Q1. The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital.
Q2. 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?
Q3. 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
Q4. WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been growing rapidly over the past several years, selling common stock in each year to finance its growth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. WineCellars weighted average cost of capital this year should be
a. zero, since no new stock will be sold.
b. less than 12%.
c. equal to 12%.
d. greater than 12%.
Q5. The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is 35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport's cost of retained earnings?
Q6. The best financial structure is determined by finding the debt and equity mix that maximizes the firm's cost of capital.
Q7. For a typical corporation, which of the following capital structures will result in the lowest weighted average cost of capital?
a. 40% debt, 20% preferred stock, 40% common equity
b. 50% debt, 10% preferred stock, 40% common equity
c. 60% debt, 10% preferred stock, 30% common equity
d. 60% debt, 15% preferred stock, 25% common equity
Q8. The cost of retained earnings is less than the cost of new common stock because
a. marginal tax brackets increase.
b. flotation costs are incurred when new stock is issued.
c. dividends are not tax deductible.
d. accounting rules allow a deduction when using retained earnings.
Q9. JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold?
a. $7.5 million
b. $12.0 million
c. $15.5 million
d. $16.0 million
Q10. The average cost associated with each additional dollar of financing for investment projects is
a. the incremental return.
b. the marginal cost of capital.
c. CAPM required return.
d. the component cost of capital.
Q11. 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.
Q12. Which of the following statements is MOST correct?
a. If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR.
d. A project with a NPV = 0 is not acceptable.
Q13. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project A is
Q14. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project B, rounded to the nearest dollar, is
Q15. Your firm is considering an investment that will cost $920000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's net present value?
Q16. 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 net present value of this project?
Q17. For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return.
Q18. A significant advantage of the payback period is that it
a. places emphasis on time value of money.
b. allows for the proper ranking of projects.
c. tends to reduce firm risk because it favors projects that generate early, less uncertain returns.
d. gives proper weighting to all cash flows.
Q19. Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return?
Q20. 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%
Q21. Trinitron, Inc. purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. Trinitron must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. What will depreciation expense be during the first year?
Q22. Which of the following should be excluded in an analysis of a new project's cash flows?
a. additional investment in fixed assets
b. additional investment in accounts receivable
c. additional investment in inventory
d. additional interest expenses on debt financing
Q23. 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?
Q24. Increased depreciation expenses affect tax-related cash flows by
a. increasing taxable income, thus increasing taxes.
b. decreasing taxable income, thus reducing taxes.
c. decreasing taxable income, with no effect on cash flow since depreciation is a non-cash expense.
d. pushing a corporation into a higher tax bracket.
Q25. Alloy Corp. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000; it will have a 10-year useful life. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. The processor will be depreciated using the straight-line method to zero expected salvage value. Studies have shown that employee-training expenses will be $125,000. What will be the annual depreciation expense of the processing line for capital budgeting purposes?