Corp Finance Flashcards
reading 35 and 36
1
Q
As the director of capital budgeting for Denver Corporation, an analyst is evaluating two mutually exclusive projects with the following net cash flows:
Year Project X Project Z 0 -$100,000 -$100,000 1 $50,000 $10,000 2 $40,000 $30,000 3 $30,000 $40,000 4 $10,000 $60,000 If Denver's cost of capital is 15%, which project should be chosen?
A) Project X, since it has the higher IRR.
B) Project X, since it has the higher net present value (NPV).
C) Neither project.
A
C
NPV for Project X = -100,000 + 50,000 / (1.15)1 + 40,000 / (1.15)2 + 30,000 / (1.15)3 + 10,000 / (1.15)4
= -100,000 + 43,478 + 30,246 + 19,725 + 5,718 = -833
NPV for Project Z = -100,000 + 10,000 / (1.15)1 + 30,000 / (1.15)2 + 40,000 / (1.15)3 + 60,000 / (1.15)4
= -100,000 + 8,696 + 22,684 + 26,301 + 34,305 = -8,014
Reject both projects because neither has a positive NPV.
2
Q
If a project has a negative cash flow during its life or at the end of its life, the project most likely has:
A) a negative internal rate of return.
B) multiple net present values.
C) more than one internal rate of return.
A
C
Projects with unconventional cash flows (where the sign of the cash flow changes from minus to plus to back to minus) will have multiple internal rates of return. However, one will still be able to calculate a single net present value for the cash flow pattern.
3
Q
Which of the following types of capital budgeting projects are most likely to generate little to no revenue?
A) New product or market development.
B) Regulatory projects.
C) Replacement projects to maintain the business.
A
B
Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.
4
Q
The greatest amount of detailed capital budgeting analysis is typically required when deciding whether to:
A) expand production capacity.
B) replace a functioning machine with a newer model to reduce costs.
C) introduce a new product or develop a new market.
A
C
Introducing a new product or entering a new market involves sales and expense projections that can be highly uncertain. Expanding capacity or replacing old machinery involves less uncertainty and analysis.
5
Q
Lane Industries has a project with the following cash flows:
Year Cash Flow 0 −$200,000 1 60,000 2 80,000 3 70,000 4 60,000 5 50,000 The project's cost of capital is 12%. The discounted payback period is closest to:
A) 2.9 years.
B) 3.4 years.
C) 3.9 years.
A
C
The discounted payback period method discounts the estimated cash flows by the project’s cost of capital and then calculates the time needed to recover the investment.
Year CF Discounted CF Cumulative Discounted CF
0 −$200,000 −$200,000.00 −$200,000.00
1 60,000 53,571.43 −146,428.57
2 80,000 63,775.51 −82,653.06
3 70,000 49,824.62 −32,828.44
4 60,000 38,131.08 5,302.64
5 50,000 28,371.30 33,673.98
discounted payback period =number of years until the year before full recovery + uncovered cost at beginning of the year/discounted CF during the year
=3+32,828.44/38,131.08=3.86
6
Q
Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:
Year Project 1 Cash Flow Project 2 Cash Flow
0 −$4.0 ?
1 $3.0 $1.7
2 $5.0 $3.2
3 $2.0 $5.8
The crossover rate of the two projects’ NPV profiles is 9%. What is the initial cash flow for Project 2?
A
4.22
The crossover rate is the rate at which the NPV for two projects is the same. That is, it is the rate at which the two NPV profiles cross. At a discount rate of 9%, the NPV of Project 1 is: CF0 = -4; CF1 = 3; CF2 = 5; CF3 = 2; I = 9%; CPT → NPV = $4.51.
Now perform the same calculations except that we need to set the unknown CF0 = 0. The remaining entries are: CF1 = 1.7; CF2 = 3.2; CF3 = 5.8; I = 9%; CPT → NPV = $8.73.
Since by definition the crossover rate produces the same NPV for both projects, we know that both projects should have an NPV = $4.51. Since the NPV of Project 2 (with CF0 = 0) is $8.73, the unknown cash flow must be a large enough negative amount to reduce the NPV for Project 2 from $8.73 to $4.51. Thus the unknown initial cash flow for Project 2 is determined as $4.51 = $8.73 + CF0, or CF0 = −$4.22.
7
Q
When using net present value (NPV) profiles:
A)
one should accept all independent projects with positive NPVs.
B)
the NPV profile’s intersection with the vertical y-axis identifies the project’s internal rate of return.
C)
one should accept all mutually exclusive projects with positive NPVs.
A
A
Where the NPV intersects the vertical y-axis you have the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero). Where the NPV intersects the horizontal x-axis you have the project’s internal rate of return. At this cost of financing, the cash inflows and cash outflows offset each other. The NPV profile is a tool that graphically plots the project’s NPV as calculated using different discount rates. Assuming an appropriate discount rate, one should accept all projects with positive net present values, if the projects are independent. If projects are mutually exclusive select the one with the higher NPV at any given level of the cost of capital.
8
Q
Where the NPV intersects the vertical y-axis you have ____
Where the NPV intersects the horizontal x-axis you have
A
- the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero).
- the project’s internal rate of return.
9
Q
Where the NPV intersects the ____ axis you have the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero). Where the NPV intersects the ___axis you have the project’s internal rate of return.
A
- y (vertical)
- x (horizontal)
10
Q
Which of the following statements regarding the net present value (NPV) and internal rate of return (IRR) is least accurate?
A)
For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation.
B)
For independent projects, the internal rate of return IRR and the NPV methods always yield the same accept/reject decisions.
C)
The NPV tells how much the value of the firm will increase if you accept the project.
A
A
(first time picked B. Only when cash flow pattern is unconventional, IRR and NPV might be different. Also, for mutually exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.)
If the NPV for two mutually exclusive projects is negative, both should be rejected.
11
Q
A single independent project with a negative net present value has an initial cost of $2.5 million and would generate cash inflows of $1 million in each of the next three years. The discount rate the company used when evaluating this project is closest to:
A) 9%.
B) 10%.
C) 8%.
A
Given that the NPV is negative, the discount rate used by the company evaluating the project must be greater than the IRR (the discount rate for which the NPV equals zero). On a financial calculator: CF0 = -2.5; CFj = 1; Nj = 3; CPT IRR = 9.7%. Since the discount rate used for this project is greater than 9.7%, it must be closer to 10% than to either of the other answer choices.
12
Q
when IRR > required rate of return ____ the project
A
accept
13
Q
when IRR < ______, reject the project
A
required rate of return
14
Q
when (NPV)_____, accept the project
independent vs mutually exclusive
A
NPV > 0 and the project is independent
or when project has the bigger NPV (if mutually exclusive)
15
Q
when NPV _____, reject the project
A
<0
16
Q
Profitability index = ?
A
= PV of future cash flow / CF0
= 1 + NPV/CF0
17
Q
when profitability index (PI) ____, accept the project
A
> 1
18
Q
Which of the following steps is least likely to be an administrative step in the capital budgeting process?
A)
Forecasting cash flows and analyzing project profitability.
B)
Conducting a post-audit to identify errors in the forecasting process.
C)
Arranging financing for capital projects.
- what are the steps?
A
(note, the capitol budgeting process has 4 “admin” steps. they are called admin, not because they aren’t important)
- Idea generation
- Analyzing project proposals (based on expected future cashflow)
- Creating the firm-wide capital budget
- Monitoring decisions and conducting a post-audit
19
Q
The effect of a company announcement that they have begun a project with a current cost of $10 million that will generate future cash flows with a present value of $20 million is most likely to:
A)
only affect value of the firm’s common shares if the project was unexpected.
B)
increase the value of the firm’s common shares by $20 million.
C)
increase value of the firm’s common shares by $10 million.
A
A
The NPV method is a measure of the expected change in company value from undertaking a project. A firm’s stock price may be affected to the extent that engaging in a project with that NPV was previously unanticipated by investors.
(and this is only in theory, as in reality stock price could increase more than CF - for example if public expect further expansion, or less than CF - for example if analyst expects a less increase than mgmt’s forecast)
20
Q
Edelman Enginenering is considering including an overhead pulley system in this year’s capital budget. The cash outlay for the pully system is $22,430. The firm’s cost of capital is 14%. After-tax cash flows, including depreciation are $7,500 for each of the next 5 years.
Calculate the internal rate of return (IRR) and the net present value (NPV) for the project, and indicate the correct accept/reject decision.
NPV IRR Accept/Reject A) $3,318 20% Accept B) $15,070 14% Reject C) $15,070 14% Accept
A
A
Using the cash flow keys:
CF0 = -22,430; CFj = 7,500; Nj = 5; Calculate IRR = 20%
I/Y = 14%; Calculate NPV = 3,318
Because the NPV is positive, the firm should accept the project.
21
Q
The underlying cause of ranking conflicts between the net present value (NPV) and internal rate of return (IRR) methods is the underlying assumption related to the:
A) cash flow timing.
B) reinvestment rate.
C) initial cost.
A
B
The IRR method assumes all future cash flows can be reinvested at the IRR. This may not be feasible because the IRR is not based on market rates. The NPV method uses the weighted average cost of capital (WACC) as the appropriate discount rate.
22
Q
projects with ____ cash flow patterns can produce multiple IRRs or no IRR.
A
unconventional
23
Q
For projects with conventional cash flow patterns, the NPV and IRR methods produce ____ accept/reject decision
A
the same
24
Q
Which of the following statements about the discounted payback period is least accurate? The discounted payback:
A) method can give conflicting results with the NPV.
B) frequently ignores terminal values.
C) period is generally shorter than the regular payback.
A
C
The discounted payback period calculates the present value of the future cash flows. Because these present values will be less than the actual cash flows it will take a longer time period to recover the original investment amount.
- For A, NPV could conflict with IRR, but prob not pay back period
25
One of the basic principles of capital budgeting is that:
A)
opportunity costs should be excluded from the analysis of a project.
B)
decisions are based on cash flows, not accounting income.
C)
cash flows should be analyzed on a pre-tax basis.
- what are the other principles? and how many
B
five principles:
- Decisions are based on cash flows, not accounting income.
- Cash flows are based on opportunity costs.
- The timing of cash flows is important.
- Cash flows are analyzed on an after-tax basis.
- Financing costs are reflected in the project's required rate of return.
26
Which of the following statements about NPV and IRR is least accurate?
A)
For mutually exclusive projects you should use the IRR to rank and select projects.
B)
The NPV method assumes that all cash flows are reinvested at the cost of capital.
C)
For independent projects if the IRR is > the cost of capital accept the project.
A
| should use NPV
27
Which of the following statements about the internal rate of return (IRR) for a project with the following cash flow pattern is CORRECT?
Year 0: -$ 2,000
Year 1: $10,000
Year 2: -$ 10,000
A) It has a single IRR of approximately 38%.
B) No IRRs can be calculated.
C) It has two IRRs of approximately 38% and 260%.
(can't rely solely on the calculator!!)
C
The number of IRRs equals the number of changes in the sign of the cash flow. In this case, from negative to positive and then back to negative. Although 38% seems appropriate, one should not automatically discount the value of 260%.
Check answers by calculation:
10,000 ÷ 1.38 - 10,000 ÷ 1.382 = 1995.38
And:
10,000 ÷ 3.6 - 10,000 ÷ 3.62 = 2006.17
Both discount rates give NPVs of approximately zero and thus, are IRRs.
28
Jack Smith, CFA, is analyzing independent investment projects X and Y. Smith has calculated the net present value (NPV) and internal rate of return (IRR) for each project:
Project X: NPV = $250; IRR = 15%
Project Y: NPV = $5,000; IRR = 8%
Smith should make which of the following recommendations concerning the two projects?
A) Accept both projects.
B) Accept Project Y only.
C) Accept Project X only.
A
The projects are independent, meaning that either one or both projects may be chosen. Both projects have positive NPVs, therefore both projects add to shareholder wealth and both projects should be accepted.
29
Which of the following statements about independent projects is least accurate?
A)
The net present value indicates how much the value of the firm will change if the project is accepted.
B)
The internal rate of return and net present value methods can yield different accept/reject decisions for independent projects.
C)
If the internal rate of return is less than the cost of capital, reject the project.
B
For independent projects the IRR and NPV give the same accept/reject decision.
For mutually exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.
30
For ______ projects the IRR and NPV give the same accept/reject decision. For _____ projects the IRR and NPV techniques can yield different accept/reject decisions.
independent ; mutually exclusive
31
For independent projects the IRR and NPV give ____ accept/reject decision. For mutually exclusive projects the IRR and NPV techniques ______ accept/reject decisions.
the same; can yield different
32
What if independent projects have unconventional cash pattern (which could create zero or more than one IRR)? Would that conflict with NPV?
