Finance Ch. 7,8,14,15 Study

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Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342, 000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs?

$134,000 for research

Pacific Cosmetics is evaluating a project to produce a perfume line. Pacific currently does not produce any body scent products. Pacific Cosmetics is an all-equity firm. (A) Should Pacific Cosmetics use its stock beta to evaluate the project? (B) How should Pacific Cosmetics compute the beta to evaluate the project?

(A) Pacific Cosmetics should use its stock beta in the evaluation of the project only if the risk of the perfume project is the same as the risk of Pacific Cosmetics. This will only be true if cosmetics and perfume have cash flows with similar levels of systematic risk. (B) The best way to estimate the beta on this project is to average the asset betas of other firms that produce perfume

Payoff to shareholders after restructuring

-Capital gains + Dividends

If the risk free rate is 7% and the cost of debt capital is 7% then what is the Beta(debt)?

0

How to compute the estimated beta of stock given stock's past returns and NYSE past returns

1. Calculate Average return on Stock and Average return on Market 2. Calculate (Rs - avg Rs) for all years 3. Calculate (Rm- avg Rm) for all years 4. Multiply Step 2 x Step 3 for all years and then add them. This will be the numerator 5. Square Step 3 for all years and add them. This will be the denominator 6. Estimated Beta = Step 4 / Step 5

What are the 3 selfish strategies?

1. Incentive to take large risks 2. Incentive toward underinvestment 3. Milking the property

Implications of the pecking order theory

1. No target D/E ratio 2. Profitable firms use less debt 3. Companies like financial slack because they'll need to internally finance projects in the future

A new machine, with a 4-year life, has an initial cost of $1,200 and annual costs of $380. The equivalent annual cost of this machine is best described as the A) 4-year annuity payment that has the same net present value as the project's costs given a stated discount rate. B) 4-year total of all costs divided by four. C) annual sales needed to offset these additional costs. D) lump sum payment at Time 0 that is equal to these additional costs at a given discount rate. E) 4-year average after-tax cash flow resulting from the annual costs.

A

Capital budgeting analysis is based on A) the discounted cash flows incremental to a project. B) the additional income generated from the sales of a newly added project. C) the expected profits generated by a project's sales and costs. D) all incremental and allocated costs assigned to a project. E) all past and future expenditures related to a proposed project.

A

Erosion can be best explained as the A) loss of current sales due to a new project being implemented. B) additional income generated from the sales of a newly added product. C) loss of revenue due to customer theft. D) loss of revenue due to employee theft. E) loss of sales due to a product become obsolete.

A

If the capital gains tax rate increases while all other tax parameters are held constant, we expect the tax benefits of debt financing to ________. (a) increase (b) decrease (c) remain unchanged

A

If the project beta and IRR corrdinates plot above the SML, the project should be: a) Accepted b) Rejected c) It is impossible to tell d) It will depend on the NPV c) None of the above

A

Recall from class that TS represents the effective personal tax rate on each dollar of corporate earnings. Firm A is a firm that pays no dividends while firm B pays a very high dividend. Which firm is a more likely to be owned by middle aged investors at the peak of their career (a) Firm A (b) Firm B

A

The Modigliani-Miller Proposition I without taxes states: a) A firm cannot change the total value of its outstanding securities by changing its capital structure proportions. b) When new projects are added to the firm the firm value is the sum of the old value plus the new. c) Managers can make correct corporate decisions that will satisfy all shareholders if they select projects that maximize value. d) The determination of value must consider the timing and risk of the cash flows. e) None of the above.

A

When determining a minimum bid price, you should assume the A) net present value is zero. B) net profit is zero. C) discount rate equals the risk-free rate. D) depreciation is based on the straight-line method. E) fixed assets are unaffected.

A

Which of the following could possibly be true according to the Modigliani and Miller theory in a world with corporate taxes, personal taxes on equity income and no personal taxes on interest income and no financial distress costs. (a) Firm value increases with the amount a firm borrows (b) Firm value decreases with the amount a firm borrows (c) Firm value is constant with the amount a firm borrows (d) a and b (e) b and c (f) a and b and c

A

Which one of the following will decrease a firm's net working capital?

A decrease in accounts receivable

The changes in the firm's future cash flows that are a direct consequence of accepting a project are called: A) Incremental cash flows. B) Stand-alone cash flows. C) Aftertax cash flows. D) Net present value cash flows. E) Erosion cash flows.

A) Incremental cash flows.

Which one of these best describes the relationship between bondholders and stockholders at a time when it appears the firm may be facing increased financial distress? A. Stockholders have an incentive to underinvest in new projects to the detriment of bondholders. B. Both parties tend to work together for the common good of the firm. C. Both bondholders and stockholders will encourage the firm to take on new high risk projects. D. Bondholders will tend to lower their required rate of interest so the firm can afford additional financing until its financial status improves. E. Bondholders tend to milk the property at the expense of stockholders.

A. Stockholders have an incentive to underinvest in new projects to the detriment of bondholders

The fact that interest payments on debt are tax deductible is a key factor in which of these propositions? A. Both MM Proposition I and II with taxes B. MM Proposition I without tax C. MM Proposition II without tax D. MM Proposition I with tax E. MM Proposition II with tax

A. Both MM Proposition I and II with taxes

Which one of these argues than the value of a firm is independent of its capital structure? A. MM Proposition I without taxes B. MM Proposition II without taxes C. Capital asset pricing model D. MM Proposition I with taxes E. MM Proposition II with taxes

A. MM Proposition I without taxes

In principle, when does a firm become bankrupt? A. When its equity value falls to zero B. When a lender refuses to lend any additional funds to the firm C. When its current ratio is less than one D. When it is one day late paying a payment to a creditor E. When a bankruptcy petition is filed with the court

A. When its equity value falls to zero

Changes in the net working capital: A. can affect the cash flows of a project every year of the project's life. B. only affect the initial cash flows of a project. C. are included in project analysis only if they represent cash outflows. D. are generally excluded from project analysis due to their irrelevance to the total project. E. affect the initial and the final cash flows of a project but not the cash flows of the middle years.

A. can affect the cash flows of a project every year of the project's life.

A project's operating cash flow will increase when the: A. depreciation expense increases. B. sales projections are lowered. C. interest expense is lowered. D. net working capital requirement increases. E. earnings before interest and taxes decreases.

A. depreciation expense increases

A firm that has a negative net worth is said to be: A. experiencing accounting insolvency. B. in legal bankruptcy. C. experiencing technical insolvency. D. experiencing a business failure. E. in Chapter 11 bankruptcy reorganization.

A. experiencing accounting insolvency.

The costs of avoiding a bankruptcy filing by a financially distressed firm are classified as _____ costs. A. indirect bankruptcy B. direct bankruptcy C. financial solvency D. capital structure E. flotation

A. indirect bankruptcy

A firm should select the capital structure which: A. maximizes the value of the firm. B. has no debt. C. is fully levered. D. minimizes taxes. E. produces the highest cost of capital.

A. maximizes the value of the firm.

In the absence of taxes, MM argues that: A. no one capital structure for a firm is superior to any other capital structure for that firm. B. the cost of equity for a levered firm is equal to the firm's unlevered WACC. C. homemade leverage is insufficient to offset a firm's use of leverage. D. the value of a levered firm exceeds the value of the unlevered firm. E. the cost of equity decreases as the debt-equity ratio increases.

A. no one capital structure for a firm is superior to any other capital structure for that firm.

The value of a firm is maximized when the: A. weighted average cost of capital is minimized. B. levered cost of capital is maximized. C. tax rate is zero. D. cost of equity is maximized. E. debt-equity ratio is minimized.

A. weighted average cost of capital is minimized.

Issuing debt instead of new equity in a closely held firm more likely causes owner-managers to: A. work harder than they would if equity had been issued. B. consume more perquisites because the cost is passed on to the debtholders. C. enjoy more leisure time than they would with an equity issue. D. accept more unprofitable projects. E. shirk their duties as they have less capital at risk.

A. work harder than they would if equity had been issued.

Sway's Market is considering a project that will require the purchase of $1.4 million in new equipment. The equipment will be depreciated straight-line to zero over the 5-year life of the project. The firm expects to sell the equipment at the end of the project for 20 percent of its original cost. New net working capital equal to 10 percent of sales will be required to support the project. All of the new net working capital will be recouped at the end of the project. Annual sales are estimated at $750,000 with costs of $338,000. The required rate of return is 12 percent and the tax rate is 34 percent. What is the amount of the aftertax salvage value of the equipment?

Aftertax salvage value = ($1,400,000 × .20) × (1 - .34) = $184,800

Margarite's Enterprises is considering a new project that will require $345,000 for new fixed assets, $160,000 for inventory, and $35,000 for accounts receivable. Short-term debt is expected to increase by $110,000. The project has a 5-year life. The fixed assets will be depreciated straight-line to zero over the life of the project. At the end of the project, the fixed assets can be sold for 25 percent of their original cost. The net working capital returns to its original level at the end of the project. The project is expected to generate annual sales of $550,000 and costs of $430,000. The tax rate is 35 percent and the required rate of return is 15 percent. What is the amount of the aftertax cash flow from the sale of the fixed assets at the end of this project?

Aftertax salvage value = .25 × $345,000 × (1 - .35) = $56,062.50

Which one of these statements related to MACRS depreciation is correct?

An asset will be depreciated faster using MACRS rather than the straight-line method.

A company that uses the MACRS system of depreciation A) cannot expense any of the cost of a new asset during the first year of the asset's life. B) will expense the entire cost of an asset over the asset's class life. C) will fully depreciate most assets over a 3-year period. D) will forgo any benefits normally derived from the depreciation tax shield. E) will have equal depreciation costs each year of an asset's life.

