Answer Choices:
a. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.
b. A project’s regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding the PV to find the IRR.
c. If a project’s IRR is greater than the WACC, then its NPV must be negative.
d. To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs.
e. To find a project’s IRR, we must find a discount rate that is equal to the WACC.
Answer:
d) To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs.
Question: For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?
Answer Choices:
a. The interest rate used to calculate the WACC is the average after-tax cost of all the company’s outstanding debt as shown on its balance sheet.
b. The WACC is calculated on a before-tax basis.
c. The WACC exceeds the cost of equity.
d. The cost of equity is always equal to or greater than the cost of debt.
e. The cost of retained earnings typically exceeds the cost of new common stock.
Answer:
Options:
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: An increase in the firm’s WACC will decrease projects’ NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects’ IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital. True False
Answer:
b) False
Question: Which of the following rules is CORRECT for capital budgeting analysis?
Answer Choices:
a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.
c. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.
d. A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.
e. If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.
Answer:
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.
Question: Companies HD and LD have the same total assets, total investor-supplied capital, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies’ returns on investors’ capital (ROIC) exceed their after-tax cost of debt, r_d(1 – T). Which of the following statements is CORRECT? Company HD has a higher return on assets (ROA) than Company LD. Company HD has a higher times interest earned (TIE) ratio than Company LD. Company HD has a higher return on equity (ROE) than Company LD, and its risk as measured by the standard deviation of ROE is also higher than LD’s. The two companies have the same ROE. Company HD’s ROE would be higher if it had no debt.
Answer:
Options:
Question: Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Answer Choices:
a. Project A, which has average risk and an IRR = 9%.
b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
e. All of these projects should be accepted as they will produce a positive NPV.
Answer:
d. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
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:
Options:
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. Since we cannot be sure that the estimate obtained with any of these methods is correct, it is often appropriate to use all three methods, then consider all three estimates, and end up using a judgmental estimate when calculating the WACC.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.
b. If the calculated beta underestimates the firm’s true investment risk—i.e., if the forward-looking beta that investors think exists exceeds the historical beta—then the CAPM method based on the historical beta will produce an estimate of rₛ and thus WACC that is too high.
c. Beta measures market risk, which is, theoretically, the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm’s stockholders are well diversified.
d. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that they are both “objective” as opposed to “subjective,” hence little or no judgment is required.
e. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.
Answer:
Options: