Finance-QA342

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I. Project Valuation
 

1. Which of the following statements concerning the principles underlying the capital
budgeting process is most accurate?
 
a) Cash flows should be based on opportunity costs
b) Financing costs should be reflected in a project’s incremental cash flows
c) The net income for a project is essential for making a correct capital budgeting
decision
 
2. Which of the following statements about the payback period method is least accurate?
The payback period
 
a) Provides a rough measure of a project’s liquidity
b) Considers all cash flows throughout the entire life of a project
c) Is the number of years it takes to recover the original cost of the investment
 
3. Which of the following statements about NPV and IRR is least accurate?
 
a) The IRR is the discount rate that equates the present value of the cash inflows with the
present value of outflows
 
b) For mutually exclusive projects, if the NPV method and the IRR method give conflicting rankings, the analyst use the IRRs to select the project
 
c) The NPV method assumes that cash flows will be reinvested at the cost of capital,while IRR ranking implicitly assume that cash flows are reinvested at the IRR
 
4. Which of the following statements about NPV and IRR is least accurate?
 
a) The IRR can be positive even if the NPV is negative
b) When the IRR is equal to the cost of capital, the NPV will be zero
c) The NPV will be positive if the IRR is less than the cost of capital
 
5. Henke Malfoy is an analyst with a major manufacturing firm. Currently, he is evaluating the replacement of some production equipment. The old machine is still functional and could continue to serve in its current capacity for three more years. If the new equipment is purchased, the old equipment (which is currently depreciated) can be sold for USD50,000. The new equipment will cost USD400,000, including shipping and installation. If the new equipment is purchased, the company’s revenues will increase by
USD175,000 and the costs by USD25,000 for each year of the equipment’s 3-year life.
 
There is no expected change in net working capital.
 
The new machine will be depreciated using a 3-year MACRS schedule (note: the 3-year MACRS schedule is 33% in the first year, 45% in the second year, and 15% in the third year, and 7% in the fourth year). At the end of the life of the new equipment (i.e. in three
years), Malfoy expects that it can be sold for USD10,000. The firm has a marginal tax rate of 40%, and the cost of capital on this project is 20%. In calculation of tax liabilities, Malfoy assumes that the firm is profitable, so any losses on this project can be offset against profits elsewhere in the firm. Malfoy calculates a project NPV of -USD62,574.
 
5.1. The initial outlay for the project is closest to
 
a) USD350,000
b) USD370,000
c) USD400,000
 
5.2. The after-tax operating cash flow for the first year of operations with the new
equipment (excluding the initial outlay) is closest to
 
a) USD10,800
b) USD132,000
c) USD142,800
 
5.3. What is the effect of taxes on the operating cash flow in year 2?
 
a) Decrease by USD7,200
b) Increase by USD7,200
c) Increase by USD12,000
 
5.4. The combined after-tax operating cash flow and terminal year after-tax nonoperating
cash flow in year 3 is closest to
 
a) USD131,200
b) USD151,200
c) USD152,200
 
5.5. Suppose for this question only that Malfoy has forgotten to reflect a decrease in
inventory that will result at the beginning of the project. The most likely effect on
estimated project NPV of this error
 
a) Is to overestimate NPV
b) Is to underestimate NPV
c) Depends on whether t
he inventory is assumed to build back up to its previous
level at the end of project or the decrease in inventory is permanent.

 
5.6. What it IRR based on Malfoy’s NPV estimate, and should the project be accepted or
rejected in order to maximize shareholder value?
 
IRR Project
a) 8.8% Accept
b) 8.8% Reject
c) 21.5% Accept
 
II.Cost of Capital
 
6. A company has USD5 million in debt outstanding with a coupon rate of 12%. Currently the yield to maturity (YTM) on these bonds is 14%. If the firm’s tax rate is 40%, what is the company’s after-tax cost of debt?
 
a) 5.6%
b) 8.4%
c) 14%
 
7. An analyst gathered the following data about a company
 
Capital structure Required rate of return
 
a) 30% debt 10% for debt
b) 20% preferred stock 11% for preferred stock
c) 50% common stock 18% for common stock
 
Assuming a 40% tax rate, what after-tax rate of return must the company earn on its
investments?
 
a) 13%
b) 14.2%
c) 18%
 
8. A company is planning a USD50 million expansion. The expansion is to be financed by selling USD20 million in new debt and USD30 million in new common equity. The before-tax required return on debt is 9%, and 14% for equity. If the company is in the 40%
tax bracket, the company’s marginal cost of capital is closest to
 
a) 7.2%
b) 10.6%
c) 12%
 
9. Derek Ramsey is an analyst with Bullseye Corporation, a major U.S.-based discount retailer. Bullseye is considering opening new stores in Brazil and wants to estimate its cost of equity capital for this investment. Ramsey has found that
 
•The yield on a Brazilian government 10-year U.S. dollar-denominated bond is
7.2%
•A 10-year U.S. Treasury bond has a yield of 4.9%
•The annualized standard deviation of the Sao Paulo Bovespa stock index in the
most recent year is 24%
•The annualized standard deviation of Brazil’s U.S. dollar denominated 10-year
government bond over the last year was 18%
•The appropriate beta to use for the project is 1.3
•The market risk premium is 6%
•The risk-free interest rate is 4.5%
Which of the following choices is closest to the appropriate country risk premium for Brazil
and the cost of equity that Ramsey should use in his analysis?
 
Country risk premium Cost of equity for project
a) 2.5% 15.6%
b) 2.5% 16.3%
c) 3.1% 16.3%
 
III. Financial Statement Analysis
 
10. Which of the following would least likely be included in the Management Discussion and Analysis (MD&A) portion of the financial statements?
 
a) Outlook for future results based on known trends
b) Discussion of depreciation methods or changes in method
c) Information about expected capital expenditures and events with liquidity
implications

 
11. Train Company paid USD8 million to acquire a franchise at the beginning o 20X5 that was expensed in 20X5. If Train had elected to capitalize the franchise as an intangible asset and amortize the cost of the franchise over eight years, what effect would this
decision have on Train’s 20X5 cash flow from operations (CFO) and 20X6 debt –toassets- ratio?
 
a) Both would be higher with capitalization
b) Both would be lower with capitalization
c) One would be higher and one would be lower with capitalization
 
12. Graphics, Inc. has a deferred tax asset of USD4 million on its books. As of December 31,
 
d) it is probable that USD2 million of the deferred tax asset’s value will never be realized
e) because of the uncertainty about future income. Graphics, Inc. should:
f) Reduce the deferred tax asset account by USD2 million
g) Establish valuation allowance of USD2 million
h) Establish an offsetting deferred tax liability of USD2 million
 
13. A firm A and firm B have the same quick ratio but firm A has a greater current ratio than i) firm B. Compared to firm B, it is most likely that a firm A has
 
a) Greater inventory
b) Greater payables
c) A higher receivables turnover ratio
 
14. Blodnick Corp. has found that its weighted average collection period has increased from 45 days last year to 55 days this year, and its average days of receivables this year is 13 compared to 22 last year. It is most likely that
 
a) Blodnick Corp. has relaxed its credit standards this year
b) Blodnick Corp. credit customers are paying more slowly this year
c) Credit sales are a greater part of Brodnick Corp. business this year
 
15. If RGB, Inc. has annual sales of USD100,000, average accounts payable of USD30,000,and average accounts receivables of USD25,000, RGB’s receivables turnover and average collection period are closest to
 
Receivables turnover Average collection period
a) 2.1 times 174 days
b) 3.3 times 111 days
c) 4.0 times 91 days
 
16. RGB, Inc.’s income statement shows sales of USD1,000, cost of goods sold of USD400,per-interest coverage operating expense of USD300, and interest expense of USD100.RGB’s interest coverage ratio is closest to
 
a) 2 times
b) 3 times
c) 4 times
 
17. The table below shows selected data from a company’s financial statements.Based on these results, what was this company’s most likely strategy for improving its operating activity during this period?
 
a) Improve its inventory management
b) Change its credit and collections policies with its customers
c) Change the degree to which it uses trade credit from suppliers
 

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IV. Company Valuation
 
18. Marsha McDonnel and Frank Lutge are analysts for private equity firm – Thomas Ventures. Their primary responsibility is to value the equity of private firms in developed global economies. Thoma’s clients consist of wealthy individuals and institutional
investors. The firm invests in and subsequently actively manages its portfolio of private firms.

