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9) Takelmer Industries has a different WACC for each of three types of projects. Low-risk
projects have a WACC of 8.00%, average-risk projects a WACC of 10.00%, and high-risk
projects a WACC of 12%. Which of the following projects do you recommend the firm accept?
Project
Level of Risk
IRR
A
Low
9.50%
B
Average
8.50%
C
Average
7.50%
D
Low
9.50%
E
High
14.50%
F
High
17.50%
G
Average
11.50%
A) A, B, C, D, G
B) B, C, E, F, G
C) A, D, E, F, G
D) A, B, C, D, E, F, G
10) Builder's Warehouse, Inc has an adjusted WACC of 9.70%. The company has a capital
structure consisting of 50% equity and 50% debt, a cost of equity of 13.00%, a before-tax cost of
debt of 8.00%, and a tax rate of 20%. Builder's Warehouse is considering expanding by building
a new outlet in a distant city and considers the project to be riskier than current operations. The
firm estimates the existing beta to be 1.0, the required return on the market portfolio to be
12.00%, the risk-free rate to be 3.00%, and the beta for the new project to be 1.25. Given this
information, and assuming the cost of debt will not change if the firm undertakes the new
project, what adjusted WACC should be used in the decision-making?
A) 10.45%
B) 12.60%
C) 13.32%
D) 9.70%
11) Rogue Industries, Inc has an adjusted WACC of 8.56%. The company has a capital structure
consisting of 80% equity and 20% debt, a cost of equity of 10.00%, a before-tax cost of debt of
6.00%, and a tax rate of 20%. The firm is considering expanding by building a new shop in a
distant city and considers the project to be less risky than the current operation. The firm has an
existing beta of 1.0, the required return on the market portfolio to be 10.00%, the risk-free rate to
be 3.00%, and the beta for the new project to be 0.90. Given this information, and assuming the
cost of debt will not change if the firm undertakes the new project, what adjusted WACC should
be used in decision-making?
A) 8.40%
B) 9.84%
C) 10.00%
D) 11.24%
12) The adjusted WACC is the correct discount rate to use when evaluating a firm's average-risk
projects.
13) Using the WACC to evaluate all projects has the effect of making low-risk projects look
MORE attractive and high-risk projects look LESS attractive.
14) You have learned how to use NPV and IRR to evaluate projects as part of a capital budgeting
decision-making process. How is WACC used in each of these capital-budgeting processes?
15) Using the WACC to evaluate all projects may lead managers into accepting high-risk
projects that do not compensate adequately for risk and into rejecting low-risk projects that
compensate fully for the level of risk but may not have particularly high rates of return. Describe
the situations when using a WACC is not appropriate and how these incorrect decisions may be
made.
16) Michigan Industries has three projects under consideration. Project L is a lower-than-
average-risk project, project A is an average-risk project, and project H is a higher-than-average-
risk project. You have gathered the following information to determine if one or more of these
projects has an acceptable rate of return for the firm.
• Sources of financing 50% debt and 50% equity
• Rd = 8.00% before taxes
• Tax Rate = 30%
• Average beta for Michigan Industries = 1.0
• Rm = 13.00%
• Rf = 4.00%
• Adjusted WACC = 9.30%
• Beta for project L = 0.80, for project A = 1.00, and for project H = 1.20
• IRRL = 9.00%, IRRA = 10.00%, and IRRH = 11.00%
Calculate the required rate of return for each project and determine which, if any, projects are
acceptable to the firm.
1) The appropriate capital budgeting decision rule is ________.
A) to accept projects with an NPV greater than $0
B) to reject projects with an IRR greater than the required rate of return
C) to reject projects with an NPV greater than $0
D) to reject projects with an IRR greater than the required payback period
2) Conde Nash Inc., is adding a new magazine project to the company portfolio and has the
following information: the expected market return is 10%, the risk-free rate is 2%, and the
expected return on the new project is 24%. What is the beta of the project?
