FINA 3000 ch 8, 9, 10, 11
52. Which of the following statements is CORRECT?
(A) A cost should be assigned to reinvested earnings due to the opportunity cost principle, which refers to the fact that the firm's stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.
4. Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
(A) Accounts payable.
44. For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure.
(A) re > rs > WACC > rd.
55. Which of the following statements is CORRECT?
(B) Beta measures market risk, which is, theoretically, the most relevant risk measure for a publiclyowned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.
51. Which of the following statements is CORRECT?
(B) If a company assigns the same cost of capital to all of its projects regardless of each project's risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
46. Which of the following statements is CORRECT?
(C) A firm's cost of reinvesting earnings is the rate of return stockholders require on a firm's common stock.
48. Which of the following statements is CORRECT?
(C) If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline.
54. Which of the following statements is CORRECT?
(C) Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity.
50. Which of the following statements is CORRECT? Assume a company's target capital structure is 50% debt and 50% common equity.
(C) The cost of equity is always equal to or greater than the cost of debt.
53. Which of the following statements is CORRECT?
(C) The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
56. Which of the following statements is CORRECT?
(C) The relevant WACC can change depending on the amount of funds a firm raises during a given year. Moreover, the WACC at each level of funds raised is a weighted average of the marginal costs of each capital component, with the weights based on the firm's target capital structure.
47. Which of the following statements is CORRECT?
(C) There is an "opportunity cost" associated with using reinvested earnings, hence they are not "free."
75. Which of the following statements is CORRECT?
(D) If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
57. Which of the following statements is CORRECT?
(D) If a firm has been suffering accounting losses that are expected to continue into the foreseeable future, and therefore its tax rate is zero, then it is possible for the after-tax cost of preferred stock to be less than the after-tax cost of debt.
92. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.
(D) Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
49. Which of the following statements is CORRECT?
(D) The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
28. When working with the CAPM, which of the following factors can be determined with the mostprecision?
(D) The beta coefficient of "the market," which is the same as the beta of an average stock.
45. Which of the following statements is CORRECT?
(E) When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
Adams Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of common from reinvested earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72%
A
Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? a. Project D probably has a higher IRR. b. Project D is probably larger in scale than Project C. c. Project C probably has a faster payback.
A
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Accounts payable. b. Common stock "raised" by reinvesting earnings. c. Common stock raised by new issues. d. Preferred stock. e. Long-term debt.
A
Which of the following statements is CORRECT? a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. b. If Project A's IRR exceeds Project B's, then A must have the higher NPV. c. A project's MIRR can never exceed its IRR. d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. e. If the NPV is negative, the IRR must also be negative.
A
Which of the following statements is CORRECT? a. Projects with "normal" cash flows can have only one real IRR. b. Projects with "normal" cash flows can have two or more real IRRs. c. 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." d. The "multiple IRR problem" can arise if a project's cash flows are "normal." e. Projects with "nonnormal" cash flows are almost never encountered in the real world.
A
Which of the following statements is CORRECT? a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. b. The discounted payback method eliminates all of the problems associated with the payback method. c. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. d. To find the MIRR, we discount the TV at the IRR. e. A project's NPV profile must intersect the X-axis at the project's WACC.
A
Which of the following statements is CORRECT? a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
A
With its current financial policies, Flagstaff Inc. will have to issue new common stock to fund its capital budget. Since new stock has a higher cost than reinvested earnings, Flagstaff would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the percentage of debt in the target capital structure. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Reduce the percentage of debt in the target capital structure. e. Increase the dividend payout ratio for the upcoming year.
A
Your consultant firm has been hired by Eco Brothers Inc. to help them estimate the cost of common equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of common can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of common from reinvested earnings? a. 12.60% b. 13.10% c. 13.63% d. 14.17% e. 14.74%
A
False
A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.
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).
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's IRR increases as the WACC declines. b. A project's NPV increases as the WACC declines. c. A project's MIRR is unaffected by changes in the WACC. d. A project's regular payback increases as the WACC declines. e. A project's discounted payback increases as the WACC declines.
B
Bartlett Company's target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6.00%, the cost of preferred is 7.50%, and the cost of common using reinvested earnings is 12.75%. The firm will not be issuing any new stock. You were hired as a consultant to help determine their cost of capital. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12%
B
Bloom and Co. has no debt or preferred stock⎯it uses only equity capital, and has two equally-sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept? a. A Division Y project with a 12% return. b. A Division X project with an 11% return. c. A Division X project with a 9% return. d. A Division Y project with an 11% return. e. A Division Y project with a 13% return.
B
Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S's undiscounted net cash flows total $20,000, while L's total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project's NPV is more sensitive to changes in the WACC? a. Project S. b. Project L. c. Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital. d. Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal. e. The solution cannot be determined because the problem gives us no information that can be used to determine the projects' relative IRRs.
B
Trahern Baking Co. common stock sells for $32.50 per share. It expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, and its expected constant dividend growth rate is 6.0%. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? a. 12.70% b. 13.37% c. 14.04% d. 14.74% e. 15.48%
B
Which of the following statements is CORRECT? a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project's full life whereas IRR does not. b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.
B
Which of the following statements is CORRECT? a. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period. c. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.
B
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. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project's NPV is greater than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPVs of relatively risky projects should be found using relatively low WACCs.
B
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 longer a project's payback period, the more desirable the project is normally considered to be by this criterion. b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money. c. If a project's payback is positive, then the project should be rejected because it must have a negative NPV. d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
B
As a consultant to Basso Inc., you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of common from reinvested earnings based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%
C
As the assistant to the CFO of Johnstone Inc., you must estimate its cost of common equity. You have been provided with the following data: D0 = $0.80; P0 = $22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 10.69% b. 11.25% c. 11.84% d. 12.43% e. 13.05%
C
Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L, because at the new WACC it will have the higher NPV. d. You should recommend Project S, because at the new WACC it will have the higher NPV. e. You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.
C
Suppose Acme Industries correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years, then the firm will most likely a. become less risky over time, and this will maximize its intrinsic value. b. accept too many low-risk projects and too few high-risk projects. c. become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. d. continue as before, because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. e.become riskier over time, but its intrinsic value will be maximized.
C
The Lincoln Company sold a $1,000 par value, noncallable bond several years ago that now has 20 years to maturity and a 7.00% annual coupon that is paid semiannually. The bond currently sells for $925 and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? a. 4.28% b. 4.46% c. 4.65% d. 4.83% e. 5.03%
C
Weatherall Enterprises has no debt or preferred stock⎯it is an all-equity firm⎯and has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than an average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? a. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. b. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment. c. The accept/reject decision depends on the firm's risk-adjustment policy. If Weatherall's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. d. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. e. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
C
Which of the following statements is CORRECT? a. The MIRR and NPV decision criteria can never conflict. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. d. The higher the WACC, the shorter the discounted payback period.
C
Which of the following statements is CORRECT? a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects. b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. e. The percentage difference between the MIRR and the IRR is equal to the project's WACC.
C
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. A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC. b. The lower the WACC used to calculate it, the lower the calculated NPV will be. c. If a project's NPV is less than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPV of a relatively low-risk project should be found using a relatively high WACC.
C
You are a finance intern at Chambers and Sons and they have asked you to help estimate the company's cost of common equity. You obtained the following data: D1 = $1.25; P0 = $27.50; g = 5.00% (constant); and F = 6.00%. What is the cost of equity raised by selling new common stock? a. 9.06% b. 9.44% c. 9.84% d. 10.23% e. 10.64%
C
Assume that the risk-free rate is 6% and the market risk premium is 5%. Given this information, which of the following statements is CORRECT? a. An index fund with beta = 1.0 should have a required return of 11%. b. If a stock has a negative beta, its required return must also be negative. c. An index fund with beta = 1.0 should have a required return of less than 11%. d. If a stock's beta doubled, its required return must also double. e. An index fund with beta = 1.0 should have a required return greater than 11%.
C.
True
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.
A company's perpetual preferred stock currently sells for $92.50 per share, and it pays an $8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock? a. 7.81% b. 8.22% c. 8.65% d. 9.10% e. 9.56%
D
Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? a. You should reject both projects because they will both have negative NPVs under the new conditions. b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. c. You should recommend Project L, because at the new WACC it will have the higher NPV. d. You should recommend Project S, because at the new WACC it will have the higher NPV. e. You should recommend Project L because it will have the higher IRR at the new WACC.
D
Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method? a. Lacks an objective, market-determined benchmark for making decisions. b. Ignores cash flows beyond the payback period. c. Does not directly account for the time value of money. d. Does not provide any indication regarding a project's liquidity or risk. e. Does not take account of differences in size among projects.
