FIN 370 Final Exam- Chapter 11-12
You are evaluating a project that is expected to produce cash flows of $5,000 each year for the next 10 years and $7,000 each year for the following 10 years. The IRR of this 20-year project is 12%. If the firm's WACC is 8%, what is the project's NPV?
$14, 321. 21 NPV with IRR of 12%: CF0=0 CF1= 5000 N= 10 CF1= 7000 N=10 I/YR= 12; Solve for NPV= $40,985.66 NPV With IRR of 8%: CF0= -40985.66 CF1= 5000 N= 10 CF1= 7000 N=10 I/YR= 8 NPV= 14, 321.21
Projects L and S have the following expected cash flows: Year: Project L: Project S 0. : -$100. :- $100 1. : 10. : 70 2. : 60 : 50 3. : 80. : 20 Both projects have a cost of capital of 10%. What is Project L's net present value (NPV)?
$18.78 NPV = -$100 + $10/1.10 + $60/(1.10)2 + $80/(1.10)3 = -$100 + $9.09 + $49.59 + $60.11 = $18.78. Financial calculator solution: Input the cash flows into the cash flow register, I/YR = r = 10, and solve for NPV = $18.78.
A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC 6% Year: CFS: CFL 0. : -1025: -2150 1. : 38. : 76 2. : 38. :76 3 : 38. : 76 4. : 380. : 765
$209.07 IRR, L= 15.781% IFF, S= 17.861% NPV, L= 500.81 NPV, S= 291.74 Change= 209.07= value lost if use the IRR criterion
Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC: 12% Year: Cash Flows 0. : -1100 1. : 40 2. : 39 3. : 38 4. : 37 5. : 360
$277.94 Plug in for NPV
Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions, choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist. WACC: 10% Year: CFS : CFL 0. : -1025: -1025 1. :650. :100 2. :450. :300 3. :25 :50 4. :50. :700
$7.82 IRR, L= 15.66% IRR, S= 19.86% NPV,L= 167.61 NPV, S= 159.79 $7.82= value lost if use the IRR criterion Crossover= 10.549%
Last month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC: 10% New WACC: 12.35% Year: Cash Flows 0. : -$1000 1. : 41 2. : 410 3. : 410
-$22.03 Old NPV= 19.61 New NPV= -2.42 Change= -22.03 (new-old)
The de minimis amount of a bond discount is determined as:
0.25% × par value × years to maturity.
Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?
0.4% D1= 2.75(0.70)= 1.93 rs=(D1/Po)+g= 1.93/45+0.06= .042+0.06= 0.103= 10.3% re=(D1/Po(1-F))+g= (1.93/45(1-0.08))+0.06= 1.93/41.40+0.06= 0.047+0.06= 0.107= 10.7% re-rs= 10.7%-10.3%= 0.4%
The expected cash flows for Projects L and S are as follows: Year: Project L: Project S 0. : -$100. : -$100 1. : 10 : 70 2 : 60 : 50 3 : 80 : 20 Both projects have a cost of capital of 10%. Determine the payback period for Project S.
1.6 Years After the first year, there is only $30 remaining to be repaid, and $50 is received in Year 2. Assuming an even cash flow throughout the year, the payback period is 1 + $30/$50 = 1.6 years.
Fernando Designs is considering a project that has the following cash flow and WACC data: WACC= 10% Year: Cash Flows 0. : -$900 1. : $500 2. : $500 3. : $500 What is the project's discounted payback?
1.85 Years Year: PV of CFs: CF 0. : -900. :-900 1. : 455. :500 2 : 413. :500 3. : 376. :500 -900+455= -445+413= -32+ 343 1.85
Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising?
10.40% If the investment requires $2.6 million, that means that it requires $1.43 million (55%) of equity and $1.17 million (45%) of debt. In this scenario, the firm would exhaust its $0.5 million of retained earnings and be forced to raise new stock at a cost of 14%. Since the firm must raise $1.17 million in debt, it will have a 10% cost (before taxes). (The problem states that the firm can raise up to $1.5 million in debt at a 10% cost—before taxes.) Therefore, its WACC is calculated as follows: WACC = 0.45(10%)(1 - 0.4) + 0.55(14%) = 10.4%
You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.0% (constant); and F = 5.0%. What is the cost of equity raised by selling new common stock?
11.3% rs=(D1/(Po(1-F))+g 1.75/(42.50(1-.050))+0.07 =11.3%
O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?
11.30% rs=rRF + b(RPm) 0.05+(1.05*0.06)= 11.30%
Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re?
11.5% Dividend yield= D1/Po= 4.5%= D1/50.00 D1= 2.25 re= D1/(Po(1-F))+g 2.25/ (50(1-0.10))+0.065 =11.50%
Superior Transportation Company has a barge division. Assuming a typical beta of 1.5 for barge operations, a risk-free rate of 4%, and a market risk premium of 5%, what is its divisional cost of capital?
11.5% rs = rRF + (RPM)b = 4% + (5%)1.5 = 11.5%.
A company is analyzing two mutually exclusive projects, S and L, whose cash flows are as follows: Year: Project S: Project L 0. : -2000. : -2000 1. : 1800. : 2000 2. : 500 : 2500 3. : 20. : 800 4. :40. : 1600 The company's cost of capital is 9%, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project? (Hint: Note that the better project may or may not be the one with the higher IRR.)
11.74% Put the cash flows into a calculator's cash flow register, and then calculate NPV at 9% and IRR: Project S: NPVS = $101.83; IRRS = 13.49%. Project L: NPVL = $172.07; IRRL = 11.74%. Because NPVL > NPVS, it is the better project. IRRL = 11.74%.
Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)?
11.77% 12%(1-0.40)= 7.2% rs= (2.4(1+0.05))/ 24)+ 0.05= 15.50% WACC= 0.45(0.072)+ 0.55(.1550)= 11.77%
Apopka Corporation's retention ratio has averaged 40% over the past 15 years, its payout ratio has averaged 60%, and its return on equity has averaged 20%. Using the retention growth model, estimate Apopka's earnings growth rate?
12.0% gL = ROE(Retention ratio) = 20% × 40% ≈ 8%.
A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity 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 equity from retained earnings?
12.60% rs = rd + Risk premium = 8.75% + 3.85% = 12.60%
Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are as follows: Year: Project X: Project Y 0. : -$2000. : -$2000 1. :200. : 2000 2. :600 : 200 3. :800. : 100 4. :1400. : 100 The projects are equally risky, and their cost of capital is 10%. You must make a recommendation, and you must base it on the modified IRR. What is the MIRR of the better project?
13.10% discount the cashflows to year 4 and then add them all up to find the TV, use PV=2000, FV= TV, pmt=0 N=
Simms Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (or even negative), in which case, it will be rejected. Year: CF 0. : -$1000 1. : 425 2. : 425 3 :425
13.21% Calculator
Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65.0%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5.0% would be incurred. What would be the cost of equity from new common stock?
13.4% Expected Dividend= D1= EPS*payout ratio= 3.5*0.65= $2.28 re= (D1/Po(1-F))+g= (2.28/32.50(1-0.05))+ 0.06= 13.4%
Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago, its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of common stock, rs?
14% CAPM: rs = rRF + (RPM)b = 7% + (6%)1.2 = 14.2% Risk Premium: rs = Bond yield + Risk premium = 10% + 4% = 14% DCF: rs = D1/P0 + g = $2.50/$30 + g, where g can be estimated as follows using a financial calculator: Enter N = 7, PV = -0.75, PMT = 0, and FV = 2.50, and solve for I/YR = g = 18.77% = 18.8%. Therefore, rs = 0.083 + 0.188 = 27.1% Roland Corporation has apparently been experiencing supernormal growth during the past 7 years, and it is not reasonable to assume that this growth will continue. The first two methods yield rs of about 14%, which appears reasonable.
Projects L and S have the following expected cash flows: Year: Project L: Project S 0. : -$100. :-$100 1. : 10. :70 2. :60 :50 3. :80. :20 Both projects have a cost of capital of 10%. What is Project L's MIRR?
16.5% 10(1.10)^2+ 60(1.10)^1+80(1.10)^0= 12.10+66+80= 158.10 N=3 PV=-100 PMT=0 FV= 158.10 I=MIRR= 16.50%
Projects L and S have the following expected cash flows: Year: Project L: Project S 0. : -$100. :-$100 1. :10. :70 2. : 60 : 50 3. :80 : 20 Both projects have a cost of capital of 10%. What is Project S's MIRR?
16.9% 70(1.10)^2+50(1.10)^1+20(1.10)^0= 159.70 N=3, PV=-100, PMT=0, FV= 159.70, I=? (16.9)
Projects L and S have the following expected cash flows: Year: Project L: Project S 0. : -$100. : -100 1. : 10. : 70 2. :60 : 50 3. :80. : 20 Both projects have a cost of capital of 10%. What is Project L's internal rate of return (IRR)?
