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FIN 101 Mid Term-Financial Management Notes Questions And Answers

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1. "Capital" is sometimes defined as funds supplied to a firm by investors. T   2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets. T   3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. T   4. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. F   5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. F   6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. F   7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. T   8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. F   9. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm. T   10. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. T   11. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm. F   12. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. F   13. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. F   14. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. F   15. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired. F   16. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. T   17. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. ANS: F In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.   18. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. T   19. The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle. T   20. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. T   21. When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs. T   22. When estimating the cost of equity by use of the bond-yield-plus-riskpremium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. T   23. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)." ANS: F This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.   24. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. ANS: T This statement is true. Here are some illustrative numbers to demonstrate this point.   25. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC). F   26. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. T   27. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. ANS: T True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.   28. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T). T   29. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. F   30. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. F   31. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate. ANS: F None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is truly correct.   32. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. T   33. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50). ANS: F The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!   34. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. ANS: F Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.   35. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt. T   36. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt. A   37. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year. ANS: A Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.   38. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines. E   39. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC. A   40. When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM). ANS: D By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.   41. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return. ANS: B The correct answer is statement b. Division X should accept only projects with returns greater than 10%, while Division Y should accept only projects with returns greater than 14%. Only statement b meets this criterion.   42. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. None of the projects should be accepted. d. All of the projects should be accepted. e. Project B, which is of below-average risk and has a return of 8.5%. ANS: E Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.   43. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. ANS: C Statement c is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.   44. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many highrisk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many lowrisk projects. ANS: E Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.   45. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized. ANS: C Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement c is correct.   46. Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. ANS: D Statement d is true, because the after-tax cost of debt is rd(1 − T). So, if rd remains constant but T increases, rd(1 − T) will decline. The other statements are false.   47. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. ANS: E Statement e is true; interest payments on debt are tax deductible. The other statements are false.   48. Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. C   49. Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. C   50. Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC. ANS: C Statement c is true, because the cost of debt for WACC purposes = rd(1 − T), so if T increases, then rd(1 − T) declines.   51. Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The WACC that should be used in capital budgeting is the firm's marginal, aftertax cost of capital. e. The WACC is calculated using before-tax costs for all components. D   52. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. Statement c is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.   53. Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. B   54. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. c. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. e. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. ANS: B By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm's value will fall. Therefore, statement b is true and the other statements are false.   55. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. E   56. Which of the following statements is CORRECT? a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. A   57. Which of the following statements is CORRECT? a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. b. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. C   58. Which of the following statements is CORRECT? a. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the riskfree rate, and the market risk premium⎯can be estimated with little error. C   59. Which of the following statements is CORRECT? a. If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. b. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. c. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. d. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. e. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. B   60. Which of the following statements is CORRECT? a. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. ANS: C Statement c is true⎯the WACC will increase if the firm raises more funds than can be supported by reinvested earnings.   61. Which of the following statements is CORRECT? a. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. b. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. c. When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. d. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. e. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings. ANS: D Statement d is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower beforetax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 70% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt.   62. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. c. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets. ANS: D The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project.   63. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical. b. If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs. c. Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged. d. Since J and F move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. e. J should have the lower WACC because it is like most other companies, and investors like that fact. ANS: B Statement b is true. The merged firm would have a beta that is a simple average of J's and F's betas, and that would result in a cost of equity that is an average of the two firms' costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC.   64. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22% ANS: B Preferred stock price $97.50 Preferred dividend $8.50 Flotation cost 4.00% rp = Dp/(Pp(1 − F)) 9.08%   65. A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56% ANS: D Preferred stock price $92.50 Preferred dividend $8.00 Flotation cost 5.00% rp = Dp/(Pp(1 − F)) 9.10%   66. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72% ANS: A rRF 5.00% RPM 6.00% b 1.05 rs = rRF + (RPM × b) 11.30%   67. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93% ANS: E rRF 4.10% RPM 5.25% b 1.30 rs = rRF + (RPM × b) 10.925%   68. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51% ANS: C D1 $0.67 P0 $27.50 g 8.00% rs = D1/P0 + g 10.44%   69. To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59% ANS: D D1 $1.45 P0 $22.50 g 6.50% rs = D1/P0 + g 12.94%   70. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74% ANS: A Bond yield 8.75% Risk premium 3.85% rs = rd + Risk premium 12.60% 7. Due to changes in regulatory requirements, the transactions costs associated with sellin g corporate securities increased by $1 per share. This change will a. cause the cost of capital to increase. 8. Which of the following should not be considered when calculating a firm's WACC? a. Cost of carrying inventory 9. Which of the following should NOT be considered when calculating a firm's WACC? a. After-tax cost of accounts payable 10. A company has preferred stock that can be sold for $21 per share. The preferred stock p ays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferr ed stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is: a. 17.72 11. KayCee Manufacturing Company paid a dividend yesterday of $3.50 per share. The divid end is expected to grow at a constant rate of 10% per year. The price of KayCee's common stock today is $40 pe r share. If KayCee decides to issue new common stock, flotation costs will equal $4.00 per share. Kaycee's marginal tax rate is 35%. Based on the above information, the cost of retained earnings is: a. 19.63 12. Cost of new common stock is: a. 20.09 13.Kelly Corporation will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. T he stock sells for $45, andflotation expenses of 5% of the selling price will be incurred o n new shares. What is the cost of new common stock be for Kelly Corp.? a. 11.79 14. Five Rivers Casino is undergoing a major expansion. The expansion will be financed by i ssuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Ga mblers flotation expense on the new bonds will be $50 per bond. Gamblers marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds? a. 8.76 15.Kendall, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield to maturity on thesebonds is 12.5 percent. If the firm's tax rate is 30 percent, what is relevant cost of debt financing to Kendall, Inc.? a. 8.75 percent 16.Clothier, Inc. has a target capital structure of 40% debt and 60% common equity, an d has a 40% marginal tax rate. If Clothier's yield to maturity on bonds is 7.5% and investors require a 15% return on Clothier's common stock, what is the firm's weighted average cost of capital? a. weighted average cost of capital an average of the individual costs of financing used by the firm   opportunity cost the cost of making a choice defined in terms of the next best alternative that is foregone   financial policy the firm's policies regarding the sources of financing it plans to use and the particular mix (proportions) in which they will be used   cost of debt the rate that has to be received from an investment in order to achieve the required rate of return for the creditors   cost of debt this rate must be adjusted for the fact that an increase in interest payments will result in lower taxes   cost of debt this cost is based on the debt holders' opportunity cost of debt in the capital markets   flotation costs the costs incurred by the firm when it issues securities to raise funds   cost of preferred equity the rate of return that must be earned on the preferred stockholders' investment in order to satisfy their required rate of return   cost of preferred equity this cost is based on the preferred stockholders' opportunity cost of preferred stock in the capital markets   cost of common equity the rate of return that must be earned on the common stockholders' investment in order to satisfy their required rate of return   cost of common equity this cost is based on the common stockholders' opportunity cost of common stock in the capital markets   capital structure the mix of long-term sources of funds used by the firm   capital structure this is also known as the firm's capitalization   capital structure the relative total of each type of fund is emphasized in this term   Divisional WACC the cost of capital for a specific business unit or division   cost of capital the rate that must be earned in order to satisfy the required rate of return of the firm's investors   cost of capital the rate of return on investments at which the price of a firm's common stock will remain unchanged   transactions costs and risk Two factors that cause the investor's required rate of return to differ from the company's cost of capital are:   corporate taxes and flotation costs Two considerations that cause a corporation's cost of capital to be different than its investors' required returns are   cause the cost of capital to increase Due to changes in regulatory requirements, the transactions costs associated with selling corporate securities increased by $1 per share. This change will   cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt In general, which of the following rankings, from highest to lowest cost, is most accurate?   the marginal cost of capital The average cost associated with each additional dollar of financing for investment projects is:   capital structure A firm's cost of capital is influenced by:   preferred stock dividend divided by the net selling price of preferred The cost of new preferred stock is equal to:   debt In general, the least expensive source of capital is:   flotation costs on new equity The cost of external equity capital is greater than the cost of retained earnings because of:   Component cost of internal equity In capital budgeting analysis, when computing the weighted average cost of capital, the CAPM approach is typically used to find which of the following:   flotation costs are incurred when new stock is issued. The cost of retained earnings is less than the cost of new common stock because:   The flotation costs incurred when issuing new securities Which of the following differentiates the cost of retained earnings from the cost of newly-issued common stock?   The cost of a particular source of capital is equal to the investor's required rate of return after adjusting for the effects of both flotation costs and corporate taxes. Which of the following statements is most correct?   an increase in the cost of common equity, whether or not the funds come from retained earnings or newly issued common stock investment A has an expected return of 15% per year, while investment B has an expected return of 12% per year. A rational investor will choose: investment A if a and b are of equal risk a typical measure for the risk-free rate of return is the: u.s. treasury bills Advertisement stock A has an expected return of 14% with a standard deviation of 6%. if returns are normally distributed, then approximately two-thirds of the time the return on stock A will be: between 8% and 20% the appropriate measure for risk according to the capital asset pricing model is beta the minimum rate of return necessary to attract an investor to purchase or hold a security is referred to as the : investor's required rate of return the relevant variable a financial manager uses to measure returns is: cash flows which is a diversifiable risk? unsystematic, or company-unique risk what is diversifying among different kinds of assets known as? asset allocation shafer corporation issued callable bonds. the bonds are most likely to be called if: interest rate decreases which of the following bond provisions will make a bond more desirable to investors, other things being equal? the bond is convertible the interest on corporate bonds is typically paid: semi-annually Advertisement if the market price of a bond decreases then: the yield to maturity increases what affects an asset's value ot an investor? amount of an asset's expected cash flow, the riskiness of the cash flows, timing of an asset's cash flows, investors req. rate of retun when the intrinsic value of an asset exceeds the market value: the asset is undervalued to the investor which is FALSE concerning bonds: debentures are secured by specific assets other than real estate the present value of the expected future cash flows of an asset represents the asset's: intinsic value caldwell corporation bonds pay an annual coupon rate of 10%. if investors required rate of return is now 12% on these bonds, they will be priced at: a discount to par value speculative or non-investment grade bonds have an S&P bond rating of: BB or less which of the following statements is true? long-term bonds have greater interest rate risk than do short-term bonds preferred stock evaluation usually treats the preferred stock as a perpetuity Sieves Corporation preferred stock pays an annual dividend of $5 per share. Which of the following statements is true for an investor with a required rate of return of 8%? the value of the preferred stock is 62.50 per share Butler corp. paid a dividned today of $3.50 per share. The dividend is expected to grow as a constant rate of 8% per year. if butler corp stock is selling for $76.50 per share, the stockholders expected rate of return is: 12.63% kilkenheimer company just paid a dividend of $4 per share. Future dividends are expected to grow at a constant rate of 6% per year. what is the value of the stock if the required rate of return is 12%? $66.67 Nuray Corp. preferred stock pays a $.50 annual dividend. what is the value of the stock if your required rate of return is 10%. $5.00 an example of the growth facor in the common stock is: retaining profits in order to reinvest into the firm preferredstock is similar to common stock in the following way: as equity, both are subordinate to bondholders in the even of bankruptcy cumulative preferred stock: required dividends in arrears to be carried over into the next period which of the following features or benefits belong to a firm's common shareholders? ownership of the firm, limited liability, and voting rights who bears the greatest risk of loss of value if a firm should fail? common stockholders two factors that cause the investor's required rate of return to differ from the company's cost of capital are: taxes and transactions costs due to changes in regulatory requirements, the transactions costs associated with selling corporate securites increased by $1 per share. This change will: cause the cost of capital to increase in general, which of the following rankings, from highest to lowest cost, is the most accurate? cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt in general, the least expensive source of capital is: debt the cost of external equity capital is greater than the cost of retained earnings because of: flotation costs on new equity which of the folowing should not be considered when calculating a fimr's WACC? cost of carrying inventory 1. The firm financed completely with equity capital has a cost of capital equal to the required return on common stock. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of common equity 2. The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm’s outstanding debt. ANSWER: False DIFFICULTY: Moderate KEYWORDS: cost of debt 3. The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged. ANSWER: True DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital 4. Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm must earn at least $20 before tax on every $100 invested. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of preferred stock 5. Other things equal, management should retain profits only if the company’s investments within the firm are at least as attractive as the stockholders’ other investment opportunities. ANSWER: True DIFFICULTY: Moderate KEYWORDS: retained earnings 6. The cost of retained earnings takes into account flotation costs. ANSWER: False DIFFICULTY: Moderate KEYWORDS: cost of retained earnings 7. The weighted cost of capital assumes that the company maintains a constant dividend payout ratio. ANSWER: True DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital, dividend payout 8. If a firm was to earn exactly its cost of capital, we would expect the price of its common stock to remain unchanged. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of capital, price of common stock 9. The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital. ANSWER: False DIFFICULTY: Easy KEYWORDS: required rate of return 10. The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project. ANSWER: False DIFFICULTY: Easy KEYWORDS: weighted average cost of capital, after-tax component costs 11. A security with a reasonably stable price will require a higher required return than a security with an unstable price. ANSWER: False DIFFICULTY: Moderate KEYWORDS: required return 12. The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class. ANSWER: False DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital 13. If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the after-tax cost of debt is 5.94%. ANSWER: True DIFFICULTY: Moderate KEYWORDS: aftertax cost of debt 8. If a firm was to earn exactly its cost of capital, we would expect the price of its common stock to remain unchanged. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of capital, price of common stock 9. The minimum rate of return necessary to attract an investor to purchase or hold a security is called the cost of capital. ANSWER: False DIFFICULTY: Easy KEYWORDS: required rate of return 10. The weighted average cost of capital is computed using before-tax costs of each of the sources of financing that a firm uses to finance a project. ANSWER: False DIFFICULTY: Easy KEYWORDS: weighted average cost of capital, after-tax component costs 11. A security with a reasonably stable price will require a higher required return than a security with an unstable price. ANSWER: False DIFFICULTY: Moderate KEYWORDS: required return 12. The average cost of capital is the appropriate rate to use when evaluating new investments, even though the new investments might be in a higher risk class. ANSWER: False DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital 13. If the before-tax cost of debt is 9% and the firm has a 34% marginal tax rate, the aftertax cost of debt is 5.94%. ANSWER: True DIFFICULTY: Moderate KEYWORDS: after-tax cost of debt 14. No adjustment is made in the cost of preferred stock for taxes since preferred stock dividends are not tax-deductible. ANSWER: 1. The firm financed completely with equity capital has a cost of capital equal to the required return on common stock. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of common equity 2. The cost of debt is equal to one minus the marginal tax rate times the coupon rate of interest on the firm’s outstanding debt. ANSWER: False DIFFICULTY: Moderate KEYWORDS: cost of debt 3. The weighted average cost of capital is the minimum required return that must be earned on additional investment if firm value is to remain unchanged. ANSWER: True DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital 4. Assuming an after-tax cost of preferred stock of 12% and a corporate tax rate of 40%, a firm must earn at least $20 before tax on every $100 invested. ANSWER: True DIFFICULTY: Moderate KEYWORDS: cost of preferred stock 5. Other things equal, management should retain profits only if the company’s investments within the firm are at least as attractive as the stockholders’ other investment opportunities. ANSWER: True DIFFICULTY: Moderate KEYWORDS: retained earnings 6. The cost of retained earnings takes into account flotation costs. ANSWER: False DIFFICULTY: Moderate KEYWORDS: cost of retained earnings 7. The weighted cost of capital assumes that the company maintains a constant dividend payout ratio. ANSWER: True DIFFICULTY: Moderate KEYWORDS: weighted average cost of capital, dividend payout Selected practice questions from Chapters 6 – 8, FIN 335, with Dr. Graham From Chapter 6 – Bonds and Bond Value 1. The stated interest payment, in dollars, made on a bond each period is called the bond's: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: A 2. The principal amount of a bond that is repaid at the end of the loan term is called the bond's: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: B 3. The rate of return required by investors in the market for owning a bond is called the: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: D 4. The annual coupon of a bond divided by its face value is called the bond's: A) Coupon. B) Face value. C) Maturity. D) Yield to maturity. E) Coupon rate. Answer: E 5. A bond with a face value of $1,000 that sells for less than $1,000 in the market is called a: A) Par bond. B) Discount bond. C) Premium bond. D) Zero coupon bond. E) Floating rate bond. Answer: B 6. A bond with a face value of $1,000 that sells for more than $1,000 in the market is called a: A) Par bond. B) Discount bond. C) Premium bond. D) Zero coupon bond. E) Floating rate bond. Answer: C 7. The long-term bonds issued by the United States government are called: A) Treasury bonds. B) Municipal bonds. C) Floating rate bonds. D) Junk bonds. E) Zero coupon bonds. Answer: A 8. A bond that makes no coupon payments (and thus is initially priced at a deep discount to par value) is called a _______ bond. A) Treasury B) municipal C) floating rate D) junk E) zero coupon Answer: E 9. A bond which, at the election of the holder, can be swapped for a fixed number of shares of common stock at any time prior to the bond's maturity is called a _____________ bond. A) zero coupon B) callable C) putable D) convertible E) warrant Answer: D 10. The annual coupon payment of a bond divided by its market price is called the: A) Coupon rate. B) Current yield. C) Yield to maturity. D) Bid-ask spread. E) Capital gains yield. Answer: B 11. The price a dealer is willing to accept for selling a security to an investor is called the: A) Equilibrium price. B) Auction price. C) Bid price. D) Ask price. E) Bid-ask spread. Answer: D 12. A bond with a face value of $1,000 has annual coupon payments of $100 and was issued 10 years ago. The bond currently sells for $1,000 and has 8 years remaining to maturity. This bond's ______________ must be 10%. I. yield to maturity II. market premium III. coupon rate A) I only B) I and II only C) III only D) I and III only E) I, II and III Answer: D 13. If you divide a bond's annual coupon payment by its current yield you get the ___________. A) yield to maturity B) investors' required rate of return C) annual coupon rate D) cost of capital E) bond price Answer: E 14. Which of the following statements regarding bond pricing is true? A) The lower the discount rate, the more valuable the coupon payments are today. B) Bonds with high coupon payments are generally (all else the same) more sensitive to changes in interest rates than bonds with lower coupon payments. C) When market interest rates rise, bond prices will also rise, all else the same. D) Bonds with short maturities are generally (all else the same) more sensitive to changes in interest rates than bonds with longer maturities. E) All else the same, bonds with larger coupon payments will have a lower price today. Answer: A 15. Your broker offers you the opportunity to purchase a bond with coupon payments of $90 per year and a face value of $1000. If the yield to maturity on similar bonds is 8%, this bond should: A) Sell for the same price as the similar bond regardless of their respective maturities. B) Sell at a premium. C) Sell at a discount. D) Sell for either a premium or a discount but it's impossible to tell which. E) Sell for par value. Answer: B 16. When pricing bonds, if a bond's coupon rate is less than the required rate of return, then: A) The holder of the bond is assured of a profit regardless of when the bond is eventually sold. B) The holder of the bond will realize a capital gain if the bond is held to maturity. C) The bond sells at par because the required rate of return is adjusted to reflect the discrepancy. D) The bond sells at a premium if it has a long maturity and at a discount if it has a short maturity. E) The bond sells at a discount if it has a long maturity and at a premium if it has a short maturity. Answer: B 17. All else the same, a(n) __________ will decrease the required return on a bond. A) call provision B) lower bond rating C) sinking fund D) increase in inflation E) increase in the size of a bond issuance Answer: C 18. Which of the following items generally appears in a corporate bond quote from The Wall Street Journal? A) Yield to maturity B) Original issue price C) Current yield D) Name of the trustee E) Bond rating Answer: C 19. For a discount bond, the current yield is _________ the yield to maturity, and the coupon rate is _____________ the yield to maturity. A) less than; less than B) less than; greater than C) greater than; less than D) greater than; greater than E) equal to; equal to Answer: A 20. For a premium bond, the required return is less than the: I. Current yield. II. Yield to maturity. III. Coupon rate. A) I only B) I and II only C) II and III only D) I and III only E) I, II, and III 21. If investors are uncertain that they will be able to sell a corporate bond quickly, the investors will demand a higher yield in the form of a(n) ____________. A) inflation premium B) liquidity risk premium C) interest rate risk premium D) default risk premium E) increased real rate of interest Answer: B 22. Dizzy Corp. bonds bearing a coupon rate of 12%, pay coupons semiannually, have 3 years remaining to maturity, and are currently priced at $940 per bond. What is the yield to maturity? A) 12.00% B) 13.99% C) 14.54% D) 15.25% E) 15.57% Answer: C Response: $940 = 1000 FV, 60 PMT, 6 N, -940 PV, CPT I/Y = 7.27%; YTM = 7.27% x 2 = 14.54% 23. Whitesell Athletic Corporation's bonds have a face value of $1,000 and a 9% coupon paid semiannually; the bonds mature in 8 years. What current yield would be reported in The Wall Street Journal if the yield to maturity is 7%? A) 4% B) 5% C) 6% D) 7% E) 8% Answer: E Response: 1000 FV, 45 PMT, 16 N, 3.5 I/Y, CPT PV = $1,120.94; Annual coupon is 45 x 2 = 90. Current Yield (CY) = $90 / 1,120.94 = 8.03% 24. D&G Enterprises issues bonds with a $1,000 face value that make coupon payments of $30 every 3 months. What is the coupon rate? A) 0.30% B) 3.00% C) 9.00% D) 12.00% E) 30.00% Answer: D Response: coupon rate = ($30 x 4) / 1,000 = 12% 25. Suppose you purchase a zero coupon bond with face value $1,000, maturing in 25 years, for $180. What is the implicit interest, in dollars, in the first year of the bond's life? A) $ 2.86 B) $ 9.84 C) $12.78 D) $19.27 E) $30.00 Answer: C 1000 FV, 25 N, -180 PV, CPT I/Y = YTM = 7.1%; Year 1 interest = $180 x .071 = $12.78 26. Suppose you purchase a zero coupon bond with a face value of $1,000 and a maturity of 25 years, for $180. If the yield to maturity on the bond remains unchanged, what will the price of the bond be 5 years from now? A) $253.64 B) $287.52 C) $310.91 D) $380.58 E) $500.00 Answer: A 1000 FV, 25 N, -180 PV, CPT I/Y = 7.1%; -180 PV, 5 N, 7.1 I/Y, CPT FV = $253.64 27. What is the yield to maturity on an 18-year, zero coupon bond selling for 30% of par value? A) 4.86% B) 5.86% C) 6.37% D) 6.92% E) 30.00% Answer: D 1000 FV, 18 N, -300 PV, CPT I/Y = YTM = 6.92% 28. J&J Enterprises wants to issue sixty 20-year, $1,000 zero-coupon bonds. If each bond is to yield 7%, how much will J&J receive (ignoring issuance costs) when the bonds are first sold? A) $11,212 B) $12,393 C) $15,505 D) $18,880 E) $20,000 Answer: C Response: price = $1,000 / 1.0720 = $258.42; proceeds = $258.42 x 60 = $15,505 There is the algebra, but what are the entries using your TVOM keys on your TI BA II Plus? And what of the algebra and keystrokes for numbers 29-40 below? Recognizing the algebra is important, and extending that recognition to the keystrokes is “key.” 29. J&J Enterprises wants to issue 20-year, $1,000 face value zero-coupon bonds. If each bond is to yield 7%, what is the minimum number of bonds J&J must sell if they wish to raise $5 million from the sale? (Ignore issuance costs.) A) 17,290 B) 19,349 C) 20,164 D) 23,880 E) 26,159 Answer: B Response: price = $1,000 / 1.0720 = $258.42; # of bonds = $5,000,000 / 258.42 = 19,349 30. What is the market value of a bond that will pay a total of fifty semiannual coupons of $80 each over the remainder of its life? Assume the bond has a $1,000 face value and a 12% yield to maturity. A) $ 734.86 B) $ 942.26 C) $1,135.90 D) $1,315.24 E) $1,545.62 Answer: D 50 N, 80 PMT, 1000 FV, 12/2 = I/Y, CPT PV = -1,315 31. J&J Manufacturing just issued a bond with a $1,000 face and a coupon rate of 8%. The bond has a life of 20 years, annual coupons, and a yield to maturity is 7.5%, what will the bond sell for? A) $ 975 B) $1,020 C) $1,051 D) $1,087 E) $1,162 Answer: C 1000 FV, 80 PMT, 20 N, 7.5 I/Y, CPT PV = -1,051 32. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what percent of the bond's total price is represented by the present value of the coupons? A) 45.7% B) 56.1% C) 77.6% D) 93.2% E) 100.0% Answer: C Response: Using the TVOM keystrokes above, you get the price of around $1,051. Now, in this problem, you must calculate the value of the annuity stream (the interest payments or coupons) and divide that into the bond price. Recall that the total bond value is comprised of the PV of the coupons plus the PV of the maturity payoff of $1000. Keystrokes for the PV of the coupons? 80 PMT, 7.5 I/Y, 20 N, CPT PV = -815.56. Divide that into 1051 and you get $815.56 / 1,050.97 = 77.6%. 33. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is the present value of the bond's face value? A) $ 235.41 B) $ 341.15 C) $ 815.56 D) $1,000.00 E) $1,050.97 Answer: A, Response: PV of par = $1,000 / 1.07520 = $235.41 (1000 FV, 20 N, 7.5 I/Y, CPT PV = 235.41) 34. J&J Manufacturing just issued a bond with a $1,000 face value and a coupon rate of 8%. If the bond has a life of 20 years, pays annual coupons, and the yield to maturity is 7.5%, what is the total present value of the bond's coupon payments? A) $ 235.41 B) $ 341.15 C) $ 815.56 D) $1,000.00 E) $1,050.97 Answer: C Response: PV of coupons = $80 [(1 1/1.07520)/ .075] = $815.56 Using the TVOM keys instead of algebra? Coupon payments are 8% of $1000 or $80. So, 80 PMT, 20 N, 7.5I/Y, CPT PV = 815.56 35. The market price of a bond is $1,236.94, it has 14 years to maturity, a $1,000 face value, and pays an annual coupon of $100 in semiannual installments. What is the yield to maturity? A) 3.18% B) 4.26% C) 5.37% D) 6.11% E) 7.27% Answer: E Response: $1,236.94 = $50 {[1 - 1/(1 + R)28] / R} + 1,000 / (1 + R)28; R = 3.637%; YTM = 3.64% x 2 = 7.27% The algebra is a bit annoying, so do the TVOM stuff, thusly: -1,236.94PV, 1000 FV, 28 N, 50 PMT, CPT I/Y = 3.637. I/Y x 2 = 3.637 x 2 = 7.274 or 7.27% 36. What would you pay for a bond that pays an annual coupon of $45, has a face value of $1,000, matures in 11 years, and has a yield to maturity of 10%? A) $642.77 B) $775.34 C) $800.18 D) $910.14 E) $976.38 Answer: A Response: price = $45 [(1 - 1/1.111) / .1] + 1,000 / 1.111 = $642.77 TVOM stuff? 1000 FV, 45 PMT, 11 N, 10 I/Y, CPT PV = -642.77 37. King Noodles' bonds have a 9% coupon rate. Interest is paid quarterly and the bonds have a maturity of 10 years. If the appropriate discount rate is 10% on similar bonds, what is the price of King Noodles' bonds? A) $937.24 B) $938.55 C) $971.27 D) $989.63 E) $991.27 Answer: A 1000 FV, 90/4 = 22.5 PMT, 10 x 4 = 40 N, 10/4=2.5 I/Y, CPT PV = -937.24 38. Cornerstone Industries has a bond outstanding with an 8% coupon rate and a market price of $874.68. If the bond matures in 6 years and interest is paid semiannually, what is the YTM? A) 4.9% B) 6.9% C) 8.9% D) 10.9% E) 12.9% Answer: D Response: $874.68 = $40 {[1 - 1/(1 + R)12] / R} + 1,000 / (1 + R)12; R = 5.45%; YTM = 5.45% x 2 = 10.9% TVOM keystrokes? 40 PMT, 12 N, 1000 FV, -874.68 PV, CPT I/Y = 5.45 x 2 = YTM = 10.9% 39. The make-believe bonds of Facebook carry a 12% annual coupon, have a $1,000 face value, and mature in 5 years. Bonds of equivalent risk yield 9%. What is the market value of Facebook bonds? A) $1,011.20 B) $1,087.25 C) $1,095.66 D) $1,116.69 E) $1,160.25 Answer: D Response: price = $120 [(1 - 1/1.095) / .09] + 1,000 / 1.095 = $1,116.69 1000 FV, 120 PMT, 5 N, 9 I/Y, CPT PV = -1,116.69 40. If the following bonds are identical except for coupon, what is the price of bond B? B o n d A B o n d B F a c e v a l u e $ 1 , 0 0 0 $ 1 , 0 0 0 S e m i a n n u a l C o u p o n $ 5 0 $ 4 0 Y e a r s t o m a t u r i t y 2 5 2 5 P r i c e $ 1 , 1 5 0 . 0 0 ? A) $ 944.58 B) $ 975.31 C) $1,037.86 D) $1,150.00 E) $1,279.47 Answer: A Response: Bond A: $1,150 = $50 {[1 - 1/(1 + R)50 ]/ R} + 1,000 / (1 + R)50; R = 4.27%; Bond B: price = $40 [(1 - 1/1.042750) / .0427] + 1,000 / 1.042750 = $944.58 First, compute the YTM for bond A, thusly: 1000 FV, 25x2=N, 50 PMT, -1,150 PV, CPT I/Y = YTM = 4.27. Then compute PV of bond B: 1000 FV, 40 PMT, 25x2= N, 4.27 I/Y, CPT PV = -944.58 41. If corporate bond yields are at 8.4% and you are in the 34% federal marginal income tax bracket, at what level of municipal bond yields would you be indifferent between owning corporate bonds or muni bonds? Ignore the impact of state and local taxes. A) 5.95% B) 5.54% C) 5.03% D) 4.67% E) 4.11% Answer: B Response: 8.4(1 - .34) = 5.54% CHAPTER 6 QUESTIONS END HERE. CHAPTER 7 QUESTIONS BEGIN HERE 1. The stock valuation model that determines the current stock price as the next dividend divided by the (discount rate less the dividend growth rate) is called the: A) Zero growth model. B) Dividend growth model. C) Capital Asset Pricing Model. D) Earnings capitalization model. Answer: B 2. A stock's next expected dividend divided by the current stock price is the: A) Current yield. B) Total yield. C) Dividend yield. D) Capital gains yield. E) Earnings yield. Answer: C 3. The rate at which the stock price is expected to appreciate (or depreciate) is the: A) Current yield. B) Total yield. C) Dividend yield. D) Capital gains yield. E) Earnings yield. Answer: D 4. Payments made by a corporation to its shareholders, in the form of either cash, stock, or payments in kind, are called: A) Retained earnings. B) Net income. C) Dividends. D) Redistributions. E) Infused equity. Answer: C 5. The market in which new securities are originally sold to investors is the ________ market. A) dealer B) auction C) over-the-counter (OTC) D) secondary E) primary Answer: E 6. The market in which previously issued securities are traded among investors is the: A) Dealer market. B) Auction market. C) Over-the-counter (OTC) market. D) Secondary market. E) Primary market. Answer: D 7. Common stock valuation requires, among other things, information regarding the: I. Expected dividend growth rate. II. Current dividend payment. III. Par value of the common stock. A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III Answer: B 8. As illustrated using the dividend growth model, the total return on a share of common stock is comprised of a ___________. A) capital gains yield and a dividend growth rate B) capital gains growth rate and a dividend growth rate C) dividend payout ratio and a required rate of return D) dividend yield and the present dividend E) dividend yield and a capital gains yield Answer: E 9. Which of the following items would usually appear for a stock quote in The Wall Street Journal? A) Capital gains rate B) Dividend yield C) Number of shares outstanding D) Par value of the stock E) Dividend growth rate Answer: B 10. If dividends on a common stock are expected to grow at a constant rate forever, and if you are told the most recent dividend paid, the dividend growth rate, and the appropriate discount rate today, you can calculate ___________. I. the price of the stock today II. the dividend that is expected to be paid ten years from now III. the appropriate discount rate ten years from now A) I only B) I and II only C) I and III only D) II and III only E) I, II, and III Answer: B 11. Which of the following statements regarding dividend yields is true? A) It measures how much the stock's price will increase in a year. B) It incorporates the par value of the stock into the calculation. C) It is analogous to the current yield for a bond. D) It is always greater than the stock's capital gains yield. E) It measures the total annual return an investor can expect to earn by owning the stock. Answer: C 12. Which of the following is (are) true? I. The dividend yield on a stock is the annual dividend divided by the par value. II. When the constant dividend growth model holds, g = capital gains yield. III. The total return on a share of stock = dividend yield + capital gains yield. A) I only B) II only C) I and II only D) II and III only E) I, II, and III Answer: D 13. If some shareholders have greater voting power than others, it must be that: A) The company has both preferred stock and common stock outstanding. B) The company has outstanding debentures. C) The company is located outside the United States in a tax-haven locale. D) The company has multiple classes of common stock. E) The company is in bankruptcy proceedings. Answer: D 14. What would you pay for a share of ABC Corporation stock today if the next dividend will be $3 per share, your required return on equity investments is 15%, and the stock is expected to be worth $90 one year from now? A) $78.26 B) $80.87 C) $82.56 D) $90.00 E) $98.12 Answer: B Response: P0 = $3 / 1.15 + 90 / 1.15 = $80.87 15. The dividend on Simple Motors common stock will be $3 in 1 year, $4.25 in 2 years, and $6.00 in 3 years. You can sell the stock for $100 in 3 years. If you require a 12% return on your investment, how much would you be willing to pay for a share of this stock today? A) $75.45 B) $77.24 C) $81.52 D) $85.66 E) $91.30 Answer: C Response: P0 = $3.00 / 1.12 + 4.25 / 1.122 + 106 / 1.123 = $81.52 16. A stock that pays a constant dividend of $1.50 forever currently sells for $10.71. What is the required rate of return? A) 10% B) 12% C) 13% D) 14% E) 15% Answer: D Response: $10.71 = $1.50 / R; R = 14% 17. ABC Company's preferred stock is selling for $30 a share. If the required return is 8%, what will the dividend be two years from now? A) $2.00 B) $2.20 C) $2.40 D) $2.80 E) $3.25 Answer: C Response: $30 = D / .08; D = $2.40 18. What would you pay today for a stock that is expected to make a $2 dividend in one year if the expected dividend growth rate is 5% and you require a 12% return on your investment? A) $28.57 B) $29.33 C) $31.43 D) $43.14 E) $54.30 Answer: A Response: P0 = $2 / (.12 - .05) = $28.57 19. The stock of MTY Golf World currently sells for $90 per share. The firm has a constant dividend growth rate of 6% and just paid a dividend of $5.09. If the required rate of return is 12%, what will the stock sell for one year from now? A) $ 90.00 B) $ 93.52 C) $ 95.40 D) $ 99.80 E) $112.78 Answer: C Response: P1 = P0(1 + g) = $90 (1.06) = $95.40 20. Llano's stock is currently selling for $40.00. The expected dividend one year from now is $2 and the required return is 13%. What is this firm's dividend growth rate assuming the constant dividend growth model is appropriate? A) 8% B) 9% C) 10% D) 11% Answer: A Response: g = .13 - ($2 / 40) = 8% 21. The current price of XYZ stock is $80.00. Dividends are expected to grow at 5% indefinitely and the most recent dividend was $2.75. What is the required rate of return on XYZ stock? A) 7.3% B) 8.7% C) 9.5% D) 10.6% E) 11.2% Answer: B Response: R = ($2.89 / 80) + .05 = 8.7% 22. ABC Corporation's common stock dividend yield is 3.61%, it just paid a dividend of $2.75, and is expected to pay a dividend of $2.89 one year from now. Dividends are expected to grow at a constant rate indefinitely. What is the required rate of return on ABC stock? A) 7.3% B) 8.7% C) 9.5% D) 10.6% E) 11.2% Answer: B Response: ($2.89 - 2.75) / 2.75 = .051; R = .036 + .051 = 8.7% 23. If Big Amp, Inc. stock closed at $36 and the current quarterly dividend is $0.75 per share, what dividend yield would be reported for the stock in The Wall Street Journal? A) 2.0% B) 3.6% C) 5.7% D) 6.6% E) 8.3% Answer: E Response: DY = ($0.75 x 4) / 36 = 8.3% 24. Suppose NoGro, Inc. has just issued a dividend of $3.25 per share. Subsequent dividends will remain at $3.25 indefinitely. Returns on the stock of firms like NoGro are currently running 10%. What is the value of one share of stock? A) $22.50 B) $27.25 C) $32.50 D) $37.25 E) $39.75 Answer: C Response: P0 = $3.25 / .10 = $32.50 25. Suppose Pale Hose, Inc. has just paid a dividend of $1.80 per share. Sales and profits for Pale Hose are expected to grow at a rate of 8% per year. Its dividend is expected to grow by the same amount. If the required return is 14%, what is the value of a share of Pale Hose? A) $18.00 B) $25.20 C) $27.80 D) $30.60 E) $32.40 Answer: E Response: P0 = [$1.80(1.08)] / (.14 - .08) = $32.40 26. Suppose that you have just purchased a share of stock for $40. The most recent dividend was $2 and dividends are expected to grow at a rate of 7% indefinitely. What must your required return be on the stock? A) 5.45% B) 7.00% C) 10.25% D) 12.35% E) 13.65% Answer: D Response: R = [$2(1.07)] / 40 + - .07 = 12.35% 27. The preferred stock of the Limbaugh Institute pays a constant annual dividend of $4 and sells for $50. You believe the stock will sell for $32 in one year. You must, therefore, believe that the required return on the stock will be _____ percentage points ________ in one year. A) 8; higher B) 8; lower C) 1.5; higher D) 2.5; lower E) 4.5; higher Answer: E Response: current: $50 = $4 / R; R = 8%; future: $32 = $4 / R; R = 12.5 28. A firm's stock has a required return of 12%. The stock's dividend yield is 5%. What is the dividend the firm is expected to pay in one year if the current stock price is $50? A) $2.00 B) $2.50 C) $3.00 D) $3.50 E) $4.00 Answer: B Response: D1 = $50 (.05) = $2.50 29. A firm's stock has a required return of 12%. The stock's dividend yield is 5%. What dividend did the firm just pay if the current stock price is $50? A) $2.18 B) $2.34 C) $2.50 D) $2.87 E) $3.60 Answer: B Use the following to answer questions 30-36: 5 2 W e e k s Y l d V o l H i L o S t o c k S y m D i v % P E 1 0 0 s H i L o C l o s e C h g . 4 8 . 7 2 2 0 . 1 0 D u k e E n e r g y D U K 1 . 0 0 3 . 3 1 8 2 0 9 2 5 3 1 . 5 5 2 9 . 4 0 3 0 . 2 0 – . 5 6 30. Duke stock must have closed at ___________ per share on the previous trading day. A) $29.64 B) $30.76 C) $30.99 D) $31.55 E) $32.11 Answer: B Response: 30.76 - 0.56 = 30.20 31. For the current year, the expected dividend per share is: A) $0.25 B) $1.00 C) $2.00 D) $3.30 E) $4.00 Answer: B Doing the algebra? Expected DPS = Yld x Close = .033 x 30.20 = 1 32. Assume the expected growth rate in dividends is 10%. Then the constant growth model suggests that the required return on Duke stock is: A) 7.4% B) 8.9% C) 11.0% D) 13.6% E) 15.8% Answer: D Response: R = [($1.00 x 1.10) / 30.20] + .10 = 13.6% 33. Based on the quote, a good estimate of EPS over the last four quarters is: A) $0.80 B) $1.21 C) $1.68 D) $1.91 E) $2.54 Answer: C Response: EPS = $30.20 / 18 = $1.68 34. On this trading day, the number of Duke shares which changed hands was: A) 209 B) 2,092 C) 20,925 D) 209,250 E) 2,092,500 Answer: E The algebra? How about 20,925 x 100 = 2,092,500 35. Assume that Duke paid a $0.92 annual dividend in the previous period. What is the dividend growth rate based on this quote? A) 4.8% B) 6.0% C) 7.2% D) 8.7% E) 9.9% Answer: D : Response: g = ($1.00 / 0.92) - 1 = 8.7% 36. You believe that the required return on Duke stock is 16% and that the expected dividend growth rate is 12%, which is expected to remain constant for the foreseeable future. Is the stock currently overvalued, undervalued, or fairly priced? A) Overvalued B) Undervalued C) Fairly priced D) Cannot tell without more information Answer: A Response: P0 = [$1.00 (1.12) ] / (.16 - .12) = $28.00; overvalued at $30.20 in the market CHAPTER 7 QUESTIONS END HERE CHAPTER 8 QUESTIONS BEGIN HERE 1. The difference between the market value of an investment and its cost is the: A) Net present value. B) Internal rate of return. C) Payback period. D) Profitability index. E) Discounted payback period. Answer: A 2. The net present value (NPV) rule can be best stated as: A) An investment should be accepted if, and only if, the NPV is exactly equal to zero. B) An investment should be rejected if the NPV is positive and accepted if it is negative. C) An investment should be accepted if the NPV is positive and rejected if its is negative. D) An investment with greater cash inflows than cash outflows, regardless of when the cash flows occur, will always have a positive NPV and therefore should always be accepted. Answer: C 3. The length of time required for an investment to generate cash flows sufficient to recover its initial cost is the: A) Net present value. B) Internal rate of return. C) Payback period. D) Profitability index. E) Discounted payback period. Answer: C 4. The payback rule can be best stated as: A) An investment is acceptable if its calculated payback period is less than some prespecified number of years. B) An investment should be accepted if the payback is positive and rejected if it is negative. C) An investment should be rejected if the payback is positive and accepted if it is negative. D) An investment is acceptable if its calculated payback period is greater than some prespecified number of years. Answer: A 5. The discount rate that makes the net present value of an investment exactly equal to zero is the: A) Payback period. B) Internal rate of return. C) Average accounting return. D) Profitability index. E) Discounted payback period. Answer: B 6. The internal rate of return (IRR) rule can be best stated as: A) An investment is acceptable if its IRR is exactly equal to its net present value (NPV). B) An investment is acceptable if its IRR is exactly equal to zero. C) An investment is acceptable if its IRR is less than the required return, else it should be rejected. D) An investment is acceptable if its IRR exceeds the required return, else it should be rejected. Answer: D 7.A situation in which taking one investment prevents the taking of another is called: A) Net present value profiling. B) Operational ambiguity. C) Mutually exclusive investment decisions. D) Issues of scale. E) Multiple rates of return. Answer: C 8. The present value of an investment's future cash flows divided by its intial cost is the: A) Net present value. B) Internal rate of return. C) Average accounting return. D) Profitability index. E) Payback period. Answer: D 9. The profitability index (PI) rule can be best stated as: A) An investment is acceptable if its PI is greater than one. B) An investment is acceptable if its PI is less than one. C) An investment is acceptable if its PI is greater than the internal rate of return (IRR). D) An investment is acceptable if its PI is less than the net present value 10. Which of the following statements is true? A) NPV should never be used if the project under consideration has nonconventional cash flows. B) NPV is similar to a cost/benefit ratio. C) If the financial manager relies on NPV in making capital budgeting decisions, she acts in the shareholders' best interests. D) NPV can normally be directly observed in the marketplace. E) IRR is generally preferred to NPV in making correct capital budgeting acceptance decisions. Answer: C 11. Net present value _____________. A) is equal to the initial investment in a project B) is equal to the present value of the project benefits C) is equal to zero when the discount rate used is equal to the IRR D) is simplified by the fact that future cash flows are easy to estimate E) requires the firm set an arbitrary cutoff point for determining whether an investment is acceptable Answer: C 12. The _______ decision rule is considered the "best" in principle. A) internal rate of return B) payback period C) average accounting return D) net present value E) profitability index Answer: D 13. Which of the following decision rules is best for evaluating projects for which cash flows beyond a specified point in time, and the time value of money, can both be ignored? A) Payback B) Net present value C) Average accounting return D) Profitability index E) Internal rate of return Answer: A 14. An investment generates $1.10 in present value benefits for each dollar of invested costs. This conclusion was most likely reached by calculating the project's: A) Net present value B) Profitability index C) Internal rate of return D) Payback period E) Average accounting return Answer: B 15. The use of which of the following would lead to correct decisions when comparing mutually exclusive investments? I. Profitability index II. Net present value III. Average accounting return A) I only B) II only C) III only D) I and II only E) I and III only Answer: B 16. You own some manufacturing equipment that must be replaced. Two different suppliers present a purchase and installation plan for your consideration. This is an example of a business decision involving _____________ projects. A) mutually exclusive B) independent C) working capital D) positive NPV E) crossover Answer: A 17. If a project with conventional cash flows has an IRR less than the required return, then: A) The profitability index is less than one. B) The IRR must be zero. C) The AAR is greater than the required return. D) The payback period is less than the maximum acceptable period. E) The NPV is positive. Answer: A 18. Calculate the NPV of the following project using a discount rate of 10%: Yr 0 = –$800; Yr 1 = –$80; Yr 2 = $100; Yr 3 = $300; Yr 4 = $500; Yr 5 = $500 A) $ 8.04 B) $ 87.28 C) $208.04 D) $459.17 E) $887.28 Answer: B Response: NPV = -$800 - 80 / 1.1 + 100 / 1.12 + 300 / 1.13 + 500 / 1.14 + 500 / 1.15 = $87.28 Using your cashflow keys? CF0= -800, CO1 = -80, FO1=1, CO2 = 100, FO2=1, CO3 = 300, FO3=1, CO4 = 500, FO4=2. Then hit the NPV key, type in 10 for “I,” hit the down arrow to get you back to the NPV display, and hit CPT and you get 87.28. 19. You are considering a project that costs $600 and has expected cash flows of $224, $250.88 and $280.99 over the next three years. If the appropriate discount rate for the project's cash flows is 12%, what is the net present value of this project? A) The NPV is negative B) $ 0.00 C) $ 9.34 D) $49.34 E) $84.75 Answer: B CFO = -600, CO1=224, CO2=250.88, CO3=280.99. All the FO’s are equal to one, with each cash flow occurring once. After entering all the Cashflows (the CO1’s, 2’s and 3’s), hit the NPV key, set I equal to 12, hit the down arrow to get back to NPV, hit CPT and you get about zero, or B. 20. A project costs $300 and has cash flows of $75 for the first three years and $50 in each of the project's last three years. What is the payback period of the project? A) The project never pays back B) 3.75 years C) 4.50 years D) 5.25 years E) 5.50 years Answer: C Response: recover $275 in 4 years, need $25 / 50 = 4.50 years 21. Suppose a project costs $2,500 and produces cash flows of $400 over each of the following 8 years. What is the IRR of the project? A) There is not enough information; a discount rate is required B) 3.27% C) 5.84% D) 9.61% E) 12.06% Answer: C Response: $2,500 = $400 {[1 - 1/(1 + IRR)8] / IRR}; IRR = 5.84% -2,500 PV, 400 PMT, 8 N, CPT I/Y = 5.84% Or you could use your CF keys … but with equally sized cashflows, the TVOM keys are easier. 22. A project has an initial investment of $25,000, with $6,500 annual inflows for each of the subsequent 5 years. If the required return is 12%, what is the NPV? A) –$6,500.00 B) –$2,447.02 C) –$1,568.95 D) $ 215.46 E) $1,763.81 Answer: C Response: NPV = -$25,000 + 6,500 [(1 - 1/1.125) / .12] = -$1,568.95 6,500 PMT, 5 N, 12 I/Y, CPT PV = 23,431 the present value of your inflows. Your NPV = PV(Inflows) – PV (outflows) = 23,431 – 25,000 or a negative 1,569. 23. What is the NPV of the following set of cash flows if the required return is 15%? Y e a r 0 1 2 3 4 C a s h F l o w – $ 1 0 , 0 0 0 – $ 1 , 0 0 0 $ 1 0 , 0 0 0 $ 1 0 , 0 0 0 – $ 5 , 0 0 0 A) The NPV is negative B) $ 408.27 C) $ 950.44 D) $1,247.90 E) $4,656.12 Answer: B CF0 = -10000 CO1 = -1000 FO1 = 1 CO2 = 10000 FO2 = 2 CO3 = -5000 I = 15 NPV = 408.27 24. Would you accept a project which is expected to pay $2,500 a year for 6 years if the initial investment is $10,000 and your required return is 8%? A) Yes; the NPV is $1,557 B) Yes; the NPV is $928 C) Yes; the NPV is $63 D) No; the NPV is –$346 E) No; the NPV is –$1,221 Answer: A Response: NPV = + 2,500[(1 - 1/1.086) / .08] = $1,557.20 2,500 PMT, 6 N, 8 I/Y, CPT PV = 11,557, which is greater than the $10,000 cost by $1,557, so you DO THIS DEAL!! You accept. 25. What is the payback period of a $15,000 investment with the following cash flows? Y e a r 1 2 3 4 5 C a s h F l o w $ 3 , 0 0 0 $ 4 , 0 0 0 $ 5 , 0 0 0 $ 6 , 0 0 0 $ 7 , 0 0 0 A) 2.75 years B) 3.50 years C) 3.75 years D) 4.50 years E) 4.75 years Answer: B Response: recover $12,000 in 3 years, need $3,000 / 6,000 = 3.50 years 26. You are considering an investment which has the following cash flows. If you require a 5 year payback period, should you take the investment? Y e a r 0 1 2 3 4 5 6 C a s h F l o w – $ 3 0 , 0 0 0 $ 1 0 , 0 0 0 $ 5 , 0 0 0 $ 5 , 0 0 0 $ 7 , 5 0 0 $ 1 0 , 0 0 0 $ 2 0 , 0 0 0 A) Yes, the payback is 3.000 years. B) Yes, the payback is 3.75 years. C) Yes, the payback is 4.25 years. D) No, the payback is 5.25 years. E) No, the payback is 5.75 years. Answer: C Response: recover $27,500 in 4 years, need $2,500 / 10,000 = 4.25 years 27. Your required return is 15%. Should you accept a project with the following cash flows? Y e a r 0 1 2 3 C a s h F l o w – $ 2 5 $ 1 0 $ 1 0 $ 2 5 A) No, because the IRR is 5%. B) No, because the IRR is 10%. C) Yes, because the IRR is 20%. D) Yes, because the IRR is 30%. E) Yes, because the IRR is 40%. Answer: D Response: $25 = $10 / (1 + IRR) + 10 / (1 + IRR)2 + 25 / (1 + IRR)3; IRR = 30% CF0=-25, CO1=10, FO1=2, CO2=25, FO2=1, IRR, CPT, IRR = 29.97% or about 30% 28. You are going to choose between two investments. Both cost $50,000, but investment A pays $25,000 a year for 3 years while investment B pays $20,000 a year for 4 years. If your required return is 12%, which should you choose? A) A because it pays back sooner. B) A because its IRR exceeds 12%. C) A because it has a higher IRR. D) B because its IRR exceeds 12%. E) B because it has a higher NPV. Answer: E Response: A: NPV = + 25,000 [(1 - 1/1.123) / .12] = $10,046 B: NPV = + 20,000 [(1 - 1/1.124) / .12] = $10,747 29. Using the profitability index, which of the following projects would you choose if you have limited funds? Project Initial Investment NPV 1 $50,000 $10,000 2 75,000 25,000 3 60,000 15,000 4 40,000 17,000 5 90,000 40,000 A) Project 1 B) Project 2 C) Project 3 D) Project 4 E) Project 5 Answer: E Response: Project 1: PI = $60,000 / 50,000 = 1.200; Project 2: PI = $100,000 / 75,000 = 1.333 Project 3: PI = $75,000 / 60,000 = 1.250; Project 4: PI = $57,000 / 40,000 = 1.425 Project 5: PI = $130,000 / 90,000 = 1.444 30. You have a choice between 2 mutually exclusive investments. If you require a 15% return, which investment should you choose? A B Y e a r C a s h F l o w C a s h F l o w 0 – $ 1 0 0 , 0 0 0 – $ 1 2 5 , 0 0 0 1 2 0 , 0 0 0 7 5 , 0 0 0 2 4 0 , 0 0 0 4 5 , 0 0 0 3 8 0 , 0 0 0 4 0 , 0 0 0 A) Project A, because it has a smaller initial investment. B) Project B, because it has a higher NPV. C) Either one, because they have the same profitability indexes. D) Project A, because it has the higher internal rate of return. E) Project B, because it pays back faster. Answer: B Response: A: NPV = + 20,000 / 1.15 + 40,000 / 1.152 + 80,000 / 1.153 = $238 B: NPV = + 75,000 / 1.15 + 45,000 / 1.152 + 40,000 / 1.153 = $545 31. For a project with an initial investment of $8,000 and cash inflows of $2,000 each year for 6 years, calculate NPV given a required return of 13%. A) –$846 B) –$263 C) $ 0 D) $149 E) $552 Answer: C Response: NPV = -$8,000 + 2,000 [(1 - 1/1.136) / .13] = $0 (actual -$4.90) Use your TVOM keys with equally-sized cash flows. Thusly: 2000 PMT, 6 N, 13 I/Y, CPT PV = 7,995, which is less than 8,000, so your NPV would be about a negative five bucks, as with the algebra above. 32. What is the IRR of an investment that costs $18,500 and pays $5,250 a year for 5 years? A) 13% B) 15% C) 19% D) 25% E) 28% Answer: A Response: $18,500 = $5,250 {[1 - 1/(1 + IRR)5] / IRR}; IRR = 12.92% Just use your TVOM keys with equal cash flows to calculate IRR. Thusly: -18,500 PV, 5,250 PMT, 5 N, CPT I/Y = IRR with equally-sized cash-flows or 12.92% 33. What is the profitability index of the following investment if the required return = 10%? Y e a r 0 1 2 3 C a s h F l o w – $ 1 5 0 $ 5 0 $ 7 5 $ 7 5 A) 0.94 B) 1.09 C) 1.18 D) 1.27 E) 1.45 Answer: B Response: PV = $50 / 1.1 + 75 / 1.12 + 75 / 1.13 = $163.79; PI = $163.79 / 150 = 1.09 34. What is the payback period for the following investment? Y e a r 0 1 2 3 4 C a s h F l o w – $ 2 5 , 0 0 0 $ 1 0 , 0 0 0 $ 8 , 0 0 0 $ 4 , 0 0 0 $ 2 , 0 0 0 A) 4 years B) 3 years C) 2 years D) 1 year E) The investment doesn't payback Answer: E Response: recover $10,000 + 8,000 + 4,000 + 2,000 = $24,000; never pays back Use the following to answer questions 35-38: Bill plans to open a do-it-yourself dog bathing center in a storefront. The bathing equipment will cost $50,000. Bill expects the after-tax cash inflows to be $15,000 annually for 8 years, after which he plans to scrap the equipment and retire to the beaches of Jamaica. 35. What is the project's payback period? A) 2.67 years B) 3.33 years C) 3.67 years D) 4.33 years E) 5.67 years Answer: B Response: payback = $50,000 / 15,000 = 3.33 years 36. Assume the required return is 10%. What is the project's NPV? A) $ 887 B) $13,322 C) $22,759 D) $30,024 E) $45,001 Answer: D Response: NPV = + 15,000 [(1 - 1/1.108) / .10] = $30,023.89 Use the CF keys for practice: CF0=-50,000, CO1=15,000, FO1=8, NPV, I=10, NPV = 30,024 Practice these questions using our BA II Plus review sheet problems 18-22. 37. Assume the required return is 20%. What is the project's IRR? Should it be accepted? A) 15%; yes B) 15%; no C) 25%; yes D) 25%; no E) 20%; indifferent Answer: C Response: $50,000 = $15,000 {[1 - 1/(1 + IRR)8] / IRR}; IRR = 24.95% > 20%; accept -50,000 PV, 15,000 PMT, 8 N, CPT I/Y = IRR = 24.95% 17. A U.S. company can borrow 12,000 pounds in Great Britain for 4% interest, paying back 12,480 pounds in one year. Alternatively, the U.S. company can borrow an equivalent amount of U.S dollars in the United States and pay 8% interest. Assuming capital markets are efficient, estimate the expected inflation rate in the United States if inflation in Great Britain is expected to be zero. a. 3.85 18. Which of the following differentiates the cost of retained earnings from the cost of newly -issued common stock? a. The flotation costs incurred when issuing new securities. 19. Why should firms that own and operate multiple businesses that have different risk char acteristics use business- specific, or divisional costs of capital? a. Not all lines of business have equal risk and it is likely that the firm will accept projects whose returns are unacceptably low in relation to the risk involved. 20. Which of the following causes a firm's cost of capital (WACC) to differ from an investor's required rate of return on the company's common stock? a. The incurrence of flotation costs when new securities are issued. 21. All the following variables are used in computing the cost of debt except: a. riskfree rate. 22. Higher flotation costs will result in all of the following except: a. higher cost of retained earnings 23. A firm's weighted average cost of capital is a function of (1) the individual costs of capit al, (2) the capital structure mix, and (3) the level of financing necessary to make the investment. a. True 24. Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiff y common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock. What is the c ost of internal common equity (retained earnings) if the longterm growth in dividends is projected to be 8 percent indefinitely? a. 13 percent 25. General Bill's will issue preferred stock to finance a new artillery line. The firm's existing preferred stock pays a dividend of $4.00 per share and is selling for $40 per share. Investment bankers have a dvised General Bill that flotation costs on the new preferred issue would be 5% of the selling price. The General' s marginal tax rate is 30%. What is the relevant cost of new preferred stock? a. 10.53 26. Triplin Corporation's marginal tax rate is 35%. It can issue 10- year bonds with an annual coupon rate of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will net the company $966 in proceeds. Determine the appropriate aftertax cost of new debt for Triplin to use in a capital budgeting analysis. a. 38.Assume the required return is 20%. What is the project's PI? Should it be accepted? A) 0.85; yes B) 0.85; no C) 1.00; indifferent D) 1.15; yes E) 1.15; no Answer: D Response: PV of inflows = $15,000 [(1 - 1/1.28) / .2] = $57,557; PI = $57,557 / 50,000 = 1.15; accept At a discount rate of 20%, the PV of the inflows equals the NPV of 7,557 plus the cost of 50,000 or 57,557. (Recall the PV(Inflows) = NPV + PV(Outflows)) END OF CHAPTER 8 QUESTIONS What is the net present value of the machine if the required rate of return is 13.5%. Select one: a. $558,378 b. $473,498 c. $447,292 Correct Question 29 Correct Mark 1 out of 1 Flag question Question text Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $4). The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 p er share. If Sentry Manufacturing decides to issue new common stock, flotation costs wil l equal $2.50 per share. Sentry Manufacturing’s marginal tax rate is 35%. Based on the above information, the cost of new common stock is Select one: a. 31.40%. b. 24.12%. c. 26.62%. d. 28.38%. Correct Question 30 Correct Mark 1 out of 1 Flag question Question text Sentry Manufacturing paid a dividend yesterday of $5 per share (D 0 = $4). The dividend is expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock today is $29 p er share. If Sentry Manufacturing decides to issue new common stock, flotation costs will equal $2.50 per s hare. Sentry Manufacturing's marginal tax rate is 35%. Based on the above information, the cost of r etained earnings is Select one: a. 28.38%. b. 26.62%. Correct Question 31 Correct Mark 1 out of 1 Flag question Question text The cost of external equity capital is greater than the cost of retained earnings because of Select one: a. greater risk for shareholders. b. flotation costs on new equity. Correct c. increasing marginal tax rates. d. higher dividends. Feedback The correct answer is: flotation costs on new equity. Question 32 Correct Mark 1 out of 1 Flag question text The DEF Company is planning a $64 million expansion. The expansion is to be financed by selling $25.6 million in new debt and $38.4 million in new common stock. The before - tax required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent. If the company is in the 35 percent tax bracket, what is the firm's cost of capital? Select one: a. 8.92% b. 11.50% c. 10.74% Correct d. 9.89% Feedback The correct answer is: 10.74% Question 33 Correct Mark 1 out of 1 Flag question Question text The internal rate of return is Select one: b. the discount rate that equates the present value of the cash inflows with the present val ue of the cash outflows. Correct Problem 45 Your company is considering a project with the following cash flows: Initial Outlay = $3,000,000 Cash Flows Year 1-8 = $547,000 Compute the internal rate of return on the project. Select one: c. 9.25% Solve: Irr: (-3000000, {547000, 547000, 547000, 547000, 547000, 547000, 547000}) Enter Problem1 A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is b. 17.72%. R ps= Dps/( Pps-F)= (.035*100)/(21-1.25) Pps(1-F %) Problem 2 A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15 years and has a current market price of $925. If the corporation sells more bonds it will incur flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital? N=15, PV= -925, PMT=50, FV=1000, I=? 5.76 After Tax of Debt= Yeald (1- Tax rate)= 5.76(1-.35)= 3.74 1. "Capital" is sometimes defined as funds supplied to a firm by investors. T   2. The cost of capital used in capital budgeting should reflect the average cost of the various sources of long-term funds a firm uses to acquire assets. T   3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns. T   4. Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt. F   5. The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. F   6. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. F   7. The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. T   8. The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income. F   9. The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, is not deductible by the issuing firm. T   10. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock. T   11. For capital budgeting and cost of capital purposes, the firm should always consider reinvested earnings as the first source of capital⎯i.e., use these funds first⎯because reinvested earnings have no cost to the firm. F   12. Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost. F   13. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. F   14. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock. F   15. The higher the firm's flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and reinvested earnings, whose cost is the average return on the assets that are acquired. F   16. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity. T   17. In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. ANS: F In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, then "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case.   18. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC. T   19. The reason why reinvested earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm's common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should distribute those earnings to its investors. Thus, the cost of reinvested earnings is based on the opportunity cost principle. T   20. When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs. T   21. When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock's expected future rate of return. This problem leaves us unsure of the true value of rs. T   22. When estimating the cost of equity by use of the bond-yield-plus-riskpremium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs. T   23. The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 − F)." ANS: F This statement is true only if the expected growth rate is zero. Here are some illustrative numbers that show that the statement is true if g = 0 but false otherwise.   24. If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 − F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. ANS: T This statement is true. Here are some illustrative numbers to demonstrate this point.   25. Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would decrease the weighted average cost of capital (WACC). F   26. Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. T   27. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. ANS: T True, but data on comparable publicly owned firms can often be obtained and used as proxies for private firms.   28. The cost of debt, rd, is normally less than rs, so rd(1 − T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 − T). T   29. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. F   30. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. F   31. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate. ANS: F None of the methods always provides accurate and reliable estimates. With the CAPM, we don't know the beta that investors are using, we are not totally sure of what rRF to use, and we don't know if the CAPM is truly correct.   32. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. T   33. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 − T)(0.70)(0.50). ANS: F The preferred dividend exclusion is a benefit to the holder of the preferred, not the issuer; hence, this statement is not true. It actually is just nonsense anyway!   34. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. ANS: F Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.   35. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity. However, other things would not stay constant if firms used a lot more debt, as that would increase the riskiness of both debt and equity and thus limit the shift toward debt. T   36. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt. A   37. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year. ANS: A Statement a is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.   38. Burnham Brothers Inc. has no retained earnings since it has always paid out all of its earnings as dividends. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e. The market risk premium declines. E   39. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC. A   40. When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM). ANS: D By definition, both the market and an average stock have betas of 1.0. Since we know this to be the case, we can obviously determine beta for the market or an average stock with precision.   41. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return. ANS: B The correct answer is statement b. Division X should accept only projects with returns greater than 10%, while Division Y should accept only projects with returns greater than 14%. Only statement b meets this criterion.   42. Taylor Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. None of the projects should be accepted. d. All of the projects should be accepted. e. Project B, which is of below-average risk and has a return of 8.5%. ANS: E Project B has a return greater than its risk-adjusted cost of capital, so it should be accepted.   43. Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. ANS: C Statement c is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected.   44. The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many highrisk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many lowrisk projects. ANS: E Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.   45. Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized. ANS: C Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. As the firm takes on more high-risk projects, its true WACC will increase over time. Of course, the true WACC might change over time due to changes in market conditions, but that could cause the true WACC to either rise or decline. Therefore, statement c is correct.   46. Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. ANS: D Statement d is true, because the after-tax cost of debt is rd(1 − T). So, if rd remains constant but T increases, rd(1 − T) will decline. The other statements are false.   47. Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. ANS: E Statement e is true; interest payments on debt are tax deductible. The other statements are false.   48. Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of reinvested earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock. d. The component cost of preferred stock is expressed as rp(1 − T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income. C   49. Which of the following statements is CORRECT? a. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. b. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. c. There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free." d. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year. e. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. C   50. Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC. ANS: C Statement c is true, because the cost of debt for WACC purposes = rd(1 − T), so if T increases, then rd(1 − T) declines.   51. Which of the following statements is CORRECT? a. The after-tax cost of debt usually exceeds the after-tax cost of equity. b. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock. c. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year. d. The WACC that should be used in capital budgeting is the firm's marginal, aftertax cost of capital. e. The WACC is calculated using before-tax costs for all components. D   52. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity. a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. Statement c is true, because equity is more risky than debt and hence investors require a higher return on equity. Also, interest on debt is deductible, and this further reduces the cost of debt. The other statements are false.   53. Which of the following statements is CORRECT? a. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes. b. If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject. c. Because no flotation costs are required to obtain capital as reinvested earnings, the cost of reinvested earnings is generally lower than the after-tax cost of debt. d. Higher flotation costs tend to reduce the cost of equity capital. e. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity. B   54. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 9%, while stand-alone furniture manufacturers typically have a 13% WACC. She also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, she estimates that the composite, or corporate, WACC is 11%. A consultant has suggested using a 9% hurdle rate for the data processing division and a 13% hurdle rate for the manufacturing division. However, the CFO disagrees, and she has assigned an 11% WACC to all projects in both divisions. Which of the following statements is CORRECT? a. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm's intrinsic value over time. c. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time. d. The decision not to risk-adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm's capital structure but it will not affect its intrinsic value. e. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. ANS: B By not making the risk adjustment, the firm will accept too many projects in the manufacturing division and too few in the data processing division. As a result, the company will become riskier overall, raising its cost of capital. Investors will discount the firm's cash flows at a higher rate, and the firm's value will fall. Therefore, statement b is true and the other statements are false.   