PRACTICE MIDTERMS

MIDTERM EXAM: FALL 1985

1. You are a prudent individual who wants to plan for your retirement. You are now
25 and plan to work for the next 40 years. You will retire at 65. Your actuarial tables
tell you that you will live to be 85 (i.e. 20 years after retirement). You estimate that
your expenses each year after your retirement till your death will be $20000 (Assume
that your expenses are at the end of each year). How much do you have to set apart at
the end of each year for the next 40 years to be able to afford this? (Assume that you
can invest the money at 10%) [ 5 points]

2. You have been observing the progressive gentrification of San Francisco with
interest. You realize that the time is ripe for you to start and run an aerobic exercise
center. You find an abandoned warehouse in Fisherman's Wharf which will meet your
needs and rents for $48000/ year. You estimate that it will initially cost $50000 to
renovate the place and buy Nautilius equipment for the center. (There will be no
salvage and the entire initial cost is depreciable) You have done a market survey
which leads you to believe that you will get 500 members each paying $500/year. You
have also found 5 instructors you can hire for $24000/year apiece. Your tax rate if you
start making profits will be 40% and you choose to use straight line depreciation on
your initial investment. If your discount rate is 15% and you expect to retire to the
Bahamas in ten years, answer the following questions:

(a) Is this a good investment? ( 5 points)

(b) How sensitive is your conclusion to your assumptions about the number of
members you expect to have? (i.e. How much margin for error do you have on
this estimate?) ( 2 points)

3a. Your superior is a cantankerous and very stubborn man who believes that the
simplest approaches are the best. Your firm has just bought a van, with a five-year
lifetime, for $10000. You superior wants you to use straight line depreciation. You
claim that using double declining balance depreciation will save you money. If your
discount rate is 10% and your tax rate is 40%, show him how much you will save in
present value dollars. ( 3 points)

3b. Brooks Brothers is thinking of investing in a new line of punk rocker clothes for
the new executive. You have been hired to evaluate the project. You find that, if the
project is accepted, you could use an abandoned warehouse already owned by Brooks
with a book value of $500000. Your superior had been planning to rent this
warehouse out to another firm for $100000/ year. If your tax rate is 40%, your
discount rate is 15%, you use straight line depreciation and your project lifetime is 10
years, what is the opportunity cost of this investment? ( 4 points)

4. You have just been given the following information on Dodger Corp and the S&P
500.

Year Dodger Corp S&P 500

Prices Levels
1979 40 150
1980 36 150
1981 34.2 145.5
1982 20.52* 160.05
1983 22.57 163.25
1984 22.34 159.99

* Stock split 2:1

a. What is your beta estimate for this firm? ( 3 points)

b. What portion of total variance is systematic and what portion is

unsystematic?

c. What is the required rate of return on Dodger Corp? (Rf=7%, E(Rm)-

Rf=8%) ( 1 point)

CORPORATE FINANCE: MIDTERM EXAM

Spring 1988

1. You have collected returns on AD Corporation and the NYSE index for five years:

Year AD Corp NYSE

1981 10% 5%
1982 5% 15%
1983 -5% 8%
1984 20% 12%
1985 -5% -5%
 a. Estimate the intercept (alpha) and slope (beta) of the regression. (2 pts)

Use enclosed worksheet to show work.

b. If you bought stock in AD Corp. today how much would you expect to make
as a return over the next year? [The six-month T.Bill rate is 6%] (1)

c. Looking back over the last five years, how would you evaluate AD's
performance relative to the market? ( 1 point)

d. Assume now that you are an undiversified investor and that you have all of
your money invested in Ad Corporation. What would be a good measure of the
risk that you are taking on? How much of this risk would you be able to
eliminate if you diversify? (2 points)

e. AD is a diversified company and is planning to sell off one of its divisions.

The division under consideration has assets which comprise half of the book
value of AD Corporation, and 20% of the market value. Its beta is twice the
average beta for AD Corp (before divestment). What will the beta of AD
Corporation be after divesting this division? ( 2 points)

2. You are graduating in June and would like to start your own business making wine
coolers. You collect the following information on the initial costs:

Cost of Plant & Equipment = $ 500000

Licensing & Legal Costs = $ 50000

You can claim an investment tax credit of 10% on plant & equipment. You also have
been left a tidy inheritance that will cover the initial cost, and is currently invested in a
CD earning 10%.

You estimate that you can sell one million bottles a year at $1/bottle. You estimate
your costs as follows:

Variable costs/bottle = 50 cents

Fixed Costs/ year = $ 200000

Adding up state, local and federal taxes, you note that you will be in the 50% tax
bracket. To be conservative, you assume that you will terminate the business in five
years and that you will get nothing from the plant and equipment as salvage. (You
also use straight line depreciation.) As a final consideration, you note that starting this
business will mean that you will not be able to take the investment banking job you
have been offered (which offered $ 75000/year for the next five years.). Should you
take on the project? ( 5 points)

3. You have just completed the analysis of a capital budgeting proposal and have
concluded that the NPV=-5000. (You used a 12% discount rate) Before you decide
that the project is not worthwhile, you note that you assumed that all the $400000 in
financing needed for the project comes from equity, and that you could easily borrow
$200000 to finance the project. If the borrowing is an 8% five-year term loan, would
it make any difference to your conclusion? ( 3 points)

4. TRUE or FALSE

1. Initial public offerings are usually underpriced by investment bankers

TRUE FALSE

2. When choosing between two projects, you always choose the one which has the
higher NPV.

TRUE FALSE

TRUE FALSE

3. The IRR >discount rate if the NPV>0

TRUE FALSE

MIDTERM EXAM: SPRING 1989

1. You are an expert at working with PCs and are considering setting up a software
development business. To set up the enterprise, you anticipate that you will need to
acquire computer hardware costing $ 100000 (The lifetime of this hardware is five
years for depreciation purposes, and straight line depreciation will be used). In
addition, you will have to rent an office for $50000/ year. You estimate that you will
need to hire five software specialists at $ 50000/ year to work on the software, and
that your marketing and selling costs will be $ 100000/ year. You expect to price the
software you produce at $100/unit and to sell 6000 units a year. The actual cost of
materials used to produce each unit is $ 20. Your tax rate will be 40% and the
appropriate opportunity cost is 12%.
 a. Should you accept the project? ( 4 points)

b. How sensitive is your decision to the number of units that you sell? ( 1
points)

2. You are an analyst for a sporting goods corporation that is considering a new
project which will take advantage of excess capacity in a existing plant. The plant has
a capacity to produce 50000 tennis racquets, but only 25000 are being produced
currently though sales of the rackets are increasing 10% a year. You want to use some
of the remaining capacity to manufacture 20000 squash rackets each year for the next
ten years (which will use up 40% of the total capacity), and this market is assumed to
be stable (no growth). An average tennis racquet sells for $100 and costs $40 to make.
The tax rate for the corporation is 40% and the discount rate is 10%. Is there an
opportunity cost involved? If so, how much is it? ( 4 points)

3. You have estimated the returns on XYZ corporation and on the overall market for
five years:

Year Rxyz Rm
1982 20% 15%
1983 -10% -5%
1984 30% 25%
1985 10% 15%
1986 0% -10%

a. Estimate the beta for this stock. ( 2 points)

b. Estimate the alpha for this stock. ( 1 point)

c. What does the alpha tell you about the stock's performance over the five
years? ( 1 point)

d. What is the expected return on XYZ corporation if you use the CAPM? (The
riskfree rate is 9%) ( 1 point)

e. If XYZ corporation has a current debt/equity ratio of 50%, what would its
beta be if it increased its debt/equity ratio to 200% ? (The tax rate is 40%) ( 2
points)

4. You have been called in to evaluate whether a pension fund is adequately funded to
meet its obligations. The cashflow obligations of the fund are defined below:
$ 1 million a year : 1990-94 ( Years 1-5)

$ 2 million a year : 1995-99 ( Years 6-10)

$ 5 million a year : 2000-09 ( Years 11-20)

How much would the fund need to have right now to meet these obligations, if the
interest rate on its deposits is 10% ? ( 4 points)

CORPORATE FINANCE: MIDTERM EXAM

Spring 1990

1. You have been hired to run the pension fund for a small company with five
employees. You estimate, based upon their ages and retirement schedules, that your
liabilities under the plan will be as follows:

Expected
Years cash
payments
6-10 $ 100,000
11-20 $ 250,000
21-25 $ 100,000

You currently have $ 500,000 in investments in the plan. You want to fully fund all
your above-listed liabilities by the end of year 5. How much would you have to set
aside each year for the next five years to ensure this, if your opportunity cost is 8%? (
5 points)

2. You are examining the viability of a capital investment that your firm is interested
in. The project will require an initial investment of $500,000 and the projected
revenues are $400,000 a year for five years. The projected cost-of-goods-sold is 40%
of revenues and the tax rate is 40%. The initial investment is primarily in plant and
equipment and can be depreciated straight-line over five years. (The salvage value is
zero.) The project makes use of other resources that your firm already owns:

(a) Two employees of the firm, each with a salary of $40,000 a year, who are
currently employed by another division will be transferred to this project. The other
division has no alternative use for them, but they are covered by a union contract
which will prevent them from being fired for three years (during which they would be
paid their current salary.)

(b) The project will use excess capacity in the current packaging plant. While this
excess capacity has no alternative use now, it is estimated that the firm will have to
invest $ 250,000 in a new packaging plant in year 4 as a consequence of this project
using up excess capacity (instead of year 8 as originally planned).

(c) The project will use a van currently owned by the firm. While the van is not
currently used, it can be rented out for $ 3000 a year for five years. The book value of
the van is $10,000 and it is being depreciated straight line (with five years remaining
for depreciation).

The discount rate to be used for this project is 10%.

(1) What (if any) is the opportunity cost associated with using the two
employees from another division (described in (a))? (1 point)

(2) What, if any, is the opportunity cost associated with the use of excess
capacity of the packaging plant? (1 point)

(3) What, if any, is the opportunity cost associated with the use of the van ? (1
point)

(4) What is the after-tax operating cashflow each year on this project? ( 1 point)

(5) What is the net present value of this project? (1 point)

3. You own a rental building in the city and are interested in replacing the heating
system for the building. You are faced with the following alternatives:

a. A solar heating system, which will cost $ 12,000 to install, $ 500 a year to
run, and will last forever. (Assume that your building will too.)

b. A gas-heating system, which will cost $ 5,000 to install, $ 1000 a year to run,
and will last 20 years.

c. An oil-heating system, which will cost $ 3,500 to install, $ 1200 a year to

run, and will last 15 years.

If your opportunity cost is 10%, which of these three options is best for you? ( 5
points)
4a. You run a regression of monthly returns of XYZ corporation on the S&P 500
index and come up with the following output (All data was entered in percent):

Intercept of the regression = 0.0015

X-coefficient of the regression = 1.50

Standard error of X-coefficient = 0.25

R squared = 0.40

There are one million shares outstanding, and the current market price is $ 30. The
firm has $ 30 million in debt outstanding. (The firm has a tax rate of 40%)

a. What would an investor in XYZ's stock require as a return, if the current 6-

month T.Bill rate is 6%? ( 1 point)

b. What proportion of this firm's risk is diversifiable? ( 1 point)

c. Assume now that XYZ has three divisions, of equal size (in market value
terms). It plans to divest itself of one of the divisions (with a beta of 1.0) for $
20 million in cash and acquire another firm (which has a beta of 2.0) for $ 50
million (It will borrow $ 30 million to complete this acquisition). What will the
beta of XYZ be after this acquisition? ( 3 points)

CORPORATE FINANCE: MIDTERM EXAM

Fall 1990

1. You are the negotiator for the New York Mets and are trying to negotiate a contract
with Darryl Strawberry. His agent has let you know that Mr. Strawberry is seeking a
five year contract paying him $ 4 million a year for five years. You make a counter-
offer of $ 3 million a year for the first five years and offer to continue to pay him $ 1
million a year for the next five (so that the total nominal value of the contract is $20
million).

Mr.
Years Strawberryís Your offer
demand
1-5 $4,000,000 $ 3,000,000
6-10 ------ $1,000,000
[The appropriate discount rate is 10%]

(a) How much would Mr. Strawberry lose in present value dollars if he
accepted your offer?(2 points)

(b) How much more would you have to pay over the last five years (over and
above the $1 million that you have offered him) so as to allow him not to lose
in present value terms? ( 2 points)

2. You are considering a capital budgeting proposal to make 'glow-in-the-dark'

pacifiers for anxious first-time parents. You estimate that the equipment to make the
pacifiers would cost you $50,000 (which you can depreciate straight line over the
lifetime of the project, which is ten years) and that you can sell 15,000 units a year at
$2 a unit. The cost of making each pacifier would be $0.80 and the tax rate that you
would face would be 40%. You also estimate that you will need to maintain an
inventory at 25% of revenues for the period of the project and that you can salvage
80% of this working capital at the termination of the project. Finally, you will be
setting up the equipment in your garage, which means you have to pay $2000 a year
to have your car garaged at a nearby private facility (Assume that you can deduct this
cost for tax purposes). To estimate the discount rate for this project, you find that
there are comparable firms being traded on the financial markets with the following
betas:

Debt-Equity
Company Tax rate Beta
ratio
Nuk-Nuk 0.50 0.40 1.3
Gerber 1.00 0.50 1.5

You expect to finance this project entirely with equity and the current T.Bill rate is
8.5%.

(a) What is the appropriate discount rate to use for this project? (2 points)

(b) What is the after-tax operating cashflow each year for the lifetime of the
project? (2 points)

(c) What is the NPV of this project? (2 point)

3. You are a financial analyst for a company that is considering a new project. If the
project is accepted, it will use 40% of a storage facility that the company already owns
but currently does not use fully. The project is expected to last ten years and the
discount rate is 10%. You research the possibilities and find that the entire storage
facility can be sold for $100,000 and a smaller facility acquired for $ 40,000. The
book value of the existing facility is $60,000 and both the existing and the new
facilities (if it is acquired) would be depreciated straight line over ten years. The
ordinary tax rate is 40% and the capital gains rate is 25%. What is the opportunity
cost, if any, of using the storage capacity? ( 4 points)

4. You run a regression of stock returns on XYZ Corp. against market returns and
come up with the following regression:

Rxyz = 0.0015 + 1.5 Rmkt

The company has, in market value terms, $500 million of debt and $500 million of
equity. The company currently has two divisions. Division A, which has a market
value of $ 600 million, produces vacuum cleaners and you find five listed companies
on the exchange which make only vacuum cleaners which have an average beta of
1.31 and an average debt equity ratio of 20%. Division B produces widgets and you
cannot find any comparable companies (textbook examples notwithstanding).(Assume
that all companies face a tax rate of 50%.)

(a) What is the beta for division B? ( 3 points)

(b) If the company divests itself of Division B and increases its debt-equity
ratio to 2, what would the company's beta be? (3 points)

CORPORATE FINANCE: MIDTERM EXAM

Spring 1991

1.You have been hired by a company to manage its pension fund obligations. You
estimate that the firm will have an obligation to pay out a lump sum of $10 million in
10 years. The interest rate that you can make on your investments currently is 8%.

a. How much would you need to set aside an annuity each year for the next ten
years to get to $10 million ? ( 1 point)

b. Assume that you set aside the annuity in (a) each year for the next five years
and that the interest rate then drops from 8% to 6% after year 5. How much
more (or less) would you need to set aside each year over the remaining five
years to have $10 million at the end of year 10? (3 points)
2. You have been hired as a capital budgeting analyst by a sporting goods firm. It
manufactures athletic shoes and has captured 10% of the overall shoe market (The
total market is worth $100 million a year). The fixed costs associated with
manufacturing these shoes is $2 million a year and variable costs are 40% of
revenues. The company's tax rate is 40%.

