- Which of the following statements is correct?
An increase in the market risk premium is likely to increase the weighted average cost of capital.
2. Which of the following makes this a true statement? Ideally, when searching for a beta for a new line of business:
All the answers make this a true statement.
3. Which of the following is most correct?
An increase in the risk-free rate will increase the cost of equity.
4. Which of the following statements is true?
If the new project is riskier than the firm’s existing projects, then it should be charged a higher cost of capital.
5. When calculating the weighted average cost of capital, weights are based on:
market values.
6. Relative to a typical level of risk for Company Z’s projects, project A is twice as risky, project B is half as risky, and project C is of about the same risk. Thus firm WACC should be used to discount cash flows for project(s) _____ , and project-specific WACC should be used for project(s) _____ .
C; A and B
7. Which of these statements is true regarding divisional WACC?
Using a simple firmwide WACC to evaluate new projects would give an unfair advantage to projects that present more risk than the firm’s average beta.
8. Which of these makes this a true statement? The WACC formula
uses market values to determine weights.
9. Which of following is a situation in which we would most likely use the CAPM approach for estimating the component cost of equity?
When we are able to estimate the firm’s beta with a high degree of confidence.
10. Which of the statements below is correct?
Using firm WACC for all projects leads to incorrect rejection of low risk projects and thus to an increase in the overall company risk.
11.
Pumpkin Pie Industries has 7 million shares of common stock outstanding, 2 million shares of preferred stock outstanding, and 50 thousand bonds. If the common shares are selling for $80 per share, the preferred shares are selling for $25 per share, and the bonds are selling for 110 percent of par ($1,000), what would be the weights used in the calculation of Pumpkin Pie’s WACC for common stock, preferred stock, and bonds, respectively?
84.21 percent, 7.52 percent, 8.27 percent
12. An all-equity firm is considering the projects shown as follows. The T-bill rate is 3 percent and the market risk premium is 6 percent. If the firm uses its current WACC of 11 percent to evaluate these projects, which project(s) will be incorrectly accepted?
Project D
13. Suppose that TipsNToes, Inc.’s capital structure features 65 percent equity, 35 percent debt, and that its before-tax cost of debt is 8 percent, while its cost of equity is 13 percent. If the appropriate weighted average tax rate is 38 percent, what will be TipsNToes’ WACC?
10.186 percent
14. IVY has preferred stock selling for 105 percent of par that pays a 6 percent annual coupon. What would be IVY’s component cost of preferred stock?
5.71 percent
15. A local bank is contemplating opening a new branch bank in a large superstore across town from their main office. It is estimated that the new branch will generate $20,000 after expenses each month. The manager wonders if all these revenues should be considered an incremental cash flow. Given this information, which of the following statements is correct?
Some amount less than the $20,000 is incremental because of substitutionary effects.
16. In capital budgeting analysis, selling a machine at the end of the project for an amount lower than its book value
Results in an after-tax cash flow from the sale of the machine higher than the machine’s market value.
17. In capital budgeting analysis, using accelerated depreciation (as opposed to straight-line depreciation) results in
Higher taxes paid in the later years of the project.
18. A new project would require an immediate increase in raw materials in the amount of $10,000. The firm expects that accounts payable will automatically increase $7,500. What will be the impact of the resulting change in the firm’s net working capital on the firm’s cash flows?
-$2,500
19. In capital budgeting analysis, using accelerated depreciation (as opposed to straight-line depreciation) results in
Higher net cash flows in the early years of the project.
20. All of the following are incremental cash flows attributable to the project EXCEPT:
financing costs.
21. If a firm has already paid an expense or is obligated to pay one in the future, regardless of whether a particular project is undertaken, that expense is a:
sunk cost.
22. In capital budgeting analysis, selling a machine at the end of the project for an amount higher than its book value
Results in an after-tax cash flow from the sale of the machine lower than the machine’s market value.
23. AB Mining Company just commissioned a firm to identify if an unused portion of their mine contains any silver or gold at a cost of $125,000. This is an example of
sunk cost.
24. Effects that arise from a new product or service that decrease sales of the firm’s existing products or services are referred to as:
substitutionary effects.
25. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of three years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, and 17.49% in years 1, 2, and 3 respectively). Revenue from the new game is expected to be $800,000 per year, with costs of $350,000 per year. The firm has a tax rate of 30 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 0 (ONLY YEAR 0!) estimated after-tax cash flow for this project be?
-$220,000
26. You are evaluating a project for your company. You estimate the sales price to be $300 per unit and sales volume to be 5000 units in year 1; 6000 units in year 2; and 4000 units in year 3. The project has a three-year life. Variable costs amount to $100 per unit and fixed costs are $150,000 per year. The project requires an initial investment of $240,000 in assets that will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $60,000. An initial investment of $50,000 in NWC is required at the beginning of the project . The tax rate is 30 percent and the required return on the project is 13 percent. What is the after-tax operating cash flow for the project in YEAR 2 (YEAR 2 ONLY!)?
$759,000
27. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of five years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, 17.49%, 12.49%, and 8.93% in years 1, 2, 3, 4, and 5 respectively). Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The firm has a tax rate of 40 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 4 (ONLY YEAR 4!) estimated after-tax cash flow for this project be?
$218,493
28. Your firm needs a computerized machine tool lathe that costs $75,000, requires $10,000 in installation, $10,000 in freight charges, and another $14,000 in maintenance for each year of its three-year life. After three years, this machine will be replaced. The machine falls into the MACRS three-year class life category (depreciation of 33.33%, 44.45%, and 14.81% in years 1, 2, and 3 respectively). Assume a tax rate of 30 percent and a discount rate of 12 percent. If the lathe can be sold for $10,000 at the end of year 3, what is the after-tax cash flow from selling it?
$9,112
29. Which of these is an estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular division?
Divisional WACC
30. Which of the following statements is correct?
An increase in the market risk premium is likely to increase the weighted average cost of capital.
31. Which of the following would likely increase the weighted average cost of capital for a company?
An increase in the market risk premium.
32. Which of the following statements is true regarding the calculation of component costs for the WACC formula?
Preferred stock represents a special case of the constant growth model, wherein the g equals zero.
33. Which of the statements below is correct?
Most companies use divisional WACC for most projects, while using project WACC for the most important ones.
34. What is the correct order of the following component costs of capital, from the highest to the lowest?
The cost of common equity (highest), the cost of preferred equity, the cost of debt (lowest)
35. Which of the following makes this a true statement? Ideally, when searching for a beta for a new line of business:
All the answers make this a true statement.
36. Which of the following is a reason why the divisional cost of capital approach may cause problems if new projects are assigned to the wrong division?
If projects are assigned to the wrong division, the risk of that division may be significantly different than the risk of the project, implying that the project will be evaluated with a divisional cost of capital that is much different from what a project-specific cost of capital would be.
37. Company A has an outstanding debt of $10,000,000, its interest payments equal $1,500,000 annually, and its marginal tax rate equals 30%. What is the after-tax cost of debt for Company C to be used in its WACC equation?
10.5%
38. Which of the following would likely reduce the weighted average cost of capital for a company?
A higher marginal tax rate faced by the company
39. Which of the following is a true statement?
To estimate the before-tax cost of debt, it would be best to solve for the Yield to Maturity (YTM) on the firm’s existing debt
40. Which of the following statements is correct?
The weights of debt and equity should be based on market values because this is the most accurate assessment of the valuation
41. Which of the following is a situation in which you would want to use the constant growth model approach for estimating the component cost of equity?
When the firm’s stock is expected to experience constant dividend growth.
42. Which of these is an estimated WACC computed using some sort of proxy for the average equity risk of the projects in a particular division?
Divisional WACC
43. Which of the following statements is true?
If the new project is riskier than the firm’s existing projects, then it should be charged a higher cost of capital
44. Which of the following would likely increase the weighted average cost of capital for a company?
An increase in the market risk premium.
45. Which of the following makes this a true statement? Ideally, when searching for a beta for a new line of business:
All the answers make this a true statement.
46. Which of the following would likely reduce the weighted average cost of capital for a company?
A higher marginal tax rate faced by the company.
47. Which of these makes this a true statement? The WACC formula
uses market values to determine weights.
48. Which of the statements below is correct?
Using firm WACC for all projects leads to incorrect rejection of low risk projects and thus to an increase in the overall company risk.
49. FlavR Co. stock has a beta of 1.5, the current risk-free rate is 3, and the expected return on the market is 12 percent. What is FlavR Co’s cost of equity?
16.5 percent
50. WC Inc. has a $10 million (face value), 10-year bond issue selling for 97 percent of par that pays an annual coupon of 6 percent. What would be WC’s before-tax component cost of debt?
6.41 percent
51. An all-equity firm is considering the projects shown as follows. The T-bill rate is 3 percent and the market risk premium is 6 percent. If the firm uses its current WACC of 11 percent to evaluate these projects, which project(s) will be incorrectly accepted?
Project D
52. Pumpkin Pie Industries has 7 million shares of common stock outstanding, 2 million shares of preferred stock outstanding, and 50 thousand bonds. If the common shares are selling for $80 per share, the preferred shares are selling for $25 per share, and the bonds are selling for 110 percent of par ($1,000), what would be the weights used in the calculation of Pumpkin Pie’s WACC for common stock, preferred stock, and bonds, respectively?
84.21 percent, 7.52 percent, 8.27 percent
53. ABC Engineering just bought a new machine. All of the following are examples of incremental cash flows to be used in evaluating this project except _______________.
Interest expense on the loan used to purchase the machine
54. A manufacturing firm is planning on expanding its existing operations. The expansion project is significant and will require the firm to house the expansion in a different location. The firm is considering building on a lot they own across town. The lot is currently vacant and it was paid for nearly 20 years ago. Given this information, which of the following statements is correct?
The lot is an incremental cash flow because it represents an opportunity cost.
55. AB Mining Company just commissioned a firm to identify if an unused portion of their mine contains any silver or gold at a cost of $125,000. This is an example of
sunk cost.
56. A new project would require an immediate increase in raw materials in the amount of $10,000. The firm expects that accounts payable will automatically increase $7,500. How much must the firm expect its net working capital to change if they accept this project?
+$2,500
57. In capital budgeting analysis, using accelerated depreciation (as opposed to straight-line depreciation) results in
Higher net cash flows in the early years of the project.
58. Concerning incremental project cash flow, which of these is a cost one would never count as an expense of the project?
Financing costs
59. In capital budgeting analysis, using accelerated depreciation (as opposed to straight-line depreciation) results in
Higher taxes paid in the later years of the project.
60. Due to rapid growth, a computer superstore is contemplating expanding by adding another location. Which of the following items should the financial officer NOT include in estimating the cash flow associated with this expansion?
The company spent $100,000 six months ago in a major advertising campaign which will help the new store become profitable sooner.
61. If a firm has already paid an expense or is obligated to pay one in the future, regardless of whether a particular project is undertaken, that expense is a:
sunk cost.
62. With regard to depreciation, the time value of money concept tells us that:
taking the depreciation expense sooner is always better.
63. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of five years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, 17.49%, 12.49%, and 8.93% in years 1, 2, 3, 4, and 5 respectively). Revenue from the new game is expected to be $800,000 per year, with costs of $350,000 per year. The firm has a tax rate of 30 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 1 (ONLY YEAR 1!) estimated after-tax cash flow for this project be?
$322,288
64. Your firm needs a computerized machine tool lathe that costs $75,000, requires $10,000 in installation, $10,000 in freight charges, and another $14,000 in maintenance for each year of its three-year life. After three years, this machine will be replaced. The machine falls into the MACRS three-year class life category (depreciation of 33.33%, 44.45%, and 14.81% in years 1, 2, and 3 respectively). Assume a tax rate of 30 percent and a discount rate of 12 percent. If the lathe can be sold for $10,000 at the end of year 3, what is the after-tax cash flow from selling it?
$9,112
65. Suppose you sell a fixed asset for $80,000 when its book value is $120,000. If your company’s marginal tax rate is 35 percent, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)?
$94,000
66. Your company is considering the purchase of a new machine. The original cost of the old machine was $80,000; it is now five years old, and it has a current market value of $30,000. The old machine is being depreciated over a 10-year life toward a zero estimated salvage value on a straight-line basis, resulting in a current book value of $40,000 and an annual depreciation expense of $8,000. The old machine can be used for six more years but has no market value after its depreciable life is over. Management is contemplating the purchase of a new machine whose cost is $90,000 and whose estimated salvage value is zero. Expected before-tax cash savings from the new machine are $15,000 a year over its full MACRS depreciable life. Depreciation is computed using MACRS over a five-year life (depreciation of 20% in year 1), and the cost of capital is 9 percent. Assume a 30 percent tax rate. What will the YEAR 1 (YEAR 1 ONLY!) after-tax operating cash flow for this project be?
$13,500
67. Your company has spent $100,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $15,000. The machine has an expected life of five years, a $25,000 estimated resale value, and falls under the MACRS five-year class life (depreciation of 20% in year 1). Revenue from the new game is expected to be $500,000 per year, with costs of $200,000 per year. The firm has a tax rate of 40 percent, an opportunity cost of capital of 17 percent, and it expects net working capital to increase by $60,000 at the beginning of the project. What will be the after-tax operating cash flow for YEAR 1 (ONLY YEAR 1!) of this project?
$193,200
68. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of five years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, 17.49%, 12.49%, and 8.93% in years 1, 2, 3, 4, and 5 respectively). Revenue from the new game is expected to be $800,000 per year, with costs of $350,000 per year. The firm has a tax rate of 30 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 2 (ONLY YEAR 2!) estimated after-tax cash flow for this project be?
$327,490
69. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of three years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, and 17.49% in years 1, 2, and 3 respectively). Revenue from the new game is expected to be $800,000 per year, with costs of $350,000 per year. The firm has a tax rate of 30 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 0 (ONLY YEAR 0!) estimated after-tax cash flow for this project be?
-$220,000
70. Your firm needs a computerized machine tool lathe that costs $75,000, requires $10,000 in installation, $10,000 in freight charges, and another $14,000 in maintenance for each year of its three-year life. After three years, this machine will be replaced. The machine falls into the MACRS three-year class life category (depreciation of 33.33%, 44.45%, and 14.81% in years 1, 2, and 3 respectively). Assume a tax rate of 30 percent and a discount rate of 12 percent. If the lathe can be sold for $10,000 at the end of year 3, what is the after-tax cash flow from selling it?
$9,112
71. You are evaluating a project for your company. You estimate the sales price to be $300 per unit and sales volume to be 5000 units in year 1; 6000 units in year 2; and 4000 units in year 3. The project has a three-year life. Variable costs amount to $100 per unit and fixed costs are $150,000 per year. The project requires an initial investment of $240,000 in assets that will be depreciated straight-line to zero over the three-year project life. The actual market value of these assets at the end of year 3 is expected to be $60,000. An initial investment of $50,000 in NWC is required at the beginning of the project . The tax rate is 30 percent and the required return on the project is 13 percent. What is the after-tax operating cash flow for the project in YEAR 2 (YEAR 2 ONLY!)?
$759,000
72. Suppose you sell a fixed asset for $80,000 when its book value is $120,000. If your company’s marginal tax rate is 35 percent, what will be the effect on cash flows of this sale (i.e., what will be the after-tax cash flow of this sale)?
$94,000
73. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of three years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, and 17.49% in years 1, 2, and 3 respectively). Revenue from the new game is expected to be $800,000 per year, with costs of $350,000 per year. The firm has a tax rate of 30 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 0 (ONLY YEAR 0!) estimated after-tax cash flow for this project be?
-$220,000
74. KADS, Inc., has spent $300,000 on research to develop a new computer game. The firm is planning to spend $150,000 on a machine to produce the new game. Shipping and installation costs of the machine will be capitalized and depreciated; they total $20,000. The machine has an expected life of five years, a $60,000 estimated resale value, and falls under the MACRS seven-year class life (depreciation of 14.29%, 24.49%, 17.49%, 12.49%, and 8.93% in years 1, 2, 3, 4, and 5 respectively). Revenue from the new game is expected to be $700,000 per year, with costs of $350,000 per year. The firm has a tax rate of 40 percent, an opportunity cost of capital of 12 percent, and it expects net working capital to increase by $50,000 at the beginning of the project. What will the YEAR 4 (ONLY YEAR 4!) estimated after-tax cash flow for this project be?
$218,493
75. Which of the following statements is correct?
All of these statements are correct.
76. Using the pure-play approach for estimating a project’s beta, to evaluate a new project consisting of opening a new line of business delivering packages across the United States, it would be best to use
An estimate of a beta of a company that specializes in delivering packages, such as Fed-Ex, adjusting properly for financial leverage.
77. Company A issued all of its outstanding bonds 4 years ago, all maturing in 21 years, with the same terms. The yield to maturity on the bonds was recorded equal to 5.5% 3 years ago, 4% 2 years ago, 4.5% 1 year ago, and 6% earlier today. What pre-tax cost of debt should be used in the WACC equation?
6%
78. When firms use multiple sources of capital, they need to calculate the appropriate discount rate for valuing their firm’s cash flows as:
a weighted average of the capital components costs.
79. Which of the statements below is correct regarding capital budgeting analysis?
An empty warehouse that is already owned by a company, and thus there is no monetary outlay to buy or rent it, must be included in project’s projected costs if the warehouse will be used for the project.
80. Effects that arise from a new product or service that increase sales of the firm’s existing products or services are referred to as:
complementary effects.
81. When calculating operating cash flow for a project, one would calculate it as being mathematically equal to which of the following?
EBIT – Taxes + Depreciation
82. ABC Engineering is contemplating purchasing a new machine that was identified to work best with their unique production process. All of the following are examples of incremental cash flows, that should be included in the cash flow calculation, except _______________.
Developmental costs to determine which machine would best work with their unique process
83. A local bank is contemplating adding a new ATM to their lobby. They will need to add another communication line to connect the new ATM machine to the network, resulting in an additional monthly cost of $50. This is an example of:
incremental cash flow.
84. When firms use multiple sources of capital, they need to calculate the appropriate discount rate for valuing their firm’s cash flows as:
a weighted average of the capital components costs.
85. Which of the following statements is correct?
All of these statements are correct.
86. Using the pure-play approach for estimating a project’s beta, to evaluate a new project consisting of opening a new line of business delivering packages across the United States, it would be best to use
An estimate of a beta of a company that specializes in delivering packages, such as Fed-Ex, adjusting properly for financial leverage.
87. A proxy beta is:
the average beta of firms that are only engaged in the proposed new line of business.
88. Which of the statements below is correct?
All of the statements are correct.
89. Which of the following statements is correct?
A decrease in NWC involves either a reduction in current assets, which generates cash, or an increase in current liabilities, thereby freeing up the shareholder’s cash for other things.
90. A decrease in net working capital (NWC) is treated as a _________ in capital budgeting.
cash inflow
91. You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck for $75,000, to be used for 3 years. The truck will be depreciated over 10 years using straight-line depreciation, but it will be sold after three years for $10,000. Use of the truck will require an increase in NWC (spare parts inventory) of $4,000. The truck will have no effect on revenues, but it is expected to save the firm $30,000 per year in before-tax operating costs, mainly labor. The firm’s marginal tax rate is 30 percent. What will the after-tax operating cash flow for this project be in its final third year (YEAR 3 ONLY! – make sure you include all relevant cash flows from year 3)?
$50,000
92. The research chemists at MegaClean created a new cleaner that keeps car and truck tires shiny and clean for one year. They believe that this product will be highly successful and will attract customers to purchase their existing line of household cleaning products. This is an example of ___________.
Complementary effect
93. Which of the following statements is true regarding the calculation of component costs for the WACC formula?
Preferred stock represents a special case of the constant growth model, wherein the g equals zero.
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