Corporate Finance

Question 1

The NPV profile is a graphical representation of the change in net present value relative to a change in the:
A) prime rate.
B) internal rate of return.
C) discount rate.

Answer 1

C) discount rate

As discount rates change the net present values change. The NPV profile is a graphic illustration of how sensitive net present values are to different discount rates. By comparison, every project has a single internal rate of return and payback period because the values are determined solely by the investment’s expected cash flows.

Question 2

Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest to:
Debt Preferred stock
A) 10.0% 7.6%

B) 6.0% 12.7%

C) 6.0% 7.6%

Answer 2

B) 6.0% 12.7%

After-tax cost of debt = 10% × (1 – 0.4) = 6%.
Cost of preferred stock = $4 / $31.50 = 12.7%.

Question 3

Corporate governance defines the appropriate rights, role, and responsibilities of:
A) management, the board of directors, and shareholders.
B) management only.
C) management and the board of directors.

Answer 3

A was correct!

Corporate governance defines the appropriate rights, roles, and responsibilities of a corporation’s management, the board of directors, and shareholders.

Question 4

During a period of expansion in the economy compared to firms with lower operating expense levels, the earnings growth for firms with high operating leverage will be:
A) lower.
B) not enough information.
C) higher.

Answer 4

C) higher.
If a high percentage of a firm’s total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.

Question 5

Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a yield to maturity of 6.8%. The company’s marginal tax rate is 35%. Ferryville plans to issue new five-year notes to finance an expansion. Ferryville’s cost of debt capital is closest to:
A) 4.9%.
B) 2.4%.
C) 4.4%.

Answer 5

C) 4.4%.

Ferryville’s cost of debt capital is kd(1 - t) = 6.8% × (1 - 0.35) = 4.42%. Note that the before-tax cost of debt is the yield to maturity on the company’s outstanding notes, not their coupon rate. If the expected yield on new par debt were known, we would use that. Since it is not, the yield to maturity on existing debt is the best approximation.

Question 6

Which of the following types of capital budgeting projects are most likely to generate little to no revenue?
A) Regulatory projects.
B) Replacement projects to maintain the business.
C) New product or market development.

Answer 6

A was correct!

Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.

Question 7

Which of the following steps is least likely to be an administrative step in the capital budgeting process?
A) Arranging financing for capital projects.
B) Conducting a post-audit to identify errors in the forecasting process.
C) Forecasting cash flows and analyzing project profitability.

Answer 7

A was correct!
Arranging financing is not one of the administrative steps in the capital budgeting process. The four administrative steps in the capital budgeting process are:
1. Idea generation
2. Analyzing project proposals
3. Creating the firm-wide capital budget
4. Monitoring decisions and conducting a post-audit

Question 8

Which of the following is used to illustrate a firm’s weighted average cost of capital (WACC) at different levels of capital?
A) Schedule of marginal capital break points.
B) Cost of capital component schedule.
C) Marginal cost of capital schedule.

Answer 8

C) Marginal cost of capital schedule.

The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is usually upward sloping and is a function of a firm’s capital structure and its cost of capital at different levels of total capital investment.

Question 9

Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Amount of New Debt (in M)
$0 to $199
$200 to $399
$400 to $599

After-tax Cost of Debt
4.5%
5.0%
5.5%

Amount of New Equity (in millions)
$0 to $299
$300 to $699
$700 to $999

Cost of Equity
7.5%
8.5%
9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both:
A) $500 million and $1,000 million.
B) $500 million and $700 million.
C) $400 million and $700 million.

Answer 9

A was correct!
Stolzenbach will have a break point each time a component cost of capital changes, for a total of three marginal cost of capital schedule breakpoints.
Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million
Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million
Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million
Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million

Question 10

Which of the following statements regarding leverage is most accurate?
A) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk.
B) High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.
C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

Answer 10

C) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

A firm with high operating leverage has a high percentage of its total costs in fixed costs.

Question 11

Which of the following is NOT a limitation to financial ratio analysis?
A) The need to use judgment.
B) A firm that operates in only one industry.
C) Differences in international accounting practices.

Answer 11

B) A firm that operates in only one industry.

If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

Question 12

Francis Investment Inc’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Francis assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Francis decides to borrow $30 million that it will use to repurchase shares. Francis’ Chief Financial Officer (CFO) has compiled the following information regarding the repurchase of the firm’s common stock:
- Share price at the time of buyback = $50
- Shares outstanding before buyback = 30,600,000
- EPS before buyback = $3.33
- Earnings yield = $3.33 / $50 = 6.7%
- After-tax cost of borrowing = 4%
- Planned buyback = 600,000 shares

Based on the information above, after the repurchase of its common stock, Francis’ EPS will be closest to:
A) $3.41.
B) $3.36.
C) $3.39.

Answer 12

B) $3.36.

Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the after-tax cost of borrowing of 4% is less than the 6.7% earnings yield (E/P) of the shares, the share repurchase will increase Francis’s EPS.

Question 13

Alton Industries will have better liquidity than its peer group of companies if its:
A) average trade payables are lower.
B) receivables turnover is higher.
C) quick ratio is lower.

Answer 13

B) receivables turnover is higher.

Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower trade payables could be related to better liquidity, but could also be consistent with very poor liquidity and a requirement from its suppliers of cash payment.

Question 14

A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm:
A) may have credit policies that are too strict.
B) has better credit controls than its peer companies.
C) has a lower cash conversion cycle than its peer companies.

Answer 14

A was correct!
The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle.

Question 15

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in years 1 through 4, $35,000 per year in years 5 through 9, and $40,000 in year 10. This investment will cost the firm $150,000 today, and the firm’s cost of capital is 10%. The payback period for this investment is closest to:
A) 5.23 years.
B) 6.12 years.
C) 4.86 years.

Answer 15

C) 4.86 years.

$150,000
120,000 (4 years)(30,000/year)
$30,000
With $30,000 unrecovered cost in year 5, and $35,000 cash flow in year 5; $30,000 / $35,000 = 0.86 years
4 + 0.86 = 4.86 years

Question 16

Which of the following events will reduce a company’s weighted average cost of capital (WACC)?
A) A reduction in the market risk premium.
B) An increase in expected inflation.
C) A reduction in the company’s bond rating.

Answer 16

A was correct!

An increase in either the company’s beta or the market risk premium will cause the WACC to increase using the CAPM approach. A reduction in the market risk premium will reduce the cost of equity for WACC.

Question 17

Which of the following statements regarding company takeover defenses is CORRECT?
A) The firm’s annual report contains pertinent details concerning takeover defenses.
B) A firm’s proxy is the most likely place to find information about present takeover defenses.
C) Newly created anti-takeover provisions may or may not require stakeholder authorization/approval.

Answer 17

C) Newly created anti-takeover provisions may or may not require stakeholder authorization/approval.
These provisions may or may not require such approval. In either case, the firm may have to, at a minimum, provide information to its shareholders about any amendments to existing takeover defenses. A firm’s articles of organization are the most likely places to locate information about present takeover defenses.

Question 18

Mollette Industries uses the payback period as its primary means for ranking capital projects. Which of the following most likely describes Mollette Industries with regard to location and management education?
Location/ Management education
A) U.S. based firm/ Undergraduate degree or lower

B) European-based firm/ MBA degree or higher

C) European-based firm/ Undergraduate degree or lower

Answer 18

The correct answer was C)
European-based firm Undergraduate degree or lower
Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that were most likely to use the payback period method were European firms and management teams with less education.

Question 19

Question 19 - #87159
A periodic payment to shareholders in the form of additional shares of stock instead of cash is a:
A) stock dividend
B) dividend reinvestment plan
C) stock repurchase
Your answer: A was correct!
Stock dividends are dividends paid out in new shares of stock instead of cash. Unlike stock dividends, dividend reinvestment plans are at the discretion of individual shareholders. In the case of stock repurchases, the company is buying back shares so the number of shares in the investment public’s hands is declining.

Answer 19

A was correct!

Stock dividends are dividends paid out in new shares of stock instead of cash. Unlike stock dividends, dividend reinvestment plans are at the discretion of individual shareholders. In the case of stock repurchases, the company is buying back shares so the number of shares in the investment public’s hands is declining.

Question 20

A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments:
Year 1: $100,000
Year 2: $82,000
Year 3: $76,000
Year 4: $111,000
Year 5: $142,000
If the required rate of return for the firm is 8%, what is the net present value of the investment? (You’ll need to use your financial calculator.)
A) $99,860.
B) $86,133.
C) $64,582.

Answer 20

C) $64,582.
In order to determine the net present value of the investment, given the required rate of return; we can discount each cash flow to its present value, sum the present value, and subtract the required investment.
Year/ Cash Flow/
PV of Cash flow at 8%
0: -336,875.00 -336,875.00
1 100,000.00 92,592.59
2 82,000.00 70,301.78
3 76,000.00 60,331.25
4 111,000.00 81,588.31
5 142,000.00 96,642.81
Net Present Value 64,581.74

Question 21

Jayco, Inc., sells blue ink for $4.00 a bottle. The ink’s variable cost per bottle is $2.00. Ink has fixed cost of $10,000. What is Jayco’s breakeven point in units?
A) 5,000.
B) 2,500.
C) 6,000.

Answer 21

A was correct!

QBE = [FC] / (P - V)
QBE = [10,000] / (4.00 - 2.00) = 5,000

Question 22

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:
A) accept profitable, low-risk projects and accept unprofitable, high-risk projects.
B) accept profitable, low-risk projects and reject unprofitable, high-risk projects.
C) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

Answer 22

C) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.

Question 23

An analyst gathered the following data about a company:
Capital Structure/ Required Rate of Return
30% debt 10% for debt
20% preferred stock 11% for preferred stock
50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?
A) 13.0%.
B) 14.2%.
C) 10.0%.

Answer 23

A was correct!

(0.3)(0.1)(1 - 0.4) + (0.2)(0.11) + (0.5)(0.18) = 0.13

Question 24

A firm expects to produce 200,000 units of flour that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the fixed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to:
DOL DTL
A) 1.3 1.3

B) 1.6 2.0

C) 1.6 1.3

Answer 24

B) 1.6 2.0

DOL = Q(P – V) / [Q(P – V) – F]
DOL = 200,000 (3 – 2) / [200,000(3 – 2) – 75,000] = 1.6
DTL = [Q(P - V) / Q(P - V) - F - I]
DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2

Question 25

A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost of capital should the firm use to determine the project's net present value (NPV)? A) 12.5%. B) 11.6%. C) 9.6%.

Answer 25

B) 11.6%. WACC = (E / V)(RE) + (D / V)(RD)(1 − TC) WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%

Question 26

- The company has a target capital structure of 40% debt and 60% equity. - Bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54. - The company stock beta is 1.2. - Risk-free rate is 10%, and market risk premium is 5%. - The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%. - The company's marginal tax rate is 40%. Part 1) The after-tax cost of debt is: A) 7.2%. B) 8.0%. C) 9.1%.

Answer 26

A was correct! N = 40; PMT = 50; FV = 1,000; PV = 849.54; Compute i = 6%, double = 12%, now (12)(1 − 0.4) = 7.2%.

Question 27

- The company has a target capital structure of 40% debt and 60% equity. - Bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54. - The company stock beta is 1.2. - Risk-free rate is 10%, and market risk premium is 5%. - The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8%. - The company's marginal tax rate is 40%. Part 2) The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash flow approach is: CAPM - Discounted Cash Flow A) 16.0% 15.4% B) 16.0% 16.0% C) 16.6% 15.4%

Answer 27

B) 16.0% 16.0% CAPM = 10 + (5)(1.2) = 16%. Discounted Cash Flow: D1 = 2(1.08) = 2.16, now (2.16 / 27) + 0.08 = 16%

Question 28

The cut-off date for receiving the dividend is known as the: A) ex-dividend date. B) holder of record date. C) date of payment.

