Corporate Finance Final Exam SG

7. What is the current level of the Dow Jones Industrial Average?

+3.12%

6. What is the current level of the S&P 500 Index?

+3.28%

26. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?

A. ACCOUNTS PAYABLE b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.

19. The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.

FALSE

42. A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).

FALSE

24. If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt.

FALSE NOTE - Increased inflation results in a parallel upward shift in the SML, which means equal percentage increases in the required return on debt and equity.

5. The before-tax cost of debt should be used when calculating a firm's WACC.

FALSE NOTE - In the United States, the interest expense of debt is deductible for corporate income tax purposes. Therefore, the after-tax cost is the real cost that should be used in the calculation of the WACC.

9. The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.

FALSE NOTE - The average coupon of a firm's outstanding (historical) debt may indicate the general levels of debt costs in the past, but not at the time of a new issuance. (Also, the Coupon rates might not even reflect the past market rates of the debt! Recall that the debt may have been sold at a discount or at a premium in the past.) The relevant cost of debt is "one minus the marginal tax rate multiplied by the cost of the new debt."

3. The component costs of capital are market-determined variables in the sense that they are based on investors' required returns.

FALSE NOTE - The choice to fund a new (marginal) project with debt does not change the fact that the overall firm is still partially funded by equity. This overall capital structure needs to be considered. Consider, for example, an ongoing policy of debt financing. As the firm grows and the debt/equity mix begins to rise, debt holders will begin to "look like" or "feel like" equity holders. The equity "firewall" or "insulation" that protects debt holders in bankruptcy will start to look increasingly skinny! Debt holders that are forced into an equity position will begin to demand returns that correspond to equity-level risk.

4. If a firm plans to fund a new project exclusively with debt, only the cost of that debt should be used to determine the capital cost of the project.

FALSE NOTE - The choice to fund a new (marginal) project with debt does not change the fact that the overall firm is still partially funded by equity. This overall capital structure needs to be considered. Consider, for example, an ongoing policy of debt financing. As the firm grows and the debt/equity mix begins to rise, debt holders will begin to "look like" or "feel like" equity holders. The equity "firewall" or "insulation" that protects debt holders in bankruptcy will start to look increasingly skinny! Debt holders that are forced into an equity position will begin to demand returns that correspond to equity-level risk.

44. Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life

FALSE (just the opposite)

11. The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.

FALSE - ALL EQUITY SHOULD BE "PRICED" AT THE MARKET COST OF EQUITY AS ESTABLISHED BY THE MARGINAL EQUITY INVESTOR (THAT INVESTOR WHO ACTUALLY BUYS THE STOCK) NOTE - The cost of new equity raised by selling stock may be slightly higher due to flotation expenses, but this does not represent the cost of equity in a firm's WACC.

16. Applying the Discounted Cash Flow (DCF) approach to calculating the Required Return on Equity is simple and reliable because there is wide agreement among investors on firms' Expected Growth Rates

FALSE - Predicting future growth rates is the big uncertainty for investors

46. Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.

FALSE - The IRR is intrinsic to the project (a simple mathematical fact of its cash flows) while the cost of capital is the external "test" figure to compare against to see if the IRR is high enough to justify the project.

43. Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.

FALSE - The present values have been rendered comparable through the appropriate discounting for the various time periods

30. The firm's cost of external equity raised by issuing new stock is the same as the required rate of return on the firm's outstanding common stock.

FALSE - a new issuance incurs FLOTATION COSTS.

23. Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the after-tax cost of preferred stock within the capital structure will be lower than the before-tax cost.

FALSE - the tax benefit cited here is on RECEIVED dividends, not PAID dividends.

49. The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant

FALSE-this is not the reason (find reason)

17. Firms can estimate their cost of equity by use of the bond-yield-plus-risk-premium method which uses the given firm's market bond yields and an estimated equity risk premium

TRUE

18. If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company.

TRUE

2. The cost of capital used in capital budgeting should reflect the weighted average cost of the various sources of long-term funds a firm uses to acquire assets.

TRUE

20. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method.

TRUE

22. The text identifies three methods for estimating the cost of common stock from reinvested earnings (not newly issued stock): the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider the results with some professional judgment when calculating the WACC.

TRUE

25. If investors' aversion to risk rose, causing the slope of the SML to increase, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Other things held constant, this would lead to an increase in the use of debt and a decrease in the use of equity

TRUE

45. Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method ranks the other one first. In theory, such conflicts should be resolved in favor of the project with the higher positive NPV.

TRUE

47. A project's IRR is independent of the firm's cost of capital. In other words, a project's IRR doesn't change with a change in the firm's cost of capital.

TRUE

48. One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.

TRUE

50. No conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital exceeds the rate at which the projects' NPV profiles cross.

TRUE

51. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.

TRUE

21. For a given firm, the tax-adjusted cost of debt is almost always lower than the cost of equity.

TRUE NOTE - Recall that equity holders are the "shock absorbers" in a firm's capital structure - they bear the direct ups and downs from the firm's performance (equity holders are the "residual claim holders.") In bankruptcy, the equity holders face the first and greatest risk of loss. The highest risk position of equity earns the highest expected rate of return.

