FINN 3013
Q3: Which of the following statements about NPV and IRR is least accurate?
B) For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, the analyst should use the IRRs to select the project NPV should always be used if NPV and IRR give conflicting decisions.
Q2: Which of the following statements is least accurate? The discounted payback period:
B) Is generally shorter than the regular payback The discounted payback is longer than the regular payback because cash flows are discounted to their present value.
Q8: When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:
B. Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only interest expense is deductible for corporate taxes.
Q7: Genoa Corp. is estimating its weighted average cost of capital (WACC). They have several pieces of data to consider. The firm pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. Genoa's 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%. The after-tax cost of debt is closest to:
The correct answer was C) 5.3%. 7.5 × (1 − 0.3) = 5.25%
Q3: A firm is considering a $200,000 project that will last 3 years and has the following financial data: Annual after-tax cash flows are expected to be $90,000. Target debt/equity ratio is 0.4. Cost of equity is 14%. Cost of debt is 7%. Tax rate is 34%. Determine the project's payback period and net present value (NPV).
A) 2.22 years $18,716 Payback Period $200,000 / $90,000 = 2.22 years NPV Method First, calculate the weights for debt and equity wd + we = 1; we = 1 − wd; wd / we = 0.40; wd = 0.40 × (1 − wd); wd = 0.40 − 0.40wd 1.40wd = 0.40; wd = 0.286, we = 0.714 Second, calculate WACC WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132 Third, calculate the PV of the project cash flows 90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716 And finally, calculate the project NPV by subtracting out the initial cash flow NPV = $218,716 − $200,000 = $18,716
Q8: An analyst has gathered the following data about a company with a 12% cost of capital: Part 1) Projects A and B are mutually exclusive. What should the company do?
A) Accept A, Reject B. For mutually exclusive projects accept the project with the highest NPV. In this example the NPV for Project A (3,024) is higher than the NPV of Project B (2,036). Therefore accept Project A and reject Project B.
Q5: Which of the following statements concerning the principles underlying the capital budgeting process is most accurate?
A) Cash flows are based on opportunity costs. Financing costs are recognized in the project's required rate of return. Accounting net income, which includes non-cash expenses, is irrelevant; incremental cash flows are essential for making correct capital budgeting decisions.
Q10: In calculating the weighted average cost of capital (WACC), which of the following statements is least accurate?
A) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt. After-tax cost of debt = bond yield − tax savings = kd − kdt = kd(1 − t)
Q12: A firm currently has a debt to equity ratio of 0.5. Given that the company's capital structure doesn't contain preferred shares, which of the following choices is closest to the equity weight?
A. D/E=(.5) D+E=1 E=.67 D=.33
Q10: The underlying cause of ranking conflicts between the net present value (NPV) and internal rate of return (IRR) methods is the underlying assumption related to the:
B was correct! The IRR method assumes all future cash flows can be reinvested at the IRR. This may not be feasible because the IRR is not based on market rates. The NPV method uses the weighted average cost of capital (WACC) as the appropriate discount rate.
Q4: Mae Kioko, an analyst with Oswald Technologies, is conducting a capital budgeting analysis on an investment the firm is considering making in Argentina. The project being considered is expected to cost $200 million, and should produce net cash flows of $50 million per year for the next seven years. Since Argentina is a developing market, Kioko believes that it is appropriate to include a country risk premium when calculating the cost of equity. Kioko has researched yields in Argentina, and has observed that Argentina's 10-year government bond yield is 9.8%, compared to a 4.6% yield for a similar 10-year U.S. government bond. Kioko also observes that the annualized standard deviation of the Argentina Merval stock exchange is 36%, which is higher than both the standard deviation of the S&P 500 at 18%, and the annualized standard deviation of Argentina's dollar- denominated government debt at 25%. The country risk premium we should add to the cost of equity to capture Argentina's country risk is:
B was correct! The country risk premium is calculated as: CRP = Sovereign yield spread (Ann. STD of index ÷ Ann. STD of sovereign bond market) CRP = (0.098 - 0.046)(0.36 ÷ 0.25) = 0.7488, or 7.49%. Note that the standard deviation of the S&P 500 is extra information that is not used for the calculation.
Q6: Genoa Corp. is estimating its weighted average cost of capital (WACC). They have several pieces of data to consider. The firm pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. Genoa's 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%. The cost of common equity is closest to:
B was correct! ROE × retention ratio = growth rate. 15% × (1 - 0.40) = 9% D0 = $5.00 × 0.40 = $2.00 [$2.00(1.09) / $42.00] + 0.09 = 14.19%
Q4: Which of the following statements about the payback period method is least accurate? The payback period:
B) Considers all cash flows throughout the entire life of a project. The payback period ignores cash flows that go beyond the payback period.
Q6: Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over next seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?
C) $280,913. The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913.
Q7: A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments: Year 1: $100,000 Year 2: $82,000 Year 3: $76,000 Year 4: $111,000 Year 5: $142,000 If the required rate of return for the firm is 8%, what is the net present value of the investment? (You'll need to use your financial calculator.)
C) $64,582. In order to determine the net present value of the investment, given the required rate of return; we can discount each cash flow to its present value, sum the present value, and subtract the required investment.
Q1: Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost of capital can be summarized as follows: The company's bonds have a nominal yield to maturity of 7%. The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share. The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7% a year. The company has no retained earnings. The company's tax rate is 40%. What is the company's weighted average cost of capital (WACC)?
C) 10.18%. WACC = (wd)(kd)(1 − t) + (wps)(kps) + (wce)(kce) where: wd = 0.40 wce = 0.50 wps = 0.10 kd = 0.07 kps = Dps / P = 4.00 / 40.00 = 0.10 kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15 WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 + 0.075 = 0.1018 or 10.18%
Q2: The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-term growth in dividends is projected at 8%. The cost of common equity is closest to
C) 19.1%. Kce = ( D1 / P0) + g Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%
Q5: Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company's capital structure in a material way for the future. To calculate the weighted average cost of Deighton's capital, what weights should be assigned to debt and to equity?
C) 53.46% 46.54% In order to calculate the weighted average cost of capital (WACC), market value weights should be used. For the bonds = 200,000 × $965 = $193,000,000 For the stocks = 6,000,000 × $28 = $168,000,000 $361,000,000 The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46% The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%
Q9: An analyst has gathered the following data about a company with a 12% cost of capital: Part 2) If the projects are independent, what should the company do?
C) Accept A, Accept B. Project A: N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT → PV = 18,024; NPV for Project A = 18,024 − 15,000 = 3,024. Project B: N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT → PV = 27,036; NPV for Project B = 27,036 − 25,000 = 2,036. For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore, accept both projects.
Q11: Which of the following projects would have multiple internal rates of return (IRRs)? The cost of capital for all projects is 9.75%.
C) Project Blackjack only. The multiple IRR problem occurs if a project has non-normal cash flows, that is, the sign of the net cash flows changes from negative to positive to negative, or vice versa. For the exam, a shortcut to look for is the project cash flows changing signs more than once. Only Project Blackjack has this cash flow pattern. The 0 net cash flow in T2 for Project Keno and likely negative net present value (NPV) for Project Roulette would not necessarily result in multiple IRRs.
Q1: Which of the following statements about NPV and IRR is least accurate?
C) The NPV will be positive if the IRR is less than the cost of capital If IRR is less than the cost of capital, the result will be a negative NPV.
Q9: Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:
C) reject profitable, low-risk projects and accept unprofitable, high-risk projects. The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.
Target Weights for Capital Sources—Problem Which of the following methods for estimating the weights for calculating a firm's WACC is least acceptable?
Current proportions of debt and equity based on balance sheet values. (Market Values are preferred over historical balance sheet values)
