FUNDAMENTAL OF FINANCIAL INVESTMENT DECISION

FUNDAMENTAL OF FINANCIAL

INVESTMENT DECISION

CORPORATE FINANCE PRACTICE QUESTIONS AND ANSWERS

CHAPTERS:

Capital Budgeting

Cost Of Capital

Measure Of Leverage

Dividends and Share Repurchases: Basics

Working Capital Management

A Corporate Governance of Listed Companies

MURTAZA MASOOD QURESHI, ACCA, CFA®

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CAPITAL BUDGETING

LOS A: Capital budget process, including the typical steps of the process and distinguish among

the various categories of capital projects.

Question 1 Which of the following steps is least likely to be an administrative step in the capital budgeting process?

A) Conducting a post-audit to identify errors in the forecasting process.

B) Forecasting cash flows and analyzing project profitability.

C) Arranging financing for capital projects.

Answer: C) Arranging financing for capital projects.

Arranging financing is not one of the administrative steps in the capital budgeting process. The four

administrative steps in the capital budgeting process are:

1. Idea generation

2. Analyzing project proposals

3. Creating the firm-wide capital budget

4. Monitoring decisions and conducting a post-audit

Question 2 Which of the following types of capital budgeting projects are most likely to generate little to no revenue?

A) Replacement projects to maintain the business.

B) Regulatory projects.

C) New product or market development.

Answer: B Mandatory regulatory or environmental projects may be required by a governmental agency or insurance company and typically involve safety-related or environmental concerns. The projects typically generate little to no revenue, but they accompany other new revenue producing projects and are accepted by the company in order to continue operating.

LOS B: Basic Principles of Capital Budgeting, including the choice of the proper cash flows.

Question 1 Ashlyn Lutz makes the following statements to her supervisor, Paul Ulring, regarding the basic principles of capital budgeting:

Statement 1: The timing of expected cash flows is crucial for determining the profitability of a capital budgeting project.

Statement 2: Capital budgeting decisions should be based on the after-tax net income produced by the capital project.

Which of the following regarding Lutz’s statements is most accurate?

Statement 1 Statement 2

A) Correct Correct

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B) Correct Incorrect

C) Incorrect Correct

Answer: B

Lutz’s first statement is correct. The timing of cash flows is important for making correct capital budgeting decisions. Capital budgeting decisions account for the time value of money. Lutz’s second statement is incorrect. Capital budgeting decisions should be based on incremental after-tax cash flows, not net (accounting) income.

Question 2 Mason Webb makes the following statements to his boss, Laine DeWalt about the principles of capital budgeting.

Statement 1: Opportunity costs are not true cash outflows and should not be considered in a capital budgeting analysis.

Statement 2: Cash flows should be analyzed on an after-tax basis.

Should DeWalt agree or disagree with Webb’s statements?

Statement 1 Statement 2

A) Agree Agree

B) Disagree Agree

C) Disagree Disagree

Answer: B

DeWalt should disagree with Webb’s first statement. Cash flows are based on opportunity costs. Any cash flows that the firm gives up because a project is undertaken should be charged to the project. DeWalt should agree with Webb’s second statement. The impact of taxes must be considered when analyzing capital budgeting projects.

Question 3 One of the basic principles of capital budgeting is that:

A) Decisions are based on cash flows, not accounting income.

B) Cash flows should be analyzed on a pre-tax basis.

C) Opportunity costs should be excluded from the analysis of a project.

Answer: A) decisions are based on cash flows, not accounting income.

The five key principles of the capital budgeting process are:

1. Decisions are based on cash flows, not accounting income.

2. Cash flows are based on opportunity costs.

3. The timing of cash flows is important.

4. Cash flows are analyzed on an after-tax basis.

5. Financing costs are reflected in the project’s required rate of return.

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Question 4 The CFO of Axis Manufacturing is evaluating the introduction of a new product. The costs of a recently completed marketing study for the new product and the possible increase in the sales of a related product made by Axis are best described (respectively) as:

A) Sunk cost; externality.

B) Opportunity cost; externality.

C) Externality; cannibalization.

Answer: A) sunk cost; externality.

The study is a sunk cost, and the possible increase in sales of a related product is an example of a

Question 5 Financing costs for a capital project are:

A) Subtracted from the net present value of a project.

B) Captured in the project’s required rate of return.

C) Subtracted from estimates of a project’s future cash flows.

Answer: B

Financing costs are reflected in a project’s required rate of return. Project specific financing costs should not be included as project cash flows. The firm's overall weighted average cost of capital, adjusted for project risk, should be used to discount expected project cash flows.

LOS C: How the following projects interactions affect the evaluation of a capital project: 1) Independent versus mutually exclusive projects, 2) Project sequencing, and 3) Unlimited funds versus Capital rationing

Question 1 If two projects are mutually exclusive, a company:

A) Can accept either project, but not both projects.

B) Must accept both projects or reject both projects.

C) Can accept one of the projects, both projects, or neither project.

Answer: A) can accept either project, but not both projects.

Mutually exclusive means that out of the set of possible projects, only one project can be selected. Given two mutually exclusive projects, the company can accept one of the projects or reject both projects, but cannot accept both projects.

Question 2 Project sequencing is best described as:

A) Arranging projects in an order such that cash flows from the first project fund subsequent projects.

B) An investment in a project today that creates the opportunity to invest in other projects in the future.

C) Prioritizing funds to achieve the maximum value for shareholders, given capital limitations.

Answer: B

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Projects are often sequenced through time so that investing in a project today may create the opportunity to invest in other projects in the future. Note that funding from the first project is not a requirement for project sequencing.

Question 3 Rosalie Woischke is an executive with ColaCo, a nationally known beverage company. Woischke is trying to determine the firm’s optimal capital budget. First, Woischke is analyzing projects Sparkle and Fizz. She has determined that both Sparkle and Fizz are profitable and is planning on having ColaCo accept both projects. Woischke is particularly excited about Sparkle because if Sparkle is profitable over the next year, ColaCo will have the opportunity to decide whether or not to invest in a third project, Bubble. Which of the following terms best describes the type of projects represented by Sparkle and Fizz as well as the opportunity to invest in Bubble?

Sparkle and Fizz Opportunity to invest in Bubble

A) Independent projects Add-on project

B) Mutually exclusive projects Project sequencing

C) Independent projects Project sequencing

Answer: C)

Independent projects Project sequencing

Independent projects are projects for which the cash flows are independent from one another and can be evaluated based on each project’s individual profitability. Since Woischke is accepting both projects, the projects must be independent. If the projects were mutually exclusive, only one of the two projects could be accepted. The opportunity to invest in Bubble is a result of project sequencing, which means that investing in a project today creates the opportunity to decide to invest in a related project in the future.

Question 4 The Chief Financial Officer of Large Closeouts Inc. (LCI) determines that the firm must engage in capital rationing for its capital budgeting projects. Which of the following describes the most likely reason for LCI to use capital rationing? LCI:

A) Has a limited amount of funds to invest.

B) Must choose between projects that compete with one another.

C) Would like to arrange projects so that investing in a project today provides the option to accept or reject certain future projects.

Answer: A) has a limited amount of funds to invest.

Capital rationing exists when a company has a fixed (maximum) amount of funds to invest. If profitable project opportunities exceed the amount of funds available, the firm must ration, or prioritize its funds to achieve the maximum value for shareholders given its capital limitations.

LOS D: Calculate and interpret the results using each of the following methods to evaluate a single capital project: net present value (NPV), Internet rate of return (IRR), payback period, discounted payback period and profitability index. Question 1 As the director of capital budgeting for Denver Corporation, an analyst is evaluating two mutually exclusive projects with the following net cash flows:

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Year Project X Project Z

0 -$100,000 -$100,000

1 $50,000 $10,000

2 $40,000 $30,000

3 $30,000 $40,000

4 $10,000 $60,000

If Denver's cost of capital is 15%, which project should be chosen?

A) Project X, since it has the higher IRR.

B) Neither project.

C) Project X, since it has the higher net present value (NPV).

Answer: B

NPV for Project X = -100,000 + 50,000 / (1.15)1 + 40,000 / (1.15)2 + 30,000 / (1.15)3 + 10,000 / (1.15)4

= -100,000 + 43,478 + 30,246 + 19,725 + 5,718 = -833

NPV for Project Z = -100,000 + 10,000 / (1.15)1 + 30,000 / (1.15)2 + 40,000 / (1.15)3 + 60,000 / (1.15)4

= -100,000 + 8,696 + 22,684 + 26,301 + 34,305 = -8,014

Reject both projects because neither has a positive NPV.

Question 2 The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in years 1 through 4, $35,000 per year in years 5 through 9, and $40,000 in year 10. This investment will cost the firm $150,000 today, and the firm's cost of capital is 10%. The payback period for this investment is closest to:

A) 5.23 years.

B) 6.12 years.

C) 4.86 years.

Answer: C) 4.86 years.

Years 0 1 2 3 4 5

Cash Flows -$150,000 $30,000 $30,000 $30,000 $30,000 $35,000

$150,000

120,000 (4 years)(30,000/year)

$30,000

With $30,000 unrecovered cost in year 5, and $35,000 cash flow in year 5; $30,000 / $35,000 = 0.86

years

4 + 0.86 = 4.86 years

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Question 3 Which of the following statements about the payback period is NOT correct?

A) The payback method considers all cash flows throughout the entire life of a project.

B) The payback period provides a rough measure of a project's liquidity and risk.

C) The payback period is the number of years it takes to recover the original cost of the investment.

Answer: A) The payback method considers all cash flows throughout the entire life of a project.

The payback period does not take any cash flows after the payback point into consideration.

Question 4 A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule: Year 1: $3,000 Year 2: $2,000

Year 3: $2,000

Determine the project's payback period and discounted payback period.

Payback Period Discounted Payback Period

A) 2.0 years 1.6 years

B) 2.0 years 2.4 years

C) 2.4 years 1.6 years

Answer: B

Regarding the regular payback period, after 1 year, the amount to recover is $2,000 ($5,000 - $3,000).

After the second year, the amount is fully recovered.

The discounted payback period is found by first calculating the present values of each future cash flow.

These present values of future cash flows are then used to determine the payback time period.

3,000 / (1 + .10)1 = 2,727

2,000 / (1 + .10)2 = 1,653

2,000 / (1 + .10)3 = 1,503.

Then:

5,000 - (2,727 + 1,653) = 620

620 / 1,503 = .4.

So, 2 + 0.4 = 2.4.

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Question 5 Which of the following statements about NPV and IRR is least accurate?

A) For independent projects if the IRR is > the cost of capital accept the project.

B) For mutually exclusive projects you should use the IRR to rank and select projects.

C) The NPV method assumes that all cash flows are reinvested at the cost of capital.

Answer: B

For mutually exclusive projects you should use NPV to rank and select projects.

Question 6 Lincoln Coal is planning a new coal mine, which will cost $430,000 to build, with the expenditure occurring next year. The mine will bring cash inflows of $200,000 annually over the subsequent seven years. It will then cost $170,000 to close down the mine over the following year. Assume all cash flows occur at the end of the year. Alternatively, Lincoln Coal may choose to sell the site today. What minimum price should Lincoln set on the property, given a 16% required rate of return?

A) $325,859.

B) $376,872.

C) $280,913.

Answer: C) $280,913.

The key to this problem is identifying this as a NPV problem even though the first cash flow will not occur until the following year. Next, the year of each cash flow must be property identified; specifically: CF0 = $0; CF1 = -430,000; CF2-8 = +$200,000; CF9 = -$170,000. One simply has to discount all of the cash flows to today at a 16% rate. NPV = $280,913.

Question 7 Lane Industries has a project with the following cash flows:

Year Cash Flow

0 −$200,000

1 60,000

2 80,000

3 70,000

4 60,000

5 50,000

The project's cost of capital is 12%. The discounted payback period is closest to:

A) 2.9 years.

B) 3.9 years.

C) 3.4 years.

Answer: B

The discounted payback period method discounts the estimated cash flows by the project’s cost of capital

and then calculates the time needed to recover the investment.

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Year Cash Flow Discounted

Cash Flow

Cumulative

Discounted

Cash Flow

0 −$200,000 −$200,000.00 −$200,000.00

1 60,000 53,571.43 −146,428.57

2 80,000 63,775.51 −82,653.06

3 70,000 49,824.62 −32,828.44

4 60,000 38,131.08 5,302.64

5 50,000 28,371.30 33,673.98

discounted payback period =number of years until the year before full recovery +

Question 8 A company is considering a $10,000 project that will last 5 years.

Annual after tax cash flows are expected to be $3,000 Target debt/equity ratio is 0.4 Cost of equity is 12% Cost of debt is 6% Tax rate 34%

What is the project's net present value (NPV)?

A) +$1,460.

B) -$1,460.

C) $+1,245

Answer: A) +$1,460.

First, calculate the weights for debt and equity

wd + we = 1

we = 1 − wd

wd / we = 0.40

wd = 0.40 × (1 − wd)

wd = 0.40 − 0.40wd

1.40wd = 0.40

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wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.06 × 0.66) + (0.714 × 0.12) = 0.0113 + 0.0857 =

0.0970

Third, calculate the PV of the project cash flows

N = 5, PMT = -3,000, FV = 0, I/Y = 9.7, CPT → PV = 11,460

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $11,460 − $10,000 = $1,460

Question 9 A company is considering the purchase of a copier that costs $5,000. Assume a cost of capital of 10 percent and the following cash flow schedule:

Year 1: $3,000 Year 2: $2,000 Year 3: $2,000

Determine the project's NPV and IRR.

NPV IRR

A) $243 20%

B) $883 15%

C) $883 20%

Answer: C)

$883 20%

To determine the NPV, enter the following:

PV of $3,000 in year 1 = $2,727, PV of $2,000 in year 2 = $1,653, PV of $2,000 in year 3 = $1,503. NPV

= ($2,727 + $1,653 + $1,503) − $5,000 = 883.

You know the NPV is positive, so the IRR must be greater than 10%. You only have two choices, 15%

and 20%. Pick one and solve the NPV. If it is not close to zero, then you guessed wrong; select the other

one.

[3000 ÷ (1 + 0.2)1 + 2000 ÷ (1 + 0.2)2 + 2000 ÷ (1 + 0.2)3] − 5000 = 46 This result is closer to zero (approximation) than the $436 result at 15%. Therefore, the approximate IRR is 20%. Question 10 Tapley Acquisition, Inc., is considering the purchase of Tangent Company. The acquisition would require an initial investment of $190,000, but Tapley's after-tax net cash flows would increase by $30,000 per year and remain at this new level forever. Assume a cost of capital of 15%. Should Tapley buy Tangent?

A) No, because k > IRR.

B) Yes, because the NPV = $30,000.

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C) Yes, because the NPV = $10,000.

Answer: C) Yes, because the NPV = $10,000.

This is a perpetuity.

PV = PMT / I = 30,000 / 0.15 = 200,000

200,000 − 190,000 = 10,000

Question 11 An analyst has gathered the following data about a company with a 12% cost of capital: Project A Project B Cost $15,000 $25,000 Life 5 years 5 years Cash inflows $5,000/year $7,500/year

Part 1) Projects A and B are mutually exclusive. What should the company do?

A) Accept A, Reject B.

B) Reject A, Accept B.

C) Reject A, Reject B.

Answer: A) Accept A, Reject B.

For mutually exclusive projects accept the project with the highest NPV. In this example the NPV for Project A (3,024) is higher than the NPV of Project B (2,036). Therefore accept Project A and reject Project B.

Part 2) If the projects are independent, what should the company do?

A) Accept A, Accept B.

B) Reject A, Reject B.

C) Accept A, Reject B.

Answer: A) Accept A, Accept B.

Project A: N = 5; PMT = 5,000; FV = 0; I/Y = 12; CPT → PV = 18,024; NPV for Project A = 18,024 −

15,000 = 3,024.

Project B: N = 5; PMT = 7,500; FV = 0; I/Y = 12; CPT → PV = 27,036; NPV for Project B = 27,036 −

25,000 = 2,036.

For independent projects the NPV decision rule is to accept all projects with a positive NPV. Therefore,

accept both projects.

Question 12

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Edelman Engineering is considering including an overhead pulley system in this year's capital budget. The cash outlay for the pulley system is $22,430. The firm's cost of capital is 14%. After-tax cash flows, including depreciation are $7,500 for each of the next 5 years.

Calculate the internal rate of return (IRR) and the net present value (NPV) for the project, and indicate the correct accept/reject decision.

NPV IRR Accept/Reject

A) $15,070 14% Accept

B) $15,070 14% Reject

C) $3,318 20% Accept

Answer: C)

$3,318 20% Accept

Using the cash flow keys:

CF0 = -22,430; CFj = 7,500; Nj = 5; Calculate IRR = 20%

I/Y = 14%; Calculate NPV = 3,318

Because the NPV is positive, the firm should accept the project.

Question 13 Landen, Inc. uses several methods to evaluate capital projects. An appropriate decision rule for Landen would be to invest in a project if it has a positive:

A) Profitability index (PI).

B) Internal rate of return (IRR).

C) Net present value (NPV).

Answer: C) net present value (NPV).

The decision rules for net present value, profitability index, and internal rate of return are to invest in a project if NPV > 0, IRR > required rate of return, or PI > 1.

Question 14 A firm is reviewing an investment opportunity that requires an initial cash outlay of $336,875 and promises to return the following irregular payments: Year 1: $100,000 Year 2: $82,000 Year 3: $76,000 Year 4: $111,000 Year 5: $142,000

If the required rate of return for the firm is 8%, what is the net present value of the investment?

A) $64,582.

B) $99,860.

C) $86,133.

Answer: A) $64,582.

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In order to determine the net present value of the investment, given the required rate of return; we can

discount each cash flow to its present value, sum the present value, and subtract the required investment.

Year Cash Flow PV of Cash flow at 8%

0 -336,875.00 -336,875.00

1 100,000.00 92,592.59

2 82,000.00 70,301.78

3 76,000.00 60,331.25

4 111,000.00 81,588.31

5 142,000.00 96,642.81

Net Present Value 64,581.74

Question 15 A firm is considering a $5,000 project that will generate an annual cash flow of $1,000 for the next 8 years. The firm has the following financial data:

Debt/equity ratio is 50%. Cost of equity capital is 15%. Cost of new debt is 9%. Tax rate is 33%.

Determine the project's net present value (NPV) and whether or not to accept it.

NPV Accept / Reject

A) +$33 Accept

B) -$33 Reject

C) +$4,968 Accept

Answer: B

First, calculate the weights for debt and equity

wd + we = 1

wd = 0.50We

0.5We + We = 1

wd = 0.333, we = 0.667

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.333 × 0.09 × 0.67) + (0.667 × 0.15) = 0.020 + 0.100 = 0.120

Third, calculate the PV of the project cash flows

N = 8, PMT = -1,000, FV = 0, I/Y = 12, CPT PV = 4,967

And finally, calculate the project NPV by subtracting out the initial cash flow

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NPV = $4,967 − $5,000 = -$33

Question 16 The process of evaluating and selecting profitable long-term investments consistent with the firm’s goal of shareholder wealth maximization is known as:

A) Financial restructuring.

B) Capital budgeting.

C) Monitoring.

Answer: B In the process of capital budgeting, a manager is making decisions about a firm’s earning assets, which provide the basis for the firm’s profit and value. Capital budgeting refers to investments expected to produce benefits for a period of time greater than one year. Financial restructuring is done as a result of bankruptcy and monitoring is a critical assessment aspect of capital budgeting. Question 17 Which of the following statements about the discounted payback period is least accurate? The discounted payback:

A) Frequently ignores terminal values.

B) Method can give conflicting results with the NPV.

C) Period is generally shorter than the regular payback.

Answer: C) period is generally shorter than the regular payback.

The discounted payback period calculates the present value of the future cash flows. Because these present values will be less than the actual cash flows it will take a longer time period to recover the original investment amount.

Question 18 A firm is considering a $200,000 project that will last 3 years and has the following financial data:

Annual after-tax cash flows are expected to be $90,000. Target debt/equity ratio is 0.4. Cost of equity is 14%. Cost of debt is 7%. Tax rate is 34%.

Determine the project's payback period and net present value (NPV).

Payback Period NPV

A) 2.43 years $18,716

B) 2.22 years $18,716

C) 2.22 years $21,872

Answer: B

Payback Period

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$200,000 / $90,000 = 2.22 years

NPV Method

First, calculate the weights for debt and equity

wd + we = 1

we = 1 − wd

wd / we = 0.40

wd = 0.40 × (1 − wd)

wd = 0.40 − 0.40wd

1.40wd = 0.40 wd = 0.286, we = 0.714

Second, calculate WACC

WACC = (wd × kd) × (1 − t) + (we × ke) = (0.286 × 0.07 × 0.66) + (0.714 × 0.14) = 0.0132 + 0.100 = 0.1132

Third, calculate the PV of the project cash flows

90 / (1 + 0.1132)1 + 90 / (1 + 0.1132)2 + 90 / (1 + 0.1132)3 = $218,716

And finally, calculate the project NPV by subtracting out the initial cash flow

NPV = $218,716 − $200,000 = $18,716

LOS E: Explain the NPV profile, compare and contrast NPV and IRR methods when evaluating independent and mutually exclusive projects, and describe the problems associated with each of the evaluation methods.

Question 1 Which of the following statements about NPV and IRR is NOT correct?

A) The IRR can be positive even if the NPV is negative.

B) When the IRR is equal to the cost of capital, the NPV equals zero.

C) The NPV will be positive if the IRR is less than the cost of capital.

Answer: C) The NPV will be positive if the IRR is less than the cost of capital.

This statement should read, "The NPV will be positive if the IRR is greater than the cost of capital. The other statements are correct. The IRR can be positive (>0), but less than the cost of capital, thus resulting in a negative NPV. One definition of the IRR is the rate of return for which the NPV of a project is zero.

Question 2 The NPV profile is a graphical representation of the change in net present value relative to a change in the:

A) Prime rate.

B) Discount rate.

C) Internal rate of return.

Answer: B

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As discount rates change the net present values change. The NPV profile is a graphic illustration of how sensitive net present values are to different discount rates. By comparison, every project has a single internal rate of return and payback period because the values are determined solely by the investment’s expected cash flows. Question 3 Which of the following is the most appropriate decision rule for mutually exclusive projects?

A) Accept both projects if their internal rates of return exceed the firm’s hurdle rate.

B) If the net present value method and the internal rate of return method give conflicting signals, select the project with the highest internal rate of return.

C) Accept the project with the highest net present value, subject to the condition that its net present value is greater than zero.

Answer: C

The project that maximizes the firm's value is the one that has the highest positive NPV.

Question 4 If the calculated net present value (NPV) is negative, which of the following must be CORRECT. The discount rate used is:

A) Greater than the internal rate of return (IRR).

B) Less than the internal rate of return (IRR).

C) Equal to the internal rate of return (IRR).

Answer: A) greater than the internal rate of return (IRR).

When the NPV = 0, this means the discount rate used is equal to the IRR. If a discount rate is used that is higher than the IRR, the NPV will be negative. Conversely, if a discount rate is used that is lower than the IRR, the NPV will be positive.

Question 5 If a project has a negative cash flow during its life or at the end of its life, the project most likely has:

A) A negative internal rate of return.

B) More than one internal rate of return.

C) Multiple net present values.

Answer: B

Projects with unconventional cash flows (where the sign of the cash flow changes from minus to plus to back to minus) will have multiple internal rates of return. However, one will still be able to calculate a single net present value for the cash flow pattern.

Question 6 Which of the following projects would have multiple internal rates of return (IRRs)? The cost of capital for all projects is 9.75%.

Cash Flows Blackjack Roulette Keno

T0 -10,000 -12,000 -8,000

T1 10,000 7,000 4,000

T2 15,000 2,000 0

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T3 -10,000 2,000 6,000

A)

Projects Roulette and Keno.

B) Projects Blackjack and Keno.

C) Project Blackjack only.

Answer: C) Project Blackjack only.

The multiple IRR problem occurs if a project has non-normal cash flows, that is, the sign of the net cash flows changes from negative to positive to negative, or vice versa. For the exam, a shortcut to look for is the project cash flows changing signs more than once. Only Project Blackjack has this cash flow pattern. The 0 net cash flow in T2 for Project Keno and likely negative net present value (NPV) for Project Roulette would not necessarily result in multiple IRRs.

Question 7 Two projects being considered by a firm are mutually exclusive and have the following projected cash flows:

Year Project 1 Cash Flow Project 2 Cash Flow

0 −$4.0 ?

1 $3.0 $1.7

2 $5.0 $3.2

3 $2.0 $5.8

The crossover rate of the two projects’ NPV profiles is 9%. What is the initial cash flow for Project 2?

A) −$4.51.

B) −$4.22.

C) −$5.70.

Answer: B

The crossover rate is the rate at which the NPV for two projects is the same. That is, it is the rate at which the two NPV profiles cross. At a discount rate of 9%, the NPV of Project 1 is: CF0 = –4; CF1 = 3; CF2 = 5; CF3 = 2; I = 9%; CPT → NPV = $4.51. Now perform the same calculations except that we need to set the unknown CF0 = 0. The remaining entries are: CF1 = 1.7; CF2 = 3.2; CF3 = 5.8; I = 9%; CPT → NPV = $8.73. Since by definition the crossover rate produces the same NPV for both projects, we know that both projects should have an NPV = $4.51. Since the NPV of Project 2 (with CF0 = 0) is $8.73, the unknown cash flow must be a large enough negative amount to reduce the NPV for Project 2 from $8.73 to $4.51. Thus the unknown initial cash flow for Project 2 is determined as $4.51 = $8.73 + CF0, or CF0 = −$4.22.

Question 8 For a project with cash outflows during its life, the least preferred capital budgeting tool would be:

A) Net present value.

B) Profitability index.

C) Internal rate of return.

Answer: C) internal rate of return.

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The IRR encounters difficulties when cash outflows occur throughout the life of the project. These projects may have multiple IRRs, or no IRR at all. Neither the NPV nor the PI suffer from these limitations.

Question 9 Which of the following statements about the internal rate of return (IRR) for a project with the following cash flow pattern is CORRECT?

Year 0: -$ 2,000 Year 1: $10,000 Year 2: -$ 10,000

A) It has two IRRs of approximately 38% and 260%.

B) No IRRs can be calculated.

C) It has a single IRR of approximately 38%.

Answer: A) It has two IRRs of approximately 38% and 260%.

The number of IRRs equals the number of changes in the sign of the cash flow. In this case, from

negative to positive and then back to negative. Although 38% seems appropriate, one should not

automatically discount the value of 260%.

Check answers by calculation:

10,000 ÷ 1.38 - 10,000 ÷ 1.382 = 1995.38

And:

10,000 ÷ 3.6 - 10,000 ÷ 3.62 = 2006.17

Both discount rates give NPVs of approximately zero and thus, are IRRs.

Question 10 Which of the following statements about the internal rate of return (IRR) and net present value (NPV) is least accurate?

A) The discount rate that causes the project's NPV to be equal to zero is the project's IRR.

B) For mutually exclusive projects, if the NPV rankings and the IRR rankings give conflicting signals, you should select the project with the higher IRR.

C) The IRR is the discount rate that equates the present value of the cash inflows with the present value of the outflows.

Answer: B

The NPV method is always preferred over the IRR, because the NPV method assumes cash flows are reinvested at the cost of capital. Conversely, the IRR assumes cash flows can be reinvested at the IRR. The IRR is not an actual market rate.

Question 11 Which of the following projects would most likely have multiple internal rates of return (IRRs)? The cost of capital for all projects is 10.0%.

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Cash Flows South East West

CF0 -15,000 -12,000 -8,000

CF1 10,000 7,000 4,000

CF2 -1,000 2,000 0

CF3 15,000 2,000 6,000

A)

Project South only.

B) Projects East and West.

C) Projects South and West.

Answer: A) Project South only.

The multiple IRR problem occurs if a project has an unconventional cash flow pattern, that is, the sign of the cash flows changes more than once (from negative to positive to negative, or vice-versa). Only Project South has this cash flow pattern. Neither the zero cash flow for Project West nor the likely negative net present value for Project East would result in multiple IRRs.

Question 12 When a company is evaluating two mutually exclusive projects that are both profitable but have conflicting NPV and IRR project rankings, the company should:

A) Accept the project with the higher net present value.

B) Accept the project with the higher internal rate of return.

C) Use a third method of evaluation such as discounted payback period.

Answer: A) accept the project with the higher net present value.

Net present value is the preferred criterion when ranking projects because it measures the firm’s expected increase in wealth from undertaking a project.

Question 13 Which of the following statements about independent projects is least accurate?

A) If the internal rate of return is less than the cost of capital, reject the project.

B) The net present value indicates how much the value of the firm will change if the project is accepted.

C) The internal rate of return and net present value methods can yield different accept/reject decisions for independent projects.

Answer: C) The internal rate of return and net present value methods can yield different accept/reject decisions for independent projects.

For independent projects the IRR and NPV give the same accept/reject decision. For mutually exclusive projects the IRR and NPV techniques can yield different accept/reject decisions.

Question 14 Apple Industries, a firm with unlimited funds, is evaluating five projects. Projects A and B are independent and Projects C, D, and E are mutually exclusive. The projects are listed with their rate of return and NPV. Assume that the applicable discount rate is 10%.

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Project Status Rate of Return Net Present Value

A Independent 14% $10,500

B Independent 12% $13,400

C Mutually Exclusive 11% $16,000

D Mutually Exclusive 15% $14,000

E Mutually Exclusive 12% $11,500

Rank the projects the firm should select.

A) All projects should be selected.

B) Project A, Project B, and Project C.

C) Project A, Project B, and Project D.

Answer: B

When it comes to independent projects, financial managers should select all with positive NPVs, resulting in inclusion of Project A and Project B. Remember that projects with positive NPVs will increase the value of the firm. Among mutually exclusive projects, financial managers would select the one with the highest NPV, in this case Project C. Although all projects have positive NPVs, only one of the latter three can be chosen. If the selection were based upon the internal rate of return, Project D would be chosen instead of Project C. This shows why NPV is the superior decision criteria because Project C is the investment that will cause the greatest increase to the value of the firm.

Question 15 The underlying cause of ranking conflicts between the net present value (NPV) and internal rate of return (IRR) methods is the underlying assumption related to the:

A) Initial cost.

B) Cash flow timing.

C) Reinvestment rate.

Answer: C) reinvestment rate.

The IRR method assumes all future cash flows can be reinvested at the IRR. This may not be feasible because the IRR is not based on market rates. The NPV method uses the weighted average cost of capital (WACC) as the appropriate discount rate.

Question 16 When using net present value (NPV) profiles:

A) The NPV profile's intersection with the vertical y-axis identifies the project's internal rate of return.

B) One should accept all independent projects with positive NPVs.

C) One should accept all mutually exclusive projects with positive NPVs.

Answer: B

Where the NPV intersects the vertical y-axis you have the value of the cash inflows less the cash outflows, assuming an absence of money having a time value (i.e., the discount rate is zero). Where the

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NPV intersects the horizontal x-axis you have the project’s internal rate of return. At this cost of financing, the cash inflows and cash outflows offset each other. The NPV profile is a tool that graphically plots the project’s NPV as calculated using different discount rates. Assuming an appropriate discount rate, one should accept all projects with positive net present values, if the projects are independent. If projects are mutually exclusive select the one with the higher NPV at any given level of the cost of capital.

Question 17 Which of the following statements regarding the internal rate of return (IRR) is most accurate? The IRR:

A) Can lead to multiple IRR rates if the cash flows extend past the payback period.

B) Assumes that the reinvestment rate of the cash flows is the cost of capital.

C) And the net present value (NPV) method lead to the same accept/reject decision for independent projects.

Answer: C) and the net present value (NPV) method lead to the same accept/reject decision for independent projects.

NPV and IRR lead to the same decision for independent projects, not necessarily for mutually exclusive projects. IRR assumes that cash flows are reinvested at the IRR rate. IRR does not ignore time value of money (the payback period does), and the investor may find multiple IRRs if there are sign changes after time zero (i.e., negative cash flows after time zero).

Question 18 Which of the following statements regarding the net present value (NPV) and internal rate of return (IRR) is least accurate?

A) For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation.

B) For independent projects, the internal rate of return IRR and the NPV methods always yield the same accept/reject decisions.

C) The NPV tells how much the value of the firm will increase if you accept the project.

Answer: A) For mutually exclusive projects, you must accept the project with the highest NPV regardless of the sign of the NPV calculation.

If the NPV for two mutually exclusive projects is negative, both should be rejected.

LOS F & LOS G: Describe and account for the relative popularity of the various capital budgeting methods and explain the relation between NPV and company value and stock price. Question 1 Mollette Industries uses the payback period as its primary means for ranking capital projects. Which of the following most likely describes Mollette Industries with regard to location and management education?

Location Management education

A) European-based firm Undergraduate degree or lower

B) U.S. based firm Undergraduate degree or lower

C) European-based firm MBA degree or higher

Answer: A)

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Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that were most likely to use the payback period method were European firms and management teams with less education.

Question 2 Which of the following firms is most likely to use a discounted cash flow technique as its primary capital budgeting tool?

A) A large, publicly held European firm that has managers with no formal business education.

B) A small, privately held European firm that has managers with no formal business education.

C) A large, publicly held U.S. firm where managers hold MBA degrees.

Answer: C) A large, publicly held U.S. firm where managers hold MBA degrees.

Companies that favor discounted cash flow capital budgeting techniques such as NPV and IRR over

payback period or other non-DCF capital budgeting techniques tend to have the following characteristics:

Location: European firms tend to favor payback period.

Size: Smaller firms tend to favor payback period.

Ownership: Private firms tend to favor payback period. Management education: The more highly educated a firm’s management, the more likely it is to

use a DCF capital budgeting technique as its primary tool.

Question 3 Osborn Manufacturing uses the NPV and IRR methods as its primary tools for evaluating capital projects. Which of the following most likely describes Osborn Manufacturing with regard to firm ownership and company size?

Firm ownership Company size

A) Public Small

B) Public Large

C) Private Large

Answer: B

Despite the theoretical superiority of the NPV and IRR methods for determining and ranking project profitability, surveys of corporate managers show that a variety of methods are used. Firms that use the NPV and IRR methods tend to be larger, publicly-traded, companies.

Question 4 Garner Corporation is investing $30 million in new capital equipment. The present value of future after-tax cash flows generated by the equipment is estimated to be $50 million. Currently, Garner has a stock price of $28.00 per share with 8 million shares outstanding. Assuming that this project represents new information and is independent of other expectations about the company, what should the effect of the project be on the firm’s stock price?

A) The stock price will increase to $34.25.

B) The stock price will increase to $30.50.

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C) The stock price will remain unchanged.

Answer: B

In theory, a positive NPV project should provide an increase in the value of a firm's shares.

NPV of new capital equipment = $50 million - $30 million = $20 million

Value of company prior to equipment purchase = 8,000,000 × $28.00 = $224,000,000

Value of company after new equipment project = $224 million + $20 million = $244 million

Price per share after new equipment project = $244 million / 8 million = $30.50

Note that in reality, changes in stock prices result from changes in expectations more than changes in

NPV.

Question 5 The effect of a company announcement that they have begun a project with a current cost of $10 million that will generate future cash flows with a present value of $20 million is most likely to:

A) Increase the value of the firm’s common shares by $20 million.

B) Increase value of the firm’s common shares by $10 million.

C) Only affect value of the firm’s common shares if the project was unexpected.

Answer: C) only affect value of the firm’s common shares if the project was unexpected.

Stock prices reflect investor expectations for future investment and growth. A new positive-NPV project will increase stock price only if it was not previously anticipated by investors.

Question 6 Polington Aircraft Co. just announced a sale of 30 aircraft to Cuba, a project with a net present value of $10 million. Investors did not anticipate the sale because government approval to sell to Cuba had never before been granted. The share price of Polington should:

A) Not necessarily change because new contract announcements are made all the time.

B) Increase by the NPV × (1 – corporate tax rate) divided by the number of common shares outstanding.

C) Increase by the project NPV divided by the number of common shares outstanding.

Answer: C) increase by the project NPV divided by the number of common shares outstanding.

Since the sale was not anticipated by the market, the share price should rise by the NPV of the project per common share. NPV is already calculated using after-tax cash flows.

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COST OF CAPITAL

LOS A: Calculate and Interpret the Weighted Average Cost of Capital (WACC) of a company.

Question 1 A firm is planning a $25 million expansion project. The project will be financed with $10 million in debt and $15 million in equity stock (equal to the company's current capital structure). The before-tax required return on debt is 10% and 15% for equity. If the company is in the 35% tax bracket, what cost of capital should the firm use to determine the project's net present value (NPV)?

A) 11.6%.

B) 12.5%.

C) 9.6%.

Answer: A) 11.6%.

WACC = (E / V)(RE) + (D / V)(RD)(1 − TC)

WACC = (15 / 25)(0.15) + (10 / 25)(0.10)(1 − 0.35) = 0.09 + 0.026 = 0.116 or 11.6%

Question 2 In calculating the weighted average cost of capital (WACC), which of the following statements is least accurate?

A) Different methods for estimating the cost of common equity might produce different results.

B) The cost of preferred equity capital is the preferred dividend divided by the price of preferred shares.

C) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

Your answer: B was incorrect. The correct answer was C) The cost of debt is equal to one minus the marginal tax rate multiplied by the coupon rate on outstanding debt.

After-tax cost of debt = bond yield − tax savings = kd − kdt = kd(1 − t)

Question 3 A firm has $100 in equity and $300 in debt. The firm recently issued bonds at the market required rate of 9%. The firm's beta is 1.125, the risk-free rate is 6%, and the expected return in the market is 14%. Assume the firm is at their optimal capital structure and the firm's tax rate is 40%. What is the firm's weighted average cost of capital (WACC)?

A) 7.8%.

B) 8.6%.

C) 5.4%.

Answer: A) 7.8%.

CAPM = RE = RF + B(RM − RF) = 0.06 + (1.125)(0.14 − 0.06) = 0.15

WACC = (E ÷ V)(RE) + (D ÷ V)(RD)(1 − t)

V = 100 + 300 = 400

WACC = (1 ÷ 4)(0.15) + (3 ÷ 4)(0.09)(1 − 0.4) = 0.078

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Question 4 A company has the following information:

A target capital structure of 40% debt and 60% equity. $1,000 par value bonds pay 10% coupon (semi-annual payments), mature in 20 years, and sell

for $849.54. The company stock beta is 1.2. Risk-free rate is 10%, and market risk premium is 5%. The company's marginal tax rate is 40%.

The weighted average cost of capital (WACC) is closest to:

A) 13.0%.

B) 13.5%.

C) 12.5%.

Answer: C) 12.5%.

Ks = 0.10 + (0.05)(1.2) = 0.16 or 16%

Kd = Solve for i: N = 40, PMT = 50, FV = 1,000, PV = -849.54, CPT I = 6 × 2 = 12%

WACC = (0.4)(12)(1 - 0.4) + (0.6)(16)= 2.88 + 9.6 = 12.48

Question 5 Hatch Corporation's target capital structure is 40% debt, 50% common stock, and 10% preferred stock. Information regarding the company's cost of capital can be summarized as follows:

The company's bonds have a nominal yield to maturity of 7%. The company's preferred stock sells for $40 a share and pays an annual dividend of $4 a share. The company's common stock sells for $25 a share and is expected to pay a dividend of $2 a

share at the end of the year (i.e., D1 = $2.00). The dividend is expected to grow at a constant rate of 7% a year.

The company has no retained earnings. The company's tax rate is 40%.

What is the company's weighted average cost of capital (WACC)?

A) 10.59%.

B) 10.03%.

C) 10.18%.

Answer: C) 10.18%.

WACC = (wd)(kd)(1 − t) + (wps)(kps) + (wce)(kce)

where:

wd = 0.40

wce = 0.50

wps = 0.10

kd = 0.07

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kps = Dps / P = 4.00 / 40.00 = 0.10

kce = D1 / P0 + g = 2.00 / 25.00 + 0.07 = 0.08 + 0.07 = 0.15

WACC = (0.4)(0.07)(1 − 0.4) + (0.1)(0.10) + (0.5)(0.15) = 0.0168 + 0.01 + 0.075 = 0.1018 or 10.18%

Question 6 Assume that a company has equal amounts of debt, common stock, and preferred stock. An increase in the corporate tax rate of a firm will cause its weighted average cost of capital (WACC) to:

A) Rise.

B) More information is needed.

C) Fall.

Answer: C) fall.

Recall the WACC equation:

WACC = [wd × kd × (1 − t)] + (wps × kps) + (wce × ks)

The increase in the corporate tax rate will result in a lower cost of debt, resulting in a lower WACC for the

company.

Question 7 Given the following information about capital structure, compute the WACC. The marginal tax rate is 40%.

Type of Capital

Percent of Capital Structure

Before-Tax Component Cost

Bonds 40% 7.5%

Preferred Stock 5% 11.0%

Common Stock 55% 15.0%

A) 13.3%.

B) 7.1%.

C) 10.6%.

Answer: C) 10.6%.

WACC = (Wd)(Kd (1 − t)) + (Wps)(Kps) + (Wce)(Ks)

WACC = 0.4(7.5%)(1 − 0.4) + 0.05(11%) + 0.55(15%) = 10.6%.

Question 8 Helmut Humm, manager at a large U.S. firm, has just been assigned to the capital budgeting area to replace a person who left suddenly. One of Humm’s first tasks is to calculate the company’s weighted average cost of capital (WACC) – and fast! The CEO is scheduled to present to the board in half an hour and needs the WACC – now! Luckily, Humm finds clear notes on the target capital component weights. Unfortunately, all he can find for the cost of capital components is some handwritten notes. He can make out the numbers, but not the corresponding capital component. As time runs out, he has to guess.

Here is what Humm deciphered:

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Target weights: wd = 30%, wps = 20%, wce = 50%, where wd, wps, and wce are the weights used for debt, preferred stock, and common equity.

Cost of components (in no particular order): 6.0%, 15.0%, and 8.5%. The cost of debt is the after-tax cost.

If Humm guesses correctly, the WACC is:

A) 11.0%.

B) 9.2%.

C) 9.0%.

Answer: A) 11.0%.

If Humm remembers to order the capital components from cheapest to most expensive, he can calculate

WACC. The order from cheapest to most expensive is: debt, preferred stock (which acts like a hybrid of

debt and equity), and common equity.

Then, using the formula for WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)

where wd, wps, and we are the weights used for debt, preferred stock, and common equity.

WACC = (0.30 × 6.0%) + (0.20 × 8.5%) + (0.50 × 15.00%) = 11.0%.

Question 9 Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:

A) Reject profitable, low-risk projects and accept unprofitable, high-risk projects.

B) Accept profitable, low-risk projects and accept unprofitable, high-risk projects.

C) Accept profitable, low-risk projects and reject unprofitable, high-risk projects.

Answer: A) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.

Question 10 A company has the following capital structure:

Target weightings: 30% debt, 20% preferred stock, 50% common equity. Tax Rate: 35%. The firm can issue $1,000 face value, 7% semi-annual coupon debt with a 15-year

maturity for a price of $1,047.46. A preferred stock issue that pays a dividend of $2.80 has a value of $35 per share. The company’s growth rate is estimated at 6%. The company's common shares have a value of $40 and a dividend in year 0 of D0 =

$3.00.

The company's weighted average cost of capital is closest to:

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A) 9.84%.

B) 9.28%.

C) 10.53%.

Answer: A) 9.84%.

Step 1: Determine the after-tax cost of debt:

The after-tax cost of debt [kd (1 – t)] is used to compute the weighted average cost of capital. It is the

interest rate on new debt (kd) less the tax savings due to the deductibility of interest (kdt).

Here, we are given the inputs needed to calculate kd: N = 15 × 2 = 30; PMT = (1,000 × 0.07) / 2 = 35; FV

= 1,000; PV = -1,047.46; CPT → I = 3.25, multiply by 2 = 6.50%.

Thus, kd (1 – t) = 6.50% × (1 – 0.35) = 4.22%

Step 2: Determine the cost of preferred stock:

Preferred stock is a perpetuity that pays a fixed dividend (Dps) forever. The cost of preferred stock (kps) =

Dps / P

where: Dps = preferred dividends.

P = price

Here, kps = Dps / P = $2.80 / $35 = 0.08, or 8.0%.

Step 3: Determine the cost of common equity:

kce = (D1 / P0) + g

where: D1 = Dividend in next year

P0 = Current stock price

g = Dividend growth rate

Here, D1 = D0 × (1 + g) = $3.00 × (1 + 0.06) = $3.18.

kce = (3.18 / 40) + 0.06 = 0.1395 or 13.95%.

Step 4: Calculate WACC:

WACC = (wd)(kd) + (wps)(kps) + (wce)(kce)

where wd, wps, and wce are the weights used for debt, preferred stock, and common equity.

Here, WACC = (0.30 × 4.22%) + (0.20 × 8.0%) + (0.50 × 13.95%) = 9.84%.

Note: Your calculation may differ slightly, depending on whether you carry all calculations in your

calculator, or round to two decimals and then calculate.

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Question 11 The following data is regarding the Link Company:

A target debt/equity ratio of 0.5 Bonds are currently yielding 10% Link is a constant growth firm that just paid a dividend of $3.00 Stock sells for $31.50 per share, and has a growth rate of 5% Marginal tax rate is 40%

What is Link's after-tax cost of capital?

A) 10.5%.

B) 12.0%.

C) 12.5%.

Answer: B

Use the revised form of the constant growth model to determine the cost of equity. Use algebra to

determine the weights for the target capital structure realizing that debt is 50% of equity. Substitute 0.5E

for D in the formula below.

ks = D1 ÷ P0 + growth = (3)(1.05) ÷ (31.50) + 0.05 = 0.15 or 15%

V = debt + equity = 0.5 + 1 = 1.5

WACC = (E ÷ V)(ks) + (D ÷ V)(kdebt)(1 − t)

WACC = (1 ÷ 1.5)(0.15) + (0.5 ÷ 1.5)(0.10)(1 − 0.4) = 0.1 + 0.02 = 0.12 or 12%

Question 12 When calculating the weighted average cost of capital (WACC) an adjustment is made for taxes because:

A) The interest on debt is tax deductible.

B) Equity earns higher return than debt.

C) Equity is risky.

Answer: A) the interest on debt is tax deductible.

Equity and preferred stock are not adjusted for taxes because dividends are not deductible for corporate taxes. Only interest expense is deductible for corporate taxes.

Question 13 A company is planning a $50 million expansion. The expansion is to be financed by selling $20 million in new debt and $30 million in new common stock. The before-tax required return on debt is 9% and the required return for equity is 14%. If the company is in the 40% tax bracket, the marginal weighted average cost of capital is closest to:

A) 9.0%.

B) 10.6%.

C) 10.0%

Answer: B

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(0.4)(9%) (1 - 0.4) + (0.6) (14%) = 10.56%

Question 14 An analyst gathered the following data about a company:

Capital Structure Required Rate of Return

30% debt 10% for debt

20% preferred stock 11% for preferred stock

50% common stock 18% for common stock

Assuming a 40% tax rate, what after-tax rate of return must the company earn on its investments?

A) 13.0%.

B) 14.2%.

C) 10.0%.

Answer: A) 13.0%.

(0.3)(0.1)(1 - 0.4) + (0.2) (0.11) + (0.5) (0.18) = 0.13

Question 15 Ravencroft Supplies is estimating its weighted average cost of capital (WACC). Ravencroft’s optimal capital structure includes 10% preferred stock, 30% debt, and 60% equity. They can sell additional bonds at a rate of 8%. The cost of issuing new preferred stock is 12%. The firm can issue new shares of common stock at a cost of 14.5%. The firm’s marginal tax rate is 35%. Ravencroft’s WACC is closest to:

A) 11.5%.

B) 13.3%.

C) 12.3%.

Answer: A) 11.5%.

0.10(12%) + 0.30(8%)(1 – 0.35) + 0.6(14.5%) = 11.46%.

Question 16 Which of the following events will reduce a company's weighted average cost of capital (WACC)?

A) An increase in expected inflation.

B) A reduction in the market risk premium.

C) A reduction in the company's bond rating.

Answer: B

An increase in either the company’s beta or the market risk premium will cause the WACC to increase using the CAPM approach. A reduction in the market risk premium will reduce the cost of equity for WACC.

LOS B: Describe how tax affect the cost of capital from different capital sources. Question 1 Which of the following choices best describes the role of taxes on the after-tax cost of capital in the U.S. from the different capital sources?

Common equity Preferred equity Debt

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A) No effect Decrease Decrease

B) No effect No effect Decrease

C) Decrease Decrease No effect

Answer: B

In the U.S., interest paid on corporate debt is tax deductible, so the after-tax cost of debt capital is less than the before-tax cost of debt capital. Dividend payments are not tax deductible, so taxes do not decrease the cost of common or preferred equity.

Question 2 At a recent Haggerty Semiconductors Board of Directors meeting, Merle Haggerty was asked to discuss the topic of the company’s weighted average cost of capital (WACC).

At the meeting Haggerty made the following statements about the company’s WACC:

Statement 1: A company creates value by producing a higher return on its assets than the cost of financing those assets. As such, the WACC is the cost of financing a firm’s assets and can be viewed as the firm’s opportunity cost of financing its assets.

Statement 2: Since a firm’s WACC reflects the average risk of the projects that make up the firm, it is not appropriate for evaluating all new projects. It should be adjusted upward for projects with greater-than-average risk and downward for projects with less-than-average risk.

Are Statement 1 and Statement 2, as made by Haggerty CORRECT?

Statement 1 Statement 2

A) Correct Correct

B) Correct Incorrect

C) Incorrect Correct

Answer: A)

Each statement that Haggerty has made to the board of directors regarding the weighted average cost of capital is correct. New projects should have a return that is higher than the cost to finance those projects.

LOS C: Describe alternative methods of calculating weights used in the WACC, including the use of the company’s target capital structure. Question 1 Hans Klein, CFA, is responsible for capital projects at Vertex Corporation. Klein and his assistant, Karl Schwartz, were discussing various issues about capital budgeting and Schwartz made a comment that Klein believed to be incorrect. Which of the following is most likely the incorrect statement made by Schwartz?

A) “The weighted average cost of capital (WACC) should be based on market values for the firm’s outstanding securities.”

B) “It is not always appropriate to use the firm’s marginal cost of capital when determining the net present value of a capital project.”

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C) “Net present value (NPV) and internal rate of return (IRR) result in the same rankings of potential capital projects.”

Answer: C) “Net present value (NPV) and internal rate of return (IRR) result in the same rankings of potential capital projects.”

It is possible that the NPV and IRR methods will give different rankings. This often occurs when there is a significant difference in the timing of the cash flows between two projects. A firm’s marginal cost of capital, or WACC, is only appropriate for computing a project’s NPV if the project has the same risk as the firm.

Question 2 Agora Systems Inc. has the following capital structure and cost of new capital:

Book Value Market Value Cost of Issuing

Debt $50 million $58 million 5.3%

Preferred stock $25 million $28 million 7.2%

Common stock $200 million $525 million 8.0%

Total capital $275 million $611 million

What is Agora’s weighted-average cost of capital if its marginal tax rate is 40%?

A) 6.23%.

B) 8.02%.

C) 7.50%.

Answer: C) 7.50%.

WACC = (1 − t) (rd) (D ÷ A) + (rp) (P/A) + (rce) (E ÷ A)

WACC = (1 − 0.4) (0.053) (58 ÷ 611) + (0.072) (28 ÷ 611) + (0.08) (525 ÷ 611)

WACC = 0.003 + 0.0033 + 0.0687

WACC = 7.50%

Question 3 Levenworth Industries has the following capital structure on December 31, 2006:

Book Value Market Value

Debt outstanding $8 million $10.5 million

Preferred stock outstanding $2 million $1.5 million

Common stock outstanding $10 million $13.7 million

Total capital $20 million $25.7 million

What is the firm’s target debt and preferred stock portion of the capital structure based on existing capital structure?

Debt Preferred Stock

A) 0.40 0.10

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B) 0.41 0.10

C) 0.41 0.06

Answer: C)

The weights in the calculation of WACC should be based on the firm’s target capital structure, that is, the proportions (based on market values) of debt, preferred stock, and equity that the firm expects to achieve over time. Book values should not be used. As such, the weight of debt is 41% ($10.5 ÷ $25.7), the weight of preferred stock is 6% ($1.5 ÷ $25.7) and the weight of common stock is 53% ($13.7 ÷ $25.7).

Question 4 Deighton Industries has 200,000 bonds outstanding. The par value of each corporate bond is $1,000, and the current market price of the bonds is $965. Deighton also has 6 million common shares outstanding, with a book value of $35 per share and a market price of $28 per share. At a recent board of directors meeting, Deighton board members decided not to change the company’s capital structure in a material way for the future. To calculate the weighted average cost of Deighton’s capital, what weights should be assigned to debt and to equity?

Debt Equity

A) 48.85% 51.15%

B) 53.46% 46.54%

C) 56.55% 43.45%

Answer: B

In order to calculate the weighted average cost of capital (WACC), market value weights should be used.

For the bonds = 200,000 × $965 = $193,000,000

For the stocks = 6,000,000 × $28 = $168,000,000

$361,000,000

The weight of debt would be: 193,000,000 / 361,000,000 = 0.5346 = 53.46%

The weight of common stock would be: 168,000,000 / 361,000,000 = 0.4654 = 46.54%

Question 5 Carlos Rodriquez, CFA, and Regine Davis, CFA, were recently discussing the relationships between capital structure, capital budgets, and net present value (NPV) analysis. Which of the following comments made by these two individuals is least accurate?

A) “The optimal capital budget is determined by the intersection of a firm’s marginal cost of capital curve and its investment opportunity schedule.”

B) “A break point occurs at a level of capital expenditure where one of the component costs of capital increases.”

C) “For projects with more risk than the average firm project, NPV computations should be based on the marginal cost of capital instead of the weighted average cost of capital.”

Answer: C)

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The marginal cost of capital (MCC) and the weighted average cost of capital (WACC) are the same thing. If a firm’s capital structure remains constant, the MCC (WACC) increases as additional capital is raised.

LOS D: Explain how the marginal cost of capital and the investment opportunity schedule are used to determine the optimal capital budget. Question 1 The marginal cost of capital is:

A) Tied solely to the specific source of financing.

B) Equal to the firm's weighted cost of funds.

C) The cost of the last dollar raised by the firm.

Answer: C) the cost of the last dollar raised by the firm.

The “marginal” cost refers to the last dollar of financing acquired by the firm assuming funds are raised in the same proportion as the target capital structure. It is a percentage value based on both the returns required by the last bondholders and stockholders to provide capital to the firm. Regardless of whether

the funding came from bondholders or stockholders, both debt and equity are needed to fund projects.

Question 2 Enamel Manufacturing (EM) is considering investing in a new vehicle. EM finances new projects using retained earnings and bank loans. This new vehicle is expected to have the same level of risk as the typical investment made by EM. Which one of the following should the firm use in making its decision?

A) Cost of retained earnings.

B) After-tax cost of debt.

C) Marginal cost of capital.

Answer: C) Marginal cost of capital.

The marginal cost of capital represents the cost of raising an additional dollar of capital. The cost of retained earnings would only be appropriate if the company avoided creditor-supplied financing or the issuance of new common or preferred stock (and preferred stock financing). The after-tax cost of debt is never sufficient, because a business, regardless of their size, always has a residual owner, and hence a cost of equity.

LOS E: Marginal cost of capital’s role in determining the net present value of the project Question 1 Which of the following statements is least accurate regarding the marginal cost of capital’s role in determining the net present value (NPV) of a project?

A) Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.

B) When using a firm’s marginal cost of capital to evaluate a specific project, there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project.

C) The NPVs of potential projects of above-average risk should be calculated using the marginal cost of capital for the firm.

Answer: C) The NPVs of potential projects of above-average risk should be calculated using the marginal cost of capital for the firm.

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The WACC is the appropriate discount rate for projects that have approximately the same level of risk as the firm’s existing projects. This is because the component costs of capital used to calculate the firm’s WACC are based on the existing level of firm risk. To evaluate a project with above (the firm’s) average risk, a discount rate greater than the firm’s existing WACC should be used. Projects with below-average risk should be evaluated using a discount rate less than the firm’s WACC. An additional issue to consider when using a firm’s WACC (marginal cost of capital) to evaluate a specific project is that there is an implicit assumption that the capital structure of the firm will remain at the target capital structure over the life of the project. These complexities aside, we can still conclude that the NPVs of potential projects of firm-average risk should be calculated using the marginal cost of capital for the firm. Projects for which the present value of the after-tax cash inflows is greater than the present value of the after-tax cash outflows should be undertaken by the firm.

Question 2 Which of the following statements about the role of the marginal cost of capital in determining the net present value of a project is most accurate? The marginal cost of capital should be used to discount the cash flows:

A) Of all projects the firm is considering.

B) For potential projects that have a level of risk near that of the firm’s average project.

C) If the firm’s capital structure is expected to change during the project’s life.

Answer: B

Net present values of projects with the average risk for the firm should be determined using the firm’s marginal cost of capital. The discount rate should be adjusted for projects with above-average or below-average risk. Using the marginal cost of capital assumes the firm’s capital structure does not change over the life of the project.

LOS F: calculate and interpret the cost of fixed rate of debt capital using the yield-to-maturity approach and the debt-rating approach Question 1 Which of the following is least likely to be useful to an analyst who is estimating the pretax cost of a firm’s fixed-rate debt?

A) The yield to maturity of the firm’s existing debt.

B) Seniority and any special covenants of the firm’s anticipated debt.

C) The coupon rate on the firm’s existing debt.

Answer: C) The coupon rate on the firm’s existing debt.

Ideally, an analyst would use the YTM of a firm’s existing debt as the pretax cost of new debt. When a firm’s debt is not publicly traded, however, a market YTM may not be available. In this case, an analyst may use the yield curve for debt with the same rating and maturity to estimate the market YTM. If the anticipated debt has unique characteristics that affect YTM, these characteristics should be accounted for when estimating the pretax cost of debt. The cost of debt is the market interest rate (YTM) on new (marginal) debt, not the coupon rate on the firm’s existing debt. If you are provided with both coupon and YTM on the exam, you should use the YTM.

Question 2 Which of the following is most accurate regarding the component costs and component weights in a firm’s weighted average cost of capital (WACC)?

A) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.

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B) The appropriate pre-tax cost of a firm’s new debt is the average coupon rate on the firm’s existing debt.

C) The weights in the WACC should be based on the book values of the individual capital components.

Answer: A) Taxes reduce the cost of debt for firms in countries in which interest payments are tax deductible.

The after-tax cost of debt = kd(1 – t) = kd – kd(t), where kd is the pretax cost of debt and t is the effective

corporate tax rate. So the tax savings from the tax treatment of debt is kd (t). Capital component weights

should be based on market weights, not book values. And, the appropriate pre-tax cost of debt is the yield

to maturity on the firm’s existing debt.

Question 3 Ferryville Radar Technologies has five-year, 7.5% notes outstanding that trade at a yield to maturity of 6.8%. The company’s marginal tax rate is 35%. Ferryville plans to issue new five-year notes to finance an expansion. Ferryville’s cost of debt capital is closest to:

A) 4.9%.

B) 4.4%.

C) 2.4%.

Answer: B

Ferryville’s cost of debt capital is kd(1 - t) = 6.8% × (1 - 0.35) = 4.42%. Note that the before-tax cost of debt is the yield to maturity on the company’s outstanding notes, not their coupon rate. If the expected yield on new par debt were known, we would use that. Since it is not, the yield to maturity on existing debt is the best approximation.

Question 4 The 6% semiannual coupon, 7-year notes of Woodbine Transportation, Inc. trade for a price of $94.54. What is the company’s after-tax cost of debt capital if its marginal tax rate is 30%?

A) 4.9%.

B) 2.1%.

C) 4.2%.

Answer: A) 4.9%.

To determine Woodbine’s before-tax cost of debt, find the yield to maturity on its outstanding notes:

PV = -94.54; FV = 100; PMT = 6 / 2 = 3; N = 14; CPT → I/Y = 3.50 × 2 = 7%

Woodbine’s after-tax cost of debt is kd(1 - t) = 7%(1 - 0.3) = 4.9%

Question 5 The debt of Savanna Equipment, Inc. has an average maturity of ten years and a BBB rating. A market yield to maturity is not available because the debt is not publicly traded, but the market yield on debt with similar characteristics is 8.33%. Savanna is planning to issue new ten-year notes that would be

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subordinate to the firm’s existing debt. The company’s marginal tax rate is 40%. The most appropriate estimate of the after-tax cost of this new debt is:

A) 5.0%.

B) More than 5.0%.

C) Between 3.3% and 5.0%.

Answer: B

The after-tax cost of debt similar to Savanna’s existing debt is kd(1 - t) = 8.33%(1 - 0.4) = 5.0%. Because the anticipated new debt will be subordinated in the company’s debt structure, investors will demand a higher yield than the existing debt carries. Therefore, the appropriate after-tax cost of the new debt is more than 5.0%.

LOS G: Calculate and interpret the cost of noncallable, nonconvertible preferred stock. Question 1 The after-tax cost of preferred stock is always:

A) Equal to the before-tax cost of preferred stock.

B) Less than the before-tax cost of preferred stock.

C) Higher than the cost of common shares.

Answer: A) equal to the before-tax cost of preferred stock.

The after-tax cost of preferred stock is equal to the before-tax cost of preferred stock, because preferred stock dividends are not tax deductible. The cost of preferred shares is usually higher than the cost of debt, but less than the cost of common shares.

Question 2 Which of the following statements is most accurate regarding a firm’s cost of preferred shares? A firm’s cost of preferred stock is:

A) The market price of the preferred shares as a percentage of its issuance price.

B) The dividend yield on the firm’s newly-issued preferred stock.

C) Approximately equal to the market price of the firm’s debt as a percentage of the market price of its common shares.

Answer: B

The newly-issued preferred shares of most companies generally sell at par. As such, the dividend yield on a firm’s newly-issued preferred shares is the market’s required rate of return. The yield on a BBB corporate bond reflects a pre-tax cost of debt. Both remaining choices make no sense.

Question 3 Justin Lopez, CFA, is the Chief Financial Officer of Waterbury Corporation. Lopez has just been informed that the U.S. Internal Revenue Code may be revised such that the maximum marginal corporate tax rate will be increased. Since Waterbury’s taxable income is routinely in the highest marginal tax bracket, Lopez is concerned about the potential impact of the proposed change. Assuming that Waterbury maintains its target capital structure, which of the following is least likely to be affected by the proposed tax change?

A) Waterbury’s return on equity (ROE).

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B) Waterbury’s after-tax cost of noncallable, nonconvertible preferred stock.

C) Waterbury’s after-tax cost of corporate debt.

Answer: B

Corporate taxes do not affect the cost of preferred stock to the issuing firm. Waterbury’s after-tax cost of debt, and consequently, its weighted average cost of capital will decrease because the tax savings on interest will increase. Also, since taxes impact net income, Waterbury’s ROE will be affected by the change.

Question 4 Which of the following is least likely to be useful to an analyst when estimating the cost of raising capital through the issuance of non-callable, nonconvertible preferred stock?

A) The stated par value of the preferred issue.

B) The firm’s corporate tax rate.

C) The preferred stock’s dividend rate.

Answer: B

The corporate tax rate is not a relevant factor when calculating the cost of preferred stock.

The cost of preferred stock, kps is expressed as:

kps = Dps / P

where:

Dps = divided per share = dividend rate × stated par value

P = market price

LOS H: Calculate and interpret the cost of equity capital using the capital pricing model approach, the dividend discount model approach and the bond-yield-plus risk-premium approach. Question 1 The expected annual dividend one year from today is $2.50 for a share of stock priced at $25. What is the cost of equity if the constant long-term growth in dividends is projected to be 8%?

A) 19%.

B) 18%.

C) 15%.

Answer: B

Ks = (D1 / P0) + g = (2.5/25) + 0.08 = 0.18 or 18%.

Question 2 A $100 par, 8% preferred stock is currently selling for $80. What is the cost of preferred equity?

A) 10.8%.

B) 8.0%.

C) 10.0%.

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Answer: C) 10.0%.

kps = $8 / $80 = 10%

Question 3 A firm has $4 million in outstanding bonds that mature in four years, with a fixed rate of 7.5% (assume annual payments). The bonds trade at a price of $98 in the open market. The firm’s marginal tax rate is 35%. Using the bond-yield plus method, what is the firm’s cost of equity risk assuming an add-on of 4%?

A) 12.11%.

B) 11.50%.

C) 13.34%.

Answer: A) 12.11%.

If the bonds are trading at $98, the required yield is 8.11%, and the market value of the issue is $3.92 million. To calculate this rate using a financial calculator (and figuring the rate assuming a $100 face value for each bond), N = 4; PMT = 7.5 = (0.075 × 100); FV = 100; PV = -98; CPT → I/Y = 8.11. By adding the equity risk factor of 4%, we compute the cost of equity as 12.11%.

Question 4 A company’s outstanding 20-year, annual-pay 6% coupon bonds are selling for $894. At a tax rate of 40%, the company’s after-tax cost of debt capital is closest to:

A) 5.1%

B) 7.0%

C) 4.2%.

Answer: C) 4.2%.

Pretax cost of debt: N = 20; FV = 1000; PV = −894; PMT = 60; CPT → I/Y = 7%

After-tax cost of debt: kd = (7%)(1−0.4) = 4.2%

Question 5 Genoa Corp. is estimating its weighted average cost of capital (WACC). They have several pieces of data to consider. The firm pays 40% of its earnings out in dividends. The return on equity (ROE) is 15%. Last year’s earnings were $5.00 per share and the dividend was just paid to shareholders. The current price of shares is $42.00. Genoa's 8% coupon bonds have a yield to maturity of 7.5%. The firm's tax rate is 30%.

Part 1) The cost of common equity is closest to:

A) 13.76%.

B) 14.19%.

C) 16.14%.

Answer: B

ROE × retention ratio = growth rate.

15% × (1 – 0.40) = 9%

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D0 = $5.00 × 0.40 = $2.00

[$2.00(1.09) / $42.00] + 0.09 = 14.19%

Part 2) The after-tax cost of debt is closest to:

A) 7.5%.

B) 5.6%.

C) 5.3%.

Answer: C) 5.3%.

7.5 × (1 − 0.3) = 5.25%

Question 6 The cost of preferred stock is equal to the preferred stock dividend:

A) Divided by its par value.

B) Divided by the market price.

C) Multiplied by the market price.

Answer: B

The cost of preferred stock, kps, is Dps ÷ price.

Question 7 Julius, Inc., is in a 40% marginal tax bracket. The firm can raise as much capital as needed in the bond market at a cost of 10%. The preferred stock has a fixed dividend of $4.00. The price of preferred stock is $31.50. The after-tax costs of debt and preferred stock are closest to:

Debt Preferred stock

A) 6.0% 12.7%

B) 10.0% 7.6%

C) 6.0% 7.6%

Answer: A)

After-tax cost of debt = 10% × (1 – 0.4) = 6%.

Cost of preferred stock = $4 / $31.50 = 12.7%.

Question 8 The following information applies to a corporation:

The company has $200 million of equity and $100 million of debt. The company recently issued bonds at 9%. The corporate tax rate is 30%.

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The company's beta is 1.125.

If the risk-free rate is 6% and the expected return on the market portfolio is 14%, the company’s after-tax weighted average cost of capital is closest to:

A) 10.5%.

B) 11.2%.

C) 12.1%.

Answer: C) 12.1%.

ks = RFR + β(Rm − RFR)

= 6% + 1.125(14% − 6%) = 15%

WACC = [D/(D + E)] × kd(1 − t) + [E/(D + E)] × ks

= (100/300)(9%)(1 − 0.3) + (200/300)(15%) = 12.1%

Question 9 The expected dividend one year from today is $2.50 for a share of stock priced at $22.50. The long-term growth in dividends is projected at 8%. The cost of common equity is closest to:

A) 19.1%.

B) 15.6%.

C) 18.0%.

Answer: A) 19.1%.

Kce = ( D1 / P0) + g

Kce = [ 2.50 / 22.50 ] + 0.08 = 0.19111, or 19.1%

Question 10

The company has a target capital structure of 40% debt and 60% equity. Bonds pay 10% coupon (semi-annual payout), mature in 20 years, and sell for $849.54. The company stock beta is 1.2. Risk-free rate is 10%, and market risk premium is 5%. The company is a constant growth firm that just paid a dividend of $2.00, sells for $27.00 per

share, and has a growth rate of 8%. The company's marginal tax rate is 40%.

Part 1) The after-tax cost of debt is:

A) 8.0%.

B) 9.1%.

C) 7.2%.

Answer: C) 7.2%.

N = 40; PMT = 50; FV = 1,000; PV = 849.54; Compute i = 6%, double = 12%, now (12)(1 − 0.4) = 7.2%.

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Part 2) The cost of equity using the capital asset pricing model (CAPM) approach and the discounted cash flow approach is:

CAPM Discounted Cash Flow

A) 16.0% 16.0%

B) 16.0% 15.4%

C) 16.6% 15.4%

Answer: A)

CAPM = 10 + (5) (1.2) = 16%.

Discounted Cash Flow: D1 = 2(1.08) = 2.16, now (2.16 / 27) + 0.08 = 16%

Question 11 If central bank actions caused the risk-free rate to increase, what is the most likely change to cost of debt and equity capital?

A) Both increase.

B) Both decrease.

C) One increase and one decrease.

Answer: A) Both increase.

An increase in the risk-free rate will cause the cost of equity to increase. It would also cause the cost of debt to increase. In either case, the nominal cost of capital is the risk-free rate plus the appropriate premium for risk.

Question 12 A company has the following data associated with it:

A target capital structure of 10% preferred stock, 50% common equity and 40% debt. Outstanding 20-year annual pay 6% coupon bonds selling for $894. Common stock selling for $45 per share that is expected to grow at 8% and expected to pay a $2

dividend one year from today. Their $100 par preferred stock currently sells for $90 and is earning 5%. The company's tax rate is 40%.

Part 1) What is the after tax cost of debt capital and after tax cost of preferred stock capital?

Debt Capital Preferred Stock Capital

A) 4.2% 5.6%

B) 4.2% 6.3%

C) 4.5% 5.6%

Answer: A)

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Debt

N = 20; FV = 1,000; PMT = 60; PV = -894; CPT → I = 7%

kd = (7%)(1 − 0.4) = 4.2%

Preferred Stock

kps = Dps / P

kps = 5 / 90 = 5.56%

Part 2) What is the weighted average cost of capital (WACC)?

A) 9.2%.

B) 8.5%.

C) 10.3%.

Answer: B

kce = (D1 / P0) + g

kce = 2 / 45 + 0.08 = 0.1244 = 12.44%

WACC = (0.4)(4.2) + (0.1)(5.6) + (0.5)(12.4) = 8.5%

Question 13 A firm has $3 million in outstanding 10-year bonds, with a fixed rate of 8% (assume annual payments). The bonds trade at a price of $92 per $100 par in the open market. The firm’s marginal tax rate is 35%. What is the after-tax component cost of debt to be used in the weighted average cost of capital (WACC) calculations?

A) 6.02%.

B) 9.26%.

C) 5.40%.

Answer: A) 6.02%.

If the bonds are trading at $92 per $100 par, the required yield is 9.26% (N = 10; PV = –92; FV = 100;

PMT = 8; CPT I/Y = 9.26). The equivalent after-tax cost of this financing is: 9.26% (1 – 0.35) = 6.02%.

Question 14 Axle Corporation earned £3.00 per share and paid a dividend of £2.40 on its common stock last year. Its common stock is trading at £40 per share. Axle is expected to have a return on equity of 15%, an effective tax rate of 34%, and to maintain its historic payout ratio going forward. In estimating Axle’s after-tax cost of capital, an analyst’s estimate of Axle’s cost of common equity would be closest to:

A) 8.8%.

B) 9.0%.

C) 9.2%.

Answer: C) 9.2%.

We can estimate the company’s expected growth rate as ROE × (1 − payout ratio): g = 15% × (1 −

2.40/3.00) = 3%

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The expected dividend next period is then £2.40(1.03) = £2.47. Based on dividend discount model

pricing, the required return on equity is 2.47 / 40 + 3% = 9.18%.

Question 15 A company has $5 million in debt outstanding with a coupon rate of 12%. Currently the YTM on these bonds is 14%. If the tax rate is 40%, what is the after tax cost of debt?

A) 7.2%.

B) 5.6%.

C) 8.4%.

Answer: C) 8.4%.

(0.14)(1 - 0.4)

LOS I: Calculate and interpret the beta and the cost of capital for a project. LOS J: Explain the country risk premium in the estimation of the cost of equity for a company located in a developing market. Question 1 Tony Costa, operations manager of Bio Chem Inc., is exploring a proposed product line expansion. Costa explains that he estimates the beta for the project by seeking out a publicly traded firm that is engaged exclusively in the same business as the proposed Bio Chem product line expansion. The beta of the proposed project is estimated from the beta of that firm after appropriate adjustments for capital structure differences. The method that Costa uses is known as the:

A) Pure-play method.

B) Build-up method.

C) Accounting method.

Answer: A) pure-play method.

The method used by Costa is known as the pure-play method. The method entails selection of the pure-play equity beta, unlevering it using the pure-play company’s capital structure, and re-levering using the subject company’s capital structure.

Question 2 A publicly traded company has a beta of 1.2, a debt/equity ratio of 1.5, ROE of 8.1%, and a marginal tax rate of 40%. The unlevered beta for this company is closest to:

A) 1.071.

B) 0.832.

C) 0.632.

Answer: C) 0.632.

The unlevered beta for this company is calculated as:

Question 3

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Affluence Inc. is considering whether to expand its recreational sports division by embarking on a new project. Affluence’s capital structure consists of 75% debt and 25% equity and its marginal tax rate is 30%. Aspire Brands is a publicly traded firm that specializes in recreational sports products. Aspire has a debt-to-equity ratio of 1.7, a beta of 0.8, and a marginal tax rate of 35%. Using the pure-play method with Aspire as the comparable firm, the project beta Affluence should use to calculate the cost of equity capital for this project is closest to:

A) 1.18.

B) 0.38.

C) 0.58.

Answer: A) 1.18.

The unlevered asset beta is:

Affluence’s debt-to-equity ratio = 0.75/0.25 = 3. To calculate the project beta, re-lever the asset beta

using Affluence’s debt-to-equity ratio and marginal tax rate:

Question 4 Jamal Winfield is an analyst with Stolzenbach Technologies, a major computer Services Company based in the U.S. Stolzenbach’s management team is considering opening new stores in Mexico, and wants to estimate the cost of equity capital for Stolzenbach’s investment in Mexico. Winfield has researched bond yields in Mexico and found that the yield on a Mexican government 10-year bond is 7.7%. A similar maturity U.S. Treasury bond has a yield of 4.6%. In the most recent year, the standard deviation of Mexico's All Share Index stock index and the S&P 500 index was 38% and 20% respectively. The annualized standard deviation of the Mexican dollar-denominated 10-year government bond over the last year was 26%. Winfield has also determined that the appropriate beta to use for the project is 1.25, and the market risk premium is 6%. The risk free interest rate is 4.2%. What is the appropriate country risk premium for Mexico and what is the cost of equity that Winfield should use in his analysis?

Country Risk Premium for Mexico

Cost of Equity for Project

A) 5.89% 17.36%

B) 4.53% 17.36%

C) 4.53% 19.06%

Answer: B

CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard

deviation of sovereign bond market in terms of the developed market currency)

= (0.077 – 0.046)(0.38 ÷ 0.26) = 0.0453, or 4.53%

Cost of equity = RF + β[E(RMKT) – RF + CRP] = 0.042 + 1.25[0.06 + 0.0453] = 0.1736 = 17.36%

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Note that you are given the market risk premium, which equals E(RMKT) – RF. Question 5 Degen Company is considering a project in the commercial printing business. Its debt currently has a yield of 12%. Degen has a leverage ratio of 2.3 and a marginal tax rate of 30%. Hodgkins Inc., a publicly traded firm that operates only in the commercial printing business, has a marginal tax rate of 25%, a debt-to-equity ratio of 2.0, and an equity beta of 1.3. The risk-free rate is 3% and the expected return on the market portfolio is 9%. The appropriate WACC to use in evaluating Degen’s project is closest to:

A) 8.9%.

B) 9.2%.

C) 8.6%.

Answer: C) 8.6%.

Hodgkins’ asset beta:

We are given Degen’s leverage ratio (assets-to-equity) as equal to 2.3. If we assign the value of 1 to

equity (A/E = 2.3/1), then debt (and the debt-to-equity ratio) must be 2.3 − 1 = 1.3.

Equity beta for the project:

βPROJECT = 0.52[1 + (1 − 0.3)(1.3)] = 0.9932

Project cost of equity = 3% + 0.9932(9% − 3%) = 8.96%

Degen’s capital structure weight for debt is 1.3/2.3 = 56.5%, and its weight for equity is 1/2.3 = 43.5%.

The appropriate WACC for the project is therefore:

0.565(12%)(1 − 0.3) + 0.435(8.96%) = 8.64%.

Question 6 Utilitarian Co. is looking to expand its appliances division. It currently has a beta of 0.9, a D/E ratio of 2.5, a marginal tax rate of 30%, and its debt is currently yielding 7%. JF Black, Inc. is a publicly traded appliance firm with a beta of 0.7, a D/E ratio of 3, a marginal tax rate of 40%, and its debt is currently yielding 6.8%. The risk-free rate is currently 5% and the expected return on the market portfolio is 9%. Using this data, calculate Utilitarian’s weighted average cost of capital for this potential expansion.

A) 4.2%.

B) 5.7%.

C) 7.1%.

Answer: B

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Question 7 In order to more accurately estimate the cost of equity for a company situated in a developing market, an analyst should:

A) Use the yield on the sovereign debt of the developing country instead of the risk free rate when using the capital asset pricing model (CAPM).

