Advertisement Upgrade to remove ads

The corporate valuation model cannot be used unless a company doesn't pay dividends.

False

Free cash flows should be discounted at the firm's weighted average cost of capital to find the value of its operations.

True

Value-based management focuses on sales growth, profitability, capital requirements, the
weighted average cost of capital, and the dividend growth rate.

False

Two important issues in corporate governance are (1) the rules that cover the board's
ability to fire the CEO and (2)the rules that cover the CEO's ability to remove members
of the board.

False

If a company's expected return on invested capital is less than its cost of equity, then the
company must also have a negative market value added (MVA).

False

A poison pill is also known as a corporate restructuring.

False

The CEO of D'Amico Motors has been granted some stock options that have provisions
similar to most other executive stock options. If D'Amico's stock underperforms the
market, these options will necessarily be worthless.

False

ESOPs were originally designed to help improve worker productivity, but today they are
also used to help prevent hostile takeovers

True

Which of the following statements is NOT CORRECT?
a. The corporate valuation model can be used both for companies that pay dividends and
those that do not pay dividends.
b. The corporate valuation model discounts free cash flows by the required return on
equity.
c. The corporate valuation model can be used to find the value of a division.
d. An important step in applying the corporate valuation model is forecasting the firm's
pro forma financial statements.
e. Free cash flows are assumed to grow at a constant rate beyond a specified date in
order to find the horizon, or terminal, value.

b. The corporate valuation model discounts free cash flows by the required return on
equity.

Which of the following does NOT always increase a company's market value?
a. Increasing the expected growth rate of sales.
b. Increasing the expected operating profitability (NOPAT/Sales).
c. Decreasing the capital requirements (Capital/Sales).
d. Decreasing the weighted average cost of capital.
e. Increasing the expected rate of return on invested capital.

a. Increasing the expected growth rate of sales.

Which of the following is NOT normally regarded as being a barrier to hostile takeovers?
a. Abnormally high executive compensation.
b. Targeted share repurchases.
c. Shareholder rights provisions.
d. Restricted voting rights.
e. Poison pills.

a. Abnormally high executive compensation.

Which of the following is NOT normally regarded as being a good reason to establish an
ESOP?
a. To increase worker productivity.
b. To enable the firm to borrow at a below-market interest rate.
c. To make it easier to grant stock options to employees.
d. To help prevent a hostile takeover.
e. To help retain valued employees.

c. To make it easier to grant stock options to employees.

Akyol Corporation is undergoing a restructuring, and its free cash flows are expected to
be unstable during the next few years. However, FCF is expected to be $50 million in
Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be
constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is
the horizon value (in millions) at t = 5?

$883

Simonyan Inc. forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it
expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of
capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t =
3?

$840

Suppose Yon Sun Corporation's free cash flow during the just-ended year (t = 0) was
$100 million, and FCF is expected to grow at a constant rate of 5% in the future. If the
weighted average cost of capital is 15%, what is the firm's value of operations, in
millions?

$1050

Suppose Leonard, Nixon, & Shull Corporation's projected free cash flow for next year is
$100,000, and FCF is expected to grow at a constant rate of 6%. If the company's
weighted average cost of capital is 11%, what is the value of its operations?

$2,000,000

Zhdanov Inc. forecasts that its free cash flow in the coming year, i.e., at t = 1, will be -
$10 million, but its FCF at t = 2 will be $20 million. After Year 2, FCF is expected to
grow at a constant rate of 4% forever. If the weighted average cost of capital is 14%,
what is the firm's value of operations, in millions?

$167

Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted
average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2,
what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to
remain constant in Year 2 and beyond (and do not make any half-year adjustments).
Year: 1 2
Free cash flow: -$50 $100

$1456

A company forecasts the free cash flows (in millions) shown below. The weighted
average cost of capital is 13%, and the FCFs are expected to continue growing at a 5%
rate after Year 3. Assuming that the ROIC is expected to remain constant in Year 3 and
beyond, what is the Year 0 value of operations, in millions?
Year: 1 2 3
Free cash flow: -$15 $10 $40

$386

Based on the corporate valuation model, Bernile Inc.'s value of operations is $750
million. Its balance sheet shows $50 million of short-term investments that are unrelated
to operations, $100 million of accounts payable, $100 million of notes payable, $200
million of long-term debt, $40 million of common stock (par plus paid-in-capital), and
$160 million of retained earnings. What is the best estimate for the firm's value of
equity, in millions?

$500

Based on the corporate valuation model, the value of a company's operations is $1,200
million. The company's balance sheet shows $80 million in accounts receivable, $60
million in inventory, and $100 million in short-term investments that are unrelated to
operations. The balance sheet also shows $90 million in accounts payable, $120 million
in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180
million in retained earnings, and $800 million in total common equity. If the company
has 30 million shares of stock outstanding, what is the best estimate of the stock's price
per share?

$27.67

Based on the corporate valuation model, the value of a company's operations is $900
million. Its balance sheet shows $70 million in accounts receivable, $50 million in
inventory, $30 million in short-term investments that are unrelated to operations, $20
million in accounts payable, $110 million in notes payable, $90 million in long-term debt,
$20 million in preferred stock, $140 million in retained earnings, and $280 million in
total common equity. If the company has 25 million shares of stock outstanding, what is
the best estimate of the stock's price per share?

$28.40

Based on the corporate valuation model, Hunsader's value of operations is $300 million.
The balance sheet shows $20 million of short-term investments that are unrelated to
operations, $50 million of accounts payable, $90 million of notes payable, $30 million of
long-term debt, $40 million of preferred stock, and $100 million of common equity. The
company has 10 million shares of stock outstanding. What is the best estimate of the
stock's price per share?

$16.00

Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted
average cost of capital is 13% and the free cash flows are expected to continue growing at
the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of
operations, in millions?
Year: 1 2 3
Free cash flow: -$20 $42 $45

$617

Which of the following statements is most correct?
a. The NPV method assumes that cash flows will be reinvested at the cost of capital while the
IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk free rate while the
IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the cost of capital while the
IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider the inflation premium.
e. The IRR method does not consider all relevant cash flows, and particularly cash flows
beyond the payback period.

The NPV method assumes that cash flows will be reinvested at the cost of capital while the
IRR method assumes reinvestment at the IRR.

Project A has an IRR of 15 percent. Project B has an IRR of 18 percent. Both projects have the
same risk. Which of the following statements is most correct?

If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A

Project A has an internal rate of return (IRR) of 15 percent. Project B has an IRR of 14 percent. Both projects have a cost of capital of 12 percent. Which of the following statements is most correct?
a. If the WACC is 10 percent, both projects will have a positive NPV, and the NPV of Project B will exceed the NPV of Project A.
b. If the WACC is 15 percent, the NPV of Project B will exceed the NPV of Project A.
c. If the WACC is less than 18 percent, Project B will always have a shorter payback than
Project A.
d. If the WACC is greater than 18 percent, Project B will always have a shorter ayback than Project A.
e. If the WACC increases, the IRR of both projects will decline.

Both projects have a positive net present value (NPV).

Projects A and B have the same expected lives and initial cash outflows. However, one project's
cash flows are larger in the early years, while the other project has larger cash flows in the later
years. The two NPV profiles are given below:
Which of the following statements is most correct?

Project A has the larger cash flows in the later years.

Which of the following statements is most correct?
a. If a project's internal rate of return (IRR) exceeds the cost of capital, then the project's net
present value (NPV) must be positive.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return
equal to the cost of capital.
d. Answers a and c are correct.
e. None of the answers above is correct.

If a project's internal rate of return (IRR) exceeds the cost of capital, then the project's net
present value (NPV) must be positive.

A major disadvantage of the payback period method is that it

e. Only answers b and c are correct.
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.

The post-audit is used to

e. Answers a and b are correct
a. Improve cash flow forecasts.
b. Stimulate management to improve operations and bring results into line with forecasts.

Your company has a cost of capital equal to 10%. If the following projects are mutually
exclusive, and you only have the information that is provided, which should you accept?
A B C E
Payback (years) 1 5 2 5
IRR 18% 20% 20% 12%
NPV (Millions) $40 $75 $35 $100

E

A project has an up-front cost of $100,000. The project's WACC is 12 percent and its net present
value is $10,000. Which of the following statements is most correct?

The project's internal rate of return is greater than 12 percent

Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash
flows are positive). Which of the following statements is most correct?

All else equal, a project's NPV increases as the cost of capital declines.

A company estimates that its weighted average cost of capital (WACC) is 10 percent. Which of
the following independent projects should the company accept?

Project A requires an up-front expenditure of $1,000,000 and generates a net present value of
$3,200.

The internal rate of return of a capital investment

e. Answers c and d are correct.
c. Must exceed the cost of capital in order for the firm to accept the investment.
d. Is similar to the yield to maturity on a bond.

Projects L and S each have an initial cost of $10,000, followed by a series of positive cash
inflows. Project L has total, undiscounted cash inflows of $16,000, while S has total
undiscounted inflows of $15,000. Further, at a discount rate of 10 percent, the two projects have
identical NPVs. Which project's NPV will be more sensitive to changes in the discount rate?
(Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)

Project L

Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows
from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000.
Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best
describes this situation?

The NPV and IRR methods will select the same project if the cost of capital is greater than
10 percent; for example, 18 percent.

Assume that you are comparing two mutually exclusive projects. Which of the following
statements is most correct?

There will be a meaningful (as opposed to irrelevant) conflict only if the projects' NPV
profiles cross, and even then, only if the cost of capital is to the left of (or lower than) the
discount rate at which the crossover occurs

Which of the following statements is incorrect?
a. Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than
the cost of capital.
b. If the multiple IRR problem does not exist, any independent project acceptable by the NPV
method will also be acceptable by the IRR method.
c. If IRR = r (the cost of capital), then NPV = 0.
d. NPV can be negative if the IRR is positive.
e. The NPV method is not affected by the multiple IRR problem

Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than
the cost of capital.

Which of the following statements is correct?
a. Because discounted payback takes account of the cost of capital, a project's discounted
payback is normally shorter than its regular payback.
b. The NPV and IRR methods use the same basic equation, but in the NPV method the discount
rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set
equal to zero and the discount rate is found.
c. If the cost of capital is less than the crossover rate for two mutually exclusive projects' NPV
profiles, a NPV/IRR conflict will not occur.
d. If you are choosing between two projects which have the same life, and if their NPV profiles
cross, then the smaller project will probably be the one with the steeper NPV profile.
e. If the cost of capital is relatively high, this will favor larger, longer-term projects over
smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over
longer periods.

The NPV and IRR methods use the same basic equation, but in the NPV method the discount
rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set
equal to zero and the discount rate is found.

In comparing two mutually exclusive projects of equal size and equal life, which of the following
statements is most correct?
a. The project with the higher NPV may not always be the project with the higher IRR.
b. The project with the higher NPV may not always be the project with the higher MIRR.
c. The project with the higher IRR may not always be the project with the higher MIRR.
d. All of the answers above are correct.
e. Answers a and c are correct.

e. Answers a and c are correct.
a. The project with the higher NPV may not always be the project with the higher IRR.
c. The project with the higher IRR may not always be the project with the higher MIRR.

Which of the following is most correct?
a. The NPV and IRR rules will always lead to the same decision in choosing between mutually
exclusive projects, unless one or both of the projects are "non-normal" in the sense of having
only one change of sign in the cash flow stream.
b. The Modified Internal Rate of Return (MIRR) compounds cash outflows at the cost of
capital.
c. Conflicts between NPV and IRR rules arise in choosing between two mutually exclusive
projects (that each have normal cash flows) when the cost of capital exceeds the crossover
point (that is, the point at which the NPV profiles cross).
d. The discounted payback method overcomes the problems that the payback method has with
cash flows occurring after the payback period.
e. None of the statements above is correct.

e. None of the statements above is correct.

Normal projects C and D are mutually exclusive. Project C has a higher net present value if the
WACC is less than 12 percent, whereas Project D has a higher net present value if the WACC
exceeds 12 percent. Both projects have a positive NPV if the WACC is 12 percent. Which of the
following statements is most correct?

Project D has a higher internal rate of return.

Which of the following statements is most correct? The modified IRR (MIRR) method:

Answers b and c are correct.
b. Overcomes the problem of multiple rates of return.
c. Compounds cash flows at the cost of capital

Which of the following statements is most correct?
a. The IRR method is appealing to some managers because it produces a rate of return upon
which to base decisions rather than a dollar amount like the NPV method.
b. The discounted payback method solves all the problems associated with the payback method.
c. For independent projects, the decision to accept or reject will always be the same using either
the IRR method or the NPV method.
d. All of the statements above are correct.
e. Statements a and c are correct.

e. Statements a and c are correct.
a. The IRR method is appealing to some managers because it produces a rate of return upon
which to base decisions rather than a dollar amount like the NPV method.
c. For independent projects, the decision to accept or reject will always be the same using either
the IRR method or the NPV method.

Which of the following statements is most correct?
a. One of the disadvantages of choosing between mutually exclusive projects on the basis of the
discounted payback method is that you might choose the project with the faster payback
period but with the lower total return.
b. Multiple IRRs can occur in cases when project cash flows are normal, but they are more
common in cases where project cash flows are nonnormal.
c. When choosing between mutually exclusive projects, managers should accept all projects
with IRRs greater than the weighted average cost of capital.
d. All of the statements above are correct.
e. Two of the statements above are correct.

One of the disadvantages of choosing between mutually exclusive projects on the basis of the
discounted payback method is that you might choose the project with the faster payback
period but with the lower total return.

Project X has an internal rate of return of 20 percent. Project Y has an internal rate of return of
15 percent. Both projects have a positive net present value. Which of the following statements is
most correct?
a. Project X must have a higher net present value than Project Y.
b. If the two projects have the same WACC, Project X must have a higher net present value.
c. Project X must have a shorter payback than Project Y.
d. Both answers b and c are correct.
e. None of the above answers is correct.

None of the above answers is correct.

Which of the following statements is most correct?
a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the
project must have a positive NPV.
b. If the IRR of Project A exceeds the IRR of Project B, then Project A must also have a higher
NPV.
c. The modified internal rate of return (MIRR) can never exceed the IRR.
d. Answers a and c are correct.
e. None of the answers above is correct

a. If a project with normal cash flows has an IRR which exceeds the cost of capital, then the
project must have a positive NPV.

Which of the following statements is most correct?
a. The MIRR method will always arrive at the same conclusion as the NPV method.
b. The MIRR method can overcome the multiple IRR problem, while the NPV method cannot.
c. The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR
method.
d. Statements a and c are correct.
e. All of the above statements are correct.

The MIRR method uses a more reasonable assumption about reinvestment rates than the IRR
method.

The capital budgeting director of Sparrow Corporation is evaluating a project which costs
$200,000, is expected to last for 10 years and produce after-tax cash flows, including
depreciation, of $44,503 per year. If the firm's cost of capital is 14 percent and its tax rate is 40
percent, what is the project's IRR?

c. 18%

An insurance firm agrees to pay you $3,310 at the end of 20 years if you pay premiums of $100
per year at the end of each year for 20 years. Find the internal rate of return to the nearest whole
percentage point.

5%

A company is analyzing two mutually exclusive projects, S and L, whose cash flows are shown
below:
Years 0
r = 12%
1 2 3
| | | |
S -1,100 1,000 350 50
L -1,100 0 300 1,500
The company's cost of capital is 12 percent, and it can get an unlimited amount of capital at that
cost. What is the regular IRR (not MIRR) of the better project, i.e., the project which the
company should choose if it wants to maximize its stock price?

19.08%

Your company is choosing between the following non-repeatable, equally risky, mutually
exclusive projects with the cash flows shown below. Your cost of capital is 10 percent. How
much value will your firm sacrifice if it selects the project with the higher IRR?
Project S: 0
r = 10%
1 2 3
| | | |
-1,000 500 500 500
Project L: 0
r = 10%
1 2 3 4 5
| | | | | |
-2,000 668.76 668.76 668.76 668.76 668.76

$291.70

Green Grocers is deciding among two mutually exclusive projects. The two projects have the
following cash flows:
Project A Project B
Year Cash Flow Cash Flow
0 -$50,000 -$30,000
1 10,000 6,000
2 15,000 12,000
3 40,000 18,000
4 20,000 12,000
The company's cost of capital is 10 percent (WACC = 10%). What is the net present value
(NPV) of the project with the highest internal rate of return (IRR)?

$15,200

Vanderheiden Inc. is considering two average-risk alternative ways of producing its patented polo
shirts. Process S has a cost of $8,000 and will produce net cash flows of $5,000 per year for 2
years. Process L will cost $11,500 and will produce cash flows of $4,000 per year for 4 years.
The company has a contract that requires it to produce the shirts for 4 years, but the patent will
expire after 4 years, so the shirts will not be produced after 4 years. Inflation is expected to be
zero during the next 4 years. If cash inflows occur at the end of each year, and if Vanderheiden's
cost of capital is 10 percent, by what amount will the better project increase Vanderheiden's
value?

$1,237.76

Braun Industries is considering an investment project which has the following cash flows:
Year Cash Flow
0 -$1,000
1 400
2 300
3 500
4 400
The company's WACC is 10 percent. What is the project's payback, internal rate of return, and
net present value?

Payback = 2.6, IRR = 21.22%, NPV = $260.

Taylor Technologies has a target capital structure which is 40 percent debt and 60 percent equity. The equity will be financed with retained earnings. The company's bonds have a yield to maturity of 10 percent. The company's stock has a beta = 1.1. The risk-free rate is 6 percent, the market risk premium is 5 percent, and the tax rate is 30 percent. The company is considering a project with the following cash flows:

Project A
Year|| Cash Flow
0|| -$50,000
1|| 35,000
2|| 43,000
3|| 60,000
4|| -40,000

What is the project's modified internal rate of return (MIRR)?

20.52

Scott Corporation's new project calls for an investment of $10,000. It has an estimated life of 10 years. The IRR has been calculated to be 15 percent. If cash flows are evenly distributed and the tax rate is 40 percent, what is the annual before-tax cash flow each year? (Assume depreciation is a negligible amount.)

$3,321

When evaluating a new project, the firm should consider all of the following factors except:
a. Changes in working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project,
if the expenditures have been expensed for tax purposes.
c. The current market value of any equipment to be replaced.
d. The resulting difference in depreciation expense if the project involves replacement.
e. All of the statements above should be considered.

Previous expenditures associated with a market test to determine the feasibility of the project,
if the expenditures have been expensed for tax purposes.

Which of the following statements is most correct?
a. The rate of depreciation will often affect operating cash flows, even though depreciation is
not a cash expense.
b. Corporations should fully account for sunk costs when making investment decisions.
c. Corporations should fully account for opportunity costs when making investment decisions.
d. All of the answers above are correct.
e. Answers a and c are correct

e. Answers a and c are correct
a. The rate of depreciation will often affect operating cash flows, even though depreciation is
not a cash expense.
c. Corporations should fully account for opportunity costs when making investment decisions.

Which of the following is not a cash flow that results from the decision to accept a project?
a. Changes in working capital.
b. Shipping and installation costs.
c. Sunk costs.
d. Opportunity costs.
e. Externalities.

c. Sunk costs.

Twin Hills Inc. is considering a proposed project. Given available information, it is currently
estimated that the proposed project is risky but has a positive net present value. Which of the
following factors would make the company less likely to adopt the current project?
a. It is revealed that if the company proceeds with the proposed project, the company will lose
two other accounts, both of which have positive NPVs.
b. It is revealed that the company has an option to back out of the project 2 years from now, if it
is discovered to be unprofitable.
c. It is revealed that if the company proceeds with the project, it will have an option to repeat
the project 4 years from now.
d. Answers a and b are correct.
e. Answers b and c are correct

. It is revealed that if the company proceeds with the proposed project, the company will lose
two other accounts, both of which have positive NPVs.

A company is considering a proposed expansion to its facilities. Which of the following statements is
most correct?
a. In calculating the project's operating cash flows, the firm should not subtract out financing
costs such as interest expense, since these costs are already included in the WACC, which is
used to discount the project's net cash flows.
b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation
rate when calculating the operating cash flows.
c. When estimating the project's operating cash flows, it is important to include any opportunity
costs and sunk costs, but the firm should ignore cash flows from externalities since they are
accounted for elsewhere.
d. Statements a and c are correct.
e. None of the statements above is correct.

a. In calculating the project's operating cash flows, the firm should not subtract out financing costs such as interest expense, since these costs are already included in the WACC, which is used to discount the project's net cash flows.

Other things held constant, which of the following would increase the NPV of a project being considered?
a. A shift from MACRS to straight-line depreciation.
b. Making the initial investment in the first year rather than spreading it over the first 3 years.
c. A decrease in the discount rate associated with the project.
d. The sale of the old machine in a replacement decision at a capital loss rather than at book
value.
e. An increase in required working capital.

c. A decrease in the discount rate associated with the project.

Which of the following statements is correct?
a. Well diversified stockholders do not consider corporate risk when determining required rates
of return.
b. Undiversified stockholders, including the owners of small businesses, are more concerned
about corporate risk than market risk.
c. Managers care only about market risk.
d. Market risk is important but does not have a direct effect on stock price because it only
affects beta.
e. All of the statements above are false

b. Undiversified stockholders, including the owners of small businesses, are more concerned
about corporate risk than market risk.

A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any method for assessing risk. In evaluating this asset, the decision maker should
a. Increase the IRR of the asset to reflect the greater risk.
b. Increase the NPV of the asset to reflect the greater risk.
c. Reject the asset, since its acceptance would increase the risk of the firm.
d. Ignore the risk differential if the asset to be accepted would comprise only a small fraction of
the total assets of the firm.
e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project

e. Increase the cost of capital used to evaluate the project to reflect the higher risk of the project

Risk in a revenue-producing project can best be adjusted for by
a. Ignoring it.
b. Adjusting the discount rate upward for increasing risk.
c. Adjusting the discount rate downward for increasing risk.
d. Picking a risk factor equal to the average discount rate.
e. Reducing the NPV by 10 percent for risky projects

b. Adjusting the discount rate upward for increasing risk.

A company estimates that an average-risk project has a WACC of 10 percent, a below-averagerisk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12
percent. Which of the following independent projects should the company accept?
a. Project A has average risk and an IRR = 9 percent.
b. Project B has below-average risk and an IRR = 8.5 percent.
c. Project C has above-average risk and an IRR = 11 percent.
d. All of the projects above should be accepted.
e. None of the projects above should be accepted.

b. Project B has below-average risk and an IRR = 8.5 percent.

Project X has an up-front cost of $1 million, whereas Project Y has an up-front cost of only $200,000.
Both projects last five years and provide positive cash flows in Years 1-5. Project X is riskier; its riskadjusted WACC is 12 percent. Project Y is safer; its risk-adjusted WACC is 8 percent. After
discounting each of the project's cash flows at the project's risk-adjusted WACC, you find that Project
X has a NPV of $20,000, and Project Y has a NPV of $15,000. The projects are mutually exclusive
and cannot be repeated. The firm is not capital constrained; it can raise as much capital as it needs,
provided it has profitable projects in which to invest. Given this information, which of the following
statements is most correct?
a. The firm should select Project Y because it has a higher return; ($15,000/$200,000) is greater
than ($20,000/$1,000,000).
b. The firm should select Project X because it has a higher NPV.
c. The firm should select Project Y because it is less risky.
d. The firm should reject both projects because their IRRs are less than the risk-adjusted
WACC.
e. Statements a and c are correct.

b. The firm should select Project X because it has a higher NPV.

Which of the following statements is correct?
a. An asset that is sold for less than book value at the end of a project's life will generate a loss
for the firm and will cause an actual cash outflow attributable to the project.
b. Only incremental cash flows are relevant in project analysis and the proper incremental cash
flows are the reported accounting profits because they form the true basis for investor and
managerial decisions.
c. It is unrealistic to expect that increases in net operating working capital that are required at
the start of an expansion project are simply recovered at the project's completion. Thus, these
cash flows are included only at the start of a project.
d. Equipment sold for more than its book value at the end of a project's life will increase income
and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at
book value.
e. All of the statements above are false.

d. Equipment sold for more than its book value at the end of a project's life will increase income
and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at
book value.

Which of the following statements is correct?
a. In a capital budgeting analysis where part of the funds used to finance the project are raised
as debt, failure to include interest expense as a cost in the cash flow statement when
determining the project's cash flows will lead to an upward bias in the NPV.
b. The preceding statement would be true if "upward" were replaced with "downward."
c. The existence of "externalities" reduces the NPV to a level below the value that would exist
in the absence of externalities.
d. If one of the assets that would be used by a potential project is already owned by the firm,
and if that asset could be leased to another firm if the project is not undertaken, then the net
rent that could be obtained should be charged as a cost to the project under consideration.
e. The rent referred to in statement d is a sunk cost, and as such it should be ignored.

d. If one of the assets that would be used by a potential project is already owned by the firm,
and if that asset could be leased to another firm if the project is not undertaken, then the net
rent that could be obtained should be charged as a cost to the project under consideration.

Which of the following is not considered a relevant concern in deter- mining incremental cash
flows for a new product?
a. The use of factory floor space which is currently unused but available for production of any
product.
b. Revenues from the existing product that would be lost as a result of some customers
switching to the new product.
c. Shipping and installation costs associated with preparing the machine to be used to produce
the new product.
d. The cost of a product analysis completed in the previous tax year and specific to the new
product.
e. None of the above. (All are relevant concerns in estimating relevant cash flows attributable
to a new-product project.)

d. The cost of a product analysis completed in the previous tax year and specific to the new
product.

Which of the following statement completions is incorrect? For a profitable firm, when MACRS
accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances
produce
a. Higher depreciation charges in the early years of an asset's life.
b. Larger cash flows in the earlier years of an asset's life.
c. Larger total undiscounted profits from the project over the project's life.
d. Smaller accounting profits in the early years, assuming the company uses the same
depreciation method for tax and book purposes.
e. None of the above. (All of the above are correct.)

c. Larger total undiscounted profits from the project over the project's life.

Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are
expressed in real dollars. In this situation, other things held constant, the calculated NPV would
a. Be correct.
b. Be biased downward.
c. Be biased upward.
d. Possibly have a bias, but it could be upward or downward.
e. More information is needed; otherwise, we can make no reasonable statement.

b. Be biased downward.

In theory, the decision maker should view market risk as being of primary importance. However,
within-firm, or corporate, risk is relevant to a firm's
a. Well-diversified stockholders, because it may affect debt capacity and operating income.
b. Management, because it affects job stability.
c. Creditors, because it affects the firm's credit worthiness.
d. All of the answers above are correct.
e. Only answers a and c are correct.

d. All of the answers above are correct.

Which of the following statements is correct?
a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key
variables as reflected in their probability distributions.
b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be
considered less risky, because a small error in estimating a variable, such as unit sales, would
produce only a small error in the project's NPV.
c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis
requires a relatively powerful computer, coupled with an efficient financial planning software
package, whereas simulation analysis can be done using a PC with a spreadsheet program or
even a calculator.
d. Sensitivity analysis is a risk analysis technique that considers both the sensitivity of NPV to
changes in key variables and the likely range of variable values.
e. Answers c and d are correct.

a. Sensitivity analysis is incomplete because it fails to consider the range of likely values of key
variables as reflected in their probability distributions.