Answer 28

A was correct! The cut-off date for receiving the dividend is known as the ex-dividend date. The holder of record date is the date on which the shareholders of record are designated. The date the checks are mailed out is known as the date of payment.

Question 29

At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average cost of capital (WACC). At the meeting Haggerty made the following statements about the company’s WACC: Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm’s assets and can be viewed as the firm’s opportunity cost of financing its assets. Statement 2: Since a firm’s WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk. Are Statement 1 and Statement 2, as made by Haggerty CORRECT? Statement 1 - Statement 2 A) Correct Correct B) Correct Incorrect C) Incorrect Correct

Answer 29

A was correct! Each statement that Haggerty has made to the board of directors regarding the weighted average cost of capital is correct. New projects should have a return that is higher than the cost to finance those projects.

Question 30

All else equal, which of the following statements about operating leverage is least accurate? A) Lower operating leverage generally results in a higher expected rate of return. B) Operating leverage reflects the tradeoff between variable costs and fixed costs. C) Firms with high operating leverage experience greater variance in operating income.

Answer 30

A was correct! Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.

Question 31

Which of the following is most accurate regarding the component costs and component weights in a firm’s weighted average cost of capital (WACC)? A) The appropriate pre-tax cost of a firm’s new debt is the average coupon rate on the firm’s existing debt. B) The weights in the WACC should be based on the book values of the individual capital components. C) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.

Answer 31

C) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible. The after-tax cost of debt = kd(1 – t) = kd – kd(t), where kd is the pretax cost of debt and t is the effective corporate tax rate. So the tax savings from the tax treatment of debt is kd(t). Capital component weights should be based on market weights, not book values. And, the appropriate pre-tax cost of debt is the yield to maturity on the firm’s existing debt.

Question 32

A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data: - Debt/equity ratio is 50%. - Cost of equity capital is 15%. - Cost of new debt is 9%. - Tax rate is 33%. Determine the project's net present value (NPV) and whether or not to accept it. NPV - Accept / Reject A) +$33 Accept B) -$33 Reject C) +$4,968 Accept

Answer 32

B) -$33 Reject First, calculate the weights for debt and equity d + we = 1 d = 0.50We e + We = 1 d = 0.333, we = 0.667 WACC = (wd × kd) × (1 − t) + (we × ke) = (0.333 × 0.09 × 0.67) + (0.667 × 0.15) = 0.020 + 0.100 = 0.120 Third, calculate the PV of the project cash flows N = 8, PMT = -1,000, FV = 0, I/Y = 12, CPT PV = 4,967 And finally, calculate the project NPV by subtracting out the initial cash flow NPV = $4,967 − $5,000 = -$33

Question 33

Laura’s Chocolates, Inc. (LC), is a maker of nut-based toffees. LC is considering a share repurchase and prefers the “tender offer” method. Which of the following is also known as a “tender offer”? A) Buying a fixed number of shares at a fixed price. B) Buying in the open market. C) Repurchasing by direct negotiation.

Answer 33

A was correct! A tender offer refers to buying a fixed number of shares at a fixed price (usually at a premium to the current market price).

Question 34

Rochelle Dixon is delivering a presentation on best practices for corporate governance. Two of her recommendations are as follows: Statement 1: To avoid the potential for harming shareholders’ interests by wasting company resources, the Board of Directors should get management’s approval before it hires outside consultants. Statement 2: The more members a Board of Directors has, the more likely it is to represent shareholders’ interests fairly. Are Dixon’s statements CORRECT? Statement 1 Statement 2 A) Incorrect Correct B) Correct Correct C) Incorrect Incorrect

Answer 34

C) Incorrect Incorrect Both statements are incorrect. An independent board should have the ability to seek specialized advice by hiring outside consultants without management approval. The size of the board should be appropriate for the facts and circumstances of the firm; having more members does not imply that the board will be more independent if the additional members are aligned closely with management or are less well qualified.

