Assignment 2Due on November 18 2010Part 1 Multiple Choice Questions1. Which of the following is NOT a true statement of the Net Present Value (NPV) analysis?A. The NPV of a project is the sum of the present value of all future after-tax incrementalcash flows generated by an initial cash outlay minus the present value of the investmentoutlays.B. Projects that have a positive NPV should be accepted and projects that have a negativeNPV should be rejected.C. The NPV is the present value of the expected cash flows net of the costs needed togenerate them.D. The firm’s after-tax marginal cost of capital is the appropriate discount rate for allprojects. 2. Suppose the Canadian Space Agency has two mutually exclusive projects: landing a womanon Mars and landing a man on Venus. Project Mars has an IRR of 12 percent and projectVenus has an IRR of 15 percent. The crossover rate is 9 percent. The project’s appropriatediscount rate is 18 percent.A. Accept project Mars.B. Accept project Venus.C. Accept both projects.D. Accept neither project. 3. Consider a five-year project that costs $20 000 today which is expected to generate $6 000 atthe end of the second year and then the cash flows will increase by $1 000 per year for eachof the subsequent years. The cost of capital is 8 percent. What are the project’s NPV andIRR?A. NPV = $1 083.24; IRR = 8.96%B. NPV = $2 706.35; IRR = 11.93%C. NPV = $3 824.56; IRR = 14.87%D. NPV = $4 522.85: IRR = 17.09% 4. Consider a project that requires an immediate cash outflow of $100 000 and provides aperpetual annual inflow of $15 000 starting two years from today. The cost of capital is 12percent. What is the project’s PI?A. 1.04B. 1.12C. 1.25D. 1.33 5. Which of the following is a TRUE statement?A. The tangent portfolio is the risky portfolio on the efficient frontier whose tangent line cutsthe horizontal axis at the risk-free rate. B. The new (or super) efficient frontier represents the portfolios composed of the risk-freerate and the tangent portfolio that offers the highest expected rate of return for any givenlevel or risk.C. Separation theorem states that the investment decision that is how to construct theportfolio of risky assets is not separate from the financing decision that is how muchshould be invested or borrowed in the risk-free asset.D. The market portfolio is a portfolio that contains some risky securities in the market.6. Which of the following investments would a risk averse investor prefer if the risk free rate iszero? InvestmentIIIIII Value of Investment if:Cost Market Return > 0% Market Return < 0%TodayProbability: 40%Probability: 60%$20$20$20$15$30$0$0-$10$10 A. I onlyB. II onlyC. III onlyD. I and III onlyThe expected return on the market is 11.5 percent with a standard deviation of 13 percent andthe risk free rate is 4 percent. Which of the following portfolios are undervalued?PortfolioExpectedStandardReturnDeviation19%7!0 15 A8$%A. 1 and 2 onlyB. 1 and 4 onlyC. 2 and 3 onlyD. 3 and 4 only 7. 8. Which of the following is a FALSE statement of the security market line (SML)?A. It is upward sloping which indicates that investors require a higher expected return onriskier securities.B. It represents the trade off between total risk and the required rate of return for any riskysecurity.C. It indicates that the size of risk premium varies directly with a security’s market risk asmeasured by beta.D. It implies that securities with betas less than the market beta of 1.0 are less risky than the“average” stock and will therefore have lower required rates of return. Given the following information what is the beta of Stock X?Stock XS&P/TSXMonthReturnReturnJanuary10%8?bruary8 %March-5%5%April-10%-2%May9%5%June15 %A. 0.08B. 0.41C. 0.62D. 1.619. 10. An analyst has obtained the following information about the Velo Co.: Book value of assets$25 000; book value of common equity $10 000; book value of preferred stock $5 000. Thecompany has 4 000 common shares outstanding which are currently trading at $5 per share.The company has 3 000 preferred shares outstanding which are currently trading at $2 pershare. The yield on the debt equals the coupon rate. The weights used to determine theweighted average cost of capital are:Common Equity:Preferred Equity:Debt:A. 55.56% ;16.67% ;27.78%B. 40% ;20% ;40%C. 80% ;10% ;10%D. Cannot be determined we need the market value of debt.Part 2 Practice Problems1. Klaatu Co. has recently completed a $300 000 two-year marketing study. Based on theresults. Klaatu has estimated that 10 000 of its new RUR-class robots could be sold annuallyover the next eight years at a price of $10 115 each. Variable costs per robot are $7 900; fixedcosts total $11.7 million per year. Starts up costs include $41 million to build productionfacilities and 9 million in net working capital. The $41 million facility is made up of abuilding valued at 6 million that will belong to CCA class 3 (rate is 5%) and $35 million ofmanufacturing equipment (belonging to CCA class 8 with rate of 20%). At the end of theproject`s life the facilities will be sold for an estimated $10.1 million assuming thebuilding`s value will be $4 million and net working capital will be recovered .When thisproject is over there will still be other assets in the CCA class. Klaatu pays taxes at a 37%and uses a 15.5 percent discount rate on projects such as this one. Should Klaatu produce theRUR-class robots?2. The Bostral Company has to choose between two machines that do the same job but havedifferent lives. The two machines have the following costs: Year0 Machine A$ 40 000 Machine B$ 50 000 1234 $ 10 000$ 10 000$ 10 000 replace $$$$ 8 0008 0008 0008 000 replace These costs are expected in real terms. Assume a 6% real discount rate and ignore taxes.Which machine should Borstal buy?3. A Treasury bill rate is 6% and the expected return on the market portfolio is 15%. On thebasis of the capital asset pricing model :a. Draw a graph showing how the expected return varies with beta.b. What is the risk premium on the market?c. What is the required return on an investment with a beta of 1.5?d. If an investment with a beta of .8 offers an expected return of 9.8% does it have a positive NPV?e. If the market expects a return of 11.2% from stock X what is its beta?4. Stocks A and B have the following historical returns:YearStock A's Returns Stock B's Returns1997-18.00%-14.50 9833.0021.80199915.0030.502000-0.50-7.60200127.0026.30a. Calculate the average rate of return for each stock during the period 1997 through 2001.Assume that someone held a portfolio consisting of 50 percent of Stock A and 50 percent ofStock B. What would have been the realized rate of return on the portfolio in each year from1997 through 2001? What would have been the average return on the portfolio during thisperiod?b. Calculate the STD DEV of returns for each stock and for the portfolio during this period.c. If you are a risk-averse investor would you prefer to hold Stock A Stock B or the portfolio?Why?
