Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
b. A project’s IRR increases as the WACC declines.
c. A project’s NPV increases as the WACC declines.
d. A project’s MIRR is unaffected by changes in the WACC.
e. A project’s regular payback increases as the WACC declines.
f. A project’s discounted payback increases as the WACC declines.
Answer: c. A project’s NPV increases as the WACC declines.
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: d. The cost of equity is always equal to or greater than the cost of debt.
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: Two conditions are used to determine whether or not a stock is in equilibrium: (1) Does the stock’s market price equal its intrinsic value as seen by the marginal investor, and (2) does the expected return on the stock as seen by the marginal investor equal this investor’s required return? If either of these conditions, but not necessarily both, holds, then the stock is said to be in equilibrium.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
b. One defect of the IRR method is that it does not take account of the time value of money.
c. One defect of the IRR method is that it does not take account of the cost of capital.
d. One defect of the IRR method is that it 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 is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
Answer: e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
Question: When working with the CAPM, which of the following factors can be determined with the most precision?
Answer Choices:
a. The market risk premium (RPM).
b. The beta coefficient, bi, of a relatively safe stock.
c. The most appropriate risk-free rate, RRF.
d. The expected rate of return on the market, rM.
e. The beta coefficient of “the market,” which is the same as the beta of an average stock.
Answer: e. The beta coefficient of “the market,” which is the same as the beta of an average stock.
Question: A basic rule in capital budgeting is that if a project’s NPV exceeds its IRR, then the project should be accepted.
Answer Choices:
a. True
b. False
Answer: b. False
Question: The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets.
Answer Choices:
a. True
b. False
Answer: a. True
Question: A conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but mutually exclusive projects, if the projects’ cost of capital is less than the rate at which the projects’ NPV profiles cross.
Answer Choices:
a. True
b. False
Answer: a. True
Question: If you were evaluating two mutually exclusive projects for a firm with a zero cost of capital, the payback method and NPV method would always lead to the same decision on which project to undertake.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Any cash flows that can be classified as incremental to a particular project—i.e., results directly from the decision to undertake the project—should be reflected in the capital budgeting analysis.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. A change in a company’s target capital structure cannot affect its WACC.
b. WACC calculations should be based on the before-tax costs of all the individual capital components.
c. Flotation costs associated with issuing new common stock normally reduce the WACC.
d. If a company’s tax rate increases, then all else equal, its weighted average cost of capital will decline.
e. An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.
Answer: d. If a company’s tax rate increases, then all else equal, its weighted average cost of capital will decline.
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
Question: Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
Answer Choices:
a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
b. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
d. The accept/reject decision depends on the firm’s risk-adjustment policy. If Norris’ policy is to increase the required return on a riskier-than-average project to 3% over rᵢ, then it should reject the project.
e. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
Answer: d. The accept/reject decision depends on the firm’s risk-adjustment policy. If Norris’ policy is to increase the required return on a riskier-than-average project to 3% over rᵢ, then it should reject the project.