55. Careco Company and Audaco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Careco having a WACC of 10% and Audaco a WACC of 12%. Careco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Careco project. Audaco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Audaco project. Now assume that the two companies merge and form a new company, Careco/Audaco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. b. After the merger, Careco/Audaco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. c. Careco/Audaco's WACC, as a result of the merger, would be 10%. d. After the merger, Careco/Audaco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. E   56. Which of the following statements is CORRECT? a. A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested. b. No cost should be assigned to reinvested earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are "free." c. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. d. If a firm has enough reinvested earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC. e. The component cost of preferred stock is expressed as rp(1 − T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes. A   57. Which of the following statements is CORRECT? a. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt. b. Suppose some of a publicly-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. c. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity. d. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital. e. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity. C   58. Which of the following statements is CORRECT? a. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the riskfree rate, and the market risk premium⎯can be estimated with little error. C   59. Which of the following statements is CORRECT? a. If the calculated beta underestimates the firm's true investment risk⎯i.e., if the forward-looking beta that investors think exists exceeds the historical beta⎯then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high. b. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified. c. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both "objective" as opposed to "subjective," hence little or no judgment is required. d. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach. e. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever. B   60. Which of the following statements is CORRECT? a. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. b. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. c. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. d. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified. e. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal. ANS: C Statement c is true⎯the WACC will increase if the firm raises more funds than can be supported by reinvested earnings.   61. Which of the following statements is CORRECT? a. Since its stockholders are not directly responsible for paying a corporation's income taxes, corporations should focus on before-tax cash flows when calculating the WACC. b. An increase in a firm's tax rate will increase the component cost of debt, provided the YTM on the firm's bonds is not affected by the change in the tax rate. c. When the WACC is calculated, it should reflect the costs of new common stock, reinvested earnings, preferred stock, long-term debt, short-term bank loans if the firm normally finances with bank debt, and accounts payable if the firm normally has accounts payable on its balance sheet. d. If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt. e. Since the costs of internal and external equity are related, an increase in the flotation cost required to sell a new issue of stock will increase the cost of reinvested earnings. ANS: D Statement d is true. The firm would receive no tax savings on interest, so its cost of debt would not be reduced by the tax factor. However, corporate investors would be able to deduct 70% of the preferred dividends they receive, which would make them willing to accept a lower beforetax yield on preferred stock than on bonds. Put another way, the market yield on this firm's preferred could be lower than the interest rate on its debt because of the 70% exclusion; however, with a zero tax rate there would be no reduction in the firm's cost of debt.   62. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm's managers want to maximize the value of their firm's stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. b. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. c. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. d. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital. e. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets. ANS: D The fact that A's returns are negatively correlated means that it serves as a sort of insurance policy to the firm. The fact that its SD is high is actually good, because the negative correlation will cause the project's beta versus the market and also with the firm's other assets to be relatively low, denoting a low risk and thus justifying a relatively low cost of capital. This answer is theoretically always true, and it is especially true if the firm is large, has many projects, and Project A is not a "bet the company" project.   63. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical. b. If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs. c. Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged. d. Since J and F move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. e. J should have the lower WACC because it is like most other companies, and investors like that fact. ANS: B Statement b is true. The merged firm would have a beta that is a simple average of J's and F's betas, and that would result in a cost of equity that is an average of the two firms' costs of equity. Since they are financed only with equity, their WACCs could also be averaged to find the merged firm's WACC.   64. Perpetual preferred stock from Franklin Inc. sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 8.72% b. 9.08% c. 9.44% d. 9.82% e. 10.22% ANS: B Preferred stock price $97.50 Preferred dividend $8.50 Flotation cost 4.00% rp = Dp/(Pp(1 − F)) 9.08%   65. A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56% ANS: D Preferred stock price $92.50 Preferred dividend $8.00 Flotation cost 5.00% rp = Dp/(Pp(1 − F)) 9.10%   66. Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72% ANS: A rRF 5.00% RPM 6.00% b 1.05 rs = rRF + (RPM × b) 11.30%   67. You have been hired as a consultant by Feludi Inc.'s CFO, who wants you to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of common from reinvested earnings? a. 9.67% b. 9.97% c. 10.28% d. 10.60% e. 10.93% ANS: E rRF 4.10% RPM 5.25% b 1.30 rs = rRF + (RPM × b) 10.925%   68. As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51% ANS: C D1 $0.67 P0 $27.50 g 8.00% rs = D1/P0 + g 10.44%   69. To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59% ANS: D D1 $1.45 P0 $22.50 g 6.50% rs = D1/P0 + g 12.94%   70. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74% ANS: A Bond yield 8.75% Risk premium 3.85% rs = rd + Risk premium 12.60% d. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of retu rn equal to the IRR. Correct Feedback The correct answer is: The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR. Question 39 Correct Mark 1 out of 1 Flag question Question text WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars ha s been growing rapidly over the past several years, selling common stock in each year to finance its gro wth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase it s retained earnings so that the common equity portion of its capital structure will include only retained earning s and no new common stock will be sold. WineCellars weighted average cost of capital this year should be Select one: a. zero, since no new stock will be sold. b. less than 12%. Correct c. greater than 12%. d. equal to 12%. Feedback The correct answer is: less than 12%. Question 40 Correct Question text You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital rati oning. Your division has 4 indivisible projects available, detailed as follows: Project Initial Outlay IRR NPV 1 2 million 18% 2,500,000 2 1 million 15% 950,000 3 1 million 10% 600,000 4 3 million 9% 2,000,000 If you must select projects subject to a budget constraint of 5 million dollars, which set o f projects should be accepted so as to maximize firm value? Select one: a. Projects 2, 3 and 4 b. Projects 1, 2 and 3 c. Projects 1 and 4 Correct d. Project 1 only Feedback The correct answer is: Projects 1 and 4 15. Rent-toOwn Equipment Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amou nts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in y ear four. Rent-toOwn's required rate of return is 8%. What is the internal rate of return of this project? a. 15.13% 16. The internal rate of return is: a. The discount rate that equates the present value of the cash inflows with the present value of the cash outflows. 17. Mutually exclusive projects occur when: a. A set of investment proposals perform essentially the same task. 18. A significant advantage of the internal rate of return is that it: a. Considers all of a project's cash flows and their timing. 19. Which of the following statements about the net present value is true? a. It may be used to select among projects of different sizes. 20. What is the internal rate of return's assumption about how cash flows are reinvested? a. They are reinvested at the project's internal rate of return 21. The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that exp ected future cash flows are reinvested at ________, and the Internal Rate of Return (or IRR) crit eria assumes that expected future cash flows are reinvested at ________. a. the firm's appropriate discount rate, the internal rate of return 22. A significant disadvantage of the internal rate of return is that it: a. may have an unrealistic reinvestment assumption with respect to the discount rate used for re-investment of the cash flows. 23. A significant disadvantage of the payback period is that it: a. Does not properly consider the time value of money. 24. An independent project should be accepted if it: a. Produces a net present value that is greater than or equal to zero. 25. When reviewing the net present value profile for a project a. the IRR will always be a point on the horizontal axis line where NPV = 0. 26. Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 pe rcent. Both projects have a required return of 12 percent. Which of the following statements is most correct? a. Both projects have a positive net present value (NPV). 27. All of the following are sufficient indications to accept a project except (assume that there is no capital rationing constraint, and no consideration is given to payback as a decision tool): a. The IRR of a mutually exclusive project exceeds the required rate of return. 28. A project has an initial cost of $27,400 and a market value of $32,600. What is the difference between these two values called? net present value internal return payback value profitability index discounted payback net present value   Which one of the following methods of project analysis is defined as computing the value of a project based upon the present value of the project's anticipated cash flows? constant dividend growth model discounted cash flow valuation average accounting return expected earnings model internal rate of return discounted cash flow valuation   The length of time a firm must wait to recoup the money it has invested in a project is called the: internal return period. payback period. profitability period. discounted cash period. valuation period. payback period.   The length of time a firm must wait to recoup, in present value terms, the money it has in invested in a project is referred to as the: net present value period. internal return period. payback period. discounted profitability period. discounted payback period. discounted payback period.   A project's average net income divided by its average book value is referred to as the project's average: net present value. internal rate of return. accounting return. profitability index. payback period. accounting return   The internal rate of return is defined as the: maximum rate of return a firm expects to earn on a project. rate of return a project will generate if the project in financed solely with internal funds. discount rate that equates the net cash inflows of a project to zero. discount rate which causes the net present value of a project to equal zero. discount rate that causes the profitability index for a project to equal zero. discount rate which causes the net present value of a project to equal zero.   You are viewing a graph that plots the NPVs of a project to various discount rates that could be applied to the project's cash flows. What is the name given to this graph? project tract projected risk profile NPV profile NPV route present value sequence NPV profile   There are two distinct discount rates at which a particular project will have a zero net present value. In this situation, the project is said to: have two net present value profiles. have operational ambiguity. create a mutually exclusive investment decision. produce multiple economies of scale. have multiple rates of return. have multiple rates of return.   If a firm accepts Project A it will not be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be: independent. interdependent. mutually exclusive. economically scaled. operationally distinct. mutually exclusive.   The present value of an investment's future cash flows divided by the initial cost of the investment is called the: net present value. internal rate of return. average accounting return. profitability index. profile period. profitability index.   A project has a net present value of zero. Which one of the following best describes this project? The project has a zero percent rate of return. The project requires no initial cash investment. The project has no cash flows. The summation of all of the project's cash flows is zero. The project's cash inflows equal its cash outflows in current dollar terms. The project's cash inflows equal its cash outflows in current dollar terms.   Which one of the following will decrease the net present value of a project? increasing the value of each of the project's discounted cash inflows moving each of the cash inflows back to a later time period decreasing the required discount rate increasing the project's initial cost at time zero increasing the amount of the final cash inflow increasing the project's initial cost at time zero   Which one of the following methods determines the amount of the change a proposed project will have on the value of a firm? net present value discounted payback internal rate of return profitability index payback net present value   If a project has a net present value equal to zero, then: the total of the cash inflows must equal the initial cost of the project. the project earns a return exactly equal to the discount rate. a decrease in the project's initial cost will cause the project to have a negative NPV. any delay in receiving the projected cash inflows will cause the project to have a positive NPV. the project's PI must be also be equal to zero. the project earns a return exactly equal to the discount rate.   Rossiter Restaurants is analyzing a project that requires $180,000 of fixed assets. When the project ends, those assets are expected to have an aftertax salvage value of $45,000. How is the $45,000 salvage value handled when computing the net present value of the project? reduction in the cash outflow at time zero cash inflow in the final year of the project cash inflow for the year following the final year of the project cash inflow prorated over the life of the project not included in the net present value cash inflow in the final year of the project   Which one of the following increases the net present value of a project? an increase in the required rate of return an increase in the initial capital requirement a deferment of some cash inflows until a later year an increase in the aftertax salvage value of the fixed assets a reduction in the final cash inflow an increase in the aftertax salvage value of the fixed assets   Net present value: is the best method of analyzing mutually exclusive projects. is less useful than the internal rate of return when comparing different sized projects. is the easiest method of evaluation for non-financial managers to use. is less useful than the profitability index when comparing mutually exclusive projects. is very similar in its methodology to the average accounting return. is the best method of analyzing mutually exclusive projects.   Which one of the following is a project acceptance indicator given an independent project with investing type cash flows? profitability index less than 1.0 project's internal rate of return less than the required return discounted payback period greater than requirement average accounting return that is less than the internal rate of return modified internal rate of return that exceeds the required return modified internal rate of return that exceeds the required return   Why is payback often used as the sole method of analyzing a proposed small project? Payback considers the time value of money. All relevant cash flows are included in the payback analysis. It is the only method where the benefits of the analysis outweigh the costs of that analysis. Payback is the most desirable of the various financial methods of analysis. Payback is focused on the long-term impact of a project. It is the only method where the benefits of the analysis outweigh the costs of that analysis.   Which of the following are advantages of the payback method of project analysis? I. works well for research and development projects II. liquidity bias III. ease of use IV. arbitrary cutoff point I and II only I and III only II and III only II and IV only II, III, and IV only II and III only   Samuelson Electronics has a required payback period of three years for all of its projects. Currently, the firm is analyzing two independent projects. Project A has an expected payback period of 2.8 years and a net present value of $6,800. Project B has an expected payback period of 3.1 years with a net present value of $28,400. Which projects should be accepted based on the payback decision rule? Project A only Project B only Both A and B Neither A nor B Answer cannot be determined based on the information given. Project A only   A project has a required payback period of three years. Which one of the following statements is correct concerning the payback analysis of this project? The cash flows in each of the three years must exceed one-third of the project's initial cost if the project is to be accepted. The cash flow in year three is ignored. The project's cash flow in year three is discounted by a factor of (1 + R)3. The cash flow in year two is valued just as highly as the cash flow in year one. The project is acceptable whenever the payback period exceeds three years. The cash flow in year two is valued just as highly as the cash flow in year one.   A project has a discounted payback period that is equal to the required payback period. Given this, which of the following statements must be true? I. The project must also be acceptable under the payback rule. II. The project must have a profitability index that is equal to or greater than 1.0. III. The project must have a zero net present value. IV. The project's internal rate of return must equal the required return. I only I and II only II and III only I, III, and IV only I, II, III, and IV I and II only   Which one of the following statements related to payback and discounted payback is correct? Payback is a better method of analysis than is discounted payback. Discounted payback is used more frequently in business than is payback. Discounted payback does not require a cutoff point like the payback method does. Discounted payback is biased towards long-term projects while payback is biased towards short-term projects. Payback is used more frequently even though discounted payback is a better method. Payback is used more frequently even though discounted payback is a better method.   Applying the discounted payback decision rule to all projects may cause: some positive net present value projects to be rejected. the most liquid projects to be rejected in favor of the less liquid projects. projects to be incorrectly accepted due to ignoring the time value of money. a firm to become more long-term focused. some projects to be accepted which would otherwise be rejected under the payback rule. some positive net present value projects to be rejected.   Which one of the following correctly applies to the average accounting rate of return? It considers the time value of money. It measures net income as a percentage of the sales generated by a project. It is the best method of analyzing mutually exclusive projects from a financial point of view. It is the primary methodology used in analyzing independent projects. It can be compared to the return on assets ratio. It can be compared to the return on assets ratio.   Which one of the following is an advantage of the average accounting return method of analysis? easy availability of information needed for the computation inclusion of time value of money considerations the use of a cutoff rate as a benchmark the use of pre-tax income in the computation use of real, versus nominal, average income easy availability of information needed for the computation   Which of the following are considered weaknesses in the average accounting return method of project analysis? I. exclusion of time value of money considerations II. need of a cutoff rate III. easily obtainable information for computation IV. based on accounting values I only I and IV only II and III only I, II, and IV only I, II, III, and IV I, II, and IV only   Which one of the following statements related to the internal rate of return (IRR) is correct? The IRR yields the same accept and reject decisions as the net present value method given mutually exclusive projects. A project with an IRR equal to the required return would reduce the value of a firm if accepted. The IRR is equal to the required return when the net present value is equal to zero. Financing type projects should be accepted if the IRR exceeds the required return. The average accounting return is a better method of analysis than the IRR from a financial point of view. The IRR is equal to the required return when the net present value is equal to zero.   The internal rate of return: may produce multiple rates of return when cash flows are conventional. is best used when comparing mutually exclusive projects. is rarely used in the business world today. is principally used to evaluate small dollar projects. is easy to understand. is easy to understand.   Tedder Mining has analyzed a proposed expansion project and determined that the internal rate of return is lower than the firm desires. Which one of the following changes to the project would be most expected to increase the project's internal rate of return? decreasing the required discount rate increasing the initial investment in fixed assets condensing the firm's cash inflows into fewer years without lowering the total amount of those inflows eliminating the salvage value decreasing the amount of the final cash inflow condensing the firm's cash inflows into fewer years without lowering the total amount of those inflows   The internal rate of return is: the discount rate that makes the net present value of a project equal to the initial cash outlay. equivalent to the discount rate that makes the net present value equal to one. tedious to compute without the use of either a financial calculator or a computer. highly dependent upon the current interest rates offered in the marketplace. a better methodology than net present value when dealing with unconventional cash flows. tedious to compute without the use of either a financial calculator or a computer.   Which of the following statements related to the internal rate of return (IRR) are correct? I. The IRR method of analysis can be adapted to handle non-conventional cash flows. II. The IRR that causes the net present value of the differences between two project's cash flows to equal zero is called the crossover rate. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend. IV. Both the timing and the amount of a project's cash flows affect the value of the project's IRR. I and II only III and IV only I, II, and III only II, III, and IV only I, II, III, and IV I, II, III, and IV   Douglass Interiors is considering two mutually exclusive projects and have determined that the crossover rate for these projects is 11.7 percent. Project A has an internal rate of return (IRR) of 15.3 percent and Project B has an IRR of 16.5 percent. Given this information, which one of the following statements is correct? Project A should be accepted as its IRR is closer to the crossover point than is Project B's IRR. Project B should be accepted as it has the higher IRR. Both projects should be accepted as both of the project's IRRs exceed the crossover rate. Neither project should be accepted since both of the project's IRRs exceed the crossover rate. You cannot determine which project should be accepted given the information provided. You cannot determine which project should be accepted given the information provided.   You are comparing two mutually exclusive projects. The crossover point is 12.3 percent. You have determined that you should accept project A if the required return is 13.1 percent. This implies you should: always accept project A. be indifferent to the projects at any discount rate above 13.1 percent. always accept project A if the required return exceeds the crossover rate. accept project B only when the required return is equal to the crossover rate. accept project B if the required return is less than 13.1 percent. always accept project A if the required return exceeds the crossover rate.   Graphing the crossover point helps explain: Answer why one project is always superior to another project. how decisions concerning mutually exclusive projects are derived. how the duration of a project affects the decision as to which project to accept. how the net present value and the initial cash outflow of a project are related. how the profitability index and the net present value are related. how decisions concerning mutually exclusive projects are derived.   A project with financing type cash flows is typified by a project that has which one of the following characteristics? conventional cash flows cash flows that extend beyond the acceptable payback period a year or more in the middle of a project where the cash flows are equal to zero a cash inflow at time zero cash inflows which are equal in amount a cash inflow at time zero   Which of the following statements generally apply to the cash flows of a financing type project? I. nonconventional cash flows II. cash outflows exceed cash inflows prior to any time value adjustments III. cash for services rendered is received prior to the cash that is spent providing the services IV. the total of all cash flows must equal zero on an unadjusted basis I only I and III only II and IV only I, II, and III only I, II, III, and IV I, II, and III only   Which one of the following statements is correct in relation to independent projects? The internal rate of return cannot be used to determine the acceptability of a project that has financing type cash flows. A project with investing type cash flows is acceptable if its internal rate of return exceeds the required return. A project with financing type cash flows is acceptable if its internal rate of return exceeds the required return. The net present value profile is upsloping for projects with both investing and financing type cash flows. Projects with financing type cash flows are acceptable only when the internal rate of return is negative. A project with investing type cash flows is acceptable if its internal rate of return exceeds the required return.   The profitability index is most closely related to which one of the following? payback discounted payback average accounting return net present value modified internal rate of return net present value   Roger's Meat Market is considering two independent projects. The profitability index decision rule indicates that both projects should be accepted. This result most likely does which one of the following? conflicts with the results of the net present value decision rule assumes the firm has sufficient funds to undertake both projects agrees with the decision that would also apply if the projects were mutually exclusive bases the accept/reject decision on the same variables as the average accounting return fails to provide useful information as the firm must reject at least one of the projects assumes the firm has sufficient funds to undertake both projects   Which one of the following methods of analysis provides the best information on the cost-benefit aspects of a project? net present value payback internal rate of return average accounting return profitability index profitability index   When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: accepted because the internal rate of return is positive. accepted because the profitability index is greater than 1. accepted because the profitability index is negative. rejected because the internal rate of return is negative. rejected because the net present value is negative. accepted because the profitability index is greater than 1.   Which one of the following is the best example of two mutually exclusive projects? building a retail store that is attached to a wholesale outlet producing both plastic forks and spoons on the same assembly line at the same time using an empty warehouse to store both raw materials and finished goods promoting two products during the same television commercial waiting until a machine finishes molding Product A before being able to mold Product B waiting until a machine finishes molding Product A before being able to mold Product B   Southern Chicken is considering two projects. Project A consists of creating an outdoor eating area on the unused portion of the restaurant's property. Project B would use that outdoor space for creating a drive-thru service window. When trying to decide which project to accept, the firm should rely most heavily on which one of the following analytical methods? Answer profitability index internal rate of return payback net present value accounting rate of return net present value   Mutually exclusive projects are best defined as competing projects which: would commence on the same day. have the same initial start-up costs. both require the total use of the same limited resource. both have negative cash outflows at time zero. have the same life span. both require the total use of the same limited resource.   The final decision on which one of two mutually exclusive projects to accept ultimately depends upon which one of the following? initial cost of each project timing of the cash inflows total cash inflows of each project required rate of return length of each project's life required rate of return   Which one of the following statements would generally be considered as accurate given independent projects with conventional cash flows? The internal rate of return decision may contradict the net present value decision. Business practice dictates that independent projects should have three distinct accept indicators before a project is actually implemented. The payback decision rule could override the net present value decision rule should cash availability be limited. The profitability index rule cannot be applied in this situation. The payback decision rule could override the net present value decision rule should cash availability be limited.   In actual practice, managers frequently use the: I. average accounting return method because the information is so readily available. II. internal rate of return because the results are easy to communicate and understand. III. discounted payback because of its simplicity. IV. net present value because it is considered by many to be the best method of analysis. I and III only II and III only I, II, and IV only II, III, and IV only I, II, III, and IV I, II, and IV only   Kristi wants to start training her most junior assistant, Amy, in the art of project analysis. Amy has just started college and has no experience or background in business finance. To get her started, Kristi is going to assign the responsibility for all projects that have initial costs less than $1,000 to Amy to analyze. Which method is Kristi most apt to ask Amy to use in making her initial decisions? discounted payback profitability index internal rate of return payback average accounting return payback   Which two methods of project analysis were the most widely used by CEO's as of 1999? net present value and payback internal rate of return and payback net present value and average accounting return internal rate of return and net present value payback and average accounting return internal rate of return and net present value   Western Beef Exporters is considering a project that has an NPV of $32,600, an IRR of 15.1 percent, and a payback period of 3.2 years. The required return is 14.5 percent and the required payback period is 3.0 years. Which one of the following statements correctly applies to this project? The net present value indicates accept while the internal rate of return indicates reject. Payback indicates acceptance. The payback decision rule could override the accept decision indicated by the net present value. The payback rule will automatically be ignored since both the net present value and the internal rate of return indicate an accept decision. The net present value decision rule is the only rule that matters when making the final decision. The payback decision rule could override the accept decision indicated by the net present value.   Which of the following are definite indicators of an accept decision for an independent project with conventional cash flows? I. positive net present value II. profitability index greater than zero III. internal rate of return greater than the required rate IV. positive internal rate of return I and III only II and IV only I, II, and III only II, III, and IV only I, II, III, and IV I and III only Foundations of Finance, 8e, Global Edition, (Keown/Martin/Petty) Chapter 10 Capital Investment Decision Analysis-I Learning Objective 1 1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal. Answer: TRUE Diff: 1 Keywords: Capital Budgeting, Free Cash Flow AACSB: Reflective thinking skills Learning Objective 2 1) The most critical aspect in determining the acceptability of a capital budgeting project is the impact the project will have on the company's net income over the projects entire useful life. Answer: FALSE Diff: 1 Keywords: Income vs. Cash Flow AACSB: Reflective thinking skills 2) Advantages of the payback period include that it is easy to calculate, easy to understand, and that it is based on cash flows rather than on accounting profits. Answer: TRUE Diff: 1 Keywords: Payback Period AACSB: Reflective thinking skills 3) If project A generates $10 million of free cash flow over its five year useful life and project B generates $8 million of free cash flow over its useful life, then Project A will have a shorter payback period than Project B, assuming both projects require the same initial investment. Answer: FALSE Diff: 1 Keywords: Payback Period AACSB: Analytic skills 4) A project with a payback period of four years is acceptable as long as the company's target payback period is greater than or equal to four years. Answer: TRUE Diff: 1 Keywords: Payback Period AACSB: Reflective thinking skills 5) Two projects that have the same cost and the same expected cash flows will have the same net present value. Answer: FALSE Diff: 1 Keywords: Net Present Value, Discount Rate AACSB: Analytic skills 6) The profitability index is the ratio of the company's net income (or profits) to the initial outlay or cost of a capital budgeting project. Answer: FALSE Diff: 1 Keywords: Profitability Index AACSB: Reflective thinking skills 7) If a project is acceptable using the net present value criteria, then it will also be acceptable under the less stringent criteria of the payback period. Answer: FALSE Diff: 1 Keywords: Net Present Value, Payback Period AACSB: Analytic skills 8) An acceptable project should have a net present value greater than or equal to zero and a profitability index greater than or equal to one. Answer: TRUE Diff: 1 Keywords: Net Present Value, Profitability Index AACSB: Reflective thinking skills 9) If a project's internal rate of return is greater than the project's required return, then the project's profitability index will be greater than one. Answer: TRUE Diff: 2 Keywords: Internal Rate of Return, Profitability Index AACSB: Analytic skills 10) The net present value profile clearly demonstrates that the NPV of a project increases as the discount rate increases. Answer: FALSE Diff: 1 Keywords: Net Present Value Profile, Discount Rate AACSB: Reflective thinking skills 11) The modified internal rate of return represents the project's internal rate of return assuming that intermediate cash flows from the project can be reinvested at the project's required return. Answer: TRUE Diff: 1 Keywords: Modified Internal Rate of Return, Required Return AACSB: Reflective thinking skills 12) One drawback of the payback method is that some cash flows may be ignored. Answer: TRUE Diff: 1 Keywords: Payback Period AACSB: Reflective thinking skills 13) The required rate of return reflects the costs of funds needed to finance a project. Answer: TRUE Diff: 1 Keywords: Required Return AACSB: Reflective thinking skills 14) The profitability index provides an advantage over the net present value method by reporting the present value of benefits per dollar invested. Answer: TRUE Diff: 1 Keywords: Profitability Index, Net Present Value AACSB: Reflective thinking skills 15) The net present value of a project will increase as the required rate of return is decreased (assume only one sign reversal). Answer: TRUE Diff: 1 Keywords: Net Present Value, Required Return AACSB: Analytic skills 16) Whenever the internal rate of return on a project equals that project's required rate of return, the net present value equals zero. Answer: TRUE Diff: 1 Keywords: Internal Rate of Return, Net Present Value, Required Return AACSB: Analytic skills 17) One of the disadvantages of the payback method is that it ignores time value of money. Answer: TRUE Diff: 1 Keywords: Payback Period, Time Value of Money AACSB: Reflective thinking skills 18) The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost. Answer: TRUE Diff: 1 Keywords: Capital Budgeting, Incremental Cash Flows AACSB: Reflective thinking skills 19) When several sign reversals in the cash flow stream occur, a project can have more than one IRR. Answer: TRUE Diff: 1 Keywords: Multiple Internal Rates of Return, Sign Reversals AACSB: Analytic skills 20) Many firms today continue to use the payback method but also employ the NPV or IRR methods especially when large projects are being analyzed. Answer: TRUE Diff: 1 Keywords: Payback Period, NPV, IRR AACSB: Reflective thinking skills 21) NPV is the most theoretically correct capital budgeting decision tool examined in the text. Answer: TRUE Diff: 1 Keywords: NPV AACSB: Reflective thinking skills 22) If the net present value of a project is zero, then the profitability index will equal one. Answer: TRUE Diff: 1 Keywords: Net Present Value, Profitability Index, Decision Rules AACSB: Analytic skills 23) The internal rate of return will equal the discount rate when the net present value equals zero. Answer: TRUE Diff: 1 Keywords: Internal Rate of Return, Discount Rate, Net Present Value AACSB: Analytic skills 24) Mutually exclusive projects have more than one IRR. Answer: FALSE Diff: 1 Keywords: Mutually Exclusive Projects, IRR AACSB: Reflective thinking skills 25) For a project with multiple sign reversals in its cash flows, the net present value can be the same for two entirely different discount rates. Answer: TRUE Diff: 1 Keywords: Sign Reversals, Net Present Value, Discount Rates AACSB: Analytic skills 26) The internal rate of return is the discount rate that equates the present value of the project's future free cash flows with the project's initial outlay. Answer: TRUE Diff: 1 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 27) If a project's profitability index is less than one then the project should be rejected. Answer: TRUE Diff: 1 Keywords: Profitability Index AACSB: Analytic skills 28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the profitability index and IRR criteria. Answer: TRUE Diff: 1 Keywords: NPV, PI, IRR AACSB: Reflective thinking skills 29) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion is to select the set of projects that has the highest positive net present value subject to the capital constraint. Answer: TRUE Diff: 1 Keywords: Capital Constraint, Net Present Value AACSB: Reflective thinking skills 30) For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return. Answer: TRUE Diff: 2 Keywords: Internal Rate of Return, Modified Internal Rate of Return AACSB: Reflective thinking skills 31) One positive feature of the payback period is it emphasizes the earliest forecasted free cash flows, which are less uncertain than later cash flows and provide for the liquidity needs of the firm. Answer: TRUE Diff: 1 Keywords: Payback Period AACSB: Reflective thinking skills 32) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of free cash flows generated by prospective projects. Answer: TRUE Diff: 1 Keywords: NPV, Free Cash Flow AACSB: Reflective thinking skills 33) The profitability index is the ratio of the present value of the future free cash flows to the initial investment. Answer: TRUE Diff: 1 Keywords: Profitability Index AACSB: Reflective thinking skills 34) Marketing is crucial to capital budgeting success because the goal of a good capital budgeting project is to maximize the company's sales. Answer: FALSE Diff: 1 Keywords: Capital Budgeting, Shareholder Wealth Maximization AACSB: Reflective thinking skills 35) Because the NPV and PI methods both yield the same accept/reject decision, a company attempting to rank capital budgeting projects for funding consideration can use either method and get the same results. Answer: FALSE Diff: 2 Keywords: NPV, PI AACSB: Reflective thinking skills 36) A project's IRR is analogous to the concept of the yield to maturity for bonds. Answer: TRUE Diff: 1 Keywords: IRR, Yield to Maturity AACSB: Reflective thinking skills 37) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR assumes reinvestment of intermediate free cash flows at the IRR. Answer: TRUE Diff: 1 Keywords: NPV, IRR, Reinvestment Rate AACSB: Reflective thinking skills 38) A project's net present value profile shows how sensitive the project is to the choice of a discount rate. Answer: TRUE Diff: 1 Keywords: Net Present Value Profile, Discount Rate AACSB: Reflective thinking skills 39) If a project has multiple internal rates of return, the lowest rate should be used for decision making purposes. Answer: FALSE Diff: 2 Keywords: Internal Rate of Return, Multiple IRRs AACSB: Reflective thinking skills 40) The payback period ignores the time value of money and therefore should not be used as a screening device for the selection of capital budgeting projects. Answer: FALSE Diff: 1 Keywords: Payback Period, Time Value of Money AACSB: Analytic skills 41) Many financial managers believe the payback period is of limited usefulness because it ignores the time value of money; hence, it is referred to as the discounted payback period. Answer: FALSE Diff: 1 Keywords: Discounted Payback Period, Payback Period, Time Value of Money AACSB: Reflective thinking skills 42) The discounted payback period takes the time value of money into account in that it uses discounted free cash flows rather than actual undiscounted free cash flows in calculating the payback period. Answer: TRUE Diff: 1 Keywords: Discounted Payback Period, Time Value of Money AACSB: Reflective thinking skills 43) Any project deemed acceptable using the discounted payback period will also be acceptable if using the traditional payback period. Answer: TRUE Diff: 2 Keywords: Discounted Payback Period, Payback Period AACSB: Reflective thinking skills 44) A major disadvantage of the discounted payback period is the arbitrariness of the process used to select the maximum desired payback period. Answer: TRUE Diff: 1 Keywords: Discounted Payback Period, Arbitrary Decision Rule AACSB: Reflective thinking skills 45) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bill are greater than zero. Answer: FALSE Diff: 1 Keywords: NPV, Decision Rule AACSB: Reflective thinking skills 46) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash flows into Excel's NPV function. Answer: FALSE Diff: 1 Keywords: NPV, Excel AACSB: Reflective thinking skills 47) The internal rate of return is the discount rate that equates the present value of the project's free cash flows with the project's initial cash outlay. Answer: TRUE Diff: 1 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 48) A project that is very sensitive to the selection of a discount rate will have a steep net present value profile. Answer: TRUE Diff: 1 Keywords: Net Present Value Profile AACSB: Reflective thinking skills 49) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes reinvestment at the project's IRR, the MIRR will always be less than the IRR. Answer: FALSE Diff: 2 Keywords: IRR, MIRR, Reinvestment Rate AACSB: Reflective thinking skills 50) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of the IRR function multiple times, once using the financing rate, and once using the reinvestment rate. Answer: FALSE Diff: 1 Keywords: MIRR, Excel, Reinvestment Rate AACSB: Reflective thinking skills 51) The capital budgeting manager for XYZ Corporation, a very profitable high technology company, completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation. This change will A) increase the present value of the NCFs. B) decrease the present value of the NCFs. C) have no effect on the NCFs because depreciation is a non-cash expense. D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years. Answer: A Diff: 2 Keywords: Net Present Value, Depreciation Expense AACSB: Analytic skills 52) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years. You analyze Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free cash flow is $100,000 too high. After making the necessary adjustments A) the payback period for Project W will be longer than 5.6 years. B) the payback period for Project W will be shorter than 5.6 years. C) the IRR of Project W will increase. D) the NPV of Project W will decrease. Answer: C Diff: 2 Keywords: Payback Period, Net Present Value, Internal Rate of Return AACSB: Analytic skills 53) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent. Both projects have a required return of 12 percent. Which of the following statements is MOST correct? A) Both projects have a positive net present value (NPV). B) Project Alpha must have a higher NPV than Project Beta. C) If the required return were less than 12 percent, Project Beta would have a higher IRR than Project Alpha. D) Project Beta has a higher profitability index than Project Alpha. Answer: A Diff: 2 Keywords: Internal Rate of Return, Net Present Value, Required Return AACSB: Reflective thinking skills 54) Which of the following statements is MOST correct? A) If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative. B) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. C) The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR. D) A project with a NPV = 0 is not acceptable. Answer: C Diff: 1 Keywords: Internal Rate of Return, Net Present Value, Reinvestment Rate AACSB: Reflective thinking skills 55) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the payback period of this project? A) 4.00 years B) 3.09 years C) 2.91 years D) 2.50 years Answer: D Diff: 1 Keywords: Payback Period AACSB: Analytic skills 56) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the net present value of this project? A) $104,089 B) $100,328 C) $96,320 D) $87,417 Answer: A Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 57) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the internal rate of return of this project? A) 10.87% B) 11.57% C) 13.68% D) 15.13% Answer: D Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 58) DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the modified internal rate of return of this project? A) 10.87% B) 11.57% C) 13.68% D) 15.13% Answer: B Diff: 2 Keywords: Modified Internal Rate of Return AACSB: Analytic skills 59) Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The project is expected to generate equal annual cash flows over the next twelve years. The required return for this project is 20%. What is project LMK's net present value? A) $600,000 B) $150,000 C) $120,000 D) $80,000 Answer: B Diff: 2 Keywords: Net Present Value, Profitability Index AACSB: Analytic skills 60) Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return? A) 19.88% B) 22.69% C) 24.78% D) 26.12% Answer: D Diff: 3 Keywords: Internal Rate of Return, Profitability Index, Ordinary Annuity AACSB: Analytic skills 61) A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project's required rate of return is 13%. The internal rate of return is A) greater than $30,000. B) less than 13%. C) between 13% and 15%. D) greater than 15% Answer: D Diff: 2 Keywords: Modified Internal Rate of Return, Net Present Value, Internal Rate of Return, Required Return AACSB: Analytic skills 62) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. The firm's required rate of return for these projects is 10%. The net present value for Project A is A) $12,358. B) $16,947. C) $19,458. D) $26,074. Answer: D Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 63) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The net present value for Project B is A) $58,097. B) $66,363. C) $74,538. D) $112,000. Answer: B Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 64) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project A is A) 1.27. B) 1.22. C) 1.17. D) 1.12. Answer: A Diff: 2 Keywords: Profitability Index AACSB: Analytic skills 65) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project B is A) 1.55. B) 1.48. C) 1.39. D) 1.33. Answer: A Diff: 2 Keywords: Profitability Index AACSB: Analytic skills 66) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project A is A) 31.43%. B) 29.42%. C) 25.88%. D) 19.45%. Answer: B Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 67) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is A) 29.74%. B) 30.79%. C) 35.27%. D) 36.77%. Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 68) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%.The modified internal rate of return for Project A is A) 19.19%. B) 24.18%. C) 26.89%. D) 29.63%. Answer: B Diff: 2 Keywords: Modified Internal Rate of Return AACSB: Analytic skills 69) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The modified internal rate of return for Project B is A) 17.84%. B) 18.52%. C) 19.75%. D) 22.80%. Answer: D Diff: 2 Keywords: Modified Internal Rate of Return AACSB: Analytic skills 70) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. Which project would you recommend using the replacement chain method to evaluate the projects with different lives? A) Project B because its NPV is higher than Project A's replacement chain NPV of $47,623 B) Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project B C) Project A because its replacement chain NPV is $45,642, which is less than the NPV for Project B D) Both projects will be valued the same since they are now both four year projects. Answer: A Diff: 2 Keywords: Replacement Chain, Net Present Value AACSB: Reflective thinking skills 71) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project B, rounded to the nearest dollar, is A) $17,385. B) $20,936. C) $22,789. D) $26,551. Answer: B Diff: 2 Keywords: Equivalent Annual Annuity AACSB: Analytic skills 72) The net present value method A) is consistent with the goal of shareholder wealth maximization. B) recognizes the time value of money. C) uses all of a project's cash flows. D) all of the above. Answer: D Diff: 1 Keywords: Net Present Value AACSB: Reflective thinking skills 73) Arguments against using the net present value and internal rate of return methods include that A) they fail to use accounting profits. B) they require detailed long-term forecasts of the incremental benefits and costs. C) they fail to consider how the investment project is to be financed. D) they fail to use the cash flow of the project. Answer: B Diff: 1 Keywords: Net Present Value, Internal Rate of Return AACSB: Reflective thinking skills 74) All of the following are sufficient indications to accept a project EXCEPT (assume that there is no capital rationing constraint, and no consideration is given to payback as a decision tool) A) the net present value of an independent project is positive. B) the profitability index of an independent project exceeds one. C) the IRR of a mutually exclusive project exceeds the required rate of return. D) the NPV of a mutually exclusive project is positive and exceeds that of all other projects. Answer: C Diff: 2 Keywords: Net Present Value, Profitability Index, Internal Rate of Return, Mutually Exclusive Projects, Independent Projects AACSB: Reflective thinking skills 75) When reviewing the net present profile for a project A) the higher the discount rate, the higher the NPV. B) the higher the discount rate, the higher the IRR. C) the IRR will always be a point on the horizontal axis line where NPV = 0. D) the IRR will always be a point on the horizontal axis equal to the required return. Answer: C Diff: 2 Keywords: Net Present Value Profile, IRR, NPV AACSB: Reflective thinking skills 76) A project requires an initial investment of $389,600. The project generates free cash flow of $540,000 at the end of year 4. What is the internal rate of return for the project? A) 138.6% B) 38.6% C) 8.5% D) 6.9% Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 77) Raindrip Corp. can purchase a new machine for $1,875,000 that will provide an annual net cash flow of $650,000 per year for five years. The machine will be sold for $120,000 after taxes at the end of year five. What is the net present value of the machine if the required rate of return is 13.5%. A) $558,378 B) $513,859 C) $473,498 D) $447,292 Answer: D Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 78) Given the following annual net cash flows, determine the internal rate of return to the nearest whole percent of a project with an initial outlay of $750,000. Year Net Cash Flow 1 $500,000 2 $150,000 3 $250,000 A) 9% B) 11% C) 13% D) 15% Answer: B Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 79) A machine that costs $1,500,000 has a 3-year life. It will generate after tax annual cash flows of $700,000 at the end of each year. It will be salvaged for $200,000 at the end of year 3. If your required rate of return for the project is 13%, what is the NPV of this investment? A) $291,417 B) $400,000 C) $600,000 D) $338,395 Answer: A Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 80) Initial Outlay Cash Flow in Period 1 2 3 4 $4,000,000 $1,546,170$1,546,170$1,546,170$1,546,170 The Internal Rate of Return (to nearest whole percent) is A) 10%. B) 18%. C) 20%. D) 24%. Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 81) We compute the profitability index of a capital budgeting proposal by A) multiplying the internal rate of return by the cost of capital. B) dividing the present value of the annual after tax cash flows by the cost of capital. C) dividing the present value of the annual after tax cash flows by the cash investment in the project. D) multiplying the cash inflow by the internal rate of return. Answer: C Diff: 2 Keywords: Profitability Index AACSB: Reflective thinking skills 82) What is the payback period for a project with an initial investment of $180,000 that provides an annual cash inflow of $40,000 for the first three years and $25,000 per year for years four and five, and $50,000 per year for years six through eight? A) 5.80 years B) 5.20 years C) 5.40 years D) 5.59 years Answer: B Diff: 2 Keywords: Payback Period AACSB: Analytic skills 83) The advantages of NPV are all of the following EXCEPT A) it can be used as a rough screening device to eliminate those projects whose returns do not materialize until later years. B) it provides the amount by which positive NPV projects will increase the value of the firm. C) it allows the comparison of benefits and costs in a logical manner through the use of time value of money principles. D) it recognizes the timing of the benefits resulting from the project. Answer: A Diff: 2 Keywords: Net Present Value AACSB: Reflective thinking skills 84) The disadvantage of the IRR method is that A) the IRR deals with cash flows. B) the IRR gives equal regard to all returns within a project's life. C) the IRR will always give the same project accept/reject decision as the NPV. D) the IRR requires long, detailed cash flow forecasts. Answer: D Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 85) The internal rate of return is A) the discount rate that makes the NPV positive. B) the discount rate that equates the present value of the cash inflows with the present value of the cash outflows. C) the discount rate that makes NPV negative and the PI greater than one. D) the rate of return that makes the NPV positive. Answer: B Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 86) All of the following are criticisms of the payback period criterion EXCEPT A) time value of money is not accounted for. B) cash flows occurring after the payback are ignored. C) it deals with accounting profits as opposed to cash flows. D) none of the above; they are all criticisms of the payback period criteria. Answer: C Diff: 1 Keywords: Payback Period AACSB: Reflective thinking skills 87) Southeast Compositions, Inc. is considering a project with the following cash flows: Initial Outlay = $126,000 Cash Flows: Year 1 = $44,000 Year 2 = $59,000 Year 3 = $64,000 Compute the net present value of this project if the company's discount rate is 14%. A) -$249,335 B) -$138,561 C) $239,209 D) $725,000 Answer: A Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 88) Design Quilters is considering a project with the following cash flows: Initial Outlay = $126,000 Cash Flows: Year 1 = $44,000 Year 2 = $59,000 Year 3 = $64,000 If the appropriate discount rate is 11.5%, compute the NPV of this project. A) -$14,947 B) $2,892 C) $7,089 D) $41,000 Answer: C Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 89) Your company is considering a project with the following cash flows: Initial Outlay = $3,000,000 Cash Flows Year 1-8 = $547,000 Compute the internal rate of return on the project. A) 6.38% B) 8.95% C) 9.25% D) 12.34% Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 90) For the net present value (NPV) criteria, a project is acceptable if NPV is ________, while for the profitability index a project is acceptable if PI is ________. A) greater than zero; greater than the required return B) greater than or equal to zero; greater than zero C) greater than one; greater than or equal to one D) greater than or equal to zero; greater than or equal to one Answer: D Diff: 2 Keywords: Net Present Value, Profitability Index AACSB: Analytic skills 91) Compute the discounted payback period for a project with the following cash flows received uniformly within each year and with a required return of 8%: Initial Outlay = $100 Cash Flows: Year 1 = $40 Year 2 = $50 Year 3 = $60 A) 2.10 years B) 2.21 years C) 2.33 years D) 3.00 years Answer: C Diff: 2 Keywords: Discounted Payback Period AACSB: Analytic skills 92) Consider a project with the following information: After-tax After-tax Accounting Cash Flow Year Profits from Operations 1 $799 $750 2 150 1,000 3 200 1,200 Initial outlay = $1,500 Compute the profitability index if the company's discount rate is 10%. A) 15.8 B) 1.61 C) 1.81 D) 0.62 Answer: B Diff: 2 Keywords: Profitability Index AACSB: Analytic skills 93) If the NPV (Net Present Value) of a project with one sign reversal is positive, then the project's IRR (Internal Rate of Return) ________ the required rate of return. A) must be less than B) must be greater than C) could be greater or less than D) cannot be determined without actual cash flows Answer: B Diff: 2 Keywords: Net Present Value, Internal Rate of Return AACSB: Analytic skills 94) You are considering investing in a project with the following year-end after-tax cash flows: Year 1: $57,000 Year 2: $72,000 Year 3: $78,000 If the initial outlay for the project is $185,000, compute the project's internal rate of return. A) 3.98% B) 5.54% C) 11.89% D) 14.74% Answer: B Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 95) Different discounted cash flow evaluation methods may provide conflicting rankings of investment projects when A) the size of investment outlays differ. B) the projects are mutually exclusive. C) the accounting policies differ. D) the internal rate of return equals the cost of capital. Answer: A Diff: 2 Keywords: Capital Budgeting Decisions, Size, Cash Flows vs Accounting Income AACSB: Reflective thinking skills 96) The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that expected future cash flows are reinvested at ________, and the Internal Rate of Return (or IRR) criteria assumes that expected future cash flows are reinvested at ________. A) the firm's discount rate; the internal rate of return B) the internal rate of return; the internal rate of return C) the internal rate of return; the firm's discount rate D) Neither criteria assumes reinvestment of future cash flows. Answer: A Diff: 2 Keywords: Net Present Value, Internal Rate of Return, Reinvestment Rate AACSB: Analytic skills 97) A significant advantage of the payback period is that it A) places emphasis on time value of money. B) allows for the proper ranking of projects. C) tends to reduce firm risk because it favors projects that generate early, less uncertain returns. D) gives proper weighting to all cash flows. Answer: C Diff: 2 Keywords: Payback Period AACSB: Reflective thinking skills 98) A significant disadvantage of the payback period is that it A) is complicated to explain. B) increases firm risk. C) does not properly consider the time value of money. D) provides a measure of liquidity Answer: C Diff: 2 Keywords: Payback Period AACSB: Reflective thinking skills 99) Your firm is considering an investment that will cost $750,000 today. The investment will produce cash flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5. What is the investment's discounted payback period if the required rate of return is 10%? A) 3.33 years B) 3.16 years C) 2.67 years D) 2.33 years Answer: B Diff: 2 Keywords: Discounted Payback Period AACSB: Analytic skills 100) A significant advantage of the internal rate of return is that it A) provides a means to choose between mutually exclusive projects. B) provides the most realistic reinvestment assumption. C) avoids the size disparity problem. D) considers all of a project's cash flows and their timing. Answer: D Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 101) An independent project should be accepted if it A) produces a net present value that is greater than or equal to zero. B) produces a net present value that is greater than the equivalent IRR. C) has only one sign reversal. D) produces a profitability index greater than or equal to zero. Answer: A Diff: 2 Keywords: Independent Projects, Net Present Value AACSB: Reflective thinking skills 102) What is the net present value's assumption about how cash flows are reinvested? A) They are reinvested at the IRR. B) They are reinvested at the APR. C) They are reinvested at the firm's discount rate. D) They are reinvested only at the end of the project. Answer: C Diff: 2 Keywords: Net Present Value, Reinvestment Rate Assumption AACSB: Reflective thinking skills 103) Your firm is considering an investment that will cost $920000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's net present value? A) $540,000 B) $378,458 C) $192,369 D) $112,583 Answer: C Diff: 2 Keywords: Net Present Value AACSB: Analytic skills 104) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's profitability index? A) 1.21 B) 1.26 C) 1.43 D) 1.69 Answer: A Diff: 2 Keywords: Profitability Index AACSB: Analytic skills 105) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's internal rate of return? A) 27.28% B) 21.26% C) 20.53% D) 15.98% Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Analytic skills 106) Which of the following statements about the internal rate of return (IRR) is true? A) It has the most conservative and realistic reinvestment assumption. B) It never gives conflicting answers. C) It fully considers the time value of money. D) It is greater than the modified internal rate of return if the discount rate is higher than the IRR. Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 107) A significant disadvantage of the internal rate of return is that it A) does not fully consider the time value of money. B) does not give proper weight to all cash flows. C) can result in multiple rates of return (more than one IRR). D) is expressed as a percentage. Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 108) A significant disadvantage of the internal rate of return is that it A) does not fully consider the time value of money. B) does not give proper weight to all cash flows. C) may have an unrealistic reinvestment assumption. D) is expressed as a percentage. Answer: C Diff: 2 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 109) A one-sign-reversal project should be accepted if it A) generates an internal rate of return that is higher than the profitability index. B) produces an internal rate of return that is greater than the firm's discount rate. C) results in an internal rate of return that is above a project's equivalent annual annuity. D) results in a modified internal rate of return that is higher than the internal rate of return. Answer: B Diff: 1 Keywords: Internal Rate of Return AACSB: Reflective thinking skills 110) What is the internal rate of return's assumption about how cash flows are reinvested? A) They are reinvested at the firm's discount rate. B) They are reinvested at the required rate of return. C) They are reinvested at the project's internal rate of return. D) They are only reinvested at the end of the project. Answer: C Diff: 1 Keywords: Internal Rate of Return, Reinvestment Rate Assumption AACSB: Reflective thinking skills 111) If the NPV (Net Present Value) of a project with multiple sign reversals is positive, then the project's required rate of return ________ its calculated IRR (Internal Rate of Return). A) must be less than B) must be greater than C) could be greater or less than D) cannot be determined without actual cash flows Answer: C Diff: 2 Keywords: Net Present Value, Internal Rate of Return, Multiple Sign Reversals AACSB: Analytic skills 112) Kingston Corp. is considering a new machine that requires an initial investment of $480,000 installed, and has a useful life of 8 years. The expected annual after-tax cash flows for the machine are $89,000 for each of the 8 years and nothing thereafter. a. Calculate the net present value of the machine if the required rate of return is 11 percent. b. Calculate the IRR of this project. c. Should Kingston accept the project (assume that it is independent and not subject to any capital rationing constraint)? Explain your answer. Answer: a. NPV = ($21,995) From Excel Spreadsheet NPV function with rate = .11, cash flows as given, and then subtracting the initial investment of $480,000. b. IRR = 9.7% From Excel Spreadsheet IRR function, with cash flows as given above. c. No, the projects NPV is negative and the IRR is less than the required rate of return. Acceptance of this project would reduce shareholder value. Diff: 2 Keywords: NPV, IRR AACSB: Analytic skills 113) D&B Contracting plans to purchase a new backhoe. The one under consideration costs $233,000, and has a useful life of 8 years. After-tax cash flows are expected to be $31,384 in each of the 8 years and nothing thereafter. Calculate the internal rate of return for the grader. Answer: IRR = 1.69% from Excel Spreadsheet function IRR with cash flows of -233000 followed by eight cash flows of 3384) Diff: 2 Keywords: IRR AACSB: Analytic skills 114) Consider two mutually exclusive projects X and Y with identical initial outlays of $600,000 and useful lives of 5 years. Project X is expected to produce an after-tax cash flow of $180,000 each year. Project Y is expected to generate a single after-tax net cash flow of $1,015,000 in year 5. The discount rate is 14 percent. a. Calculate the net present value for each project. b. Calculate the IRR for each project. c. What decision should you make regarding these projects? Answer: a. NPV of A = $17,955 NPV of B = $23,242 b. IRR of A = 15.24% IRR of B = 14.87% c. B should be accepted because it is the mutually exclusive project with the highest positive NPV. Diff: 2 Keywords: NPV, IRR AACSB: Analytic skills 115) A project that requires an initial investment of $340,000 is expected to have an aftertax cash flow of $70,000 per year for the first two years, $90,000 per year for the next two years, and $150,000 for the fifth year? Assume the required return for this project is 10%. a. What is the NPV of the project%? b. What is the IRR of the project? c. What is the MIRR of the project? d. What is the PI of the project? e. What decision would you make regarding this project if the required rate of return is 10%? f. What is the equivalent annual annuity using a 10% required rate of return? Answer: a. NPV = $3,715.34 b. IRR = 10.38% c. MIRR = 10.24% d. PI = 1.011 e. Accept the project because its NPV is positive, or because its IRR and MIRR are greater than the required return of 10%, or because the PI is greater than 1. f. The EAA = $980.10 Diff: 2 Keywords: NPV, IRR, MIRR, PI, Equivalent Annual Annuity AACSB: Analytic skills 116) The Bolster Company is considering two mutually exclusive projects: Year Initial Outlay NPV 0 -$100,000 -$100,000 1 31,250 0 2 31,250 0 3 31,250 0 4 31,250 0 5 31,250 200,000 The required rate of return on these projects is 12 percent. a. What is each project's payback period? b. What is each project's discounted payback period? c. What is each project's net present value? d. What is each project's internal rate of return? e. Fully explain the results of your analysis. Which project do you prefer, and why? Answer: a. Payback of A = 3.2 years Payback of B = 4.5 years b. Discounted Payback of A = 4.29 Discounted Payback of B = 4.88 b. NPV of A = $12,649.26 NPV of B = $13,485.37 c. IRR of A = 16.99% IRR of B = 14.87% d. B is preferred because it has the greatest positive NPV. Diff: 2 Keywords: Payback Period, Net Present Value, Internal Rate of Return AACSB: Analytic skills Learning Objective 3 1) The payback period may be more appropriate to use for companies experiencing capital rationing. Answer: TRUE Diff: 1 Keywords: Payback Period, Capital Rationing AACSB: Reflective thinking skills 2) The profitability index can be helpful when a financial manager encounters a situation where capital rationing is required. Answer: TRUE Diff: 1 Keywords: Profitability Index, Capital Rationing AACSB: Reflective thinking skills 3) Positive NPV projects may be rejected when capital must be rationed. Answer: TRUE Diff: 1 Keywords: Capital Rationing, NPV AACSB: Reflective thinking skills 4) Capital rationing generally leads to higher stock prices as management is doing the best job it can in selecting only the best capital budgeting projects. Answer: FALSE Diff: 1 Keywords: Capital Rationing, Firm Value AACSB: Analytic skills 5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in order of their PI's or IRR's. Answer: FALSE Diff: 2 Keywords: Capital Rationing, PI, IRR AACSB: Reflective thinking skills 6) The net present value always provides the correct decision provided that A) cash flows are constant over the asset's life. B) the required rate of return is greater than the internal rate of return. C) capital rationing is not imposed. D) the internal rate of return is positive. Answer: C Diff: 2 Keywords: Net Present Value, Capital Rationing AACSB: Analytic skills 7) Capital rationing may be imposed because of all of the following EXCEPT A) capital market conditions are poor. B) management has a fear of debt. C) stockholder control problems prevent issuance of additional stock. D) the company's stock price is at an historically high level. Answer: D Diff: 1 Keywords: Capital Rationing AACSB: Reflective thinking skills 8) You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital rationing. Your division has 4 indivisible projects available, detailed as follows: Project Initial Outlay IRR NPV 1 2 million 18% 2,500,000 2 1 million 15% 950,000 3 1 million 10% 600,000 4 3 million 9% 2,000,000 If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should be accepted so as to maximize firm value? A) Projects 1, 2 and 3 B) Project 1 only C) Projects 1 and 4 D) Projects 2, 3 and 4 Answer: C Diff: 2 Keywords: Capital Rationing, Net Present Value AACSB: Analytic skills 9) Under what condition would you NOT accept a project that has a positive net present value? A) If the project has a profitability index less than zero. B) If two or more projects are mutually inclusive. C) If the firm is limited in the capital it has available (capital rationing). D) If a project has more than one sign reversal. Answer: C Diff: 1 Keywords: Net Present Value, Capital Rationing AACSB: Reflective thinking skills 10) I301 Motors has several investment projects under consideration, all with positive net present values. However, due to a shortage of trained personnel, a limit of $1,250,000 has been placed on the capital budget for this year. Which of the projects listed below should be included in this year's capital budget? Explain your answer. Projec t Initial Outlay NPV A $250,000 $325,000 B 250,000 350,000 C 100,000 700,000 D 375,000 112,500 E 375,000 75,000 Answer: Accept B and C because their combined NPV ($1,050,000) is the greatest of any combination of projects that fit within the capital constraint. Diff: 2 Keywords: Capital Rationing, NPV AACSB: Reflective thinking skills Learning Objective 4 1) If two projects are mutually exclusive then the IRR is more important than the NPV in deciding the project that should be chosen. Answer: FALSE Diff: 1 Keywords: Mutually Exclusive, IRR, NPV AACSB: Analytic skills 2) IRR should not be used to choose between mutually exclusive projects. Answer: TRUE Diff: 1 Keywords: IRR, Mutually Exclusive Projects AACSB: Reflective thinking skills 3) The mutually exclusive project with the highest positive NPV will also have the highest IRR. Answer: FALSE Diff: 1 Keywords: Mutually Exclusive Projects, NPV, IRR AACSB: Analytic skills 4) The size disparity problem occurs when mutually exclusive projects of unequal size are being examined. Answer: TRUE Diff: 1 Keywords: Size Disparity, Mutually Exclusive Projects AACSB: Reflective thinking skills 5) A project's equivalent annual annuity (EAA) is the annuity cash flow that yields the same present value as the project's NPV. Answer: TRUE Diff: 1 Keywords: Equivalent Annual Annuity AACSB: Reflective thinking skills 6) An infinite-life replacement chain allows projects of different lengths to be compared. Answer: TRUE Diff: 1 Keywords: Infinite-life Replacement Chain AACSB: Reflective thinking skills 7) Two projects are mutually exclusive if the accept/reject decision for one project has no impact on the accept/reject decision for the other project. Answer: FALSE Diff: 2 Keywords: Mutually Exclusive Projects AACSB: Reflective thinking skills 8) Finance theory suggests that the IRR criterion is the most favorable capital budgeting decision tool. Answer: FALSE Diff: 1 Keywords: NPV, IRR AACSB: Reflective thinking skills 9) If a project is acceptable using the NPV criterion, then it will also be acceptable using the discounted payback period since both methods use discounted cash flows to make the accept/reject decision. Answer: FALSE Diff: 2 Keywords: NPV, Discounted Payback Period AACSB: Analytic skills 10) Both the profitability index (PI) and net present value (NPV) are based on the present value of all future free cash flows, but the PI is a relative measure while the NPV is an absolute measure of a project's desirability. Answer: TRUE Diff: 1 Keywords: Profitability Index, Net Present Value AACSB: Reflective thinking skills 11) If a project's IRR is equal to its required return, then the project's NPV is equal to zero and its PI is equal to one. Answer: TRUE Diff: 2 Keywords: NPV, PI, IRR AACSB: Analytic skills 12) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR criterion. Answer: TRUE Diff: 1 Keywords: IRR, MIRR AACSB: Analytic skills 13) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project A is A) $12,989. B) $13,357. C) $15,024. D) $18,532 Answer: C Diff: 2 Keywords: Equivalent Annual Annuity AACSB: Analytic skills 14) Interstate Appliance Inc. is considering the following 3 mutually exclusive projects. Projected cash flows for these ventures are as follows: Plan A Plan B Plan C Initial Initial Initial Outlay=$3,600,000 Outlay=$6,000,000 Outlay=$3,500,000 Cash Flow: Cash Flow: Cash Flow: Yr 1=$ -0- Yr 1=$4,000,000 Yr 1=$2,000,000 Yr 2= -0- Yr 2= 3,000,000 Yr 2= -0- Yr 3= -0- Yr 3= 2,000,000 Yr 3=2,000,000 Yr 4= -0- Yr 4= -0- Yr 4=2,000,000 Yr 5=$7,000,000 Yr 5= -0- Yr 5=2,000,000 If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the projects above? A) accept plan A B) accept plan B C) accept plan C D) accept Plans A, B and C Answer: C Diff: 2 Keywords: Net Present Value, Mutually Exclusive Projects AACSB: Analytic skills 15) Your company is considering an investment in one of two mutually exclusive projects. Project one involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax cash flows of $500 per year in years 1-5. Project two involves a capital intensive process, requiring an initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5. Your firm's discount rate is 10%. If your company is not subject to capital rationing, which project(s) should you take on? A) Project 1 B) Project 2 C) Projects 1 and 2 D) Neither project is acceptable. Answer: B Diff: 2 Keywords: Mutually Exclusive Projects, Net Present Value AACSB: Reflective thinking skills 16) Your firm is considering investing in one of two mutually exclusive projects. Project A requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of $1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing. Assuming both projects can be replaced with a similar investment at the end of their respective lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project B. A) $2,232 and $85 B) $5,000 and $1,500 C) $2,865 and $94 D) $3,528 and $136 Answer: A Diff: 2 Keywords: Replacement Chain, Net Present Value, Mutually Exclusive Projects AACSB: Analytic skills 17) Determine the five-year equivalent annual annuity of the following project if the appropriate discount rate is 16%: Initial Outflow = $150,000 Cash Flow Year 1 = $40,000 Cash Flow Year 2 = $90,000 Cash Flow Year 3 = $60,000 Cash Flow Year 4 = $0 Cash Flow Year 5 = $80,000 A) $7,058 B) $8,520 C) $9,454 D) $9,872 Answer: B Diff: 2 Keywords: Equivalent Annual Annuity AACSB: Analytic skills 18) Which of the following statements about the net present value is true? A) It produces a percentage result that is easy to describe. B) It has an inadequate reinvestment assumption. C) It is likely that there will be more than one NPV for a project. D) It may be used to select among projects of different sizes. Answer: D Diff: 2 Keywords: Net Present Value, Unequal Size Projects AACSB: Reflective thinking skills 19) A project would be acceptable if A) the payback is greater than the discounted equivalent annual annuity. B) the equivalent annual annuity is greater than or equal to the firm's discount rate. C) the profitability index is greater than the net present value. D) the net present value is positive. Answer: D Diff: 1 Keywords: Net Present Value, Equivalent Annual Annuity AACSB: Reflective thinking skills 20) Mutually exclusive projects occur when A) projects have uneven cash flows. B) more than one firm can use the projects. C) a set of investment proposals perform essentially the same task. D) projects are independent. Answer: C Diff: 1 Keywords: Mutually Exclusive Projects AACSB: Reflective thinking skills 21) Which of the following methods of evaluating investment projects can properly evaluate projects of unequal lives? A) the net present value B) the payback C) the internal rate of return D) the equivalent annual annuity Answer: D Diff: 1 Keywords: Equivalent Annual Annuity AACSB: Reflective thinking skills 22) Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's equivalent annual annuity? A) $52,377 B) $42,923 C) $41,387 D) $40,399 Answer: A Diff: 3 Keywords: Equivalent Annual Annuity AACSB: Analytic skills 23) Consider the following two projects: Initial Outlay Net Cash Flow Each Period 1 2 3 4 Project A $4,000,000 $2,003,000 $2,003,000 $2,003,000 $2,003,000 Project B $4,000,000 0 0 0 $11,000,000 a. Calculate the net present value of each of the above projects, assuming a 14 percent discount rate. b. What is the internal rate of return for each of the above projects? c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts a and b above. d. If 14 percent is the required rate of return, and these projects are independent, what decision should be made? e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what decision should be made? Answer: a. NPV of A = $1,836,166 NPV of B = $2,512,883 b. IRR of A = 35.0% IRR of B = 28.78% c. B has more distant cash flows, thus its IRR is less while its NPV is greater. This time disparity is one of IRR's ranking problems. d. If these projects are independent we would accept them both because they each have a positive NPV. e. If these projects are mutually exclusive we would select B because it has the highest positive NPV. Diff: 2 Keywords: IRR, NPV, Mutually Exclusive Projects, Independent Projects AACSB: Analytic skills 24) The Meacham Tire Company is considering two mutually exclusive projects with useful lives of 3 and 6 years. The after-tax cash flows for projects S and L are listed below. Year Cash Flow S Cash Flow L 0 -$60,000 -$115,000 1 38,000 28,500 2 25,000 49,500 3 35,000 26,850 4 22,600 5 18,750 6 23,500 The required rate of return on these projects is 14 percent. What decision should be made? As part of your answer, calculate the NPV assuming a replacement chain for Project S, and also calculate the equivalent annual annuity for each project. Answer: Accept Project S because its replacement chain NPV of $1,999.96 is positive and is greater than the NPV of Project L of $1,237.09. Also, the equivalent annual annuity for Project S is $514.30 while that of Project L is only $318.13. Diff: 2 Keywords: NPV, Replacement Chain, Equivalent Annual Annuity AACSB: Analytic skills 25) The Dickerson PR Firm is considering two mutually exclusive projects with useful lives of 3 and 6 years. The after-tax cash flows for projects S and L are listed below. Year Cash Flow S Cash Flow L 0 -$60,000 -$51,500 1 40,000 13,000 2 20,000 19,000 3 17,000 11,000 4 20,000 5 10,000 6 8,000 Calculate the equivalent annual annuity for each project assuming a required return of 15%. What decision should be made? Answer: Choose Project S. Although the NPV of Project L (NPV = $1,269.21) is greater than the NPV of Project S (NPV = $1,083.26), this is due to the longer life of project L. The equivalent annual annuity for Project S is $474.44, while the equivalent annual annuity for Project L is only $335.37. Diff: 2 Keywords: NPV, Equivalent Annual Annuity AACSB: Analytic skills 26) Company K is considering two mutually exclusive projects. The cash flows of the projects are as follows: YearProject A Project B 0 -$2,000,000 -$2,000,000 1 500,000 2 500,000 3 500,000 4 500,000 5 500,000 6 500,000 7 500,000 5,650,000 a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of return. b. Discuss the ranking conflict. c. What decision should be made regarding these two projects? Answer: a. NPV of A = $211,305 NPV of B = $401,592.64 IRR of A = 16.33% IRR of B = 15.99% b. The later cash flow of B causes its lower IRR even though it has the higher NPV. c. B should be accepted because it is the mutually exclusive project with the highest positive NPV. Diff: 2 Keywords: NPV, IRR AACSB: Analytic skills download instant at http://testbankinstant.com Exam Name___________________________________ TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 1) Accounting profits are used to make capital budgeting decisions because generally accepted accounting principles ensure that profits are the best measure of a company's economic activity. 1) Answer: False 2) Capital budgeting decisions are based on free cash flow because free cash flow better reflects when money is received and available for reinvestment than account profits. 2) Answer: True 3) The guiding rule in deciding if a free cash flow is incremental is to look at the company with, versus without, the new project. 3) Answer: True 4) A grocery store decides to offer beer for sale and this decision results in more potato chip sales. This is an example of a synergistic effect. 4) Answer: True 5) Additional investment in working capital, even if it may be recovered at the end of a project, must be included in capital budgeting analysis because of the time value of money. 5) Answer: True 6) Sunk costs are cash outflows that will occur regardless of the current accept/reject decision, and therefore should be excluded from the analysis. 6) Answer: True 7) Overhead costs are sometimes incremental cash flows and other times are considered sunk costs. 7) Answer: True 8) Interest payments on a loan obtained specifically to fund a new project should be considered an incremental cash flow for the new project when determining the accept/reject decision. 8) Answer: False 9) To be included in a capital budgeting analysis, all incremental free cash flows must be expensed on the company's books, otherwise generally accepted accounting principles will be violated. 9) Answer: False 10) In measuring cash flows we are interested only in the incremental or incremental aftertax cash flows that are attributed to the investment proposal being evaluated. 10) Answer: True 11) The initial outlay for a new project is an example of an opportunity cost. 11) Answer: False 12) Synergistic benefits from an investment project include cannibalism. 12) Answer: False 1 download instant at http://testbankinstant.com 13) A project's annual free cash flow is the change in operating cash flow less any change in net working capital and less any change in capital spending. 13) Answer: True MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 14) The calculation of incremental free cash flows over a project's life should include 14) A) labor and material saving. B) additional revenue. C) interest to bondholders. D) A and B. Answer: D 15) Eastlick Dairy invests in a new kind of frozen dessert called polar cream that becomes very popular. So many new customers come to the store that the sales of existing ice cream products are increased. The extra sales revenue 15) A) should not be counted as incremental revenue for the polar cream project because the sales come from existing products. B) are cannibalized sales that should be excluded from the analysis. C) are synergistic effects that should be counted as incremental revenues for the polar cream project. D) should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring expense. Answer: C 16) Sunk costs are: 16) A) not deductible for tax purposes. B) not relevant in capital budgeting. C) recoverable. D) incremental. Answer: B TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 17) In general, a project's free cash flows will fall in one of the following three categories: initial outlay, differential cash flows over the project's life, and the terminal cash flow. 17) Answer: True 18) If an old asset is sold for less than its book value the resulting loss will save the company taxes, hence lowering the cost of the project. 18) Answer: True 19) If an old asset is sold for its depreciated, or book, value, then no taxes result and there is no tax effect from the sale. 19) Answer: True 20) One example of a terminal cash flow is the recapture of the net working capital associated with the project. 20) Answer: True 21) The initial outlay of a project may be reduced by the after-tax salvage value of replaced equipment. 21) Answer: True 2 22) A weakness in the capital budgeting process is the funds for an investment proposal obtained by issuing bonds, and the respective interest payments, are not considered in the capital budgeting process. 22) Answer: False 23) The initial outlay includes the immediate cash outflow necessary to purchase the asset and put it in operating order. 23) Answer: True 24) If the increase in net working capital is recovered entirely at the end of the project then it may be ignored. 24) Answer: False 25) Cash flows associated with a project's termination generally include the salvage value of the project net of any taxes associated with the sale. Answer: True 26) Increasing depreciation expense results in a decrease of the incremental after-tax free cash flow. 26) Answer: False 27) Increases in working capital needs should be included as part of the initial outlay of a project, but decreases in working capital for a project should not be considered because they are not guaranteed. 27) Answer: False 28) Any increase in interest payments caused by a project should be counted in the incremental cash flows. 28) Answer: False 29) Terminal cash flows are always positive because they result from the shutting down of a project with the sale of any assets with remaining value. 29) Answer: False 30) Proceeds from the issuance of new debt and principal payments upon maturity of debt used to finance a project should be included in the calculation of the project's after-tax cash flows. 30) Answer: False 31) Interest payments on debt are not included in a project's incremental cash flows, but are instead accounted for in the project's discount rate. 31) Answer: True 32) Depreciation is a non-cash deduction so it may be ignored in the calculation of a project's incremental after-tax cash flows. 32) Answer: True False 33) Depreciation expense produces a cash inflow equal to the depreciation expense multiplied by the firm's marginal tax rate. 33) Answer: True 34) TRL, Inc. has spent $2,000,000 in nonrefundable engineering fees in contemplation of building a convention center and the additional costs to complete the project are $18,000,000. The present value of all benefits the center will produce in its lifetime are $19,000,000, so TRL should not build the convention center. 34) Answer: False 35) Free cash flow calculations can be broken down into three parts: cash flows from operations, cash flows associated with working-capital requirements, and financing cash flows relating to interest and dividend payments. 35) Answer: False 36) An opportunity cost is a relevant incremental cost for capital budgeting decisions. 36) Answer: True MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 37) Taste Good Chocolates develops a new candy bar and plans to sell each bar for $1. Taste Good predicts that 1 million candy bars will be sold in the first year if the new candy bar is produced and sold, and includes $1 million of incremental revenues in its capital budgeting analysis. A senior executive in the company believes that 1 million candy bars will be sold, but lowers the estimate of incremental revenue to $700,000. What would explain this change? 37) A) a higher selling price for the new candy bars B) cannibalization of 300,000 of Taste Good Chocolates' other candy bars C) a lower discount rate D) excessive marketing costs to sell the 1 million candy bars Answer: B 38) Laural Inc. is a household products firm that is considering developing a new detergent. In evaluating whether to go ahead with the new detergent project, which of the following statements is most correct? 38) A) The company will produce the detergent in a building that they already own. The cost of the building is therefore zero and should be excluded from the analysis. B) The company will need to hire 10 new workers whose salaries and benefits will total $400,000 per year. Labor costs are not part of capital budgeting and should be excluded. C) The company will produce the detergent in a building that it renovated 2 years ago for $300,000. The $300,000 should be excluded from the analysis. D) The company will need to use some equipment that it could have leased to another company. This equipment lease could have generated $200,000 per year in after-tax income. The $200,000 should be excluded because the equipment can no longer be leased. Answer: C 39) JW Enterprises is considering a new marketing campaign that will require the addition of a new computer programmer and new software. The programmer will occupy an office in JW's current building and will be paid $8,000 per month. The software license costs $1,000 per month. The rent for the building is $4,000 per month. JW's computer system is always on, so running the new software will not change the current monthly electric bill of $900. The incremental expenses for the new marketing campaign are: 39) A) $8,000 per month. B) $13,000 per month. C) $9,000 per month. D) $13,900 per month. Answer: C 4 40) A local restaurant owner is considering expanding into another urban area. The expansion project will be financed through a line of credit with First National Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy an existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include: 40) A) $500 administrative costs, $2,500 per month rent. B) $1,000 per month interest payments, $2,500 per month rent. C) $2,500 per month rent. D) $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent. Answer: C 41) Margo Inc. wants to replace a 7-year-old machine with a new machine that is more efficient. The old machine cost $50,000 when new and has a current book value of $10,000. Margo can sell the machine to a foreign buyer for $12,000. Margo's tax rate is 30%. The effect of the sale of the old machine on the initial outlay for the new machine is: 41) A) ($11,400). B) $0. C) ($8,400). D) ($12,600). Answer: A 42) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the initial outlay required to fund this project? 42) A) $77,500 B) $75,000 C) $74,500 D) $62,500 Answer: B 43) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the incremental free cash flow for the first year of the project? 43) A) $22,800 B) $24,750 C) $30,880 D) $28,400 Answer: A 5 44) You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $2,500 and recommended the purchase of the latest model from Equipment Corp. of America. The equipment costs $60,000, and it will cost another $12,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $18,000. Use of the equipment will require an increase in your company's net working capital of $3,000, but this $3,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs. Your company's marginal tax rate is 40%. What is the terminal cash flow for this project? 44) A) $10,200 B) ($4,200) C) $21,000 D) $17,400 Answer: A 45) A new project is expected to generate $600,000 in revenues, $200,000 in cash operating expenses, and depreciation expense of $100,000 in each year of its 10-year life. The corporation's tax rate is 40%. The project will require an increase in net working capital of $75,000 in year one and a decrease in net working capital of $50,000 in year ten. What is the free cash flow from the project in year one? 45) A) $355,000 B) $105,000 C) $280,000 D) $205,000 Answer: D 46) Jones Company expects the following results in year one of a new project: Revenue $300,000 Cash Expenses 100,000 Depreciation 80,000 EBIT $120,000 Taxes 40,800 Net Income $79,200 The annual change in operating cash flow is equal to: 46) A) $147,200. B) $159,200. C) $200,000. D) $80,800. Answer: B 47) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the incremental free cash flow for year one? 47) A) $18,850 B) $22,250 C) $21,305 D) $19,900 Answer: A 6 48) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the terminal cash flow? 48) A) $18,000 B) $12,750 C) $9,750 D) $23,250 Answer: B 49) The recapture of net working capital at the end of a project will 49) A) decrease terminal year free cash flow by the change in net working capital times the corporate tax rate. B) increase terminal year free cash flow. C) increase terminal year free cash flow by the change in net working capital times the corporate tax rate. D) have no effect on the terminal year free cash flow because the net working capital change has already been included in a prior year. Answer: B 50) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of a synergistic effect from the new diagnostic testing procedure is the: 50) A) increase in revenue of $10,000 per month for the diagnostic testing. B) increase in all activities totaling $19,000 per month. C) increase in revenues from oil changes and brake jobs of $4,000 per month. D) increase in inventory levels of oil and brake parts. Answer: C 51) Acme Auto Repair developed a new diagnostic testing procedure that is expected to increase sales by $10,000 per month. As more drivers bring in their vehicles, Acme expects to also do more oil changes and brake repairs. As a result, inventory levels of oil and brake parts must be increased by $5,000. Revenues from oil changes and brake jobs are expected to increase by $4,000 per month. An example of an increase in net working capital requirements from the new diagnostic testing procedure is the: 51) A) increase in revenues from oil changes and brake jobs of $4,000 per month. B) increase in inventory levels of oil and brake parts of $5,000. C) increase in all activities totaling $19,000 per month. D) increase in revenue of $10,000 per month for the diagnostic testing. Answer: B 52) If depreciation expense in year one of a project increases for a highly profitable company, 52) A) net income increases and incremental free cash flow increases. B) net income decreases and incremental free cash flow decreases. C) net income decreases and incremental free cash flow increases. D) the book value of the depreciating asset increases at the end of year one. Answer: C 53) Salvage value would most likely not be considered by 53) A) internal rate of return. B) net present value. C) payback. D) A and B. Answer: C 54) Which of the following cash flows are not considered in the calculation of the initial outlay for a capital investment proposal? 54) A) cost of issuing new bonds if the project is financed by a new bond issue B) installation costs C) increase in accounts receivable D) none of the above - all are considered Answer: A 55) Which of the following is NOT considered in the calculation of incremental cash flows? 55) A) tax saving due to increased depreciation expense B) interest payments if new debt is issued C) increased dividend payments if additional preferred stock is issued D) B and C Answer: D 56) A project for Jevon and Aaron, Inc. results in additional accounts receivable of $200,000, additional inventory of $120,000, and additional accounts payable of $50,000. What is the additional investment in net working capital? 56) A) $30,000 B) $370,000 C) $270,000 D) $130,000 Answer: C 57) Project XYZ requires an investment in equipment of $500,000 to replace existing equipment. The existing equipment will produce after-tax salvage value of $50,000. Net working capital requirements are increased by $50,000. What is the total cash outflow at time zero? 57) A) $400,000 B) $550,000 C) $500,000 D) $600,000 E) $450,000 Answer: C 58) A five-year project for East Nile, Inc. results in additional accounts receivable of $120,000, additional inventory of $30,000, and additional accounts payable of $70,000 today. What is the change in the NPV of a project solely due to the additional net working capital (NWC) needs. Assume a 12% discount rate, and the typical expected recovery of the NWC investment. 58) A) a decrease of $34,606 B) a decrease of $138,423 C) a decrease of $45,395 D) a decrease of $181,577 Answer: A 59) Which of the following should be included in the initial outlay? 59) A) taxable gain on the sale of old equipment being replaced B) increased investment in inventory and accounts receivable C) preexisting firm overhead reallocated to the new project D) first year depreciation expense on any new equipment purchased Answer: B 60) Increased depreciation expenses affect tax-related cash flows by 60) A) decreasing taxable income, with no effect on cash flow since depreciation is a non-cash expense. B) increasing taxable income, thus increasing taxes. C) pushing a corporation into a higher tax bracket. D) decreasing taxable income, thus reducing taxes. Answer: D 61) Which of the following are included in the terminal cash flow? 61) A) any tax payments or receipts associated with the salvage value of the asset B) recapture of any working capital increase included in the initial outlay C) the expected salvage value of the asset D) all of the above Answer: D 62) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. What will depreciation expense be during the first year? 62) A) $7,500 B) $8,500 C) $8,700 D) $8,100 Answer: A 63) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. J.B. is replacing an old machine that was purchased 7 years ago for $50,000. The old machine was being depreciated on a straight-line basis over a ten year expected useful life. The machine was sold for $10,000. J.B.'s marginal tax rate is 40%. What is the amount of the initial outlay? 63) A) $81,000 B) $85,000 C) $77,000 D) $75,000 Answer: D 64) When terminating a project for capital budgeting purposes, the working capital outlay required at the initiation of the project will 64) A) increase the cash flow because it is recaptured. B) decrease the cash flow because it is a historical cost. C) decrease the cash flow because it is an outlay. D) not affect the cash flow. Answer: A 65) J.B. Enterprises purchased a new molding machine for $75,000. The company paid $6,000 for shipping and another $4,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $2,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 10 years. Which of the following statements concerning the change in working capital is most accurate? 65) A) The $2,000 paid for oil is added to the initial outlay, offset by the tax savings $800. B) The $2,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR. C) The $2,000 may be expensed each year over the life of the project as part of the incremental free cash flows. D) Even if the $2,000 is fully recovered at the end of the project, the project's NPV and IRR will be lower if the change in working capital is included in the analysis. Answer: D 66) XYZ company is considering replacing an old machine with a new one. Two months ago their chief engineer completed a training seminar on the new machine's operation and efficiency. The $4,000 cost for this training session has already been paid. If the new machine is purchased, it would require $5,000 in installation and modification costs to make it suitable for operation in the factory. The old machine originally cost $90,000 five years ago and is being depreciated by $15,000 per year. The new machine will cost $80,000 before installation and modification. It will be depreciated by $5,000 per year. The old machine can be sold today for $10,000. The marginal tax rate for the firm is 40%. Compute the relevant initial outlay in this capital budgeting decision. 66) A) $73,000 B) $77,000 C) $72,500 D) $84,000 Answer: A 67) Brooke Burke Corporation is considering a new product line. The company currently manufactures several lines of snow skiing apparel. The new products, insulated ski bikinis, are expected to generate sales of $1 million per year for the next five years. They expect that during this five-year period, they will lose about $250,000 in sales on their existing lines of longer ski pants. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products. The new project will, however, require that the company spend an additional $80,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $45,000 per year in salary and benefits. Because of the different construction of the bikinis, an increase in inventory of $3,800 would be required initially. If the marginal tax rate is 30%, compute the incremental after tax cash flows for years 1-5. 67) A) $437,500 per year B) $434,500 per year C) $187,500 per year D) $625,000 per year Answer: A 68) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The initial outlay for the new machine is: 68) A) $109,800. B) $112,200. C) $113,000. D) $111,000. Answer: A 69) The financial manager selecting one of two projects of differing risk should: 69) A) choose the project with greater return even if that project has greater risk. B) select the project with the larger risk-adjusted net present value. C) choose the project with less risk even though that project has less return. D) choose the project with the least relative risk. Answer: B 70) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the incremental free cash flow during year 1 of the project? 70) A) $12,800 B) $11,400 C) $14,400 D) $15,200 Answer: C 71) Incremental cash flows refer to: 71) A) The difference between after-tax cash flows and before-tax accounting profits. B) The cash flows of a project, minus financing costs. C) The new cash flows that will be generated if a project is undertaken. D) The cash flows that are foregone if a firm does not undertake a project. Answer: C 72) Which of the following should be included in an analysis of a new project's cash flows? 72) A) All sunk costs. B) No opportunity costs. C) All financing costs. D) Any sales from existing products that would be lost if customers were expected to purchase a new product instead. Answer: D 73) It is important to consider a new project's affect on the cash flows of existing projects because of: 73) A) synergy. B) cannibalism. C) sunk costs. D) A and B above. Answer: D 74) Which of the following should be excluded in an analysis of a new project's cash flows? 74) A) Additional interest expenses on debt financing B) Additional investment in inventory C) Additional investment in fixed assets D) Additional investment in accounts receivable Answer: A 75) Which of the following expenses associated with a project should not be included in a capital budgeting analysis? 75) A) Reengineering of a production line associated with a new project B) Additional maintenance expenses associated with new equipment C) Training sales staff on a new product D) Additional allocated fixed overhead from corporate headquarters Answer: D 76) A new machine can be purchased for $1,000,000. It will cost $65,000 to ship and $35,000 to modify the machine. A $30,000 recently completed feasibility study indicated that the firm can employ an existing factory owned by the firm, which would have otherwise been sold for $150,000. The firm will borrow $750,000 to finance the acquisition. Total interest expense for 5-years is expected to approximate $250,000. What is the investment cost of the machine for capital budgeting purposes? 76) A) $1,280,000 B) $2,030,000 C) $1,530,000 D) $1,250,000 E) $1,100,000 Answer: D 77) Zinc, Inc. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. Studies have shown that employee-training expenses will be $125,000. What is the total investment in the processing line for capital budgeting purposes? 77) A) $4,125,250 B) $3,980,000 C) $4,190,250 D) $3,875,000 Answer: A 78) Which of the following should not be included as investment costs in evaluating a capital asset? 78) A) Shipping expenses B) Installation expenses C) Employee training expenses D) Interest payments and other financing cash flows that result from raising funds to finance a project Answer: D 79) A new machine can be purchased for $1,500,000. It will cost $45,000 to ship and $55,000 to fine-tune the machine. The new machine will replace an older version that is fully depreciated and will be sold for $125,000. The firm's income tax rate is 40%. What is the initial outlay for capital budgeting purposes? 79) A) $1,525,000 B) $1,725,000 C) $1,675,000 D) $1,600,000 Answer: A 80) Blue Jay Industries is considering the purchase of a new machine. It will replace an existing but obsolete machine that will be sold for $40,000. The existing machine is 8 years old, cost $150,000, had a 10-year useful life, and is being depreciated to zero using the straight-line method. Blue Jay's income tax rate is 40%. What is the after-tax salvage value of the old machine? 80) A) $6,000 B) $36,000 C) $24,000 D) $40,000 Answer: B 81) Zinc, Inc. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000; it will have a 10-year useful life. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. The processor will be depreciated using the straight-line method to zero expected salvage value. Studies have shown that employee-training expenses will be $125,000. What will be the annual depreciation expense of the processing line for capital budgeting purposes? 81) A) $419,025 B) $400,025 C) $390,000 D) $375,000 Answer: B 82) Nickel Industries is considering the purchase of a new machine that will cost $178,000, plus an additional $12,000 to ship and install. The new machine will have a 5-year useful life and will be depreciated using the straight-line method. The machine is expected to generate new sales of $85,000 per year and is expected to increase operating costs by $10,000 annually. Nickel's income tax rate is 40%. What is the projected incremental cash flow of the machine for year 1? 82) A) $66,350 B) $60,200 C) $54,800 D) $68,200 Answer: B 83) Crighton Industries is considering the purchase of a new machine that will cost $250,000, plus an additional $10,000 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to have a salvage value of $30,000 at the end of year five. Crighton's income tax rate is 40%. The additional net working capital from this project of $50,000 is expected to return to its pre-project level upon termination. What is the non-operating terminal cash flow of the machine? 83) A) -$32,000 B) $80,000 C) $68,000 D) $48,000 Answer: C 84) Creighton Industries is considering the purchase of a new strapping machine, which will cost $120,000, plus an additional $7,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $25,000 per year and is expected to save $17,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $30,000. Creighton's income tax rate is 40%. What is the machine's IRR? 84) A) 13.5% B) 12.0% C) 15.0% D) 18.3% Answer: C 85) A company is expanding and has already signed a lease on new office space that costs $10,000 per month. The company also needs a new information system and hired a consultant to recommend new software. The consultant was paid $5,000 for her recommendation. Now the company is trying to make a choice between three competing software products. In the capital budgeting decision to purchase new software, the monthly rent for the office space is ________ and the consultant's fee is ________. 85) A) an opportunity cost, a sunk cost B) a sunk cost, a part of the initial outlay C) a sunk cost, a sunk cost D) incremental cash outflow, an opportunity cost Answer: C 13 86) As part of its expansion project, A.J. Industries Equipment Division has expanded its office space by 200 square feet. The company's administrative overhead is allocated based on the square footage of each business segment. Although the total administrative overhead for the company will remain the same, the Equipment Division will be charged more for administrative overhead. For the Equipment Division expansion project, the administrative overhead is an example of a(n) 86) A) incremental cash flow. B) opportunity cost. C) incremental opportunity cash flow. D) sunk cost. Answer: D 87) An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project. The company has a tax rate of 30%. This transaction will have what impact on the project's initial outlay? 87) A) reduce it by $20,000 B) reduce it by $6,000 C) reduce it by $15,000 D) reduce it by $50,000 Answer: C 88) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the incremental free cash flow during years 2 through 10 of the project? 88) A) $14,400 B) $15,800 C) $13,600 D) $16,400 Answer: D 89) PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What is the project's terminal cash flow? 89) A) $3,000 B) $8,000 C) $5,000 D) $6,000 Answer: D 90) Ames Manufacturing is considering the purchase of new, sophisticated machinery for a special three-year project. The machinery requires a special lubricating oil that probably will never be used, but must be available at all times should the machine break down. Ames purchases $2,000 of lubricating oil to keep on hand just in case it is needed. At the end of the three-year project, it is expected the lubricating oil can be sold back to the distributor for $2,000. Which of the following statements is most correct? 90) A) The $2,000 for lubricating oil is simply an accounting entry and does not represent a real cash flow. B) The $2,000 represents an additional investment in working capital that should be included in the capital budgeting analysis. C) The $2,000 for the lubricating oil should be excluded from the analysis because it is recovered at the end of three years, so the final cost is zero. D) The lubricating oil is a sunk cost that should be excluded from the analysis. Answer: B 91) A major corporation is considering a capital budgeting project that involves the development of a new technology. The controller estimates the net present value to be negative, yet argues that the company should invest in the project. Which of the following statements is most correct? 91) A) Capital rationing may exist for the current year. B) The profitability index may be greater than one, giving an accept decision. C) The controller should be fired for making such a poor decision. D) The controller may be considering the option to expand or modify the project in the future. Answer: D 92) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine? 92) A) a savings of $3,500 B) a tax savings of $1,200 C) a savings of $1,750 D) additional taxes paid of $1,750 Answer: A 93) Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $30,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 10 years. The old van could be sold today for $5,000. The new van has an invoice price of $75,000, and it will cost $5,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $22,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $15,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $3,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the initial outlay required to fund this replacement project? 93) A) $78,500 B) $81,500 C) $74,500 D) $71,500 Answer: C 15 TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 94) A small, family-owned corporation would be more likely to use the contribution-to-firm risk criteria rather than the systematic risk to evaluate capital budgeting projects. 94) Answer: True 95) Since stockholders are able to reduce their exposure to risk by efficiently diversifying their holdings of securities, there is no reason for individual firms to seek diversification of their holdings of assets. 95) Answer: False 96) According to the CAPM, systematic risk is the only relevant risk for capital budgeting purposes. 96) Answer: True 97) A project's contribution-to-firm risk does allow for diversification within the firm. 97) Answer: True 98) A project's standing alone risk allows for diversification within a sole firm. 98) Answer: False MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 99) A wildcat oil driller has enough capital to invest in only one project, that is, to drill one well in an East Texas oil field. A major oil company is drilling 100 wells in the same field. The probability of successfully striking oil is 10% for any well drilled in this field. Which of the following statements is most correct concerning the risk involved in these capital budgeting projects? 99) A) The risk for the wildcat driller is the same as the risk for the major oil company since they are both drilling in the same oilfield. B) The best measure of risk for the wildcat oil driller is project standing alone risk. C) The appropriate risk for the wildcat driller is systematic risk. D) The appropriate risk for the major oil company is contribution-to-firm risk, if all shareholders of the firm are well diversified. Answer: B 100) Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net worth. When considering capital budgeting projects for their boutiques, the appropriate measure of risk is 100) A) Beta risk. B) Project standing alone risk. C) Systematic risk. D) Contribution-to-firm risk. Answer: D 101) If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk is relevant when evaluating project risk in capital budgeting? 101) A) Contribution-to-firm risk B) Capital rationing risk C) Systematic risk D) Total project risk Answer: A 102) Which of the following is the most relevant measure of risk for capital budgeting purposes? 102) A) Contribution-to-firm risk B) Unsystematic risk C) Project standing alone risk D) Symbiotic risk Answer: A 103) Which of the following statements about project standing alone risk is true? 103) A) It provides the best measure of project risk for a large, widely-held company. B) It ignores the cash flows that are associated with a project that occur beyond the payback period. C) It takes into consideration the effects of diversification of the firm's shareholders. D) It ignores the fact that much of the risk of a project will be diversified away as the project is combined with the firm's other projects. Answer: D TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 104) Interest expenses are not included as incremental free cash flows because the cost of funds is recognized as cash flows are discounted back to present value. 104) Answer: True 105) The use of risk-adjusted discount rates is based on the concept that investors require a higher rate of return for more risky projects. 105) Answer: True 106) The risk-adjusted discount rate method implicitly assumes that distant cash flows have the same risk as near cash flows. 106) Answer: False 107) If the cash flows of an accepted investment project are negatively correlated with the average cash flow of the firm's existing assets, then the company's total exposure to risk can decrease. 107) Answer: True 108) Financial theory assumes that individuals are risk averse. 108) Answer: True 109) The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same firm when considering a new product line. 109) Answer: True 110) The less-risky investment is always the more desirable choice. 110) Answer: False MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 111) A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven, and another capital budgeting project involving research and development into synthetic food substitutes. Which of the following statements is most correct concerning the risk-adjusted discount rate(s) for the projects? 111) A) The rate should be the same for both projects because they are being considered by one company with the same common shareholders. B) The rate will likely be higher for the research and development project because of the uncertainty involved with research and development projects. C) The rate should be higher for the replacement project because the company is more certain of the returns from a project similar to their existing business. D) The rate will likely be higher for the replacement project because the likelihood of success is higher. Answer: B 112) The pure play method: 112) A) selects a firm similar to the project being analyzed and uses its returns as the market return in estimating a project beta. B) selects one of the firm's existing projects that is similar to the project being analyzed and uses that project's required rate of return. C) calculates beta using only project returns. D) uses the beta of a firm that is similar to the project being analyzed to determine the required rate of return for the project. Answer: D 113) Which of the following is NOT an important consideration in measuring risk for a capital budgeting project for a well-diversified firm? 113) A) Systematic risk B) Total project risk C) Contribution to firm risk D) None of the above - all may be important in measuring project risk Answer: B 114) Humongous Corporation is a multidivisional conglomerate. The Food Division is undergoing a capital budgeting analysis and must estimate the division's beta. This division has a different level of systematic risk than is typical for Humungous Corporation as a whole. The most appropriate method for estimating this beta is ________. 114) A) The regression coefficient from a time series regression of Food Division's return on assets on a market index B) To multiply the company's beta by the ratio of the Food Division's total assets/Humungous Corporation total assets C) The regression coefficient from a time series regression of Food Division's net income on the Humungous Corporation's return on assets D) The regression coefficient from a time series regression of Humungous Corporation stock returns on a market index Answer: A 115) One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project. This method is referred to as ________. 115) A) the pure play method B) sensitivity analysis C) the accounting beta method D) scenario analysis Answer: A 116) Creighton Industries is considering the purchase of a new strapping machine, which will cost $120,000, plus an additional $7,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $25,000 per year and is expected to save $17,000 in labor and electrical expenses over the next 5-years. The machine is expected to have a salvage value of $30,000. Creighton uses a 13.5% discount rate for capital budgeting purposes and the firm's income tax rate is 40%. What is the machine's NPV? 116) A) $8,888 B) $25,000 C) $12,153 D) $5,062 Answer: D TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 117) Sensitivity analysis involves changing one variable at a time. 117) Answer: True 118) A typical decision rule used in simulation is to accept the project if the probability is sufficiently high that the net present value is positive. 118) Answer: True 119) Reducing the probability of bankruptcy is a benefit of diversification. 119) Answer: True 120) Using simulation provides the financial manager with a probability distribution of an investment's net present value or internal rate of return. 120) Answer: True MULTIPLE CHOICE. Choose the one alternative that best completes the statement or answers the question. 121) Advantages of using simulation include: 121) A) a range of possible outcomes presented. B) is good only for single period investments since discounting is not possible. C) graphically displays all possible outcomes of the investment. D) adjustment for risk in the resulting distribution of net present values. Answer: A 122) What method is used for calculation of the accounting beta? 122) A) regression analysis B) sensitivity analysis C) simulation D) both A and C Answer: A 19 123) The simulation approach provides us with: 123) A) a probability distribution of the project's net present value or internal rate of return. B) a graphic exposition of the year-by-year sequence of possible outcomes. C) an approximation of the systematic risk level. D) a single value for the risk-adjusted net present value. Answer: A 124) Which of the following is not an acceptable method of measuring risk for capital budgeting purposes? 124) A) Modified internal rate of return B) Proxy, or pure play method for estimating a project's beta C) Using a risk-adjusted discount rate D) Sensitivity analysis Answer: A TRUE/FALSE. Write 'T' if the statement is true and 'F' if the statement is false. 125) Fluctuating currency exchange rates should be ignored in capital budgeting because for a U.S. firm, all incremental cash flows will be properly measured in dollars. 125) Answer: False 1. Amish Enterprises makes wooden play sets. The company pays annual rent of $350,000 per year and pays administrative salaries totaling $120,000 per year. Each play set requires $300 of wood, ten hours of labor at $50 per hour, and variable overhead costs of $50. Fixed advertising expenses equal $40,000 per year. Each play set sells for $ 2,350. What is Amish Enterprises' break even output level? (Points :1) 340 play sets 217 play sets 159 play sets 270 play sets 2. A plant may remain operating when sales are depressed _________ (Points :1) If the selling price per unit exceeds the variable cost per unit To help the local economy In an effort to cover at least some of the variable cost Unless variable costs are zero when production is zero 3. A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have ______ earnings per share fluctuations resulting from changes in levels of sales. (Points :1) No Constant Large D Small 4. Financial leverage could mean financing some of a firm’s assets with _______ (Points :1) Common stock Retained earnings Corporate bonds Sales revenues 5. Break even analysis is used to study the effect on EBIT of changes in all of the following except: (Points :1) Corporate taxes Prices Cost structure Volume 6. The break even point in sales dollars is convenient if ______ (Points :1) The firm sells a large amount of one product The firm deals with more than one product The price per unit is very low Depreciation expense is high 7. A corporation with very high growth prospects and many positive NPV projects to fund may want to increase its dividend based on _______ (Points :1) The tax bias against capital gains. The residual dividend theory The information effect The very low agency costs of the corporation 8. Stock dividends ________ (Points :1) Decrease stock prices because no cash goes to shareholders but companies pay transactions costs. May increase stock prices if the dividend is used to maintain an optimal trading range for common stock. May increase stock prices if investors perceive the dividend as containing favorable information about the firm’s future prospects. Both B and C are true. 9. Which of the following is the most valid reason to split a stock that has a market price of $110 per share? (Points :1) Conserve cash Reduce the market price to a more popular trading range. Obtain additional capital. Increase investor’s net worth. 10. What is the economic difference between a stock dividend and a stock split? (Points :1) Stock splits create greater economic benefits to shareholders than stock dividends Stock splits increase EPS more than stock dividends There is no economic difference between a stock dividend and a stock split. Stock dividends create greater economic benefits to shareholders than stock splits 1. Operating leverage refers to ________ Financing a portion of the firm’s assets with securities bearing a fixed rte of return The additional chance or 1. Operating leverage refers to ________ Financing a portion of the firm’s assets with securities bearing a fixed rte of return The additional chance or insolvency borne by the common shareholder. The incurrence of fixed operating costs in the firm’s income insolvency borne by the common shareholder. The incurrence of fixed operating costs in the firm’s income stream A high degree of variable costs of production http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 stream A high degree of variable costs of production http://entirecourse.com/course/BUS-401-Principles-ofFinance/BUS-401-Week-4-Quiz-4 2. A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have ______ earnings per share fluctuations resulting from changes in levels of sales. No Constant Large Small http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 2. A firm that uses large amounts of debt financing in an industry characterized by a high degree of business risk would have ______ earnings per share fluctuations resulting from changes in levels of sales. No Constant Large Small http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 3. JB Corporation has a retained earnings balance of $1,000,000. The company 3. JB Corporation has a retained earnings balance of $1,000,000. The company reported net income of $200,000, sales of $2,000,000, and had 100,000 shares of common stock outstanding. The company announced a dividend of $ 1 per share. Therefore, the company’s dividend payout ratio is _________. 10% 20% 50% 100% http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 reported net income of $200,000, sales of $2,000,000, and had 100,000 shares of common stock outstanding. The company announced a dividend of $ 1 per share. Therefore, the company’s dividend payout ratio is _________. 10% 20% 50% 100% http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 4. Assume Harris, Inc. Has 10,000,000 common shares outstanding that have a par value of $2 per share. The stock is currently trading for $30 per share. The firm reported a net profit aftertax of $25,000,000. All else equal, what will happen to earnings per share if the company issues a 10 % stock dividend? Earnings per share will remain the same since a stock dividend does not 4. Assume Harris, Inc. Has 10,000,000 common shares outstanding that have a par value of $2 per share. The stock is currently trading for $30 per share. The firm reported a net profit aftertax of $25,000,000. All else equal, what will happen to earnings per share if the company issues a 10 % stock dividend? Earnings per share will remain the same since a stock dividend does not create an expense. Earnings per share will increase because the dividend increases the value of the company. Earnings per share will decrease because the number of shares outstanding will go up. The impact cannot be determined without additional information on the new price per share. http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 create an expense. Earnings per share will increase because the dividend increases the value of the company. Earnings per share will decrease because the number of shares outstanding will go up. The impact cannot be determined without additional information on the new price per share. http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 5. All of the following are likely to result in the use of less debt in a company’s capital structure expect: Desire to maintain financial flexibility Desire to maintain a high credit rating Insufficient internal funds An increase in a company’s marginal tax rate http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 5. All of the following are likely to result in the use of less debt in a company’s capital structure expect: Desire to maintain financial flexibility Desire to maintain a high credit rating Insufficient internal funds An increase in a company’s marginal tax rate http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 6. Which of the following statements would be consistent with the Dividend Irrelevance Theory? There is no relationship between a firm’s dividend policy and the value of its common stock. Perfect capital markets are assumed to exist which allow investors to buy and sell stock without incurring any transaction costs. Investors are indifferent whether stock returns come from dividend income or capital gains income. All of the above. http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 6. Which of the following statements would be consistent with the Dividend Irrelevance Theory? There is no relationship between a firm’s dividend policy and the value of its common stock. Perfect capital markets are assumed to exist which allow investors to buy and sell stock without incurring any transaction costs. Investors are indifferent whether stock returns come from dividend income or capital gains income. All of the above. http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 7. The break even point in sales dollars is convenient if ______ The firm sells a large amount of one product The firm deals with more than one product The price per unit is very low Depreciation expense is high 7. The break even point in sales dollars is convenient if ______ The firm sells a large amount of one product The firm deals with more than one product The price per unit is very low Depreciation expense is high http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 8. In perfect capital markets there ______ Is no informational content assigned to a particular dividend policy. Are no income taxes Are no flotation costs All of the above http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 8. In perfect capital markets there ______ Is no informational content assigned to a particular dividend policy. Are no income taxes Are no flotation costs All of the above http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 9. Financial leverage could mean financing some of a firm’s assets with _______ Common stock Retained earnings Corporate bonds Sales revenues http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 9. Financial leverage could mean financing some of a firm’s assets with _______ Common stock Retained earnings Corporate bonds Sales revenues http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 10. Dividend policy is influenced by _______ A company’s investment opportunities A firm's capital structure mix A company’s availability of internally generated funds. All of the above http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 10. Dividend policy is influenced by _______ A company’s investment opportunities A firm's capital structure mix A company’s availability of internally generated funds. All of the above http://entirecourse.com/cour se/BUS-401-Principles-ofFinance/BUS-401-Week-4- Quiz-4 The long-run goal of the firm maximize shareholder wealth Maximizing shareholder wealth means maximizing the market value of the firm's common stock. Advertisement According to principle 3 By determining if the return is more than expected given the level of risk. The five basic principles include all of the following except Incremental profits determine value A corporate manager decides to build a new store the opportunity cost of the lot is $250,000 and should be included in the calculating the value of the project To measure, the concept of time value of money is used to bring the future benefits and costs of a project measured by its cash flows, back to the present The principle of risk - return tradeoff means that a rational investor Profits are down the stock price is likely to be unaffected When evaluating an investment project, which of the following best describes the financial information needed by decision maker? after-tax incremental cash flows In which of the following cases will the agency problem between shareholders and managers be the greatest? The common stock of the company is owned Ethical behavior is essential in business because unethical behavior destroys Advertisement Assume the you went to Las Vegas The $5 million today The financial manager most directly responsible for producing the company's financial statement and directing its cost accounting functions is the controller A corporate treasurer is typically responsible for each of the following duties except: cost accounting The three basic types of issues addressed by the study of finance are capital budgeting, capital structure, and working capital managment Working capital management is concerned with how a firm can best manage its cash flows as they arise in its day-to-day operations Capital budgeting is concerned with what long-term investments a firm should undertake Determining the best way to raise money to fund a firm's long-term investments is called the capital structure decision Advantages of the corporation include transferability of ownership & ability of the corporation to raise capital Disadvantages of the partnership are lack of performance & unlimited liability A limited partnership provides limited liability to only to limited partners who do not participate Joe is deciding $10,000 if Joe is a limited partner Bill, a local investor, developed a diet pill limited-liability company with Bill Limited partnership are not as prevalent as corporations because it is easier to transfer ownership by selling common stock than it is sell partnership Which of the following is an advantage of the sole proprietorshp? no significant legal requirements Which of the following is NOT a benefit provided by the existence of organized security exchanges Keeping long-term bond prices below 8 percent a Which of the following statements is an example of a futures market transaction? A company agrees to purchase 1000 barrels of oil for delivery in six months at a price of $70 per barrel General Electric (GE) has been a public company for many years a seasoned equity offering because GE has sold common stock before. Money market instruments include: T-bills A wealthy private investor providing a direct transfer of funds is called an angel investor Which of the following is an example of both a capital market and a primary market transaction? Ford Motor Company sells a new issue of common stock to raise funds through a public offering. All of the following are benefits of organized stock exchanges except increased stock price volatility The Securities and Exchange Commission (SEC) regulates both primary and secondary markets The New York Stock Exchange (NYSE) is a hybrid market, allowing for face-to-face trading Which of the following functions is NOT a major function that an investment banker performs? Regulating Which method listed below is NOT a method by which securities are distributed to final investors? Upset Agreement Investment firms, such as Goldman Sachs facilitating indirect transfers from savers Spandra Electronics a commission or best-- efforts agreement Investment banking firms offer to facilitate the sale of securities to the public an underwriting A "Dutch auction" allowing investors to submit bids say how many shares they'd like to buy Private placements are especially appealing to new, small, and medium - sized companies A basis point is equal to one-hundreth of one percent The prime lending rate is the base rate on corporate loans The real rate of return is the return earned above the inflation risk premium Over the period 1926 to 2008 common stocks of small firms Which of the following represents the correct ordering of returns over the period 1926 to 2008 (low to high) Treasury bills, long-term corporate bonds, common stocks, small firm common stocks Which of the following represents the correct ordering of standard deviation of return over the period 1926 to 2008 (h to l) Small firm common stocks, common stocks, long-term corporate bonds, treasury bills Which of the following securities will likely have the highest liquidity premium? Aaa- rated corporate bond maturing in 2015 not actively traded. Which of the following securites will likely have the highest default risk premium? Bbb- rated corporate bond Common stocks of small firms have ______ risk and produce _______ average annual returns...____percent and ___percent more;higher; 17.4;11.6 Over long periods of time, ________ tend to have higher "real rate or return" Common stocks premium can be defined as the additional return required by investors in longer-term maturity-risk The one-year interest rate is 4% The two year- security is 6% According to unbiased expectations theory the one-year interest 8.04% One year interest is 4% Two year security is 6% and one year interest rate from now is 8.04% the second one year is 30% You are considering an investment in U.S.treasury realriskfree interest rate 1.0% expected to be 1.5% maturityrisk 2.5% Aaa 5.0% Considering an investment in Aaa....What is the U.S. corporate bond 8.5% (add everything that benefits AAA) What is the term for a graphical representation of the relationship between interest rates and the maturities of debt securit yield curve Which of the following is NOT a valid theory that attempts to explain the shape of the term structure of interest rates? the Fisher Effect theory A "normal" yield curve is Upward Sloping (Computing earnings per share) If ABC company earned $280,000 dividends $40,000, what are ABC's EPS has 80,000 shares $280,000/80000 shares =$3.5 Earnings per share are _____ divided by the ______ net income; the number of shares Dividends per share ____divided by ____. dividends; the number of shares What are profit margins? The profit margins and the profits-to-sales relationships. Three types are gross profit margin, operating profit margin, and net profit margin. The December 31, 2009 balance sheet shows $135,000 Wheeler Corporation Wheeler paid a dividend in 2010 of $2 million The two principle sources of financing for corporations are debt and equity Net working capital is equal to current assets minus current liabilities What information does a firm's balance sheet provide to the viewing public? an itemization of all of firm's assets, liabilities, and equity as of the balance sheet date A company borrows $2,000,000 and uses the money to purchase high technology machinery for its operations. These are examples cash flow from financing and cash flow from investing Racing Horse Corporation reported $220,000 Examples of uses of cash include paying cash dividends to stockholders. What information does a firm's statement of cash flows provide to the viewing public? a report documenting a firm's cash inflows and cash outflows A firm has after-tax cash flow from operations equal to $100,000. Operating increased $20,000, and the firm purchased $30,000 $50,000 Rogue Corp has sales of $4,250,000, COGS $2,500,000, total operating exp. are $600,000. firm interest exp. $250,000 crptx .40 $360,000 The income statement for Simpson, Inc. indicates $25,000 Is it possible for two companies to have the same financial performance, but their financial statements can be differ. True In the United States, financial statements are prepared following the Financial Accounting Standards Board's True Financial analysis uses historical financial statements Common-sized balance sheets show each balance sheet account as a percentage of total assets Which of the following transactions will increase a corporation's operating return on assets? negotiate a new contract that lowers raw material cost by 10% An analyst is evaluating two companies A and B Company B has a higher operating return on assets that Company A Smith Corporation has earned a return on capital invested of 10% investors' required rate of return is 12% All of the following measure liquidity except: operating return on assets Jones, Inc. The company writes a $30,000 check to pay off some existing accounts payable For a retailer with inventory to sell, the acid-test ratio will be less than the current ratio, thus providing a more stringent measure of liquidity Company A has a higher day's sales outstanding ratio than Company B. Therefore, Other things being equal When company inventory turnover ratios, other things being equal, a higher inventory turnover is preferred to improve liquidity Company A and Company B have the same gross profit Company A has lower selling and administrative expenses Nelson Industries Nelson may have more non-interest Benkart Corporation has sales of $5,000,000 $96 per share The current ratio of a firm would be increased by which of the following land held for investment is sold for cash The current ratio of a firm would be decreased by inventories are sold on a long-term credit basis Given an accounts receivable of turnover of 10 and annual credit sales of $900,000, the average collection period is 36.50 days Which of the following financial ratios is the best measure of the operating effectiveness of a firm's management? operating return on assets Which of the following ratios would be the poorest indicator times interest earned Jeter Industries $1,232.88 Which of the following does NOT provide an indication of liquidity? debt ratio A firm wants to know if it has enough cash to meet its bills liquidity Which of the following ratios would be the best way to determine how customers are paying for their purchases? Average collection period Financial ratios are used by personnel in marketing, True It is commonly accepted that the industry average for a ratio False Seasonality causes True Seasonality is introduced False The three major components responsible for variation True (Business and financial risk) Which of the following...represents the effect of business versus financial risk (discuss the ) -100% of the money -financial -business -business The break-even quantity of output is that quantity of output, in units True Break-even analysis is a short-term concept True As production levels increase, True Over the relevant range of output, True Depreciation is considered a fixed cost. True The break-even model enables managers of the firm to: determine the quantity of output As production levels increase, fixed cost per unit decrease and variable costs per unit The break-even point is equal to fixed cost divided by ( sales price per unit - variable cost per unit). (Break-even Analysis) the Hugo Boss Corporation. What is the firms' break even point? If sales should increase by 30% $20,219,706; 55.52% (Break-even point and selling price) Parks Castings Inc. What selling price per unit is necessary? Set up the following analy $6.875; Sales($1,375,000). Less:VC 60% of sales ($825,000)... Dakota Oil, Inc. high financial leverage A firms uses large amounts of debt financing in an industry characterized by a high degree large Financial leverage could mean financing some of a firm's assets with: preferred stock If a firm has no operating leverage and no financial leverage, then a 10% increase in sales..What effect on EPS? EPS will increase by 10% Which of the following statements about operating leverage is true? Operating leverage is the responsiveness of the firms' EBIT to fluctuations in sales How do operating and financial leverage interact to affect the volatity of a firm's earnings per share? "Combining operating. True If a firms' operating and financial leverage..If sales revenues will decline by 25%, what % change in earnings would you expe -100% Ribbon Industries reported sales of $3 million and net income of $400,000 for 2012. $7,350,000 A company calculates its discretionary financing needed and determines this amount of capital cannot be raised reduce the company's sales growth rate Ribbon Industries reported sales of $3 million and net incomes of $400,000 $7,350,000 The CFO of Twine Enterprises expects sales $7,500,000 Which of the following will most likely result in an increase in discretionary funding needed? The company's dividend payout ratio increases Using percentage of sales method, forecasted retained earnings balance is equal to prior year retained earnings plus projected net income less projected dividends. The first step involved in predicting financing needs is: project the firm's sales revenues and expenses over the planning period. The "percentage" used in the percent of sales calculation can come: from any of the above or combination of the above. Spontaneous sources of financing include: accounts payable and accrued expenses A discretionary form of financing would be: notes payable is MOST correct concerning the relationship between a company's cash budget and its income statement? Cash flow could be positive A firm's cash position would most likely be helped by: delaying payment of accounts payable. A firm's cash position would most like be HURT by: retiring outstanding debt. The primary purchase of a cash budget is to: provide a detailed plan of future cash flows. Which of the following is always a non-cash expense? depreciation Would NOT be found in a cash budget? depreciation What is the primary tool for short-term financial forecasting? Pro forma cash budget In what way does a cash budget provide management with better information about financing requirments than a pro... A pro forma cash budget not only delinates A company that increases its liquidity by holding more cash and marketable securities is likely to achieve a lower ...concerning liquidity and debt is true? A firm can reduce its risk ...is a disadvantage of the use of current liabilities to finance assets? greater risk of illiquidity ...actions would improve a firm's liquidity? selling bonds and increasing cash ....actions would DECREASE a firm's liquidity? reducing accounts receivable and buying bonds ...Advantage of utilizing short-term debt to finance the acquisition of shortterm assets? Interest rates on short-term debt Net working capital refers to which of the following? current assets minus current lliabilities ...is an advantage associated with use of current versus long term liabilities? None of the above. ...accounts would NOT be a prime consideration in working capital management? Bonds payable. plant and equipment should be financed with long-term funds A toy manufacturer following hedging principle trade credit ...accounts should be financed with permanent sources of financing? levels of inventory and accounts recievable With regard to hedging principle, expansion of accounts receivable to meet seasonal demand Trade credit is an example of spontaneous Spontaneous financing consists of accounts payable and trade credit ...illustrates the use of the hedging approach? permanent assets ... and temporary assets financed w/ short-term liabilities The cash conversion cycle is a measure of a firm's effectiveness in managing its working capital. True Simms has made dramatic improvement to its working capital management by making a reduction conversion cycle. True Total Revenue is: The price of a product times the quantity sold in a given time. P x Q   Price elasticity of demand The amount by which price will change if quantity demanded changed is measured by   Utility is The pleasure or satisfaction obtained from goods and services   Total utility is maximized when marginal utility is maximized   The largest portion of the average U.S. consumer dollar is spent on Housing   The maximum output that can be produced from a set of inputs is measured by The production function   What is most likely a fixed cost? Property insurance   Marginal physical product is The additional output from using one more unit of labor   The law of diminishing returns implies that at some output level Marginal costs must rise   Marginal cost is The change in total cost from producing one additional unit of output, the change in total variable cost from producing one additional unit of output, and eventually rises with greater output because of declining marginal physical product   Factors of production Land, labor, capital, and entrepreneurship   In the long run, the firm can change the scale of operations   Explicity costs Are the sum of actual monetary payments made for resources used to produce a good   The long run refers to a period of time long enough for all inputs to be varied   When a firm makes a investment decision, it views all inputs as Variable over the long run   Which of the following is U-shaped? Average total cost curve   The reason the ATC curve has an upturn is because of rising marginal costs   Which of the following is a short-run choice? the product decision   Ceteris paribus, the law of diminishing returns states that the Marginal physical product of a variable input declines as more of it is used   The law of diminishing returns indicates that the marginal physical product of a factor declines as more of the factor is used, holding other inputs constant   The limits to the production of any good are reflected in the production function   Total revenue minus total cost equals profit   A production function is significant because it reveals the Maximum output that can be obtained from alternative combinations of inputs   The sum of fixed cost and variable cost at any rate of output is equal to Total cost   The distinction between short-run and long-run supply decisions is based on Whether or not there are any fixed inputs   A product function describes the maximum amount of output attainable from a given combination of factor inputs   An improvement in technology shifts the short-run production function upward   In the short run an increase in fixed cost causes no change to a firm;s profit-maximizing output since it has no effect on marginal cost and reduces short-run profit but has no effect on short-run output   Compared to account costs, economics costs are: more inclusive   As output increases, fixed costs do not change and variable costs increase   As output increases, variable costs increase   In the long run there are no fixed costs   As more inputs are added, at first the short0run production function increases rapidly   If the price is greater than marginal cost but not average total cost, then Eventually the firm will go out of business   Economic cost is the value of all resources used to produce a good or service   Average total cost is total cost divided by the quantity produced   if a firm increases output, total costs will rise because of a change in variable costs   The demand for ________ goods increases when the price of a related product goes up substitute   The second largest portion of the average U.S consumer dollar is spent on: transportation   Elasticity refers to responsiveness   According to the law of diminishing marginal utility: as one consumes more of a good, marginal utility declines but total utility continues to increase so long as marginal utility is positive   To increase total revenue Prices should be decreased when the demand is elastic and increased when the demand is inelastic   Inelastic means People will buy the goods no matter what the price because they need it, it is a necessity. For example, gas.   Elastic means People will buy the goods depending on the price   If the demand for a good is elastic, when price increases, total revenue will decrease   Determinants of price elasticity are: the availability of substitutes, the price of the good relative to income, necessities versus luxuries   Characteristics of a good with an elastic demand: The coefficient of price elasticity of demand is greater than one, the good has many substitutes, the good is a luxury   Utility is maximized by consuming more of a good until the marginal utility is zero   A relatively elastic good tends to be a ____ or is a good with ___ substitutes luxury, many   Total utility refers to the amount of utility obtained from the entire consumption of a good   The law of diminishing marginal utility helps to explain the downward sloping demand curve   A price cut will increase the total revenue a firm receives, ceteris paribus, only if the demand for its product is elastic   The amount by which price will change if quantity demanded changes is measured by price elasticity of demand   The law of demand explains why people are willing to buy more of a good as price falls   A market shortage is Caused by a price ceiling   If the price of a good is currently below the equilibrium price, the price will increase over time because a surplus exists at the old price   A market surplus occurs when the quantity supplied exceeds the quantity demanded at a given price   The market supply of a particular good is the sum of the quantities of the good that all producers are willing and able to sell   The complete opportunity cost of a particular good is the most desired goods that are given up in order to obtain the particular good   In a market, the equilibrium price is determined v by the interaction of both demand and supply   Economic interactions with others are necessary because resources are limited   Ceteris paribus, the demand curve for a good will shift to the right in response to an increase in tastes or preferences for the good   If the price of a good is currently above the equilibrium price,the price will decrease over time because a shortage exists at the old price   A movement along the supply curve is the same as a change in the quantity supplied   Surpluses are the same thing as excess Supply caused by price floors   The following represent the four groups of participants in the market process consumers, business firms, governments, and foreigners   A decrease in supply increases equilibrium price and reduces equilibrium quantity   A rightward shift of the demand curve will ____ the equilibrium price and ___ the equilibrium quantity increase, increase   Business firms ___ goods and services and ____ factors of production supply, demand   When price is above equilibrium a surplus occurs   Producers ___ finished goods and service in the ___ market sell, product   If a market surplus existsq producers will compete for customers by reducing the prices   The goals of the principal participants in a market economy are to maximize satisfaction, profits, and public welfare given their limited resoucers   A price ceiling is the max price of a good and is represented by rent controls on apartments   If the demand decreases, then the demand curve shifts left   Which of the following would cause a decrease in the price of automobiles? A technological advance in automobile manufacturing.   Which of the following does affect marginal costs? An increase in payroll taxes. A decrease in Social Security taxes.   Which of the following does not affect marginal costs? An increase in property taxes.   The short run is the time period: In which some costs are fixed.   Which of the following represents the change in total cost that results from a 1- unit increase in production? Marginal cost.   Which of the following is generally a fixed cost? Lease payments for plant and equipment   Short-run profits are maximized, for a perfectly competitive firm, at the rate of output where: Marginal revenue is equal to marginal cost.   If price is greater than marginal cost, a perfectly competitive firm should increase output because: Additional units of output will add to the firm's profits (or reduce losses).   If price is less than marginal cost, a perfectly competitive firm should decrease output because: The firm is producing units that cost more to produce than the firm receives in revenue thus reducing profits (or increasing losses).   