MAFIN 2

Multiple ChoiceIdentify the choice that best completes the statement or answers the question.

____1.Which of the following statements is CORRECT?a.One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a projects full life.

b.One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.

c.One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.

d.One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until some time in the future.

e.One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.

____2.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.a.A projects regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.

b.A projects regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.

c.If a projects IRR is greater than the WACC, then its NPV must be negative.

d.To find a projects IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the projects costs.

e.To find a projects IRR, we must find a discount rate that is equal to the WACC.

____3.Which of the following statements is CORRECT?a.If a project has normal cash flows, then its IRR must be positive.

b.If a project has normal cash flows, then its MIRR must be positive.

c.If a project has normal cash flows, then it will have exactly two real IRRs.

d.The definition of normal cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the projects life.

e.If a project has normal cash flows, then it can have only one real IRR,

____4.Which of the following statements is CORRECT?a.The regular payback method recognizes all cash flows over a projects life.

b.The discounted payback method recognizes all cash flows over a projects life, and it also adjusts these cash flows to account for the time value of money.

c.The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.

d.The regular payback is useful as an indicator of a projects liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

e.The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

____5.Which of the following statements is CORRECT?a.The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a projects profitability.

b.If the cost of capital declines, this lowers a projects NPV.

c.The NPV method is regarded by most academics as being the best indicator of a projects profitability, hence most academics recommend that firms use only this one method.

d.A projects NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the projects life.

e.The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

____6.Which of the following statements is CORRECT?a.The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

b.The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

c.The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.

d.The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

e.The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

____7.Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?a.It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).

b.It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).

c.The firm will accept too many projects in all economic states because a 4-year payback is too low.

d.The firm will accept too few projects in all economic states because a 4-year payback is too high.

e.If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

____8.Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project Ss undiscounted net cash flows total $20,000, while Ls total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which projects NPV is more sensitive to changes in the WACC?a.Project S.

b.Project L.

c.Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.

d.Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.

e.The solution cannot be determined because the problem gives us no information that can be used to determine the projects relative IRRs.

____9.Which of the following statements is CORRECT?a.The MIRR and NPV decision criteria can never conflict.

b.The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.

c.One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.

d.The higher the WACC, the shorter the discounted payback period.

e.The MIRR method assumes that cash flows are reinvested at the crossover

____10.Which of the following statements is CORRECT?a.For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

b.To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.

c.The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.

d.If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.

e.If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

____11.Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project Ls IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?a.If the WACC is 10%, both projects will have positive NPVs.

b.If the WACC is 6%, Project S will have the higher NPV.

c.If the WACC is 13%, Project S will have the lower NPV.

d.If the WACC is 10%, both projects will have a negative NPV.

e.Project Ss NPV is more sensitive to changes in WACC than Project L's.

____12.Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?a.If the WACC is 13%, Project As NPV will be higher than Project Bs.

b.If the WACC is 9%, Project As NPV will be higher than Project Bs.

c.If the WACC is 6%, Project Bs NPV will be higher than Project As.

d.If the WACC is greater than 14%, Project As IRR will exceed Project Bs.

e.If the WACC is 9%, Project Bs NPV will be higher than Project As.

____13.You are on the staff of Camden Inc. The CFO believes project acceptance should be based on the NPV, but Steve Camden, the president, insists that no project should be accepted unless its IRR exceeds the projects risk-adjusted WACC. Now you must make a recommendation on a project that has a cost of $15,000 and two cash flows: $110,000 at the end of Year 1 and -$100,000 at the end of Year 2. The president and the CFO both agree that the appropriate WACC for this project is 10%. At 10%, the NPV is $2,355.37, but you find two IRRs, one at 6.33% and one at 527%, and a MIRR of 11.32%. Which of the following statements best describes your optimal recommendation, i.e., the analysis and recommendation that is best for the company and least likely to get you in trouble with either the CFO or the president?a.You should recommend that the project be rejected because its NPV is negative and its IRR is less than the WACC.

b.You should recommend that the project be rejected because, although its NPV is positive, it has an IRR that is less than the WACC.

c.You should recommend that the project be accepted because (1) its NPV is positive and (2) although it has two IRRs, in this case it would be better to focus on the MIRR, which exceeds the WACC. You should explain this to the president and tell him that that the firms value will increase if the project is accepted.

d.You should recommend that the project be rejected because (1) its NPV is positive and (2) it has two IRRs, one of which is less than the WACC, which indicates that the firms value will decline if the project is accepted.

e.You should recommend that the project be rejected because, although its NPV is positive, its MIRR is less than the WACC, and that indicates that the firms value will decline if it is accepted.

