Test Bank Chapter 17
Chapter 17—Long-Term Investment Analysis
MULTIPLE CHOICE
1. Capital expenditures:
a.
are easily reversible
b.
are forms of operating expenditures
c.
Affect long-run future profitability
d.
Involve only money, not machinery
e.
none of the above
2. Any current outlay that is expected to yield a flow of benefits beyond one year in the future is:
a.
a capital gain
b.
a wealth maximizing factor
c.
a capital expenditure
d.
a cost of capital
e.
a dividend reinvestment
3. If the acceptance of Project A makes it impossible to accept Project B, these projects are:
a.
contingent projects
b.
complementary projects
c.
mutually inclusive projects
d.
mutually exclusive projects
e.
none of the above
4. Which of the following is (are) a guideline(s) to be used in the estimation of cash flows?
a.
cash flows should be measured on an incremental basis
b.
cash flows should be measured on an after-tax basis
c.
all the indirect effects of the project should be included
d.
all of the above
e.
none of the above
5. In order to help assure that all relevant factors will be considered, the capital-expenditure selection
process should include the following steps except:
a.
generating alternative capital-investment project proposals
b.
estimating cash flows for the project proposals
c.
reviewing the investment projects after they have been implemented
d.
allocate manpower to the various divisions within the firm
e.
a and d
6. Which of the following would not be classified as a capital expenditure for decision-making purposes?
a.
purchase of a building
b.
investment in a new milling machine
c.
purchase of 90-day Treasury Bills
d.
investment in a management training program
e.
all of the above are capital expenditures
7. The decision by the Municipal Transit Authority to either refurbish existing buses, buy new large
buses, or to supplement the existing fleet with mini-buses is an example of:
a.
independent projects
b.
mutually exclusive projects
c.
contingent projects
d.
separable projects
e.
none of the above
8. Which of the following is (are) a basic principle(s) when estimating a project’s cash flows?
a.
cash flows should be measured on a pre-tax basis
b.
cash flows should ignore depreciation since it is a non-cash charge
c.
only direct effects of a project should be included in the cash flow calculations
d.
cash flows should be measured on an incremental basis
e.
all of the above
9. Which of the following items is (are) not considered as part of the net investment calculation?
a.
installation and shipping charges
b.
acquisition cost of new asset
c.
salvage value of old equipment that is being replaced
d.
first year’s net cash flow
e.
c and d
10. The relationship between NPV and IRR is such that :
a.
both approaches always provide the same ranking of alternatives
b.
the IRR of a project is equal to the firm’s cost of capital when the NPV of a project is $0
c.
if the NPV of a project is negative, then the IRR must be greater than the cost of capital
d.
all of the above
e.
none of the above
11. GE Appliance Division believes which of the following warrants shifting assembly of appliances back
from Shanghai to Louisville, KY:.
a.
The negotiation of a two-tiered wage structure for union labor,
b.
Faster innovations when product design engineers and assembly line team leaders are
located in the same place,
c. quicker delivery to retail dealers reduce inventory storage
d. none of the above,
Test Bank Chapter 17
e. all of the above.
12. The cost of capital can be thought of as the rate of return required by investors in the firm’s securities.
a.
true
b.
false
13. In cost of capital calculations, the flotation cost on new debt is usually ignored because the flotation
cost percentage for large debt issues is relatively low.
a.
true
b.
false
14. The cost of internal equity (retained earnings) is ____ the cost of external equity (new common stock).
a.
greater than
b.
equal to
c.
less than
15. The expected rate of return from a share of stock consists of:
a.
a dividend return
b.
capital appreciation (or depreciation)
c.
interest
d.
a and b only
e.
a, b, and c
16. The weights used in calculating the firm’s weighted-average cost of capital are equal to the proportion
of debt and equity ____.
a.
used to finance the project
b.
used to finance the projects undertaken last year
c.
in the industry average capital structure
d.
in the firm’s target capital structure
e.
none of the above
17. In determining the optimal capital budget, one should choose those project’s whose ____ exceeds the
firm’s ____ cost of capital.
a.
internal rate of return, average
b.
internal rate of return, marginal
c.
internal rate of return, historic
d.
average rate of return, marginal
e.
