Corporate Finance Final

True or False: Capital budgeting is the process of planning and controlling investments in assets that are expected to produce cash flows for more than one year

True

True or False: The NPV and IRR methods can lead to conflicting decisions for mutually exclusive projects

True

True/False: Debt is a less risk than equity because a debt holder's claim has priority to an equity holder's claim

True

True/False: One reason that flotation costs associated with the sale of new equity is significantly greater than those associated with the sale of new debt is the difference in number and characteristics of the purchasers of the new securities

True

True/False: The cost of retained earnings and the cost of new common stock are calculated in the same manner, except that the cost of the new shares is based on the value of the firm's share price net of its flotation cost, while the cost of a firm's retained earnings is based solely on the share's expected future cash flows, its current market price, and the expected rate of growth of the firm's earnings and the share's dividends

True

True/False: When using the PI to evaluate an independent project, you will accept projects with a PI greater than 1.0 and reject projects with a PI less than 1.0

True

The required return (or cost) of newly-issued debt is often referred to as the ______. It usually differs from the average cost of the financial capital raised by a firm in the past

marginal

Assume Clancy wants to earn a return of 8.75% and is offered the opportunity to purchase a $1,000 par value bond that pays a 7.50% coupon rate (distributed semiannually) with three years remaining to maturity. Find the bond's semiannual coupon payment, the bond's par value and its semiannual required return. Is it reasonable or unreasonable to expect that Clancy's potential bond investment is currently exhibiting a value of greater than $1,000?

$37.50; $1,000; 4.375%; unreasonable. When the coupon rate is greater than Clancy's required return, the bond should trade at a premium.

To calculate the after-tax cost of debt, multiply the before-tax cost of debt by _____

(1-T)

Bostain, Inc. has total assets of $625,000. Its total debt outstanding is $185,000. The Board of Directors has directed the CFO to move towards a debt-to-assets ratio of 55%. How much debt must the company add or subtract to achieve the target debt ratio?

.55 x 625,000 = 343,750 - 185,000 = 158,750

What are the 4 Pillars of corporate Finance?

1. Capital budgeting 2. Capital Structure 3. Working Capital Management 4. Dividend Policy

For which of the following reasons are capital budgeting decisions important to a business organization: Check all that apply

1. Capital investments tend to be expensive. 2. Capital investments affect the firm's long-term performance and profitability. NOT: Capital investments are easily and quickly reversed.

Which of the following are examples of a capital budgeting project: Check all that apply

1. Lancashire Railway Co.'s investment in employee education and training programs. 2. Houston Horticulture Co.'s investment in a research and development program

Companies often use several methods to evaluate the project's cash flows and each of them has its benefits and disadvantages. Based on your understanding of the capital budgeting evaluation methods, which of the following conclusions about capital budgeting are valid

1. The discounted payback period improves on the regular payback period by accounting for the time value of money. 2. For most firms, the reinvestment rate assumption in the MIRR is more realistic than the assumption in the IRR.

Suppose you borrowed $14,000 at a rate of 10% and must repay it in 5 equal installments at the end of each of the next 5 years. How much interest would you have to pay in the first year?

14,000 x 10% = 1,400

Last year Baron Enterprises had $350 million of sales, and it had $270 million of fixed assets that were used at 65% of capacity last year. In millions by how much could Baron's sales increase before it is required to increase its fixed assets?

350/.65 = 538.46 - 350 = 188.46 million

Maggie's Muffin Bakery generated $4 million in sales during 2021, and its year-end operating assets were $3 million. Also, at year-end 2021, current liabilities were $1 million, consisting of $300,000 of notes payable, $500,000 of accounts payable, and $200,000 of accruals. Looking ahead to 2022, the company estimates that its operating assets must increase at the same rate as sales, its spontaneous liabilities will increase at the same rate as sale, its profit margin will be 6%, and its payout ratio will be 60%. How large a sales increase can the company achieve without having to raise funds externally — that is, what is its self-supporting growth rate?

6%(1-60%)4,000,000 / 3,000,000 - 700,000 - 96,000 = 4.36%

Chambliss Corp.'s total assets at the end of the last year were $305,000 and its EBIT was 62,500. What was its basic earning power (BEP)?