B

A firm signs a loan agreement in which it agrees to provide financial statements to the lender on a quarterly basis. This is an example of __________. (a) a negative covenant (b) a positive covenant (c) the "playing for time" strategy (d) none of the above

B

Global Enterprises has spent $134,000 on research developing a new type of shoe. For this shoe to now be manufactured, the firm will need to expand into an empty building that it currently owns. The firm was offered $229,000 last week for that building. An additional $342,000 will be required for new equipment and building improvements. Labor and material costs are estimated at $4.98 per pair of shoes. Interest expense on the loan needed to finance the production of this new shoe will be $17,800 a year. Which one of these correctly identifies the sunk costs? A) $229,000 value of the building B) $134,000 for research C) $229,000 value of the building plus $342,000 for new equipment and improvements D) $17,800 for interest plus $134,000 for research E) $229,000 for the building plus $134,000 for research

B

If a firm issues debt and includes protective covenants in the indenture then the firm's debt will probably be issued at _____ similar debt without the covenants. A) A variable interest rate rather than the fixed rate paid on B) A lower interest rate than C) A significantly higher interest rate than D) An interest rate equal to that of E) A slightly higher interest rate than

B

Net working capital A) can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B) requirements generally, but not always, create a cash outflow at the beginning of a project. C) expenditures commonly occur at the end of a project. D) is ignored in project analysis because any change in net working capital is a sunk cost. E) is the only initial expenditure where at least a partial recovery can be made at the end of a project.

B

One of the indirect costs of bankruptcy is the incentive toward under-investment. Under investment generally would result in: A) The firm selecting all projects with positive NPVs. B) The firm turning down positive NPV projects that would clearly be accepted if the firm were all-equity financed. C) Bondholders contributing the full amount of any new investment, but both stockholders and bondholders sharing in the benefits of those investments. D) Shareholders making decisions based on the best interests of the bondholders. E) The firm accepting more projects than it would if the probability of bankruptcy was ignored.

B

The MM theory with taxes implies that firms should issue maximum debt. In practice, this does not occur because: A) Debt is more risky than equity. B) Bankruptcy is a disadvantage to debt. C) The weighted average cost of capital is inversely related to the debt-equity ratio. D) The weighted average cost of capital is directly related to the debt-equity ratio. E) U.S. regulations require the debt-equity ratio of publicly-traded firms to be in the range of .3 to .7.

B

The book value of an asset is primarily used to compute the A) annual depreciation tax shield. B) amount of tax due on the sale of that asset. C) amount of tax saved annually due to the depreciation expense. D) amount of cash that can be received from the sale of that asset. E) change in depreciation needed to reflect the market value of the asset.

B

The cash flows of a project include the A) net operating cash flow generated by the project, less both sunk and erosion costs. B) incremental operating cash flow, as well as any changes in capital spending and net working capital. C) net income generated by the project plus the annual depreciation expense. D) sunk costs, opportunity costs, and erosion costs of the project. E) incremental operating cash flow plus any after-tax salvage value minus opportunity costs.

B

The incremental cash flows of a project are best defined as A) the cash received from the additional sales generated by the project. B) any change in a firm's cash flows resulting from the addition of the project including opportunity costs. C) the cash received or lost from changes in the sales of a firm's current products as a result of adding the project. D) the increase or decrease in a firm's cash flows resulting from adding the project, excluding all sunk and opportunity costs. E) the total cash flows of a firm once the new project is completely integrated into the firm's operations.

B

The most valuable investment given up if an alternative investment is chosen is referred to as a(n) A) sunk cost. B) opportunity cost. C) salvage value expense. D) equivalent annual cost. E) erosion cost.

B

The top-down approach to computing the operating cash flow A) applies only if a project produces sales. B) ignores all noncash items. C) can only be used if the entire cash flows of a firm are included. D) is equal to (Sales − Costs − Taxes + Depreciation). E) includes the interest expense related to a project.

B

Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and after-tax income of $74,200? A) Depreciation increases the net book value of the firm's assets. B) Depreciation is a noncash expense that increases the firm's cash flows. C) Depreciation lowers the firm's net income but does not affect its cash flows. D) Depreciation has no effect on either the firm's net income or its cash flows. E) Depreciation decreases both the firm's net income and its cash flows.

B

You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up, and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) ________ cost. A) opportunity B) sunk C) incremental D) fixed E) relevant

B

A firm's current equity value is $10 million and its current debt value is $100 million. The firm is contemplating using $8 million of the firm's cash and investing this cash in a very risky project. If the firm were an all equity firm, the NPV of the project would be -$3 million (i.e., the project costs $8 million and generates a cash flow down the road with a present value of only $5 million). If the firm undertakes the project, the bonds will go down in value to $96 million. Do shareholders want the managers to take this project? (a) no (b) yes

B Change in V = Change in S + Change in B -3=Change in S+-4 so Change in S = 1 = accept

A firm currently has 2,000 shares selling for $10 a share. The firm currently has no debt. The corporate tax rate is 50% and there are no personal taxes or financial distress costs. If the firm announces it is issuing $10,000 in bonds and using the proceeds to repurchase shares, what will the share price be after the restructuring is complete? (a) 12.00 (b) 12.50 (c) 14.50 (d) 15.00 (e) 16.25

B Price = 10+((10,000).5/2,000) = 12

A firm is currently valued at $300 in a boom and $160 otherwise. The chance of a boom is 35 percent. The firm owes $200 to its debt holders. What is the value of the firm to the shareholders? A) $0 B) $35.00 C) $27.50 D) $209.00 E) $9.00

B Shareholder value = .35 × MAX[($300 - 200),0] + (1 - .35) × MAX[($160 - 200),0] = $35

Which one of the following statements concerning bankruptcy is correct? A. Bondholders have a greater incentive than stockholders to keep a firm from filing for bankruptcy. B. An indirect cost of bankruptcy is the loss of key employees. C. Bankruptcy is sometimes used as a means to increase payroll costs. D. The assets of a firm tend to increase in value when a firm is in financial distress. E. The administrative costs incurred in a bankruptcy are considered indirect bankruptcy costs.

B. An indirect cost of bankruptcy is the loss of key employees.

The interest tax shield is a key reason why: A. the value of an unlevered firm is equal to the value of a levered firm. B. the net cost of debt to a firm is generally less than the cost of equity. C. firms tend to minimize their borrowing. D. the cost of debt is equal to the cost of equity for a firm with a debt-to-equity ratio of 1. E. firms prefer equity financing over debt financing.

B. the net cost of debt to a firm is generally less than the cost of equity.

Which one of the following statements is correct concerning a Chapter 7 bankruptcy? A. A firm reorganizes its operations in an effort to return to being a viable concern. B. A trustee will assume control of the firm's assets until those assets can be liquidated. C. Chapter 7 bankruptcies are always involuntary on the part of the firm. D. The claims of creditors are paid prior to the bankruptcy administrative costs. E. The firm generally issues new shares of stock prior to coming out of to bankruptcy.

B. A trustee will assume control of the firm's assets until those assets can be liquidated.

Which one of these describes a bankruptcy situation known as a "cram down"? A. The absolute priority rule forces common shareholder claims to the very bottom of the payee list. B. Creditors are forced to accept a bankruptcy plan that they voted to reject. C. The filing firm can be forced by the court to accept a plan submitted by the firm's creditors. D. Shareholders are forced to forfeit all their of claims on the bankrupt firm. E. A firm submits a reorganization plan simultaneously with its bankruptcy petition thereby forcing the court to agree to the submitted plan.

B. Creditors are forced to accept a bankruptcy plan that they voted to reject.

Which of these will appear on a market value balance sheet? I. Original cost of fixed assets less any depreciation to date II. Issue value of bonds III. Current sales value of a firm's plant and equipment IV. Current market value of the outstanding shares of stock A. I and II only B. III and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, III, and IV

B. III and IV only

Which one of the following is true? A. A firm with low anticipated profits will likely take on a high level of debt. B. Investors will generally view an increase in debt as a positive sign of the firm's value. C. Rational investors are likely to infer a higher firm value if a firm is all-equity financed. D. Rational firms raise debt levels when profits are expected to decline. E. High-growth firms with future positive net present value projects tend to have high levels of debt.

B. Investors will generally view an increase in debt as a positive sign of the firm's value

Which of these proposes that the value of a levered firm exceeds the value of an unlevered firm by the present value of the tax shield? A. MM Proposition I with and without taxes B. MM Proposition I with tax C. MM Proposition II with tax D. MM Proposition I without tax E. MM Proposition II without tax

B. MM Proposition I with tax

Which one of these presents the idea that the cost of equity is a positive linear function of capital structure? A. MM Proposition I without taxes B. MM Proposition II with and without taxes C. Capital asset pricing model D. MM Proposition I with taxes E. Homemade leverage

B. MM Proposition II with and without taxes

Which one of the following claims on a firm would be paid first in a bankruptcy liquidation if the court adheres to the absolute priority rule? A. Government tax claims B. Wages, salaries, and commissions C. Consumer claims D. Preferred stockholder dividends E. Contributions to employee benefit plans

B. Wages, salaries, and commissions

MM Proposition II is the proposition that: A. supports the argument that the capital structure of a firm is irrelevant to the value of the firm. B. a firm's cost of equity is a positive linear function of the firm's capital structure. C. the cost of levered equity is determined solely by the return on debt, the debt-equity ratio, and the tax rate. D. the cost of equity depends on the market value of the firm's assets. E. supports the argument that the size of the pie does not depend on how the pie is sliced.

B. a firm's cost of equity is a positive linear function of the firm's capital structure.

The legal proceeding for liquidating or reorganizing a firm operating in default is called a: A. tender offer. B. bankruptcy. C. merger. D. takeover. E. proxy fight.

B. bankruptcy.

The optimal capital structure has been achieved when the: A. weight of equity is equal to the weight of debt. B. debt-to-equity ratio selected results in the lowest possible weighted average cost of capital. C. firm is totally financed with debt. D. debt-to-equity ratio is such that the cost of debt exceeds the cost of equity. E. cost of equity is maximized.

B. debt-to-equity ratio selected results in the lowest possible weighted average cost of capital.

One purpose of identifying all of the incremental cash flows related to a proposed project is to: A. isolate the total sunk costs so they can be evaluated to determine if the project will add value to the firm. B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project. C. make each project appear as profitable as possible for the firm. D. include both the proposed and the current operations of a firm in the analysis of the project. E. identify any and all changes in the cash flows of the firm for the past year so they can be included in the analysis.

B. eliminate any cost which has previously been incurred so that it can be omitted from the analysis of the project.

A valuable firm will tend to: A. see its stock price increase if it issues debt beyond its optimal debt level. B. issue more debt than a less valuable firm of comparable size. C. reduce its debt level as a positive signal for the firm. D. issue debt, but only on a temporary basis purely to fool investors regarding the firm's value. E. see its stock price increase when it announces an exchange offer that decreases its leverage.

B. issue more debt than a less valuable firm of comparable size.

MM Proposition I with no tax supports the argument that: A. business risk determines the return on assets. B. it is completely irrelevant how a firm arranges its finances. C. the cost of equity rises as leverage rises. D. a firm should borrow money up to the point where the cost of debt equals the cost of equity. E. financial risk is determined by the debt-equity ratio.

B. it is completely irrelevant how a firm arranges its finances.

The optimal capital structure will tend to include more debt for firms with: A. less taxable income. B. lower probability of financial distress. C. substantial tax shields from other sources. D. the lowest marginal tax rate. E. the highest depreciation deductions.

B. lower probability of financial distress.

MM Proposition I without taxes illustrates that: A. the value of an unlevered firm is less than that of a levered firm. B. one capital structure is as good as any other capital structure. C. corporate use of homemade leverage affects the value of the firm. D. the debt-equity ratio affects the cost of equity capital. E. the slope of the cost of equity function is equal to the rate of return on bonds.

B. one capital structure is as good as any other capital structure.

A legal attempt to financially restructure a failing firm so that it can continue operating as a going concern is called a: A. merger. B. reorganization. C. liquidation. D. repurchase program. E. divestiture.

B. reorganization.

Bryan invested in Bryco stock when the firm was financed solely with equity. The firm is now utilizing debt in its capital structure. To unlever his position, Bryan needs to: A. borrow some money and purchase additional shares of Bryco stock. B. sell some shares of Bryco stock and loan it out. C. sell some shares of Bryco stock and hold the proceeds in cash. D. maintain his current position because the firm's use of leverage did not affect him. E. sell some of his shares and also borrow money to increase his cash reserves.

B. sell some shares of Bryco stock and loan it out.

When comparing levered versus unlevered capital structures, leverage works to increase EPS for high levels of EBIT because interest payments on the debt: A. vary with EBIT levels. B. stay fixed, leaving more income to be distributed over fewer shares. C. stay fixed, leaving less income to be distributed over fewer shares. D. stay fixed, leaving less income to be distributed over more shares. E. stay fixed, leaving more income to be distributed over more shares.

B. stay fixed, leaving more income to be distributed over fewer shares.

The bottom-up approach to computing the operating cash flow applies only when: A. both the depreciation expense and the interest expense are equal to zero. B. the interest expense is equal to zero. C. the project is a cost-cutting project. D. no fixed assets are required for the project. E. taxes are ignored and the interest expense is equal to zero.

B. the interest expense is equal to zero.

Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?

Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13

Farris Industrial purchased a machine five years ago at a cost of $164,900. The machine is being depreciated using the straight-line method over eight years. The tax rate is 35 percent and the discount rate is 14 percent. If the machine is sold today for $42,500, what will the aftertax salvage value be?

Book value = $164,900 - 5 × ($164,900/8) = $61,837.50 Aftertax salvage value = $42,500 - .35 × ($42,500 - 61,837.50) = $49,268.13

Lefty's just purchased some equipment that is classified as 7-year property for MACRS. The equipment cost $67,600. The MACRS table values are .1429, .2449, .1749, .1249, and .0893, for Years 1 to 5, respectively. What will the book value of this equipment be at the end of four years?

Book valueYear 4 = $67,600 - (1 - .1429 - .2449 - .1749 - .1249)] = $21,118.24

What's the difference between business risk and financial risk and what affects each of them?

Business risk: The risk of whether or not a firm will be able to generate enough revenue from sales to cover its operating expenses and make a profit. Things that go into sales variability, like CFs, market conditions, industry conditions, COGS, profit margins, competition, overall demand for its products, whether the firm's assets are concrete, etc. Financial risk: Deals with leverage and debt financing, so it's whether or not a company can generate enough CFs to make interest payments. Interest rate changes and the weight of debt in the company's capital structure.

A key assumption of MM's Proposition I without taxes is: a) That financial leverage increases risk. b) That individuals can borrow on their own account at rates less than the firm. c) that individuals must be able to borrow on their own account at rates equal to the firm. d) Managers are acting to maximize the value of the firm. e) All of the above.

C

Assume an asset costs $38,700 and has a current book value of $18,209. The asset is sold today for $15,000 cash. The tax rate is 34 percent. As a result of this sale, the company's net cash flow will A) increase by exactly $15,000. B) decrease by the difference between the $18,209 and the $15,000. C) increase by more than $15.000. D) increase by less than $15,000. E) decrease by some amount.

C

Changes in net working capital A) are included in project analysis only if they represent cash outflows. B) only affect the initial cash flows of a project. C) can affect the cash flows of a project every year of the project's life. D) are generally excluded from project analysis due to their irrelevance to the total project. E) affect the initial and the final cash flows of a project but not the cash flows of the middle years.

C

In project analysis, which one of these is a common assumption regarding net working capital? A) Only changes in current assets are included in net working capital for project analysis purposes. B) The aftertax salvage value of an asset that is sold is included as a net working capital item. C) Net working capital will be returned to its preproject level at the end of a project. D) Increases in net working capital will be treated as a cash inflow. E) Any change in net working capital will only occur when a project commences.

C

One of the indirect costs of bankruptcy is the incentive for managers to take large risks. When following this strategy: A) The firm will rank all projects and select the project which results in the highest expected firm value. B) Bondholders expropriate value from stockholders by selecting high-risk projects. C) Stockholders expropriate value from bondholders by selecting high-risk projects. D) The firm will always select the lowest-risk project available. E) The firm will select only all-equity financed projects.

C

Sunk costs include any cost that A) will change if a project is undertaken. B) will be incurred if a project is accepted. C) has previously been incurred and cannot be changed. D) will occur if a project is accepted and once incurred, cannot be recouped. E) is paid to a third party and cannot be refunded for any reason whatsoever.

C

The bottom-up approach to computing the operating cash flow of a project applies only when A) both the depreciation expense and the interest expense are equal to zero. B) the project is a cost-cutting project. C) the interest expense is equal to zero. D) no fixed assets are required for the project. E) taxes are ignored and the interest expense is equal to zero.

C

The cash flows of a new project that come at the expense of a firm's existing projects are called A) opportunity costs. B) net working capital expenses. C) erosion costs. D) salvage value expenses. E) sunk costs.

C

The optimal capital structure of a firm _____ the marketable claims and _____ the non-marketable claims against the cash flows of the firm. A) Minimizes; minimizes B) Minimizes; maximizes C) Maximizes; minimizes D) Maximizes; maximizes E) Equates; (leave blank)

C

The sale of an asset creates an aftertax cash flow in an amount equal to the A) Sale price - Book value. B) Sale price - Tax rate × (Book value - Sale price). C) Sale price - Tax rate × (Sale price - Book value). D) Sale price + Tax rate × (Sale price - Book value). E) Sale price × (1 - Tax rate).

C

Which one of these statements related to MACRS depreciation is correct? A) The MACRS percentages in the IRS tables are applied annually to the then current book value of an asset. B) The MACRS system of depreciation was eliminated by the IRS in 2012. C) An asset will be depreciated faster using MACRS rather than the straight-line method. D) An asset classified as 3-year MACRS property will be fully depreciated at the end of Year 3. E) All newly acquired property is considered to be placed in service at the start of the year for MACRS purposes.

C

10. A firm has a debt-to-equity ratio of 1. Its cost of equity is 16%, and its cost of debt is 8%. If there are no taxes or other imperfections, what would be its cost of equity if the debt-to-equity ratio were 0? a. 8% b. 10% c. 12% d. 14% e. 16%

C rs = ro + 1(ro - 8%) = 16% So r0=12% Rs=12% + 0(12%-8%) = 12%

A firm has $100 million in stock and $300 million in bonds. The firm's borrowing rate is 4% and the expected return on the firm's stock is 10%. The corporate tax rate is 30%. What is this firm's weighted average cost of capital? (a) 4% (b) 4.4% (c) 4.6% (d) 6% (e) 8% (f) 10%

C .25(.1)+.75(.04)(1-.3) = 4.6%

MM Proposition II without taxes implies that the required return on equity is: A. a result of homemade leverage. B. inversely related to the firm's debt-to-equity ratio. C. a linear function of the firm's debt-to-equity ratio. D. independent of the firm's capital structure. E. a linear function of the market's rate of interest.

C. a linear function of the firm's debt-to-equity ratio.

Why does MM Proposition I not hold in the presence of corporate taxation? A. Bondholders require higher rates of return when their interest payments are taxed. B. Dividends are no longer relevant when taxes are introduced. C. A levered firm will pay less tax than the same firm unlevered. D. The cost of equity increases with leverage. E. The pretax cost of debt increases when taxes are considered .

C. A levered firm will pay less tax than the same firm unlevered.

Which one of these best supports the argument that leverage increases shareholder risk? A. EPS is directly related to EBIT. B. Individuals employ homemade leverage. C. EPS variability increases when leverage is used. D. Firm values rise with leverage in the presence of taxes. E. The number of shares outstanding tends to decrease when leverage is used.

C. EPS variability increases when leverage is used.

The interest tax shield has no value for a firm when the: I. the tax rate is equal to zero. II. the debt-equity ratio is exactly equal to 1. III. the firm is unlevered. IV. a firm elects an all-equity capital structure. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only

C. I, III, and IV only

Which of these statements apply MM Proposition II without taxes? I. The expected return on equity is positively related to leverage. II. The value of a firm cannot be changed by changing its capital structure. III. Risk to equity holders increases with leverage. IV. The expected return on equity is affected by the firm's debt-to-equity ratio. A. II and IV only B. I, II, and III only C. I, III, and IV only D. I and III only E. I, II, III, and IV

C. I, III, and IV only

In an EPS-EBI graphical relationship, the debt line and the no debt line intersect. Which of these are true at the intersection point? I. The advantages of debt outweigh the disadvantages of debt. II. The aftertax earnings of both capital structures are equal. III. The earnings per share for both capital structures are equal. IV. There is no advantage or disadvantage to debt. A. I and III only B. II and IV only C. III and IV only D. I, II, and III only E. II, III, and IV only

C. III and IV only

Which one of these statements is correct? A. There is no condition known to date whereby a corporation can increase firm value through the use of leverage. B. Corporations generally pay a lower cost on debt than do individuals due to their vast pool of liquid assets. C. If individual's pay a higher cost to borrow than corporations do, then corporations can increase firm value by borrowing. D. Margin accounts tend to be high interest rate sources of funds for individuals. E. Corporations can increase firm value by borrowing provided their interest rate on debt exceeds that paid by individuals.

C. If individual's pay a higher cost to borrow than corporations do, then corporations can increase firm value by borrowing.

Which one of these actions by a firm is an example of milking the property? Assume the firm is in a period of financial distress. A. Repaying a bond that matured B. Paying the semiannual bond interest C. Paying an extra dividend D. Cutting a regular dividend E. Paying a regular dividend

C. Paying an extra dividend

Given a world without taxes, RWACC of an unlevered firm will equal: A. RS. B. RB. C. R0. D. RS - R0. E. Rs - RB.

C. R0.

Which one of these symbols is correctly matched with its definition? A. tc; Taxable corporate income B. Rs; Rate of return on corporate savings C. R0; Unlevered cost of equity D. RWACC; Levered cost of equity E. RB; Weight of debt in the capital structure

C. R0; Unlevered cost of equity

Which one of these relationships will exist if a firm is operating under its optimal capital structure? A. The net present value of the firm will equal zero. B. The firm's cost of capital will equal the risk-free rate. C. The present value of the financial distress costs will equal the present value of the tax shield on debt. D. The value of the firm equal the maximum value obtainable according to the MM theories. E. The firm will be financed with equal amounts of long-term debt and equity.

C. The present value of the financial distress costs will equal the present value of the tax shield on debt.

The net working capital of a firm will decrease if there is: A. a decrease in accounts payable. B. an increase in inventory. C. a decrease in accounts receivable. D. an increase in the firm's checking account balance. E. a decrease in fixed assets.

C. a decrease in accounts receivable.

In a world with corporate taxes, MM theory implies that that all firms should: A. maintain a constant value. B. decrease in value as the leverage of the firm increases. C. choose an all-debt capital structure. D. select the capital structure that maximizes the firm's WACC. E. select the capital structure that equates the marginal cost of debt with the marginal benefits.

C. choose an all-debt capital structure.

The explicit costs, such as the legal expenses, associated with corporate default are classified as _____ costs. A. unlevered B. beta conversion C. direct bankruptcy D. indirect bankruptcy E. flotation

C. direct bankruptcy

The free cash flow hypothesis supports: A. decreasing stockholder dividends to retain more cash within the firm. B. reducing a firm's level of debt to save the cash currently being spent on interest payments. C. increasing the debt portion of a firm's capital structure. D. hiring managers with little or no stock ownership in the firm. E. the idea that firms with high levels of free cash flow are more apt to make good acquisitions than firms with low levels.

C. increasing the debt portion of a firm's capital structure.

You are writing a comparison of an all-equity structure to a levered capital structure for a firm. It is accurate to state in this comparison that: A. earnings per share will always be higher in the all-equity structure. B. firms will only select the levered structure when individual rates on borrowed funds are lower than corporate rates. C. leverage lowers shareholders' returns in bad times. D. the all-equity firm has a greater advantage the higher the firm's earnings before interest. E. leverage improves shareholders' returns regardless of the firm's level of earnings.

C. leverage lowers shareholders' returns in bad times.

The complete termination of a firm as a going business concern is called a: A. merger. B. repurchase program. C. liquidation. D. divestiture. E. reorganization.

C. liquidation.

All of the following are anticipated effects of a proposed project. Which of these should be considered when computing the cash flow for the final year of a project? A. operating cash flow and salvage values B. salvage values and net working capital recovery C. operating cash flow, net working capital recovery, salvage values D. net working capital recovery and operating cash flow E. operating cash flow only

C. operating cash flow, net working capital recovery, salvage values

MM Proposition I with tax supports the theory that: A. the value of an unlevered firm is equal to the value of a levered firm plus the interest tax shield. B. the value of a firm is inversely related to the amount of leverage used by the firm. C. there is a positive linear relationship between the debt-to-equity ratio and firm value. D. a firm's cost of capital is the same regardless of the mix of debt and equity used by the firm. E. a firm's weighted average cost of capital increases as the debt-equity ratio of the firm increases.

C. there is a positive linear relationship between the debt-to-equity ratio and firm value.

A general rule for managers to follow is to establish a firm's capital structure such that the firm's: A. cost of equity is minimized. B. bondholders are fully secured. C. value is maximized. D. dividend payout is maximized. E. assets are minimized.

C. value is maximized.

Dilwater Furniture purchased a corner lot in Pittsburg five years ago at a cost of $890,000. The lot was recently appraised at $1,070,000. At the time of the purchase, the company spent $80,000 to grade the lot and another $120,000 to pave the lot for commuter parking. The company now wants to build a new retail store on the site. The building cost is estimated at $1.8 million. What amount should be used as the initial cash flow for this building project?

CF0 = $1,070,000 + 1,800,000 = $2,870,000

Riverton Sails currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $89,000 and spent $26,000 on grading and excavation costs at that time. Today, the land is valued at $221,000. The company currently has some unused equipment that it currently owns with a current market value of $45,000. This equipment could be used for producing awnings if $9,000 is spent for equipment modifications. Other equipment costing $315,000 will be required. What is the amount of the initial cash flow for this expansion project?

CF0 = $221,000 + 45,000 + 9,000 + 315,000 = $590,000

Riverton Sails currently produces boat sails and is considering expanding its operations to include awnings for homes and travel trailers. The company owns land beside its current manufacturing facility that could be used for the expansion. The company bought this land ten years ago at a cost of $89,000 and spent $26,000 on grading and excavation costs at that time. Today, the land is valued at $221,000. The company currently has some unused equipment that it currently owns with a current market value of $45,000. This equipment could be used for producing awnings if $9,000 is spent for equipment modifications. Other equipment costing $315,000 will be required. What is the amount of the initial cash flow for this expansion project?

CF0 = $221,000 + 45,000 + 9,000 + 315,000 = $590,000

What is the internal rate of return on an investment that has an initial cost of $38,400 and projected cash inflows of $11,200, $19,600, and $18,100 for Years 1 to 3, respectively?

CF0 = -38400 CF1 = 11,200 F01 = 1 CF2 = 19,600 F02 = 1 CF3 = 18,100 F03 = 1 IRR CPT --> 12.15%

Solve for NPV

CF0 must be negative List the CF, F will likely be 1 CPT NPV, Enter I %, NPV CPT

Solve for IRR

CF0 must be negative List the CF, F will likely be 1, IRR CPT

A project requires an initial investment of $21,600 and will produce cash inflows of $4,900, $14,200, and $8,700 over the next three years, respectively. What is the project's NPV at a required return of 14 percent?

CF0=-21600 CF1=4900 F1=1 CF2=14200 F2=1 CF3=8700 F3=1 NPV CPT I=14 NPV CPT --> -$503.06

Bloomfield Tires has assigned a discount rate of 14.4 percent to a new project that has an initial cost of $229,000 and cash flows of $74,300, $128,700, and $89,500 for Years 1 to 3, respectively. What is the net present value of this project?

CF0=-229,000 C01=74300 F1=1 C02=128700 F2=1 C03=89500 F3=1 CPT NPV I=14.4 NPV CPT --> -$5,934.79

All else equal, a project's operating cash flow will increase when the A) net working capital requirement increases. B) sales projections are lowered. C) interest expense is lowered. D) depreciation expense increases. E) earnings before interest and taxes decreases.

