Fin 338 - Exam 2

Other things held constant, which of the following would increase the NPV of a project being considered? a. A shift from straight-line to MACRS depreciation. b. Making the initial investment in the first year rather than spreading it over the first three years. c. An increase in the discount rate associated with the project. d. An increase in required net operating working capital. e. The project would decrease sales of another product line.

a. A shift from straight-line to MACRS depreciation.

Cornell Enterprises 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: 10.00% Year 0 1 2 3 Cash flows -$1,050 $450 $460 $470 a. $ 92.37 b. $ 96.99 c. $101.84 d. $106.93 e. $112.28

a. $ 92.37

Tesar Chemicals is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the NPV. If the decision is made by choosing the project with the higher IRR rather than the one with the higher NPV, how much, if any, value will be forgone, i.e., what's the chosen NPV versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. NPV will have no effect on the value gained or lost. WACC: 7.50% Year 0 1 2 3 4 CFS -$1,100 $550 $600 $100 $100 CFL -$2,700 $650 $725 $800 $1,400 a. $138.10 b. $149.21 c. $160.31 d. $171.42 e. $182.52

a. $138.10

Anderson Systems is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. WACC: 9.00% Year 0 1 2 3 Cash flows -$1,000 $500 $500 $500 a. $265.65 b. $278.93 c. $292.88 d. $307.52 e. $322.90

a. $265.65

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False

b; False

Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow? Equipment cost (depreciable basis) $65,000 Sales revenues, each year $60,000 Operating costs (excl. depreciation) $25,000 Tax rate 35.0% a. $30,258 b. $31,770 c. $33,359 d. $35,027 e. $36,778

a. $30,258

As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow? Sales revenues $13,000 Depreciation $4,000 Other operating costs $6,000 Tax rate 35.0% a. $5,950 b. $6,099 c. $6,251 d. $6,407 e. $6,568

a. $5,950

Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next 4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. The controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is selected over Project S, i.e., what is the value of NPVL - NPVS? a. $56.50 b. $62.15 c. $68.37 d. $75.21 e. $82.73

a. $56.50

Lasik Vision Inc. recently analyzed the project whose cash flows are shown below. However, before Lasik decided to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC: 8.00% New WACC: 11.25% Year 0 1 2 3 Cash flows -$1,000 $410 $410 $410 a. -$59.03 b. -$56.08 c. -$53.27 d. -$50.61 e. -$48.08

a. -$59.03

Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE? Assets $200,000 Interest rate 8% Debt/Assets, book value 65% Tax rate 40% EBIT $25,000 a. 12.51% b. 13.14% c. 13.80% d. 14.49% e. 15.21%

a. 12.51%

Simkins Renovations Inc. 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 (and even negative), in which case it will be rejected. Year 0 1 2 3 4 Cash flows -$850 $300 $290 $280 $270 a. 13.13% b. 14.44% c. 15.89% d. 17.48% e. 19.22%

a. 13.13%

Gator Fabrics Inc. currently has zero debt (i.e., wd = 0). It is a zero growth company, and additional firm data are shown below. Now the company is considering using some debt, moving to the new capital structure indicated below. The money raised would be used to repurchase stock at the current price. It is estimated that the increase in risk resulting from the additional leverage would cause the required rate of return on equity to rise somewhat, as indicated below. If this plan were carried out, by how much would the WACC change, i.e., what is WACCOld - WACCNew? wd 55% Orig. cost of equity, rs 10.0% wc 45% New cost of equity = rs 11.0% Interest rate new = rd 7.0% Tax rate 40% a. 2.74% b. 3.01% c. 3.32% d. 3.65% e. 4.01%

a. 2.74%

Longstreet Inc. has fixed operating costs of $470,000, variable costs of $2.80 per unit produced, and its product sells for $4.00 per unit. What is the company's break-even point, i.e., at what unit sales volume would income equal costs? a. 391,667 b. 411,250 c. 431,813 d. 453,403 e. 476,073

a. 391,667

You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $400,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROEL - ROEU? 0% Debt, U 60% Debt, L Oper. income (EBIT) $400,000 $400,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35% 35% a. 5.85% b. 6.14% c. 6.45% d. 6.77% e. 7.11%

a. 5.85%

Thorley Inc. 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 5 Cash flows -$1,250 $325 $325 $325 $325 $325 a. 9.43% b. 9.91% c. 10.40% d. 10.92% e. 11.47%

a. 9.43%

The relative risk of a proposed project is best accounted for by which of the following procedures? a. Adjusting the discount rate upward if the project is judged to have above-average risk. b. Adjusting the discount rate upward if the project is judged to have below-average risk. c. Reducing the NPV by 10% for risky projects. d. Picking a risk factor equal to the average discount rate. e. Ignoring risk because project risk cannot be measured accurately.

a. Adjusting the discount rate upward if the project is judged to have above-average risk.

Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company's operating leverage. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company's stock price hits a new high.

a. An increase in the corporate tax rate.

An increase in the debt ratio will generally have no effect on which of these items? a. Business risk. b. Total risk. c. Financial risk. d. Market risk. e. The firm's beta

a. Business risk.

Which of the following statements is CORRECT? a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt. b. A change in the personal tax rate should not affect firms' capital structure decisions. c. "Business risk" is differentiated from "financial risk" by the fact that financial risk reflects only the use of debt, while business risk reflects both the use of debt and such factors as sales variability, cost variability, and operating leverage. d. The optimal capital structure is the one that simultaneously (1) maximizes the price of the firm's stock, (2) minimizes its WACC, and (3) maximizes its EPS. e. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio.

a. If Congress lowered corporate tax rates while other things were held constant, and if the Modigliani-Miller tax-adjusted theory of capital structure were correct, this would tend to cause corporations to decrease their use of debt.

Which of the following statements is CORRECT? a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. b. If Project A's IRR exceeds Project B's, then A must have the higher NPV. c. A project's MIRR can never exceed its IRR. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. e. If the NPV is negative, the IRR must also be negative.

a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.

A firm's CFO is considering increasing the target debt ratio, which would also increase the company's interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases. b. If the plan reduces the WACC, the stock price is likely to decline. c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. d. If the plan does increase the EPS, the stock price will automatically increase at the same rate. e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

a. Since the proposed plan increases the firm's financial risk, the stock price might fall even if EPS increases.

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? a. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, "double count" it. b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. c. When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.

a. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.

Which of the following statements is CORRECT? a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. b. There is no reason to think that changes in the personal tax rate would affect firms' capital structure decisions. c. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. d. If a firm's after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. e. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.

a. In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs.

Projects A and B have identical expected lives and identical initial cash outflows (costs). However, most of one project's cash flows come in the early years, while most of the other project's cash flows occur in the later years. The two NPV profiles are given below: Which of the following statements is CORRECT? a. More of Project A's cash flows occur in the later years. b. More of Project B's cash flows occur in the later years. c. We must have information on the cost of capital in order to determine which project has the larger early cash flows. d. The NPV profile graph is inconsistent with the statement made in the problem. e. The crossover rate, i.e., the rate at which Projects A and B have the same NPV, is greater than either project's IRR.

a. More of Project A's cash flows occur in the later years.

Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? a. Project D probably has a higher IRR. b. Project D is probably larger in scale than Project C. c. Project C probably has a faster payback. d. Project C probably has a higher IRR. e. The crossover rate between the two projects is below 12%.

a. Project D probably has a higher IRR.

Which of the following statements is CORRECT? a. Projects with "normal" cash flows can have only one real IRR. b. Projects with "normal" cash flows can have two or more real IRRs. c. Projects with "normal" cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is "nonnormal." d. The "multiple IRR problem" can arise if a project's cash flows are "normal." e. Projects with "nonnormal" cash flows are almost never encountered in the real world.

a. Projects with "normal" cash flows can have only one real IRR.

Which of the following statements is CORRECT? a. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV. c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. e. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

a. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

Which of the following statements is CORRECT? a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. b. The discounted payback method eliminates all of the problems associated with the payback method. c. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. d. To find the MIRR, we discount the TV at the IRR. e. A project's NPV profile must intersect the X-axis at the project's WACC.

a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides.

Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

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

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. The new project is expected to reduce sales of one of the company's existing products by 5%. b. Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. c. The company has spent and expensed $1 million on research and development costs associated with the new project. d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

a. The new project is expected to reduce sales of one of the company's existing products by 5%.

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company 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? a. The proposed new project would have more stand-alone risk than the firm's typical project. b. The proposed new project would increase the firm's corporate risk. c. The proposed new project would increase the firm's market risk. d. The proposed new project would not affect the firm's risk at all. e. The proposed new project would have less stand-alone risk than the firm's typical project.

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

Which of the following statements is CORRECT? a. Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. c. Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. d. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. e. Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

a. Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

O'Brien Inc. has the following date: r(RF) = 5 %; RP(m) = 6 %; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72%

a; 11.30%

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT? a. If the WACC is 10%, both projects will have positive NPVs. b. If the WACC is 6%, Project S will have the higher NPV. c. If the WACC is 13%, Project S will have the lower NPV. d. If the WACC is 10%, both project will have a negative NPV.

a; If the WACC is 10%, both projects will have positive NPVs.

Rebels Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted.

a; Project B, which is of below-average risk and has a return of 8.5%

"Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False

a; True

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

a; True

For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False

a; True

The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. a. True b. False

a; True

The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False

a; True

The cost of perpetual preferred stock is found as the preferred's annual dividend divided 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. a. True b. False

a; True

The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. a. True b. False

a; True

Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project's life. a. True b. False

a; True

Malholtra Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 10.00% Year 0 1 2 3 4 Cash flows -$850 $300 $320 $340 $360 a. 14.08% b. 15.65% c. 17.21% d. 18.94% e. 20.83%

b. 15.65%

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 a. 1.88 years b. 2.09 years c. 2.29 years d. 2.52 years e. 2.78 years

b. 2.09 years

You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow? Sales revenues, each year $62,500 Depreciation $8,000 Other operating costs $25,000 Interest expense $8,000 Tax rate 35.0% a. $25,816 b. $27,175 c. $28,534 d. $29,960 e. $31,458

b. $27,175

Barry Company 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: 12.00% Year 0 1 2 3 4 5 Cash flows -$1,100 $400 $390 $380 $370 $360 a. $250.15 b. $277.94 c. $305.73 d. $336.31 e. $369.94

b. $277.94

TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no change in net operating working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) WACC 10.0% Pre-tax cash flow reduction for other products (cannibalization) -$5,000 Investment cost (depreciable basis) $80,000 Straight-line depreciation rate 33.333% Annual sales revenues $67,500 Annual operating costs (excl. depreciation) -$25,000 Tax rate 35.0% a. $3,636 b. $3,828 c. $4,019 d. $4,220 e. $4,431

b. $3,828

Liberty Services is now at the end of the final year of a project. The equipment originally cost $22,500, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. What is the equipment's after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale. a. $5,558 b. $5,850 c. $6,143 d. $6,450 e. $6,772

b. $5,850

Simms Corp. 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 Cash flows -$1,000 $425 $425 $425 a. 12.55% b. 13.21% c. 13.87% d. 14.56% e. 15.29%

b. 13.21%

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)? a. 12,600 b. 14,000 c. 15,400 d. 16,940 e. 18,634

b. 14,000

Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $250.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 25,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.) Machine A Machine B Price per phone (P) $250.00 $250.00 Fixed costs (F) $1,000,000 $2,000,000 Variable cost/unit (V) $200.00 $150.00 Expected unit sales (Q) 25,000 25,000 Required equity investment $2,500,000 $3,000,000 a. 6.00% b. 6.67% c. 7.00% d. 7.35% e. 7.72%

b. 6.67%

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's IRR increases as the WACC declines. b. A project's NPV increases as the WACC declines. c. A project's MIRR is unaffected by changes in the WACC. d. A project's regular payback increases as the WACC declines. e. A project's discounted payback increases as the WACC declines.

b. A project's NPV increases as the WACC declines.

Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.

Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase.

Companies HD and LD have identical tax rates, total assets, total investor-supplied capital, and returns on investors' capital (ROIC), and their ROICs exceed their after-tax costs of debt, rd(1 - T). However, Company HD has a higher debt ratio and thus more interest expense than Company LD. Which of the following statements is CORRECT? a. Company HD has a higher net income than Company LD. b. Company HD has a lower ROA than Company LD. c. Company HD has a lower ROE than Company LD. d. The two companies have the same ROA. e. The two companies have the same ROE.

b. Company HD has a lower ROA than Company LD.

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. a. True b. False

b; False

Firms U and L each have the same amount of assets, investor-supplied capital, and both have a return on investors' capital (ROIC) of 12%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has an after-tax cost of 8%. Both firms have positive net income and a 35% tax rate. Which of the following statements is CORRECT? a. The two companies have the same times interest earned (TIE) ratio. b. Firm L has a lower ROA than Firm U. c. Firm L has a lower ROE than Firm U. d. Firm L has the higher times interest earned (TIE) ratio. e. Firm L has a higher EBIT than Firm U.

b. Firm L has a lower ROA than Firm U.

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT? a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project. b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. c. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.

Which of the following statements is CORRECT? a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not. b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. The longer a project's payback period, the more desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. c. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.

Which of the following statements is CORRECT? a. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period. c. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.

Which of the following rules is CORRECT for capital budgeting analysis? a. The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows. b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects. c. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision. d. A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted. e. If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis.

b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. Changes in net operating working capital attributable to the project. b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. c. The value of a building owned by the firm that will be used for this project. d. A decline in the sales of an existing product, provided that decline is directly attributable to this project. e. The salvage value of assets used for the project that will be recovered at the end of the project's life.

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

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects? a. Project A, which has average risk and an IRR = 9%. b. Project B, which has below-average risk and an IRR = 8.5%. c. Project C, which has above-average risk and an IRR = 11%. d. Without information about the projects' NPVs we cannot determine which one or ones should be accepted. e. All of these projects should be accepted as they will produce a positive NPV.

b. Project B, which has below-average risk and an IRR = 8.5%.

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC? a. Project S. b. Project L. c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. e. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs.

b. Project L.

Which of the following statements is CORRECT? a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. b. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm's weighted average cost of capital is also the capital structure that maximizes its earnings per share. d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.

b. The capital structure that minimizes a firm's weighted average cost of capital is also the capital structure that maximizes its stock price.

Which of the following would tend to increase a firm's target debt ratio, other things held constant? a. The costs associated with filing for bankruptcy increase. b. The corporate tax rate is increased. c. The personal tax rate is increased. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company's stock price hits a new low.

b. The corporate tax rate is increased.

The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False

b; False

Which of the following statements is CORRECT? a. A firm's business risk is determined solely by the financial characteristics of its industry. b. The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control. c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy. d. A firm's financial risk can be minimized by diversification. e. The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

b. The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project's NPV is greater than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPVs of relatively risky projects should be found using relatively low WACCs.

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

Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.

b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price.

A major contribution of the Miller model is that it demonstrates, other things held constant, that a. personal taxes increase the value of using corporate debt. b. personal taxes lower the value of using corporate debt. c. personal taxes have no effect on the value of using corporate debt. d. financial distress and agency costs reduce the value of using corporate debt. e. debt costs increase with financial leverage.

b. personal taxes lower the value of using corporate debt.

You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12%

b; 9.26%

Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's IRR increases as the WACC declines. b. A project's NPV increases as the WACC declines. c. A project's MIRR is unaffected by changes in the WACC. d. A project's regular payback increases as the WACC declines.

b; A project's NPV increases as the WACC declines

Which of the following is NOT a capital component when calculating the weighted average capital cost (WACC) for use in capital budgeting? a. Long-term debt b. Accounts payable c. Retained earnings d. Common stock e. Preferred stock

b; Accounts payable

A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted. a. True b. False

b; False

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

b; False

An increase in the firm's WACC will decrease project's NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False

b; False

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

b; False

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

b; False

The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False

b; False

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

b; False

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income a. True b. False

b; False

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. a. True b. False

b; False

The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. a. True b. False

b; False

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project's NPV is greater than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero.

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

Carlyle Inc. is considering two mutually exclusive projects. Both require an initial investment of $15,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2, respectively. In addition, Project S can be repeated at the end of Year 2 with no changes in its cash flows. Project L has an expected life of 4 years with after-tax cash inflows of $5,200 at the end of each of the next 4 years. Each project has a WACC of 9.00%. What is the equivalent annual annuity of the most profitable project? a. $ 569.97 b. $ 782.34 c. $ 865.31 d. $1,522.18 e. $1,846.54

c. $ 865.31

Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow? Sales revenues $22,250 Depreciation $8,000 Other operating costs $12,000 Tax rate 35.0% a. $ 8,903 b. $ 9,179 c. $ 9,463 d. $ 9,746 e. $10,039

c. $ 9,463

You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow? Applicable to Both Firms Firm High's Data Firm Low's Data Capital $3,000,000 wd 70% wd 20% EBIT $500,000 Shares 90,000 Shares 240,000 Tax rate 35% Int. rate 12% Int. rate 10% a. $0.49 b. $0.54 c. $0.60 d. $0.66 e. $0.73

c. $0.60

Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow? Equipment cost (depreciable basis) $70,000 Sales revenues, each year $42,500 Operating costs (excl. depreciation) $25,000 Tax rate 35.0% a. $11,814 b. $12,436 c. $13,090 d. $13,745 e. $14,432

c. $13,090

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.00% Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 a. $188.68 b. $198.61 c. $209.07 d. $219.52 e. $230.49

c. $209.07

Warnock 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: 10.00% Year 0 1 2 3 Cash flows -$950 $500 $400 $300 a. $54.62 b. $57.49 c. $60.52 d. $63.54 e. $66.72

c. $60.52

Tuttle Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. WACC: 11.00% Year 0 1 2 3 4 Cash flows -$1,000 $350 $350 $350 $350 a. $77.49 b. $81.56 c. $85.86 d. $90.15 e. $94.66

c. $85.86

Resnick Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$350 $200 $200 $200 a. 1.42 years b. 1.58 years c. 1.75 years d. 1.93 years e. 2.12 years

c. 1.75 years

Hindelang Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 12.25% Year 0 1 2 3 4 Cash flows -$850 $300 $320 $340 $360 a. 13.42% b. 14.91% c. 16.56% d. 18.22% e. 20.04%

c. 16.56%

Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$1,150 $500 $500 $500 a. 1.86 years b. 2.07 years c. 2.30 years d. 2.53 years e. 2.78 years

c. 2.30 years

Mansi Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$750 $300 $325 $350 a. 1.91 years b. 2.12 years c. 2.36 years d. 2.59 years e. 2.85 years

c. 2.36 years

Susmel Inc. is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 Cash flows -$500 $150 $200 $300 a. 2.03 years b. 2.25 years c. 2.50 years d. 2.75 years e. 3.03 years

