16, 10, 9 DSM

Assume you have two projects with different lives. Project A is expected to generate present value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A has an equivalent annual annuity of __________ which is __________ than Project B.

$1.03319 million, better

Giancarlo received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 What would be Giancarlo's initial investment in the Suzuki XL7?

$24,675 + $1,732 - $9,285 = $17,122

Firm XYZ is evaluating whether to introduce a new energy drink. The marketing research department estimates sales will be around $10 million per year for the next 6 years. However, the product is also expected to erode sales of the firm's current product line by about $1 million per year. What are the relevant annual sales figures that should be used to evaluate this new product?

$9 million

Last year Harmon Manufacturing paid $3 million in interest payments. Harmon is in the 30% tax bracket. Harmon's interest tax shield for the year was __________.

$900,000

What is the after-tax cost of debt for a 10% coupon rate bond if the firm is in a 28% marginal tax bracket?

(1 - .28) = 7.2%

Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?

10%

The concept of synergy can be whimsically expressed by:

2 + 2 = 5

The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.

9.57%

Which of the following is an example of a sunk cost?

Amount spent on a test market.

Simons Industries has just borrowed $1 million by issuing 20-year bonds. The company's cost of debt is 5% so it will need to pay $50,000 in interest each year for the next 20 years and then repay the principal of $1 million in year 20. The company's marginal tax rate is 30%. How much should the interest tax shield increase the value of Simons?

Bond amount= 1000000 Interest amount= 50000 Interest rate or Discount rate (i)= 5% Tax rate = 30% Time (n) = 20 years Formula for interest tax shield = Interest * tax rate 50000*30% $15000 P.V. of tax shield = Interest tax shield*(1-(1/(1+i)^n))/i 15000*(1-(1/(1+5%)^20))/5% 186933.1551 So, Interest tax shield will add $186,933.16 to the Value of Simons

The cost of common stock equity may be estimated by using the __________.

CAPM

Which of these cash flows should be included as an incremental cash flow when you evaluate a project?

Capital expenditures necessary to fund the new project.

__________ are the actual outflow or inflow of money while __________ are an accounting measure of performance.

Cash flows; profits

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the dividend growth model, what is the company's cost of equity?

Cost of equity = $1.50/$45 + .04 = .073 or 7.3%

A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________.

Cost of equity = risk-free rate + beta(market return - risk-free rate) So, the cost of equity = 4% + .90(12% - 4%) = 11.2%

Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?

Current stock price

The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction's effective cost of debt is:

Effective cost of debt = 6.2%(1 - .25) = 4.65%.

Giancarlo has received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 What would be Giancarlo's operating cash flow in year 5?

Giancarlo's operating cash flow in year 5 would be -$575. To evaluate his operating cash flows from accepting the project you need to determine the incremental difference. In this case he would have spent $925 but instead spent $350. So his operating cash flows for buying the new car would be $350 - $925 = -$575. The formula is; Replacement cash flows = cash flow for new asset - cash flow for the old asset.

Corona Publishing has debt outstanding with a market value of $10 million. The company's common stock has a book value of $20 million and a market value of $30 million. What weight for equity should Corona use in its WACC calculation?

In this case Corona's total value is $10 million debt + $30 million in equity = $40 million. Equity represents $30m/$40m, or 75% of that amount.

Which of the following is a direct cost of bankruptcy?

Legal fees

Which of the following is an indirect cost of bankruptcy?

Loss of employees

Which of the following is a relevant opportunity cost that should be considered an incremental cash flow?

Lost facility rental income

A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14% year cash inflow 1 $50,000 2 $65,000 3 $90,000 What is the NPV for this project?

NPV = $50,000/(1.14) + $65,000/(1.14)2 + $90,000/(1.14)3 - $100,000 = $43,860 + $50,015 + $60,748 - $100,000 = $54,623

A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:

NPV = $6,000 - $8,000 = -$2,000

What is the NPV of a project expected to generate $1,000 a year for 5 years assuming a discount rate of 10% and an initial outlay of $3,250?

NPV = -$3,250 + $1,000/1.10 + $1,000/1.102 + $1,000/1.103 + $1,000/1.104 + $1,000/1.105 NPV = $540.79

Assume that you expect to sell a stock for $50 in two years and your required return is 8%. If the stock is currently selling for $41, what is its NPV?

NPV = [$50/(1.08)2] - $41 = $42.87 - $41 = $1.87

Which of the following decision rules is always correct because it is directly tied to the goal of maximizing shareholder wealth?

NPV rule

Which of these items should NOT be counted as a relevant cash flow for project evaluation?

Overhead assigned to the project from the corporate office.

What is the discounted payback of a project that has an initial outlay of $20,000 and will generate $6,000 in year 1, $12,000 in year 2, $9,000 in year 3, and $14,000 in year 4 assuming the cost of capital is 10%?

PV of year 1 = $6,000/(1.1) = $5,455 PV of year 2 = $12,000/(1.1)2 = $9,917 PV of year 3 = $9,000/(1.1)3 = $6,762 PV of year 4 = $14,000/(1.1)4 = $9,562 So the discounted payback is equal to: Initial outlay = $20,000 - $5,455 - $9,917 = $4,628 remaining to be recovered after two years. So, discounted payback = 2 years + $4,628/$6,762 = 2.68 years.

A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm's marginal tax rate is 40%. The cost of the preferred stock is;

Rps = $8/($100 - $3) = $8/$97 = .08247 or 8.25%

A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources; Long-term debt = 45%, after-tax cost = 7% Preferred stock = 15%, after-tax cost = 10% Common stock equity = 40%, after-tax cost = 14% The weighted average cost of capital for this firm is;

Since this problem gives you the after-tax cost you will not need to adjust the cost of debt for taxes. So, WACC = (.45)(7%) + (.15)(10%) + (.40)(14%) = 3.15% + 1.5% + 5.6% = 10.25%

The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CAPM, what is the company's cost of equity?

So, Cost of equity = 4% + 1.3(5%) = 10.5%

Firm XYZ has total assets of $4,500,000 and owes $1,210,000 in debt. What is Firm XYZ's debt-to-equity ratio?

So, Firm XYZ's equity = $4,500,000 - $1,210,000 = $3,290,000. The debt-to-equity ratio is therefore = $1,210,000/$3,290,000 = .3678 or approximately 37%.

James is considering starting a new business based on the results of some market research he paid a firm $45,000 to conduct. What type of cost is the $45,000?

Sunk cost

A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:

The payback period is the length of time it takes to recover the initial investment so in this case you see that a total of $40,000 is recovered in the first three years, which leaves $5,000 to be recovered. In the fourth year, you will generate $10,000 so the fraction of the year required to capture the remaining $5,000 investment is $5,000/$10,000 or 0.5. The payback period is, therefore, 3.5 years.

Cogswell Cola purchased a machine for $237,500. The firm paid another $5,750 for delivery and installation. In addition the firm will have to hire another employee and pay them $50,000 per year to run the machine. What is the initial outlay for this machine?

The total outlay is $237,500 + $5,750 = $243,250.

Which of the following should be used as the firm's cost of debt?

The yield to maturity of the existing debt outstanding.

Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest?

To calculate the payback you need to calculate Chris' annual cash return which is equal to $25,000 (1 - 0.30) = $17,500 per year in after-tax proceeds from the investment. Given that annual amount, his payback is equal to $120,000 / $17,500 = 6.86 years. Since the payback exceeds his six year cut off he should not make the investment. No, because the payback period is 6.86 years.

Bartleman Industries is raising $5 million through the sale of $100 par value preferred stock that pays a 5% dividend. If flotation costs are $2 a share how much is the percentage cost of the preferred stock?

To compute the cost you divide the dividend by the net price received for the preferred. In this case the new issue pays a dividend equal to 5% of the par value which is a $5 dividend. The cost is therefore $5/($100 - $2 flotation cost) or $5/$98 = .051 or 5.1%.

A firm must choose from 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Project Initial Investment IRR NPV 1 $100,000 17% $50,000 2 200,000 15% 10,000 3 125,000 14% 30,000 4 100,000 11% -2,500 5 75,000 19% 25,000 Using the internal rate of return approach to ranking projects, which projects should the firm accept?

Using IRR, the firm should accept any project that generates an IRR at least as high as the firm's cost of capital. The only project that does not exceed the firm's 12% cost of capital is project 4. 1,2,3,5

The appropriate discount rate to use when evaluating capital budgeting projects using NPV is the:

WACC.

To compute the after-tax cost of debt you need to multiply the cost of debt by:

a factor equal to one minus the marginal tax rate, or (1 - marginal tax rate).

Financial distress costs occur when __________.

a firm is unable to meet debt obligations

An NPV profile is __________.

a graph of a project's NPV over a range of different discount rates

When using the net present value (NPV) to evaluate capital budgeting projects, you should:

accept all projects with a positive NPV

We only want to consider incremental earnings in the capital budgeting process. Incremental earnings are the:

additional sales and costs associated with the project.

The specific cost of each source of long-term financing is based on __________ costs.

after-tax and current

An incremental cash flow valuation considers:

all project cash flows including cannibalization.

When debt levels increase beyond the optimal level __________ will begin to outweigh the __________.

bankruptcy costs; benefits of the tax shield

The cost of an asset carried on the balance sheet is known as:

book value.

A firm's optimal capital structure:

can change over time.

A firm's __________ refers to the mix of debt and equity used for financing its assets and operations.

capital structure

MIRR is used when:

cash flows of a project change sign

ABC Energy company leased the mineral rights to drill for oil and gas on 10,000 acres for $500,000. Now the firm is trying to determine whether the cost to drill the well is justified given the poor results on nearby acreage. For financial decision-making, the $500,000 should be:

considered a sunk cost and ignored.

The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock.

cost of capital

The WACC represents the average __________ for the firm.

cost of financing

Sunk costs are:

costs that once made cannot be recovered.

A firm's __________ refers to the amount of additional debt a firm could take on and still make timely payments.

debt capacity

The lowest cost financing for a firm is typically:

debt.

The cost of debt financing is __________ by the effects of income taxes.

decreased

Firm XYZ's debt-to-equity ratio is 32%. Based on this information, has financed more of its assets with:

equity

The term 'unlevered equity' refers to the __________.

equity in a firm with no debt

One method that can be used to evaluate capital budgeting projects with different lives is to convert the project's cash flows to a level annual cash flow that has the same present value as the project's overall cash flows. This annual cash flow is known as the:

equivalent annual annuity

Capital budgeting is the process of:

evaluating a firm's investment choices.

Seeking funds from the __________ markets is more expensive and time consuming than seeking funds from the __________ markets.

external; internal

Cogswell Cola expanded its product line by about 20%. However, the firm's management failed to consider it would need additional investments in inventory and accounts receivable. This oversight is an example of:

failing to consider changes in working capital.

The practice of financing a portion of the firm's assets with borrowed funds in hopes of increasing the ultimate return to shareholders refers to __________.

financial leverage

The degree to which a firm uses borrowed money to generate an investment return is known as:

financial leverage.

To use the CAPM to estimate the cost of equity you need to know the:

firm's beta.

Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:

firm's cost of capital

If a firm sells a capital asset for $45,000 that has a book value of $50,000 the firm:

has a tax loss of $5,000.

When resources are limited you should select the projects with the:

highest NPV

A firm's minimum required return on a capital budgeting project is known as the:

hurdle rate.

Since preferred stock dividends are fixed in the same manner of a coupon bond's interest payment it is referred to as:

hybrid equity.

Modigliani and Miller argued that __________.

in a perfect capital market, the total value of the firm was equal to the market value of its free cash flows and not affected by choice of capital structure

When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as:

increased inventory levels.

The relevant cash flows of a project are best described as:

incremental cash flows

The relevant cash flows of a project are best described as:

incremental cash flows.

Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as:

independent projects

In many cases, the __________ costs of bankruptcy exceed the __________ costs even though they are much harder to quantify.

indirect, direct

For financial decision-making in capital budgeting we remove __________ as a relevant cash flow since the financing and investing components are two separate decisions.

interest expense

is higher than the value of the unlevered firm due to the value of the tax shield

is higher than the value of the unlevered firm due to the value of the tax shield

The effective cost of debt is:

less than the return paid to debt holders due to tax benefits of interest paid

A tax adjustment must be made in determining the cost of:

long-term debt

The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have:

longer project lives

Optimal capital structure is the mix of debt and equity that __________.

maximizes shareholder wealth

If a fully depreciated asset is sold for $10,000 the firm:

must pay tax on the $10,000.

As you increase the required return used in an NPV calculation, the likelihood of a __________ NPV __________.

negative, increases

The sale of an ordinary asset for its book value results in:

no tax benefit.

The profitability index is a ratio of the:

present value of benefits to the present value of costs.

Sunk costs are:

previous cash outflows not relevant to the project decision.

One way to adjust for projects with different levels of risk is to compute the NPV using a WACC computed with a:

project-specific beta.

With a perfect capital market, as the amount of leverage increases, the WACC __________.

remains constant

According to the pecking order hypothesis, managers will have a preference to fund investment using __________.

retained earnings, followed by debt and finally new equity

According to the pecking order theory, firms will only __________ when they have exhausted all other options.

sell equity

Depreciating a capital asset by a fixed amount over its useful life is known as:

straight-line depreciation.

In order to calculate a project's NPV, you need to know the appropriate discount rate, the amount of the initial outlay, and:

the amount and timing of the expected cash flows

Firms will not be able to use 100% debt financing because:

the possibility of bankruptcy increases with leverage.

The discounted payback period method takes __________ into consideration.

time value of money

The pure play method of assigning project-based betas involves:

using the beta of a firm in a similar line of business.