Question
1. Zeta Inc.s cost of capital is 12% and the risk-free rate is 5%. It plans to invest in a new project. The cash flow
1. Zeta Inc.s cost of capital is 12% and the risk-free rate is 5%. It plans to invest in a new project. The cash flow projections ($000) for the project are given below. Calculate the difference in the traditional NPV and the certainty equivalent NPV.
Year | 0 | 1 | 2 | 3 | 4 |
Cash Flow | -240 | 75 | 75 | 75 | 75 |
CE factor | 1 | 0.9 | 0.85 | 0.8 | 0.75 |
a. | $9.43 | |
b. | $30.35 | |
c. | $20.92 | |
d. | $7.59 |
2. If a project comes with its own funding offered at a rate lower than the cost of capital, the capital budgeting analysis should be conducted using:
a. | the cost of capital because to do otherwise would be unfair to departments whose projects don't happen to have separate funding. | |
b. | an average of the offered rate and the cost of capital because that gives the best measure of the effect of the offer on the firm. | |
c. | the offered rate because it is appropriate to match sources and uses of funding whenever possible. | |
d. | the cost of capital because doing otherwise leads to irrational capital budgeting decisions. |
3. Projects with IRRs above the intersection of the IOS and MCC:
a. | should be accepted. | |
b. | should be rejected. | |
c. | have returns greater than the cost of financing. | |
d. | Both a & c |
4. Which of the following statements about the marginal cost of capital (MCC) and the investment opportunity schedule (IOS) is incorrect?
a. | A company's WACC for the planning period is at the intersection of the MCC and the IOS. | |
b. | The MCC will break when low cost debt runs out and is replaced with higher cost debt. | |
c. | The IOS ranks projects from highest to lowest according to their individual NPV's. | |
d. | A break in the MCC may occur because of the floatation costs associated with issuing new stock. | |
e. | All of the above statements are correct. |
5. Which of the following is NOT true regarding the marginal cost of capital (MCC)?
a. | Breaks when common stock is exhausted | |
b. | Is a graph of the WACC | |
c. | Represents the cost of the next dollar raised | |
d. | Increases due to flotation costs |
6. The first break in the MCC usually occurs because:
a. | equity capital is more expensive when raised from outside sources. | |
b. | debt costs more as more is raised because the firm appears riskier to investors. | |
c. | it becomes impossible to sell more preferred stock. | |
d. | the firm runs out of money. |
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