c. 2.50 years

Maxwell Feed & Seed 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 (and even negative), in which case it will be rejected. Year 0 1 2 3 4 5 Cash flows -$9,500 $2,000 $2,025 $2,050 $2,075 $2,100 a. 2.08% b. 2.31% c. 2.57% d. 2.82% e. 3.10%

c. 2.57%

Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000. What sales volume would be required to break even, i.e., to have EBIT = zero? a. 28,880 b. 30,400 c. 32,000 d. 33,600 e. 35,280

c. 32,000

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the break-even formula, but include the required profit in the numerator.) a. 4,513 b. 4,750 c. 5,000 d. 5,250 e. 5,513

c. 5,000

Firms HD and LD are identical except for their use of debt and the interest rates they pay--HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD's ROE be versus that of LD, i.e., what is ROEHD - ROELD? Applicable to Both Firms Firm HD's Data Firm LD's Data Capital $3,000,000 wd 70% wd 20% EBIT $500,000 Int. rate 12% Int. rate 10% Tax rate 35% a. 5.41% b. 5.69% c. 5.99% d. 6.29% e. 6.61%

c. 5.99%

You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the percentage of debt in the capital structure (wd) to only 10%. Other things held constant, and based on the data below, if the firm uses more debt, by how much would the ROE change, i.e., what is ROENew - ROEOld? Operating Data Other Data Capital $4,000 Higher wd 60% ROIC = EBIT(1 - T)/Capital 13.00% Higher interest rate 13% Tax rate 35% Lower wd 10% Lower interest rate 9% a. 5.44% b. 5.73% c. 6.03% d. 6.33% e. 6.65%

c. 6.03%

Your firm's debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell bonds and use the proceeds to buy back and retire common shares so the percentage of common equity in the capital structure (wc) = 1 - wd. Other things held constant, and based on the data below, if the firm increases the percentage of debt in its capital structure (wd) to 60.0%, by how much would the ROE change, i.e., what is ROENew - ROEOld? Operating Data Other Data Capital $150,000 Old wd 5% ROIC = EBIT(1 - T)/Capital 13.00% Old interest rate 10% Tax rate 35% New wd 60% New interest rate 12% a. 6.73% b. 7.09% c. 7.46% d. 7.83% e. 8.22%

c. 7.46%

Firm A is very aggressive in its use of debt to leverage up its earnings for common stockholders, whereas Firm NA is not aggressive and uses no debt. The two firms' operations are identical--they have the same total investor-supplied capital, sales, operating costs, and EBIT. Thus, they differ only in their use of financial leverage (wd). Based on the following data, how much higher or lower is A's ROE than that of NA, i.e., what is ROEA - ROENA? Applicable to Both Firms Firm A's Data Firm NA's Data Capital $150,000 wd 50% wd 0% EBIT $40,000 Int. rate 12% Int. rate 10% Tax rate 35% a. 8.60% b. 9.06% c. 9.53% d. 10.01% e. 10.51%

c. 9.53%

Which of the following statements is CORRECT? a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project's NPV. e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.

c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

Which of the following statements is CORRECT? a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase. b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios. d. Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC. e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income

c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.

Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD's return on investors' capital (ROIC) exceeds its after-tax cost of debt, rd(1 - T). Which of the following statements is CORRECT? a. Company HD has a higher return on assets (ROA) than Company LD. b. Company HD has a higher times interest earned (TIE) ratio than Company LD. c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's. d. The two companies have the same ROE. e. Company HD's ROE would be higher if it had no debt.

c. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD's.

Based on the information below, what is the firm's optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20.

Masulis Inc. 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 4 Cash flows -$950 $525 $485 $445 $405 a. 1.61 years b. 1.79 years c. 1.99 years d. 2.22 years e. 2.44 years

d. 2.22 years

Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' returns on investors' capital (ROIC) exceed their after-tax costs of debt, rd(1 - T). Which of the following statements is CORRECT? a. HD should have a higher return on assets (ROA) than LD. b. HD should have a higher times interest earned (TIE) ratio than LD. c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's. d. Given that ROIC > rd(1 - T), HD's stock price must exceed that of LD. e. Given that ROIC > rd(1 - T), LD's stock price must exceed that of HD.

c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC. b. The lower the WACC used to calculate it, the lower the calculated NPV will be. c. If a project's NPV is less than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPV of a relatively low-risk project should be found using a relatively high WACC.

c. If a project's NPV is less than zero, then its IRR must be less than the WACC.

Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce a. Higher depreciation charges in the early years of an asset's life. b. Larger cash flows in the earlier years of an asset's life. c. Larger total undiscounted profits from the project over the project's life. d. Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes. e. Lower tax payments in the earlier years of an asset's life.

c. Larger total undiscounted profits from the project over the project's life.

