Corporate Finance 1 & 2
Practice Set
A. Time value of money
Futures Value
1. At age 25 you invest $1,500 that earns 8 percent each year. At age 40 you invest $1,500 that earns 11 percent per year. In which case would you have more money at age 65?
Solving for Rates
2. You invested $3,000 in the stock market one year ago. Today, the investment is valued at $3,500. What return did you earn? What return would you suffer next year for your investment to be valued at the original $3,000?
Moving Cash Flows
3. You are scheduled to receive a $500 cash flow in one year, a $1,000 cash flow in two years, and pay an $800 payment in three years. If interest rates are 10 percent per year, what is the combined present value of these cash flows?
General Time Value of Money
4. Ten years ago, Hailey invested $2,000 and locked in a 9 percent annual interest rate for 30 years (end 20 years from now). Aidan can make a twenty year investment today and lock in a 10 percent interest rate. How much money should he invest now in order to have the same amount of money in 20 years as Hailey?
Present Value of Multiple Annuities
5. A small business owner visits his bank to ask for a loan. The owner states that he can repay a loan at $1,000 per month for the next three years and then $2,000 per month for two years after that. If the bank is charging customers 7.5 percent APR, how much would it be willing to lend the business owner?
Low Financing or Cash Back
6. A car company is offering a choice of 2 deals. You can receive $500 cash back on the purchase, and a 7% APR, 4 year-loan. The other option is you could obtain a 4-year loan from your credit union, at 3% APR. The price of the car is $15000. Which deal is cheaper ?
Investing for Retirement
7. Monica has decided that she wants to build enough retirement wealth that, if invested at 8 percent per year, will provide her with $3,500 of monthly income for 30 years. To date, she has saved nothing, but she still has 25 years until she retires. How much money does she need to contribute per month to reach her goal?
B. Bond Valuation
Compute Bond Price
8. Compute the price of a 4.5 percent coupon bond with 15 years left to maturity and a market interest rate of 6.8 percent. (Assume interest payments are semi-annual.) Is this a discount or premium bond?
Bond Prices and Interest Rate Changes
9. A 6.25 percent coupon bond with 22 years left to maturity is priced to offer a 5.5 percent yield to maturity. You believe that in one year, the yield to maturity will be 6.0 percent. If this occurs, what would be the total return of the bond in dollars and percent?
Bond Ratings and Prices
10. A corporate bond with a 6.5 percent coupon has 15 years left to maturity. It has had a credit rating of BBB and a yield to maturity of 7.2 percent. The firm has recently gotten into some trouble and the rating agency is downgrading the bonds to BB. The new appropriate discount rate will be 8.5 percent. What will be the change in the bond’s price in dollars and percentage terms? (Assume interest payments are paid semi-annually.)
C. Valuing Stocks
Value a Constant Growth Stock
11. Financial analysts forecast Safeco Corp. (SAF) growth for the future to be 10 percent. Safeco’s recent dividend was $1.20. What is the value of Safeco stock when the required return is 12 percent?
Value of Future Cash Flows
12. A firm recently paid a $0.45 annual dividend. The dividend is expected to increase by 10 percent in each of the next four years. In the fourth year, the stock price is expected to be $80. If the required return for this stock is 13.5 percent, what is its value?
Variable Growth
13. A fast growing firm recently paid a dividend of $0.35 per share. The dividend is expected to increase at a 20 percent rate for the next 3 years. Afterwards, a more stable 12 percent growth rate can be assumed. If a 13 percent discount rate is appropriate for this stock, what is its value?
P/E Model and Cash Flow Valuation
14. Suppose that a firm’s recent earnings per share and dividend per share are $2.50 and $1.30, respectively. Both are expected to grow at 8 percent. However, the firm’s current P/E ratio of 22 seems high for this growth rate. The P/E ratio is expected to fall to 18 within five years. Compute a value for this stock by first estimating the dividends over the next five years and the stock price in five years. Then discount these cash flows using a 10 percent required rate.
D. Calculating the cost of capital
15. Suppose that Tap Dance, Inc.’s capital structure features 65 percent equity, 35 percent debt, and that its before-tax cost of debt is 8 percent, while its cost of equity is 13 percent. If the appropriate weighted average tax rate is 34 percent, what will be Tap Dance’s WACC?
16. An all-equity firm is considering the projects shown below. The T-bill rate is 4 percent and the market risk premium is 7 percent. If the firm uses its current WACC of 12 percent to evaluate these projects, which project(s), if any, will be incorrectly rejected?
| Project | Expected Return | Beta |
| A | 8.0% | 0.5 |
| B | 19.0% | 1.2 |
| C | 13.0% | 1.4 |
| D | 17.0% | 1.6 |
E. Weighing net present value and other capital budgeting criteria
Suppose your firm is considering investing in a project with the cash flows shown below, that the required rate of return on projects of this risk class is 8 percent, and that the maximum allowable payback and discounted payback statistics for the project are 3.5 and 4.5 years, respectively.
| Time | 0 | 1 | 2 | 3 | 4 | 5 | 6 |
| Cash Flow | -$5,000 | $1,200 | $1,400 | $1,600 | $1,600 | $1,400 | $1,200 |
17. Use the payback decision rule to evaluate this project; should it be accepted or rejected?
18. Use the discounted payback decision rule to evaluate this project; should it be accepted or rejected?
19. Use the IRR decision rule to evaluate this project; should it be accepted or rejected?
20. Use the NPV decision rule to evaluate this project; should it be accepted or rejected?
F. Assessing long-term debt, equity, and capital structure
21. Landry Corp. is looking at two possible capital structures. Currently, the firm is an all-equity firm with $1.2 million dollars in assets and 200,000 shares outstanding. The market value of each stock is $6.00. The CEO of Landry is thinking of leveraging the firm by selling $600,000 of debt financing and retiring 100,000 shares, leaving 100,000 outstanding. The cost of debt is 10% annually, and the current corporate tax rate for Landry is 30%. If the CEO believes that Landry's EBIT will be $120,000, should the CEO leverage the firm? Explain.
22. Consider the Modigliani and Miller's world of corporate taxes. An unleveraged (all-equity) firm value is $100 million. By adding debt, the annual interest expense is $10 million, the corporate tax rate is 40%, and the discount rate on the tax shield is 10%. What is the gain to leverage or the value added from issuing debt?
23. Roxy Broadcasting has an annual EBIT of $3,500,000 and a WACC of 14%. The current tax rate is 40%. Roxy will have the same EBIT forever. The company currently has debt of $6,250,000 with a cost of debt of 14%. Roxy will sell $12,500,000 more of debt and retire stock with the proceeds. What is the value of equity in the higher-levered firm? What is the government’s value in the higher-levered firm?
G. Dividends, share repurchases, and other payouts
24. JBK Inc normally pays a quarterly dividend. The last such dividend paid was $2.50, all future quarterly dividends are expected to grow at 5 percent, and the firm faces a required rate of return on equity of 11 percent. If the firm just announced that the next dividend will be an extraordinary dividend of $17 per share that is not expected to affect any other future dividends, what should the stock price be?
