The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital. True b. False Q2. GPS...

Q1. The firm's best financial structure is determined by finding the capital structure that minimizes the firm's cost of capital.

   a. True

   b. False

Q2. GPS Inc. wishes to estimate its cost of retained earnings. The firm's beta is 1.3. The rate on 6-month T-bills is 2%, and the return on the S&P 500 index is 15%. What is the appropriate cost for retained earnings in determining the firm's cost of capital?

   a. 17.0%

   b. 19.5%

   c. 18.9%

   d. 22.1%

Q3. A company has preferred stock that can be sold for $21 per share. The preferred stock pays an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the cost of preferred stock is

   a. 18.87%.

   b. 17.72%.

   c. 14.26%.

   d. 12.94%.

Q4. WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has been growing rapidly over the past several years, selling common stock in each year to finance its growth. However, due to difficult economic times this year, WineCellars decides to cut its dividend and increase its retained earnings so that the common equity portion of its capital structure will include only retained earnings and no new common stock will be sold. WineCellars weighted average cost of capital this year should be

   a. zero, since no new stock will be sold.

   b. less than 12%.

   c. equal to 12%.

   d. greater than 12%.

Q5. The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is 35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport's cost of retained earnings?

   a. 16.4%

   b. 17.7%

   c. 19.6%

   d. 20.1%

Q6. The best financial structure is determined by finding the debt and equity mix that maximizes the firm's cost of capital.

   a. True

   b. False

Q7. For a typical corporation, which of the following capital structures will result in the lowest weighted average cost of capital?

   a. 40% debt, 20% preferred stock, 40% common equity

   b. 50% debt, 10% preferred stock, 40% common equity

   c. 60% debt, 10% preferred stock, 30% common equity

   d. 60% debt, 15% preferred stock, 25% common equity

Q8. The cost of retained earnings is less than the cost of new common stock because

   a. marginal tax brackets increase.

   b. flotation costs are incurred when new stock is issued.

   c. dividends are not tax deductible.

   d. accounting rules allow a deduction when using retained earnings.

Q9. JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to earn $30 million in net income next year and retain 40% of it, how large can the capital budget be before common stock must be sold?

   a. $7.5 million

   b. $12.0 million

   c. $15.5 million

   d. $16.0 million

Q10. The average cost associated with each additional dollar of financing for investment projects is

   a. the incremental return.

   b. the marginal cost of capital.

   c. CAPM required return.

   d. the component cost of capital.

Q11. What is the net present value's assumption about how cash flows are reinvested?

   a. They are reinvested at the IRR.

   b. They are reinvested at the APR.

   c. They are reinvested at the firm's discount rate.

   d. They are reinvested only at the end of the project.

Q12. Which of the following statements is MOST correct?

   a. If a project's internal rate of return (IRR) exceeds the required return, then the project's net present value (NPV) must be negative.

   b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

   c. The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return equal to the IRR.

   d. A project with a NPV = 0 is not acceptable.

Q13. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project A is

   a. $12,989.

   b. $13,357.

   c. $15,024.

   d. $18,532

Q14. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%. The equivalent annual annuity amount for project B, rounded to the nearest dollar, is

   a. $17,385.

   b. $20,936.

   c. $22,789.

   d. $26,551.

Q15. Your firm is considering an investment that will cost $920000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's net present value?

   a. $540,000

   b. $378,458

   c. $192,369

   d. $112,583

Q16. DYI Construction Co. is considering a new inventory system that will cost $750,000. The system is expected to generate positive cash flows over the next four years in the amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four. DYI's required rate of return is 8%. What is the net present value of this project?

   a. $104,089

   b. $100,328

   c. $96,320

   d. $87,417

Q17. For any individual project, if the project is acceptable based on its internal rate of return, then the project will also be acceptable based on its modified internal rate of return.

   a. True

   b. False

Q18. A significant advantage of the payback period is that it

   a. places emphasis on time value of money.

   b. allows for the proper ranking of projects.

   c. tends to reduce firm risk because it favors projects that generate early, less uncertain returns.

   d. gives proper weighting to all cash flows.

