D076 Unit 6 Practice Questions
A company is considering five projects that are not mutually exclusive. However, the company does not have enough money to do all of them. In order to prioritize projects that fit within the company's budget, which capital budgeting method should be used? -Profitability index (PI) -Comparing the initial outlay to start with the biggest project -Internal rate of return (IRR) -Net present value (NPR)
A
An investor is reviewing the bonds of four different companies: Company A issues AA-rated bonds. Company B issues A-rated bonds. Company C issues BB-rated bonds. Company D issues C-rated bonds. Which company is likely to provide the lowest rate of return to the investor? -Company A -Company B -Company C -Company D
A
Should a firm accept a project that has a PI of 0.8? Why? -No, because the project would be generating cash inflows that are 20% short of the initial investment. -Yes, because the PI is less than the cost of capital. -Yes, because the PI would generate cash flows that are 80% more than the initial investment. -No, because the PI is supposed to be represented as a dollar amount.
A
What are incremental cash flows? -Any additional cash flows, whether in or out of the firm, that are created as a result of accepting a project -All cash flows that the firm has that may be affected by accepting a new project -The sum of all positive and negative cash flows that create an incremental increase or decrease in revenue -The positive cash flows of a project discounted back to their present value
A
An investor really cares about having voting rights in a firm. Which type of financial security should this investor purchase? -Secured bonds -Common stock -Zero-coupon bonds -Preferred stock
B
0 / 1 Talia is comparing four mutually exclusive projects. In order to choose the best project to optimize the goal of the firm, which capital budgeting method should Talia use? -Internal rate of return (IRR) -Time value of money -Net present value (NPV) -Profitability index (PI)
C
A company is trying to decide which of four projects to invest in. Project 1 has an IRR of 14% and an NPV of $54,000. Project 2 has an IRR of 11% and an NPV of $67,000. Project 3 has an IRR of 9% and an NPV of $60,000. Project 4 has an IRR of 13% and an NPV of $47,000. If the company can do only one project, which project should it choose to add the greatest value to the firm? -Project 3 -Project 4 -Project 2 -Project 1
C
A financial analyst for the company Bobby's Books has been asked to evaluate a potential investment using a method that considers the time value of money. Is there more than one way to do this? -No, the analyst could only use cash budgeting to evaluate the project. -No, there are no valuation methods that take into account the time value of money. -Yes, the analyst could use both the NPV and the IRR. -Yes, the analyst could use the current ratio and could compare cost of capital rates.
C
How are non-incremental cash flows different from incidental cash flows? -Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Therefore, they must not be included in the analysis. -All incidental cash flows should be excluded. If a company will incur a cost regardless of whether it adopts a specific project, the cost should not be counted as a cost of the project. -Incidental cash flows are indirect cash flows that are not explicitly revenues or costs. Nevertheless, they must be included in the analysis. -All non-incremental cash flows should be included. It is unclear if a company will incur a cost regardless of whether it adopts a specific project, so that cost should be counted as a cost of the project.
C
How does cannibalization factor into capital investment decisions? -If your company is planning on launching a product, and that product is going to harm the sales of another of your products, it is better not to compete with yourself and lose market shares. -If your company is planning on launching a product, and that product is going to steal some of the sales of another company's products, that could be an incidental cost or revenue caused by the new product. -If your company is planning on launching a product, and that product is going to steal some of the sales of another of the company's products, that loss of sales could be an incidental cost or revenue caused by the new product. -If your company is planning on launching a product, and that product is going to diminish some of the company's cash flows generated from another product, it is better not to harm your products' reputations.
C
The lowest rate of return is required by which type of investor or lender? -Preferred stockholder -Bondholder -Bank -Common stockholder
C
Which NPV value indicates that the IRR has been reached? -(-$100.00) -($99.99) -($0.00) -($15.00)
C
Which method should you use to calculate a bond value? -The IRR method -The perpetuity model -The PV function in Excel -The constant growth model
C
Why is it important to consider the cost of capital in an ideal evaluation method of capital investment? -Because if you can receive money earlier, you can reinvest the cash into different projects earlier -Because the value of a cash flow today is different from the value of a cash flow of the same amount of in 10 years -Because cash flows for a project may be uncertain -Because it cannot be determined how a potential project enhances the firm's value without considering every cash flow of the project
C
Why might a firm seek capital investment? -To fulfill expected dividend payments -To pay short-term loans -To purchase long-term assets for future growth -To pay off bondholders
C
You are considering a project that has a profitability index of 1. What does this mean? -The project has a positive net present value. -The benefit outweighs the cost of the project by the exact same amount as the initial cost. -The project has the internal rate of return equal to the cost of capital. -The project has a negative net present value.
