Exam 4: Chapters 10, 11, and 12

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.

$277.94

Consider the following projects for Optico Lenses, which has an overall (composite) WACC of 10% that reflects the cost of capital for its average asset. Its assets vary widely in risk, and Optico evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. Which set of projects would maximize shareholder wealth?

A, B, and D

Refer to Exhibit 11-2. What is Project S's MIRR?

16.9%

In capital budgeting decisions, corporate risk will be of least interest to:

Institutional investors.

What is the payback period for Project S given the following? Both projects have a cost of capital of 10%.

1.6 years After the first year, there is only $30 remaining to be repaid, and $50 is received in Year 2. Assuming an even cash flow throughout the year, the payback period is 1 + $30/$50 = 1.6 years.

Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings?

0.37% rs (cost of new stock) D1 / P0 +g re D1 / (P0 (1 - F)) + g

Given the following, what is the project's expected NPV (in millions)?The Carlisle Corporation is considering a proposed project for its capital budget. The company estimates that the project's NPV is $5 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company's CFO, however, forecasts that there is only a 40% chance that the economy will be average. Recognizing this uncertainty, she has also performed the following scenario analysis:

$0.85 Correct. E(NPV) = 0.05(-$28) + 0.25(-$10) + 0.40($5) + 0.25($8) + 0.05($15) = -$1.40 + -$2.50 + $2.00 + $2.00 + $0.75 = $0.85

Hobart Industries is trying to estimate its first-year operating cash flow (at t = 1) for a proposed project. The financial staff has collected the following information: The company faces a 40% tax rate. What is the project's operating cash flow for the first year (t = 1)?

$1,260,000 Sales: 3,000,000 O.C: 1,200,000 Depr: 450,000 EBIT: 1,350,000 Taxes: 540,000 EBIT (1-T): 810,000 Add: Dep. 450,000 OCF: 1,260,000 Operating Cash Flow = EBIT (1-T) + Depreciation

You are evaluating a project that is expected to produce cash flows of $5,000 each year for the next 10 years and $7,000 each year for the following 10 years. The IRR of this 20-year project is 12%. If the firm's WACC is 8%, what is the project's NPV?

$14,321.21 NPV with IRR at 12% = $40,985.66 NPV with IRR at 8% = 14321.21 Use 40,985.66 as Cash Outflow. To solve 14,321.21

Your firm has a marginal tax rate of 40% and a cost of capital of 14%. You are performing a capital budgeting analysis on a new project that will cost $500,000. The project is expected to have a useful life of 10 years, although its MACRS class life is only 5 years. The applicable MACRS depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. The project is expected to increase the firm's net income by $61,257 per year and to have a salvage value of $35,000 at the end of 10 years. What is the project's NPV?

$177,902 Check EXCEL; Question 6

What is Project L's NPV given the following? Both projects have a cost of capital of 10%

$18.78

You are evaluating a capital budgeting project for your company that is expected to last for six years. The project begins with the purchase of a $1,200,000 investment in equipment. You are unsure what method of depreciation to use in your analysis, straight-line depreciation or the 5-year MACRS accelerated method. Straight-line depreciation results in the cost of the equipment depreciated evenly over its life. The 5-year MACRS depreciation rates are 20%, 32%, 19%, 12%, 11%, and 6%. Your company's WACC is 10.5% and it has a tax rate of 35%. For purposes of this question, we are ignoring the half-year convention for the straight-line depreciation method. What is the NPV of the project given by the better depreciation method, i.e., the method that gives the higher NPV?

$20,473.06 Set up: Year, Accelerated depreciation using rate Find straight line depreciation over 6 years as well. Subtract accelerated by straight line to find the difference Multiply difference by tax rate Use those answers to find NPV

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?

$209.07

Assume that all projects in the table below have average risk. What is the dollar total of the firm's optimal capital budget? The Braxton Corp. has the following investment opportunities in the coming planning period: Projects H and H* are mutually exclusive. The firm's WACC is 11%.

$600,000 As all projects have average risk, they are all evaluated at a project cost of capital of 11%. Clearly, Projects F and G are acceptable because their IRRs exceed 11%. (As they are independent projects, it is permissible to use the IRR method as a proxy for the NPV method.) The decision between Projects H and H* must be made according to the NPV rule. As we do not know the project cash flows, we cannot calculate their NPVs. However, one of the two would be chosen because both will have positive NPVs. Thus, the optimal capital budget consists of Projects F and G, and either Project H or H*, and totals $600,000.

Aggarwal Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most-likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth to the firm?

$61.0

Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions, choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist.

$7.82

Conglomerated Industries' overall cost of capital (WACC) is 10%. Division HR is riskier than average, Division AR has average risk, and Division LR is less risky than average. Conglomerated adjusts for risk by adding or subtracting 2 percentage points. What is the risk-adjusted project cost of capital for a low-risk project in the HR division?

10% rHR = 10% + 2% = 12%; rProject = 12% - 2% = 10%

Given the following, what is the project's standard deviation?The Carlisle Corporation is considering a proposed project for its capital budget. The company estimates that the project's NPV is $5 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company's CFO, however, forecasts that there is only a 40% chance that the economy will be average. Recognizing this uncertainty, she has also performed the following scenario analysis:

10.04 Standard Deviation = 0.05 (-28 -0.85)^2 + 0.25 (-10 - 0.85)^2 + 0.4 (5-0.85)^2 + 0.25 (8-0.85)^2 = 41.62 + 29.43 + 6.89 + 12.78 +10.01 = sqrt 100.73 = 10.04

Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising?

10.40% WACC = 0.45(10%)(1-0.4) + 0.55(14%) = 10.4%

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 = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach?

10.44%

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM?

11.30%

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock?

11.33% re = D1 / P0(1-F) + g

Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re?

11.50% Dividend yield = D1/P0 4.5% = D1/$50.00 D1 = $2.25 re = D1/[P0(1 - F)] + g = $2.25/[$50.00(1 - 0.10)] + 0.065 = 11.50%

A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: The company's cost of capital is 9%, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project? (Hint: Note that the better project may or may not be the one with the higher IRR.)

11.74% Correct. Put the cash flows into the cash flow register, and then calculate NPV at 9% and IRR:Project S: NPVS = $101.83; IRRS = 13.49%. Project L: NPVL = $172.07; IRRL = 11.74%. Because NPVL > NPVS, it is the better project. IRRL = 11.74%.

Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)?

11.77% rd = 12% (1-0.4) = 7.2% rs = [2.40 (1.05)] / $24 + 5% = 15.50% WACC - 0.45 (7.2%) + 0.55 (15.50%) = 11.77%

What is the project's coefficient of variation given the following?The Carlisle Corporation is considering a proposed project for its capital budget. The company estimates that the project's NPV is $5 million. This estimate assumes that the economy and market conditions will be average over the next few years. The company's CFO, however, forecasts that there is only a 40% chance that the economy will be average. Recognizing this uncertainty, she has also performed the following scenario analysis:

11.81 CV = $10.04/$0.85 = 11.81

Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are shown below: The projects are equally risky, and their cost of capital is 10%. You must make a recommendation, and you must base it on the modified IRR. What is the MIRR of the better project?

13.10%

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock?

13.37%

Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of retained earnings, rs?

14% Correct. Use all three methods to estimate rs. CAPM: rs = rRF + (RPM)b = 7% + (6%)1.2 = 14.2% Risk Premium: rs = Bond yield + Risk premium = 10% + 4% = 14% DCF: rs = D1/P0 + g = $2.50/$30 + g, where g can be estimated as follows using a financial calculator: Enter N = 7, PV = -0.75, PMT = 0, and FV = 2.50, and solve for I/YR = g = 18.77% = 18.8%. Therefore, rs = 0.083 + 0.188 = 27.1% Roland Corporation has apparently been experiencing supernormal growth during the past 7 years, and it is not reasonable to assume that this growth will continue. The first two methods yield rs of about 14%, which appears reasonable.

Refer to Exhibit 11-2. What is Project L's IRR?

18.1% Correct. Input the cash flows into the cash flow register and solve for IRR = 18.1%

Mansi Inc. is considering a project that has the following cash flow data. What is the project's payback?

2.36 years Payback period = # of years prior to full recovery + (unrecovered cost at start of year / cash flow during full recovery year)

What is the payback period for Machine B given the following?

2.4 years After Year 1, there is $5,000 - $2,085 = $2,915 remaining to pay back. After Year 2, only $2,915 - $2,085 = $830 is remaining. In Year 3, another $2,085 is collected. Assuming that the Year 3 cash flow occurs evenly over time, then payback occurs $830/$2,085 = 0.4 of the way through Year 3. Thus, the payback period is 2.4 years. Easiest way to solve: Set up cumulative cash flow

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.

2.57%

Your firm is considering a fast-food concession at the World's Fair. The cash flow pattern is somewhat unusual because you must build the stands, operate them for 2 years, and then tear the stands down and restore the site to its original condition. You estimate the cash flows to be as follows: What is the approximate IRR of this venture?

25% Correct. Calculator solution: Input CF0 = -800000, CF1-2 = 700000, CF3 = -400000. Output: IRR = 25.48%. Note that this project actually has multiple IRRs, with a second IRR at about 53%

Bosio Inc.'s perpetual preferred stock sells for $97.50 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?

9.08% Preferred Stock Price = 97.50 Annual Dividend = 8.50 Flotation Cost = 4.00% rp = Dp / Pp (1-F) 8.50 / [97.50 (1-0.04)[ = 9.08%

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

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. Correct. Net operating working capital, effects on other divisions, opportunity costs, and salvage values should be considered. Sunk costs and interest expenses should not be.

Consolidated Inc. uses a weighted average cost of capital of 12% to evaluate average-risk projects and adds/subtracts two percentage points to evaluate projects of greater/lesser risk. Currently, two mutually exclusive projects are under consideration. Both have a cost of $200,000 and last four years. Project A, which is riskier than average, will produce annual after-tax cash flows of $71,000. Project B, which has less-than-average risk, will produce after-tax cash flows of $146,000 in Years 3 and 4 only. What should Consolidated do?

Accept Project B with an NPV of $9,412. Input the cash flows of Project A in the cash flow register of a financial calculator, enter I/YR = 14, and then solve for NPVA = $6,873.57. Input the cash flows of Project B in the cash flow register, enter I/YR = 10, and then solve for NPVB = $9,411.93. Note that both discount rates are adjusted for risk. As the projects are mutually exclusive, the project with the higher NPV is chosen

Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Preferred stock. Retained earnings. Accounts payable. Common stock. Long-term debt.

Accounts payable. Correct. Long-term debt, retained earnings, common stock, and preferred stock are components of WACC. Accounts payable is not.

International Advertising Services has two projects that are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. International's WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is CORRECT? The crossover rate for the two projects must be 12%. As Project B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%. Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale). The crossover rate for the two projects must be less than 12%. Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

Which of the following statements could be true concerning the costs of debt and equity? The cost of retained earnings for Firm A is less than its cost of debt. The cost of debt for Firm A is greater than the cost of equity for Firm B. The cost of retained earnings for Firm A is less than its cost of new outside equity. The cost of debt for Firm A is greater than the cost of equity for Firm A. Both statements b and c could be true.

Both statements b and c could be true.

McDonald's is planning to open a new store across from the student union. Annual revenues are expected to be $5 million. However, opening the new location will cause annual revenues to drop by $3 million at McDonald's existing stadium location. The relevant sales revenues for the capital budgeting analysis are $2 million per year.

True Incremental revenues, which are relevant in a capital budgeting decision, must consider the effects on other parts of the firm.

The NPV and MIRR methods lead to the same decision for mutually exclusive projects regardless of the projects' relative sizes.

False Correct. NPV and MIRR criteria may not lead to the same decision when the projects differ in scale (project size or timing of cash flows)

If a project would lead to an increase a firm's cost of capital (its' WACC), it should not be accepted.

False Correct. A firm should accept all positive NPV projects.

If the debt ratio is 50%, the interest rate on new debt is 8%, the tax rate is 40%, and the current cost of equity is 16%, then an increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC).

False Correct. An increase in the debt ratio may increase the interest rate on debt and the current cost of equity.

Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC.

False Correct. The after-tax cost of debt is lower than the before-tax cost.

In general, the value of land currently owned by a firm is irrelevant to a capital budgeting decision because the cost of that property is a sunk cost.

False Correct. The net market value of land currently owned is an opportunity cost of the project. If the project is not undertaken, the land could be sold to realize its current market value less any taxes and expenses. Thus, project acceptance means forgoing this cash inflow

As a general rule, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects. After all, 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.

False In general, this statement is false, because the firm should be viewed as an ongoing entity, and using debt (or equity) to fund a given project will change the capital structure, and this factor should be recognized by basing the cost of capital for all projects on a target capital structure. Under some special circumstances, where a project is set up as a separate entity, "project financing" may be used, and only the project's specific situation is considered. This is a specific situation, however, and not the "in general" case

Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project's IRR.

False The IRR calculation is independent of the project's cost of capital

Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT?

If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. For a project with normal cash flows and a positive NPV, WACC is lower than IRR because the higher rate will reduce the present value to zero.

Which of the following statements about capital budgeting is CORRECT? 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. 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. 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. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. 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.

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

Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, 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?

If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. Correct. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

Global Spice Co. is considering a new project, but all methods for assessing risk indicate that the project's risk is greater than the risk of the firm's average project. In evaluating this project, it would be reasonable for Global Spice's management to do which of the following?

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. Correct. Projects that have greater risk than the firm average should be evaluated with a higher cost of capital.

Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock

Increase the percentage of debt in the target capital structure. Correct. Increase the percentage of debt in the target capital structure is correct, because if more debt is used, then less equity will be needed to fund the capital budget, so the need for a stock issue would be reduced.

The IRR method can be used in place of the NPV method for all independent projects.

True Both the NPV and IRR methods lead to the same accept/reject decisions for independent projects. Thus, the IRR method can be used as a proxy for the NPV method when choosing independent projects

Which of the following statements about IRR and WACC is CORRECT?

Multiple IRRs can only occur if the signs of the cash flows change more than once. Correct. More than one negative cash flow will cause a project to have multiple IRRs.

Haverford Industries recently purchased a new delivery truck. The new truck costs $56,250 and it is expected to generate after-tax operating cash flows, including depreciation, of $15,625 per year. The truck has a 5-year expected life. The expected year-end abandonment values (salvage values after tax adjustments) for the truck are given below. The company's cost of capital is 11%.

No; the firm should operate the truck for 3 years because the NPV of doing so is $2,041, and this maximizes the truck's NPV. Find NPV for each year. For CF1, add operating cash flow and abandonment value Year 1: CF0=-56,250 -- CF1 = 15,625 + 43750 abandonment value = 59,375 Year 2: CF0 = - 56,250 --- CF1 = 15,625 === CF3 = 50,625

Use Exhibit 10.1 to determine the best estimate of the after-tax cost of debt: Exhibit 10.1 Assume that you have been hired as a consultant by CGT, a major producer of chemicals and plastics, including plastic grocery bags, styrofoam cups, and fertilizers, to estimate the firm's weighted average cost of capital. The balance sheet and some other information are provided below. The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%.

Periods/year 2 N = 2 × 20 = 40 Maturity PV = -$875.00 PMT = (7.25% × 1000)/2 = $36.25 FV = Par value = $1,000 Yield = I/YR, which we solve for = 4.28% Tax rate 40% Before-tax cost of debt = r d = 4.28 × 2 = 8.57% After-tax cost of debt for use in WACC = r d (1 − T) = 5.14%

If the cost of capital for both projects in the table below is 14%, which project would you choose? Neither; both have negative NPVs. Project O; it has the higher positive NPV. Project B; it has the higher positive NPV. Either; both have the same NPV.

Project B; it has the higher positive NPV. Correct. Calculate NPVs: Project B: CF0 = -5000; CF1-4 = 2085; I/YR = 14; solve for NPVB = $1,075.09. Project O: CF0 = -5000; CF1-3 = 0; CF4 = 9677; I/YR = 14; solve for NPVO = $729.56.

To assess the risk of two potential projects, X and Y, Green Plastics Inc. estimated the beta of each project versus the company's other assets. Green Plastics also estimated the beta of each project against the stock market. Together with a thorough scenario and simulation analyses, the company's research revealed the following:

Project X has more market risk than Project Y. Correct. Project X has more market risk than Project Y is true, while the other statements are false. Stand-alone risk is measured by standard deviation. Therefore, as Y's standard deviation is higher than X's, Y has higher stand-alone risk than X. Statement b is false because corporate risk is affected by the correlation of project cash flows with other company cash flows, and as Y's cash flows are more highly correlated with the cash flows of existing projects than X's, Y has more corporate risk than X. Market risk is measured by beta. Therefore, as X's beta is greater than Y's, statement c is true.

In general, small businesses use DCF capital budgeting techniques less often than large businesses do. 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.

True Correct. Large businesses are most likely to use DCF, in part due to the cost of analysis.

Which of the following statements about sensitivity analysis and simulation analysis is CORRECT? 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. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. Simulation analysis is better than scenario analysis because 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. 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.

Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables Simulation analysis is a version of scenario analysis that requires a powerful computer, which is a drawback that is slowly going away. Sensitivity analysis does not look at diversification, nor does it consider the probability of specific risks. Shareholders do need to consider market risk, which does affect stock prices. Projects with more risk are graphed with steeper lines

One definition of "capital" is funds supplied to a firm by investors. True False

True Correct. Money supplied to a firm by investors is often known as "capital." See Section 10.1, An Overview of the Weighted Average Cost of Capital.

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

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. Correct. One of the differences between IRR and NPV is the reinvestment rate, which is assumed to be WACC for NPV and IRR for the IRR.

The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, 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?

The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project is correct. Here is the proof: rs = 5% + 4%(2.0) = 5% + 8% = 13%. Required return for risky projects = 13% + 3% = 16%. Project return = 14% < adjusted rs = 16%. Thus, the project should be rejected

Assume that Project F on the table below is riskier than average and that Project I is less risky than average. The remaining projects have average risk. Braxton's policy is to adjust the WACC up or down by 2 percentage points to account for risk. What is the effect of differential risk on Braxton's optimal capital budget? The Braxton Corp. has the following investment opportunities in the coming planning period: Projects H and H* are mutually exclusive. The firm's WACC is 11%.

The capital budget is now $700,000 and Project I is acceptable. . As Project F is riskier than average, its cost of capital must be adjusted upward to 11% + 2% = 13%. However, its IRR is 18%, so Project F remains acceptable. On the other hand, Project I's cost of capital is adjusted downward to 9%, and hence it becomes acceptable. Thus, the optimal capital budget increases to $700,000. Because Projects H and H* are mutually exclusive, only one of those projects can be selected.

Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. What is likely to happen over time if the CEO's position is accepted?

The company will take on too many high-risk projects and reject too many low-risk projects. Correct. Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time.

Among the conditions that may cause a project to have more than one IRR, one might be the situation in which a negative cash flow (or cost) occurs at the end of the project's life in addition to the initial investment at time = 0.

True Correct. More than one negative cash flow will cause a project to have multiple IRRs.

The NPV method is preferred over the IRR method because the NPV method's reinvestment rate assumption is better.

True Correct. Project cash flows are substitutes for outside capital. Thus, the opportunity cost of these cash flows is the firm's cost of capital, adjusted for risk. The NPV method uses this cost as the reinvestment rate, while the IRR method assumes reinvestment at the IRR.

Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?

The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time Correct. The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time.

If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT? The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. 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. If a project's NPV is greater than zero, then its IRR must be less than zero. If a project's NPV is greater than zero, then its IRR must be less than the WACC. The NPVs of relatively risky projects should be found using relatively low WACCs.

The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. When discounting anything, a higher rate leads to a lower price. This means that a higher WACC leads to a lower NPV.

Crawford Mill Products' sales and profits are positively correlated with the overall economy, and the company has a beta of 1.0. Crawford Mill 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?

The proposed new project would have more stand-alone risk than the firm's typical project. The proposed new project would have more stand-alone risk than the firm's typical project is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be counter cyclical to the rest of the firm's and to other firms' revenues; hence, its within-firm and market risks would be relatively low.

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. Managers' tastes, choice of accounting method, or the profitability of other independent projects should not be considered.

True Correct. A firm should accept all positive NPV projects, regardless of other considerations

6. Assume that a project has one initial cash outflow followed by a series of positive cash inflows. To use the modified IRR (MIRR) method, you would compound the cash inflows out to the end of the project's life, sum those compounded cash flows to form a terminal value (TV), and then find the discount rate that causes the PV of the TV to equal the project's cost.

True Correct. Modified MIRR looks at terminal value to solve some of the problems involved in using IRR.

In capital budgeting, the cost of capital should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.

True Correct. Money supplied to a firm by investors is often known as "capital." The cost of capital is the average cost of funds from each source

An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant.

True Correct. The after-tax cost of debt is lower than the before-tax cost

Because they are based on investors' required returns, the component costs of capital are market-determined variables.

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

To find the cost of perpetual preferred stock, divide the preferred's annual dividend 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.

True Correct. The cost of preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock.

Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.

True Correct. The cost of retained earnings is the opportunity cost of investing the money instead of paying it out to shareholders.

Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward.

True Correct. The cost of the preferred stock is equal to the preferred dividend divided by the current price, adjusted for flotation costs

The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.)

Yes; the expected return is 2.5 percentage points higher than the cost of capital. cost of equity = rs = $2 / 40 + 0.06 = 11% Cost of debt = rd = yield to maturity N = 25 PV = -804 PMT = 70 FV = 1000 Solve I/YR = rd = 9% Wd = debt / debt + equity = 4/4+5 wc = equity / assets = 5/9 WACC = rd (1-T)(wd) + rs(wc) 0.09(1-0.4)(4/9) + 0.11 (5/9) = 0.024 + 0.061 = 8.5%

Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure.

re > rs > WACC > rd. Correct. The cost of new common stock is greater than the cost of retained earnings, which is greater than the cost of debt, meaning that WACC is greater than the cost of debt