,000: ($1,000)0.15 = $150

b.

for $10,000: ($10,000)0.15 = $1,500

c.

for $100,000: ($50,000).15 + (25,000).25 +

25,000(.34) = $22,250

d.

for $1,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(235,000).39 + (665,000).34 = $340,000

e.

for $10,000,000:
($50,000).15 + (25,000).25 + 25,000(.34) +
(335,000).39 + (665,000).34 + (9,000,000)x.34 =
$3,400,000

POINTS:

-- / 1

REF:

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33.

Given the following information, answer the following questions.

TR = $3Q
TC = $1,500 + $2Q
a.

What is the break-even level of output?

b.

If the firm sells 1,300 units, what are its earnings or losses?

c.

If sales rise to 2,000 units, what are the firm's earnings or losses?

d.

If the total cost equation were

TC = $2,000 + $1.80Q,
what happens to the break-even level of output units?

RESPONSE:

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ANSWER:
a.

Break-even level of output:

$1,500/($3 - $2) = 1,500 units

b.

Earnings

= $3Q - $1,500 - $2Q

= $3(1,300) - 1,500 - 2(1,300) = ($200)

c.

Earnings

= $3Q - $1,500 - $2Q

= 3(2,000) - 1,500 - 2(2,000) = $500

d.

Break-even level of output:

$2,000/($3 - $1.80) = 1,667 units

POINTS:

-- / 1

REF:

24/37

34.

Given the following information, what happens to operating income and net income if output is increased
by 10 percent? Verify your answer.
Total assets

$100,000

Debt (12% interest rate)

$80,000

Equity

$20,000

Variable costs of production

$14 per unit

Fixed cost of production

$27,000

Units sold

12,300

Sale price per unit

$19.75

RESPONSE:
ANSWER:

The operating income:

Revenues: $19.75(12,300) = $242,925
Expenses: $14.00(12,300) + $27,000 = $199,200
Operating income: $242,925 - 199,200 = $43,725
Net income: $43,725 - (.12)(80,000) = $34,125
Operating income rose from $43,725 to $50,797.50 for a 16.2 percent increase.
Net income rose from $34,125 to $41,197.50 for a 20.7 percent increase.

POINTS:

-- / 1

REF:

35.

(This is a simple problem that replicates the example in the chapter.) A firm needs $100 to start and
expects
Sales

$200

Expenses

$185

Tax rate

33% of earnings

a.

What are earnings if the owners invest the $100?

b.

If the firm borrows $40 of the $100 at any interest rate of 10%, what are the firm's net earnings?

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c.

What is the return on the owners' investment in each case? Why do the returns differ?

d.

If expenses rise to $194, what will be the returns in each case?

e.

In which case did the returns decline more?

f.

What generalization can you draw form the above?

RESPONSE:
ANSWER:
a.

and b.

Sales

no financial

with financial

leverage

leverage

$200

$200

185

185

Expenses
EBIT

15

15

Interest

EBT

15

11

Taxes

c.

Net earnings

10

Return on equity

$10/$100 = 10%

3.63
$

7.37

$7.37/$60 = 12.28%

The return for b is higher because of the successful use of financial leverage.
(Point out that operating income is 15% of assets versus the 10% interest rate
and the reduction in taxes that results from the interest expense.)

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d.

Sales

no financial

with financial

leverage

leverage

$200

$200

194

194

Expenses

POINTS:

EBIT

Interest

EBT

Taxes

0.66

Net earnings

Return on equity

$4/$100 = 4%

1.34

$1.34/$60 = 2.23%

e.

The return on equity fell more for the firm that was financially leveraged.

f.

The generalization is that the use of financial leverage to increase the return
on equity works both ways. If revenues fall and/or expenses rise, the use of
financial leverage will magnify the swing in the firm's return on equity.

-- / 1

REF:

36.
a.

Given the following schedules,

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cost of

cost of

debt/assets s

debt

equity

0%

7%

14%

10

14

20

14

30

14

40

16

50

10

18

60

12

20

What is firm's cost of capital at the various combinations of debt and equity?

b.

What is the firm's optimal capital structure? Construct a balance sheet showing that combination
of debt and equity financing.

Balance Sheet for Firm as of XX/XX/XX

Assets

$100

Debt
Equity
$100

c.

If the firm earns $10 on every $100 of assets, will the stockholders receive more or less than their
required rate of return if the firm uses its optimal combination of debt and equity financing?

d.

If the above cost of equity is the cost of retained earnings, what happens to the cost of capital if
the cost of new shares is one percentage point higher at the firm's optimal capital structure?

e.

If the firm has retained earnings of $1,500,000, what is the cost of capital at the optimal capital
structure if the firm needs $2,000,000?

28/37

RESPONSE:
ANSWER:
a.

Determination of cost of capital:

= weight cost of debt + weight cost of equity

= .0(.07) + 1(.14) = 14.00%
= .1(.07) + .9(.14) = 13.30
= .2(.07) + .8(.14) = 12.60
= .3(.08) + .7(.14) = 12.20
= .4(.08) + .6(.16) = 12.80
= .5(.10) + .5(.18) = 14.00
= .6(.12) + .4(.20) = 15.20

b.

The optimal capital structure is 30% debt and 70% equity.

The balance sheet is

Balance Sheet for Firm as of XX/XX/XX

Assets

$100

Liabilities
Equity

$ 30
70
$100

c.

If the firm earns $10 on every $100 of assets (i.e., 10% on assets), the
stockholders will not receive their required return of 14%. With 30% debt
financing, $2.40 must go to creditors ($30 .08 = $2.40), which leaves $7.60
for stockholders ($10 - 2.40). Since the stockholders have invested $70, they
earn a return of 10.86% ($7.60/$70).

For the stockholders to earn their required return, the firm must earn at 12.2%.
Then the firm can pay the creditors $2.40 and have sufficient left over ($9.80)
so that the stockholders earn the 14% required rate of return (i.e., $9.80/$70 =
14%).

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d.

If the cost of new equity rises to 15 percent, the cost of capital at the optimal
capital structure becomes:
.3(.08) + .7(.15) = 12.90.

e.

If the firm has retained earnings of $1,500,000, the breakpoint in the marginal
cost of capital schedule is
$1,500,000/.7 = $2,142,857.

The cost of capital from $0 - $2,142,857 is 12.2%.

The cost of capital above $2,142,857 is 12.9%.

The cost of $2,000,000 is 12.2 percent. The cost of the next $2,000,000 is
$142,857 at 12.2 percent and $1,857,143 at 12.7 percent.

POINTS:

-- / 1

REF:

37.

The firm's cost of debt is 8 percent, and the cost of retained earnings is 14 percent. However, if the firm
exhausts its retained earnings of $23,678, the cost of equity rises to 14.9 percent. Currently management
believes that the firm's current combination of 35 percent debt and 65 percent equity is the optimal capital
structure.
a.

What is the firm's cost of capital if it uses only retained earnings?

b.

What is the firm's cost of capital if it uses new equity?

c.

How much total financing may the firm have before the marginal cost of capital rises?

RESPONSE:

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ANSWER:
a.

The cost of capital using retained earnings:

(.35)(.08) + (.65)(.14) = 11.9%

b.

The cost of capital using new equity:

(.35)(.08) + (.65)(.149) = 12.485%

Notice that the marginal cost of capital rises after the firm exhausts its
retained earnings and must start using more expensive new equity.

c.

The break-point in the marginal cost of capital schedule:

$23,678/.65 = $36,428

The retained earnings can support up to $36,428 in total financing and still
maintain the optimal combination of debt and equity financing. However, after
$36,428 of total financing, the retained earnings are exhausted, and the firm
must start using more expensive new equity.

POINTS:

-- / 1

REF:
38.

An investment costs $10,000 and will generate annual cash inflows of $1,770 for ten years. According to
the net present value and internal rate of return methods of capital budgeting, should the firm make this
investment if its cost of capital is (a) 10% or (b) 14%?

RESPONSE:

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ANSWER:

Internal rate of return:

$10,000 = (PVAIF x%, 10y)$1,770
$10,000 = $1,770X
X = $10,000/$1,770 = 5.650
r = 12%
(PV = -10000; N= 10; I = ?; PMT = 1770, and FV = 0.
I = 12.)
Net present value at 10%:
NPV

= $1,770(PVAIF 10%, 10y)

= $1,770(6.145) - $10,000 = $10,876.65 - $10,000
= $876.65

(PV = ?; N = 10; I = 10; PMT = 1770, and FV = 0.