____14.Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows.a.A projects MIRR is always greater than its regular IRR.

b.A projects MIRR is always less than its regular IRR.

c.If a projects IRR is greater than its WACC, then its MIRR will be greater than the IRR.

d.To find a projects MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost.

e.To find a projects MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.

____15.Projects S and L both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT?a.Project S must have a higher NPV than Project L.

b.If Project S has a positive NPV, Project L must also have a positive NPV.

c.If the WACC falls, each projects IRR will increase.

d.If the WACC increases, each projects IRR will decrease.

e.If Projects S and L have the same NPV at the current WACC, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the WACC used to evaluate the projects declined.

____16.Projects A and B are mutually exclusive and have normal cash flows. Project A has an IRR of 15% and B's IRR is 20%. The companys WACC is 12%, and at that rate Project A has the higher NPV. Which of the following statements is CORRECT?a.The crossover rate for the two projects must be less than 12%.

b.Assuming the timing pattern of the two projects cash flows is the same, Project B probably has a higher cost (and larger scale).

c.Assuming the two projects have the same scale, Project B probably has a faster payback than Project A.

d.The crossover rate for the two projects must be 12%.

e.Since B has the higher IRR, then it must also have the higher NPV if the crossover rate is less than the WACC of 12%.

____17.Resnick Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year0123

Cash flows-$450$200$200$200

a.2.39 years

b.1.94 years

c.1.71 years

d.2.25 years

e.2.66 years

____18.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%

Year0123

Cash flows-$825$450$460$470

a.$396.72

b.$317.37

c.$336.42

d.$323.72

e.$257.07

____19.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:9.25%

Year012345

Cash flows-$1,100$400$390$380$370$360

a.$349.07

b.$442.91

c.$375.34

d.$311.54

e.$360.33

____20.Maxwell Feed & Seed 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.

Year012345

Cash flows-$9,000$2,000$2,025$2,050$2,075$2,100

a.3.52%

b.3.34%

c.4.68%

d.4.46%

e.3.39%

____21.Ehrmann Data Systems is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC:8.75%

Year0123

Cash flows-$1,000$450$450$450

a.13.74%

b.11.41%

c.14.16%

d.12.23%

e.16.90%

____22.Malholtra Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC:10.00%

Year01234

Cash flows-$1,175$300$320$340$360

a.7.65%

b.6.12%

c.5.13%

d.7.72%

e.6.66%

____23.Hindelang Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC:13.25%

Year01234

Cash flows-$850$300$320$340$360

a.17.31%

b.14.43%

c.12.90%

d.17.65%

e.16.97%

____24.Fernando Designs is considering a project that has the following cash flow and WACC data. What is the project's discounted payback?

WACC:10.00%

Year0123

Cash flows-$950$500$500$500

a.2.22 years

b.2.04 years

c.2.75 years

d.1.69 years

e.2.35 years

____25.Sexton 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 IRR, how much value will be forgone? Note that under certain conditions choosing projects on the basis of the IRR will not cause any value to be lost because the one with the higher IRR will also have the higher NPV, so no value will be lost if the IRR method is used.

WACC:15.25%

01234

CFS-$2,050$750$760$770$780

CFL-$4,300$1,500$1,518$1,536$1,554

a.$0.00

b.$111.84

c.$76.05

d.$102.89

e.$84.10

____26.Kosovski Company is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and are not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be forgone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost.