Q19. Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The project is expected to generate equal annual cash flows over the next ten years. The required return for this project is 16%. What is project LMK's internal rate of return?

   a. 19.88%

   b. 22.69%

   c. 24.78%

   d. 26.12%

Q20. A capital budgeting project has a net present value of $30,000 and a modified internal rate of return of 15%. The project's required rate of return is 13%. The internal rate of return is

   a. greater than $30,000.

   b. less than 13%.

   c. between 13% and 15%.

   d. greater than 15%

Q21. Trinitron, Inc. purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company's existing assets. Trinitron must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. What will depreciation expense be during the first year?

   a. $13,000

   b. $12,500

   c. $11,625

   d. $11,500

Q22. Which of the following should be excluded in an analysis of a new project's cash flows?

   a. additional investment in fixed assets

   b. additional investment in accounts receivable

   c. additional investment in inventory

   d. additional interest expenses on debt financing

Q23. You are analyzing the purchase of new equipment. Since you are not an expert on this type of equipment, you hire a consulting firm to make recommendations. The consultant charged you $1,500 and recommended the purchase of the latest model from ACME Corp. of America. The equipment costs $80,000, and it will cost another $10,000 to modify it for special use by your firm. The equipment will be depreciated on a straight-line basis over six years with no salvage value. You expect the equipment will be sold after three years for $28,000. Use of the equipment will require an increase in your company's net working capital of $4,000, but this $4,000 will be recovered at the end of year three. The use of the equipment will have no effect on revenues, but it is expected to save the firm $50,000 per year in before-tax operating costs. Your company's marginal tax rate is 35%. What is the terminal cash flow for this project?

   a. $17,000

   b. $24,500

   c. $33,950

   d. $37,950

Q24. Increased depreciation expenses affect tax-related cash flows by

   a. increasing taxable income, thus increasing taxes.

   b. decreasing taxable income, thus reducing taxes.

   c. decreasing taxable income, with no effect on cash flow since depreciation is a non-cash expense.

   d. pushing a corporation into a higher tax bracket.

Q25. Alloy Corp. is considering the acquisition of a new processing line. The processor can be purchased for $3,750,000; it will have a 10-year useful life. It will cost $165,000 to ship and $85,250 to install the processor. A recently completed feasibility study that was performed at a cost of $65,000 indicated that the processor would produce a positive NPV. The processor will be depreciated using the straight-line method to zero expected salvage value. Studies have shown that employee-training expenses will be $125,000. What will be the annual depreciation expense of the processing line for capital budgeting purposes?

   a. $375,000

   b. $419,025

   c. $390,000

   d. $400,025

Q26. A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven, and another capital budgeting project involving research and development into synthetic food substitutes. Which of the following statements is MOST correct concerning the risk-adjusted discount rate(s) for the projects?

   a. The rate will likely be higher for the replacement project because the likelihood of success is higher.

   b. The rate will likely be higher for the research and development project because of the uncertainty involved with research and development projects.

   c. The rate should be the same for both projects because they are being considered by one company with the same common shareholders.

   d. The rate should be higher for the replacement project because the company is more certain of the returns from a project similar to their existing business.

Q27. If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk is relevant when evaluating project risk in capital budgeting?

   a. total project risk

   b. contribution-to-firm risk

   c. systematic risk

   d. capital rationing risk

Q28. Which of the following should be included in the initial outlay?

   a. taxable gain on the sale of old equipment being replaced

   b. first year depreciation expense on any new equipment purchased

   c. preexisting firm overhead reallocated to the new project

   d. increased investment in inventory and accounts receivable

Q29. If depreciation expense in year one of a project increases for a highly profitable company

   a. net income decreases and incremental free cash flow decreases.

   b. net income increases and incremental free cash flow increases.

   c. the book value of the depreciating asset increases at the end of year one.

   d. net income decreases and incremental free cash flow increases.

Q30. Accounting profits, adjusted for taxes and differences in accounting methods, provide the best measure of relevant cash flows for capital budgeting purposes.

   a. True

   b. False

Q31. The primary weakness of EBIT-EPS analysis is that

   a. it ignores the implicit cost of debt financing.

   b. it double counts the cost of debt financing.

   c. it applies only to firms with large amounts of debt in their capital structure.

   d. it may only be used by firms that are profitable this year.

Q32. A high degree of variability in a firm's earnings before interest and taxes refers to

   a. business risk.

   b. financial risk.

   c. financial leverage.

   d. operating leverage.

Q33. A Bristal Boats, Inc. reports sales of $4,000,000, variable costs of $500,000, fixed operating costs of $1,250,000, and interest expense of $350,000. The corporation's EBIT is $3,250,000 and its marginal tax rate is 30%. If the corporation is able to increase its sales by 25%, then

   a. its EBIT will increase by 25% and its EPS will increase by 25%.

   b. its EBIT will increase by more than 25% and its EPS will increase by less than 25%.

   c. its EBIT and EPS will both increase, but less than 25% due to fixed costs and taxes.

   d. its EBIT will increase by more than 25% and its EPS will increase by more than the percentage increase in EBIT.

