Answers FOR FREE!

The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt.
Correct Answer: False

The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation's taxable income.
Correct Answer: False

The cost of common stock is the rate of return the marginal stockholder requires on the firm's common stock.
Correct Answer: True

For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital, i.e., use these funds first, because retained earnings have no cost to the firm.
Correct Answer: False

The cost of debt, rd, is normally less than rs, so rd(1 - T) will normally be less than rs. Therefore, as long as the firm is not completely debt financed, the weighted average cost of capital (WACC) will normally be greater than rd(1 - T).
Correct Answer: True

The lower the firm's tax rate, the lower will be its after-tax cost of debt and WACC, other things held constant.
Correct Answer: False

A firm should never undertake an investment if accepting the project would lead to an increase in the firm's cost of capital.
Correct Answer: False

Because "present value" refers to the value of cash flows that occur at different points in time, a series of present values should not be summed to determine the value of a capital budgeting project.
Correct Answer: False

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

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

In theory, any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity cost of capital. The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.
Correct Answer: True

When considering two mutually exclusive projects, the firm should always select that project with an internal rate of return that is higher, provided the projects have the same initial cost. This statement is true regardless of whether the projects can be repeated or not.
Correct Answer: True

Which of the following is NOT a cash flow and thus should not be reflected in the analysis of a capital budgeting project?
Correct Answer: Sunk costs that have been expensed for tax purposes.

Suppose Tapley Corporation uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Correct Answer: Project B, which has below-average risk and an IRR = 8.5%.

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in a capital budgeting analysis.
Correct Answer: False

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.
Correct Answer: True

A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s WACC. Which one of the following factors should the CFO include in the cash flows when estimating the relevant cash flows?
Correct Answer: The investment in working capital required to operate the project, even if that investment will be recovered at

Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
Correct Answer: The end-of-project recovery of any working capital required to operate the project.

Real options exist when managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows.
Correct Answer: True

Real options are options to buy real assets, like stocks, rather than interest-bearing assets, like bonds.
Correct Answer: False

The option to abandon a project is a real option, but a call option on a stock is not a real option.
Correct Answer: True

Real options are most valuable when the underlying source of risk is very low.
Correct Answer: False

Commodore Corporation is deciding whether to invest in a project today or to postpone the decision until next year. The project has a positive expected NPV, but its cash flows could be less than expected, in which case the NPV could be negative. No competitors are likely to invest in a similar project if Commodore decides to wait. Which of the following statements best describes the issues that Commodore faces when considering this investment timing option?
Correct Answer: Waiting would probably reduce the project’s risk.

If Diplomat goes ahead with this project today, it will obtain knowledge that will give rise to additional opportunities 5 years from now (at t = 5). The company can decide at t = 5 whether or not it wants to pursue these additional opportunities. Based on the best information available today, there is a 35% probability that the outlook will be favorable, in which case the future investment opportunity will have a net present value of $6 million at t = 5. There is a 65% probability that the outlook will be unfavorable, in which case the future investment opportunity will have a net present value of -$6 million at t = 5. Diplomat.com does not have to decide today whether it wants to pursue the additional opportunity. Instead, it can wait to see what the outlook is. However, the company cannot pursue the future opportunity unless it makes the $3 million investment today. What is the estimated net present value of the project, after consideration of the potential future opportunity?
Correct Answer: $199,328

Which of the following is NOT a key element in strategic planning as it is described in the text?
Correct Answer: The statement of cash flows.

Which of the following assumptions is embodied in the AFN formula forecasting method?
Correct Answer: Accounts payable and accruals are tied directly to sales.

Pro forma financial statements, as discussed in the text, are used primarily to assess a firm's historical performance.
Correct Answer: False

The first, and most critical step in constructing a set of pro forma financial statements is the sales forecast.
Correct Answer: True

Kamath-Meier Corporation's CFO uses this equation, which was developed by regressing inventories on sales over the past 5 years, to forecast inventory requirements: Inventories = $22.0 + 0.125(Sales). The company expects sales of $400 million during the current year, and it expects sales to grow by 30% next year. What is the inventory forecast for next year? All dollars are in millions.
Correct Answer: $87.0

Last year Godinho Corp. had $250 million of sales, and it had $75 million of fixed assets that were being operated at 80% of capacity. In millions, how large could sales have been if the company had operated at full capacity?
Correct Answer: $312.5

The corporate valuation model cannot be used unless a company doesn’t pay dividends.
Correct Answer: False

Free cash flows should be discounted at the firm’s weighted average cost of capital to find the value of its operations.
Correct Answer: True

Akyol Corporation is undergoing a restructuring, and its free cash flows are expected to be unstable during the next few years. However, FCF is expected to be $50 million in Year 5, i.e., FCF at t = 5 equals $50 million, and the FCF growth rate is expected to be constant at 6% beyond that point. If the weighted average cost of capital is 12%, what is the horizon value (in millions) at t = 5?
Correct Answer: $883

Simonyan Inc. forecasts a free cash flow of $40 million in Year 3, i.e., at t = 3, and it expects FCF to grow at a constant rate of 5% thereafter. If the weighted average cost of capital is 10% and the cost of equity is 15%, what is the horizon value, in millions at t = 3?
Correct Answer: $840

If a company’s expected return on invested capital is less than its cost of equity, then the company must also have a negative market value added (MVA).
Correct Answer: False

A poison pill is also known as a corporate restructuring.
Correct Answer: False

Different borrowers have different risks of bankruptcy, and bankruptcy is costly to lenders. Therefore, lenders charge higher rates to borrowers judged to be more at risk of going bankrupt.
A) True
B) False
Correct Answer: True

A firm's business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.
A) True
B) False
Correct Answer: False

Financial risk refers to the extra risk stockholders bear as a result of using debt as compared with the risk they would bear if no debt were used.
A) True
B) False
Correct Answer: True

As the text indicates, a firm's financial risk has identifiable market risk and diversifiable risk components.
A) True
B) False
Correct Answer: False

If debt financing is used, which of the following is CORRECT?
A) The percentage change in net operating income will be greater than a given percentage change in net income.
B) The percentage change in net operating income will be equal to a given percentage change in net income.
C) The percentage change in net income relative to the percentage change in net operating income will depend on the interest rate charged on debt.
D) The percentage change in net income will be greater than the percentage change in net operating income.
E) The percentage change in sales will be greater than the percentage change in EBIT, which, in turn, will be greater than the percentage change in net income.
Correct Answer: D

Which of the following statements is CORRECT, holding other things constant?
A) Firms whose assets are relatively liquid tend to have relatively low bankruptcy costs, hence they tend to use relatively little debt.
B) An increase in the personal tax rate is likely to increase the debt ratio of the average corporation.
C) If changes in the bankruptcy code make bankruptcy less costly to corporations, then this would likely reduce the debt ratio of the average corporation.
D) An increase in the company’s degree of operating leverage is likely to encourage a company to use more debt in its capital structure.
E) An increase in the corporate tax rate is likely to encourage a company to use more debt in its capital structure.
Correct Answer: E

In a world with no taxes, MM show that a firm’s capital structure does not affect the firm’s value. However, when taxes are considered, MM show a positive relationship between debt and value, i.e., its value rises as its debt is increased.
A) True
B) False
Correct Answer: True

According to MM, in a world without taxes the optimal capital structure for a firm is approximately 100% debt financing.
A) True
B) False
Correct Answer: False

MM showed that in a world with taxes, a firm’s optimal capital structure would be almost 100% debt.
A) True
B) False
Correct Answer: True

MM showed that in a world without taxes, a firm’s value is not affected by its capital structure.
A) True
B) False
Correct Answer: True

The major contribution of the Miller model is that it demonstrates that:
A) personal taxes increase the value of using corporate debt.
B) personal taxes decrease the value of using corporate debt.
C) financial distress and agency costs reduce the value of using corporate debt.
D) equity costs increase with financial leverage.
E) debt costs increase with financial leverage.
Correct Answer: B

Which of the following statements concerning capital structure theory is NOT CORRECT?
A) The major contribution of Miller's theory is that it demonstrates that personal taxes decrease the value of using corporate debt.
B) Under MM with zero taxes, financial leverage has no effect on a firm’s value.
C) Under MM with corporate taxes, the value of a levered firm exceeds the value of the unlevered firm by the product of the tax rate times the market value dollar amount of debt.
D) Under MM with corporate taxes, rs increases with leverage, and this increase exactly offsets the tax benefits of debt financing.
E) Under MM with corporate taxes, the effect of business risk is automatically incorporated because rsL is a function of rsU.
Correct Answer: D

Brammer Corp.'s projected capital budget is $1,000,000, its target capital structure is 60% debt and 40% equity, and its forecasted net income is $550,000. If the company follows a residual dividend policy, what total dividends, if any, will it pay out?
A) $122,176
B) $128,606
C) $135,375
D) $142,500
E) $150,000
Correct Answer: E

Blease Inc. has a capital budget of $625,000, and it wants to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $475,000. If it follows the residual dividend policy, what is its forecasted dividend payout ratio?
A) 40.61%
B) 42.75%
C) 45.00%
D) 47.37%
E) 49.74%
Correct Answer: D

P&D Co. has a capital budget of $1,000,000. The company wants to maintain a target capital structure which is 30% debt and 70% equity. The company forecasts that its net income this year will be $800,000. If the company follows a residual dividend policy, what will be its total dividend payment?
A) $100,000
B) $200,000
C) $300,000
D) $400,000
E) $500,000
Correct Answer: A

D&P Co. has a capital budget of $2,000,000. The company wants to maintain a target capital structure that is 35% debt and 65% equity. The company forecasts that its net income this year will be $1,800,000. If the company follows a residual dividend policy, what will be its total dividend payment?
A) $100,000
B) $200,000
C) $300,000
D) $400,000
E) $500,000
Correct Answer: E

Underlying the dividend irrelevance theory proposed by Miller and Modigliani is their argument that the value of the firm is determined only by its basic earning power and its business risk.
A) True
B) False
Correct Answer: True

One implication of the bird-in-the-hand theory of dividends is that a given reduction in dividend yield must be offset by a more than proportionate increase in growth in order to keep a firm's required return constant, other things held constant.
A) True
B) False
Correct Answer: True

The cost of meeting SEC and possibly additional state reporting requirements regarding disclosure of financial information, the danger of losing control, and the possibility of an inactive market and an attendant low stock price are potential disadvantages of going public.
A) True
B) False
Correct Answer: True

The term “leaving money on the table” refers to the situation where an investment banking house makes a very low bid for the right to underwrite a firm’s new stock offering. The banker is, in effect, “buying the job” with the low bid and thus not getting all the money his firm would normally earn on the job.
A) True
B) False
Correct Answer: False

The term “equity carve-out” refers to the situation where a firm’s managers give themselves the right to purchase new stock at a price far below the going market price. Since this dilutes the value of the public stockholders, it “carves out” some of their value.
A) True
B) False
Correct Answer: False

Suppose a company issued 30-year bonds 4 years ago, when the yield curve was inverted. Since then long-term rates (10 years or longer) have remained constant, but the yield curve has resumed its normal upward slope. Under such conditions, a bond refunding would almost certainly be profitable.
A) True
B) False
Correct Answer: False

Which of the following is generally NOT true and an advantage of going public?
A) Facilitates stockholder diversification.
B) Increases the liquidity of the firm's stock.
C) Makes it easier to obtain new equity capital.
D) Establishes a market value for the firm.
E) Makes it easier for owner-managers to engage in profitable self-dealings.
Correct Answer: E

Which of the following statements about listing on a stock exchange is most CORRECT?
A) Listing is a decision of more significance to a firm than going public.
B) Any firm can be listed on the NYSE as long as it pays the listing fee.
C) Listing provides a company with some "free" advertising, and it may enhance the firm's prestige and help it do more business.
D) Listing reduces the reporting requirements for firms, because listed firms file reports with the exchange rather than with the SEC.
E) The OTC is the second largest market for listed stock, and it is exceeded only by the NYSE.
Correct Answer: C