Exam 3

Q1. Adventure Outfitter Corp. can sell common stock for $27 per share and its investors require a 17% return. However, the administrative or flotation costs associated with selling the stock amount to $2.70 per share. What is the cost of capital for Adventure Outfitter if the corporation raises money by selling common stock?

a. 27.00%

b. 18.89%

c. 18.33%

d. 17.00%

Q2. WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been growing rapidly over the past several years, selling common stock in each year to finance its growth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. WineCellars weighted average cost of capital this year should be

a. zero, since no new stock will be sold.

b. less than 12%.

c. equal to 12%.

d. greater than 12%.

Q3. JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold?

a. $7.5 million

b. $12.0 million

c. $15.5 million

d. $16.0 million

Q4. Why should firms that own and operate multiple businesses that have different risk characteristics use business-specific, or divisional costs of capital?

a. Not all divisions have equal risk and the firm might accept projects whose returns are higher than are deemed appropriate.

b. Not all business divisions have equal risk and the firm will likely become less risky in the future.

c. Not all lines of business have equal risk and it is likely that the firm will accept projects whose returns are unacceptably low in relation to the risk involved.

d. Use of the same weighted average cost of capital for all divisions may result in too much money being allocated to the least risky division.

Q5. All else equal, an increase in beta results in

a. an increase in the cost of retained earnings.

b. an increase in the cost of newly issued common stock .

c. an increase in the after-tax cost of debt.

d. an increase in the cost of common equity, whether or not the funds come from retained earnings or newly issued common stock.

Q6. A firm's cost of capital is influenced by

a. the current ratio.

b. par value of common stock.

c. capital structure.

d. net income.

Q7. GHJ Inc. is investing in a major capital budgeting project that will require the expenditure of $16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred stock, and $10 million of new common stock. The company estimates is after-tax cost of debt to be 7%, its cost of preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost of new common stock to be 17%. What is the weighted average cost of capital for this project?

a. 12.20%

b. 13.12%

c. 13.75%

d. 14.23%

Q8. Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock. What is the cost of internal common equity (retained earnings) if the long-term growth in dividends is projected to be 8 percent indefinitely?

a. 13 percent

b. 14 percent

c. 15 percent

d. 16 percent

Q9. Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of 14 percent. Both projects have a required return of 12 percent. Which of the following statements is MOST correct?

a. Both projects have a positive net present value (NPV).

b. Project Alpha must have a higher NPV than Project Beta.

c. If the required return were less than 12 percent, Project Beta would have a higher IRR than Project Alpha.

d. Project Beta has a higher profitability index than Project Alpha.

Q10. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. Which project would you recommend using the replacement chain method to evaluate the projects with different lives?

a. Project B because its NPV is higher than Project A's replacement chain NPV of $47,623

b. Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project B

c. Project A because its replacement chain NPV is $45,642, which is less than the NPV for Project B

d. Both projects will be valued the same since they are now both four year projects.

Q11. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The profitability index for Project A is

a. 1.27.

b. 1.22.

c. 1.17.

d. 1.12.

Q12. Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return?

a. 19.88%

b. 22.69%

c. 24.78%

d. 26.12%

Q13. Your company is considering an investment in one of two mutually exclusive projects. Project one involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with expected after tax cash flows of $500 per year in years 1-5. Project two involves a capital intensive process, requiring an initial outlay of $6,704. After tax cash flows for Project 2 are expected to be $2,000 per year for years 1-5. Your firm's discount rate is 10%. If your company is not subject to capital rationing, which project(s) should you take on?

a. Project 1

b. Project 2

c. Projects 1 and 2

d. Neither project is acceptable.