Q34. Kohler Manufacturing typically achieves one of three production levels in any given year: 8 million pounds of steel, 10 million pounds of steel, or 16 million pounds of steel. In tracking some of its costs, Kohler's controller discovered one cost that was $10 per pound at a production level of 8 million pounds, $8 per pound at a production level of 10 million pounds, and $5 per pound at a production level of 16 million pounds. This is an example of a

   a. variable cost.

   b. fixed cost.

   c. semivariable cost.

   d. semifixed cost.

Q35. Dakota Oil, Inc. reported that its sales and EBIT increased by 10%, but its EPS increased by 30%. The much larger change in earnings per share could be the result of

   a. high operating leverage.

   b. high financial leverage.

   c. a high percentage of credit sale collections from prior years.

   d. high fixed costs of production.

Q36. Financial leverage is distinct from operating leverage since it accounts for

   a. use of debt and preferred stock.

   b. variability in fixed operating costs.

   c. variability in sales.

   d. changes in EBIT.

Q37. The "threat hypothesis"

   a. reduces management's tendency to spend freely.

   b. encourages management to use debt to further their own interests.

   c. increases the agency problem.

   d. increases agency monitoring costs.

Q38. Raising funds internally is effectively increasing the investment of the firm's existing common shareholders.

   a. True

   b. False

Q39. Optimal capital structure is

   a. the mix of permanent sources of funds used by the firm in a manner that will maximize the company's common stock price.

   b. the mix of all items that appear on the right-hand side of the company's balance sheet.

   c. the mix of funds that will minimize the firm's cost of equity capital.

   d. the mix of funds that will maximize the firm's interest tax shield.

Q40. Which of the following is a fixed cost?

   a. insurance

   b. direct material

   c. direct labor

   d. freight costs on products

Q41. According to the clientele effect

   a. companies should have dividend payout ratios of either 100% or 0%.

   b. companies should avoid making capricious changes in their dividend policies.

   c. companies should change their dividend policies to please their target group of investors.

   d. even if capital markets are perfect, dividend policy still matters.

Q42. Which of the following strategies may be used to alter a firm's capital structure toward a higher percentage of debt compared to equity?

   a. stock dividend

   b. stock split

   c. maintain a low dividend payout ratio

   d. stock repurchase

Q43. Concentric Corporation has 10 million shares of stock outstanding. Concentric's after-tax profits are $140 million and the corporation's stock is selling at a price-earnings multiple of 18, for a stock price of $252 per share. Concentric's management issues a 40% stock dividend. What is the effect on an investor who owns 100 shares of Concentric before the dividend if Concentric's price-earnings multiple remains the same after the dividend is paid?

   a. The investor will own 140 shares worth $25,200.

   b. The investor will own 140 shares worth $35,280.

   c. The investor will own 100 shares worth $25,200.

   d. The investor will own 100 shares worth $35,280.

Q44. A firm that maintains a "stable dollar dividend per share" will generally not increase the dividend unless

   a. a stock split occurs.

   b. the firm merges with another profitable firm.

   c. the firm is sure that a higher dividend level can be maintained.

   d. the P/E ratio has increased steadily over the past 5 years.

Q45. A corporation announces a significant increase in its annual dividend and its stock price increases on the news. This could be explained most directly by

   a. residual dividend theory.

   b. bird-in-the-hand theory.

   c. perfect capital markets.

   d. MM"s indifference theorem.

Q46. Which of the following will result from a stock repurchase?

   a. Earnings per share will rise.

   b. Number of shares will increase.

   c. Corporate cash is conserved.

   d. Ownership is diluted.

Q47. The problem with the constant dividend payout ratio is

   a. investors may come to expect a specified amount.

   b. the dollar amount of the dividend fluctuates from year to year.

   c. management is reluctant to cut the dividend even if there are low profits that year.

   d. management cannot decrease the dividend when times are tough.

Q48. Which of the following factors would most likely be present if a company increases its dividend payout ratio significantly?

   a. a high debt/equity ratio (i.e), use of a large amount of financial leverage.

   b. a quick ratio that is significantly below the industry average

   c. current shareholders cannot participate in a new offering and desire to maintain ownership control

   d. the variability of expected future earnings decreases

Q49. According to the perfect markets approach to dividend policy

   a. other things equal, the greater the payout ratio, the greater the share price of the firm.

   b. the price of a share of stock is unrelated to dividend policy.

   c. the firm should retain earnings so stockholders will receive a capital gain.

   d. the firm should pay a dividend only after current equity financing needs have been met.

Q50. The difference between the capital gains tax rate and the income tax rate is an incentive for

   a. firms never to split their stock.

   b. firms to declare more stock dividends.

   c. firms to pay more earnings as dividends.

   d. firms to retain more earnings.