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LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? a. Project B, which is of below-average risk and has a return of 8.5%. b. Project A, which is of average risk and has a return of 9%. c. All of the projects should be accepted. d. None of the projects should be accepted. e. Project C, which is of above-average risk and has a return of 11%.
A
Which of the following actions would be likely to reduce potential conflicts of interest between stockholders and managers? a. The composition of the board of directors is changed from all inside directors to all outside directors, and the directors are compensated with stock rather than cash. b. The company changes the way executive stock options are handled, with all options vesting after 2 years rather than having 20% of the options awarded vest every 2 years over a 10-year period. c. Congress passes a law that severely restricts hostile takeovers. d. A firm's compensation system is changed so that managers receive larger cash salaries but fewer long-term options to buy stock. e. The company's outside auditing firm is given a lucrative year-by-year consulting contract with the company.
A
Which of the following statements is CORRECT? a. Both NASDAQ dealers and "specialists" on the NYSE hold inventories of stocks. b. Capital market transactions involve only preferred stock or common stock. c. Money market transactions do not involve securities denominated in currencies other than the U.S. dollar. d. If General Electric were to issue new stock this year, this would be considered a secondary market transaction since the company already has stock outstanding. e. The most important difference between spot markets versus futures markets is the maturity of the instruments that are traded. Spot market transactions involve securities that have maturities of less than one year whereas futures markets transactions involve securities with maturities greater than one year.
A
Which of the following statements is CORRECT? a. If a company's tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall. b. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. c. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. d. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. e. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
A
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. 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. b. To find a project's IRR, we must find a discount rate that is equal to the WACC. c. If a project's IRR is greater than the WACC, then its NPV must be negative. d. 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. 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.
A
Which of the following statements regarding a 15-year (180-month) $125,000, fixed-rate mortgage is CORRECT? (Ignore taxes and transactions costs.) a. The outstanding balance declines at a faster rate in the later years of the loan's life. b. The remaining balance after three years will be $125,000 less one third of the interest paid during the first three years. c. The proportion of the monthly payment that goes towards repayment of principal will be lower 10 years from now than it will be the first year. d. Interest payments on the mortgage will increase steadily over time, but the total amount of each payment will remain constant. e. Because the outstanding balance declines over time, the monthly payments will also decline over time.
A
Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A's cost of capital is 10.0%, Division B's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A's projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. Division A project with a 9% return. b. Division A project with an 11% return. c. Division B project with an 11% return. d. Division B project with a 12% return. e. Division B project with a 13% return.
B
Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? a. Project C probably has a faster payback. b. Project D probably has a higher IRR. c. Project C probably has a higher IRR. d. Project D is probably larger in scale than Project C. e. The crossover rate between the two projects is below 12%.
B
Which is the best measure of risk for a single asset held in isolation, and which is the best measure for an asset held in a diversified portfolio? a. Beta; beta. b. Standard deviation; beta. c. Beta; variance. d. Variance; correlation coefficient. e. Standard deviation; correlation coefficient.
B
Which of the following statements is CORRECT? a. If some cash flows occur at the beginning of the periods while others occur at the ends, then we have what the textbook defines as a variable annuity. b. The cash flows for an annuity due must all occur at the beginning of the periods. c. If a series of unequal cash flows occurs at regular intervals, such as once a year, then the series is by definition an annuity. d. The cash flows for an ordinary (or deferred) annuity all occur at the beginning of the periods. e. The cash flows for an annuity may vary from period to period, but they must occur at regular intervals, such as once a year or once a month.
B
Which of the following statements is CORRECT? a. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. b. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. c. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. d. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices. e. If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.
B
A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? a. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. b. All interest expenses on debt used to help finance the project. c. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows. d. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life. e. All sunk costs that have been incurred relating to the project.
