Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following is NOT a capital component when calculating the weighted average cost of capital (WACC) for use in capital budgeting?
Answer Choices:
a. Long-term debt.
b. Accounts payable.
c. Retained earnings.
d. Common stock.
e. Preferred stock.
Answer: b. Accounts payable.
Question: In general, firms should use their weighted average cost of capital (WACC) to evaluate capital budgeting projects because most projects are funded with general corporate funds, which come from a variety of sources. However, if the firm plans to use only debt or only equity to fund a particular project, it should use the after-tax cost of that specific type of capital to evaluate that project.
Answer Choices:
a. True
b. False
Answer: b. False
Question: “Capital” is sometimes defined as funds supplied to a firm by investors.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project’s full life.
b. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.
c. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.
d. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.
e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
Answer: e. One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.
Question: The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.
c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock as measured by the CAPM.
d. If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence must issue new stock.
Answer: a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.
Question: The NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, will lead to different accept/reject decisions and thus capital budgets if the cost of capital at which the projects’ NPV profiles cross is greater than the crossover rate.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Firms raise capital at the total corporate level by retaining earnings and by obtaining funds in the capital markets. They then provide funds to their different divisions for investment in capital projects. The divisions may vary in risk, and the projects within the divisions may also vary in risk. Therefore, it is conceptually correct to use different risk-adjusted costs of capital for different capital budgeting projects.
Answer Choices:
a. True
b. False
Answer: a. True
Question: In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers’ tastes, choice of accounting method, or the profitability of other independent projects.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm’s stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital for use in capital budgeting during the current year is the after-tax cost of debt.
Answer Choices:
a. True
b. False
Answer: b. False
Question: SafeCo Company and RisCo Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in SafeCo having a WACC of 10% and RisCo a WACC of 12%. SafeCo is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical SafeCo project. RisCo is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical RisCo project.
Answer Choices:
a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
b. If evaluated using the correct post-merger WACC, Project Y would have a negative NPV.
c. After the merger, SafeCo/RisCo would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
d. SafeCo/RisCo’s WACC, as a result of the merger, would be 10%.
e. After the merger, SafeCo/RisCo should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
Answer: a. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since debt capital can cause a company to go bankrupt but equity capital cannot, debt is riskier than equity, and thus the after-tax cost of debt is always greater than the cost of equity.
b. The tax-adjusted cost of debt is always greater than the interest rate on debt, provided the company does in fact pay taxes.
c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
d. Because flotation costs are required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.
e. Higher flotation costs tend to reduce the cost of equity capital.
Answer: c. If a company assigns the same cost of capital to all of its projects regardless of each project’s risk, then the company is likely to reject some safe projects that it actually should accept and to accept some risky projects that it should reject.
Question: The firm’s cost of external equity raised by issuing new stock is the same as the required rate of return on the firm’s outstanding common stock.
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 NPV.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The MacMillen Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm’s overall WACC is 12%. The CFO believes that this is the correct WACC for the company’s average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO’s position is accepted, what is likely to happen over time?
Answer Choices:
a. The company will take on too many high-risk projects and reject too many low-risk projects.
b. The company will take on too many low-risk projects and reject too many high-risk projects.
c. Things will generally even out over time, and, therefore, the firm’s risk should remain constant over time.
d. The company’s overall WACC should decrease over time because its stock price should be increasing.
e. The CEO’s recommendation would maximize the firm’s intrinsic value.
Answer: a. The company will take on too many high-risk projects and reject too many low-risk projects.
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.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects’ IRRs are greater than their costs of capital.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The reason why retained earnings have a cost equal to rs is because investors think they can (i.e., expect to) earn rs on investments with the same risk as the firm’s common stock, and if the firm does not think that it can earn rs on the earnings that it retains, it should pay those earnings out to its investors. Thus, the cost of retained earnings is based on the opportunity cost principle.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The IRR 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: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are deductible by the paying corporation.
b. All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rᵢ.
c. All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, rₑ.
d. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.
e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
Answer: e. If a company’s tax rate increases but the YTM on its noncallable bonds remains the same, the after-tax cost of its debt will fall.
Question: When estimating the cost of equity by use of the CAPM, three potential problems are (1) whether to use long-term or short-term rates for RF, (2) whether or not the historical beta is the beta that investors use when evaluating the stock, and (3) how to measure the market risk premium, RPM. These problems leave us unsure of the true value of rs.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The higher the firm’s flotation cost for new common equity, the more likely the firm is to use preferred stock, which has no flotation cost, and retained earnings, whose cost is the average return on the assets that are acquired.
Answer Choices:
a. True
b. False
Answer: b. False
Question: For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project’s life, summing those compounded cash flows to a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project’s cost.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Funds acquired by the firm through retaining earnings have no cost because there are no dividend or interest payments associated with them, and no flotation costs are required to raise them, but capital raised by selling new stock or bonds does have a cost.
Answer Choices:
a. True
b. False
Answer: b. False