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ECO359-05MidA - DEPARTMENT OF ECONOMICS UNIVERSITY OF...

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D EPARTMENT OF E CONOMICS U NIVERSITY OF T ORONTO ECO359 – Financial Economics II Summer 2005 Midterm: July 22 Instructions : This is a closed book examination. You are allowed one 4’’x6" crib card and the use of a calculator. Show all your work otherwise you will not get full credit . Only written re-grade requests submitted with a completely unaltered exam paper can be considered. You have 2 hours. Good Luck! NAME: _____________________________________________ ID#: _____________________________________________ 1 _______________ (20 points) 2 _______________ (10 points) 3 _______________ (15 points) 4 _______________ (15 points) 5 _______________ (20 points) Total _____________ (80 points)
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2 Problem 1: [20 points] 1A: Mr. Rubber is considering a new plastics process. The new process will require an investment of $100,000 in machinery. This machine is expected to last 5 years and will have a salvage value of $10,000. The new process will save $35,000 in wages each year and increase revenues by $15,000 per year. Furthermore, the process will require an increase in working capital (at t=0) of $5,000. If the firm' s tax rate is 34% and the opportunity cost of capital is 15%, should Mr. Rubber invest in the project? (Assume straight line depreciation to a book value of zero at the end of the project.)
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3 1B: ABC Inc. is considering buying one of two machines. Machine 1 costs $10,000, has a 7-year operating life, and has annual operating costs of $500. Machine 2 costs $5,000 and has a 2-year operating life. During the first year of its operating life, Machine 2 has an operating cost of $300 and during the second year its operating cost is $1,500. Assume that the two machines do the same work that all operating costs occur at year-end, that there are no taxes or salvage values applicable. What machine should ABC Inc. buy using a discount rate of 14%?
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4 Problem 2: [10 points] An analyst has recommended that Mr. Y. Young purchase shares in a private firm (a firm that is not traded on any exchange) called D. Corp. D. Corp has 30% debt and 70% equity. The analyst believes that D. Corp will generate a return of 10% over the next year. Since Y. Young is new to the job, he decides to do a little research on his own. He finds a company, E. Unlimited that is very similar to D. Corp. E. Unlimited has an equity beta of 1.05 and is composed of 40% debt and 60% equity. Should Y. Young buy the stock? The expected return on the market is 12% and the expected risk-free rate is 5%.
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