Since all independent projects can all be accepted if they add value, NPV and IRR conflict doesn’t arise. The company can accept all projects with positive NPV.
(还是不是很理解，但就记住吧）
33
In a net present value (NPV) profile, the internal rate of return is represented as the:
A) intersection of the NPV profile with the horizontal axis.
B) intersection of the NPV profile with the vertical axis.
C) point where two NPV profiles intersect.
A
B - that's assuming no time value exist or no capitol cost
C - that's crossover point where two projects have the same IRR
34
A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments:
```
Year 1: $100,000
Year 2: $82,000
Year 3: $76,000
Year 4: $111,000
Year 5: $142,000
```
If the required rate of return for the firm is 8%, what is the net present value of the investment? (You'll need to use your financial calculator.)
A) $86,133.
B) $99,860.
C) $64,582.
C
35
A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project's NPV and IRR.
NPV IRR
A) $243 20%
B) $883 20%
C) $883 15%
B
36
The effects that the acceptance of a project may have on other firm cash flows are best described as:
A) externalities.
B) opportunity costs.
C) pure plays.
A
| Externalities refer to the effects that the acceptance of a project may have on other firm cash flows
37
give an example of externalities
Cannibalization is one example of an externality (a negative one where accepting this project will decrease CF of other projects)
good example: diet coke
38
A firm is evaluating two mutually exclusive projects of the same risk class, Project X and Project Y. Both have the same initial cash outlay and both have positive NPVs. Which of the following is a sufficient reason to choose Project X over Project Y?
A) Project Y has a lower internal rate of return than Project X.
B) Project X has both a shorter payback period and a shorter discounted payback period compared to Project Y.
C) Project Y has a lower profitability index than Project X.
C
The correct method of choosing between two mutually exclusive projects is to choose the one with the higher NPV. The profitability index is calculated as the present value of the future cash flows divided by the initial outlay for the project. Because both projects have the same initial cash outlay, the one with the higher profitability index has both higher present value of future cash flows and the higher NPV. Ranking projects on their payback periods or their internal rates of return can lead to incorrect ranking.
39
If the calculated net present value (NPV) is negative, which of the following must be CORRECT. The discount rate used is:
A) less than the internal rate of return (IRR).
B) greater than the internal rate of return (IRR).
C) equal to the internal rate of return (IRR).
B
When the NPV = 0, this means the discount rate used is equal to the IRR. If a discount rate is used that is higher than the IRR, the NPV will be negative. Conversely, if a discount rate is used that is lower than the IRR, the NPV will be positive.
40
Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?
A) $376,872.
B) $325,859.
C) $280,913.
(be careful of timing, "not till end of the year" = CF0 = $0)
C
The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913.
41
The NPV profile is a graphical representation of the change in net present value relative to a change in the:
A) discount rate.
B) prime rate.
C) internal rate of return.
A
42
The Chief Financial Officer of Large Closeouts Inc. (LCI) determines that the firm must engage in capital rationing for its capital budgeting projects. Which of the following describes the most likely reason for LCI to use capital rationing? LCI:
A) has a limited amount of funds to invest.
B) would like to arrange projects so that investing in a project today provides the option to accept or reject certain future projects.
C) must choose between projects that compete with one another.
A
Capital rationing exists when a company has a fixed (maximum) amount of funds to invest. If profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize its funds to achieve the maximum value for shareholders given its capital limitations.
B - project sequencing
C - mutually exclusive projects
43
_____ concerns the opportunities for future capital projects that may be created by undertaking a current project.
Project sequencing
44
Project sequencing is best described as:
A)
an investment in a project today that creates the opportunity to invest in other projects in the future.
B)
arranging projects in an order such that cash flows from the first project fund subsequent projects.
C)
prioritizing funds to achieve the maximum value for shareholders, given capital limitations.
A
Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future.
!! Note that funding from the first project is not a requirement for project sequencing.
45
T or F?
| funding from the first project is a requirement for project sequencing.
False
46
T or F?
project sequencing is arranging projects in an order such that cash flows from the first project fund subsequent projects.
False. CF from first project is not a requirement for project sequencing
47
The process of evaluating and selecting profitable long-term investments consistent with the firm's goal of shareholder wealth maximization is known as:
A) monitoring.
B) financial restructuring.
C) capital budgeting.
C
In the process of capital budgeting, a manager is making decisions about a firm's earning assets, which provide the basis for the firm's profit and value. Capital budgeting refers to investments expected to produce benefits for a period of time greater than one year.
B - Financial restructuring is done as a result of bankruptcy
C - monitoring is a critical assessment aspect of capital budgeting (last step of admin steps).
48
A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project's payback period and discounted payback period.
Payback Period Discounted Payback Period
A) 2.0 years 1.6 years
B) 2.0 years 2.4 years
C) 2.4 years 1.6 years
B
Regarding the regular payback period, after 1 year, the amount to recover is $2,000 ($5,000 - $3,000). After the second year, the amount is fully recovered.
The discounted payback period is found by first calculating the present values of each future cash flow. These present values of future cash flows are then used to determine the payback time period.
3,000 / (1 + .10)1 = 2,727
2,000 / (1 + .10)2 = 1,653
2,000 / (1 + .10)3 = 1,503.
Then:
5,000 - (2,727 + 1,653) = 620
620 / 1,503 = .4.
So, 2 + 0.4 = 2.4.
49
Which of the following statements about the internal rate of return (IRR) and net present value (NPV) is least accurate?
A)
The IRR is the discount rate that equates the present value of the cash inflows with the present value of the outflows.
B)
For mutually exclusive projects, if the NPV rankings and the IRR rankings give conflicting signals, you should select the project with the higher IRR.
C)
The discount rate that causes the project's NPV to be equal to zero is the project's IRR.
B
The NPV method is always preferred over the IRR, because the NPV method assumes cash flows are reinvested at the cost of capital. Conversely, the IRR assumes cash flows can be reinvested at the IRR. The IRR is not an actual market rate.
50
Landen, Inc. uses several methods to evaluate capital projects. An appropriate decision rule for Landen would be to invest in a project if it has a positive:
A) profitability index (PI).
B) internal rate of return (IRR).
C) net present value (NPV).
C
The decision rules for net present value, profitability index, and internal rate of return are to invest in a project if
- NPV > 0,
- IRR > required rate of return, or
- PI > 1.
51
A company is considering two mutually exclusive investment projects. The firm's cost of capital is 12%. Each project costs $7 million and the after-tax cash flows for each are as follows:
Project One Project Two
Year 1 $6.6 million $3.0 million
Year 2 $1.5 million $3.0 million
Year 3 $0.1 million $3.0 million
Indicate which project should be accepted and whether the IRR and NPV methods would lead to the same decision.
Project accepted? Same decision?
A) Project One No
B) Project Two Yes
C) Project Two No
C
The NPVs for Project One and Project Two are $0.160 million and $0.206 million, respectively, thus, Project Two should be selected. The IRRs for Projects One and Project Two are 14.2% and 13.7%, respectively. NPV is considered a superior method for ranking mutually exclusive projects.
52
When a company is evaluating two mutually exclusive projects that are both profitable but have conflicting NPV and IRR project rankings, the company should:
A) accept the project with the higher internal rate of return.
B) use a third method of evaluation such as discounted payback period.
C) accept the project with the higher net present value.
C
53
An analyst has gathered the following data about a company with a 12% cost of capital:
Project P Project Q
Cost $15,000 $25,000
Life 5 years 5 years
Cash inflows $5,000/year $7,500/year
If the projects are independent, what should the company do?
A) Reject both Project P and Project Q.
B) Accept both Project P and Project Q.
C) Accept Project P and reject Project Q.
B
Project P: N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT → PV = 18,024; NPV for Project A = 18,024 − 15,000 = 3,024.
Project Q: N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT → PV = 27,036; NPV for Project B = 27,036 − 25,000 = 2,036.
For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore, accept both projects
54
Financing costs for a capital project are:
A) subtracted from estimates of a project's future cash flows.
B) subtracted from the net present value of a project.
C) captured in the project's required rate of return.
C
| one of the principles
55
Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR:
A)
can lead to multiple IRR rates if the cash flows extend past the payback period.
B)
assumes that the reinvestment rate of the cash flows is the cost of capital.
C)
and the net present value (NPV) method lead to the same accept/reject decision for independent projects.
C
NPV and IRR lead to the same decision for independent projects, not necessarily for mutually exclusive projects.
B - IRR assumes that cash flows are reinvested at the IRR rate.
C - IRR does not ignore time value of money (the payback period does), and the investor may find multiple IRRs if there are sign changes after time zero (i.e., negative cash flows after time zero).
56
A company is considering a $10,000 project that will last 5 years.
Annual after tax cash flows are expected to be $3,000
Cost of capital = 9.7%
What is the project's net present value (NPV)?
A) -$1,460.
B) +$1,460.
C) +$11,460.
Calculate the PV of the project cash flows
N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460
Calculate the project NPV by subtracting out the initial cash flow
NPV = $11,460 − $10,000 = $1,460
(or use the NPV function directly)
57
Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net present value of $10 million. Investors did not anticipate the sale because government approval to sell to Cuba had never before been granted. The share price of Polington should:
A)
increase by the NPV × (1 - corporate tax rate) divided by the number of common shares outstanding.
B)
not necessarily change because new contract announcements are made all the time.
C)
increase by the project NPV divided by the number of common shares outstanding.
Explanation
C
Since the sale was not anticipated by the market, the share price should rise by the NPV of the project per common share.
A - NPV is already calculated using after-tax cash flows.
58
Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share with 8 million shares outstanding. Assuming that this project represents new information and is independent of other expectations about the company, what should the effect of the project be on the firm's stock price?
A) The stock price will increase to $30.50.
B) The stock price will remain unchanged.
C) The stock price will increase to $34.25.
A
In theory, a positive NPV project should provide an increase in the value of a firm's shares.
NPV of new capital equipment = $50 million - $30 million = $20 million
Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000
Value of company after new equipment project = $224 million + $20 million = $244 million
Price per share after new equipment project = $244 million / 8 million = $30.50
Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.
59
The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as:
A) externality; cannibalization.
B) sunk cost; externality.
C) opportunity cost; externality.
B
60
Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm's optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble?
Sparkle and Fizz Opportunity to invest in Bubble
A) Independent projects Add-on project
B) Independent projects Project sequencing
C) Mutually exclusive projects Project sequencing
B
Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project's individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.
61
The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in years 1 through 4, $35,000 per year in years 5 through 9, and $40,000 in year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%. The payback period for this investment is ?
4.86 years
150K-30K*4=30K ==> balance after 4 years
30/35=.86
4+.86=4.86 years
62
Tapley Acquisition, Inc., is considering the purchase of Tangent Company. The acquisition would require an initial investment of $190,000, but Tapley's after-tax net cash flows would increase by $30,000 per year and remain at this new level forever. Assume a cost of capital of 15%. Should Tapley buy Tangent?
A) Yes, because the NPV = $10,000.
B) No, because k > IRR.
C) Yes, because the NPV = $30,000.
A
This is a perpetuity.
PV = PMT / I = 30,000 / 0.15 = 200,000
200,000 − 190,000 = 10,000
63
An analyst has gathered the following data about a company with a 12% cost of capital:
Project P Project Q
Cost $15,000 $25,000
Life 5 years 5 years
Cash inflows $5,000/year $7,500/year
If Projects P and Q are mutually exclusive, what should the company do?
A) Accept Project Q and reject Project P.
B) Reject both Project P and Project Q.
C) Accept Project P and reject Project Q.
C - can use the NPV calculation function for faster results
Project P:
N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT PV = 18,024
NPV for Project A = 18,024 − 15,000 = 3,024.
Project Q:
N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT PV = 27,036
NPV for Project B = 27,036 − 25,000 = 2,036.
For mutually exclusive projects, accept the project with the highest positive NPV. In this example the NPV for Project P (3,024) is higher than the NPV of Project Q (2,036). Therefore accept Project P.
64
Which of the following projects would most likely have multiple internal rates of return (IRRs)? The cost of capital for all projects is 10.0%.
Cash Flows South East West
CF0 -15,000 -12,000 -8,000
CF1 10,000 7,000 4,000
CF2 -1,000 2,000 0
CF3 15,000 2,000 6,000
A) Project South only.
B) Projects South and West.
C) Projects East and West.
A
The multiple IRR problem occurs if a project has an unconventional cash flow pattern, that is, the sign of the cash flows changes more than once (from negative to positive to negative, or vice-versa). Only Project South has this cash flow pattern. Neither the zero cash flow for Project West nor the likely negative net present value for Project East would result in multiple IRRs.
65
T or F?
| The payback period provides a rough measure of a project's liquidity and risk.
T
66
T or F?
| The payback period is the number of years it takes to recover the original cost of the investment.