D

Assume a firm has an ongoing need for a machine, and the current machine is operating efficiently. The firm should plan to replace this machine when it A) reaches the end of its depreciable life. B) is fully paid for. C) reaches a point where the book value is less than half of the original cost. D) can be replaced with a machine that has a lower equivalent annual cost. E) can be sold at a price that exceeds the current book value.

D

Beta measure depend highly on the: a) Direction of the market variance b) Overall cycle of the market c) Variance of the market and assets, but not their co-movement d) Covariance of the security with the market and how they are correlated e) All of the above

D

Bloomfield's has some idle equipment that is debt-free and also fully depreciated. If the company decides to use this equipment for a new project, what cost, if any, should be included for this equipment in the project's start-up costs? A) Zero cost B) Original purchase price of the equipment C) Original purchase price minus any tax savings realized to date on the depreciation D) Current market value of the equipment E) Annual storage cost for the equipment

D

Computers used for business purposes are assigned to which MACRS property class? A) 3-year B) 7-year C) 10-year D) 5-year E) 15-year

D

Financial leverage impacts the performance of the firm by: a) Increasing the volatility of the firm's EBIT. b) Decreasing the volatility of the firm's EBIT. c) Decreasing the volatility of the firm's net income. d) Increasing the volatility of the firm's net income e) None of the above.

D

Peter's Audio Shop has a cost of debt of 7%, a cost of equity of 11%, and a cost of preferred stock of 8%. The firm has 104,000 shares of common stock outstanding at a market price of $20 a share. There are 40,000 shares of preferred stock outstanding at a market price of $34 a share. The bond issue has a total face value of $500,000 and sells at 102% of face value. The tax rate is 34%. What is the weighted average cost of capital for Peter's Audio Shop? a. 6.14% b. 6.54% c. 8.60% d. 9.14% e. 9.45%

D

Project analysis is focused on ________ costs. A) total B) sunk C) variable D) incremental E) fixed

D

The optimal capital structure will tend to include more debt for firms with: A) The highest depreciation deductions. B) The lowest marginal tax rate. C) Substantial tax shields from other sources. D) Lower probability of financial distress. E) Less taxable income.

D

The value of a firm is maximized when the: A) Cost of equity is maximized. B) Tax rate is zero. C) Levered cost of capital is maximized. D) Weighted average cost of capital is minimized. E) Debt-equity ratio is minimized.

D

Which of the following are correct methods of computing the operating cash flow of a project assuming that the interest expense is equal to zero? I. EBIT + Depreciation − Taxes II. EBIT − Depreciation + Taxes III. Net Income − Depreciation IV. [(Sales − Costs) × (1 − Tax rate)] + [Depreciation × Tax rate] A) I and III only B) II and IV only C) II and III only D) I and IV only E) I, III, and IV only

D

Which of the following should be included in the analysis of a proposed project? A) Incremental and sunk costs only B) Opportunity costs, erosion, and sunk costs C) Opportunity costs and synergy only D) Synergy, erosion, opportunity costs, and incremental costs E) Incremental costs minus any sunk costs plus synergy

D

Which one of the following is an example of an incremental cash flow for Project A? A) Insurance on a building the company currently owns that will house the operations for Project A B) Property taxes on a currently owned warehouse that has been sitting idle but is going to be utilized by Project A C) Cost of the test marketing to ascertain whether or not Project A is feasible D) Rental cost of some new machinery that will be acquired for Project A E) Contractual annual salary of the company president

D

Which one of these represents the difference between a nominal rate and a real rate as they relate to project analysis? A) Interest rate on any project debt B) Risk-free rate of interest C) Market rate of return D) Rate of inflation E) Required rate of return

D

Which one of these statements is correct? A) All allocated costs should be included in the initial cost of a project. B) Sunk costs should be included in the initial cost of a project. C) Synergy occurs when a new product reduces the sales of a current product. D) Costs incurred prior to deciding whether or not to produce a new product are sunk costs. E) Incremental costs should not be included in a project's initial cost estimate.

D

Which one of these statements is correct? A. Firms across all industries in the U.S. tend to have similar debt-to-equity ratios. B. The banking industry tends to have the lowest debt-to-equity ratio of any U.S. industry. C. Financial leverage lowers risk to equity holders. D. MM Propositions ignore bankruptcy costs. E. MM Propositions without taxes illustrate that a firm's overall cost of capital is affected by leverage.

D. MM Propositions ignore bankruptcy costs.

Which of these represent a payment of a nonmarketed claim on a firm's cash flows? I. Payment of a customer's liability claim II. Principal repayment of a bond III. Federal corporate tax payment IV. Dividend payment A. II only B. I only C. II and IV only D. I and III only E. I, II, and III only

D. I and III only

Which of the following are given as reasons why individual investors may be able to borrow at the same rates as corporations? I. Corporate loans must be negotiated and supervised. II. Corporations often borrow using illiquid assets as collateral. III. Individuals tend to borrow smaller amounts. IV. Individuals can borrow on margin through a broker. A. I and II only B. III and IV only C. II, III, and IV only D. I, II, and IV only E. I, II, III, and IV

D. I, II, and IV only

Which of these represent indirect costs of financial distress? I. Court fees paid to a bankruptcy court II. A firm's supplier requiring payment in cash rather than offering its normal credit terms III. Cost of a manager's time spent renegotiating the terms of a debt to avoid bankruptcy IV. Loss of a key employee concerned about job security and the future of the firm A. I and II only B. III and IV only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV

D. II, III, and IV only

How is the value of equity determined for a market value balance sheet? A. Summation of all the sale prices for shares of stock sold to shareholders B. Summation of the market value of the firm's outstanding equity and debt securities C. Summation of all shareholder investments in the firm plus the value of any retained earnings D. Number of shares outstanding multiplied by the current price per share E. Number of shares outstanding multiplied by the current price per share minus the amount of debt outstanding

D. Number of shares outstanding multiplied by the current price per share

Consider the pie models of corporate structure. What is the difference between the all-equity pie and the levered pie for a firm in the presence of taxes? A. The size of the levered pie is smaller than the all-equity pie. B. Taxes eat a slice of the levered pie but pass by the all-equity pie. C. Both pies are the same size and are sliced identically. D. Taxes eat a slice of both pies but take a larger slice of the all-equity pie. E. The all-equity pie is smaller in size than the levered pie.

D. Taxes eat a slice of both pies but take a larger slice of the all-equity pie.

In an EPS-EBI graphical relationship, why does the debt line have a lower vertical intercept point than the no debt line? A. The debt line has a negative slope while the no debt line has a positive slope. B. The break-even point is higher with debt. C. The debt line is horizontal while the no debt line has a positive slope. D. With debt, a fixed interest charge is paid out of earnings. E. The debt line has less of a slope than the no debt line.

D. With debt, a fixed interest charge is paid out of earnings.

Conflicts of interest between stockholders and bondholders are known as: A. trustee costs. B. financial distress costs. C. dealer costs. D. agency costs. E. underwriting costs.

D. agency costs.

The explicit and implicit costs associated with corporate default are referred to as the _____ costs of a firm. A. flotation B. default beta C. direct bankruptcy D. financial distress E. indirect bankruptcy

D. financial distress

MM Proposition II with tax: A. reaches the final conclusion that the capital structure decision is irrelevant to the value of a firm. B. reveals how the interest tax shield relates to the value of a firm. C. supports the argument that business risk is determined by the capital structure employed by a firm. D. has the same general implications as MM Proposition II without taxes. E. supports the argument that the cost of equity decreases as the debt-equity ratio increases.

D. has the same general implications as MM Proposition II without taxes.

Indirect bankruptcy costs: A. effectively limit the amount of equity a firm issues. B. serve as an incentive to increase the financial leverage of a firm. C. tend to increase as the debt-equity ratio decreases. D. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection. E. include the legal and accounting fees incurred during the bankruptcy process.

D. include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

Financial leverage impacts the performance of a firm by: A. increasing the volatility of the firm's EBIT. B. decreasing the volatility of the firm's EBIT. C. decreasing the volatility of the firm's net income. D. increasing the volatility of the firm's net income E. lowering the firm's level of risk.

D. increasing the volatility of the firm's net income

Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B. requirements generally, but not always, create a cash inflow at the beginning of a project. C. expenditures commonly occur at the end of a project. D. is frequently affected by the additional sales generated by a new project. E. is the only expenditure where at least a partial recovery can be made at the end of a project.

D. is frequently affected by the additional sales generated by a new project.

A firm is technically insolvent when: A. the value of its stock declines by more than 50 percent in any given 12-month period. B. the value of the firm's assets is less than the value of the firm's liabilities. C. it files the legal forms petitioning for bankruptcy protection. D. it is unable to meet its financial obligations. E. it has a negative net worth on its balance sheet.

D. it is unable to meet its financial obligations.

The optimal capital structure of a firm _____ the marketed claims and _____ the nonmarketed claims against the cash flows of the firm. A. minimizes; minimizes B. maximizes; maximizes C. minimizes; maximizes D. maximizes; minimizes E. equates; (blank)

D. maximizes; minimizes

A firm's capital structure refers to the: A. division of a firm's assets into current and fixed assets. B. amount shareholders have invested into the firm. C. types of fixed assets owned by the firm. D. mix of debt and equity used to finance the firm's assets. E. amount of cash and cash equivalents held by a firm.

