Multiple Choice
Identify the choice that best completes the statement or answers the
question.
1) Several years ago the Haverford Company sold
a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual
coupon that is paid quarterly. The bond currently sells for $900.90, and the
company’s tax rate is 40%. What is the component cost of debt for use in the
WACC calculation?
|
A. |
5.40% |
|
B. |
5.73% |
|
C. |
5.98% |
|
D. |
6.09% |
|
E. |
6.24% |
2) Assume that Mary Brown Inc. hired you as a
consultant to help it estimate the cost of capital. You have been provided with
the following data: D0= $1.20; P0= $40.00; and g= 7% (constant). Based on the DCF approach, what is Brown’s cost of
equity from retained earnings?
|
A. |
10.06% |
|
B. |
10.21% |
|
C. |
10.37% |
|
D. |
10.54% |
|
E. |
10.68% |
3) Crum International’s target capital structure
calls for 80% debt and 20% equity. The company expects to have $3 million of
net income this year, and 60% of the net income will be paid out in dividends.
How large can the firm’s capital budget be this year before it will have to
issue new common stock?
|
A. |
$5.5 million |
|
B. |
$6.0 million |
|
C. |
$6.3 million |
|
D. |
$6.8 million |
|
E. |
$7.1 million |
4) Assume that you are on the financial staff of
Christopher Inc., and you have collected the following data: (1) The yield
on the company’s outstanding bonds is 7.0%, and its tax rate is 40%.
(2) The expected year-end dividend is $0.80 a share, the dividend is
expected to grow at a constant rate of 6% a year, the price of Christopher’s
stock is $25 per share, and the flotation cost for selling new shares is 10%.
(3) The target capital structure is 40% debt and 60% equity. What is
Christopher’s WACC assuming that it must issue new stock to finance its capital
budget?
|
A. |
7.11% |
|
B. |
7.26% |
|
C. |
7.41% |
|
D. |
7.67% |
|
E. |
7.89% |
5) Moussawi Enterprises, which finances only
with equity from retained earnings, is considering two large capital budgeting
projects, and its CFO hired you to assist in deciding whether one, both, or
neither of the projects should be accepted. You have the following information:
(1) rRF= 5.5%; RPM= 6%; and b= 0.8. (2) The company adds 3% to the corporate WACC when it
evaluates relatively risky projects, and it deducts 1% from the WACC when
evaluating relatively safe projects. (3) Project S is relatively safe, it
costs $10,000, and its expected rate of return is 8%, while Project R is relatively
risky, it costs $15,000, and its expected rate of return is 12%. If these are
the only two projects under consideration, how large should the capital budget
be?
|
A. |
$ 5,000 |
|
B. |
$10,000 |
|
C. |
$15,000 |
|
D. |
$20,000 |
|
E. |
$25,000 |
6) Which of the following statements is CORRECT?
|
A. |
If a company’s tax rate increases but the YTM of its noncallable bonds |
|
B. |
All else equal, an increase in a company’s stock price will increase |
|
C. |
All else equal, an increase in a company’s stock price will increase |
|
D. |
Since the money is readily available, the after-tax cost of retained |
|
E. |
When calculating the cost of preferred stock, a company needs to |
7) Maese Sisters Inc has been paying out all of
its earnings as dividends, and hence 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
the WACC?
|
A. |
The flotation costs associated with issuing new common stock increase. |
|
B. |
The market risk premium declines. |
|
C. |
The company’s beta increases. |
|
D. |
Expected inflation increases. |
|
E. |
The flotation costs associated with issuing preferred stock increase. |
8) The Nunnally Company has equal amounts of
low-risk, average-risk, and high-risk projects. Nunnally estimates that its
overall WACC is 12%. The CFO believes that this is the correct WACC for the
company’s average-risk projects, but that a lower rate should be used for lower
risk projects and a higher rate for higher risk projects. However, the CEO
argues that, even though the company’s projects have different risks, the WACC
used to evaluate each project should be the same because the company obtains
capital for all projects from the same sources. If the CEO’s opinion is
followed, what is likely to happen over time?
|
A. |
The company will take on too many low-risk projects and reject too |
|
B. |
The company will take on too many high-risk projects and reject too |
|
C. |
Things will generally even out over time, and, therefore, the firm’s |
|
D. |
The company’s overall WACC should decrease over time because its stock |
|
E. |
The CEO’s recommendation would maximize the firm’s intrinsic value. |
9) Given the following information, what is the
required cash outflow associated with the acquisition of a new machine; that
is, in a project analysis, what is the cash outflow at t= 0?
|
Purchase price of new machine |
$8,000 |
|
Installation charge |
2,000 |
|
Market value of old machine |
2,000 |
|
Book value of old machine |
1,000 |
|
Inventory decrease if new machine |
|
|
is installed |
1,000 |
|
Accounts payable increase if new |
|
|
machine is installed |
500 |
|
Tax rate |
35% |
|
Cost of capital |
15% |
|
A. |
-$ 8,980 |
|
B. |
-$ 6,460 |
|
C. |
-$ 5,200 |
|
D. |
-$ 6,850 |
|
E. |
-$12,020 |
10) Blanchford Enterprises is considering a
project that has the following cash flow and WACC data. What is the project’s
discounted payback?
|
|
Year: |
0 |
1 |
2 |
3 |
|
Cash flows: |
-$1,000 |
$500 |
$500 |
$500 |
|
A. |
2.01 years |
|
B. |
2.26 years |
|
C. |
2.65 years |
|
D. |
2.84 years |
|
E. |
3.17 years |
11) Rockmont Recreation Inc. is considering a
project that has the following cash flow and WACC data. What is the project’s
MIRR? Note that a project’s projected MIRR can be less than the WACC (and even
negative), in which case it will be rejected.
|
WACC= 10% |
||||||
|
|
Year: |
0 |
1 |
2 |
3 |
4 |
|
Cash flows: |
-$900 |
$300 |
$320 |
$340 |
$360 |
|
A. |
13.33% |
|
B. |
14.01% |
|
C. |
15.69% |
|
D. |
16.35% |
|
E. |
17.18% |
12) Pettway Inc. is considering Projects S and L,
whose cash flows are shown below. These projects are mutually exclusive,
equally risky, and not repeatable. If the decision is made by choosing the
project with the higher IRR, how much value will be foregone? Note that under
some conditions choosing projects on the basis of the IRR will cause $0.00
value to be lost.
|
WACC= 12% |
||||||
|
|
Year: |
0 |
1 |
2 |
3 |
4 |
|
CFS: |
-$1,025 |
$375 |
$380 |
$385 |
$390 |
|
|
CFL: |
-$2,153 |
$750 |
$759 |
$768 |
$777 |
|
A. |
$15.57 |
|
B. |
$21.49 |
|
C. |
$28.02 |
|
D. |
$33.69 |
|
E. |
$37.39 |
13) You must find the payback for a project, and
you have misplaced some of the information that you were given. You know that
the project will generate positive cash flows of $60,000 per year at the end of
each of the next 5 years, that its NPV is $75,000, and that the company’s WACC
is 10%. What is the project’s regular payback? Hint: You must first find the
project’s cost, then use it to find the payback.
|
A. |
2.11 years |
|
B. |
2.27 years |
|
C. |
2.38 years |
|
D. |
2.45 years |
|
E. |
2.54 years |
14) Assume a project has normal cash flows. All
else equal, which of the following statements is CORRECT?
|
A. |
The project’s IRR increases as the WACC declines. |
|
B. |
The project’s NPV increases as the WACC declines. |
|
C. |
The project’s MIRR is unaffected by changes in the WACC. |
|
D. |
The project’s regular payback increases as the WACC declines. |
|
E. |
The project’s discounted payback increases as the WACC declines. |
15) 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 found by compounding the cash inflows at the IRR to |
|
B. |
The lower the WACC used to calculate it, the lower the calculated NPV |
|
C. |
If a project’s NPV is less than zero, then its IRR must be less than |
|
D. |
If a project’s NPV is greater than zero, then its IRR must be less |
|
E. |
The NPV of a relatively low risk project should be found using a |
16) Which of the following statements is CORRECT?
|
A. |
One advantage of the NPV over the IRR method is that NPV takes account |
|
B. |
One advantage of the NPV over the IRR is that NPV assumes that cash |
|
C. |
One advantage of the NPV over the MIRR method is that NPV takes |
|
D. |
One advantage of the NPV over the MIRR method is that NPV discounts |
|
E. |
Since cash flows under the IRR and MIRR are both discounted at the |
17) 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 D has a higher IRR. |
|
B. |
Project D is probably larger in scale than Project C. |
|
C. |
Project C probably has a faster payback. |
|
D. |
Project C has a higher IRR. |
|
E. |
The crossover rate between the two projects is below 12%. |
18) Sacramento Paper is considering two equally
risky, mutually exclusive projects, and both projects have normal cash flows.
Project A has an IRR of 11%, while Project B has an IRR of 14%. When the WACC
is 8%, the projects have the same NPV. Given this information, which of the
following statements is CORRECT?
|
A. |
If the WACC is 13%, Project A’s NPV will be higher than Project B’s. |
|
B. |
If the WACC is 9%, Project A’s NPV will be higher than Project B’s. |
|
C. |
If the WACC is 6%, Project B’s NPV will be higher than Project A’s. |
|
D. |
If the WACC goes over 14%, Project A’s IRR will exceed Project B’s. |
|
E. |
If the WACC is 9%, Project B’s NPV will be higher than Project A’s. |
19) As a member of Gamma Corporation’s financial
staff, you must estimate the Year 1 operating net cash flow for a proposed
project with the following data. What is the Year 1 operating cash flow?
|
Sales |
$33,000 |
|
|
Depreciation |
$10,000 |
|
|
Other operating costs |
$17,000 |
|
|
Interest expense |
$ 4,000 |
|
|
Tax rate |
35% |
|
A. |
$ 9,500 |
|
B. |
$10,600 |
|
C. |
$11,700 |
|
D. |
$12,800 |
|
E. |
$13,900 |
20) Big Air Services is now in the final year of
a project. The equipment originally cost $20 million, of which 75% has been
depreciated. Big Air can sell the used equipment today for $6 million, and its
tax rate is 40%. What is the equipment’s after-tax net salvage value?
|
A. |
$500,000 |
|
B. |
$600,000 |
|
C. |
$700,000 |
|
D. |
$800,000 |
|
E. |
$900,000 |
21) The Movie Place is considering a new
investment whose data are shown below. The required equipment has a 3-year tax
life and would be fully depreciated by the straight line method over the 3
years, but it would have a positive salvage value at the end of Year 3, when
the project would be closed down. Also, some new working capital would be
required, but it would be recovered at the end of the project’s life. Revenues
and other operating costs are expected to be constant over the project’s 3-year
life. What is the project’s NPV?
|
WACC |
10% |
|
|
Net equipment cost (depreciable basis) |
$65,000 |
|
|
Required new working capital |
$10,000 |
|
|
Straight line depr’n rate |
33.33% |
|
|
Sales revenues |
$70,000 |
|
|
Operating costs excl. depr’n |
$25,000 |
|
|
Expected pretax salvage value |
$ 5,000 |
|
|
Tax rate |
35% |
|
A. |
$24,971.86 |
|
B. |
$25,538.17 |
|
C. |
$26,553.97 |
|
D. |
$27,356.82 |
|
E. |
$28,879.81 |
22) Which of the following statements is CORRECT?
|
A. |
A sunk cost is any cost that must be expended in order to complete a |
|
B. |
A sunk cost is any cost that was expended in the past but can be |
|
C. |
A sunk cost is a cost that was incurred and expensed in the past and |
|
D. |
Sunk costs were formerly hard to deal with, but once the NPV method |
|
E. |
A good example of a sunk cost is a situation where a retailer opens a |
23) Which of the following factors should be
included in the cash flows used to estimate a project’s NPV?
|
A. |
All costs associated with the project that have been incurred to date. |
|
B. |
Interest on funds borrowed to help finance the project. |
|
C. |
The end-of-project recovery of any working capital required to operate |
|
D. |
Cannibalization effects, but only if those effects increase the |
|
E. |
Expenditures to date on research and development related to the |
24) Berry Beverage Company spent $3 million two
years ago to build a plant for a project. It then decided not to go forward
with the project, so the building is available for sale or for a new project.
It owns the building free and clear—there is no mortgage on it. Which of the
following statements is CORRECT?
|
A. |
Since the building has been paid for, it can be used by another |
|
B. |
If the building could be sold, then the after-tax proceeds that would |
|
C. |
This is an example of an externality, because the very existence of |
|
D. |
Since the building was built in the past, its cost is a sunk cost and |
|
E. |
If there was a mortgage loan on the building, then the interest on |
25) Merlin Labs has an overall (composite) WACC
of 10%, which reflects the cost of capital for its average asset. Its assets
vary widely in risk, and Merlin evaluates low-risk projects with a WACC of 8%,
average projects at 10%, and high-risk projects at 12%. The company is considering
the following projects:
|
Project |
Risk |
Expected Return |
|
A |
High |
15% |
|
B |
Average |
12 |
|
C |
High |
11 |
|
D |
Low |
9 |
|
E |
Low |
6 |
Which set of projects would maximize shareholder wealth?
|
A. |
A and B. |
|
B. |
A, B, and C. |
|
C. |
A, B, and D. |
|
D. |
A, B, C, and D. |
|
E. |
A, B, C, D, and E. |
