Q&A Hero

Q: Your firm has $500 million of investor-supplied capital, its return on investors capital (ROIC) is 15%, and it currently has no debt in its capital structure (i.e., wd = 0). The CFO is contemplating a recapitalization where it would issue debt at an after-tax cost of 10% and use the proceeds to buy back some of its common stock, such that the percentage of common equity in the capital structure (wc) is 1 - wd. If the company goes ahead with the recapitalization, its operating income, the size of the firm (i.e., total assets), total investor-supplied capital, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization? a. The ROA would increase. b. The ROA would remain unchanged. c. The return on investors capital would decline. d. The return on investors capital would increase. e. The ROE would increase.

Q: Which of the following statements is CORRECT? a. Increasing its use of financial leverage is one way to increase a firm's return on investors capital (ROIC). b. If a firm lowered its fixed costs but increased its variable costs by just enough to hold total costs at the present level of sales constant, this would increase its operating leverage. c. The debt ratio that maximizes expected EPS generally exceeds the debt ratio that maximizes share price. d. If a company were to issue debt and use the money to repurchase common stock, this would reduce its return on investors capital (ROIC). (Assume that the repurchase has no impact on the company's operating income.) e. If a change in the bankruptcy code made bankruptcy less costly to corporations, this would tend to reduce corporations' debt ratios.

Q: 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.

Q: Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, this a. normally leads to an increase in its fixed assets turnover ratio. b. normally leads to a decrease in its business risk. c. normally leads to a decrease in the standard deviation of its expected EBIT. d. normally leads to a decrease in the variability of its expected EPS. e. normally leads to a reduction in its fixed assets turnover ratio.

Q: Which of the following statements is CORRECT? a. A firm's business risk is determined solely by the financial characteristics of its industry. b. The factors that affect a firm's business risk include industry characteristics and economic conditions, both of which are generally beyond the firm's control. c. One of the benefits to a firm of being at or near its target capital structure is that this generally minimizes the risk of bankruptcy. d. A firm's financial risk can be minimized by diversification. e. The amount of debt in its capital structure can under no circumstances affect a company's EBIT and business risk.

Q: 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).

Q: 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.

Q: Which of the following would tend to increase a firm's target debt ratio, other things held constant? a. The costs associated with filing for bankruptcy increase. b. The corporate tax rate is increased. c. The personal tax rate is increased. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company's stock price hits a new low.

Q: Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant? a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company's operating leverage. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company's stock price hits a new high.

Q: Which of the following statements best describes the optimal capital structure? a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company's stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company's cost of preferred stock.

Q: Based on the information below, what is the firm's optimal capital structure? a. Debt = 40%; Equity = 60%; EPS = $2.95; Stock price = $26.50. b. Debt = 50%; Equity = 50%; EPS = $3.05; Stock price = $28.90. c. Debt = 60%; Equity = 40%; EPS = $3.18; Stock price = $31.20. d. Debt = 80%; Equity = 20%; EPS = $3.42; Stock price = $30.40. e. Debt = 70%; Equity = 30%; EPS = $3.31; Stock price = $30.00.

Q: Which of the following statements is CORRECT? a. The capital structure that maximizes expected EPS also maximizes the price per share of common stock. b. The capital structure that minimizes the interest rate on debt also maximizes the expected EPS. c. The capital structure that minimizes the required return on equity also maximizes the stock price. d. The capital structure that minimizes the WACC also maximizes the price per share of common stock. e. The capital structure that gives the firm the best bond rating also maximizes the stock price.

Q: Which of the following statements is CORRECT? a. Since debt financing raises the firm's financial risk, increasing the target debt ratio will always increase the WACC. b. Since debt financing is cheaper than equity financing, raising a company's debt ratio will always reduce its WACC. c. Increasing a company's debt ratio will typically reduce the marginal costs of both debt and equity financing. However, this action still may raise the company's WACC. d. Increasing a company's debt ratio will typically increase the marginal costs of both debt and equity financing. However, this action still may lower the company's WACC. e. Since a firm's beta coefficient is not affected by its use of financial leverage, leverage does not affect the cost of equity.

