FIN301 Final chp 10,11,13,14

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

The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

False

The cost of external equity capital raised by issuing new common stock (re) is defined as follows, in words: "The cost of external equity equals the cost of equity capital from retaining earnings (rs), divided by one minus the percentage flotation cost required to sell the new stock, (1 - F)."

False

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.

False

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.

False

The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.

False

The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.

False

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not.

False

When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.

False

Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life.

True

When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use longterm or short-term rates for rRF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.

True

When estimating the cost of equity by use of the bond-yield-plus-risk-premium method, we can generally get a good idea of the interest rate on new long-term debt, but we cannot be sure that the risk premium we add is appropriate. This problem leaves us unsure of the true value of rs.

True

Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost. WACC: 6.25% 0 1 2 3 4 CFS -$1,050 $675 $650 CFL -$1,050 $360 $360 $360 $360 a. $29.26 b. $35.69 c. $34.82 d. $26.33 e. $31.31

a. $29.26

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: 10.00% New WACC: 9.50% Year 0 1 2 3 Cash flows -$1,000 $410 $410 $410 a. 0$9.04 b. 0$11.12 c. 0$10.22 d. 0$10.85 e. 0$10.13

a. 0$9.04

Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 9.00% Year 0 1 2 3 Cash flows -$1,000 $450 $450 $450 a. 13.84% b. 14.53% c. 17.29% d. 13.28% e. 13.70%

a. 13.84%

Susmel Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$475 $150 $200 $300 a. 2.42 years b. 1.96 years c. 2.88 years d. 2.47 years e. 2.85 years

a. 2.42 years

The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital.

False

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

Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.

False

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR.

False

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm.

False

Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.

False

If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y, we can conclude that the firm should always select X rather than Y if X has NPV > 0.

False

In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.

False

Indicate whether the statement is true or false. A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.

False

Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rp s(1 - T)(0.70)(0.50).

False

Suppose the debt ratio is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

False

Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.

False

The IRR method is based on the assumption that projects' cash flows are reinvested at the project's riskadjusted cost of capital.

False

The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.

False

A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross.

True

A firm's capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.

True

Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.

True

Financial risk refers to the extra risk borne by stockholders as a result of a firm's use of debt as compared with their risk if the firm had used no debt.

True

Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.

True

For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost.

True

For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.

True

If a firm borrows money, it is using financial leverage.

True

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.

True

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient.

True

Small businesses make less use of DCF capital budgeting techniques than large businesses. 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 NPV method is based on the assumption that projects' cash flows are reinvested at the project's riskadjusted cost of capital.

True

The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

True

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor supplied funds a firm uses to acquire assets.

True

The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

True

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.

True

The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.

True

The reason why retained 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 pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

True

A company's perpetual preferred stock currently sells for $102.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 8.22% b. 9.28% c. 6.90% d. 9.53% e. 7.97%

a. 8.22%

Daves Inc. recently hired you as a consultant to estimate the company's WACC. You have obtained the following information. (1) The firm's noncallable bonds mature in 20 years, have an 8.00% annual coupon, a par value of $1,000, and a market price of $1,225.00. (2) The company's tax rate is 40%. (3) The risk-free rate is 4.50%, the market risk premium is 5.50%, and the stock's beta is 1.20. (4) The target capital structure consists of 35% debt and the balance is common equity. The firm uses the CAPM to estimate the cost of equity, and it does not expect to issue any new common stock. What is its WACC? Do not round your intermediate calculations. a. 8.48% b. 10.01% c. 7.80% d. 6.79% e. 7.63%

a. 8.48%

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.00%. The firm will not be issuing any new stock. What is its WACC? a. 8.93% b. 7.59% c. 6.96% d. 7.68% e. 6.69%

a. 8.93%

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. d. Safeco/Risco's WACC, as a result of the merger, would be 10%. e. After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.

a. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted. e. All of the projects should be accepted.

a. Project B, which is of below-average risk and has a return of 8.5%.

