Corp Finance Flashcards

Question 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.

Answer

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.

Question 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.

Answer

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.

Question 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.

Answer

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.

Question 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.

Answer

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.

Question 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.

Answer

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

Question 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?

Answer

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.

Question 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.

Answer

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.

Question 8

Q

Where the NPV intersects the vertical y-axis you have ____

Where the NPV intersects the horizontal x-axis you have

Answer

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.

Question 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.

Answer

A

y (vertical)

- x (horizontal)

Question 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.

Answer

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.

Question 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%.

Answer

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.

Question 12

Q

when IRR > required rate of return ____ the project

Question 13

Q

when IRR < ______, reject the project

Answer

A

required rate of return

Question 14

Q

when (NPV)_____, accept the project

independent vs mutually exclusive

Answer

A

NPV > 0 and the project is independent

or when project has the bigger NPV (if mutually exclusive)

Question 15

Q

when NPV _____, reject the project

Question 16

Q

Profitability index = ?

Answer

A

= PV of future cash flow / CF0

= 1 + NPV/CF0

Question 17

Q

when profitability index (PI) ____, accept the project

Question 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?

Answer

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

Question 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.

Answer

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)

Question 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

Answer

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.

Question 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.

Answer

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.

Question 22

Q

projects with ____ cash flow patterns can produce multiple IRRs or no IRR.

Answer

A

unconventional

Question 23

Q

For projects with conventional cash flow patterns, the NPV and IRR methods produce ____ accept/reject decision

Question 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.

Answer

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

Question 25

Q

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

Answer

A

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.

Question 26

Q

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.

Answer

A

should use NPV

Question 27

Q

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%.

Answer

A

(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.

Question 28

Q

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.

Answer

A

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.

Question 29

Q

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.

Answer

A

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.

Question 30

Q

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.

Answer

A

independent ; mutually exclusive

Question 31

Q

For independent projects the IRR and NPV give ____ accept/reject decision. For mutually exclusive projects the IRR and NPV techniques ______ accept/reject decisions.

Answer

A

the same; can yield different

Question 32

Q

What if independent projects have unconventional cash pattern (which could create zero or more than one IRR)? Would that conflict with NPV?

Answer

A

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）

Question 33

Q

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.

Answer

A

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

Question 34

Q

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.

Question 35

Q

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%

Question 36

Q

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.

Answer

A

Externalities refer to the effects that the acceptance of a project may have on other firm cash flows

Question 37

Q

give an example of externalities

Answer

A

Cannibalization is one example of an externality (a negative one where accepting this project will decrease CF of other projects)
good example: diet coke

Question 38

Q

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.

Answer

A

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.

Question 39

Q

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).

Answer

A

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.

Question 40

Q

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.

Answer

A

(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.

Question 41

Q

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.

Question 42

Q

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.

Answer

A

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

Question 43

Q

_____ concerns the opportunities for future capital projects that may be created by undertaking a current project.

Answer

A

Project sequencing

Question 44

Q

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.

Answer

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.

Question 45

Q

T or F?

funding from the first project is a requirement for project sequencing.

Question 46

Q

T or F?
project sequencing is arranging projects in an order such that cash flows from the first project fund subsequent projects.

Answer

A

False. CF from first project is not a requirement for project sequencing

Question 47

Q

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.

Answer

A

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).

Question 48

Q

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

Answer

A

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.

Question 49

Q

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.

Answer

A

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.

Question 50

Q

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).

Answer

A

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.

Question 51

Q

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

Answer

A

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.

Question 52

Q

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.

Question 53

Q

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.

Answer

A

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

Question 54

Q

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.

Answer

A

C

one of the principles

Question 55

Q

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.

Answer

A

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).

Question 56

Q

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.

Answer

A

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)

Question 57

Q

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

Answer

A

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.

Question 58

Q

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.

Answer

A

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.

Question 59

Q

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.

Question 60

Q

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

Answer

A

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.

Question 61

Q

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 ?

Answer

A

4.86 years
150K-30K*4=30K ==> balance after 4 years
30/35=.86

4+.86=4.86 years

Question 62

Q

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.

