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Midterm Practice I Financial Management 1. For a typical firm, which of the following is correct? All rates are after taxes, and assume the firm operates at its target capital structure. a. b. c. d. e. rd > re > rs > WACC. rs > re > rd > WACC. WACC > re > rs > rd. re > rs > WACC > rd. WACC > rd > rs > re. 2. Which of the following statements is CORRECT? a. The WACC is calculated using before-tax costs for all components. b. The after-tax cost of debt usually exceeds the after-tax cost of equity. c. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital. d. Retained earnings that were generated in the past and are reflected on the firm's balance sheet are generally available to finance the firm's capital budget during the coming year. e. The after-tax cost of debt is generally more expensive than the after-tax cost of preferred stock. 3. Which of the following statements is CORRECT? a. Since debt capital is riskier than equity capital, the after-tax cost of debt is always greater than the WACC. b. Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital. c. If a company assigns the same cost of capital to all of its projects regardless of the project's risk, then it follows that the company will tend to reject some safe projects that it actually should accept and accept some risky projects that it should reject. d. Because companies' flotation costs are not required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt. e. Higher flotation costs tend to reduce the cost of equity capital. 4. The Nunnally Company has equal amounts of low-risk, average-risk, and high-risk projects. Nunnally estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. However, the CEO argues that, even though the company's projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's opinion is followed, what is likely to happen over time? a. The company will take on too many low-risk projects and reject too many high-risk projects. b. The company will take on too many high-risk projects and reject too many low-risk projects. c. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. d. The company's overall WACC should decrease over time because its stock price should be increasing. e. The CEO's recommendation would maximize the firm's intrinsic value. 5. Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a 12% WACC. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of projects X and Y. Which of the following statements is CORRECT? a. Safeco/Risco's WACC, as a result of the merger, would be 10%. b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV. c. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. d. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time. e. After the merger, Safeco/Risco should select Project Y but reject Project X. 6. Which of the following statements is CORRECT? a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects. d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects. 7. 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 project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC. b. The lower the WACC used to calculate it, the lower the calculated NPV will be. c. If a project's NPV is less than zero, then its IRR must be less than the WACC. d. If a project's NPV is greater than zero, then its IRR must be less than zero. e. The NPV of a relatively low risk project should be found using a relatively high WACC. 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 project's profitability. b. If the cost of capital is reduced, this reduces a project's NPV. c. The NPV method is regarded by most academics as being the best indicator of a project's profitability, hence academics recommend that firms use only this one method. d. A project's 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 project's 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. 8. 9. Which of the following statements is CORRECT? a. The MIRR and NPV decision criteria never conflict. b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. c. One reason why some people prefer the MIRR method to the IRR method is that the MIRR is based on a more reasonable assumption about reinvestment rates than the IRR method. d. The higher the WACC, the lower the discounted payback period. e. The MIRR method assumes that cash flows are reinvested at the crossover rate. 10. Which of the following statements is CORRECT? a. b. c. d. e. For a project to have more than one IRR, then both IRRs must be greater than the WACC. If two projects are mutually exclusive, then they are likely to have multiple IRRs. If a project is independent, then it cannot have multiple IRRs. Multiple IRRs can only occur if the signs of the cash flows change more than once. If a project has two IRRs, then the one that is closest to the vertical axis is the one that should be accepted. 11. An analyst is estimating Burress Inc.'s intrinsic value. The analyst has estimated the company's free cash flows for the following years: Year 1 2 3 Free Cash Flow $3,000 4,000 5,000 The analyst estimates that after three years, free cash flow will grow at a constant rate of 6% per year. The analyst estimates that the company's WACC is 10%. The company's debt and preferred stock has a total market value of $25,000 and there are 1,000 outstanding shares of common stock. What is the (per-share) intrinsic value of the company's common stock? a. b. c. d. e. 12. $ 78.31 $ 84.34 $ 98.55 $109.34 $112.50 Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D1 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach? a. 9.79% b. 9.86% c. 10.00% d. 10.20% e. 10.33% 13. To help finance a major expansion, Dimkoff Development Company sold a bond several years ago that now has 20 years to maturity. This bond has a 7% annual coupon, paid quarterly, and it now sells at a price of $1,103.58. The bond cannot be called and has a par value of $1,000. If Dimkoff's tax rate is 40%, what component cost of debt should be used in the WACC calculation? a. b. c. d. e. 3.03% 3.28% 3.66% 3.85% 4.04% 14. You were hired as a consultant to Locke Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The interest rate on new debt is 7.5%, the yield on the preferred is 7.0%, the cost of retained earnings is 11.50%, and the tax rate is 40%. The firm will not be issuing any new stock. What is the firm's WACC? a. b. c. d. e. 8.25% 8.38% 8.49% 8.61% 8.76% 15. Shilling Co.'s common stock currently sells for $40.00 per share, the company expects to earn $3.50 per share during the current year, its expected payout ratio is 40%, and its expected constant growth rate is 4.0%. New stock can be sold to the public at the current price, but a flotation cost of 10% would be incurred. By how much would the cost of new stock exceed the cost of retained earnings? a. c. b. d. e. 0.26% 0.39% 0.51% 0.60% 0.72% 16. Dobson Dairies has a capital structure consisting of 60% debt and 40% common stock. The company's CFO has obtained the following information: The before-tax YTM on the company's bonds is 8%. The company's common stock is expected to pay a $3.00 dividend at year end (D1 = $3.00), and the dividend is expected to grow at a constant rate of 7% a year. The common stock currently sells for $60 a share. Assume the firm will be able to use retained earnings to fund the equity portion of its capital budget. The company's tax rate is 40%. What is the company's WACC? a. 12.00% b. 8.03% c. 9.34% d. 8.00% e. 7.68% 17. Blanchford Enterprises is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected. Year: Cash flows: 0 -$1,000 1 $400 2 $400 3 $400 4 $400 a. b. c. d. e. 18. 17.76% 19.17% 20.56% 21.86% 23.01% Rockmont Recreation Inc. 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% Year: Cash flows: 0 -$1,000 1 $450 2 $440 3 $430 a. b. c. d. e. 19. $ 88.84 $ 92.25 $ 95.79 $ 98.49 $102.63 Sam's Stores Enterprises 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. WACC = 10% Year: Cash flows: 0 -$1,000 1 $300 2 $295 3 $290 4 $285 5 $280 a. b. c. d. e. 20. 12.00% 13.00% 14.00% 15.00% 16.00% Last month, Wong Systems Inc. decided to accept the project whose cash flows are shown below. However, before actually starting the project, the Federal Reserve took actions that changed interest rates and Wong's WACC. By how much did the change in the WACC affect the project's forecasted NPV? Assume that the Fed action will not affect the cash flows, and note that a project's projected NPV can be negative, in which case it should be rejected. Old WACC = 10% New WACC = 5% Year: 0 1 2 Cash flows: -$1,000 $500 $500 3 $500 a. b. c. d. e. $ 88.67 $ 92.16 $104.93 $118.19 $124.18 21. Pettway 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 shorter payback, some value may be forgone. How much value will be lost in this instance? Note that under some conditions choosing projects on the basis of the shorter payback will not cause value to be lost. WACC = 13% Year: CFS: CFL: 0 -$1,000 -$2,100 1 $400 $800 2 $400 $800 3 $400 $800 4 $400 $800 a. b. c. d. e. 22. $55.16 $66.42 $78.79 $89.79 $96.16 Coughlin Motors is considering a project with the following expected cash flows: Year 0 1 2 3 4 Project Cash Flow -$700 million 200 million 370 million 225 million 700 million If, the project's WACC is 10%, what is the project's discounted payback? a. b. c. d. e. 23. 3.15 years 4.09 years 1.62 years 2.58 years 3.09 years Haig Aircraft is considering a project that has an up-front cost paid today at t = 0. The project will generate positive cash flows of $60,000 a year at the end of each of the next five years. The project's NPV is $75,000 and the company's WACC is 10%. What is the project's regular payback? a. b. c. d. e. 3.22 years 1.56 years 2.54 years 2.35 years 4.16 years 24. A company is considering a project with the following cash flows: Year 0 1 2 3 4 Project Cash Flow -$100,000 50,000 50,000 50,000 -10,000 The project's WACC is estimated to be 10%. What is the MIRR? a. b. c. d. e. 11.25% 11.56% 13.28% 14.25% 20.34% 1. 2. Capital components WACC and capital components Register to View AnswerRegister to View Answer EASY MEDIUM 3. 4. Miscellaneous cost of capital concepts Register to View AnswerRisk-adjusted cost of capital MEDIUM MEDIUM Register to View Answer By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects since their returns will be lower than the average cost of capital, and it will take on high-risk projects since their returns will be higher than the average cost of capital. For this reason, statement b is true, while all remaining statements are false. 5. 6. Divisional risk and project selection Ranking methods Register to View AnswerRegister to View AnswerHARD EASY Statement d is true. Academics prefer NPV because it indicates the amount by which a project increases the firm's value. 7. 8. NPV Ranking methods: NPV Register to View AnswerRegister to View AnswerEASY MEDIUM Statement e is correct. The others are all false. If you draw an NPV profile for one project, you will see that if the WACC is less than the IRR, the NPV must be positive. 9. 10. 11. NPV, IRR, and MIRR Multiple IRRs FCF model for valuing stock Time Line: 0 | FCFs Continuing Value Total FCFs 10% 1 | 3,000 3,000 2 | 4,000 4,000 3 | 5,000 5,000(1 + 0.06) 132,500 = 0.10 0.06 137,500 Register to View AnswerRegister to View Answer MEDIUM MEDIUM Register to View Answer 0 Enter the following data as inputs in the financial calculator: CF0 = 0; CF1 = 3000; CF2 = 4000; CF3 = 137500; I/YR = 10; and then solve for NPV = Total value of firm = $109,338.84. So, the entire company is worth $109,338.84. This, less the market value of debt and preferred stock, which was given in the problem, leaves $109,338.84 - $25,000 = $84,338.84 as the value of the firm's common 12. Coupon rate 7.00% Periods/year 4 equity. The value of its common stock is calculated as $84,338.84/1,000 Maturity (yr) 20 shares = $84.34/share. Bond price $1,103.58 Par value $1,000 D1 $1.00 Tax rate 40% P0 $25.00 g Component cost of retained earnings: DCF, D1 Register to View