Fin test 2 t/f
3-part question. 1/3 Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financings (r(sub~d)). Statement: Company A has a higher return on assets (ROA) than Company B. T/F
F
4-Part Question: 4/5 The MacMillen 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? Statement: The company will take on too many high-risk projects and reject too many low-risk projects.
T
An important step in applying the corporate valuation model is forecasting the firm's pro forma financial statements. T/F
T
If a firm uses no debt, the uncertainty inherent in projections of future returns on equity can be described as business risk. T/F
T
The corporate valuation model can be used both for companies that pay dividends and those that do not pay dividends. T/F
T
3-part question. 2/3 Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financings (rd). Statement: Company A has a higher times interest earner (TIE) ratio than Company B. T/F
F
4-Part Question: 1/5 The MacMillen 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? Statement: The company's overall WACC should decrease over time because its stock price should be increasing. T/F
F
4-Part Question: 2/5 The MacMillen 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? Statement: The company will take on too many low-risk projects and reject too many high-risk projects. T/F
F
4-Part Question: 3/5 The MacMillen 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? Statement: Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
F
4-Part Question: 5/5 The MacMillen 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? Statement: The CEO's recommendation would maximize the firm's intrinsic value.
F
5-part question. 1/5 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 hae 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, is the statement correct? Statement: You should reject both projects because they will both have negative NPVs under the new conditions. T/F
F
5-part question. 1/5 Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 (today) followed by a series of positive cash flows. Statement: A project's MIRR is always greater than its regular IRR. T/F
F
5-part question. 1/5 Rowelll Copamny spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale for a new product. Rowell owns the building free and clear - there is no mortgage on it. Statement: Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project. T/F
F
5-part question. 2/5 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 hae 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, is the statement correct? Statement: 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. T/F
F
5-part question. 2/5 Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 (today) followed by a series of positive cash flows. Statement: A project's MIRR is always less than its regular IRR. T/F
F
5-part question. 3/5 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 hae 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, is the statement correct? Statement: You should recommend Project L, because at the new WACC, it will have the higher NPV. T/F
F
5-part question. 3/5 Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 (today) followed by a series of positive cash flows. Statement: If a project's IRR is greater than its WACC, then its MIRR will be greater than the IRR. T/F
F
5-part question. 3/5 Rowelll Copamny spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale for a new product. Rowell owns the building free and clear - there is no mortgage on it. Statement: This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. T/F
F
5-part question. 4/5 Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 (today) followed by a series of positive cash flows. Statement: To find a project's MIRR, the textbook procedure compounds cash inflows at the regular IRR and then finds the discount rate that causes the terminal, or future, value to equal initial cost. T/F
F
5-part question. 4/5 Rowelll Copamny spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale for a new product. Rowell owns the building free and clear - there is no mortgage on it. Statement: Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. T/F
F
5-part question. 5/5 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 hae 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, is the statement correct? Statement: You should recommend Project S, beacuse it has the higher IRR and will continue to have the higher IRR, even at the new WACC. T/F
F
5-part question. 5/5 Rowelll Copamny spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale for a new product. Rowell owns the building free and clear - there is no mortgage on it. Statement: If there were a mortgage on the building, then the interest on that loan would have to be charged to any new project that used the building. T/F
F
A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of its capital (its WACC). T/F
F
As a firm increases its operating leverage for a given quantity of output, this decreases its financial leverage. T/F
F
Assume a project has normal cash flows. Statement: A project's IRR increases as the WACC declines. T/F
F
Assume a project has normal cash flows. Statement: A project's MIRR is unaffected by changes in the WACC. T/F
F
Assume a project has normal cash flows. Statement: A project's regular payback increases as the WACC declines. T/F
F
Does the statement always increase a company's market value? T/F Increasing the expected growth rate of sales.
F
Financial leverage affects both EPS and EBIT, while operating leverage only affects EBIT. T/F
F
Firm A has a higher degree of business risk than Firm B. Firm A can offset this by using less financial leverage. Therefore, the variability of both firms' expected EBITs could actually be identical. T/F
F
For mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method. T/F
F
Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, but capital raised by selling new stock or bonds do have a cost. T/F
F
In general, firms should use their weighted aerage 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. T/F
F
Increasing a company's debt ratio will typically reduce the marginal cost of both dept and equity financing; however, it still may raise the company's WACC. T/F
F
Other things held constant, a change in the cost of capital will change a project's IRR. T/F
F
Should the factor be included in the cash flows used to estimate a project's NPV? -All cash expenditures associated with the project that were incurred prior to the time the analysis is being conducted. T/F
F
Should the factor be included in the cash flows used to estimate a project's NPV? -Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. T/F
F
Should the factor be included in the cash flows used to estimate a project's NPV? -Interest on funds borrowed to help finance the project. T/F
F
Suppose the debt ratio (D/TA) is 50%, the interest rate on new debt is 8%, the current cost of equity is 16%, and the tax rate is 40%. An increase in the debt ratio to 60% must decrease the weighted average cost of capital (WACC). T/F
F
Suppose you are the president of a small, publicly traded corporation. Since you believe that your firm's stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in the capital budgeting during the current year is the after-tax cost of debt. T/F
F
The corporate valuation model cannot be used for a company that doesn't pay dividends. T/F
F
The corporate valuation model discounts free cash flows by the required return on equity. T/F
F
The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt. T/F
F
The optimal capital structure is that which results in the highest earnings per share because that will ensure maximum stock price. T/F
F
Two firms, although they operate in different industries, have the same expected earnings per share and the same standard deviation of expected EPS. Thus, the two firms must have the same business risk. T/F
F
Value-based management metrics in Chapter 11 focus on sales growth, profitability, capital requirements, the weighted average cost of capital, and dividend growth. T/F
F
Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce the company's WACC. T/F
F Cassnote: No, at some point the cost goes back up
Since debt financing raises the firm's financial risk, raising a company's debt ratio will always increase the company's WACC. T/F
F Cassnote: No, in the beginning it will go down
3-part question. 3/3 Company A and Company B have the same total assets, operating income (EBIT), tax rate, and business risk. Company A, however, has a much higher debt ratio than Company B. Company A's basic earning power (BEP) exceeds its cost of debt financings (r(sub~d)). Statement: Company A has a higher return on equity (ROE) than Company B, and its risk, as measured by the standard deviation of ROE, is also higher than Company B's. T/F
T
5-part question. 2/5 Rowelll Copamny spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale for a new product. Rowell owns the building free and clear - there is no mortgage on it. Statement: If the building could not be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. T/F
T
5-part question. 4/5 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 hae 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, is the statement correct? Statement: You should recommend Project S, because at the new WACC, it will have the higher NPV. T/F
T
Assume a project has normal cash flows. Statement: A project's NPV increases as the WACC declines. T/F
T
Assuming a project has the same risk and financing as the firm, it will hae a positive NPV if that project's rate of return is greater than the firm's WACC. T/F
T
Assuming a project has the same risk and financing as the firm, it will have a positive NPV if that project's rate of return is greater than the firm's WACC. T/F
T
Does the statement always increase a company's market value? T/F Decreasing the capital requirements (Capital/Sales).
T
Does the statement always increase a company's market value? T/F Decreasing the weighted average cost of capital.
T
Does the statement always increase a company's market value? T/F Increasing the expected operating profitability (NOPAT/Sales).
T
Does the statement always increase a company's market value? T/F Increasing the expected rate of return on invested capital.
T
For most healthy firms, the yield to maturity (YTM) on their existing bonds is the coupon rate investors expect if the company sells a new issue of bonds. T/F
T
Free cash flows are assumed to grow at a constant rate beyond a specified date in order to find the horizon, or terminal, value. T/F
T
Free cash flows should be discounted at the weighted average cost of capital to find the value of a company's operations. T/F
T
If a firm is privately owned, and its stock is not traded in public markets, then we cannot measure its beta for use in the CAPM model, we cannot observe its stock price for use in the DCF model, and we don't know what the risk premium is for use in the bond-yield-plus-risk-premium method. All this makes it especially difficult to estimate the cost of equity for a private company. T/F
T
If a firm utilizes debt financing, a decrease in earnings before interest and taxes (EBIT) will result in a more than proportionate decrease in earnings per share. T/F
T
Should the factor be included in the cash flows used to estimate a project's NPV? -The end-of-project recovery of any working capital required to operate the project. T/F
T
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. T/F
T
The NPV, IRR, and MIRR 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. T/F
T
The corporate valuation model can be used to find the value of a division. T/F
T
The cost of debt, rd, is normally less tha the cost of equity, rs, so rd(1 - T) will normally be much less than the cost of equity. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T) AND the cost of equity will be higher than the weighted average cost of capital, rc. T/F
T
The cost of equity raised by retaining earnings, r(sub~s), can be less than, equal to, but never greater than the cost of equity raised by issuing new common stock, r(sub~e), depending on tax rates, flotation costs, the attitude of investors, and other factors. T/F
T
The degree of operating leverage changes with sales such that as sales rise above the break-even point, the degree of operating leverage, DOL, will decline. In fact, the degree of operating leverage is most positive (or negative) just above (or below) the firm's break-even point. T/F
T
The firm's business AND financial risk may have both systematic (non-diversifiable or market) risk and diversifiable risk components. T/F
T
The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firms common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle. T/F
T
The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC. T/F
T
When evaluating a single capital budgeting project, the Net Present Value method and the Internal Rat eof Return method will ALWAYS lead to the same accept/reject decision if the project has normal cash flows, that is, the project has one outflow followed by a series of inflows. However, with two mutually exclusive projects, conflicts between the decision criteria, NPV and IRR, can occur. That is, occasionally, the NPV method may rank one project higher but the IRR method might put the other one first. Such conflicts should be resolved in favor of the project with the higher NPV. T/F
T
When using the WACC as the required rate of return, it should be adjusted upward for riskier projects and downward for safer projects. T/F
T
5-part question. 5/5 Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 (today) followed by a series of positive cash flows. Statement: To find a project's MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the terminal, or future, value to equal the initial cost. T/F
T Added Cass notes: WACC = Weighted Average Cost of Capital - the rate that a company is expected to pay on avg to all its security holders to finance its assets. "Firm's cost of capital" (Listed WACC formula)