Reference no: EM131123139

1. Donner, Inc. will finance a proposed investment by issuing new securities while maintaining its optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of $950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8% and a face value of $1,000. The company can issue new equity at a before-tax cost of 16% and its marginal tax rate is 34%. What is the appropriate cost of capital to use in analyzing this project?

a. 3.63%

b. 8.77%

c. 9.97%

d. 11.81%

2. A firm's cost of capital is influenced by

a. the current ratio.

b. par value of common stock.

c. capital structure.

d. net income.

3. QRM, Inc.'s marginal tax rate is 35%. It can issue 10-year bonds with an annual coupon rate of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will net the company $966 in proceeds. Determine the appropriate after-tax cost of new debt for the firm to use in a capital budgeting analysis.

a. 2.62%

b. 4.87%

c. 7.50%

d. 7.8%

4. A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in 15 years and has a current market price of $925. If the corporation sells more bonds it will incur flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt capital?

a. 3.74%

b. 4.45%

c. 5.29%

d. 6.78%

5. (True/False)The market risk premium remains constant over time because the risk free rate of return moves inversely with beta.

6. A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is

a. 18.87%.

b. 17.72%.

c. 14.26%.

d. 12.94%.

7. The cost of external equity capital is greater than the cost of retained earnings because of

a. flotation costs on new equity.

b. increasing marginal tax rates.

c. higher dividends.

d. greater risk for shareholders.

8. GPS Inc. wishes to estimate its cost of retained earnings. The firm's beta is 1.3. The rate on 6-month T-bills is 2%, and the return on the S&P 500 index is 15%. What is the appropriate cost for retained earnings in determining the firm's cost of capital?

a. 17.0%

b. 19.5%

c. 18.9%

d. 22.1%

9. Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The project is expected to generate equal annual cash flows over the next twelve years. The required return for this project is 20%. What is project LMK's net present value?

a. $600,000

b. $150,000

c. $120,000

d. $80,000

10. Which of the following methods of evaluating investment projects can properly evaluate projects of unequal lives?

a. the net present value

b. the payback

c. the internal rate of return

d. the equivalent annual annuity

11. A significant advantage of the internal rate of return is that it

a. provides a means to choose between mutually exclusive projects.

b. provides the most realistic reinvestment assumption.

c. avoids the size disparity problem.

d. considers all of a project's cash flows and their timing.

12. A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project's required rate of return is 13%. The internal rate of return is

a. greater than $30,000.

b. less than 13%.

c. between 13% and 15%.

d. greater than 15%

13. A significant disadvantage of the internal rate of return is that it

a. does not fully consider the time value of money.

b. does not give proper weight to all cash flows.

c. can result in multiple rates of return (more than one IRR).

d. is expressed as a percentage. 

14. DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the modified internal rate of return of this project?

a. 10.87%

b. 11.57%

c. 13.68%

d. 15.13%

15. Arguments against using the net present value and internal rate of return methods include that

a. they fail to use accounting profits.

b. they require detailed long-term forecasts of the incremental benefits and costs.

c. they fail to consider how the investment project is to be financed.

d. they fail to use the cash flow of the project.

16. What is the net present value's assumption about how cash flows are reinvested?

a. They are reinvested at the IRR.

b. They are reinvested at the APR.

c. They are reinvested at the firm's discount rate.

d. They are reinvested only at the end of the project.

17. You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your company's net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the terminal cash flow for this project?

a. $17,000

b. $24,500

c. $33,950

d. $37,950

18. Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the tax effect of selling the old machine?

a. a savings of $2,800

b. a savings of $2,450

c. additional taxes paid of $2,450

d. a tax savings of $1,400

19. Waterford Industries is considering the purchase of a new machine. It will replace an existing but obsolete machine that will be sold for $50,000. The existing machine is 8 years old, cost $200,000, had a 10-year useful life, and is being depreciated to zero using the straight-line method. Waterford's income tax rate is 35%. What is the after-tax salvage value of the old machine?

a. $42,000

b. $46,500

c. $50,000

d. $53,500

20. (True/False)The less-risky investment is always the more desirable choice.

21. (True/False) Since stockholders are able to reduce their exposure to risk by efficiently diversifying their holdings of securities, there is no reason for individual firms to seek diversification of their holdings of assets.

22. Your company is considering the replacement of an old delivery van with a new one that is more efficient. The old van cost $40,000 when it was purchased 5 years ago. The old van is being depreciated using the simplified straight-line method over a useful life of 8 years. The old van could be sold today for $7,000. The new van has an invoice price of $80,000, and it will cost $6,000 to modify the van to carry the company's products. Cost savings from use of the new van are expected to be $28,000 per year for 5 years, at which time the van will be sold for its estimated salvage value of $18,000. The new van will be depreciated using the simplified straight-line method over its 5-year useful life. The company's tax rate is 35%. Working capital is expected to increase by $5,000 at the inception of the project, but this amount will be recaptured at the end of year five. What is the incremental free cash flow for year one?

a. $18,875

b. $19,985

c. $22,305

d. $24,220

23. If depreciation expense in year one of a project increases for a highly profitable company

a. net income decreases and incremental free cash flow decreases.

b. net income increases and incremental free cash flow increases.

c. the book value of the depreciating asset increases at the end of year one.

d. net income decreases and incremental free cash flow increases.

24. Which of the following should be included in the initial outlay?

a. taxable gain on the sale of old equipment being replaced

b. first year depreciation expense on any new equipment purchased

c. preexisting firm overhead reallocated to the new project

d. increased investment in inventory and accounts receivable

25. (True/False) Business risk refers to the relative dispersion (variability) of a company's net income.

26. Assuming no corporate taxes, the independence hypothesis suggests that a firm's weighted average cost of capital will

a. remain constant regardless of capital structure because the cost of debt and the cost of equity are the same.

b. remain constant because the cost of equity will be increasing as the amount of debt increases due to the increased risk.

c. increase proportionally with the increase in the amount of debt a firm uses.

d. decrease proportionally with the increase in the amount of debt a firm uses.

27. Operating leverage refers to

a. financing a portion of the firm's assets with securities bearing a fixed rate of return.

b. the additional chance of insolvency borne by the common shareholder.

c. the incurrence of fixed operating costs in the firm's income stream.

d. a high degree of variable costs of production.

28. Which of the following statements about combined (operating & financial) leverage is true?

a. If a firm employs both operating and financial leverage, any percent change in sales will produce a larger percent change in earnings per share.

b. A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm that employs low levels of operating leverage.

c. Usage of both operating and financial leverage reduces a firm's risk.

d. High operating leverage and high financial leverage offset one another, meaning that if sales increase by 10%, then EPS will also increase by 10%.

29. Kohler Manufacturing typically achieves one of three production levels in any given year: 8 million pounds of steel, 10 million pounds of steel, or 16 million pounds of steel. In tracking some of its costs, Kohler's controller discovered one cost that was $10 per pound no matter what the production level for the year. This is an example of a

a. variable cost.

b. fixed cost.

c. semivariable cost.

d. semifixed cost.

30. The break-even model enables the manager of the firm to

a. calculate the minimum price of common stock for certain situations.

b. set appropriate equilibrium thresholds.

c. determine the quantity of output that must be sold to cover all operating costs.

d. determine the optimal amount of debt financing to use.

31. Which of the following would be considered the firm's optimal capital structure?

a. Stock Price = $25, Earnings Per Share = $10, Cost of Equity Capital = 15%

b. Stock Price = $23, Earnings Per Share = $11, Cost of Equity Capital = 18%

c. Stock Price = $24, Earnings Per Share = $12, Cost of Equity Capital = 17%

d. Stock Price = $20, Earnings Per Share = $12, Cost of Equity Capital = 20%

32. Financial leverage could mean financing some of a firm's assets with

a. preferred stock.

b. retained earnings.

c. private equity capital.

d. sales revenues.

33. According to the clientele effect

a. companies should have dividend payout ratios of either 100% or 0%.

b. companies should avoid making capricious changes in their dividend policies.

c. companies should change their dividend policies to please their target group of investors.

d. even if capital markets are perfect, dividend policy still matters.

34. A corporation announces a significant increase in its annual dividend and its stock price increases on the news. This could be explained most directly by

a. residual dividend theory.

b. bird-in-the-hand theory.

c. perfect capital markets.

d. MM"s indifference theorem.

35. The difference between the capital gains tax rate and the income tax rate is an incentive for

a. firms never to split their stock.

b. firms to declare more stock dividends.

c. firms to pay more earnings as dividends.

d. firms to retain more earnings.

36. LaMike owns 1,000 shares of DAS. Inc.'s common stock. The stock has a par value of $1 per share and is currently selling for $80 per share. DAS declares a 20% stock dividend. In a perfect capital market, after the dividend Sam will have

a. 1,200 shares selling for $66.67 each.

b. 1,020 shares selling for $80.80 each.

c. 1,200 shares selling for $96.00 each.

d. 1,020 shares selling for $64.00 each.

37. AFB, Inc. stock is currently selling for $20 per share. The company completed a 5-for-1 stock split two days earlier. Two years ago, the company had a 2-for-1 stock split. If the stock splits had not happened, the price of AFB, Inc. stock would, other things being equal, be

a. $140.00 per share.

b. $200.00 per share.

c. $100.00 per share.

d. $2.00 per share.

38. You are a retired worker whose income is derived from your company pension plan and social security. However, you are highly dependent upon the income generated from your 401(k) plan, which is heavily weighted in stocks that pay substantial dividends. Which of the following dividend policies would you prefer?

a. constant dividend payment ratio

b. stable dollar dividend per share

c. small, regular dividend plus a year-end extra

d. any of the above would be equally desirable

39. Assume that a firm has a steady record of paying high dividends for years. A new management team decided to cut the current year's dividend in half without disclosing why. The market value of the stock fell 35% on the day the dividend cut was announced. Which of the following would best explain the stock market's reaction to the announcement?

a. empirical theory

b. dividend irrelevance theory

c. residual dividend theory

d. information effect

40. A firm that maintains a "stable dollar dividend per share" will generally not increase the dividend unless

a. a stock split occurs.

b. the firm merges with another profitable firm.

c. the firm is sure that a higher dividend level can be maintained.

d. the P/E ratio has increased steadily over the past 5 years.