Question 35

Landen, Inc. uses several methods to evaluate capital projects. An appropriate decision rule for Landen would be to invest in a project if it has a positive: A) net present value (NPV). B) profitability index (PI). C) internal rate of return (IRR).

Answer 35

A was correct! The decision rules for net present value, profitability index, and internal rate of return are to invest in a project if NPV > 0, IRR > required rate of return, or PI > 1.

Question 36

Which of the following statements about leverage is most accurate? A) An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage. B) A decrease in interest expense will increase the company's degree of total leverage. C) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

Answer 36

C) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage. If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I) If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1 DTL = (DOL)(DFL) If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs will increase the company’s DOL.

Question 37

A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to: A) 1.071. B) 0.832. C) 0.632.

Answer 37

C) 0.632.

Question 38

Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating Degen’s project is closest to: A) 8.9%. B) 8.6%. C) 9.2%.

Answer 38

B) 8.6%. We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3. Equity beta for the project: βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932 Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96% Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%. The appropriate WACC for the project is therefore: 0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.

Question 39

Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%. Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated? Project 1 NPV - Project 2 NPV A) Overstated Overstated B) Understated Overstated C) Understated Understated

Answer 39

A was correct! The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the project by a fixed percentage that does not necessarily reflect the present value of the flotation costs. The impact on project evaluation depends on the length of the project and magnitude of the flotation costs, however, for most projects that are shorter, the incorrect method will overstate NPV, and that is exactly what we see in this problem. Correct method of accounting for flotation costs: After-tax cost of debt = 8.0% (1-0.30) = 5.60% Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50% WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55% Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000 Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000 NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535) = $117,535 NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823) = $31,823 Incorrect Adjustment for cost of equity method for accounting for flotation costs: After-tax cost of debt = 8.0% (1-0.30) = 5.60% Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69% WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65% NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) = $120,327 NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523

Question 40

The following data is regarding the Link Company: - A target debt/equity ratio of 0.5 - Bonds are currently yielding 10% - Link is a constant growth firm that just paid a dividend of $3.00 - Stock sells for $31.50 per share, and has a growth rate of 5% - Marginal tax rate is 40% What is Link's after-tax cost of capital? A) 12.0%. B) 10.5%. C) 12.5%.

Answer 40

A was correct! Use the revised form of the constant growth model to determine the cost of equity. Use algebra to determine the weights for the target capital structure realizing that debt is 50% of equity. Substitute 0.5E for D in the formula below. ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15% V = debt + equity = 0.5 + 1 = 1.5 WACC = (E ÷ V)(ks) + (D ÷ V)(kdebt)(1 − t) WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or 12%

Question 41

Sinclair Construction Company’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Sinclair assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Sinclair decides to borrow $30 million that it will use to repurchase shares. Sinclair’s Chief Executive Officer (CEO) has compiled the following information regarding the repurchase of the firm’s common stock: - Share price at the time of buyback = $50 - Shares outstanding before buyback = 30,600,000 - EPS before buyback = $3.33 - Earnings yield = $3.33 / $50 = 6.7% - After-tax cost of borrowing = 8.0% - Planned buyback = 600,000 shares Based on the information above, Sinclair’s earnings per share (EPS) after the repurchase of its common stock will be closest to: A) $3.18. B) $3.23. C) $3.32.

Answer 41

C) $3.32. Total earnings = $3.33 × 30,600,000 = $101,898,000 Since the 8.0% after-tax cost of borrowing is greater than the 6.7% earnings yield (E/P) of the shares, the share repurchase reduces Sinclair’s EPS.

