fin300 Final
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 -$1565 $400 $400 $400 $400 a. 0.78% b. 0.76% c. 0.85% d. 0.91% e. 0.89%
E. .89
Assuming that their NPVs based on the firm's cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. a. True b. False
False
T/F: Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision--estimates of its effect would really just be guesses. In this case, the externality should be ignored--i.e., not considered at all--because if it were considered it would make the analysis appear more precise than it really is.
False
T/F: The IRR of normal Project X is greater than the IRR of normal Project Y, and both IRRs are greater than zero. Also, the NPV of X is greater than the NPV of Y at the cost of capital. If the two projects are mutually exclusive, Project X should definitely be selected, and the investment made, provided we have confidence in the data. Put another way, it is impossible to draw NPV profiles that would suggest not accepting Project X.
False
Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows. a. True b. False
True
If a dollar will buy fewer units of a foreign currency in the forward market than in the spot market, then the forward currency is said to be selling at a premium to the spot rate. a. True b. False
True
If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. a. True b. False
True
Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt. a. True b. False
True
Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms. a. True b. False
True
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 6.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.00%. The firm will not be issuing any new stock. What is its WACC? a. 8.93% b. 7.68% c. 6.69% d. 7.59% e. 6.96%
a. 8.93%
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 a project's NPV is less than zero, then its IRR must be less than the WACC. b. 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. c. The lower the WACC used to calculate it, the lower the calculated NPV will be. 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.
a. If a project's NPV is less than zero, then its IRR must be less than the WACC.
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. 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. b. 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. c. 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. d. 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. e. 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.
a. 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. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. b. 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. c. 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. d. 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. e. The percentage difference between the MIRR and the IRR is equal to the project's WACC.
a. 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 "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock. b. The "break point" as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock. c. The "break point" as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned. d. The "break point" as discussed in the text refers to the point where the firm's tax rate increases. e. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.
a. The "break point" as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project. b. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. c. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. d. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. e. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
a. The accept/reject decision depends on the firm's risk-adjustment policy. If Norris' policy is to increase the required return on a riskier-than-average project to 3% over rs, then it should reject the project.
Project X's IRR is 19% and Project Y's IRR is 17%. The projects have the same risk and the same lives, and each has constant cash flows during each year of their lives. If the WACC is 10%, Project Y has a higher NPV than X. Given this information, which of the following statements is CORRECT? a. The crossover rate must be greater than 10%. b. If the WACC is 8%, Project X will have the higher NPV. c. The crossover rate must be less than 10%. d. Project X is larger in the sense that it has the higher initial cost. e. If the WACC is 18%, Project Y will have the higher NPV.
a. The crossover rate must be greater than 10%.
Multinational financial management requires that a. the effects of changing currency values be included in financial analyses. b. political risk should be excluded from multinational corporate financial analyses. c. traditional U.S. and European financial models incorporating the existence of a competitive marketplace not be recast when analyzing projects in other parts of the world. d. cultural differences need not be accounted for when considering firm goals and employee management. e. legal and economic differences need not be considered in financial decisions because these differences are insignificant
a. the effects of changing currency values be included in financial analyses.
Bosio Inc.'s perpetual preferred stock sells for $85.00 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? a. 12.81% b. 10.42% c. 8.75% d. 8.44% e. 11.35%
b. 10.42%
Other things held constant, which of the following would increase the NPV of a project being considered? a. An increase in required net operating working capital. b. A shift from straight-line to MACRS depreciation. c. The project would decrease sales of another product line. d. An increase in the discount rate associated with the project. e. Making the initial investment in the first year rather than spreading it over the first three years.
b. A shift from straight-line to MACRS depreciation.
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. Does not directly account for the time value of money. b. Does not provide any indication regarding a project's liquidity or risk. c. Lacks an objective, market-determined benchmark for making decisions. d. Ignores cash flows beyond the payback period. e. Does not take account of differences in size among projects.
b. Does not provide any indication regarding a project's liquidity or risk.
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 IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. b. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. c. If Project A has a higher IRR than Project B, then Project A must have the lower NPV. d. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. e. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC.
b. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.
Which of the following statements is CORRECT? 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. 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. d. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. e. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.
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. Management believes that the firm's stock is currently overvalued. b. The corporate tax rate is increased. c. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. Its sales are projected to become less stable in the future.
b. The corporate tax rate is increased.