AnswerEASY Calculator inputs: 6.00% N 80 rs 10.00% PV -$1,103.58 PMT $17.50 Expected EPS1 cost of debt FV $3.50 Component $1,000 Weights AT Costs Rate I/YR ratio = Before-tax cost of debt 1.52% times 4 =7.50% 6.1%4.50% Payout 40% Debt 40% Preferred 10% 7.00% Current stock price3.66% = After-tax cost of debt (A-T rd) for use in WACC $40.00 13. Register to View Answer MEDIUM 14. Common g Tax WACC F rate 50% 40% 11.50% 4.00% 10.00% Register to View Answer MEDIUM 15. WACC 8.25% D1 $1.40 rS 7.50% Cost of retained earnings vs. cost of new common stock re 7.89% Difference = higher cost of re 0.39% Register to View Answer HARD 16. WACC rs = D1/P0 + g = $3.00/$60.00 + 0.07 = 0.12 = 12%. WACC = wdrd(1 - T) + wcrs = (0.6)(0.08)(1 - 0.4) + (0.4)(0.12) = 0.0768 = 7.68%. Register to View Answer 17. IRR (constant cash flows; 4 years) 0 -$1,000 1 $400 2 $400 3 $400 4 $400 Register to View Answer EASY Cash flows Answer: IRR = 21.86% Year 0: -$1,000 18. NPV (uneven cash flows; 3 years) WACC: Cash flows Answer: NPV = 10.00% 0 -$1,000 Register to View Answer EASY/MEDIUM 1 $450 2 $440 3 $430 $95.79 WACC: 10.0% 19. IRR (uneven cash flows; 5 years) Register to View Answer EASY/MEDIUM Cash flows Answer: IRR = 0 -$1,000 1 $300 2 $295 3 $290 4 $285 5 $280 14.00% Year 0: -$1,000 20. NPV vs IRR (constant cash flows; 3 years) Old WACC: Cash flows Answer: Old NPV = New NPV = Change 10.00% 0 -$1,000 New WACC: 2 $500 5.00% 3 $500 Register to View Answer MEDIUM 1 $500 $243.43 $361.62 $118.19 21. NPV vs payback WACC: CFS CFL Answer: Cumulative CF, S Cumulative CF, L Payback S 2.50 Payback L 2.63 NPV, L $279.58 NPV, S $189.79 Value lost $89.79 13.00% 0 -$1,000 -$2,100 1 $400 $800 2 $400 $800 Register to View Answer MEDIUM/HARD 3 $400 $800 4 $400 $800 -$1,000 -$2,100 - -$600 -$1,300 - -$200 -$500 - $200 $300 2.50 2.63 $600 $1,100 - Project S WACC: 13.0% Year 0: -$1,000 Year 1: $400 L 279.6 1,100.0 946.2 803.9 672.1 549.7 435.9 329.9 231.0 138.5 52.0 -29.0 -105.1 -176.6 Project L WACC: 13.0% Year 0: -$2,100 Year 1: $800 S 0% 2% 4% 6% 8% 10% 12% 14% 16% 18% 20% 22% 24% 189.8 600.0 523.1 452.0 386.0 324.9 267.9 214.9 165.5 119.3 76.0 35.5 -2.5 -38.3 1,200 1,000 800 600 400 200 0 -200 0% 5% 10% 15% 20% 25% S L 22. Discounted payback Register to View Answer The PV of the outflows is -$700 million. To find the discounted payback you need to keep adding cash flows until the cumulative PVs of the cash inflows equal the PV of the outflow: Year 0 1 2 3 4 Cash Flow -$700 million 200 million 370 million 225 million 700 million Discounted Cash Flow @ 10% -$700.0000 181.8182 305.7851 169.0458 478.1094 Cumulative PV -$700.0000 -518.1818 -212.3967 -43.3509 434.7585 The payback occurs somewhere in Year 4. To find out exactly where, we calculate $43.3509/$478.1094 = 0.0907 through the year. Therefore, the discounted payback is 3.091 years. 23. Payback period Step 1: Register to View Answer Step 2: Step 3: Year 0 1 2 3 4 5 Calculate the PV of the cash flows: Inputs: N = 5; I/YR = 10; PMT = 60000; FV =0. Output: PV = -$227,447.21. PV of cash flows = $227,447.21 $227,447. Calculate the Year 0 outflow: The outflow at t = 0 is X where $227,447 - X = $75,000. X or CF0 = -$152,447. Calculate the regular payback: CF Cumulative CF -$152,447 -$152,447 60,000 -92,447 60,000 -32,447 60,000 27,553 60,000 87,553 60,000 147,553 $32,447 $60,000 So the payback is 2 + 24. MIRR = 2.54 years. Register to View Answer First, calculate the present value of costs: N = 4; I/YR = 10; PMT = 0; FV = 10000; and then solve for PV = -$6,830.13. Add -$100,000 + -$6,830.13 = -$106,830.13. Find the terminal value of inflows: CF0 = 0; CF1 = 50000; CF2 = 50000; CF3 = 50000; CF4 = 0; I/YR = 10. Solve for NPV = $124,342.60. Use the TVM keys to calculate the future value of this present value. N = 4; I/YR = 10; PV = -124342.60; PMT = 0. Solve for FV = $182,050. Solve for MIRR: N = 4; PV = -106830.13; PMT = 0; FV = 182050; and then solve for I/YR = MIRR = 14.25%. ... View Full Document

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