Corporate Finance Questions

At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company's weighted average cost of capital (WACC). At the meeting Haggerty made the following statements about the company's WACC: Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm's assets and can be viewed as the firm's opportunity cost of financing its assets. Statement 2: Since a firm's WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk. A - Correct and Correct B - Correct and Incorrect C - Incorrect and correct

A

Company X and Company Y have identical capital structures and identical costs of debt, common equity, and preferred stock. If Company X is subject to a higher corporate income tax rate than Company Y: A)the weighted average cost of capital and the after-tax cost of debt will be lower for Company X. B)the after-tax cost of all capital components in the weighted average cost of capital will be higher for Company X. C)Company X will have a lower weighted average cost of capital, but Company Y will have a lower after-tax cost of debt.

A

Johnson's Jar Lids is deciding whether to begin producing jars. Johnson's pays a consultant $50,000 for market research that concludes Johnson's sales of jar lids will increase by 5% if it also produces jars. In choosing the cash flows to include when evaluating a project to begin producing jars, Johnson's should: A)exclude the cost of the market research and include the effect on the sales of jar lids. B)include the cost of the market research and exclude the effect on the sales of jar lids. C)include both the cost of the market research and the effect on the sales of jar lids.

A

Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting. Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis. Statement 2: Cash flows should be analyzed on an after-tax basis. Should DeWalt agree or disagree with Webb's statements? A)Disagree. Agree B)Disagree. Disagree C)Agree. Agree

A

Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock? A)The firm's corporate tax rate. B)The stated par value of the preferred issue. C)The preferred stock's dividend rate.

A

Which of the following statements about leverage is most accurate? A)If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. B)An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage. C)A decrease in interest expense will increase the company's degree of total leverage.

A

Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR: A)and the net present value (NPV) method lead to the same accept/reject decision for independent projects. B)assumes that the reinvestment rate of the cash flows is the cost of capital. C)can lead to multiple IRR rates if the cash flows extend past the payback period.

A

Which yield measure is the most appropriate for comparing a company's investments in short-term securities? A)Bond equivalent yield. B)Money market yield. C)Discount basis yield.

A

Which of the following statements regarding leverage is most accurate? A)A firm with low operating leverage has a small proportion of its total costs in fixed costs. B)A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk. C)High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.

A A firm with high operating leverage has a high percentage of its total costs in fixed costs.

For a profitable company, issuing debt in order to retire common stock will most likely: A)increase both the level and variability of return on equity. B)decrease both operating income and net income. C)increase both net income and return on equity.

A An increase in debt will increase interest expense, which will decrease net income but not operating income, which is calculated before subtracting interest expense. For a profitable firm, the decrease in net income will be offset by the decrease in equity from the repurchase of common stock, so that ROE increases. The effect of the increase in financial leverage will, however, increase the variability of ROE for a given change in operating earnings.

With respect to inventory management,: A)an increase in days of inventory on hand can be the result of either good or poor inventory management. B)a firm with inventory turnover higher than the industry average can be expected to have better profitability as a result. C)a decrease in a firm's days of inventory on hand indicates better inventory management and can lead to increased profits.

A An increase in inventory could indicate poor sales and an accumulation of obsolete items or could be the result of a conscious effort to have adequate supplies to avoid losses from not having items to satisfy customer orders (stock outs). Higher-than-average inventory turnover could indicate better inventory management or could indicate that a less than optimal inventory is being maintained by the company.

If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital? A)Both increase. B)Both decrease. C)One increase and one decrease.

A An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.

Which of the following forms of short-term financing is typically used to facilitate international trade? A)Banker's acceptances. B)Commercial paper. C)Overdraft line of credit.

A Banker's acceptances are used by firms that export goods. A banker's acceptance is a guarantee from the bank of the firm that has ordered the goods stating that a payment will be made upon receipt of the goods. The exporting company can then sell this acceptance at a discount in order to generate immediate funds.

An investment is purchased at a cost of $775,000 and returns $300,000 at the end of years 2 and 3. At the end of year 4 the investment receives a final payment of $400,000. The IRR of this investment is closest to: A)8.65%. B)9.45%. C)13.20%.

A Cf0 = -775,000, C01 = 0, F01 = 1, C02 = 300,000, F02 = 2, C03 = 400,000, F03 = 1; IRR = 8.6534.

In a recent staff meeting, David Hurley, stated that analysts should understand that financial ratios mean little by themselves. He advised his colleagues to evaluate financial ratios carefully. During the discussion he made the following statements: Statement 1: A company can be compared with others in its industry by relating its financial ratios to industry norms. However, care must be taken because many ratios are industry-specific, but not all ratios are important to all industries. Statement 2: Comparing a company to the overall economy is useless because overall business conditions are constantly changing. Specifically, it is not the case that financial ratios tend to improve when the economy is strong and weaken during recessionary times. Are statements 1 and 2 as made by Hurley regarding financial ratio analysis CORRECT? Statement 1Statement 2 A)Correct and Incorrect B)Incorrect and Correct C)Correct and Correct

A Financial ratios are meaningless by themselves. To have meaning an analyst must use them with other information. An analyst should evaluate financial ratios based on industry norms and economic conditions. Statement 1 is correct. However, statement 2 is not because financial ratios tend to improve when the economy is strong and weaken when the economy is in a recession. So, financial ratios should be reviewed in light of the current stage of the business cycle.

The financial manager at Genesis Company is looking into the purchase of an apartment complex for $550,000. Net after-tax cash flows are expected to be $65,000 for each of the next five years, then drop to $50,000 for four years. Genesis' required rate of return is 9% on projects of this nature. After nine years, Genesis Company expects to sell the property for after-tax proceeds of $300,000. What is the respective internal rate of return (IRR) and net present value (NPV) on this project? A)7.01%; -$53,765. B)6.66%; -$64,170. C)13.99%; $166,177.

A IRR Keystrokes: CF0 = -$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1. NPV Keystrokes: CF0 = -$550,000; CF1 = $65,000; F1 = 5; CF2 = $50,000; F2 = 3; CF3 = $350,000; F3 = 1. Compute NPV, I = 9.

Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm's fixed-rate debt? A)The coupon rate on the firm's existing debt. B)The yield to maturity of the firm's existing debt. C)Seniority and any special covenants of the firm's anticipated debt

A Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a firm's debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.

Which of the following statements regarding the impact of financial leverage on a company's net income and return on equity (ROE) is most accurate? A)Using financial leverage increases the volatility of ROE for a level of volatility in operating income. B)If a firm has a positive operating profit margin, using financial leverage will always increase ROE. C)Increasing financial leverage increases both risk and potential return of existing bondholders.

A If a firm is financed with 100% equity, there is a direct relationship between changes in the firm's ROE and changes in operating income. Adding financial leverage (debt) to the firm's capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm's net profit margin negative, which would in turn make ROE negative.

Which of the following is NOT a limitation to financial ratio analysis? A)A firm that operates in only one industry. B)The need to use judgment. C)Differences in international accounting practices.

A If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

A new project is expected to be less risky than the average risk of existing projects. The appropriate discount rate to use when evaluating this project is: A)less than the firm's marginal cost of capital. B)greater than the firm's marginal cost of capital. C)the firm's marginal cost of capital.

A If the new project is less risky than the average risk of existing projects, the MCC should be adjusted downward. A lower discount rate will increase project's the net present value.

A conflict of interest between corporate stakeholders is least likely to be mitigated by: A)issuing stock dividends. B)covenants in debt indentures. C)including stock options as part of manager compensation.

A Issuing stock dividends does not necessarily favor one group of stakeholders over another because neither firm value nor earnings are affected by issuing a stock dividend. Covenants in debt issues protect creditor interests from management actions that would increase the risk of the debt. Including stock options as part of manager compensation serves to align the interests of senior management and shareholders.

Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting: Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project. Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project. Which of the following regarding Lutz's statements is most accurate? A)Correct Incorrect B)Correct Correct C)Incorrect Correct

A Lutz's second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.

All else equal, which of the following statements about operating leverage is least accurate? A)Lower operating leverage generally results in a higher expected rate of return. B)Operating leverage reflects the tradeoff between variable costs and fixed costs. C)Firms with high operating leverage experience greater variance in operating income.

A Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.

Operating risk is most likely to increase as a result of: A)an increase in fixed production costs. B)an increase in sales risk. C)increased variability of costs.

A Operating risk refers to uncertainty about operating earnings arising from fixed production (operating) costs.

A firm is considering a $200,000 project that will last 3 years and has the following financial data: Annual after-tax cash flows are expected to be $90,000. Target debt/equity ratio is 0.4. Cost of equity is 14%. Cost of debt is 7%. Tax rate is 34%. Determine the project's payback period and net present value (NPV). Payback PeriodNPV A)2.22 years$18,716 B)2.43 years$18,716 C)2.22 years$21,872

A Payback Period $200,000 / $90,000 = 2.22 years First, calculate the weights for debt and equity wd + we = 1 we = 1 - wd wd / we = 0.40 wd = 0.40 × (1 - wd) wd = 0.40 - 0.40wd 1.40wd = 0.40 wd = 0.286, we = 0.714 Second: calculate WACC WACC = (wd × kd) × (1 - t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132 then use that in CF function

If a project has a negative cash flow during its life or at the end of its life, the project most likely has: A)more than one internal rate of return. B)a negative internal rate of return. C)multiple net present values.

A Projects with unconventional cash flows (where the sign of the cash flow changes from minus to plus to back to minus) will have multiple internal rates of return. However, one will still be able to calculate a single net present value for the cash flow pattern.

Genoa Corp. pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. The firm's tax rate is 30%. The cost of common equity is closest to: A)14.2%. B)16.1%. C)13.8%.

A ROE × retention ratio = growth rate 15% × (1 - 0.40) = 9% D0 = $5.00 × 0.40 = $2.00 [$2.00(1.09) / $42.00] + 0.09 = 14.19%

The stakeholders of a company that prefer a relatively riskier company strategy that has the potential for superior company performance are: A)shareholders. B)creditors. C)suppliers.

A Shareholders have the greatest gains from superior company performance. Suppliers may benefit but, in general, have a preference for stable business operations and continuation of their business relationship with the company. Creditors prefer less risk because their potential gains from superior company performance are limited while the have significant downside risk.

Robel Company, which pays no dividends, carries out a 3-for-5 reverse split of its common shares. How will this transaction affect Robel's forecasts of its net cash position? A)No effect because this transaction does not affect future cash flows. B)No effect on the short-term forecast but less net cash in the longterm forecast. C)More net cash in both the short-term forecast and the long-term forecast.

A Stock splits and reverse stock splits do not affect a firm's future cash flows unless dividend yields are increased as a result. These transactions change the number of shares outstanding but they do not raise capital for the firm.

For a project with cash outflows during its life, the least preferred capital budgeting tool would be: A)internal rate of return. B)net present value. C)profitability index.

A The IRR encounters difficulties when cash outflows occur throughout the life of the project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor the PI suffer from these limitations.

A high cash conversion cycle suggests that a company's investment in working capital is: A)too high. B)appropriate. C)too low.

A The cash conversion cycle is equal to average days of receivables plus average days of inventory minus average days of payables. High cash conversion cycles relative to those of comparable firms are considered undesirable. A cash conversion cycle that is too high implies that the company has excessive investment in working capital.

A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate? A)A project's internal rate of return decreases when a breakpoint is reached. B)An increase in the after-tax cost of debt may occur at a break point. C)Any given project's NPV will decline when a breakpoint is reached.

A The internal rate of return is independent of the firm's cost of capital. It is a function of the amount and timing of a project's cash flows.

In a net present value (NPV) profile, the internal rate of return is represented as the: A)intersection of the NPV profile with the horizontal axis. B)point where two NPV profiles intersect. C)intersection of the NPV profile with the vertical axis.

A The internal rate of return is the rate of discount at which the NPV of a project is zero. On an NPV profile, this is the point where the profile intersects the horizontal axis.

Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis? A)Debt-equity ratio. B)Input price variability. C)Unit sales levels.

A The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels affect financial risk, not business (operating) risk.

Pierce Motor Company has an operating cycle of 150 days and a cash conversion cycle of 120 days, while Dunhill Motor, Inc. has an operating cycle of 140 days and a cash conversion cycle of 125 days. Based on these figures it is most likely that: A)average days of payables for Dunhill is less than for Pierce. B)average days of inventory for Dunhill is less than for Pierce. C)average days of receivables for Dunhill is less than for Pierce.

A The operating cycle is days of inventory plus days of receivables. The cash conversion cycle is the operating cycle minus days of payables. Therefore, average days of payables are the operating cycle minus the cash conversion cycle. Dunhill's average days of payables (140 - 125 = 15) are less than Pierce's average days of payables (150 - 120 = 30). Which company has higher average days of inventory or receivables cannot be determined from the information provided.

The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as: A)sunk cost; externality. B)opportunity cost; externality. C)externality; cannibalization.

A The study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality.

A firm is choosing among three short-term investment securities: Security 1: A 30-day U.S. Treasury bill with a discount yield of 3.6%. Security 2: A 30-day banker's acceptance selling at 99.65% of face value. Security 3: A 30-day time deposit with a bond equivalent yield of 3.65%. Based only on these securities' yields, the firm would: A)prefer the banker's acceptance. B)prefer the U.S. Treasury bill. C)prefer the time deposit.

A We can compare the yields of these securities on any single basis. The preferred basis is the bond equivalent yield. Security 1 = discount is 3.6%(30 / 360) = 0.3% BEY = (0.3 / 99.7) (365 / 30) = 3.661% BEY of Security 2 = (0.35 / 99.65) × (365 / 30) = 4.273% BEY of Security 3 = 3.65%

The additional risk a firm's common shareholders must bear when a firm uses fixed cost financing is bestdescribed as: A)financial risk. B)business risk. C)operating risk

A When a company finances its operations with fixed cost financing (debt), it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm's capital structure, the greater the firm's financial risk. Business risk refers to the risk associated with a firm's operating income. Operating risk refers to the additional uncertainty about operating earnings caused by fixed operating costs.

The condition that occurs when a company disburses cash too quickly, stretching the company's cash reserves, is best described as a: A)pull on liquidity. B)drag on liquidity. C)liquidity premium.

A When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidity occurs when cash inflows lag.

Minority shareholder groups are most likely to have influence over corporate strategy when board elections: A)use cumulative voting. B)are staggered. C)use majority voting.

A With cumulative voting, minority shareholders are more likely to gain seats on the board of directors and influence corporate strategy and decisions than with majority voting. Staggered board elections limit the ability of shareholders to select an entirely new board, except over a period of years.

A firm has one actively traded bond issue outstanding, with a 6% coupon and a yield to maturity of 5%. When estimating the firm's weighted average cost of capital (WACC), the appropriate after-tax cost of debt capital should most likely be: A)less than 5%. B)between 5% and 6%. C)equal to 6%.

A Yield to maturity is an appropriate estimate of a firm's before-tax cost of capital. Its after-tax cost of capital may be estimated as YTM × (1 - tax rate) and will be less than the before-tax cost of capital, as long as the firm faces a positive tax rate, which is the most likely case.

Additional debt should be used in the firm's capital structure if it increases: A)firm earnings. B)the value of the firm. C)earnings per share.

B

The NPV profile is a graphical representation of the change in net present value relative to a change in the: A)prime rate. B)discount rate. C)internal rate of return.

B

A company primarily engaged in the production of cement has the following characteristics: Beta = 0.8. Market value debt = $180 million. Market value equity = $540 million. Effective tax rate = 25%. Marginal tax rate = 34%. The asset beta that should be used by a company considering entering into cement production is closest to: A)0.640. B)0.656. C)0.725.

B ** use marginal tax rate The unlevered (asset) beta is 0.8{1 / [1 + (1 - 0.34)(180 / 540)]} = 0.656.

Simcox Financial is considering raising additional capital to finance a takeover of one of the firm's major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital: Amount of New Debt (in millions) $0 to $149 at. 4.2% $150 to $349 at. 5.0% Amount of New Equity $0 to $399. at. 7.5% $400 to $799. at. 8.5% Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively? Breakpoint for new debt capitalBreakpoint for new equity capital A)$375.0 million and $615.4 million B)$428.6 million and $615.4 million C)$428.6 million and $533.3 million

B A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.

Which of the following sources of liquidity is the most reliable? A)Uncommitted line of credit. B)Revolving line of credit. C)Committed line of credit.

B A revolving line of credit is typically for a longer term than an uncommitted or committed line of credit and thus is considered a more reliable source of liquidity. With an uncommitted line of credit, the issuing bank may refuse to lend if conditions of the firm change. An overdraft line of credit is similar to a committed line of credit agreement between banks and firms outside of the U.S. Both committed and revolving lines of credit can be verified and can be listed in the footnotes to a firm's financial statements as sources of liquidity.

In the absence of any ESG-related constraints specified in an investment policy statement, a portfolio manager is most likelyto violate fiduciary duty by using ESG factors to: A)assess the expected return and risk of potential portfolio investments. B)exclude investments with negative ESG characteristics from the investor's portfolio. C)choose among investments with similar risk and return characteristics.

B Constructing a portfolio based on ESG factors may violate fiduciary duty if doing so reduces expected returns. Analyzing ESG factors when assessing investment risk or using ESG factors to choose among otherwise equivalent investments would likely not violate fiduciary duty.

The effects that the acceptance of a project may have on other firm cash flows are best described as: A)pure plays. B)externalities. C)opportunity costs.

B Externalities refer to the effects that the acceptance of a project may have on other firm cash flows. Cannibalization is one example of an externality.

Which of the following statements about independent projects is least accurate? A)If the internal rate of return is less than the cost of capital, reject the project. B)The internal rate of return and net present value methods can yield different accept/reject decisions for independent projects. C)The net present value indicates how much the value of the firm will change if the project is accepted.

B For independent projects the IRR and NPV give the same accept/reject decision. For mutually exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.

Wanton's San Y'isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity? A)1,750 units. B)2,500 units. C)3,000 units.

B For this problem you need 2 equations. Break-even quantity = Fixed Costs / (Price - Variable cost) Q = FC / (P - V) Fixed Costs = Total Costs - Variable Costs FC = TC - VC = 200,000 - 150,000 = 50,000 Q = 50,000 / (35 - 15) = 2,500

Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm's first tasks is to calculate the company's weighted average cost of capital (WACC) - and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC - now! Luckily, Humm finds clear notes on the target capital component weights. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component. As time runs out, he has to guess. Here is what Humm deciphered: Target weights: wd = 30%, wps = 20%, wce = 50%, where wd, wps, and wceare the weights used for debt, preferred stock, and common equity. Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%. The cost of debt is the after-tax cost. If Humm guesses correctly, the WACC is: A)9.2%. B)11.0%. C)9.0%.

B If Humm remembers to order the capital components from cheapest to most expensive, he can calculate WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), and common equity. Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce) where wd, wps, and we are the weights used for debt, preferred stock, and common equity. WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%.

During a period of expansion in the economy, compared to firms with lower operating leverage, earnings growth for firms with high operating leverage will be: A)lower. B)higher. C)unaffected.

B If a high percentage of a firm's total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.

A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The bonds trade at a price of $98 in the open market. The firm's marginal tax rate is 35%. Using the bond-yield plus method, what is the firm's cost of equity risk assuming an add-on of 4%? A)13.34%. B)12.11%. C)11.50%.

B If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million. To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = -98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.

Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? The marginal cost of capital should be used to discount the cash flows: A)of all projects the firm is considering. B)for potential projects that have a level of risk near that of the firm's average project. C)if the firm's capital structure is expected to change during the project's life.

B Net present values of projects with the average risk for the firm should be determined using the firm's marginal cost of capital. The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital assumes the firm's capital structure does not change over the life of the project.

Which of the following is least likely an indicator of a firm's liquidity? A)Inventory turnover. B)Amount of credit sales. C)Cash as a percentage of sales

B No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales and inventory turnover are indicators of liquidity.

A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm: A)has a lower cash conversion cycle than its peer companies. B)may have credit policies that are too strict. C)has better credit controls than its peer companies.

B The firm's average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm's credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are "better." We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle.

Which of the following statements about business risk and financial risk is least accurate? A)Business risk is the riskiness of the company's assets if it uses no debt. B)The greater a company's business risk, the higher its optimal debt ratio. C)Factors that affect business risk are demand, sales price, and input price variability.

B The greater a company's business risk, the lower its optimal debt ratio.

All else equal, a firm's business risk is higher when: A)the firm has low operating leverage. B)fixed costs are the highest portion of its expense. C)variable costs are the highest portion of its expense.

B The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.

Thematic investing is most accurately described as: A)identifying the best companies in each sector with respect to environmental and social factors. B)considering a single environmental or social factor when selecting investments. C)excluding companies or sectors from consideration for investment based on environmental and social factors.

B Thematic investing refers to selecting investments with a view to a specific environmental, social, or governance factor. Identifying the best companies in each sector with respect to environmental and social factors is referred to as best-in-class investing. Excluding companies or sectors from consideration for investment based on environmental and social factors is referred to as negative screening.

Which of the following statements about corporate governance is most accurate? Corporate governance: A)is defined in the same way in most countries. B)may be focused only on shareholder interests. C)best practices are essentially the same in developed economies.

B Under the shareholder theory of corporate governance, practices are primarily those that support shareholder interests, while under the stakeholder theory of corporate governance, the interests of various affected groups are considered and balanced. Corporate governance practices and definitions vary across countries.

Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle's after-tax cost of capital, an analyst's estimate of Axle's cost of common equity would be closest to: A)8.8%. B)9.2%. C)9.0%.

B We can estimate the company's expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3% The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.

Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian's weighted average cost of capital for this potential expansion. A)4.2%. B)5.7%. C)7.1%.

B βJF Black asset=0.7[1/1+(1−0.40)3.0]=0.25 βUtilitarian project=0.25[1+(1−0.3)(2.5)]=0.6875 project cost of equity=5%+0.6875(9%−5%)=7.75% WACCproject=13.5(7.75)+2.53.5(7%)(1−0.3)=5.71%

A company has the following capital structure: Target weightings: 30% debt, 20% preferred stock, 50% common equity. Tax Rate: 35%. The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year maturity for a price of $1,047.46. A preferred stock issue that pays a dividend of $2.80 has a value of $35 per share. The company's growth rate is estimated at 6%. The company's common shares have a value of $40 and a dividend in year 0 of D0 = $3.00. The company's weighted average cost of capital is closest to: A)9.28%. B)9.84%. C)10.53%.

C

The financial manager at Johnson & Smith estimates that its required rate of return is 11%. Which of the following independent projects should Johnson & Smith accept? A)Project Y requires an up-front expenditure of $800,000 and generates an internal rate of return of 10.5%. B)Project X requires an up-front expenditure of $1,000,000 and generates a net present value of -$4,600. C)Project Z requires an up-front expenditure of $600,000 and generates an internal rate of return of 12.0%.

C

The internal rate of return (IRR) method and net present value (NPV) method of project selection will always provide the same accept or reject decision when: A)the projects are mutually exclusive. B)up-front project costs are under $1.0 million. C)the projects are independent.

C

A firm records the following cash flows on the same day: $250 million from debt proceeds; $100 million funds transferred to a subsidiary; $125 million in interest payments; and $30 million in tax payments. The net daily cash position: A)improved. B)remained the same. C)worsened.

C $250 - $100 - $125 - $30 = -$5 million.

Which one of the following statements about the marginal cost of capital (MCC) is most accurate? A)The MCC falls as more and more capital is raised in a given period. B)The MCC is the cost of the last dollar obtained from bondholders. C)A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.

C A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure. The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.

An analyst who is evaluating a firm's working capital management would be least likely to be concerned if the firm's: A)number of days of inventory is higher than that of its peers. B)total asset turnover is lower than its industry average. C)operating cycle is shorter than that of its peers.

C A shorter operating cycle will lead to a shorter cash conversion cycle, other things equal, which is an indication of better working capital management. Higher days inventory on hand, compared to peer company averages, will lengthen the cash conversion cycle, an indication of poorer working capital management. Good working capital management would tend to increase a firm's total asset turnover since a given amount of sales can be supported with less working capital (less current assets).

An analyst is reviewing the working capital portfolio investment policy of a publicly traded firm. Which of the following components of the policy is the analyst least likely to find acceptable? A)Investments must have an A-1 rating from S&P or an equivalent rating from another agency. B)Authority for selecting and managing short-term investments rests with the firm's treasurer and any designees selected by the treasurer. C)Investments in U.S. T-bills, commercial paper, and bank CDs are acceptable unless issued by Stratford Bank.

C An investment policy for short-term portfolios should have the following elements: purpose, authorities, limitations/restrictions, quality, and other items. The purpose section should state the general reason the portfolio exists and the general strategy that will be followed. The limitations section generally states the types of investments that are or are not acceptable and should note only categories of securities rather than specific issuers of securities. The authorities section should state the executives who will oversee the portfolio. The quality section should state guidelines for the credit quality of the investments in the portfolio. The "other" section may be used for portfolio requirements not covered in the first four sections, such as auditing or reporting requirements.

An investment policy statement for a firm's short-term cash management function would least appropriately include: A)procedures to follow if the investment guidelines are violated. B)information on who is allowed to invest corporate cash. C)a list of permissible securities.

C An investment policy statement typically begins with a statement of the purpose and objective of the investment portfolio, some general guidelines about the strategy to be employed to achieve those objectives, and the types of securities that will be used. A list of permitted securities for investment would be limited and likely too restrictive. A list of permitted security types is appropriate and can provide the necessary flexibility to increase yield within the safety and liquidity constraints appropriate for the firm.

The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will: A)increase. B)change, but can either increase or decrease. C)decrease.

C As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component's cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle's debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion. break point =amount of capital at which a component's cost of capital changes / weight of the component in the capital structure

A guarantee stating that a payment will be made upon receipt of goods or services is best described as: A)commercial paper. B)a revolving line of credit. C)a banker's acceptance.

C Banker's acceptances are guarantees from a bank on behalf of a firm that has ordered goods, stating that a payment will be made upon receipt of the goods

Which of the following factors is least likely to affect business risk? A)Operating leverage. B)Demand variability. C)Interest rate variability.

C Business risk can be defined as the uncertainty inherent in a firm's return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other two choices.

The uncertainty in return on assets due to the nature of a firm's operations is known as: A)financial leverage. B)tax efficiency. C)business risk.

C Business risk is a function of the firm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax efficiency is tied to mutual fund investing, while financial leverage requires the existence of debt.

Variability in a firm's operating income is most closely related to its: A)financial risk. B)internal risk. C)business risk.

C Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return? A)$325,859. B)$376,872. C)$280,913.

C CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000.

The stakeholders most likely to be concerned with their legal liabilities are: A)regulators. B)creditors. C)directors.

C Directors are legally responsible for their decisions and actions as board members. Neither regulators nor creditors face significant legal liabilities for their actions.

Yangtze Delta High Technology produces multimedia-enabled wireless phones. The factory incurs rent, depreciation, salary, and other fixed costs totaling RMB 10 million per year. Also, the company incurs annual interest of RMB 3 million on debt. Each phone sold by Yangtze Delta sells for RMB 200. The variable cost per phone is RMB 150. Yangtze Delta's operating breakeven quantity of sales is closest to: A)65,000. B)260,000. C)200,000.

C F = Fixed operating cost = RMB 10,000,000 P = Price per unit = RMB 200 V = Variable cost per unit = RMB 150 Operating breakeven quantity = F / (P - V) = 10,000,000 / (200 - 150) = 200,000.

Which of the following sources of financing is least likely to increase a firm's financial risk? A)Fixed-rate debt. B)Operating leases. C)Common equity.

C Financial risk, in the context of a firm's financing of its operations, results from taking on fixed financial obligations such as debt or operating leases. Common equity financing does not involve fixed obligations.

Financing costs for a capital project are: A)subtracted from estimates of a project's future cash flows. B)subtracted from the net present value of a project. C)captured in the project's required rate of return.

C Financing costs are reflected in a project's required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

Which of the following factors is most likely to cause a firm to need short-term financing? A)Return of principal from maturing investments. B)Shorter cash conversion cycle than the industry average. C)Operating cash inflows that fluctuate seasonally.

C Firms with operating cash inflows that fluctuate seasonally are likely to experience short-term imbalances between cash inflows and cash outflows and must forecast these imbalances to manage their net daily cash positions, for example by arranging short-term borrowing over seasons when operating cash inflows are expected to be relatively low and operating cash outflows are relatively high.

Which of the following stakeholders are most likely to benefit from a company's growth and excellent financial performance? A)Creditors. B)Customers. C)Governments.

C Governments receive greater tax revenues when financial performance is excellent and profits are higher. Creditors do not receive extra returns for performance better than that is adequate to repay debt. Customers seek company stability and ongoing relationships with the company.

A company prepares a chart with the net present value (NPV) profiles for two mutually exclusive projects with equal lives of five years. Project Jones and Project Smith have the same initial cash outflow and total undiscounted cash inflows, but 75% of the cash inflows for Project Jones occur in years 1 and 2, while 75% of the cash inflows for Project Smith occur in years 4 and 5. Which of the following statements is most accurate regarding these projects? A)There is a range of discount rates in which the company should choose Project Jones and a range in which it should choose Project Smith. B)Project Smith has a higher internal rate of return than Project Jones. C)There is a range of discount rates in which the optimal decision is to reject both projects.

C If the total undiscounted cash flows from two projects are equal, their NPV profiles intersect the vertical axis at the same value. The NPV profile will have a steeper slope for Project Smith, which has more of its cash inflows occurring later in its life, and therefore the IRR of Project Smith (its intersection with the horizontal axis) must be less than the IRR of Project Jones. The NPV for Project Jones will be greater at any rate of discount, and Project Jones will be preferred over the entire range. However, if the discount rate applied to the cash flows is greater than the IRR of Project Jones, both projects will have negative NPVs and the company should reject both of them.

A company is most likely to have a longer operating cycle than its peers if it: A)has a higher payables turnover ratio than its peers. B)has a higher inventory turnover ratio than its peers. C)grants more lenient credit terms to its customers than its peers.

C More lenient credit terms can be expected to increase days' receivables outstanding and therefore the operating cycle.

Which of the following factors should an analyst most likely consider favorable for shareholders' interests? A)Dual-class share structures. B)Anti-takeover provisions. C)Non-executive directors.

C Non-executive, or external, directors are typically viewed as more likely to act in shareholders' interests than executive, or internal, directors. Dual-class structures may allow a small group of shareholders, such as company founders and their heirs, to exercise control disproportionate to their ownership stake. Anti-takeover provisions limit shareholders' ability to bring about changes in management.

Project sequencing is best described as: A)prioritizing funds to achieve the maximum value for shareholders, given capital limitations. B)arranging projects in an order such that cash flows from the first project fund subsequent projects. C)an investment in a project today that creates the opportunity to invest in other projects in the future.

C Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future. Note that funding from the first project is not a requirement for project sequencing.

Liquidating short-term assets and renegotiating debt agreements are best described as a firm's: A)primary sources of liquidity. B)pulls and drags on liquidity. C)secondary sources of liquidity.

C Secondary sources of liquidity include liquidating short-term or long-lived assets, negotiating debt agreements (i.e., renegotiating), or filing for bankruptcy and reorganizing the company. Primary sources of liquidity are the sources of cash a company uses in its normal operations. Pulls and drags on liquidity refer to factors that weaken a company's liquidity position.

Which of the following is least relevant in determining project cash flow for a capital investment? A)Tax impacts. B)Opportunity costs. C)Sunk costs.

C Sunk costs are not to be included in investment analysis. Opportunity costs and the project's impact on taxes are relevant variables in determining project cash flow for a capital investment.

The marginal cost of capital is: A)tied solely to the specific source of financing. B)equal to the firm's weighted cost of funds. C)the cost of the last dollar raised by the firm.

C The "marginal" cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.

The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm's existing debt. The company's marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is: A)5.0%. B)Between 3.3% and 5.0%. C)More than 5.0%.

C The after-tax cost of debt similar to Savanna's existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company's debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to: A)accept profitable, low-risk projects and reject unprofitable, high-risk projects. B)accept profitable, low-risk projects and accept unprofitable, high-risk projects. C)reject profitable, low-risk projects and accept unprofitable, high-risk projects.

C The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.

Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence's capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this project is closest to: A)0.38. B)0.58. C)1.18.

C The unlever and then relever it

A result that is most likely to give a financial manager concern that his firm's credit policy may have become too lenient is: A)receivables turnover has increased significantly. B)inventory turnover has decreased considerably. C)weighted average collection period has increased.

C The weighted average collection period is the average number of days it takes to collect a dollar of receivables. A decreased percentage of sales made on credit or an increase in the receivables turnover ratio might result from more strict credit terms. Inventory turnover is not directly affected by credit terms, only though the effect of credit terms on overall sales.

An appropriate cash management strategy for a company that has a seasonally high need for cash prior to the holiday shopping season would least likely include: A)borrowing funds though a bank line of credit. B)allowing short-term securities to mature without reinvestment. C)investing in U.S. Treasury notes at other times of the year because they are highly liquid.

C Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than those of securities suitable for cash management. Allowing short-term securities to mature without reinvesting the cash generated would be one way to meet seasonal cash needs. Short-term bank borrowing or issuing commercial paper that can be paid off when holiday sales generate cash would be appropriate strategies for dealing with a predictable short-term need for cash.

Levenworth Industries has the following capital structure on December 31, 2006: Debt = $8 BV $10.5 MV Preferred $2 BV $1.5 MV Common = $10 BV $13.7 MV Total = $20 BV $25.7 MV What is the firm's target debt and preferred stock portion of the capital structure based on existing capital structure? A) 0.400 debt .10 PS B)0.41 debt. 0.10 PS C)0.41 debt. 0.06 PS

C Use market values to calculate

First Choice, Inc., sold 40,000 units during its most recent quarter; had fixed operating costs of $70,000, total variable costs of $140,000, and interest expense of $80,000; and charged a price of $7.75 per unit. First Choice's breakeven level of sales, based on these values, is closest to: A)16,500. B)28,000. C)35,000.

C Variable cost per unit is 140,000 / 40,000 = $3.50. Breakeven level of sales = 70,000+80,000/ 7.75−3.50=35,294

An analyst gathered the following information about a capital budgeting project: The proposed project cost $10,000. The project is expected to increase pretax net income and cash flow by $3,000 in each of the next eight years. The company has 50% of its capital in equity at a cost of 12%. The pretax cost of debt capital is 6%. The company's tax rate is 33%. The project's net present value is closest to: A)$6,604. B)$7,240. C)$1,551.

C WACC = (wd)(kd)(1 - t) + (wce)(kce) WACC = (0.5)(6%)(1 - 0.33) + (0.5)(12%) = 8.0% then: CF0= -10,000 CF1 = (3,000 * 1-.33) F01 = 8 I= 8 CPT NPV = 1,550.74

Langler, Inc., is evaluating two capital projects. Langler has a capital budget of $50 million. Project P has an internal rate of return of 24% and a net present value of $5 million. Project Q has an internal rate of return of 18% and a net present value of $12 million. Project P will cost $15 million, and Project Q will cost $48 million. Based on this information, Langler should accept: A)Project P to earn the higher return on investment. B)both projects because they both add value to the firm. C)Project Q to maximize shareholder wealth.

C When the IRR and NPV methods conflict, the general rule is to take the higher NPV project, as NPV measures the expected increase in the value of the firm from undertaking the project. IRR is not the best measure for ranking mutually exclusive projects of different sizes, and the capital budget is not large enough to do both projects.

** FACT is a decline or increase in net operating cycle indicate an improvement in liquidity

The decline in net operating cycle days in year 2 indicates an improvement in liquidity

Responsibilities of a board of directors' nominations committee are least likelyto include: A)recruiting qualified members to the board. B)selecting an external auditor for the company. C)evaluating the independence of directors.

b Selecting an external auditor (subject to shareholder approval) is a responsibility of the Board's audit committee.