Module 4 Questions

Which of the following is true of a break point on a firms marginal cost of capital (MCC) schedule?

A break point (BP) is defined as the last dollar of new total capital that can be raised before an increase in the firms weighted average cost of capital (WACC) occurs.

Which of the following statements is correct?

A firm has estimated that it will save $40,000 in utility expenses annually if it replaces an old machine with a new, more technologically advanced machine. The $40,000 is a relevant cash flow that should be included in the computation of the machines supplemental operating cash flows.

Which of the following statements is true about capital budgeting analysis?

A project should be purchased if its net present value (NPV) is positive.

Which of the following statements about the opportunity cost associated with a capital budgeting project is correct?

A projects opportunity cost is the return (cash flow) that will not be earned (generated) if funds are invested in a particular capital budgeting project.

Which of the following statements concerning the effect of taxes on a firms cost of capital is correct?

All else equal, an increase in the corporate tax rate will result in a decrease in the firms weighted average cost of capital.

Which of the following is a major assumption that is embedded in the capital asset pricing model (CAPM), which is often used to estimate the cost of retained earnings, rs?

All investors are well diversified.

Which of the following statements about the marginal cost of capital is correct? Assume everything else is equal.

An increase in the tax rate will decrease a firms marginal cost of debt.

Which of the following should be included in the computation of an expansion projects terminal cash flow?

Any change in net working capital that was recognized at the time the project was purchased

Which of the following provides a measure of systematic risk?

Beta coefficient.

Which of the following statements is correct?

Capital budgeting projects with fairly risky cash flows should be evaluated using relatively high discount rates (required rates of return).

Which of the following cost of capital measures must be adjusted to account for tax savings?

Cost of debt.

Two firms, Tangerine Inc. and Cyan Inc. analyzed the same capital budgeting project. Tangerine Inc. determined that the projects internal rate of return (IRR) is 9 percent. Cyan Inc. used the net present value (NPV) method to evaluate the project and determined that it is not acceptable. Given this information, which of the following statements is correct?

Cyan Inc.s required rate of return is greater than 9 percent.

Which of the following statements concerning cash flow evaluation in capital budgeting is correct?

Even though it is a noncash expense, a capital budgeting projects depreciation expense must be computed because it affects the after-tax cash flows of the project.

Which of the following statements is true about the flotation costs that are incurred when a firm issues new securities to raise funds?

Floatation costs increase the cost of using funds; e.g., the cost of issuing new common stock is greater than the cost of retained earnings because the firm must pay flotation costs to issue new equity.

Suppose a firms senior management is careful to make decisions that contribute to the goal of wealth maximization. If our basic assumptions about the relationship between risk and return are valid, which of the following statements is correct?

If the beta coefficient of a capital budgeting project is greater than the firms existing beta coefficient, the firms required rate of return will increase if the project is purchased.

Which of the following is true about the net present value (NPV) capital budgeting technique?

If the net benefit computed on a present value basisthat is, NPVis positive, then the asset (project) is considered an acceptable investment.

Which of the following statements about the internal rate of return (IRR) capital budgeting technique is correct?

It is the discount rate that equates the present value of a projects cash outflows (or costs) with the present value of its cash inflows.

Hill Top Lumber Company is considering building a sawmill in the state of Washington because the company doesnt have such a facility to service its growing customer base located on the west coast. When evaluating the acceptability of the project, which of the following would be considered a relevant cash flow that should be included when determining the sawmills initial investment outlay?

It will cost Hill Top $3 million to clear the land on which the sawmill will be built.

If a projects net present value (NPV) is positive,:

Its initial investment is recovered on a present value basis prior to the end of the projects useful life.

When evaluating capital budgeting projects, how do most firms incorporate risk in their decision-making analyses?

Most firms increase the required rate of return used in their capital budgeting analyses when evaluating projects with higher-than-average risks.

If a capital budgeting project is purchased, a firms value, and thus its stockholders wealth, will change by the amount of the projects _____.

NPV

Which of the following statements about capital budgeting analyses is correct?

Only incremental cash flows, which are the cash flows that will change if a project is purchased, should be included in capital budgeting analyses.

Ace Inc. is evaluating two mutually exclusive projectsProject A and Project B. The initial investment for each project is $50,000. Project A will generate cash inflows equal to $15,625 at the end of each of the next five years; Project B will generate only one cash inflow in the amount of $99,500 at the end of the fifth year (i.e., no cash flows are generated in the first four years). The required rate of return of Ace Inc. is 10 percent. Which project should Ace Inc. purchase?

Project B should be purchased because it has a higher net present value (NPV) than Project A.

Which of the following statements is correct concerning various techniques used for assessing a capital budgeting projects stand-alone risk?

Sensitivity analysis fails to consider the range of likely values for the key input variables that are used to evaluate a capital budgeting project.

Which of the following is a correct statement about the discounted payback period (DPB) technique that is used to evaluate capital budgeting projects?

The DPB method considers the time value of money.

Which of the following statements is correct about the reinvestment assumptions that are inherent in the use of the net present value (NPV) method and the internal rate of return (IRR) method?

The NPV method assumes that the projects cash flows will be reinvested at the firms required rate of return, whereas the IRR method assumes reinvestment at the projects IRR.

Alpha Inc. combines the marginal cost of capital (MCC) schedule with the investment opportunity schedule (IOS) on a single graph. Which of the following areas on the MCC/IOS graph shows the maximum excess of marginal returns over marginal costs?

The area that is above the MCC schedule but below the IOS schedule when the IOS line is above the MCC line

Which of the following statements is correct about using the capital asset pricing model (CAPM) to determine a firms component costs of capital?

The capital asset pricing model (CAPM) assumes investors are well diversified, whereas the discounted cash flow (DCF) approach assumes the firm grows at a constant growth rate.

A firm is evaluating a new machine to replace one of its existing, older machines. If the old machine is replaced, the change in the annual depreciation expense will be $3,000. The firms marginal tax rate is 30 percent. Which of the following statements is correct?

The depreciation expense can be added to the machines after-tax net operating income to determine its supplemental operating cash flows.

Which of the following is a reason the modified internal rate of return (MIRR) measure is a better indicator of a projects true profitability than the internal rate of return (IRR) measure?

The modified internal rate of return (MIRR) assumes that the projects cash flows are reinvested at the firms required rate of return, which is a better assumption than the IRR assumption that the cash flows are reinvested at its IRR.

Stonewood Manufacturing is evaluating whether to replace one of its existing machines with a new, more technologically advanced one. Which of the following statements concerning a replacement decision analysis is correct?

The net cash flow from the sale of old machine should be included as part of the new machines initial investment outlay.

Which of the following statements is correct?

The net present value (NPV) technique and internal rate of return (IRR) technique can lead to conflicting investment decisions when mutually exclusive projects are being evaluated.

Suppose a capital budgeting project generates its largest cash flows in the early years of its life(i.e., up front) rather than near the end of its life. In this situation. Which of the following statements about the project must be correct?

The net present value of the project is not as sensitive to changes in the firms required rate of return as the net present value of a project that generates large cash flows later in its life.

Which of the following statements best describes the post-audit function in the capital budgeting process?

The post-audit involves comparing the actual results of previous capital budgeting decisions with the forecasted results to identify and explain any differences.

Union Atlantic Corporation, which has a required rate of return equal to 14 percent, is evaluating a capital budgeting project that requires an initial investment of $170,000. The project will generate a $60,750 cash inflow at the year-end of each of the next four years. According to this information, which of the following statements is correct?

The project is acceptable because its net present value is positive.

To expand sales, Sandine Corporation is evaluating whether to purchase a machine to manufacture a new product line. Which of the following statements is correct concerning an expansion analysis like the one Sandine faces?

