Questions and Answers of Contemporary Financial Management

Given a corporate income tax, financial distress costs, and agency costs, an optimal capital structure consists of some combination of debt and equity. L0358
The optimal capital structure consists entirely of debt if a corporate income tax exists and there are no financial distress costs or agency costs. L0358
The value of the firm is independent of capital structure, given perfect capital markets and no corporate income taxes.L0358
Financial risk is the additional variability of earnings per share and the increased probability of insolvency resulting from the use of fixed-cost sources of capital, such as debt and preferred
Business risk is the inherent variability or uncertainty of a firm’s operating income. Business risk is caused by many factors, including sales variability and the use of operating leverage. L0358
Leverage involves the firm’s use of fixed operating costs or fixed capital costs. L0358
Capital structure consists of the relative amounts of permanent short-term debt, long-term debt, preferred stock, and common equity used to finance a firm. The optimal capital structure occurs at the
Total project risk refers to the chance that a project will not perform up to expectations. It is often measured by either the standard deviation or the coefficient of variation of cash flows from a
The portfolio, or beta, risk of a project refers to the contribution a project makes to the risk of the firm when the interactions between the cash flows of the project are considered in conjunction
A number of techniques can be used to analyze total project risk. These techniques includea. The net present value/payback approachb. The simulation analysis approachc. The sensitivity analysis
When considering the systematic risk of individual projects, the beta concept can be used to determine risk-adjusted discount rates for individual projects. P-698
The risk of an investment project is defined in terms of the potential variability of its returns. When only one return is possible—for example, as with U.S. government securities held to
A decision maker can adjust for total project risk in capital budgeting in several different ways, including the net present value/payback approach, simulation analysis, sensitivity analysis,
The simulation approach is the most expensive of the techniques discussed in this chapter; it is normally applied only when large projects are being analyzed. The widespread availability of
The risk-adjusted discount rate approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures. It requires that a risk premium be computed
When a project differs significantly in its systematic risk profile (as measured by beta) from the systematic risk of the total firm, a risk-adjusted discount rate appropriate for that project can be
The decision to employ some risk analysis technique to evaluate an investment project depends on the project’s size and the additional cost of applying such a technique as compared with the
How does the basic net present value model of capital budgeting deal with the problem of project risk? What are the shortcomings of this approach? P-698
How would you define risk as it is used in a capital budgeting analysis context? P-698
Recalling the discussion in Chapter 8, when is the standard deviation of a project’s cash flows an appropriate measure of project risk? When is the coefficient of variation an appropriate measure?
How does the basic net present value capital budgeting model deal with the phenomenon of increasing risk of project cash flows over time? P-698
When should a firm consider the portfolio effects of a new project? P-698
What are the primary advantages and disadvantages of applying simulation to capital budgeting risk analysis? P-698
Describe how certainty equivalent cash flow estimates can be derived for individual project cash flows. P-698
Will all individuals apply the same certainty equivalent estimates to the cash flows from a project? Why or why not? P-698
Lehigh Products Company is considering the purchase of new automated equipment. The project has an expected net present value of $250,000 with a standard deviation of $100,000. What is the
The Jacobs Company is financed entirely with equity. The beta for Jacobs has been estimated to be 1.0. The current risk-free rate is 10 percent and the expected market return is 15 percent.a. What
Homer Stores is considering a new location that is expected to yield the following net cash flows following an initial (year 0), certain outlay (NINV) of $75,000: P-698
Mitchell Auto Parts, Inc., has estimated the probability distribution of its annual net cash flows as follows:a. Compute the expected annual cash flow.b. Compute the standard deviation of annual cash
Two projects have the following expected net present values and standard deviations of net present values:Project Expected Net Present Value Standard Deviation A $50,000 $20,000 B 10,000 7,000a.
Valley Products, Inc. is considering two independent investments having the following cash flow streams:Year Project A Project B 0 $50,000 $40,000 1 þ20,000 þ20,000 2 þ20,000 þ10,000 3 þ10,000
The Seminole Production Company is analyzing the investment in a new line of business machines. The initial outlay required is $35 million. The net cash flows expected from the investment are as
Project Alpha offers the following net cash flows following an initial (year 0), certain outlay (NINV) of $70,000:Year Net Cash Flow Certainty Equivalent Factor 1 $30,000 0.91 2 30,000 0.79 3 30,000
A new project is expected to have an 8-year economic life. The project will have an initial cost of $100,000. Installation and shipping charges for the equipment are estimated at $10,000. The
You have estimated the expected NPV from a project to be $3 million with a standard deviation of $4 million. The distribution of the possible NPVs is approximately normal. If you are willing to
Albright Properties, Inc., (API) has three divisions:Division Beta Proportion of Firm’s Assets Property management 1.1 40%Land resources 1.6 30 Financial services — 30 The leveraged beta for API
The Carthage Sceptre Corporation is evaluating a possible investment in a new regional distribution warehouse. A careful evaluation of the anticipated net cash flows and net investment expected from
Use the sensitivity-analysis calculator maintained by CCH to perform a cash flow sensitivity-analysis of a firm or project (http://www.toolkit.cch.com/tools/cfsens_ m.asp). Q-698
Boris’ Bucket Work. 29.Boris’ Bucket Works, Inc. (BBW) is the maker of new “easy spill” buckets. These buckets have quickly gained market share and now control 90 percent of the spillable
Compute the net investment required to establish the collection subsidiary. Q-698
Compute the annual net cash flows over the 10-year life of the project. Q-698
Compute the net present value of this project assuming it is an average-risk investment. Q-698
Should ZeeBancorp invest in the new subsidiary? Q-698
ZeeBancorp requires all expansion projects such as this to have a payback of four years or less. Under these conditions, should ZeeBancorp invest in the new subsidiary? Q-698
If management decides that this project has above-average risk and hence the required return is 20 percent, should the investment be made? Q-698
If collections are only 80 percent of projections and the required return is 20 percent, should the investment be made? Q-698
If operating (excluding depreciation) and lease expenses are expected to increase at an annual rate of 13 percent, should the collection subsidiary be established, assuming a required return of 20
Commercial Hydronics is considering replacing one of its larger control devices.A new unit sells for $29,000 (delivered). An additional $3,000 will be needed to install the device. The new device has
At the end of year 3, L-S will have a net cash outflow of$17 million to cover the cost of closing the mine and reclaiming the land.a. Calculate the net present value of the strip mine if the cost of
The L-S Mining Company is planning to open a new strip mine in western Pennsylvania. The net investment required to open the mine is $10 million. Net cash flows are expected to be þ$20 million at
A junior executive is fed up with the operating policies of his boss. Before leaving the office of his angered superior, the young man suggests that a well-trained monkey could handle the trivia
Two mutually exclusive projects (G and H) have the following expected cash flows:b. Calculate the net present value for each project, assuming the firm’s weighted cost of capital is 12 percent.c.
Calculate the internal rate of return and profitability index for a project that is expected to generate eight years of annual net cash flows of $75,000. The project has a net investment of $360,000
Calculate the net present value of a project with a net investment of $20,000 for equipment and an additional net working capital investment of $5,000 at time 0.The project is expected to generate
What are the primary types of real options in capital budgeting? Give examples of each type. GT=75
What effect would you expect the use of MACRS depreciation rules to have on the acceptability of a project having a 10-year economic life but a 7-year MACRS classification? GT=75
What major problems can you foresee in applying capital budgeting techniques to investments made by public sector and not-for-profit enterprises or organizations? GT=75
What is the likely effect of inflation on the level of capital expenditures made by private firms? What must the financial manager do to ensure that a firm’s capital budgeting procedures will be
What are the primary objectives of the investment project postaudit review? GT=75
What are the primary strengths and weaknesses of the payback approach in capital budgeting? GT=75
Describe how the profitability index approach may be used by a firm faced with a capital rationing investment funds constraint. GT=75
When is it possible for the net present value and the internal rate of return approaches to give conflicting rankings of mutually exclusive investment projects? GT=75
How does the net present value model complement the objective of maximizing shareholder wealth? GT=75
Financial managers must be aware that using conventional discounted cash flow techniques in capital budgeting without considering real options results in a downward-biased estimate of the true value
The net present value and internal rate of return approaches normally yield the same accept/reject decisions for a particular project. However, conflicts may arise when dealing with mutually