T
67
T or F?
| The payback method considers all cash flows throughout the entire life of a project.
F
68
For a project with cash outflows during its life, the least preferred capital budgeting tool would be____
IRR
The IRR encounters difficulties when cash outflows occur throughout the life of the project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor the PI suffer from these limitations.
69
Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting:
Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project.
Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project.
Which of the following regarding Lutz's statements is most accurate?
Statement 1 Statement 2
A) Correct Incorrect
B) Correct Correct
C) Incorrect Correct
A
Lutz's first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz's second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.
70
Which of the following statements about NPV and IRR is NOT correct?
A)
The NPV will be positive if the IRR is less than the cost of capital.
B)
The IRR can be positive even if the NPV is negative.
C)
When the IRR is equal to the cost of capital, the NPV equals zero.
A
This statement should read, "The NPV will be positive if the IRR is greater than the cost of capital. The other statements are correct. The IRR can be positive (>0), but less than the cost of capital, thus resulting in a negative NPV. One definition of the IRR is the rate of return for which the NPV of a project is zero.
71
If two projects are mutually exclusive, a company:
A)
can accept either project, but not both projects.
B)
must accept both projects or reject both projects.
C)
can accept one of the projects, both projects, or neither project.
A
Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.
72
Which of the following projects would have multiple internal rates of return (IRRs)? The cost of capital for all projects is 9.75%.
Cash Flows Blackjack Roulette Keno
T0 -10,000 -12,000 -8,000
T1 10,000 7,000 4,000
T2 15,000 2,000 0
T3 -10,000 2,000 6,000
A) Project Blackjack only.
B) Projects Roulette and Keno.
C) Projects Blackjack and Keno.
A
The multiple IRR problem occurs if a project has non-normal cash flows, that is, the sign of the net cash flows changes from negative to positive to negative, or vice versa. For the exam, a shortcut to look for is the project cash flows changing signs more than once. Only Project Blackjack has this cash flow pattern. The 0 net cash flow in T2 for Project Keno and likely negative net present value (NPV) for Project Roulette would not necessarily result in multiple IRRs.
73
Which of the following is the most appropriate decision rule for mutually exclusive projects?
A)
If the net present value method and the internal rate of return method give conflicting signals, select the project with the highest internal rate of return.
B)
Accept the project with the highest net present value, subject to the condition that its net present value is greater than zero.
C)
Accept both projects if their internal rates of return exceed the firm's hurdle rate.
B
*has to be positive! (high NPV sometimes in questions just mean high absolute value..)
The project that maximizes the firm's value is the one that has the highest positive NPV.
74
Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting.
Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis.
Statement 2: Cash flows should be analyzed on an after-tax basis.
Should DeWalt agree or disagree with Webb's statements?
Statement 1 Statement 2
A) Agree Agree
B) Disagree Disagree
C) Disagree Agree
C
DeWalt should disagree with Webb's first statement. Cash flows are based on opportunity costs. Any cash flows that the firm gives up because a project is undertaken should be charged to the project. DeWalt should agree with Webb's second statement. The impact of taxes must be considered when analyzing capital budgeting projects.
75
The following data is regarding the Link Company:
A target debt/equity ratio of 0.5
Bonds are currently yielding 10%
Link is a constant growth firm that just paid a dividend of $3.00
Stock sells for $31.50 per share, and has a growth rate of 5%
Marginal tax rate is 40%
What is Link's after-tax cost of capital?
A) 12.5%.
B) 10.5%.
C) 12.0%.
C
Use the revised form of the constant growth model to determine the cost of equity. Use algebra to determine the weights for the target capital structure realizing that debt is 50% of equity. Substitute 0.5E for D in the formula below.
ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15%
V = debt + equity = 0.5 + 1 = 1.5
WACC = (E ÷ V)(ks) + (D ÷ V)(kdebt)(1 − t)
WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or 12%
76
Ks = D? / P? +/- ____
ks = D1 ÷ P0 + growth
77
The following is a schedule of Tiger Company's new debt and equity capital costs ($ millions):
Amount of New Debt After-tax Cost of Debt
< $30 3.5%
$30 - $60 4.0%
> $60 4.7%
Amount of New Equity Cost of Equity
$90 12.5%
The company has a target capital structure of 30% debt and 70% equity. Tiger needs to raise an additional $135.0 million of capital for a new project while maintaining its target capital structure. The company's second debt break point and its marginal cost of capital (MCC) are closest to:
Debt Break Point #2 MCC
A) $100 million 8.4%
B) $200 million 8.4%
C) $200 million 10.0%
C
Debt break point #2 = $60 million / 0.30 = $200 million.
$135 million × 30% = $40.5 million new debt
$135 million × 70% = $94.5 million new equity
MCC = 4.0%(0.30) + 12.5%(0.70) = 9.95%.
78
A _____ is calculated as the amount of capital where component cost changes / weight of component in the WACC
breakpoint
79
Simcox Financial is considering raising additional capital to finance a takeover of one of the firm's major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:
Amount of New Debt (in millions)
After-tax Cost of Debt
$0 to $149 4.2%
$150 to $349 5.0%
Amount of New Equity (in millions)
Cost of Equity
$0 to $399 7.5%
$400 to $799 8.5%
Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively?
Breakpoint for new debt capital Breakpoint for new equity capital
A) $428.6 million $615.4 million
B) $375.0 million $615.4 million
C) $428.6 million $533.3 million
A
The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.
80
A breaking point is calculated as the amount of capital where component cost changes / _____
weight of component in the WACC
| (for example, d=40%, e=60%, if changing point for debt is $10M, breaking point = $10M/40%
81
The following information applies to World Turn Company:
10% rate of interest on newly issued bonds.
7% growth rate in earnings and dividends.
The last dividend paid was $0.93.
Shares sell for $16.
Stock's beta is 1.5.
Market risk premium is 6%.
Risk-free rate of interest is 5%.
The firm is in a 40% marginal tax bracket.
If the appropriate risk premium relative to the bond yield is 4%, World Turn's equity cost of capital using the dividend discount model is closest to:
A) 12.8%.
B) 13.2%.
C) 14.0%.
B
| ($.93*1.07)/16 + 7% = 13.2%
82
Which of the following statements is least accurate regarding the marginal cost of capital's role in determining the net present value (NPV) of a project?
A)
The NPVs of potential projects of above-average risk should be calculated using the marginal cost of capital for the firm.
B)
When using a firm's marginal cost of capital to evaluate a specific project, there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.
C)
Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.
A
The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm's existing projects. This is because the component costs of capital used to calculate the firm's WACC are based on the existing level of firm risk.
To evaluate a project with above (the firm's) average risk, a discount rate greater than the firm's existing WACC should be used. Projects with below-average risk should be evaluated using a discount rate less than the firm's WACC.
B - An additional issue to consider when using a firm's WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project. These complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk should be calculated using the marginal cost of capital for the firm.
C - Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.
83
Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and his assistant, Karl Schwartz, were discussing various issues about capital budgeting and Schwartz made a comment that Klein believed to be incorrect. Which of the following is most likely the incorrect statement made by Schwartz?
A)
"The weighted average cost of capital (WACC) should be based on market values for the firm's outstanding securities."
B)
"It is not always appropriate to use the firm's marginal cost of capital when determining the net present value of a capital project."
C)
"Net present value (NPV) and internal rate of return (IRR) result in the same rankings of potential capital projects."
C
It is possible that the NPV and IRR methods will give different rankings. This often occurs when there is a significant difference in the timing of the cash flows between two projects.
B - A firm's marginal cost of capital, or WACC, is only appropriate for computing a project's NPV if the project has the same risk as the firm.
84
WACC should be calculated based on a firm's ____capital structure weights.
If information is not available, an analyst can use the firm's _____, based on _____ values, or the ____ as estimates of the target capital structure.
target;
current capital structure;
market;
average capital structure in the firm's industry
85
Levenworth Industries has the following capital structure on December 31, 2006:
Book Value Market Value
Debt outstanding $8 million $10.5 million
Preferred stock outstanding $2 million $1.5 million
Common stock outstanding $10 million $13.7 million
Total capital $20 million $25.7 million
What is the firm's target debt and preferred stock portion of the capital structure based on existing capital structure?
Debt Preferred Stock
A) 0.41 0.06
B) 0.40 0.10
C) 0.41 0.10
A !!BV should not be used
The weights in the calculation of WACC should be based on the firm's target capital structure, that is, the proportions (based on market values) of debt, preferred stock, and equity that the firm expects to achieve over time. Book values should not be used.
As such, the weight of debt is 41% ($10.5 ÷ $25.7), the weight of preferred stock is 6% ($1.5 ÷ $25.7) and the weight of common stock is 53% ($13.7 ÷ $25.7).
86
Which of the following statements is most accurate regarding a firm's cost of preferred shares? A firm's cost of preferred stock is:
A) approximately equal to the market price of the firm's debt as a percentage of the market price of its common shares.
B)
the market price of the preferred shares as a percentage of its issuance price.
C)
the dividend yield on the firm's newly-issued preferred stock.
C
The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm's newly-issued preferred shares is the market's required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.
87
k ps = ?
Preferred stock annual dividend / market price of preferred stock
88
When calculating NPV for projects, there are two methods to incorporate flotation costs:
- The first method, commonly used in textbooks, is?
- The second, is?
Which one is more accurate?
Method 1 generally calculates _____ (higher/lower) NPV than Method 2 when project time is shorter
- incorporate flotation costs directly into the cost of equity
use (1-flotation cost rate) * market price instead of just market price
- to subtract the dollar value of the flotation costs from the project NPV.
- 2nd one is more accurate
- Higher (overstate NPV)
89
Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch's weighted average cost of capital. Torch's current stock price is $40 per share, and next year's expected dividend is $1.80. The firm's growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%.
If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?
Project 1 NPV Project 2 NPV
A) Understated Overstated
B) Understated Understated
C) Overstated Overstated
C
Correct method of accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50%
WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55%
Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000
Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000
- NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535) = $117,535
- NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823) = $31,823
Incorrect Adjustment for cost of equity method for accounting for flotation costs:
After-tax cost of debt = 8.0% (1-0.30) = 5.60%
Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69%
WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65%
- NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) = $120,327
- NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523
90
Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company's capital structure in a material way for the future. To calculate the weighted average cost of Deighton's capital, what weights should be assigned to debt and to equity?
Debt Equity
A) 48.85% 51.15%
B) 56.55% 43.45%
C) 53.46% 46.54%
C
In order to calculate the weighted average cost of capital (WACC), market value weights should be used.
For the bonds = 200,000 × $965 = $193,000,000
For the stocks = 6,000,000 × $28 = $168,000,000
$361,000,000
The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%
The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%
91
A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate of 9%. The firm's beta is 1.125, the risk-free rate is 6%, and the expected return in the market is 14%. Assume the firm is at their optimal capital structure and the firm's tax rate is 40%. What is the firm's weighted average cost of capital (WACC)?
A) 5.4%.
B) 7.8%.
C) 8.6%.
B
CAPM = RE = RF + B(RM − RF) = 0.06 + (1.125)(0.14 − 0.06) = 0.15
WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)
V = 100 + 300 = 400
WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078
92
Capital Asset Pricing Model (CAPM) Formula = ?
CAPM = RF + B(RM − RF)
93
The cost of equity capital, kce, is ____
| ways to calculate cost of common equity?
the required rate of return on the firm's common stock.
- Dividend growth (or discounted cashflow) method: D1/P0 + g
- CAPM approach: kce = RF + β[E(Rmkt) − RF].
- Bond yield plus risk premium approach: add a risk premium of 3% to 5% to the market yield on the firm's long-term debt.
94
A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost of capital should the firm use to determine the project's net present value (NPV)?
A) 11.6%.
B) 12.5%.
C) 9.6%.
A
WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)
WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%
95
how to calculate g (growth rate)
g = ROE * Retension rate
96
Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle's after-tax cost of capital, an analyst's estimate of Axle's cost of common equity would be closest to:
A) 8.8%.
B) 9.0%.
C) 9.2%.
We can estimate the company's expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 − 2.40/3.00) = 3%
The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.
97
_____ is the required rate of return on the firm's common stock.
The cost of equity capital, kce
98
To calculate Kce, we can use bond yield plus risk premium approach: add a risk premium of ____ to the ____
3% to 5%; market yield on the firm's long-term debt.
99
An analyst gathered the following information about a capital budgeting project:
The proposed project cost $10,000.
The project is expected to increase pretax net income and cash flow by $3,000 in each of the next eight years.
The company has 50% of its capital in equity at a cost of 12%.
The pretax cost of debt capital is 6%.
The company's tax rate is 33%.
The project's net present value is closest to:
A) $6,604.
B) $1,551.
C) $7,240.
B
```
WACC = (wd)(kd)(1 - t) + (wce)(kce)
WACC = (0.5)(6%)(1 - 0.33) + (0.5)(12%) = 8.0%
```
The increase in after-tax cash flows for each year is 3,000 × (1 - 0.33) = $2,010.
I =8; N =8; PMT = $2,010; CPT→PV = $11,550.74
NPV = PV income - cost = $11,550.74 - $10,000 = $1,550.74
100
Cullen Casket Company is considering a project that requires a $175,000 cash outlay and is expected to produce cash flows of $65,000 per year for the next four years. Cullen's tax rate is 40% and the before-tax cost of debt is 9%. The current share price for Cullen stock is $32 per share and the expected dividend next year is $1.50 per share. Cullen's expected growth rate is 5%. Cullen finances the project with 70% newly issued equity and 30% debt, and the flotation costs for equity are 4.5%. What is the dollar amount of the flotation costs attributable to the project, and that is the NPV for the project, assuming that flotation costs are accounted for correctly?
Dollar amount of floatation costs NPV of project
A) $5,513 $30,510
B) $7,875 $30,510
C) $5,513 $32,872
C
In order to determine the discount rate, we need to calculate the WACC.
After-tax cost of debt = 9.0% (1 - 0.40) = 5.40%
Cost of equity = ($1.50 / $32.00) + 0.05 = 0.0469 + 0.05 = 0.0969, or 9.69%
WACC = 0.70(9.69%) + 0.30(5.40%) = 8.40%
Since the project is financed with 70% newly issued equity, the amount of equity capital raised is 0.70 × $175,000 = $122,500
Flotation costs are 4.5 percent, which equates to a dollar flotation cost of $122,500 × 0.045 = $5,512.50.
NPV: CF0 = -180,513, CF1=8.4%, F01=4 ==> 32,872
101
A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate?
A)
A project's internal rate of return decreases when a breakpoint is reached.
B)
An increase in the after-tax cost of debt may occur at a break point.
C)
Any given project's NPV will decline when a breakpoint is reached.
A
The internal rate of return is independent of the firm's cost of capital. It is a function of the amount and timing of a project's cash flows.
102
An analyst gathered the following data about a company:
Capital Structure Required Rate of Return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock
Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?
A) 14.2%.
B) 13.0%.
C) 10.0%.
B
| (0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13
103
Which of the following is used to illustrate a firm's weighted average cost of capital (WACC) at different levels of capital?
A) Cost of capital component schedule.
B) Schedule of marginal capital break points.
C) Marginal cost of capital schedule.
C
The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is usually upward sloping and is a function of a firm's capital structure and its cost of capital at different levels of total capital investment.
104
Ravencroft Supplies is estimating its weighted average cost of capital (WACC). Ravencroft's optimal capital structure includes 10% preferred stock, 30% debt, and 60% equity. They can sell additional bonds at a rate of 8%. The cost of issuing new preferred stock is 12%. The firm can issue new shares of common stock at a cost of 14.5%. The firm's marginal tax rate is 35%. Ravencroft's WACC is closest to:
A) 11.5%.
B) 13.3%.
C) 12.3%.
A
| 0.10(12%) + 0.30(8%)(1 - 0.35) + 0.6(14.5%) = 11.46%.
105
Hanson Aluminum, Inc. is considering whether to build a mill based around a new rolling technology the company has been developing. Management views this project as being riskier than the average project the company undertakes. Based on their analysis of the projected cash flows, management determines that the project's internal rate of return is equal to the company's marginal cost of capital. If the project goes forward, the company will finance it with newly issued debt with an after-tax cost less than the project's IRR. Should management accept or reject this project?
A)
Reject, because the project reduces the value of the company when its risk is taken into account.
B)
Accept, because the project returns the company's cost of capital.
C)
Accept, because the marginal cost of the new debt is less than the project's internal rate of return.
```
A - NOT C, since all projects need to be compared against WACC.
The marginal (or weighted average) cost of capital is the appropriate discount rate for projects that have the same level of risk as the firm's existing projects. For a project with a higher degree of risk, cash flows should be discounted at a rate higher than the firm's WACC. Since this project's IRR is equal to the company's WACC, its NPV must be zero if the cash flows are discounted at the WACC. If the cash flows are discounted at a rate higher than the WACC to account for the project's higher risk, the NPV must be negative. Therefore, the project would reduce the value of the company, so management should reject it. A company considers its capital raising and budgeting decisions independently. Each investment decision must be made assuming a WACC which includes each of the different sources of capital and is based on the long-run target weights.
```
106
Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost of capital can be summarized as follows:
The company's bonds have a nominal yield to maturity of 7%.
The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share.
The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7% a year.
The company has no retained earnings.
The company's tax rate is 40%.
What is the company's weighted average cost of capital (WACC)?
A) 10.18%.
B) 10.03%.
C) 10.59%.
A
WACC = (wd)(kd)(1 − t) + (wps)(kps) + (wce)(kce)
```
where:
wd = 0.40
wce = 0.50
wps = 0.10
kd = 0.07
```
kps = Dps / P = 4.00 / 40.00 = 0.10
kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15
WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 + 0.075 = 0.1018 or 10.18%
107
Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate?
A)
"For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital."
B)
"The optimal capital budget is determined by the intersection of a firm's marginal cost of capital curve and its investment opportunity schedule."
C)
"A break point occurs at a level of capital expenditure where one of the component costs of capital increases."
A
The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm's capital structure remains constant, the MCC (WACC) increases as additional capital is raised.
108
Nippon Post Corporation (NPC), a Japanese software development firm, has a capital structure that is comprised of 60% common equity and 40% debt. In order to finance several capital projects, NPC will raise USD1.6 million by issuing common equity and debt in proportion to its current capital structure. The debt will be issued at par with a 9% coupon and flotation costs on the equity issue will be 3.5%. NPC's common stock is currently selling for USD21.40 per share, and its last dividend was USD1.80 and is expected to grow at 7% forever. The company's tax rate is 40%. NPC's WACC based on the cost of new capital is closest to:
A) 9.6%.
B) 13.1%.
C) 11.8%.
C
kd = 0.09(1 - 0.4) = 0.054 = 5.4%
kce = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%
WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%
Flotation costs, treated correctly, have no effect on the cost of equity component of the WACC.
(if using the incorrect method, market price of stock will be reduced by (1-flotation rate)
109
A company has a target capital structure of 40% debt and 60% equity. The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.
The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54.
The company's stock beta is 1.2.
The company's marginal tax rate is 40%.
The risk-free rate is 10%.
The market risk premium is 5%.
The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash flow approach is:
CAPM Discounted cash flow
A) 16.0% 15.4%
B) 16.6% 15.4%
C) 16.0% 16.0%
C
CAPM = Risk free rate + beta x market premium (sometimes it needs to be calculated as market return rate - risk free rate)
= 10% + 1.2 * 5% = 16%
```
Discounted CF (or dividend growth) method = D1/Po + g
= 1.08*2/27 + 8% = 16%
```
110
Agora Systems Inc. has the following capital structure and cost of new capital:
BV FV Cost of Issuing
Debt $50 million $58 million 5.3%
Preferred stock $25 million $28 million 7.2%
Common stock $200 million $525 million 8.0%
Total capital $275 million $611 million
What is Agora's weighted-average cost of capital if its marginal tax rate is 40%?
A) 6.23%.
B) 7.50%.
C) 8.02%.
B
WACC = (1 − t) (rd) (D ÷ A) + (rp) (P/A) + (rce) (E ÷ A)
WACC = (1 − 0.4) (0.053) (58 ÷ 611) + (0.072) (28 ÷ 611) + (0.08) (525 ÷ 611)
WACC = 0.003 + 0.0033 + 0.0687
WACC = 7.50%
111
The marginal cost of capital is:
A) the cost of the last dollar raised by the firm.
B) tied solely to the specific source of financing.
C) equal to the firm's weighted cost of funds.
A
The "marginal" cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.
112
____ refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure.
Marginal cost of capital
113
Marginal cost of capital refers to the last dollar of financing acquired by the firm assuming funds are raised in the same ____ as _______.
proportion; the target capital structure
114
The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the constant long-term growth in dividends is projected to be 8%?
A) 18%.
B) 15%.
C) 19%.
Here we calculate required rate of return for common equity by using _____ method?
A
Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.
This is the discounted cashflow (or dividend growth) method
115
Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury's taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change?
A) Waterbury's after-tax cost of corporate debt.
B) Waterbury's return on equity (ROE).
C) Waterbury's after-tax cost of noncallable, nonconvertible preferred stock.
C
Corporate taxes do not affect the cost of preferred stock to the issuing firm.
A - Waterbury's after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase.
B - Also, since taxes impact net income, Waterbury's ROE will be affected by the change.
116
A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The bonds trade at a price of $98 in the open market. The firm's marginal tax rate is 35%. Using the bond-yield plus method, what is the firm's cost of equity risk assuming an add-on of 4%?
A) 12.11%.
B) 11.50%.
C) 13.34%.
A
If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million.
To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = -98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.
117
Which of the following choices best describes the role of taxes on the after-tax cost of capital in the U.S. from the different capital sources?
Common equity Preferred equity Debt
A) No effect Decrease Decrease
B) No effect No effect Decrease
C) Decrease Decrease No effect
B
In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not decrease the cost of common or preferred equity.
118
Which is the most expensive and cheapest cost of capital?
The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), and common equity.
119
A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt?
A) 7.2%.
B) 5.6%.
C) 8.4%.
C
(use market rate)
(0.14)(1 - 0.4) = 8.4%
120
A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to:
A) 1.071.
B) 0.632.
C) 0.832.
B
The unlevered beta for this company is calculated as:
beta x 1 / (1 + ROE x net of tax rate)
= 1.2 * 1/(1+1.5*60%)
121
unleveled beta = ?
beta x 1 / (1 + ROE x net of tax rate)
122
Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest to:
Debt Preferred stock
A) 10.0% 7.6%
B) 6.0% 12.7%
C) 6.0% 7.6%
B
After-tax cost of debt = 10% × (1 - 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.
123
One of the primary limitations of using beta in calculating the cost of equity in a developing country is:
A) beta does not capture country risk.
B) beta does not capture inflation risk.
C) the market portfolio in developing countries is often not well diversified.
A
Because beta does not capture country risk, we add a country risk premium to the market risk premium when calculating expected returns using the CAPM.
124
The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of 94.54. What is the company's after-tax cost of debt capital if its marginal tax rate is 30%?
A) 2.1%.
B) 4.2%.
C) 4.9%.
C - pay attention to interest frequency!!
To determine Woodbine's before-tax cost of debt, find the yield to maturity on its outstanding notes:
PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%
Woodbine's after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%
125
Genoa Corp. pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year's earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. The firm's tax rate is 30%. The cost of common equity is closest to:
A) 13.8%.
B) 16.1%.
C) 14.2%.
C
ROE × retention ratio = growth rate
15% × (1 - 0.40) = 9%
D0 = $5.00 × 0.40 = $2.00
[$2.00(1.09) / $42.00] + 0.09 = 14.19%
126
Arlington Machinery currently has assets on its balance sheet of $300 million that is financed with 70% equity and 30% debt. The executive management team at Arlington is considering a major expansion that would require raising additional capital. Jeffery Marian, an analyst with Arlington Machinery, has put together the following schedule for the costs of debt and equity:
Amount of New Debt After-tax Cost of Debt
(in millions)
$0 to $49 4.0%
$50 to $99 4.2%
$100 to $149 4.5%
Amount of New Equity Cost of Equity
(in millions)
$0 to $99 7.0%
$100 to $199 8.0%
$200 to $299 9.0%
In a presentation to Arlington's executive management team, Marian makes the following statements:
Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the breakpoint at which our cost of equity will increase to 9.0% is approximately $286 million in new capital.
Statement 2: If we want to finance total assets of $600 million, our weighted average cost of capital (WACC) for the additional financing needed will be 7.56%.
Marian's statements are:
Statement 1 Statement 2
A) Correct Incorrect
B) Correct Correct
C) Incorrect Incorrect
B
Marian's first statement is correct. A breakpoint calculated as (amount of capital where component cost changes / weight of component in the WACC). The component cost of equity for Arlington will increase when the amount of new equity raised is $200 million, which will occur at ($200 million / 0.70) = $285.71 million, or $286 million of new capital.
Marian's second statement is also correct. If Arlington wants to finance $600 million of total assets, the firm will need to raise $600 − $300 = $300 million of additional capital. Using the target capital structure of 70% equity and 30% debt, Arlington will need to raise $300 × 0.70 = $210 million in new equity and $300 × 0.30 = $90 million in new debt. Looking at the capital schedules, these levels of new financing correspond with rates of 9.0% and 4.2% for costs of equity and debt respectively, and the WACC is equal to (9.0% × 0.70) + (4.2% × 0.30) = 7.56%.
