Corporate Finance Solution Ex-1

Chapter 3 Financial Decision Making and the Law of One Price

Valuing Decisions

1) Due to a pre-existing contract, Recycle America Inc. has the opportunity to acquire 10,000
pounds of scrap aluminum and 2,500 pounds of scrap lead for $10,750. If the current market
price for scrap aluminum is $0.83 per pound and the current market price for lead is $1.06 per
pound, then the added benefit (cost) to you if you acquire this metal is:
A) ($200)
B) $200
C) ($1,925)
D) $1,925

Answer: B
Explanation: B) Added Benefit = 10,000 × $0.83 + 2,500 × $1.06 - $10,750 = $200
Diff: 1

Interest Rates and the Time Value of Money

A project that you are considering today is expected to provide benefits worth $168,000 in one
year. If the risk-free rate of interest (rf) is 4.5%, then the value of the benefits of this project
today are closest to:
A) $160,440
B) $160,766
C) $168,000
D) $175,560

Answer: B
Explanation: B) $168,000/1.045 = $160,765.55
Diff: 1

2) Suppose you have $500 today and the risk-free interest rate (rf) is 5%. The equivalent value
in one year is closest to:
A) $475
B) $476
C) $500
D) $525

Answer: D
Explanation: D) $500 × (1.05) = $525
Diff: 1

Arbitrage and the Law of One Price

Consider the following prices from a McDonald's Restaurant:

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Big Mac Sandwich $2.99
Large Coke $1.39
Large Fry $1.09

1) A McDonald's Big Mac value meal consists of a Big Mac Sandwich, Large Coke, and a
Large Fry. Assuming that there is a competitive market for McDonald's food items, at what
price must a Big Mac value meal sell to insure the absence of an arbitrage opportunity and
uphold the law of one price?
A) $4.08
B) $4.38
C) $5.47
D) $5.77

Answer: C
Explanation: C) 2.99 + 1.39 + 1.09 = 5.47
Diff: 1

Chapter 4 The Time Value of Money

The Timeline

Use the information for the question(s) below.

Joe just inherited the family business, and having no desire to run the family business, he has
decided to sell it to an entrepreneur. In exchange for the family business, Joe has been offered an
immediate payment of $100,000. Joe will also receive payments of $50,000 in one year, $50,000
in two years, and $75,000 in three years. The current market rate of interest for Joe is 6%.

4) Draw a timeline detailing Joe's cash flows from the sale of the family business.
Answer:

Diff: 2
Section: 4.1 The Timeline
Skill: Conceptual

The Three Rules of Time Travel

Use the following information to answer the question(s) below.

Your great aunt Matilda put some money in an account for you on the day you were born. This
account pays 8% interest per year. On your 21st birthday the account balance was $5,033.83.

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1) The amount of money that your great aunt Matilda originally put in the account is closest to:
A) $600
B) $800
C) $1,000
D) $1,200
Answer: C
Explanation: C) PV = FV/(1 + i)N = 5033.83(/1.08)21 = 1,000
Diff: 1

2) The amount of money that would be in the account if you left the money there until your 65th
birthday is closest to:
A) $29,556
B) $148,780
C) $168,824
D) $748,932
Answer: B
Explanation: B) FV = PV(1 + i)N = 5033.83(1.08)(65 - 21) = $148,779.85
Diff: 2

Valuing a Stream of Cash Flows

1) Consider the following timeline detailing a stream of cash flows:

If the current market rate of interest is 8%, then the present value of this stream of cash flows is
closest to:
A) $22,871
B) $21,211
C) $24,074
D) $26,000
Answer: B
Explanation: B) PV = 5000/(1.08)1 + 6000/(1.08)2 + 7000/(1.08)3 + 8000/(1.08)4 = $21,210.72
Diff: 2

2) Consider the following timeline detailing a stream of cash flows:

