Finance 331 Test 3 Conceptual Practice
Chapter 10
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Chapter 11
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Chapter 12
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The most critical step in capital budgeting analysis is ___________ estimation. The key is to focus on ______________.
Cash flow; incremental cash flows
An opportunity cost is an amount that a firm would receive if it does not make a given investment. An example would be the purchase price from a building that a firm owns and could sell if it does not make an investment that would call for the use of the building. Opportunity costs should not be reflected in a capital budgeting analysis. True or false?
False
Suppose a project has a negative cash flow (a cost), then a series of positive cash inflows, and then another cost at the end of its life. In this situation it would be impossible for the project to have more than one IRR. True or false?
False
The optimal capital structure is the one where the percentages of debt, preferred stock, and common equity minimize the firm's value. True or false?
False
The cash flows for Project X are -550, +900, +1100, -11675. One IRR for Project X is 81.30%. What's the other IRR? a. 18.10% b. 15.66% c. 21.08% d. 23.33% e. 12.00%
c. 21.08%
A firm's optimal capital budget consists of all potential independent projects that have positive NPVs when evaluated at the projects' own risk-adjusted costs of capital, plus those mutually exclusive projects with the highest positive NPVs. True or false?
True
A project's incremental cash flow is the difference between the firm's cash flow if it accepts the project versus if it rejects the project. Thus, if a project has an initial cost of $1 million in Year 1 and no other costs or revenues, then the incremental cash flow in that year will be -$1 million. True or false?
True
A project's payback gives us an idea of the project's liquidity because it indicates how long funds will be tied up in the project. True or false?
True
A sunk cost is a cost that has been incurred and cannot be recovered regardless of whether a project is accepted or rejected. Sunk costs should not be reflected in a capital budgeting analysis. True or false?
True
An NPV profile is a graph that shows a project's NPV on the vertical axis, the cost of capital on the horizontal axis, and a line that shows the project's NPV at each cost of capital. The point on the horizontal axis where the NPV crosses the axis—i.e., where the NPV is zero—is the IRR. True or false?
True
An opportunity to expand if a project is successful is an example of a real option. This particular type of option is called an expansion option. True or false?
True
Assume that Project X's cost of capital is 12% and analyze the following statement: "Even though Project 2's IRRs are both greater than the cost of capital, the project should still be rejected because its NPV is negative at the project's cost of capital, and consequently, the firm's value will be reduced if it is accepted." True or false?
True
Barlett Co. has two divisions. Its risky division, Division R, has a WACC = 12%, while its safer division, Division S, has a WACC = 8%. Since the two divisions are the same size, the company's composite WACC is 10%. A Division S project has a 9% expected return. Since this project's return exceeds the division's WACC, the company should accept the project even though its return is less than the company's composite WACC. True or false?
True
Capital budgeting divides the project's cash flows into three components: Initial investment outlays, operating cash flows the company receives over the life of the project, and terminal cash flows that are realized when the project is completed. True or false?
True
Conflicts such as those between mutually exclusive projects can never occur between independent projects. One project might have the higher IRR and the other the higher NPV, but this does not lead to problems in deciding whether to invest in either, neither, or both of the projects. True or false?
True
If 2 projects are independent, then according to the IRR decision criterion both should be accepted because both have an IRR that exceeds the cost of capital. True or false?
True
If 2 projects are mutually exclusive, then according to the IRR decision criterion the project with the largest IRR (so long as it's larger than WACC) should be accepted because both have an IRR that exceeds the cost of capital. True or false?
True
If a firm accepts less than all of its prospective projects with positive NPVs when evaluated at their own risk-adjusted costs of capital and those mutually exclusive projects with the highest positive NPVs, then it is said to be employing capital rationing. True or false?
True
If a project is negatively correlated with the firm's other projects, it might stabilize the firm's total earnings and thus be relatively safe. True or false?
True
roject L has the following cash flows, and its cost of capital is 10%. What is L's MIRR? Y0: -1,500; Y1: 200; Y2: 2,000 a. 24.29% b. 22.53% c. 21.66% d. 23.17% e. 25.40%
c. 21.66%
In some instances, replacements add capacity as well as lower operating costs. When this is the case, sales revenues would be increased; and if that led to an increase in net operating working capital, that number would be shown as a Time 0 expenditure along with its recovery at the end of the project's life. These changes would, of course, be reflected in the differential cash flows for the analysis. True or false?
