FIN 3030

Chapter 10

100

Schalheim Sisters Inc. has always paid out all of its earnings as dividends, hence the firm has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity, its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would REDUCE its WACC? a. The market risk premium declines. b. The flotation costs associated with issuing new common stock increase. c. The company’s beta increases. d. Expected inflation increases. e. The flotation costs associated with issuing preferred stock increase.

a. The market risk premium declines.

200

When working with the CAPM, which of the following factors can be determined with the most precision? 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.

E. The beta coefficient of “the market,” which is the same as the beta of an average stock.

300

Duval Inc. uses only equity capital, and it has two equally-sized divisions. Division A’s cost of capital is 10.0%, Division B’s cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division A’s projects are equally risky, as are all of Division B's projects. However, the projects of Division A are less risky than those of Division B. Which of the following projects should the firm accept? a. A Division B project with a 13% return. b. A Division B project with a 12% return. c. A Division A project with an 11% return. d. A Division A project with a 9% return. e. A Division B project with an 11% return.

a. A Division B project with a 13% return.

400

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? 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.

a. The company will take on too many high-risk projects and reject too many low-risk projects.

500

Firm M's earnings and stock price tend to move up and down with other firms in the S&P 500, while Firm W's earnings and stock price move counter cyclically with M and other S&P companies. Both M and W estimate their costs of equity using the CAPM, they have identical market values, their standard deviations of returns are identical, and they both finance only with common equity. Which of the following statements is CORRECT? a. M should have the lower WACC because it is like most other companies, and investors like that fact. b. M and W should have identical WACCs because their risks as measured by the standard deviation of returns are identical. c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. d. Without additional information, it is impossible to predict what the merged firm's WACC would be if M and W merged. e. Since M and W move counter cyclically to one another, if they merged, the merged firm's WACC would be less than the simple average of the two firms' WACCs.

c. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs.

Chapter11

100

Cornell Enterprises is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC: 10.00% Year 0 1 2 3 Cash flows -$1,050 $450 $460 $470 a. $ 92.37 b. $ 96.99 c. $101.84 d. $106.93 e. $112.28

a. $ 92.37

200

Barry Company is considering a project that has the following cash flow and WACC data. What is the project's NPV? Note that a project's projected NPV can be negative, in which case it will be rejected. WACC: 12.00% Year 0 1 2 3 4 5 Cash flows -$1,100 $400 $390 $380 $370 $360 a. $250.15 b. $277.94 c. $305.73 d. $336.31 e. $369.94

b. $277.94

300

Simkins Renovations Inc. is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected. Year 0 1 2 3 4 Cash flows -$850 $300 $290 $280 $270 a. 13.13% b. 14.44% c. 15.89% d. 17.48% e. 19.22%

a. 13.13%

400

A firm is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO wants to use the IRR criterion, while the CFO favors the NPV method. You were hired to advise the firm on the best procedure. If the wrong decision criterion is used, how much potential value would the firm lose? WACC: 6.00% Year 0 1 2 3 4 CFS -$1,025 $380 $380 $380 $380 CFL -$2,150 $765 $765 $765 $765 a. $188.68 b. $198.61 c. $209.07 d. $219.52 e. $230.49

c. $209.07

500

Nast Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher MIRR rather than the one with the higher NPV, how much value will be forgone? Note that under some conditions choosing projects on the basis of the MIRR will cause $0.00 value to be lost. WACC: 8.75% Year 0 1 2 3 4 CFS -$1,100 $375 $375 $375 $375 CFL -$2,200 $725 $725 $725 $725 a. $32.12 b. $35.33 c. $38.87 d. $40.15 e. $42.16

d. $40.1

Chapter 12

100

Which of the following statements is CORRECT? a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality. b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline. c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. e. Identifying an externality can never lead to an increase in the calculated NPV.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to decline.

200

Which of the following statements is CORRECT? a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer. c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes. e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

300

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product? a. Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration. b. Revenues from an existing product would be lost as a result of customers switching to the new product. c. Shipping and installation costs associated with a machine that would be used to produce the new product. d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year. e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.

400

Sub-Prime Loan Company is thinking of opening a new office, and the key data are shown below. The company owns the building that would be used, and it could sell it for $100,000 after taxes if it decides not to open the new office. The equipment for the project would be depreciated by the straight-line method over the project's 3-year life, after which it would be worth nothing and thus it would have a zero salvage value. No change in net operating working capital would be required, and revenues and other operating costs would be constant over the project's 3-year life. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) WACC 10.0% Opportunity cost $100,000 Net equipment cost (depreciable basis) $65,000 Straight-line depreciation rate for equipment 33.333% Annual sales revenues $123,000 Annual operating costs (excl. depreciation) $25,000 Tax rate 35% a. $10,521 b. $11,075 c. $11,658 d. $12,271 e. $12,885