When a firm minimizes its losses in the short run: It continues to produce only if price exceeds average variable cost.   In making an investment decision, an entrepreneur: Treats all costs as variable.   Short-run supply determinants include: technology   Short-run supply determinants include Expectations. Price of factor inputs. Taxes and subsidies.   The supply curve is upward-sloping, i.e. it takes a higher price to induce greater production, because of: Increasing marginal costs.   The marginal cost curve: Will be affected by changes in the price of variable inputs. Slopes upward to the right as output increases. Is the short run supply curve for a competitive firm at prices above the AVC.   A shift of the supply curve would be caused by: A change in supply determinants   Normal profit is: The profit which covers the full opportunity cost of the resources used by the firm. The average rate of return. The accounting profit earned when economic profit is zero.   Economic costs and economic profits are: Usually greater and smaller, respectively, than their accounting counterparts.   Economic profit Is less than accounting profit by the amount of implicit cost   Accounting costs and economic costs differ because: Economic costs include the opportunity costs of all resources used while accounting costs include actual dollar outlays.   Explicit costs: Are the sum of actual monetary payments made for resources used to produce a good   Which of the following causes demand to be more elastic with respect to price? A higher ratio of price to income.   Diminishing returns are first observed when: Marginal physical product begins to decline.   Implicit costs Are the total value of resources used to produce a good but for which no direct payment is made.   In defining costs, economists recognize: Explicit and implicit costs while accountants recognize only explicit costs. Question 19 1 out of 1 points Which of the following is an advantage of the use of current liabilities to finance assets? Answer Selected Answer: d. more flexibility and lower interest costs Correct Answer: d. more flexibility and lower interest costs Question 20 1 out of 1 points According to the hedging principle, which of the following assets should be financed with permanent sources of financing? Answer Selected Answer: c. levels of inventory and accounts receivable the firm maintains throughout the year Correct Answer: c. levels of inventory and accounts receivable the firm maintains throughout the year Question 21 1 out of 1 points According to the hedging principle, plant and equipment should be financed with Answer Selected Answer: b. long-term funds. Correct Answer: b. long-term funds. Question 22 3 out of 3 points Sweet Tooth Bakery bakes and sells pies. Sweet Tooth has annual fixed costs of $350,000 and a variable cost per pie of $5.50. Each pie sells for $12.50 each. The firm expects to sell 400,000 pies annually. What is the break-even point in pies? Answer Selected Answer: c. 50,00 0 Correct Answer: c. 50,00 0 Question 23 1 out of 1 points As production levels increase, Answer Selected Answer: d. fixed costs per unit decrease and variable costs per unit stay the same. Correct Answer: d. fixed costs per unit decrease and variable costs per unit stay the same. Question 24 1 out of 1 points The break-even model enables the manager of the firm to: Answer Selected Answer: c. determine the quantity of output that must be sold to cover all operating costs. Correct Answer: c. determine the quantity of output that must be sold to cover all operating costs. Question 25 1 out of 1 points Which of the following transactions will lower a company's financial leverage? Answer Selected Answer: c. Common stock is sold and the proceeds are used to pay off existing short-term debt. Correct Answer: c. Common stock is sold and the proceeds are used to pay off existing short-term debt. Question 26 1 out of 1 points Variable costs include all of the following except; Answer Selected Answer: d. annual rent. Correct Answer: d. annual rent. Question 27 1 out of 1 points Assuming no corporate taxes, the independence hypothesis suggests that a firm's weighted average cost of capital will Answer Selected Answer: b. remain constant because the cost of equity will be increasing as the amount of debt increases due to the increased risk. Correct Answer: b. remain constant because the cost of equity will be increasing as the amount of debt increases due to the increased risk. Question 28 1 out of 1 points Translation exposure to exchange rate risk is primarily associated with the: Answer Selected Answer: c. accounting for a firm's overseas Horizontal analysis involves comparing two or more years' financial data for a single company. T   The gross margin percentage is computed by dividing the gross margin by sales. T   If a company's return on assets is substantially higher than its cost of borrowing, then the common stockholders would normally want the company to have a relatively high debt/equity ratio. T   Dividing the market price of a share of stock by the dividends per share gives the price-earnings ratio. F   The dividend yield ratio is calculated by dividing dividends per share by earnings per share. F   Financial leverage is positive if the interest rate on debt is lower than the return on total assets. F   Issuing common stock will increase a company's financial leverage. F   If the assets in which borrowed funds are invested are able to earn a rate of return greater than the interest rate required by the lender, then financial leverage is positive. T   One would expect the book value of a share of stock to be about the same as the stock's market value. F   The acid-test ratio is always smaller than the current ratio. T   All debt is considered in the computation of the acid-test ratio. F   When computing the acid-test ratio, a short-term note receivable would be included in the numerator. T   The purchase of marketable securities for cash will lower a firm's acid-test ratio. F   As the inventory turnover increases, the number of days required to sell the inventory one time also increases. F   Negative working capital indicates that the sum of all current assets is negative. F   The formula for the gross margin percentage is: (Sales - Cost of goods sold)/Sales   The gross margin percentage is most likely to be used to assess: the overall profitability of the company's products.   The market price of XYZ Company's common stock dropped from $25 to $21 per share. The dividend paid per share remained unchanged. The company's dividend payout ratio would: be unchanged.   A drop in the market price of a firm's common stock will immediately affect its: dividend yield ratio.   Financial leverage is negative when: the return on total assets is less than the rate of return demanded by creditors.   Which of the following is not a potential source of financial leverage? Common Stock   Issuing new shares of stock in a five-for-one split of common stock would: decrease the book value per share of common stock.   A company's current ratio and acid-test ratios are both greater than 1. Issuing bonds to finance purchase of an office building with the first installment of the bonds due in the current year would: decrease net working capital. decrease the current ratio. decrease the acid-test ratio. ANS: affect all of the above as indicated.   What is the effect of a purchase of inventory on account on the current ratio and on working capital, respectively? (Assume a current ratio greater than one prior to this transaction.) A) Current Ratio decrease No Effect on Working Capital   At the beginning of the year, a company's current ratio is 2.2. At the end of the year, the company has a current ratio of 2.5. Which of the following could help explain the change in the current ratio? An increase in inventories.   A company's current ratio and acid-test ratios are both greater than 1. The collection of a current accounts receivable of $29,000 would: not affect the current ratio or the acid-test ratio.   Assume a company has a current ratio that is greater than 1. Which of the following transactions will reduce the company's current ratio? Borrowing by taking out a short-term loan.   Higgins Company presently has a current ratio of 0.6. It is currently negotiating a loan, but it has been informed it must improve its current ratio before the loan will be approved. Which of the following actions would improve its current ratio? Purchase additional inventory on credit.   The ratio of cash, trade receivables, and marketable securities to current liabilities is: the acid-test ratio.   Wolbers Company has an acid-test ratio of 1.4. Which of the following events will cause this ratio to decrease? Borrowing using a short-term note.   Park Company purchased $100,000 in inventory from its suppliers, on account. The company's acid-test ratio would: decrease   Assuming stable business conditions, an increase in the accounts receivable turnover ratio could be explained by: stricter policies with respect to the granting of credit to customers.   Last year the return on total assets in Jeffrey Company was 8.5%. The total assets were 2.9 million at the beginning of the year and 3.1 million at the end of the year. The tax rate was 30%, interest expense totaled $110 thousand, and sales were $5.2 million. Net income for the year was: $178,000   Jersey Corporation has total interest expense of $10,000, sales of $1 million, a tax rate of 40%, and net income (after taxes) of $60,000. What is this firm's times interest earned ratio? 11   Krast Company has total assets of $160,000 and total liabilities of $70,000. The company's debt-to-equity ratio is closest to: 0.78 Questions 1 The minimum wage is an example of a a price floor. b a price ceiling. c a tax on a market. d a tax on a market. 2 The existence of a shortage in a market will cause: a market price to rise and quantity supplied to increase. b market price to rise and quantity supplied to decrease. c market price to fall and quantity supplied to decrease. d market price to fall and quantity supplied to increase. Figure 3.1 3 In figure 3.1, if supply decreases, then equilibrium: a price falls and quantity rises. b price and quantity rise. c price rises and quantity falls. d price and quantity fall. 4 If the demand for cars increases when the price of good gasoline decreases, then: a the two goods are complementary. b gasoline is a normal good. c cars are an inferior good. d the two goods are substitutes. 5 If the demand for a good increases when there is high unemployment, we can conclude that the commodity is: a a good for which the law of demand does not apply. b a normal good. c an inferior good. d a luxury good. 6 As more firms produce a product: a market supply increases. b market demand increases. c market price increases. d production costs must increase. 7 If you would have been willing to pay $10 for a pizza and you only had to pay $8, what does the difference between $10 and $8 represent? a Total benefit. b Marginal benefit. c Average benefit. d Consumer surplus. 8 If at a price of $50, 20 units are sold while at a price of $40, 25 units are sold, then the elasticity of demand for this good is: a elastic. b perfectly inelastic. c inelastic. d unit elastic. 9 A horizontal demand curve is: a relatively elastic. b perfectly inelastic. c perfectly elastic. d unit elastic. 10 If the price of gasoline increases 30 percent and this causes the quantity demanded to fall 15 percent, the elasticity of demand is equal to:: a minus 2. b minus 450. c minus 0.5. d minus 15. 11 If the cross-price elasticity of demand for goods A and B is a negative value, this means the two goods are: a inferior. b substitutes. c normal. d complements. 12 A primary difference between a sole proprietorship and a partnership is: a sole proprietorships have unlimited liability while partnerships have limited liability. b sole proprietorships have more layers of management than partnerships. c partnerships have more owners than do sole proprietorships. d partnerships can issue stocks and bonds while sole proprietorships cannot. 13 Economic profit is: a gross revenue minus explicit and implicit costs. b gross revenue minus implicit costs. c gross revenue minus explicit costs. d equal to accounting profit. 14 Economists assume the goal of consumers is to: a do as little work as possible to survive. b consume as much as possible. c make themselves as well off as possible. d make themselves as well off as possible. 15 If you ate too many pieces of pie and got sick, then at least the last piece of pie: a had constant total utility. b had negative marginal utility. c had constant marginal utility. d had positive marginal utility. 16 If an inferior good you are consuming has its price increase, you will buy less of it because: a the negative income and substitution effects work together. b the negative income effect is smaller than the positive substitution effect. c the positive income effect is larger than and the negative substitution effect. d the positive income and substitution effects work together. 17 Total utility: a always increases as a person consumes more and more of a good. b is equal to the sum of the marginal utilities of all units consumed. c is negative when marginal utility is declining. d has a constant rate of increase as a person consumes more and more of a good. 18 If 11 workers can produce a total of 54 units of a product and another worker has a marginal product of six, then the average product of 12 workers is: a 5. b 54. c 60. d 48. 19 In the short run if marginal product is below average product then: a total cost is at its minimum. b average variable cost is increasing. c average total cost is at its minimum. d marginal cost is falling. 20 Which of the following is a fixed cost? a Payments to an electric utility. b Payment to hire a security worker to guard the gate to the factory around the clock. c Wages to hire assembly line workers. d Costs of raw materials. 21 A factor of production that generally is fixed in the short run is: a labor. b water. c raw materials. d a building. 22 A factor of production that is not fixed in the short run is: a physical capital. b labor. c technology. d land. Figure 10.2 23 In figure 10.2, the difference between average total costs and average variable costs is: a sunk costs. b fixed costs. c marginal costs. d average fixed costs. Figure 11.1 24 At price P4 in the long run, the industry including the firm in figure 11.1 would: a remain the same size. b cease to exist. c have exit of some existing firms. d have entry of new firms. 25 At price P3, the firm in figure 11.1 would produce: a Q5. b Q7. c Q4. d Q6. 26 If a perfectly competitive firm's price is equal to average total cost, the firm is: a incurring a loss. b breaking even. c earning a profit. d not producing in a profit maximizing manner. 27 If a perfectly competitive seller is producing at an output where price is $11 and the marginal cost is $14.54, then to maximize profits the firm should: a produce a larger level of output. b not enough information given to answer the question. c continue producing at the current output. d produce a smaller level of output. 28 Among the characteristics of a perfectly competitive market structure is: a a very large number of firms that are small compared to the market. b there are no restrictions to entry by new firms. c all firms sell identical products. d all of the above 29 The demand for an individual seller's product in perfect competition is: a vertical. b downward sloping. c horizontal. d the same as market demand. 30 Among the characteristics of an oligopoly market structure is: a a unique product. b it is easy for new firms to enter the industry. c very few sellers. d all of the above. 1 A 2 A 3 C 4 A 5 C 6 A 7 D 8 D 9 C 10 C 11 D 12 C 13 A 14 C 15 B 16 B 17 B 18 A 19 B 20 B 21 D 22 B 23 D 24 D 25 D 26 B 27 D 28 D 29 C 30 C From Our Students Question 1 1 points Save Dividends per share divided by earnings per share equal the dividend payout ratio. True Question 2 1 points Save Investor A owns 10% of the common stock of IDE Corporation. After IDE completes a 2-for-1 stock split, Investor A will own 20% of the common stock of the corporation. True Question 3 1 points Save From the shareholders' perspective, a stock repurchase has a potential tax advantage over the payment of a cash dividend. True Question 4 1 points Save A fast-growing company with many high net present value projects may maximize shareholder wealth by NOT paying a dividend. True Question 5 1 points Save There is no difference on an economic basis between a stock dividend and a stock split. True Question 6 1 points Save Shareholders may prefer a share repurchase program to dividends because dividends are subject to taxation and increasing value per share due to repurchase programs is tax deferred. True Question 7 1 points Save A stock repurchase plan that involves issuing long-term debt to fund the purchase of the company's stock may be used as a way to alter a corporation’s capital structure. True Question 8 1 points Save We typically expect to find rapidly growing firms to have high payout ratios. False Question 9 1 points Save As long as a firm has a positive level of retained earnings, it can pay a dividend. True Question 10 1 points Save Other things equal, individuals in high-income tax brackets should have a preference for firms that retain their earnings rather than pay dividends. True Question 11 1 points Save The existence of taxes can directly affect a common shareholder's preference for capital gains or dividend income. True Question 12 1 points Save When Firm X makes the decision to pay dividends, they also make the decision not to reinvest the cash in the firm. True False Question 13 1 points Save In a perfect market, investors are only concerned with total returns and are not concerned whether it is in capital gains or dividend income. False Question 14 1 points Save Conceptually, stock dividends and stock splits may be expected to increase the shareholder's value. True Direct cost Are ones that can be feasibly traced to a cost object.   Statement of cash flows - To provide relevant info about cash receipts & cash disputes menus of the company during the period./ - serves to complement the other financial statements./ - focus is on cash flows, not income./ - reconciles the balance sheet & the income statement ./ - explains the changes in cash & cash equivalents.   Characteristics of managerial accounting info 1- Info for managers inside the organization to use. 2- can be creative (no GAAP). 3- future oriented info. 4- highly defined info. 5- generation depends upon the benefit exceeding the cost of the info.   Marketing (selling) costs Are costs necessary to market distribute, & service a product or service. Ex. Ad, storage costs, & freight out.   Administrative Costs Are costs associated with research, development& general. Administration of the organization that cannot reasonably be associated to either marketing or production. Ex. Legal fees, salary of CEO.   Leases Contract granting use of occupation of property dusting a specified period of time in exchange for rent payments. Ex. Land, buildings, machinery, equipment.   Common stock Advantages: voting rights, rights to residual profits(after preferred). Disadvantages: lost I liquidation, no guaranteed return.   Economic consequences (reporting liabilities on the balance sheet) Shareholders & investors: - interest expense is tax deductible, but more debt means more risk to shareholders. - equity ownership is subordinated to creditors. Creditors: restrictive covenants regarding debt limits. Management: ways to minimize debt on b/s often looks far"off balance sheet" financing less debt now improves ability to borrow influence.   Contingent liability Contributed Brent in some future event or activity in order to know exact ...? Ex.. Warranties, coupons,& lawsuits. Changes in estimate may be made in subsequent periods when future event is concluded.   Other comprehensive income Includes certain direct equity adjustments that are not part of the current income statement but which may have an eventual effect on income. Ex. available-for-sale investments => we found that unrealized gains/losses from revaluation to market are shown in SE (as ---) rather than an income statement.   Non- value-added-activities - activities that if eliminated, would not reduce the utility revived by the customer for the product or service vice. Ex. Materials handling, inspection waiting, storing & rework.   A cured liabilities Accuse expense & liability at the end of the current period & usually pay sometime during the next year. For each item debit expense & credit liability. - wages payable. - Property. - salary payable. - interest payable. - tax payable. - rent payable. - insurance payable. - employe bonuses.   Warranties - contingent liability. - a promise by a manufacturer or seller to ensure the quality or performance of quality or performance of the product for a specific period of time.   Warranties recorded - Uncertain future cost. - record estimated expense & liability when products are sold (matching concept) ( warranty expense xx dr. Estimated warranty liability xx cr.) - as costs are incurred (usually in subsequent periods) charge expenditure twice to warranties liability) (Estimated warr. Liability xx dr. Cash, etc. xx cr.) -   Deferred taxes Generated by the discrepancy between income & expense for taxation (specified by IRS) & financial reporting (specified by GAAP). Ex. Equip purchased purchased on 1/1/12 for 9000. - 3yr useful life- no salvage value. - DDB for income tax purposes. - SL for financial reporting purposes. - income tax rate of 30%   (Retirement cost) defined benefit plans - benefits must be predicted therefore several assumptions "astigmatism are required . - social securities is from if this entry to record estimated liability is simple, but calculation can be complex. Pension expense dr. Pension liability cr.   (Retirement cost) defined contribution plans - less expensive than defined benefits plans. - entry to record period contribution is: Pension expense dr. Cash cr.   Liability Probable future sacrifice of economic benefits arising form present obligations of particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events   Full absorption costing - cost inclusion method. - includes all production costs in COGS (fixed variables). This is GAAP because of matching and historical cost   Contribution margin Sales minus all variable costs   Nonmanufacturing (period) cists Include all costs outside the factory such as selling (marketing), general, and administrative.   Deficiency of accounting rate of return Ignores the time value of money   Full absorption costing Costs are organized by function ( manufacturing or non- manufacturing). Profit us a function of both sales &production   Contribution margin per unit Selling per unit minus variable cost per unit   Discount rate - also know adviser of capital or hurdle rate. - minimum rate of return required by the owner to justify purchase of some asset. * riskier project require higher discount rates.   Variable (direct) costing - cost inclusion methods. - includes direct materials, direct labor, & variable overhead in COGS. Fixed manufacturing costs are expenses in the period incurred.   Net present value Is the difference b/t present value of the cash inflows + outflows associated with a project. Involves: 1- estimating future cash inflows & outflows. 2- selecting an appropriate discount rate & discounting the flows back to today. 3- accepting (positive N.P.V) or rejecting (negative NP.) the project   Indirect method adjustments 3 categories: 1- items that affect NI but not cash (no cash items like depreciation & amortization). 2- double counted gains & losses. 3- changes in current assets & liabilities from: A) revenues recognized because of cash is received. B) expenses recognized after cash is paid. C) revenues recognized after cash is revived. D) expenses recognized b/f cash is paid   Indirect method This technique starts w/ net income & makes adjustments to net income to convert it to a cash basis. ( most companies present only this method)   Dividends & Interest expense Cash paid for dividends is classified as a financing activity. Cash received for dividends an cash received for interest are both classified operating activities   3 general tax effects For tax: Gains => bad Losses => good 1- all periodic cash flows (sakes- you get to keep 1-tax rate ; expenses- you only have to pay 1- tax rate) 2- depreciation tax shield (tax rate times the amount of depreciation) 3- gains & losses on sales of assets ( gains have negative tax effects & losses have positive)   Non-unit related overhead cost - The use of either plant wide or departmental rates assumes the numbers of units produced causes overhead costs to increase. - there are some OH costs that are not driven by # of units produced. Ex. Setup costs or engineering cost. Product diversify can also cause product cost distortion (cross- subsidization)   Direct method This technique shows cash received from customers & cash paid to various entities for operating activities ( more informative method)   3 sections of cash flow statements 1- cash flow from operating activities. 2- cash flow from financing activities. 3- cash flow from investing activities.   Cash flow from operating activities Is based on income statement & converts income activity to a cash basis (should ideally be positive) 2 formats for presentation of CD from OP activity: 1- direct method. 2- Indirect method.   Internal rate of return (IRR) Is the interest rate that sets the NPV at ZERO. If positive IRR: it's higher than discount rate you use. If IRR > discount rate, the project should be accepted   Sunk cost Are one that have resulted from previous expenditures. No current or future decision can can change them.   Expenses Are expired assets based on historical cost (a technical financial accounting term)   Indirect cost Cannot be feasibly traced to cost object   Variable costs Vary in total with the level of activity (stay constant per unit)   Operating leverage The stent to which there are fixed cost I the cost structure. (it is a measure of risk)   Relevant range Activity level over which cost relationship are valid (Ex. The activity level over which fixed cost do not change)   Fixed cost Stay constant in total as activity level change ( vary per unit)   Direct Materials - manufacturing (production costs). - are those materials that are directly traceable to the goods owe services being produced. Ex. Cost of wood in furniture   Differential cost (Incremental, marginal) are ones that change in response to some action   Direct labor Is the labor that is directly traceable to the goods or services being produced. Ex. Wages of assembly line workers. (- manufacturing cost)   Overhead (Indirect cost) - are all other manufacturing cost (other than direct materials & direct labor)   Costs The sacrifice of resources   Cost object Something for which we want a separate measure bet if cost ( ex. Plant, friary net, product line, individual product and service)   Opportunity costs Are foregone returns   Variable costing Costs are organized by behavior (variable or fixed) - profit is a function of sales only.'   Deficiencies of the payback period - ignored the time value of money - ignores the performance of the investment beyond the payback period   Capital Budgeting techniques - payback period. - accounting rate of return. - net present value (NPV). - internal rate of rating (IRR)   Cost-volume-profit model assumption 1- the analysis assumes a linear revenue function &is linear cost function. 2- the analysis assumes that price,total fixed costs & unit variable costs can be accurately identified & remain constant over the relevant range. 3- assumes what is produced is sold. 4- for multiple product analysis m, sales mix is assumed to be known. 5- selling price & costs are assumed to be known with certainty   Margin of safety The excess of sales units over the break even unit sales   Difference between NPV and IRR - NPV assumes cash inflows are reinvested at the required rTe of return. Whereas the URR method assumes that the inflows are reinvested at the internal rate of return (IRR). - NPV measures the profitability of a project in absolute dottats, whereas the IRR method measures it as a percentage.   Types of measurements 3 #2 external financial measures Ex.stock price   Types of measurement 3 # 1 non- financial measures Include market share, delivery time, manufacturing lead time, quality measures, etc.   Types of measurements 3 # 3 financial measures Ex. Return on Investment (ROI) Residual Income (RI) And Economic Value Added (EVA) => Basically Residual Income   Types of measurements 3 #1 non- financial measures #2 external financial measures #3 financial measures   Problems with allocated costs 1- allocated costs are not within the managers control. 2- may lead managers to drop a product line with a positive contribution margin   Use of performance measure 1- provide info about the past (how well did we perform?) 2- affect future behavior by informing & motivating managers   Balanced scorecard perspectives 1- customer perspective- how do customers see us? 2- internal process perspective- what must excel at? 3- learning & growth perspective- can we continue to improve and create value? 4- financial perspective- how do we look to shareholders?   Balanced scorecard Criteria for divisional performance measurement 1- should provide a common basis for evaluating divisions with different characteristics. 2- should be timely. 3- should be seen as fair. 4- they should be congruent with the goals of the company.   Net book value = Maturity value minus unamortized discount Book value= fv - discount   Proceeds at issuance Dollar amount collected when the bonds are issued, equal to the price the buyers paid for each bond multiplied by the number of bonds issued. This amount is usually net of issuance fees.   Effective interest rate The actual interest rate paid on the bond. This rate when used to discount the future interest and principal cash payments, results in a present value tat is equal to the amounts received by issuance.   Unamortized discount = Discount of prior period minus amortized discount   Amortized discount = different between interest payment and interest expense.   Interest expense = effective interest rate X net book value @ the beginning of period)   Time value of money Determined by: - Interest ( discount) rate. - number of periods of discounting.   Face value Dollar amount written on the bond certificate. Sometimes referred to as the principal, par value or maturity value, the face value is usually 1,000   Life (bond) Time period from date of issuance to the maturity date, usually from 5 to 30 yet as.   Long-term liabilities Are recorded at the resent value (PV) of the future cash flow.   Maturity value Date when the dollar amount written on the face of the bond (face value) and final interest payment are paid to the bond-holder.   Interest payment The interest rate stated on the bond, multiplied by the face value. This rate is called the stated rate or coping rate, and is usually fixed for the entire life of the bond. Stated (semiannual)interest rate x maturity value   Non- interest bearing obligations Requires no periodic payments, but only a single cash payment are the end of the contract period.   Interest bearing obligation Contracts require periodic (annual or semiannual) cash payments ) called interest) that are determined as a go if the face, principal or maturity value, which must be paid at the end of the contract period.   Breakeven point The point of zero profit.   Debt - formal legal contract. - fixed maturity date. - fixed periodic payments. - security in case of default. - no voice in measurement. - interest expense deductible.   How to finance a corporation? - borrow: Note, bond, lease. (The debt holders are legally entitled to repayment of their principal & interest claims.) Issue equity: Common & proffered. ( the shareholders, as owners have voting rights, limited liability & a residual interest in the corporate asset. Internally generated cash   Equity - no legal contract. - no mixed maturity date. - discretionary dividends. - residual asset interest. - voting rights - common - dividends not deductible. - doubke taxation.   Retained earnings RE beginning (unadjusted) +/- prior period adjustments= RE, beginning (restated) + net income - (less) dividends: cash dividends - common- cash dividends - preferred stock dividends property dividends - (less) adj. for T.S transactions appropriation of RE (RE ending)   Treasury stock - created when a company buys back shares of its own common stock. - reasons for buyback? (Signal to market, need shares for stock options, improve EPS) the debit balance account called "treasury stock"" is reported in SE as a contra account to SE. - it is not an asset. The stock remain issued, but is no longer outstanding. - does not have virtually be rights & doesn't receive cash dividends. Maybe reissued or retired . - no gains or losses are ever recognized from these.   Stock split No journal entry necessary.   Preferred stock Advantages: preference in liquidation. - state dividend. - preference in dividend payout. Disadvantages: subordinate to debt in liquidation. - stated did ideas can be skipped. - no voting rights. Debt or equity: components of both. Usually classified as equity.   Capital leases Risks + benefits of ownership have effectively transferred to the lessee. - record the leased the leased asset as a capital asset & reflect the PV of the related payment & contract as a liability.   Operating lease Pure rental agreement where the lessor maintains all ownership responsibilities. - off balance sheet financing.   Current liabilities Classification: expected to require the use of current assets (or the creation of other current liabilities) to settle the obligation. Valuing current liabilities on the B.S. - ignore present value (report at face value).   Cash flow from investing activities Explain the Ganges => in cash from the purchase or sale of the company's (primarily) long-term asset. Ex. 1- cash paid for purchase of equipment, land, buildings, marketable securities, intangible assets & most other long term assets. 2- cash received from sale of all of the above. 3- cash paid for issue of non-trade note receive. 4- cash received for repayment on non-trade note receivable (both short & long term)   Identification of cash flows 1) inspection (asset cost, working capital, salvage value of old asset, tax effects of purchase or disposal). 2) periodic (receipts, firm sales, payment for the production or sena... Cost, income tax, tax shield depreciation) we assume these occur at end of period. 4) terminal/ salvage value of asset, net of tax effect; working capital return)   Cash Gina Ingrid sctivitues Explain the changes in cash from the issue or retirement at the company's (primarily) long-term liabilities + equity. Ex. 1) cash received from issue of bonds, mortgages & other long- term debt. 2) cash received from issue of common stock & preferred stock. 3) cash paid for the retirement of long-term debt. 4) cash paid for the repurchase of treasury stock. 5) cash paid for dividends. 6) cash received for issue of non- trade notes payable (both LT+ST). 7) cash paid for retirement or repayment on non-trade notes payable (both ST+ LT)   Indirect method Changes in current assets & liabilities See the note card   A/R end = A/R beg. + sales - cash collections   Cash collections = A/R beg + sales - A/R end   Current assets Increase => (-) from accrual # Decrease => (+) to add to accrual #   Current liabilities Increase => (+) to accrual # Decrease => (-) from accrual #   Bond 1- life. 2- maturity date. 3- face value. 4- interest expense. 5- proceeds @ issuance. 6- effective interest rate.   Liabilities 1- liability. 2- current liabilities. 3- recording liability. 4- long term liability (bond, note, lease).   Types of leases 1- capital lease. 2-Operating lease.   Pension Retirement   Benefit pension/ retirement Pension Expense Pension liability   Contributed pension/ retirement Pension expenses Cash   Liability A future economic sacrifice arising from present obligation.   Current liabilities Obligation expected to require the use of current assets or the creation of other current liabilities. Report at face value & ignore present value.   Reporting liabilities 1- shareholders and investors. 2- Equity ownership. 3- Creditors. 4- Management.   Reporting liabilities: 1- shareholders & investors: Interest expense is tax deductible., more debt.   Reporting liabilities: 2- Equity ownership: Is subordinated to creditors.   Reporting liabilities: 3- creditors: Restrictive covenants regarding debt limits.   Reporting liabilities: 4- management: 1- wants to minimize debt on the balance sheet. 2- often looks got off balance sheet financing. 3- less debt now means ability to borrow in the future.   Bonds: 1- life: Time period from date of issuance to the maturity date, usually from 5-30 years.   Bonds: 2- maturity date: Date when the dollar amount written on the face of the bond (face value) and the final interest payment are paid to the bond holder.   Bonds: 3- face value: Dollar amount written on the bond certificate. Sometimes referred to as the principal, par, or maturity value, the face value is usually 1000.   Bonds: 4- interest payment: The interest rate stated on the bond multiplied by the face value. This rate is called the stated rate, or coupon rate and it is usually fixed for the entire life of the bond.   Bonds: 5- proceeds at issuance: Dollar amount collected when the bonds are issued, equal to the price the buyers paid for each bond multiplied by the number of bonds issued. This amount is usually net issuance fees.   Bonds: 6- effective interest rate: The actual interest rate paid in the bond. This rate, when used to discount the future interest and principal cash payments, results in a present value that is equal to the amount received by the issuer.   Contingent liability Contingent on some future event or activity to know exact amount.   Warranty A promise by a manufacture or seller to ensure the quality or performance of a product for a specific period of time.   Defined (contribution) plan Less expensive than defined (benefit) plan. JE of (contribution): Dr. Pension expense Cr. Cash   Defined (benefit) plan Benefit must be predicted. Example: social security. JE of (benefit): Dr. Pension expense Cr. Pension liability   Deferred taxes Generated by the discrepancy between income and expense for taxation (IRS) and financial reporting (GAAP).   Conservatism ratio Can be calculated to assess how aggressive or conservative management has been in their choices about accelerating tax-deductible expense such as (depreciation expense).   Contractual forms May contain additional terms such as: security or collateral, and if cash payment requireddefault, as well as other restrictive covenants.   Long term liabilities: Are recorded at present value of future cash flows. (bond, note, lease).   Long term liabilities: Two components: 1- interest (discount rate). 2- number period of discounting.   Long liabilities 1- note. 2- bonds payable & bond investments. 3- capital lease.   Lease 1- operating leases. 2- capital leases.   Operating leases Pure rental agreements where the lessor maintains all ownership responsibilities. Off balance sheet financing.   Capital leases Risks and benefits of ownership have effectively transferred to the lessee. Requirements of SDASNo. 