PV = -10876.)
Net present value at 14%:
NPV

= $1,770(PVAIF 14%, 10y)

= $1,770(5.216) - $10,000 = ($767.68)

(PV = ?; N = 14; I = 10; PMT = 1770, and FV = 0.

PV = -9233.)
At k = 10% the firm should make the investment. (NPV is positive and IRR exceeds
the firm's cost of capital.) At k = 14% the firm should not make the investment. (NPV is
negative and IRR is less than the firm's cost of capital.)

POINTS:

39.

-- / 1

REF:
A firm has two $1,000, mutually exclusive investment alternatives with the following cash inflows. The cost
of capital is 6 percent.
Year

Cash Inflow
A

$175

$1,100

175

175

175

175

175

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175

175

a.

What is the internal rate of return on each investment? Which investment should the firm make?

b.

What is the net present value of each investment? Which investment should the firm make?

c.

If the cash inflows can be reinvested at 8 percent, which investment should be made?

RESPONSE:
ANSWER:
a.

Determination of the internal rates of return:

A:

$175(PVAIF x%, 8y) = $1,000

Interest factor = $1,000/$175 = 5.174
rA = approximately 8%
(PV = -1000; N = 8; I = ?; PMT = 175, and FV = 0.
I = 8.15.)

B:

$1,100/(1 + r B) = $1,000
Interest factor = $1,000/$1,100 = .909
rB = 10%

Since the investments are mutually exclusive, the firm should select B
because it has the higher internal rate of return.

b.

Determination of the net present values:

A:

Net present value A:

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$175(PVAIF 6%, 8y) - $1,000 = $175(6.210) - $1,000

= $87

B:

Net present value B:

$1,100/(1 + .06) - $1,000 = $1,100(.943) - $1,000 = $37

Since the investments are mutually exclusive, the firm should select A
because it has the higher net present value.(This contradicts part a, which
selected investment B.)

c.

If the firm is able to reinvest the annual payments of $175, the terminal value
of A is $175(10.637) = $1,861.48
(10.637 is the interest factor for the future value of an ordinary annuity at 8%
for eight years.)

If the firm selects B, it receives $1,100 in year one, which is reinvested at 8%

for seven years. The terminal value is $1,100(1.714) = $1,885.40. This is
higher than the terminal value for A, so the firm should make investment B.

POINTS:

-- / 1

REF:

40.

A firm has the following investment alternatives:

Cash Inflows
Year

$400

$ ---

$ ---

400

400

---

400

800

---

400

800

1,800

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Each investment costs $1,400 and the firm's cost of capital is 10 percent.
a.

What is each investment's internal rate of return?

b.

Should the firm make any of these investments?

c.

What is each investment's net present value?

d.

Should the firm make any of these investments?

RESPONSE:
ANSWER:
a.

Determination of the internal rates of return:

Investment A:
$400(PVAIF x%, 4y) = $1,400
Interest factor = $1,400/$400 = 3.5
rA = approximately 5.6%
(PV = -1400; N = 4; I = ?; PMT = 400, and FV = 0.
I = 5.56.)

Investment B:
$1,400 = $400/(1 + r B)2 + $800/(1 + r B)3 + $800/(1 + r B)4

Use 12%:
$400(.780) + $800(.712) + $800(.634) = $1,389
rB = approximately 12% (11.9%)

Investment C:

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$1,400 = $1,800/(1 + r C)4

Interest factor = $1,400/$1,800 = .778
rC = approximately 7% (6.5%)

b.

The firm should make only investment B.

c.

Determination of the net present values:

Investment A:
$400(PVAIF 10%, 4y) $1,400 = $400(3.170) - $1,400 = ($132)

Investment B:
$400/(1 + .1) 2 + $800/(1 + .1) 3 + $800/(1 + .1) 4 - 1,400
= $400(.826) + $800(.751) + $800(.683) - $1,400
= $1,477.60 - $1,400 = $77.60

Investment C:
$1,800/(1 + .1) 4 - $1,400 = $1,800(.683) - $1,400
= ($170.60)

d.

POINTS:

According to the net present value, only investment B should be made. (This
confirms the answer to part b.)

-- / 1

REF:

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