1. For a typical firm, which of the following is correct? All rates are after taxes, and assume the firm operates at its target capital structure. (rd= rate on debt; re= rate on equity (ROE), rs= rate on company’s stock, WACC= weighted average cost of capital)

(Points : 4)

rd > re > rs > WACC.

rs > re > rd > WACC.

WACC > re > rs > rd.

re > rs > WACC > rd.

WACC > rd > rs > re.

2. You were hired as a consultant to Keys Company, and you were provided with the following data: Target capital structure: 40% debt, 10% preferred, and 50% common equity. The after-tax cost of debt is 4.00%, the cost of preferred is 7.50%, and the cost of retained earnings is 11.50%. The firm will not be issuing any new stock. What is the firm’s WACC?

(Points : 4)

7.55%

7.73%

7.94%

8.10%

8.32%

= ( 0.4 × 4) + (0.10 × 7.5) + (0.40 × 11.50)

= 8.10%

3. Which of the following is not a capital component when calculating the weighted average cost of capital (WACC)?

(Points : 4)

Long-term debt.

Common stock.

Retained earnings.

Accounts payable.

Preferred stock.

4. Assume that you are a consultant to Morton Inc., and you have been provided with the following data: D1 = $1.00; P0 = $25.00; and g = 6% (constant). What is the cost of equity from retained earnings based on the DCF approach?

(Points : 4)

9.79%

9.86%

10.00%

10.20%

10.33%

5. To help finance a major expansion, Dimkoff Development Company sold a bond several years ago that now has 20 years to maturity. This bond has a 7% annual coupon, paid quarterly, and it now sells at a price of $1,103.58. The bond cannot be called and has a par value of $1,000. If Dimkoff’s tax rate is 40%, what component cost of debt should be used in the WACC calculation?

(Points : 4)

3.03%

3.28%

3.66%

3.85%

4.04%

6. Which of the following statements is CORRECT?

(Points : 4)

Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock.

When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.

When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

If a company’s beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company has does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock.

Higher flotation costs reduce investor returns, and that leads to a reduction in a company’s WACC.

7. For a company whose target capital structure calls for 50% debt and 50% common equity, which of the following statements is CORRECT?

(Points : 4)

The cost of equity is usually greater than or equal to the cost of debt.

The WACC exceeds the cost of equity.

The WACC is calculated on a before-tax basis.

The interest rate used to calculate the WACC is the average cost of all the debt the company has outstanding and shown on its balance sheet.

The cost of retained earnings typically exceeds the cost of new common stock.

8. Which of the following statements about the cost of capital is CORRECT?

(Points : 4)

A change in a company’s target capital structure cannot affect its WACC.

WACC calculations should be based on the before-tax costs of all the individual capital components.

If a company’s tax rate increases, then, all else equal, its weighted average cost of capital will decrease.

Flotation costs associated with issuing new common stock normally lead to a decrease in the WACC.

An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing.

9. Which of the following statements is CORRECT?

(Points : 4)

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.

All else equal, an increase in a company’s stock price will increase its marginal cost of retained earnings, rs.

All else equal, an increase in a company’s stock price will increase its marginal cost of new common equity, re.

Since the money is readily available, the after-tax cost of retained earnings is usually much lower than the after-tax cost of debt.

When calculating the cost of preferred stock, a company needs to adjust for taxes, because preferred stock dividends are tax deductible.

10. Thomson Electric Systems is considering a project that has the following cash flow and WACC data. What is the project’s NPV? Note that a project’s projected NPV can be negative, in which case it will be rejected. (cash flows are: -$1,000, $500, $500, $500 in periods 0, 1, 2, 3 respectively)

WACC = 10%

Year: 0 1 2 3

Cash flows: -$1,000 $500 $500 $500

(Points : 4)

$243.43

$221.30

$268.91

$272.46

$289.53

11. Blanchford Enterprises considering a project that has the following cash flow and WACC data. What is the project’s NPV? Note that a project’s projected NPV can be negative, in which case it will be rejected.

WACC = 10%

Year: 0 1 2 3 4

Cash flows: -$1,000 $475 $475 $475 $475

(Points : 4)

$482.16

$496.38

$505.69

$519.05

$459.71

12. Blanchford Enterprises is considering a project that has the following cash flow data. What is the project’s payback?

Year: 0 1 2 3

Cash flows: -$1,000 $500 $500 $500

(Points : 4)

1.50 years

1.75 years

2.00 years

2.25 years

2.50 years

13. Tapley Dental Associates is considering a project that has the following cash flow data. What is the project’s payback?

Year: 0 1 2 3 4 5

Cash flows: -$1,000 $300 $310 $320 $330 $340

(Points : 4)

2.11 years

2.50 years

2.71 years

3.05 years

3.21 years

14. Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?

(Points : 4)

The project’s IRR increases as the WACC declines.

The project’s NPV increases as the WACC declines.

The project’s MIRR is unaffected by changes in the WACC.

The project’s regular payback increases as the WACC declines.

The project’s discounted payback increases as the WACC declines.

15. Edison Electric Systems is considering a project that has the following cash flow and WACC data. What is the project’s NPV? Note that a project’s projected NPV can be negative, in which case it will be rejected.

WACC = 10%

Year: 0 1 2 3

Cash flows: -$1,000 $450 $460 $470

(Points : 4)

$142.37

$129.43

$166.51

$173.26

$189.94

16. Tapley Dental Associates is considering a project that has the following cash flow and WACC data. What is the project’s NPV? Note that a project’s projected NPV can be negative, in which case it will be rejected.

WACC = 10%

Year: 0 1 2 3 4 5

Cash flows: -$1,000 $300 $300 $300 $300 $300

(Points : 4)

$124.76

$123.15

$128.47

$131.96

$137.24

17. The Seattle Corporation has an investment opportunity that will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost $150,000 today, and the firm’s WACC is 10%. What is the payback period for this investment?

(Points : 4)

5.23 years

4.86 years

4.00 years

6.12 years

4.35 years

18. Which of the following statements is CORRECT? (Points : 4)

One defect of the IRR method is that it does not take account of cash flows over a project’s full life.

One defect of the IRR method is that it does not take account of the time value of money.

One defect of the IRR method is that it does consider the time value of money.

One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until some time in the future.

One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is rarely trun in the real world.

19. . Which of the following statements is CORRECT?

(Points : 4)

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.

The NPV method does not consider all relevant cash flows, particularly, cash flows beyond the payback period.

The IRR method does not consider all relevant cash flows, particularly, cash flows beyond the payback period.

20. 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.

(Points : 4)

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.

The lower the WACC used to calculate it, the lower the calculated NPV will be.

If a project’s NPV is less than zero, then its IRR must be less than the WACC.

If a project’s NPV is greater than zero, then its IRR must be less than zero.

The NPV of a relatively low risk project should be found using a relatively high WACC.

21. Which of the following statements is CORRECT?

(Points : 4)

The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

22. Which of the following statements is CORRECT?

(Points : 4)

If a project has “normal” cash flows, then its IRR must be positive.

If a project has “normal” cash flows, then its MIRR must be positive.

If a project has “normal” cash flows, then it will have exactly two real IRRs.

The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.

If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.

23. Which of the following statements is CORRECT?

(Points : 4)

Since debt capital is riskier than equity capital, the after-tax cost of debt is always greater than the WACC.

Because of the risk of bankruptcy, the cost of debt capital is always higher than the cost of equity capital.

If a company assigns the same cost of capital to all of its projects regardless of the project’s risk, then it follows that the company will tend to reject some safe projects that it actually should accept and accept some risky projects that it should reject.

Because companies’ flotation costs are not required to obtain capital as retained earnings, the cost of retained earnings is generally lower than the after-tax cost of debt.

Higher flotation costs tend to reduce the cost of equity capital.

24. Blanchford Enterprises is considering a project that has the following cash flow data. What is the project’s IRR? Note that a project’s projected IRR can be less than the WACC (and even negative), in which case it will be rejected.

Year: 0 1 2 3

Cash flows: -$1,000 $450 $450 $450

(Points : 4)

16.20%

16.65%

17.10%

17.55%

18.00%

25. 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.

(Points : 4)

If Project A has a higher IRR than Project B, then Project A must have the lower NPV.

If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC.

The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.

If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive.