FIN304 Mid term - The most common motive for adding fixed assets to the firm is:

FIN304 Mid term

It consist of 27 multiple choice/true or false questions and 5 word problems.

Question 1

1. The most common motive for adding fixed assets to the firm is:

a. Expansion

b. Replacement

c. Renewal

d. Transformation

Question 2

2. ________ is the process of evaluating and selecting long-term investments consistent with the firm's goal of wealth maximization.

a. Recapitalizating assets

b. Capital Budgeting

c. Ratio analysis

d. Restructuring debt

Question 3

3. Consider the following cash flow pattern. In year zero: capital expense = $100,000; year 1 cash inflow = $25,000; year 2 cash inflow = $10,000; year 3 cash inflow = $50,000; year 4 cash inflow = $60,000. This cash flow pattern is best described as a(n):

a. annuity and a conventional cash flow

b. mixed stream and a non-conventional cash flow

c. annuity and a non-conventional cash flow

d. mixed stream and a conventional cash flow

e. Beats me! - like you expected me to actually read the book?

Question 4

4. ________________ projects do not compete with each other, the acceptance of one ___________ the others from consideration.

a. Capital projects; eliminates

b. Independent; does not eliminate

c. Mutually exclusive; eliminates

d. Replacement; does not eliminate

Question 5

5. A firm with limited dollars available for capital expenditures is subject to:

a. Capital dependency

b. Independent projects

c. Working capital constraints

d. Capital rationing

Question 6

6. The ____________ is the exact amount of time it takes the firm to recover its initial investment

a. Average rate of return

b. Initial rate of return

c. Net Present Value

d. Payback

Question 7

7. All of the following are weaknesses of the payback method except:

a. it is easy to calculate

b. it ignores cash flow beyond the payback period

c. present value of cash flows is not used

d. none of the above

Question 8

8. A firm is evaluating a proposal which has an initial investment of $35,000 and has cash inflows of $10,000 in year one; $20,000 in year two; and $10,000 in year 3. The payback period of the project is:

a. 1 year

b. 2 years

c. between 1 & 2 years

d. between 2 & 3 years

e. none of the above

Question 9

9. A firm is evaluating an investment proposal which has an initial investment of $5,000 and cash inflows presently valued at $4,000. The NPV pf the investment is:

a. - $1,000

b. $0

c. $1,000

d. 25%

Question 10

10. The _________________ is the discount rate that equates the present value of the cash inflows with the initial investment.

a. payback

b. NPV

c. cost of capital

d. IRR

Question 11

11. A firm with a cost of capital of 12.5% is evaluating 3 capital projects. The IRRs are as follows:

Project IRR

1 12%

2 15%

3 13.5%

The firm should:

a. accept 2; reject 1 & 3

b. accept 2 & 3; reject 1

c. accept 1; reject 2 & 3

d. accept 3; reject 1 & 2

e. accept all projects

f. reject all projects

Question 12

12. When NPV is negative, the IRR is ______________ the cost of capital.

a. greater than

b. greater than or equal to

c. less than

d. equal to

Question 13

13. In comparing NPV to IRR:

a. IRR is theoretically superior, but financial managers prefer NPV

b. NPV is theoretically superior, but financial mangers prefer IRR

c. Financial managers prefer NPV because it is presented as a % of the investment

d. I get confused

Question 14

14. In the context of capital budgeting, risk refers to:

a. the degree of variability of the cash inflows

b. the degree of variability of the initial investment

c. the chance that NPV will be greater than zero

d. the chance that IRR will exceed the cost of capital

Question 15

15. The initial investment for replacement decisions includes all of the following except:

a. the cost of the equipment

b. the installation costs of the new equipment

c. a subtraction of the sale of the old machine that is being replaced

d. all of the above would be included

Question 16

16. The four basic sources of long-term funds for a business are:

a. current liabilities, long-term debt, common stock and preferred stock

b. current liabilities, long-term debt, common stock and retained earnings

c. current liabilities, paid in capital in excess of par, common stock and retained earnings

d. long-term debt, common stock, preferred stock and retained earnings

Question 17

17. The higher the risk of a project, the higher its RADR and thus the lower the NPV for a given stream of inflows.

True

False

Question 18

18. The firm's optimal mix of debt and equity is called its:

a. optimal ratio

b. target capital structure

c. maximum potential wealth, MPW

d. book value

e. Fred

Question 19

19. The ____________________ is the weighted average cost of funds which relates the interrelationship of financial decisions.