Answer

A

A
This is a perpetuity.
PV = PMT / I = 30,000 / 0.15 = 200,000
200,000 − 190,000 = 10,000

Question 63

Q

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.

Answer

A

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.

Question 64

Q

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.

Answer

A

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.

Answer 55

A

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.

Answer 56

A

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.

Answer 57

A

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.

Answer 58

A

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.

Answer 59

A

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.

Answer 60

A

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.

Answer 61

A

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.

Answer 62

A

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%

Answer 63

A

ks = D1 ÷ P0 + growth

Answer 64

A

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%.

Answer 65

A

breakpoint

Answer 66

A

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.

Answer 67

A

weight of component in the WACC

(for example, d=40%, e=60%, if changing point for debt is $10M, breaking point = $10M/40%

Answer 68

A

B

($.93*1.07)/16 + 7% = 13.2%

Answer 69

A

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.

Answer 70

A

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.

Answer 71

A

target;
current capital structure;
market;
average capital structure in the firm’s industry

Answer 72

A

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).

Answer 73

A

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.

Answer 74

A

Preferred stock annual dividend / market price of preferred stock

Answer 75

A

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)

Answer 76

A

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

Answer 77

A

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%

Answer 78

A

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

Answer 79

A

CAPM = RF + B(RM − RF)

Answer 80

A

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.

Answer 81

A

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%

Answer 82

A

g = ROE * Retension rate

Answer 83

A

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%.

Answer 84

A

The cost of equity capital, kce

Answer 85

A

3% to 5%; market yield on the firm’s long-term debt.

Answer 86

A

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

Answer 87

A

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

Answer 88

A

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.

Answer 89

A

B

(0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13

Answer 90

A

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.

Answer 91

A

0.10(12%) + 0.30(8%)(1 - 0.35) + 0.6(14.5%) = 11.46%.

Answer 92

A

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.

Answer 93

A

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%

Answer 94

A

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.

Answer 95

A

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)

Answer 96

A

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%

Answer 97

A

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%

Answer 98

A

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.

Answer 99

A

Marginal cost of capital

Answer 100

A

proportion; the target capital structure

Answer 101

A

A
Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.

This is the discounted cashflow (or dividend growth) method

Answer 102

A

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.

Answer 103

A

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%.

Answer 104

A

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.

Answer 105

A

The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of debt and equity), and common equity.

Answer 106

A

C
(use market rate)
(0.14)(1 - 0.4) = 8.4%

Answer 107

A

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%)

Answer 108

A

beta x 1 / (1 + ROE x net of tax rate)

Answer 109

A

B
After-tax cost of debt = 10% × (1 - 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.

Answer 110

A

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.

Answer 111

A

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%

Answer 112

A

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%

Answer 113

A

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%.

Answer 114

A

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.

Answer 115

A

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.

Answer 116

A

Upward; downward

Answer 117

A

marginal cost of capital; investment opportunity schedule

Answer 118

A

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%.

Answer 119

A

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.

Answer 120

A

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%

Answer 121

A

kps = $8 / $80 = 10%

Answer 122

A

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%

Answer 123

A

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.

Answer 124

A

pure-play

Answer 125

A

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)

Answer 126

A

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)

Answer 127

A

A
βasset=βequity * 1 / [(1+(ROE(1-tax rate))] = 0.7 * [1/1+ (30.6)
] = 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%

Answer 128

A

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%

Answer 129

A

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

Answer 130

A

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.

Answer 131

A

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%.

Answer 132

A

7.5 × (1 − 0.3) = 5.25%.

Answer 133

A

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.

Answer 134

A

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.

Answer 135

A

The cost of preferred stock, kps, is Dps ÷ price.

Answer 136

A

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.

Answer 137

A

A
βasset = .8 x 1/ (1+1.7 x 65%) = .38
βproject = .38 x (1+3x70%) = 1.178

Answer 138

A

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.

Answer 139

A

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

Answer 140

A

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%.

Answer 141

A

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.

Answer 142

A

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.

Answer 143

A

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.

Answer 144

A

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%.

Answer 145

A

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%.

Answer 146

A

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.

Answer 147

A

B is correct. Compared with other stakeholder groups, customers tend to be less concerned with, and affected by, a company’s financial performance.