Which of the following statements is CORRECT? a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects. b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. e. The percentage difference between the MIRR and the IRR is equal to the project's WACC.

c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.

Which of the following statements is CORRECT? a. The MIRR and NPV decision criteria can never conflict. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. d. The higher the WACC, the shorter the discounted payback period. e. The MIRR method assumes that cash flows are reinvested at the crossover rate.

c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.

Taussig Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV $350,000 $350,000 Standard deviation (σNPV) $100,000 $150,000 Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows with cash flows from currently existing projects Cash flows are not correlated with the cash flows from existing projects Cash flows are highly correlated with the cash flows from existing projects Which of the following statements is CORRECT? a. Project X has more stand-alone risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has more market risk than Project Y. d. Project X has the same level of corporate risk as Project Y. e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.

c. Project X has more market risk than Project Y.

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? a. All sunk costs that have been incurred relating to the project. b. All interest expenses on debt used to help finance the project. c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life. d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. e. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

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? a. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products. b. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. c. 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. d. The new product will cut into sales of some of the firm's other products. e. If the project is accepted, the company must invest an additional $2 million in net operating working capital. However, all of these funds will be recovered at the end of the project's life.

c. 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.

Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with an after-tax yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company's total investor-supplied capital, the size of the firm (i.e., total assets), and it would not affect the firm's return on investors' capital (ROIC), which is 15%. The CFO believes that this recapitalization would reduce the firm's WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan? a. The company's net income would increase. b. The company's earnings per share would decline. c. The company's cost of equity would increase. d. The company's ROA would increase. e. The company's ROE would decline.

c. The company's cost of equity would increase.

Which of the following statements is CORRECT? a. Increasing its use of financial leverage is one way to increase a firm's return on investors' capital (ROIC). b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage. c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price. d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors' capital (ROIC). (Assume that the repurchase has no impact on the company's operating income.) e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.

c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price.

Which of the following factors should be included in the cash flows used to estimate a project's NPV? a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted. b. Interest on funds borrowed to help finance the project. c. The end-of-project recovery of any additional net operating working capital required to operate the project. d. Cannibalization effects, but only if those effects increase the project's projected cash flows. e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

c. The end-of-project recovery of any additional net operating working capital required to operate the project.

Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L, because at the new WACC it will have the higher NPV. d. You should recommend Project S, because at the new WACC it will have the higher NPV. e. You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

c. You should recommend Project L, because at the new WACC it will have the higher NPV.

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% (constant). What is the cost of equity based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%

c; 10.44%

Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual annuity of the most profitable project? a. $1,345.50 b. $1,346.30 c. $1,361.52 d. $1,376.74 e. $1,411.15

d. $1,376.74

You work for the CEO of a new company that plans to manufacture and sell a new type of laptop computer. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $600,000. Other data for the firm are shown below. How much higher or lower will the firm's expected EPS be if it uses some debt rather than only equity, i.e., what is EPSL - EPSU? 0% Debt, U 60% Debt, L Oper. income (EBIT) $600,000 $600,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Shares issued, $10/share 250,000 100,000 Interest rate NA 10.00% Tax rate 35% 35% a. $1.00 b. $1.11 c. $1.23 d. $1.37 e. $1.50

d. $1.37

Southwest U's campus book store sells course packs for $15 each, the variable cost per pack is $9, fixed costs to produce the packs are $200,000, and expected annual sales are 50,000 packs. What are the pre-tax profits from sales of course packs? a. $ 72,900 b. $ 81,000 c. $ 90,000 d. $100,000 e. $110,000

d. $100,000

Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No change in net operating working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) WACC 10.0% Opportunity cost $100,000 Net equipment cost (depreciable basis) $65,000 Straight-line depreciation rate for equipment 33.333% Annual sales revenues $123,000 Annual operating costs (excl. depreciation) $25,000 Tax rate 35% a. $10,521 b. $11,075 c. $11,658 d. $12,271 e. $12,885

d. $12,271

Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $25.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 75,000 units, how much higher or lower will the firm's expected EBIT be if it uses Machine B with high fixed costs rather than Machine A with low fixed costs, i.e., what is EBITB - EBITA? Machine A Machine B Price per mouse (P) $25.00 $25.00 Fixed costs (F) $100,000 $400,000 Variable cost/unit (V) $15.25 $9.00 Exp. unit sales (Q) 75,000 75,000 a. $123,019 b. $136,688 c. $151,875 d. $168,750 e. $185,625

d. $168,750

Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 50,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs? a. $164,025 b. $182,250 c. $202,500 d. $225,000 e. $247,500

d. $225,000

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% a. $28,115 b. $28,836 c. $29,575 d. $30,333 e. $31,092

d. $30,333

Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,900 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project? a. $4,242 b. $4,246 c. $4,286 d. $4,325 e. $4,433

d. $4,325

Last month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC: 10.00% New WACC: 11.25% Year 0 1 2 3 Cash flows -$1,000 $410 $410 $410 a. -$18.89 b. -$19.88 c. -$20.93 d. -$22.03 e. -$23.13

d. -$22.03

Datta Computer Systems 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 (and even negative), in which case it will be rejected. Year 0 1 2 3 Cash flows -$1,100 $450 $470 $490 a. 9.70% b. 10.78% c. 11.98% d. 13.31% e. 14.64%

d. 13.31%

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 a. 14.05% b. 15.61% c. 17.34% d. 19.27% e. 21.20%

d. 19.27%

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the break-even points for Machines A and B? (Hint: Find BEB - BEA) Machine A Machine B Price per pair (P) $20.00 $20.00 Fixed costs (F) $25,000 $100,000 Variable cost/unit (V) $7.00 $4.00 a. 3,154 b. 3,505 c. 3,894 d. 4,327 e. 4,760

d. 4,327

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes. b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. d. 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. e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.

d. 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.

Which of the following statements is CORRECT? a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. c. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices. d. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. e. If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.

d. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC. b. A project's regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR. c. If a project's IRR is smaller than the WACC, then its NPV will be positive. d. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. e. If a project's IRR is positive, then its NPV must also be positive.

d. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost.

Which of the following statements is CORRECT? a. An NPV profile graph shows how a project's payback varies as the cost of capital changes. b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. c. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. d. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital. e. We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV.

d. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.

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? a. Lacks an objective, market-determined benchmark for making decisions. b. Ignores cash flows beyond the payback period. c. Does not directly account for the time value of money. d. Does not provide any indication regarding a project's liquidity or risk. e. Does not take account of differences in size among projects.

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

Which of the following statements is CORRECT? a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (rs). b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm's times interest earned (TIE) ratio. d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC. e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios.

d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company's WACC.

Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the project's completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a project's life. d. 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. e. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.

d. 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 is CORRECT? a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. c. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. d. 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. e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

d. 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.

Which of the following statements is CORRECT? a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC. d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC.

Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can only occur if the signs of the cash flows change more than once. e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

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

Which of the following statements is CORRECT? a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the required return on equity also maximizes the stock price. d. The capital structure that minimizes the WACC also maximizes the price per share of common stock. e. The capital structure that gives the firm the best bond rating also maximizes the stock price.

d. The capital structure that minimizes the WACC also maximizes the price per share of common stock.

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration. b. Revenues from an existing product would be lost as a result of customers switching to the new product. c. Shipping and installation costs associated with a machine that would be used to produce the new product. d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.

Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk? a. Demand variability. b. Sales price variability. c. The extent to which operating costs are fixed. d. The extent to which interest rates on the firm's debt fluctuate. e. Input price variability.

d. The extent to which interest rates on the firm's debt fluctuate.

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

d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

Which of the following statements is CORRECT? a. The regular payback method recognizes all cash flows over a project's life. b. 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. c. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. d. 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. e. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

d. 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.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. b. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. c. If a project's IRR is greater than the WACC, then its NPV must be negative. d. 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. e. To find a project's IRR, we must find a discount rate that is equal to the WACC.

d. 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.

Which of the following statements is CORRECT? a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV. e. Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project's forecasted NPV.

d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.

Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L, because at the new WACC it will have the higher NPV. d. You should recommend Project S, because at the new WACC it will have the higher NPV. e. You should recommend Project L because it will have the higher IRR at the new WACC

d. You should recommend Project S, because at the new WACC it will have the higher NPV.

Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRS. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can only occur if the signs of the cash flows change more than once.

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

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 a. $ 8,878 b. $ 9,345 c. $ 9,837 d. $10,355 e. $10,900

e. $10,900

Harry's Inc. is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that if a project's projected NPV is negative, it should be rejected. WACC: 10.25% Year 0 1 2 3 4 5 Cash flows -$1,000 $300 $300 $300 $300 $300 a. $105.89 b. $111.47 c. $117.33 d. $123.51 e. $130.01

e. $130.01

Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No change in net operating working capital would be required. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Risk-adjusted WACC 10.0% Net investment cost (depreciable basis) $65,000 Straight-line depreciation rate 33.3333% Sales revenues, each year $65,500 Annual operating costs (excl. depreciation) $25,000 Tax rate 35.0% a. $15,740 b. $16,569 c. $17,441 d. $18,359 e. $19,325

e. $19,325

As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow? Sales revenues, each year $42,500 Depreciation $10,000 Other operating costs $17,000 Interest expense $4,000 Tax rate 35.0% a. $16,351 b. $17,212 c. $18,118 d. $19,071 e. $20,075

e. $20,075

As a consultant to First Responder Inc., you have obtained the following data (dollars in millions). The company plans to pay out all of its earnings as dividends, hence g = 0. Also, no net new investment in operating capital is needed because growth is zero. The CFO believes that a move from zero debt to 20.0% debt would cause the cost of equity to increase from 10.0% to 12.0%, and the interest rate on the new debt would be 8.0%. What would the firm's total market value be if it makes this change? Hints: Find the FCF, which is equal to NOPAT = EBIT(1 - T) because no new operating capital is needed, and then divide by (WACC - g). Oper. income (EBIT) $800 Tax rate 40.0% New cost of equity (rs) 12.00% New wd 20.0% Interest rate (rd) 8.00% a. $2,982 b. $3,314 c. $3,682 d. $4,091 e. $4,545

e. $4,545

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 a. $41.25 b. $45.84 c. $50.93 d. $56.59 e. $62.88

e. $62.88

El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.25. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta, bU? a. 0.71 b. 0.75 c. 0.79 d. 0.83 e. 0.87

e. 0.87

Ingram Electric Products is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 11.00% Year 0 1 2 3 Cash flows -$800 $350 $350 $350 a. 8.86% b. 9.84% c. 10.94% d. 12.15% e. 13.50%

e. 13.50%

Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected. WACC: 10.00% Year 0 1 2 3 Cash flows -$1,000 $450 $450 $450 a. 9.32% b. 10.35% c. 11.50% d. 12.78% e. 14.20%

e. 14.20%

Stern Associates is considering a project that has the following cash flow data. What is the project's payback? Year 0 1 2 3 4 5 Cash flows -$1,100 $300 $310 $320 $330 $340 a. 2.31 years b. 2.56 years c. 2.85 years d. 3.16 years e. 3.52 years

e. 3.52 years

Which of the following statements is CORRECT, holding other things constant? a. Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt. b. An increase in the personal tax rate is likely to increase the debt ratio of the average corporation. c. If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely lead to lower debt ratios for corporations. d. An increase in the company's degree of operating leverage would tend to encourage the firm to use more debt in its capital structure so as to keep its total risk unchanged. e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.

e. An increase in the corporate tax rate would in theory encourage companies to use more debt in their capital structures.

Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. d. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its IRR must be positive. b. If a project has "normal" cash flows, then its MIRR must be positive. c. If a project has "normal" cash flows, then it will have exactly two real IRRs. d. The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life. e. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR.

e. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. d. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. e. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.

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

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? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a 4-year payback is too low. d. The firm will accept too few projects in all economic states because a 4-year payback is too high. e. 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.

e. 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.

Which of the following statements is CORRECT? a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Which of the following statements is CORRECT? a. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. b. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. c. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. e. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

e. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated IRR of the project to reflect its greater risk. b. Increase the estimated NPV of the project to reflect its greater risk. c. Reject the project, since its acceptance would increase the firm's risk. d. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

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

The firm's target capital structure should do which of the following? a. Maximize the earnings per share (EPS). b. Minimize the cost of debt (rd). c. Obtain the highest possible bond rating. d. Minimize the cost of equity (rs). e. Minimize the weighted average cost of capital (WACC).

e. Minimize the weighted average cost of capital (WACC).

Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of cash flows over a project's full life. b. One defect of the IRR method is that it does not take account of the time value of money. c. One defect of the IRR method is that it does not take account of the cost of capital. d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure? a. Its sales are projected to become less stable in the future. b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. c. Management believes that the firm's stock is currently overvalued. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. The corporate tax rate is increased.

e. The corporate tax rate is increased.

Which of the following statements is CORRECT? a. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. c. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. d. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.

e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.

Which of the following statements is CORRECT? a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. c. Well-diversified stockholders do not need to consider market risk when determining required rates of return. d. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project? a. Changes in net operating working capital. b. Shipping and installation costs for machinery acquired. c. Cannibalization effects. d. Opportunity costs. e. Sunk costs that have been expensed for tax purposes.

e. Sunk costs that have been expensed for tax purposes.

Which of the following statements is CORRECT? a. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability. b. If the cost of capital declines, this lowers a project's NPV. c. The NPV method is regarded by most academics as being the best indicator of a project's profitability, hence most academics recommend that firms use only this one method and disregard other methods. d. A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project's life. e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

Your firm has $500 million of investor-supplied capital, its return on investors' capital (ROIC) is 15%, and it currently has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would increase. b. The ROA would remain unchanged. c. The return on investors' capital would decline. d. The return on investors' capital would increase. e. The ROE would increase.

e. The ROE would increase.

Which of the following statements is CORRECT? a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this a. normally leads to an increase in its fixed assets turnover ratio. b. normally leads to a decrease in its business risk. c. normally leads to a decrease in the standard deviation of its expected EBIT. d. normally leads to a decrease in the variability of its expected EPS. e. normally leads to a reduction in its fixed assets turnover ratio.

e. normally leads to a reduction in its fixed assets turnover ratio.