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Questions and Answers of Finance

Thoma Pharmaceutical Company may buy DNA-testing equipment costing $60,000. This equipment is expected to reduce labor costs of the clinical staff by $20,000 annually. The equipment has a useful life
In Problem 1, suppose that 6 percent inflation in savings from labor costs is expected over the last four years, so that savings in the first year are $20,000, savings in the second year are $21,200,
The City of San Jose must replace a number of its concrete-mixer trucks with new trucks. It has received two bids and has evaluated closely the performance characteristics of the various trucks. The
US Blivet is contemplating the purchase of a more advanced blivet-extrusion machine to replace the machine currently being used in its production process. The firm's production engineers contend that
In Problem 4, suppose that you just discovered that the production engineers had slipped up twice in their statement of the relevant facts concerning the potential purchase of the new machine:• The
Explain what is meant by the time value of money. Why is a bird in the hand worth two (or so) in the bush? Which capital budgeting approach ignores this concept? Is it optimal?
Some people have suggested combining the payback period (PBP) method with present value analysis to calculate a "discounted" payback period (DPBP). Instead of using cumulative inflows, cumulative
Why does the payback period bias the process of asset selection toward short-lived assets?
Why does the net present value method favor larger projects over smaller ones when used to choose between mutually exclusive projects? Is this a problem?
Contrast the internal rate of return method of project evaluation and selection with the net present value method. Why might these two discounted cash flow techniques lead to conflicts in project
Although it is conceptually unsound, the payback period is very popular in business as a criterion for assigning priorities to investment projects. Why is it unsound, and why is it popular?
Is the economic efficiency of a country enhanced by the use of modern capital budgeting techniques? Why?
If capital rationing is not optimal, why would any company use it?
The internal rate of return method implies that intermediate cash flows are reinvested at the internal rate of return. Under what circumstances is this assumption likely to lead to a seriously
Lobers, Inc., has two investment proposals, which have the following characteristics:For each project, compute its payback period, its net present value, and its profitability index using a discount
In Problem 1, what criticisms may be offered against the payback method?
The following are exercises on internal rates of return: a. An investment of $1,000 today will return $2,000 at the end of 10 years. What is its internal rate of return? b. An investment of $1,000
Two mutually exclusive projects have projected cash flows as follows:a. Determine the internal rate of return for each project. b. Determine the net present value for each project at discount
Zaire Electronics can make either of two investments at time 0. Assuming a required rate of return of 14 percent, determine for each project(a) The payback period.(b) The net present value.(c) The
Thoma Pharmaceutical Company may buy DNA testing equipment costing $60,000. This equipment is expected to reduce labor costs of clinical staff by $20,000 annually. The equipment has a useful life of
In Problem 6, suppose that 6 percent inflation in cost savings from labor is expected over the last four years, so that savings in the first year are $20,000, savings in the second year are $21,200,
The Lake Tahow Ski Resort is comparing a half dozen capital improvement projects. It has allocated $1 million for capital budgeting purposes. The following proposals and associated profitability
The City of San Jose must replace a number of its concrete mixer trucks with new trucks. It has received two bids and has evaluated closely the performance characteristics of the various trucks. The
Why should we be concerned with risk in capital budgeting? Why not just work with the expected cash flows as we did in Chapter 13?
What is meant by "dominance" in a portfolio sense?
What are managerial options and why are they important?
In general terms, what determines the value of a managerial option?
Name the various types of managerial option, and describe how they differ from one another.
Is the standard deviation an adequate measure of risk? Can you think of a better measure?
How do you go about "standardizing" the dispersion of a probability distribution to make generalizations about the risk of a project?
Risk in capital budgeting can be judged by analyzing the probability distribution of possible returns. What shape distribution would you expect to find for a safe project whose returns were
If project A has an expected value of net present value of $200 and a standard deviation of $400, is it more risky than project B, whose expected value is $140 and standard deviation is $300? Explain.
In a probability tree approach to project risk analysis, what are initial, conditional, and joint probabilities?
Why should the risk-free rate be used for discounting cash flows to their present value when evaluating the risk of capital investments?
What are the benefits of using simulation to evaluate capital investment projects?
What role does the correlation between net present values play in the risk of a portfolio of investment projects?
