Fin 125 - Exam 3

The concept of homemade leverage is most associated with: M&M Proposition I with no tax. M&M Proposition II with no tax. M&M Proposition I with tax. M&M Proposition II with tax. the static theory proposition.

M&M Proposition I with no tax.

Westover Mills reduced its taxes last year by $210 by increasing its interest expense by $1,000. Which one of the following terms is used to describe this tax savings? a. Interest tax shield b. Interest credit c. Homemade leverage shield d. Current tax yield e. Tax-loss interest

a. Interest tax shield

You have computed the break-even point between a levered and an unlevered capital structure. Ignore taxes. At the break-even level, the: a. company is earning just enough to pay for the cost of the debt. b. company's earnings before interest and taxes are equal to zero. c. earnings per share for the levered option are exactly double those of the unlevered option. d. advantages of leverage exceed the disadvantages of leverage. e. company has a debt-equity ratio of .50.

a. company is earning just enough to pay for the cost of the debt.

M&M Proposition II with taxes: a. has the same general implications as M&M Proposition II without taxes. b. states that capital structure is irrelevant to shareholders. c. supports the argument that business risk is determined by the capital structure decision. d. supports the argument that the cost of equity decreases as the debt-equity ratio increases. e. concludes that the capital structure decision is irrelevant to the value of a firm.

a. has the same general implications as M&M Proposition II without taxes.

The difference between a company's future cash flows if it accepts a project and the company's future cash flows if it does not accept the project is referred to as the project's: a. incremental cash flows. b. internal cash flows. c. external cash flows. d. erosion effects. e. financing cash flows.

a. incremental cash flows.

Which one of the following is an example of a sunk cost? a. $1,500 of lost sales because an item was out of stock b. $1,200 paid to repair a machine last year c. $20,000 project that must be forfeited if another project is accepted d. $4,500 reduction in current shoe sales if a store commences selling sandals e. $1,800 increase in comic book sales if a store ceases selling puzzles

b. $1,200 paid to repair a machine last year

All of the following are related to a proposed project. Which one of these should be included in the cash flow at Time 0? a. Loan obtained to finance the project b. Initial investment in inventory to support the project c. Annual depreciation tax shield d. Aftertax salvage value e. Net working capital recovery

b. Initial investment in inventory to support the project

Which one of the following states that the value of a company is unrelated to the company's capital structure? a. Homemade leverage b. M&M Proposition I, no tax c. M&M Proposition II, no tax d. Pecking-order theory e. Static theory of capital structure

b. M&M Proposition I, no tax

The fact that a proposed project is analyzed based on the project's incremental cash flows is the assumption behind which one of the following principles? a. Underlying value principle b. Stand-alone principle c. Equivalent cost principle d. Salvage principle e. Fundamental principle

b. Stand-alone principle

A firm should select the capital structure that: a. produces the highest cost of capital. b. maximizes the value of the firm c. minimizes taxes. d. is fully unlevered e. equates the value of debt with the value of equity.

b. maximizes the value of the firm

A project's cash flow is equal to the project's operating cash flow: a. plus the project's depreciation expense minus both b. the project's taxes and capital spending. b. minus both the project's change in net working capital and capital spending. c. minus the project's change in net working capital plus all of the depreciation expenses. d. plus the project's depreciation expenses minus the project's taxes. e. minus the project's taxes.

b. minus both the project's change in net working capital and capital spending.

The basic lesson of M&M theory is that the value of a company is dependent upon: a. the total cash flows of that company.the company's capital structure. b. the total cash flows of that company. c. minimizing the marketed claims. d. the amount of the company's marketed claims. e. size of the stockholders' claims.

b. the total cash flows of that company.

If a company has the optimal amount of debt, then the: a. direct financial distress costs must equal the present value of the interest tax shield. b. value of the levered company will exceed the value of the unlevered company. c. company has no financial distress costs. d. Value of the firm is equal to VL + TCD. e. debt-equity ratio is equal to 1.

b. value of the levered company will exceed the value of the unlevered company.

Kelley's Baskets makes handmade baskets and is currently considering making handmade wreaths as well. Which one of the following is the best example of an incremental operating cash flow related to the wreath project? a. Storing supplies in the same space currently used for materials storage b. Utilizing the basket manager to oversee wreath production c. Hiring additional employees to handle the increased workload should the firm accept the wreath project d. Researching the market to determine if wreath sales might be profitable before deciding to proceed e. Planning on lower interest expense by assuming the proceeds of the wreath sales will be used to reduce the firm's currently outstanding debt

c. Hiring additional employees to handle the increased workload should the firm accept the wreath project

