Question

Instructions: Use of a regular calculator and a formula sheet is allowed. There are 20 multiple choice questions, all questions are compulsory, and carry equal points. 1) The internal rate of return is A) the discount rate that makes the NPV positive. B) the discount rate that equates the present value of the cash inflows with the present value of the cash outflows. C) the discount rate that makes NPV negative and the PI greater than one. D) the rate of return that makes the NPV positive. 2) Tenna Inc. is investing in a major capital budgeting project that will require the expenditure of $16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred stock, and $10 million of new common stock. The company estimates is before-tax cost of debt to be 16%, its cost of preferred stock to be 9%, and the cost of new common stock to be 17%. The tax rate is 25%, what is the weighted average cost of capital for this project? A) 12.20% B) 13.12% C) 14.38% D) 13.75% 3) Delta Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. The company's required rate of return is 8%. What is the net present value of this project? A) S104,089 B) $100,328 C) $96,320 D) $87,417 4) A company has preferred stock that can be sold for $21 per share. The preferred stock pays a annual dividend of 7% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is A) 38.87%. B) 17.72% C) 35.44%. D) 27.94%.

Answer 1

Answer to Question 1:

The internal rate of return is the discount rate that equates the present value of the cash inflows with the present value of the cash outflows.

Answer to Question 2:

Weight of Debt = $2,000,000 / $16,000,000
Weight of Debt = 0.1250

Weight of Preferred Stock = $4,000,000 / $16,000,000
Weight of Preferred Stock = 0.2500

Weight of Common Stock = $10,000,000 / $16,000,000
Weight of Common Stock = 0.6250

WACC = Weight of Debt * Pretax Cost of Debt * (1 - tax) + Weight of Preferred Stock * Cost of Preferred Stock + Weight of Common Stock * Cost of Common Stock
WACC = 0.1250 * 16.00% * (1 - 0.25) + 0.2500 * 9.00% + 0.6250 * 17.00%
WACC = 14.38%

Answer to Question 3:

Cash Flows:
Year 0 = -$750,000
Year 1 = $350,000
Year 2 = $325,000
Year 3 = $150,000
Year 4 = $180,000

Required Return = 8%

NPV = -$750,000 + $350,000/1.08 + $325,000/1.08^2 + $150,000/1.08^3 + $180,000/1.08^4
NPV = $104,089

Answer to Question 4:

Par Value = $100

Annual Dividend = 7% * Par Value
Annual Dividend = 7% * $100
Annual Dividend = $7

Net Price = Current Price - Flotation Cost
Net Price = $21.00 - $1.25
Net Price = $19.75

Cost of Preferred Stock = Annual Dividend / Net Price
Cost of Preferred Stock = $7.00 / $19.75
Cost of Preferred Stock = 0.3544 or 35.44%