 
During a discussion with junior analysts at the firm, McDonnel compared the characteristics of private firms with those of public firms and makes the following statements
 
Statement 1: Private firms typically have higher risk premiums and required returns than public firms because private firms are usually smaller and thus thought to be riskier.Furthermore, the lack of access to liquid public equity markets can limit a private firm’s
growth.
 
Statement 2: Because of their higher risk, private firms may not be able to attract as many qualified applicants for top positions as public firms. Due to the higher risk, the managers they do attract tend to have a shorter-term view of the firm and their tenure at the firm,compared to public firm managers. As a result, the private firm may neglect profitable long-term projects.
 
Due to its considerable success, Thomas has recently attracted a substantial inflow of capital from investors. To deploy that capital, McDonnel and Lutge are considering the purchase of Albion Biotechnology. Albion is using advances in biotechnology for
application in the pharmaceutical field. The analysts are primarily interested in Albion because the firm’s research team is developing a drug that Thomas current pharmaceutical field is also working on. McDonnel estimates that combining research teams would result
in advances that no pharmaceutical competitor could match for at least two years. The firm is currently owned by its founders, who are familiar to Lutge through previous social contacts. Lutge hopes to avoid a competitive bidding process for the firm, because its
founders have not publicly advertised the firm’s sale.
 
McDonnel is also examining the prospects of Balanced Metals, a metal fabrication firm. Thomas currently does not have any manufacturing firms in its portfolio, and Balanced would provide needed exposure. The growth in sales in Balanced has been impressive recently, but it is expected to slow considerably in the years ahead due to increased competition from overseas firms. The firm’s most valuable assets are its equipment and factory, located in a prime industrial area.
 
Balanced was previously considered for possible purchase by a competitor in the metal fabrication industry. Although the sale was not consummated, McDonnel has learnt that the firm estimated that costs could be reduced at Balanced by eliminating redundant overhead expenses. McDonnel has obtained the following financial figures from the Balanced Metals CFO, as well as the previously estimated synergies savings from cost reductions. Capital expenditures will equal depreciation plus approximately 4% of the firm’s incremental revenues.
 
•Current revenues USD22 million
•Revenue growth 7%
•Gross profit margin 25%
•Depreciation expense as a percent of sales 1%
•Working capital as percent of sales 15%
•Operating expenses USD5.4 million
•Synergistic cost savings USD1.2 million
•Tax rate 30%
 
Lutge is valuing a non-controlling equity interest in Jensen Gear, a small outdoors equipment retailer. Jensen has experienced healthy growth in earnings over the past three years.However, given its size and private status, Lutge does not expect that Jensen can be easily sold. To obtain the appropriate price multiple for the Jensen valuation, he has prepared a database of price multiples from the sale of entire public and private companies over the past ten years, organized by industry classification. Using historical data, Lutge estimates a control premium of 18.7% and discount for lack of marketability of 24%.
 
To obtain the cost of capital for Jensen, Lutge uses a cost of capital database that includes public company betas, cost of equity, weighted average cost of capital, and other financial statistics by industry. Given Jensen’s small size, Lutge obtains a size premium using the smallest decile of the database. McDonnel examines Lutge’s cost of capital calculations and makes the following statements
 
Statement 1: I am concerned about the use of this database. The estimate of the size of premium may result in an undervaluation of the Jensen equity interest.
 
Statement 2: The use of betas and the CAPM from the database may be inappropriate. If so, Lutge should consider using the buil-up method whereby an industry risk premium is used
instead of beta.
 
Regarding the statements made by McDonnel on the comparison of private firms and public firms, are both statements correct?
 
a) Yes
b) No, both statements are incorrect
c) No, one statement is correct, but the other statement is incorrect
 
18.2. Which of the following best describes the standard of value that McDonnel and Lutge will apply to Albion Biotechnology?
 
a) Market value
b) Intrinsic value
c) Investment value
 
18.3. Which of the following is closest to the FCFF that McDonnel should estimate for Balanced Metals?

 
a) –USD117,800
b) USD344,120
c) USD722,120
 
18.4. Which of the following income approaches would be most appropriate for valuing Balanced Metals?
 
a) The free cash flow method
b) The excess earnings method
c) The capitalized cash flow method
 
18.5. Which of the following is closest to the total adjustment for control and marketability that would be applied to the Jensen valuation?
 
a) A discount of 5.3% would be applied
b) A discount of 36% would be applied
c) A discount of 42.7% would be applied
 
18.6. Regarding the statements made by McDonnel on Lutge’s cost of capital calculations for Jensen, are both statements correct?
 
a) Yes
b) No, both statements are incorrect
c) No, one statement is correct, but the other statement is incorrect
 
I. Project Valuation
 
1. Which of the following statements about the payback period method is least accurate?
The payback period
 
a. Provides a rough measure of a project’s liquidity
b. Considers all cash flows throughout the entire life of a project
c. Is the number of years it takes to recover the original cost of the investment
 

2. An analyst has gathered the following information about a project
 
• Cost USD 10,000
• Annual cash flow USD 4,000
• Life 4 years
• Cost of capital 12%
 
Which of the following statements about the project is least accurate?
 
a. The discounted payback period is 3.5 years
b. The IRR of the project is 21.9%; accept the project
c. The NPV of the project is USD2,149; accept the project
 
3. Which of the following statements about NPV and IRR is least accurate?
 
a) The IRR is the discount rate that equates the present value of the cash inflows with the present value of outflows
b) For mutually exclusive projects, if the NPV method and the IRR method give
conflicting rankings, the analyst use the IRRs to select the project
c) The NPV method assumes that cash flows will be reinvested at the cost of capital,
while IRR ranking implicitly assume that cash flows are reinvested at the IRR
 
II. Financial Ratios
 
4. A company’s current ratio is 1.9. If some of the accounts payable are paid off from the cash account, the
 
a. Numerator would decrease by a greater percentage than the denominator, resulting in a lower current ratio
b. Denominator would decrease by a greater percentage than the numerator, resulting in a higher current ratio
c. Numerator and denominator would decrease proportionally, leaving the current
ratio unchanged
 
5. A company’s quick ratio is 1.2. If inventory were purchased for cash, the
 
a. Numerator would decrease more than the denominator, resulting in a lower quick
ratio
b. Denominator would decrease more than the numerator, resulting in a higher
current ratio
c. Numerator and denominator would decrease proportionally, leaving the current
ratio unchanged
 
6. If a firm’s inventory turnover and number of days of payables both increase, the effect on a firm’s cash conversion cycle is
 
a. To shorten it
b. To lengthen it
c. uncertain
 
7. A decrease in a firm’s inventory ratio is most likely to result from
 
a. A write-down of inventory
b. Goods in inventory becoming obsolete
c. Decreasing purchases in a period of stable sales
 
III. Cost of Capital
8.
• The company has a target capital structure of 40% debt and 60% equity
• Bonds with face value of USD1,000 pay 10% coupon (semiannual), mature in 20
• years, and sell for USD849.54 with a yield to maturity of 12%
 
• The company stock beta is 1.2
 
• Risk-free rate is 10%, and market risk premium is 5%
• The company is constant-growth form that just paid a dividend of USD2, sells for
• USD27 per share, and has a growth rate of 8%
• The company’s marginal tax rate is 40%
 
• 9.1. The company’s after-tax cost of debt is
 
• a. 7.2%
• b. 8%
• c. 9.1%
 
• 9.2. The company’s cost of equity using the capital asset pricing model (CAPM) approach is
 
• a. 16%
• b. 16.6%
• c. 16.9%
 
• 9.3. The company’s cost of equity using the dividend discount model is
 
• a. 15.4%
• b. 16%
• c. 16.6%
 
• 9.4. The company’s weighted average cost of capital (using the cost of equity from CAPM) is closest to
 
• a. 12.5%
• b. 13%
• c. 13.5%
• 10. What happens to a company’s weighted average cost of capital (WACC) if the firm’s
• corporate tax rate increases and if the Federal Reserve causes an increase in the risk-free
 
• rate, respectively? (Consider the events independently, and assume a beta of less than one). WACC will
 
• Tax rate increase in risk-free rate
• a. Decrease Increase
• b. Decrease
• c. Increase
 
IV. Economic Value Added
 
11. VBM, Inc. reports NOPAT of $2,100, a WACC of 14.2%, and invested capital of $18,000. The market price of the firm’s stock is $25 per share, and VBM has 800 shares outstanding. The market value of the firm’s long-term debt is $4,000. What is the EVA of VBM?
 
a. $2,556
b. $-456
c. $465
d. $6,000
 
12. Henry always believed that Sharon Smith, head of the supersonic division was his best manager. The ROA of Smith’s division was generally in the high double digits but the best estimate of the WACC for the division was only 20 per cent. Furthermore, the
division has been growing rapidly. However as soon as Henry paid bonuses based on ROA, the division stopped growing. At that time Smith’s division had after-tax earnings of $2 mln on an asset base of $2 mln, which gives ROA at 100%. Henry found out that suggested to Sharon to run a project what would earn $1 mln per year on an investment of $2 mln. What is ROA for this project and would Sharon accept it if he had bonus paid on ROA?
 
a. ROA = 50%, accept the project
b. ROA=100%, accept the project
c. ROA=50%, reject the project
d. ROA=100%, reject the project
 
Henry was later exposed to the economic value added (EVA) approach. What is the EVA for this project and should Sharon accept it?
 
a. 50%, accept the project
b. $2.2 million, accept the project
c. $222 million, accept the project
d. 22%, reject the project
 
Financial Analysis
 
1. The table below shows selected data from a company’s financial statements operating activity during this period?
 
a) Improve its inventory management
b) Change its credit and collections policies with its customers
c) Change the degree to which it uses trade credit from suppliers
 
2. Credit analysts are likely to consider a company’s credit quality to be improving if the company reduces its
 
a) scale and diversification
b) margin stability
c) leverage
 
3. A firm’s financial statements reflect the following information
 
Beginning inventory $3,200,000
Purchase during the year $1,700,000
Ending inventory $2,100,00
Sales $4,800,000
What was the firm’s gross profit margin?
 
a) 0.58
b) 0.42
c) 2.29
 
4. What is Luther’s net working capital in 2008?
 
a) $12 million
b) $27 million
c) $39 million
d) $63.6 million
 
5. If in 2009 Luther has 10.2 million shares outstanding and these shares are trading at $16 per share, then Luther’s Market-to-book ratio would be closest to
 
a) 0.39
b) 0.76
c) 1.29
d) 2.57
 
6. Luther’s current ratio for 2009 is closest to
 
a) 0.84
b) 0.92
c) 1.09
d) 1.19
 
7. Wyatt Oil has a net profit margin of 4.0%, a total asset turnover of 2.2, total assets of $525 million, and a book value of equity of $220 million. Wyatt Oil’s current return-on-assets (ROA) is closest to
 
a) 8.8%
b) 9.5%
c) 21.0%
d) 22.8%
 
8. If Firm A and Firm B are in the same industry and use the same production method, and Firm A’s asset turnover is higher than that of Firm B, then all else equal we can conclude that
 
a) Firm A is more efficient than Firm B.
b) Firm A has a lower dollar amount of assets than Firm B.
c) Firm A has higher sales than Firm B.
d) Firm A has a lower ROE than Firm B.
9. If Alex Corporation takes out a bank loan to purchase a machine used in production and everything else stays the same, its equity multiplier will ________, and its ROE will ________.
 
a) increase; increase
b) decrease; decrease
c) increase; decrease
d) decrease; increase
 
10. Suppose Novak Company experienced a reduction in its ROE over the last year. This fall could be attributed to:
 
a) an increase in Net Profit Margin
b) a decrease in Asset Turnover
c) an increase in Leverage
d) a decrease in Equity
 
11. The inventory days ratio measures
 
a) the average length of time it takes a company to sell its inventory.
b) the average length of time it takes the company’s suppliers to deliver its inventory.
c) the level of sales required to keep a company’s average inventory on the books.
d) the percentage change in inventory over the past year.
 
12. If Moon Corporation has an increase in sales, which of the following would result in no change in its EBIT margin?
 
a) A proportional increase in its net income
b) A proportional decrease in its EBIT
c) A proportional increase in its EBIT
d) An increase in its operating expenses
 
Project Valuation
 
13. In the absence of capital rationing, a firm should take on the most profitable investments first and keep expanding their investments to the point where the marginal
 
a) cost of debt equals the marginal cost of equity
b) return of the last investment equals the risk free rate
c) return of the last investment equals the marginal cost of capital.
 
14. Eldon Windows Inc. has an $80,000 capital budget and has the opportunity to invest in five different projects. The initial investment and NPV of the projects is shown in the table. In which combination of projects should Eldon Windows invest?
 
15. Which of the following statements is least accurate?
 
a) If a project is riskier than the firm’s normal project, the firm should adjust the project’s discount rate upward
b) In the absence of capital rationing, a firm should take all projects with a positive net present value
c) When a capital is rationed, the projects with the highest IRRs should be selected Cummings Enterprise, Inc. (CEI), is a U.S.
 
conglomerate that operates in a variety of markets. One of CEI’s divisions manufacturers small fiberglass products, such bird baths and outdoor storage lockers. CEI is currently considering the expansion of its fiberglass product line to include booms and buckets for aerial lift trucks (often called cherry pickers), which are used for applications such as high voltage power line maintenance. The addition of this new product line is expected to increase CEI’s sales by $750,000 per year. Cal Holbrook, CEI’s manager of fiberglass operations, is deciding whether to purchase a robotic system to produce cherry picker booms and buckets.
 
The price of the robotic system will be $700,000, plus an additional $100,000 for shipping, site preparation, and installation. The new equipment will require a $50,000 increase in inventory and a $20,000 increase in accounts payables. The company uses MARCS to calculate depreciation for tax purposes and the straight-line method for financial reporting. The project has an expected life of four years, at which time the robot is expected to be sold for $75,000. The project will be funded with the debt/equity mix reflected by the company’s current capital structure. CEI’s pretax cost of new debt is 7%. Assume a WACC of 8%. Some of the relevant end-of-ear cash flows for the
 
Holbrook calculates the NPV of the robotic project and presents his findings to his supervisor,Geoffrey Mans. After reviewing the report, Mans makes the following recommendations
 
1. “You forgot to include the $100,000 we have spent so far on consultants and project engineers and how knows what else to evaluate the project’s feasibility. Rerun the numbers including that amount and get the revised calculations to me this afternoon”.
2. “Return the analysis assuming straight-line depreciation for tax purposes. The NPV will be higher, and we will be more likely to get the project funded.”
 
Cummings has two other projects under consideration that would affect the production of storage lockers.

Project 1 relates to changing the production process, and Project 2 relates to expanding the distribution facility. Holbrook estimates the NPV of the expected cash flows for Project 1 at negative $7 million. An additional investment of $3 million would allow management to more rapidly adjust to the demand for a certain type of locker. The value of this flexibility is estimated at $9 million. He estimates that the NPV of the expected cashrobotic project are presented in Exhibit 1.
 
Project 2 at $3 million. An expansion option would require an additional investment of $2 million. At this time, Cummings does not have any capital rationing restrictions. Holbrook emails the lead analyst for the budgeting group and indicates that he cannot make a decision on Project 2 without knowing the value of the expansion option will provide. Holbrook calls a capital budgeting meeting with CEI’s production and quality control manager. Holbrook opens the meeting by stating: “I think we should accept this project based solely on the fact that it provides great operating margins. Nevertheless, I think we should conduct net present value (NPV) analysis to confirm my opinion.” Holbrook then receives the following comments
 
Comment 1: It is important that interest is included in the discounted cash flows used with NPV analysis because interest is a real and very significant expense.
 
Comment 2: If applied correctly, the NPV of this project will be higher if we discount
economic profits instead of net after-tax operating cash flows in our analysis. I suggest we calculate economic profit as net operating profit after tax minus the dollar cost of capital.
 