13 as capital lease for the lesser if: Title transfers Bargain purchase option 75% of useful life 90% of FMV   Contingent liability Obligation that will go into effect if a particular condition is met.   Types of activities that require PV calulations 1- note payable. 2- bond payable & bond investment. 3- capital leases.   Lease A contract granting use of occupation of property during a specified period of time in exchange for rent payment.   Types of leases 1- land. 2- building. 3- machinery. 5- equipment.   Capital leases JE: 1- recognized capital lease: Dr. Machinery Cr. Lease liability made first lease payment: Dr. Interest expense Dr. Lease liability Cr. Cash 2- recognized depreciation Dr. Depreciation expense Cr. Accum. Dep.   Debt characteristics: Debt: 1- formal legal contract. 2- fixed maturity date. 3- fixed periodicpayments. 4- security on case of default. 5- no voice in management. 6- interest expensedeductible.   Equity characteristics: Equity: 1- no legal cobtract. 2- no fixed maturity date. 3- discretiobary dividends. 4- residual asset interest. 5- voting rights- common 6- dividends not defuctible. 7- double taxation.   Stock issuance and stock repurchase Treasury stock   Account for treasury stock 1- issue treasury stock: Dr. Cash Cr. Treasury stock 2- repurchase treasury stock: Dr. Treasury stock Cr. Cash   Account for issuing treasury stocjy Dr. Cash Cr. Treasury stock   Account for repurchasing treasury stock Dr. Treasury stock Cr. Cash   Preferred stock (debt vs. equity) (+) 1- preference over common in liquidation. 2- stated dividend. 3- preference over common in dividend payout. (-) 1- subordinate to debt in liquidation. 2- stated dividend can be skipped. 3- no voting rights ( versus Common) Debt/ equity: 1- Components of both. 2- usually classified as equity.   Common stock (debt vs. equity) (+) 1- voting rights. 2- rights to residual profits (after preferred). (-) 1- last in liquidation. 2- no guaranteed return.   Stock dividends - par value per share. - stock dividend require (JE) > the amount for CS & RE change.   Stock dividend vs. stock split. Stock dividends: dividend - par value per share. - stock dividend require (JE) > the amount for CS & RE change. Stock split: - par value per share. - stock split does not require a JE > the amount for CS & RE do not change.   Stock split - par value per share. - stock split does not require a JE > the amount for CS & RE do not change.   Events affect Retained Earnings ( net income, loss, dividend)   Steps of the events that affect RE 1- RE beg (unadjusted). 2- Add/ subtract prior period adjustment. 3- RE beg (restated). 4- add net income, 5- less dividends (4 types): Types of (less dividend): 1- cash dividends. 2- cash dividends. 3- stock dividends. 4- property dividends. 6- less adjustment for TS transactions Appropriation of RE We get > RE ending   4 types of (less dividend): 1- cash dividends. 2- cash dividends. 3- stock dividends. 4- property dividends.   Calculate earning per share Earnings per share= net income / outstanding shares. Unit 3 Exam 1. The DEF Company is planning a $64 million expansion. The expansion is to be financed by selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax required rate of return on debt is 9% and the required rate of return on equity is 14%. If the company is in the 35% tax bracket, what is the firm’s cost of capital? a. 8.92% b. 10.74% c. 11.50% d. 9.89% 2. Which of the above projects should the company take on? a. Project 3 only b. Projects 1, 2 and 3 c. Projects 1 and 3 d. Projects 1 and 2 3. PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred stock, and $11 million of common equity, based upon current market values. The firm’s yield to maturity on its bonds is 7.4%, and investors require an 8% return on the firm’s preferred stock and a 14% return on PrimaCare’s common stock. If the tax rate is 35%, what is PrimaCare’s WACC? a. 7.21% b. 10.18% c. 12.25% d. 8.12% 4. JPR Company is financed 75% by equity and 25% by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold? a. $15.5 million b. $7.5 million c. $16.0 million d. $12.0 million 5. All else equal, an increase in beta results in: a. An increase in the cost of retained earnings b. An increase in the cost of common equity, whether or not the funds come from retained earnings or newly issued common stock c. An increase in the cost of newly issued common stock d. An increase in the after-tax cost of debt 6. Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and dividends are expected to grow at 6% annually. Flotation costs on new stock sales are 5% of the selling price. What is the cost of Haroldson’s retained earnings? a. 12.09% b. 11.78% c. 11.45% d. 5.73% 7. A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock is equal to $1.25 per share. The company’s marginal tax rate is 35%. Therefore, the cost of preferred stock is: a. 14.26% b. 12.94% c. 18.87% d. 17.72% 8. Which of the following should NOT be considered when calculating a firm’s WACC? a. After-tax YTM on a firm’s bonds b. Cost of newly issued preferred stock c. After-tax cost of accounts payable d. Cost of newly issued common stock 9. Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s profitability index? a. 1.26 b. 1.69 c. 1.21 d. 1.43 10. Your firm is considering investing in one of two mutually exclusive projects. Project A requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of $1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it is not subject to capital rationing. Assuming both projects can be replaced with a similar investment at the end of their respective lives, compute the NPV of the two chain cycle for Project A and three chain cycle for Project B. a. $2,865 and $94 b. $3,528 and $136 c. $5,000 and $1,500 d. $2,232 and $85 11. The capital budgeting manager for XYZ Corporation, a very profitable high technology company, completed her analysis of Project A assuming 5-year depreciation. Her accountant reviews the analysis and changes the depreciation method to 3-year depreciation. This change will: a. Increase the present value of the NCFs b. Have no effect on the NCFs because depreciation is a non-cash expense c. Only change the NCFs if the useful life of the depreciable asset is greater than 5 12. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects is 10%. The modified internal rate of return for Project B is: a. 18.52% b. 22.80% c. 19.75% d. 17.84% 13. A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project’s required rate of return is 13%. The internal rate of return is: a. Greater than $30,000 b. Greater than 15% c. Between 13% and 15% d. Less than 13% 14. A new project is expected to generate $800,000 in revenues, $250,000 in cash operating expenses, and depreciation expense of $150,000 in each year of its 10-year life. The corporation’s tax rate is 35%. The project will require an increase in net working capital of $85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the free cash flow from the project in year one? a. $410,000 b. $375,000 c. $380,000 d. $298,000 15. A local restaurant owner is considering expanding into another rural area. The expansion project will be financed through a line of credit with City Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy and existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include: a. $2,500 per month rent b. $500 administrative costs, $1,000 per month interest costs, $2,500 per month rent c. $1,000 per month interest payments, $2,500 per month rent d. $500 administrative costs, $2,500 per month rent 16. Which of the following should be included in the initial outlay? a. Increased investment in inventory and accounts receivable b. Preexisting firm overhead reallocated to the new project c. First year depreciation expense on any new equipment purchased d. Taxable gain on the sale of old equipment being replaced 17. QRW Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new machine costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. QRW’s marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project’s ten-year life. What is the incremental free cash flow during year 1 of the project? a. $11,400 b. $15,200 c. $12,800 d. $14,400 18. The cost of retained earnings is less than the cost of new common stock because: a. Dividends are not tax deductible b. Flotation costs are incurred when new stock is issued c. Accounting rules allow a deduction when using retained earnings d. Marginal tax brackets increase 19. Beauty Inc. plans to maintain its optimal capital structure of 40% debt, 10% preferred stock, and 50% common equity indefinitely. The required return on each component source of capital is as follow: debt—8%; preferred stock—12%; common equity—16%. Assuming a 40% marginal tax rate what after-tax rate of return must the firm earn on its investments if the value of the firm is to remain unchanged? a. 12.00% b. 11.12% c. 12.40% d. 10.64% 20. Your firm is considering an investment that will cost $920,000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s internal rate of return? a. 15.98% b. 27.28% c. 20.53% d. 21.26% 21. The advantages of NPV are all of the following EXCEPT: a. It provides the amount by which positive NPV projects will increase the value of the firm b. It allows the comparison of benefits and costs in a logical manner through the use of time value of money principles c. It recognized the timing of the benefits resulting from the project d. It can be used as a rough screening device to eliminate those projects whose returns do not materialize until later years 22. Which of the following are included in the terminal cash flow? a. Recapture of any working capital increase included in the initial outlay b. The expected salvage value of the asset c. Any tax payments or receipts associated with the salvage value of the asset d. All of the above 23. Which of the following differentiates the cost of retained earnings from the cost of newly issued common stock? a. The larger dividends paid to the new common stockholders b. The flotation costs incurred when issuing new securities c. The cost of the pre-emptive rights held by existing shareholders d. The greater marginal tax rate faced by the now-larger firm 24. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects is 10%. The profitability index for Project B is: a. 1.55 b. 1.39 c. 1.33 d. 1.48 25. When terminating a project for capital budgeting purposes, the working capital outlay required at the initiation of the project will: a. Increase the cash flow because it is recaptured b. Decrease the cash flow because it is an outlay c. Not affect the cash flow d. Decrease the cash flow because it is a historical cost 1 B 2 Missing information 3B 4C 5B 6A 7D 8C 9C 10D 11A 12B 13B 14A 15B 16A 17C 18B 19B 20C 21D 22D 23B 24A 25A Unit 4 Exam 1. A high degree risk of variability in a firm’s earnings before interest and taxes refers to: a. A business risk b. Financial leverage c. Operating leverage d. Financial risk 2. If a firm has no operating leverage and no financial leverage, then a 10% increase in sales will have what effect on EPS? a. EPS will increase by 10% b. EPS will remain the same c. EPS will increase by less than 10% d. EPS will decrease by 10% 3. According to the moderate view of capital costs and financial leverage, as the use of debt financing increases: a. The cost of capital continuously increases b. There is an optimal level of debt financing c. The cost of capital remains constant d. The cost of capital continuously decreases 4. The primary weakness of EBIT-EPS analysis is that: a. It double counts the cost of debt financing b. It applies only to firms with large amounts of debt in their capital structure c. It may only be used by firms that are profitable this year d. It ignores the implicit cost of debt financing 5. Potential applications of the break-even model include: a. Optimizing he cash-marketable securities position of a firm b. Replacement for time-adjusted capital budgeting techniques c. Pricing policy d. All of the above 6. The Modigliani and Miller hypothesis does NOT work in the “real world” because: a. Interest expense is tax deductible, providing an advantage to debt financing b. Higher levels of debt increase the likelihood of bankruptcy, and bankruptcy has real costs for any corporation c. Both A and B d. Dividend payments are fixed and tax deductible for the corporation 7. A corporation with very high growth prospects and many positive NPV projects to fund may want to increase its dividend based on the: a. Very low agency costs of the corporation b. Information effect c. Tax bias against capital gains d. Residual dividend theory 8. Which of the following strategies may be used to alter a firm’s capital structure toward a higher percentage of debt compared to equity? a. Stock split b. Stock repurchase c. Stock dividend d. Maintain a low dividend payout ratio 9. AFB, Inc.’s dividend policy is to maintain a constant payout ratio. This year AFB, Inc. paid out a total of $2 million in dividends. Next year, AFB, Inc.’s sales and earnings per share are expected to increase. Dividend payments are expected to: a. Increase above $2 million only if the company issues additional shares of common stock b. Decrease below $2 million c. Increase above $2 million d. Remain at $2 million 10. Which of the following is true? a. In industries with volatile earnings, the residual dividend policy results in the most consistent dividend stream b. If the clientele effect is correct, firms should follow a constant dividend payout ratio policy c. In general, the higher the number of positive NPV investment opportunities for a firm, the lower the dividend payout ratio d. According to the informational content of dividends, an increase in dividends is always a positive signal 11. Which of the following is always a non-cash expense? a. Salaries b. Depreciation c. Income taxes d. None of the above 12. Which of the following is a limitation of the “percent of sales method” of preparing pro forma financial statements? a. Inventory levels are seldom affected by changes in sales volume b. A firm’s investment in accounts receivable is seldom related to sales volume c. Not all assets and liabilities increase or decrease as a constant percent of sales d. The dividend payout ratio may change from one year to the next 13. Spontaneous sources of funds refer to all of the below EXCEPT: a. b. c. d. Accounts payable Accruals Common stock A bank loan 14. Selection of a source of short-term financing should include all of the following EXCEPT: a. The effect of the use of credit from a particular source on the cost and availability of other sources of credit b. The flotation costs for debentures c. The effective cost of credit d. The availability of financing in the amount and for the time needed 15. The terminal warehouse agreement differs from the field warehouse agreement in that: a. The cost of the terminal warehouse agreement is lower due to the lower degree of risk b. The warehouse procedure differs for both agreements c. The terminal agreement transport the collateral to a public warehouse d. The borrower of the field warehouse agreement can sell the collateral without the consent of the lender 16. Your company buys supplies on credit terms of 2/10 net 45. Suppose the company makes a purchase of $20,000 today. Which of the following payment options makes the most sense as a general rule? a. Pay the bill as soon as possible to keep the supplier happy b. Pay the bill on day 10 to get the discount c. Either pay the bill on day 10 to get the discount, or wait until day 45 d. Pay the bill on day 45 due to the time value of money 17. Which of the following statements about financial leverage is true? a. Financial leverage is the responsiveness of the firm’s EBIT to fluctuations in sales b. Financial leverage is the responsiveness of the firm’s EPS to fluctuations in EBIT c. Financial leverage involves the occurrence of fixed operating costs in the firm’s income stream d. Financial leverage reduces a firm’s risk 18. Which of the following statements about combined (operating & financial) leverage is true? a. Usage of both operating and financial leverage reduces a firm’s risk b. If a firm employs both operating and financial leverage, any percent change in sales will produce a larger percent change in earnings per share c. High operating leverage and high financial leverage offset one another, meaning that if sales increase by 10%, then EPS will also increase by 10% d. A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm that employs low levels of operating leverage 19. The “bird-in-the-hand-dividend theory” supports which view of the effect of dividend policy on company value? a. Constant dividends increase stock values b. High dividends increase stock values c. A firm’s dividend policy is irrelevant d. Low dividends increase stock values 20. All of the following will increase the discretionary financing needed EXCEPT: a. Decrease the dividend payout ratio b. Decrease the spontaneous financing c. Decrease the sales growth rate d. Decrease the net profit margin 21. If a firm relies on short-term debt or current liabilities in financing its asset investments, and all other things remain the same, what can be said about the firm’s liquidity? a. The liquidity of the firm will be unchanged b. The firm will be relatively more liquid c. The firm will be relatively less liquid d. The firm will be more liquid only if interest rates are below the company’s weighted average cost of capital 22. Dakota Oil, Inc. reported that its sales and EBIT increased by 10%, but its EPS increased by 30%. The much larger change in earnings per share could be the result of: a. High operating leverage b. High financial leverage c. High fixed costs of production d. A high percentage of credit sale collections from prior years 23. Which of the following statements would be consistent with the bird-in-the-hand dividend theory? a. Dividends are less certain than capital gains b. Investors are indifferent whether stock returns come from dividend income or capital gains income c. Wealthy investors prefer corporations to defer dividend payments because capital gains produce greater after-tax income d. Dividends are more certain than capital gains income 24. The term “lumpy asset” means: a. Assets that have economies of scale but not economies of scope b. Assets that must be purchased in discrete quantities c. The same thing as assets that exhibit scale economies d. Assets that can be purchased in incremental units 25. All of the following are potential advantages of commercial paper EXCEPT: a. Ability to borrow very large amounts b. Flexible repayment terms c. No compensating balance requirements d. Lower interest rates than comparable sources of short-term financing 1A 2A 3B 4D 5C 6C 7B 8B 9C 10D 11B 12C 13C 14B 15C 16C 17B 18B 19B 20C 21C 22B 23D 24B 25B Individuals or companies that prefer low-risk, low-return investments are: Your Answer: risk-averse 3. Business risk: Your Answer: is due to the variability in operating profits or cash flows 4. Financial risk is not: Your Answer: caused by exchange rate fluctuations Correct Answer: one part of unsystematic risk 5. Using the CAPM, ß is a measure of: Your Answer: profit volatility Correct Answer: share price volatility 6. Which of the following is not a measure of risk? Your Answer: standard deviation Correct correlation coefficient An important portfolio theory was developed in 1952 by: Your Answer: Markowitz 8. The starting point of a capital market line (CML) is the: Your Answer: risk-free return 9. The slope of a capital market line (CML) is: Your Answer: risk-free return/(market portfolio return – risk-free return) Correct Answer: (market portfolio return – risk-free return)/market portfolio risk 10 . An investor’s indifference curve is also called: Your Answer: probability curve Correct Answer: utility curve 1. Which of the following could explain why a business might choose to organize as a corporation rather than as a sole proprietorship or a partnership? a. Corporations generally face fewer regulations. b. Corporations generally face lower taxes. c. Corporations generally find it easier to raise capital. d. Corporations enjoy unlimited liability. e. Statements c and d are correct. 2. Which of the following statements is most correct? a. Due to limited liability, unlimited lives, and ease of ownership transfer, the vast majority of U.S. businesses (in terms of number of businesses) are organized as corporations. b. Most businesses (by number and total dollar sales) are organized as proprietorships or partnerships because it is easier to set up and operate in one of these forms rather than as a corporation. However, if the business gets very large, it becomes advantageous to convert to a corporation, primarily because corporations have important tax advantages over proprietorships and partnerships. c. Due to legal considerations related to ownership transfers and limited liability, most business (measured by dollar sales) is conducted by corporations. d. Statements a, b, and c are correct. e. All of the statements are false. 3. Harmeling Enterprises experienced a decline in net operating profit after taxes (NOPAT). Which of the following definitely cannot help explain this decline? a. Sales revenues decreased. b. Costs of goods sold increased. c. Depreciation increased. d. Interest expense increased. e. Taxes increased cash flow of the machine for year 1? (Points : 1) $54,800 $60,200 $66,350 $68,200 9. Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Zellars, Inc.'s required rate of return for these projects is 10%. The internal rate of return for Project B is (Points : 1) 29.74%. 30.79%. 35.27%. 36.77%. 10. J & B Corp. is investing in a major capital budgeting project that will require the expenditure of $16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred stock, and $10 million of new common stock. The company estimates is after-tax cost of debt to be 7%, its cost of preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost of new common stock to be 17%. What is the weighted average cost of capital for this project? (Points : 1) 12.20% 13.12% 13.75% 14.23% 1.Five Rivers Casino is undergoing a major expansion. Issuing new 15–year, $1,000 par, 9% annual coupon bonds, will finance the expansion. The market price of the bonds is $1,070 each. Gamblers floatation expense on the new bonds will be $50 per bond. Gamblers marginal tax rate is 35%. What is the pre-tax cost of the debt for the newly issued bonds? A 7.49% B 10.25% C 8.76% D 8.12% 2. Kelly Corporation will issue new common stock to finance an expansion. The existing common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be incurred on new shares. What is the cost of retained earnings for Kelly Corp.? A. 11.33% B. 11.79% C. 11.60% D. 12.53% E. 11.51% 3. Royal Mediterranean Cruise Line’s common stock is selling for $22 per share. The last dividend was $1.20, and dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of the selling price. What is the cost of Royal’s new common stock? A. 11.45% B. 12.09% C. 5.73% D. 11.78% 4. Clothier, Inc. has a target capital structure of 40% debt and 60% common equity, and has a 40% marginal tax rate. If Clothier’s yield to maturity on bonds is 7.5% and investors require a 15% return on Clothier’s common stock, what is the firm’s weighted average cost of capital? A. 10.80% B. 7.20% C. 12.25% D. 12.00% 5. Milton Parker has a capital structure that consists of $7 million of debt, $2 million of preferred stock, and $11 million of common equity, based upon current market values. Parker’s yield to maturity on its bonds is 7.4%, and investors require an 8% return on Parker’s and a 14% return on Parker’s common stock. If the tax rate is 35%, what is Parker’s WACC? A. 7.21% B. 12.25% C. 10.18% D 8.12% 6. Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75, 000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Zellars, Inc’s required rate of return for these projects is 10%. The modified internal rate of return for Project B is: A. 19.75% B. 17.84% C. 18.52% D. 22.80% 7. Given the following annual net cash flows, determine the internal rate of return to the nearest whole percent of a project with an initial outlay of $750,000 YEAR NET CASH FLOW 1 $500,000 2 $150,000 3 $250,000 A 11% B 13% C 15% D 9% 8. A machine that costs $1,500,000 has a 3 – year life. It will generate after tax annual cash flows of $700,000 at the end of each year. It will be salvaged for $200,000 at the end of year 3. If your required rate of return for the project is 13%, what is the NPV of this investment? A. $338,395 B. $400,000 C. $600,000 D. $291,417 9. Simplicity Printers is considering a project with the following cash flows: Initial Outlay = $126,000 Cash Flows: Year 1 = $44,000 Year 2 = $59,000 Year 3 = $64,000 If the appropriate discount rate is 11.5%, compute the NPV of this project. A $2,892 B $41,000 C -$14,947 D $7,089 10. You are in charge of one division of Bigfella Conglomerate Inc. Your division is subject to capital rationing. Your division has 4 indivisible projects available, detailed as follows: Project Initial Outlay IRR NPV 1 2 million 18% 2,500,000 2 1 million 15% 950,000 3 1 million 10% 600,000 4 3 million 9% 2,000,000 If you must select projects subject to a budget constraint of 5 million dollars, which set of projects should be accepted so as to maximize firm value? A Projects 1, 2 and 3 B Projects 2, 3 and 4 C Projects 1 and 4 D Projects 1 only 11. Snow Fun Corporation is considering a new product line. The company currently Manufactures several lines of snow skiing apparel. The new products, insulated ski bikinis, are expected to generate sales of $1.2 million per year for the next five years. They expect that during this five-year period, they will lose about $150,000 each year in sales on their existing lines of longer ski pants. The new line will require no additional equipment or space in the plant and can be produced in the same manner as the apparel products. The new project will, however, require that the company spend an additional $50,000 per year on insurance in case customers sue for frostbite. Also, a new marketing director would be hired to oversee the line at $75,000 per year in salary and benefits. Because of the different construction of the bikinis, an increase in inventory of $9,000 would be required initially. If the marginal tax rate is 35%, compute the incremental after tax cash flows for years 1-5. A) $634,500 per year B) $625,000 per year C) $601,250 per year D) $537,500 per year 12. Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company’s tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the incremental free cash flow for year one? A) $18,875 B) $19,985 C) $22,305 D) $24,220 13. Creighton Industries is considering the purchase of a new strapping machine, which will cost $150,000, plus an additional $10,500 to ship and install. The new machine will have a 5-year useful life and will be depreciated to zero using the straight-line method. The machine is expected to generate new sales of $45,000 per year and is expected to save $16,000 in labor and electrical expenses over the next 5- years. The machine is expected to have a salvage value of $20,000. Creighton's income tax rate is 35%. What is the machine's IRR? A) 15.75% B) 18.86% C) 19.15% D) 20.03% 14. PDF Corp. needs to replace an old lathe with a new, more efficient model. The old lathe was purchased for $50,000 nine years ago and has a current book value of $5,000. (The old machine is being depreciated on a straight-line basis over a ten-year useful life.) The new lathe costs $100,000. It will cost the company $10,000 to get the new lathe to the factory and get it installed. The old machine will be sold as scrap metal for $2,000. The new machine is also being depreciated on a straight-line basis over ten years. Sales are expected to increase by $8,000 per year while operating expenses are expected to decrease by $12,000 per year. PDF's marginal tax rate is 40%. Additional working capital of $3,000 is required to maintain the new machine and higher sales level. The new lathe is expected to be sold for $5,000 at the end of the project's ten-year life. What are the cash flows associated with the termination of the project at the end of year 10? (Hint: Do not include the operating cash flows from year 10.) A. $8,000 B. $6,000 C. $3,000 D. $5,000 15. Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company’s tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the initial outlay required to fund this replacement project? A) $81,200 B) $78,600 C) $74,500 D) $73,580 . Question : Clanton Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold? Student Answer: $7.5 million $12.0 million $15.5 million $16.0 million Points Received: 0 of 1 Comments: 2. Question : J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. J.B. is replacing an old machine that was purchased 6 years ago for $50,000. The old machine was being depreciated on a straight-line basis over a ten year expected useful life. The machine was sold for $15,000. J.B.'s marginal tax rate is 40%. What is the amount of the initial outlay? Student Answer: $89,000 $87,000 $91,000 $85,000 Points Received: 1 of 1 Comments: 3. Question : A project for Jevon and Aaron, Inc. results in additional accounts receivable of $400,000, additional inventory of $180,000, and additional accounts payable of $70,000. What is the additional investment in net working capital? Student Answer: $580,000 $510,000 $270,000 $150,000 Points Received: 1 of 1 Comments: 4. Question : J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. What will depreciation expense be during the first year? Student Answer: $13,000 $12,500 $11,625 $11,500 Points Received: 1 of 1 Comments: 5. Question : Five Rivers Casino is undergoing a major expansion. The expansion will be financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is $1,070 each. Gamblers flotation expense on the new bonds will be $50 per bond. Gamblers marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds? Student Answer: 8.76% 8.12% 7.49% 10.25% Points Received: 1 of 1 Comments: 6. Question : Porky Pine Co. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors are expected to pay $1,100 for the 12-year bond. Porky will pay $50 per bond in flotation costs. What is the after-tax cost of new debt if the firm is in the 35% tax bracket? Student Answer: 8.23% 4.55% 4.70% 7.45% Points Received: 1 of 1 Comments: 7. Question : Zellars, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Zellars, Inc.'s required rate of return for these projects is 10%. The profitability index for Project A is Student Answer: 1.27. 1.22. 1.17. 1.12. Points Received: 1 of 1 Comments: 8. Question : The simulation approach provides us with Student Answer: a single value for the risk-adjusted net present value. an approximation of the systematic risk level. a probability distribution of the project's net present value or internal rate of return. a graphic exposition of the year-by-year sequence of possible outcomes. Points Received: 0 of 1 Comments: 9. Question : Jones Distributing Corp. can sell common stock for $27 per share and its investors require a 17% return. However, the administrative or flotation costs associated with selling the stock amount to $2.70 per share. What is the cost of capital for Jones Distributing if the corporation raises money by selling common stock? Student Answer: 27.00% 18.89% 18.33% 17.00% A corporation is incorporated in only one state regardless of the number of states in which it operates. TRUE 2. The preemptive right allows stockholders the right to vote for directors of the company. FALSE 3. Common stock is the residual corporate interest that bears the ultimate risks of loss. TRUE 4. Earned capital consists of additional paid-in capital and retained earnings. FALSE 5. True no-par stock should be carried in the accounts at issue price without any additional paid-in capital reported. TRUE 6. Companies allocate the proceeds received from a lump-sum sale of securities based on the securities’ par values. FALSE 7. Companies should record stock issued for services or noncash property at either the fair value of the stock issued or the fair value of the consideration received. TRUE 8. Treasury stock is a company’s own stock that has been reacquired and retired. FALSE 9. The cost method records all transactions in treasury shares at their cost and reports the treasury stock as a deduction from capital stock. FALSE 10. When a corporation sells treasury stock below its cost, it usually debits the difference between cost and selling price to Paid-in Capital from Treasury Stock. TRUE 11. Participating preferred stock requires that if a company fails to pay a dividend in any year, it must make it up in a later year before paying any common dividends. FALSE 12. Callable preferred stock permits the corporation at its option to redeem the outstanding preferred shares at stipulated prices. TRUE 13. The laws of some states require that corporations restrict their legal capital from distribution to stockholders. TRUE 14. The SEC requires companies to disclose their dividend policy in their annual report. FALSE 15. All dividends, except for liquidating dividends, reduce the total stockholders’ equity of a corporation. FALSE 21. The residual interest in a corporation belongs to the a. management. b. creditors. c. common stockholders. d. preferred stockholders. 22. The pre-emptive right of a common stockholder is the right to a. share proportionately in corporate assets upon liquidation. b. share proportionately in any new issues of stock of the same class. c. receive cash dividends before they are distributed to preferred stockholders. d. exclude preferred stockholders from voting rights. 23. The pre-emptive right enables a stockholder to a. share proportionately in any new issues of stock of the same class. b. receive cash dividends before other classes of stock without the pre-emptive right. c. sell capital stock back to the corporation at the option of the stockholder. d. receive the same amount of dividends on a percentage basis as the preferred stockholders. S 24. In a corporate form of business organization, legal capital is best defined as a. the amount of capital the state of incorporation allows the company to accumulate over its existence. b. the par value of all capital stock issued. c. the amount of capital the federal government allows a corporation to generate. d. the total capital raised by a corporation within the limits set by the Securities and Exchange Commission. S 25. Stockholders of a business enterprise are said to be the residual owners. The term residual owner means that shareholders a. are entitled to a dividend every year in which the business earns a profit. b. have the rights to specific assets of the business. c. bear the ultimate risks and uncertainties and receive the benefits of enterprise ownership. d. can negotiate individual contracts on behalf of the enterprise. 26. Total stockholders' equity represents a. a claim to specific assets contributed by the owners. b. the maximum amount that can be borrowed by the enterprise. c. a claim against a portion of the total assets of an enterprise. d. only the amount of earnings that have been retained in the business. 27. A primary source of stockholders' equity is . income retained by the corporation. b. appropriated retained earnings. c. contributions by stockholders. d. both income retained by the corporation and contributions by stockholders. 28. Stockholders' equity is generally classified into two major categories: a. contributed capital and appropriated capital. b. appropriated capital and retained earnings. c. retained earnings and unappropriated capital. d. earned capital and contributed capital. 29. The accounting problem in a lump sum issuance is the allocation of proceeds between the classes of securities. An acceptable method of allocation is the a. pro forma method. b. proportional method. c. incremental method. d. either the proportional method or the incremental method. 1. The organization that is responsible for providing oversight for auditors of public companies is called the ________. a. Auditing Standards Board. b. American Institute of Certified Public Accountants. c. Public Oversight Board. d. Public Company Accounting Oversight Board. 2. The Sarbanes-Oxley Act applies to which of the following companies? a. All companies. b. Privately held companies. c. Public companies. d. All public companies and privately held companies with assets greater than $500 million. 3. An operational audit has as one of its objectives to: a. determine whether the financial statements fairly present the entity’s operations. b. evaluate the feasibility of attaining the entity’s operational objectives. c. make recommendations for improving performance. d. report on the entity’s relative success in attaining profit maximization. 5. Which of the following services provides the lowest level of assurance on a financial statement? a. A review. b. An audit. c. Neither service provides assurance on financial statements. d. Each service provides the same level of assurance on financial statements. 6. Which of the following audits can be regarded as generally being a compliance audit? a. IRS agents’ examinations of taxpayer returns. b. GAO auditor’s evaluation of the computer operations of governmental units. c. An internal auditor’s review of a company’s payroll authorization procedures. d. A CPA firm’s audit of the local school district. 1 7. An audit of historical financial statements most commonly includes the: a. balance sheet, the income statement, and the statement of cash flows. b. income statement, the statement of cash flows, and the statement of net working capital. c. statement of cash flows, the balance sheet, and the retained earnings statement. d. all of the above 8. The generally accepted auditing standard that requires “Adequate technical training and proficiency” is normally interpreted as requiring the auditor to have: a. formal education in auditing and accounting. b. adequate practical experience for the work being performed. c. continuing professional education. d. all of the above. 9. Which of the following statements most accurately captures the intent of the performance standards (standards of field work)? a. They are primarily concerned with personal attributes necessary during the conduct of the audit. b. They provide extensive guidance regarding the conduct of an audit. c. The standards are primarily directed at the auditor’s planning, understanding of internal control, and evidence accumulation. 1) Auditing standards require that the audit report must be titled and that the title must: a. include the word “independent.” b. indicate if the auditor is a CPA. c. indicate if the auditor is a proprietorship, partnership, or incorporated. d. indicate the type of audit opinion issued. 2) To emphasize the fact that the auditor is independent, a typical addressee of the audit report could be: Company Controller a. No Shareholders Yes Board of Directors yes a. No Yes Yes b. No No Yes c. Yes Yes No d. Yes No No 3) In which of the following situations would the auditor most likely issue an unqualified report? a. The client valued ending inventory by using the replacement cost method. b. The client valued ending inventory by using the Next-In-First-Out (NIFO) method. c. The client valued ending inventory at selling price rather than historical cost. d. The client valued ending inventory by using the First-In-First-Out (FIFO) method, but showed the replacement cost of inventory in the Notes to the Financial Statements.

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