FIN 4010 - Exam 2

All of the following can be a source of external funds for the firm, except: a) notes payable b) retained earnings c) long term debt d) equity

b) retained earnings

In the LFPT case the management is deciding whether...

to keep outsourcing the 10 and 12 inch pipes or start producing them in-house

What are the main disadvantages of the Payback Period criterion? I. Ignores time value of money II. Not valid evaluating irregular cash flows III. Biased against long-term projects IV. May have multiple solutions V. Difficult to communicate

1, 2, 3

What are the main disadvantages of the Payback Period criterion? 1. Ignores time value of money 2. Not valid evaluating irregular cash flows 3. Biased against long-term projects 4. May have multiple solutions 5. Difficult to communicate

1, 2, 3

What if equipment can be expensed right away instead of being depreciated, does that change the NPV? If so, how and why?

NPV increases if equipment can be expensed instead of depreciated. This happens because you realize the tax savings immediately at time 0, which has the highest present value

A firm's WACC of 12% means that 12% is the minimum rate of return that this firm must earn overall on its existing asset base to produce value for its creditors, owners, and other providers of capital. If the firm earns less than 12% on the overall portfolio of products/projects they will invest elsewhere. However, if it earns more than this, value is created. (T/F)

True

If COGS are expected to increase from 75% to 85% of sales the NPV of the project(s) will decrease. This will occur because we will have higher expenses associated with the project but the same revenue/sales, which will result in lower OCF and lower FCF in each year 2009-2013. (T/F)

True

Net Present Value (NPV) investment decision rule evaluates all of the project's cash flows (also referred to as free cash flows (FCF)) discounted to their present value at the appropriate discount rate. Managers accept projects if NPV > 0. (T/F)

True

The NPV of the project with the following cash flows cannot be positive if one uses positive discount rates: CF0 -$4400 CF1 $1100 CF2 $1100 CF3 $1100 CF4 $1100 (T/F)

True

The cost of capital (WACC) is lower for Firm B than for Firm A. This happens because a portion of Firm B is financed with debt (leverage), which is a cheaper source of financing than equity. Even though the cost of equity is higher for Firm B than for Firm A, since Firm B has debt (leverage), the overall cost of capital (WACC) is lower for Firm B because of debt financing. (T/F)

True

When computing a firm's Weighted Average Cost of Capital (WACC) we use an after-tax figure for the cost of debt because interest is tax deductible. We do not use an after-tax figure for the cost of equity because there is no difference between the pre-tax and after-tax equity costs, since dividends are paid from Net Income. (T/F)

True

You DO NOT include INTEREST (also called Financing Costs) in the Income Statement pro-forma statements used for Capital Budgeting as you need to find cash flows for an unlevered firm. (T/F)

True

Coca Cola is considering launching a new line of business - personal computer. Coca Cola's beta is 1.2, and Dell's beta is 1.9. Risk free rate is 3.5%, market return is 11%. What is the appropriate discount rate for this new project (assume the firms are financed only by equity)? a) 17.75% b) 11.75% c) 15.75% d) 12.5% e) 13.75%

a) 17.75%

Your firm, FedererTennisMarketing, follows the NPV decision rule. If you firm's WACC is 5% and Projects A and B are mutually exclusive, which project would you decide to undertake? a) Project A b) Project B

a) Project A

Firm A and firm B have identical assets and operation, but firm B has 30% more leverage in its capital structure. Firm A is an all equity firm with a beta of 1.5. The beta of firm B is _____________ than that of firm A, ___________________. Accordingly, the cost of equity (Re) of firm B is ____________________ than that of firm A. a) higher; since firm B is more levered ; higher b) lower; since firm B is more levered, lower c) lower; as firm B has higher variability in Earnings Per Share (EPS) and Return on Equity (ROE); higher d) the same; since they have identical assets and operation; the same

a) higher; since firm B is more levered; higher

Conflicts between two mutually exclusive projects with greatly differing cash flow timing where the NPV method chooses one project but the IRR method chooses the other: a) should generally be resolved in favor of the project with the higher NPV b) instead requires the use of payback period or other methods to makes a final decision c) results in both projects being rejected since no clear preference occurs d) should not happen if calculations are done accurately

a) should generally be resolved in favor of the project with the higher NPV

A piece of asset was bought at $300 three years ago. The depreciation follows a three-year MACRS and asset is depreciated to 0. This year it is sold for $50. The tax rate is 40%. The after-tax salvage value is $____ in Yr3. a) $19.9 b) $38.9 c) $50.0 d) $13.7 e) $30

b) $38.9

Firm A and firm B have identical assets and operation, but firm B has 30% more leverage in its capital structure. Accordingly, the weighted average cost of capital (WACC) for firm B will be __________ the WACC for firm A. a) higher than b) lower than c) the same as

b) lower than

Using a discount rate (required rate of return) of 10%, which is appropriate for projects of similar risk, you determined that the NPV of the project with a cash outflow of $5,000 in year 0, followed by positive cash flows of $1,000 in several of the subsequent years is around $335. The IRR of this project is: a) below 10% b) 10% c) above 10%

c) about 10%

If a firm used WACC as the discount rate for ALL (including projects involving different risk levels) projects that the firm undertakes, then the firm will tend to: a) reject some positive NPV projects b) accept some negative NPV projects c) favor high risk projects over low risk projects d) increase its overall level of risk over time

c) favor high risk projects over low risk projects

The beta of firm can change if there are changes in... a) firm's operating leverage b) firm's financial leverage c) firm's products d) all of the options listed

d) all of the options listed

In calculating weights in the WACC formula you would ideally use: a) book value of debt and equity b) yield-to-maturity (YTM) and Beta c) market value of debt but book value of equity d) market values of debt and equity

d) market values of debt and equity

What is the main purpose behind the LFPT case? a) whether or not the company will survive the 2008 recession b) to see if producing the 10 inch and 12 inch pipes is more profitable by producing them in-house for less than $0.32 per pipe c) figuring out how to address the "lost order" accounts d) to see if producing the 10 inch and 12 inch pipes is more profitable by producing them in-house for less than $0.45 per pipe

d) to see if producing the 10 inch and 12 inch pipes is more profitable by producing them in-house for less than $0.45 per pipe

What mistake did the firm's accountant, Don Carlione, make in determining the annual sales of 10-inch and 12-inch pipes? a) calculated the wrong percentages attributed to labor costs b) didn't take the weighted average of all annual sales estimates c) used the wrong unit cost for the projected annual sales d) took the space costs into consideration under incremental costs e) a, b, and d are correct

e) a, b, and d are correct

Your friend John, who is the CFO of ThatFirm, mentioned the following information: "You know, I had to choose between 3 different mutually exclusive projects today. All projects were of different risk, one with the highest cash flows was very risky, another had pretty typical level risk and the last one with smaller cash flows was quite safe. Once I calculated up the NPV, I decided to choose the __________ given that it had the highest NPV. Oh....you know I used the same rate to discount all cash flows." a) the project with the typical level of risk b) safest project c) all three projects if they have a positive NPV d) both the riskiest project and the project with the typical level of risk e) riskiest project

e) riskiest project

Circle all of the cash flows we DO NOT consider when evaluating Free Cash Flows (FCF) from a project for the purposes of Capital Budgeting. (Here you are asked to identify IRRELEVANT cash flows that we would not include in our Capital Budgeting analysis. What is the 1 question you need to ask yourself when evaluating whether the cash flow is relevant or not?) a) change in NWC b) opportunity costs at current market value c) cap expenditures related to the project, such as equipment purchases for the project d) depreciation tax shield e) operating cash flow f) taxes g) sunk costs h) depreciation (full) i) salvage value (full-before tax) j) salvage value (after tax) k) financing charges (interest) l) side effect to other projects m) opportunity costs at original value

g, h, i, k, m

All else equal, the more the firm has in INTERNAL funds, the less will be the firm's need for EXTERNAL funds. All of the following can help increase INTERNAL funds for the firm, except: a) increase in sales b) increase in assets, especially in net plant and equipment c) decrease in costs (COGS and operating expense) d) lower tax rates e) lower dividends and lower dividend payout ratios

increase in assets, especially in net plant and equipment