Problem Set #2 – Questions

1. A bond has an annual 8 percent coupon
rate, a maturity of 10 years, a face value of $1,000, and makes semiannual
payments. If the price is $934.96, what
is the annual nominal yield to maturity on the bond?

a. 8%

b. 9%

c. 10%

d. 11%

e. 12%

2. Which of the following Treasury bonds
will have the largest amount of interest rate risk (price risk)?

a. A
7 percent coupon bond which matures in 12 years.

b. A
9 percent coupon bond which matures in 10 years.

c. A
12 percent coupon bond which matures in 7 years.

d. A
7 percent coupon bond which matures in 9 years.

e. A
10 percent coupon bond which matures in 10 years.

3. Assume that you want to purchase a
10-year bond, with an annual coupon rate of 13%, a face value of $100 and
semiannual interest payments. If the
market interest rate is 9%, what is the maximum price you would pay for the
bond?

a. $115.63

b. $97.179

c. $129.23

d. $126.16

e. $83.43

4. What is the YTM of the following bond?

Bond pays semi-annual coupons

Price = $95.46

Par = $100

Bond matures in 6 years and pays 2 coupon
payments per year

Coupon = $5.25

5. A share of common stock has just paid a
dividend of $2.50 and will pay a dividend with a growth rate of 5% each year
for years 1-3. After year 3, the
dividend will increase at a constant rate of 6%. If investors require a 13% rate of return,
what is the price of the stock?

a.
$36.86

b.
$39.38

c.
$40.28

d.
$37.65

e.
$38.98

6. Multiple part question:

Starline Corporation is estimating its
WACC. Its target capital structure is 30
percent debt and 70 percent common equity. Its bonds have a 11 percent coupon,
paid semiannually, a current maturity of 10 years, and sell for $90. Starline’s
beta is .7, the risk-free rate is 5 percent, and the market risk premium is 8
percent. Starline is growing its dividend at growth rate of 6% a year for years
1-2, and just paid a dividend of $2.00.
It expects to pay a dividend that grows at 6% after year 2. The stock sells for $30.00 per share, and has
a growth rate of 9 percent. The firm’s
policy is to use a risk premium of 4 percentage points when using the
bond-yield-plus-risk-premium method to find R(_E). The firm’s marginal tax rate is 40 percent.

a. What is Starline’s component cost of
debt?

1) 8.03%

2) 14.95%

3) 7.48%

4) 9.35%

5) 7.68%

b. What is Starline’s cost of common stock
using the CAPM approach?

1) 10.3%

2) 10.6%

3) 11.0%

4) 9.5%

5) 12.2%

c. What is Starline’s cost of common stock
using the DCF (dividend discount model approach discussed in class) approach?

1) 13.70%

2) 13.06%

3) 14.05%

4) 13.92%

5) 12.50%

d. What is the firm’s WACC (use an average
of the DCF and the CAPM for cost of equity – as shown below)

R_E= (13.06% + 10.60% / 2)

R_E = 11.83%

1) 10.58%

2) 10.35%

3) 11.02%

4) 5.65%

5) 8.92%

7. A company has determined that its
optimal capital structure consists of 40 percent debt and 60 percent
equity. Given the following information,
calculate the firm’s weighted average cost of capital.

R_D = 6%

Tax rate = 40%

P₀ = $25

Growth = 0%

D₀ = $2.00

a. 6.0%

b. 6.2%

c. 7.0%

d. 7.2%

e. 8.0%

8. You check The Wall Street Journal and
see that CGT stock is currently selling for $7.50 per share and that CGT bonds
are selling for $88.95 per bond. These
bonds have a 7.25 percent annual coupon rate, with semi-annual payments. The bonds mature in twenty years. The beta for your company is approximately
equal to 1.1. The yield on a 6-month
Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5
percent. The expected return on the
stock market is 11.5 percent, but the stock market has had an average annual
return of 14.5 percent during the past five years. CGT is in the 40 percent tax bracket.