The internal rate of return of a project is the discount rate that gives the project a net present value equal to zero. GT=75
The profitability index is the ratio of the present value of net cash flows to the net investment. It gives a measure of the relative present value return per dollar of initial investment. The
The net present value is calculated by subtracting a project’s net investment from the expected net cash flows discounted at the firm’s cost of capital. GT=75
The net present value of an investment made by a firm represents the contribution of the investment to the value of the firm and, accordingly, to the wealth of shareholders. GT=75
The effects of inflation in capital budgeting analysis? GT=75
The relative merits and limitations of the different capital budgeting evaluation methods. GT=75
Several widely used capital budgeting evaluation methods. GT=75
For international projects, the present value of a project’s net cash flows to the parent company is equal to the present value of the project’s net cash flows from the foreign company converted
The use of conventional discounted cash flow techniques in capital budgeting without considering“real” options may result in a downward-biased estimate of the true value of a project’s net
Project post-audits and reviews can assist management in uncovering biases in the project analysis procedure of a firm, and can assist management in making abandonment decisions. GT=75
The payback period of an investment is the period of time required for the cumulative cash inflows (net cash flows) from a project to equal the initial cash outlay.a. Weaknesses of the payback method
The internal rate of return (IRR) is defined as the discount rate that equates the present value of the expected net cash flows from a project with the present value of the net investment.a. A
The profitability index (PI) is the ratio of the preset value of expected net cash flows over the life of the project to the net investment.a. If the project has a PI equal to or greater than 1.0, it
The net present value of an investment project is defined as the present value of the stream of expected net cash flows from the project minus the project’s net investment.a. A project is
Risk represents the variability of possible future returns from an investment. Risk tends to increase as one looks farther into the future. P=74
Capital budgeting is the process of planning for purchases of assets whose cash flows are expected to continue beyond one year. P=857
The cost of capital is defined as the cost of funds supplied to a firm. It represents the required rate of return a firm must earn on its investments and thus is an important input in the capital
There are four key steps in the capital budgeting process:a. Generating investment project proposalsb. Estimating cash flowsc. Evaluating alternatives and selecting projects to be implementedd.
Investment projects can be generated by growth opportunities, by cost reduction opportunities, and to meet legal requirements and health and safety standards. P=857
The initial outlay required to implement a project is called the net investment. It includesa. The installed cost of the assetsb. Plus any initial net working capital requirementsc. Less any cash
The net operating cash flow from a project is equal to the change in net operating earnings after tax plus the change in depreciation minus the change in net working capital investment requirements
The economic viability of a project can be affected by special tax considerations, such as the use of accelerated depreciation methods like the Modified Accelerated Cost Recovery System (MACRS) of
The principles of estimating cash flows and their application P=857
The identification and estimation of net investment and net cash flows? P=857
The effect of accelerated depreciation on net cash flow estimates? P=857
Capital budgeting is the process of planning for purchases of assets whose returns are expected to continue beyond one year. P=857
Projects may be classified as independent, mutually exclusive, or contingent. The acceptance of an independent project does not directly eliminate other projects from consideration; the acceptance of
There are four basic steps in the capital budgeting process: the generation of proposals, the estimation of cash flows, the evaluation and selection of alternatives, and the post-audit or review.
Project cash flows should be measured on an incremental after-tax basis and should include all the indirect effects the project will have on the firm. P=857
Resources of a firm used in an investment project should be valued at their opportunity cost based upon the cash flows these resources could generate in their next-best alternative use. P=857
Sunk costs represent outlays that have already been made or committed and that cannot be recovered.Sunk costs should not be considered when evaluating an investment project. P=857
The net investment (NINV) in a project is the net cash outlay required to place the project in service. It includes the project cost plus any necessary increases in initial net working capital minus
Discuss how capital budgeting procedures might be used by each of the following: P=857a. Personnel managersb. Research and development staffsc. Advertising executives
What is a mutually exclusive investment project? An independent project? P=857 A contingent project? Give an example of each.
What effect does capital rationing have on a firm’s ability to maximize shareholder wealth? P=857

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