Monte Carlo simulation
a. Can be useful for estimating a project's stand-alone risk.
b. Is capable of using probability distributions for variables as input data instead of a single
numerical estimate for each variable.
c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
d. All of the answers above.
e. Only answers a and b are correct.

d. All of the answers above.
a. Can be useful for estimating a project's stand-alone risk.
b. Is capable of using probability distributions for variables as input data instead of a single
numerical estimate for each variable.
c. Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.

If a company uses the same discount rate for evaluating all projects, which of the following
results is likely?
a. Accepting poor, high-risk projects.
b. Rejecting good, low-risk projects.
c. Accepting only good, low-risk projects.
d. Accepting no projects.
e. Answers a and b are correct.

e. Answers a and b are correct.
a. Accepting poor, high-risk projects.
b. Rejecting good, low-risk projects.

If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most
likely become
a. Riskier over time, and its value will decline.
b. Riskier over time, and its value will rise.
c. Less risky over time, and its value will rise.
d. Less risky over time, and its value will decline.
e. There is no reason to expect its risk position or value to change over time as a result of its use
of a single discount rate.

a. Riskier over time, and its value will decline.

The Target Copy Company is contemplating the replacement of its old printing machine with a
new model costing $60,000. The old machine, which originally cost $40,000, has 6 years of
expected life remaining and a current book value of $30,000 versus a current market value of
$24,000. Target's corporate tax rate is 40 percent. If Target sells the old machine at market value,
what is the initial after-tax outlay for the new printing machine?
a. -$22,180
b. -$30,000
c. -$33,600
d. -$36,000
e. -$40,000

c. -$33,600

Dandy Product's overall weighted average required rate of return is 10 percent. Its yogurt division
is riskier than average, its fresh produce division has average risk, and its institutional foods
division has below-average risk. Dandy adjusts for both divisional and project risk by adding or
subtracting 2 percentage points. Thus, the maximum adjustment is 4 percentage points. What is
the risk-adjusted required rate of return for a low-risk project in the yogurt division?
a. 6%
b. 8%
c. 10%
d. 12%
e. 14%

c. 10%

Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by
$5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs
by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually.
Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine
at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40
percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's
cost is $40,000, what is the project's NPV?
a. -$15,394
b. -$14,093
c. -$58,512
d. -$21,493
e. -$46,901

d. -$21,493

Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs
by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually.
Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine
at the end of its 5-year operating life for $10,000 before taxes. Stanton's marginal tax rate is 40
percent, and it uses a 9 percent cost of capital to evaluate projects of this type. If the machine's
cost is $40,000, what is the project's NPV?
a. $1,014
b. $2,292
c. $7,550
d. $ 817
e. $5,040

b. $2,292

Klott Company encounters significant uncertainty with its sales volume and price in its primary
product. The firm uses scenario analysis in order to determine an expected NPV, which it then
uses in its budget. The base case, best case, and worse case scenarios and probabilities are
provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and
coefficient of variation of NPV?
Probability Unit Sales Sales NPV
of Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000
a. Expected NPV = $35,000; σNPV = 17,500; CVNPV = 2.00.
b. Expected NPV = $35,000; σNPV = 11,667; CVNPV = 0.33.
c. Expected NPV = $10,300; σNPV = 12,083; CVNPV = 1.17.
d. Expected NPV = $13,900; σNPV = 8,476; CVNPV = 0.61.
e. Expected NPV = $10,300; σNPV = 13,900; CVNPV = 1.35.

c. Expected NPV = $10,300; σNPV = 12,083; CVNPV = 1.17.

Virus Stopper Inc., a supplier of computer safeguard systems, uses a cost of capital of 12 percent
to evaluate average-risk projects, and it adds or subtracts 2 percentage points to evaluate projects
of more or less risk. Currently, two mutually exclusive projects are under consideration. Both
have a cost of $200,000 and will last 4 years. Project A, a riskier-than-average project, will
produce annual end of year cash flows of $71,104. Project B, of less than average risk, will
produce cash flows of $146,411 at the end of Years 3 and 4 only. Virus Stopper should accept
a. B with a NPV of $10,001.
b. Both A and B because both have NPVs greater than zero.
c. B with a NPV of $8,042.
d. A with a NPV of $7,177.
e. A with a NPV of $15,968.

a. B with a NPV of $10,001.

Real Time Systems Inc. is considering the development of one of two mutually exclusive new
computer models. Each will require a net investment of $5,000. The cash flow figures for each
project are shown below:

Period Project A Project B
1 $2,000 $3,000
2 2,500 2,600
3 2,250 2,900

Model B, which will use a new type of laser disk drive, is considered a high-risk project, while
Model A is of average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted cost of
capital when evaluating a high-risk project. The cost of capital used for average-risk projects is 12
percent. Which of the following statements regarding the NPVs for Models A and B is most
correct?
a. NPVA = $380; NPVB = $1,815.
b. NPVA = $197; NPVB = $1,590.
c. NPVA = $380; NPVB = $1,590.
d. NPVA = $5,380; NPVB = $6,590.
e. None of the statements above is correct.

c. NPVA = $380; NPVB = $1,590.

Ridgefield Enterprises has total assets of $300 million. The company currently has no
debt in its capital structure. The company's basic earning power is 15 percent. The
company is contemplating a recapitalization where it will issue debt at 10 percent and use
the proceeds to buy back shares of the company's common stock. If the company
proceeds with the recapitalization, its operating income, total assets, and tax rate will
remain the same. Which of the following will occur as a result of the recapitalization?
a. The company's ROA will decline.
b. The company's ROE will increase.
c. The company's basic earning power will decline.
d. Answers a and b are correct.
e. All of the above answers are correct.

d. Answers a and b are correct.
a. The company's ROA will decline.
b. The company's ROE will increase.

Which of the following statements is most correct?
a. Since debt financing raises the firm's financial risk, raising a company's debt ratio
will always increase the company's WACC.
b. Since debt financing is cheaper than equity financing, raising a company's debt ratio
will always reduce the company's WACC.
c. Increasing a company's debt ratio will typically reduce the marginal cost of both debt
and equity financing; however, it still may raise the company's WACC.
d. Statements a and c are correct.
e. None of the statements above is correct.

e. None of the statements above is correct.

Which of the following events is likely to encourage a company to raise its target debt
ratio?
a. An increase in the corporate tax rate.
b. An increase in the personal tax rate.
c. An increase in the company's operating leverage.
d. Statements a and c are correct.
e. All of the statements above are correct.

a. An increase in the corporate tax rate.

Which of the following would increase the likelihood that a company would increase its
debt ratio in its capital structure?
a. An increase in costs incurred when filing for bankruptcy.
b. An increase in the corporate tax rate.
c. An increase in the personal tax rate.
d. A decrease in the firm's business risk.
e. Statements b and d are correct.

e. Statements b and d are correct.
b. An increase in the corporate tax rate.
d. A decrease in the firm's business risk.

Volga Publishing is considering a proposed increase in its debt ratio, which will also
increase the company's interest expense. The plan would involve the company issuing
new bonds and using the proceeds to buy back shares of its common stock. The
company's CFO expects that the plan will not change the company's total assets or
operating income. However, the company's CFO does estimate that it will increase the
company's earnings per share (EPS). Assuming the CFO's estimates are correct, which of
the following statements is most correct?
a. Since the proposed plan increases Volga's financial risk, the company's stock price
still might fall even though its EPS is expected to increase.
b. If the plan reduces the company's WACC, the company's stock price is also likely to
decline.
c. Since the plan is expected to increase EPS, this implies that net income is also
expected to increase.
d. Statements a and b are correct.
e. Statements a and c are correct

a. Since the proposed plan increases Volga's financial risk, the company's stock price
still might fall even though its EPS is expected to increase.

Which of the following statements is false? As a firm increases its operating leverage for a given
quantity of output, this
a. changes its operating cost structure.
b. increases its business risk.
c. increases the standard deviation of its EBIT.
d. increases the variability in earnings per share.
e. decreases its financial leverage.

e. decreases its financial leverage.

If debt financing is used, which of the following is true?
a. The percentage change in net operating income is greater than a given percentage
change in net income.
b. The percentage change in net operating income is equal to a given percentage change in
net income.
c. The percentage change in net income relative to the percentage change in net operating
income depends on the interest rate charged on debt.
d. The percentage change in net operating income is less than the percentage change in net
income.
e. The degree of operating leverage is greater than 1.

d. The percentage change in net operating income is less than the percentage change in net
income.

Company A and Company B have the same total assets, operating income (EBIT), tax rate,
and business risk. Company A, however, has a much higher debt ratio than Company B.
Company A's basic earning power (BEP) exceeds its cost of debt financing (rd). Which of
the following statements is most correct?
a. Company A has a higher return on assets (ROA) than Company B.
b. Company A has a higher times interest earned (TIE) ratio than Company B.
c. Company A has a higher return on equity (ROE) than Company B, and its risk, as
measured by the standard deviation of ROE, is also higher than Company B's.
d. Statements b and c are correct.
e. All of the statements above are correct.

c. Company A has a higher return on equity (ROE) than Company B, and its risk, as

Which of the following statements is most correct?
a. A firm can use retained earnings without paying a flotation cost. Therefore, while the
cost of retained earnings is not zero, the cost of retained earnings is generally lower
than the after-tax cost of debt financing.
b. The capital structure that minimizes the firm's cost of capital is also the capital
structure that maximizes the firm's stock price.
c. The capital structure that minimizes the firm's cost of capital is also the capital
structure that maximizes the firm's earnings per share.
d. If a firm finds that the cost of debt financing is currently less than the cost of equity
financing, an increase in its debt ratio will always reduce its cost of capital.
e. Statements a and b are correct.

b. The capital structure that minimizes the firm's cost of capital is also the capital
structure that maximizes the firm's stock price.

Elephant Books sells paperback books for $7 each. The variable cost per book is $5. At
current annual sales of 200,000 books, the publisher is just breaking even. It is estimated
that if the authors' royalties are reduced, the variable cost per book will drop by $1.
Assume authors' royalties are reduced and sales remain constant; how much more money
can the publisher put into advertising (a fixed cost) and still break even?
a. $600,000
b. $466,667
c. $333,333
d. $200,000
e. None of the above

d. $200,000

The Congress Company has identified two methods for producing playing cards. One
method involves using a machine having a fixed cost of $10,000 and variable costs of
$1.00 per deck of cards. The other method would use a less expensive machine (fixed cost
= $5,000), but it would require greater variable costs ($1.50 per deck of cards). If the
selling price per deck of cards will be the same under each method, at what level of output
will the two methods produce the same net operating income?
a. 5,000 decks
b. 10,000 decks
c. 15,000 decks
d. 20,000 decks
e. 25,000 decks

b. 10,000 decks

A consultant has collected the following information regarding Young Publishing:
Total assets $3,000 million Tax rate 40%
Operating income (EBIT) $800 million Debt ratio 0%
Interest expense $0 million WACC 10%
Net income $480 million M/B ratio 1.00×
Share price $32.00 EPS = DPS $3.20
The company has no growth opportunities (g = 0), so the company pays out all of its
earnings as dividends (EPS = DPS). The consultant believes that if the company moves to
a capital structure financed with 20 percent debt and 80 percent equity (based on market
values) that the cost of equity will increase to 11 percent and that the pre-tax cost of debt
will be 10 percent. If the company makes this change, what would be the total market
value of the firm? (The answers are in millions.)
a. $3,200 b. $3,600 c. $4,000 d. $4,200 e. $4,800

e. $4,800

Dabney Electronics currently has no debt. Its operating income is $20 million and its tax
rate is 40 percent. It pays out all of its net income as dividends and has a zero growth
rate. The current stock price is $40 per share, and it has 2.5 million shares of stock
outstanding. If it moves to a capital structure that has 40 percent debt and 60 percent
equity (based on market values), its investment bankers believe its weighted average cost
of capital would be 10 percent. What would its stock price be if it changes to the new
capital structure?
a. $40 b. $48 c. $52 d. $54 $60

b. $48

Simon Software Co. is trying to estimate its optimal capital structure. Right now, Simon
has a capital structure that consists of 20 percent debt and 80 percent equity, based on
market values. (Its D/S ratio is 0.25.) The risk-free rate is 6 percent and the market risk
premium, rM - rRF, is 5 percent. Currently the company's cost of equity, which is based
on the CAPM, is 12 percent and its tax rate is 40 percent. What would be Simon's
estimated cost of equity if it were to change its capital structure to 50 percent debt and 50
percent equity?
a. 14.35% b. 30.00% c. 14.72% d. 15.60% 13.64%

a. 14.35%

Aaron Athletics is trying to determine its optimal capital structure. The company's capital
structure consists of debt and common stock. In order to estimate the cost of debt, the
company has produced the following table:
Percent financed Percent financed Debt-to-equity Bond Before-tax
With debt (wd) with equity (wc) ratio (D/S) rating cost of debt

0.10 0.90 0.10/0.90 = 0.11 AA 7.0%
0.20 0.80 0.20/0.80 = 0.25 A 7.2
0.30 0.70 0.30/0.70 = 0.43 A 8.0
0.40 0.60 0.40/0.60 = 0.67 BB 8.8
0.50 0.50 0.50/0.50 = 1.00 B 9.6
The company's tax rate, T, is 40 percent.
The company uses the CAPM to estimate its cost of common equity, rs. The risk-free rate
is 5 percent and the market risk premium is 6 percent. Aaron estimates that if it had no
debt its beta would be 1.0. (Its "unlevered beta," bU, equals 1.0.)
On the basis of this information, what is the company's optimal capital structure, and
what is the firm's cost of capital at this optimal capital structure?
a. wc = 0.9; wd = 0.1; WACC = 14.96%
b. wc = 0.8; wd = 0.2; WACC = 10.96%
c. wc = 0.7; wd = 0.3; WACC = 7.83%
d. wc = 0.6; wd = 0.4; WACC = 10.15%
e. wc = 0.5; wd = 0.5; WACC = 10.18%

d. wc = 0.6; wd = 0.4; WACC = 10.15%

The A. J. Croft Company (AJC) currently has $200,000 market value (and book value) of
perpetual debt outstanding carrying a coupon rate of 6 percent. Its earnings before interest
and taxes (EBIT) are $100,000, and it is a zero-growth company. AJC's current cost of
equity is 8.8 percent, and its tax rate is 40 percent. The firm has 10,000 shares of common
stock outstanding selling at a price per share of $60.00. What is AJC's current total market value and weighted average cost of capital?
a. $600,000; 7.5%
b. $600,000; 8.0%
c. $800,000; 7.0%
d. $800,000; 7.5%
e. $800,000; 8.0%

d. $800,000; 7.5%

The firm is considering moving to a capital structure that is comprised of 40 percent debt
and 60 percent equity, based on market values. The new funds would be used to replace
the old debt and to repurchase stock. It is estimated that the increase in riskiness resulting
from the leverage increase would cause the required rate of return on debt to rise to 7
percent, while the required rate of return on equity would increase to 9.5 percent. If this
plan were carried out, what would be AJC's new WACC and total value?
a. 7.38%; $800,008
b. 7.38%; $813,008
c. 7.50%; $813,008
d. 7.50%; $790,008
e. 7.80%; $790,008

b. 7.38%; $813,008

Now assume that AJC is considering changing from its original capital structure to a new
capital structure with 50 percent debt and 50 percent equity. If it makes this change, its
resulting market value would be $820,000. What would be its new stock price per share?
a. $58
b. $59
c. $60
d. $61
e. $62

e. $62

Now assume that AJC is considering changing from its original capital structure to a new
capital structure that results in a stock price of $64 per share. The resulting capital structure
would have a $336,000 total market value of equity and $504,000 market value of debt.
How many shares would AJC repurchase in the recapitalization?
a. 4,250
b. 4,500
c. 4,750
d. 5,000
e. 5,250

c. 4,750

Please allow access to your computer’s microphone to use Voice Recording.

Having trouble? Click here for help.

We can’t access your microphone!

Click the icon above to update your browser permissions above and try again

Example:

Reload the page to try again!

Reload

Press Cmd-0 to reset your zoom

Press Ctrl-0 to reset your zoom

It looks like your browser might be zoomed in or out. Your browser needs to be zoomed to a normal size to record audio.

Please upgrade Flash or install Chrome
to use Voice Recording.

For more help, see our troubleshooting page.

Your microphone is muted

For help fixing this issue, see this FAQ.

Star this term

You can study starred terms together

NEW! Voice Recording

Create Set