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If the current market rate of interest is 8%, then the future value of this stream of cash flows is
closest to:
A) $11,699
B) $10,832
C) $12,635
D) $10,339
Answer: A
Explanation: A) FV = 1000(1.08)4 + 2000(1.08)3 + 3000(1.08)2 + 4000(1.08)1 = $11,699
Diff: 2

Calculating the Net Present Value

1 ) Nielson Motors is considering an opportunity that requires an investment of $1,000,000 today

and will provide $250,000 one year from now, $450,000 two years from now, and $650,000
three years from now. If the appropriate interest rate is 10%, then calculate the NPV of this
opportunity and decide to invest or not:
A) ($88,000)
B) $88,000
C) $300,000
D) $1,300,000
Answer: B
Explanation: B) NPV = -1,000,000 + 250,000/(1.10)1 + 450,000/(1.10)2 + 650,000/(1.10)3 =
87,528.17
Invest since NPV is positive.
Diff: 2

2) Rearden Metal needs to order a new blast furnace that will be delivered in one year. The
$1,000,000 price for the blast furnace is due in one year when the new furnace is installed. The
blast furnace manufacturer offers Rearden Metal a discount of $50,000 if they pay for the
furnace now. If the interest rate is 7%, then the NPV of paying for the furnace now is closest to:
A) ($15,421)
B) $15,421
C) ($46,729)
D) $46,729

Answer: A Explanation:
A) Solution: $1,000,000/1.07 - $950,000 = -$15,420.56
Diff: 1

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3) You have an investment opportunity in Germany that requires an investment of $250,100
today and will produce a cash flow of €208,650 in one year with no risk. Suppose the risk-free
rate of interest in Germany is 7% and the current competitive exchange rate is €0.78 to $1.00.
What is the NPV of this project? Would you take the project?
A) NPV = -$100; No
B) NPV = $100; Yes
C) NPV = $2,358; Yes
D) NPV = $3,650; Yes

Answer: A
Explanation: A) NPV = -250,100 + (€208,650/1.07) × $1.00/€0.78 = -$100, so since NPV is not
> 0, reject
Diff: 3

4. An independent film maker is considering producing a new movie. The initial cost for making
this movie will be $20 million today. Once the movie is completed, in one year, the movie will
be sold to a major studio for $25 million. Rather than paying for the $20 million investment
entirely using its own cash, the film maker is considering raising additional funds by issuing a
security that will pay investors $11 million in one year. Suppose the risk-free rate of interest is
10%. Assuming that the film maker issues the new security, what is the NPV of project? Should
the film maker make the investment?
A) $1.7 million; Yes
B) $1.7 million; No
C) $2.7 million; Yes
D) $2.7 million; No
Answer: C
Explanation: C) PV of external investment =11/1.10 =10M so

Net cost = -20+10 = -10

Net benefit =25 - 14

NPV of film maker = -10 + 14/1.10 = 2.7 million, since NPV > 0 then invest

4.5 Perpetuities and Annuities

1) The British government has a consol bond outstanding that pays ₤100 in interest each year.
Assuming that the current interest rate in Great Britain is 5% and that you will receive your first
interest payment immediately upon purchasing the consol bond, then the value of the consol
bond is closest to:
A) ₤2000
B) ₤2100
C) ₤1000
D) ₤1100
Answer: B
Explanation: B) PVP = C/r = 100/.05 = 2000 + 100 immediate interest payment = ₤2100
Diff: 2

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2) You work for a pharmaceutical company that has developed a new drug. The patent on the
drug will last for 17 years. You expect that the drug will produce cash flows of $10 million in its
first year and that this amount will grow at a rate of 4% per year for the next 17 years. Once the
patent expires, other pharmaceutical companies will be able to produce generic equivalents of
your drug and competition will drive any future profits to zero. If the interest rate is 12% per
year, then the present value of producing this drug is closest to:
A) $71 million
B) $90 million
C) $170 million
D) $105 million
Answer: B
 17 
  1 .04  
Explanation: B) $10 × 1     = $89.53 million


 1 .12  
Diff: 2

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