62,500 / 305,000 = 20.49%

1. Several factors affect a firm's need for external funds. Which of the following factors are likely to increase a firm's need for external capital—that is, its AFN (additional funds needed)? Check all that apply. a. The firm switches its supplier for the majority of its raw materials. The new supplier offers less favorable credit terms and thus reduces the trade credit available to the firm, resulting in a reduction in accounts payable. b. The firm previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity. c. The firm's forecasted sales are unexpectedly increased.

A,B

Which of the following are assumptions of the sustainable (self-supporting) growth model? Check all that apply. a. The firm uses all equity and no debt financing. b. The firm maintains a constant ratio of assets to equity. c. The firm must issue the same number of new common shares that it issued last year. d. The firm's total asset turnover ratio remains constant.

A,B,C

If projects are mutually exclusive, only one project can be chosen. The internal rate of return (IRR) and the net present value (NPV) methods will not always choose the same project. If the crossover rate on the NPV profile is below the horizontal axis, the methods will ____ agree

Always

A legal document that details the rights of bondholders and the issuer is called

An indenture

Which feature of a bond contract allows the issuer to redeem bonds under specified terms prior to maturity?

Call Provision

T/F: A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.

False

T/F: A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

False

True or False: Sophisticated firms use only the NPV method in capital budgeting decisions

False

True/False: Because 50% 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(.30)(.50) + rps(1-T)(.5)(.5)

False

True/False: Firms raise capital from retained earnings only when they cannot issue new common stock due to market conditions outside of their control

False

True/False: 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.

False

True/False: 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.

False

True/False: The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the dividend growth method, and the bond-yield-plus-risk-premium method. However, only the dividend growth method is widely used in practice.

False

If a firm cannot invest retained earnings to earn a rate of return ________ the required rate of return on retained earnings, it should return those funds to its stockholders

Greater than or equal to

In general, the ______ the risk of a firm as perceived by its existing and potential investors, the greater is the firm's weighted average cost of capital (WACC)

Greater. Why: Greater perceived risk increases the yield to maturity required by the firm's existing and prospective bondholders, which in turn increases both the before-tax and after-tax costs of the firm's debt capital. Increased perceived risk also increases the required returns of the firm's preferred and common equity holders. This increases the after-tax costs of the firm's preferred stock and common equity (either retained earnings or new common stock). These increases will cause the firm's weighted average cost of the firm's financial capital to increase as well.

Which criteria assume that the project's net cash flows (NCFs) are reinvested at the project's internal rate of return

IRR

What does operating current liabilities include and not include?

Include: accounts payable and accruals DO NOT INCLUDE: Notes payable - source of financing, not a part of operations

What does operating current assets include and not include?

Include: cash, inventory, receivables NOT INCLUDE: short-term investments, because these are not a part of operations

When raising funds by issuing new preferred stock, the company will incur an underwriting, or flotation, cost that ______ the cost of preferred stock. Because the flotation cost is usually expressed as a percentage of price of each share, the difference between the cost of preferred stock with and without flotation cost is ______ enough to not ignore

Increases; significant

When there is a conflict, a key to resolving this it is the assumed reinvestment rate. The IRR calculation assumes that intermediate cash flows are reinvested at the__________ , and the NPV calculation implicitly assumes that the rate at which cash flows can be reinvested is the__________

Internal rate of return (IRR); required rate of return

Suppose a new law made it more difficult to stage a hostile takeover. Which of the following groups would benefit the most?

Management

As a result, when evaluating mutually exclusive projects, the _________ is usually the better decision criterion

NPV method. Why: The IRR assumes that intermediate cash flows can be reinvested and continue earning the IRR. For most firms, it is more accurate to assume that the firm can reinvest cash flows at the WACC, not the IRR. Remember, the WACC is the opportunity cost of capital and represents the rate at which external capital can be attained. The WACC is the assumed reinvestment rate when calculating the NPV.

The calculation of a firm's weighted average cost of capital should be based on the after-tax cost of the _____ dollar of financial capital raised

Next. Why: This allows the firm to compare the return on its next potential investment with the cost of the next dollar of financial capital raised and potentially spent on the project. Historic average capital costs are not relevant to the making of new investments.

