Fin 221 Fall 2006 Exam 4

Multiple Choice Identify the choice that best completes the statement or answers the question. 1) Several years ago the Haverford Company sold a $1,000 par value bond that now has 25 years to maturity and an 8.00% annual coupon that is paid quarterly. The bond currently sells for $900.90, and the company's tax rate is 40%. What is the component cost of debt for use in the WACC calculation? A. 5.40% B. 5.73% C. 5.98% D. 6.09% E. 6.24%

2) Assume that Mary Brown Inc. hired you as a consultant to help it estimate the cost of capital. You have been provided with the following data: D0 = $1.20; P0 = $40.00; and g = 7% (constant). Based on the DCF approach, what is Brown's cost of equity from retained earnings? A. 10.06% B. 10.21% C. 10.37% D. 10.54% E. 10.68%

3) Crum International's target capital structure calls for 80% debt and 20% equity. The company expects to have $3 million of net income this year, and 60% of the net income will be paid out in dividends. How large can the firm's capital budget be this year before it will have to issue new common stock? A. $5.5 million B. $6.0 million C. $6.3 million D. $6.8 million E. $7.1 million

4) Assume that you are on the financial staff of Christopher Inc., and you have collected the following data: (1) The yield on the company's outstanding bonds is 7.0%, and its tax rate is 40%. (2) The expected year-end dividend is $0.80 a share, the dividend is expected to grow at a constant rate of 6% a year, the price of Christopher's stock is $25 per share, and the flotation cost for selling new shares is 10%. (3) The target capital structure is 40% debt and 60% equity. What is Christopher's WACC assuming that it must issue new stock to finance its capital budget? A. 7.11% B. 7.26% C. 7.41% D. 7.67% E. 7.89%

5) Moussawi Enterprises, which finances only with equity from retained earnings, is considering two large capital budgeting projects, and its CFO hired you to assist in deciding whether one, both, or neither of the projects should be accepted. You have the following information: (1) rRF = 5.5%; RPM = 6%; and b = 0.8. (2) The company adds 3% to the corporate WACC when it evaluates relatively risky projects, and it deducts 1% from the WACC when evaluating relatively safe projects. (3) Project S is relatively safe, it costs $10,000, and its expected rate of return is 8%, while Project R is relatively risky, it costs $15,000, and its expected rate of return is 12%. If these are the only two projects under consideration, how large should the capital budget be? A. $ 5,000 B. $10,000 C. $15,000 D. $20,000 E. $25,000

6) Which of the following statements is CORRECT? A. If a company's tax rate increases but the YTM of its noncallable bonds remains the same, the after-tax cost of its debt will fall. B. All else equal, an increase in a company's stock price will increase its marginal cost of retained earnings, rs. C. All else equal, an increase in a company's stock price will increase its marginal cost of new common equity, re. D. Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt. E. When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible.

7) Maese Sisters Inc has been paying out all of its earnings as dividends, and hence has no retained earnings. This same situation is expected to persist in the future. The company uses the CAPM to calculate its cost of equity. Its target capital structure consists of common stock, preferred stock, and debt. Which of the following events would reduce the WACC? A. The flotation costs associated with issuing new common stock increase. B. The market risk premium declines. C. The company's beta increases. D. Expected inflation increases. E. The flotation costs associated with issuing preferred stock increase.

8) The Nunnally Company has equal amounts of low-risk, average-risk, and high-risk projects. Nunnally estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. However, the CEO argues that, even though the company's projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's opinion is followed, what is likely to happen over time? A. The company will take on too many low-risk projects and reject too many high-risk

projects. B. The company will take on too many high-risk projects and reject too many low-risk projects. C. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time. D. The company's overall WACC should decrease over time because its stock price should be increasing. E. The CEO's recommendation would maximize the firm's intrinsic value.

9) Given the following information, what is the required cash outflow associated with the acquisition of a new machine; that is, in a project analysis, what is the cash outflow at t = 0? Purchase price of new machine Installation charge Market value of old machine Book value of old machine Inventory decrease if new machine is installed Accounts payable increase if new machine is installed Tax rate Cost of capital A. B. C. D. E. -$ 8,980 -$ 6,460 -$ 5,200 -$ 6,850 -$12,020 $8,000 2,000 2,000 1,000 1,000 500 35% 15%

10) Blanchford Enterprises is considering a project that has the following cash flow and WACC data. What is the project's discounted payback? Year: Cash flows: A. B. C. D. E. 2.01 years 2.26 years 2.65 years 2.84 years 3.17 years 0 -$1,000 1 $500 2 $500 3 $500

11) Rockmont Recreation Inc. is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's projected MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC = 10% Year: Cash flows: A. B. C. D. E. 13.33% 14.01% 15.69% 16.35% 17.18%

0 -$900

1 $300

2 $320

3 $340

4 $360

12) Pettway Inc. is considering Projects S and L, whose cash flows are shown below. These projects are mutually exclusive, equally risky, and not repeatable. If the decision is made by choosing the project with the higher IRR, how much value will be foregone? Note that under some conditions choosing projects on the basis of the IRR will cause $0.00 value to be lost. WACC = 12% Year: CFS: CFL: A. B. C. D. E. $15.57 $21.49 $28.02 $33.69 $37.39 0 -$1,025 -$2,153 1 $375 $750 2 $380 $759 3 $385 $768 4 $390 $777

13) You must find the payback for a project, and you have misplaced some of the information that you were given. You know that the project will generate positive cash flows of $60,000 per year at the end of each of the next 5 years, that its NPV is $75,000, and that the company's WACC is 10%. What is the project's regular payback? Hint: You must first find the project's cost, then use it to find the payback. A. 2.11 years B. 2.27 years C. 2.38 years D. 2.45 years E. 2.54 years

14) Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT? A. The project's IRR increases as the WACC declines. B. The project's NPV increases as the WACC declines. C. The project's MIRR is unaffected by changes in the WACC. D. The project's regular payback increases as the WACC declines. E. The project's discounted payback increases as the WACC declines.

15) Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A. A project's NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC. B. The lower the WACC used to calculate it, the lower the calculated NPV will be. C. If a project's NPV is less than zero, then its IRR must be less than the WACC. D. If a project's NPV is greater than zero, then its IRR must be less than zero. E. The NPV of a relatively low risk project should be found using a relatively high WACC.

16) Which of the following statements is CORRECT? A. One advantage of the NPV over the IRR method is that NPV takes account of cash flows over a project's full life whereas IRR does not. B. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC whereas IRR assumes that cash flows are reinvested at the IRR, and the NPV's assumption is generally more likely to be appropriate. C. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project's full life whereas MIRR does not. D. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. E. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

17) 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%.

18) Sacramento Paper is considering two equally risky, mutually exclusive projects, and both projects have normal cash flows. Project A has an IRR of 11%, while Project B has an IRR of 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? A. If the WACC is 13%, Project A's NPV will be higher than Project B's. B. If the WACC is 9%, Project A's NPV will be higher than Project B's. C. If the WACC is 6%, Project B's NPV will be higher than Project A's. D. If the WACC goes over 14%, Project A's IRR will exceed Project B's. E. If the WACC is 9%, Project B's NPV will be higher than Project A's.

19) As a member of Gamma Corporation's financial staff, you must estimate the Year 1 operating net cash flow for a proposed project with the following data. What is the Year 1 operating cash flow?

Sales Depreciation Other operating costs Interest expense Tax rate A. B. C. D. E. $ 9,500 $10,600 $11,700 $12,800 $13,900

$33,000 $10,000 $17,000 $ 4,000 35%

20) Big Air Services is now in the final year of a project. The equipment originally cost $20 million, of which 75% has been depreciated. Big Air can sell the used equipment today for $6 million, and its tax rate is 40%. What is the equipment's after-tax net salvage value? A. $500,000 B. $600,000 C. $700,000 D. $800,000 E. $900,000

21) The Movie Place is considering a new investment whose data are shown below. The required equipment has a 3year tax life and would be fully depreciated by the straight line method over the 3 years, but it would have a positive salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? WACC Net equipment cost (depreciable basis) Required new working capital Straight line depr'n rate Sales revenues Operating costs excl. depr'n Expected pretax salvage value Tax rate A. B. C. D. E. $24,971.86 $25,538.17 $26,553.97 $27,356.82 $28,879.81 10% $65,000 $10,000 33.33% $70,000 $25,000 $ 5,000 35%

22) Which of the following statements is CORRECT? A. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

B. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. C. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. D. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the PV. E. A good example of a sunk cost is a situation where a retailer opens a new store, and that leads to a decline in sales of some of the firm's existing stores.

23) Which of the following factors should be included in the cash flows used to estimate a project's NPV? A. All costs associated with the project that have been incurred to date. B. Interest on funds borrowed to help finance the project. C. The end-of-project recovery of any working capital required to operate the project. D. Cannibalization effects, but only if those effects increase the project's projected cash flows. E. Expenditures to date on research and development related to the project that have already been expensed for tax purposes.

24) Berry Beverage Company spent $3 million two years ago to build a plant for a project. It then decided not to go forward with the project, so the building is available for sale or for a new project. It owns the building free and clear---there is no mortgage on it. Which of the following statements is CORRECT? A. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project or projects. B. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. C. This is an example of an externality, because the very existence of the building affects the cash flows for any new project the Berry might consider. D. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. E. If there was a mortgage loan on the building, then the interest on that loan would have to be charged to the new project.

25) Merlin Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Merlin evaluates low-risk projects with a WACC of 8%, average projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Project A B C D E Risk High Average High Low Low Expected Return 15% 12 11 9 6

Which set of projects would maximize shareholder wealth? A. A and B. B. A, B, and C. C. A, B, and D. D. A, B, C, and D. E. A, B, C, D, and E.

Fin 221 Fall 2006 Exam 4 Answer Section

MULTIPLE CHOICE 1) 2) 3) 4) 5) 6) 7) 8) 9) 10) 11) 12) 13) 14) 15) 16) 17) 18) 19) 20) 21) 22) 23) 24) 25) A B B C C A B B D B B C E B C B A E E B C C C B C