Question 42

Which of the following choices best describes the role of taxes on the after-tax cost of capital in the U.S. from the different capital sources? Common equity - Preferred equity - Debt A) No effect Decrease Decrease B) Decrease Decrease No effect C) No effect No effect Decrease

Answer 42

C) No effect No effect Decrease In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not decrease the cost of common or preferred equity.

Question 43

Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco’s degree of financial leverage (DFL) and total leverage (DTL)? DFL DTL A) 1.33 1.75 B) 1.20 2.00 C) 1.33 2.00

Answer 43

B) 1.20 2.00 DOL = [Q(P − V)] / [Q(P − V) − F] = [10,000(5 − 3)] / [10,000(5 − 3) − 8,000] = 1.67 DFL = EBIT / (EBIT − I) = 12,000 / (12,000 − 2,000) = 1.2 DTL = DOL × DFL = 1.67 × 1.2 = 2.0

Question 44

Edelman Enginenering is considering including an overhead pulley system in this year's capital budget. The cash outlay for the pully system is $22,430. The firm's cost of capital is 14%. After-tax cash flows, including depreciation are $7,500 for each of the next 5 years. Calculate the internal rate of return (IRR) and the net present value (NPV) for the project, and indicate the correct accept/reject decision. NPV IRR Accept/Reject A) $15,070 14% Accept B) $15,070 14% Reject C) $3,318 20% Accept

Answer 44

C) $3,318 20% Accept Using the cash flow keys: CF0 = -22,430; CFj = 7,500; Nj = 5; Calculate IRR = 20% I/Y = 14%; Calculate NPV = 3,318 Because the NPV is positive, the firm should accept the project.

Question 45

Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate? A) “The optimal capital budget is determined by the intersection of a firm’s marginal cost of capital curve and its investment opportunity schedule.” B) “For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital.” C) “A break point occurs at a level of capital expenditure where one of the component costs of capital increases.”

Answer 45

B) “For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital.” The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm’s capital structure remains constant, the MCC (WACC) increases as additional capital is raised.

Question 46

A 91-day Treasury bill has a holding period yield of 1.5%. What is the annual yield of this T-bill on a bond-equivalent basis? A) 6.65%. B) 6.24%. C) 6.02%.

Answer 46

C) 6.02%. BEY = 1.5% × (365/91) = 6.02%.

Question 47

What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor wants to avoid receiving a dividend and thereby avoid paying tax on the distribution, if the date of record is Thursday, October 31? A) Monday, October 28. B) Thursday, October 24. C) Tuesday, October 29.

Answer 47

C) Tuesday, October 29. The ex-dividend date is now two business days prior to the date of record. Counting back two business days identifies Tuesday, October 29 as the date when the shares can be purchased without the dividend.

Question 48

Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis: - Indian 10-year government bond yield = 7.20% - 10-year U.S. Treasury bond yield = 4.60% - Annualized standard deviation of the Bombay Sensex stock index = 40%. - Annualized standard deviation of Indian dollar denominated 10-year government bond = 24% - Annualized standard deviation of the S&P 500 Index = 18%. The estimated country risk premium for India based on Marian’s research is closest to: A) 2.6%. B) 5.8%. C) 4.3%.

Answer 48

C) 4.3%. CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard deviation of sovereign bond market in terms of the developed market currency) = (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

Question 49

A strong corporate code of ethics is vitally important. Which of the following statements concerning a firm’s code of ethics is least likely accurate? A) A firm’s code of ethics sets standards for ethical conduct based on basic principles of integrity, trust and honesty. B) As part of investor review of the firm’s ethical climate, investors should determine whether the firm gives the board access to relevant corporate information in a timely manner. C) A firm’s code of ethics should require clear disclosure of any advantages given to the firm’s insiders that are not also offered to shareholders.

Answer 49

C) A firm’s code of ethics should require clear disclosure of any advantages given to the firm’s insiders that are not also offered to shareholders. The firm’s code of ethics should prohibit practices that give advantages to company insiders that are not also offered to shareholders.