Suppose your boss has asked you to analyze two mutually exclusive projects—project A and project B. Both projects require the same investment amount, and the sum of cash inflows of Project A is larger than the sum of cash inflows of project B. A coworker told you that you don't need to do an NPV analysis of the projects because you already know that project A will have a larger NPV than project B. Do you agree with your coworker's statement

No, the NPV calculation will take into account not only the projects' cash inflows but also the timing of cash inflows and outflows. Consequently, project B could have a larger NPV than project A, even though project A has larger cash inflows.

What are pros and cons of the payback period method?

Pros: 1. provides an indication of a project's risk and liquidity 2. easy to calculate and understand Cons: 1. Ignores the TVM 2. Ignores CFs occurring after the payback period 3. No specification of acceptable payback

It is generally believed that the proportions, or weights, used in the calculation of a firm's weighted average cost of capital should be based on the market values of the firm's capital sources. This is because the market value weighting system is more consistent with maximizing the value of the firm's ________

Shareholder wealth

If the project's cost of capital were to increase, how would that affect the IRR

The IRR would not change.

Which of the following statements indicate a disadvantage of using the discounted payback period for capital budgeting decisions

The discounted payback period does not take the project's entire life into account.

Which version of a project's payback period should the CFO use when evaluating Project Beta, given its theoretical superiority

The discounted payback period. Why: the discounted payback period takes the expected cash flows' time value of money effects into account and the regular payback period does not.

Each of the following factors affects the weighted average cost of capital (WACC) equation. Which are factors that a firm can control

The firm's dividend payout ratio. The firm's capital budgeting decision rules

True or False: A firm's new investments, existing assets, and capital structure affect its overall degree of risk and, in turn, its weighted average cost of capital (WACC)

True

True or False: A firm's weighted average cost of capital (WACC) reflects the composite cost of its debt, preferred stock, and common equity capital

True

Which of the following types of bonds has the least default risk?

Treasury bonds

T/F: A typical firm's IRR will be greater than its MIRR.

True

T/F: One advantage of the payback method for evaluating potential investments is that it provides information about project's liquidity and risk.

True

T/F: 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.

True

Shen bought shares of a heavily traded stock listed on the New York Stock Exchange (NYSE), whereas Valerie bought stocks of a rural bank with a very small number of shareholders. Whose investment is more exposed to marketability risk?

Valerie's investment

Which of the following statements is true?

When interest rates increase, the prices of U.S. Treasuries decline.

Assume that a $1,000,000 par value, semiannual coupon U.S. Treasury note with four years to maturity has a coupon rate of 3%. The yield to maturity (YTM) of the bond is 11.00%. Using this information and ignoring the other costs involved, the value of the Treasury note is

a. $746617.36 b. N = 8; I/Y = 5.5; FV = 1,000,000; PMT = 15000 c. Because the price is below the par value, the bond is selling at a discount. If rates remain constant, the bond's price will appreciate (increase) gradually over time until it equals the face value of $1,000,000 at maturity.

Green Moose Industries reported sales of $890,000 at the end of last year; but this year, sales are expected to grow by 8%. Green Moose expects to maintain its current profit margin of 24% and dividend payout ratio of 20%. The firm's total assets equaled $500,000 and were operated at full capacity. Green Moose's balance sheet shows the following current liabilities: accounts payable of $65,000, notes payable of $25,000, and accrued liabilities of $60,000. Based on the AFN (Additional Funds Needed) equation, what is the firm's AFN for the coming year?

a. ($500,000/$890,000)×$71,200-($125,000/$890,000)×$71,200-$961,200×0.24×(1−0.20) b. -$154,550

Which of the following assumptions is embodied in the AFN equation? a. Accounts payable and accruals are tied directly to sales b. Common stock and long-term debt are tied directly to sales c. Fixed assets, but not current assets are tired directly to sales d. Last year's total assets were not optimal for last year's sales e. None of the firm's ratios will change

a. Accounts payable and accruals are tied directly to sales

Additional funds needed could be acquired through which of the following forms? a. Issuing additional common stock b. Borrowing from a bank using notes payable c. Issuing long-term bonds

a. Issuing additional common stock

Purple Lemon Fruit Company currently has $1.1 billion in cash on its balance sheet. The CFO thinks the firm will need $600 million in cash to finance operations for the next year. The CFO has recommended that the firm keep the excess cash in a marketable securities portfolio to allow for unexpected costs. However, the board of directors has decided that the firm will pay this money out to the shareholders in the form of a cash dividend. a. The board's decision will help align management's interests with the shareholders' interests. b. The board's decision will give management the incentive to make decisions that are not in the shareholders' best interest. c. The board's decision is extremely risky and not very practical.

a. The board's decision will help align management's interests with the shareholders' interests.