D. mix of debt and equity used to finance the firm's assets.

The cash flow from a project is computed as the: A. net operating cash flow generated by the project, less any sunk costs and erosion costs. B. sum of the incremental operating cash flow and aftertax salvage value of the project. C. net income generated by the project, plus the annual depreciation expense. D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project. E. sum of the sunk costs, opportunity costs, and erosion costs of the project.

D. sum of the incremental operating cash flow, capital spending, and net working capital cash flows incurred by the project.

Corporations in the U.S. tend to: A. have extremely high debt-to-equity ratios. B. rely less on equity financing than they should. C. minimize taxes. D. underutilize debt. E. rely more heavily on bonds than stocks as the major source of financing.

D. underutilize debt.

MM Proposition I with tax is based on the concept that the: A. optimal capital structure is the one that is totally financed with equity. B. capital structure of the firm does not matter because investors can use homemade leverage. C. firm is worse off levered than unlevered. D. value of the firm increases as total debt increases because of the interest tax shield. E. cost of equity increases as the debt-equity ratio of a firm increases.

D. value of the firm increases as total debt increases because of the interest tax shield.

Net working capital: A. can be ignored in project analysis because any expenditure is normally recouped by the end of the project. B. requirements generally, but not always, create a cash inflow at the beginning of a project. C. expenditures commonly occur at the end of a project. D. is frequently affected by the additional sales generated by a new project. E. is the only expenditure where at least a partial recovery can be made at the end of a project

D. is frequently affected by the additional sales generated by a new project.

Pecking order theory definition and rules

Definition: The cost of financing increases with asymmetric info. Rules: 1. Use internal financing as much as possible 2. If outside financing is needed, debt should be issued before equity

Which one of these statements related to depreciation is correct for a firm with taxable income of $121,600 and aftertax income of $74,200?

Depreciation in a non-cash expense that increases the firm's cash flows.

All else equal, an increase in which one of the following will increase the operating cash flow? A) Employee salaries B) Office rent C) Building maintenance D) Equipment rental E) Equipment depreciation

E

Assume you computed the NPV of a project using nominal values. Your partner computed the NPV of the identical project using real values, given a positive rate of inflation. When you compare your results, you should discover that A) the discount rate used by your partner is higher than the rate you used. B) both computations used the identical discount rate. C) your NPV value is greater than your partner's NPV value. D) your partner's initial cash flow at Time 0 is less than the value you used for Time 0. E) your NPV values are identical.

E

In a world with taxes and financial distress, when a firm is operating with the optimal capital structure the: A) Debt-equity ratio will be less than optimal. B) Weighted average cost of capital will be maximized. C) Firm will be all-equity financed. D) Required return on assets will be at its maximum point. E) Increased benefit from additional debt is equal to the increased bankruptcy costs of that debt.

E

In general, the capital structures used by U.S. firms: A) Tend to overweight debt in relation to equity. B) Are easily explained in terms of earnings volatility. C) Are easily explained by analyzing the types of assets owned by the various firms. D) Tend to be those which maximize the use of the firm's available tax shelters. E) Vary significantly across industries.

E

Indirect costs of financial distress: A) Effectively limit the amount of equity a firm issues. B) Serve as an incentive to increase the financial leverage of a firm. C) Include costs such as legal and accounting fees. D) Tend to increase as the debt-equity ratio decreases. E) Include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

E

The asset beta of a levered firm is generally: a) Equal to the equity beta b) Different from the equity beta c) Different from the debt beta d) The simple average of the equity beta and debt beta e) Both B and C

E

The capital structure chosen by a firm doesn't really matter because of: a) Taxes. b) The interest tax shield. c) The relationship between dividends and earnings per share. d) The effects of leverage on the cost of equity. e) Homemade leverage.

E

The equivalent annual cost is a method used to primarily compare mutually exclusive machines A) with different initial costs but similar lives. B) depreciated using various methods. C) that will be replaced with those that will not. D) that perform different functions. E) that will be replaced and have unequal lives.

E

The optimal capital structure has been achieved when the: A) Debt-equity ratio is equal to 1. B) Weight of equity is equal to the weight of debt. C) Cost of equity is maximized given a pretax cost of debt. D) Debt-equity ratio is such that the cost of debt exceeds the cost of equity. E) Debt-equity ratio selected results in the lowest possible weighed average cost of capital.

E

The pretax salvage value of an asset is equal to the A) book value if straight-line depreciation is used. B) book value if MACRS depreciation is used. C) market value minus the book value. D) book value minus the market value. E) market value.

E

Toni's Tools is comparing machines to determine which one to purchase. The machines sell for differing prices, have differing operating costs, differing machine lives, and will be replaced when worn out. These machines should be compared using A) net present value only. B) both net present value and the internal rate of return. C) the replacement parts approach. D) the depreciation tax shield approach. E) the equivalent annual cost method.

E

When compiling the relevant cash flows for a project, the after-tax value of any asset sold any time during the life of the project should be treated as a A) cash outflow at Time 0. B) change in net working capital. C) reduction in the cash flow for Time 0. D) cash flow in the last year of the project. E) cash flow in the year of sale.

E

Which of the following are true according to the Modigliani and Miller theory in a world with no taxes and no financial distress costs. (a) Total firm value is independent of capital structure (b) A firm's weighted-average-cost-of-capital is dependent of capital structure (c) The expected return on a firm's stock is dependent of capital structure (d) a and b (e) a and c (f) a and b and c

E

Which one of the following will decrease a firm's net working capital? A) A decrease in fixed assets B) An increase in inventory C) An increase in the firm's checking account balance D) A decrease in accounts payable E) A decrease in accounts receivable

E

Which one of these is a requirement when computing the net present value of a capital project? A) The discount rate used must be a nominal rate. B) The discount rate must be stated in real terms. C) Nominal cash flows must be discounted using a real rate. D) Real cash flows must be converted to nominal cash flows. E) Real cash flows must be discounted using a real rate.

E

You own 25% of Unique Vacations, Inc. You have decided to retire and want to sell your shares in this closely held, all equity firm. The other shareholders have agreed to have the firm borrow $1.5 million to purchase your 1,000 shares of stock. What is the total value of this firm today if you ignore taxes? a. $4.8 million b. $5.1 million c. $5.4 million d. $5.7 million e. $6.0 million

E

The MM propositions would suggest that firms should prefer which one of these debt-to-equity ratios? A. .0 B. .1 C. .5 D. .7 E. .9

E. .9

Financial analysts value items in terms of their: A. useful life. B. tax benefits. C. original cost. D. depreciated value. E. market value.

E. market value.

Which one of these events might cause the biggest challenge to the MM propositions? A. An increase in the corporate tax rates B. A decrease in the cost of debt C. An increase in a firm's unlevered WACC D. A new law requiring equal lending rates for all borrowers E. A change in tax laws to treat interest and dividends equally

E. A change in tax laws to treat interest and dividends equally

A firm may file for Chapter 11 bankruptcy: I. in an attempt to gain a competitive advantage. II. using a prepack. III. while allowing the current management to continue running the firm. IV. even though it is not insolvent. A. I and III only B. I, II, and IV only C. I and II only D. III and IV only E. I, II, III, and IV

E. I, II, III, and IV

Which of the following are common loan covenants? Assume each item applies only during the term of the loan. I. Limit on future borrowing II. Requirement that the borrower maintains a minimum stated level of net working capital III. Limit on any sales or switches of assets IV. Limit on the amount of dividends that can be paid A. I and IV only B. II and III only C. I, III, and IV only D. I, II, and III only E. I, II, III, and IV

E. I, II, III, and IV

Which of these will occur in a world with taxes and financial distress when a firm is operating at its optimal capital structure? I. The debt-to-equity ratio will be optimal. II. The weighted average cost of capital will be at its minimal point. III. The required return on assets will be at its maximum point. IV. The increased benefit from additional debt will equal the increased bankruptcy costs of that debt. A. I and IV only B. II and III only C. I and II only D. II, III, and IV only E. I, II, and IV only

E. I, II, and IV only

Which one of these statements most applies to a firm that is suffering from financial distress? A. Bondholders will desire high risk projects in order to protect their investment. B. Stockholders will increase their investment in the firm to protect their current investment. C. Stockholders will generally prefer low-risk over high-risk projects. D. Managers will tend to lower dividends in an effort to protect shareholder value. E. Stockholders will bear the cost of selfish investment strategies through higher interest payments.

E. Stockholders will bear the cost of selfish investment strategies through higher interest payments.

What does the present value of the tax shield from debt formula assume? A. The interest rate on the debt is less than cost of equity. B. The debt will not be replaced when paid. C. Interest on the debt is paid only when the debt matures. D. The interest is paid semiannually. E. The debt is perpetual.

E. The debt is perpetual.

Which one of these statements is correct for a levered firm? A. An increase in tax rates will decrease the value of the firm. B. An increase in financial distress costs increases the value of a firm. C. To obtain its maximum value, a firm should select an all-equity capital structure. D. The value of a firm is maximized when its cost of capital is also maximized. E. The optimal level of debt for a firm results in the value of that firm being maximized.

E. The optimal level of debt for a firm results in the value of that firm being maximized.

Which one of these statements is correct? A. Only the nonmarketed claims of a firm can be bought and sold. B. An increase in a firm's marketed claims will increase the total value of a firm. C. The total value of a firm is independent of the firm's cash flows. D. Managers try to maximize both marketed and nonmarketed claims in order to maximize total firm value. E. The value of a firm's marketed claims can change with changes in the firm's capital structure.