C
What is a disadvantage of using the NPV method? -It is not an effective way to compare projects with different time spans. -It does not consider the time value of money. -It often underestimates cash flows. -It is not an effective way to compare projects of different sizes.
D
What would an analyst predict for a potential investment with an NPV of zero? -The profitability index would also be equal to zero. -The project would add value to the firm. -The project would take away value from the firm, but only a small amount. -The project would earn exactly the rate of return required by the firm.
D
Which scenario correctly describes opportunity cost? -Buster buys a pizza and with the same amount of money he could have used to buy a hamburger and fries. There is no opportunity cost because they cost the same. -Caroline makes $25 an hour. Instead of working one night, she goes to a concert that costs $50 and lasts two hours. The opportunity cost of the concert is $50. -Donatello has a side business making sculptures in addition to his regular job. If he spends more time on his side business, the opportunity cost is the money he makes from selling his sculptures. -Alexandra decides to spend $50 on some new clothes instead of using that money to pay her electric bill. The opportunity cost is having the electricity turned off.
D
Why is NPV the most reliable method for evaluating investments? -It is capable of considering cash flows without taking into account the time value of money, it is useful for comparing two projects of different sizes, and it is an infallible rule for accepting or rejecting capital projects. -It makes it easy to estimate the cost of capital, it ignores risk, and it is better for tax purposes. -It does not require you to estimate the cost of capital. -It considers the time value of money, it tells you the dollar value that the investment will add to the firm, and it takes risk into account.
D
Why is it important to consider the time value of money in an ideal evaluation method for capital investment? -Because each project has different amount of risk -Because a project's cash flows may be uncertain -Because without considering every cash flow of a potential project, you do not know how the project would enhance the firm's value -Because the value of a cash flow today is different from the value of a cash flow of the same dollar amount in 10 years
D
Why is there always a cost for bringing funds into a business? -A business must compensate investors for the opportunity cost of investing in the business. -Investors will only choose the investment vehicle with the highest return. -Investors need an investment vehicle to fight inflation. -A business must compensate investors for the risk that they are taking to invest in the business.
D
Why might a firm prefer to raise debt capital through stocks instead of bonds? -Stocks do not require a firm to give up any ownership. -Stocks do not allow investors to have voting rights. -Stocks provide a steady stream of income to a firm. -Stocks do not require the firm to repay the par value to investors.
D
You just purchased a bond for $1,000 that has a par value of $1,000. What type of bond is this? -A discount bond -A preferred bond -A premium bond -A par bond
D
Which cash flow of a particular project would be a sunk cost? -$20,000 market value of equipment at the end of the project -$35,000 incremental cash flows for the third year of the project -$50,000 marketing study conducted three months ago for the project -$100,000 initial investment for the project
C
Which example demonstrates a financing decision in a firm? -Whether a company should use a third-party public affairs firm to promote its new product -How a company will increase its sales for next year by attracting new customers -How a company will fund its assets and operations—namely, what proportions of debt and equity the business will use -Whether a company should hire executive leadership from outside the company or promote managers from within
C
What part of the NPV calculation is very important but difficult to estimate? -The expected cash flows -The initial outlay -The life of the project -The cost of capital
D
What is the name for the process of evaluating and planning for purchases of long-term assets? -Capital budgeting -The time value of money -The constant growth model -The perpetuity model
A
Alphabet Co. has $50,000 to spend on capital investment projects for the next year. It will do as many projects as it has cash for. Alphabet Co. calculates the potential incremental cash flows and costs of the projects as well as the NPV, IRR, and PI for each project. How should the company decide which projects to invest in if it wants to maximize the total amount of value created? -It should choose the projects with the highest PIs until all capital has been used. -It should choose the projects with the highest NPVs until all capital has been used. -It should choose the projects with the highest IRRs until all capital has been used. -It should choose the projects with the highest costs until all capital has been used.
A
How do you factor sunk costs into capital investment analysis? -For the purposes of analysis, sunk costs are irrelevant. -Sunk costs are subtracted from the opportunity cost and attributed to net cash flow. -They can be added into our analysis, depending on management's decision. -They are inputted as negative cash inflows along with the initial outlay.
A
How does the PI aid in interpretation of the NPV? -It gives an idea of the return generated by a project. -It does not take into account the initial outlay of the project, which makes the NPV easier to understand in comparison. -It communicates the value that would be lost to the company if it rejected the project. -It converts the NPV to a percentage, which is easier for management to understand.
A
In what way is preferred stock different from bonds? -Companies are allowed to skip payments to preferred stockholders but not to bondholders. -Preferred stockholders do not have voting rights, but bondholders do. -Companies must pay preferred stockholders but not bondholders before common stockholders. -Preferred stock payments are fixed, but bond payments are not.
A
What is the effect of debt financing on a firm's income? -Debt interest payments reduce taxable income. -Income is taxed at a lower rate when a firm has more debt. -Debt interest payments have no effect on taxable income. -Income is taxed at a lower rate when a firm has no debt.
A
What is the relationship between the risk and the rate of return? -The higher the risk investors have to take on, the higher return they require. -Investors must be incentivized with higher returns or else they will choose a risk-free asset. -The rate of return describes the inherent risk of a project. -Risk has no relationship to the rate of return but is related instead to the cost of capital.
A
What would profitability index (PI) be useful for? -Determining whether a firm should invest in projects with different initial outlays -Computing the future value of a project in the future rather than the present value -Calculating returns for a project that does not have a definite return rate for IRR or NPV -Deciding between projects that are mutually exclusive
A
Which capital investment evaluation method is presented as a ratio? -Profitability index (PI) -Internal rate of return (IRR) -Quick ratio -Net present value (NPV)
A
Which item is considered a sunk cost? -The consulting cost spent three months prior to the start of a project -The price of selling old equipment that will be replaced by new equipment -The required training in order to operate new equipment -The shipping cost of a new machine for a project
A
Which term describes the reduction in sales of a company's own products due to the introduction of another similar product? -Cost of cannibalization -Opportunity cost -Sunk costs -Interest cost
A
Which term refers to the metrics and calculations that use tools such as net present value (NPV), internal rate of return (IRR), and profitability index (PI) to evaluate investments? -Capital budgeting criteria -Accounting investment criteria -Projected financing criteria -Security analysis criteria
A
Why is it important to consider all relevant cash flows in an ideal evaluation method for capital investment? -Without considering every cash flow of a potential project, you do not know how the project will enhance the value of a firm. -A project's cash flows may be uncertain. -If you can receive money earlier, you can reinvest the cash into different projects earlier. -The value of a cash flow today is different from the values of a cash flow of the same dollar amount in 10 years.
A
Why is it important to have an accurate, carefully calculated required rate of return as part of the NPV? -An inaccurate required rate estimate could cause a firm to reject good projects or accept bad projects. -An accurate required rate of return actually is not very important, as the required rate of return is only a minor part of the NPV calculation. -The SEC and GAAP require an accurate rate of return as part of their capital investment standards. -Lenders will provide a firm with funds to invest in a project only if the required rate of return is extremely accurate.
A
You are evaluating a common stock. What is a key assumption for this evaluation? -The growth rate is assumed to stay the same forever. -Coupon payments are made semiannually. -Dividends are fixed. -There is a maturity date.
A
A company called Bobby's Books is considering purchasing a new bookbinding machine. The company calculates the hurdle rate of the project to be 9% and the IRR to be 11%. Should the company purchase the bookbinding machine? -No, because the hurdle rate is lower than the IRR. -Yes, because the IRR exceeds the cost of capital. -Yes, because newer models of equipment are always profitable investments. -No, because the old bookbinding machine still works.
B
How does an analyst use the hurdle rate? -It is used to calculate the IRR for a project and determine its value. -It is used to compare with the IRR to determine whether a project should be accepted. -It is used with the IRR as a method to find the required payment amount for a project. -It is used to determine the time frame of a project.
B
How is the cost of capital used in the decision-making process for a capital investment project? -It is part of the initial investment. -It is used as the discount rate of cash flows. -It is input into cash flow calculations. -It is compared to the NPV.
B
Suppose Alice is trying to explain to her friend, who knows nothing about the time value of money, why she should invest in Alice's new company. Which method of valuation should Alice use to convince her friend to invest? -Net present value (NPV) -Internal rate of return (IRR) -Cash budgeting -Debt-to-equity ratio
B
Suppose you are a manager at a firm. One of your financial analysts places a report on your desk of valuation calculations for some potential investment projects. When you look at the calculations later, you notice that the analyst did not indicate if she used the NPV or IRR method. However, you do notice that the results of the calculations are all percentages. What can you conclude? -The analyst used the NPV method. -The analyst used the IRR method. -The calculations are incomplete. -The calculations are all wrong.
B
The YTM of a bond went from 8% to 7%. What can be predicted about the price of the bond? -It will decrease. -It will increase. -It is not possible to predict what will happen to the bond price. -It will stay the same.
B
What indicates to a firm that a project will increase shareholder wealth? -The project's cash flows are projected closer to the present. -The NPV is positive. -The project's cash flows are projected far into the future. -The NPV is negative.
B
What is an advantage of using the NPV method? -It can be used to compare multiple projects when a firm faces capital constraints. -It calculates the dollar value that would be added to the firm by doing the project. -It does not consider the time value of money. -It tells the percent return on an investment.
B
What is an opportunity cost? -The opportunities a company has and how to rank them -The loss of the ability to use an asset toward the next best project once you have invested it in another project -The difference between the cost of a project and its potential profit -The cost that must be incurred to make a profit
B
What is opportunity cost as it relates to the time value of money? -It is the cost at the terminal stage of a project in a TVM model. -It is the opportunity you forgo to invest in other options due to the time scope of an investment. -It is the cost of having more investment options than one. -It is the lowered cost over time of money used for an investment.
B
What is the disadvantage of debt financing? -Debt financing creates a tax shield disadvantage. -Debt financing does not actually achieve an optimal capital structure for a company. -A company with high amounts of debt will have a shorter YTM for its bonds. -The more debt a company takes on, the less equity it can raise.
B
Which condition indicates that an investment will add value to a company? -The future value of the benefits of the investment outweigh the future value of the costs of the investment. -The present value of the benefits of the investment outweigh the present value of the costs of the investment. -The opportunity costs of the project outweigh the present value of current operations of the company. -The positive cash inflows of the project are greater than the negative cash outflows of the project.
B
A potential project to expand the size of an apartment complex will cost $100,000. Its calculated net present value is $5,000. Given this information, which statement is correct? -The project should be rejected because it has a negative IRR. -The project should be rejected because it has a negative NPV. -The project should be accepted because it has a positive NPV. -The project should be accepted because it has a positive IRR.
C
An investor just purchased a bond for $973 that has a par value of $1,000. What type of bond is this? -A premium bond -A par bond -A discount bond -A preferred bond
C
Beckingham Sports is an American sporting goods company. Based on a $400,000 market study and a $600,000 fee for consulting spent prior to the project, the firm can increase its annual operating cash flow by $3,000,000 by selling overseas. Because the firm was considering the expansion, it spent $2,000,000 to purchase a land for new factory and equipment. However, someone is making an offer to pay the company $3,000,000 for the land it purchased for the new factory. What is relevant to include in the company's capital budgeting decision? -$400,000 spent on the market study -$600,000 for the consulting -$3,000,000 for the offer price of the land -$2,000,000 spent to purchase the land
C
How can having more debt benefit a company? -It protects a company from having to buy more assets. -Debt is never beneficial for a company due to its increasing costs over time. -Interest expense on debts is paid before taxes are calculated. -It allows management to retain more control over the company.
C
How do bond payments to investors differ from stock payments to investors? -Stock payments are fixed, and bond payments are variable. -Bond payments are larger than stock payments. -Bond payments are fixed, and stock payments are variable. -Stock payments have a shorter duration than bond payments.
C
If two projects are mutually exclusive, which decision-making criterion will help you make the best decision about which project to accept? -Initial outlay (IO) -Profitability index (PI) -Net present value (NPV) -Internal rate of return (IRR)
C
Quiet Flag Industries has a large piece of land worth $250,000 that it is considering using for a miniature golf business. When evaluating the cash flows that would result from doing this project, should Quiet Flag consider the land value? Why or why not? -No, the land value represents an existing expense. -No, the land value represents a sunk cost. -Yes, the land value represents an opportunity cost. -Yes, the land value represents cannibalization.
C
What must be determined in order to compare the values of two projects with differently timed cash flows that does not need to be determined for projects with similarly timed cash flows? -Positive cash inflows and negative cash outflows -Future value of the benefits and future value of the costs -Opportunity cost -Present value of the benefits
C
Which scenario is an example of an opportunity cost that is not associated with cash flows? -Bill wants ice cream now. However, he eats dinner first and then buys an ice cream cone. -Daisy lost $50 playing poker. Because of this, she decides not to gamble again. -Albert decides to stay home and study for his test instead of going to the movies. -Charlie stays home all weekend. He did not have any other plans.
