Corporate Finance: Cost of Common Equity / Equity Capital; NPV Technique; Capital Budgeting

CORPORATE FINANCE—MG 5002

1. For a typical firm with a given capital structure, which of the
following is correct? (Note: All rates are after taxes.)

a. kd > ke > ks > WACC.

b. ks > ke > kd > WACC.

c. WACC > ke > ks > kd.

d. ke > ks > WACC > kd.

2. Which of the following approaches to estimating the cost of common
equity is the least difficult to estimate?

a. Expected growth rate, g.

Dividend yield, D1/Po.

Required return, ks.

Expected rate of return, k(hat)s.

3. Wyden Brothers has no retained earnings. The company uses the CAPM
to calculate the cost of equity capital. The company’s capital
structure consists of common stock, preferred stock, and debt. Which of
the following events will reduce the company’s WACC?

a. A reduction in the market risk premium.

b. An increase in the flotation costs associated with issuing new common
stock.

c. An increase in the company’s beta.

d. An increase in expected inflation.

If the result of applying the NPV technique for evaluating a capital
project is a

negative figure, it implies that:

the required rate of return has not been achieved

the investment will not add value or contribute to shareholder wealth

the present value of the expected cash outflows is greater than the
present value of the expected cash flows.

All of the above

A firm may not be able to undertake all possible capital projects that
have

positive NPVs. Some reasons may not be financial, but for a
firm to

determine which capital techniques are most financially
viable:

the payback method has always proved reliable in ranking the best of the
best capital projects

request that the treasury department secure more funding

techniques known as capital rationing must be used

all of the above

When evaluating capital budgeting projects, most managers of big
companies

gravitate toward

NPV

Payback method

IRR

None of the above

7. A project has an up-front cost of $100,000. The project’s WACC is
12 percent and its net present value is $10,000. Which of the following
statements is most correct?

a. The project should be rejected since its return is less than the
WACC.

b. The project’s internal rate of return is greater than 12 percent.

c. The project’s modified internal rate of return is less than 12
percent.

d. All of the statements above are correct.

8. Which of the following statements is most correct?

a. If a project with normal cash flows has an IRR which exceeds the cost
of capital, then the project must have a positive NPV.

b. If the IRR of Project A exceeds the IRR of Project B, then Project A
must also have a higher NPV.

c. The modified internal rate of return (MIRR) can never exceed the IRR.

d. Statements a and c are correct.

9. A company estimates that its weighted average cost of capital (WACC)
is 10 percent. Which of the following independent projects should the
company accept?

a. Project A requires an up-front expenditure of $1,000,000 and
generates a net present value of $3,200.

b. Project B has a modified internal rate of return of 9.5 percent.

c. Project C requires an up-front expenditure of $1,000,000 and
generates a positive internal rate of return of 9.7 percent.

d. Project D has an internal rate of return of 9.5 percent.

10. The internal rate of return (IRR) is the rate of interest that
makes the present

value of the cash inflows:

greater than the present value of cash outflows

less than the present value of the cash outflows

equal to the present value of cash outflows

none of the above.

11. A company is considering a new project. The company’s CFO plans
to calculate the project’s NPV by discounting the relevant cash flows
(which include the initial up-front costs, the operating cash flows, and
the terminal cash flows) at the company’s cost of capital (WACC).
Which of the following factors should the CFO include when estimating
the relevant cash flows?

a. Any sunk costs associated with the project.

b. Any interest expenses associated with the project.

c. Any opportunity costs associated with the project.

d. Statements b and c are correct.

12. Which of the following is discussed in the text as a method for
analyzing risk in capital budgeting?

a. Sensitivity analysis.

b. Monte Carlo simulation.

Scenario analysis.

All of the above

13. A firm is considering the purchase of an asset whose risk is
greater than the current risk of the firm, based on any method for
assessing risk. In evaluating this asset, the decision maker should

a. Increase the NPV of the asset to reflect the greater risk.

b. Reject the asset, since its acceptance would increase the risk of the
firm.

c. Ignore the risk differential if the asset to be accepted would
comprise only a small fraction of the total assets of the firm.

d. Increase the cost of capital used to evaluate the project to reflect
the higher risk of the project.

14. Business risk is concerned with the operations of the firm. Which
of the following is not associated with (or not a part of) business
risk?

a. Demand variability.

b. Sales price variability.

c. The extent to which operating costs are fixed.

d. Changes in required returns due to financing decisions.

15. Which of the following statements is most correct?

a. The capital structure that maximizes stock price is also the capital
structure that minimizes the weighted average cost of capital (WACC).

b. The capital structure that maximizes stock price is also the capital
structure that maximizes earnings per share.

c. The capital structure that maximizes stock price is also the capital
structure that maximizes the firm’s times interest earned (TIE) ratio.

d. Statements a and b are correct.

16. Which of the following statements is most correct?

a. Increasing financial leverage is one way to increase a firm’s basic
earning power (BEP).

b. Firms with lower fixed costs tend to have greater operating leverage.

c. The debt ratio that maximizes EPS generally exceeds the debt ratio
which maximizes share price.

d. Statements a and b are correct.

17. Which of the following statements is most correct?

An increase in the personal tax rate would not affect firms’ capital
structure decisions.

b. In general, a firm with low operating leverage has a small
proportion of its total costs in the form of fixed costs.

c. A firm with high business risk is more likely to increase its use of
financial leverage than a firm with low business risk, assuming all else
equal.

d. Statements a and b are correct.

When a firm offers its shareholders the opportunity to reinvest their
dividends

into additional shares of stock as an alternative to cash
dividends, the tax

implications:

are of no consequence because the shareholder does not receive any cash

require that the shareholder pay a tax at the time the additional shares
are sold

require that the shareholder pay a tax in the year he or she receives
the additional share to the extent of their dividend equivalency

require that the shareholder pay a tax on the appreciated value of the
additional shares when they are eventually sold.

The underlying reason for investors’ aversion to receiving income from


dividends is the less favorable tax treatment of dividend
income. Capital

gain income offers the following tax advantage(s) over
dividend income:

the deferral of any capital gains tax until the sale of the appreciated
stock

upon the death of the investor, transfer of the stock to heirs at the
stock’s then current market value, thus avoiding a capital gains

a slight reduction, under current law, in the tax rates applied to
capital gains

all of the above