George Gau, Inc., can invest in one of two mutually exclusive, one-year projects requiring equal initial outlays. The two proposals have the following discrete probability distributions of net cash
Smith, Jones, and Nguyen, Inc., is faced with several possible investment projects. For each, the total cash outflow required will occur in the initial period. The cash outflows, expected net present
The probability distribution of possible net present values for project X has an expected value of $20,000 and a standard deviation of $10,000. Assuming a normal distribution, calculate the
Xonics Graphics, Inc., is evaluating a new technology for its reproduction equipment. The technology will have a three-year life, will cost $1,000, and will have an impact on cash flows that is
The Flotsam and Jetsam Wreckage Company will invest in two of three possible proposals, the cash flows of which are normally distributed. The expected net present value (discounted at the risk-free
Plaza Corporation is confronted with various combinations of risky investments.a. Plot the above portfolios. b. Which combinations dominate the others?
The Bertz Merchandising Company uses a simulation approach to judge investment projects. Three factors are employed: market demand, in units; price per unit minus cost per unit (on an after-tax
The Bates Pet Motel Company is considering opening a new branch location. If it constructs an office and 100 pet cages at its new location, the initial outlay will be $100,000, and the project is
Why is it important to use marginal weights in calculating a weighted average cost of capital?
When a project is evaluated on the basis of its total risk, who determines whether the project is acceptable? How? Is share price likely to be maximized?
What is the risk-adjusted discount rate (RADR) approach to project selection? How is it similar to the CAPM approach? How is it different from the CAPM approach?
What is the distinction between evaluating the expected value of net present value and standard deviation for an individual investment project and those for a group or combination of projects?
Should companies in the same industry have approximately the same required rates of return on investment projects? Why or why not?
If you use debt funds to finance a project, is the after-tax cost of debt the required return for the project? As long as the project earns more than enough to pay interest and service the
If the cost of bankruptcy proceedings (attorney fees, trustee fees, delays, inefficiencies, and so on) were to rise substantially, would this occurrence have an effect on a company's required rate of
Should a company with multiple divisions establish separate required rates of return, or costs of capital, for each division as opposed to using the company's overall cost of capital? Explain.
For a corporation investing in capital projects, how is value created by using required return calculations?
Under what circumstances is it appropriate to use the weighted average cost of capital as an acceptance criterion?
What will happen to the cost of debt funds for cost of capital purposes if a company should go into a period when it has negligible profits and pays no taxes?
With a dividend discount model, how do you estimate the cost of equity capital? What is the critical variable in this model?
What is the critical assumption inherent in the capital-asset pricing model (CAPM) as it relates to the acceptance criterion for risky investments?
Instead of using the expected return on the market portfolio and the risk-free rate in a CAPM approach to estimating the required return on equity, how would one use the firm's debt cost in a
What is the purpose of proxy companies in the application of the capital-asset pricing model to estimating required returns?
Distinguish a project-specific required return from a group-specific required return.
Zapata Enterprises is financed by two sources of funds: bonds and common stock. The cost of capital for funds provided by bonds is ki, and ke is the cost of capital for equity funds. The capital
The Totally Tubular Tube Company wishes to evaluate three new investment proposals. The firm is concerned with the impact of the proposals on its total risk. Consequently, it has determined expected
Willie Sutton Bank Vault Company has a debt-to-equity ratio (in market value terms) of 0.75. Its present cost of debt funds is 15 percent, and it has a marginal tax rate of 40 percent. Willie
Aspen Plowing, Inc., is considering investing in a new snowplow truck costing $30,000. The truck is likely to provide after-tax incremental operating cash flows of $10,000 per year for six years. The
Assume that B (in Problem 1) is $3 million and S is $7 million. The bonds have a 14 percent yield to maturity, and the stock is expected to pay $500,000 in dividends this year. The growth rate of
On January 1, 20X1, International Copy Machines (ICOM), one of the favorites of the stock market, was priced at $300 per share. This price was based on an expected dividend at the end of the year of
K-Far Stores has launched an expansion program that should result in the saturation of the Bay Area marketing region of California in six years. As a result, the company is predicting a growth in
The Manx Company was recently formed to manufacture a new product. It has the following capital structure in market value terms:Debentures……………………………….$ 6,000,000Preferred
The R-Bar-M Ranch in Montana would like a new mechanized barn, which will require a $600,000 initial cash outlay. The barn is expected to provide after-tax annual cash savings of $90,000 indefinitely
Cohn and Sitwell, Inc., is considering manufacturing special drill bits and other equipment for oil rigs. The proposed project is currently regarded as complementary to its other lines of business,
Acosta Sugar Company has estimated that the overall return for the S&P 500 Index will be 15 percent over the next 10 years. The company also feels that the interest rate on Treasury securities will
Able Elba Palindrome, Inc., is evaluating a capital investment project. The after-tax cash flows for the project are listed as follows:YEAREXPECTED CASH
Define operating leverage and the degree of operating leverage (DOL). How are the two related?
The EBIT-EPS chart suggests that the higher the debt ratio, the higher are the earnings per share for any level of EBIT above the indifference point. Why do firms sometimes choose financing
Why is the percentage of debt for an electric utility higher than that for the typical manufacturing company?
Is the debt-to-equity ratio a good proxy for financial risk as represented by the cash-flow ability of a company to service debt? Why or why not?
How can a company determine in practice whether it has too much debt? Too little debt?
How can coverage ratios be used to determine an appropriate amount of debt to employ? Are there any shortcomings to the use of these ratios?
In financial leverage, why not simply increase leverage as long as the firm is able to earn more on the employment of the funds thus provided than they cost? Would not earnings per share increase?
Describe how a company could determine its debt capacity by increasing its debt hypothetically until the probability of running out of cash reached some degree of tolerance.
How might a company's bond rating influence a capital structure decision?
Classify the following short-run manufacturing costs as either typically fixed or typically variable. Which costs are variable at management's discretion? Are any of these costs fixed in the long
What would be the effect on the firm's operating break-even point of the following individual changes? a. An increase in selling price b. An increase in the minimum wage paid to the firm's
Your friend, Jacques Fauxpas, suggests, "Firms with high fixed operating costs show extremely dramatic fluctuations in operating profits for any given change in sales volume." Do you agree with
You can have a high degree of operating leverage (DOL) and still have low business risk. Why? By the same token, you can have a low DOL and still have high business risk. Why?
Define financial leverage and the degree of financial leverage (DFL). How are the two related?
Discuss the similarities and differences between financial leverage and operating leverage.
The Andrea S. Fault Seismometer Company is an all-equity-financed firm. It earns monthly, after taxes, $24,000 on sales of $880,000. The tax rate of the company is 40 percent. The company's only
What would be the effect of the following on the break-even point of the Andrea S. Fault Company (Problem 1)? a. An increase in selling price of $50 per unit (assume that sales volume remains
Cybernauts, Ltd., is a new firm that wishes to determine an appropriate capital structure. It can issue 16 percent debt or 15 percent preferred stock. The total capitalization of the company will be
Hi-Grade Regulator Company currently has 100,000 shares of common stock outstanding with a market price of $60 per share. It also has $2 million in 6 percent bonds. The company is considering a $3
Hi-Grade Regulator Company (see Problem 5) expects the EBIT level after the expansion program to be $1 million, with a two-thirds probability that it will be between $600,000 and $1,400,000. a. Which
Fazio Pump Corporation currently has 1.1 million shares of common stock outstanding and $8 million in debt bearing an interest rate of 10 percent on average. It is considering a $5 million expansion
Boehm-Gau Real Estate Speculators, Inc., and the Northern California Electric Utility Company have the following EBIT and debt-servicing burden:The tax rate for Boehm-Gau is 40 percent, and for
The debt ratios of four companies are*Total capitalization represents all long-term debt plus shareholders' equity. The companies are part of the following industries: supermarket, chemical, apparel
Contrast the net operating income (NOI) approach with the Modigliani and Miller (M&M) approach to the theory of capital structure.
Dividends are currently taxed twice. The corporation must pay taxes on its earnings, and then shareholders must pay taxes on the dividends paid. What would be the effect on corporate financing if
Why might capital structure changes speak louder than words if management believed its stock were undervalued? What is the likely direction of the financial signal?
Why might you suspect that the optimal capital structure would differ significantly from one industry to another? Would the same factors produce differing optimal capital structures within all
What factors determine the interest rate a firm must pay for debt funds? Is it reasonable to expect this rate to rise with an increasing debt-to-equity ratio? Why?

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