15.1.Which of the following choices is closest to the Year 4 total cash flow for the robotics project in Exhibit 1?
 
a) $292,400
b) $345,400
c) $367,400
 
15.2. Are Man’s recommendations regarding the robotic project correct or incorrect?

 
a) Both recommendations are correct
b) Only one of the recommendations is correct
c) Both recommendations are incorrect
 
15.3. For this question only, assume that the investment in net working capital of $30,000 at the project inception is an inflow and that the amount nets to zero with the outflow what will occur at the end of the project. However, Holbrook does not include a cash flow for net working capital at the beginning or the end of the project. Assuming he correctly analyzes all the other components of the project, has Holbrook correctly estimated the project’s net present value?
 
a) Yes
b) No, he underestimated the project’s NPV by approximately $7,950
c) No, he underestimated the project’s NPV by approximately $2,222
 
15.4. Which of the following choices is closest to the overall NPV for Project 1, and is
Holbrook correct to wait for more information before deciding on Project 2?
 
a) The overall NPV is -$1million, and Holbrook is correct
b) The overall NPV is -$1million, and Holbrook is incorrect
c) The overall NPV is $13million, and Holbrook is incorrect.
 
15.5.All the comments made by the CEI’s production and quality assurance manager correct or incorrect?
 
a) Both comments are correct
b) Only one of the comments is correct
c) Both comments are incorrect
 
Cost of Capital
16. Wanda Brunner is working on a capital project valuation and needs to determine the appropriate discount rate. She has the following information available
 
Risk-free-rate = 8%
Market Beta = 1.0
Company Beta = 1.1
Project Beta = 1.2
Expected market return = 13%
Trailing 12-months market return = 12%
 
Which of the following is closest to the most appropriate discount rate?
 
a) 13.5%.
b) 14.0%.
c) 13.0%.
 
17. Firms should adjust for execution risk by
 
a) assigning a higher cost of capital to new projects.
b) ignoring execution risk since it is diversifiable.
c) capturing this risk in the expected cash flows generated by the project.
d) noticing missteps in the firm’s execution of new projects.
 
18. Which of the following statements is false?
 
a) Many practitioners prefer to use average industry betas rather than individual stock betas.
b) When estimating beta by using past returns it is best to use the longest time horizon of returns available.
c) The CAPM predicts that a security’s expected return depends on its beta with regard to the market portfolio of all risky investments available to investors.
d) If we use too short a time horizon when estimating beta, our estimate of beta will be unreliable.

 
19. Assume that the S&P 500 currently has a dividend yield of 3% and that on average, the dividends of S&P 500 firms have increased by about 5% per year. If the risk-free interest rate is 4%, then your estimate for the future market risk premium is
 
a) 7%
b) 8%

c) 6%
d) 4%
 
20. Assume that the risk-free rate of interest is 3% and you estimate the market’s expected return to be 9%.Which firm has the most total risk?
 
a) Eenie
b) Meenie
c) Miney
d) Moe
 
21. Which firm has the highest cost of equity capital?
 
a) Eenie
b) Meenie
c) Miney
d) Moe
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22. The equity cost of capital for “Miney” is closest to
 
a) 6.30%
b) 7.50%
c) 9.30%
d) 9.75%
 
23. The risk premium for “Meenie” is closest to
 
a) 4.50%
b) 7.50%
c) 9.30%
d) 9.75%
 
24. Your firm is planning to invest in a new power generation system. Galt Industries is an all equity firm that specializes in this business. Suppose Galt’s equity beta is 0.75, the riskfree rate is 3%, and the market risk premium is 6%. If your firm’s project is all equity financed, then your estimate of your cost of capital is closest to
 
a) 5.25%
b) 6.00%
c) 6.75%
d) 7.50%
 
25. The firm’s unlevered (asset) cost of capital is
 
a) the weighted average of the equity cost of capital and the debt cost of capital.
b) the weighted average of the levered cost of capital and the equity cost of capital.
c) the debt cost of capital minus the equity cost of capital.
d) the unlevered beta minus the cost of capital.
 
26. The WACC can be used throughout the firm as the company wide cost of capital for new investments that are of comparable risk to the rest of the firm and that will not alter the firm’s debt-equity ratio.
 
a) A disadvantage of the WACC method is that you need to know how the firm’s
leverage policy is implemented to make the capital budgeting decision.
b) The intuition for the WACC method is that the firm’s weighted average cost of capital represents the average return the firm must pay to its investors (both deb and equity holders) on an after-tax basis.
c) To be profitable, a project should generate an expected return of at least the firm’s
weighted average cost of capital.
 
Product code: Finance-QA342
 

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