a. risk premium

b. nominal cost

c. cost of capital

d. risk-free rate

Question 20

20. A tax adjustment must be made in determining the cost of ____________.

a. long-term debt

b. common stock

c. preferred stock

d. retained earnings

e. b & c

Question 21

21. The before tax cost of debt for a firm which has a marginal tax rate of 40%, is 12%. Therefore the interest rate that should be included in the cost of capital is:

a. 4.8%

b. 6.0%

c. 7.2%

d. 12%

Question 22

22. Debt is generally the least expensive source of capital. This is primarily due to:

a. the fixed (certain) interest payments

b. its position in the priority of claims on assets and earnings in the event of liquidation

c. the tax deductibility of interest payments

d. the secured nature of a debt obligation

Question 23

23. The cost of common equity may be estimated by using the:

a. yield curve

b. NPV method: NPV = CF (PVIFA) - CF

c. the Gordon model; r = D/P + g

d. Dupont analysis

Question 24

24. The investment opportunity schedule (IOS) combined with thee WACC indicates:

a. the initial investment in the project

b. those projects that will result in the highest positive cash flows

c. which projects are acceptable

d. that a hotel on Boardwalk costs $2,000

Question 25

25. As the cumulative amount of money invested in capital projects increases, its return on the projects increases.

True

False

Question 26

26. BONUS The cost of capital can be thought of as the rate of return required by market suppliers of capital in order to attract their funds to the firm.

True

False

Question 27

27. BONUS Sunk costs are cash outlays that may have a substantial impact on the capital budgeting decision and should be included in the initial investment calculation.

True

False

Question 28

NOTE: FOR ALL PROBLEMS YOU MUST (as in MUST!) SHOW ALL WORK - if you just give an answer I will mark it wrong.

P-1. What is the payback for a project that has anticipated cash inflows of $10,000 for 5 years and a cost of $22,000?

Question 29

P-2. Good old XYZorp (they're back!) is considering two mutually exclusive projects, A & B in order to expand their product line. After letting the cost accountants out of their cages, it was determined that project A's initial investment must be $42,400, while project B will cost $60,000.

Project A has projected cash inflows of $25,000 per year for three years. Project B's inflows are more variable: $10,000 in year 1; $30,000 in year 2; and $40,000 in its final year.

The firm's cost of capital is 12%. YES - this IS important!

Using NPV analysis, if the NPV for project B = + $ 1,320 (yes, I did the computation for you!), which project do you prefer? In other words - which project will have the higher NPV.

Question 30

P-3. Given the information for project A in problem P-2, what is this project's IRR?

Question 31

P-4. Assuming a target capital structureof:

40% debt

20% preferred stock

40% common equity

What would be the WACC given the following: all debt will be from the sale of bonds with a coupon of 10% (assume no flotation costs), preferred stock's associated cost will be 13%, and common equity will be from retained earnings with an associated cost of 15%. The tax rate for this corporation is 30%.

Question 32

A note to students on this problem. yes, it is a bit involved so think about what information you will need to develop in order to answer the questions. Hint: You might want to take a look at Figure 12.4 on page 486. I do not expect you to send me a graph, but you might find figure 12.4 helpful in figuring out what you need to know.

P-5. The Acme Chip Manufacturing Company (potato not computer) has a target capital structure of 40% debt and 60% common equity. They also have a 40% tax rate. HINT: you need this to calculate the "after-tax" cost of debt!

They have three projects under consideration code named: Manny, Moe, and Jack. All are independent.

The IRRs for the three projects:

Manny 16%

Moe 13%

Jack 10%

All three projects have an initial investment of $1,000,000.

Acme can borrow up to $2,000,000 from the bank at a quoted interest rate (the "before-tax" cost of debt) of 8%. They also have a reported $3,000,000 in Retained Earnings available for new projects.

Additional information: The next common stock dividend they pay will be $4.00 per share. They also expect a growth rate of 5% on common equity. New common stock can be sold for $50.00 per share, with flotation costs of $10.00 per share. Now if I were mean I would have you now calculate the "cost of issuing new common stock" - see page 368 in your text - as you have all the data you need. OK - so I'm mean - BUT (hint time) if I were you at this point I'd go to page 368 and use equation 9.8 to figure out that cost of using new common stock! But remember - it's always cheaper to use retained earnings than issuing new common stock. Soooo as long as they have retained earnings to use (as they DO in part 1) you don't have to sell new common for part 1. For part two on the other hand ...

Part 1:

a. Which projects would you accept and why? Yes, I need to see some "number crunching".

b. What would be your capital budget?

Part 2: Let's change one thing. The federal government has decided to increase the regulations affecting the manufacturing of chips. Complying with these new regulations will cost Acme $3 million, wiping out their retained earnings. So now:

a. Which projects would you accept and why? More number crunching please!

b. What would be their capital budget now?