127
Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:
A) more information is needed.
B) rise.
C) fall.
C
Recall the WACC equation:
WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)
The increase in the corporate tax rate will result in a lower cost of debt, resulting in a lower WACC for the company.
128
The optimal capital budget is the amount of capital determined by the:
A)
upward sloping marginal cost of capital curve's intersection with a downward sloping investment opportunity schedule.
B)
downward sloping marginal cost of capital curve's intersection with a upward sloping investment opportunity schedule.
C)
point of tangency between the marginal cost of capital curve and the investment opportunity schedule.
A
The marginal cost of capital increases as additional capital is raised, which means the curve is upward sloping. The investment opportunity schedule slopes downward, representing the diminishing returns of additional capital invested. The point where the two curves intersect is the firm's optimal capital budget, the amount of capital that will finance all the projects that have positive net present values.
129
The optimal capital budget is the amount of capital determined by the _____ sloping marginal cost of capital curve's intersection with a _____ sloping investment opportunity schedule.
Upward; downward
130
The optimal capital budget is the amount of capital determined by the upward sloping ____ curve's intersection with a downward sloping ______.
marginal cost of capital; investment opportunity schedule
131
difficult one!
Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a debt-to-equity ratio of 1.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. If the risk-free rate is 3% and the expected return on the market portfolio is 9%, the appropriate WACC to use in evaluating Degen's project is closest to:
A) 9.2%.
B) 8.6%.
C) 8.9%.
Hodgkins' asset (unlevered) beta:
= 1.3 * 1/ (1+75%*2) = .52
So Degen's project beta is:
βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932
Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%
Since ROE is 1.3, D = 56.52%, E = 43.48%
Degen"s capital structure (D/A) weight for debt is 1.3/(1 + 1.3) = 56.5%, and its weight for equity is 100% − 56.5% = 43.5%.
The appropriate WACC for the project is therefore:
0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.
132
Which one of the following statements about the marginal cost of capital (MCC) is most accurate?
A)
The MCC falls as more and more capital is raised in a given period.
B)
A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.
C)
The MCC is the cost of the last dollar obtained from bondholders.
B
A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital changes by the weight of that component in the capital structure.
The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds, preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.
133
A company's outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of 40%, the company's after-tax cost of debt capital is closest to:
A) 7.0%
B) 5.1%
C) 4.2%.
C
Pretax cost of debt: N = 20; FV = 1000; PV = −894; PMT = 60; CPT → I/Y = 7%
After-tax cost of debt: kd = (7%)(1−0.4) = 4.2%
134
A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?
A) 10.0%.
B) 8.0%.
C) 10.8%.
A
| kps = $8 / $80 = 10%
135
The following information applies to a corporation:
The company has $200 million of equity and $100 million of debt.
The company recently issued bonds at 9%.
The corporate tax rate is 30%.
The company's beta is 1.125.
If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company's after-tax weighted average cost of capital is closest to:
A) 12.1%.
B) 11.2%.
C) 10.5%.
A !! be careful of the D to E ratio (which one is D which one is E)
ks = RFR + β(Rm − RFR)
= 6% + 1.125(14% − 6%) = 15%
WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks
= (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1%
136
Tony Costa, operations manager of BioChem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the proposed BioChem product line expansion. The beta of the proposed project is estimated from the beta of that firm after appropriate adjustments for capital structure differences. The method that Costa uses is known as the:
A) pure-play method.
B) accounting method.
C) build-up method.
A
The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta, unlevering it using the pure-play company's capital structure, and re-levering using the subject company's capital structure.
137
When a project's risk differs from that of the firm's average project, we can use the beta of a company or group of companies that are exclusively in the same business as the project to calculate the project's required return. This is known as _____
pure-play
138
Pure play involves the following steps:
1. Estimate the beta for ______
2. Unlever the beta to get the asset beta using the marginal tax rate and debt-to-equity ratio for the comparable company. What is the formula?
3. Re-lever the beta using the marginal tax rate and debt-to-equity ratio for the firm considering the project. What is the formula?
4. Use the CAPM to estimate the required return on equity to use when evaluating the project. What's the formula for CAPM?
5. Calculate the WACC for the firm using the project"s required return on equity.
- a comparable company or companies.
- βasset=βequity * 1 / [(1+(ROE*(1-tax rate))]
- βproject = βasset * [1+(ROE*(1-tax rate))]
- CAPM = RF + B(RM − RF)
139
The most accurate way to account for flotation costs when issuing new equity to finance a project is to:
A)
adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.
B)
increase the cost of equity capital by dividing it by (1 - flotation cost).
C)
increase the cost of equity capital by multiplying it by (1 + flotation cost).
A
Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project.
*the incorrect way is by multiplying market cost by (1-flotation cost rate)
140
Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian's weighted average cost of capital for this potential expansion.
A) 5.7%
B) 4.2%.
C) 7.1%.
A
βasset=βequity * 1 / [(1+(ROE*(1-tax rate))] = 0.7 * [1/1+ (3*0.6)
] = 0.25
βproject = βasset * [1+(ROE*(1-tax rate))] = 0.25 * (1+2.5*.7) = .6875
Kcs = 5% + 0.6875 x (9%-5%) = 7.75%
Since D/E=2.5, D=71.43%, E = 28.57%
WACC = 71.43% x 70% x 7% + 28.57% x 7.75% = 5.71%
141
An analyst gathered the following information for ABC Company, which has a target capital structure of 70% common equity and 30% debt:
```
Dividend yield 3.50%
Expected market return 9.00%
Risk-free rate 4.00%
Tax rate 40%
Beta 0.90
Bond yield-to-maturity 8.00%
ABC's weighted-average cost of capital is closest to:
```
A) 8.4%.
B) 7.4%.
C) 6.9%.
```
B
The problem must be solved in two steps. First, calculate the cost of equity:
rCE = Rf + β(RM - Rf)
= 0.04 + 0.9(0.09 - 0.04)
= 0.085 = 8.5%
```
Next, calculate the WACC.
WACC = wDrD(1 - t) + wPrP + wCErCE
= (0.30)(0.08)(1 - 0.40) + 0 + (0.70)(0.085)
= 0.0739 or 7.39%
142
A firm is considering a $200,000 project that will last 3 years and has the following financial data:
Annual after-tax cash flows are expected to be $90,000.
Target debt/equity ratio is 0.4.
Cost of equity is 14%.
Cost of debt is 7%.
Tax rate is 34%.
Determine the project's payback period and net present value (NPV).
Payback Period NPV
A) 2.22 years $18,716
B) 2.43 years $18,716
C) 2.22 years $21,872
A
Payback Period
$200,000 / $90,000 = 2.22 years
NPV Method
First, calculate the weights for debt and equity
```
wd + we = 1
we = 1 − wd
wd / we = 0.40
wd = 0.40 × (1 − wd)
wd = 0.40 − 0.40wd
1.40wd = 0.40
wd = 0.286, we = 0.714
```
Second, calculate WACC
WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132
Third, calculate the PV of the project cash flows
90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716
And finally, calculate the project NPV by subtracting out the initial cash flow
NPV = $218,716 − $200,000 = $18,716
143
A new project is expected to be less risky than the average risk of existing projects. The appropriate discount rate to use when evaluating this project is:
A) greater than the firm's marginal cost of capital.
B) the firm's marginal cost of capital.
C) less than the firm's marginal cost of capital.
C
If the new project is less risky than the average risk of existing projects, the MCC should be adjusted downward. A lower discount rate will increase project's the net present value.
144
The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be subordinate to the firm's existing debt. The company's marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is:
A) Between 3.3% and 5.0%.
B) More than 5.0%.
C) 5.0%.
B
The after-tax cost of debt similar to Savanna's existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company's debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.
145
DeSoto Corp. 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%. The after-tax cost of debt is closest to:
A) 5.3%.
B) 5.6%.
C) 7.5%.
A
| 7.5 × (1 − 0.3) = 5.25%.
146
Which of the following events will reduce a company's weighted average cost of capital (WACC)?
A) A reduction in the market risk premium.
B) A reduction in the company's bond rating.
C) An increase in expected inflation.
A
An increase in either the company's beta or the market risk premium will cause the WACC to increase using the CAPM approach. A reduction in the market risk premium will reduce the cost of equity for WACC.
147
A company has the following data associated with it:
A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
Outstanding 20-year annual pay 6% coupon bonds selling for $894.
Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2 dividend one year from today.
Their $100 par preferred stock currently sells for $90 and is earning 5%.
The company's tax rate is 40%.
What is the after-tax cost of debt capital and after-tax cost of preferred stock?
Debt capital Preferred stock
A) 4.5% 3.3%
B) 4.2% 5.6%
C) 4.2% 3.3%
B
Debt:
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT I/Y = 7%
kd = (7%)(1 − 0.4) = 4.2%
Preferred stock:
kps = Dps / P = 5 / 90 = 5.56%
Note that the cost of preferred stock is not adjusted for taxes because preferred dividends are usually not tax-deductible.
148
The cost of preferred stock is equal to the preferred stock dividend:
A) divided by the market price.
B) divided by its par value.
C) multiplied by the market price.
A
| The cost of preferred stock, kps, is Dps ÷ price.
149
Which of the following is most accurate regarding the component costs and component weights in a firm's weighted average cost of capital (WACC)?
A)
Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.
B)
The appropriate pre-tax cost of a firm's new debt is the average coupon rate on the firm's existing debt.
C)
The weights in the WACC should be based on the book values of the individual capital components.
A
The after-tax cost of debt = kd(1 - t) = kd - kd(t), where kd is the pretax cost of debt and t is the effective corporate tax rate. So the tax savings from the tax treatment of debt is kd(t).
C - Capital component weights should be based on market weights, not book values.
B - And, the appropriate pre-tax cost of debt is the yield to maturity on the firm's existing debt.
150
Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence's capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this project is closest to:
A) 1.18.
B) 0.58.
C) 0.38.
A
βasset = .8 x 1/ (1+1.7 x 65%) = .38
βproject = .38 x (1+3x70%) = 1.178
151
Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? The marginal cost of capital should be used to discount the cash flows:
A)
for potential projects that have a level of risk near that of the firm's average project.
B)
if the firm's capital structure is expected to change during the project's life.
C)
of all projects the firm is considering.
A
Net present values of projects with the average risk for the firm should be determined using the firm's marginal cost of capital. The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital assumes the firm's capital structure does not change over the life of the project.
152
Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?
A) The preferred stock's dividend rate.
B) The firm's corporate tax rate.
C)The stated par value of the preferred issue.
B
The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.
The cost of preferred stock, kps is expressed as:
kps = Dps / P
where:
Dps = divided per share = dividend rate × stated par value
P = market price
153
A company has a target capital structure of 40% debt and 60% equity. The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%.
```
The company's bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54.
The company's stock beta is 1.2.
The company's marginal tax rate is 40%.
The risk-free rate is 10%.
The market risk premium is 5%.
The company's after-tax cost of debt is:
```
A) 4.8%.
B) 7.2%.
C) 12.0%.
B
Before-tax cost of debt capital:
N = 40; PMT = 50; FV = 1,000; PV = 849.54; CPT I/Y = 6% × 2 = 12%
After-tax cost of debt capital = (12)(1 − 0.4) = 7.2%.
154
To finance a proposed project, Youngham Corporation would need to issue £25 million in common equity. Youngham would receive £23 million in net proceeds from the equity issuance. When analyzing the project, analysts at Youngham should:
A)
add the £2 million flotation cost to the project's initial cash outflow.
B)
increase the cost of equity capital to account for the 8% flotation cost.
C)
not consider the flotation cost because it is a sunk cost.
A
The recommended method is to treat flotation costs as a cash outflow at project initiation rather than as a component of the cost of equity.
155
A financial analyst is estimating the effect on the cost of capital for a company of a decrease in the marginal tax rate. The company is financed with debt and common equity. A decrease in the firm's marginal tax rate would:
A)
decrease the cost of capital because of a lower after-tax cost of debt and equity.
B)
increase the cost of capital because of a higher after-tax cost of debt.
C)
increase the cost of capital because of a higher after-tax cost of debt and equity.
B
The cost of debt capital is affected by the marginal tax rate because interest costs are tax-deductible. A lower marginal tax rate decreases the value to the firm of the tax deduction for interest and therefore increases the after-tax cost of debt capital. Cost of equity capital is not affected by the marginal tax rate.
156
If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?
A) Both increase.
B) Both decrease.
C) One increase and one decrease.
A
An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.
157
Given the following information about capital structure, compute the WACC. The marginal tax rate is 40%.
Type of Capital % of Capital Structure Before-Tax Cost
Bonds 40% 7.5%
Preferred Stock 5% 11.0%
Common Stock 55% 15.0%
A) 13.3%.
B) 10.6%.
C) 7.1%.
B
WACC = (Wd)(Kd (1 − t)) + (Wps)(Kps) + (Wce)(Ks)
WACC = 0.4(7.5%)(1 − 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.
158
The Garden and Home Store recently issued preferred stock paying $2 annual dividends. The price of its preferred stock is $20. The after-tax cost of fixed-rate debt capital is 6% and the cost of common stock equity is 12%. The cost of preferred stock is closest to:
A) 9%.
B) 10%.
C) 11%.
B
Preferred stock pays constant dividends into perpetuity. The price of preferred stock equals the present value of the preferred stock dividends: $20 = $2 / kps. Therefore, the cost of preferred stock capital equals $2 / $20 = 0.10 = 10%.
159
Corporate governance:
A. complies with a set of global standards.
B. is independent of both shareholder theory and stakeholder theory.
C. seeks to minimize and manage conflicting interests between insiders and external shareholders.
C is correct. Corporate governance is the arrangement of checks, balances, and incentives a company needs to minimize and manage the conflicting interests between insiders and external shareholders.
160
Which group of company stakeholders would be least affected if the firm’s financial position weakens?
A. Suppliers
B. Customers
C. Managers and employees
B is correct. Compared with other stakeholder groups, customers tend to be less concerned with, and affected by, a company’s financial performance.
161
Which of the following represents a principal–agent conflict between shareholders and management?
A. Risk tolerance
B. Multiple share classes
C. Accounting and reporting practices
A is correct. Shareholder and manager interests can diverge with respect to risk tolerance. In some cases, shareholders with diversified investment portfolios can have a fairly high risk tolerance because specific company risk can be diversified away. Managers are typically more risk averse in their corporate decision making to better protect their employment status.
162
Which of the following issues discussed at a shareholders’ general meeting would most likely require only a simple majority vote for approval?
A. Voting on a merger
B. Election of directors
C. Amendments to bylaws
B is correct. The election of directors is considered an ordinary resolution and, therefore, requires only a simple majority of votes to be passed.
163
Which of the following statements regarding stakeholder management is most accurate?
A. Company management ensures compliance with all applicable laws and regulations.
B. Directors are excluded from voting on transactions in which they hold material interest.
C. The use of variable incentive plans in executive remuneration is decreasing.
B is correct. Often, policies on related-party transactions require that such transactions or matters be voted on by the board (or shareholders), excluding the director holding the interest.
164
Which of the following represents a responsibility of a company’s board of directors?
A. Implementation of strategy
B. Enterprise risk management
C. Considering the interests of shareholders only
B is correct. The board typically ensures that the company has an appropriate enterprise risk management system in place.
165
Which of the following statements about non-market factors in corporate governance is most accurate?
A. Stakeholders can spread information quickly and shape public opinion.
B. A civil law system offers better protection of shareholder interests than does a common law system.
C. Vendors providing corporate governance services have limited influence on corporate governance practices.
A is correct. Social media has become a powerful tool for stakeholders to instantly broadcast information with little cost or effort and to compete with company management in influencing public sentiment.
166
Which of the following statements regarding corporate shareholders is most accurate?
A. Cross-shareholdings help promote corporate mergers.
B. Dual-class structures are used to align economic ownership with control.
C. Affiliated shareholders can protect a company against hostile takeover bids.
C is correct. The presence of a sizable affiliated stockholder (such as an individual, family trust, endowment, or private equity fund) can shield a company from the effects of voting by outside shareholders.
167
Which of the following statements about environmental, social, and governance (ESG) in investment analysis is correct?
A. ESG factors are strictly intangible in nature.
B. ESG terminology is easily distinguishable among investors.
C. Environmental and social factors have been adopted in investment analysis more slowly than governance factors.
C is correct. The risks of poor corporate governance have long been understood by analysts and shareholders. In contrast, the practice of considering environmental and social factors has been slower to take hold.
168
Which of the following statements regarding ESG implementation methods is most accurate?
A. Negative screening is the most commonly applied method.
B. Thematic investing considers multiple factors.
C. The best-in-class strategy excludes industries with unfavorable ESG aspects.
A is correct. Negative screening, which refers to the practice of excluding certain sectors or companies that violate accepted standards in such areas as human rights or environmental concerns, is the most common ESG investment strategy (implementation method).
169
Given the following cash flows for a capital project, calculate the NPV and IRR. The required rate of return is 8 percent.
Year 0 1 2 3 4 5
Cash flow −50K 15K 15K 20K 10K 5K
NPV IRR
A $1,905 10.9%
B $1,905 26.0%
C $3,379 10.9%
C
170
Given the following cash flows for a capital project, calculate its payback period and discounted payback period. The required rate of return is 8 percent.
Year 0 1 2 3 4 5
Cash flow −50K 15K 15K 20K 10K 5K
The discounted payback period is:
A. 0.16 years longer than the payback period.
B. 0.51 years longer than the payback period.
C. 1.01 years longer than the payback period.
C
171
An investment of $100 generates after-tax cash flows of $40 in Year 1, $80 in Year 2, and $120 in Year 3. The required rate of return is 20 percent. The net present value is closest to:
A. $42.22.
B. $58.33.
C. $68.52.
B
172
An investment of $150,000 is expected to generate an after-tax cash flow of $100,000 in one year and another $120,000 in two years. The cost of capital is 10 percent. What is the internal rate of return?
A. 28.39 percent.
B. 28.59 percent.
C. 28.79 percent.
C
173
Kim Corporation is considering an investment of 750 million won with expected after-tax cash inflows of 175 million won per year for seven years. The required rate of return is 10 percent. What is the project’s:
NPV? IRR?
A 102 million won 14.0%
B 157 million won 23.3%
C 193 million won 10.0%
A
174
Kim Corporation is considering an investment of 750 million won with expected after-tax cash inflows of 175 million won per year for seven years. The required rate of return is 10 percent. Expressed in years, the project’s payback period and discounted payback period, respectively, are closest to:
A. 4.3 years and 5.4 years.
B. 4.3 years and 5.9 years.
C. 4.8 years and 6.3 years.
B
175
An investment of $20,000 will create a perpetual after-tax cash flow of $2,000. The required rate of return is 8 percent. What is the investment’s profitability index?
A. 1.08.
B. 1.16.
C. 1.25.
C
176
Hermann Corporation is considering an investment of €375 million with expected after-tax cash inflows of €115 million per year for seven years and an additional after-tax salvage value of €50 million in Year 7. The required rate of return is 10 percent. What is the investment’s PI?
A. 1.19.
B. 1.33.
C. 1.56.
C
177
Erin Chou is reviewing a profitable investment project that has a conventional cash flow pattern. If the cash flows for the project, initial outlay, and future after-tax cash flows all double, Chou would predict that the IRR would:
A. increase and the NPV would increase.
B. stay the same and the NPV would increase.
C. stay the same and the NPV would stay the same.
B is correct. The IRR would stay the same because both the initial outlay and the after-tax cash flows double, so that the return on each dollar invested remains the same. All of the cash flows and their present values double. The difference between total present value of the future cash flows and the initial outlay (the NPV) also doubles.
178
Shirley Shea has evaluated an investment proposal and found that its payback period is one year, it has a negative NPV, and it has a positive IRR. Is this combination of results possible?
A. Yes.
B. No, because a project with a positive IRR has a positive NPV.
C. No, because a project with such a rapid payback period has a positive NPV.
A is correct. If the cumulative cash flow in one year equals the outlay and additional cash flows are not very large, this scenario is possible. For example, assume the outlay is 100, the cash flow in Year 1 is 100 and the cash flow in Year 2 is 5. The required return is 10 percent. This project would have a payback of 1.0 years, an NPV of −4.96, and an IRR of 4.77 percent.
179
An investment has an outlay of 100 and after-tax cash flows of 40 annually for four years. A project enhancement increases the outlay by 15 and the annual after-tax cash flows by 5. As a result, the vertical intercept of the NPV profile of the enhanced project shifts:
A. up and the horizontal intercept shifts left.
B. up and the horizontal intercept shifts right.
C. down and the horizontal intercept shifts left.
A is correct. The vertical intercept changes from 60 to 65 (NPV when cost of capital is 0%), and the horizontal intercept (IRR, when NPV equals zero) changes from 21.86 percent to 20.68 percent.
180
Projects 1 and 2 have similar outlays, although the patterns of future cash flows are different. The cash flows as well as the NPV and IRR for the two projects are shown below. For both projects, the required rate of return is 10 percent.
Year 0 1 2 3 4 NPV IRR (%)
Project 1 −50 20 20 20 20 13.40 21.86
Project 2 −50 0 0 0 100 18.30 18.92
The two projects are mutually exclusive. What is the appropriate investment decision?
A. Invest in both projects.
B. Invest in Project 1 because it has the higher IRR.
C. Invest in Project 2 because it has the higher NPV.
C is correct. When valuing mutually exclusive projects, the decision should be made with the NPV method because this method uses the most realistic discount rate, namely the opportunity cost of funds. In this example, the reinvestment rate for the NPV method (here 10 percent) is more realistic than the reinvestment rate for the IRR method (here 21.86 percent or 18.92 percent).
181
Consider the two projects below. The cash flows as well as the NPV and IRR for the two projects are given. For both projects, the required rate of return is 10 percent.
Year 0 1 2 3 4 NPV IRR (%)
Project 1 −100 36 36 36 36 14.12 16.37
Project 2 −100 0 0 0 175 19.53 15.02
What discount rate would result in the same NPV for both projects?
A. A rate between 0.00 percent and 10.00 percent.
B. A rate between 10.00 percent and 15.02 percent.
C. A rate between 15.02 percent and 16.37 percent.
B is correct. For these projects, a discount rate of 13.16 percent would yield the same NPV for both (an NPV of 6.73).
182
Wilson Flannery is concerned that this project has multiple IRRs.
Year 0 1 2 3
Cash flows −50 100 0 −50
How many discount rates produce a zero NPV for this project?
A. One, a discount rate of 0 percent.
B. Two, discount rates of 0 percent and 32 percent.
C. Two, discount rates of 0 percent and 62 percent.
C is correct. Discount rates of 0 percent and approximately 61.8 percent both give a zero NPV.
183
With regard to the net present value (NPV) profiles of two projects, the crossover rate is best described as the discount rate at which:
A. two projects have the same NPV.
B. two projects have the same internal rate of return.
C. a project’s NPV changes from positive to negative.
A is correct. The crossover rate is the discount rate at which the NPV profiles for two projects cross; it is the only point where the NPVs of the projects are the same.
184
With regard to net present value (NPV) profiles, the point at which a profile crosses the vertical axis is best described as:
A. the point at which two projects have the same NPV.
B. the sum of the undiscounted cash flows from a project.
C. a project’s internal rate of return when the project’s NPV is equal to zero.
B is correct. The vertical axis represents a discount rate of zero. The point where the profile crosses the vertical axis is simply the sum of the cash flows.
185
With regard to net present value (NPV) profiles, the point at which a profile crosses the horizontal axis is best described as:
A. the point at which two projects have the same NPV.
B. the sum of the undiscounted cash flows from a project.
C. a project’s internal rate of return when the project’s NPV is equal to zero.
C is correct. The horizontal axis represents an NPV of zero. By definition, the project’s IRR equals an NPV of zero.
186
With regard to capital budgeting, an appropriate estimate of the incremental cash flows from a project is least likely to include:
A. externalities.
B. interest costs.
C. opportunity costs.
B is correct. Costs to finance the project are taken into account when the cash flows are discounted at the appropriate cost of capital; including interest costs in the cash flows would result in double-counting the cost of debt.
187
A company has the following data associated with it:
- A target capital structure of 10% preferred stock, 50% common equity and 40% debt.
- Outstanding 20-year annual pay 6% coupon bonds selling for $894.
- Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2 dividend one year from today.
- Their 5%, $100 par preferred stock currently sells for $90.
- The company's tax rate is 40%.
What is the weighted average cost of capital (WACC)?
A) 10.3%.
B) 9.2%.
C) 8.5%.
B
After-tax cost of debt:
N = 20; FV = 1,000; PMT = 60; PV = -894; CPT I/Y = 7%
kd = (7%)(1 − 0.4) = 4.2%
Cost of preferred stock:
kps = Dps / P = 5 / 90 = 5.56%
Cost of common equity:
kce = (D1 / P0) + g
kce = 2 / 45 + 0.08 = 0.1244 = 12.44%
WACC = (0.4)(4.2) + (0.1)(5.6) + (0.5)(12.4) = 8.5%
188
If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?
A) Both increase.
B) Both decrease.
C) One increase and one decrease.
A
An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.
189
Given the following information about capital structure, compute the WACC. The marginal tax rate is 40%.
Type of Capital % of Capital Structure Before-Tax Cost
Bonds 40% 7.5%
Preferred Stock 5% 11.0%
Common Stock 55% 15.0%
A) 13.3%.