What is best estimate for the after-tax
cost of debt for CGT?

a. 2.52%

b. 4.20%

c. 4.35%

d. 5.04%

e. 5.37%

9. Two projects being considered by a firm
are mutually exclusive and have the following projected cash flows:

Project A Project B

Year Cash
Flow Cash Flow

0 ($100,000) ($100,000)

1
39,500 0

2
39,500 0

3
39,500 133,000

Based only on the information given, which
of the two projects would be preferred, and why?

a. Project
A, because it has a shorter payback period.

b. Project
B, because it has a higher IRR.

c. Indifferent,
because the projects have equal IRRs.

d. Include
both in the capital budget, since the sum of the cash inflows exceeds the initial investment in both cases.

e. Choose
neither, since their NPVs are negative.

10. King Racing Company (KRC) is
considering which of two mutually exclusive engine development projects to
pursue. King’s RPX design has an
expected life of 4 years and projected cash inflows are $3.6 million at the end
of each of the first two years and $1.8 million in each of the next two
years. King’s RPB design is more
flexible and has an eight-year life. The
projected end-of-year flows from the RPB design are $2.4 million in each of the
first two years and $2.0 million in each of the next six years. Both projects require an initial investment
of $5.4 million, and King’s cost of capital is 12 percent. Frequent changes in racing rules and engine
technology make engine development risky, but King feels that the basic designs
can be refined and modified. Thus, King
often assumes that continuous replacements can be made as a project’s life
ends. What is the net present value (on
an eight-year extended basis) of the project with the most value to the
company?

a. $
3.109 million

b. $
1.976 million

c. $
5.085 million

d. $
5.211 million

e. $
6.218 million

11. Returns on the market and Dell’s stock
during the last 3 years are shown below:

Year Market Dell

2004 22% 36%

2003 10% 13%

2002
-24% -22%

You have calculated beta and it is
1.21109

The risk-free rate is 5 percent, and the
required return on the market is 11 percent.
You are considering a low-risk project whose market beta is 0.5 less
than the company’s overall corporate beta.
You finance only with equity, all of which comes from retained
earnings. The project has a cost of $500
million, and it is expected to provide cash flows of $100 million per year at
the end of Years 1 through 5 and then $50 million per year at the end of Years
6 through 10. What is the project’s NPV
(in millions of dollars)?

a. $
7.10

b. $
9.26

c. $10.42

d. $12.10

e. $15.75

12. A company is analyzing two mutually
exclusive projects, S and L, whose cash flows are shown below:

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The company’s cost of capital is 12
percent, and it can get an unlimited amount of capital at that cost. What is the NPV of the better project?

13. Genuine Products Inc. requires a new
machine. Two companies have submitted
bids, and you have been assigned the task of choosing one of the machines. Cash flow analysis indicates the following:

Machine
A Machine B

Year Cash Flow Cash Flow

0 -$2,000 -$2,000

1
0 832

2
0 832

3
0 832

4
3,877 832

What is the internal rate of return for
each machine?

a. IRR(A)
= 16%; IRR(B) = 20%

b. IRR(A)
= 24%; IRR(B) = 20%

c. IRR(A)
= 18%; IRR(B) = 16%

d. IRR(A)
= 18%; IRR(B) = 24%

e. IRR(A)
= 24%; IRR(B) = 26%

14. Toya Motors needs a new machine for
production of its new models. The
financial vice president has appointed you to do the capital budgeting
analysis. You have identified two
different machines that are capable of performing the job. You have completed the cash flow analysis,
and the expected net cash flows are as follows:

Expected
Net Cash Flows

Year Machine
B Machine O

0 ($5,000) ($5,000)

1 2,085 0

2 2,085 0

3 2,085 0

4 2,085 0

5 2,085 9,677

What is the
payback period for Machine B?

1. 1.0 year
2. 2.0 years
3. 2.4 years
4. 2.6 years
5. 3.0 years