# The WACC can be used throughout the firm as the company-wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio. A disadvantage of the WACC method is that you need to know how the firm’s leverage policy is implemented to make the capital budgeting decision.

**Division ** **Asset Beta Next Period’s Expected Expected Growth Rate Free Cash Flow ($mm) **

**Oil Exploration ** **1.4 ** **450 ** **4.0% **

**Oil Refining ** **1.1 ** **525 ** **2.5% **

**Gas & Convenience Stores ** **0.8 ** **600 ** **3.0% **

** The risk-free rate of interest is 3% and the market risk premium is 5%.**

**Which is the cost of capital for the oil refining division closest to?**

**A) 6.5%**

**B) 7.0%**

**C) 8.5%**

**D) 10.0%**

**Cost of Capital = Risk Free Return + Beta x Market Risk Premium**

**Cost of Capital = 3% + 1.1 x 5% = 8.5%**

**Number 2 question**

**You expect CCM Corporation to generate the following free cash flows over the next 5 years.**

**Year** **1** **2** **3** **4** **5**

**FCF ($ millions)** **25** **28** **32** **37** **40**

**If CCM has $150 million of debt and 12 million shares of stock outstanding, then which is the share price for CCM closest to?**

**A) $49.50**

**B) $11.25**

**C) $20.50**

**D) $22.75**

**Value at end of Year 5 = (40*1.05)/(.13-.05) =525**

**Value of Firm Today = 25/(1.13) + 28/(1.13^2) + 32/(1.13^3) + 37/(1.13^4) + (40+525)/(1.13^5) = 395.58**

**Value of Equity = 395.58-150 = 245.58**

**Value per Share = (245.58/12) = 20.47 or 20.5**

**Note: For this question we need required return and growth rate. From my previous experience it is 13% and 5%. If your figures are different please let me know.**

**Number 3 question**

**Which is the variance of the returns on the Index from 2000 to 2009 closest to?**

**Year End**

**Index Realized Return**

**(R-R)**

**(R-R)^2**

**2000**

**23.60%**

**14.78%**

**0.0218448**

**2001**

**24.70%**

**15.88%**

**0.0252174**

**2002**

**30.50%**

**21.68%**

**0.0470022**

**2003**

**9.00%**

**0.18%**

**0.0000032**

**2004**

**-2.00%**

**-10.82%**

**0.0117072**

**2005**

**-17.30%**

**-26.12%**

**0.0682254**

**2006**

**-24.30%**

**-33.12%**

**0.1096934**

**2007**

**32.20%**

**23.38%**

**0.0546624**

**2008**

**4.40%**

**-4.42%**

**0.0019536**

**2009**

**7.40%**

**-1.42%**

**0.0002016**

**Sum**

**0.3405116**

**Variance = (.3405116/(10-1)) = .0378345**

A) **0.0450**

**B) 0.3400**

**C) 0.1935**

**D) 0.0375**

**(TCO A) Which of the following statements is false? (Points : 5)**

**The WACC can be used throughout the firm as the company-wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.**

**A disadvantage of the WACC method is that you need to know how the firm’s leverage policy is implemented to make the capital budgeting decision.**

**The intuition for the WACC method is that the firm’s weighted average cost of capital represents the average return the firm must pay to its investors (both debt and equity holders) on an after-tax basis.**

**To be profitable, a project should generate an expected return of at least the firm’s weighted average cost of capital.**

**number 2…**

**. (TCO F) Which of the following statements is correct? (Points : 5)**

**One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life, whereas IRR does not.**

**One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.**

**One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life, whereas MIRR does not.**

**One advantage of the NPV over the MIRR method is that NPV discounts cash flows, whereas the MIRR is based on undiscounted cash flows.**

**Because cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.**

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