UNT FINA 4300 - Test 3

A. increase the variability in earnings per share.

Under the simplifying assumptions of Modigliani and Miller, an increase in a firm's financial leverage will: A. increase the variability in earnings per share. B. reduce the operating risk of the firm. C. increase the value of the firm. D. decrease the value of the firm.

C. 1.02 PVinflows = (12,200/1.145) + (38,400/1.1452) + (11,300/1.1453) = $47,472.78 BCR = $47,472.78/$46,500 = 1.02

What is the benefit-cost ratio for an investment with the following cash flows at a 14.5 percent required return? YEAR CASH FLOW 0 $(46,500) 1 $12,200 2 $38,400 3 $11,300 A. 0.94 B. 0.98 C. 1.02 D. 1.06 E. 1.11 F. None of the above.

A. $28 The present value of the perpetuity is 5,000/0.08 = $62,500. For the annuity: The difference = 62,500 - 62,472 = $28

What is the difference in the value of a $5,000 annual perpetuity and an annuity of $5,000 for 100 years? Assume that the discount rate is 8% and that cash flows are received at the end of the year. A. $28 B. $656 C. $1,656 D. $5,000

True

When a company is in financial distress, its shareholders may have an incentive to undertake excessively risky investments. T/F

False

When conducting a discounted cash flow analysis of a project, it is important to always include a careful estimate of financing costs in the project's cash flows. T/F

A. ABC's cash flows from operations are less volatile than XYZ's.

When considering the impact of distress costs on capital structure, which of the following facts should lead ABC Corporation to set a higher target debt ratio than XYZ Corporation (all else equal)? A. ABC's cash flows from operations are less volatile than XYZ's. B. ABC is a computer software firm, and XYZ is an electric utility. C. ABC operates in a more competitive industry than XYZ. D. ABC's assets have lower resale values than XYZ's assets.

True

When evaluating investments under capital rationing that are independent and can be acquired fractionally, ranking by the BCR is the appropriate technique. T/F

E. None of the above. In Year 0 there is a $60,000 outflow. In Year 5 there is a $60,000 inflow, which has a present value of 60,000/1.097 = $32,822. The decrease in NPV is 60,000 - 32,822 = $27,178.

A divisional manager submitted a project proposal to the chief financial officer, complete with a calculated NPV for the project. The chief financial officer studied the proposal and pointed out that the divisional manager had failed to account for a one-time increase in net working capital of $60,000 that will be required over the life of the seven-year project. Assuming the full value of net working capital will be recovered at the end of the project, how will the project's NPV change after making the chief financial officer's adjustment? Assume a discount rate of 9%. A. The NPV will decrease by $16,411. B. The NPV will decrease by $32,822. C. The NPV will decrease by $60,000. D. The NPV will not be affected. E. None of the above.

B. $2,168.02 Solve for the PV of the cash inflows, and then subtract the initial investment: NPV = 11668.02 - 9,500 = $2,168.02

A project will produce after-tax operating cash inflows of $3,200 a year for 5 years. The after-tax salvage value of the project is expected to be $2,500 in year 5. The project's initial cost is $9,500. What is the net present value of this project if the required rate of return is 16 percent? A. -$311.02 B. $2,168.02 C. $4,650.11 D. $9,188.98 E. $21,168.02 F. None of the above.

D. Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

According to the pecking order theory of capital structure, why do firms avoid issuing equity? A. Because fees associated with issuing new equity are so high B. Because they want to avoid dilution of earnings per share C. Because they don't want to commit to paying dividends on the new equity D. Because equity issuance signals that managers believe their stock is overvalued, which causes the price of the stock to fall

D. I, II, and IV only

According to the pecking order theory proposed by Stewart Myers of MIT, which of the following are correct? I. For financing needs, firms prefer to first tap internal sources such as retained profits and excess cash. II. There is an inverse relationship between a firm's profit level and its debt level. III. Firms prefer to issue new equity rather than source external debt. IV. A firm's capital structure is dictated by its need for external financing. A. I and III only B. II and IV only C. I, III, and IV only D. I, II, and IV only E. I, II, III, and IV F. None of the above.

False

As a noncash expense, depreciation is irrelevant in the determination of a project's cash flows. T/F

True

Debt financing results in lower after-tax earnings relative to equity financing. T/F

A. $895.43 Price = present value of coupons and face value Coupon payment = 0.095 × 1000 = $95 per year

EAC Nutrition offers a 9.5 percent coupon bond with annual payments, maturing 11 years from today. Your required return is 11.2 percent. What price are you willing to pay for this bond if the face (or par) value is $1,000? A. $895.43 B. $896.67 C. $941.20 D. $946.18 E. $953.30 F. None of the above.

D. II, III, and IV only

Financial leverage: I. increases expected ROE but does not affect its variability. II. increases breakeven sales, like operating leverage, but increases the rate of earnings per share growth once breakeven is achieved. III. is a fundamental financial variable affecting sustainable growth. IV. increases expected return and risk to owners. A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

C. -$1,800

Giant Corp. is considering a project that requires a $1,500 initial cost for a new machine that will be depreciated straight line to a salvage value of 0 on a 5-year schedule. The project will require a one-time increase in the level of net working capital of $300. The project will generate an additional $1,600 in revenues and $700 in operating expenses each year. The project will end at the end of year 2, at which time the machinery is expected to be sold for $800. Giant's tax rate is 50%. In a discounted cash flow analysis of this project, what would be the projected Year 0 free cash flow? A. -$1,200 B. -$1,500 C. -$1,800 D. -$2,100

C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage.

Homemade leverage is: A. the incurrence of debt by a corporation in order to pay dividends to shareholders. B. the exclusive use of debt to fund a corporate expansion project. C. the borrowing or lending of money by individual shareholders as a means of adjusting their level of financial leverage. D. best defined as an increase in a firm's debt-equity ratio. E. the term used to describe the capital structure of a levered firm. F. None of the above.

C. maximizes expected cash flows.

The best financing choice is the one that: A. sets the debt-to-assets ratio equal to 1. B. trades off the tax disadvantage of debt against the signaling effects of equity. C. maximizes expected cash flows. D. ignores the false comfort of financial flexibility. E. results in the lowest possible financial distress costs.

C. In today's dollars, Ian's money is worth more than Sunny's.

Ian is going to receive $20,000 six years from now. Sunny is going to receive $20,000 nine years from now. Which one of the following statements is correct if both Ian and Sunny apply a 7 percent discount rate to these amounts? A. The present values of Ian and Sunny's monies are equal. B. In future dollars, Sunny's money is worth more than Ian's money. C. In today's dollars, Ian's money is worth more than Sunny's. D. Twenty years from now, the value of Ian's money will be equal to the value of Sunny's money. E. Sunny's money is worth more than Ian's money given the 7 percent discount rate. F. None of the above.

True

If the maturity of a company's liabilities is less than that of its assets, the company incurs a refinancing risk. T/F

B. $600

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 1 free cash flow? A. $300 B. $600 C. $750 D. $900

D. $1,750

In a discounted cash flow analysis of Giant Corp.'s project described in the problem above, what would be the projected Year 2 free cash flow? A. $1,300 B. $1,450 C. $1,700 D. $1,750

D. vary significantly across industries.

In general, the capital structures used by non-financial U.S. firms: A. typically result in debt-to-asset ratios between 60 and 80 percent. B. tend to converge to the same proportions of debt and equity. C. tend to be those that maximize the use of the firm's available tax shelters. D. vary significantly across industries. E. None of the above.

True

In some instances, additional debt financing can encourage managers to act more in the interests of owners. T/F

D. $2,333,572

Naomi plans on saving $3,000 a year and expects to earn an annual rate of 10.25 percent. How much will she have in her account at the end of 45 years? A. $1,806,429 B. $1,838,369 C. $2,211,407 D. $2,333,572 E. $2,508,316 F. None of the above.

B. II and III only

Pro forma free cash flows for a proposed project should: I. exclude the cost of employing existing assets that could be sold anyway. II. exclude interest expense. III. include the depreciation tax shield related to the project. IV. exclude any required increase in operating current assets. A. I and II only B. II and III only C. II and IV only D. I, III, and IV only E. I, II, III, and IV F. None of the above.

True

The evidence indicates that, on average, a company's stock price declines when it announces a new issue of equity. T/F

A. $560,000

Salinas Corporation has net income of $15 million per year on net sales of $90 million per year. It currently has no long-term debt, but is considering a debt issue of $20 million. The interest rate on the debt would be 7%. Salinas Corp. currently faces an effective tax rate of 40%. What would be the annual interest tax shield to Salinas Corp. if it goes through with the debt issuance? A. $560,000 B. $1,400,000 C. $8,000,000 D. $20,000,000

E. $32,409.57 The initial investment consists of the fixed assets and incremental working capital: $39,000 + $3000 = $42,000. The working capital amount is recovered at the end of year 4. Solve for the PV of the cash inflows, and then subtract the initial investment: NPV = 74,409.57 - 42,000 = $32,409.57

Sol's Sporting Goods is expanding, and as a result expects additional operating cash flows of $26,000 a year for 4 years. This expansion requires $39,000 in new fixed assets. These assets will be worthless at the end of the project. In addition, the project requires an additional $3,000 of net working capital throughout the life of the project; Sol expects to recover this amount at the end of the project. What is the net present value of this expansion project at a 16 percent required rate of return? A. $18,477.29 B. $21,033.33 C. $28,288.70 D. $29,416.08 E. $32,409.57 F. None of the above.

False

The IRR and NPV always yield the same investment recommendations T/F

False

The IRR is the discount rate at which an investment's NPV equals its initial cost. T/F

False

The M&M irrelevance proposition assures financial managers that their choice between equity or debt financing will ultimately have no impact on firm value. T/F

True

The accounting rate of return is deficient as a figure of merit because it is insensitive to the timing of cash flows T/F

B. the total cash flow of the firm.

The basic lesson of the M&M theory is that the value of a firm is dependent upon: A. the firm's capital structure. B. the total cash flow of the firm. C. minimizing the marketed claims. D. the amount of marketed claims to that firm. E. the size of the stockholders' claims. F. None of the above.

C. I, III, and IV only

The interest tax shield has no value when a firm has: I. no taxable income. II. debt-equity ratio of 1. III. zero debt. IV. no leverage. A. I and III only B. II and IV only C. I, III, and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above.

E. I, II, III, and IV

The term "financial distress costs" includes which of the following? I. Direct bankruptcy costs II. Indirect bankruptcy costs III. Direct costs related to being financially distressed, but not bankrupt IV. Indirect costs related to being financially distressed, but not bankrupt A. I only B. III only C. I and II only D. III and IV only E. I, II, III, and IV F. None of the above.

C. III only

When making a capital budgeting decision, which of the following is/are NOT relevant? I. The size of a cash flow. II. The risk of a cash flow. III. The accounting earnings from a cash flow. IV. The timing of a cash flow. A. I only B. II only C. III only D. II and III only E. III and IV only F. They are all relevant.

B. I and III only

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

B. I and III only

Which of the following factors favor the issuance of debt in the financing decision? I. Market signaling II. Distress costs III. Tax benefits IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. I, II, and III only E. I, II, and IV only F. None of the above.

C. II and IV only

Which of the following factors favor the issuance of equity in the financing decision? I. Market signaling II. Distress costs III. Management incentives IV. Financial flexibility A. I and II only B. I and III only C. II and IV only D. II, III, and IV only E. I, II, and IV only F. None of the above.

E. I & IV only

Which of the following figures of merit does not directly take into consideration the time value of money? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Accounting rate of return A. IV only B. I & III only C. II & III only D. I & II only E. I & IV only F. I, II, III, and IV

D. I only

Which of the following figures of merit might not use all possible cash flows in its calculations? I. Payback period II. Internal rate of return III. Net present value (NPV) IV. Benefit-cost ratio A. III only B. I & III only C. II & III only D. I only E. III & IV only F. I, II, III, and IV

B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort.

Which of the following is NOT a likely financing policy for a rapidly growing business? A. Adopt a modest dividend payout policy that enables the company to finance most of its growth externally. B. Borrow funds rather than limit growth, thereby limiting growth only as a last resort. C. Maintain a conservative leverage ratio to ensure continuous access to financial markets. D. If external financing is necessary, use debt to the point it does not affect financial flexibility. E. None of the above.

B. The value of a dollar in the future will be compounded more than the value of a dollar today.

Which of the following is NOT a reason why a dollar today is worth more than a dollar in the future? A. Inflation reduces the purchasing power of future dollars. B. The value of a dollar in the future will be compounded more than the value of a dollar today. C. There is more uncertainty of receiving dollars further into the future. D. A dollar today can be productively invested in the time before receiving a dollar in the future.

C. More-profitable firms (all else equal) should have higher debt ratios.

Which of the following is NOT an implication of the pecking order theory of capital structure? A. On average, a firm's stock price drops when it announces an equity issue. B. Firms may want to maintain a reserve of cash or unused borrowing capacity. C. More-profitable firms (all else equal) should have higher debt ratios. D. Firms may fail to undertake positive-NPV projects if they would have to be financed with a new issue of equity.

B. Estimate the accounting rate of return for the investment.

Which of the following is NOT an important step in the financial evaluation of an investment opportunity? A. Calculate a figure of merit for the investment. B. Estimate the accounting rate of return for the investment. C. Estimate the relevant cash flows. D. Compare the figure of merit to an acceptance criterion. E. All of the above are important steps.

C. I and III only

Which of the following is/are helpful for evaluating the effect of leverage on a company's risk and potential returns? I. Estimated pro forma coverage ratios II. The recognition that financing decisions do not affect firm or shareholder value III. A range of earnings chart and proximity of expected EBIT to the breakeven value IV. A conservative debt policy that obviates the need to evaluate risk A. I only B. III only C. I and III only D. II and III only E. IV only F. None of the above.

A. II and III only

Which of the following should be included in the cash flow projections for a new product? I. Money already spent for research and development of the new product II. Capital expenditures for equipment to produce the new product III. Increase in working capital needed to finance sales of the new product IV. Interest expense on the loan used to finance the new product launch A. II and III only B. II and IV only C. I, II, and III only D. II, III, and IV only E. I, II, III, and IV F. None of the above.

D. Taxable income is reduced by the amount of the interest on a firm's debt.

Which of the following statements regarding interest tax shields is correct? A. Taxes are reduced by the amount of a firm's interest-bearing debt. B. Taxable income is reduced by the amount of a firm's interest-bearing debt. C. Taxes are reduced by the amount of the interest on a firm's debt. D. Taxable income is reduced by the amount of the interest on a firm's debt.

B. I and III only

Which of the following statements related to the internal rate of return (IRR) are correct? I. The IRR is the discount rate at which an investment's NPV equals zero. II. An investment should be undertaken if the discount rate exceeds the IRR. III. The IRR tends to be used more than net present value simply because its results are easier to comprehend. IV. The IRR is the best tool available for deciding between mutually exclusive investments. A. I and II only B. I and III only C. II and III only D. I, II, and IV only E. I, II, III, and IV F. None of the above.

A. Lack of interest tax shields

Which of the following would not be considered a cost of financial distress? A. Lack of interest tax shields B. Bankruptcy costs C. Excessive risk-taking by shareholders D. Loss of customers or suppliers

E. You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today. The number of monthly periods = 20 × 12 = 240 The monthly interest rate = 6%/12 = 0.5%

You are the beneficiary of a life insurance policy. The insurance company informs you that you have two options for receiving the insurance proceeds. You can receive a lump sum of $200,000 today or receive payments of $1,400 a month for 20 years. You can earn a 6 percent annual rate on your money, compounded monthly. Which option should you take and why? A. You should accept the monthly payments because they are worth $209,414 to you. B. You should accept the $200,000 lump sum because the monthly payments are only worth $16,057 to you today. C. You should accept the monthly payments because they are worth $336,000 to you. D. You should accept the $200,000 lump sum because the monthly payments are only worth $189,311 to you today. E. You should accept the $200,000 lump sum because the monthly payments are only worth $195,413 to you today. F. None of the above.

B. $5,585.97 The PV = $6,144.57. But the first payment is received in two years, not one year, so discount the PV by one more year: 6,144.57/1.1 = $5,585.97

You are to receive an annuity of $1,000 per year for 10 years. You will receive the first payment two years from today. At a discount rate of 10%, what is the present value of this annuity? A. $5,078.15 B. $5,585.97 C. $6,144.57 D. $6,759.03

C. $99,517.41 Future value = $82,500 × (1 + 0.048)4 = $99,517.41

You plan to buy a new Mercedes four years from now. Today, a comparable car costs $82,500. You expect the price of the car to increase by an average of 4.8 percent per year over the next four years. How much will your dream car cost by the time you are ready to buy it? A. $98,340.00 B. $98,666.67 C. $99,517.41 D. $99,818.02 E. $100,023.16 F. None of the above.

C. 4.80% r = A/P = $2.40/$50 = 4.80%

You plan to pay $50 for a share of preferred stock that pays a $2.40 dividend per year forever. What annual rate of return will you realize? A. 0.48% B. 2.40% C. 4.80% D. 5.10% E. 20.83% F. None of the above.

E. $366.05 The number of monthly periods = 5 × 12 = 60 The monthly interest rate = 8.6%/12 = 0.71667%

Your brother will borrow $17,800 to buy a car. The terms of the loan call for monthly payments for 5 years at an 8.6 percent annual interest rate, compounded monthly. What is the amount of each payment? A. $287.71 B. $296.67 C. $301.12 D. $342.76 E. $366.05 F. None of the above.

C. $17,444.86 Present value = $51,480.79/(1 + 0.0425)26 = $17,444.86

Your grandmother invested a lump sum 26 years ago at 4.25 percent interest. Today, she gave you the proceeds of that investment which totaled $51,480.79. How much did she originally invest? A. $15,929.47 B. $16,500.00 C. $17,444.86 D. $17,500.00 E. $17,999.45 F. None of the above.