Question 1 – 87234
The two major types of risk affecting a firm are:
A) financial risk and cash flow risk.
B) business risk and financial risk.
C) business risk and collection risk.
The correct answer was B) business risk and financial risk.
Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to
the uncertainty caused by the fixed cost associated with borrowed money.
Question 5 – 97597
A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10
percent and the following cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project’s NPV and IRR.
NPV IRR
A) $883 20%
B) $243 20%
C) $883 15%
The correct answer was A) $883 20%
To determine the NPV, enter the following:
PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653, PV of $2,000 in year 3 = $1,503.
NPV = ($2,727 + $1,653 + $1,503) − $5,000 = 883.
You know the NPV is positive, so the IRR must be greater than 10%. You only have two choices, 15%
and 20%. Pick one and solve the NPV. If it is not close to zero, then you guessed wrong; select the
other one.
[3000 ÷ (1 + 0.2)1 + 2000 ÷ (1 + 0.2)2 + 2000 ÷ (1 + 0.2)3] − 5000 = 46 This result is closer to zero
(approximation) than the $436 result at 15%. Therefore, the approximate IRR is 20%.
Question 6 – 96775
Which of the following statements is least accurate regarding the marginal cost of capital’s role in
determining the net present value (NPV) of a project?
A) Projects for which the present value of the after-tax cash inflows is greater than the present
value of the after-tax cash outflows should be undertaken by the firm.
B) The NPVs of potential projects of above-average risk should be calculated using the
marginal cost of capital for the firm.
C)
When using a firm’s marginal cost of capital to evaluate a specific project, there is an implicit
assumption that the capital structure of the firm will remain at the target capital structure over
the life of the project.
B was correct!
calculate NPV -> WACC=MCC
The WACC is the appropriate discount rate for projects that have approximately the same level of risk
as the firm’s existing projects. This is because the component costs of capital used to calculate the
firm’s WACC are based on the existing level of firm risk. To evaluate a project with above (the firm’s)
average risk, a discount rate greater than the firm’s existing WACC should be used. Projects with
below-average risk should be evaluated using a discount rate less than the firm’s WACC. An additional
issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is
that there is an implicit assumption that the capital structure of the firm will remain at the target capital
structure over the life of the project. These complexities aside, we can still conclude that the NPVs of
potential projects of firm-average risk should be calculated using the marginal cost of capital for the
firm. Projects for which the present value of the after-tax cash inflows is greater than the present value
of the after-tax cash outflows should be undertaken by the firm.
Question 7 – 97494
A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt
and $15 million in equity stock (equal to the company’s current capital structure). The before-tax
required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost
of capital should the firm use to determine the project’s net present value (NPV)?
A) 12.5%.
B) 9.6%.
C) 11.6%.
The correct answer was C) 11.6%.
WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)
WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%
Question 9 – 140463 ?
The effect of a company announcement that they have begun a project with a current cost of $10 million
that will generate future cash flows with a present value of $20 million is most likely to:
A) only affect value of the firm’s common shares if the project was unexpected.
B) increase the value of the firm’s common shares by $20 million.
C) increase value of the firm’s common shares by $10 million.
The correct answer was A) only affect value of the firm’s common shares if the project was
unexpected.
Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project
will increase stock price only if it was not previously anticipated by investors.
Question 10 – 97490
The NPV profile is a graphical representation of the change in net present value relative to a change in
the:
A) prime rate.
B) internal rate of return.
C) discount rate.
The correct answer was C) discount rate.
As discount rates change the net present values change. The NPV profile is a graphic illustration of how
sensitive net present values are to different discount rates. By comparison, every project has a single
internal rate of return and payback period because the values are determined solely by the investment’s
expected cash flows.
Question 11 – 96785 ?
The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market
yield to maturity is not available because the debt is not publicly traded, but the market yield on debt
with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be
subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate
estimate of the after-tax cost of this new debt is:
A) 5.0%.
B) Between 3.3% and 5.0%.
C) More than 5.0%.
The correct answer was C) More than 5.0%.
