Finance 504 questionsFI 504
1. (16%) King, Inc., a successful Midwest firm, is considering opening a branch
office on the West Coast. Under normal economic conditions, with a 45%
probability of occurring, King can expect to earn a net income of $70,000 per
year. In a mini-recession, at 25% probability, King will earn $20,000. In a severe
recession, at a 20% probability, King will lose $15,000. There is also a slight
probability (10%) that King will lose $300,000 if the expansion fails and the
branch office must be closed. Should King open a branch office in California
based on these assumptions? Explain.
2. (24%) The law firm of Bushmaster, Cobra, and Asp (BCA) is considering
investing in a complete small business computer system, manufactured by
Massey Ferguson. The initial investment will be $60,000. The computer will be
depreciated using the straight line method and the firm’s tax rate is 34%. The
computer system is expected to provide additional revenue of $32,000 per year
for the next six years, and to reduce expenses other than depreciation by $7,000
per year for the same period. BCA’s current system can be sold for $5,000, with
no impact on its income taxes.
a) Calculate the net after-tax cash flows from this investment.
b) Calculate the net present value of the system, given that the law firm’s
weighted average cost of capital is 12%.
c) Should BCA buy the computer system? Why?
d) If BCA uses the payback method to screen investments, and requires payback
within three years, should BCA buy the computer system? Why?
Questions 3 – 8 are short answer questions. Each of them should take no more than
a paragraph or so to answer.
3. (10%) Once our company has sold stock, any changes in its price do not directly affect
us. Why, then, is important that companies take actions that maintain the price of their
stock?
4. (10%) How is risk associated with financial leverage? Why are firms willing to take this
risk?
5. (10%) Why do we use discounted cash flows to help us account for the time value of
money?
6. (10%) When we undertake more risk, why do we expect a higher level of return?
7. (10%) If we are presented with two mutually exclusive investment opportunities with
positive net present values, how should we decide on which opportunity to invest?
8. (10%) What is the role of cash flows in the pricing of stocks and bonds?
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