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 a project's IRR is greater than the WACC, then its NPV must be negative. b. 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. c. To find a project's IRR, we must find a discount rate that is equal to the WACC. d. 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. e. 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.
b. 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
Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 75,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR , per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant? Do not round your intermediate calculations. a. $2.00 b. $2.25 c. $2.50 d. $2.78 e. $1.88
c. $2.50
Liberty Services is now at the end of the final year of a project. The equipment originally cost $20,000, 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. $5,712 b. $6,328 c. $5,600 d. $5,040 e. $5,992
c. $5,600
Which of the following statements is CORRECT? a. 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. b. If a project has "normal" cash flows, then its IRR must be positive. c. 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. d. If a project has "normal" cash flows, then its MIRR must be positive. e. If a project has "normal" cash flows, then it will have exactly two real IRRs.
c. 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.
You are considering two mutually exclusive, equally risky, projects. Both have IRRs that exceed the WACC. Which of the following statements is CORRECT? Assume that the projects have normal cash flows, with one outflow followed by a series of inflows. a. If the cost of capital is less than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. One project will rank higher by both criteria. b. For a conflict to exist between NPV and IRR, the initial investment cost of one project must exceed the cost of the other. c. If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. One project will rank higher by both criteria. d. If the two projects' NPV profiles do not cross, then there will be a sharp conflict as to which one should be selected. e. For a conflict to exist between NPV and IRR, one project must have an increasing stream of cash flows over time while the other has a decreasing stream. If both sets of cash flows are increasing or decreasing, then it would be impossible for a conflict to exist, even if one project is larger than the other.
c. If the cost of capital is greater than the crossover rate, then the IRR and the NPV criteria will not result in a conflict between the projects. One project will rank higher by both criteria.
Which of the following statements is CORRECT? a. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company's WACC for capital budgeting purposes. b. The cost of new equity (re) could possibly be lower than the cost of retained earnings (rs) if the market risk premium, risk-free rate, and the company's beta all decline by a sufficiently large amount. c. Its cost of retained earnings is the rate of return stockholders require on a firm's common stock. d. The component cost of preferred stock is expressed as rp(1 - T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt. e. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
c. Its cost of retained earnings is the rate of return stockholders require on a firm's common stock.
Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. e. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
c. 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.
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. Without information about the projects' NPVs we cannot determine which one or ones should be accepted. b. Project A, which has average risk and an IRR = 9%. c. Project B, which has below-average risk and an IRR = 8.5%. d. Project C, which has above-average risk and an IRR = 11%. e. All of these projects should be accepted as they will produce a positive NPV.
c. Project B, which has below-average risk and an IRR = 8.5%.
LaPango 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 C, which is of above-average risk and has a return of 11%. b. Project A, which is of average risk and has a return of 9%. c. Project B, which is of below-average risk and has a return of 8.5%. d. None of these projects should be accepted. e. All of these projects should be accepted.
c. Project B, which is of below-average risk and has a return of 8.5%.
Which of the following statements is CORRECT? a. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. b. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. c. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. d. Well-diversified stockholders do not need to consider market risk when determining required rates of return. e. 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. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
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. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. b. Its sales are projected to become less stable in the future. c. The corporate tax rate is increased. d. Management believes that the firm's stock is currently overvalued. e. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. Hide Feedback
c. The corporate tax rate is increased.
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 increase the firm's corporate risk. b. The proposed new project would not affect the firm's risk at all. c. The proposed new project would have more stand-alone risk than the firm's typical project. d. The proposed new project would increase the firm's market risk. e. The proposed new project would have less stand-alone risk than the firm's typical project
c. The proposed new project would have more stand-alone risk than the firm's typical project.
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. rs > re > rd > WACC. b. WACC > rd > rs > re. c. re > rs > WACC > rd. d. WACC > re > rs > rd. e. rd > re > rs > WACC.
c. re > rs > WACC > rd.
Multinational financial management requires that a. cultural differences need not be accounted for when considering firm goals and employee management. b. legal and economic differences need not be considered in financial decisions because these differences are insignificant. c. the effects of changing currency values be included in financial analyses. d. political risk should be excluded from multinational corporate financial analyses. e. traditional U.S. and European financial models incorporating the existence of a competitive marketplace not be recast when analyzing projects in other parts of the world.
c. the effects of changing currency values be included in financial analyses.
Which of the following statements is CORRECT? a. If Project A's IRR exceeds Project B's, then A must have the higher NPV. b. A project's MIRR can never exceed its IRR. c. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. d. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. e. If the NPV is negative, the IRR must also be negative.
d. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
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 long-term projects and reject too many short-term projects (as judged by the NPV). b. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). c. The firm will accept too few projects in all economic states because a 4-year payback is too high. d. 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. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. 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.
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. 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. d. 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. e. The new product will cut into sales of some of the firm's other products.
d. 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.
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 a project's NPV is greater than zero, then its IRR must be less than zero. b. If a project's NPV is greater than zero, then its IRR must be less than the WACC. c. 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. d. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. e. The NPVs of relatively risky projects should be found using relatively low WACCs.
d. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
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 $16,000. 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. $12,350 b. $12,610 c. $11,700 d. $16,250 e. $13,000
e. $13,000
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: 9.75% Year 0 1 2 3 4 Cash flows -$1,200 $400 $425 $450 $475 a. $222.13 b. $157.34 c. $174.00 d. $198.07 e. $185.11
e. $185.11
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: 9.50% Year 0 1 2 3 4 5 Cash flows -$1,000 $300 $300 $300 $300 $300 a. 0135.20 b. 0120.01 c. 0179.26 d. 0133.68 e. 0151.91
e. 0151.91
Which of the following statements is CORRECT? a. 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. b. 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. c. 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. d. 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. e. 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. 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.
Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? a. After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. d. Safeco/Risco's WACC, as a result of the merger, would be 10%. e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
e. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
Which of the following statements is CORRECT? a. 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. b. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. c. 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. d. 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. 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. Reject the project, since its acceptance would increase the firm's risk. b. Increase the estimated NPV of the project to reflect its greater risk. c. Increase the estimated IRR of the project to reflect its greater 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.
When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. The salvage value of assets used for the project that will be recovered at the end of the project's life. b. A decline in the sales of an existing product, provided that decline is directly attributable to this project. c. The value of a building owned by the firm that will be used for this project. d. Changes in net operating working capital attributable to the project. e. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
e. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
Which of the following statements is CORRECT? a. The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk. b. A firm's business risk is determined solely by the financial characteristics of its industry. 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 factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control.
e. 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 procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. b. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments - managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately. c. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. d. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. e. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.
e. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or do
A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses. a. True b. False
false
According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good. a. True b. False
false
Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process. a. True b. False
false
Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. a. True b. False
false
If expectations for long-term inflation rose, but the slope of the SML remained constant, this would have a greater impact on the required rate of return on equity, rs, than on the interest rate on long-term debt, rd, for most firms. Therefore, the percentage point increase in the cost of equity would be greater than the increase in the interest rate on long-term debt. a. True b. False
false
In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project. a. True b. False
false
Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be Cost of equity = rs(0.30)(0.50) + rps(1 - T)(0.70)(0.50). a. True b. False
false
Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision--estimates of its effect would really just be guesses. In this case, the externality should be ignored--i.e., not considered at all--because if it were considered it would make the analysis appear more precise than it really is. a. True b. False
false
The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital. a. True b. False
false
The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes. a. True b. False
false
The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital. a. True b. False
false
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
false
The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater. a. True b. False
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
false
The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the DCF method is widely used in practice. a. True b. False
false
A Eurodollar is a U.S. dollar deposited in a bank outside the United States. a. True b. False
true
A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross. a. True b. False
true
Exchange rate risk is the risk that the cash flows from a foreign project, when converted to the parent company's currency, will be worth less than was originally projected because of exchange rate changes. a. True b. False
true
Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects. a. True b. False
true
If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. a. True b. False
true
If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. a. True b. False
true
If the expected dividend growth rate is zero, then the cost of external equity capital raised by issuing new common stock (re) is equal to the cost of equity capital from retaining earnings (rs) divided by one minus the percentage flotation cost required to sell the new stock, (1 - F). If the expected growth rate is not zero, then the cost of external equity must be found using a different formula. a. True b. False
true
Some people--including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke) --have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms. a. True b. False
true
The NPV method's assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR's assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. a. True b. False
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
true
When considering the risk of a foreign investment, a higher risk might arise from exchange rate risk and political risk while lower risk might result from international diversification. a. True b. False
true