Finance Final
Which of the following statements is correct about the reinvestment assumptions that are inherent in the use of the net present value (NPV) method and the internal rate of return (IRR) method?
The NPV method assumes that the project's cash flows will be reinvested at the firm's required rate of return, whereas the IRR method assumes reinvestment at the project's IRR.
Alpha Inc. combines the marginal cost of capital (MCC) schedule with the investment opportunity schedule (IOS) on a single graph. Which of the following areas on the MCC/IOS graph shows the maximum excess of marginal returns over marginal costs?
The area that is above the MCC schedule but below the IOS schedule when the IOS line is above the MCC line
Which of the following statements is correct about using the capital asset pricing model (CAPM) to determine a firm's component costs of capital?
The capital asset pricing model (CAPM) assumes investors are well diversified, whereas the discounted cash flow (DCF) approach assumes the firm grows at a constant growth rate.
Which of the following situations would intensify the business risk borne by a firm's common stockholders?
The firm issues new fixed-income securities, such as bonds, to raise funds to support operations.
Which of the following factors would tend to reduce a firm's business risk?
The firm takes actions to improve the stability of its day-to-day operations.
Which of the following statements is correct?
The net present value (NPV) technique and internal rate of return (IRR) technique can lead to conflicting investment decisions when mutually exclusive projects are being evaluated.
Which of the following statements best describes the post-audit function in the capital budgeting process?
The post-audit involves comparing the actual results of previous capital budgeting decisions with the forecasted results to identify and explain any differences.
Union Atlantic Corporation, which has a required rate of return equal to 14 percent, is evaluating a capital budgeting project that requires an initial investment of $170,000. The project will generate a $60,750 cash inflow at the year-end of each of the next four years. According to this information, which of the following statements is correct?
The project is acceptable because its net present value is positive. (NPV) of the project = Present value of cash inflows - Present value of cash outflow = = {[$60,750/(1.14)1] + [$60,750/(1.14)2] + [$60,750/(1.14)3 + [$60,750/(1.14)4]} - $170,000 = ($53,289.47 + $46,745.15 + $41,004.52 + $35,968.88) − $170,000.00 =$177,008.02 - $170,000.00 = $7,008.02; the project's IRR = 16% Because the net benefit computed on a present value basis—that is, NPV—is positive, the asset (project) is considered an acceptable investment.
Suppose a firm uses both the net present value (NPV) technique and the internal rate of return (IRR) technique to evaluate two mutually exclusive capital budgeting projects. If a ranking conflict exists between NPV and IRR, which of the following criteria should be used to make the final investment decision?
The project with the higher net present value (NPV) should be purchased.
________ is a measure that indicates a firm's ability to meet the annual interest obligations on its outstanding debt.
Times-interest-earned (TIE) ratio
Which of the following capital budgeting evaluation techniques is based on the concept that it is better to recover the cost of (investment in) a project sooner rather than later?
Traditional payback period (PB)
A firm should continue to invest in capital budgeting projects to the point where the marginal cost of capital (MCC) equals the marginal return (internal rate of return, IRR) generated by the last project that is purchased.
True
According to the signaling theory to explain differences in firms' capital structures, if a firm raises new capital by issuing debt rather than by issuing stock, it is a signal that the firm has very good future prospects.
True
Any capital budgeting decision should depend solely on a project's forecasted cash flows and the firm's required rate of return. Such a decision should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.
True
Because the value of a firm's stock depends on the after-tax cash flows it generates during its life, after-tax component costs of capital (i.e., the after-tax cost of debt) are used when computing a firm's weighted average cost of capital (WACC).
True
Effective capital budgeting can improve the timing of asset acquisition and the quality of assets purchased. By forecasting the needs for capital assets in advance, a firm will have an opportunity to purchase and install assets before they are needed.
True
Even if a firm obtains all of its common equity financing from retained earnings, its marginal cost of capital (MCC) schedule could still increase if very large amounts of new capital are raised.
True
One advantage to using the traditional payback period technique is that it provides a rough measure of a project's liquidity and risk.
True
Suppose a firm is evaluating a capital budgeting project using the net present value (NPV) technique. If the firm's required rate of return increases, the project's NPV will decrease.
True
The component costs of capital are market-determined variables in as much as they are based on investors' required returns.
True
The net present value (NPV) method implicitly assumes that the rate at which cash flows can be reinvested is the required rate of return, whereas the internal rate of return (IRR) method implies that the firm has the opportunity to reinvest at the project's IRR.
True
The optimal capital structure is the capital structure that strikes a balance between risk and return such that the firm's stock price is maximized.
True
The two main purposes of post-audit are to improve forecasts and to improve operations.
True
According to the signaling theory, when should a firm use debt to finance beyond the normal target capital structure?
When the firm has favorable prospects
For a particular project, other things held constant, an increase in the firm's required rate of return will result in _____.
a decrease in the project's net present value (NPV)
If the net present value (NPV) of a project is positive,:
accepting the project will increase the value of the firm.
Beige Inc. is evaluating three capital budgeting projects whose internal rates of return (IRRs) are greater than the firm's marginal cost of capital (MCC). Beige should choose:
all of the projects whose internal rates of return (IRRs) are greater than the firm's weighted average cost of capital WACC).
Under normal circumstances, the weighted average cost of capital (WACC) is used as the firm's required rate of return because:
as long as the firm's investments earn returns greater than its WACC, the value of the firm will not decrease.
When determining a project's true profitability, it is normally better to compute the project's modified internal rate of return (MIRR) rather than its internal rate of return (IRR) because the MIRR technique:
assumes that the project's cash flows are reinvested at the firm's required rate of return, whereas IRR assumes the cash flows are reinvested at the project's IRR.
The situation in which managers have different (better) information about their firm's prospects than outside investors is known as _____ information.
asymmetric
The average rate of return that investors require to provide funds to the firm in the form of debt is the ________.
average yield to maturity (YTM) on the firm's bonds
The risk associated with a firm's operations, ignoring any financing effects, is known as _____ risk.
business
A company's capital structure consists of common stock only, which amounts to $14 million. However, this year, the company plans to issue $7 million of debt, and use the proceeds to repurchase $7 million of its existing equity. The stock repurchase should not change the size of the company. As a result, any change in the firm's earnings per share (EPS) must be a result of the change in its:
capital structure.
The value of any asset—real or financial—is based on the _____ and the _____.
cash flow expected to be generated by the asset; the rate of return required by investors
In capital budgeting analyses, the primary difference between the traditional payback period (PB) technique and the discounted payback period (DPB) technique is that the DPB:
considers the time value of money.
A firm's weighted average cost of capital (WACC) is:
determined by participants in the financial markets, because investors set the minimum return they require (demand) to provide the funds the firm invests in capital budgeting projects.
Suppose that a firm has a degree of financial leverage (DFL) that is greater than 1.0; that is, DFL > 1. If the firm's sales decrease by 1 percent, its ______ will decrease by more than 1 percent.
earnings per share (EPS)
At the time Modigliani and Miller (MM) developed their capital structure theory, the assumptions that they made were realistic.
false
If a firm increases the proportions of debt and preferred stock that are contained in its capital structure, its _____.
financial risk will increase
Operating leverage refers to the presence of _____.
fixed operating costs
The marginal cost of capital (MCC) schedule generally rises, which implies that the weighted average cost of capital:
generally increases because the firm incurs higher flotation costs and higher financial risk as it raises more funds through new debt and new equity issues.
The net present value (NPV) of a project is negative when the discount rate used is:
greater than the project's internal rate of return (IRR).