Which one of the following is a correct method for computing the operating cash flow of a project assuming that the interest expense is equal to zero? a. EBIT + Depreciation b. EBIT(1 + Taxes) c. Net income + Depreciation d. (Sales − Costs)(1 − Depreciation)(1 − Taxes) e. (Sales − Costs)(1 − Taxes)

c. Net income + Depreciation

Which one of the following best illustrates erosion as it relates to a hot dog stand located on the beach? a. Providing both ketchup and mustard for customers' use b. Repairing the roof of the hot dog stand because of water damage c. Selling fewer hot dogs because hamburgers were added to the menu d. Offering french fries but not onion rings e. Losing sales due to bad weather

c. Selling fewer hot dogs because hamburgers were added to the menu

Which one of the following costs was incurred in the past and cannot be recouped? a. Incremental b. Side c. Sunk d. Opportunity e. Erosion

c. Sunk

Which one of the following best describes the concept of erosion? a. Expenses that have already been incurred and cannot be recovered b. Change in net working capital related to implementing a new project c. The cash flows of a new project that come at the expense of a firm's existing cash flows d. The alternative that is forfeited when a fixed asset is utilized by a project e. The differences in a firm's cash flows with and without a particular project

c. The cash flows of a new project that come at the expense of a firm's existing cash flows

Which one of the following statements is correct in relation to M&M Proposition II, without taxes? a. The cost of equity remains constant as the debt-equity ratio increases. b. The cost of equity is inversely related to the debt-equity ratio. c. The required return on assets is equal to the weighted average cost of capital. d. Financial risk determines the return on assets. e. Financial risk is unaffected by the debt-equity ratio.

c. The required return on assets is equal to the weighted average cost of capital.

The costs incurred by a business in an effort to avoid bankruptcy are classified as _____ costs. a.flotation b. direct bankruptcy c. indirect bankruptcy d. financial solvency e. capital structure

c. indirect bankruptcy

Pro forma financial statements can best be described as financial statements: a. expressed in a foreign currency. b. where the assets are expressed as a percentage of total assets and costs are expressed as a percentage of sales. c. showing projected values for future time periods. d. expressed in real dollars, given a stated base year. where all accounts are expressed as a percentage of last year's values.

c. showing projected values for future time periods.

The operating cash flow for a project should exclude which one of the following? a. Taxes b. Variable costs c. Fixed costs d. Interest expense e. Depreciation tax shield

d. Interest Expense

The option that is forgone so that an asset can be utilized by a specific project is referred to as which one of the following? a. Salvage value b. Wasted value c. Sunk cost d. Opportunity cost e. Erosion

d. Opportunity cost

A company's current cost of capital is based on: a. only the return required by the company's current shareholders. b. the current market rate of return on equity shares. c. the weighted costs of all future funding sources. d. both the returns currently required by its debt holders and stockholders. e. the company's original debt-equity ratio.

d. both the returns currently required by its debt holders and stockholders.

M&M Proposition I with taxes is based on the concept that a. the optimal capital structure is the one that is totally financed with equity. b. capital structure is irrelevant because investors and companies have differing tax rates. c. WACC is unaffected by a change in the company's capital structure. d. the value of a taxable company increases as the level of debt increases. e. the cost of equity increases as the debt-equity ratio increases.

d. the value of a taxable company increases as the level of debt increases.

Which one of the following makes the capital structure of a company irrelevant? a. Taxes b. Interest tax shield c. 100 percent dividend payout ratio d. Debt-equity ratio that is greater than 0 but less than 1 e. Homemade leverage

e. Homemade leverage

Which form of financing do companies prefer to use first according to the pecking-order theory? a. Regular debt b. Convertible debt c. Common stock d. Preferred stock e. Internal funds

e. Internal funds

GL Plastics spent $1,200 last week repairing a machine. This week the company is trying to decide if the machine could be better utilized if they assigned it a proposed project. When analyzing the proposed project, the $1,200 should be treated as which type of cost? a. Opportunity b. Fixed c. Incremental d. Erosion e. Sunk

e. Sunk

Which one of the following is the primary determinant of a firm's cost of capital? a. Debt-equity ratio of any new funds raised b. Marginal tax rate c. Pretax cost of equity d. Aftertax cost of equity e. Use of the funds raised

e. Use of the funds raised

The optimal capital structure has been achieved when the: a. debt-equity ratio is equal to 1. b. weight of equity is equal to the weight of debt. c. cost of equity is maximized given a pretax cost of debt. d. debt-equity ratio is such that the cost of debt exceeds the cost of equity. e. debt-equity ratio results in the lowest possible weighted average cost of capital.

e. debt-equity ratio results in the lowest possible weighted average cost of capital.

The cost of capital for a new project: a. is determined by the overall risk level of the firm. b. is dependent upon the source of the funds obtained to fund that project. c. is dependent upon the firm's overall capital structure. d. should be applied as the discount rate for all other projects considered by the firm. e. depends upon how the funds raised for that project are going to be spent.

e. depends upon how the funds raised for that project are going to be spent.

Pro forma statements for a proposed project should generally do all of the following except: a. be compiled on a stand-alone basis. b. include all project-related fixed asset acquisitions and disposals. c. include all the incremental cash flows related to the project. d. include taxes. e. include interest expense.

e. include interest expense.

The discount rate assigned to an individual project should be based on: a. the company's overall weighted average cost of capital. b. the actual sources of funding used for the project. c. an average of the company's overall cost of capital for the past five years. d. the current risk level of the overall firm. e. the risks associated with the use of the funds required by the project.

e. the risks associated with the use of the funds required by the project.