Q: Business risk is affected by a firm's operations. Which of the following is NOT directly associated with (or does not directly contribute to) business risk? a. Demand variability. b. Sales price variability. c. The extent to which operating costs are fixed. d. The extent to which interest rates on the firm's debt fluctuate. e. Input price variability.

Q: An increase in the debt ratio will generally have no effect on which of these items? a. Business risk. b. Total risk. c. Financial risk. d. Market risk. e. The firm's beta.

Q: If a firm utilizes debt financing, a 10% decline in earnings before interest and taxes (EBIT) will result in a decline in earnings per share that is larger than 10%, and the higher the debt ratio, the larger this difference will be. a. True b. False

Q: A firm's treasurer likes to be in a position to raise funds to support operations whenever such funds are needed, even in "bad times". This is called "financial flexibility," and the lower the firm's debt ratio, the greater its financial flexibility, other things held constant. a. True b. False

Q: Other things held constant, the lower a firm's tax rate, the more logical it is for the firm to use debt. a. True b. False

Q: Other things held constant, firms that use assets that can be sold easily (like trucks) tend to use more debt than firms whose assets are harder to sell (like those engaged in research and development). a. True b. False

Q: Other things held constant, firms with more stable and predictable sales tend to use more debt than firms with less stable sales. a. True b. False

Q: According to the signaling theory of capital structure, firms first use common equity for their capital, then use debt if and only if they can raise no more equity on "reasonable" terms. This occurs because the use of debt financing signals to investors that the firm's managers think that the future does not look good. a. True b. False

Q: The Modigliani and Miller (MM) articles implicitly assumed, among other things, that outside stockholders have the same information about a firm's future prospects as its managers. That was called "symmetric information," and it is questionable. The introduction of "asymmetric information" led to the development of the "signaling" theory of capital structure, which postulated that firms are reluctant to issue new stock because investors will interpret such an act as a signal that the firm's managers are worried about its future. Other actions give off different signals, and the end result is that capital structure is affected by managers' perceptions about how their financing decisions will affect investors' views of the firm and thus its value. a. True b. False

Q: Some people--including the former chairman of the Federal Reserve Board of Governors (Ben Bernanke) --have argued that one advantage of corporate debt from the stockholders' standpoint is that the existence of debt forces managers to focus on cash flow and to refrain from spending too much of the firm's money on private plane and other "perks." This is one of the factors that led to the rise of LBOs and private equity firms. a. True b. False

Q: Modigliani and Miller (MM), in their second article, took account of taxes, bankruptcy, and other factors that were assumed away in their original article. Once they took account of all these assumptions, they concluded that every firm has a unique optimal capital structure. Moreover, a manager can use the second MM model to determine his or her firm's optimal debt ratio. a. True b. False

Q: The Modigliani and Miller (MM) articles implicitly assumed that bankruptcy did not exist. That led to the development of the "trade-off" model, where the firm's value first rises with the use of debt due to the tax shelter of debt, but later falls as more debt is added because the potential costs of bankruptcy begin to more than offset the tax shelter benefits. Under the trade-off theory, an optimal capital structure exists. a. True b. False

Q: The Miller model begins with the Modigliani and Miller (MM) model without corporate taxes and then adds personal taxes. a. True b. False

Q: The Miller model begins with the Modigliani and Miller (MM) model with corporate taxes and then adds personal taxes. a. True b. False

Q: Modigliani and Miller's second article, which assumed the existence of corporate income taxes, led to the conclusion that a firm's value would be maximized, and its cost of capital minimized, if it used (almost) 100% debt. However, this model did not take account of bankruptcy costs. The existence of bankruptcy costs leads to the assumption of an optimal capital structure where the debt ratio is less than 100%. a. True b. False

Q: Modigliani and Miller's first article led to the conclusion that capital structure is "irrelevant" because it has no effect on a firm's value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm's value would be maximized if it used (almost) 100% debt. a. True b. False

Q: According to Modigliani and Miller (MM), in a world without corporate income taxes the use of debt has no effect on the firm's value. a. True b. False

Q: According to Modigliani and Miller (MM), in a world with corporate income taxes the optimal capital structure calls for approximately 100% debt financing. a. True b. False

Q: According to Modigliani and Miller (MM), in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing. a. True b. False

Q: In a world with no taxes, Modigliani and Miller (MM) show that a firm's capital structure does not affect its value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., the firm's value rises as it uses more and more debt, other things held constant. a. True b. False

Q: If two firms have the same expected earnings per share (EPS) and the same standard deviation of expected EPS, then they must have the same amount of business risk. a. True b. False

Q: As the text indicates, a firm's financial risk can and should be divided into separate market and diversifiable risk components. a. True b. False

Q: It is possible for Firms A and B to have identical financial and operating leverage, yet for Firm A to have more risk as measured by the variability of EPS. This would occur if Firm A has more business risk than Firm B. a. True b. False

Q: Aggarwal Enterprises is considering a new project that has an initial cash outflow of $1,000,000, and the CFO set up the following simple decision tree to show its three most-likely scenarios. The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties. How much is the option to abandon worth (in thousands of dollars) to the firm? Do not round the intermediate calculations. WACC = 11.5% Dollars in Thousands NPV this Prob x t = 0 t = 1 t = 2 t = 3 State NPV Prob = 20% $800.0 $800.0 $800.0 $938.1 $187.6 Prob = 60% -$1,000 $520.0 $520.0 $520.0 $259.8 $155.9 Prob = 20% -$170.0 -$170.0 -$170.0 -$1,411.8 -$282.4 Exp. NPV= $61.1 u200b a. $59.7 b. $44.6 c. $58.1 d. $57.1 e. $51.9

Q: Florida Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the project's 3-year life, it would have zero salvage value. No change in net operating working capital (NOWC) would be required for the project. Revenues and operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV change? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Equipmentcost $60,000 Number of cars washed 2,960 Average price per car $25.00 Fixed op. cost $10,000 Variable op. cost/unit (i.e., VC per car washed) $5.375 u200b u200b Tax rate 25.0% u200b a. -$43,339 b. -$33,804 c. -$28,170 d. -$46,199 e. -$36,433

Q: Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. The equipment would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, additional net operating working capital (NOWC) would be required, but it would be recovered at the end of the project's life. Revenues and operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Equipment cost $70,000 Required net operating working capital (NOWC) $10,000 u200b u200b Annual sales revenues $61,000 Annual operating costs $30,000 Expected pre-tax salvage value $5,000 Tax rate 25.0% a. $5,650 b. $378 c. $344 d. $8,521 e. $2,543

Q: Foley Systems is considering a new project whose data are shown below. Under the new tax law, the equipment for the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. After the project's 3-year life, the equipment would have zero salvage value. The project would require additional net operating working capital (NOWC) that would be recovered at the end of the project's life. Revenues and operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows from operations are constant in Years 1 to 3.) Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Equipment cost $75,000 Required net operating working capital (NOWC) $15,000 u200b u200b Annual sales revenues $73,000 Annual operating costs $25,000 Tax rate 25.0% a. $2,549 b. $18,970 c. $4,571 d. $20,001 e. $1,348

