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Chapter 13: Capital Budgeting Techniques

1. A profitability index of .85 for a project means that: a. b. c. d. the present value of benefits is 85% greater than the project's costs. the project's NPV is greater than zero. the project returns 85 cents in present value for each current dollar invested the payback period is less than one year.

2. BackInSoon, Inc., has estimated that a proposed project's 10-year annual net cash benefit, received each year end, will be $2,500 with an additional terminal benefit of $5,000 at the end of the tenth year. Assuming that these cash inflows satisfy exactly BackInSoon's required rate of return of 8 percent, calculate the initial cash outlay. (Hint: With a desired IRR of 8%, use the IRR formula: ICO = discounted cash flows.) a. $16,775 c. $25,000 b. d. $19,090 $30,000

3. Woatich Windmill Company is considering a project that calls for an initial cash outlay of $50,000. The expected net cash inflows from the project are $7,791 for each of 10 years. What is the IRR of the project? [(Hint: The cash flows from the project are an annuity so you can solve for i in the equation PVA = R(PVIFAi,10).] a. 6% b. 7% c. 8% d. 9%

4. Which of the following statements is correct? a. b. c. d. If the NPV of a project is greater than 0, its PI will equal 0. If the IRR of a project is 0%, its NPV, using a discount rate, k, greater than 0, will be 0. If the PI of a project is less than 1, its NPV should be less than 0. If the IRR of a project is greater than the discount rate, k, its PI will be less than 1 and its NPV will be greater than 0.

5. Assume that a firm has accurately calculated the net cash flows relating to an investment proposal. If the net present value of this proposal is greater than zero and the firm is not under the constraint of capital rationing, then the firm should: a. calculate the IRR of this investment to be certain that the IRR is greater than the cost of capital. b. compare the profitability index of the investment to those of other possible investments. c. calculate the payback period to make certain that the initial cash outlay can be recovered within an appropriate period of time. d. accept the proposal, since the acceptance of value-creating investments should increase shareholder wealth.

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6. A project's profitability index is equal to the ratio of the of a project's future cash flows to the project's . a. present value; initial cash outlay c. present value; depreciable basis b. net present value; initial cash outlay d. net present value; depreciable basis

7. The discount rate at which two projects have identical is referred to as Fisher's rate of intersection a. present values c. IRRs b. net present values d. profitability indexes

8. Two mutually exclusive investment proposals have "scale differences" (i.e., the cost of the projects differ). Ranking these projects on the basis of IRR, NPV, and PI methods give contradictory results. a. will never c. may b. will always d. will generally

9. If capital is to be rationed for only the current period, a firm should probably first consider selecting projects by descending order of . a. net present value c. internal rate of return b. payback period d. profitability index

10. The method provides correct rankings of mutually exclusive projects, when the firm is not subject to capital rationing. a. net present value c. payback period b. internal rate of return d. profitability index

11. In an NPV sensitivity graph, a steep sensitivity line for a particular input variable means that a in that variable results in a in NPV. a. small percentage change; large change b. large percentage change; small change

12. One potential problem with sensitivity analysis is that it generally looks at sensitivity "one variable at a time." However, one way to judge the sensitivity of results to simultaneous changes in two variables, at least, is to construct an . a. NPV profile b. NPV sensitivity matrix c. NPV sensitivity graph

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Chapter 14: Risk and Managerial Options in Capital Budgeting

1. The investment proposal with the greatest relative risk would have a. b. c. d. the highest standard deviation of net present value. the highest coefficient of variation of net present value. the highest expected value of net present value. the lowest opportunity loss likelihood.

2. Probability-tree analysis is best used when cash flows are expected to be a. independent over time. b. risk-free. c. related to the cash flows in previous periods. d. known with certainty. 3. You are considering two mutually exclusive investment proposals, project A and project B. B's expected value of net present value is $1,000 less than that for A and A has less dispersion. On the basis of risk and return, you would say that a. b. c. d. Project A dominates project B. Project B dominates project A. Project A is more risky and should offer greater expected value. Each project is high on one variable, so the two are basically equal.

4. If two projects are completely independent (or unrelated), the measure of correlation between them is: a. 0 b. .5 c. 1 d. -1

5. Managerial options can be viewed as a. b. c. d. methods for reducing agency risk through the use of incentives. methods for reducing total firm risk through diversification. strategies for increasing management compensation. opportunities for altering management decisions in the future.

6. A managerial option, in effect, a. b. c. d. limits the flexibility of management's decision-making. limits the downside risk of an investment project. limits the profit potential of a proposed project. applies only to new projects.

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7. When using a probability tree approach, we discount the various cash flows to their present value at a. b. c. d. the firm's weighted-average cost of capital. the project's required rate of return. the risk-free rate. the after-tax cost of the firm's long-term debt.

8. The presence of managerial, or real, options the worth of an investment project. a. Increases c.. does not affect b. decreases d. increase or decreases

Chapter 15: Required Returns and the Cost of Capital 1. A single, overall cost of capital is often used to evaluate projects because: a. it avoids the problem of computing the required rate of return for each investment proposal. b. it is the only way to measure a firm's required return. c. it acknowledges that most new investment projects have about the same degree of risk. d. it acknowledges that most new investment projects offer about the same expected return. 2. The cost of equity capital is all of the following EXCEPT: a. the minimum rate that a firm should earn on the equity-financed part of an investment. b. a return on the equity-financed portion of an investment that, at worst, leaves the market price of the stock unchanged. c. by far the most difficult component cost to estimate. d. generally lower than the before-tax cost of debt. 3. In calculating the proportional amount of equity financing employed by a firm, we should use: a. b. c. d. the common stock equity account on the firm's balance sheet. the sum of common stock and preferred stock on the balance sheet. the book value of the firm. the current market price per share of common stock times the number of shares outstanding.

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4. To compute the required rate of return for equity in a company using the CAPM, it is necessary to know all of the following EXCEPT: a. the risk-free rate. b. the beta for the firm. c. the earnings for the next time period. d. the market return expected for the time period.

5. In calculating the costs of the individual components of a firm's financing, the corporate tax rate is important to which of the following component cost formulas? a. common stock. b. debt. c. preferred stock. d. none of the above.

6. The common stock of a company must provide a higher expected return than the debt of the same company because a. b. c. d. there is less demand for stock than for bonds. there is greater demand for stock than for bonds. there is more systematic risk involved for the common stock. there is a market premium required for bonds.

7. A quick approximation of the typical firm's cost of equity may be calculated by a. b. c. d. adding a 5 percent risk premium to the firm's before-tax cost of debt. adding a 5 percent risk premium to the firm's after-tax cost of debt. subtracting a 5 percent risk discount from the firm's before-tax cost of debt. subtracting a 5 percent risk discount from the firm's after-tax cost of debt.

8. Market values are often used in computing the weighted average cost of capital because a. b. c. d. this is the simplest way to do the calculation. this is consistent with the goal of maximizing shareholder value. this is required in the U.S. by the Securities and Exchange Commission. this is a very common mistake.

9. For an all-equity financed firm, a project whose expected rate of return plots____should be rejected. a. above the characteristic line c. below the security market line b. above the security market line d. below the characteristic line

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10. Some projects that a firm accepts will undoubtedly result in zero or negative returns. In light of this fact, it is best if the firm a. b. c. d. adjusts its hurdle rate (i.e., cost of capital) upward to compensate for this fact. adjusts its hurdle rate (i.e., cost of capital) downward to compensate for this fact. does not adjust its hurdle rate up or down regardless of this fact. raises its prices to compensate for this fact.

11. The Tchotchke Knick-Knack Company relies on preferred stock, bonds, and common stock for its long-term financing. Rank in ascending order (i.e., 1 = lowest, while 3 = highest) the likely after-tax component costs of the Tchotchke Company's long-term financing. a. b. c. d. 1 = bonds; 2 = common stock; 3 = preferred stock. 1 = bonds; 2 = preferred stock; 3 = common stock. 1 = common stock; 2 = preferred stock; 3 = bonds. 1 = preferred stock; 2 = common stock; 3 = bonds.

12. Lei-Feng, Inc.'s $100 par value preferred stock just paid its $10 per share annual dividend. The preferred stock has a current market price of $96 a share. The firm's marginal tax rate (combined federal and state) is 40 percent, and the firm plans to maintain its current capital structure relationship into the future. The component cost of preferred stock to Lei-Feng, Inc. would be closest to . a. 6 percent b. 6.25 percent c. 10 percent d. 10.4 percent

13. David Ding is evaluating two conventional, independent capital budgeting projects (X and Y) by making use of the risk-adjusted discount rate (RADR) method of analysis. Projects X and Y have internal rates of return of 16 percent and 12 percent, respectively. The RADR appropriate to Project X is 18 percent, while Project Y's RADR is only 10 percent. The company's overall, weighted-average cost of capital is 14 percent. David should . a. accept Project X and accept Project Y. c. reject Project X and accept Project Y. b. accept Project X and reject Project Y. d. reject Project X and reject Project Y.

14. One way to visualize the RADR approach is to make (new) use of an "old friend," the . a. Security Market Line (SML) b. characteristic line c. NPV profile

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Chapter 16: Operating and Financial Leverage 1. If I believe in the basic principle of a risk-reward relationship, my conclusion regarding security ratings and yields between an Aaa bond and a Baa bond would be that: a. b. c. d. the Aaa bond would have the lower yield. the Aaa bond would have the higher yield. the Baa bond would have lower default risk. default risks would differ but yields would be equal.

2. A firm's degree of operating leverage (DOL) depends primarily upon its a. sales variability. b. level of fixed operating costs. c. closeness to its operating break-even point. d. debt-to-equity ratio. 3. An EBIT-EPS indifference analysis chart is used for_________ a. b. c. d. evaluating the effects of business risk on EPS. examining EPS results for alternative financing plans at varying EBIT levels. determining the impact of a change in sales on EBIT. showing the changes in EPS quality over time.

