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ECON S-190 INTRODUCTION TO FINANCIAL AND

MANAGERIAL ECONOMICS
MOCK FINAL EXAMINATION 2021 – Solution outline

Question #1

Your company is considering a machine which will cost $100,000 at time t = 0 and which
can be sold after three years for $20,000. $15,000 must be invested at time 0 in
inventories and receivables (i.e. NWC); and these funds will be recovered when the
operation is closed at the end of year 3.

The facility will produce sales revenues of $45,000 per year for three years; operating
cash costs (OCC) (excluding depreciation) will be 20% of sales. Operating cash inflows
will begin one year from today (at t=1). The machine will be depreciated straight line.

The company has a 30% tax rate, $500,000 taxable income from other operations, and a
20% cost of capital for projects of this risk level.

What is the project’s NPV?

Step 1: Initial Cash Flows

Basic Price 100,000
+ Installation n/a
= Depreciable basis 100,000
+ NWC 15,000
=CF_0 115,000

Step 2: Operating Cash Flows

t=1 t=2 t=3
Revenues 45,000 45,000 45,000
- OCCs 9,000 9,000 9,000
(20%*sales)
- Depn 26,667 26,667 26,667
= EBIT 9,333 9,333 9,333
- Taxes (30%) 2800 2800 2800
= NOPAT 6,533 6,533 6,533
+DEPN 26,667 26,667 26,667
= OCF_t 33,200 33,200 33,200
+ Other 0 0 0
= CF_t 33,200 33,200 33,200

Step 3: Terminal Cash Flows

Expected Salvage 20,000
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- Tax on gain on sale (20,000-20,000)*0.3 = 0

+ Recovery of NWC 15,000
= TCF 35,000

Step 4: Calculate Project NPV:

33,200 33,200 33,200 + 35,000
𝑁𝑃𝑉 = −115,000 + + +
1.20 (1.20)2 (1.20)3
𝑁𝑃𝑉 = −24,810

Question #2

(a) Investors in the stock of the HSL Corp. have a required return of 10%. The
Distribution just made (D0) was $5.00. What is the value of the stock if it is
growing perpetually at:

+8%
-1% (respectively)?

Value of the stock if it grows perpetually at +8%:

$5*(1+8%) / (10%-8%) =$270
Value of the stock if it grows perpetually at -1%:
$5*(1-1%) / (10%+1%) =$45

(b) JO Corp. has been experiencing growth at a rate of 50% in recent years, and that
super-growth rate is expected to continue for 4 more years. After the four years,
it is expected to enter into steady state growth at a 5% annual rate.

If D0 (dividend/distributable flow just paid) is $1.00 and the required rate of return
on the stock is 20%, what is the value of the stock?

Value of the stock from the super-growing period:

PVyr1=1*(1+50%) / (1+20%) = $1.25
PVyr2=1*(1 + 50%)2/(1 + 20%)2 = $1.56
PVyr3=1*(1 + 50%)3/(1 + 20%)3 = $1.95
PVyr4=1*(1 + 50%)4/(1 + 20%)4 = $2.44

Value of the stock at the end of the super-growing period:

Vyr4=1*(1 + 50%)4 ∗ (1 + 5%)/ (20%-5%) = $35.44
PV=$35.44/(1 + 20%)4 = $17.09

Value of the stock:

PV=$1.25+$1.56+$1.95+$2.44+$17.09=$24.29

(c) What is the role of the P/E Multiple approach in the valuation of equity securities?
How does the DCF technique work?
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P/E Multiple approach uses the comparable companies’ P/E ratio to value the
targeted company. DCF calculates future cash flows of the targeted company and
discounts these cash flows to present value using appropriate cost of capital, in
order to determine targeted company’s value.

Question #3

(a) What is the Marginal Cost of Capital (MCC)?

Marginal Cost of Capital is the cost of the last dollar of capital raised; often times,
if a firm has some retained earnings (i.e. $1M) with a capital structure of x%
equity, finance needs exceeding $1M/(x%) will require additional equity, thereby
increasing the firm’s weighted average cost of capital.

(b) What is the relationship between dividend policy and the MCC curve?
If a company continues to raise larger capital for its business, MCC will start to
rise. There comes a point when retained earnings are depleted and new common
stock has to be issued. This “breakpoint” is between using lower-cost internal
common equity and issuing new common equity. As dividend increases, the
payout ratio increases, reducing retained earnings, making the breakpoint move
toward lower value in the MCC curve graph. Also, see above.

Question #4

(a) You are given the following information for the ABC Company:
Current cost of preferred stock = 10%.
Cost of Debt = 6%
The corporation has a tax rate of 30%.

The common stock has a beta of 1.1, the Risk-free rate (Rf) is 3%, and the
return on the market (Rm) is 14%.

