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Question 1

(10 points) Two firms in the same/identical business will have the same return on equity.

Your Answer | Score | Explanation |

False | 10.00 | Correct. You recognize that return on assets reflect business risk. |

Total | 10.00/10.00 | |

Question Explanation | ||

Testing the fundamentals about the effects of financing. |

Question 2

(10 points) If the IRR of a project is high, it will always have a positive NPV.

Your Answer | Score | Explanation |

False | 10.00 | Correct. You understand that high is not enough; high relative to discount rate. |

Total | 10.00/10.00 | |

Question Explanation | ||

Fundamental issue about decision criteria. |

Question 3

(15 points) Qin has just graduated from the Harvard with a BA in mathematics and must decide whether to start working now or to get a Masters in Financial Engineering (MFE). In either case, he intends to retire 40 years from today. An MFE requires an expenditure/tuition of $40,000 per year for each of the next two years, and Qin will start working immediately after getting his MFE. Qin’s discount rate for valuing cash flows is 5% per year. Assume that cash inflows occur at the end of the year, while the cash outflows (tuition payments) occur at the beginning of the year. If Qin goes to work now, he can expect a starting salary of $40,000, with a growth rate of 1%, thereafter. If Qin gets an MFE, his starting salary will be $50,000 and will grow at 2% thereafter. What is the net present value (NPV) of his decision if Qin decides to do an MFE? [Ignore taxes.]

Your Answer | Score | Explanation |

142668 | 15.00 | Correct. You understand that NPV takes into account only incremental cash flows. |

Total | 15.00/15.00 | |

Question Explanation | ||

This is a real-world example of decisions that you make, and you always have choices. Value creation and measurement is always relative. |

Question 4

(15 points) You bought a house five years ago for $400,000. At that time you borrowed 80% of its value at a fixed rate 15-year loan at an annual stated rate of 8%, with monthly payments. You have just made the 60th monthly payment and another bank has offered you a 10-year loan at a stated rate of 7%, but only if you transfer your savings account to the bank from your existing bank. This transfer will cost you $50 every month. Should you refinance the remaining balance of your loan with the new bank? How much would you save/lose if you decided to refinance? [Ignore taxes.]

Your Answer | Score | Explanation |

Yes, 7024 | 15.00 | |

Total | 15.00/15.00 | |

Question Explanation | ||

Testing your understanding of borrowing, an activity that is all around us. |

Question 5

(15 points) Your boss has requested that you analyze two projects for him and pick the one you would recommend for investment. Both projects have the same risk because they are in the same business, and their cash flows are: Project A (Year 0: -$100,000; Year 1: $30,000; Year 2: $40,000; Year 3: $50,000; Year 4: $100,410); Project B (Year 0: -$100,000; Year 1: 0; Year 2: $10,000; Year 3: $10,000; Year 4: $224,990). Which project will you recommend if the discount rate is 35%?

Your Answer | Score | Explanation |

Neither one. | 15.00 | Correct. You understand that IRRs do not matter but NPVs do. |

Total | 15.00/15.00 | |

Question Explanation | ||

Analyzing your ability to make decisions based on sound analysis. A very common situation in the real world. |

Question 6

(15 points) Your company is evaluating two different water purification systems for its main factory: Option X will cost $3.00 million and $500,000 annually to operate, and has a life of five years. Option Y will cost $4.80 million and $20,000 per year to operate, and has a life of six years. Straight-line depreciation is to be used, and both systems will be depreciated fully over their respective lives. The systems will have no salvage values at the end of their respective lives. Suppose your company is very profitable, has a discount rate of 10%, and the corporate tax rate is 40%. Which filtration system should your company buy?

Your Answer | Score | Explanation |

Option Y. | 15.00 | Correct. You know how we should not compare different-lived machines, without adjusting for their lives in an appropriate fashion. |

Total | 15.00/15.00 | |

Question Explanation | ||

A very common real-life situation where some care needs to be taken in figuring out real costs. |

Question 7

(20 points) LongLegs, Inc. is an all-equity firm whose current business involves manufacturing and selling designer jeans. The company is blessed in that it operates in capital markets that are perfect, that is, there are no taxes or bankruptcy costs. The current weighted average cost of capital (WACC) of LongLegs, Inc. is 3%, and its equity beta is 1.00. LongLegs, Inc. is considering penetrating the wind energy business. The wind project requires a $14 investment at t = 0 and will yield $25.4 a year for the foreseeable future, starting a year from today (at t = 1). The manager of the new wind project realizes that he is only responsible for the production of electricity and that virtually all the risk is idiosyncratic; after all, wind just blows whenever it wants to. The risk free rate is 1%, the market risk premium (the average difference between the return on the market and the risk-free rate) is 2%, and the wind project will be financed with equity. What is the NPV of this project?(Enter just the number without the $ sign or a comma.)

Your Answer | Score | Explanation |

-5.65 | 20.00 | |

Total | 20.00/20.00 | |

Question Explanation | ||

This is a difficult question if you do not recognize the nature of risks. |