Everything else equal, a project that has a long traditional payback period (PB) _____.
has greater implied risk than a project that has a shorter PB
The present value of the expected net cash flows of all the projects undertaken by a firm will most likely exceed the present value of the firm's expected net profit after tax, because:
income is reduced by depreciation and other non-cash charges, whereas cash flows are not.
The marginal cost of capital generally _____ as more capital is raised during a given period.
increases
To determine the actual cost of using debt, a firm must adjust its bonds' average yield to maturity for the fact that _____.
interest payments on debt represent a tax deductible expense to the firm
If a project's _____ exceeds the firm's weighted average cost of capital (WACC), its net present value (NPV) will be positive.
internal rate of return (IRR)
Which of the following capital budgeting assumes that any cash flows generated by a project can be reinvested at its internal rate of return (IRR)?
internal rate of return (IRR) method
The rates of return, or costs, that a firm must pay to raise funds to invest in capital budgeting projects are determined by the:
investors who purchase the firm's stocks and bonds in the financial markets.
The traditional payback period technique that is used in capital budgeting analyses:
is the simplest and oldest formal method used to evaluate capital budgeting projects.
If a project's net present value (NPV) is positive,:
it is an acceptable investment.
According to the bond-yield-plus-risk-premium approach, a firm's cost of retained earnings, rs, can be estimated by adding a risk premium of 3 to 5 percentage points to:
its before-tax interest cost of debt, rs.
If a capital budgeting project has a negative net present value (NPV),
its discounted payback period (DPB) is greater than the project's economic life.
The annual growth of Omega Inc's operations fluctuates substantially. As a result, using the dividend discount model (DDM) to estimate Omega's cost of retained earnings, rs, is difficult because:
its growth rate (g) is not stable, which makes it difficult to estimate.
With the improvement in the technology and understanding of discounting techniques, both the net present value (NPV) technique and internal rate of return (IRR) technique used in capital budgeting analyses have become more popular because these techniques provide decisions that help the firm to _____.
maximize its value
As a general rule, the optimal capital structure is the one that:
maximizes its stock price and minimizes its weighted average cost of capital.
A times-interest-earned (TIE) ratio that is less than 1 suggests that a firm _____.
might not be able to meet its annual interest obligations on its debt
If a capital budgeting project is purchased, a firm's value, and thus its stockholders' wealth, will change by the amount of the project's _____.
net present value (NPV)
Suppose a firm has evaluated four capital budgeting projects and, using one of the time value of money capital budgeting techniques, has determined that all of the projects are acceptable. If the projects are mutually exclusive, which of the following capital budgeting techniques should be used to make the purchasing decision to ensure the firm's value is maximized?
net present value (NPV)
Which of the following capital budgeting techniques makes the assumption that the project's cash flows are reinvested at the firms required rate of return?
net present value (NPV)
The percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales is known as the degree of _____.
operating leverage
The presence of fixed operating costs is known as _____.
operating leverage
Modified internal rate of return (MIRR) is the discount rate that forces the present value of a project's terminal value to equal the _____.
present value of its cash outflows
Which of the following mathematical expressions is used to calculate the after-tax cost of debt, rdT?
rdT = Bondholders' required rate of return (YTM) - Tax savings
According to the signaling theory, a firm with unfavorable future prospects might issue common stock in an effort to:
share any losses with new stockholders (owners).
A firm should raise capital according to its optimal capital structure so as to maximize its _____.
stock price
The ultimate purpose of a capital budget is to forecast _____.
the funds required to purchase fixed assets for future projects
If the traditional payback period method is used to evaluate a capital budgeting project, the project is considered acceptable if _____.
the payback period is less than the maximum cost-recovery time established by the firm
If a project's discounted payback period is less than its useful life, _____.
the present value of its future cash flows exceeds its initial cost
A project's net present value is equal to:
the present value of the expected future cash inflows minus the present value of all the cash outflows.
