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Reading 45: Cost of Capital - LOS k ~Q5-8

Q5. Assuming all of the projects have equal risk, Conover creates an investment opportunity set (IOS) by ranking the projects starting with the most favorable to the least favorable project as follows:

A)   ABCDE.

B)   DBACE.

C)   DBCAE.

Q6. Conover calculates new WACC beyond the retained earnings break-even point as:

A)   15.30%.

B)   18.00%.

C)   14.36%.

Q7. Based on the investment opportunity schedule (IOS) and marginal cost of capital (MCC) schedule, which projects should be accepted?

A)   A, B, and D.

B)   A, B, C, and D.

C)   A and D.

Q8. Conover uses a technique involving random variables in a simulation to estimate the NPV of the projects. This technique is known as:

A)   bootstrapping.

B)   scenario analysis.

C)   Monte Carlo.

答案和详解如下:

Q5. Assuming all of the projects have equal risk, Conover creates an investment opportunity set (IOS) by ranking the projects starting with the most favorable to the least favorable project as follows:

A)   ABCDE.

B)   DBACE.

C)   DBCAE.

Correct answer is B)

Start by calculating the NPV of each project as follows:

NPV(A) = (1,000) + 100 / (1.1156)1 + 250 / (1.1156)2 + 450 / (1.1156)3 + 650 / (1.1156)4 + 0 = 34.26

NPV(B) = (2,500) + 500 / (1.1156)1 + 900 / (1.1156)2 + 1200 / (1.1156)3 + 1200 / (1.1156)4 + 700 / (1.1156)5 = 715.44

NPV(C) = (1,750) + 200 / (1.1156)1 + 300 / (1.1156)2 + 600 / (1.1156)3 + 700 / (1.1156)4 + 800 / (1.1156)5 = 17.34

NPV(D) = (4,000) + 1,400 / (1.1156)1 + 1,400 / (1.1156)2 + 1,400 / (1.1156)3 + 1,400 / (1.1156)4 + 1,400 / (1.1156)5 = 1,102.18

NPV(E) = (2,000) + 300 / (1.1156)1 + 400 / (1.1156)2 + 700 / (1.1156)3 + 700 / (1.1156)4 + 700 / (1.1156)5 = (48.51)

Ranking the projects starting with the highest NPV to lowest NPV: DBACE.

Q6. Conover calculates new WACC beyond the retained earnings break-even point as:

A)   15.30%.

B)   18.00%.

C)   14.36%.

Correct answer is C)

Cost to issue new equity is given as 18%.

WACC = wdkd(1 − t) + weke = 0.30(0.09)(1 − 0.35) + 0.70(0.18) = 0.1436.

Q7. Based on the investment opportunity schedule (IOS) and marginal cost of capital (MCC) schedule, which projects should be accepted?

A)   A, B, and D.

B)   A, B, C, and D.

C)   A and D.

Correct answer is C)

Pro forma earnings are $7,000 and the dividend payout ratio is 50%, meaning that Bailey’s retained earnings for 2005 are estimated to be $7,000 (1 – 0.5) = $3,500.

The retained earnings break-even point is calculated as follows: $3,500 / 0.70 = $5,000.

Projects B and D are mutually exclusive therefore only the project with the highest NPV is chosen, NPV(D) = 1,102.18. Project A has the next highest NPV(A) = 34.26. The total investment required for projects D and A is $5,000. Therefore, new equity must be issued before considering other projects. The new WACC is 14.36% including the increased cost of 18% for equity. The remaining projects have IRR below the new WACC and their NPVs are negative using the higher WACC. Projects D and A are the only projects that should be accepted.

Q8. Conover uses a technique involving random variables in a simulation to estimate the NPV of the projects. This technique is known as:

A)   bootstrapping.

B)   scenario analysis.

C)   Monte Carlo.

Correct answer is C)

Monte Carlo simulation requires the analyst to estimate the probability distributions of input variables (e.g., sales, variable cost per unit, etc.), and then generate random values representing possible outcomes for each of these input variables. After the process is repeated many times, these variables are used in a simulation model to generate an expected NPV for a project.

Scenario analysis is a technique that requires the analyst to estimate project NPVs over a range of possible scenarios (such as recession, average, boom). The range of NPVs provides evidence concerning the project’s risk. Bootstrapping describes the effect that can occur when a high-growth, high-P/E firm (high P/E) merges with a low-growth, low-P/E firm.

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