B) 10.6%.
C) 7.1%.
B
```
WACC = (Wd)(Kd (1 − t)) + (Wps)(Kps) + (Wce)(Ks)
WACC = 0.4(7.5%)(1 − 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.
```
190
The Garden and Home Store recently issued preferred stock paying $2 annual dividends. The price of its preferred stock is $20. The after-tax cost of fixed-rate debt capital is 6% and the cost of common stock equity is 12%. The cost of preferred stock is closest to:
A) 9%.
B) 10%.
C) 11%.
B
Preferred stock pays constant dividends into perpetuity. The price of preferred stock equals the present value of the preferred stock dividends: $20 = $2 / kps. Therefore, the cost of preferred stock capital equals $2 / $20 = 0.10 = 10%.
191
A company has the following information:
A target capital structure of 40% debt and 60% equity.
$1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20 years, and sell for $849.54.
The company stock beta is 1.2.
Risk-free rate is 10%, and market risk premium is 5%.
The company's marginal tax rate is 40%.
The weighted average cost of capital (WACC) is closest to:
A) 12.5%.
B) 13.0%.
C) 13.5%.
A
Ks = 0.10 + (0.05)(1.2) = 0.16 or 16%
Kd = Solve for i: N = 40, PMT = 50, FV = 1,000, PV = -849.54, CPT I = 6 × 2 = 12%
WACC = (0.4)(12)(1 - 0.4) + (0.6)(16)= 2.88 + 9.6 = 12.48
192
In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:
A)
use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).
B)
add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).
C)
add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).
B
In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.
193
The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will:
A) increase.
B) decrease.
C) change, but can either increase or decrease.
B
A break point refers to a level of new investment at which a component's cost of capital changes. The formula for break point is:
breaking level/ % of component in the capital structure
As indicated, as the weight of a capital component in the capital structure increases, the break point at which a change in the component"s cost will decline. No computation is necessary, but when Hardcastle has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle"s debt increases to 50%, the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.
194
A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data:
```
Debt/equity ratio is 50%.
Cost of equity capital is 15%.
Cost of new debt is 9%.
Tax rate is 33%.
Determine the project's net present value (NPV) and whether or not to accept it.
```
NPV Accept / Reject
A) +$4,968 Accept
B) -$33 Reject
C) +$33 Accept
B
First, calculate the weights for debt and equity
wd + we = 1
wd = 0.50We
0.5We + We = 1
wd = 0.333, we = 0.667
Second, calculate WACC
WACC = (wd × kd) × (1 − t) + (we × ke) = (0.333 × 0.09 × 0.67) + (0.667 × 0.15) = 0.020 + 0.100 = 0.120
Third, calculate the PV of the project cash flows
N = 8, PMT = -1,000, FV = 0, I/Y = 12, CPT PV = 4,967
And finally, calculate the project NPV by subtracting out the initial cash flow
NPV = $4,967 − $5,000 = -$33
195
The after-tax cost of preferred stock is always:
A) equal to the before-tax cost of preferred stock.
B) higher than the cost of common shares.
C) less than the before-tax cost of preferred stock.
A
The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.
196
Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm's fixed-rate debt?
A) The yield to maturity of the firm's existing debt.
B) The coupon rate on the firm's existing debt.
C) Seniority and any special covenants of the firm's anticipated debt.
B
Ideally, an analyst would use the YTM of a firm's existing debt as the pretax cost of new debt. When a firm's debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm's existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.
197
BPM Ltd. has the following capital structure: 40% debt and 60% equity. The cost of equity is 16%. Its before tax cost of debt is 8%, and its corporate tax rate is 40%. BPM is considering between two mutually exclusive projects that have the following cash flows (in Million):
Today Year 1 Year 2 Year 3
Project X -100 50 30 50
Project Y -150 50 60 80
Which project should BPM choose?
A) Project X because its NPV is $5 million.
B) Project Y because its NPV is $22 million.
C) Project X because its NPV is $16 million.
A
Use the WACC as the discount rate to calculate NPV.
WACC = (wd × (kd × (1 - T))) + (we × ke)
= [0.4 × 0.08 × (1 - 0.4)] + [0.6 × 0.16] = 11.52%
NPV of project X = -100 + 50 / (1.1152) + 30 / (1.11522) + 50 / (1.11523) = +5.01
NPV of project Y = -150 + 50 / (1.1152) + 60 / (1.11522) + 80 / (1.11523) = +0.76
198
When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:
A) equity earns higher return than debt.
B) equity is risky.
C) the interest on debt is tax deductible.
C
Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only interest expense is deductible for corporate taxes.
199
Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:
A)
accept profitable, low-risk projects and accept unprofitable, high-risk projects.
B)
accept profitable, low-risk projects and reject unprofitable, high-risk projects.
C)
reject profitable, low-risk projects and accept unprofitable, high-risk projects.
C
The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.
200
Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames:
Sales of $3,500,000.
Variable costs at 45% of sales.
Fixed costs of $1,050,000.
Debt interest payments on $750,000 issued at par with an annual 9.0% coupon; market yield is currently 7.0%.
ArtFrames's degree of operating leverage (DOL) and degree of financial leverage (DFL) are closest to:
DOL DFL
A) 3.00 1.50
B) 2.20 1.50
C) 2.20 1.08
C
DOL = (sales - variable costs) / (sales - variable costs - fixed costs)
Variable costs = $3,500,000 × 45% = $1,575,000
Fixed costs = $1,050,000
DOL = ($3,500,000 - $1,575,000) / ($3,500,000 - $1,575,000 - $1,050,000) = 2.20
```
DFL = EBIT / (EBIT - interest)
Interest = $750,000 × 9% = $67,500
EBIT = sales - variable costs - fixed costs = $3,500,000 - $1,575,000 - $1,050,000 = $875,000
DFL = $875,000 / ($875,000 - $67,500) = 1.08
```
201
The combination of operating risk and sales risk is known as:
A) gearing risk.
B) financial risk.
C) business risk.
C
202
_____ risk refers to the risk associated with a firm's operating income and is the result of uncertainty about a firm's revenues and the expenditures necessary to produce those revenues. The components are : _____ and ______
Business; operating risk and sales risk
203
Business risk refers to the risk associated with a firm's ______ and is the result of uncertainty about a firm's ______ necessary to produce those revenues.
operating income; revenues and the expenditures
*The uncertainty in return on assets due to the nature of a firm's operations is also business risk.
don't mix up~~
204
_____ risk is the uncertainty about the firm's sales. Operating risk refers to the additional uncertainty about operating earnings caused by fixed operating costs. The greater the proportion of fixed costs to variable costs, the greater a firm's operating risk.
Sales
205
Operating risk refers to the additional uncertainty about _____ caused by _____ costs. The _____ (greater/less) the proportion of fixed costs to variable costs, the _____ (greater/less) a firm's operating risk.
Operating earnings; fixed operating; greater; greater
206
_____ risk refers to the additional risk that the firm's common stockholders must bear when a firm uses fixed cost (debt) financing.
Financial
207
Financial risk refers to the additional risk that the firm's _____ must bear when a firm uses fixed cost (debt) financing.
common stockholders
208
Myron Jackson is a private equity fund manager specializing in distressed companies. His investment philosophy is based on the principle that capital structure problems can be fixed, but industry characteristics dictate business models. Jackson would most likely be interested in distressed firms with which of the following characteristics?
A) High operating risk and high financial risk.
B) High operating risk and low financial risk.
C) High financial risk and low operating risk.
C
Financial risk refers to the capital structure, while operating risk refers to the operating cost structure. A firm's capital structure is well within the control of management as to how much debt to assume. In contrast, a firm's operating cost structure is usually driven by industry characteristics. This distressed firm's specialist would be looking for firms with capital structure problems that can be solved with an increase in equity capital and a reduction in debt financing. Changing the operating characteristics of the industry is far more challenging.
209
Jayco, Inc., sells blue ink for $4.00 a bottle. The ink's variable cost per bottle is $2.00. Ink has fixed cost of $10,000. What is Jayco's breakeven point in units?
A) 2,500.
B) 5,000.
C) 6,000.
B
QBE = [FC] / (P - V)
QBE = [10,000] / (4.00 - 2.00) = 5,000
210
Which of the following is a key determinant of operating leverage?
A) The tradeoff between fixed and variable costs.
B) Level and cost of debt.
C) The competitive nature of the business.
A
211
All else equal, which of the following statements about operating leverage is least accurate?
A)
Firms with high operating leverage experience greater variance in operating income.
B)
Operating leverage reflects the tradeoff between variable costs and fixed costs.
C)
Lower operating leverage generally results in a higher expected rate of return.
C
Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.
B - Operating leverage is the trade off between fixed and variable costs.
A - Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance).
212
A company's use of financial leverage:
A)
decreases default risk and decreases potential return on equity.
B)
increases default risk and decreases potential return on equity.
C)
increases default risk and increases potential return on equity.
C
Issuing debt introduces default risk. The interest expense associated with using debt represents a fixed cost that reduces net income. However, compared to financing entirely with equity, the lower net income is spread over a smaller base of shareholders' equity. This financing structure increases the potential return on equity.
213
Yangtze Delta High Technology produces multimedia-enabled wireless phones. The factory incurs rent, depreciation, salary, and other fixed costs totaling RMB 10 million per year. Also, the company incurs annual interest of RMB 3 million on debt. Each phone sold by Yangtze Delta sells for RMB 200. The variable cost per phone is RMB 150. Yangtze Delta's operating breakeven quantity of sales is closest to:
A) 260,000.
B) 65,000.
C) 200,000.
C
The operating breakeven point is the quantity of product sold at which operating income is zero (revenue equals operating cost).
```
F = Fixed operating cost = RMB 10,000,000
P = Price per unit = RMB 200
V = Variable cost per unit = RMB 150
```
Operating breakeven quantity = F / (P − V) = 10,000,000 / (200 − 150) = 200,000.
214
FCO, Inc. (FCO) is comparing EBIT forecasts to help determine the impact its capital structure has on net income.
Expected EBIT EBIT + 10%
EBIT $80,000 $88,000
Interest expense 15,000 15,000
EBT 65,000 73,000
Taxes 26,000 29,200
Net income 39,000 43,800
Liabilities 200,000
Shareholder equity 250,000
Return on equity 15.60%
FCO's degree of financial leverage is closest to:
A) 1.25.
B) 0.60.
C) 0.80.
A
The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change in net income to the percentage change in EBIT. FCO can compare two EBIT forecasts to determine how net income is being driven by financial leverage.
```
DFL = change of NI/change of EBIT
DLF = [(43,800-39,000)/39000] / [(88K-80K)/80] =1.23
```
*I just calculated using EBIT/(EBIT-I)
215
Additional debt should be used in the firm's capital structure if it increases:
A) earnings per share.
B) the value of the firm.
C) firm earnings.
B (not c)
The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.
216
The key to finding the optimal capital structure is identifying the level of debt that will maximize ____
firm value.
| not earning/NI/EPS, since that does not consider risk
217
Variability in a firm's operating income is most closely related to its:
A) business risk.
B) financial risk.
C) internal risk.
A
Business risk is the uncertainty regarding the operating income of a company.
B - Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.
218
Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even?
A) 40.
B) 2,708.
C) 8,125.
C
QBreakeven = Fixed Cost / (Price - Variable Cost)
QBreakeven = $325,000 / (160 - 120) = 8,125
219
Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows:
Per Unit PY (Basic) Blanket This Year's (New) Blanket
Sales Price $25 $40
Variable Cost $20 $33
Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year's booth costs, Korotkin needs to sell:
A) 42 more blankets than last year.
B) 30 fewer blankets than last year.
C) 42 fewer blankets than last year.
B
To obtain this result, we need to calculate Last Year's Breakeven Quantity, This Year's Breakeven Quantity, and calculate the difference.
Step 1: Determine Last Year's (Basic Blanket) breakeven quantity:
QBE = (Fixed Costs) / (Sales Price per unit − Variable Cost per unit) = 750 / (25 − 20) = 150
Step 2: Determine This Year's (New Blanket) breakeven quantity:
QBE = (Fixed Costs) / (Sales Price per unit - Variable Cost per unit) = 840 / (40 − 33) = 120
Step 3: Determine Change in Units:
DQ = QThis Year - QLast Year = 120 − 150 = −30. Korotkin needs to sell 30 fewer blankets.
220
Which of the following statements regarding the impact of financial leverage on a company's net income and return on equity (ROE) is most accurate?
A)
If a firm has a positive operating profit margin, using financial leverage will always increase ROE.
B)
Using financial leverage increases the volatility of ROE for a level of volatility in operating income.
C)
Increasing financial leverage increases both risk and potential return of existing bondholders.