Q14. For the net present value (NPV) criteria, a project is acceptable if NPV is ________, while for the profitability index a project is acceptable if PI is ________.

a. greater than zero; greater than the required return

b. greater than or equal to zero; greater than zero

c. greater than one; greater than or equal to one

d. greater than or equal to zero; greater than or equal to one

Q15. Two projects that have the same cost and the same expected cash flows will have the same net present value.

a. True

b. False

Q16. The capital budgeting decision-making process involves measuring the incremental cash flows of an investment proposal and evaluating the attractiveness of these cash flows relative to the project's cost.

a. True

b. False

Q17. J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. Which of the following statements concerning the change in working capital is most accurate?

a. The $4,000 paid for oil is added to the initial outlay, offset by the tax savings $1600.

b. The $4,000 may be expensed each year over the life of the project as part of the incremental free cash flows.

c. The $4,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR.

d. Even if the $4,000 is fully recovered at the end of the project, the project's NPV and IRR will be lower if the change in working capital is included in the analysis.

Q18. A new project is expected to generate $800,000 in revenues, $250,000 in cash operating expenses, and depreciation expense of $150,000 in each year of its 10-year life. The corporation's tax rate is 35%. The project will require an increase in net working capital of $85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the free cash flow from the project in year one?

a. $298,000

b. $375,000

c. $380,000

d. $410,000

Q19. A local restaurant owner is considering expanding into another rural area. The expansion project will be financed through a line of credit with City Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy an existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include

a. $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent.

b. $500 administrative costs, $2,500 per month rent.

c. $1,000 per month interest payments, $2,500 per month rent.

d. $2,500 per month rent.

Q20. If depreciation expense in year one of a project increases for a highly profitable company

a. net income decreases and incremental free cash flow decreases.

b. net income increases and incremental free cash flow increases.

c. the book value of the depreciating asset increases at the end of year one.

d. net income decreases and incremental free cash flow increases.

Q21. An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project. The company has a tax rate of 30%. This transaction will have what impact on the project's initial outlay?

a. reduce it by $20,000

b. reduce it by $50,000

c. reduce it by $6,000

d. reduce it by $15,000

Q22. Tillamook Farms invests in a new kind of frozen dessert called polar cream that becomes very popular. So many new customers come to the store that the sales of existing ice cream products are increased. The extra sales revenue

a. should not be counted as incremental revenue for the polar cream project because the sales come from existing products.

b. are synergistic effects that should be counted as incremental revenues for the polar cream project.

c. are cannibalized sales that should be excluded from the analysis.

d. should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring expense.

Q23. You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your company's net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the terminal cash flow for this project?

a. $17,000

b. $24,500

c. $33,950

d. $37,950

Q24. Which of the following should be excluded in an analysis of a new project's cash flows?

a. additional investment in fixed assets

b. additional investment in accounts receivable

c. additional investment in inventory

d. additional interest expenses on debt financing

Q25. Financial leverage could mean financing some of a firm's assets with

a. preferred stock.

b. retained earnings.

c. private equity capital.

d. sales revenues.

Q26. The "threat hypothesis"

a. reduces management's tendency to spend freely.

b. encourages management to use debt to further their own interests.

c. increases the agency problem.

d. increases agency monitoring costs.

Q27. Corporations utilize external financing either because they do not have sufficient earnings to reinvest or they want to rebalance their capital structures.

a. True

b. False

Q28. Which of the following transactions will lower a company's financial leverage?

a. A mortgage loan is obtained and the proceeds are used to pay off existing short-term debt.

b. Preferred stock is sold and the proceeds are used to pay off existing short-term debt.

c. Common stock is sold and the proceeds are used to pay off existing short-term debt.

d. Short-term debt is obtained to get the company through a period of negative net income and cash flow.

Q29. Kohler Manufacturing typically achieves one of three production levels in any given year: 8 million pounds of steel, 10 million pounds of steel, or 16 million pounds of steel. In tracking some of its costs, Kohler's controller discovered one cost that was $10 per pound at a production level of 8 million pounds, $8 per pound at a production level of 10 million pounds, and $5 per pound at a production level of 16 million pounds. This is an example of a

a. variable cost.

b. fixed cost.

c. semivariable cost.

d. semifixed cost.