A company expects sales to increase during the coming year, and it is using the AFN equation to forecast the additional capital that it must raise. Which of the following conditions would cause the AFN to increase? a. The company increases its dividend payout ratio. b. The company begins to pay employees monthly rather than weekly c. The company's profit margin increases d. The company decides to stop taking discounts on purchased materials. e. The company previously thought its fixed assets were being operated at full capacity, but now it learns that it actually has excess capacity.

a. The company increases its dividend payout ratio.

Green Caterpillar Clothiers has 9% annual coupon bonds that are callable and have 18 years left until maturity. The bonds have a par value of $1,000, and their current market price is $980.35. However, Green Caterpillar may call the bonds in eight years at a call price of $1,060. What are the YTM and the yield to call (YTC) on Green Caterpillar's bonds? What is the current yield?

a. YTM = 9.23% i. N = 18; FV = 1,000; PV = -980.35; PMT = 90 b. YTC = 9.89% i. N = 8; FV = 1060; PV = -980.35; PMT = 90 c. Current yield = coupon payment in dollars / bond's current price i. 90/980.35 = 9.18%

A positively signed AFN value represents a. a shortage of internally generated funds that must be raised outside the company to finance the company's forecasted future growth. b. a point at which the funds generated within the firm equal the demands for funds to finance the firm's future expected sales requirements. c. a surplus of internally generated funds that can be invested in physical or financial assets or paid out as additional dividends.

a. a shortage of internally generated funds that must be raised outside the company to finance the company's forecasted future growth.

To prevent, reduce, or correct these conflicts between their managers and themselves, shareholders often have to incur additional real costs called ____ costs.

agency

Last year Urbana corp. had $197,500 of assets, $307,500 of sales, $19,575 of net income, and a debt-to-total assets ratio of 37.5%. The new CFO believes a new computer program will enable it to reduce costs and thus raise net income of $33,000. Assets, sales, and the debt ratio would not be affected. By how much would the cost reduction improve the ROE?

assets - liabilities = equity; 197,500 - (197,000 x 37.5%) = 123,438. ROE = 19,575 / 123,438 = 15.86% ROE new = 33,000 / 123,438 = 26.43% - 15.86 = 10.88%

Most appropriate form of control device: a. Develop a code of ethics that prohibits shirking. b. Develop a management evaluation and compensation program that puts the burden on the management team to reduce shirking or excessive concern about job security. c. Hire an external consultant to address the psychological concerns of the plant managers.

b. Develop a management evaluation and compensation program that puts the burden on the management team to reduce shirking or excessive concern about job security.

Out of the three which one of these is not a part of spontaneous liabilities? a. Accounts payable b. Notes payable c. Accruals

b. Notes payable

1. Which of the following actions will help ease agency conflicts and better align managers' objectives with the firm's shareholder wealth? a. Pay the manager a large base salary with a huge stock option package that matures on a single date. b. Pay the manager a combination of salary and stock options (phased in over several years) that reward him or her for consistently increasing shareholder wealth.

b. Pay the manager a combination of salary and stock options (phased in over several years) that reward him or her for consistently increasing shareholder wealth.

Green Penguin Pencil Company recently created an ESOP. The company issued 200,000 new shares of stock at $50 per share, which it sold to the ESOP. The ESOP borrowed $10 million to purchase the newly issued shares from the company. The financial institution was willing to lend the money to the ESOP, because Green Penguin Pencil Company signed a guarantee for the loan. The firm used the money from the ESOP to repurchase its shares on the open market at $50 per share. Which of the following statements describes the net effect of these transactions on the company's cash balance? a. The company's cash balance will decrease by $10 million at the end of these transactions. b. The company's cash balance will be unchanged at the end of these transactions. c. The company's cash balance will increase by $10 million at the end of these transactions.

b. The company's cash balance will be unchanged at the end of these transactions.