The firm believes that it can increase its market share to 20% by investing $10 million
in a new distribution system (which can be depreciated over the system's life of 10
years to a salvage value of zero) and spending $1 million a year in additional
advertising. The company proposes to continue to maintain working capital at 10% of
Annual Revenues. The discount rate to be used for this project is 8%.

a. What is the initial investment for this project? (1 point)

b. What is the annual operating cashflow from this project? (2 points)

c. What is the NPV of this project? (1 point)

d. How much would the firm's market share have to go up for you to be
indifferent to taking or rejecting this project? ( 2 points)

3. Your company is considering producing a new product. You have a production

facility that is currently used to only 50% of capacity and you plan to some of the
excess capacity for the new product. The production facility cost $50 million five
years ago when it was built and is being depreciated straight line over 25 years. (In
real dollars, assume that this cost will stay constant over time.)

Product Capacity Growth Fixed Variable

Revenues
Line Used Rate Costs Costs
Old
50% 5% p.a. 100 Mil 25 Mil 50 Mil/Yr
Product
New
30% 10% p.a. 80 Mil 20 Mil 44 Mil/Yr
Product

The new product has a life of 10 years, the tax rate is 40% and the appropriate
discount rate (real) is 10%.

a. If you take on this project, when would you run out of capacity? (1 point)

b. When you run out of capacity, what would you lose if you chose to cut back
production (in present value after-tax dollars)? (You have to decide which
product you are going to cut back production on) (2 points)
 c. What would the opportunity cost (to be assigned to this new product) be if
you chose to build a new facility when you run out of capacity instead of
cutting back on production? (1 point)

4. You run a regression of XYZ stock's returns against the market returns over a five-
year time period (using monthly data) and come up with the following output:

Intercept = .20%

Slope = 1.20

Your stock had an annualized standard deviation of returns of 40% whereas the
market standard deviation was only 20%. The riskfree rate, on average, over the last
five years has been 6% and it is currently at 7%. The annualized dividend per share
currently is $2.00 and the stock is currently selling for $50 (There are 100,000 share
outstanding)

a. Evaluate the performance of XYZ over the five-year time period of your
analysis. Did it do better or worse than expected (using the CAPM)? If so, how
much better or worse did it do than expected? (1 point)

b. What proportion of XYZ risk is diversifiable? (1 point)

c. What would you expect XYZ's stock price to be one year from today? (1
point)

d. XYZ currently has $ 5 million in debt outstanding and the tax rate is 40%.
XYZ is planning on selling one of its divisions for $ 5 million (This division
has an asset beta of 0.5). It will use the proceeds to pay $3 million as dividends
to its stockholders and the remaining $2 million to repay debt. What will the
beta be after the restructuring? (3 points)

CORPORATE FINANCE: MIDTERM EXAM

Fall 1992

1. You have been hired to run a pension fund for a major corporation. The firm
currently has $5 million in the fund, and expects to have cash inflows of $2 million a
year for the first five years followed by cash outflows of $ 3 million a year for the
next five years. Assume that interest rates are at 8%.
 a. How much money will be left in the fund at the end of the tenth year? ( 4
points)

b. If you were required to pay a perpetuity after the tenth year (starting in year
11 and going through infinity) out of the balance left in the pension fund, how
much could you afford to pay?

(1 point)

2. You are currently employed at a major investment bank and are making $
50,000/year (and expect to make that amount each year for the next five years). A
friend comes to you with an idea for a project to make soundproof glass shields for
cars to protect parents from whiny kids. You will have to quit your job, and the
project will require an initial investment in equipment of $350,000 (which can be
depreciated straight line over five years to a salvage value of $100,000). You expect
to sell 10000 units at $50/unit each year for the next five years. It will cost you $20
per unit to manufacture and other fixed costs will amount to $50,000/year. You own a
house (which you are renting out right now for $14,000/year), that you think you can
use for this project. (You cannot depreciate this house if you rent it, but you can claim
depreciation of $10,000 a year if you take this project) In addition your tax rate is
40% and your discount rate is 10%.

a. What is the opportunity cost (if any) of using your house for this project? (1
point)

b. What is the opportunity cost (if any) of having to quit your job to take this
project? (1 point)

c. What is the after-tax cashflow each year from this project? (1 point)

d. What is the NPV of this project? (1 point)

e. How many units would you have to sell to break even? (2 points)

3. You are trying to choose a new siding for your house. A salesman offers you two
choices:

a. Wooden siding, which will last ten years, cost $5000 to install and
$1000/year to maintain

b. Aluminium siding, which will last forever, cost $15,000 to install and will
have a lower maintentance cost per year
If your discount rate is 10%, how much your maintenance costs have to be for you to
choose to go with aluminium siding? (4 points)

4. You have just done a regression of monthly stock returns (on XYZ corp.) on
monthly market returns over the last five years and come up with the following
regression:

RXYZ = 0.5% + 1.2 RM

The variance of the stock is 50% and the variance of the market is 20%. The current
riskfree rate is 3% (It has come down 2% over the last year). The stock is currently
selling for $50, down $4 over the last year, and has paid a dividend of $2 during the
last year and expects to pay a dividend of $2.50 over the next year. The NYSE
composite has gone down 5% over the last year, with a dividend yield of 3%.

a. What is the expected return on XYZ over the next year? (1 point)

b. What would you expect XYZ's price to be one year from today? ( 1point)

c. Evaluate the performance of XYZ over the last year. (2 points)

d. What proportion of the risk of XYZ Corporation is due to the market? ( 1

point)

CORPORATE FINANCE: MIDTERM EXAM

Fall 1993

1. Derrick Coleman, a forward for the New Jersey Nets, has been offered a seven-
year, $ 75 million contract, where he will be paid $9 million a year for the next three
years, and $12 million a year for the following four years. The appropriate discount
rate is 8%.

a. What is the present value of this contract? ( 2 points)

b. He is weighing an alternative offer from the Minnesota Timberwolves,

where he will be paid $8 million a year for the next seven years and an
additional $25 million at the end of the seventh year. What is the present value
of this contract? (1 point)
 c. What would the payment at the end of the seventh year need to be for Mr.
Coleman to be indifferent between the two offers? (2 points)

2. You are analyzing a project that plans to invest $20 million in a new theme park
called "Bonehead Park" , based upon the infamous cartoon on MTV, Beavis and
Butthead. The park will take two years to build and the expenditure will also be
spread out across the two years.

Today: $10 million

One year from now: $5 million

Two years from now: $5 million

Once the park is built, you expect to attract teenagers in record numbers, and have
revenues of $10 million a year for the next ten years (your assumed project life). The
park will cost $3 million a year to operate, and the depreciation will be $1 million a
year. You plan to build it on land that you already own, that you bought three years
ago for $1 million. If you do not take this project, you plan to lease the land out and
make $200,000 a year before taxes. At the end of the ten years, it is assumed that the
park can be salvaged for book value. The tax rate is 40%, and the discount rate is
15%.

a. What is the initial investment (in present value terms)? (2 points)

b. What is the annual after-tax operating cashflow on this park? (1 point)

c. What is the NPV of the project? (1 point)

d. What would the NPV be, if, instead of stopping the project in the tenth year
and salvaging, the project were assumed to continue for another ten years, with
the same operating cashflows? (2 points)

3. You run your own business and spend $2,000 a year on printing expenses, using an
outside printing service. You estimate that it will cost you $10,000 to buy your own
printer, and $500 a year to maintain this printer. If the printer life is ten years, and
your discount rate is 10%, does it make sense to buy the printer? (Assume no
inflation, and no taxes) (4 points)

4. You have just run a regression of weekly returns of EK Inc. against the S&P 500
over the last two years. You have misplaced some of the output and are trying to
derive it from what you have.
 a. You know the R squared of the regression is 0.48, and that your stock has a
variance of 60%. The market variance is 20%. What is the beta of EK Inc.? (2
points)

b. You also remember that EK Inc. was not a very good investment during the
period of the regression and that it did worse than expected (after adjusting for
risk) by 0.01% a week for the two years of the regression. During this period,
the average riskfree rate was 3.64%. What was the intercept on the regression?
(2 points)

c. You are comparing EK Inc. to another firm called LMN Inc, which also has
an R squared of 0.48. Will the two firms have the same beta? If not, why not?
(1 point)

CORPORATE FINANCE: MIDTERM EXAM

Fall 1994

1. You are an investment advisor who has been approached by a client for help on his
financial strategy. He has $250,000 in savings in the bank. He is fifty five years old,
and expects to work for ten more years, making $100,000 a year. (He expects to make
a return of 5% on his investments for the foreseeable future. You can ignore taxes)

a. Once he retires ten years from now, he would like to be able to withdraw $80,000 a
year for the following twenty five years (His actuary has told him he will live to be
ninety years old.). How much would he need in the bank ten years from now to be
able to do this? (1 point)

b. How much of his income would he need to save each year for the next ten years to
be able to afford these planned withdrawals ($80,000 a year) after year ten? (2 points)

c. Assume now that interest rates decline to 4% ten years from now. How much, if
any, would he have to lower his annual withdrawal by, assuming that he still plans to
withdraw cash each year for the following 25 years? (2 points)

2. You run a mail-order firm, selling upscale clothing. You are considering replacing
your manual ordering system with a computerized system, to make your operations
more efficient and to increase sales. (All the cash flows given below are in real terms.)
  The computerized system will cost $10 million to instal, and $500,000 to
operate each year. It will replace a manual order system that costs $1,500,000
to operate each year.
 The system is expected to last ten years, and have no salvage value at the end
of the period.
 The computerized system is expected to increase annual revenues from $5
million to $8 million for the next ten years.
 The costs of goods sold is expected to remain at 50% of revenues.
 The tax rate is 40%.
 As a result of the computerized system, the firm will be able to cut its inventory
from 50% of revenues to 25% of revenues immediately. There is no change
expected in the other working capital components.

The real discount rate is 8%.

a. What is your expected cash flow at time=0? (1 point)

b. What is the expected incremental annual cash flow from computerizing the
system? (3 points)

c. What is the net present value of this project? (1 point)

3. You have been asked to compare three alternative investments and make a
recommendation.

 Project A has an initial investment of $5 million, and after-tax cashflows of $

2.5 million a year for the next five years.
 Project B has no initial investment, has after-tax cash flows of $ 1 million a
year for the next ten years, and a salvage value of $2 million (from working
capital).
 Project C has an initial investment of $10 million, another investment of $5
million in ten years, and after-tax cashflows of $ 2.5 million a year forever.

The discount rate is 10% for all three projects.

Which of the three projects would you pick? Why? (4 points)

4. You have run a regression of monthly returns on a stock against monthly returns on
the S&P 500 index, and come up with the following output ñ

Rstock = 0.25% + 1.25 RMarket R2= 0.60

The current one-year treasury bill rate is 4.8%, the current ten-year bond rate is 7.25%
and the current thirty-year bond rate is 8%. The firm has 10 million shares
outstanding, selling for $10 per share.

i. What is the expected return on this stock over the next year? (1 point)

ii. Would your expected return estimate change if the purpose was to get a
discount rate to analyze a thirty-year capital budgeting project? (1 point)

iii. An analyst has estimated, correctly, that the stock did 4.2% better than
expected, annually, during the period of the regression. Can you estimate the
annualized riskfree rate that he used for his estimate? (2 points)

iv. The firm has a debt/equity ratio of 50%, and faces a tax rate of 40%. It is
planning to issue $50 million in new debt and acquire a new business for that
amount, with the same risk level as the firm's existing business. What will the
beta be after the acquisition? (2 points)

CORPORATE FINANCE

MID TERM EXAMINATION: Fall 1995

1. Mr. William Poirot has come to you for advice on his retirement planning. He is 45
years old, and has $ 100,000 in his savings account. He also expects to receive an
additional $80,000, after taxes, in ten years, when he sells his house. He plans to work
for 20 years more, and expects to save $ 10,000 a year for the next 10 years, and $
15,000 a year for the following 10 years.

a. Assuming that he earns 5% on both his current and future savings, how much
should he expect to have in savings, when he retires in 20 years? ( 2 points)

b. If Mr. Poirot plans to withdraw the money in equal annual installments over
the 15 years following his retirement, how much can each withdrawal be?
(Assume that the interest rate continues to be 5% after the twentieth year.) ( 1
point)

c. How would your answer to (a) change if interest rates are expected to rise to
6% after ten years? ( 2 points)

2. You watched a product demonstration for a wonder mop at a demonstration fair,

and were so impressed that you paid $ 50,000 for the rights to the product. You are
now analysing whether you should start producing the wonder mops, and have
collected the following information ñ

 The equipment needed to manufacture the mop will cost $150,000, and it can
be depreciated straight line over a 5-year life time to a salvage value of $
25,000.
 You will be using a building that you currently own, but rent out, as the facility
to house the equipment. You will have to obviously evict the current tenants,
who pay you $ 15,000 a year in rent. This building is being depreciated straight
line, and is yielding $5,000 in depreciation each year.
 You expect to sell 5,000 mops a year at $ 40 a mop. The raw materials and
labor associated with producting each mop will be $ 10.
 You expect to spend $ 50,000 a year producing infomercials (30-minute TV
spots to promote your product).
 You will need to produce and maintain an inventory, equal to three months of
sales, to meet demand. (This will have to occur before you sell any units.)
 Your tax rate is 40% and you estimate your discount rate to be 12%.

a. Estimate the opportunity cost of the rental building that will be used for the
facilities. (1 point)

b. Estimate the net present value of the project. ( 4 points)

3. You have been asked to analyse a capital budgeting project, where the initial
investment is $ 100,000, and the project is expected to generate $ 30,000 in real pre-
tax cash flow savings each year for the next 5 years. The inital investment is
depreciable, straight line, over 5 years to a salvage value of zero. The tax rate is 30%
and the nominal discount rate is 10%. If the net present value of this project
is $10,705, estimate the expected inflation rate. ( 4 points)

4a. You have just run a regression of monthly returns on MAD Inc against returns on
the S&P 500, and arrived at the following result ñ

RMAD = ñ 0.05% + 1.20 RS&P

The regression has an R-squared of 22%. The current T.Bill rate is 5.5% and the
current T.Bond rate is 6.5%. The riskfree rate during the period of the regression was
6%.. Answer the following questions relating to the regression ñ

a. Based upon the intercept, you can conclude that the stock did

A. 0.05% worse than expected on a monthly basis, during the regression.

 B. 0.05% better than expected on a monthly basis during the period of
the regression

C. 1.25% better than expected on a monthly basis during the period of

the regression.

D. 1.25% worse than expected on a monthly basis during the period of

the regression.

E. None of the above. (1 point)

b. You now realize that MAD Inc went through a major restructuring at the end
of last month (which was the last month of your regression), and made the
following changes ñ

o The firm sold off its magazine division, which had an unlevered beta of
0.6, for $ 20 million.
o It borrowed an additional $ 20 million, and bought back stock worth $ 40
million.

After the sale of the division and the share repurchase, MAD Inc. had $ 40 million in
debt and $ 120 million in equity outstanding.

If the firmís tax rate is 40%, re-estimate the beta, after these changes. (5 points)