Question

1.Which one of the following indicates that an independent project is definitely acceptable?

Profitability index of 2

Negative net present value

Modified internal rate return that is lower than the requirement

Zero internal rate of return

Positive average accounting return

2.

Companies A and B issued 10 year, 8% semi-annual coupon bonds two years ago. Yesterday, company A reported its financial statements, and analysts' consensus is that because lower than expected sales, the company may struggle to pay the next coupon, due in two weeks.

The price of A should increase because the company may declare default.

The discount rate of A should increase due to higher default risk.

The coupon rate of B will decrease to match the yield of A.

Both companies will be unaffected by the news.

None of the above.

3.

Pharmacrops, Inc., currently pays no dividend but is expected to pay its first annual dividend of $4.80 per share exactly 5 years from today. After that, the dividends are expected to grow at 3.3 percent forever. If the required return is 11.1 percent, what is the price of the stock today?

61.54

47.12

40.39

36.36

54.04

Answer 1

1]

According to capital budgeting rules, an independent project should be accepted if :

• It has a positive NPV
• It has a PI more than 1
• It has an IRR/MIRR higher than the required return

Accounting rate of return is irrelevant in capital budgeting.

Therefore, the answer is (1) -  Profitability index of 2

2]

Bond price and yields are inversely related. Higher a bond's yield, lower the discount rate.

Yield is the required return for the bond's investors. Higher a bond's risk, higher the required return. If a bond has higher default risk, it will have a higher yield.

The answer is (2) -  The discount rate of A should increase due to higher default risk.