Q30. Operating leverage refers to

a. financing a portion of the firm's assets with securities bearing a fixed rate of return.

b. the additional chance of insolvency borne by the common shareholder.

c. the incurrence of fixed operating costs in the firm's income stream.

d. a high degree of variable costs of production.

Q31. Which of the following statements about combined (operating & financial) leverage is true?

a. If a firm employs both operating and financial leverage, any percent change in sales will produce a larger percent change in earnings per share.

b. A firm that is in a capital-intensive industry should use a higher level of financial leverage than a firm that employs low levels of operating leverage.

c. Usage of both operating and financial leverage reduces a firm's risk.

d. High operating leverage and high financial leverage offset one another, meaning that if sales increase by 10%, then EPS will also increase by 10%.

Q32. QuadCity Manufacturing, Inc. reported the following items: Sales = $6,000,000; Variable Costs of Production = $1,500,000; Variable Selling and Administrative Expenses = $550,000; Fixed Costs = $1,350,000; EBIT = $2,600,000; and the Marginal Tax Rate %. QuadCity's break-even point in sales dollars is

a. $2,050,633.

b. $2,197,500.

c. $2,438,750.

d. $2,785,000.

Q33. According to the clientele effect

a. companies should have dividend payout ratios of either 100% or 0%.

b. companies should avoid making capricious changes in their dividend policies.

c. companies should change their dividend policies to please their target group of investors.

d. even if capital markets are perfect, dividend policy still matters.

Q34. The residual dividend theory suggests that dividends will only be paid

a. if the tax rate on capital gains is higher than the tax rate on dividends.

b. if the corporation has more positive NPV projects than it can fund.

c. if interest rates available to shareholders are higher than the required return on the company's stock.

d. if current retained earnings exceed the equity portion of the firm's capital budget.

Q35. Assume that a firm has a steady record of paying high dividends for years. A new management team decided to cut the current year's dividend in half without disclosing why. The market value of the stock fell 35% on the day the dividend cut was announced. Which of the following would best explain the stock market's reaction to the announcement?

a. empirical theory

b. dividend irrelevance theory

c. residual dividend theory

d. information effect

Q36. AFB, Inc.'s dividend policy is to maintain a constant payout ratio. This year AFB, Inc. paid out a total of $2 million in dividends. Next year, AFB, Inc.'s sales and earnings per share are expected to increase. Dividend payments are expected to

a. remain at $2 million.

b. increase above $2 million.

c. decrease below $2 million.

d. increase above $2 million only if the company issues additional shares of common stock.

Q37. A firm's dividend payout ratio is

a. the ratio of dividends to sales.

b. the ratio of dividends to market equity.

c. the ratio of dividends to earnings.

d. the ratio of dividends to book equity.

Q38. Grainery Distillers, Inc. is experiencing high demand for its products and high growth rates. The company just reported earnings per share of $5 for the most recent year and has many positive NPV projects to fund. One vice president wants to pay a dividend of $5 per share, arguing that this will maximize shareholder value. You argue that a much smaller dividend will maximize value. Your argument may be based on

a. the bird-in-the-hand theory.

b. the residual dividend theory.

c. the information effect.

d. the very high agency costs of the corporation.

Q39. A firm that maintains a "stable dollar dividend per share" will generally not increase the dividend unless

a. a stock split occurs.

b. the firm merges with another profitable firm.

c. the firm is sure that a higher dividend level can be maintained.

d. the P/E ratio has increased steadily over the past 5 years.

Q40. Concentric Corporation has 10 million shares of stock outstanding. Concentric's after-tax profits are $140 million and the corporation's stock is selling at a price-earnings multiple of 18, for a stock price of $252 per share. Concentric's management issues a 40% stock dividend. What is the effect on an investor who owns 100 shares of Concentric before the dividend if Concentric's price-earnings multiple remains the same after the dividend is paid?

a. The investor will own 140 shares worth $25,200.

b. The investor will own 140 shares worth $35,280.

c. The investor will own 100 shares worth $25,200.

d. The investor will own 100 shares worth $35,280.