Practice

Question 1

A company is considering a $10,000 project that will last 5 years.

Annual after tax cash flows are expected to be $3,000
Cost of capital = 9.7%
What is the project’s net present value (NPV)?

(Understand how to evaluate a project; understand NPV)

Answer 1

Calculate the PV of the project cash flows

N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460

Calculate the project NPV by subtracting out the initial cash flow

NPV = $11,460 – $10,000 = $1,460

Question 2

The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as:

Answer 2

The study is a sunk cost, and the possible increase in sales of a related product is an example of a positive externality.

(Module 31.1, LOS 31.b)

Question 3

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:

Answer 3

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 cannot 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.

(Module 32.1, LOS 32.d)

Question 4

Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share with 8 million shares outstanding. Assuming that this project represents new information and is independent of other expectations about the company, what should the effect of the project theoretically be on the firm’s stock price?

Answer 4

In theory, a positive NPV project should provide an increase in the value of a firm’s shares.

NPV of new capital equipment = $50 million - $30 million = $20 million

Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000

Value of company after new equipment project = $224 million + $20 million = $244 million

Price per share after new equipment project = $244 million / 8 million = $30.50

Note that in reality, changes in stock prices result from changes in expectations more than changes in NPV.

Question 5

One of the basic principles of capital allocation is that:

Answer 5

Capital allocation process is identifying and evaluating capital projects. (eg. building a new machine, equipment… )

Key principles of the capital allocation process are:

• Decisions are based on cash flows, not accounting income.
• Cash flows are based on opportunity costs.
• The timing of cash flows is important.
• Cash flows are analyzed on an after-tax basis.
• Financing costs are reflected in the project’s required rate of return.
  (Module 31.1, LOS 31.b)

Question 6

Jack Smith, CFA, is analyzing independent investment projects X and Y. Smith has calculated the net present value (NPV) and internal rate of return (IRR) for each project:

Project X: NPV = $250; IRR = 15%

Project Y: NPV = $5,000; IRR = 8%

Smith should make which of the following recommendations concerning the two projects?

Answer 6

Explanation
The projects are independent, meaning that either one or both projects may be chosen. Both projects have positive NPVs, therefore both projects add to shareholder wealth and both projects should be accepted.

(Module 31.2, LOS 31.c)

Question 7

Johnson’s Jar Lids is deciding whether to begin producing jars. Johnson’s pays a consultant $50,000 for market research that concludes Johnson’s sales of jar lids will increase by 5% if it also produces jars. In choosing the cash flows to include when evaluating a project to begin producing jars, Johnson’s should:

Answer 7

Explanation
Sunk costs should be excluded from cash flows, as they are costs that cannot be avoided even if the project is not undertaken. Externalities, such as positive or negative effects of accepting a project on sales of the company’s existing products, should be included in the cash flows. (Module 31.1, LOS 31.b)

Question 8

Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net present value of $10 million. Investors did not anticipate the sale because government approval to sell to Cuba had never before been granted. The share price of Polington should theoretically:

Answer 8

Since the sale was not anticipated by the market, the share price should rise by the NPV of the project per common share. NPV is already calculated using after-tax cash flows.
After-tax cash flow

Question 9

The effect of a company announcement that they have begun a project with a current cost of $10 million that will generate future cash flows with a present value of $20 million is most likely to:

Answer 9

Explanation
Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project will increase stock price only if it was not previously anticipated by investors.

Question 10

Should a company accept a project that has an IRR of 14% and an NPV of $2.8 million if the cost of capital is 12%?

Answer 10

The project should be accepted on the basis of its positive NPV and its IRR, which exceeds the cost of capital.

(Module 31.2, LOS 31.c)

Question 11

Which of the following steps is least likely to be a step in the capital allocation process?

Answer 11

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 12

Thematic investing is most accurately described as:

Answer 12

Thematic investing refers to selecting investments with a view to a specific environmental, social, or governance factor. Identifying the best companies in each sector with respect to environmental and social factors is referred to as best-in-class investing. Excluding companies or sectors from consideration for investment based on environmental and social factors is referred to as negative screening.

Question 13

Financing costs for a capital project are:

Answer 13

Financing costs are reflected in a project’s required rate of return. Project specific financing costs should not be included as project cash flows. The firm’s overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

Question 14

A bank offers a corporation a line of credit for a certain amount but reserves the right to refuse to honor any request for the use of the line. This arrangement is best described as:

Answer 14

With an uncommitted line of credit, a bank extends an offer of credit for a certain amount but may refuse to lend if circumstances change. With a regular or committed line of credit, a bank extends an offer of credit that it commits to for a given time period. A revolving line of credit allows companies to borrow and repay funds as their needs change over time.

(Module 32.1, LOS 32.a)

Question 15

An example of macro risk that companies may face is:

Answer 15

Macro risks include economic factors such as exchange-rate changes. ESG risk and capital investment risk are examples of firm-specific risks.

(Module 30.1, LOS 30.c)

Question 16

A firm is least likely to reduce its capital needs by adopting which of the following business models?

Answer 16

Bundling is a pricing strategy for multiple products. Firms that rent or lease major assets (an asset-light model) or receive cash before providing goods or services (a pay-in-advance model) tend to have less need for capital than firms that own fixed assets or do not collect cash in advance.

(Module 30.1, LOS 30.b)

Question 17

Which of the following sources of short-term liquidity is considered reliable enough that it can be listed in the footnotes to a firm’s financial statements as a source of liquidity?

Answer 17

With an uncommitted line of credit, the lender is not committed to make loans in any amount. A revolving line of credit is typically for a longer period and involves an agreement to lend funds in the future up to some maximum amount. Factoring does not typically involve an agreement for future receivables purchases.

Question 18

Which of the following payments are contractual obligations of a corporation?

Answer 18

Interest and principal payments to lenders are contractual obligations. A corporation may distribute dividends to owners but is not required to do so.

Question 19

Debrin Company uses a tiered pricing strategy. Debrin is most likely to:

Answer 19

Tiered pricing refers to setting prices based on a customer’s volume of purchases.

(Module 30.1, LOS 30.a)

Question 20

Which of the following payments are contractual obligations of a corporation?

Answer 20

In either a general partnership or a limited partnership, general partners have unlimited liability.

Question 21

Which of the following payments are contractual obligations of a corporation?

Answer 21

Interest and principal payments to lenders are contractual obligations. A corporation may distribute dividends to owners but is not required to do so.

(Module 28.1, LOS 28.c)

Question 22

A firm is least likely to reduce its capital needs by adopting which of the following business models?

Answer 22

Bundling is a pricing strategy for multiple products. Firms that rent or lease major assets (an asset-light model) or receive cash before providing goods or services (a pay-in-advance model) tend to have less need for capital than firms that own fixed assets or do not collect cash in advance.

(Module 30.1, LOS 30.b)

Question 23

An example of macro risk that companies may face is:

Answer 23

Macro risks include economic factors such as exchange-rate changes. ESG risk and capital investment risk are examples of firm-specific risks.

(Module 30.1, LOS 30.c)

Question 24

With respect to a corporation’s mechanisms to manage stakeholder relationships, special resolutions are most accurately described as a:

Answer 24

Resolutions refer to matters that require approval by a voting majority of shareholders. Special resolutions are those that amend a corporation’s bylaws or address issues such as mergers or takeovers, and may require a supermajority of shareholder votes. (Module 29.1, LOS 29.c)

Question 25

A company with stock that is infrequently traded should most appropriately use a beta for a traded company in the same business facing the same business risks, adjusted for differences in:

Answer 25

A company with shares that do not trade or are infrequently traded should unlever the beta of a traded company in the same business facing the same business risks, using that company’s debt-to-equity ratio and tax rate, and then re-lever it using the debt-to-equity ratio and tax rate of their own company. (Module 33.2, LOS 33.f)