A) 1.00
B) 3.50
C) 2.00
D) 2.75
3) Pixi, Inc is adding a new line of cosmetics to the company portfolio and has the following
information: the expected market return is 12%, the risk-free rate is 4%, and the expected return
on the new project is 28%. What is the beta of the project?
A) 1.60
B) 2.70
C) 3.00
D) 3.90
4) Under which of the following circumstances is the pure play method of estimating a project's
beta particularly useful?
A) The firm is looking to expand its current business operations, doing essentially the same
work.
B) The firm is looking to expand its current business operations into a brand new area unlike any
of its internal projects.
C) The firm is looking to expand its current business operations. The work will be essentially the
same as current operations but there is no obvious outside provider of the same service or
product.
D) The pure play method works equally effectively under each and all of these scenarios.
5) ________ refers to a method of matching a single project of a company to another company
with a single business focus in an effort to assign an appropriate level of risk to the project.
A) Ghosting
B) Pure play
C) Outside assignment
D) Subjective assignment
6) Branson works for a firm that is expanding into a completely new line of business. He has
been asked to determine an appropriate WACC for an average-risk project in the expansion
division. Branson finds two publicly traded stand-alone firms that produce the same products as
his new division. The average of the two firm's betas is 1.40. Further, he determines that the
expected return on the market portfolio is 11.00% and the risk-free rate of return is 3.00%.
Branson's firm finances 70% of its projects with equity and 30% with debt, and has a before-tax
cost of debt of 8% and a corporate tax rate of 20%. What is the WACC for the new line of
business?
A) About 12.64%
B) About 13.12%
C) About 10.78%
D) About 11.86%
7) Fortunately for investors, assigning a beta to individual projects is more of a science than an
art.
8) The simplest application of assigning a beta to an individual project is called a "pure play," in
which a manager finds the beta of a firm whose sole business is similar to the project in question
and assigns that beta to the project.
9) In general, a subjective assessment of betas and projects is preferred to the pure play
approach.
10) Using beta as a risk measurement device has not caught on in the real world because finding
the value is nearly impossible for most investors.
11) Define "pure play" as it applies to assigning a beta to a project. Under what circumstances do
you think the pure-play approach to assigning project betas would be particularly useful?
1) The best rule for choosing projects when a firm has a limited amount of funds is to accept the
group of projects with the greatest combined ________.
A) number of projects
B) IRR
C) NPV
D) time to completion
2) Your firm has $2,000,000 available for investment in capital projects. Which combination of
projects is the best, given this budget constraint?
Project
Initial Investment
NPV
A
$750,000
$100,000
B
$1,500,000
$125,000
C
$500,000
$75,000
D
$500,000
$35,000
A) B, C
B) A, B, C
C) A, B, C, D
D) A, C, D
3) What could happen to "unused" dollars after a firm has chosen capital projects but still has
remaining unallocated funds?
A) The remaining funds may be invested at the "going rate" of the company.
B) The remaining funds, if internally generated, may be paid back to shareholders as a dividend.
C) If the remaining funds are part of borrowing, then the firm may choose to borrow less money.
D) All of the choices above are potential uses of unallocated funds.
4) Your firm has $4,000,000 available for investment in capital projects. Which combination of
projects is the best, given this budget constraint?
Project
Initial Investment
NPV
A
$1,000,000
$150,000
B
$500,000
$200,000
C
$1,500,000
$175,000
D
$1,750,000
$135,000
A) A, B, C
B) A, B, D
C) A, C, D
D) B, C, D
5) On a practical basis a, manager should always accept all positive NPV projects even if this
means exceeding a limited budget.
6) Unused capital budget funds are assumed to earn the same rate of return as the average IRR of
accepted projects.
7) Unused capital budget funds are assumed to earn the same rate of return as the average cost of
capital for the firm. In other words they may be invested in $0.0 NPV projects. (Or, alternatively,
excess funds may be returned to creditors and shareholders.)
8) With an unlimited amount of funds, a firm could accept all positive NPV projects. However,
with limited budgets, managers are forced to accept some positive NPV projects while rejecting
others. What overall financial rule should managers follow when choosing the portfolio of
projects to accept? Why?
