Exam 3
In order to calculate a project's NPV, you need to know the appropriate discount rate, the amount of the initial outlay, and:
the amount and timing of the expected cash flows
The discounted payback period method takes __________ into consideration.
time value of money
The pure play method of assigning project-based betas involves:
using the beta of a firm in a similar line of business.
A firm's __________ refers to the mix of debt and equity used for financing its assets and operations.
capital structure
MIRR is used when:
cash flows of a project change sign
A firm is evaluating an investment proposal, which has an initial investment of $8,000 and discounted cash flows valued at $6,000. The net present value of this investment is:
-$2,000
A firm must choose from 5 capital budgeting proposals outlined below. The firm is subject to capital rationing and has a capital budget of $500,000. The firm's cost of capital is 12%. Using the internal rate of return approach to ranking projects, which projects should the firm accept?
1,2,3,5
Assume that you expect to sell a stock for $50 in two years and your required return is 8%. If the stock is currently selling for $41, what is its NPV?
1.87
To compute the after-tax cost of debt you need to multiply the cost of debt by:
a factor equal to one minus the marginal tax rate, or (1 - marginal tax rate).
Jenna is considering an investment which has a price of $16,000. She expects to receive $3,000 for eight years. What is the investment's internal rate of return?
10%
Assume you have two projects with different lives. Project A is expected to generate present value cash flows of $5.2 million and will last 7 years. Project B is expected to generate present value cash flows of $3.8 million and will last 5 years. Given a required return of 9%, Project A has an equivalent annual annuity of __________ which is __________ than Project B.
$1.03319 million, better
Cogswell Cola purchased a machine for $237,500. The firm paid another $5,750 for delivery and installation. In addition the firm will have to hire another employee and pay them $50,000 per year to run the machine. What is the initial outlay for this machine?
$237,500 + $5,750 = $243,250.
A firm has undertaken a project with an initial investment of $100,000. The firm's cost of capital is 14% What is the NPV for this project?
$54,623
What is the NPV of a project expected to generate $1,000 a year for 5 years assuming a discount rate of 10% and an initial outlay of $3,250?
$540.79
Firm XYZ is evaluating whether to introduce a new energy drink. The marketing research department estimates sales will be around $10 million per year for the next 6 years. However, the product is also expected to erode sales of the firm's current product line by about $1 million per year. What are the relevant annual sales figures that should be used to evaluate this new product?
$9 million
A firm has determined its cost of each source of capital and its optimal capital structure which is comprised of the following sources; Long-term debt = 45%, after-tax cost = 7% Preferred stock = 15%, after-tax cost = 10% Common stock equity = 40%, after-tax cost = 14% The weighted average cost of capital for this firm is;
10.25%
The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the CAPM, what is the company's cost of equity?
10.5%
A firm has a beta of 0.90. If market returns are 12% and the risk-free rate is 4%, the estimated cost of equity is __________.
11.2%.
The concept of synergy can be whimsically expressed by:
2 + 2 = 5
What is the discounted payback of a project that has an initial outlay of $20,000 and will generate $6,000 in year 1, $12,000 in year 2, $9,000 in year 3, and $14,000 in year 4 assuming the cost of capital is 10%?
2.68 years
A firm is evaluating a proposal which has an initial investment of $45,000 and has cash flows of $5,000 in year 1, $20,000 in year 2, $15,000 in year 3, and $10,000 in year 4. The payback period of the project is:
3.5 years
The debt issued by Coastal Construction has a coupon rate of 5% and a yield to maturity of 6.2%. The company is in the 25% tax bracket. Coastal Construction's effective cost of debt is:
4.65
The stock of Canadian Ski Wear is currently trading at $45 a share and the equity beta of the company is estimated to be 1.3. The company is expected to pay a dividend of $1.50 a share next year, and this dividend is expected to grow at a rate of 4% per year. The rate on the 10-year U.S. Treasury bond is 4% and you estimate the market risk premium to be 5%. Using the dividend growth model, what is the company's cost of equity?
7.3%
Corona Publishing has debt outstanding with a market value of $10 million. The company's common stock has a book value of $20 million and a market value of $30 million. What weight for equity should Corona use in its WACC calculation?
75%
A firm has issued 8% preferred stock, which sold for $100 per share par value. The flotation costs of the stock equaled $3 and the firm's marginal tax rate is 40%. The cost of the preferred stock is;
8.25%
The approximate before-tax cost of debt for a 20-year, 9%, $1,000 par value bond selling for $950 is __________.
9.57%
Which of these cash flows should be included as an incremental cash flow when you evaluate a project?
Capital expenditures necessary to fund the new project.
__________ are the actual outflow or inflow of money while __________ are an accounting measure of performance.
Cash flows; profits
Which of the following inputs is needed when you use the constant dividend growth model (CDGM) to estimate the cost of equity?
Current stock price
Giancarlo has received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 What would be Giancarlo's operating cash flow in year 5?
Giancarlo has received an inheritance from his rich uncle and is contemplating the purchase of a Suzuki XL7. In an attempt to make a rational decision, Giancarlo has identified the following cash flow estimates: Negotiated price of new Suzuki XL 7 $24,675 Taxes and fees on a new car purchase $1,732 Proceeds from the trade-in of old car $9,285 Estimated value of the Suzuki XL7 in 5 years $7,285 Estimated value of old car in 5 years $3,572 Estimated annual repair cost on Suzuki XL7 $350 Estimated annual repair cost on old car $925 Giancarlo's initial investment in the Suzuki XL7 will be $17,122. To arrive at this number you have to include the total out-of-pocket costs for the car and deduct any trade-in value so you can evaluate only incremental cash flows. So, the initial investment = $24,675 + $1,732 - $9,285 = $17,122. If Giancarlo decides to buy this car this will be the amount he will need to complete the transaction. $17,122
Which of the following is a relevant opportunity cost that should be considered an incremental cash flow?
Lost facility rental income
Which of the following decision rules is always correct because it is directly tied to the goal of maximizing shareholder wealth?
NPV rule
Chris has been offered the chance to invest $120,000 in a partnership, which is expected to return $25,000 per year. If Chris is in the 30% tax bracket and limits investments to those with a payback of six years, should Chris invest?
No, because the payback period is 6.86 years.
Which of the following is an example of a sunk cost?
Overhead assigned to the project from the corporate office.
Which of these items should NOT be counted as a relevant cash flow for project evaluation?
Overhead assigned to the project from the corporate office.
James is considering starting a new business based on the results of some market research he paid a firm $45,000 to conduct. What type of cost is the $45,000?
Sunk Cost
The cost of common stock equity may be estimated by using the __________.
The cost of common stock equity may be estimated by using the CAPM. The capital asset pricing model is one of the methods you can use to compute the cost of equity based on the risk of the firm. Both the NPV and the IRR are capital budgeting project evaluation tools and are not related to any method of computing the cost of
Which of the following should be used as the firm's cost of debt?
The yield to maturity of the existing debt outstanding.
Bartleman Industries is raising $5 million through the sale of $100 par value preferred stock that pays a 5% dividend. If flotation costs are $2 a share how much is the percentage cost of the preferred stock
To compute the cost you divide the dividend by the net price received for the preferred.issue pays a dividend equal to 5% of the par value which is a $5 dividend. The cost is therefore $5/($100 - $2 flotation cost) or $5/$98 = .051 or 5.1%.
The appropriate discount rate to use when evaluating capital budgeting projects using NPV is the:
WACC
ABC Energy company leased the mineral rights to drill for oil and gas on 10,000 acres for $500,000. Now the firm is trying to determine whether the cost to drill the well is justified given the poor results on nearby acreage. For financial decision-making, the $500,000 should be:
considered a sunk cost and ignored.
An NPV profile is __________.
a graph of a project's NPV over a range of different discount rates
When using the net present value (NPV) to evaluate capital budgeting projects, you should:
accept all projects with a positive NPV
We only want to consider incremental earnings in the capital budgeting process. Incremental earnings are the:
additional sales and costs associated with the project.
The specific cost of each source of long-term financing is based on __________ costs.
after-tax and current
An incremental cash flow valuation considers:
all project cash flows including cannibalization.
Depreciating a capital asset by a fixed amount over its useful life is known as:
straight-line depreciation.
The __________ is the rate of return a firm must earn on its investment in order to maintain the market value of its stock.
cost of capital
The WACC represents the average __________ for the firm.
cost of financing
The cost of an asset carried on the balance sheet is known as:
book value
One method that can be used to evaluate capital budgeting projects with different lives is to convert the project's cash flows to a level annual cash flow that has the same present value as the project's overall cash flows. This annual cash flow is known as the:
equivalent annual annuity
Capital budgeting is the process of:
evaluating a firm's investment choices.
Cogswell Cola expanded its product line by about 20%. However, the firm's management failed to consider it would need additional investments in inventory and accounts receivable. This oversight is an example of:
failing to consider changes in working capital.
To use the CAPM to estimate the cost of equity you need to know the:
firm's beta.
Unlike the IRR criteria, the NPV approach assumes an interest rate equal to the:
firm's cost of capital
If a firm sells a capital asset for $45,000 that has a book value of $50,000 the firm:
has a tax loss of $5,000
When resources are limited you should select the projects with the:
highest NPV
A firm's minimum required return on a capital budgeting project is known as the:
hurdle rate.
Since preferred stock dividends are fixed in the same manner of a coupon bond's interest payment it is referred to as:
hybrid equity.
When a business undertakes a new project it will often need to invest additional funds in net working capital to cover items such as:
increased inventory levels.
The relevant cash flows of a project are best described as:
incremental cash flows
Projects that do not compete with one another so that the acceptance of one project will have no bearing on the acceptance of other projects being considered by the firm are known as:
independent projects
For financial decision-making in capital budgeting we remove __________ as a relevant cash flow since the financing and investing components are two separate decisions.
interest expense
The effective cost of debt is:
less than the return paid to debt holders due to tax benefits of interest paid
A tax adjustment must be made in determining the cost of:
long-term debt
The IRR can lead to incorrect project rankings because projects with much higher NPVs may also have:
longer project lives
If a fully depreciated asset is sold for $10,000 the firm:
must pay tax on the $10,000.
As you increase the required return used in an NPV calculation, the likelihood of a __________ NPV __________.
negative - increases
The sale of an ordinary asset for its book value results in:
no tax benefit.
The profitability index is a ratio of the:
present value of benefits to the present value of costs.
One way to adjust for projects with different levels of risk is to compute the NPV using a WACC computed with a:
project-specific beta.