AGEC 424 Third Hour Exam 11-20/24-2008 (100 Points)

AGEC 424 Third Hour Exam 11-20/24-2008 (100 points) Name______To receive credit you must show all work (calculator inputs/output when appropriate).

1. (2 points) Which of the following statements is false? a. Beta is meaningful only if an investor holds a well-diversified portfolio. b. You can completely eliminate risk if you hold a well diversified portfolio. c. A portfolio composed of only one stock will not be well diversified. d. A wise investor diversifies to capture the high average return of stocks while avoiding as much risk as possible. e. All of the above statements are correct. 2. (2 points) Which of the following is not an example of a source of systematic or market risk? a. Interest rate changes b. Foreign competition with an industry’s products c. Changes in the overall economic outlook d. Changes in the inflation rate

3. (2 points) A statistic known as a stock’s beta coefficient measures: a. total risk. b. systematic or market risk. c. unsystematic or business-specific risk. d. none of the above 4. (2 points) Which of the following statements about the beta coefficient is not true? a. A beta of > 1 implies that the stock’s volatility is greater than that of the market. b. A beta of < 0 implies that the stock tends to move against the market. c. A beta of 1 implies a volatility equal to that of the market. d. All of the above are true.

5. (2 points) Scenario/Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the _____ is to changes in a particular variable. a. probability b. return distribution c. net present value d. standard deviation

6. (2 points) The ______method consists of regressing historical values of a division’s return on equity against the return on a major stock market index. a. accounting beta model b. CAPM c. overlay d. pure play 7. (2 points) When a similar company can’t be found to use in estimating a divisional beta, the division’s own records can sometimes be used instead. This method is called: a. pure play. b. CAPM. c. accounting beta. d. financial accounting.

1 6. (9 points) Use the following information for the next two questions. Norlin Corporation is considering an expansion project that will begin next year (Time 0). Norlin’s cost of capital is 12%. The initial cost of the project will be $300,000, and it is expected to generate the following cash flows over its five-year life: Year $ 1 $60,000 2 $60,000 3 $90,000 4 $90,000 5 $90,000 a. What is the payback period for the expansion project?

b. What are the net present value (NPV) and internal rate of return (IRR) of the expansion project?

7. (12 points) The projected cash flows for two mutually exclusive projects are as follows:

Year Project A Project B 0 ($150,000) ($200,000) 1 80,000 40,000 2 60,000 50,000 3 50,000 50,000 4 60,000 5 50,000 6 53,000

If the firm’s cost of capital is 10% and the equivalent annual annuity method is used to eliminate the disparity between the projects’ lives, which project should be undertaken? a. Project A b. Project B c. either because the difference in lives makes a comparison meaningless d. Project A but the EAAs are so close that either is probably ok

2 New Investment 8. (30 points) The Ewert Company is evaluating the proposed acquisition of a new milling machine. The machine’s base price is $108,000, and it would cost another $12,500 to modify it for special use by the firm. The machine falls into the MACRS three-year class, and it would be sold after three years for $65,000. (Use the MACRS depreciation percentages that we have been using: 33%, 45%, 15% and 7%.) The machine would require an increase in net working capital (inventory) of $5,500. The milling machine would have no effect on revenues, but it is expected to save the firm $44,000 per year in before- tax operating costs, mainly labor. Ewert’s marginal tax rate is 34 percent and the project’s required rate of return is 12%. Determine the cash flows, NPV and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

Replacement Problem: 9. (35 points) Galveston Shipyards is considering the replacement of an old riveting machine with a new one that will increase earnings before depreciation from $27,000 to $81,000 per year. The new machine will cost $82,500, and it will have an estimated life of four years and a $15,000 value at the end of four years. The new machine will be depreciated using 3-year MACRS depreciation. The firm’s marginal tax rate is 40 percent, and the firm’s required rate of return is 10 percent. At this time the old machine is fully depreciated with a zero basis. It is worth $10,000 if you sold it today, and will be worth $2000 if you keep it for another 4 years. Determine the cash flows, NPV, and IRR on the attached sheet. Recommend either acceptance or rejection and say why.

3 Question 8 Initial Outlay Depreciation [initial basis = ]

Operating Cash flow

minus deprec. EBT less taxes

Dep. Add back OCF

Terminal CF Timeline, calculator inputs/outputs and investment decision

4 Question 9 Initial Outlay Depreciation [initial basis = ]

Operating Cash flow

minus deprec. EBT less taxes

Dep. Add back OCF

Terminal CF Timeline, calculator inputs/outputs and investment decision