Eastern Michigan University
Department of Accounting/Finance
SAMPLE FIN 620 MIDTERM Questions
1. The puzzle of optimal capital structure is that there appears to be regularities in the observed ratios of
debt to equity of U.S. firms. For example, the steel industry appears to carry a higher percentage of debt than the public
accounting industry does. How can this be explained?
2. The WAACC formula seems to imply that debt is cheaper than equity – that is, that a firm with more
debt will have a lower cost of capital compared to one with less debt. Does this make sense? Why or why not?
3. What is wrong with the following statement –
"As a firm borrows more and debt becomes risky, both stockholders and bondholders demand higher rates of return.
Thus by reducing the debt ratio we can reduce both the cost of debt and the cost of equity, making everybody better off."
4. It has been suggested, in some of the cases we have done in class, that one disadvantage of common stock
financing is that share prices tend to decline in recessions, thereby increasing the cost of capital and deterring investment.
Discuss this view. Is it an argument for greater use of debt financing?
5. Whispering Pines, Inc., is all-equity-financed. The expected rate of return on the company’s shares
is 12 % and its beta is 1.0. The risk free rate is 7% and the market risk premium is 5%. Suppose the company issues debt,
repurchases shares, and moves to a 30 percent debt to total assets ratio. What will the company’s WACC be at the new
capital structure? The borrowing rate is 7.5% and the tax rate is 40%.
B (unleveraged) = B (leveraged)/(1 + Debt/Equity
6. Fonderia is negotiating for the purchase of a new piece of equipment for their current operations. Fonderia
wants to know the maximum price that it should be willing to pay for the equipment. That is, how high must the price be for
the equipment to have an NPV of zero? You are given the following facts:
The new equipment would replace existing equipment that has a current market value of $20,000.
The new equipment would not affect revenues, but before-tax operating costs would be reduced by $10,000 per
year for eight years. These savings in cost would occur at year-end.
The old equipment is now five years old. It is expected to last for another eight years, and it is expected
to have no resale value at the end of those eight years. It was purchased for $40,000 and is being depreciated to zero on
a straight-line basis over 10 years.
The new equipment will be depreciated to zero using straight-line depreciation over five years. Fonderia expects
to be able to sell the equipment for $5000 at the end of eight years. The proceeds from this sale would be subject to taxes
at the ordinary corporate income tax rate of 34 percent.
Fonderia’s cost of capital is 8 percent.
7. The cash flows for projects A, B, and C are given below. Calculate the payback period, IRR, and NPV for each
project. The firm’s COC is 10%. The projects are in the same risk class. If A and B are mutually exclusive, and C is
independent which project or combination of projects is preferred using
Year A B C
0 -1 -1 -1
1 0 1 0
2 2 0 0
3 -1 1 3
The Marriott Case
In April 1988, the vice president of project finance at the Marriott Corporation, was preparing his annual recommendations
for the hurdle rates at each of the firm’s two divisions. Your assignment is to help him out by 1) calculating the cost
of capital for Marriott Corporation ; 2) calculating the hurdle rates for both the lodging and restaurant divisions; and 3)
explaining to him why using hurdle rates for project evaluation is better than using the WACC of Marriott.
Use the data listed below and the information on the attached page.
Marriott’s hotels include 361 hotels, with more than 100,000 rooms in total. Hotels ranged from the full-service,
high-quality Marriott hotels and suites to the moderately priced Fairfield Inn. Lodging generated 41% of 1987 sales and 51%
of profits. Marriott’s restaurants included Big Boy, Roy Rogers, and Hot Shoppe’s. Restaurants provided 13% of
198 7 sales and 16% o the profits.
The 30-year T bond rate in 1988 was 8.95% and the debt rate premium above the T bond for Marriott was 1.3%,
for lodging was 1.1% and restaurants 1.8%.
The target debt to equity ratios for Marriott was 60%, for lodging was 74%, and for restaurants was 42%.
The corporate tax rate was 40%.
11. Benson Enterprises, Inc., is evaluating alternative uses for a three-story manufacturing and warehousing
building that is has purchased for $225,000. The company could continue to rent the building to the present occupants for
$12,000 per year. The present occupants have indicated an interest in staying in the building for at least another 15 years.
Alternatively, the company could modify the existing structure to use for its own manufacturing and warehousing needs. Benson’s
production engineer feels the building could be adapted to handle one of two new product lines. The cost and revenue data
for the two products alternatives follow:
Product A Product B
Initial cash outlay for building modifications $36,000 $54,000
Initial cash outlay for equipment 144,000 162,000
Annual pretax cash revenues (generated for
15 years) 105,000 127,500
Annual pretax cash expenditures (generated for
15 years) 60,000 75,000
The building will be used for only 15 years for either product A or product B. After 15 years, the building
will be too small for efficient production of either product line. At that time, Benson plans to rent the building of firms
similar to the current occupants. To rent the building again, Benson will need to restore the building to its present layout.
The estimated cash cost of restoring the building if product A h as been undertaken is $3750; if product B has been produced,
the cash cost will be $28,125. These cash costs ca be deducted for tax purposes in the year the expenditures occur.
Benson will depreciate the original building shell(purchased for $225,000) over a 30-year life to zero, regardless
of which alternative it chooses. The building modifications and equipment purchases for either product are estimated to have
a 15 year life; also, they can and will be depreciated on a straight-line basis. The firm’s tax rate is 34 percent,
and its required rate of return on such investments is 12 percent.
For simplicity, assume all cash flows for a given year occur at the end of the year. The initial outlays for
modifications and equipment will occur at t = 0, and the restoration outlays will occur at the end of year 15. Also, Benson
has other profitable ongoing operations that are sufficient to cover any losses.
Which use of the building would you recommend to management?
12. The Erickson Toy Company currently uses an injection-molding machine that was purchased 5 years ago. This
machine is being depreciated on a straight-line basis toward a $10,000 salvage value, and it has 5 years of remaining life.
The cost of the machine 5 years ago was $100,000. It can be sold for $40,000 at this time.
The firm is offered a replacement machine, which has a cost of $120,000 and an estimated useful life of 5 years
and an estimated salvage value of zero. The replacement machine would permit an output expansion so sales would rise by $30,000
per year, but costs would increase by $5,000 per year. The new machine would require that inventories by increase by $2000.
The tax rate is 40% and the firm’s COC is 12%. Should it replace the old machine? Calculate the NPV of this decision.
T. S. Hawkey Inc., a large building materials manufacturer, is evaluating the possible acquisition of the Marvin
Laurence Company, a small aluminum siding manufacturer. Hawkey’s analysts project the following post merger cash flows
for Laurence (in thousands of dollars).
1997 1998 1999 2000
Net Sales $250 $288 $312 $338
Selling/Adm Exp 25 31 38 40
Interest 12 15 16 18
Cost of goods sold as a percentage of sales (including depreciation): 65%
Terminal growth rate of cash flows available to Hawkey: 8%
If the acquisition is made, it will occur on January 1, 1997. All cash flows are assumed to occur at year end.
Laurence’s current market-determined beta is 1.0, but its investment bankers think that its beta would rise to 1.68
if the merger takes place. Depreciation generated funds would be used to replace worn-out equipment so they would not be available
to Hawkey’s shareholders. The risk-free rate is 8 percent, and the market risk premium is 6 percent. The post merger
tax rate would be 40 percent. Synergy could reduce the cost of goods sold ratio to sales to 60% and the sales could also increase
by $100,000 per year after the merger. However the beta would rise to 1.8.
Determine the range of value of Laurence to Hawkey’s shareholders.
14. Furniture Depot, Inc. is an all equity firm with a beta of 0.95. The market-risk premium is 9% and the risk
free rate is 5%. The company must decide whether or not to undertake a project that requires an immediate investment of $1.2
million and will generate annual after-tax cash flows of $340,000 at year-end for 5 years. If the project has the same risk
as the firm as a whole, should the firm undertake the project?
15. The treasurer argues that the project should be accepted The XYZ Company has a current market value of $1
million half of which is financed with debt. Its current WACC is 9% and its tax rate is 40%. The company’s treasurer
proposes a new project, which costs $500,000 and which can be financed completely with debt. The project’s cash flow
is expected to have the same risk as the firm’s operating cash flow and earn 8.5%.
As it earns more than 5%, which is the before-tax cost of debt used to finance it. Do you agree with the treasurer?
Why or why not?
16. The firm’s cost of equity is 18%, the market value of the firm’s equity is $8 million, and the
firm’s cost of debt capital is 9%, and the market value of debt is $4 million. The firm is considering a new investment
with an expected rate of return of 17%. This project is 30% riskier that the firm’s average operations. The risk free
rate of return is 5% and the return of the market is 15%. Assuming that the tax rate is zero. Does the project have an NPV
greater than zero? Why or why not? Explain.