Jazz World Inc. 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: 9.75% Year 0 1 2 3 4 Cash flows -$1,200 $400 $425 $450 $475 a. 0$222.13 b. 0$185.11 c. 0$157.34 d. 0$174.00 e. 0$198.07

b. 0$185.11

Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many high-risk projects and reject too many low-risk projects. b. The company will take on too many low-risk projects and reject too many high-risk projects. c. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. d. The company's overall WACC should decrease over time because its stock price should be increasing. e. The CEO's recommendation would maximize the firm's intrinsic value.

a. The company will take on too many high-risk projects and reject too many low-risk projects.

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company's beta increases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase.

a. The market risk premium declines.

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: 6.75% 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 a. $214.44 b. $186.47 c. $218.17 d. $182.74 e. $220.03

b. $186.47

Yonan Inc. 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 shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. WACC: 10.25% 0 1 2 3 4 CFS -$950 $500 $800 $0 $0 CFL -$2,100 $400 $800 $800 $1,000 a. $39.40 b. $33.11 c. $41.39 d. $28.47 e. $37.74

b. $33.11

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: 6.75% 0 1 2 3 4 CFS -$1,025 $650 $450 $250 $50 CFL -$1,025 $100 $300 $500 $700 a. $62.75 b. $59.20 c. $53.28 d. $51.51 e. $65.71

b. $59.20

Cornell Enterprises 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: 10.00% Year 0 1 2 3 Cash flows -$1,275 $450 $460 $470 a. -$106.10 b. -$132.63 c. -$139.26 d. -$125.99 e. -$165.78

b. -$132.63

Eakins Inc.'s common stock currently sells for $15.00 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? Do not round your intermediate calculations. a. 0.78% b. 1.12% c. 0.67% d. 1.45% e. 0.89%

b. 1.12%

Several years ago the Jakob Company sold a $1,000 par value, noncallable bond that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $875, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? Do not round your intermediate calculations. a. 4.58% b. 4.97% c. 3.78% d. 4.92% e. 5.87%

b. 4.97%

Sorensen Systems Inc. is expected to pay a $2.50 dividend at year end (D1 = $2.50), the dividend is expected to grow at a constant rate of 5.50% a year, and the common stock currently sells for $37.50 a share. The beforetax cost of debt is 7.50%, and the tax rate is 40%. The target capital structure consists of 45% debt and 55% common equity. What is the company's WACC if all the equity used is from retained earnings? Do not round your intermediate calculations. a. 9.41% b. 8.72% c. 7.58% d. 9.94% e. 8.80%

b. 8.72%

Indicate the answer choice that best completes the statement or answers the question. Bankston Corporation 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. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the percentage of debt in the target capital structure. c. Increase the proposed capital budget. d. Reduce the amount of short-term bank debt in order to increase the current ratio. e. Reduce the percentage of debt in the target capital structure.

b. Increase the percentage of debt in the target capital structure.

Stern Associates is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 4 5 Cash flows -$975 $300 $310 $320 $330 $340 a. 2.54 years b. 2.42 years c. 3.83 years d. 3.14 years e. 3.61 years

d. 3.14 years Masulis Inc. is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 10.00% Year 0 1 2 3 4 Cash flows -$925 $525 $485 $445 $405 a. 2.40 years b. 2.14 years c. 2.25 years d. 1.95 years e. 1.86 years b. 2.14 years

Which of the following statements is CORRECT? a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not. b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.

Which of the following statements is CORRECT? a. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period. c. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC? a. Project S. b. Project L. c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. e. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs.

b. Project L. Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? a. Project D probably has a higher IRR. b. Project D is probably larger in scale than Project C. c. Project C probably has a faster payback. d. Project C probably has a higher IRR. e. The crossover rate between the two projects is below 12%. a. Project D probably has a higher IRR.