True
Including real options in a capital budgeting analysis can raise, but not lower, a project's expected NPV as found in a traditional analysis. This is true because, by definition, an option can be exercised or not, and if the option has a negative value, it will be rejected. True or false?
True
Is this statement true or false? "The primary difference between the MIRR and the regular IRR is that MIRR assumes that cash inflows are reinvested at the WACC, whereas the regular IRR assumes reinvestment at the IRR. Since reinvestment is generally at a rate close to the WACC, the MIRR is generally closer to the "true" rate of return a project will provide."
True
Monte Carlo simulation is similar to scenario analysis, except in a simulation the computer chooses the values used for the input variables based on probability distributions for the variables. Simulation analysis provides an expected NPV along with information about the range of possibilities, including the standard deviation of the NPV. True or false?
True
Of the three types of risk, market risk is theoretically the most relevant, but it is quite difficult to measure a new project's market risk. Stand-alone risk is easier to estimate, and it is usually positively correlated with market risk. Therefore, the focus of risk analysis for most projects is on stand-alone risk. True or false?
True
One important difference between capital budgeting and security analysis is that in security analysis the analyst must generally take the projected cash flows as given rather than something the analyst can influence, whereas firms can often influence the cash flows from projects by making operating changes. True or false?
True
Post-audits point out errors in forecasts, and they identify why the errors occurred. This information should help firms obtain better forecasts in the future and improve their capital budgeting process. True or false?
True
Scenario analysis is similar to sensitivity analysis, but here the variables are typically set at "good," "normal," and "bad" levels, and then the NPV is calculated under each situation. This analysis is designed to give management an idea of just how good or bad the results might turn out to be, along with the most likely (or expected) result. The spreadsheet model used to do a sensitivity analysis could be modified slightly and used for the scenario analysis. True or false?
True
Sometimes a cost must be incurred to obtain an abandonment option. This cost should be incurred if and only if the value of the option exceeds its cost. The value of an abandonment option can be estimated by first calculating the value of the project considering the possibility of abandonment, then subtracting the value of the project if it could not be abandoned. The difference in values is the value of the abandonment option. True or false?
True
Sunk costs, opportunity costs, externalities, changes in NOWC, and salvage values are factors that complicate capital budgeting analysis. True or false?
True
The MIRR is superior to the regular IRR as an indicator of a project's "true" rate of return, while the NPV is better than IRR and MIRR when choosing among competing projects. True or False?
True
The cost of depreciation-generated funds is approximately equal to the WACC calculated from retained earnings, preferred stock, and debt. True or false?
True
The inputs used in most capital budgeting analyses are not known with certainty; hence, the results of a quantitative analysis may be quite different from the actual, after-the-fact results. Also, five capital budgeting criteria are commonly used, and each provides a somewhat different bit of information. Therefore, it is rational for a firm to calculate and give some consideration to each of the five criteria. For most decisions, the greatest weight should be given to the NPV, but it would be foolish to ignore the information provided by the other criteria. True or false?
True
The investor-supplied items—debt, preferred stock, and common equity—are called capital components. Increases in assets must be financed by increases in these capital components. True or false?
True
The rate at which the NPV profile lines of two mutually exclusive projects cross is called the "crossover rate." If the cost of capital is greater than the crossover rate, then no conflict will occur because the project with the higher NPV will also have the higher IRR. True or false?
True
The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the project's risk, the higher its cost of capital. True or false?
True
The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. True or false?
True
There has been a strong trend in recent years toward the use of the NPV and IRR methods as the primary criteria, and away from the regular payback as the primary criterion for selecting capital budgeting projects. True or false?
True
To do a sensitivity analysis, one would set up a spreadsheet model that calculates a project's NPV, using as inputs unit sales, sale prices, fixed and variable costs, the tax rate, and the cost of capital. Input variables are then changed one at a time to determine their effects on the NPV. If small changes in the variables could result in a large decline in the NPV, then the project is judged to be relatively risky. True or false?
True
Myers Corporation's stock currently trades at $40 a share. Investors estimate that the year-end dividend will be $2.00 a share and that its dividend will grow at 5% a year (i.e., D1 = $2.00 and g = 5%). The company needs to issue new stock in order to fund its upcoming projects, and investment bankers estimate that the flotation cost will be 4%. What is Myers' cost of new external equity? a. 10.2% b. 8.5% c. 12.0% d. 11.3% e. 9.6%
a. 10.2%
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the CAPM approach? a. 10.3% b. 8.8% c. 10.0% d. 10.5% e. 9.3%
a. 10.3%
A company has outstanding long-term bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company's tax rate is 30%, what would be its after-tax cost of debt? a. 6.3% b. 5.2% c. 7.5% d. 7.0% e. 8.0%
a. 6.3%
A firm has the following data: target capital structure of 50% debt and 50% common equity; tax rate = 40%; rd = 7.5%; and rs = 12%. Assume the firm will not be issuing new common stock. What is this firm's WACC? a. 8.3% b. 7.5% c. 10.0% d. 9.5% e. 12.0%
a. 8.3%
Which of the following is an example of cannibalization? a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks. b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes). c. Apple's investment in the iTunes music store boosted sales of its iPod. d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it. e. Statements c and d are both examples of cannibalization.
a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks.
If the IRS shortened the depreciable lives of the assets, thus increasing their depreciation rates, which of the following statements reflects what would happen to the calculated NPV? a. The calculated NPV would increase. b. The calculated NPV would not change. c. The calculated NPV would decrease.
a. The calculated NPV would increase.
Among the following factors that affect the cost of capital, which can the firm most directly control? a. The firm's capital structure b. Interest rates c. Tax rates
a. The firm's capital structure
A company's perpetual preferred stock pays a $4.50 annual dividend per share, and it currently sells for $60 per share. If the company were to sell a new preferred issue, what would be the cost of that capital? Ignore flotation costs. a. 5.6% b. 4.5% c. 7.5% d. 6.4% e. 8.3%
c. 7.5%
The company plans to use a building that it owns to house the project. The building could be sold for $2 million after taxes and real estate commissions. How would that fact affect your answer? a. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost. b. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds before taxes and commissions must be charged against the project as a cost. c. The potential sale of the building represents an externality and therefore should not be charged against the project. d. The potential sale of the building represents a real option and therefore should be charged against the project. e. The potential sale of the building represents a real option and therefore should not be charged against the project.
a. The potential sale of the building represents an opportunity cost of conducting the project in that building. Therefore, the possible proceeds after taxes and commissions must be charged against the project as a cost.
Adjustments to capital budgeting analysis must be made for ______. We concentrate on expansion project analyses here, but there are similarities when analyzing replacement projects. a. inflation b. Interest c. dividends
a. inflation
Which of the following is an example of an opportunity cost? a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks. b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes). c. Apple's investment in the iTunes music store boosted sales of its iPod. d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it. e. Statements a and d are both examples of opportunity costs.
b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).
Which of the following factors could lead to a conflict between the NPV and IRR methods for two mutually exclusive projects? a. Differences in the projects' sizes. b. both statements are true. c. Differences in the timing of the projects' cash flows.
b. both statements are true
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the bond-yield-plus-risk-premium approach? Use a 4% judgmental risk premium in your calculation. a. 8.8% b. 9.3% c. 10.5% d. 10.0% e. 10.3%
c. 10.5%
Project X has the following cash flows. If the firm's WACC is 15%, what is Project X's discounted payback? Y0: -$500; Y1: 200; Y2: 200; Y3: 400 a. 3.11 years b. 2.25 years c. 2.66 years d. 1.73 years e. 3.50 years
c. 2.66 years
All else equal, which of the following is most likely to increase a company's retained earnings breakpoint? a. both factors will lead to an increase in the retained earnings breakpoint. b. An increase in the company's dividend payout ratio c. A decrease in the fraction of equity used in the company's target capital structure
c. A decrease in the fraction of equity used in the company's target capital structure
Which of the following statements is correct? a. Mutually exclusive projects generally have higher NPVs than independent projects. b. If two projects are mutually exclusive, then the one with the higher IRR should be accepted. c. If a firm is considering 5 independent projects, then as a general rule it should invest in all 5 of them if the analysis shows that each of them has a positive NPV. If it were considering 5 mutually exclusive projects (i.e., 5 ways of performing a given task), then as a general rule it should not invest in all 5 of them even if they all have positive NPVs.
c. If a firm is considering 5 independent projects, then as a general rule it should invest in all 5 of them if the analysis shows that each of them has a positive NPV. If it were considering 5 mutually exclusive projects (i.e., 5 ways of performing a given task), then as a general rule it should not invest in all 5 of them even if they all have positive NPVs.
Which of the following statements suggests that assuming reinvestment at the WACC is a more reasonable reinvestment rate assumption? a. Firms do not have reasonably good access to the capital markets, so firms cannot raise all the capital they need at the going interest rate. b. If firms have reinvestment opportunities with positive NPVs, they will be constrained in accepting them and financing them at their costs of capital. c. If firms use internally generated cash flows from past projects rather than external capital, then they will save their costs of capital. Thus, their costs of capital represent the opportunity costs of their cash flows; thus, the effective returns on their reinvested funds.
c. If firms use internally generated cash flows from past projects rather than external capital, then they will save their costs of capital. Thus, their costs of capital represent the opportunity costs of their cash flows; thus, the effective returns on their reinvested funds.
The NPV should be used as the primary capital budgeting decision criterion because: a. It tells us how long it will take to recover the investment in a project. b. It tells us what rate of return is expected on a project. c. It tells us how much the project is expected to add or subtract from a firm's value.
c. It tells us how much the project is expected to add or subtract from a firm's value.
An outlay that was incurred in the past and can't be recovered in the future regardless of whether the project under consideration is accepted is known as a. opportunity cost b. externality c. sunk cost d. cannibalization
c. sunk cost
A company has outstanding long-term bonds with a face value of $1,000, a 7% coupon, and a 9% yield to maturity. If the company were to issue new debt, what is a reasonable estimate of the interest rate (rd) on that debt? a. 5.7% b. 6.2% c. 7.0% d. 9.0% e. 8.0%
d. 9.0%
Which of the following items should be included in capital budgeting analysis? a. sunk costs b. interest payments c. dividend payments d. opportunity costs
d. opportunity costs
Suppose you must estimate the cost of equity for a firm, and you have the following data: rRF = 5.5%; rM - rRF = 6%; b = 0.8; D1 = $1.00; P0 = $25.00; g = 6%; and rd = the firm's bond yield = 6.5%. What is this firm's cost of equity using the DCF approach? a. 8.8% b. 10.3% c. 9.3% d. 10.5% e. 10.0%
e. 10.0%
Wyatt Inc. uses the dividend-yield-plus-growth-rate approach to calculate the cost of equity. Investors expect Wyatt's year-end dividend (D1) to be $3.00 a share, its expected dividend growth rate is 5%, and the stock currently sells for $60 a share. What is Wyatt's cost of equity? a. 5.0% b. 7.4% c. 9.2% d. 8.5% e. 10.0%
e. 10.0%
A company's perpetual preferred stock pays a $5 annual dividend per share, and it currently sells for $80 per share. If the company were to sell a new preferred issue, what is a good estimate of the cost of that capital? Ignore flotation costs. a. 6.75% b. 7.33% c. 5.40% d. 5.00% e. 6.25%
e. 6.25%
A firm's target capital structure consists of 10% debt and 90% common equity. Its tax rate = 40%; rd = 6.5%; and rs = 9.5%. Assuming that the firm will not be issuing new common stock, what is its WACC? a. 10.33% b. 8.25% c. 9.50% d. 6.50% e. 8.94%
e. 8.94%
Which of the following statements is correct? More than one statement may be correct. a. A project's IRR is conceptually similar to a bond's YTM. b. A project's IRR is the discount rate that causes the project's NPV to equal zero. c. If an independent project's IRR exceeds its cost of capital, then the project should be accepted. d. If an independent project's IRR is less than its cost of capital, then the project should be rejected. e. All of these are all true.
e. All of these are all true.