The cost of capital for two mutually exclusive projects that are being considered is 8%. Project K has an IRR of 20% while Project R's IRR is 15%. The projects have the same NPV at the 8% current cost of capital. However, you believe that money costs and thus your cost of capital will also increase. You also think that the projects will not be funded until the cost of capital has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should recommend Project R, because at the new cost of capital it will have the higher NPV. b. You should recommend Project K, because at the new cost of capital it will have the higher NPV. c. You should recommend Project K because it has the higher IRR and will continue to have the higher IRR even at the new cost of capital. d. You should reject both projects because they will both have negative NPVs under the new condition

b. You should recommend Project K, because at the new cost of capital it will have the higher NPV.

A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. issue new common stock and use the proceeds to acquire additional fixed assets b. offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable c. issue new common stock and use the proceeds to increase in inventories

b. offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable

Which of the following is NOT a potential problem with beta and its estimation? a. There is a wide confidence interval around a stock's estimated beta b. Sometimes a security or project does not have a past history which can be used as a basis for calculating beta c. The beta of "the market" can change over time, sometimes drastically

c. The beta of "the market" can change over time, sometimes drastically

Stock A's beta is 1.5 and Stock B's beta is .5. Which of the following statements must be true about these securities? a. Stock B must be a more desirable addition to a portfolio than Stock A b. Stock A must be a more desirable addition to a portfolio than Stock B c. The expected return on Stock A should be greater than that on Stock B d. The expected return on Stock B should be greater than that on Stock A e. When held in isolation, Stock A has greater risk than Stock B

c. The expected return on Stock A should be greater than that on Stock B

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. become riskier over time, but its intrinsic value will be maximized

c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized

Which type of bonds offer a higher yield?

callable bonds

Which of the following would be most likely to lead to higher interest rates on all debt securities in the economy?

corporations set up their expansion plans and thus increase their demand for capital

A project's IRR will _____ if the project's cash inflows decrease, and everything else is unaffected

decrease

Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. If a stock has a negative beta, its required return must also be negative b. An index fund with beta = 1.0 should have a required return less than 11%. c. If a stock's beta doubles, its required return must also double d. An index fund with beta = 1.0 should have a required return greater than 11% e. An index fund with beta = 1.0 should have a required return of 11%

e. An index fund with beta = 1.0 should have a required return of 11%

Which of the following statements in correct? a. An investor can eliminate virtually all market risk if he or she holds a very large and well-diversified portfolio of stocks. b. The higher the correlation between the stocks in a portfolio, the lower the risk inherent in the portfolio. c. It is impossible to have a situation where the market risk of a single stock is less than that of a portfolio that includes the stock. d. Once a portfolio has about 40 stocks, adding additional stocks will not reduce its risk by even a small amount. e. An investor can eliminate virtually all diversifiable risk if he or she bolds a very large, well-diversified portfolio of stock.

e. An investor can eliminate virtually all diversifiable risk if he or she bolds a very large, well-diversified portfolio of stock.

Considered alone, which of the following would increase a company's current ratio? a. an increase in accounts payable b. an increase in net fixed assets c. an increase in accrued liabilities d. an increase in notes payable e. an increase in accounts receivable

e. an increase in accounts receivable

In general, bondholders purchase corporate securities that provide a ____return, whereas shareholders purchase shares that are likely to provide a return that _____ the riskiness of the firm.

fixed; fluctuates with

In addition, potential bondholders may require a _____ interest rate on the firm's soon-to-be-issued bond as compensation for the risks that cannot be adequately protected against using the restrictive covenants.

higher

Generally, investors would prefer to invest in assets that have:

higher-than-average expected rate of return given the perceived risk.

You invest $100,000 in 40 stocks, 20 bonds, and a certificate of deposit (CD). What kind of risk will you primarily be exposed to?

portfolio risk

Other things held constant, which of the following alternatives would increase a company's cash flow for the current year?

reduce the days' sales outstanding (DSO) without affecting sales or operating costs

A bond's yield to maturity (YTM) refers to the rate of return expected from a bond held until its maturity date. However, the YTM equals an investor's expected rate of return under certain assumptions. Which of the following is one of those assumptions?

the bond will not be called

Remember, a bond's coupon rate partially determines the interest-based return that a bond ____ pay, and a bondholder's required return reflects the return that a bondholder _____ to receive from a given investment.

will; would like