14. When estimating the cost of equity for project selection purposes, use of the CAPM presents three potential issues: (1) whether to use long-term or short-term rates for the Risk Free Rate, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the Market Risk Premium. These issues create uncertainty about the Required Return on Equity.

TRUE NOTE - These are among the main challenges of the CAPM. Projects may have limited timeframes compared to the firm's anticipated unlimited lifespan. This raises the question about the appropriate term of the risk-free rate. Historical beta has the problem of "driving by looking into the rear-view mirror." That is, historical data is easy to use because it's available, but it doesn't represent the future outcomes that investors actually want to price. Finally, the Market Risk Premium changes through time (but generally ranges between 3% and 7%).

13. If the firm does not think that it can earn Equity Investors' Expected Rate of Return on the earnings that it retains, it should distribute those earnings to its investors.

TRUE - If the Retained Earnings cannot earn the cost of equity capital, they would become "wealth destroyers" in the firm. That capital should be returned to investors by dividend or share repurchase.

12. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC

TRUE - Interest expense is tax-deductible

10. The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm's common stock.

TRUE - RETAINED EARNIGS ARE NOT FREE $

15. The Discounted Cash Flow (DCF) approach to calculating the Required Return on Equity looks to the current dividend yield (Annual Dividend/Current Share Price) and adds the Expected Growth Rate

TRUE- by definition

31. For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity

TRUE. Note that preferred stock is relatively uncommon among American firms. Also note that the key point here is the target capital structure, which may not be directly connected to individual projects funded by the firm.

1. "Capital" is sometimes defined as funds supplied to a firm by investors.

True

41. Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common 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 common from reinvested earnings?

a. 12.60% CORRECT ANSWER b. 13.10% c. 13.63% d. 14.17% e. 14.74%

32. Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept?

a. A Division Y project with a 12% return. b. A DIVISION X PROJECT WITH AN 11% RETURN. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return.

27. With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?

a. INCREASE THE PERCENTAGE OF DEBT IN THE TARGET CAPITAL STRUCTURE. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year.

40. Firm J's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm F's earnings and stock price move counter cyclically with J and other S&P companies. Both J and F estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT?

a. J and F should have identical WACCs because their risks as measured by the standard deviation of returns are identical. b. If J and F merge, then the merged firm MW should have a WACC that is a simple average of J's and F's WACCs. c. Without additional information, it is impossible to predict what the merged firm's WACC would be if J and F merged. d. Since J and F move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs. e. J should have the lower WACC because it is like most other companies, and investors like that fact. Correct answer is "B"

39. Which of the following statements is CORRECT?

a. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model's logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain. b. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm's own cost of debt and its risk premium, can be found by using standardized and objective procedures. c. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. d. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield. e. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs⎯beta, the risk-free rate, and the market risk premium⎯can be estimated with little error. Answer "C"

37. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.

a. The WACC is calculated on a before-tax basis. b. The WACC exceeds the cost of equity. c. The cost of equity is always equal to or greater than the cost of debt. d. The cost of reinvested earnings typically exceeds the cost of new common stock. e. The interest rate used to calculate the WACC is the average after-tax cost of all the company's outstanding debt as shown on its balance sheet. Answer "C." Due to its risk position, equity demands a higher return than debt.

38. Which of the following statements is CORRECT?

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

29. When working with the CAPM, which of the following factors can be determined with the most precision?

a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM). NOTE - this is a bit of a trick question. Answer "D" is correct because the beta coefficient of "the market" (and, therefore, the average stock) is exactly 1.0, by definition. You can't get any more precise than that!

34. Sg The Anderson 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?

a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. THE COMPANY WILL TAKE ON TOO MANY HIGH-RISK PROJECTS AND REJECT TOO MANY LOW-RISK PROJECTS.

52. Which of the following statements is CORRECT

a. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money. b. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. c. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. d. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. e. The regular payback method recognizes all cash flows over a project's life. Answer "C"

28. Assume that a given firm has no retained earnings because it has always maintained a 100% dividend payout ratio. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, and its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC?

a. The flotation costs associated with issuing new common stock increase. b. The company's beta increases. c. Expected inflation increases. d. The flotation costs associated with issuing preferred stock increase. e.THE MARKET RISK PREMIUM DECLINES

53. Which of the following statements is CORRECT?

a. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. Answer "C"

Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?

a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. The correct answer is "C" Use the CAPM equation to calculate the required cost of equity and then apply the risk adjustment.

36. Which of the following statements is CORRECT?

a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. Flotation costs associated with issuing new common stock normally reduce the WACC. c. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. d. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. e. A change in a company's target capital structure cannot affect its WACC. The correct answer is "C" because of the "tax shield" created by the tax deductibility of interest expense.

35. Suppose Acme Industries 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, then the firm will most likely

a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e. become riskier over time, but its intrinsic value will be maximized. f. The correct answer is "C." If the firm does not do anything to "risk adjust" its project selection, it will approve or select risker projects over time as they will beat the WACC. Lower risk projects will be less able to do so. As noted in class, this firm will morph into a higher-risk firm as it does so

8. What is the yield of the 10-year US Treasury bond?

about 2%