4. EBIT is usually the same thing as: a. funds provided by operations. c. net income. b. earnings before taxes. d. operating profit.

5. In the context of operating leverage break-even analysis, if selling price per unit rises and all other variables remain constant, the operating break-even point in units will: a. b. c. d. fall. rise. stay the same. still be indeterminate until interest and preferred dividends paid are known.

6. If a firm has a DOL of 5 at Q units, this tell us that: a. if sales rise by 5%, EBIT will rise by 5%. c. if sales rise by 5%, EBIT will fall by 25%. 7. a. b. c. d. b. if sales rise by 1%, EBIT will rise by 1%. d. if sales rise by 1%, EBIT will rise by 5%.

This statistic can be used as a quantitative measure of relative "financial risk." coefficient of variation of earnings per share (CVEPS) coefficient of variation of operating income (CVEBIT) (CVEPS - CVEBIT) (CVEPS + CVEBIT)

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8. A firm's degree of total leverage (DTL) is equal to its degree of operating leverage_____ its degree of financial leverage (DFL). a. Plus b. minus c. divided by d. multiplied by

9. The further a firm operates above its operating break-even point, the closer its degree of operating leverage (DOL) measure approaches____ a. minus one. b. zero. c. one. d. infinity.

Chapter 17: Capital Structure Determination

1. The term "capital structure" refers to: a. b. c. d. long-term debt, preferred stock, and common stock equity. current assets and current liabilities. total assets minus liabilities. shareholders' equity.

2. A critical assumption of the net operating income (NOI) approach to valuation is: a. b. c. d. that debt and equity levels remain unchanged. that dividends increase at a constant rate. that ko remains constant regardless of changes in leverage. that interest expense and taxes are included in the calculation.

3. The traditional approach towards the valuation of a company assumes: a. b. c. d. that the overall capitalization rate holds constant with changes in financial leverage. that there is an optimum capital structure. that total risk is not altered by changes in the capital structure. that markets are perfect.

4. Two firms that are virtually identical except for their capital structure are selling in the market at different values. According to M&M a. b. c. d. one will be at greater risk of bankruptcy. the firm with greater financial leverage will have the higher value. this proves that markets cannot be efficient. this will not continue because arbitrage will eventually cause the firms to sell at the same value.

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5. The cost of monitoring management is considered to be a (an): a. bankruptcy cost. c. agency cost. b. transaction cost. d. institutional cost.

6. What is the value of the tax shield if the value of the firm is $5 million, its value if unlevered would be $4.78 million, and the present value of bankruptcy and agency costs is $360,000? a. $140,000 c. $360,000 b. $220,000 d. $580,000

7. According to the concept of financial signaling, management behavior results in new debt issues being regarded as "___ news" by investors. a. Good b. bad c. non-event d. risk-neutral

8. The cost of capital for a firm -- when we allow for taxes, bankruptcy, and agency costs -a. b. c. d. remains constant with increasing levels of financial leverage. first declines and then ultimately rises with increasing levels of financial leverage. increases with increasing levels of financial leverage. decreases with increasing levels of financial leverage.

9. When sequential long-term financing is involved, the choice of debt or equity influences the future financial____ of the firm. a. Timing b. flexibility c. liquidity

Chapter 18: Dividend Policy

1. Retained earning are a. b. c. d. an indication of a company's liquidity. the same as cash in the bank. not important when determining dividends. the cumulative earnings of the company after dividends.

2. Which of the following is an argument for the relevance of dividends? a. Informational content. c. Some investors' preference for current income. b. Reduction of uncertainty. d. All of the above.

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3. All of the following are true of stock splits EXCEPT: a. b. c. d. market price per share is reduced after the split. the number of outstanding shares is increased. retained earnings are changed. proportional ownership is unchanged.

4. If Ian O'Connor Enterprises, Inc., repurchased 50 percent of its outstanding common stock from the open (secondary) market, the result would be a. a decline in EPS. c. a decrease in total assets. b. an increase in cash. d. an increase in the number of stockholders.

5. On May 7, Melbourne Mining declared a $.50-per-share quarterly dividend payable June 28 to stockholders of record on Friday, June 7. What is the latest date by which you could purchase the stock and still get the recently declared dividend? a. June 3 b. June 4 c. June 5 d. June 6

6. An offer by a firm to repurchase some of its own shares is known as a. a DRIP. b. a self-tender offer. c. a reverse split.

7. If an individual stockholder reinvests dividends under a company's dividend reinvestment plan, the reinvested dividends are a. not taxable to the shareholder. 8. The dividend-payout ratio is equal to a. b. c. d. the dividend yield plus the capital gains yield. dividends per share divided by earnings per share. dividends per share divided by par value per share. dividends per share divided by current price per share. b. taxable to the shareholder.