C
Assume that the rate on a 1-year bond is now 6%, but all investors expect 1-year rates to be 7% one year from now and then to rise to 8% two years from now. Assume also that the pure expectations theory holds, hence the maturity risk premium equals zero. Which of the following statements is CORRECT? a. The yield curve should be downward sloping, with the rate on a 1-year bond at 6%. b. The interest rate today on a 3-year bond should be approximately 8%. c. The interest rate today on a 3-year bond should be approximately 7%. d. The interest rate today on a 2-year bond should be approximately 7%. e. The interest rate today on a 2-year bond should be approximately 6%.
C
For a typical firm, which of the following sequences is CORRECT? All rates are after taxes, and assume that the firm operates at its target capital structure. a. rd > rs > WACC. b. WACC > rs > rd. c. rs > WACC > rd. d. WACC > rd > rs. e. rs > rd > WACC.
C
If the Treasury yield curve is downward sloping, how should the yield to maturity on a 10-year Treasury coupon bond compare to that on a 1-year T-bill? a. The yields on the two securities would be equal. b. It is impossible to tell without knowing the relative risks of the two securities. c. The yield on a 10-year bond would be less than that on a 1-year bill. d. It is impossible to tell without knowing the coupon rates of the bonds. e. The yield on a 10-year bond would have to be higher than that on a 1-year bill because of the maturity risk premium.
C
Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. Expected inflation increases. b. The company's beta increases. c. The market risk premium declines. d. The flotation costs associated with issuing new common stock increase. e. The flotation costs associated with issuing preferred stock increase.
C
Walter Industries' current ratio is 0.5. Considered alone, which of the following actions would increase the company's current ratio? a. Use cash to reduce short-term notes payable. b. Use cash to reduce accruals. c. Borrow using short-term notes payable and use the cash to increase inventories. d. Use cash to reduce accounts payable. e. Use cash to reduce long-term bonds outstanding.
C
Which of the following actions would be likely to encourage a firm's managers to make decisions that are in the best interests of shareholders? a. The state legislature passes a law that makes it more difficult to successfully complete a hostile takeover. b. The firm's board of directors gives the firm's managers greater freedom to take whatever actions they think best without obtaining board approval. c. The percentage of the firm's stock that is held by institutional investors such as mutual funds, pension funds, and hedge funds rather than by small individual investors rises from 10% to 80%. d. The percentage of executive compensation that comes in the form of cash is increased and the percentage coming from long-term stock options is reduced. e. The firm's founder, who is also president and chairman of the board, sells 90% of her shares.
C
Which of the following statements is CORRECT? a. If a project has "normal" cash flows, then its MIRR must be positive. b. If a project has "normal" cash flows, then its IRR must be positive. c. If a project has "normal" cash flows, then it can have only one real IRR, whereas a project with "nonnormal" cash flows might have more than one real IRR. d. The definition of "normal" cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project's life. e. If a project has "normal" cash flows, then it will have exactly two real IRRs.
C
Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.
C
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. 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. b. If a project's NPV is greater than zero, then its IRR must be less than the WACC. c. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPVs of relatively risky projects should be found using relatively low WACCs. Which of the following statements is CORRECT?
C
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. a. If a project's NPV is greater than zero, then its IRR must be less than zero. b. The lower the WACC used to calculate it, the lower the calculated NPV will be. c. If a project's NPV is less than zero, then its IRR must be less than the WACC. d. The NPV of a relatively low-risk project should be found using a relatively high WACC. e. A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.
C
Bankston Corporation 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. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock? a. Increase the dividend payout ratio for the upcoming year. b. Increase the proposed capital budget. c. Reduce the amount of short-term bank debt in order to increase the current ratio. d. Increase the percentage of debt in the target capital structure. e. Reduce the percentage of debt in the target capital structure.
D
The Nantell Corporation just purchased an expensive piece of equipment. Assume that the firm planned to depreciate the equipment over 5 years on a straight-line basis, but Congress then passed a provision that requires the company to depreciate the equipment on a straight-line basis over 7 years. Other things held constant, which of the following will occur as a result of this Congressional action? Assume that the company uses the same depreciation method for tax and stockholder reporting purposes. a. Nantell's reported net income for the year will be lower. b. Nantell's tax liability for the year will be lower. c. Nantell's taxable income will be lower. d. Nantell's operating income (EBIT) will increase. e. Nantell's cash position will improve (increase).
D
Under normal conditions, which of the following would be most likely to increase the coupon rate required for a bond to be issued at par? a. Adding additional restrictive covenants that limit management's actions. b. Making the bond a first mortgage bond rather than a debenture. c. Adding a sinking fund. d. Adding a call provision. e. The rating agencies change the bond's rating from Baa to Aaa.
D
Which of the following actions would be most likely to reduce potential conflicts of interest between stockholders and bondholders? a. Abolishing the Security and Exchange Commission. b. Compensating managers with stock options. c. Financing risky projects with additional debt. d. The use of covenants in bond agreements that limit the firm's use of additional debt and constrain managers' actions. e. The threat of hostile takeovers.
D
Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project? a. Shipping and installation costs for machinery acquired. b. Opportunity costs. c. Changes in net operating working capital. d. Sunk costs that have been expensed for tax purposes. e. Cannibalization effects.
D
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. b. The company has spent and expensed $1 million on research and development costs associated with the new project. c. Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. d. The new project is expected to reduce sales of one of the company's existing products by 5%. e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
D
Which of the following statements is CORRECT? a. Assume that two bonds have equal maturities and are of equal risk, but one bond sells at par while the other sells at a premium above par. The premium bond must have a lower current yield and a higher capital gains yield than the par bond. b. A discount bond's price declines each year until it matures, when its value equals its par value. c. If a bond sells for less than par, then its yield to maturity is less than its coupon rate. d. A bond's current yield must always be either equal to its yield to maturity or between its yield to maturity and its coupon rate. e. If a bond sells at par, then its current yield will be less than its yield to maturity.
D
Which of the following statements is CORRECT? a. Because bankruptcy requires that corporate bondholders be paid in full before stockholders receive anything, bondholders generally prefer to see corporate managers invest in high risk/high return projects rather than low risk/low return projects. b. One advantage of operating a business as a corporation is that stockholders can deduct their pro rata share of the taxes the firm pays, thereby eliminating the double taxation investors would face in a partnership. c. Potential conflicts between stockholders and bondholders are increased if a firm's bonds are convertible into its common stock. d. Since bondholders receive fixed payments, they do not share in the gains if risky projects turn out to be highly successful. However, they do share in the losses if risky projects fail and drive the firm into bankruptcy. Therefore, bondholders generally prefer to see corporate managers invest in low risk/low return projects rather than high risk/high return projects. e. One drawback of forming a corporation is that you lose the limited liability that you would otherwise receive as a proprietor.
D
Which of the following statements is CORRECT? a. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM. b. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock. c. Higher flotation costs reduce investors' expected returns, and that leads to a reduction in a company's WACC. d. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation. e. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
D
Which of the following statements is CORRECT? a. By law in most states, the chairman of the board must also be the CEO. b. The CFO is responsible for raising capital and for making sure that capital expenditures are desirable, but he or she is not responsible for the validity of the financial statements, as the controller and the auditors have that responsibility. c. The CFO generally reports to the firm's chief accounting officer, who is normally the controller. d. The board of directors is the highest-ranking body in a corporation, and the chairman of the board is the highest-ranking individual. The CEO generally works under the board and its chairman, and the board generally has the authority to remove the CEO under certain conditions. The CEO, however, cannot remove the board, but he or she can endeavor to have the board voted out and a new board voted in should a conflict arise. It is possible for a person to simultaneously serve as CEO and chairman of the board, though many corporate control experts believe it is bad to vest both offices in the same person. e. In most corporations, the CFO ranks above the CEO.
D
Which of the following statements is CORRECT? a. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 - T) + Capital expenditures. b. Most rapidly growing companies have positive free cash flows because cash flows from existing operations generally exceed fixed asset purchases and changes to net operating working capital. c. Managers should be less concerned with free cash flow than with accounting net income. Accounting net income is the "bottom line" and represents how much the firm can distribute to all its investors--both creditors and stockholders. d. Free cash flow (FCF) is defined as follows: FCF = EBIT(1 - T) + Depreciation - Capital expenditures required to sustain operations - Required changes in net operating working capital. e. Changes in working capital have no effect on free cash flow.
D
Which of the following statements is CORRECT? a. If a coupon bond is selling at a discount, its price will continue to decline until it reaches its par value at maturity. b. e. If a bond's yield to maturity exceeds its annual coupon, then the bond will trade at a premium. c. If a coupon bond is selling at a premium, its current yield equals its yield to maturity. d. If a coupon bond is selling at par, its current yield equals its yield to maturity. e. If interest rates increase, the price of a 10-year coupon bond will decline by a greater percentage than the price of a 10-year zero coupon bond.
D
Which of the following statements is CORRECT? a. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. b. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. c. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. d. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself. e. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.
D
Which of the following statements is CORRECT? a. The shorter a project's payback period, the less desirable the project is normally considered to be by this criterion. b. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback. c. If a project's payback is positive, then the project should be accepted because it must have a positive NPV. d. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period. e. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
D
Which of the following statements is CORRECT? a. WACC calculations should be based on the before-tax costs of all the individual capital components. b. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing. c. Flotation costs associated with issuing new common stock normally reduce the WACC. d. If a company's tax rate increases, then, all else equal, its weighted average cost of capital will decline. e. A change in a company's target capital structure cannot affect its WACC.
D
If a stock's dividend is expected to grow at a constant rate of 5% a year, which of the following statements is CORRECT? The stock is in equilibrium. a. The price of the stock is expected to decline in the future. b. The stock's required return must be equal to or less than 5%. c. The stock's dividend yield is 5%. d. The expected return on the stock is 5% a year. e. The stock's price one year from now is expected to be 5% above the current price.
E
The relative risk of a proposed project is best accounted for by which of the following procedures? a. Ignoring risk because project risk cannot be measured accurately. b. Reducing the NPV by 10% for risky projects. c. Picking a risk factor equal to the average discount rate. d. Adjusting the discount rate upward if the project is judged to have below-average risk. e. Adjusting the discount rate upward if the project is judged to have above-average risk.
E
Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting? a. Preferred stock. b. Long-term debt. c. Common stock. d. Retained earnings. e. Accounts payable.
E
Which of the following statements is CORRECT? a. For a project to have more than one IRR, then both IRRs must be greater than the WACC. b. If a project is independent, then it cannot have multiple IRRs. c. 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. d. If two projects are mutually exclusive, then they are likely to have multiple IRRs. e. Multiple IRRs can occur only if the signs of the cash flows change more than once.
E
Which of the following statements is CORRECT? a. A two-stock portfolio will always have a lower beta than a one-stock portfolio. b. A stock with an above-average standard deviation must also have an above-average beta. c. If portfolios are formed by randomly selecting stocks, a 10-stock portfolio will always have a lower beta than a one-stock portfolio. d. A two-stock portfolio will always have a lower standard deviation than a one-stock portfolio. e. A portfolio that consists of 40 stocks that are not highly correlated with "the market" will probably be less risky than a portfolio of 40 stocks that are highly correlated with the market, assuming the stocks all have the same standard deviations.
E
Which of the following statements is CORRECT? a. An NPV profile graph shows how a project's payback varies as the cost of capital changes. b. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life. c. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases. d. We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV. e. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.
E
Which of the following statements is CORRECT? a. The stock valuation model, P0 = D1/(rs - g), can be used only for firms whose growth rates exceed their required return. b. The preemptive right gives stockholders the right to approve or disapprove of a merger between their company and some other company. c. The stock valuation model, P0 = D1/(rs - g), cannot be used for firms that have negative growth rates. d. If a company has two classes of common stock, Class A and Class B, the stocks may pay different dividends, but under all state charters the two classes must have the same voting rights. e. The preemptive right is a provision in the corporate charter that gives common stockholders the right to purchase (on a pro rata basis) new issues of the firm's common stock.
E
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. b. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. c. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products. d. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes. e. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
E