18.1% Input the cash flows into a calculator's cash flow register and solve for IRR = 18.1%.
Mansi Inc. is considering a project that has the following cash flow data. What is the project's payback? Year: Cash Flows 0. : -$750 1. : 300 2. : 320 3. : 350
2.36 years
What is the payback period for Machine B given the following? Year: Machine B: Machine O 0. : -5000. : -5000 1. : 2085. : 0 2. : 2085. : 0 3. : 2085. : 0 4. : 2085. : 9677
2.4 Years After Year 1, there is $5,000 - $2,085 = $2,915 remaining to pay back. After Year 2, only $2,915 - $2,085 = $830 is remaining. In Year 3, another $2,085 is collected. Assuming that the Year 3 cash flow occurs evenly over time, then payback occurs $830/$2,085 = 0.4 of the way through Year 3. Thus, the payback period is 2.4 years.
Maxwell Feed & Seed is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected. Year: Cash Flows 0. : -$9500 1. : $2000 2. : $2025 3. : $2050 4. : $2075 5. : $2100
2.57%
Your firm is considering a fast-food concession at the World's Fair. The cash flow pattern is somewhat unusual because you must build the stands, operate them for 2 years, and then tear the stands down and restore the site to its original condition. You estimate the cash flows to be as follows: Year: Cash Flows 0. : -800,000 1. : 700,000 2. : 700,000 3. : -400,000 What is the approximate IRR of this venture?
25% Calculator solution: Input CF0 = −800000, CF1-2 = 700000, CF3 = −400000. Output: IRR = 25.48%. Note that this project actually has multiple IRRs, with a second IRR at about 53%.
For privately owned firms, some analysts use a subjective, ad hoc procedure to estimate a firm's cost of common equity by adding a judgmental risk premium of _____ to the cost of debt.
3% to 5% Judgmental risk premium
Stern Associates is considering a project that has the following cash flow data. What is the project's payback? Year: Cash Flows 0. : -$1100 1. :300 2. : 310 3 : 320 4. : 330 5. : 340
3.52 Year: Cumulative CF 0. :-1100 (-1100+300) 1. :-800 (-800+310) 2. :-490 (-490+320) 3. :-170 (-170/330)=0.52+ 3 years
Zebra Corporation's retention rate has averaged 60% over the past 15 years and its ROE has averaged 14%. Zebra's payout ratio has averaged:
40% The retention ratio is a complement of the payout ratio. If the retention ratio is 60%, then the payout ratio must be 40% 1-.60=.040
Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. CGT's balance sheet data are as follows: Assets: current assets 38,000,000 Net plant, prop, equip 101,000,000 total assets= 139,000,000 Liabilities and Equity: Accounts payable 10,000,000 Accruals 9,000,000 Current liabilities= 19,000,000 Longterm debt 40,000,000 Total liabilities= 59,000,000 Common stock 30,000,000 Retained earning 50,000,000 Total sharholder equity= 80,000,000 Total liab and share equity= 139,000,000 The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Determine the best estimate of the after-tax cost of debt.
5.14% coupon rate=7.25% periods/yr= 2 Maturity(yr)= 20 bond price= 875 par val= 1000 tax rate= 40% Calculator: N= 2*20=40 Pv= -875 PMT= (7.25%*1000)/2= 36.25 FV=1000 I= ? 4.28% Before-tax cost of debt= rd= yield*2= 8.56% After-tax cost of debt= rd(1-T)= 5.14%
Jay Company's tax rate is 40%. The company issued a 20-year, $1,000, 9% bond at a premium, making its yield to maturity 8.6%. The after-tax cost of the debt is:
5.2% 0.086(1-0.40)= 5.2%
The projected dividend yield for the next year is 2.56%, the expected constant growth rate in dividends is 5.04%, and the 10-year T-bond yield is 2.00%. The estimated forward-looking market risk premium is:
5.60% 2.56%+5.04%-2%= 5.60%
Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate?
7.40% Cost of common equity: WACC= Wd(rd)(1-T)+ Wc(rs) 12.0%=0.45(.09)(1-0.4)+ 0.55(rs) 9.57%=0.55(rs) rs= 0.1740 or 17.40% Expected growth Rate: rs= D1/Po +g 0.1740=4/40+g g=0.0740 or 7.40%
Bosio Inc.'s perpetual preferred stock 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?
9.08% rp= Dp/(Pp(1-F)) 8.50/(97.5*(1-0.04)) =9.08%
Betas determined by running a regression of the division's accounting return on assets against the average return on assets for a large sample of companies are called:
Accounting Betas Betas determined using accounting data rather than stock market data are called accounting betas.
Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Accounts payable Long-term debt, retained earnings, common stock, and preferred stock are components of WACC; accounts payable is not. Recall that the impact of payables and accruals is already incorporated into the calculation of FCF.
International Advertising Services has two projects that are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. International's WACC is 12%, and at that rate, Project A has the higher NPV. Which of the following statements is correct?
Assuming the two projects have the same scale, Project B probably has a faster payback than Project A. Make a graph
Armbrister Pyrotechnics Inc. has imposed a limit of $50 million for capital expenditures, causing it to forgo a number of value-adding projects. This is an example of:
Capital rationing Sometimes firms set an upper limit on the size of their capital budgets, which is known as capital rationing.
Which of the following types of decisions would most likely be made at the board level?
Contraction Decisions Downsizing decisions are made at the board level.
If a project would lead to an increase in a firm's cost of capital (its WACC), it should NOT be accepted.
FALSE A firm should accept all positive NPV projects. Even with the higher cost of capital, the company should go ahead and raise external equity and accept the project.
Projects with non-normal cash flows sometimes have multiple MIRRs.
FALSE IRRs occur in projects with non-normal cash flows, but there is only one MIRR for each project.
Because the cost of equity for a private company cannot be measured by means of stock market activity, industry-wide averages of traded companies are used.
FALSE Most analysts begin by identifying one or more publicly traded firms that are in the same industry and that are approximately the same size as the privately owned firm. The analyst then estimates the betas for these publicly traded firms and uses their average beta as an estimate of the beta of the privately owned firm.
The NPV and MIRR methods lead to the same decision for mutually exclusive projects regardless of the projects' relative sizes.
FALSE NPV and MIRR criteria may not lead to the same decision when the projects differ in scale (project size or timing of cash flows)
If a firm has zero cost of capital and two mutually exclusive projects, the payback method and NPV method would always lead to the same decision on which project to undertake.
FALSE One project might have cash flows that extend well past the payback year, leading to different rankings.
Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project's IRR.
FALSE The IRR calculation is independent of the project's cost of capital
Mathematically, the NPV, IRR, MIRR, and PI methods will always lead to the same accept/reject decisions for mutually exclusive projects that differ in size or timing of cash flows.
FALSE These methods will always lead to the same accept/reject decisions for normal, independent projects, but can give conflicting rankings for mutually exclusive projects if the projects differ in size or in the timing of cash flows.
If the NPV ranking conflicts with the PI ranking, then the PI ranking should be used.
False If the PI ranking conflicts with the NPV, then the NPV ranking should be used.
Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC.
False The after-tax cost of debt is lower than the before-tax cost.
A firm should base the cost of debt on the coupon rate of the firm's existing debt
False The cost of debt must be based on the interest rate the firm would pay if it issued new debt today.
The time period in which a project is maximizing NPV and thus shareholder wealth is called the project's:
Golden Life A project's economic life is the period in which it maximizes the NPV and thus shareholder wealth.
Which of the following statements is correct?
If a project has an NPV greater than zero, then taking on the project will increase the value of the firm's stock. The IRR must be greater than the cost of capital; conflicts arise if the cost of capital is less than the crossover rate; and for independent normal projects, NPV and IRR methods will lead to the same accept/reject decisions.
Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is accurate?
If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. For a project with normal cash flows and a positive NPV, WACC is lower than IRR because the higher rate will reduce the present value to zero.
Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10%, and New York Accessories has a WACC of 12%, because the riskiness of their assets and cash flows is somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, 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 accurate?
If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would reduce its need to issue new common stock?
Increase the percentage of debt in the target capital structure. 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.
Which of the following statements regarding mutually exclusive projects with unequal lives is NOT accurate?
It is appropriate to extend the analysis to a common life even if the probability that a project will actually be repeated at the end of its initial life is low. Accurate: When choosing between two mutually exclusive alternatives with significantly different lives, an adjustment is necessary. Serious weaknesses in the replacement chain (common life) approach include that it does not account for inflation and new technology that could affect future replacements and change the cash flows. To apply the equivalent annual annuity (EAA) method, find the constant payment streams that the projects' NPVs would provide over their respective lives. The key to the replacement chain (common life) approach for projects that will have to be repeated in the future is to analyze both projects over an equal life.
The required rate of return on new debt is also known as the:
Marginal Rate
Which of the following factors related to the cost of capital is beyond a firm's control?
Market Risk Premium Investors' aversion to risk determines the market risk premium
Which of the following statements regarding IRR and WACC is accurate?
Multiple IRRs can only occur if the direction of the cash flows changes more than once. More than one negative cash flow will cause a project to have multiple IRRs.
Which of the following measures established for screening projects is considered the best single measure?
Net present value (NPV) The NPV is the best single measure, primarily because it directly relates to the firm's central goal of maximizing intrinsic value.
Which of the following project evaluation measures determines how much value a project creates for each dollar of the project's cost?
PI The profitability index (PI) measures how much value a project creates for each dollar of the project's cost.
Which of the following is NOT a project evaluation measure?
Profitability payback Profitability payback is not a project evaluation measure. The six project evaluation measures are (1) net present value, (2) internal rate of return (IRR), (3) modified internal rate of return (MIRR), (4) profitability index, (5) regular payback, and (6) discounted payback.
The expected cash flows for Machines B and O are as follows: Year: Machine B: Machine O 0. : -$5000. :-$5000 1. : 2085. : 0 2. : 2085 : 0 3. : 2085. : 0 4. : 2085. : 9677 The cost of capital for both projects is 14%. Which project would you choose?
Project B; it has the higher positive NPV. Project B: CF0 = −5000; CF1-4 = 2085; I/YR = 14; solve for NPVB = $1,075.09. Project O: CF0 = −5000; CF1-3 = 0; CF4 = 9677; I/YR = 14; solve for NPVO = $729.56.
Which of the following types of decisions might be made in order to comply with the terms of an insurance policy?
Safety and/or environmental projects Expenditures necessary to comply with environmental orders, labor agreements, or insurance policy terms fall into the category of safety and/or environmental projects.
In general, small businesses use DCF capital budgeting techniques less often than large businesses do. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms.
TRUE
The IRR method can be used in place of the NPV method for all independent projects.
TRUE Both the NPV and IRR methods lead to the same accept/reject decisions for independent projects. Thus, the IRR method can be used as a proxy for the NPV method when choosing independent projects.
Among the conditions that may cause a project to have more than one IRR, one might be the situation in which a negative cash flow (or cost) occurs at the end of the project's life in addition to the initial investment at time = 0.
TRUE More than one negative cash flow will cause a project to have multiple IRRs.
The NPV method is preferred over the IRR method because the NPV method's reinvestment rate assumption is better.
TRUE Project cash flows are substitutes for outside capital. Thus, the opportunity cost of these cash flows is the firm's cost of capital, adjusted for risk. The NPV method uses this cost as the reinvestment rate, while the IRR method assumes reinvestment at the IRR.
Assume that a project has one initial cash outflow followed by a series of positive cash inflows. To use the modified internal rate of return (MIRR) method, you would compound the cash inflows out to the end of the project's life, sum those compounded cash flows to form a terminal value (TV), and then find the discount rate that causes the PV of the TV to equal the project's cost.
TRUE The MIRR method looks at terminal value to solve some of the problems involved in using the IRR method.
An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant.
TRUE The after-tax cost of debt is lower than the before-tax cost.
Because they are based on investors' required returns, the component costs of capital are market-determined variables.
TRUE The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.
To find the cost of perpetual preferred stock, divide the preferred stock's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.
TRUE The cost of preferred stock is found as the preferred stock's annual dividend divided by the market price of the preferred stock.
Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.
TRUE The cost of retained earnings is the opportunity cost of investing the money instead of paying it out to shareholders.
The WACC is used to find the present value of future cash flows, so it would be inconsistent to use weights based on past history of the company.
TRUE The weights should be based on the target capital structure rather than past capital structure.
Which of the following statements regarding IRR and NPV is accurate?
The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. One of the differences between IRR and NPV is the reinvestment rate, which is assumed to be WACC for NPV and IRR for the IRR.
Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. 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. What is likely to happen over time if the CEO's position is accepted?
The company will take on too many high-risk projects and reject too many low-risk projects. 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.
Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is accurate?
The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.
If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is accurate?
The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. When discounting anything, a higher rate leads to a lower price. This means that a higher WACC leads to a lower NPV.
The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, 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 the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is accurate?
The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. 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.
Superior Transportation Company has a barge division. Superior found five companies devoted exclusively to operating barges and used the average beta of those firms as an estimate of its barge division's beta. Superior used which method for measuring divisional betas?
The pure play method In the pure play method, the company tries to find the betas of several publicly held specialized companies in the same line of business as the division being evaluated, and it then averages those betas to determine the cost of capital for its own division
A project is described as having normal cash flows, meaning one outflow followed by a series of inflows. Which of the following statements regarding normal cash flows is accurate?
To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. The internal rate of return, or IRR, is the discount rate that makes the NPV equal to zero.
In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. Managers' tastes, choice of accounting method, or the profitability of other independent projects should not be considered.
True A firm should accept all positive NPV projects, regardless of other considerations.
Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward.
True The cost of the preferred stock is equal to the preferred dividend divided by the current price, adjusted for flotation costs.
In the equation for finding the weighted average cost of capital, which of the following variables does NOT represent a target capital structure weight?
Wps wd, wstd, wps, and ws equal the weights of long-term debt, short-term debt, preferred stock, and common stock. These target capital structure weights are the percentages of the different sources of capital the firm plans to use on a regular basis, with the percentages based on the market values of those sources..
The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)
Yes; the expected return is 2.5 percentage points higher than the cost of capital. Cost of equity = rs = $2/$40 + 0.06 = 0.11 = 11% Cost of debt = rd = Yield to maturity on outsting bonds based on current market price Using a financial calculator: Input N = 25, PV = -804, PMT = 70, FV = 1000, solve for I/YR = rd = 9% Wd= debt/(debt+equity)= 4/(4+5)= 4/9 Wc= equity/ assets= 5/9 WACC= rd(1-T)(Wd)+ rs(Wc) = 0.09(1-0.4)(4/9)+0.11(5/9) =8.5%
Assume that All-American Sporting Goods 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. The firm will most likely:
become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. 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.
The second step in project analysis is to:
calculate the evaluation measures The second step in project analysis is to calculate the evaluation measures.
The commissions, legal expenses, fees, and other costs that a company incurs when it issues new securities are known as _____ costs:
discount Flotation costs are the commissions, legal expenses, fees, and any other costs that a company incurs when it issues new securities.
Which of the following factors related to the cost of capital is within a firm's control?
dividend policy A firm can affect its cost of capital through its dividend policy.
The first step in project analysis is to:
estimate the project's expected cash flows. The first step in project analysis is to estimate the project's expected cash flows.
A project is acceptable if its PI is:
greater than 1.0; the higher the better. A project is acceptable if its PI is greater than 1.0. Projects with higher PIs should be ranked above projects with lower PIs.
Short-term debt should be included in the capital structure
if the company plans to continually renew it. Short-term debt should be included in the capital structure only if it is a permanent source of financing in the sense that the company plans to continually repay and refinance the short-term debt.
An increase in the required market risk premium means:
investors have become more risk averse, requiring a higher return on stocks, causing stock prices to go down. An increase in the required premium means that investors have become more risk averse and require a higher return on stocks, but applying a higher discount rate to a stock's future cash flows causes a decline in stock price.
Because a privately held firm is _____ than that of a publicly held firm, investors require a liquidity _____ the firm's cost of equity
less liquid; premium be added to Privately held firms are less liquid, and therefore a liquidity premium is added to the firm's cost of equity.
Most companies use only two major sources of capital, which are:
long-term debt and common stock. Some companies use short-term debt and preferred stock as sources of funding, but most companies use only two major sources of capital: long-term debt and common stock.
The extra return that investors require to induce them to invest in risky equities over and above the return on a Treasury bond is called the:
market risk premium, equity risk premium, or equity premium This extra return is called the market risk premium, the equity risk premium, or just the equity premium.
Accounts payable and accruals arise from _____ decisions.
operating Accounts payable and accruals arise from operating decisions rather than financing decisions, and are therefore excluded from capital structure weights.
To overcome estimation bias, some firms:
require managers to use an unrealistically high cost of capital, limit the size of the capital budget, and/or use post-audit programs that link accuracy to compensation.
Which of the following show how growth is related to reinvestment?
retention growth equation The retention growth equation shows how growth is related to reinvestment.
Which of the following is a complement of the payout ratio?
retention growth equation The retention ratio is a complement of the payout ratio, representing how much of each dollar of earnings the company retains in the business after paying dividends.
The correct rate for estimating the present value of a company's (or project's) free cash flows is the:
weighted average of the required rates of return on the various sources of capital. The correct rate for estimating the present value of a company's (or project's) free cash flows is the weighted average of the required rates of return on the various sources of capital or the weighted average cost of capital (WACC).
