Answer Choices:
a. True
b. False
Answer: b. False
Question: The NPV method’s assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR’s assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The “break point” as discussed in the text refers to the point where the firm’s tax rate increases.
b. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it is simply unable to borrow any more money.
c. The “break point” as discussed in the text refers to the point where the firm is taking on investments that are so risky the firm is in serious danger of going bankrupt if things do not go exactly as planned.
d. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
e. The “break point” as discussed in the text refers to the point where the firm has exhausted its supply of additions to retained earnings and thus must begin to finance with preferred stock.
Answer: d. The “break point” as discussed in the text refers to the point where the firm has raised so much capital that it has exhausted its supply of additions to retained earnings and thus must raise equity by issuing stock.
Question: For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. In the WACC calculation, we must adjust the cost of preferred stock (the market yield) to reflect the fact that 70% of the dividends received by corporate investors are excluded from their taxable income.
b. We should use historical measures of the component costs from prior financings that are still outstanding when estimating a company’s WACC for capital budgeting purposes.
c. The cost of new equity (rₑ) could possibly be lower than the cost of retained earnings (rᵢ) if the market risk premium, risk-free rate, and the company’s beta all decline by a sufficiently large amount.
d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
e. The component cost of preferred stock is expressed as rₚ(1 – T), because preferred stock dividends are treated as fixed charges, similar to the treatment of interest on debt.
Answer: d. Its cost of retained earnings is the rate of return stockholders require on a firm’s common stock.
Question: The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
Answer Choices:
a. True
b. False
Answer: b. False
Question: When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The cost of debt, rd, is normally less than rs, so rd(1 – T) will normally be much less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 – T).
Answer Choices:
a. True
b. False
Answer: a. True
Question: The lower the firm’s tax rate, the lower will be its after-tax cost of debt and also its WACC, other things held constant.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Bankston Corporation forecasts that if all of its existing financial policies are followed, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than retained earnings, Bankston would like to avoid issuing new stock. Which of the following actions would REDUCE its need to issue new common stock?
Answer Choices:
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short-term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.
Answer: b. Increase the percentage of debt in the target capital structure.
Question: Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project’s life.
Answer Choices:
a. True
b. False
Answer: a. True
Question: When estimating the cost of equity by use of the DCF method, the single biggest potential problem is to determine the growth rate that investors use when they estimate a stock’s expected future rate of return. This problem leaves us unsure of the true value of rs.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Projects with “normal” cash flows can have only one real IRR.
b. Projects with “normal” cash flows can have two or more real IRRs.
c. Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.”
d. The “multiple IRR problem” can arise if a project’s cash flows are “normal.”
e. Projects with “nonnormal” cash flows are almost never encountered in the real world.
Answer: a. Projects with “normal” cash flows can have only one real IRR.
Question: The cost of common equity obtained by retaining earnings is the rate of return the marginal stockholder requires on the firm’s common stock.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation’s taxable income.
Answer Choices:
a. True
b. False
Answer: b. False
Question: LaPango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
Answer Choices:
a. Project B, which is of below-average risk and has a return of 8.5%.
b. Project C, which is of above-average risk and has a return of 11%.
c. Project A, which is of average risk and has a return of 9%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
Answer: a. Project B, which is of below-average risk and has a return of 8.5%.
Question: The text identifies three methods for estimating the cost of common stock from retained earnings: the CAPM method, the DCF method, and the bond-yield-plus-risk-premium method. However, only the CAPM method always provides an accurate and reliable estimate.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt.
Answer Choices:
a. True
b. False
Answer: a. True
Question: For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly common equity.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Since 70% of the preferred dividends received by a corporation are excluded from taxable income, the component cost of equity for a company that pays half of its earnings out as common dividends and half as preferred dividends should, theoretically, be rs(0.30)x(0.50) + rps(1 – T)(0.70)x(0.50).
Answer Choices:
a. True
b. False
Answer: b. False