WACC:8.25%

01234

CFS-$1,050$675$650

CFL-$1,050$360$360$360$360

a.$7.50

b.$7.13

c.$7.80

d.$6.68

e.$8.41

____27.Noe Drilling Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. The CEO believes the IRR is the best selection criterion, while the CFO advocates the MIRR. If the decision is made by choosing the project with the higher IRR rather than the one with the higher MIRR, how much, if any, value will be forgone, i.e., what's the NPV of the chosen project versus the maximum possible NPV? Note that (1) "true value" is measured by NPV, and (2) under some conditions the choice of IRR vs. MIRR will have no effect on the value lost.

WACC:8.00%

01234

CFS -$1,100$550$600$100$100

CFL -$2,750$725$725$800$1,400

a.$118.69

b.$99.12

c.$130.43

d.$152.60

e.$121.30

____28.The relative risk of a proposed project is best accounted for by which of the following procedures?a.Adjusting the discount rate upward if the project is judged to have above-average risk.

b.Adjusting the discount rate downward if the project is judged to have above-average risk.

c.Reducing the NPV by 10% for risky projects.

d.Picking a risk factor equal to the average discount rate.

e.Ignoring risk because project risk cannot be measured accurately.

____29.Which of the following statements is CORRECT?a.A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

b.A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

c.A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

d.Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV.

e.A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firms existing stores.

____30.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 accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a projects forecasted NPV.

e.Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a projects forecasted NPV.

____31.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 R&D 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.

____32.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, the firm does not need to deal with depreciation when calculating the operating cash flows.

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.

e.The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.

____33.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 working capital required at the start of an expansion project can be recovered at the projects completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with 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 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.

____34.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?Sales revenues$12,700

Depreciation$4,000

Other operating costs$6,000

Tax rate35.0%

a.$6,165

b.$4,950

c.$5,410

d.$4,495

e.$5,755

____35.Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow?Sales revenues$23,500

Depreciation$8,000

Other operating costs$12,000

Tax rate35.0%

a.$10,275

b.$12,125

c.$7,809

d.$10,686

e.$9,864

____36.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. What is the Year 1 cash flow?Sales revenues, each year$40,500

Depreciation$10,000

Other operating costs $17,000

Interest expense$4,000

Tax rate35.0%

a.$15,959

b.$18,024

c.$18,775

d.$20,465

e.$14,457

____37.You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow?Sales revenues, each year$48,500

Depreciation$8,000

Other operating costs $25,000

Interest expense$8,000

Tax rate35.0%

a.$19,160

b.$17,533

c.$17,171

d.$15,183

e.$18,075

____38.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, and the allowed depreciation rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating costs are expected to be constant over the project's 10-year expected life. What is the Year 1 cash flow?Equipment cost (depreciable basis)$48,000

Sales revenues, each year$60,000

Operating costs (excl. depr.)$25,000

Tax rate35.0%

a.$29,992

b.$28,294

c.$21,786

d.$33,670

e.$24,333

____39.Your company, CSUS Inc., is considering a new project whose data are shown below. The required equipment has a 3-year tax life, and the accelerated rates for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other 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 (depreciable basis)$70,000

Sales revenues, each year$41,000

Operating costs (excl. depr.)$25,000

Tax rate35.0%

a.$11,270

b.$12,115

c.$9,930

d.$10,185

e.$11,275

____40.Liberty Services is now at the end of the final year of a project. The equipment originally cost $30,000, of which 75% has been depreciated. The firm can sell the used equipment today for $6,000, and its tax rate is 40%. 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.a.$6,670

b.$8,250

c.$6,070

d.$6,600

e.$7,660

____41.Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,900 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 11.00%. Use the replacement chain approach to determine the NPV of the most profitable project.a.$2,573

b.$3,341

c.$3,809

d.$3,141

e.$3,909

____42.Wilson Co. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,500 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 7.00%. What is the equivalent annual annuity of the most profitable project?a.$1,810.96

b.$2,062.48

c.$1,676.81

d.$1,743.88

e.$1,878.03

____43.TexMex Food Company is considering a new salsa whose data are shown below. The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required. Revenues and other 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.)WACC10.0%

Pre-tax cash flow reduction for other products (cannibalization)-$5,000

Investment cost (depreciable basis)$80,000

Straight-line depr. rate33.333%

Sales revenues, each year for 3 years$73,500

Annual operating costs (excl. depr.)-$25,000

Tax rate35.0%

a.$14,067

b.$10,550

c.$16,772

d.$16,095

e.$13,526

____44.Foley Systems is considering a new investment whose data are shown below. The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's life. What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)WACC10.0%

Net investment in fixed assets (basis)$75,000

Required new working capital$15,000

Straight-line depr. rate33.333%

Sales revenues, each year$81,000

Operating costs (excl. depr.), each year$25,000

Tax rate35.0%

a.$33,551

b.$39,926

c.$40,597

d.$29,860

e.$41,939

____45.Thomson Media is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV?WACC10.0%

Net investment in fixed assets (depreciable basis)$70,000

Required new working capital$10,000

Straight-line depr. rate33.333%

Sales revenues, each year$80,000

Operating costs (excl. depr.), each year$30,000

Expected pretax salvage value$5,000

Tax rate35.0%

a.$31,694

b.$35,066

c.$38,438

d.$40,124

e.$33,717

____46.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.

____47.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.

____48.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.

____49.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.

____50.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 (r).

c.Obtain the highest possible bond rating.

d.Minimize the cost of equity (r).

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

____51.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.

____52.Which of the following statements is CORRECT? As a firm increases the operating leverage used to produce a given quantity of output, thisa.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.

____53.Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, 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 basic earning power ratio would decline.

d.The basic earning power ratio would increase.

e.The ROE would increase.

____54.Which of the following statements is CORRECT?a.Increasing its use of financial leverage is one way to increase a firm's basic earning power (BEP).

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 basic earning power ratio. (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.

____55.Firms U and L each have the same amount of assets, and both have a basic earning power ratio of 20%. Firm U is unleveraged, i.e., it is 100% equity financed, while Firm L is financed with 50% debt and 50% equity. Firm L's debt has a before-tax cost of 8%. Both firms have positive net income. Which of the following statements is CORRECT?a.The two companies have the same times interest earned (TIE) ratio.

b.Firm L has a lower ROA than Firm U.

c.Firm L has a lower ROE than Firm U.

d.Firm L has the higher times interest earned (TIE) ratio.

e.Firm L has a higher EBIT than Firm U.

____56.Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies' basic earning power (BEP) ratios exceed their cost of debt (r). Which of the following statements is CORRECT?a.HD should have a higher return on assets (ROA) than LD.

b.HD should have a higher times interest earned (TIE) ratio than LD.

c.HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD's.

d.Given that BEP > r, HD's stock price must exceed that of LD.

e.Given that BEP > r, LD's stock price must exceed that of HD.

____57.Which of the following statements is CORRECT?a.When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase.

b.The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share.

c.All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios.

d.Since debt financing raises the firm's financial risk, increasing a company's debt ratio will always increase its WACC.

e.Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income.

____58.Your uncle is considering investing in a new company that will produce high quality stereo speakers. The sales price would be set at 1.5 times the variable cost per unit; the variable cost per unit is estimated to be $75.00; and fixed costs are estimated at $1,200,000. What sales volume would be required to break even, i.e., to have EBIT = zero?a.39,680

b.39,040

c.32,640

d.35,840

e.32,000

____59.Southwest U's campus book store sells course packs for $16 each. The variable cost per pack is $10, and at current annual sales of 51,000 packs, the store earns $75,000 before taxes on course packs. How much are the fixed costs of producing the course packs?a.$175,560

b.$205,590

c.$242,550

d.$231,000

e.$191,730

____60.Your company plans to produce a new product, a wireless computer mouse. Two machines can be used to make the mouse, Machines A and B. The price per mouse will be $25.00 regardless of which machine is used. The fixed and variable costs associated with the two machines are shown below. At the expected sales level of 40,000 units, how much higher or lower will the firm's expected EBIT be if it uses high fixed cost Machine B rather than low fixed cost Machine A, i.e., what is EBITB - EBITA ?

Machine AMachine B

Price per mouse (P)$25.00$25.00

Fixed costs (F)$100,000$400,000

Variable cost/unit (V)$15.25$9.00

Exp. unit sales (Q)40,00040,000

a.-$49,500

b.-$53,500

c.-$38,000

d.-$57,500

e.-$50,000

____61.Your company, which is financed entirely with common equity, plans to manufacture a new product, a cell phone that can be worn like a wristwatch. Two robotic machines are available to make the phone, Machine A and Machine B. The price per phone will be $250.00 regardless of which machine is used to make it. The fixed and variable costs associated with the two machines are shown below, along with the capital (all equity) that must be invested to purchase each machine. The expected sales level is 27,000 units. Your company has tax loss carry-forwards that will cause its tax rate to be zero for the life of the project, so T = 0. How much higher or lower will the project's ROE be if you select the machine that produces the higher ROE, i.e., what is ROEB - ROEA? (Hint: Since the firm uses no debt and its tax rate is zero, ROE = EBIT/Required investment.)

Machine AMachine B

Price per phone (P)$250.00$250.00

Fixed costs (F)$1,000,000$2,000,000

Variable cost/unit (V)$200.00$150.00

Expected unit sales (Q)27,00027,000

Reqd equity investment$2,500,000$3,000,000

a.9.43%

b.8.49%

c.8.68%

d.9.33%

e.8.12%

____62.You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $240,000. Other data for the firm are shown below. How much higher or lower will the firm's expected ROE be if it uses some debt rather than all equity, i.e., what is ROE - ROE?

0% Debt, U60% Debt, L

Oper. income (EBIT)$240,000$240,000

Required investment$2,500,000$2,500,000

% Debt0.0%60.0%

$ of Debt$0.00$1,500,000

$ of Common equity$2,500,000$1,000,000

Interest rateNA10.00%

Tax rate35%35%

a.0.44%

b.0.45%

c.0.39%

d.0.37%

e.0.34%

____63.Confu Inc. expects to have the following data during the coming year. What is the firm's expected ROE?

Assets$165,000Interest rate8%

Debt/Assets, book value65%Tax rate40%

EBIT$25,000

a.14.50%

b.14.33%

c.19.28%

d.17.06%

e.16.38%

____64.Senate Inc. is considering two alternative methods for producing playing cards. Method 1 involves using a machine with a fixed cost (mainly depreciation) of $15,000 and variable costs of $1.00 per deck of cards. Method 2 would use a less expensive machine with a fixed cost of only $5,000, but it would require a variable cost of $1.50 per deck. The sale price per deck would be the same under each method. At what unit output level would the two methods provide the same operating income (EBIT)?a.20,600

b.19,600

c.20,000

d.23,200

e.15,200

____65.A group of venture investors is considering putting money into Lemma Books, which wants to produce a new reader for electronic books. The variable cost per unit is estimated at $250, the sales price would be set at twice the VC/unit, or $500, and fixed costs are estimated at $675,000. The investors will put up the funds if the project is likely to have an operating income of $500,000 or more. What sales volume would be required in order to meet the minimum profit goal? (Hint: Use the breakeven formula, but include the required profit in the numerator.)a.5,781

b.4,700

c.5,452

d.4,841

e.3,854

____66.El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.15. Based on the Hamada equation, what would the firm's beta be if it used no debt, i.e., what is its unlevered beta?a.0.94

b.0.80

c.1.00

d.0.87

e.0.78

____67.Southeast U's campus book store sells course packs for $15.00 each, the variable cost per pack is $11.00, fixed costs for this operation are $300,000, and annual sales are 75,000 packs. The unit variable cost consists of a $4.00 royalty payment, VR , per pack to professors plus other variable costs of VO = $7.00. The royalty payment is negotiable. The book store's directors believe that the store should earn a profit margin of 10% on sales, and they want the store's managers to pay a royalty rate that will produce that profit margin. What royalty per pack would permit the store to earn a 10% profit margin on course packs, other things held constant?a.$2.08

