Answer:
b) False
Question: The firm’s target capital structure should do which of the following? Maximize the earnings per share (EPS). Minimize the cost of debt (rd). Obtain the highest possible bond rating. Minimize the cost of equity (rs). Minimize the weighted average cost of capital (WACC).
Answer:
Options:
Question: Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions for capital budgeting projects. True False
Answer:
b) False
Question: Which of the following statements is CORRECT? A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt.
Answer:
Options:
Question: Which of the following statements is CORRECT?
Answer Choices:
a. An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.
c. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.
d. An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.
e. We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV.
Answer:
d) An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.
Question: The NPV method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital. True 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. True 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:
Options:
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since companies can deduct dividends paid but not interest paid, our tax system favors the use of equity financing over debt financing, and this causes companies’ debt ratios to be lower than they would be if interest and dividends were both deductible.
b. Interest paid to an individual is counted as income for federal tax purposes and taxed at the individual’s regular tax rate, which in 2014 could go up to 39.6%, but qualified dividends received were taxed at a maximum tax rate of 15% for individuals earning less than $400,000 and married taxpayers filing jointly earning less than $450,000.
c. The maximum federal tax rate on corporate income in 2014 was 50%.
d. Corporations obtain capital for use in their operations by borrowing and by raising equity capital, either by selling new common stock or by retaining earnings. The cost of debt capital is the interest paid on the debt, and the cost of the equity is the dividends paid on the stock. Both of these costs are deductible from income when calculating income tax for tax purposes.
e. The maximum federal tax rate on personal income in 2014 was 50%.
Answer:
b. Interest paid to
an individual is counted as income for federal tax purposes and taxed at the individual’s regular tax rate, which in 2014 could go up to 39.6%, but qualified dividends received were taxed at a maximum tax rate of 15% for individuals earning less than $400,000 and married taxpayers filing jointly earning less than $450,000.
Question: Which of the following statements is CORRECT, holding other things constant? In general, a firm with low operating leverage also has a small proportion of its total costs in the form of fixed costs. There is no reason to think that changes in the personal tax rate would affect firms’ capital structure decisions. A firm with a relatively high business risk is more likely to increase its use of financial leverage than a firm with low business risk, assuming all else equal. If a firm’s after-tax cost of equity exceeds its after-tax cost of debt, it can always reduce its WACC by increasing its use of debt. Suppose a firm has less than its optimal amount of debt. Increasing its use of debt to the point where it is at its optimal capital structure will decrease the costs of both debt and equity.
Answer:
Options:
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 NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.
b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
c. If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be less than zero.
e. The NPVs of relatively risky projects should be found using relatively low WACCs.
Answer:
b) The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
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: Which of the following statements is CORRECT?
Answer Choices:
a. The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.
b. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.
c. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
d. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.
e. The percentage difference between the MIRR and the IRR is equal to the project’s WACC.
Answer:
c) Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.
Question: Projected free cash flows should be discounted at the firm’s weighted average cost of capital to find the firm’s total corporate value.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: If a firm’s marginal tax rate is increased, this would, other things held constant, lower the cost of debt used to calculate its WACC.
Answer Choices:
a. True
b. False
Answer:
a. True
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. True False
Answer:
b) False
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:
Options:
Question: Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.
Answer Choices:
a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms’ assets.
b. If a firm’s managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project’s expected future cash flows.
c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.
d. Projects with above-average risk typically have higher-than-average betas and, therefore, to maximize a firm’s intrinsic value, its managers should favor high-beta projects over those with lower betas.
e. Project A has a standard deviation of expected returns of 20%, while Project B’s standard deviation is only 10%. As returns are negatively correlated with both the firm’s other assets and the returns on most stocks in the economy, while B’s returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.
Answer:
Options:
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: 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: Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data 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 it will not affect its intrinsic value.
Answer:
Options:
Question: A firm should never accept a project if its acceptance would lead to an increase in the firm’s cost of capital (its WACC). True False
Answer:
b) False
Question: A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
Answer Choices:
a. Increase the estimated IRR of the project to reflect its greater risk.
b. Increase the estimated NPV of the project to reflect its greater risk.
c. Reject the project, since its acceptance would increase the firm’s risk.
d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
Answer:
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
Question: The component costs of capital are market-determined variables in the sense that they are based on investors’ required returns.
Answer Choices:
a. True
b. False
Answer:
a. True
Question: Which of the following statements is CORRECT? As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.
Answer:
Options: