Fin 338 Final Review

One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant. a. True b. False

True

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 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

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis. a. True b. False

False

Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions. 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 fact that 70% of the interest income received by a corporation is excluded from its taxable income encourages firms to use more debt financing than they would in the absence of this tax law provision. a. True b. False

False

The free cash flow valuation model cannot be used unless a company doesn't pay dividends. a. True b. False

False

The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant. a. True b. False

False

The interest and dividends paid by a corporation are considered to be deductible operating expenses, hence they decrease the firm's tax liability. 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 rate used to discount projected merger cash flows should be the cost of capital of the new consolidated firm because it incorporates the actual capital structure of the new firm. a. True b. False

False

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly. a. True b. False

False

Net operating profit after taxes (NOPAT) is the amount of net income a company would generate from its operations if it had no interest income or interest expense. a. True b. False

True

Net operating working capital is equal to operating current assets minus operating current liabilities. a. True b. False

True

On the balance sheet, total assets must always equal total liabilities and equity. a. True b. False

True

One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk. a. True b. False

True

When a firm has risky debt, its equity can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the debt. a. True b. False

True

The "apparent," but not the "true," financial position of a company whose sales are seasonal can differ dramatically, depending on the time of year when the financial statements are constructed. a. True b. False

True

The Miller model begins with the MM model with corporate taxes and then adds personal taxes. a. True b. False

True

The NPV 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

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 annual report contains four basic financial statements: the income statement, balance sheet, statement of cash flows, and statement of stockholders' equity. a. True b. False

True

The appropriate discount rate to use when analyzing a refunding decision is the after-tax cost of new debt, in part because there is relatively little risk of not realizing the interest savings. a. True b. False

True

The cash flows associated with common stock are more difficult to estimate than those related to bonds because stock has a residual claim against the company versus a contractual obligation for a bond. a. True b. False

True

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return. a. True b. False

True

The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public. a. True b. False

True

To estimate the cash flow from operations, depreciation must be added back to net income because it is a non-cash charge that has been deducted from revenue. a. True b. False

True

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

True

Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk. a. True b. False

True

Leaving money on the table occurs when a security issue is underpriced. a. True b. False

True

MM showed that in a world with taxes, a firm's optimal capital structure would be almost 100% debt. a. True b. False

True

MM showed that in a world without taxes, a firm's value is not affected by its capital structure. a. True b. False

True

Which of the following statements is NOT CORRECT? a. "Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares. b. Publicly owned companies have sold shares to investors who are not associated with management, and they must register with and report to a regulatory agency such as the SEC. c. When stock in a closely held corporation is offered to the public for the first time, the transaction is called "going public," and the market for such stock is called the new issue market. d. It is possible for a firm to go public and yet not raise any additional new capital. e. When a corporation's shares are owned by a few individuals who own most of the stock or are part of the firm's management, we say that the firm is "closely, or privately, held."

"Going public" establishes a firm's true intrinsic value and ensures that a liquid market will always exist for the firm's shares.

NNR Inc.'s balance sheet showed total current assets of $1,875,000 plus $4,225,000 of net fixed assets. All of these assets were required in operations. The firm's current liabilities consisted of $475,000 of accounts payable, $375,000 of 6% short-term notes payable to the bank, and $150,000 of accrued wages and taxes. Its remaining capital consisted of long-term debt and common equity. What was NNR's total investor-provided operating capital?

$5,475,000 Current assets $1,875,000 Net fixed assets $4,225,000 Total assets (all are operating assets) $6,100,000 Spontaneous "free" capital: Acc'ts payable -$475,000 Accruals -$150,000 Investor-provided operating capital $5,475,000

Swinnerton Clothing Company's balance sheet showed total current assets of $2,250, all of which were required in operations. Its current liabilities consisted of $575 of accounts payable, $300 of 6% short-term notes payable to the bank, and $145 of accrued wages and taxes. What was its net operating working capital that was financed by investors?

$1,530 Current assets $2,250 Accounts payable -$575 Accrued wages and taxes -$145 Net operating working capital $1,530

Hunter Manufacturing Inc.'s December 31, 2014 balance sheet showed total common equity of $2,050,000 and 100,000 shares of stock outstanding. During 2015, Hunter had $250,000 of net income, and it paid out $100,000 as dividends. What was the book value per share at 12/31/2015, assuming that Hunter neither issued nor retired any common stock during 2015?

$22.00 12/31/2014 common equity $2,050,000 2015 net income $250,000 2015 dividends $100,000 2015 addition to retained earnings $150,000 12/31/2015 common equity $2,200,000 / Shares outstanding 100,000 = 12/31/2015 BVPS $22.00

Tucker Electronic System's current balance sheet shows total common equity of $3,125,000. The company has 125,000 shares of stock outstanding, and they sell at a price of $52.50 per share. By how much do the firm's market and book values per share differ? a. $27.50 b. $28.88 c. $30.32 d. $31.83 e. $33.43

$27.50 3,125,000/125,000 = $25 BV/s $52.50 - $25 = $27.50

Frederickson Office Supplies recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,250 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was the firm's taxable income, or earnings before taxes (EBT)?

$3,400.00 Sales $12,500.00 Operating costs excluding depr'n $7,250.00 Depreciation $1,250.00 Operating income (EBIT) $4,000.00 Interest charges = $8,000 * -7.50% = −$600.00 Taxable income $3,400.00

Meric Mining Inc. recently reported $15,000 of sales, $7,500 of operating costs other than depreciation, and $1,200 of depreciation. The company had no amortization charges, it had outstanding $6,500 of bonds that carry a 6.25% interest rate, and its federal-plus-state income tax rate was 35%. How much was the firm's net income after taxes? Meric uses the same depreciation expense for tax and stockholder reporting purposes.

$3,830.94 Bonds $6,500 Interest rate 6.25% Tax rate 35% Sales $ 15,000 Operating costs excluding depr'n $ 7,500 Depreciation $ 1,200 Operating income (EBIT) $6,300 Interest charges −$ 406.25 Taxable income $5,893.75 Taxes −$2,062.81 Net income $3,830.94

Companies generate income from their "regular" operations and from other sources like interest earned on the securities they hold, which is called non-operating income. Lindley Textiles recently reported $12,500 of sales, $7,250 of operating costs other than depreciation, and $1,000 of depreciation. The company had no amortization charges and no non-operating income. It had $8,000 of bonds outstanding that carry a 7.5% interest rate, and its federal-plus-state income tax rate was 40%. How much was Lindley's operating income, or EBIT?

$4,250 Sales $12,500 Operating costs excluding depr'n -$7,250 Depreciation -$1,000 = Operating income (EBIT) $4,250

TSW Inc. had the following data for last year: Net income = $800; Net operating profit after taxes (NOPAT) = $700; Total assets = $3,000; and Total operating capital = $2,000. Information for the just-completed year is as follows: Net income = $1,000; Net operating profit after taxes (NOPAT) = $925; Total assets = $2,600; and Total operating capital = $2,500. How much free cash flow did the firm generate during the just-completed year?

$425 $2,500 - $2,000 = $500 $925 - $500 = $425

Barnette Inc.'s free cash flows are expected to be unstable during the next few years while the company undergoes restructuring. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5?

$883 50(1 + 0.06)/(0.12 − 0.06) = $53/0.06 = $883

Which of the following statements is CORRECT? a. If a firm reports a loss on its income statement, then the retained earnings account as shown on the balance sheet will be negative. b. Since depreciation is a source of funds, the more depreciation a company has, the larger its retained earnings will be, other things held constant. c. A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments. d. Common equity includes common stock and retained earnings, less accumulated depreciation. e. The retained earnings account as shown on the balance sheet shows the amount of cash that is available for paying dividends.

A firm can show a large amount of retained earnings on its balance sheet yet need to borrow cash to make required payments.

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. b. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. c. A firm has spent $2 million on R&D 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. d. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. e. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

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

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

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

A project's NPV increases as the cost of capital declines.

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

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

Which of the following statements is CORRECT? a. A typical industrial company's balance sheet lists the firm's assets that will be converted to cash first, and then goes on down to list the firm's longest lived assets last. b. The balance sheet for a given year is designed to give us an idea of what happened to the firm during that year. c. The balance sheet for a given year tells us how much money the company earned during that year. d. The difference between the total assets reported on the balance sheet and the debts reported on this statement tells us the current market value of the stockholders' equity, assuming the statements are prepared in accordance with generally accepted accounting principles (GAAP). e. For most companies, the market value of the stock equals the book value of the stock as reported on the balance sheet.

A typical industrial company's balance sheet lists the firm's assets that will be converted to cash first, and then goes on down to list the firm's longest lived assets last.

Which of the following items is NOT included in current assets? a. Short-term, highly liquid, marketable securities. b. Accounts receivable. c. Inventory. d. Bonds. e. Cash.

Bonds

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

All else equal, an increase in the corporate tax rate would tend to encourage a company to increase its debt ratio.

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

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

Which of the following statements is CORRECT? a. An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin. b. The ratio of long-term debt to total capital is more likely to experience seasonal fluctuations than is either the DSO or the inventory turnover ratio. c. If two firms have the same ROA, the firm with the most debt can be expected to have the lower ROE. d. An increase in the DSO, other things held constant, could be expected to increase the total assets turnover ratio. e. An increase in the DSO, other things held constant, could be expected to increase the ROE.

An increase in a firm's debt ratio, with no changes in its sales or operating costs, could be expected to lower the profit margin.

Considered alone, which of the following would increase a company's current ratio?

An increase in accounts receivable.

Which of the following would increase the likelihood that a company would increase its debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. The Federal Reserve tightens interest rates in an effort to fight inflation. d. The company's stock price hits a new low. e. An increase in costs incurred when filing for bankruptcy.

An increase in the corporate tax rate.

Which of the following statements is CORRECT? a. "Window dressing" is any action that improves a firm's fundamental, long-run position and thus increases its intrinsic value. b. Borrowing by using short-term notes payable and then using the proceeds to retire long-term debt is an example of "window dressing." Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is another example of "window dressing." c. Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing." d. Offering discounts to customers who pay with cash rather than buy on credit and then using the funds that come in quicker to purchase additional inventories is an example of "window dressing." e. Using some of the firm's cash to reduce long-term debt is an example of "window dressing."

Borrowing on a long-term basis and using the proceeds to retire short-term debt would improve the current ratio and thus could be considered to be an example of "window dressing."

Which of these items will not generally be affected by an increase in the debt ratio? a. Total risk. b. Financial risk. c. Market risk. d. The firm's beta. e. Business risk.

Business risk.

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

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

Which of the following items cannot be found on a firm's balance sheet under current liabilities? a. Accrued payroll taxes. b. Accounts payable. c. Short-term notes payable to the bank. d. Accrued wages. e. Cost of goods sold.

Cost of goods sold.

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

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

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

On its 2014 balance sheet, Barngrover Books showed $510 million of retained earnings, and exactly that same amount was shown the following year in 2015. Assuming that no earnings restatements were issued, which of the following statements is CORRECT? a. Dividends could have been paid in 2015, but they would have had to equal the earnings for the year. b. If the company lost money in 2015, they must have paid dividends. c. The company must have had zero net income in 2015. d. The company must have paid out half of its earnings as dividends. e. The company must have paid no dividends in 2015.

Dividends could have been paid in 2015, but they would have had to equal the earnings for the year.

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project. a. True b. False

False

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

False

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

False

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

False

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 MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing. a. True b. False

False

According to the basic FCF stock valuation model, the value an investor should assign to a share of stock is dependent on the length of time he or she plans to hold the stock. a. True b. False

False

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects. a. True b. False

False

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components. a. True b. False

False

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

False

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical. a. True b. False

False

Going public establishes a market value for the firm's stock, and it also ensures that a liquid market will continue to exist for the firm's shares. This is especially true for small firms that are not widely followed by security analysts. a. True b. False

False

High current and quick ratios always indicate that a firm is managing its liquidity position well. a. True b. False

False

If a firm's stockholders are given the preemptive right, this means that stockholders have the right to call for a meeting to vote to replace the management. Without the preemptive right, dissident stockholders would have to seek a change in management through a proxy fight. a. True b. False

False

If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis. a. True b. False

False

If its managers make a tender offer and buy all shares that were not held by the management team, this is called a private placement. a. True b. False

False

If the capital structure is stable, and free cash flows are expected to be growing at a constant rate at the horizon date, then the compressed adjusted present value model calculates the horizon value by discounting the post-horizon free cash flows and post-horizon expected future tax shields at the weighted average cost of capital. a. True b. False

False

If the firm uses the after-tax cost of new debt as the discount rate when analyzing a refunding decision, and if the NPV of refunding is positive, then the value of the firm will be maximized if it immediately calls the outstanding debt and replaces it with an issue that has a lower coupon rate. a. True b. False

False

If the tax laws were changed so that $0.50 out of every $1.00 of interest paid by a corporation was allowed as a tax-deductible expense, this would probably encourage companies to use more debt financing than they presently do, other things held constant. a. True b. False

False

In accounting, emphasis is placed on determining net income in accordance with generally accepted accounting principles. In finance, the primary emphasis is also on net income because that is what investors use to value the firm. However, a secondary financial consideration is cash flow, because cash is needed to operate the business. a. True b. False

False

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the WACC. a. True b. False

False

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the after-tax cost of debt. a. True b. False

False

Its retained earnings is the actual cash that the firm has generated through operations less the cash that has been paid out to stockholders as dividends. Retained earnings are kept in cash or near cash accounts and, thus, these cash accounts, when added together, will always be equal to the firm's total retained earnings. a. True b. False

False

MM's dividend irrelevance theory says that while dividend policy does not affect a firm's value, it can affect the cost of capital. a. True b. False

False

One problem with ratio analysis is that relationships can be manipulated. For example, if our current ratio is greater than 1.5, then borrowing on a short-term basis and using the funds to build up our cash account would cause the current ratio to increase. a. True b. False

False

One problem with ratio analysis is that relationships can be manipulated. For example, we know that if our current ratio is less than 1.0, then using some of our cash to pay off some of our current liabilities would cause the current ratio to increase and thus make the firm look stronger. a. True b. False

False

Operating plans sketch out broad approaches for realization of the firm's strategic vision. These plans usually are developed for a period no longer than a 1-year time horizon because detail is "lost" by extending out the time horizon by more than 1 year. a. True b. False

False

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

False

Provided a firm does not use an extreme amount of debt, financial leverage typically affects both EPS and EBIT, while operating leverage only affects EBIT. 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 announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock. a. True b. False

False

The balance sheet is a financial statement that measures the flow of funds into and out of various accounts over time, while the income statement measures the firm's financial position at a point in time. a. True b. False

False

The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects. a. True b. False

False

The current cash flow from existing assets is highly relevant to the investor. However, since the value of the firm depends primarily upon its growth opportunities, profit projections from those opportunities are the only relevant future flows with which investors are concerned. a. True b. False

False

The dividend irrelevance theory, proposed by Miller and Modigliani, says that provided a firm pays at least some dividends, how much it pays does not affect either its cost of capital or its stock price. a. True b. False

False

The term "equity carve-out" refers to the situation where a firm's managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it "carves out" some of their value. a. True b. False

False

The term "leaving money on the table" refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm's new stock offering. The banker is, in effect, "buying the job" with the low bid and thus not getting all the money his firm would normally earn on the job. a. True b. False

False

Total net operating capital is equal to net fixed assets. a. True b. False

False

Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk. a. True b. False

False

We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis. a. True b. False

False

When a firm has risky debt, its debt can be viewed as an option on the total value of the firm with an exercise price equal to the face value of the equity. a. True b. False

False

When considering two mutually exclusive projects, the firm should always select the project whose internal rate of return is the highest, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not. a. True b. False

False

Which of the following statements is CORRECT? a. Net cash flow (NCF) is defined as follows: NCF = Net income - Depreciation and Amortization. b. Changes in working capital have no effect on free cash flow. c. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T) + Depreciation and Amortization − Capital expenditures required to sustain operations − Required changes in net operating working capital. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T)+ Depreciation and Amortization + Capital expenditures. e. Net cash flow is the same as free cash flow (FCF).

Free cash flow (FCF) is defined as follows: FCF = EBIT(1 − T) + Depreciation and Amortization − Capital expenditures required to sustain operations − Required changes in net operating working capital.

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

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

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk. However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk. a. True b. False

True

Which of the following statements is correct? a. If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy. b. If a firm follows a strict residual dividend policy, then, holding all else constant, its dividend payout ratio will tend to rise whenever the firm's investment opportunities improve. c. If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged, this would motivate companies to increase their dividend payout ratios. d. Despite its drawbacks, following the residual dividend policy will tend to stabilize actual cash dividends, and this will make it easier for firms to attract a clientele that prefers high dividends, such as retirees. e. One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.

If a company has an established clientele of investors who prefer a high dividend payout, and if management wants to keep stockholders happy, it should not follow the strict residual dividend policy.

Which of the following statements is CORRECT? a. If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year's balance. b. Dividends paid reduce the net income that is reported on a company's income statement. c. If a company uses some of its bank deposits to buy short-term, highly liquid marketable securities, this will cause a decline in its current assets as shown on the balance sheet. d. If a company issues new long-term bonds during the current year, this will increase its reported current liabilities at the end of the year. e. Accounts receivable are reported as a current liability on the balance sheet.

If a company pays more in dividends than it generates in net income, its retained earnings as reported on the balance sheet will decline from the previous year's balance.

Which of the following statements is correct? a. One nice feature of dividend reinvestment plans (DRIPs) is that they reduce the taxes investors would have to pay if they received cash dividends. b. Empirical research indicates that, in general, companies send a negative signal to the marketplace when they announce an increase in the dividend, and as a result share prices fall when dividend increases are announced. The reason is that investors interpret the increase as a signal that the firm has relatively few good investment opportunities. c. If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense. d. Dividend reinvestment plans have not caught on in most industries, and today about 99% of all companies with DRIPs are utilities. e. Under the tax laws as they existed in 2008, a dollar received for repurchased stock must be taxed at the same rate as a dollar received as dividends.

If a company wants to raise new equity capital rather steadily over time, a new stock dividend reinvestment plan would make sense. However, if the firm does not want or need new equity, then an open market purchase dividend reinvestment plan would probably make more sense.

Which of the following statements is correct? a. The clientele effect can explain why so many firms change their dividend policies so often. b. One advantage of adopting the residual dividend policy is that this policy makes it easier for corporations to develop a specific and well-identified dividend clientele. c. New-stock dividend reinvestment plans are similar to stock dividends because they both increase the number of shares outstanding but don't change the firm's total amount of book equity. d. Investors who receive stock dividends must pay taxes on the value of the new shares in the year the stock dividends are received. e. If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

If a firm follows the residual dividend policy, then a sudden increase in the number of profitable projects is likely to reduce the firm's dividend payout.

Which of the following statements is CORRECT? a. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will decrease. b. A reduction in inventories held would have no effect on the current ratio. c. An increase in inventories would have no effect on the current ratio. d. If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase. e. A reduction in the inventory turnover ratio will generally lead to an increase in the ROE.

If a firm increases its sales and cost of goods sold while holding its inventories constant, then, other things held constant, its inventory turnover ratio will increase.

Which of the following is generally NOT true and an advantage of going public? a. Increases the liquidity of the firm's stock. b. Makes it easier to obtain new equity capital. c. Establishes a market value for the firm. d. Makes it easier for owner-managers to engage in profitable self-dealings. e. Facilitates stockholder diversification.

Makes it easier for owner-managers to engage in profitable self-dealings.

Which of the following statements is CORRECT? a. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline. b. If a security analyst saw that a firm's days' sales outstanding (DSO) was higher than the industry average and was also increasing and trending still higher, this would be interpreted as a sign of strength. c. If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding (DSO) will increase. d. There is no relationship between the days' sales outstanding (DSO) and the average collection period (ACP). These ratios measure entirely different things. e. A reduction in accounts receivable would have no effect on the current ratio, but it would lead to an increase in the quick ratio.

If a firm increases its sales while holding its accounts receivable constant, then, other things held constant, its days' sales outstanding will decline.

Which of the following statements is CORRECT? a. The more depreciation a firm has in a given year, the higher its EPS, other things held constant. b. Typically, a firm's DPS should exceed its EPS. c. Typically, a firm's EBIT should exceed its EBITDA. d. If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share. e. If a firm is more profitable than most other firms, we would normally expect to see its book value per share exceed its stock price, especially after several years of high inflation.

If a firm is more profitable than average (e.g., Google), we would normally expect to see its stock price exceed its book value per share.

Which of the following statements is correct? a. An open-market dividend reinvestment plan will be most attractive to companies that need new equity and would otherwise have to issue additional shares of common stock through investment bankers. b. Stock repurchases tend to reduce financial leverage. c. If a company declares a 2-for-1 stock split, its stock price should roughly double. d. One advantage of adopting the residual dividend policy is that this makes it easier for corporations to meet the requirements of Modigliani and Miller's dividend clientele theory. e. If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

If a firm repurchases some of its stock in the open market, then shareholders who sell their stock for more than they paid for it will be subject to capital gains taxes.

Which of the following statements is CORRECT? a. Back before the SEC was created in the 1930s, companies would declare reverse splits in order to boost their stock prices. However, this was determined to be a deceptive practice, and it is illegal today. b. Stock splits create more administrative problems for investors than stock dividends, especially determining the tax basis of their shares when they decide to sell them, so today stock dividends are used far more often than stock splits. c. When a company declares a stock split, the price of the stock typically declines⎯by about 50% after a 2-for-1 split⎯and this necessarily reduces the total market value of the equity. d. If a firm's stock price is quite high relative to most stocks⎯say $500 per share⎯then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share. e. When firms are deciding on the size of stock splits⎯say whether to declare a 2-for-1 split or a 3-for-1 split, it is best to declare the smaller one, in this case the 2-for-1 split, because then the after-split price will be higher than if the 3-for-1 split had been used.

If a firm's stock price is quite high relative to most stocks⎯say $500 per share⎯then it can declare a stock split of say 10-for-1 so as to bring the price down to something close to $50. Moreover, if the price is relatively low⎯say $2 per share⎯then it can declare a "reverse split" of say 1-for-25 so as to bring the price up to somewhere around $50 per share.

Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its MIRR must be positive. b. If a project has "normal" cash flows, then it will have exactly two real IRRs. c. 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. d. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR. e. If a project has "normal" cash flows, then its IRR must be positive.

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

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

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

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 lower the cost of capital used to calculate a project's NPV, the lower the calculated NPV will be. b. If a project's NPV is less than zero, then its IRR must be less than the cost of capital. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPV of a relatively low-risk project should be found using a relatively high cost of capital. e. 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 cost of capital.

If a project's NPV is less than zero, then its IRR must be less than the cost of capital.

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

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

Which of the following statements is CORRECT? a. 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. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life. c. 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. d. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis. e. 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.

If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.

Which of the following statements is CORRECT? a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. b. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. c. 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 after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. d. 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. e. 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.

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 after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.

Companies Heidee and Leaudy have the same total assets, sales, operating costs, and tax rates, and they pay the same interest rate on their debt. However, company Heidee has a higher debt ratio. Which of the following statements is CORRECT? a. If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE. b. Given this information, Leaudy must have the higher ROE. c. Company Leaudy has a higher basic earning power ratio (BEP). d. Company Heidee has a higher basic earning power ratio (BEP). e. If the interest rate the companies pay on their debt is more than their basic earning power (BEP), then Company Heidee will have the higher ROE.

If the interest rate the companies pay on their debt is less than their basic earning power (BEP), then Company Heidee will have the higher ROE.

Which of the following statements is CORRECT? a. One way to increase EVA is to achieve the same level of operating income but with more investor-supplied capital. b. If a firm reports positive net income, its EVA must also be positive. c. One drawback of EVA as a performance measure is that it mistakenly assumes that equity capital is free. d. One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital. e. Actions that increase reported net income will always increase net cash flow.

One way to increase EVA is to generate the same level of operating income but with less investor-supplied capital.

Which of the following statements is CORRECT? a. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a higher profit margin on sales. b. If one firm has a higher debt ratio than another, we can be certain that the firm with the higher debt ratio will have the lower TIE ratio, as that ratio depends entirely on the amount of debt a firm uses. c. A firm's use of debt will have no effect on its profit margin on sales. d. If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales. e. The debt ratio as it is generally calculated makes an adjustment for the use of assets leased under operating leases, so the debt ratios of firms that lease different percentages of their assets are still comparable.

If two firms differ only in their use of debt⎯i.e., they have identical assets, sales, operating costs, interest rates on their debt, and tax rates⎯but one firm has a higher debt ratio, the firm that uses more debt will have a lower profit margin on sales

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

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

Which of the following statements is CORRECT? a. In the statement of cash flows, a decrease in accounts receivable is reported as a use of cash. b. Dividends do not show up in the statement of cash flows because dividends are considered to be a financing activity, not an operating activity. c. In the statement of cash flows, a decrease in accounts payable is reported as a use of cash. d. In the statement of cash flows, depreciation charges are reported as a use of cash. e. In the statement of cash flows, a decrease in inventories is reported as a use of cash.

In the statement of cash flows, a decrease in accounts payable is reported as a use of cash.

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

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

Which of the following statements is CORRECT? a. The maximum federal tax rate on personal income in 2014 was 50%. b. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies' debt ratios to be lower than they would be if interest and dividends were both deductible. c. Interest paid to an individual is counted as income for tax purposes and taxed at the individual's regular tax rate, which in 2014 could go up to 35%, but dividends received were taxed at a maximum rate of 15%. d. The maximum federal tax rate on corporate income in 2014 was 50%. e. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income for tax purposes.

Interest paid to an individual is counted as income for tax purposes and taxed at the individual's regular tax rate, which in 2014 could go up to 35%, but dividends received were taxed at a maximum rate of 15%.

Which of the following would be most likely to lead to a decrease in a firm's dividend payout ratio? a. Its access to the capital markets increases. b. Its R&D efforts pay off, and it now has more high-return investment opportunities. c. Its accounts receivable decrease due to a change in its credit policy. d. Its stock price has increased over the last year by a greater percentage than the increase in the broad stock market averages. e. Its earnings become more stable.

Its R&D efforts pay off, and it now has more high-return investment opportunities.

Which of the following statements is correct? a. If a company uses the residual dividend model to determine its dividend payments, dividends payout will tend to increase whenever its profitable investment opportunities increase. b. The stronger management thinks the clientele effect is, the more likely the firm is to adopt a strict version of the residual dividend model. c. Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm's financial risk. d. A dollar paid out to repurchase stock is taxed at the same rate as a dollar paid out in dividends. Thus, both companies and investors are indifferent between distributing cash through dividends and stock repurchase programs. e. The tax code encourages companies to pay dividends rather than retain earnings.

Large stock repurchases financed by debt tend to increase earnings per share, but they also increase the firm's financial risk

Which of the following statements about listing on a stock exchange is most CORRECT? a. Any firm can be listed on the NYSE as long as it pays the listing fee. b. Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business. c. Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC. d. The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE. e. Listing is a decision of more significance to a firm than going public.

Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business.

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

Minimize the weighted average cost of capital (WACC).

Which of the following statements is CORRECT? a. Depreciation and amortization are not cash charges, so neither of them has an effect on a firm's reported profits. b. The more depreciation a firm reports, the higher its tax bill, other things held constant. c. People sometimes talk about the firm's net cash flow, which is shown as the lowest entry on the income statement, hence it is often called "the bottom line." d. Depreciation reduces a firm's cash balance, so an increase in depreciation would normally lead to a reduction in the firm's net cash flow. e. Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income + Depreciation and Amortization Charges.

Net cash flow (NCF) is often defined as follows: Net Cash Flow = Net Income + Depreciation and Amortization Charges.

A firm wants to strengthen its financial position. Which of the following actions would increase its quick ratio? a. Issue new common stock and use the proceeds to acquire additional fixed assets. b. Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable. c. Issue new common stock and use the proceeds to increase inventories. d. Speed up the collection of receivables and use the cash generated to increase inventories. e. Use some of its cash to purchase additional inventories.

Offer price reductions along with generous credit terms that would (1) enable the firm to sell some of its excess inventory and (2) lead to an increase in accounts receivable.

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

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

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

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

40. If a bank loan officer were considering a company's request for a loan, which of the following statements would you consider to be CORRECT? a. Other things held constant, the lower the current ratio, the lower the interest rate the bank would charge the firm. b. The lower the company's EBITDA coverage ratio, other things held constant, the lower the interest rate the bank would charge the firm. c. Other things held constant, the higher the debt ratio, the lower the interest rate the bank would charge the firm. d. Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm. e. The lower the company's TIE ratio, other things held constant, the lower the interest rate the bank would charge the firm.

Other things held constant, the lower the debt ratio, the lower the interest rate the bank would charge the firm.

A security analyst obtained the following information from Prestopino Products' financial statements: ∙ Retained earnings at the end of 2014 were $700,000, but retained earnings at the end of 2015 had declined to $320,000. ∙ The company does not pay dividends. ∙ The company's depreciation expense is its only non-cash expense; it has no amortization charges. ∙ The company has no non-cash revenues. ∙ The company's net cash flow (NCF) for 2015 was $150,000. On the basis of this information, which of the following statements is CORRECT? a. Prestopino had negative net income in 2015. b. Prestopino's depreciation expense in 2015 was less than $150,000. c. Prestopino had positive net income in 2015, but its income was less than its 2014 income. d. Prestopino's NCF in 2015 must be higher than its NCF in 2014. e. Prestopino's cash on the balance sheet at the end of 2015 must be lower than the cash it had on the balance sheet at the end of 2014.

Prestopino had negative net income in 2015.

Which of the following statements is most CORRECT? a. Private placements occur most frequently with stocks, but bonds can also be sold in a private placement. b. Private placements are convenient for issuers, but the convenience is offset by higher flotation costs. c. The SEC requires that all private placements be handled by a registered investment banker. d. Private placements can generally bring in funds faster than is the case with public offerings. e. In a private placement, securities are sold to private (individual) investors rather than to institutions.

Private placements can generally bring in funds faster than is the case with public offerings.

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

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

Any cash flows that can be classified as incremental to a particular project⎯i.e., results directly from the decision to undertake the project⎯should be reflected in the capital budgeting analysis. a. True b. False

True

Which of the following statements is CORRECT? a. 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. b. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. c. 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. d. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. e. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

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

Daylight Solutions is considering a recapitalization that would increase its debt ratio and increase its interest expense. The company would issue new bonds and use the proceeds to buy back shares of its common stock. The company's CFO thinks the plan will not change total assets or operating income, but that it will increase earnings per share (EPS). Assuming the CFO's estimates are correct, which of the following statements is CORRECT? a. If the plan reduces the WACC, the stock price is also likely to decline. b. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. c. If the plan does increase the EPS, the stock price will automatically increase at the same rate. d. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds. e. Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Since the proposed plan increases Daylight's financial risk, the company's stock price still might fall even if EPS increases.

Which of the following statements is CORRECT? a. All corporations other than non-profit corporations are subject to corporate income taxes, which are 15% for the lowest amounts of income and 35% for the highest amounts of income. b. The income of certain small corporations that qualify under the Tax Code is completely exempt from corporate income taxes. Thus, the federal government receives no tax revenue from these businesses. c. All businesses, regardless of their legal form of organization, are taxed under the Business Tax Provisions of the Internal Revenue Code. d. Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm's income as personal income and pay taxes on that income. e. Congress recently changed the tax laws to make dividend income received by individuals exempt from income taxes. Prior to the enactment of that law, corporate income was subject to double taxation, where the firm was first taxed on the income and stockholders were taxed again on the income when it was paid to them as dividends.

Small businesses that qualify under the Tax Code can elect not to pay corporate taxes, but then their owners must report their pro rata shares of the firm's income as personal income and pay taxes on that income.

Companies can issue different classes of common stock. Which of the following statements concerning stock classes is CORRECT? a. All common stocks, regardless of class, must have the same voting rights. b. All firms have several classes of common stock. c. All common stock, regardless of class, must pay the same dividend. d. Some class or classes of common stock are entitled to more votes per share than other classes. e. All common stocks fall into one of three classes: A, B, and C.

Some class or classes of common stock are entitled to more votes per share than other classes.

Which of the following statements is correct? a. One advantage of dividend reinvestment plans is that they enable investors to postpone paying taxes on the dividends credited to their account. b. Stock repurchases can be used by a firm that wants to increase its debt ratio. c. Stock repurchases make sense if a company expects to have a lot of profitable new projects to fund over the next few years, provided investors are aware of these investment opportunities. d. One advantage of an open market dividend reinvestment plan is that it provides new equity capital and increases the shares outstanding. e. One disadvantage of dividend reinvestment plans is that they increase transactions costs for investors who want to increase their ownership in the company.

Stock repurchases can be used by a firm that wants to increase its debt ratio.

Assets other than cash are expected to produce cash over time, but the amount of cash they eventually produce could be higher or lower than the values at which these assets are carried on the books a. True b. False

True

Which of the following statements is correct? a. One advantage of the residual dividend policy is that it leads to a stable dividend payout, which investors like. b. An increase in the stock price when a company decreases its dividend is consistent with signaling theory as postulated by MM. c. If the "clientele effect" is correct, then for a company whose earnings fluctuate, a policy of paying a constant percentage of net income will probably maximize the stock price. d. Stock repurchases make the most sense at times when a company believes its stock is undervalued. e. Firms with a lot of good investment opportunities and a relatively small amount of cash tend to have above average payout ratios.

Stock repurchases make the most sense at times when a company believes its stock is undervalued.

Which of the following statements concerning common stock and the investment banking process is NOT CORRECT? a. If a firm sells 1,000,000 new shares of Class B stock, the transaction occurs in the primary market. b. Listing a large firm's stock is often considered to be beneficial to stockholders because the increases in liquidity and reputation probably outweigh the additional costs to the firm. c. Stockholders have the right to elect the firm's directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management's performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer. d. The announcement of a large issue of new stock could cause the stock price to fall. This loss is called "market pressure," and it is treated as a flotation cost because it is a cost to stockholders that is associated with the new issue. e. The preemptive right gives each existing common stockholder the right to purchase his or her proportionate share of a new stock issue.

Stockholders have the right to elect the firm's directors, who in turn select the officers who manage the business. If stockholders are dissatisfied with management's performance, an outside group may ask the stockholders to vote for it in an effort to take control of the business. This action is called a tender offer.

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

Sunk costs that have been expensed for tax purposes

Which of the following would, generally, indicate an improvement in a company's financial position, holding other things constant? a. The total assets turnover decreases. b. The TIE declines. c. The DSO increases. d. The EBITDA coverage ratio increases. e. The current and quick ratios both decline.

The EBITDA coverage ratio increases.

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

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

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

The NPV method assumes that cash flows will be reinvested at the cost of capital, while the IRR method assumes reinvestment at the IRR.

Which of the following statements is CORRECT? a. The statement of cash needs tells us how much cash the firm will require during some future period, generally a month or a year. b. The four most important financial statements provided in the annual report are the balance sheet, income statement, cash budget, and the statement of stockholders' equity. c. The balance sheet gives us a picture of the firm's financial position at a point in time. d. The income statement gives us a picture of the firm's financial position at a point in time. e. The statement of cash flows tells us how much cash the firm has in the form of currency and demand deposits.

The balance sheet gives us a picture of the firm's financial position at a point in time.

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

The capital structure that maximizes the stock price is also the capital structure that minimizes the weighted average cost of capital (WACC).

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

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

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

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

Which of the following statements about dividend policies is correct? a. One reason that companies tend to avoid stock repurchases is that dividend payments are taxed at a lower rate than gains on stock repurchases. b. One advantage of dividend reinvestment plans is that they allow shareholders to avoid paying taxes on the dividends that they choose to reinvest. c. One key advantage of a residual dividend policy is that it enables a company to follow a stable dividend policy. d. The clientele effect suggests that companies should follow a stable dividend policy. e. Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains. They call this the "bird-in-the hand" effect.

The clientele effect suggests that companies should follow a stable dividend policy

Below is the common equity section (in millions) of Fethe Industries' last two year-end balance sheets: 2015 2014 Common stock $2,000 $1,000 Retained earnings 2,000 2,340 Total common equity $4,000 $3,340 The company has never paid a dividend to its common stockholders. Which of the following statements is CORRECT? a. The company's net income in 2014 was higher than in 2015. b. The company issued common stock in 2015. c. The market price of the company's stock doubled in 2015. d. The company had positive net income in both 2014 and 2015, but the company's net income in 2014 was lower than it was in 2015. e. The company has more equity than debt on its balance sheet.

The company issued common stock in 2015

Other things held constant, which of the following actions would increase the amount of cash on a company's balance sheet?

The company issues new common stock.

Danielle's Sushi Shop last year had (1) a negative net cash flow from operations, (2) a negative free cash flow, and (3) an increase in cash as reported on its balance sheet. Which of the following factors could explain this situation?

The company sold a new issue of common stock

If a company's free cash flows are expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The company's stock's dividend yield is 5%. b. The value of operations is expected to decline in the future. c. The company's WACC must be equal to or less than 5%. d. The company's value of operations one year from now is expected to be 5% above the current price. e. The expected return on the company's stock is 5% a year.

The company's value of operations one year from now is expected to be 5% above the current price

Which of the following statements is CORRECT? a. Two firms with the same expected free cash flows and growth rates must also have the same value of operations. b. It is appropriate to use the constant growth model to estimate a stock's value even if its growth rate is never expected to become constant. c. If a company has a weighted average cost of capital WACC = 12%, and if its free cash flows are expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. d. The value of operations is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. e. The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

The constant growth model takes into consideration the capital gains investors expect to earn on a stock.

Which of the following statements is CORRECT? a. If a firm lowered its fixed costs while increasing its variable costs, holding total costs at the present level of sales constant, this would decrease its operating leverage. b. The debt ratio that maximizes EPS generally exceeds the debt ratio that maximizes share price. c. If a company were to issue debt and use the money to repurchase common stock, this action would have no impact on its basic earning power ratio. (Assume that the repurchase has no impact on the company's operating income.) d. If changes in the bankruptcy code made bankruptcy less costly to corporations, this would likely reduce the average corporation's debt ratio. e. Increasing financial leverage is one way to increase a firm's basic earning power (BEP).

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

Which of the following should not influence a firm's dividend policy decision? a. A strong preference by most shareholders for current cash income versus capital gains. b. Constraints imposed by the firm's bond indenture. c. The fact that much of the firm's equipment has been leased rather than bought and owned. d. The fact that Congress is considering changes in the tax law regarding the taxation of dividends versus capital gains. e. The firm's ability to accelerate or delay investment projects.

The fact that much of the firm's equipment has been leased rather than bought and owned.

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

The factors that affect a firm's business risk are affected by industry characteristics and economic conditions. Unfortunately, these factors are generally beyond the control of the firm's management.

Reynolds Paper Products Corporation follows a strict residual dividend policy. All else equal, which of the following factors would be most likely to lead to an increase in the firm's dividend per share? a. The company increases the percentage of equity in its target capital structure. b. The number of profitable potential projects increases. c. Congress lowers the tax rate on capital gains. The remainder of the tax code is not changed. d. Earnings are unchanged, but the firm issues new shares of common stock. e. The firm's net income increases.

The firm's net income increases

Which of the following statements is NOT CORRECT? a. The free cash flow valuation model discounts free cash flows by the required return on equity. b. The free cash flow valuation model can be used to find the value of a division. c. An important step in applying the free cash flow valuation model is forecasting the firm's pro forma financial statements. d. Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. e. The free cash flow valuation model can be used both for companies that pay dividends and those that do not pay dividends.

The free cash flow valuation model discounts free cash flows by the required return on equity.

Which of the following statements is CORRECT? a. If a company has a WACC = 12% and its free cash flow is expected to grow at a constant rate of 5%, this implies that the stock's dividend yield is also 5%. b. The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate. c. The value of operations of a stock is the present value of all expected future free cash flows, discounted at the free cash flow growth rate. d. The constant growth model cannot be used for a zero growth stock, where free cash flows are expected to remain constant over time. e. The constant growth model is often appropriate for evaluating start-up companies that do not have a stable history of growth but are expected to reach stable growth within the next few years.

The free cash flow valuation model for constant growth, Vop = FCF1/(WACC − g), can be used to value firms whose free cash flows are expected to decline at a constant rate, i.e., to grow at a negative rate.

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 higher the cost of capital used to calculate the NPV, the lower the calculated NPV will be. b. If a project's NPV is greater than zero, then its IRR must be less than the cost of capital. c. If a project's NPV is greater than zero, then its IRR must be less than zero. d. The NPVs of relatively risky projects should be found using relatively low costs of capital. e. A project's NPV is generally found by compounding the cash inflows at the cost of capital to find the terminal value (TV), then discounting the TV at the IRR to find its PV.

The higher the cost of capital used to calculate the NPV, the lower the calculated NPV will be.

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the cost of debt. b. The horizon value is calculated by discounting the expected earnings at the WACC. c. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC. d. The horizon value must always be more than 20 years in the future. e. The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the levered cost of equity.

The horizon value is calculated by discounting the free cash flows beyond the horizon date and any tax savings at the WACC.

Which of the following statements is CORRECT? a. The income statement for a given year is designed to give us an idea of how much the firm earned during that year. b. The focal point of the income statement is the cash account, because that account cannot be manipulated by "accounting tricks." c. The reported income of two otherwise identical firms cannot be manipulated by different accounting procedures provided the firms follow Generally Accepted Accounting Principles (GAAP). d. The reported income of two otherwise identical firms must be identical if the firms are publicly owned, provided they follow procedures that are permitted by the Securities and Exchange Commission (SEC). e. If a firm follows Generally Accepted Accounting Principles (GAAP), then its reported net income will be identical to its reported net cash flow.

The income statement for a given year is designed to give us an idea of how much the firm earned during that year.

Which of the following statements is most CORRECT? a. The key benefits associated with refunding debt are the reduction in the firm's debt ratio and the creation of more reserve borrowing capacity. b. The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates. c. If a firm with a positive NPV refunding project delays refunding and interest rates rise, the firm can still obtain the entire NPV by locking in a low coupon rate when the rates are low, even though it actually refunds the debt after rates have risen. d. Suppose a firm is considering refunding and interest rates rise during time when the analysis is being done. The rise in rates would tend to lower the expected price of the new bonds, which would make them cheaper to the firm and thus increase the expected interest savings. e. If new debt is used to refund old debt, the correct discount rate to use in the refunding analysis is the before-tax cost of new debt.

The mechanics of finding the NPV of a refunding decision are fairly straightforward. However, the decision of when to refund is not always clear because it requires a forecast of future interest rates.

It is possible that two firms could have identical financial and operating leverage, yet have different degrees of risk as measured by the variability of EPS. a. True b. False

True

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

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

If debt financing is used, which of the following is CORRECT? a. The percentage change in net operating income will be equal to a given percentage change in net income. b. The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt. c. The percentage change in net income will be greater than the percentage change in net operating income. d. The percentage change in sales will be greater than the percentage change in EBIT, which in turn will be greater than the percentage change in net income. e. The percentage change in net operating income will be greater than a given percentage change in net income.

The percentage change in net income will be greater than the percentage change in net operating income.

Which of the following statements is CORRECT? a. The discounted payback method recognizes all cash flows over a project's life, and it also adjusts these cash flows to account for the time value of money. b. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. c. The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project. d. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect. e. The regular payback method recognizes all cash flows over a project's life.

The regular payback is useful as an indicator of a project's liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

For managerial purposes, i.e., making decisions regarding the firm's operations, the standard financial statements as prepared by accountants under Generally Accepted Accounting Principles (GAAP) are often modified and used to create alternative data and metrics that provide a somewhat different picture of a firm's operations. Related to these modifications, which of the following statements is CORRECT? a. The standard statements make adjustments to reflect the effects of inflation on asset values, and these adjustments are normally carried into any adjustment that managers make to the standard statements. b. The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions' performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units. c. The standard statements provide useful information on the firm's individual operating units, but management needs more information on the firm's overall operations than the standard statements provide. d. The standard statements focus on cash flows, but managers are less concerned with cash flows than with accounting income as defined by GAAP. e. The best feature of standard statements is that, if they are prepared under GAAP, the data are always consistent from firm to firm. Thus, under GAAP, there is no room for accountants to "adjust" the results to make earnings look better.

The standard statements focus on accounting income for the entire corporation, not cash flows, and the two can be quite different during any given accounting period. However, for valuation purposes we need to discount cash flows, not accounting income. Moreover, since many firms have a number of separate divisions, and since division managers should be compensated on their divisions' performance, not that of the entire firm, information that focuses on the divisions is needed. These factors have led to the development of information that is focused on cash flows and the operations of individual units.

Which of the following statements is CORRECT? a. The statement of cash flows shows how much the firm's cash⎯the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)⎯increased or decreased during a given year. b. The statement of cash flows reflects cash flows from operations, but it does not reflect the effects of buying or selling fixed assets. c. The statement of cash flows shows where the firm's cash is located; indeed, it provides a listing of all banks and brokerage houses where cash is on deposit. d. The statement of cash flows reflects cash flows from continuing operations, but it does not reflect the effects of changes in working capital. e. The statement of cash flows reflects cash flows from operations and from borrowings, but it does not reflect cash obtained by selling new common stock.

The statement of cash flows shows how much the firm's cash⎯the total of currency, bank deposits, and short-term liquid securities (or cash equivalents)⎯increased or decreased during a given year.

Which of the following statements concerning the compressed adjusted present value (APV) model is NOT CORRECT? a. The value of a growing tax shield is greater than the value of a constant tax shield. b. For a given D/S, the levered cost of equity in the compressed APV model is greater than the levered cost of equity under MM's original (with tax) assumptions. c. For a given D/S, the WACC in the compressed APV model is greater than the WACC under MM's original (with tax) assumptions. d. The total value of the firm is independent of the amount of debt it uses. e. The tax shields should be discounted at the unlevered cost of equity.

The total value of the firm is independent of the amount of debt it uses.

Which of the following statements about valuing a firm using the compressed adjusted present value (CAPV) approach is most CORRECT? a. The value of equity is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity. b. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity. c. The value of equity is calculated by discounting the horizon value and the free cash flows at the cost of equity. d. The CAPV approach stands for the accounting pre-valuation approach. e. The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows at the cost of equity.

The value of operations is calculated by discounting the horizon value, the tax shields, and the free cash flows before the horizon date at the unlevered cost of equity.

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows. a. A project's MIRR is always less than its regular IRR. b. If a project's IRR is greater than its cost of capital, then its MIRR will be greater than the IRR. c. To find a project's MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost. d. To find a project's MIRR, the textbook procedure compounds cash inflows at the cost of capital and then finds the discount rate that causes the PV of the terminal value to equal the initial cost. e. A project's MIRR is always greater than its regular IRR.

To find a project's MIRR, the textbook procedure compounds cash inflows at the cost of capital and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.

A firm's capital structure does not affect its calculated free cash flows, because FCF reflects only operating cash flows. a. True b. False

True

A project's IRR is independent of the firm's cost of capital. In other words, a project's IRR doesn't change with a change in the firm's cost of capital. a. True b. False

True

A proxy is a document giving one party the authority to act for another party, including the power to vote shares of common stock. Proxies can be important tools relating to control of firms. a. True b. False

True

A reverse split reduces the number of shares outstanding. a. True b. False

True

According to the nonconstant growth model discussed in the textbook, the discount rate used to find the present value of the expected cash flows during the initial growth period is the same as the discount rate used to find the PVs of cash flows during the subsequent constant growth period. a. True b. False

True

Although a full liquidity analysis requires the use of a cash budget, the current and quick ratios provide fast and easy-to-use measures of a firm's liquidity position. a. True b. False

True

Classified stock differentiates various classes of common stock, and using it is one way companies can meet special needs such as when owners of a start-up firm need additional equity capital but don't want to relinquish voting control. a. True b. False

True

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

True

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt. a. True b. False

True

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

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used. a. True b. False

True

Founders' shares are a type of classified stock where the shares are owned by the firm's founders, and they generally have more votes per share than the other classes of common stock. a. True b. False

True

If a firm utilizes debt financing, an X% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than X. 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 investors prefer firms that retain most of their earnings, then a firm that wants to maximize its stock price should set a low payout ratio. a. True b. False

True

If the signaling, hypothesis (which is also called the information content hypothesis) is correct, then changes in dividend policy can have an important effect on the firm's value and capital costs. a. True b. False

True

In a world with no taxes, MM show that a firm's capital structure does not affect the firm's value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased. a. True b. False

True

In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows. a. True b. False

True

In the compressed adjusted present value model, the appropriate discount rate for the tax shield is the unlevered cost of equity. a. True b. False

True

Interest paid by a corporation is a tax deduction for the paying corporation, but dividends paid are not deductible. This treatment, other things held constant, tends to encourage the use of debt financing by corporations. a. True b. False

True

It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis. a. True b. False

True

One of the necessary steps in the financial planning process is a forecast of financial statements under each alternative version of the operating plan in order to analyze the effects of different operating procedures on projected profits and financial ratios. a. True b. False

True

Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. a. True b. False

True

Other things held constant, an increase in financial leverage will increase a firm's market (or systematic) risk as measured by its beta coefficient. a. True b. False

True

Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life. Neither has negative cash flows after Year 0, and at the current cost of capital, the two projects have identical NPVs. Now suppose interest rates and money costs decline. Other things held constant, this change will cause L to become preferred to S. a. True b. False

True

Projected free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations. a. True b. False

True

Ratio analysis involves analyzing financial statements in order to appraise a firm's financial position and strength. a. True b. False

True

Significant variations in accounting methods among firms make meaningful ratio comparisons between firms more difficult than if all firms used similar accounting methods. a. True b. False

True

Stock dividends and stock splits should, at least conceptually, have the same effect on shareholders' wealth. a. True b. False

True

The current ratio and inventory turnover ratios both help us measure the firm's liquidity. The current ratio measures the relationship of a firm's current assets to its current liabilities, while the inventory turnover ratio gives us an indication of how long it takes the firm to convert its inventory into cash. a. True b. False

True

The income statement shows the difference between a firm's income and its costs⎯i.e., its profits⎯during a specified period of time. However, not all reported income comes in the form or cash, and reported costs likewise may not correctly reflect cash outlays. Therefore, there may be a substantial difference between a firm's reported profits and its actual cash flow for the same period. 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

The optimal distribution policy strikes that balance between current dividends and capital gains that maximizes the firm's stock price. a. True b. False

True

The preemptive right gives current stockholders the right to purchase, on a pro rata basis, any new shares issued by the firm. This right helps protect current stockholders against both dilution of control and dilution of value. a. True b. False

True

The present value of the free cash flows discounted at the unlevered cost of equity is the value of the firm's operations if it had no debt. a. True b. False

True

The primary reason the annual report is important in finance is that it is used by investors when they form expectations about the firm's future earnings and dividends, and the riskiness of those cash flows. a. True b. False

True

The retained earnings account on the balance sheet does not represent cash. Rather, it represents part of stockholders' claims against the firm's existing assets. This implies that retained earnings are in fact stockholders' reinvested earnings. a. True b. False

True

The time dimension is important in financial statement analysis. The balance sheet shows the firm's financial position at a given point in time, the income statement shows results over a period of time, and the statement of cash flows reflects changes in the firm's accounts over that period of time. a. True b. False

True

When a firm refunds a debt issue, the firm's stockholders gain and its bondholders lose. This points out the risk of a call provision to bondholders and explains why a non-callable bond will typically command a higher price than an otherwise similar callable bond. a. True b. False

True

Whenever a firm borrows money, it is using financial leverage. a. True b. False

True

Whereas commercial banks take deposits from some customers and make loans to other customers, the principal activities of investment banks are (1) to help firms issue new stock and bonds and (2) to give firms advice with regard to mergers and other financial matters. However, financial corporations often own and operate subsidiaries that operate as commercial banks and others that are investment banks. This was not true some years ago, when the two types of banks were required by law to be completely independent of one another. a. True b. False

True

Which of the following statements concerning capital structure theory is NOT CORRECT? a. Under MM with zero taxes, financial leverage has no effect on a firm's value. b. Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt. c. Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing. d. Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU. e. The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.

Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.

Which of the following statements is correct? a. Capital gains earned in a share repurchase are taxed less favorably than dividends; this explains why companies typically pay dividends and avoid share repurchases. b. Very often, a company's stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen. c. Stock repurchases increase the number of outstanding shares. d. The clientele effect is the best explanation for why companies tend to vary their dividend payments from quarter to quarter. e. If a company has a 2-for-1 stock split, its stock price should roughly double.

Very often, a company's stock price will rise when it announces that it plans to commence a share repurchase program. Such an announcement could lead to a stock price decline, but this does not normally happen.

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

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

If a firm adheres strictly to the residual dividend policy, the issuance of new common stock would suggest that a. the dividend payout ratio is increasing. b. no dividends were paid during the year. c. the dividend payout ratio is decreasing. d. the dollar amount of investments has decreased. e. the dividend payout ratio has remained constant.

no dividends were paid during the year.

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

normally lead to a reduction in its fixed assets turnover ratio.

The preemptive right is important to shareholders because it

protects the current shareholders against a dilution of their ownership interests

Last year Tiemann Technologies reported $10,500 of sales, $6,250 of operating costs other than depreciation, and $1,300 of depreciation. The company had no amortization charges, it had $5,000 of bonds that carry a 6.5% interest rate, and its federal-plus-state income tax rate was 35%. This year's data are expected to remain unchanged except for one item, depreciation, which is expected to increase by $750. By how much will net after-tax income change as a result of the change in depreciation? The company uses the same depreciation calculations for tax and stockholder reporting purposes.

−487.50 $750(1-.35) = −$487.50