none of the above
18. In the constant-growth dividend valuation model, the required rate of return on common stock (i.e.,
cost of equity capital) can be shown to be equal to the sum of the dividend yield plus the ____.
a.
yield-to-maturity
b.
present value yield
c.
risk-free rate
d.
dividend growth rate
e.
none of the above
19. The ____ depicts the risk-return relationship in the market for all securities:
a.
characteristic line
b.
security market line
c.
investment opportunity curve
d.
marginal cost of capital schedule
e.
none of the above
20. Beta in the CAPM is ____.
a.
one measure of the systematic risk of a stock
b.
estimated as the slope of a regression line between an individual security’s returns and
returns for the market index.
c.
useful in estimating the firm’s cost of debt capital
d.
a and b only
e.
a, b, and c
21. The effect of changes in the level of interest rates on security returns is an example of ____.
a.
systematic risk
b.
unsystematic risk
c.
nondiversifiable risk
d.
a and c only
e.
b and c only
22. The ____ method assumes that the cash flows over the life of the project are reinvested at the ____.
a.
net present value; computed internal rate of return
b.
internal rate of return; firm’s cost of capital
c.
net present value; firm’s cost of capital
d.
net present value; risk-free rate of return
e.
none of the above
23. All of the following except ____ are shortcomings of cost-benefit analysis.
a.
difficulty in measuring third-party costs
b.
difficulty in measuring third-party benefits
c.
failure to consider the time value of benefits and costs
d.
difficulty of accounting for program interactions
e.
a and b
24. Which of the following should not be counted in a cost-benefit analysis?
a.
direct benefits and costs
b.
real secondary benefits
c.
technological secondary costs
d.
pecuniary benefits
e.
intangibles
25. The social rate of discount is best approximated by:
a.
the cost of government borrowing
b.
the opportunity cost of resources taken from the private sector
c.
3 percent
d.
30 percent
e.
none of the above
26. In cost-effectiveness analysis, constant cost studies:
a.
are rarely used
b.
attempt to specify the output which may be achieved from a number of alternative
programs, assuming all are funded at the same level
c.
are useless because they fail to adequately evaluate program benefits
d.
try to find the least expensive way of achieving a certain objective
e.
none of the above
27. Cost-benefit analysis is the public sector counterpart to ____ used in private, profit-oriented firms.
a.
ratio analysis
b.
break-even analysis
c.
capital budgeting techniques
d.
economic forecasting
e.
none of the above
28. Direct costs of a public sector investment project are generally easier to measure than the direct
benefits.
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a.
true
b.
false
29. In calculating the benefit-cost ratio, social benefits and costs are discounted at the
a.
internal rate of return
b.
federal funds rate
c.
Treasury Bill rate
d.
long-term government bond rate
e.
none of the above
30. The discount rate utilized in public sector budgeting performs the functions of:
a.
allocating funds between the public and private sectors
b.
allocating funds between present consumption and investment (i.e., future consumption)
c.
allocating funds between debt and equity securities
d.
a and b only
e.
none of the above
31. In cost-benefit analysis, a low discount rate tends to favor projects with relatively ____ lives.
a.
short
b.
long
32. The social discount rate used in cost-benefit analysis is equal to a weighted average of the Treasury
Bill rate and the long-term government borrowing rate.
a.
true
b.
false
33. Public sector investment projects are economically justifiable only when:
a.
the discounted social benefits exceed the discounted social costs
b.
the internal rate of return exceeds the social discount rate
c.
the benefit-cost ratio exceeds zero
d.
a and b only
e.
a, b, and c
34. In cost-benefit analysis, intangibles include such factors as:
a.
quality of life considerations
b.
changes in land values resulting from a project
c.
aesthetic contributions
d.
a and b only
e.
a and c only
Test Bank Chapter 17
PROBLEMS
1. RCB Corporation is considering the purchase of a machine for which the initial cash outlay will be
$100,000. Predicted net cash inflows before depreciation and taxes are $25,000 per year for the next
five years. The machine will be depreciated (using the straight-line method) over the 5-year period
with a zero estimated salvage value at the end of the period. The corporation’s marginal tax rate is 40
percent and its cost of capital is 12 percent.
Determine the annual net cash flow after depreciation and taxes for years 1-5.