Noe Drilling Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone, i.e., what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost. WACC: 9.00% 0 1 2 3 4 CFS -$1,100 $550 $600 $100 $100 CFL -$2,750 $725 $725 $800 $1,400 a. $73.38 b. $79.56 c. $0.00 d. $96.55 e. $78.01

c. $0.00

Sapp Trucking's balance sheet shows a total of noncallable $45 million long-term debt with a coupon rate of 7.00% and a yield to maturity of 6.00%. This debt currently has a market value of $50 million. The balance sheet also shows that the company has 10 million shares of common stock, and the book value of the common equity (common stock plus retained earnings) is $65 million. The current stock price is $22.50 per share; stockholders' required return, rs, is 14.00%; and the firm's tax rate is 40%. The CFO thinks the WACC should be based on market value weights, but the president thinks book weights are more appropriate. What is the difference between these two WACCs? a. 2.48% b. 2.25% c. 2.36% d. 2.95% e. 1.77%

c. 2.36%

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $57.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? Do not round your intermediate calculations. a. 11.02% b. 10.17% c. 9.50% d. 10.07% e. 7.98%

c. 9.50%

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $115.00; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? a. 9.98% b. 10.49% c. 8.52% d. 8.60% e. 7.05%

d. 8.60%

Which of the following statements is CORRECT? a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects. b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. e. The percentage difference between the MIRR and the IRR is equal to the project's WACC.

c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.

Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method? a. Lacks an objective, market-determined benchmark for making decisions. b. Ignores cash flows beyond the payback period. c. Does not directly account for the time value of money. d. Does not provide any indication regarding a project's liquidity or risk. e. Does not take account of differences in size among projects.

d. Does not provide any indication regarding a project's liquidity or risk.

Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can occur only if the signs of the cash flows change more than once. e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

d. Multiple IRRs can occur only if the signs of the cash flows change more than once.

Which of the following statements is CORRECT? a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs —beta, the risk-free rate, and the market risk premium—can be estimated with little error. b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.

Which of the following statements is CORRECT? a. The "break point" as discussed in the text refers to the point where the firm's tax rate increases. b. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money. c. The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. d. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock. e. The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock.

d. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.

For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT? a. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. b. The WACC is calculated on a before-tax basis. c. The WACC exceeds the cost of equity. d. The cost of equity is always equal to or greater than the cost of debt. e. The cost of retained earnings typically exceeds the cost of new common stock.

d. The cost of equity is always equal to or greater than the cost of debt.

Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Which of the following statements is CORRECT? a. The regular payback method recognizes all cash flows over a project's life. b. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money. c. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. d. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. e. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

d. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

Which of the following statements is CORRECT? a. The bond-yield-plus-risk-premium approach to estimating the cost of common equity involves adding a risk premium to the interest rate on the company's own long-term bonds. The size of the risk premium for bonds with different ratings is published daily in The Wall Street Journal or is available online. b. The WACC is calculated using a before-tax cost for debt that is equal to the interest rate that must be paid on new debt, along with the after-tax costs for common stock and for preferred stock if it is used. c. An increase in the risk-free rate is likely to reduce the marginal costs of both debt and equity. d. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure. e. Beta measures market risk, which is generally the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. However, this is not true unless all of the firm's stockholders are well diversified.

d. The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.

Which of the following statements is CORRECT? a. The WACC as used in capital budgeting is an estimate of a company's before-tax cost of capital. b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt. c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets. d. There is an "opportunity cost" associated with using retained earnings, hence they are not "free." e. The WACC as used in capital budgeting would be simply the before-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.

d. There is an "opportunity cost" associated with using retained earnings, hence they are not "free."

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. b. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. c. If a project's IRR is greater than the WACC, then its NPV must be negative. d. 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.

d. 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.

Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC 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 reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L, because at the new WACC it will have the higher NPV. d. You should recommend Project S, because at the new WACC it will have the higher NPV. e. You should recommend Project L because it will have the higher IRR at the new WACC.

d. You should recommend Project S, because at the new WACC it will have the higher NPV.