The percentage change in earnings per share (EPS) that results from a given percentage change in sales is known as the firm's degree of_____ leverage.
total
In countries where capital gains are not taxed, investors should prefer to own stocks rather than bonds.
true
The degree of operating leverage is defined as the percentage change in earnings before interest and taxes (EBIT) associated with a given percentage change in sales.
true
The _____ on a bond is the cost to the firm for using bondholders' funds.
yield to maturity (YTM)
Trueware Corporation is a start-up firm with a capital structure that includes 25 percent debt. Trueware has no preferred stock. The firm has two possible scenarios for its operations: Ruby or Emerald. The Ruby scenario has a 70 percent probability of occurring and the forecast earnings before interest and taxes (EBIT) in this scenario is $80,000. The Emerald scenario has a 30 percent chance of occurring and the EBIT is expected to be $32,000. Further, the firm's cost of debt is 10 percent. The firm has $500,000 in total assets and its marginal tax rate is 30 percent. The company has 22,000 shares of common stock outstanding. Calculate the difference in earnings per share (EPS) for the capital structure
$1.53 Total assets = $500,000; Debt = 0.25 × Total assets = 0.25 × $500,000 = $125,000 Equity = (1 − 0.25) × Total assets = 0.75 × $500,000 = $375,000 Net income (NIRuby) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) Net income (NIRuby) = [$80,000 - (0.10 × $125,000)] × (1 - 0.3) = $47,250 EPSRuby = Net income/Number of shares outstanding EPSRuby = $47,250/22,000 shares = $2.15 per share Net income (NIEmerald) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) Net income (NIEmerald) = [$32,000 - (0.10 × $125,000)] × (1 - 0.3) = $13,650 EPSEmerald = Net income/Number of shares outstanding EPSEmerald = $13,650/22,000 shares = $0.62 per share Difference between the earnings per share = $2.15 - $0.62 = $1.53
Smart Solutions Inc. is evaluating a capital project for expansion. The project costs $10,000, and it is expected to generate $5,000 per year for three years. If the firm's required rate of return is 10 percent, what is the project's terminal value?
$16,550 Terminal value = [$5,000 × (1.10)2] + [$5,000 × (1.10)1] + [$5,000 × (1.10)0] = $6,050 + $5,500 + $5,000 = $16,550 Alternative solution using TVM keys on a financial calculator: N = 3, I/Y = 10, PV = 0, PMT = −5,000 Compute FV = $16,550.
A firm is evaluating a capital budgeting project that generates cash inflows equal to $50 per year for the next five years. If the project's traditional payback period (PB) is 3.6 years, what is its initial cost?
$180 Project's initial cost = Payback period × Cash flow generated every year = 3.6 years × $50 = $180.
Copybold Corporation is a start-up company that has a capital structure with a debt/assets ratio equal to 0.75. Copybold has no preferred stock. There are two possible scenarios with respect to the firm's operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring, and the forecast earnings before interest and taxes (EBIT) in this scenario is $60,000. The Famine scenario has a 40 percent chance of occurring, and the EBIT is expected to be $20,000. Further, the firm's cost of debt is 12 percent. The firm has $400,000 in total assets, and its marginal tax rate is 40 percent. The company has 10,000 shares of stock outstanding. What is the difference between the earnings per share (EPS) forecasts for the Feast scenario and the Famine scenario?
$2.40 per share Total assets = $400,000; Debt = 0.75 × Total assets = 0.75 × $400,000 = $300,000 Equity = (1 − 0.75) × Total assets = 0.25 × $400,000 = $100,000 Net income (NIFeast) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) = [$60,000 - (0.12 × $300,000)] × (1 - 0.4) = $14,400 EPSFeast = Net income/Number of shares outstanding EPSFeast = $14,400/10,000 shares = $1.44 per share Net income (NIFamine) = [EBIT - (Cost of debt × Total debt)] × (1 - Tax rate) Net income (NIFamine) = [$20,000 - (0.12 × $300,000)] × (1 - 0.4) Net income (NIFamine) = -$9,600 EPSFamine = Net income/Number of shares outstanding EPSFamine = -$9,600/10,000 shares = -$0.96 per share Difference between the earnings per share = $1.44 - (-$0.96) = $2.40 per share
Allison Engines Corporation has established a target capital structure of 40 percent debt and 60 percent common equity. The firm expects to earn $150,000 in after-tax income during the coming year, and it will retain 30 percent of those earnings. What is the break point of retained earnings?
$75,000 Break point = Maximum amount of retained earnings/Proportion of common equity = ($150,000 × 30%)/(60%) = $45,000/60% = $75,000.
Quick Launch Rocket Company, expects its sales to increase by 50 percent in the coming year. The firm's current earnings per share (EPS) is $3.25. Its degree of operating leverage is 1.6 and its degree of financial leverage is 2.1. What is the firm's projected EPS for the coming year?
$8.71 EPS0) × [1 + (DTL × %ΔSales)] = $3.25 [1 + (1.6 × 2.1 × 0.5)] = $3.25[1 + 3.36(0.5)] = $3.25 × 2.68 = $8.71
Beige Inc. plans to issue preferred stock that pays a dividend equal to $11.52 per share and sells for $120 per share to raise funds to support future growth. It will cost 4 percent, or $4.80 per share, to issue the new preferred stock, which means that Beige will net $115.20 per share. What is the cost of preferred stock Beige should use when computing its weighted average cost of capital (WACC)?
10.0% Beige's cost of preferred stock = Preference dividend/(Current market price - Flotation costs) = $11.52/($120.00 - $4.80) = $11.52/$115.20 = 0.10 = 10.0%
Coral Inc.'s preferred stock currently sells for $90 a share and pays a dividend of $10 per share. However, the firm will net only $80 per share if it issues new preferred stock. What is Coral's cost of preferred stock? Coral's marginal tax rate is 35 percent.
12.50% Cost of newly issued preferred stock = Preferred dividend/Net funds raised from the issue of preferred stock = $10/$80 = 12.50%
Bouchard Company's stock sells for $20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company must pay flotation cost equal to 20 percent when it issues new common stock. What is Bouchard's cost of issuing new common stock?
12.63% Cost of new equity = (Expected dividend/Net price per share received) + Constant growth rate of the firm = {[$1.00 × (1 + 0.06)]/[$20 × (1 - 0.20)]} + 0.06 = [($1.06)/($16)] + 0.06 = 0.1263 = 12.63%
Los Angeles Lumber Company (LALC) is considering a project with a cost of $1,000 at Year 0 and inflows of $300 at the end of Years 1-5. LALC's cost of capital is 10 percent. What is the project's modified IRR (MIRR)?
12.87% future value (FV) of cash flows (CFs) at 10%: N = 5; I/Y = 10; PMT = 300; PV = 0; Solve for FV = $1,831.53; To find MIRR: N = 5; PV = -1,000.00; PMT = 0; FV = 1,831.53; Solve for I/Y = 12.866% or MIRR = 12.87%.
Oval Inc. just paid a dividend equal to $1.50 per share on its common stock, and it expects this dividend to grow by 4 percent per year indefinitely. The firm plans to issue common stock, which has a $16 per share market price, to raise funds to support operations. Oval's investment bankers estimate that the flotation costs for new issues of common stock will be equal to 8 percent of the issue (market) price. What is Oval's cost of new common equity, re?
14.60% Cost of newly issued common stock = [Dividend expected at the end of year 1/Market price × (1 - Flotation cost)] + Growth rate = {[$1.50 × (1 + 0.04)]/[$16 × (1 - 0.08)]} + 4% = $1.56/$14.72 + 0.06 = 0.1460 = 14.60%
J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for $40 per share. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. If it issues new common stock, the firm will incur flotation costs equal to 7 percent. What is the firm's cost of retained earnings?
15.50% Cost of retained earnings = (Dividend expected to be paid at the end of year 1/Current market price of stock) + Growth rate = {[$2 × (1 + 10%)]/$40.00} + 10% = ($2.20/$40) + 10% = 15.50%
Super Solutions Inc. just paid a dividend equal to $3.00 per share. Its stock sells for $33.00 per share, it is growing at an annual rate equal to 6 percent, which is expected to continue long into the future. What is Super's cost of retained earnings?
15.64% Cost of retained earnings using discounted cash flow (DCF) approach = (Dividend expected to be paid at the end of year 1/Current market price of stock) + Growth rate = {[$3 × (1 + 6%)]/$33.00} + 6% = ($3.18/$33) + 6% = 9.64% + 6% = 15.64%
Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon rate, semiannual interest payments, a current maturity of 20 years, and a market value equal to their par value of $1,000. The firm's marginal tax rate is 40 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to determine its cost of retained earnings. What is Tangerine's component cost of retained earnings?
16.0% Cost of retained earnings per bond-yield-plus-risk-premium approach = Bond yield to maturity (YTM) + Risk premium = 12% + 4% = 16%
Marigold Inc.'s common stock currently sells for $40 per share, but the firm will net only $34 per share if it issues new common stock. The firm recently paid a dividend equal to $2 per share on its common stock, and investors expect the dividend to grow indefinitely at a constant rate of 10 percent per year. What is Marigold's cost of new common equity?
16.47% Cost of newly issued common stock = [Dividend expected at the end of year 1/Net funds received from issue] + Growth rate = {[$2.00 × (1 + 0.10)]/$34} + 0.10 = 0.1647 = 16.47 %
The capital budgeting director of Sparrow Corporation is evaluating a project that costs $200,000, is expected to last for 10 years, and produces after-tax cash flows equal to $44,503 per year. If the firm's required rate of return is 14 percent and its tax rate is 40 percent, what is the project's internal rate of return (IRR)?
18% Inputs: N = 10, PV = -200,000, PMT = 44,503, FV = 0
Assume that a firm's degree of financial leverage (DFL) is 1.2. If sales this year increase by 20 percent, the firm expects a 60 percent increase in earnings per share (EPS). What is the firm's degree of operating leverage of the firm?
2.5× (DTL) = %Δ in EPS ÷ %Δ in Sales = 60% ÷ 20% = 3.0× = DOL × DFL DOL = DTL ÷ DFL = 3.0 ÷ 1.2 = 2.5×
Project A, which costs of $1,000 to purchase, will generate net cash inflows equal to $500 at the end of each of the next three years. The project's required rate of return is 10 percent. What are the project's internal rate of return (IRR) and modified internal rate of return (MIRR)?
23.4%; 18.3% CFO = -$1,000, CF1 = $500, CF2 = $500, CF3 = $500, IRRA = 23.38%; For computing MIRR, find future value (FV) of cash flows (CFs) at 10%: N = 3; I/Y = 10; PV = 0; PMT = 500; Solve for FV = $1,655.00; To find MIRR: N = 3; PV = -1,000; PMT = 0; FV = 1,655; Solve for I/Y = 18.29% or MIRR = 18.29%.
An investment firm is selling a new product that will pay $100at the end of each of the next 20 years. If the new investment costs $1,246 to purchase, what is its internal rate of return (IRR)?
5% N = 20, PV = -1,246, PMT =100, FV = 3,310; Output: I/Y = IRR = 5%.
The degree of leverage concept is designed to show how changes in sales affect earnings before interest and taxes (EBIT) and earnings per share (EPS). If a 10 percent increase in sales causes EPS to increase from $1.00 to $1.50 and if the firm uses no debt, then what is its degree of operating leverage?
5.0×' DTL = %ΔEPS/%ΔSales Note that EPS rises by 50 percent, from $1.00 to $1.50, on a 10 percent increase in sales. Hence, DTL = 0.50/0.10 DTL = 5.00 Now, DTL = 5.00 = (DOL) × (DFL) Because the firm uses no debt, DFL equals 1. Therefore, DOL = DTL × DFL = 5.0 × 1.0 = 5.0×
SW Inc.'s preferred stock, which pays a $5.25 dividend each year, currently sells for $62.50. The company's marginal tax rate is 40 percent. When it issues preferred stock, SW normally incurs flotation costs equal to 8 percent. What is the cost of preferred stock, rps, that should be included in the computation of the SW Inc.'s weighted average cost of capital (WACC)?
9.13% Component cost of preferred stock = Preferred stock dividend/[Current market price of the preferred stock × (1 - Percentage cost of issue of preferred stock)] = $5.25/[$62.50 × (1 - 0.08)] = $5.25/$57.50 = 0.0913 = 9.13%
Which of the following is true of a break point on a firm's marginal cost of capital (MCC) schedule?
A break point (BP) is defined as the last dollar of new total capital that can be raised before an increase in the firm's weighted average cost of capital (WACC) occurs.
Which of the following statements concerning the effect of taxes on a firm's cost of capital is correct?
All else equal, an increase in the corporate tax rate will result in a decrease in the firm's weighted average cost of capital.
Which of the following is a major assumption that is embedded in the capital asset pricing model (CAPM), which is often used to estimate the cost of retained earnings, rs?
All investors are well diversified.
Suppose a firm evaluates four independent investments using only capital budgeting techniques that consider the time value of money. Which of the following statements is correct?
All of the capital budgeting techniques the company uses should provide the same accept/reject decisions.
Which of the following statements about the marginal cost of capital is correct? Assume everything else is equal.
An increase in the tax rate will decrease a firm's marginal cost of debt.
Which of the following statements concerning the capital structures of Japanese companies is correct?
Companies in Japan use greater proportions of debt than companies in most other countries.
Which of the following statements concerning a firm's degree of financial leverage (DFL) is correct? Assume everything else is equal.
Compared to a lower DFL, a higher DFL implies a greater financial risk.
According to the trade-off theory that has been suggested as a possible explanation for the differences in firms' capital structures that we observe in the real world, which of the following securities is the least expensive form of financing for a particular firm?
Corporate debt
Which of the following cost of capital measures must be adjusted to account for tax savings?
Cost of debt, which is measured as the debt's yield to maturity (YTM)
Two firms, Tangerine Inc. and Cyan Inc. analyzed the same capital budgeting project. Tangerine Inc. determined that the project's internal rate of return (IRR) is 9 percent. Cyan Inc. used the net present value (NPV) method to evaluate the project and determined that it is not acceptable. Given this information, which of the following statements is correct?
Cyan Inc.'s required rate of return is greater than 9 percent.
Which of the following statements concerning capital structures around the world is correct?
Differences among countries in both bankruptcy costs and equity reporting costs leads to the conclusion that U.S. firms should have more equity and less debt than firms in Japan and Germany.
The degree of financial leverage (DFL) is defined as the percentage change in ______ that results from a particular percentage change in _____.
EPS; EBIT
A capital budgeting project is acceptable if the firm's rate of return required is greater than the project's internal rate of return (IRR).
False
A firm's cost of capital (WACC) represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm does not decrease.
False
A firm's cost of external equity capital (cost of issuing new stock) is equal to the rate of return that stockholders demand (require) to invest in the firm's outstanding common stock.
False
A firm's risk can be partitioned into financial risk and business risk. An increase in the financial risk results in a decrease in business risk.
False
According to the signaling theory to explain differences in firms' capital structures, an announcement of a new stock issue by a mature, seasoned firm that has numerous financing alternatives generally is seen as a signal that the its future prospects are very positive.
False
For a particular firm, depending on tax rates, flotation costs, and the attitude of investors, the cost of new common equity, re, can be less than, equal to, or greater than its before-tax cost of debt, rd.
False
If a firm's times-interest-earned (TIE) ratio decreases, the probability that it will default on its outstanding debt also decreases.
False
If the debt/assets ratio increases, the costs of both debt and equity normally decrease.
False
It is fairly easy to determine how changes in a firm's degree of financial leverage (DFL) affect its P/E ratio.
False
The internal rate of return (IRR) of a project that generates its largest cash flows in the early years of its life is more sensitive to changes in the firm's required rate of return than is the IRR of a project whose largest cash flows come later in life.
False
The main reason that the net present value (NPV) method is regarded as being conceptually superior to the internal rate of return (IRR) method for the purpose of evaluating mutually exclusive investments, is that mutually exclusive projects have multiple internal rates of return (IRRs).
False
The marginal cost of capital (MCC) is the weighted average cost of the last dollar of new capital that the firm raises. The MCC generally declines as greater amounts of a specific type of capital are raised during a given period.
False
The net present value (NPV) and internal rate of return (IRR) methods will always lead to the same investment decisions when mutually exclusive projects are being evaluated.
False
The probability of incurring bankruptcy increases as a firm's debt/equity ratio decreases.
False
When considering two mutually exclusive projects, the financial manager should always select the project with the higher internal rate of return, provided the projects have the same initial cost.
False
When the discounted payback period (DPB) technique is used to evaluate a capital budgeting project, it should be accepted when its DPB is greater than the project's expected life.
False
This year, Ferro Inc. generated sales of $10 million. Its fixed operating cost is $1 million and its variable cost ratio is 30 percent of sales. Ferro has $60 million of debt outstanding with a before-tax cost of 12 percent. Which of the following statements about Ferro's times interest earned (TIE) ratio is correct?
Ferro's TIE ratio is 0.83, which suggests it does not have enough earnings to meet the required interest payments. Times-interest-earned ratio = Earnings before interest and taxes/Interest charges = (Sales - Variable cost - Fixed cost)/Interest charges = [$10,000,000 - ($10,000,000 × 30%) - $1,000,000]/($60,000,000 × 12%) = 0.83
Which of the following industries normally has relatively low business risk?
Firms that produce staple goods, such as grocery stores and utility companies
Which of the following statements is true about the flotation costs that are incurred when a firm issues new securities to raise funds?
Floatation costs increase the cost of using funds; e.g., the cost of issuing new common stock is greater than the cost of retained earnings because the firm must pay flotation costs to issue new equity.
What does a degree of financial leverage (DFL) of 2.0 indicate?
For every 1 percent change in its EBIT, the firm's EPS will change by 2 percent.
Which of the following statements concerning a firm's times-interest earned (TIE) ratio is correct?
Generally the lower its TIE ratio, the higher the probability that the firm will default on its debt.
Which of the following is considered a component of financial risk?
Interest payments on bonds
Luxury Production Materials (LPM) generated the following information for its capital budgeting manager: Capital Structure Project Cost IRR Type of Capital Proportion D $70,000 18.0% Debt 60.0% E 65,000 15.0 Common equity 40.0 F 75,000 14.0 G 72,000 12.0 LPM's weighted average cost of capital (WACC) is 13 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If LPM expects to generate $80,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible.
Projects D and E should be purchased.
Marvelous Manufacturing (MM) generated the following information for its capital budgeting manager: Capital Structure Project Cost IRR Type of Capital Proportion W $65,000 15% Debt 30% X 70,000 13 Common equity 70 Y 75,000 12 Z 70,000 11 MM's weighted average cost of capital (WACC) is 12 percent if the firm does not have to issue new common equity; if new common equity is needed, its WACC is 16 percent. If MM expects to generate $70,000 in retained earnings this year, which project(s) should be purchased? Assume that the projects are independent and indivisible.
Projects W and X should be purchased.