Determine the internal rate of return.
Determine the net present value.
Should RCB purchase the machine? Why or why not?
at r percent. From Table 5, D.F. = 4.4518 for 4% and D.F. = 4.3295 for 5%.
Therefore,
NOTE: This problem requires the use of present value tables or a financial calculator.
——————-k = 12%——————
Year
1-5
RCB should not purchase the machine since NPV < 0, IRR < 12%.
2. The capital structure of Wildcat Wells, an independent petroleum exploration and drilling company,
consists of 40 percent debt and 60 percent equity capital. Debt capital consists of a bond (which
matures in 10 years) issued five years ago at an interest rate of 10 percent. Since then market interest
rates have risen substantially. The firm has been advised by its investment banker that additional debt
financing (bonds) could be obtained at a rate of 12 percent. In the last six years of operations, Wildcat
Wells has averaged a 12 percent compound rate of growth in earnings and dividends. This rate is
expected to continue for the foreseeable future. Next year’s dividend is projected to be $.75 per share.
The firm’s stock is currently selling for $25 per share. Wildcat Wells has a 40 percent marginal income
tax rate.
What is the firm’s after-tax cost of debt financing?
What is the firm’s after-tax cost of internal equity capital?
Assuming that Wildcat Wells plans to maintain its present capital structure, what is the
firm’s weighted cost of capital?
Cost of debt capital
Cost of internal equity capital
Weighted cost of capital
3. The production superintendent of the Holloway Company has proposed that the firm purchase a new
$40,000 grinding machine for use in the plant. The machine is expected to generate $10,000 per year
in pre-tax cash savings (labor and spoilage) for the next 10 years. At the end of 10 years the salvage
value of the machine is estimated to be $5,000. Holloway uses straight-line depreciation and its
marginal income tax rate is 40 percent. The firm’s cost of capital is 12 percent.
What are the net cash inflows after depreciation and taxes for the machine in years 1-10?
What is the net present value for the machine?
What is the internal rate of return for the machine?
Would you recommend purchasing the machine? Why or why not?
Years 1-9
Year 10
NOTE: This problem requires the use of present value tables or a financial calculator.
Year
10
NPV
Year
1-9
A purchase is recommended because NPV > 0, IRR > 12% (the firm’s cost of capital).
4. Aspen Industries currently pays an annual common stock dividend of $5.00 per share. The company’s
dividend has grown steadily over the past 10 years at a 7 percent rate and this rate is expected to
continue for the foreseeable future. The company’s stock currently sells for $70 per share. The
company can issue new common stock at a net price of $65 per share.
Determine the firm’s cost of internal equity capital using the dividend capitalization
(constant-growth) model.
Determine the firm’s cost of external equity capital using the dividend capitalization
(constant-growth) model.
5. Piedmont Power Company’s common stock has a beta, ß, estimated to be .85. The risk-free rate is 8
percent and the expected market return is 14 percent. Compute Peidmont’s cost of equity capital.
6. The Jackson Company has the following capital expenditure projects available for possible investment
next year:
Investment
Internal
Project
(Million)
Rate of Return
A
$10
22%
B
25
14
C
20
18
D
40
12
E
15
10
F
10
13
G
50
15
H
30
11
The company has developed the following costs of various increments of capital needed to finance its
capital budget for next year:
Amount of
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Capital Raised
Cost of
(Million)
Capital
Up to $50
11.0
$50-$125
12.5
Over $125
14.5
Cumulative
Investment
Investment
A
G
H
Determine the optimal capital budget for the company.
7. The Ministry of Recreation has decided to consider a proposal to build a new regional park. A piece of
land is available which can be purchased, after condemnation proceedings, for $1,000,000. A private
developer has offered the owner of the land $2 million. The value of direct recreational benefits from
the park is estimated at $175,000 per year for 25 years. In addition, indirect benefits of $12,500 per
year for 25 years have been projected. Increased values in land surrounding the project will provide
immediate, one-time pecuniary benefits to the land-owners of $1,000,000.
The direct cost to operate and maintain the park is estimated at $50,000 per year. The Ministry
believes a 10% discount rate is appropriate to evaluate projects of this sort. Should the park be built?
Justify your answer using cost benefit analysis.