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College of Business & Finance

The MBA Program
Financial Management (FINC 501)
Mid-Term Exam
2nd Semester 2015
Dr. Wajeeh Elali
18:00 20:30
Wednesday, April 8, 2015
Student Name:
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Suggested Solutions
REMARKS:
This is a CLOSED BOOK examination.
You are permitted noiseless, non-programmable CALCULATORS.
The purpose of this Exam is to help you reflect on the lectures and to apply
the tools we have learnt to real life examples.
The problems are to be answered in the space provided for them in this
booklet.
Clearly show ALL your working and encircle the final answer.
Neatness will be greatly appreciated
This Exam consists of three parts (13 questions plus 3 mini cases) on a total
of 12 pages, including cover page.
Good Luck!
Honor Code
In recognition and spirit of the Honor Code, I certify that I have not and will not
receive or give aid on the examination and that I will report, to the best of my
ability, all honor Code violations observed by me.
Signed_________________________________________________
THIS EXAMINATION PAPER MUST BE RETURNED

Prof. Wajeeh Elali

Financial Management (FINC 501)

Show your work in the space provided

Part I
Conceptual Questions (15 marks)
Q1.

A consumer product firm is considering making a major investment in China. The

investment is expected to cost $2 billion, and the present value of the expected
cash flows on the investment is only $1.5 billion. However, the firm believes that
there are substantial expansion opportunities in China. Would that justify investing
the $2 billion? Why or why not?

Answer:
Base case NPV = - $2 Billion + $1.5 Billion = -$0.5 Billion
Based on conventional NPV analysis the project should be rejected. However, the real
option (here the option to expand) has value and therefore should be considered when
taking a capital budgeting decision.
The market value of the project (MV project) will be the sum of the NPV of the project
without options and the value of the managerial options.
In our case,
MV project = NPV + OPTION to expand
The substantial expansion opportunities could justify investing the $2 billion, providing
these opportunities have a PV (at t=0) exceeding $0.5 billion. In other words, if the
option to expand has value greater than $0.5 billion, the project should be accepted.
Q2.

Explain the similarities and differences between Net Present Value (NPV),
Profitability Index (PI), and Economic Value Added (EVA).

Answer:
NPV, PI, and EVA are all based on the same underlying idea, that investments should
earn a rate of return high enough to meet investors expectations. The PI differs from
NPV in that it is expressed as a rate of return. That is, it measures the present value of
an investments cash inflows relative to the up-front cash outflow. EVA calculates a cost
of capital charge which is deducted each year from a projects cash flows. To calculate
the overall project EVA, you take the annual EVA figures and discount them at the cost
of capital. In general, NPV, PI, and EVA will always agree on whether a project is worth
investing in or not.

Q3.

Home Builder Supply, a retailer in the home improvement industry, currently

operates seven retail outlets in Manama and Dubai. Management is
contemplating building an eighth retail store across town from its most successful

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

retail outlet. The company already owns the land for this store, which currently
has an abandoned warehouse located on it. Last month, the marketing
department spent $10,000 on market research to determine the extent of
customer demand for the new store. Now Home Builder Supply must decide
whether to build and open the new store.
Which of the following should be included as part of the incremental earnings (or
cash flow) for the proposed new retail store?
a. The cost of the land where the store will be located.
b. The cost of demolishing the abandoned warehouse and clearing the lot.
c. The loss of sales in the existing retail outlet, if customers who previously drove
across town to shop at the existing outlet become customers of the new store
instead.
d. The $10,000 in market research spent to evaluate customer demand.
e. Construction costs for the new store.
f. The value of the land if sold.
g. Interest expense on the debt borrowed to pay the construction costs.
Answer:
a. No, this is a sunk cost and will not be included directly.
b. Yes, this is a cost of opening the new store.
c. Yes, this loss of sales at the existing store should be deducted from the sales
at the new store to determine the incremental increase in sales that opening
the new store will generate for HBS.
d. No, this is a sunk cost.
e. Yes, this is a capital expenditure associated with opening the new store.
These costs will, therefore, increase HBSs depreciation expenses.
f. Yes, this is an opportunity cost of opening the new store. (By opening the new
store, HBS forgoes the after-tax proceeds it could have earned by selling the
property. This loss is equal to the sale price less the taxes owed on the capital
gain from the sale, which is the difference between the sale price and the book
value of the property. The book value equals the initial cost of the property
less accumulated depreciation.)
g. No, while these financing costs will affect HBSs actual earnings, for capital
budgeting purposes we calculate the incremental earnings without including
financing costs to determine the projects unlevered net income.

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

Part II
Quantitative Problems (40 marks)
Show ALL CALCULATIONS. Answers without supporting calculations will be
deemed a guess and will not receive any credit.
You plan to invest some money in a bank account. Which of the following banks
provides you with the highest effective rate of interest (EAR)?

1.

ABC Bank; 6% with daily (365-day) compounding

DDT Bank; 6% with annual compounding.
CBS Bank; 6% with monthly compounding
NBC Bank; 6% with quarterly compounding.

Solution:
By inspection, we can see that ABC dominates DDT, CBC, and NBC because, with the
same interest rate, the account with the most frequent compounding has the highest
EAR. Thus, the correct answer must be ABC Bank.
= (1+0.06/365)365 1 = 6.183%
= (1+0.06/1)1 1 = 6.000%
= (1+0.06/12)12 1 = 6.167%
= (1+0.06/4)4 1 = 6.061%

ABC
DDT
CBC
NBC
2.

Suppose you could borrow using either a credit card that charges 1 percent per
month or a bank loan with a 12 percent quoted interest rate that is compounded
daily. Which one should you choose?

Solution:
EAR (1

APR m
) 1
m

Credit card loan : EAR (1

0.12 12
) 1 (1.01)12 1 0.12683 12.68%
.12

0.12 365
) 1 0.12747 12.75%
365
Thus, the bank loan a little more than the credit card loan
Bank loan : EAR (1

3.

Jasmin recently purchased a new automobile for $25,000. She made a $5,000
down payment and financed the balance over 48 months using a loan with a 12
percent annual nominal rate of interest. What are her monthly payments?

Solution:

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

PV0 $25,000 $5,000 $20,000

m 12
r
12%

1% per month
m 12month
1 (1 r / m) n*m

r/m

rate per period

PVA PMT

PMT

4.

PVA
1 (1 r / m)

r/m

n*m

20,000
1 (1 .12 / 12)

.12 / 12

48

20,000
$526.676 / month
37.97395949

You can earn 8 percent interest, compounded annually. How much must you deposit
today to withdraw $10,000 in 6 years?

Solution:
PV FV (1 r ) n
PV 10,000(1 .08) 6 $6,301.6962
5.

A firm with a cost of capital (COC) of 15% is evaluating four capital projects. The
internal rates of return (IRR) are as follows:
Project
1
2
3
4

IRR
13%
16%
17%
14%

Which project(s) should be accepted and why?

Answer:
Project 2 and 3
If IRR > COC accept
If IRR < COC reject

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

6.

Financial Management (FINC 501)

A tenant wants to lease a building for $48,000 per year. She signs a five-year rental
agreement that states that she will pay $24,000 every six months for the next five
years. Which of the following is the timeline for her rental payments, assuming she
makes the first payment immediately?
a)
Date
(years)

Cash Flows
$48
(thousands)
b)
Date
(years)

$48

$48

$48

$48

$48

1/2

1 1/2 2

2 1/2 3

3 1/2 4

4 1/2 5

Cash Flows
-$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 -$24 0
(thousands)
c)
Date
(years)

Cash Flows
$24
(thousands)
d)
Date
(years)

Cash Flows
-$48
(thousands)

Answer:
7.

3 1/2 4

4 1/2 5

$24

$24

$24

$24

$24

$24

$24

$24

-$48

-$48

-$48

-$48

-$48

$24

$24

If you deposit $300 at the beginning of each year for three years in a savings
account that pays 6 percent interest per year, how much will you have at the end of
three years?

Solution:
(1 k ) n 1
(1 r )
k

(1 .06) 3 1
FVA $300
(1 .06) $1,012.38
.06

FVA PMT

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

8. If the required return is 10%, what is the Profitability Index (PI) of the following
investment and what does the IP rule say about whether you should invest?
Year

Net Cash
Flow
-$50
$20
$40
$60

0
1
2
3
Solution:
n

PI

PI

PV .benefits

Cost

CFt

(1 r )
t 1

Cost

20
40
60

2
(1.10) 3
1.10 1.10
50

1.93

Decision Rule:
Take any investment opportunity if PI > 1.
Turn down any opportunity whoes PI < 1.

9.

South West Industries is considering a project which has the following cash flows:
Year
0
1
2
3
4

Cash Flow
?
$4,000
3,000
3,000
1,500

The project has a payback period of 2.5 years. The firms cost of capital is 12
percent.
a) What is the projects net present value (NPV).
b) What does the NPV rule advise regarding this investment opportunity?
Solution:
Initial Investment

= CF1+CF2+0.5 CF3
= $4,000+3,000+(3,000/2)=$8,500

4,000
3,000
3,000
1,500

$551.626
1
2
3
(1.12)
(1.12)
(1.12)
(1.12) 4
If NPV 0, accept
If NPV < 0, reject
NPV 8,500

Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

10.

Financial Management (FINC 501)

You have just arranged a $20,000 loan from your bank at an annual rate of 10%.
The loan calls for annual payments of $1,000 over the next 14 years, and a final
payment at the end of year 15. How big will the final payment (balloon) be?

Solution
14

PV ( Loan)
t 1

PMTt
PMT15 (1 k ) 15
t
(1 k )

1 (1 .10) 14
15
PMT15 (1 .10)
.
10

20,000 1,000

20,000 7,366.68745 0.239392 PMT15

PMT15 $52,772.49

Part III
Mid-Term Exam

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

Mini Cases
(45 marks)

Case #1
South West Mining Company is considering investing in a new mining project. The firm's
cost of capital is 12 percent and the project is expected to have an initial after tax cost of
$5,000,000. Furthermore, the project is expected to provide after-tax operating cash
flows of $2,500,000 in year 1, $2,300,000 in year 2, $2,200,000 in year 3 and
($1,300,000) in year 4?
(a)
(b)
(c)

Calculate the project's NPV.

