FIN3403

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT? A. If the WACC is 10%, both projects will have positive NPVs. B. If the WACC is 6%, Project S will have the higher NPV. C. If the WACC is 13%, Project S will have the lower NPV. D. If the WACC is 10%, both projects will have a negative NPV. E. Project S's NPV is more sensitive to changes in WACC than Project L's.

A. If the WACC is 10%, both projects will have positive NPVs.

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

Which of the following statements is CORRECT? A. The component cost of preferred stock is expressed as rp(1-T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes B. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested C. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past, hence they are "free" D. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm's before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm's currently outstanding debt, provided that debt was issued during the past 5 years. E. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC

B. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were paid out rather than retained and reinvested

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? A. A project's IRR increases as the WACC declines B. A project's NPV increases as the WACC declines C. A project's MIRR is unaffected by changes in the WACC D. A project's regular payback increases as the WACC declines E. A project's discounted payback increases as the WACC declines

B. A project's NPV increases as the WACC declines

Rowell Company spent $3 million two years ago to build a plant for a new project. It then decided not to go forward with the project, so the building is available for sale or for a new project. Rowell owns the building free and clear - there is no mortgage on it. Which of the following statements is CORRECT? A. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected int he cash flows of the capital budgeting analysis for any new project. B. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it C. This is an example of an externality, because the very existence f the building affects the cash flows for any new project that Rowell might consider D. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects E. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project and used that building

B. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it

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. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion B. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money C. If a project's payback is positive, then the project should be rejected because it must have a negative NPV D. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem E. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

B. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money

Project's X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is CORRECT? A. The crossover rate must be less than 10% B. The crossover rate must be greater than 10% C. If the WACC is 8%, Project X will have the higher NPV D. If the WACC is 18%, Project Y will have the higher NPV E. Project X is larger in the sense that it has the higher initial cost

B. The crossover rate must be greater than 10%

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? A. All sunk costs that have been incurred relating to the project B. All interest expenses on debt used to help finance the project C. The additional investment in net operating working capital (NOWC) required to operate the project, even if that investment will be recovered at the end of the project's life D. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year E. Effects of the projects on other divisions of the firm, but only if those effects lower the project's own direct cash flows

C. The additional investment in net operating working capital (NOWC) required to operate the project, even if that investment will be recovered at the end of the project's life

Duval Inc. uses only equity capital, and it has two-equally sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? A. a Division B project with a 13% return B. a Division B project with a 12% return C. a Division A project with a 11% return D. a Division A project with a 9% return E. a Division B project with a 11% return

C. a Division A project with a 11% return

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? A. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes. B. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products C. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery D. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. E. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.

D. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

Which of the following statements is CORRECT? A. A change in a company's target capital structure cannot affect its WACC B. WACC calculations should be based on the before-tax costs of all the individual capital components C. Floatation costs associated with issuing new common stock normally reduce the WACC D. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline E. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing

D. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline

A company is choosing between two projects. The larger project has an initial cost of $100,000, annual cash flows of $30,000 for 5 years, and an IRR of 15.24%. The smaller project has an initial cost of $51,600, annual cash flows of $16,000 for 5 years, and an IRR of 16.65%. The projects are equally risky. Which of the following statements is CORRECT? A. Since the smaller project has the higher IRR, the two projects' NPV profiles cannot cross, and the smaller project's NPV will be higher at all positive values of WACC. B. Since the smaller project has the higher IRR, the two projects' NPV profiles will cross, and the larger project will look better based on the NPV at all positive values of WACC. C. If the company uses the NPV method, it will tend to favor smaller, shorter-term projects over larger, longer-term projects, regardless of how high or low the WACC is. D. Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate. E. Since the smaller project has the higher IRR and the larger NPV at a zero discount rate, the two projects' NPV profiles will cross, and the smaller project will look better if the WACC is less than the crossover rate.

D. Since the smaller project has the higher IRR but the larger project has the higher NPV at a zero discount rate, the two projects' NPV profiles will cross, and the larger project will have the higher NPV if the WACC is less than the crossover rate.

Which of the following statements is CORRECT?** A. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR B. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate C. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period D. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR

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

Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? A. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. B. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. C. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. D. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project. E. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.

D. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project.

Which of the following is CORRECT? A. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity B. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm's outstanding debt C. Suppose some of the publicity-traded firm's stockholders are not diversified; they hold only the one firm's stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm's intrinsic value. D. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity E. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm's cost of equity capital

D. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity

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 is CORRECT? Assume that all 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 the 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 E. To find a project's IRR, we must find a discount rate that is equal to the WACC

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, 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 NPV's 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

Which of the following statements is CORRECT? A. If a firm is found guilty of cannibalization ni a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. B. If a firm if found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. C. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward D. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized E. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes id done to the firm itself.

E. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes id done to the firm itself.

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? A. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). B. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). C. The firm will accept too many projects in all economic states because a 4-year payback is too low. D. The firm will accept too few projects in all economic states because a 4-year payback is too high. E. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

E. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

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? A. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. B. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. C. Well-diversified stockholders do not need to consider market risk when determining required rates of return D. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta E. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

E. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

T/F: Normal Projects S and L have the same NPV when the discount rate is zero. However, Project S's cash flows come in faster than those of L. Therefore, we know that at any discount rate greater than zero, L will have the higher NPV

False

T/F: Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions for capital budgeting projects

False

T/F: 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

T/F: We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.

False

T/F: since the focus of capital budgeting is on cash flows rather than on net income, changes in non-cash balance sheet accounts such as inventory are not included in a capital budgeting analysis

False

T/F: "Capital" is sometimes defined as funds supplied to a firm by investors

True

T/F: Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows

True

T/F: 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 mangers' tastes, choice of accounting method, or the profitability of other independent projects.

True

T/F: Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.

True

T/F: 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 assests

True

T/F: 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

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR = 9%. b. Project B, which has below-average risk and an IRR = 8.5%. c. Project C, which has above-average risk and an IRR = 11%. d. Without information about the projects' NPVs we cannot determine which one or ones should be accepted. e. All of these projects should be accepted.

b. Project B, which has below-average risk and an IRR = 8.5%.