D
To help them estimate the company's cost of capital, Smithco has hired you as a consultant. You have been provided with the following data: D1 = $1.45; P0 = $22.50; and g = 6.50% (constant). Based on the DCF approach, what is the cost of common from reinvested earnings? a. 11.10% b. 11.68% c. 12.30% d. 12.94% e. 13.59%
D
When working with the CAPM, which of the following factors can be determined with the most precision? a. The beta coefficient, bi, of a relatively safe stock. b. The most appropriate risk-free rate, rRF. c. The expected rate of return on the market, rM. d. The beta coefficient of "the market," which is the same as the beta of an average stock. e. The market risk premium (RPM).
D
Which of the following statements is CORRECT? a. An NPV profile graph shows how a project's payback varies as the cost of capital changes. b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. c. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. d. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.
D
Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRs. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can only occur if the signs of the cash flows change more than once. e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.
D
Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
D
Which of the following statements is CORRECT? a. The regular payback method recognizes all cash flows over a project's life. b. 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. c. The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today. d. 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. e. The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.
D
Which of the following statements is CORRECT? a. All else equal, an increase in a company's stock price will increase its marginal cost of reinvested earnings (not newly issued stock), rs. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of reinvested earnings (not newly issued stock) is usually much lower than the after-tax cost of debt. d. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
D
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. A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. b. A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR. c. If a project's IRR is greater than the WACC, then its NPV must be negative. d. To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. e. To find a project's IRR, we must find a discount rate that is equal to the WACC.
D
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. A project's regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC. b. A project's regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR. c. If a project's IRR is smaller than the WACC, then its NPV will be positive. d. A project's IRR is the discount rate that causes the PV of the inflows to equal the project's cost. e. If a project's IRR is positive, then its NPV must also be positive.
D
Stock A's beta is 1.5 and Stock B's beta is 0.5. Which of the following statements must be true, assuming the CAPM is correct. a. Stock A would be a more desirable addition to a portfolio than stock B. b. In equilibrium, the expected return on Stock B will be greater than on Stock A. c. when held in isolation, Stock A has more risk than Stock B. d. In equilibrium, the expected return on Stock A will be greater than stock B.
D.
Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV). b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV). c. The firm will accept too many projects in all economic states because a 4-year payback is too low. d. The firm will accept too few projects in all economic states because a 4-year payback is too high. e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
E
The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. c. The company's overall WACC should decrease over time because its stock price should be increasing. d. The CEO's recommendation would maximize the firm's intrinsic value. e. The company will take on too many high-risk projects and reject too many low-risk projects.
E
When working with the CAPM, which of the following factors can be determined with the most precision? a. The market risk premium. b. The beta coefficient of a relatively safe stock. c. The most appropriate risk free rate. d. The expected rate of return on the market. e. The beta coefficient of "the market", which is the same as the beta of an average stock.
E
Which of the following statements is CORRECT? a. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. b. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. c. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. e. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.
E
Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its IRR must be positive. b. If a project has "normal" cash flows, then its MIRR must be positive. c. If a project has "normal" cash flows, then it will have exactly two real IRRs. d. 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. e. 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
Which of the following statements is CORRECT? a. One defect of the IRR method is that it does not take account of cash flows over a project's full life. b. One defect of the IRR method is that it does not take account of the time value of money. c. One defect of the IRR method is that it does not take account of the cost of capital. d. 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. e. 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
Which of the following statements is CORRECT? a. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project's full life. b. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. c. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. d. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future. e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
E
Which of the following statements is CORRECT? a. 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. b. If the cost of capital declines, this lowers a project's NPV. c. 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 and disregard other methods. d. A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project's life. e. 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
Which of the following statements is CORRECT? a. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation. b. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. c. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough reinvested earnings to take care of its equity financing and hence must issue new stock. d. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. e. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
E
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 have the lower NPV. b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. c. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. d. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. e. If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive.
E
A basic rule in capital budgeting is that if a project's NPV exceeds its IRR, then the project should be accepted.
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).
FALSE
An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.
FALSE
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.
FALSE
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.
FALSE
Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods.
FALSE
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR.
FALSE
If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.
FALSE
Other things held constant, an increase in the cost of capital will result in a decrease in a project's IRR.
FALSE
The IRR method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.
FALSE
The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects' NPV profiles cross is greater than the crossover rate.
FALSE
The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their costs of capital.
FALSE
The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared.
FALSE
The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant.
FALSE
The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.
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.
FALSE
When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.
FALSE
A basic rule in capital budgeting is that if a projects NPV exceeds its IRR, the the project should be accepted.
False
A stocks beta measures its diversifiable risk to the diversifiable risks of other firms
False
An increase in the firm's WACC will decrease projects' NPV, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.
False
Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.
False
In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
False
The IRR method assumes that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.
False
The before-tax cost of debt, which is lower than the after-tax, is used as the component cost of debt for purposes of developing the firm's WACC.
False
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
False
The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporations taxable income.
False
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.
False
The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault.
False
A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects' cost of capital is less than the rate at which the projects' NPV profiles cross.
TRUE
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV.
TRUE
For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost.
TRUE
In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.
TRUE
One advantage of the payback method for evaluating potential investments is that it provides information about a project's liquidity and risk.
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.
TRUE
Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms.
TRUE
The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.
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.
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.
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.
TRUE
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.
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.
Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.
True
In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the profitability of other independent projects.
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.
True
The NPV method is based on the assumption that projects' cash flows are reinvested at the project's risk-adjusted cost of capital.
True
Under certain conditions a project may have more than one IRR. One such condition is when in addition to the initial investment at the time = 0, a negative cash flow (or cost) occurs at the end of the projects life.
True
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.
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. re > rs > WACC > rd. b. WACC > re > rs > rd. c. rd > re > rs > WACC. d. WACC > rd > rs > re. e. rs > re > rd > WACC.
a. re > rs > WACC > rd.
O'Brien Inc. has the following date: r(RF) = 5 %; RP(m) = 6 %; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? a. 11.30% b. 11.64% c. 11.99% d. 12.35% e. 12.72%
a; 11.30%
Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L's IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT? a. If the WACC is 10%, both projects will have positive NPVs. b. If the WACC is 6%, Project S will have the higher NPV. c. If the WACC is 13%, Project S will have the lower NPV. d. If the WACC is 10%, both project will have a negative NPV.
a; If the WACC is 10%, both projects will have positive NPVs.
Rebels Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project C, which is of above-average risk and has a return of 11%. c. Project A, which is of average risk and has a return of 9%. d. None of the projects should be accepted.
a; Project B, which is of below-average risk and has a return of 8.5%
"Capital" is sometimes defined as funds supplied to a firm by investors. a. True b. False
a; True
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the projects with the higher NPV. a. True b. False
a; True
For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project's life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project's cost. a. True b. False
a; True
The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. a. True b. False
a; True
The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. a. True b. False
a; True
The cost of perpetual preferred stock is found as the preferred's annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. a. True b. False
a; 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
a; 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
a; True
You were hired as a consultant to Giambono Company, whose target capital structure is 40% debt, 15% preferred, and 45% common equity. The after-tax cost of debt is 6%, the cost of preferred is 7.50%, and the cost of retained earnings is 12.75%. What is its WACC? a. 8.98% b. 9.26% c. 9.54% d. 9.83% e. 10.12%
b; 9.26%
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? a. A project's IRR increases as the WACC declines. b. A project's NPV increases as the WACC declines. c. A project's MIRR is unaffected by changes in the WACC. d. A project's regular payback increases as the WACC declines.
b; A project's NPV increases as the WACC declines
Which of the following is NOT a capital component when calculating the weighted average capital cost (WACC) for use in capital budgeting? a. Long-term debt b. Accounts payable c. Retained earnings d. Common stock e. Preferred stock
b; Accounts payable
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
b; 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
b; False
An increase in the firm's WACC will decrease project's NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. a. True b. False
b; False
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. a. True b. False
b; False
Other things held constant, an increase in the cost of capital will result in a a decrease in a project's IRR. a. True b. False
b; False
The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm's WACC. a. True b. False
b; False
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. a. True b. False
b; False
The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income a. True b. False
b; False
The lower the firm's tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant. a. True b. False
b; False
The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False
b; False
The phenomenon called "multiple internal rates of return" arises when two or more mutually exclusive projects that have different lives are being compared. a. True b. False
b; False
The primary reason that the NPV method is conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist, and when that happens, we don't know which IRR is relevant. a. True b. False
b; False
The regular payback method is deficient in that it does not take account of cash flows beyond the payback period. The discounted payback method corrects this fault. a. True b. False
b; False
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. A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. c. If a project's NPV is greater than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero.
b; The higher the WACC used to calculate the NPV, the lower the calculated NPV will be
Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8% (constant). What is the cost of equity based on the DCF approach? a. 9.42% b. 9.91% c. 10.44% d. 10.96% e. 11.51%
c; 10.44%
Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If two projects are mutually exclusive, then they are likely to have multiple IRRS. c. If a project is independent, then it cannot have multiple IRRs. d. Multiple IRRs can only occur if the signs of the cash flows change more than once.
d; Multiple IRRs can only occur if the signs of the cash flows change more than once.
