Answer:
Options:
Question: The IRR method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital. True False
Answer:
b) False
Question: Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B’s projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept?
Answer Choices:
a. A Division B project with a 13% return.
b. A Division B project with a 12% return.
c. A Division A project with an 11% return.
d. A Division A project with a 9% return.
e. A Division B project with an 11% return.
Answer:
c. A Division A project with an 11% return
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.
c. A project’s MIRR can never exceed its IRR.
d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.
e. If the NPV is negative, the IRR must also be negative.
Answer:
a) If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
Question: A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
Answer Choices:
a. All sunk costs that have been incurred relating to the project.
b. All interest expenses on debt used to help finance the project.
c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.
Answer:
c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
Question: Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer Choices:
a. A project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
b. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.
c. If a project’s IRR is smaller than the WACC, then its NPV will be positive.
d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
e. If a project’s IRR is positive, then its NPV must also be positive.
Answer:
d) A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
Question: A firm’s CFO is considering increasing the target debt ratio, which would also increase the company’s interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO’s estimates are correct, which of the following statements is CORRECT? Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases. If the plan reduces the WACC, the stock price is likely to decline. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. If the plan does increase the EPS, the stock price will automatically increase at the same rate. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.
Answer:
Options:
Question: Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
Answer Choices:
a. A project’s IRR increases as the WACC declines.
b. A project’s NPV increases as the WACC declines.
c. A project’s MIRR is unaffected by changes in the WACC.
d. A project’s regular payback increases as the WACC declines.
e. A project’s discounted payback increases as the WACC declines.
Answer:
b) A project’s NPV increases as the WACC declines.
Question: Which of the following statements is CORRECT? The capital structure that maximizes expected EPS also maximizes the price per share of common stock. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. The capital structure that minimizes the required return on equity also maximizes the stock price. The capital structure that minimizes the WACC also maximizes the price per share of common stock. The capital structure that gives the firm the best bond rating also maximizes the stock price.
Answer:
Options:
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The WACC as used in capital budgeting is an estimate of a company’s before-tax cost of capital.
b. The percentage flotation cost associated with issuing new common equity is typically smaller than the flotation cost for new debt.
c. The WACC as used in capital budgeting is an estimate of the cost of all the capital a company has raised to acquire its assets.
d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
e. The WACC as used in capital budgeting would be simply the after-tax cost of debt if the firm plans to use only debt to finance its capital budget during the coming year.
Answer:
Options:
Question: Modigliani and Miller’s second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm’s value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%.
Answer:
Options:
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputs—beta, the risk-free rate, and the market risk premium—can be estimated with little error.
b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.
c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures.
d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker’s confidence in the estimated cost of equity.
e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.
Answer:
Options:
Question: Assuming that their NPVs based on the firm’s cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. True False
Answer:
b) False
Question: Companies HD and LD have identical amounts of assets, investor-supplied capital, operating income (EBIT), tax rates, and business risk. Company HD, however, has a higher debt ratio than LD. Company HD’s return on investors’ capital (ROIC) exceeds its after-tax cost of debt, r_d(1 – T). Which of the following statements is CORRECT? HD should have a higher return on assets (ROA) than LD. HD should have a higher times interest earned (TIE) ratio than LD. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD’s. Given that ROIC > r_d(1 – T), HD’s stock price must exceed that of LD. Given that ROIC > r_d(1 – T), LD’s stock price must exceed that of HD.
Answer:
Options:
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project, i.e., it is the after-tax cost of debt if debt is to be used to finance the project or the cost of equity if the project will be financed with equity.
b. The after-tax cost of debt that should be used as the component cost when calculating the WACC is the average after-tax cost of all the firm’s outstanding debt.
c. Suppose some of a publicly-traded firm’s stockholders are not diversified; they hold only the one firm’s stock. In this case, the CAPM approach will result in an estimated cost of equity that is too low in the sense that if it is used in capital budgeting, projects will be accepted that will reduce the firm’s intrinsic value.
d. The cost of equity is generally harder to measure than the cost of debt because there is no stated, contractual cost number on which to base the cost of equity.
e. The bond-yield-plus-risk-premium approach is the most sophisticated and objective method for estimating a firm’s cost of equity capital.
Answer:
Options: