Finance final

what can a firm not control

1) Interest rates in economy-if interest rates rise, cost of debt increases 2) general level of stock prices -if stock prices decline the cost of equity will rise 3) tax rates

what can a firm affect its cost of capital by

1) by changing its capital structure 2) by changing its dividend payout ratio 3) by altering capital budgeting decision rules to accept projects with more or less risk than projects

Of the following new product expansion situations, only one would not result in incremental cash flows so it should not be included in the capital budgeting analysis. Which situation is it?

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

A shift from straight-line to MACRS depreciation.

A shift from straight-line to MACRS depreciation.

rd(1-T)

After-tax component cost of debt is the debt used to calculate the weighted average cost of capital - the after tax cost of debt is lower than its before tax cost because interest is tax deductible T is the firms marginal tax rate

nternational Advertising Services has two projects that are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. International's WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is CORRECT?

Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely:

Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized.

A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings?

Bond yield 8.75% Risk premium 3.85% rs = rd + Risk premium 12.60%

r upper d (1-T)

Calculate weighted average cost of capital = interest rate on new debt - tax savings usually used to calculate wacc

Rivoli Inc. hired you as a consultant to help estimate its cost of capital. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

D0 $0.80 P0 $22.50 g 8.00% D1 = D0 × (1 + g) $0.864 rs = D1/P0 + g 11.84%

Assume that Kish Inc. hired you as a consultant to help estimate its cost of capital. You have obtained the following data: D0 = $0.90; P0 = $27.50; and g = 7.00% (constant). Based on the DCF approach, what is the cost of equity from retained earnings?

D0 $0.90 P0 $27.50 g 7.00% D1 = D0 × (1 + g) $0.963 rs = D1/P0 + g 10.50%

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

D1 $0.67 P0 $27.50 g 8.00% rs = D1/P0 + g 10.44%

Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years, and it can be depreciated according to the depreciation rates below. The firm expects to operate the machine for 4 years and then to sell it for $12,500. If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? Year Depreciation Rate 1 0.20 2 0.32 3 0.19 4 0.12 5 0.11 6 0.06

Deprec. Annual Year-end Year Rate Basis Deprec. Book Value 1 0.20 $50,000 $10,000 $40,000 2 0.32 50,000 16,000 24,000 3 0.19 50,000 9,500 14,500 4 0.12 50,000 6,000 8,500 5 0.11 50,000 5,500 3,000 6 0.06 50,000 3,000 0 1.00 $50,000 Gross sales proceeds $12,500 Book value, end of Year 4 8,500 Profit $ 4,000 Tax on profit Rate = 40% 1,600 AT salvage value = market value +/- taxes $ 10,900

Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?

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

Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow? Equipment cost (depreciable basis) $65,000 Straight-line depreciation rate 33.333% Sales revenues, each year $60,000 Operating costs (excl. depreciation) $25,000 Tax rate 35.0%

Equipment life, years 3 Equipment cost $65,000 Depreciation: Rate = 33.333% $21,667 Sales revenues $60,000 - Basis × rate = depreciation 21,667 - Operating costs (excl. deprec.) 25,000 Operating income (EBIT) $13,333 - Taxes Rate = 35.0% 4,667 EBIT(1 - T) $ 8,667 + Depreciation 21,667 Cash flow, Year 1 $ $30,333

independent projects

If IRR exceeds projects wacc accept the project if IRR is less than project reject it

Which of the following statements is correct?

If a project has an NPV greater than zero, then taking on the project will increase the value of the firm's stock.

Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT?

If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

Which of the following statements is CORRECT?

If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.

Which of the following statements about capital budgeting is CORRECT?

If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration

Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?

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

Mountaineer Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Mountaineer has a WACC of 10%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT

If the crossover rate is 8%, Project B will have the higher NPV

Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

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

Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?

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

Global Spice Co. is considering a new project, but all methods for assessing risk indicate that the project's risk is greater than the risk of the firm's average project. In evaluating this project, it would be reasonable for Global Spice's management to do which of the following?

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock?

Increase the percentage of debt in the target capital structure.

In capital budgeting decisions, corporate risk will be of least interest to:

Institutional investors.

IFF

Internal rate of return

Which of the following statements about IRR and WACC is CORRECT?

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

A company's new project evaluation should include all of the following EXCEPT:

Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.

modified IRR (MIRR)

Similar to IRR except it is based on the assumption that cash flows are reinvested at the wacc or some other explicit rate

CAPM approach

Step 1 Estimate the risk-free rate, . We generally use the 10-year Treasury bond rate as the measure of the risk-free rate, but some analysts use the short-term Treasury bill rate. Step 2 Estimate the stock's beta coefficient, , and use it as an index of the stock's risk. The i signifies the ith company's beta. Step 3 Estimate the market risk premium. Recall that the market risk premium is the difference between the return that investors require on an average stock and the risk-free rate.Footnote Step 4 Substitute the preceding values in the CAPM equation to estimate the required rate of return on the stock in question: rs= rRF + (RPM)bi =rRF + (rM-rRF)bi bi= beta RPM= market risk free premium

You were hired as a consultant to Quigley Company, whose target capital structure is 35% debt, 10% preferred, and 55% common equity. The interest rate on new debt is 6.50%, the yield on the preferred is 6.00%, the cost of retained earnings is 11.25%, and the tax rate is 40%. The firm will not be issuing any new stock. What is Quigley's WACC?

Tax rate = 40% Weights BT Costs AT Costs Debt 35% 6.50% 3.90% Preferred 10% 6.00% 6.00% Common 55% 11.25% 11.25% WACC 100% 8.15%

Which of the following statements about IRR and NPV is CORRECT?

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

Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

The company has spent and expensed for tax purposes $3 million on research related to the new product. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.

Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted?

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

The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

The company will take on too many high-risk projects and reject too many low-risk projects. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement a is correct.

Which of the following statements could be true concerning the costs of debt and equity?

The cost of debt for Firm A is greater than the cost of equity for Firm B. The cost of retained earnings for Firm A is less than its cost of new outside equity.

Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.

If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT?

The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

Crawford Mill Products' sales and profits are positively correlated with the overall economy, and the company has a beta of 1.0. Crawford Mill estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?

The proposed new project would have more stand-alone risk than the firm's typical project

A project is described as having normal cash flows, meaning one outflow followed by a series of inflows. Which of the following statements about normal cash flows is CORRECT?

To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs.

Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? WACC: 10.00% Year 0 1 2 3 Cash flows −$900 $500 $500 $500

WACC: 10.00% Year 0 1 2 3 Cash flows -$900 $500 $500 $500 PV of CFs -$900 $455 $413 $376 Cumulative CF -$900 -$445 -$32 $343 Payback = 2.09 - - - 2.09

Jazz World Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC: 14.00% Year 0 1 2 3 4 Cash flows −$1,200 $400 $425 $450 $475

WACC: 14.00% Year 0 1 2 3 4 Cash flows −$1,200 $400 $425 $450 $475 62.88

mutually exclusive

accept project with highest IFF if thhe IRR is greater than WACC reject them all if the irr does not exceed wacc

Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

accounts payable

opportunity costs

associated with assets the firm already owns

rs

component cost of common equity raised by issuing new stock

rp

component cost of common equity raised by retaining earnings, or internal equity rs is defined as the rate that investors require on a firms common stock

rd(1-t)

cost of debt

rp component cost of preferred stock rp=Dp/Pp

cost of preferred stock calculate weighted average cost of capital is the preferred dividend (Dp) preferred stock (Pp)

rs required rate of return rs= rRF +RP expected rate of return =D1/P0 +g

cost of retained earnings rRF= risk free rate RP= risk premium g= growth rate D1= P0= current stock price

P0

current stock price

internal rate of return (IRR)

discount rate that forces a projects npv to equal zero IRR is like the npv but it is solving for a particular discount rate

Warr Company is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, in both cases it will be rejected. Year 0 1 2 3 4 Cash flows −$1,050 $400 $400 $400 $400

ear 0 1 2 3 4 Cash flows −$1,050 $400 $400 $400 $400 IRR = 19.27%

externalities

effects on the firm or the environment that are bit reflected in the projects cash flows

The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)

es; the expected return is 2.5 percentage points higher than the cost of capital.

Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project's IRR.

false

rd

interest rate on firms new debt = before - tax component cost of debt

MIRR

modified internal rate of return

npv

net present value- Present value of the projects free cash flows discounted at the cost of capital -tells us how much a project contributes to shareholder wealth -the larger the npv the more value the projects add

payback period

number of years required to recover the funds invested in a project from its cash flows = number of years prior to full recovery + unrecovered cost at start year/ cash flow during full recovery year the shorter the payback the better the project

incremental cash flows

occur if and only if some specific event occurs

mutually exclusive

projects where if one project is accepted the other must be rejected accept project with highest positive npv, if no projects have positive reject them all

independent

projects whose cash flows are not affected by one another if npv exceeds 0 acceot

Scanlon Inc.'s CFO hired you as a consultant to help her estimate the cost of capital. You have been provided with the following data: rRF = 4.10%; RPM = 5.25%; and b = 1.30. Based on the CAPM approach, what is the cost of equity from retained earnings?

rRF 4.10% RPM 5.25% b 1.30 rs = rRF + b(RPM) 10.925

'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

rRF 5.00% RPM 6.00% b 1.05 rs = rRF + b(RPM) 11.30%

Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. Refer to Exhibit 10.1. Based on the CAPM, what is the firm's cost of equity?

rRF 5.50% Expected rM 11.50% RPM = rM - rRF = 6.00% b 1.25 rs = r RF + b(RPM) 13.00%

Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure.

re > rs > WACC > rd.

rs

rs= bond yield + risk premium

cannibalization

situation when a new project reduces cash flows that the firm would otherwise have had

wd, wp, wc

target weight if debt, preferred stock, and common equity which includes retained earnings internal equity, new common stock, external equity

WACC

the firms weighted average or overall cost of capital wd (debt) wp (preferred stock) wc (common equity) wacc= % of debt * after tax cost + % preferred stock * cost of preferred stock wacc= wdrd(1-T) + wprp

capital components

the investor supplied items such as debt, preferred stock, and common equity

To find the cost of perpetual preferred stock, divide the preferred's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm.

true