Q: Poulsen 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. Under the new tax law, the equipment for the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the projects life, the equipment will have no salvage value. No change in net operating working capital (NOWC) would be required for the project. 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. The marketing manager does not think it is necessary to adjust for inflation since both the sales price and the variable costs will rise at the same rate, but the CFO thinks an inflation adjustment is required. What is the difference in the expected NPV if the inflation adjustment is made versus if it is not made? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Equipment cost $200,000 Units sold 54,000 Average price per unit, Year 1 $25.00 Fixed op. cost excl. depr. (constant) $150,000 Variable op. cost/unit, Year 1 $20.20 Expected annual inflation rate 4.0% Tax rate 25.0% a. $18,345 b. $12,621 c. $16,437 d. $15,409 e. $13,648

Q: 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. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the projects life, the equipment would have zero salvage value. No change in net operating working capital (NOWC) would be required for the project. Revenues and 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.) Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Opportunity cost $100,000 Equipment cost) $65,000 Annual sales revenues $116,000 Annual operating costs $25,000 Tax rate 25.0% a. $20,978 b. $36,761 c. $18,450 d. $34,900 e. $12,543

Q: 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. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the projects life, the equipment would have no salvage value. No change in net operating working capital (NOWC) would be required for the project. 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? Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Equipment cost $200,000 Units sold 56,000 Average price per unit, Year 1 $25.00 Fixed op. cost excl. depr. (constant) $150,000 Variable op. cost/unit, Year 1 $20.20 Expected annual inflation rate 5.0% Tax rate 25.0% a. $98,569 b. $68,303 c. $51,384 d. $95,434 e. $48,877

Q: TexMex Food Company is considering a new salsa whose data are shown below. Under the new tax law, the equipment to be used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. At the end of the projects life, the equipment would have zero salvage value, and no change in net operating working capital (NOWC) would be required for the project. Revenues and operating costs are expected to be constant over the project's 3-year life. However, this project would compete with other TexMex products and would reduce their pre-tax annual cash flows. What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) Do not round the intermediate calculations and round the final answer to the nearest whole number. WACC 10.0% Pre-tax cash flow reduction for other products (cannibalization) -$5,000 Equipment cost $80,000 u200b u200b Annual sales revenues $55,000 Annual operating costs -$25,000 Tax rate 25.0% u200b a. -$4,152 b. -$3,848 c. -$13,372 d. -$4,253 e. -$14,432

Q: Marshall-Miller & Company is considering the purchase of a new machine for $50,000, installed. The machine has a tax life of 5 years. Under the new tax law, the machine is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. The firm expects to operate the machine for 4 years and then to sell it for $21,500. If the marginal tax rate is 25%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? a. $12,551 b. $12,877 c. $12,225 d. $16,125 e. $14,833

Q: Liberty Services is now at the end of the final year of a project. The equipment was purchased prior to the new tax law and originally cost $20,000, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 25%. What is the equipments after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment's final market value is less than its book value, the firm will receive a tax credit as a result of the sale that will offset income from the companys other projects. a. $5,750 b. $5,060 c. $5,335 d. $4,180 e. $6,380

Q: Temple Corp. is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. The equipment would have a zero salvage value at the end of the projects life. No change in net operating working capital (NOWC) would be required. Revenues and operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Do not round the intermediate calculations and round the final answer to the nearest whole number. Risk-adjusted WACC 10.0% Equipment cost $65,000 Sales revenues, each year $55,500 Annual operating costs $25,000 Tax rate 25.0% a. $10,236 b. $3,350 c. $2,592 d. $8,137 e. $2,908

Q: Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life. Under the new law, the equipment used in the project is eligible for 100% bonus depreciation, so the equipment will be fully depreciated at t = 0. The equipment has no salvage value at the end of the projects life, and the project does not require any additional operating working capital. Revenues and operating costs are expected to be constant over the project's 10-year expected operating life. What is the project's Year 4 cash flow? Equipment cost $70,000 Sales revenues, each year $38,500 Operating costs $25,000 Tax rate 25.0% a. $8,707 b. $9,231 c. $10,125 d. $10,805 e. $9,756

Q: You work for Whittenerg Inc., which is considering a new project whose data are shown below. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. What is the project's Year 1 cash flow? Sales revenues, each year $67,750 Other operating costs $25,000 Interest expense $8,000 Tax rate 25.0% a. $22,849 b. $26,149 c. $32,063 d. $20,818 e. $30,211

Q: Fool Proof Software is considering a new project whose data are shown below. The equipment that would be used has a 3-year tax life. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. Revenues and operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow? Equipment cost $55,000 Sales revenues, each year $90,000 Operating costs (excl. depr.) $25,000 Tax rate 25.0% a. $33,177 b. $22,409 c. $48,750 d. $26,483 e. $22,991

Q: As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. What is the Year 1 cash flow? Do not round the intermediate calculations and round the final answer to the nearest whole number. Sales revenues, each year $45,000 Other operating costs $17,000 Interest expense $4,000 Tax rate 25.0% a. $22,922 b. $17,677 c. $20,785 d. $21,375 e. $17,871

Q: Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless. Under the new tax law, the equipment is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. Revenues and operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow? Do not round the intermediate calculations and round the final answer to the nearest whole number. Equipment cost (depreciable basis) $100,000 Sales revenues, each year $60,000 Operating costs (excl. depr.) $25,000 Tax rate 25.0% a. $33,040 b. $32,008 c. $29,598 d. $28,222 e. $26,250

Q: As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow? Do not round the intermediate calculations and round the final answer to the nearest whole number. Sales revenues $11,900 Operating costs $6,000 Tax rate 35.0% a. $4,425 b. $4,554 c. $4,869 d. $4,240 e. $6,334

Q: Your company, RMU Inc., is considering a new project whose data are shown below. Under the new tax law, the equipment used in the project is eligible for 100% bonus depreciation, so it will be fully depreciated at t = 0. What is the project's Year 1 cash flow? Sales revenues $26,750 Operating costs $12,000 Tax rate 25.0% a. $2,350 b. $4,345 c. $12,883 d. $1,063 e. $10,529

Q: Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a projects life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the projects completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a projects life. d. If equipment is expected to be sold for more than its book value at the end of a projects life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.

Q: Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: u200b Project Risk Expected Return A High 15% B Average 12% C High 11% D Low 9% E Low 6% u200b Which set of projects would maximize shareholder wealth? a. A and B b. A, B, and C c. A, B, and D d. A, B, C, and D e. A, B, C, D, and E

Q: Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? a. The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. b. Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify. It is better to not risk adjust at all. c. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. d. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure. e. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments - managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.

Q: Which of the following statements is CORRECT? a. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the projects NPV. c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. e. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

Q: Which of the following statements is CORRECT? a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. c. Well-diversified stockholders do not need to consider market risk when determining required rates of return. d. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

Q: A firm is considering a new project whose risk is greater than the risk of the firms 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? 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 firms risk. d. Ignore the risk differential if the project would amount to only a small fraction of the firms total assets. e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

Q: Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new projects sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT? a. The proposed new project would have more stand-alone risk than the firms typical project. b. The proposed new project would increase the firms corporate risk. c. The proposed new project would increase the firms market risk. d. The proposed new project would not affect the firms risk at all. e. The proposed new project would have less stand-alone risk than the firms typical project.

Q: Taussig Technologies is considering two potential projects, X and Y. In assessing the projects risks, the company estimated the beta of each project versus both the companys other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV $350,000 $350,000 Standard deviation (NPV) $100,000 $150,000 Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects. Which of the following statements is CORRECT? a. Project X has more stand-alone risk than Project Y. b. Project X has more corporate (or within-firm) risk than Project Y. c. Project X has more market risk than Project Y. d. Project X has the same level of corporate risk as Project Y. e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.

Q: A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? a. In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, double count it. b. Since depreciation is a non-cash expense, it has no impact on a projects calculated NPV.. c. When estimating the projects operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.

Q: 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.

Q: 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. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes. b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firms current products. c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firms other products.

Q: Which of the following statements is CORRECT? a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the projects cash flows will lead to an upward bias in the NPV. b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the projects cash flows will lead to a downward bias in the NPV. c. The existence of any type of externality will reduce the calculated NPV versus the NPV that would exist without the externality. d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration. e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

Q: Which of the following rules is CORRECT for capital budgeting analysis? a. The interest paid on funds borrowed to finance a project must be included in estimates of the projects 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 projects other costs when reaching the accept/reject decision. d. A proposed projects estimated net income as determined by the firms accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the projects cost, the project should be accepted. e. If a product is competitive with some of the firms 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 firms other products, this fact need not be reflected in the analysis.

Q: Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated? a. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm's products. b. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. c. The company has spent and expensed for tax purposes $3 million on research related to the new product. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. d. The new product will cut into sales of some of the firms other products. e. If the project is accepted, the company must invest an additional $2 million in net operating working capital (NOWC). However, all these funds will be recovered at the end of the projects life.

Q: Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? a. The new project is expected to reduce sales of one of the companys existing products by 5%. b. Since the firms director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the projects initial cost. c. The company has spent and expensed $1 million on research and development costs associated with the new project. d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

Q: Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT? a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project. b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. c. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

Q: When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT: a. Changes in net operating working capital attributable to the project. b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes. c. The value of a building owned by the firm that will be used for this project. d. A decline in the sales of an existing product, provided that decline is directly attributable to this project. e. The salvage value of assets used for the project that will be recovered at the end of the projects life.

Q: Which of the following factors should be included in the cash flows used to estimate a projects NPV? a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted. b. Interest on funds borrowed to help finance the project. c. The end-of-project recovery of any additional net operating working capital required to operate the project. d. Cannibalization effects, but only if those effects increase the projects projected cash flows. e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

Q: Other things held constant, which of the following would increase the NPV of a project being considered? a. A shift from straight-line to bonus depreciation. b. Making the initial investment in the first year rather than spreading it over the first three years. c. An increase in the discount rate associated with the project. d. An increase in required net operating working capital (NOWC). e. The project would decrease sales of another product line.

Q: A company is considering a new project. The CFO plans to calculate the projects NPV by estimating the relevant cash flows for each year of the projects life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the companys overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? a. All sunk costs that have been incurred relating to the project. b. All interest expenses on debt used to help finance the project. c. The additional investment in net operating working capital (NOWC) required to operate the project, even if that investment will be recovered at the end of the projects life. d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. e. Effects of the project on other divisions of the firm, but only if those effects lower the projects own direct cash flows.

Q: 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 firms use bonus depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projects forecasted NPVswould normally be lower than they would be if straight-line depreciation were required for tax purposes.. d. If firms use bonus depreciation, they can write off assets faster than they could under straight-line depreciation, and as a result projects forecasted NPVs would normally be lower than they would be if straight-line depreciation were required for tax purposes. e. If firms use bonus depreciation, they can write off assets faster than they could under straight-line depreciation, and as a result projects forecasted NPVs would normally be higher than they would be if straight-line depreciation were required for tax purposes.

Q: Which of the following statements is CORRECT? a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. d. Using bonus depreciation rather than straight line normally has the effect of receiving depreciation cash flows immediately and thus increasing a projects forecasted NPV. e. Using bonus depreciation rather than straight line normally has the effect of delaying the receipt of depreciation cash flows and thus reducing a projects forecasted NPV.

Q: Which of the following statements is CORRECT? a. Using bonus depreciation rather than straight line would normally have no effect on a projects total projected cash flows, but it would affect the timing of the cash flows and thus the NPV. b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. c. Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. d. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. e. Under bonus depreciation, higher depreciation charges occur at t = 0, and this increases the initial investment outlay and thus lowers a project's projected NPV.

Q: Which of the following statements is CORRECT? a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. d. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Q: 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 firms 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 banks other offices to increase. 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.

Q: 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 firms 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 banks 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.