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Free CMA Exam Braindumps (page: 64)

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The method that recognizes the time value of money by discounting the after-tax cash flows over the life of a project, using the company's minimum desired rate of return is the

  1. Accounting rate of return method.
  2. Net present value method.
  3. Internal rate of return method.
  4. Payback method.

Answer(s): B

Explanation:

The net present value (NPV) method computes the discounted present value of future cash inflows to determine whether they are greater than the initial cash outflow. The discount rate (cost of capital or hurdle rate) must be known to discount the future cash inflows. If the NPV is positive (present value of future cash inflows exceeds initial cash outflow), the project should be accepted. If the NPV is negative, the project should be rejected.



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Mulva Inc. is considering the following five independent projects:


The company has a target capital structure which is 40 percent debt and 60 percent equity. The company can issue bonds with a yield to maturity of 10 percent. The company has $900000 in retained earnings, and the current stock price is $40 per share. The flotation costs associated with issuing new equity are $2 per share. Mulva's earnings are expected to continue to grow at 5 percent per year. Next year's dividend (D1) is forecasted to be $2.50. The firm faces a 40 percent tax rate. What is the size of Mulva's capital budget?

  1. $1,200,000
  2. $1,750,000
  3. $2,400,000
  4. $800,000

Answer(s): B

Explanation:

The size of Mulva's capital budget will be determined by the number of projects it can profitably undertake, i.e., those projects for which the IRR is greater than the applicable weighted average cost of capital.
First, the cost of each type of capital must be determined. The formula for calculating the cost of retained earnings is ks = (D1 + Po) + G, where D equals the dividend after year one, P0 equals the current stock price, and G equals the expected growth rate. The cost of retained earnings is 11 .25% [($2.50 ÷ $40) + 0.05]. The formula for calculating the cost of new equity is ke = [(D1 + (Po --floating cost)]+ G. The cost of new equity is 11 .58%{[$2.50 + ($40 --$2)] + 0 .05}.
Given the firm's target capital structure and its retained earnings balance of $900,000, the firm can raise $1 500,000 with debt and retained earnings before it must use outside equity. Therefore, the WACC for $0 -- $1 500,000 of financing is equal to 9.15% [04 (0.10)(1 --04) + 0.6(0.1125) = 0.0915]. Above $1,500,000, the firm must issue some new equity, so the WACC is 9.35% [04(0.10)(1 --04) + 0.6(0.1158) = 0.0935]. Projects A, B, and C will definitely be undertaken because the IRR is greater than the WACC. Next, determine whether Project D will be profitable. Financing Projects A, B, and C, requires $1 200,000 in capital. Therefore, the $550,000 needed for Project D would involve financing $300,000 with debt and retained earnings and $250,000 with debt and equity. Thus, the WACC for Project D is 9.24% [($300,000 + $550,000) x 0.0935], which is less than Project D's IRR. Thus, Projects A, B, C, and D should be accepted, and the firm's capital budget is $1 750,000.



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Rohan Transport is considering two alternative busses to transport people between cities that are in the Southeastern U.S., such as Baton Rouge and Gainesville. A gas-powered bus has a cost of $55,000, and will produce end-of-year net cash flows of $22,000 per year for 4 years. A new electric bus will cost $90,000, and will produce cash flows of $28000 per year for 8 years. The company must provide bus service for 8 years, after which it plans to give up its franchise and to cease operating the route. Inflation is not expected to affect either costs or revenues during the next 8 years. If Rohan Transports cost of capital is 16%, by what amount will the better project increase the company's value?

  1. $6,556
  2. $(14,432)
  3. $13,112
  4. $31,632

Answer(s): D

Explanation:

The NPV of the electric bus is $31,632, which is greater than that of two gas-powered busses bought4 years apart. The NPV for the $90,000 electric bus involves multiplying the $28,000 annual cash flows times the present value factor of 4.344, which equals $121,632. Deducting the $90,000 initial cost results in an NPV of $31,632. The NPV for the two gas-powered busses is $10,208, calculated as follows:



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Mesa Company is considering an investment to open a new banana processing division. The project in question would entail an initial investment of $45000, and as a result of the project cash inflows of $20000 can be expected in each of the next 3 years. The hurdle rate is 10%. What is the profitability index for the project?

  1. 1.0784
  2. 1.1053
  3. 1.1379
  4. 1.1771

Answer(s): B

Explanation:

At a 10% hurdle rate1 the present value of the future inflows is:
20,000 x 2487 = $49,740
Thus, the net present value is $4,740 (49,740 -- 45000). The profitability index calculation is:
49,740 =-- 1.1053
45,000






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