B
If a firm is financed with 100% equity, there is a direct relationship between changes in the firm's ROE and changes in operating income. Adding financial leverage (debt) to the firm's capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders.
C - Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged.
A - Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm's net profit margin negative, which would in turn make ROE negative.
221
T or F?
| If a firm has a positive operating profit margin, using financial leverage will always increase ROE.
F
Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm's net profit margin negative, which would in turn make ROE negative.
222
Which of the following statements regarding leverage is most accurate?
A)
High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.
B)
A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk.
C)
A firm with low operating leverage has a small proportion of its total costs in fixed costs.
C
223
Financial leverage magnifies:
A) taxes.
B) earnings per share variability.
C) operating income variability.
B
Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a fixed asset base, result in a greater earnings per share variability.
C - Operating income is based on the products and assets of the firm and not on the firm's financing and, hence, has no impact on financial leverage.
A - Greater financial leverage is likely to reduce taxes due to the tax deductibility of interest payments.
224
The additional risk a firm's common shareholders must bear when a firm uses fixed cost financing is best described as:
A) operating risk.
B) business risk.
C) financial risk.
C
When a company finances its operations with fixed cost financing (debt), it takes on fixed expenses in the form of interest payments. The greater the proportion of debt in a firm's capital structure, the greater the firm's financial risk.
B - Business risk refers to the risk associated with a firm's operating income.
A - Operating risk refers to the additional uncertainty about operating earnings caused by fixed operating costs.
225
Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco's degree of financial leverage (DFL) and total leverage (DTL)?
DFL DTL
A) 1.33 1.75
B) 1.33 2.00
C) 1.20 2.00
C
DOL = [Q(P − V)] / [Q(P − V) − F] = [10,000(5 − 3)] / [10,000(5 − 3) − 8,000] = 1.67
DFL = EBIT / (EBIT − I) = 12,000 / (12,000 − 2,000) = 1.2
DTL = DOL × DFL = 1.67 × 1.2 = 2.0
226
Steven's Bakery produces snack cakes and bread. Listed below are the operating costs for the snack cakes division and the bread division.
Snack cakes Bread
Price per package $2.00 $2.50
Variable cost per package $1.00 $1.30
Fixed operating costs $25,000 $30,000
Fixed financing costs $10,000 $10,000
Compared to the snack cakes division, the operating breakeven quantity for the bread division is:
A) the same.
B) less.
C) greater.
A
The operating breakeven quantity for the snack cakes division is $25,000/($2.00 − $1.00) = 25,000.
The operating breakeven quantity for the bread division is $30,000/($2.50 − $1.30) = 25,000.
227
Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?
A) 4.20.
B) 3.50.
C) 3.75.
C
Sales = $100,000,000
VC of 25% of sales = 25,000,000
FC of 40,000,000 + 15,000,000 = 55,000,000
DOL= [100,000,000 - 25,000,000] / [100,000,000 - 25,000,000 - 55,000,000] = 3.75
228
Which of the following factors is least likely to affect business risk?
A) Interest rate variability.
B) Operating leverage.
C) Demand variability.
A
Business risk can be defined as the uncertainty inherent in a firm's return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other two choices.
229
____ risk refers to the uncertainty about operating earnings (EBIT) and results from variability in sales and expenses. It is magnified by operating leverage.
Business;
230
Business risk refers to the uncertainty about _____ and results from _____. Business risk is magnified by ______.
```
operating earnings (EBIT);
variability in sales and expenses;
operating leverage
```
231
A firm expects to produce 200,000 units of flour that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the fixed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to:
DOL DTL
A) 1.3 1.3
B) 1.6 1.3
C) 1.6 2.0
C
DOL = Q(P - V) / [Q(P - V) - F]
DOL = 200,000 (3 - 2) / [200,000(3 - 2) - 75,000] = 1.6
```
DTL = [Q(P - V) / Q(P - V) - F - I]
DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2
```
232
Wanton's San Y'isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity?
A) 3,000 units.
B) 2,500 units.
C) 1,750 units.
B
For this problem you need 2 equations.
Break-even quantity = Fixed Costs / (Price - Variable cost)
Q = FC / (P - V)
Fixed Costs = Total Costs - Variable Costs
FC = TC - VC = 200,000 - 150,000 = 50,000
Q = 50,000 / (35 - 15) = 2,500
233
Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of financial leverage (DFL)?
Sales of $3.5 million
Variable Costs at 45% of sales
Fixed Costs of $1.05 million
Debt interest payments on $750,000 issued at par with an annual 9.0% coupon (current yield is 7.0%)
Which of the following choices is closest to the correct answer? ArtFrame's DOL and DFL are:
DOL DFL
A) 2.20 1.08
B) 2.20 1.50
C) 3.00 1.50
A
ArtFrames Annual Operating Results
- Sales $3,500,000
- Variable Costs(1) 1,575,000
1,925,000
- Fixed Costs 1,050,000
- EBIT 875,000
- Interest Expense(2) 67,500
807,500
(1) Variable costs = 0.45 × 3,500,000
(2) Interest Expense = 0.09 × 750,000
Second, calculate DOL:
DOL = (Sales - Variable Costs) / (Sales - Variable Costs - Fixed Costs)
= (3,500,000 - 1,575,000) / (3,500,000 - 1,575,000 - 1,050,000) = 2.20
Third, calculate DFL:
DFL = EBIT / (EBIT - I) = 875,000 / 807,500 = 1.08
234
Which of the following best describes a firm with low operating leverage? A large change in:
A)
earnings before interest and taxes result in a small change in net income.
B)
sales result in a small change in net income.
C)
the number of units a firm produces and sells result in a similar change in the firm's earnings before interest and taxes.
!! difficult
C
Operating leverage is the result of a greater proportion of fixed costs compared to variable costs in a firm's capital structure and is characterized by the sensitivity in operating income (earnings before interest and taxes) to change in sales.
A firm that has equal changes in sales and operating income would have low operating leverage (the least it can be is one).
Note that the relationship between operating income and net income is impacted by the degree of financial leverage (option A), and the relationship between sales and net income is impacted by the degree of total leverage (option B).
235
All else equal, a firm's business risk is higher when:
A) the firm has low operating leverage.
B) fixed costs are the highest portion of its expense.
C) variable costs are the highest portion of its expense.
B
The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.
236
The uncertainty in return on assets due to the nature of a firm's operations is known as:
A) tax efficiency.
B) financial leverage.
C) business risk.
C
Business risk is a function of the firm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax efficiency is tied to mutual fund investing, while financial leverage requires the existence of debt.
237
The main factors affecting business risk are? (4)
- demand variability,
- sales price variability,
- input price variability,
- ability to adjust output prices, and
- operating leverage.
238
During a period of expansion in the economy, compared to firms with lower operating expense levels, earnings growth for firms with high operating leverage will be:
A) higher.
B) unaffected.
C) lower.
A
If a high percentage of a firm's total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.
239
The two major types of risk affecting a firm are:
A) business risk and financial risk.
B) financial risk and cash flow risk.
C) business risk and collection risk.
A
Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.
240
Which of the following statements about business risk and financial risk is least accurate?
A)
The greater a company's business risk, the higher its optimal debt ratio.
B)
Factors that affect business risk are demand, sales price, and input price variability.
C)
Business risk is the riskiness of the company's assets if it uses no debt.
A
| The greater a company's business risk, the lower its optimal debt ratio.
241
____ risk refers to the additional variability of EPS compared to EBIT. It increases with greater use of fixed cost financing (debt) in a company's capital structure.
Financial
242
Financial risk refers to the additional variability of ____compared to ___. Financial risk increases with greater use of _____ in a company's capital structure.
EPS; EBIT;
| fixed cost financing (debt)
243
As financial leverage increases, what will be the impact on the expected rate of return and financial risk?
A) One will rise while the other falls.
B) Both will fall.
C) Both will rise.
C
A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company's common stock also rises.
244
If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?
A) 5.0.
B) 4.2.
C) 4.7.
!!
A
Upon first glance, it appears there is not enough information to complete the problem. However when one realizes DTL = (DOL)(DFL) it is possible to complete this problem.
```
DTL = %∆EPS/%∆Sales = 5
DFL = EBIT/(EBIT-I) = 1.
```
(DOL)(1) =5
DOL= 5.
245
Which of the following statements about leverage is most accurate?
A)
An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage.
B)
If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.
C)
A decrease in interest expense will increase the company's degree of total leverage.
B
If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)
If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1
DTL = (DOL)(DFL)
If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL
A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company's DOL.
246
If debt = 0 then
- DFL = ___?
- __ = 0 and DFL = ___?
1 - because DFL = EBIT/(EBIT - I)
interest;
1 - because EBIT/(EBIT - 0) = EBIT/EBIT = 1
247
Which of the following sources of financing is least likely to increase a firm's financial risk?
A) Operating leases.
B) Fixed-rate debt.
C) Common equity.
C
Financial risk, in the context of a firm's financing of its operations, results from taking on fixed financial obligations such as debt or operating leases. Common equity financing does not involve fixed obligations.
Financial leverage increases with fixed financing costs.
248
Financial leverage increases with ____ cost.
fixed financing costs
249
Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven?
A) $2.75.
B) $2.50.
C) $2.25.
C
40,000 = $10,000/(P - $2)
40,000P - $80,000 = $10,000
P = $90,000/40,000 = $2.25.
250
Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis?
A) Unit sales levels.
B) Debt-equity ratio.
C) Input price variability.
B
The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels affect financial risk, not business (operating) risk.
251
An analyst has gathered the following expenditure information for three different firms, each of which has a sales level of $4 million.
Costs for firms under consideration
(in millions)
Firm A Firm B Firm C
Variable Costs $2.00 $2.60 $2.40
Fixed Costs $1.00 $1.30 $1.40
Interest Expense $0.20 $0.00 $0.20
Which firm has the highest degree of operating leverage (DOL)?
A) Firm B.
B) Firm A.
C) Firm C.
A
The DOL for the three companies is as follows:
DOL = (Total Revenue - Total Variable Costs) / (TR − TVC − Total Fixed Costs)
Firm A: ($4.00 − $2.00) / ($4.00 − $2.00 − $1.00) = 2
Firm B: ($4.00 − $2.60) / ($4.00 − $2.60 − $1.30) = 14
Firm C: ($4.00 − $2.40) / ($4.00 − $2.40 − $1.40) = 8
(Note: Interest expense does not affect operating leverage.)
252
Nelson, Inc. has fixed financing costs of $3 million, fixed operating costs of $5 million, and variable costs of $2.00 per unit. If the price of Nelson's product is $4.00, Nelson's operating breakeven quantity of sales is:
A) 4.0 million units.
B) 1.0 million units.
C) 2.5 million units.
C
Operating breakeven quantity = fixed operating costs / (price - variable cost per unit) = $5 million / ($4.00 - $2.00) = 2,500,000 units.
253
The following information reflects the projected operating results for Opstalan, a catalog printer.
- Sales of $5.0 million.
- Variable Costs at 40% of sales.
- Fixed Costs of $1.0 million.
- Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is 8.0%).
- Tax Rate of 0.0%.
Opstalan's degree of total leverage (DTL) is closest to:
A) 1.41.
B) 1.59.
C) 2.58.
B
Variable costs = 0.40 × 5,000,000=2M
Interest Expense = 0.07 × 1,500,000==0.105M
calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) = 3,000,000 / 2,000,000 = 1.50
calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.
Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.
254
Which of the following stakeholders are most likely to benefit from a company's growth and excellent financial performance?
A) Governments.
B) Customers.
C) Creditors.
A
Governments receive greater tax revenues when financial performance is excellent and profits are higher.
C - Creditors do not receive extra returns for performance better than that is adequate to repay debt.
B - Customers seek company stability and ongoing relationships with the company.
255
Shareholders who use their share voting power or other means to pressure companies to make changes they believe will increase shareholder value are most accurately described as:
A) ESG shareholders.
B) proxy shareholders.
C) activist shareholders.
C
| Activist shareholders seek changes in company operations that they believe will increase shareholder value.
256
A 91-day Treasury bill has a holding period yield of 1.5%. What is the annual yield of this T-bill on a bond-equivalent basis?
A) 6.24%.
B) 6.02%.
C) 6.65%.
B
Bond-equivalent yields = HPY × (365/days).
BEY = 1.5% × (365/91) = 6.02%.
257
Discount-basis yields = % discount from face value × (_____/days)
360
258
_______ = % discount from face value × (360/days)
Discount-basis yields
259
_____ yields = HPY × (360/days).
Money market
260
_____ yields = HPY × (365/days).
Bond-equivalent
261
_____ yields = HPY × (365/days).
Bond-equivalent
262
Which of the following is NOT a limitation to financial ratio analysis?
A) A firm that operates in only one industry.
B) The need to use judgment.
C) Differences in international accounting practices.
A