C
Why is it appropriate to calculate the value of a preferred stock in the same way that you would find the present value of a perpetuity? -The cash flows that come from owning a preferred stock grow at a constant rate every year and continue forever. -Even though a preferred stock has a fixed length, the cash flows differ each year. -For a preferred stock, a fixed amount is paid forever to compensate the investors. -Preferred stocks pay a coupon every six months, the coupon amount is constant, and the stock has a maturity date.
C
Why is the IRR a poor valuation method for a project with unconventional cash flows? -The hurdle rate is always too large for projects with unconventional cash flows. -The IRR method can be used only to calculate projects that add value to a firm, and projects with unconventional cash flows never add value to a firm. -There are multiple sign changes in the calculation resulting in multiple IRRs, and it is impossible to tell which IRR is the correct one. -Projects with unconventional cash flows are only possible to evaluate using trial and error, which is not an acceptable way to calculate the IRR.
C
Why might a firm prefer to raise debt capital through bonds instead of stocks? -Bonds do not require a firm to give up any ownership. -Bonds have no expiration date. -Bonds do not require the firm to pay back its loan. -Bonds take advantage of upside potential.
C
You calculate the PI of a project to be 1 but realize that some aspect of your calculation was incorrect and needs to be adjusted. Which adjustment to the PI estimation should cause you to reject the project? -The initial outlay estimation was inaccurate, and after you adjust it, the new initial outlay is lower than the original. -The length of project was underestimated, so in the new estimation, the life of the project is a couple of years longer with positive cash flows. -The cost of capital was underestimated, so you adjust the cost of capital to be higher. -The cash flows were underestimated, so the adjusted annual cash flows are higher than the original ones.
C
A pharmaceutical company recently spent $2 million developing a new drug. The company then conducts capital budgeting analysis to determine if it should produce the newly developed drug. The net present value (NPV) of the project is $1.5 million. Why should this company produce the drug? -Because the development costs are greater than the value of the project -Because the project will provide a total value of $3.5 million to the company -Because the losses due to cannibalization are less than the value of the project -Because the NPV is greater than zero
D
How do corporations and purchasers of financial securities view returns? -Corporations look at returns as the risk posed to stockholders and bondholders if a corporation isn't able to make payments. -Corporations look at high returns as a cost to investors that prevents them from either lending to or investing in a corporation. -Purchasers of financial securities look at returns as the percentage that they as investors must receive to break even on the money they invested. -Purchasers of financial securities look at returns as the amount of money they require in order to lend or give their money to the corporation that issued those securities.
D
How does allocated overhead affect the selection of capital investment projects? -Overhead is allocated to the various projects of the firm, but never capital investment projects. -Accountants are paid to allocate cash flows such as "overhead" to the various projects of a firm. Therefore, these cash flows are added to new projects during analysis. -Overhead represents costs from specific projects, so it tells us the overall impact of a project on a company. -These cash flows are not a direct result of a specific project but are a general cost to the firm.
D
How does management choose between two projects that are seemingly the same? -If two projects are seemingly the same, it does not matter what choice management makes. -Management can analyze the effect each project will have on the firm's overall capital structure. -As stated in the reinvestment assumption, there cannot be two projects that are the same. -Management can analyze the different inherent risks that change the cost of capital to the firm.
D
Maria is planning to invest in some company stocks for retirement and is trying to figure out if the stocks are a good buy. She calculates the intrinsic value of one of the stocks, Quiet Flag Industries, to be $35. The stock is currently trading on the market for $30, so she decides to buy it. Why was it a good idea for Maria to buy this stock? -The stock's intrinsic value is greater than 1. -The stock is overvalued. -The stock's intrinsic value is less than its actual value. -The stock is undervalued.
D
Why is it appropriate to calculate the value of a bond in the same way that the present value of an annuity is calculated? -A bond is a fixed amount paid each period forever to compensate investors. -The cash flows that come from owning a bond grow at a constant rate every year, and the payments continue forever. -Even though bonds have a fixed length, the cash flows differ each year. -Bonds pay a coupon every six months, pay a constant coupon amount, and have a maturity date.
D
Why is the timing of cash flows an important characteristic of capital investment? -Timing of cash flows is related to the sunk costs associated with those cash flows. -Companies are wary of inflation risks due to timing of cash flows. -Companies need to know if they will have enough cash inflows to pay off their debt expenses. -Timing of cash flows is related to the opportunity cost associated with those cash flows.
D