Calculate the project's IRR.
Should the firm make the investment?

Answer:

Cash
Flow

Time
0
1
2
3
4

500000
0
250000
0
230000
0
220000
0
130000
0

NPV@1
2%
IRR

Mid-Term Exam

(1+.12
)^t
1
0.8928
57
0.7971
94
0.7117
8
0.6355
18

PV of CF
@12%
-5000000
2,232,142.85
7
1,833,545.91
8
1,565,916.54
5
826,173.501
9
194,568.18
12
9.105%

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

No, the firm should not accept the project.

Case #2:
Gulf Packaging is considering expanding its production capacity by purchasing a new
machine, the XC-13. The cost of the XC-13 is $100 million. Once the machine is
operating, the extra capacity is expected to generate $15 million per year in additional
earnings after tax [EBIT (1-T)], which will continue for the 5-year life of the machine. This
new machine will be depreciated evenly over the five years, at which point it must be
replaced. The opportunity cost of capital for this type of machines is 10%.
a) What is your estimate of the EVAs of this project?
b) What is your estimate of the NPV of this project?
c) Calculate the present value of the EVAs (i.e., MVA) and verify that they equal the
NPV.
Hint: you may arrange your answer as follows:

Year 0
Initial
-$100
Investment
EBIT(1-T)
+ Depreciation
=After tax CF
-$100

Standard NPV Analysis

($ in millions)
Year 1
Year 2
Year 3

Year 4

Year 5

$15

$15

$15

$15

$15

NPV @10% = ??
Discounted EVA Analysis
($ in millions)
Year Beginning
Capital Employed
(TIC)
COC (%)
Capital Charge
(COC x TIC)

Mid-Term Exam

Year 1

Year 2

Year 3

Year 4

Year 5

10%

10%

10%

10%

10%

10

2nd Semester 2015

Prof. Wajeeh Elali

EBIT(1-T)
- Capital Charge
=EVA

Financial Management (FINC 501)

$15

$15

$15

$15

$15

MVA = PV of all future EVAs @ the projects cost of capital of 10%.

MVA = ??
General Comments
Show that the summed discounted value of EVAs for the project is the same as its
respective NPV.

Answer:
Standard NPV Analysis
($ in millions)

Initial Investment
EBIT(1-T)
+ Depreciation
=After tax CF

Year 0
-$100
-$100

Year 1

Year 2

Year 3

Year 4

Year 5

$15
$20
$35

$15
$20
$35

$15
$20
$35

$15
$20
$35

$15
$20
$35

NPV @10% = -100+35(1.1)^-1+35(1.1)^-2+35(1.1)^-3+35(1.1)^-4+35(1.1)^-5 = $32.68

Discounted EVA Analysis
($ in millions)
Year Beginning
Capital Employed (TIC)
COC (%)
Capital Charge (COC x TIC)

Year 1
$100
10%
$10

Year 2
$80
10%
$8

Year 3
$60
10%
$6

Year 4
$40
10%
$4

Year 5
$20
10%
$2

EBIT(1-T)
- Capital Charge
=EVA

$15
$10
$5

$15
$8
$7

$15
$6
$9

$15
$4
$11

$15
$2
$13

MVA = PV of all future EVAs @ the projects cost of capital of 10%.

MVA = 5(1.10)^-1+7(1.10)^-2+9(1.10)^-3+11(1.10)^-4+13(1.10)^-5 = $32.68
General Comments

Mid-Term Exam

11

2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

Show that the summed discounted value of EVAs for the project is the same as its
respective NPV.
From the above tables:
NPV=MVA=$32.68

Case #3:
OpenSeas, Inc. is evaluating the purchase of a new cruise ship. The ship would
cost $500 million, and would operate for 20 years. OpenSeas expects annual
cash flows from operating the ship to be $70 million (at the end of each year) and
its cost of capital is 12%.
a. Prepare an NPV profile of the purchase.
b. Estimate the IRR (to the nearest 1%) from the graph.
c. Is the purchase attractive based on these estimates?
d. How far off could OpenSeas cost of capital be (to the nearest 1%) before your
purchase decision would change?
Solution:
a.

1 (1 .12) 20

.12

NPV 500million 70million

NPV 500million 70million (7.469443624) $22,861,053

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Prof. Wajeeh Elali

Financial Management (FINC 501)

b. The IRR is the point at which the line crosses the x-axis. In this case, it falls very close
to 13%. Using Excel, the IRR is 12.72%.

c. Yes, because the NPV is positive at the discount rate of 12%.

d. The discount rate could be off by 0.72% before the investment decision would change.

Mid-Term Exam

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2nd Semester 2015

Prof. Wajeeh Elali

Financial Management (FINC 501)

Bonus (5 Marks):
I guess that my mark on this exam will be ____________.

END OF EXAMINATION

Mid-Term Exam

14

2nd Semester 2015