b.$2.33

c.$2.60

d.$2.65

e.$2.50

____68.Monroe Inc. is an all-equity firm with 500,000 shares outstanding. It has $2,000,000 of EBIT, and EBIT is expected to remain constant in the future. The company pays out all of its earnings, so earnings per share (EPS) equal dividends per share (DPS), and its tax rate is 40%. The company is considering issuing $4,250,000 of 9.00% bonds and using the proceeds to repurchase stock. The risk-free rate is 4.5%, the market risk premium is 5.0%, and the firm's beta is currently 0.90. However, the CFO believes the beta would rise to 1.10 if the recapitalization occurs. Assuming the shares could be repurchased at the price that existed prior to the recapitalization, what would the price per share be following the recapitalization? (Hint: P0 = EPS/rs because EPS = DPS.)a.$21.37

b.$28.49

c.$30.49

d.$34.76

e.$28.78

____69.Which of the following statements concerning risk management is NOT CORRECT?a.Risk management can reduce the volatility of cash flows, and this decreases the probability of bankruptcy.

b.Risk management makes sense for firms directly engaged in activities that involve commodities whose values can be hedged, and it doesn't make much sense for most other firms.

c.Companies with volatile earnings pay more taxes than more stable companies due to the treatment of tax credits and the rules governing corporate loss carry-forwards and carry-backs. Therefore, our tax system encourages risk management to stabilize earnings.

d.Risk management can reduce the likelihood of low cash flows, and therefore reduce the probability of financial distress.

e.Risk management involves identifying events that could have adverse financial consequences and then taking actions to prevent and/or to minimize the damage caused by these events.

____70.An option that an investor holds without holding an offsetting position in the underlying stock is called a(n)a.Call option.

b.Put option.

c.Out-of-the-money option.

d.Naked option.

e.Covered option.

____71.Which of the following statements is CORRECT?a.Put options give investors the right to buy a stock at a certain exercise price before a specified date.

b.Call options give investors the right to sell a stock at a certain exercise price before a specified date.

c.Options typically sell for less than their exercise value.

d.LEAPS are very short-term options that have begun trading on the exchanges in recent years.

e.Option holders are not entitled to receive dividends unless they choose to exercise their option.

____72.Deeble Construction Co.'s stock is trading at $30 a share. There are also call options on the company's stock, some with an exercise price of $25 and some with an exercise price of $35. All options expire in 3 months. Which of the following best describes the value of these options?a.If Deeble's stock price rose by $5, the exercise value of the options with the $25 exercise price would also increase by $5.

b.The options with the $25 exercise price will sell for less than the options with the $35 exercise price.

c.The options with the $25 exercise price have an exercise value greater than $5.

d.The options with the $35 exercise price have an exercise value greater than $0.

e.The options with the $25 exercise price will sell for $5.

____73.A swap is a method used to reduce financial risk. Which of the following statements about swaps, if any, is NOT CORRECT?a.A swap involves the exchange of cash payment obligations.

b.The earliest swaps were currency swaps, in which companies traded debt denominated in different currencies, say dollars and pounds.

c.Swaps are very often arranged by a financial intermediary, who may or may not take the position of one of the counterparties.

d.A problem with swaps is that no standardized contracts exist, which has prevented the development of a secondary market.

e.Swaps can involve side payments in order to get the counterparty to agree to the swap.

____74.Which of the following events is likely to decrease the value of call options on the common stock of GCC Company?a.An increase in GCC's stock price.

b.An increase in the exercise price of the option.

c.An increase in the amount of time until the option expires.

d.An increase in the risk-free rate.

e.GCC's stock price becomes more risky (higher variance).

____75.Warnes Motors' stock is trading at $20 a share. Three-month call options with an exercise price of $20 have a price of $1.50. Which of the following will occur if the stock price increases 10% to $22 a share?a.The price of the call option will increase by $2.

b.The price of the call option will increase by less than $2, but the percentage increase in price will be more than 10%.

c.The price of the call option will increase by less than $2, and the percentage increase in price will be less than 10%.

d.The price of the call option will increase by more than $2.

e.The price of the call option will increase by more than $2, but the percentage increase in price will be less than 10%.