Vang Enterprises, which is debt-free and finances only with equity from retained earnings, is considering 7 equal-sized capital budgeting projects. Its CFO hired you to assist in deciding whether none, some, or all of the projects should be accepted. You have the following information: rRF = 4.50%; RPM = 5.50%; and b = 0.98. The company adds or subtracts a specified percentage to the corporate WACC when it evaluates projects that have above- or below-average risk. Data on the 7 projects are shown below. If these are the only projects under consideration, how large should the capital budget be? Expected Project Risk Risk factor return Cost (millions) 1 Very low -2.00% 7.60% $25.0 2 Low -1.00% 9.15% $25.0 3 Average 0.00% 10.10% $25.0 4 High 1.00% 10.40% $25.0 5 Very high 2.00% 10.80% $25.0 6 Very high 2.00% 10.90% $25.0 7 Very high 2.00% 13.00% $25.0 a. $100 b. $125 c. $25 d. $50 e. $75

e. $75

Keys Printing plans to issue a $1,000 par value, 20-year noncallable bond with a 7.00% annual coupon, paid semiannually. The company's marginal tax rate is 40.00%, but Congress is considering a change in the corporate tax rate to 45.00%. By how much would the component cost of debt used to calculate the WACC change if the new tax rate was adopted? a. -0.36% b. -0.42% c. -0.44% d. -0.30% e. -0.35%

e. -0.35%

Malholtra Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 10.00% Year 0 1 2 3 4 Cash flows -$975 $300 $320 $340 $360 a. 14.45% b. 12.92% c. 12.57% d. 11.28% e. 11.75%

e. 11.75%

Teall Development Company hired you as a consultant to help them estimate its cost of capital. You have been provided with the following data: D1 = $1.45; P0 = $19.00; and g = 6.50% (constant). Based on the DCF approach, what is the cost of equity from retained earnings? a. 10.88% b. 15.26% c. 14.41% d. 13.00% e. 14.13%

e. 14.13%

Datta Computer Systems 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 0 1 2 3 Cash flows -$1,050 $450 $470 $490 a. 12.69% b. 13.98% c. 15.58% d. 18.15% e. 16.07%

e. 16.07%

Simkins Renovations Inc. 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 0 1 2 3 4 Cash flows -$625 $300 $290 $280 $270 a. 29.04% b. 32.63% c. 24.55% d. 30.83% e. 29.94%

e. 29.94%

Assume that you are on the financial staff of Vanderheiden Inc., and you have collected the following data: The yield on the company's outstanding bonds is 7.75%, its tax rate is 40%, the next expected dividend is $0.65 a share, the dividend is expected to grow at a constant rate of 6.00% a year, the price of the stock is $17.00 per share, the flotation cost for selling new shares is F = 10%, and the target capital structure is 45% debt and 55% common equity. What is the firm's WACC, assuming it must issue new stock to finance its capital budget? a. 9.51% b. 6.65% c. 6.18% d. 5.80% e. 7.73%

e. 7.73%

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 0.70. Based on the CAPM approach, what is the cost of equity from retained earnings? a. 9.25% b. 7.00% c. 8.47% d. 7.08% e. 7.78%

e. 7.78%

Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation. b. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. c. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

e. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.

e. To find a project's IRR, we must find a discount rate that is equal to the WACC. Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its IRR must be positive. b. If a project has "normal" cash flows, then its MIRR must be positive. c. If a project has "normal" cash flows, then it will have exactly two real IRRs. d. The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life. e. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR.

e. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR.

Indicate the answer choice that best completes the statement or answers the question. Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of cash flows over a project's full life. b. One defect of the IRR method is that it does not take account of the time value of money. c. One defect of the IRR method is that it does not take account of the cost of capital. d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth. a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets. b. If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows. c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time. d. Projects with above-average risk typically have higher-than-average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas. e. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

e. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. M should have the lower WACC because it is like most other companies, and investors like that fact. b. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. d. Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged.

e. Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

Which of the following statements is CORRECT? a. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability. b. If the cost of capital declines, this lowers a project's NPV. c. The NPV method is regarded by most academics as being the best indicator of a project's profitability, hence most academics recommend that firms use only this one method and disregard other methods. d. A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project's life. e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

When working with the CAPM, which of the following factors can be determined with the most precision? a. The market risk premium (RPM). b. The beta coefficient, bi, of a relatively safe stock. c. The most appropriate risk-free rate, rRF. d. The expected rate of return on the market, rM. e. The beta coefficient of "the market," which is the same as the beta of an average stock.

e. The beta coefficient of "the market," which is the same as the beta of an average stock.