Capital structure (market weights):

30% debt
10% preferred stock
60% common equity

Compute the weighted average cost of capital (WACC) for the ABC Company.

Cost of common stock = 3%+1.1*(14% - 3%) = 15.1%

WACC= 30%*6%*(1-30%)+10%*10%+60%*15.1% = 11.32%

(b) Your company is considering two mutually exclusive projects, Y and Z, whose
costs and cash flow projections are shown below:

Year Project Y Project Z

0 -$1,000 -$1,000,000
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1 0 +$300,000
2 0 +$300,000
3 0 +$300,000
4 +$5,000 +$300,000

The projects are equally risky, and their required rate of return is 10%.

Compute the NPVs and IRRs for both projects.

5000
NPV for Project Y = −1,000 + (1+10%)4 = $2,415
IRR for Project Y:
5000
−1,000 + (1+𝐼𝑅𝑅)4 =0
IRR=49.53%
300,000 300,000 300,000 300,000
NPV for Project Z = −1,000,000 + + (1+10%)2 + (1+10%)3 + (1+10%)4
1+10%
= $-49,040
IRR for Project Z:
300,000 300,000 300,000 300,000
−1,000,000 + 1+𝐼𝑅𝑅 + (1+𝐼𝑅𝑅)2 + (1+𝐼𝑅𝑅)3 + (1+𝐼𝑅𝑅)4=0
IRR=7.71%

(c) Project X has a cost of $60,000, and its expected net cash inflows are $10,000 per
year for 8 years (and zero salvage) with WACC of 12%.

Compute the project’s payback, NPV and IRR.

$60,000
The project’s payback = $10,000 = 6 years

10,000 10,000 10,000 10,000 10,000

NPV= −60,000 + 1+12% + (1+12%)2 + (1+12%)3 + (1+12%)4 + (1+12%)5 +
10,000 10,000 10,000
+ (1+12%)7 + (1+12%)8 = -$10,323.60
(1+12%)6

IRR for the project:

10,000 10,000 10,000 10,000 10,000 10,000
−60,000 + + (1+𝐼𝑅𝑅)2 + (1+𝐼𝑅𝑅)3 + + + +
1+𝐼𝑅𝑅 (1+𝐼𝑅𝑅)4 (1+𝐼𝑅𝑅)5 (1+𝐼𝑅𝑅)6
10,000 10,000
+ (1+𝐼𝑅𝑅)8 = 0
(1+𝐼𝑅𝑅)7
IRR=6.88%
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Question #5

(a) The Boston Lawn Supply Company is reviewing its inventory policy regarding
lawn seed. The following relationships and conditions exist:

• Orders must be placed in multiples of 100 bags.

• Requirements for the year are 30,000 bags.
• The purchase price per bag is $2.00.
• The carrying cost is 25 percent of inventory value.
• The fixed costs per order are $30.
• The desired safety stock is 100 bags; this amount is on hand
initially.
• Four days are required for delivery.
• Assume 360 days per year.

(i) What is the EOQ?

2∗30∗30,000
EOQ=√ = 1,897 bags ≈ 1,900 bags
25%∗2

(ii) How many orders should Boston Lawn Supply place each year?
30,000
N= = 15.79 orders ≈ 16 orders
1,900

(iii) What is the reorder point?

30,000
R=4 ∗ + 100 = 433 bags
360

Question #6

(a) Discuss the results of Modigliani-Miller (1958).

Assumptions:
1 No change in investment policy.
2 No taxes.
3 Bankruptcy is not costly.
4 Managers maximize shareholder wealth.
5 Perfect and complete capital markets (no transactions costs, complete set of
traded securities).
6 Symmetric information.

Modigliani & Miller Proposition I: Firm value is independent of capital structure.

Although higher leverage implies higher risk to equity holders, this does not
invalidate the proposition. Because for the overall firm, increased leverage means
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more debt (with lower risk) is held.

Modigliani & Miller Proposition II: rE=rA+D/E( rA-rD )

Leverage does not change the cost of capital, as the total discount rate is constant
at rA. While the fraction of ’lower cost’ debt increases, equity demands a higher
return, enough to compensate for the extra risk it is bearing.

(b) What errors in capital structure choice will a firm make if it seeks to maximize
EPS when choosing the capital structure?
EPS can be mechanically increased by repurchasing outstanding shares.
Assuming ordinary Modigliani-Miller proposition I assumptions, share
repurchases will retain the same enterprise value (overall firm value, inclusive of
debt), while increasing leverage. Hence changing capital structure to increase EPS
will be misguided, since no change occurs to the economics of the firm. However,
if cost of financial distress exists along with debt tax shield, there will be an
optimal level of leverage which maximizes firm value. An excessive leverage
beyond such point to achieve higher EPS will be destructive, and expose the firm
to bankruptcy risks.