The after-tax cost of debt similar to Savanna’s existing debt is kd(1 – t) = 8.33%(1 – 0.4) = 5.0%.
Because the anticipated new debt will be subordinated in the company’s debt structure, investors will
demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the
new debt is more than 5.0%.
Question 12 – 98220
Nippon Post Corporation (NPC), a Japanese software development firm, has a capital structure that is
comprised of 60% common equity and 40% debt. In order to finance several capital projects, NPC will
raise USD1.6 million by issuing common equity and debt in proportion to its current capital structure.
The debt will be issued at par with a 9% coupon and flotation costs on the equity issue will be 3.5%.
NPC’s common stock is currently selling for USD21.40 per share, and its last dividend was USD1.80
and is expected to grow at 7% forever. The company’s tax rate is 40%. NPC’s WACC based on the cost
of new capital is closest to:
A) 11.8%.
B) 9.6%.
C) 13.1%.
The correct answer was A) 11.8%.
kd = 0.09(1 – 0.4) = 0.054 = 5.4%
kce = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%
WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%
Flotation costs, treated correctly, have no effect on the cost of equity component of the WACC.
Question 15 – 97840
Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in
the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:
A) rise.
B) fall.
C) more information is needed.
B was correct!
Recall the WACC equation:
WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)
The increase in the corporate tax rate will result in a lower cost of debt, resulting in a lower WACC for
the company.
Question 16 – 96536
A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10
percent and the following cash flow schedule:
Year 1: $3,000
Year 2: $2,000
Year 3: $2,000
Determine the project’s payback period and discounted payback period.
Payback Period Discounted Payback Period
A) 2.0 years 2.4 years
B) 2.0 years 1.6 years
C) 2.4 years 1.6 years
The correct answer was A) 2.0 years 2.4 years
Regarding the regular payback period, after 1 year, the amount to recover is $2,000 ($5,000 – $3,000).
After the second year, the amount is fully recovered.
The discounted payback period is found by first calculating the present values of each future cash flow.
These present values of future cash flows are then used to determine the payback time period.
3,000 / (1 + .10)1 = 2,727
2,000 / (1 + .10)2 = 1,653
2,000 / (1 + .10)3 = 1,503.
Then:
5,000 – (2,727 + 1,653) = 620
620 / 1,503 = .4.
So, 2 + 0.4 = 2.4.
Question 17 – 127343
The following information applies to a corporation:
The company has $200 million of equity and $100 million of debt.
The company recently issued bonds at 9%.
The corporate tax rate is 30%.
The company’s beta is 1.125.
If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company’s after-
tax weighted average cost of capital is closest to:
A) 10.5%.
B) 12.1%.
C) 11.2%.
B was correct!
ks = RFR + β(Rm − RFR)
= 6% + 1.125(14% − 6%) = 15%
WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks
= (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1%
Question 18 – 96568
Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR:
A) and the net present value (NPV) method lead to the same accept/reject decision for
independent projects.
B) can lead to multiple IRR rates if the cash flows extend past the payback period.
C) assumes that the reinvestment rate of the cash flows is the cost of capital.
The correct answer was A) and the net present value (NPV) method lead to the same accept/reject
decision for independent projects.
NPV and IRR lead to the same decision for independent projects, not necessarily for mutually exclusive
projects. IRR assumes that cash flows are reinvested at the IRR rate. IRR does not ignore time value of
money (the payback period does), and the investor may find multiple IRRs if there are sign changes
after time zero (i.e., negative cash flows after time zero).
Question 19 – 98212
The most accurate way to account for flotation costs when issuing new equity to finance a project is to:
A) increase the cost of equity capital by dividing it by (1 – flotation cost).
B) increase the cost of equity capital by multiplying it by (1 + flotation cost).
C) adjust cash flows in the computation of the project NPV by the dollar amount of the flotation
costs.
The correct answer was C) adjust cash flows in the computation of the project NPV by the dollar
amount of the flotation costs.
Question 21 – 87216
Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is
$120 for the typical mattress. Sales prices for mattresses average $160. How many units must King
Mattress sell to break even?
