Fin 3403 Chapter 14
Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel. Wilderness Adventures has an after tax cost of capital of 13 percent and Travel Excitement has an after tax cost of capital of 11 percent. Both firms are considering investing in new web sites that will enhance online reservations. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project? A. Wilderness Adventures only. B. Travel Excitement only. C. Both Wilderness Adventures and Travel Excitement. D. Neither Wilderness Adventures nor Travel Excitement. E. Cannot be determined without further information.
Both wilderness Adventures and Travel Excitement
When computing the adjusted cash flow from assets the tax amount is calculated as: A. EBT TC. B. (EBT - Depreciation) TC. C. (EBIT + Depreciation - Change in NWC - Capital spending) TC. D. EBIT x Tc. E. (EBIT - Depreciation - Change in NWC - Capital spending) TC.
EBIT x Tc
A firm's overall cost of equity is: A. Generally less than the firm's WACC given a debt-equity ratio of .40. B. Unaffected by changes in the market risk premium. C. Highly dependent upon the risk level of the firm. D. Generally less than the firm's after tax cost of debt. E. Inversely related to changes in the firm's tax rate.
Highly dependent upon the risk level of the firm.
When a firm has flotation costs equal to 6.8 percent of the funding need, project analysts should: A. Increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.068. B. Increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - .068). C. Add 6.8 percent to the firm's WACC to determine the discount rate for the project. D. Increase the initial project cost by multiplying that cost by 1.068. E. Increase the initial project cost by dividing that cost by (1 - .068).
Increase the initial project cost by dividing that cost by (1 - .068).
The cost of preferred stock: A. Is equal to the dividend yield. B. Is equal to the yield to maturity. C. Is highly dependent on the dividend growth rate. D. Is independent of the stock's price. E. Decreases when tax rates increase.
Is equal to the dividend yield.
The dividend growth model: A. Is only as reliable as the estimated rate of growth. B. Can only be used if historical dividend information is available. C. Considers the risk that future dividends may vary from their estimated values. D. Applies only when a firm is currently paying dividends. E. Uses beta to measure the systematic risk of a firm.
Is only as reliable as the estimated rate of growth.
If a firm uses its WACC as the discount rate for all of the projects it undertakes, then the firm will tend to do all of the following except: A. Reject some positive net present value projects. B. Lower the average risk level of the firm over time. C. Increase the firm's overall level of risk over time. D. Accept some negative net present value projects. E. Favor high risk projects over low risk projects.
Lower the average risk level of the firm over time.
The flotation cost for a firm is computed as: A. The arithmetic average of the flotation costs of both debt and equity. B. The weighted average of the flotation costs associated with each form of financing. C. The geometric average of the flotation costs associated with each form of financing. D. One-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. A weighted average based on the book values of the firm's debt and equity.
The weighted average of the flotation costs associated with each form of financing.
Which one of these will increase a firm's aftertax cost of debt? A. a Decrease in the market value of the firm's outstanding bonds. B. a Decrease in the firm's tax rate. C. An increase in the bond's credit rating. D. An increase in the firm's beta. E. A Decrease in the market rate of interest.
a decrease in the firm's tax rate
Which one of the following statements is correct? A. Firms should accept low-risk projects prior to funding high-risk projects. B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm. C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns. D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations. E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate.
a project that is unacceptable today might be acceptable tomorrow given a change in market returns
All else constant, which one of the following will increase a firm's cost of equity if the firm computes that cost using the security market line approach? Assume the firm currently pays an annual dividend of $1 a share and has a beta of 1.2. A. A reduction in the dividend amount. B. An increase in the dividend amount. C. A reduction in the market rate of return. D. A reduction in the firm's beta. E. A reduction in the risk-free rate.
a reduction in the risk-free rate
The capital structure weights used in computing a firm's weighted average cost of capital: A. Are based on the book values of the firm's debt and equity. B. Are based on the market values of the firm's debt and equity securities. C. Depend upon the financing obtained to fund each specific project. D. Remain constant over time unless the firm issues new securities. E. Are restricted to the firm's debt and common stock.
are based on the market values of the firm's debt and equity securities
Preston Industries has two separate divisions. Each division is in a separate line of business. Division A is the largest division and represents 70 percent of the firm's overall sales. Division A is also the riskier of the two divisions. Division B is the smaller and least risky of the two. When management is deciding which of the various divisional projects should be accepted, the managers should: A. Allocate more funds to Division A since it is the largest of the two divisions. B. Fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values. C. Allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital. D. Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values. E. Fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.
assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values
The subjective approach to project analysis: A. Is used only when a firm has an all-equity capital structure. B. Uses the WACC of Firm X as the basis for the discount rate for a project under consideration by Firm Y. C. Assigns discount rates to projects based on the discretion of the senior managers of a firm. D. Allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined. E. Applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt.
assigns discount rates to projects based on the discretion of the senior managers of a firm
The capital asset pricing model approach to equity valuation: A. Is dependent upon the unsystematic risk of a security. B. Assumes the reward-to-risk ratio increases as beta increases. C. Can only be applied to dividend-paying firms. D. Assumes a firm's future risks will be higher than its current risks. E. Assumes the reward-to-risk ratio is constant.
assumes the reward-to-risk ratio is constant
High Adventure is considering a new project that is similar in risk to the firm's current operations. The firm maintains a debt-equity ratio of .55 and retains all profits to fund the firm's rapid growth. How should the firm determine its cost of equity? A. By adding the market risk premium to the after tax cost of debt. B. By multiplying the market risk premium by 1.55. C. By using the dividend growth model. D. By using the capital asset pricing model. E. By averaging the costs based on the dividend growth model and the capital asset pricing model.
by using the capital asset pricing model
Textile Mills borrows money at a rate of 13.5 percent. This interest rate is referred to as the: A. Compound rate. B. Current yield. C. Cost of debt. D. Capital gains yield. E. Cost of capital.
cost of debt
A group of individuals got together and purchased all of the outstanding shares of common stock of DL Smith, Inc. What is the return that these individuals require on this investment called? A. Dividend yield. B. Cost of equity. C. Capital gains yield. D. Cost of capital. E. Income return.
cost of equity
A firm's cost of capital: A. Will decrease as the risk level of the firm increases. B. For a specific project, is primarily dependent upon the source of the funds used for the project. C. Is independent of the firm's capital structure. D. Should be applied as the discount rate for any project considered by the firm. E. Depends upon how the funds raised are going to be spent.
depends upon how the funds raised are going to be spent
The dividend growth model cannot be used to compute the cost of equity for a firm that: A. Pays an increasing dividend. B. Reduces its dividend on a regular basis. C. Has a dividend payout ratio of 100 percent. D. Pays a constant dividend year after year. E. Has a retention ratio of 100 percent.
has a retention ratio of 100 percent
The cost of equity for a firm with a debt-equity ratio of .35: A. Tends to remain static for firms with increasing levels of risk. B. Increases as the unsystematic risk of the firm increases. C. Ignores the firm's risks when that cost is based on the dividend growth model. D. Equals the risk-free rate plus the market risk premium. E. Equals the firm's pretax weighted average cost of capital.
ignores the firm's risks when that cost is based on the dividend growth model
Incorporating flotation costs into the analysis of a project will: A. Cause the project to be improperly evaluated. B. Increase the net present value of the project. C. Increase the project's rate of return. D. Increase the initial cash outflow of the project. E. Have no effect on the present value of the project.
increase the initial cash outflow of the project
The pretax cost of debt: A. Is based on the current yield to maturity of the firm's outstanding bonds. B. Is equal to the coupon rate on the latest bonds issued by a firm. C. Is equivalent to the average current yield on all of a firm's outstanding bonds. D. Is based on the original yield to maturity on the latest bonds issued by a firm. E. Has to be estimated as it cannot be directly observed in the market.
is based on the current yield to maturity of the firm's outstanding bonds
The aftertax cost of debt: A. Varies inversely to changes in market interest rates. B. Will generally exceed the cost of equity if the relevant tax rate is zero. C. Will generally equal the cost of preferred if the tax rate is zero. D. Is unaffected by changes in the market rate of interest. E. Is highly dependent upon the firm's tax rate.
is highly dependent upon the firm's tax rate
The weighted average cost of capital for a wholesaler: A. Is equivalent to the after tax cost of the firm's liabilities. B. Should be used as the required return when analyzing a potential acquisition of a retail outlet. C. Is the return investors require on the total assets of the firm. D. Remains constant when the debt-equity ratio changes. E. Is unaffected by changes in corporate tax rates.
is the return investors require on the total assets of the firm
Assigning discount rates to individual projects based on the risk level of each project: A. May cause the firm's overall weighted average cost of capital to either increase or decrease over time. B. Will prevent the firm's overall cost of capital from changing over time. C. Will cause the firm's overall cost of capital to decrease over time. D. Decreases the value of the firm over time. E. Negates the firm's goal of creating the most value for the shareholders.
may cause the firm's overall weighted average cost of capital to either increase or decrease over time
Which one of the following statements is correct? A. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project. B. Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects. C. Firms will correctly accept or reject every project if they adopt the subjective approach. D. Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate. E. The pure play approach should only be used with low-risk projects.
overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects
Jenner's is a multi division firm that uses its overall WACC as the discount rate for all proposed projects. Each division is in a separate line of business and each presents risks unique to those lines. Given this, a division within the firm will tend to: A. Receive less project funding if its line of business is riskier than that of the other divisions. B. Avoid risky projects so it can receive more project funding. C. Become less risky over time based on the projects that are accepted. D. Have an equal probability with all the other divisions of receiving funding. E. Prefer higher risk projects over lower risk projects.
prefer higher risk projects over lower risk projects
When a manager develops a cost of capital for a specific project based on the cost of capital for another firm that has a similar line of business as the project, the manager is utilizing the _____ approach. A. Subjective risk. B. Pure play. C. Divisional cost of capital. D. Capital adjustment. E. Security market line.
pure play
The weighted average cost of capital for a firm with debt is the: A. Discount rate that the firm should apply to all of the projects it undertakes. B. Rate of return a firm must earn on its existing assets to maintain the current value of its stock. C. Coupon rate the firm should expect to pay on its next bond issue. D. Minimum discount rate the firm should require on any new project. E. Rate of return shareholders should expect to earn on their investment in this firm.
rate of return a firm must earn on its existing assets to maintain the current value of its stock
The cost of preferred stock is computed the same as the: A. Pretax cost of debt. B. Rate of return on an annuity. C. Aftertax cost of debt. D. Rate of return on a perpetuity. E. Cost of an irregular growth common stock.
rate of return on a perpetuity
The discount rate assigned to an individual project should be based on the: A. Firm's weighted average cost of capital. B. Actual sources of funding used for the project. C. Average of the firm's overall cost of capital for the past five years. D. Current risk level of the overall firm. E. Risks associated with the use of the funds required by the project.
risks associated with the use of the funds required by the project
The weighted average cost of capital for a firm can depend on all of the following except the: A. Firm's beta. B. Coupon rate of the outstanding bonds. C. Growth rate of the firm's dividends. D. Firm's marginal tax rate. E. Standard deviation of the firm's common stock.
standard deviation of the firm's common stock
Which one of the following statements related to WACC is correct for a firm that uses debt in its capital structure? A. The WACC should decrease as the firm's debt-equity ratio increases. B. The weight assigned to preferred stock decreases as the market value of the stock increases. C. The WACC will decrease as the corporate tax rate decreases. D. The weight of equity is based on the number of shares outstanding and the book value per share. E. The WACC will remain constant unless a firm retires some of its debt.
the WACC should decrease as the firm's debt-equity ratio increases
Black River Tours has a capital structure of 55 percent common stock, 5 percent preferred stock, and 40percent debt. The firm has a 30 percent dividend payout ratio, a beta of 1.21, and a tax rate of 34 percent. Given this, which one of the following statements is correct? A. The after tax cost of debt will be greater than the current yield-to-maturity on the firm's outstanding bonds. B. The firm's cost of preferred is most likely less than the firm's actual cost of debt. C. The firm's cost of equity is unaffected by a change in the firm's tax rate. D. The cost of equity can only be estimated using the capital asset pricing model. E. The firm's weighted average cost of capital will remain constant as long as the firm's capital structure remains constant.
the firm's cost of equity is unaffected by a change in the firm's tax rate
Which one of the following statements related to the capital asset pricing model approach to equity valuation is correct? Assume the firm uses debt in its capital structure. A. This model considers a firm's rate of growth. B. The model applies only to non-dividend-paying firms. C. The model is dependent upon a reliable estimate of the market risk premium. D. The model generally produces the same cost of equity as the dividend growth model. E. This approach generally produces a cost of equity that equals the firm's overall cost of capital.
the model is dependent upon a reliable estimate of the market risk premium
Why does the tax amount need adjusted when valuing a firm using the cash flow from assets approach? A. The tax effect of the dividend payments must be eliminated. B. Only straight-linedepreciation can be used when computing taxes for valuation purposes. C. Taxes must be computed for valuation purposes based solely on the marginal tax rate. D. The tax effect of the interest expense must be removed. E. The taxes must be computed for valuation purposes based on the average tax rate for the past 10 years.
the tax effect of the interest expense must be removed
Which one of the following is the primary determinant of a firm's cost of capital? A. Debt-equity ratio. B. Applicable tax rate. C. Cost of equity. D. Cost of debt. E. Use of the funds.
use of the funds
Flotation costs for a levered firm should be: A. Ignored when analyzing a project because they are a sunk cost. B. Spread over the life of a project thereby reducing the cash flows for each year of the project. C. Considered only when two projects are mutually exclusive. D. Weighted and included in the initial cash flow. E. Totally ignored when internal equity funding is utilized.
weighted and included in the initial cash flow
The average of a firm's cost of equity and after tax cost of debt that is weighted based on the firm's capital structure is called the: A. Reward to risk ratio. B. Weighted capital gains rate. C. Structured cost of capital. D. Subjective cost of capital. E. Weighted average cost of capital.
weighted average cost of capital