The shipping and installation costs associated with purchasing the new machine are included in the computation of its initial investment outlay.

Which of the following is a correct statement about the traditional payback period (PB) method that is used to evaluate capital budgeting projects?

To compute a projects PB, simply add up the expected cash flows for each year until the cumulative value equals the amount that is initially invested.

Which of the following statements is correct?

To compute the NPV for a project, the firms required rate of return must be known. To compute a projects internal rate of return (IRR), the firms required rate of return is not used because the IRR is the discount rate where the projects NPV equals zero.

Which of the following capital budgeting evaluation techniques is based on the concept that it is better to recover the cost of (investment in) a project sooner rather than later?

Traditional payback period (PB)

Which of the following statements is correct?

Undiversified stockholders, including the owners of small businesses, probably are more concerned about the corporate risk associated with a particular firm than are diversified stockholders.

The _____ on a bond is the cost to the firm for using bondholders funds.

Yield to maturity

Beige Inc. is evaluating three capital budgeting projects whose internal rates of return (IRRs) are greater than the firms marginal cost of capital (MCC). Beige should choose:

all of the projects whose internal rates of return (IRRs) are greater than the firms weighted average cost of capital WACC).

Under normal circumstances, the weighted average cost of capital (WACC) is used as the firms required rate of return because:

as long as the firms investments earn returns greater than its WACC, the value of the firm will not decrease.

When determining a projects true profitability, it is normally better to compute the projects modified internal rate of return (MIRR) rather than its internal rate of return (IRR) because the MIRR technique:

assumes that the projects cash flows are reinvested at the firms required rate of return, whereas IRR assumes the cash flows are reinvested at the projects IRR.

The average rate of return that investors require to provide funds to the firm in the form of debt is the ________.

average yield to maturity (YTM) on the firms bonds

The value of any assetreal or financialis based on the _____ and the _____.

cash flow expected to be generated by the asset; the rate of return required by investors

In capital budgeting analyses, the primary difference between the traditional payback period (PB) technique and the discounted payback period (DPB) technique is that the DPB:

considers the time value of money.

For a particular project, other things held constant, an increase in the firms required rate of return will result in _____.

decrease in NPV

A projects depreciation expense must be considered when evaluating its incremental operating cash flows because:

depreciation has an impact on the taxes paid by the firm, which is a cash flow.

A firms weighted average cost of capital (WACC) is:

determined by participants in the financial markets, because investors set the minimum return they require (demand) to provide the funds the firm invests in capital budgeting projects.

A major difference between capital budgeting for domestic operations and foreign operations is that:

estimating cash flows generated from foreign operations is more complex due to fluctuating exchange rates.

Which of the following is not relevant in a capital budgeting analysis because it is not an incremental cash flow?

externalities

The marginal cost of capital (MCC) schedule generally rises, which implies that the weighted average cost of capital:

generally increases because the firm incurs higher flotation costs and higher financial risk as it raises more funds through new debt and new equity issues.

If a capital budgeting project has a higher corporate risk than the average risk contained in the firms portfolio of assets, it generally has a:

greater beta risk

The net present value (NPV) of a project is negative when the discount rate used is:

greater than the projects IRR

Everything else equal, a project that has a long traditional payback period (PB) _____.

has greater implied risk than a project that has a shorter PB

The present value of the expected net cash flows of all the projects undertaken by a firm will most likely exceed the present value of the firms expected net profit after tax, because:

income is reduced by depreciation and other non-cash charges, whereas cash flows are not.

A firm is considering the purchase of an asset whose stand-alone risk is greater than the average risk of its existing portfolio of assets. In evaluating this asset, the decision maker should:

increase the required rate of return that is used to evaluate the asset to reflect its higher risk.

The marginal cost of capital generally _____ as more capital is raised during a given period.

increases

The incremental cash flows associated with a capital budgeting project that occur only at the start of a projects life are included in the computation of the projects _____.

initial investment outlay

When evaluating the cash flows associated with a capital budgeting project, the shipping and installation costs associated with the purchase of an asset are included in the computation of the:

initial investment outlay, because these expenses are part of the projects depreciable basis.

To determine the actual cost of using debt, a firm must adjust its bonds average yield to maturity for the fact that _____.

interest payments on debt represent a tax deductible expense to the firm

If a projects _____ exceeds the firms weighted average cost of capital (WACC), its net present value (NPV) will be positive.

internal rate of return

Everything else equal, an assets value is:

inversely related to the rate of return investors require to purchase it.

A graph of the capital budgeting projects a firm is evaluating ranked in the order of their internal rates of return is called a(n) _____.

investment opportunity schedule (IOS)

The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by the:

investors who purchase the firms stocks and bonds in the financial markets.

If a projects net present value (NPV) is positive,:

it is an acceptable investment.

According to the bond-yield-plus-risk-premium approach, a firms cost of retained earnings, rs, can be estimated by adding a risk premium of 3 to 5 percentage points to:

its before-tax interest cost of debt, rs.

If a capital budgeting project has a negative net present value (NPV),

its discounted payback period (DPB) is greater than the projects economic life.

The annual growth of Omega Incs operations fluctuates substantially. As a result, using the dividend discount model (DDM) to estimate Omegas cost of retained earnings, rs, is difficult because:

its growth rate (g) is not stable, which makes it difficult to estimate.

A project should be accepted if _____.

its internal rate of return (IRR) exceeds the firms required rate of return

A firm should continue to invest in capital budgeting projects until its marginal cost of capital is equal to the:

marginal return (internal rate of return, IRR) generated by the last project purchased.

With the improvement in the technology and understanding of discounting techniques, both the net present value (NPV) technique and internal rate of return (IRR) technique used in capital budgeting analyses have become more popular because these techniques provide decisions that help the firm to _____.

maximize its value

The target capital structure of a firm is the capital structure that:

maximizes the price of the firms stock.

The weighted average cost of capital of a firm represents the:

minimum rate of return a firm must earn on average-risk investments to maintain its current value.

Multinational companies can reduce the chance of a loss from expropriation by:

obtaining insurance against economic losses associated with expropriation.

Modified internal rate of return (MIRR) is the discount rate that forces the present value of a projects terminal value to equal the _____.

present value of its cash outflows

The modified internal rate of return (MIRR) is the discount rate that forces the ______.

present value of the projects terminal value to equal the present value of its costs (cash outflows)

Which of the following methods involves calculating an average of the beta coefficients of numerous firms that are in the same (or a quite similar) line of business and then using that average beta coefficient to determine the appropriate required rate of return for a new capital budgeting project?

pure play method

Which of the following mathematical expressions is used to calculate the after-tax cost of debt, rdT?

rdT = Bondholders required rate of return (YTM) Tax savings

Which of the following is the correct relationship between different capital components of a firm? rd = before-tax cost of debt; rs = cost of retained earnings; re = cost of new common equity

rs < re

A projects terminal value is the _____.

sum of the future values of the cash inflows compounded at the firms required rate of return

The ultimate purpose of a capital budget is to forecast _____.

the funds required to purchase fixed assets for future projects

If the traditional payback period method is used to evaluate a capital budgeting project, the project is considered acceptable if _____.

the payback period is less than the maximum cost-recovery time established by the firm

If a projects discounted payback period is less than its useful life, _____.

the present value of its future cash flows exceeds its initial cost

A projects net present value is equal to:

the present value of the expected future cash inflows minus the present value of all the cash outflows.

Investment in foreign subsidiaries is less risky when:

the subsidiaries are geographically (globally) diversified.

Sensitivity analysis is a technique in which:

the values of key input variables are changed to observe the resulting changes in a projects net present value (NPV) and its internal rate of return (IRR).

The investment opportunity schedule (IOS) shows the:

total funds required to invest in capital budgeting projects the firm is evaluating for possible purchase.