2. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is correct?
a. The cost of equity is usually greater than cost of debt.
b. The WACC exceeds the cost of equity.
c. The WACC is calculated on a before-tax basis.
d. The interest rate used to calculate the WACC is the average cost of all the debt the company has outstanding and shown on its balance sheet.
e. The cost of retained earnings typically exceeds the cost of new common stock.
3. Wagner Inc estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept?
a. Project A is of average risk and has a return of 9%.
b. Project B is of below-average risk and has a return of 8.5%.
c. Project C is of above-average risk and has a return of 11%.
d. None of the projects should be accepted.
e. All of the projects should be accepted.
4. Nachman Corporation forecasts that if all of its existing financial policies are adhered to, its proposed capital budget would be so large that it would have to issue new common stock. Since new stock has a higher cost than of retained earnings, Nachman would like to avoid issuing new stock. Which of the following actions would reduce its need to issue new common stock?
a. Increase the dividend payout ratio for the upcoming year.
b. Increase the percentage of debt in the target capital structure.
c. Increase the proposed capital budget.
d. Reduce the amount of short term bank debt in order to increase the current ratio.
e. Reduce the percentage of debt in the target capital structure.
5. A stock just paid a dividend of $1. The required rate of return is rs = 11% and the constant growth rate is 5%. What is the current stock price?
Based on the following information, please answer questions 6-8.
The Connors Company's last dividend was $1.00. Its dividend growth rate is expected to be constant at 15% for 2 years, after which dividends are expected to grow at a rate of 10% forever. Connors’ required return (rs) is 12%.
6. What is Connors’ dividend at year 3?
7. What is Connors’ terminal price?
8. What is Connors’ current stock price?
9. Grant Corporation’s stock is selling for $40 in the market. The company’s beta is 0.8, the market risk premium is 6%, and the risk-free rate is 9%. The previous dividend was $2 (D0 = $2) and dividends are expected to grow at a constant rate. What is the stock’s growth rate?
10. If a stock’s expected return exceeds its required return, this suggests that
a. The stock is experiencing supernormal growth.
b. The stock should be sold.
c. The company is probably not trying to maximize price per share.
d. The stock is probably a good buy.
e. Dividends are not being declared.
11. Which of the following statements is/are incorrect?
a. The constant growth model takes into consideration the capital gains earned on a stock.
b. The price of a stock is the present value of all expected future dividends, discounted at the dividend growth rate.
c. Two firms with the same expected dividend and growth rate must also have the same stock price.
d. All of the above statements are incorrect.
e. Both b and c are incorrect.
12. If a stock’s dividend is expected to grow at a constant rate of 5% a year, which of the following statements is/are correct?
a. The expected return on the stock is 5% a year.
b. The stock’s dividend yield is 5%.
c. The stock’s price one year from now is expected to be 5% higher.
d. Both b and c are correct.
e. Both a and c are correct.
Based on the following information, please answer questions 13-16.
Richards Enterprises is considering two projects that have the following cash flows and WACC data.
Time Project A Project B
0 <1,500> <1,500>
1 900 200
2 700 300
3 500 400
4 200 700
5 100 900
Project A and Project B are MUTUALLY EXCLUSIVE projects. WACC is 10%. Richards Enterprises takes 3 years as a cutoff period.
13. What is Project A’s discounted payback?
a. 4.44 years.
b. 4.72 years.
c. 3.5 years
d. 2.28 years.
14. Based on the results of payback, which project should Richard Enterprise accept?
a. Both A and B projects.
b. A project only.
c. B project only.
d. Neither projects.
15. What are the IRR and MIRR of the project with higher NPV?
a. IRR 26.72% MIRR 18.09%
b. IRR 15.25% MIRR 11.28%
c. IRR 26.72% MIRR 16.175%
d. IRR 10.55% MIRR 9.87%
16. If Richard Enterprise decides to increases its WACC from 10% to 20%, what is its IRR of Project B?
17. Which of the following situations is/are correct?
a. One defect of the IRR method is that it does not take account of cash flows over a project’s full life.
b. One defect of the IRR method is that it may have multiple solutions.
c. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.
d. All of the above are correct statements.
e. Both b and c are correct statements.
18. Which of the following statements is/are correct?
a. An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
b. An NPV profile graph for a project normally shows a positive (upward) slope as the WACC increases.
c. NPV and IRR have always reached the same conclusions regarding capital budgeting.
d. All of the above are correct statements.
e. None of the above is correct statements.
19. Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is correct?
a. Project D has a higher IRR.
b. Project D is probably larger in scale than Project C.
c. Project C probably has a faster payback.
d. Project C has a higher IRR.
e. The crossover rate between the two projects is below 12%.
20. Which of the following statements is/are correct? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
a. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not take account of cash flows beyond the payback period.
c. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.
d. Both a and b are correct.
e. Both b and c are correct.
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