Review

Simms Corp. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC or negative, and in both cases it will be rejected. 12.55% 14.56% 15.29% 13.21% 13.87%

13.21

If a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT? A) The NPVs of relatively risky projects should be found using relatively low WACCs. B) If a project's NPV is greater than zero, then its IRR must be less than zero. C) If a project's NPV is greater than zero, then its IRR must be less than the WACC. D) A project's NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV. E) The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

E)

International Advertising Services has two projects that are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and Project B's IRR is 20%. International's WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is CORRECT? A) Assuming the timing pattern of the two projects' cash flows is the same, Project B probably has a higher cost (and larger scale). B) As Project B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%. C) The crossover rate for the two projects must be 12%. D) The crossover rate for the two projects must be less than 12%. E) Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

E)

Which of the following statements about IRR and NPV is CORRECT? A) The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. B) The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. C) The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. D) The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. E) The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

E)

According to the signaling theory of capital structure, the use of debt financing signals to investors that the firm's managers think that the future does not look good, otherwise the managers would be able to raise equity on reasonable terms and would not need to turn to debt. True False

False

The NPV and MIRR methods lead to the same decision for mutually exclusive projects regardless of the projects' relative sizes. True False

False

Among the conditions that may cause a project to have more than one IRR, one might be the situation in which a negative cash flow (or cost) occurs at the end of the project's life in addition to the initial investment at time = 0. True False

True

Which of the following sequences is CORRECT for a typical firm? All rates are after taxes, and assume that the firm operates at its target capital structure. WACC > rd > rs > re. rs > re > rd > WACC. rd > re > rs > WACC. WACC > re > rs > rd. re > rs > WACC > rd.

re > rs > WACC > rd.

Hairston Industries has $5 million of debt and $20 million of equity. If Hairston's beta is currently 1.75 and its tax rate is 40%, what is its unlevered beta, bU? 1.2525 2.0125 1.0000 0.7564 1.5217

1.5217

What is the payback period for Project S given the following? Both projects have a cost of capital of 10%. 1.6 years 2.5 years 2.8 years 1.8 years 2.1 years

1.6

Sunrise Canoes Inc. has determined that its optimal capital structure consists of 55% equity and 45% debt. Sunrise must raise additional capital to fund its upcoming expansion. The firm has $0.5 million in retained earnings that has a cost of 11%. Its investment bankers have informed the company that it can issue an additional $3 million of new common equity at a cost of 14%. Furthermore, the firm can raise up to $1.5 million of debt at 10% (before taxes) and an additional $2 million of debt at 12% (before taxes). The firm has estimated that the proposed expansion will require an investment of $2.6 million. The firm's tax rate is 40%. What is the WACC for the funds Sunrise will be raising? 10.00% 11.50% 11.20% 10.75% 10.40%

10.40%

Assume that you are a consultant to Broske Inc., and you have been provided with the following data: D1 = $0.67; P0 = $27.50; and g = 8.00% (constant). What is the cost of equity from retained earnings based on the DCF approach? rs=D1/Po+g 10.96% 11.51% 10.44% 9.91% 9.42%

10.44%

Two firms operate in different industries, but they have the same expected EPS and the same standard deviation of expected EPS. Thus, the two firms must have the same financial risk. True False

False

To find the cost of perpetual preferred stock, divide the preferred's annual dividend by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. True False

True

Two firms could have identical financial and operating leverage yet have different degrees of business risk. True False

True

Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. $250.15 $336.31 $369.94 $277.94 $305.73

$277.94

Last month, Lloyd's Systems analyzed the project whose cash flows are shown below. However, before the decision to accept or reject the project, the Federal Reserve took actions that changed interest rates and therefore the firm's WACC. The Fed's action did not affect the forecasted cash flows. By how much did the change in the WACC affect the project's forecasted NPV? Note that a project's projected NPV can be negative, in which case it should be rejected. −$18.89 −$22.03 −$23.13 −$19.88 −$20.93

-22.03

Eakins Inc.'s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? 0.56% 0.84% 0.37% 0.19% 0.09%

0.37%

Refer to Exhibit 11-2. What is Project L's IRR? 18.1% 23.6% 24.2% 19.7% 21.4%

18.1

The Hampton Hardware Company is trying to estimate its optimal capital structure. Hampton's current capital structure consists of 20% debt and 80% equity; however, management believes the firm should use more debt. The risk-free rate, rRF, is 7%, the market risk premium is 5%, and the firm's tax rate is 35%. Currently, Hampton's cost of equity is 16%, which is determined on the basis of the CAPM. What would be Hampton's estimated cost of equity if it were to change its capital structure from its present capital structure to 40% debt and 60% equity? 18.10% 20.33% 15.45% 14.93% 19.25%

18.10%

What is Project L's NPV given the following? Exhibit 11-2 Both projects have a cost of capital of 10%. $50.00 $18.78 $10.06 $34.25 $22.64

18.78

Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? 1.88 years 2.52 years 2.78 years 2.09 years 2.29 years

2.09

Mansi Inc. is considering a project that has the following cash flow data. What is the project's payback? 1.91 years 2.59 years 2.85 years 2.12 years 2.36 years

2.36

What is the payback period for Machine B given the following? 1.0 year 2.6 years 3.0 years 2.0 years 2.4 years

2.4

Maxwell Feed & Seed is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected. 2.08% 2.82% 3.10% 2.31% 2.57%

2.57

Brown Products is a new firm just starting operations. The firm will produce backpacks that will sell for $22.00 each. Fixed costs are $500,000 per year, and variable costs are $2.00 per unit of production. The company expects to sell 50,000 backpacks per year, and its effective federal-plus-state tax rate is 40%. Brown needs $2 million to build facilities, obtain working capital, and start operations. If Brown borrows part of the money, the interest charges will depend on the amount borrowed as follows: Assume that stock can be sold at a price of $20 per share on the initial offering regardless of how much debt the company uses. Then after the company begins operating, its price will be determined as a multiple of its earnings per share. The multiple (or the P/E ratio) will depend upon the capital structure as follows: What is Brown's optimal capital structure, which maximizes stock price, as measured by the debt/capital ratio? The firm will use only debt and common equity in its capital structure. 30% 50% 20% 10% 40%

20%

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? $188.68 $219.52 $230.49 $198.61 $209.07

209.07

Your firm is considering a fast-food concession at the World's Fair. The cash flow pattern is somewhat unusual because you must build the stands, operate them for 2 years, and then tear the stands down and restore the site to its original condition. You estimate the cash flows to be as follows: What is the approximate IRR of this venture? 5% 35% 45% 15% 25%

25%

Stern Associates is considering a project that has the following cash flow data. What is the project's payback? 2.31 years 3.16 years 3.52 years 2.56 years 2.85 years

3.52

Assume that you and your brother plan to open a business that will make and sell a newly designed type of sandal. Two robotic machines are available to make the sandals, Machine A and Machine B. The price per pair will be $20.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. What is the difference between the break-even points for Machines A and B? (Hint: Find BEB − BEA) 3,894 4,760 3,505 3,154 4,327

4327

To help finance a major expansion, Castro Chemical Company sold a noncallable bond several years ago that now has 20 years to maturity. This bond has a 9.25% annual coupon, paid semiannually, sells at a price of $1,075, and has a par value of $1,000. If the firm's tax rate is 40%, what is the component cost of debt for use in the WACC calculation? 5.08% 5.33% 4.83% 4.58% 4.35%

5.08%

Backroads Sporting Goods is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred stock in its capital structure, and it does not plan to do so in the future. To estimate how much its debt would cost at different debt levels, the company's treasury staff has consulted with investment bankers and, on the basis of those discussions, has created the following table: Backroads uses the CAPM to estimate its cost of common equity, rs. The company estimates that the risk-free rate is 6%, the market risk premium is 5%, and its tax rate is 40%. Backroads estimates that if it had no debt, its "unlevered" beta, bU, would be 1.25. On the basis of this information, what would be the WACC at the optimal capital structure? 11.13% 12.25% 10.48% 9.56% 11.45%

11.13

O'Brien Inc. has the following data: rRF = 5.00%; RPM = 6.00%; and b = 1.05. What is the firm's cost of equity from retained earnings based on the CAPM? 12.35% 12.72% 11.99% 11.64% 11.30%

11.30%

You were recently hired by Scheuer Media Inc. to estimate its cost of capital. You obtained the following data: D1 = $1.75; P0 = $42.50; g = 7.00% (constant); and F = 5.00%. What is the cost of equity raised by selling new common stock? 12.50% 13.12% 11.90% 11.33% 10.77%

11.33%

Hodor Manufacturing Co.'s (HMC) common stock currently sells for $50.00 per share. Assume the stock is in a state of constant growth, has an expected dividend yield of 4.5%, and an expected capital gains yield of 6.5%. The current dividend payout ratio is 30% and the firm's return on equity is 9.3%. The firm requires external funds for a new project and anticipates issuing additional shares of common stock at its current price of $50.00. However, the process of issuing this new equity is expected to result in a flotation expense equivalent to 10% of the stock price. If the firm goes ahead with its equity issue, what will be the firm's cost for this new common stock, re? 12.00% 13.25% 9.65% 11.50% 10.75%

11.50%

A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown below: The company's cost of capital is 9%, and it can get an unlimited amount of capital at that cost. What is the regular IRR (not MIRR) of the better project? (Hint: Note that the better project may or may not be the one with the higher IRR.) 11.45% 13.49% 12.67% 11.74% 13.02%

11.74

Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was $2.40, its expected constant growth rate is 5%, and its stock sells for $24. SPC's tax rate is 40%. Four projects are available: Project A has a cost of $240 million and a rate of return of 13%, Project B has a cost of $125 million and a rate of return of 12%, Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%. All of the company's potential projects are independent and equally risky. What is SPC's WACC? In other words, what WACC should it use to evaluate capital budgeting projects (these four projects plus any others that might arise during the year, provided the WACC remains constant)? 12.50% 10.61% 11.77% 13.40% 12.05%

11.77

A. Butcher Timber Company hired your consulting firm to help them estimate the cost of equity. The yield on the firm's bonds is 8.75%, and your firm's economists believe that the cost of equity can be estimated using a risk premium of 3.85% over a firm's own cost of debt. What is an estimate of the firm's cost of equity from retained earnings? rs=rd+RP 14.17% 14.74% 13.63% 13.10% 12.60%

12.60%

Your company is considering two mutually exclusive projects, X and Y, whose costs and cash flows are shown below: The projects are equally risky, and their cost of capital is 10%. You must make a recommendation, and you must base it on the modified IRR. What is the MIRR of the better project? 11.50% 12.50% 13.10% 12.00% 11.70%

13.10

Weaver Chocolate Co. expects to earn $3.50 per share during the current year, its expected dividend payout ratio is 65%, its expected constant dividend growth rate is 6.0%, and its common stock currently sells for $32.50 per share. New stock can be sold to the public at the current price, but a flotation cost of 5% would be incurred. What would be the cost of equity from new common stock? re=[D1/Po(1-F)]+g 14.74% 15.48% 14.04% 13.37% 12.70%

13.75%

Roland Corporation's next expected dividend (D1) is $2.50. The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm's beta coefficient is 1.2. The estimated market risk premium is 6%, and the risk-free rate is 7%. Roland's A-rated bonds are yielding 10%, and its current stock price is $30. Which of the following values is the most reasonable estimate of Roland's cost of retained earnings, rs? 20% 26% 14% 12% 10%

14%

Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $12,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sales price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)? 15,400 18,634 14,000 12,600 16,940

14000

You are evaluating a project that is expected to produce cash flows of $5,000 each year for the next 10 years and $7,000 each year for the following 10 years. The IRR of this 20-year project is 12%. If the firm's WACC is 8%, what is the project's NPV? $10,989.95 $15,100.50 $16,000.00 $12,276.33 $14,321.21

14321.21

Refer to Exhibit 11-2. What is Project L's MIRR? 15.3% 17.1% 17.4% 16.5% 16.9%

16.5

Refer to Exhibit 11-2. What is Project S's MIRR? 15.3% 17.1% 17.4% 16.5% 16.9%

16.9

Tapley Dental Supplies Inc. is in a stable, no-growth situation. Its $1,000,000 of debt consists of perpetuities that have a 10% coupon and sell at par. Tapley's EBIT is $500,000, its cost of equity is 15%, it has 100,000 shares outstanding, all earnings are paid out as dividends, and its federal-plus-state tax rate is 40%. Tapley could borrow an additional $500,000 at an interest rate of 13% without having to retire the original debt, and it would use the proceeds to repurchase stock at the current price, not at the new equilibrium price. The increased risk from the additional leverage will raise the cost of equity to 17%. If Tapley does recapitalize, what will be the new stock price? $16.50 $16.75 $16.00 $17.20 $17.00

17.20

The stock is currently selling for $15.25 per share, and its noncallable $1,000 par value, 20-year, 7.25% bonds with semiannual payments are selling for $875.00. The beta is 1.25, the yield on a 6-month Treasury bill is 3.50%, and the yield on a 20-year Treasury bond is 5.50%. The required return on the stock market is 11.50%, but the market has had an average annual return of 14.50% during the past 5 years. The firm's tax rate is 40%. 5.40% 5.67% 5.14% 4.88% 4.64%

5.14%

A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $750,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the break-even formula, but include the required profit in the numerator.) 5,000 5,513 4,750 4,513 5,250

5000

The Fisher Company will produce 50,000 10-gallon aquariums next year. Variable costs will equal 40% of dollar sales, while fixed costs total $100,000. At what price must each aquarium be sold for the firm's EBIT to be $90,000? $5.50 $6.33 $5.33 $5.00 $6.00

6.33

Helena's Candies Co. (HCC) has a target capital structure of 55% equity and 45% debt to fund its $5 billion in capital. Furthermore, HCC has a WACC of 12.0%. Its before-tax cost of debt is 9%; and its tax rate is 40%. The company's retained earnings are adequate to fund the common equity portion of the capital budget. The firm's expected dividend next year (D1) is $4 and the current stock price is $40. What is the company's expected growth rate? 6.30% 7.40% 5.75% 5.25% 4.50%

7.40%

Moerdyk & Co. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under certain conditions, choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, i.e., no conflict will exist. $5.47 $7.29 $7.82 $6.02 $6.62

7.82

Bosio Inc.'s perpetual preferred stock sells for $97.50 per share, and it pays an $8.50 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 4.00% of the price paid by investors. What is the company's cost of preferred stock for use in calculating the WACC? 9.82% 10.22% 9.44% 9.08% 8.72%

9.08%

Currently, Pam's Petals Inc. (PPI) has a capital structure consisting of 30% debt and 70% equity. PPI's debt currently has a 7% yield to maturity. The risk-free rate (rRF) is 5.5% and the market risk premium (RPM) is 5%. Using the CAPM, PPI estimates that its cost of equity is currently 11.75%. The company has a 35% tax rate. PPI's financial staff is considering changing its capital structure to 45% debt and 55% equity. If the company went ahead with the proposed change, the yield to maturity on the company's bonds would rise to 8.75%. The proposed change will have no effect on the company's tax rate. What would be the company's new WACC if it adopted the proposed change in capital structure? 9.70% 9.33% 11.20% 8.76% 10.10%

9.70%

Assume that All-American Sporting Goods correctly estimates its WACC at a given point in time and then uses that same cost of capital to evaluate all projects for the next 10 years. The firm will most likely: A) Become more risky and also have an increasing WACC. Its intrinsic value will not be maximized. B) Continue as before because there is no reason to expect its risk position or value to change over time as a result of its use of a single cost of capital. C) Become riskier over time, but its intrinsic value will be maximized. D) Become less risky over time, and this will maximize its intrinsic value. E) Accept too many low-risk projects and too few high-risk projects.

A)

Assuming that a project being considered has normal cash flows, with one outflow followed by a series of inflows, which of the following statements is CORRECT? A) If a project has normal cash flows and its IRR exceeds its WACC, then the project's NPV must be positive. B) The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. C) The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. D) If Project A has a higher IRR than Project B, then Project A must have the lower NPV. E) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

A)

The chief financial officer of Panther Products, which is an all-equity firm with a beta of 2.0, is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm's average project in terms of both its beta risk and its total risk. Which of the following statements is CORRECT? A) The accept/reject decision depends on the firm's risk-adjustment policy. If Panther's policy is to increase the required return on a riskier-than-average project to 3% over rS, then it should reject the project. B) Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision. C) The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return. D) The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return. E) Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.

A)

Red Bird Manufacturing would like to avoid issuing new stock because new stock has a higher cost than retained earnings, but the company forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Which of the following actions would REDUCE its need to issue new common stock? A) Increase the proposed capital budget. B) Reduce the amount of short-term bank debt in order to increase the current ratio. C) Increase the percentage of debt in the target capital structure. D) Increase the dividend payout ratio for the upcoming year. E) Reduce the percentage of debt in the target capital structure.

C)

Which of the following statements about debt ratios CORRECT? A) Wide variations in capital structures exist both between industries and among individual firms within given industries. These differences are caused by differing business risks and also managerial attitudes. B) Generally, debt ratios do not vary much among different industries, although they do vary among firms within a given industry. C) Airline companies tend to have very volatile earnings, and as a result they generally have high target debt-to-equity ratios. D) Gas and electric utilities companies generally have very high common equity ratios because their revenues are more volatile than those of firms in most other industries. E) Since most stocks sell at or very close to their book values, book value capital structures are typically adequate for use in estimating firms' weighted average costs of capital.

A)

Which of the following should NOT be included when calculating the weighted average cost of capital (WACC) for use in capital budgeting? Common stock. Long-term debt. Preferred stock. Accounts payable. Retained earnings.

Accounts payable.

The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm's target capital structure calls for a debt/equity ratio of 0.8. See-Saw currently has a bond issue outstanding that will mature in 25 years and has a 7% annual coupon rate. The bonds are currently selling for $804. The firm has maintained a constant growth rate of 6%. See-Saw's next expected dividend is $2 (D1), its current stock price is $40, and its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.) A) Yes; the expected return is 1.0 percentage point higher than the cost of capital. B) Yes; the expected return is 2.5 percentage points higher than the cost of capital. C) Yes; the expected return is 0.5 percentage point higher than the cost of capital. D) No; the expected return is 1.0 percentage point lower than the cost of capital. E) No; the expected return is 2.5 percentage points lower than the cost of capital.

B)

Which of the following statements is correct? A) For independent (as opposed to mutually exclusive) normal projects, the NPV and IRR methods will generally lead to conflicting accept/reject decisions. B) If a project has an NPV greater than zero, then taking on the project will increase the value of the firm's stock. C) Assume that you plot the NPV profiles of two mutually exclusive projects with normal cash flows and that the cost of capital is greater than the rate at which the profiles cross one another. In this case, the NPV and IRR methods will lead to contradictory rankings of the two projects. D) If a project has an IRR greater than zero, then taking on the project will increase the value of the company's common stock because the project will make a positive contribution to net income. E) All of the above statements are true.

B)

A decrease in the debt ratio will normally have no effect on Business risk. Firm-unique risk. Total risk. Financial risk. Systematic risk.