Answer 148

A

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.

Answer 149

A

B is correct. The election of directors is considered an ordinary resolution and, therefore, requires only a simple majority of votes to be passed.

Answer 150

A

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.

Answer 151

A

B is correct. The board typically ensures that the company has an appropriate enterprise risk management system in place.

Answer 152

A

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.

Answer 153

A

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.

Answer 154

A

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.

Answer 155

A

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).

Answer 156

A

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.

Answer 157

A

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.

Answer 158

A

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.

Answer 159

A

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).

Answer 160

A

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).

Answer 161

A

C is correct. Discount rates of 0 percent and approximately 61.8 percent both give a zero NPV.

Answer 162

A

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.

Answer 163

A

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.

Answer 164

A

C is correct. The horizontal axis represents an NPV of zero. By definition, the project’s IRR equals an NPV of zero.

Answer 165

A

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.

Answer 166

A

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%

Answer 167

A

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.

Answer 168

A

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%.

Answer 169

A

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%.

Answer 170

A

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

Answer 171

A

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.

Answer 172

A

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.

Answer 173

A

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

Answer 174

A

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.

Answer 175

A

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.

Answer 176

A

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

Answer 177

A

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.

Answer 178

A

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.

Answer 179

A

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

Answer 180

A

Business; operating risk and sales risk

Answer 181

A

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~~

Answer 182

A

Operating earnings; fixed operating; greater; greater

Answer 183

A

Financial

Answer 184

A

common stockholders

Answer 185

A

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.

Answer 186

A

B
QBE = [FC] / (P - V)
QBE = [10,000] / (4.00 - 2.00) = 5,000

Answer 187

A

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).

Answer 188

A

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.

Answer 189

A

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.

Answer 190

A

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)

Answer 191

A

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.

Answer 192

A

firm value.

not earning/NI/EPS, since that does not consider risk

Answer 193

A

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.

Answer 194

A

C
QBreakeven = Fixed Cost / (Price - Variable Cost)
QBreakeven = $325,000 / (160 - 120) = 8,125

Answer 195

A

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.

Answer 196

A

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.

Answer 197

A

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.

Answer 198

A

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.

Answer 199

A

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.

Answer 200

A

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

Answer 201

A

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.

Answer 202

A

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

Answer 203

A

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.

Answer 204

A

Business;

Answer 205

A

operating earnings (EBIT); 
variability in sales and expenses; 
operating leverage

Answer 206

A

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

Answer 207

A

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

Answer 208

A

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

Answer 209

A

!! 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).

Answer 210

A

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.

Answer 211

A

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.

Answer 212

A

demand variability,
sales price variability,
input price variability,
ability to adjust output prices, and
operating leverage.

Answer 213

A

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.

Answer 214

A

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.

Answer 215

A

The greater a company’s business risk, the lower its optimal debt ratio.

Answer 216

A

Financial

Answer 217

A

EPS; EBIT;

fixed cost financing (debt)

Answer 218

A

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.

Answer 219

A

!!
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.

Answer 220

A

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.

Answer 221

A

1 - because DFL = EBIT/(EBIT - I)
interest;
1 - because EBIT/(EBIT - 0) = EBIT/EBIT = 1

Answer 222

A

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.

Answer 223

A

fixed financing costs

Answer 224

A

C
40,000 = $10,000/(P - $2)
40,000P - $80,000 = $10,000
P = $90,000/40,000 = $2.25.

Answer 225

A

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.

Answer 226

A

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.)

Answer 227

A

C
Operating breakeven quantity = fixed operating costs / (price - variable cost per unit) = $5 million / ($4.00 - $2.00) = 2,500,000 units.

Answer 228

A

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.

Answer 229

A

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.

Answer 230

A

C

Activist shareholders seek changes in company operations that they believe will increase shareholder value.

Answer 231

A

B
Bond-equivalent yields = HPY × (365/days).
BEY = 1.5% × (365/91) = 6.02%.

Answer 232

A

Discount-basis yields

Answer 233

A

Money market

Answer 234

A

Bond-equivalent

Answer 235

A

Bond-equivalent

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