A) 40.
B) 8,125.
C) 2,708.
B was correct!
QBreakeven = Fixed Cost / (Price – Variable Cost)
QBreakeven = $325,000 / (160 – 120) = 8,125
Question 22 – 119456
Landen, Inc. uses several methods to evaluate capital projects. An appropriate decision rule for Landen
would be to invest in a project if it has a positive:
A) profitability index (PI).
B) net present value (NPV).
C) internal rate of return (IRR).
B was correct!
The decision rules for net present value, profitability index, and internal rate of return are to invest in a
project if NPV > 0, IRR > required rate of return, or PI > 1.
Question 24 – 97274
Which of the following statements about NPV and IRR is least accurate?
A) For mutually exclusive projects you should use the IRR to rank and select projects.
B) For independent projects if the IRR is > the cost of capital accept the project.
C) The NPV method assumes that all cash flows are reinvested at the cost of capital.
The correct answer was A) For mutually exclusive projects you should use the IRR to rank and select
projects.
For mutually exclusive projects you should use NPV to rank and select projects.
Question 25 – 131566
Two projects being considered by a firm are mutually exclusive and have the following projected cash
flows:
Year Project 1 Cash
Flow Project 2 Cash Flow
0 −$4.0 ?
1 $3.0 $1.7
2 $5.0 $3.2
3 $2.0 $5.8
The crossover rate of the two projects’ NPV profiles is 9%. What is the initial cash flow for Project 2?
A) −$4.22.
B) −$4.51.
C) −$5.70.
The correct answer was A) −$4.22.
The crossover rate is the rate at which the NPV for two projects is the same. That is, it is the rate at
which the two NPV profiles cross. At a discount rate of 9%, the NPV of Project 1 is: CF0 = –4; CF1 = 3;
CF2 = 5; CF3 = 2; I = 9%; CPT → NPV = $4.51. Now perform the same calculations except that we need
to set the unknown CF0 = 0. The remaining entries are: CF1 = 1.7; CF2 = 3.2; CF3 = 5.8; I = 9%; CPT →
NPV = $8.73. Since by definition the crossover rate produces the same NPV for both projects, we know
that both projects should have an NPV = $4.51. Since the NPV of Project 2 (with CF0 = 0) is $8.73, the
unknown cash flow must be a large enough negative amount to reduce the NPV for Project 2 from
$8.73 to $4.51. Thus the unknown initial cash flow for Project 2 is determined as $4.51 = $8.73 + CF0,
or CF0 = −$4.22.
Question 27 – 96780
Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital
budgeting.
Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital
budgeting analysis.
Statement 2: Cash flows should be analyzed on an after-tax basis.
Should DeWalt agree or disagree with Webb’s statements?
Statement 1 Statement 2
A) Agree Agree
B) Disagree Disagree
C) Disagree Agree
The correct answer was C) Disagree Agree
DeWalt should disagree with Webb’s first statement. Cash flows are based on opportunity costs. Any
cash flows that the firm gives up because a project is undertaken should be charged to the project.
DeWalt should agree with Webb’s second statement. The impact of taxes must be considered when
analyzing capital budgeting projects.
Question 28 – 87152 ?
If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of
debt and equity capital?
A) Both increase.
B) Both decrease.
C) One increase and one decrease.
The correct answer was A) Both increase.
An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of
debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate
premium for risk.
Question 29 – 134987
Lane Industries has a project with the following cash flows:
Year Cash Flow
0 −$200,000
1 60,000
2 80,000
3 70,000
4 60,000
5 50,000
The project’s cost of capital is 12%. The discounted payback period is closest to:
A) 3.9 years.
B) 2.9 years.
C) 3.4 years.
The correct answer was A) 3.9 years.
The discounted payback period method discounts the estimated cash flows by the project’s cost of
capital and then calculates the time needed to recover the investment.
Year Cash Flow Discounted
Cash Flow
Cumulative
Discounted
Cash Flow
0 −$200,000 −$200,000.00 −$200,000.00