Business risk

Global Goodness Foods has two divisions of equal size: a snack food division and a beverage division. The company's CFO believes that stand-alone snack food companies typically have a WACC of 8%, while stand-alone beverage producers typically have a 12% WACC. He also believes that the snack food and beverage divisions have the same risk as their typical peers; consequently, the CFO estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the snack food division and a 12% hurdle rate for the beverage division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT? A) While the decision to use just one WACC will result in its accepting more projects in the beverage division and fewer projects in its snack food division than if it followed the consultant's recommendation, this should not affect the firm's intrinsic value. B) The decision not to risk adjust means that the company will accept too many projects in the beverage business and too few projects in the snack food business. This may affect the firm's capital structure but it will not affect its intrinsic value. C) The decision not to adjust for risk means that the company will accept too many projects in the beverage division and too few in the snack food division. This will lead to a reduction in the firm's intrinsic value over time. D) The decision not to risk-adjust means that the company will accept too many projects in the snack food business and too few projects in the beverage business. This will lead to a reduction in its intrinsic value over time. E)The decision not to adjust for risk means, in effect, that it is favoring the snack food division. Therefore, that division is likely to become a larger part of the consolidated company over time.

C)

Merton Miller, working independently without Franco Modigliani, developed a theory that stated that, other things held constant: A) Financial distress and agency costs reduce the value of using corporate debt. B) Debt costs increase with financial leverage. C) Personal taxes lower the value of using corporate debt. D) Personal taxes increase the value of using corporate debt. E) Personal taxes have no effect on the value of using corporate debt.

C)

Which of the following statements about IRR and WACC is CORRECT? A) Two projects are likely to have multiple IRRs if they are mutually exclusive. B) If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon. C) For a project to have more than one IRR, then both IRRs must be greater than the WACC. D) A project cannot have multiple IRRs if it is independent. E) Multiple IRRs can only occur if the signs of the cash flows change more than once.

E)

A project is described as having normal cash flows, meaning one outflow followed by a series of inflows. Which of the following statements about normal cash flows is CORRECT? A) A project's regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC. B) If a project's IRR is greater than the WACC, then its NPV must be negative. C) To find a project's IRR, we must find a discount rate that is equal to the WACC. D) To find a project's IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project's costs. E) A project's regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.

D)

Akita Development, which has an overall WACC of 12%, has equal amounts of low-risk, average-risk, and high-risk projects. 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. What is likely to happen over time if the CEO's position is accepted? A) The company's overall WACC should decrease over time because its stock price should be increasing. B) The CEO's recommendation would maximize the firm's intrinsic value. C) The company will take on too many low-risk projects and reject too many high-risk projects. D) The company will take on too many high-risk projects and reject too many low-risk projects. E) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.

D)

All else being equal, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure? A) The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. B) The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. C) Management believes that the firm's stock is currently overvalued. D) The corporate tax rate is increased. E) Its sales are projected to become less stable in the future.

D)

If the cost of capital for both projects in the table below is 14%, which project would you choose? A) Neither; both have negative NPVs. B) Project O; it has the higher positive NPV. C) Either; both have the same NPV. D) Project B; it has the higher positive NPV.

D)

Modern Fashions, Inc. and New York Accessories Co. are identical in size and capital structure. However, Modern Fashions has a WACC of 10% and New York Accessories a WACC of 12%, because the riskiness of their assets and cash flows somewhat different. New York Accessories is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical New York Accessories project. Modern Fashions is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Modern Fashions project. Now assume that the two companies merge and form a new company, New York Modern, Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT? A) If evaluated using the correct post-merger WACC, Project X would have a negative NPV. B) New York Modern's WACC, as a result of the merger, would be 10%. C) After the merger, New York Modern should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%. D) After the merger, New York Modern would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. E) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.

E)

Mountaineer Manufacturing is considering two normal, equally risky, mutually exclusive, but not repeatable projects. The two projects have the same investment costs, but Project A has an IRR of 15%, while Project B has an IRR of 20%. Mountaineer has a WACC of 10%. Assuming the projects' NPV profiles cross in the upper right quadrant, which of the following statements is CORRECT? A) Only one project has a positive NPV. B) Each project must have a negative NPV. C) If the crossover rate is 8%, Project A will have the higher NPV. D) As the projects are mutually exclusive, the firm should always select Project B. E) If the crossover rate is 8%, Project B will have the higher NPV.

E)

Which of the following statements could be true concerning the costs of debt and equity? A)The cost of retained earnings for Firm A is less than its cost of debt. B) The cost of debt for Firm A is greater than the cost of equity for Firm B. C) The cost of retained earnings for Firm A is less than its cost of new outside equity. D) The cost of debt for Firm A is greater than the cost of equity for Firm A. E) Both statements b and c could be true.

E)

As a general rule, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects. After all, 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. True False

False

Because the before-tax cost of debt is lower than the after-tax cost, it is used as the component cost of debt for purposes of developing the firm's WACC. True False

False

Firm A has a higher degree of business risk than Firm B. Firm A can offset this by increasing its operating leverage. True False

False

If a firm has zero cost of capital and two mutually exclusive projects, the payback method and NPV method would always lead to the same decision on which project to undertake. True False

False

If a project would lead to an increase a firm's cost of capital (its' WACC), it should not be accepted. True False

False

If the debt ratio is 50%, the interest rate on new debt is 8%, the tax rate is 40%, and the current cost of equity is 16%, then an increase in the debt ratio to 60% would have to decrease the weighted average cost of capital (WACC). True False

False

Merton Miller built on the Modigliani and Miller (MM) model by excluding the effects of corporate taxes and then adding the effect of personal taxes. True False

False

Modigliani and Miller (MM) made a number of assumptions in their first article that they reversed in their second article, including the existence of taxes, bankruptcy, and other factors. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio. True False

False

Other things held constant, a decrease in the cost of capital (discount rate) will cause an increase in a project's IRR. True False

False

Projects with nonnormal cash flows sometimes have multiple MIRRs. True False

False

"Symmetric information" is one of Modigliani and Miller's (MM) more questionable assumptions that outside stockholders have the same information about a firm's future prospects as its managers. The introduction of asymmetric information led to the development of the signaling theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value. True False

True

An increase in a firm's marginal tax rate would lower the cost of debt used to calculate its WACC, other things held constant. True False

True

Assume that a project has one initial cash outflow followed by a series of positive cash inflows. To use the modified IRR (MIRR) method, you would compound the cash inflows out to the end of the project's life, sum those compounded cash flows to form a terminal value (TV), and then find the discount rate that causes the PV of the TV to equal the project's cost. True False

True

Because they are based on investors' required returns, the component costs of capital are market-determined variables. True False

True

Bulldog Building Supply's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in bad times. This is called "financial flexibility," and the lower Bulldog's debt ratio, the greater its financial flexibility, other things held constant. True False

True

By assuming that bankruptcy was not possible, Modigliani and Miller (MM) developed the trade-off model, where the firm's value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists. True False

True

Funds acquired by the firm through preferred stock have a cost to the firm equal to the preferred dividend divided by the current price of the preferred stock. If significant flotation costs are involved the cost of the preferred should be adjusted upward. True False

True

If all else is equal, firms that use assets that can be sold easily (such as equipment) tend to use more debt than firms whose assets are harder to sell (such as patents). True False

True

In Modigliani and Miller's second article, the authors concluded that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt, assuming the existence of corporate income taxes. However, their model did not take into account bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%. True False

True

In capital budgeting, the cost of capital should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. True False

True

In general, firms with more stable and predictable sales tend to use more debt than firms with less stable sales. True False

True

In general, small businesses use DCF capital budgeting techniques less often than large businesses do. This may reflect a lack of knowledge on the part of small firms' managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms. True False

True

In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. Managers' tastes, choice of accounting method, or the profitability of other independent projects should not be considered. True False

True

One definition of "capital" is funds supplied to a firm by investors. True False

True

Retained earnings have a cost equal to rs because investors expect to earn rs on investments with the same risk as the firm's common stock. If the firm cannot 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. True False

True

Some notable economists believe that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane travel and other "perks," a situation that becomes an advantage to the stockholders. This is one of the factors that led to the rise of LBOs and private equity firms. True False

True

The IRR method can be used in place of the NPV method for all independent projects. True False

True

The NPV method is preferred over the IRR method because the NPV method's reinvestment rate assumption is better. True False

True