d. $12,271

500

Desai Industries is analyzing an average-risk project, and the following data have been developed. Unit sales will be constant, but the sales price should increase with inflation. Fixed costs will also be constant, but variable costs should rise with inflation. The project should last for 3 years, it will be depreciated on a straight-line basis, and there will be no salvage value. No change in net operating working capital would be required. This is just one of many projects for the firm, so any losses on this project can be used to offset gains on other firm projects. What is the project's expected NPV? WACC 10.0% Net investment cost (depreciable basis) $200,000 Units sold 50,000 Average price per unit, Year 1 $25.00 Fixed oper. costs excl. depreciation (constant) $150,000 Variable oper. cost/unit, Year 1 $20.20 Annual depreciation rate 33.333% Expected inflation rate per year 5.00% Tax rate 40.0% a. $15,925 b. $16,764 c. $17,646 d. $18,528 e. $19,455

c. $17,646

Chapter 13

100

The firm’s target capital structure should do which of the following? a. Maximize the earnings per share (EPS). b. Minimize the cost of debt (rd). c. Obtain the highest possible bond rating. d. Minimize the cost of equity (rs). e. Minimize the weighted average cost of capital (WACC).

e. Minimize the weighted average cost of capital (WACC).

200

Which of the following statements is CORRECT? a. As a rule, the optimal capital structure is found by determining the debt-equity mix that maximizes expected EPS. b. The optimal capital structure simultaneously maximizes EPS and minimizes the WACC. c. The optimal capital structure minimizes the cost of equity, which is a necessary condition for maximizing the stock price. d. The optimal capital structure simultaneously minimizes the cost of debt, the cost of equity, and the WACC. e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

e. The optimal capital structure simultaneously maximizes the stock price and minimizes the WACC.

300

A firm's CFO is considering increasing the target debt ratio, which would also increase the company’s interest expense. New bonds would be issued and the proceeds would be used to buy back shares of common stock. Neither total assets nor operating income would change, but expected earnings per share (EPS) would increase. Assuming the CFO’s estimates are correct, which of the following statements is CORRECT? a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases. b. If the plan reduces the WACC, the stock price is likely to decline. c. Since the plan is expected to increase EPS, this implies that net income is also expected to increase. d. If the plan does increase the EPS, the stock price will automatically increase at the same rate. e. Under the plan there will be more bonds outstanding, and that will increase their liquidity and thus lower the interest rate on the currently outstanding bonds.

a. Since the proposed plan increases the firm’s financial risk, the stock price might fall even if EPS increases.

400

Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure? a. Its sales are projected to become less stable in the future. b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. c. Management believes that the firm’s stock is currently overvalued. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. The corporate tax rate is increased.

e. The corporate tax rate is increased. What is

500

You plan to invest in one of two home delivery pizza companies, High and Low, that were recently founded and are about to commence operations. They are identical except for their use of debt (wd) and the interest rates on their debt--High uses more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will High's expected EPS be versus that of Low, i.e., what is EPSHigh - EPSLow? Applicable to Both Firms Firm High's Data Firm Low's Data Capital $3,000,000 wd 70% wd 20% EBIT $500,000 Shares 90,000 Shares 240,000 Tax rate 35% Int. rate 12% Int. rate 10% a. $0.49 b. $0.54 c. $0.60 d. $0.66 e. $0.73

c. $0.60

Chapter 14

100

The announcement of an increase in the cash dividend should, according to MM, lead to an increase in the price of the firm's stock, other things held constant. a. True b. False

What is b. False

200

Some investors prefer dividends to retained earnings (and the capital gains retained earnings bring), while others prefer retained earnings to dividends. Other things held constant, it makes sense for a company to establish its dividend policy and stick to it, and then it will attract a clientele of investors who like that policy. a. True b. False

a. True

300

Myron Gordon and John Lintner believe that the required return on equity increases as the dividend payout ratio is lowered. Their argument is based on the assumption that a. investors are indifferent between dividends and capital gains. b. investors require that the dividend yield plus the capital gains yield equal a constant. c. capital gains are taxed at a higher rate than dividends. d. investors view dividends as being less risky than potential future capital gains. e. investors prefer a dollar of expected capital gains to a dollar of expected dividends because of the lower tax rate on capital gains.

d. investors view dividends as being less risky than potential future capital gains.

400

D. Paul Inc. forecasts a capital budget of $725,000. The CFO wants to maintain a target capital structure of 45% debt and 55% equity, and she also wants to pay a dividend of $500,000. If the company follows the residual dividend model, how much income must it earn, and what will its dividend payout ratio be? a. $ 898,750; 55.63% b. $ 943,688; 58.41% c. $ 990,872; 61.34% d. $1,040,415; 64.40% e. $1,092,436; 67.62%

What is b. $ 943,688; 58.41%

500

Grullon Co. is considering a 7-for-3 stock split. The current stock price is $75.00 per share, and the firm believes that its total market value would increase by 5% as a result of the improved liquidity that should follow the split. What is the stock's expected price following the split? a. $32.06 b. $33.75 c. $35.44 d. $37.21 e. $39.07

b. $33.75