E. The value of a firm's marketed claims can change with changes in the firm's capital structure

The protective covenants contained within a loan agreement: A. impose restrictions on the lender. B. are designed to protect the borrower's shareholders. C. increase the borrower's flexibility. D. tend in increase the bond's interest rate. E. can increase the value of the borrowing firm.

E. can increase the value of the borrowing firm.

Which one of these represents the difference between the value of a levered and an unlevered firm? A. R0 - RS B. R × tcB C. VU + R × tcB D. B/S(1 - tc)( R0 - RS) E. tcB

E. tcB

The pecking order states how financing should be raised. In order to avoid asymmetric information problems and misinterpretation of whether management is sending a signal on security overvaluation the firm's first rule is to: A. issue convertible debt prior to straight debt to save funds. B. use short-term debt to its maximum available limit prior to issuing long-term debt. C. issue new equity first in order to retain internal funds and avoid interest costs. D. issue new debt prior to new equity. E. use internal financing prior to external financing.

E. use internal financing prior to external financing.

In general, the capital structures used by U.S. firms: A. tend to overweight debt in relation to equity. B. are easily explained in terms of earnings volatility. C. are easily explained by analyzing the types of assets owned by the various firms. D. tend to be those which maximize the use of the firm's available tax shelters. E. vary significantly across industries.

E. vary significantly across industries

The optimal capital structure of a firm: A. will remain constant over time unless the firm makes an acquisition. B. is unaffected by changes in the financial markets. C. will be the same for all firms in the same industry. D. places more emphasis on the operations than on the financing of the firm. E. will vary over time as taxes and market conditions change.

E. will vary over time as taxes and market conditions change.

Leverage becomes a disadvantage to a firm as soon as the firm's earnings before interest: A. become negative. B. exceed the break-even point. C. are taxed. D. exceed the firm's unlevered earnings. E. fall below the break-even point.

E. fall below the break-even point.

The cash flows of a new project that come at the expense of a firm's existing projects are called:

Erosion Costs

Turkey Hill Motor Homes currently sells 1,200 Class A motor homes, 2,600 Class C motor homes, and 4,000 pop-up trailers each year. It is considering adding a mid-range camper and expects that if it does so the firm can sell 1,500 of them. However, if the new camper is added, the firm expects its Class A sales to decline by 10 percent while the Class C camper sales decline to 2,100 units. The sales of pop-ups will not be affected. Class A motor homes sell for an average of $162,000 each. Class C homes are priced at $59,500 and the pop-ups sell for $5,500 each. The new mid-range camper will sell for $32,900. What is the erosion cost?

Erosion cost = [.10 × 1,200 × $162,000] + [(2,600 - 2,100) × $59,500] = $49,190,000

Why does net working capital increase?

Essentially, you are making an investment in working capital (negative cash flow) At end of project - usually assumed to be completely recovered Increases then decreases

How to calculate the Market-Risk Premium

Expected Return on Market - Risk Free Rate

R0

Expected earnings to unlevered firm/Unlevered equity

A firm currently has $60,000 in debt outstanding and $160,000 in equity outstanding. The interest rate on the outstanding debt is 10% and the corporate tax rate is 40%. If the firm sells $30,000 in stock and uses the proceeds to repurchase some of the outstanding debt, by how much will the firm's income tax bill in the following year change? (a) no change (b) tax bill will increase by $600 (c) tax bill will decrease by $400 (d) tax bill will increase by $900 (e) tax bill will decrease by $800 (f) tax bill will increase by $1,200 (g) tax bill will decrease by $1,200

F Increase by (.4)(30,000)(.1) = 1,200

A firm currently has no debt and its equity has a market value of $400 million. The firm is contemplating selling $40 million in bonds and using the proceeds to repurchase shares of stock. The corporate income tax rate is 30%, the effective personal tax rate on equity income is 10%, and the personal income tax rate on interest income is 40%. Given these tax parameters, what should be the total value of the firm after the repurchase is complete? (a) $315 million (b) $199 million (c) $512 million (d) $402 million (e) $400 million (f) $398 million

F VL = 400+ [(1-.3)(1-.1)/(1-.4)] *40 = 398

True of False: In a world with no taxes or financial distress costs, if a firm issues equity to repurchase some of its debt, the price of the shares will rise because those shares are less risky.

False: If you repurchase the debt it is true that the shares will be less risky. However, the expected return on the shares will also decrease since the profits will be spread over a larger number of shares. The MM argument states that the decrease in risk is exactly offset by the decrease in expected return and thus share values do not change when leverage changes.

The internal rate of return (IRR): I. rule states that a project is acceptable when the IRR exceeds the required rate of return. II. ignores the initial investment in a project. III. is the rate that causes the net present value of a project to equal zero. IV. can effectively be used to analyze all investment scenarios. I and III only II and IV only I and II only II, III, and IV only I, II, III, and IV

I and III only

Which of the following are elements of the internal rate of return method of analysis? I. the timing of the cash flows II. the cutoff point after which any future cash flows are ignored III. the rate designated as the minimum acceptable rate of return for a project IV. the amount of each cash flow? I and II only III and IV only I, II, and III only I, III, and IV only II, III, and IV only

I, III, and IV only

*Changes in the firms cash flows that occur as a direct consequence of accepting the project. We are interested in the difference between the cash flows of the firm with the project and the cash flows of the firm without the project.*

Incremental cash flows

A project will produce an operating cash flow of $7,300 a year for three years. The initial cash outlay for equipment will be $11,600. The net aftertax salvage value of $3,500 will be received at the end of the project. The project requires $800 of net working capital that will be fully recovered. What is the net present value of the project if the required rate of return is 11 percent?

NPV = -$11,600 - 800 + $7,300[(1 - 1/1.113)/.11] + ($3,500 + 800)/1.113 = $8,583.24

A project will produce an operating cash flow of $7,300 a year for three years. The initial cash outlay for equipment will be $11,600. The net aftertax salvage value of $3,500 will be received at the end of the project. The project requires $800 of net working capital that will be fully recovered. What is the net present value of the project if the required rate of return is 11 percent?

NPV = -$11,600 - 800 + $7,300[(1 - 1/1.113)/.11] + ($3,500 + 800)/1.113 = $8,583.24

A project will produce operating cash flows of $42,000 a year for four years. During the life of the project, inventory will be lowered by $12,000, accounts receivable will increase by $15,000, and accounts payable will increase by $10,000. The project requires $120,000 of new equipment that will be depreciated straight-line to a zero book value over four years. At the end of the project, net working capital will return to its normal level and the equipment will be sold for $25,000, after taxes. What is the net present value given a required return of 14 percent?

NWC requirement = $12,000 - 15,000 + 10,000 = $7,000 CF0 = $7,000 - 120,000 = -$113,000 C04, excluding OCF = -$7,000 + 25,000 = $18,000 NPV = -$113,000 + $42,000[(1 - 1/1.144)/.14] + $18,000/1.144 = $20,033.36

In project analysis, which one of these is a common assumption regarding net working capital?

Net working capital will be returned to its pre-projected level at the end of a project.

The Java House is considering a project that will produce sales of $47,500 and increase cash expenses by $22,500. If the project is implemented, taxes will increase by $7,600. The additional depreciation expense will be $10,100. An initial cash outlay of $7,300 is required for net working capital. What is the amount of the operating cash flow using the top-down approach?

OCF = $47,500 - 22,500 - 7,600 = $17,400

Kurt's Kabinets is looking at a project that will require $80,000 in fixed assets and another $20,000 in net working capital. The project is expected to produce sales of $138,000 with associated costs of $74,000. The project has a 4-year life. The company uses straight-line depreciation to a zero book value over the life of the project. The tax rate is 34 percent. What is the operating cash flow for this project?

OCF = ($138,000 - 74,000)(1 - .34) + ($80,000/4)(.34) = $49,040

Ernie's Electrical is evaluating a project that will increase sales by $39,000 and costs by $6,000. The project will initially cost $102,000 for fixed assets that will be depreciated straight-line to a zero book value over the 10-year life of the project. The applicable tax rate is 35 percent. What is the operating cash flow for this project?

OCF = ($39,000 - 6,000)(1 - .35) + ($102,000/10)(.35) = $25,020

Thornley Co. is considering a 3-year project with an initial cost of $587,000. The project will not directly produce any sales but will reduce operating costs by $265,000 a year. The equipment is classified as MACRS 7-year property. The MACRS table values are .1429, .2449, .1749, .1249, .0893, .0892, .0893, and .0446 for Years 1 to 8, respectively. At the end of the project, the equipment will be sold for an estimated $295,000. The tax rate is 34 percent and the required return is 9 percent. An extra $23,000 of inventory will be required for the life of the project. What is the total cash flow for Year 3?

OCF3 = $265,000 (1 - .34) + ($587,000 × .1749)(.34) = $209,806.54 Book value3 = $587,000 × (1 - .1429 - .2449 - .1749) = $256,695.10 Aftertax salvage value = $295,000 - .34($295,000 - 256,695.10) = $281,976.33 C03 = $209,806.54 + 23,000 + 281,976.33 = $514,782.87

REFER BACK TO THE QUIZ RESULTS ON BB FOR QUANTITATIVE PROBLEMS

REFER BACK TO THE QUIZ RESULTS ON BB FOR QUANTITATIVE PROBLEMS

Which one of these is a requirement when computing the net present value of a capital project?

Real cash flows must be discounted using a real rate

How to calculate r to determine NPA when the project is the same risk as the firm as a whole

Risk Free Rate + Beta(Market-Risk Premium)

The sale of an asset creates an aftertax cash flow in an amount equal to the:

Sale price - Tax rate × (Sales price - Book value).

Walks Softly sells customized shoes. Currently, it sells 16,000 pairs of shoes annually at an average price of $68 a pair. The company is considering adding a lower-priced line of shoes that will sell for $39 a pair. Walks Softly estimates it can sell 7,000 pairs of the lower-priced shoes but will sell 1,000 less pairs of the higher-priced shoes by doing so. What is the amount of the sales that should be used when evaluating the addition of the lower-priced shoes?

Sales = (7,000 × $39) - (1,000 × $68) = $205,000

When new product increases the cash flows of existing projects

Synergy (Incremental IRR side effect)

Which one of these statements is correct?

The cost of test marketing a product prior to deciding whether or not to produce is a sunk cost.

Bloomfield's has some equipment sitting idle in a warehouse. The equipment is fully paid for and also fully depreciated. If the firm decides to use this equipment for a new project, what cost, if any, should the firm include in its startup costs for the project?

The current market value of the equipment should be included in the startup costs.

Tradeoff theory

There's a tradeoff between the tax benefits of debt and the costs of financial distress

Down Under Boomerang, Inc., is considering a new three-year expansion project that requires an initial fixed asset investment of $2.61 million. The fixed asset will be depreciated straight-line to zero over its three-year tax life, after which time it will be worthless. The project is estimated to generate $2,050,000 in annual sales, with costs of $745,000. The tax rate is 30 percent and the required return on the project is 15 percent. What is the project's NPV?

Using the tax shield approach to calculating OCF (Remember the approach is irrelevant; the final answer will be the same no matter which of the four methods you use.), we get: OCF = (Sales − Costs)(1 − tC) + tC(Depreciation) OCF = ($2,050,000 − 745,000)(1 − .30) + .30($2,610,000 / 3) OCF = $1,174,500 Since we have the OCF, we can find the NPV as the initial cash outlay plus the PV of the OCFs, which are an annuity, so the NPV is: NPV = −$2,610,000 + $1,174,500(PVIFA15%,3) NPV = $71,647.90

Howell Petroleum is considering a new project that complements its existing business. The machine required for the project costs $3.97 million. The marketing department predicts that sales related to the project will be $2.67 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 25 percent of sales. Howell also needs to add net working capital of $320,000 immediately. The additional net working capital will be recovered in full at the end of the project's life. The corporate tax rate is 35 percent. The required rate of return for Howell is 13 percent. What is the NPV for this project?

We will begin by calculating the initial cash outlay, that is, the cash flow at Year 0. To undertake the project, we will have to purchase the equipment and increase net working capital. So, the cash outlay today for the project will be: Equipment -$3,970,000 NWC - 320,000 Total -$4,290,000 Using the bottom-up approach to calculating the operating cash flow, we find the operating cash flow each year will be: Sales $ 2,670,000 Costs 667,500 Depreciation 992,500 EBT $ 1,010,000 Tax 353,500 Net income $ 656,500 The operating cash flow is: OCF = Net income + Depreciation OCF = $656,500 + 992,500 OCF = $1,649,000 To find the NPV of the project, we add the present value of the project cash flows. We must be sure to add back the net working capital at the end of the project life, since we are assuming the net working capital will be recovered. So, the project NPV is: NPV = −$4,290,000 + $1,649,000(PVIFA13%,4) + $320,000 / 1.134 NPV = $811,165.21

You are evaluating two different silicon wafer milling machines. The Techron I costs $249,000, has a three-year life, and has pretax operating costs of $66,000 per year. The Techron II costs $435,000, has a five-year life, and has pretax operating costs of $39,000 per year. For both milling machines, use straight-line depreciation to zero over the project's life and assume a salvage value of $43,000. If your tax rate is 35 percent and your discount rate is 10 percent, compute the EAC for both machines.

We will need the aftertax salvage value of the equipment to compute the EAC. Even though the equipment for each product has a different initial cost, both have the same salvage value. The aftertax salvage value for both is: Aftertax salvage value = $43,000(1 − .35) Aftertax salvage value = $27,950 To calculate the EAC, we first need the OCF and NPV of each option. The OCF and NPV for Techron I is: OCF = −$66,000(1 − .35) + .35($249,000 / 3) OCF = −$13,850 NPV = −$249,000 − $13,850(PVIFA10%,3) + ($27,950 / 1.103) NPV = −$262,443.65 EAC = −$262,443.65 / (PVIFA10%,3) EAC = −$105,532.48 And the OCF and NPV for Techron II is: OCF = −$39,000(1 − .35) + .35($435,000 / 5) OCF = $5,100 NPV = −$435,000 + $5,100(PVIFA10%,5) + ($27,950 / 1.105) NPV = −$398,312.24 EAC = −$398,312.24 / (PVIFA10%,5) EAC = −$105,073.76 The two milling machines have unequal lives, so they can only be compared by expressing both on an equivalent annual basis, which is what the EAC method does. Thus, you prefer the Techron II because it has the lower (less negative) annual cost.

Which one of the following statements is correct?

When the NPV is positive, both the PI and the IRR will indicate acceptance. Answers: A positive NPV signals a reject decision. Projects should be accepted when the PI is less than one. A payback period that is greater than the required period signals an accept decision. When the IRR exceeds the required return, a project should be rejected.

With corporate taxes and bankruptcy costs, the firm value is maximized where the ____________________________ from the _______________________ is _____________________ by the _______________ in ______________________________.

Where the additional benefit from the interest tax shield is just offset by the increase in expected bankruptcy costs

A project has an initial cost of $68,300 and cash flows of $38,700, $102,300, and -$18,100 for Years 1 to 3, respectively. If the required rate of return for this investment is 8.7 percent, should you accept it based solely on the internal rate of return rule? Why or why not?

You cannot apply the IRR rule in this case because there are multiple IRRs. --Since the cash flow in Year 3 is a negative value, there are multiple IRRs. Thus, the IRR rule does not apply.

When the present value of the cash inflows exceeds the initial cost of a project, then the project should be: accepted because the internal rate of return is positive. accepted because the profitability index is greater than 1. accepted because the profitability index is negative. rejected because the internal rate of return is negative. rejected because the net present value is negative.

accepted because the profitability index is greater than 1.

The book value of an asset is primarily used to compute the: The book value of an asset is primarily used to compute the:

amount of tax due on the sale of an asset.

The incremental cash flows of a project are best defined as:

any change in a firm's cash flows resulting from the addition of the project including opportunity costs.

A project that will improve the manufacturing efficiency of a firm but will generate no additional sales is referred to as a(n) _____ project.

cost-cutting

Which of the following is incorrect? a. net working capital Appears on the balance sheet b. net working capital Appears on the statement of cash flows c. net working capital Not on the income statement d. net working capital On the income statement

d. net working capital On the income statement

Which one of the following is a capital budgeting decision? the constant dividend growth model. discounted cash flow valuation. average accounting valuation. the expected earnings model. the Capital Asset Pricing Model.

discounted cash flow valuation.

New product reduces the sales and the cash flows of existing products.

erosion (Incremental IRR side effect)

Sunk costs include any cost that:

has previously been incurred and cannot be changed.

The payback method

ignores the time value of money.

The cash flows for a project include the:

incremental operating cash flow, as well as the capital spending and net working capital requirements.

The discount rate that makes the net present value of an investment exactly equal to zero is called the:

internal rate of return.

The discount rate that makes the net present value of an investment exactly equal to zero is called the: external rate of return. internal rate of return. average accounting return. profitability index. equalizer.

internal rate of return.

What is net working capital?

is a capital expenditure on fixed assets

Net present value: when applied properly, can accurately predict the cash flows that will occur if a project is implemented. is highly independent of the rate of return assigned to a particular project. is the preferred method of analyzing a project even though the cash flows are only estimates. is unaffected by the timing of each and every cash flow related to a project. is unaffected by the timing of the purchase of the fixed assets required for a project.

is the preferred method of analyzing a project even though the cash flows are only estimates.

Which one of the following will decrease the net working capital of a firm?

making a payment on a long-term debt

The possibility that more than one discount rate will make the NPV of an investment equal to zero is called the _____ problem. net present value profiling operational ambiguity mutually exclusive investment decision economies of scale multiple rates of return

multiple rates of return

For capital budgeting purposes, *allocated cost* should be viewed as a cash outflow of a project only if it is an incremental cost of the project

n/a

Incremental cash flows (side effects, externalities) cannibalism or synergy

n/a

incremental cash flows -opportunity cost -side effects -taxes -inflation Irrelevant -sunk cost

n/a

The difference between an investment's market value and its cost is the: net present value. internal rate of return. payback period. profitability index. discounted payback period.

net present value.

The most valuable investment given up if an alternative investment is chosen is referred to as a(n):

opportunity cost.

The length of time required for an investment to generate cash flows sufficient to recover the initial cost of the investment is called the:

payback period

The present value of an investment's future cash flows divided by the initial cost of the investment is called the:

profitability index

You spent $500 last week fixing the transmission in your car. Now, the brakes are acting up and you are trying to decide whether to fix them or trade the car in for a newer model. In analyzing the brake situation, the $500 you spent fixing the transmission is a(n) _____ cost.

sunk

A cost that already occurred and cannot be changed by the decision to accept or reject the project. *not incremental cash flows, should be ignored*

sunk cost

A project creates value for a firm's owners: when the net present value of the project is positive. any time the cash inflows exceed the cash outflows. whenever the internal rate of return is less than the required return. whenever the profitability index is less than one. whenever the payback period exceeds the life of the project.

when the net present value of the project is positive.

The internal rate of return:

will provide the same accept/reject decision as NPV when cash flows are conventional and projects are independent.


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