Answer Choices:
a. True
b. False
Answer: a. True
Question: If in the opinion of a given investor a stock’s expected return exceeds its required return, this suggests that the investor thinks
Answer Choices:
a. the stock is experiencing supernormal growth.
b. the stock should be sold.
c. the stock is a good buy.
d. management is probably not trying to maximize the price per share.
e. dividends are not likely to be declared.
Answer: c. the stock is a good buy.
Question: The NPV method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Because “present value” refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR.
Answer Choices:
a. True
b. 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%, 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: Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. A consultant has suggested using an 8% hurdle rate for the data processing division and a 12% hurdle rate for the manufacturing division. However, the CFO disagrees, and he has assigned a 10% WACC to all projects in both divisions. Which of the following statements is CORRECT?
Answer Choices:
a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time.
c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time.
d. The decision not to risk-adjust means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This will lead to a reduction in its intrinsic value over time.
e. The decision not to risk adjust means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This may affect the firm’s capital structure but will not affect its intrinsic value.
Answer: c. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing division and too few in the data processing division. This will lead to a reduction in the firm’s intrinsic value over time.
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: 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: d. There is an “opportunity cost” associated with using retained earnings, hence they are not “free.”
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. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
Answer: b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.