B) Add a country risk premium to the market risk premium when using the capital asset pricing model (CAPM).

C) Add a country risk premium to the risk-free rate when using the capital asset pricing model (CAPM).

Answer: B

In order to reflect the increased risk when investing in a developing country, a country risk premium is added to the market risk premium when using the CAPM.

Question 8 Jeffery Marian, an analyst with Arlington Machinery, is estimating a country risk premium to include in his estimate of the cost of equity for a project Arlington is starting in India. Marian has compiled the following information for his analysis:

Indian 10-year government bond yield = 7.20% 10-year U.S. Treasury bond yield = 4.60% Annualized standard deviation of the Bombay Sensex stock index = 40%. Annualized standard deviation of Indian dollar denominated 10-year government bond = 24% Annualized standard deviation of the S&P 500 Index = 18%.

The estimated country risk premium for India based on Marian’s research is closest to:

A) 2.6%.

B) 4.3%.

C) 5.8%.

Answer: B

CRP = Sovereign Yield Spread(Annualized standard deviation of equity index ÷ Annualized standard

deviation of sovereign bond market in terms of the developed market currency)

= (0.072 – 0.046)(0.40/0.24) = 0.043, or 4.3%.

LOS K: Describe the marginal cost of capital schedule, explain why it may be upward-sloping with respect to additional capital, and calculate and interpret its break-points.

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Question 1 Which of the following is used to illustrate a firm’s weighted average cost of capital (WACC) at different levels of capital?

A) Schedule of marginal capital break points.

B) Marginal cost of capital schedule.

C) Cost of capital component schedule.

Answer: B

The marginal cost of capital schedule shows the WACC at different levels of capital investment. It is usually upward sloping and is a function of a firm’s capital structure and its cost of capital at different levels of total capital investment.

Question 2 Which one of the following statements about the marginal cost of capital (MCC) is most accurate?

A) The MCC is the cost of the last dollar obtained from bondholders.

B) The MCC falls as more and more capital is raised in a given period.

C) A breakpoint on the MCC curve occurs when one of the components in the weighted average cost of capital changes in cost.

Answer: C)

A breakpoint is calculated by dividing the amount of capital at which a component's cost of capital

changes by the weight of that component in the capital structure.

The marginal cost of capital (MCC) is defined as the weighted average cost of the last dollar raised by the company. Typically, the marginal cost of capital will increase as more capital is raised by the firm. The

marginal cost of capital is the weighted average rate across all sources of long-term financings—bonds,

preferred stock, and common stock—when the final dollar was obtained, regardless of its specific source.

Question 3 The before-tax cost of debt for Hardcastle Industries, Inc. is currently 8.0%, but it will increase to 8.25% when debt levels reach $600 million. The debt-to-total assets ratio for Hardcastle is 40% and its capital structure is composed of debt and common equity only. If Hardcastle changes its target capital structure to 50% debt / 50% equity, which of the following describes the effect on the level of new investment at which the cost of debt will increase? The level will:

A) Decrease.

B) Change, but can either increase or decrease.

C) Increase.

Answer: A) decrease.

A break point refers to a level of new investment at which a component’s cost of capital changes. The

formula for break point is:

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As indicated, as the weight of a capital component in the capital structure increases, the break point at

which a change in the component’s cost will decline. No computation is necessary, but when Hardcastle

has 40% debt, the breakpoint is $600,000,000 / 0.4 = $1.5 billion. If Hardcastle’s debt increases to 50%,

the breakpoint will decline to $600,000,000 / 0.5 = $1.2 billion.

Question 4 A North American investment society held a panel discussion on the topics of capital costs and capital budgeting. Which of the following comments made during this discussion is the least accurate?

A) An increase in the after-tax cost of debt may occur at a break point.

B) A project’s internal rate of return decreases when a breakpoint is reached.

C) Any given project’s NPV will decline when a breakpoint is reached.

Answer: B

The internal rate of return is independent of the firm’s cost of capital. It is a function of the amount and timing of a project’s cash flows.

Question 5 Simcox Financial is considering raising additional capital to finance a takeover of one of the firm’s major competitors. Reuben Mellum, an analyst with Simcox, has put together the following schedule of costs related to raising new capital:

Amount of New Debt (in millions)

After-tax Cost of Debt

Amount of New Equity (in millions)

Cost of Equity

$0 to $149 4.2% $0 to $399 7.5%

$150 to $349 5.0% $400 to $799 8.5%

Assuming that Simcox has a target debt to equity ratio of 65% equity and 35% debt, what are the marginal cost of capital schedule breakpoints for raising additional debt capital and equity capital, respectively?

Breakpoint for new debt capital Breakpoint for new equity capital

A) $428.6 million $533.3 million

B) $375.0 million $615.4 million

C) $428.6 million $615.4 million

Answer: C)

$428.6 million $615.4 million

A breakpoint is calculated as the amount of capital where component cost changes / weight of component in the WACC. The breakpoint for raising new debt capital occurs at ($150 / 0.35) = $428.6 million, and the breakpoint for raising new equity capital occurs at ($400 / 0.65) = $615.4 million.

Question 6 BPM Ltd. has the following capital structure: 40% debt and 60% equity. The cost of retained earnings is 13%, and the cost of new common stock is 16%. BPM will not have any retained earnings available in the upcoming year. It’s before tax cost of debt is 8%, and its corporate tax rate is 40%. BPM is considering between two mutually exclusive projects that have the following cash flows:

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Today Year 1 Year 2 Year 3

Project A Cost = 100 million + 50 million + 30 million + 50 million

Project B Cost = 150 million + 50 million + 60 million + 80 million

Which project should BPM choose?

A) Project A since its NPV is $16 million.

B) Project A since its net present value (NPV) is +$5.01 million.

C) Project B since its NPV is $22 million.

Answer: B

Use the Marginal cost of capital (= WACCnew equity) as the discount rate to calculate NPV.

WACCnew equity = (wd × (kd × (1 - T))) + (Wce × Ke)

= [0.4 × 0.08 × (1 - 0.4)] + [0.6 × 0.16] = 11.52%

NPV of project A = -100 + 50 / (1.1152) + 30 / (1.11522) + 50 / (1.11523) = +5.01

NPV of project B = -150 + 50 / (1.1152) + 60 / (1.11522) + 80 / (1.11523) = +0.76

Question 7 Arlington Machinery currently has assets on its balance sheet of $300 million that is financed with 70% equity and 30% debt. The executive management team at Arlington is considering a major expansion that would require raising additional capital. Jeffery Marian, an analyst with Arlington Machinery, has put together the following schedule for the costs of debt and equity:

Amount of New Debt (in millions)

After-tax Cost of Debt

Amount of New Equity (in millions)

Cost of Equity

$0 to $49 4.0% $0 to $99 7.0%

$50 to $99 4.2% $100 to $199 8.0%

$100 to $149 4.5% $200 to $299 9.0%

In a presentation to Arlington’s executive management team, Marian makes the following statements:

Statement 1: If we maintain our target capital structure of 70% equity and 30% debt, the breakpoint at which our cost of equity will increase to 9.0% is approximately $286 million in new capital.

Statement 2: If we want to finance total assets of $600 million, our weighted average cost of capital (WACC) for the additional financing needed will be 7.56%.

Marian’s statements are:

Statement 1 Statement 2

A) Correct Correct

B) Incorrect Incorrect

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C) Correct Incorrect

Answer: A)

Marian’s first statement is correct. A breakpoint calculated as (amount of capital where component cost

changes / weight of component in the WACC). The component cost of equity for Arlington will increase

when the amount of new equity raised is $200 million, which will occur at ($200 million / 0.70) = $285.71

million, or $286 million of new capital.

Marian’s second statement is also correct. If Arlington wants to finance $600 million of total assets, the

firm will need to raise $600 − $300 = $300 million of additional capital. Using the target capital structure of

70% equity and 30% debt, Arlington will need to raise $300 × 0.70 = $210 million in new equity and $300

× 0.30 = $90 million in new debt. Looking at the capital schedules, these levels of new financing

correspond with rates of 9.0% and 4.2% for costs of equity and debt respectively, and the WACC is equal

to (9.0% × 0.70) + (4.2% × 0.30) = 7.56%.

Question 8 Stolzenbach Technologies has a target capital structure of 60% equity and 40% debt. The schedule of financing costs for the Stolzenbach is shown in the table below:

Amount of New Debt (in millions)

After-tax Cost of Debt

Amount of New Equity (in millions)

Cost of Equity

$0 to $199 4.5% $0 to $299 7.5%

$200 to $399 5.0% $300 to $699 8.5%

$400 to $599 5.5% $700 to $999 9.5%

Stolzenbach Technologies has breakpoints for raising additional financing at both:

A) $500 million and $1,000 million.

B) $500 million and $700 million.

C) $400 million and $700 million.

Answer: A) $500 million and $1,000 million.

Stolzenbach will have a break point each time a component cost of capital changes, for a total of three

marginal cost of capital schedule breakpoints.

Break pointDebt > $200mm = ($200 million ÷ 0.4) = $500 million

Break pointDebt > $400mm = ($400 million ÷ 0.4) = $1,000 million

Break pointEquity > $300mm = ($300 million ÷ 0.6) = $500 million

Break pointEquity > $700mm = ($700 million ÷ 0.6) = $1,167 million

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LOS L: Explain and demonstrate the correct treatment for flotation costs. Question 1 The most accurate way to account for flotation costs when issuing new equity to finance a project is to:

A) Increase the cost of equity capital by dividing it by (1 – flotation cost).

B) Increase the cost of equity capital by multiplying it by (1 + flotation cost).

C) Adjust cash flows in the computation of the project NPV by the dollar amount of the flotation costs.

Answer: C) Adjusting the cost of equity for flotation costs is incorrect because doing so entails adjusting the present value of cash flows by a fixed percentage over the life of the project. In reality, flotation costs are a cash outflow that occurs at the initiation of a project. Therefore, the correct way to account for flotation costs is to adjust the cash flows in the computation of project NPV, not the cost of equity. The dollar amount of the flotation cost should be considered an additional cash outflow at initiation of the project. Question 2 Nippon Post Corporation (NPC), a Japanese software development firm, has a capital structure that is comprised of 60% common equity and 40% debt. In order to finance several capital projects, NPC will raise USD1.6 million by issuing common equity and debt in proportion to its current capital structure. The debt will be issued at par with a 9% coupon and flotation costs on the equity issue will be 3.5%. NPC’s common stock is currently selling for USD21.40 per share, and its last dividend was USD1.80 and is expected to grow at 7% forever. The company’s tax rate is 40%. NPC’s WACC based on the cost of new capital is closest to:

A) 9.6%.

B) 13.1%.

C) 11.8%.

Answer: C) 11.8%.

kd = 0.09(1 – 0.4) = 0.054 = 5.4%

kce = [(1.80 × 1.07) / 21.40] + 0.07 = 0.16 = 16.0%

WACC = 0.6(16.0%) + 0.4(5.4%) = 11.76%

Flotation costs, treated correctly, have no effect on the cost of equity component of the WACC.

Question 3 Meredith Suresh, an analyst with Torch Electric, is evaluating two capital projects. Project 1 has an initial cost of $200,000 and is expected to produce cash flows of $55,000 per year for the next eight years. Project 2 has an initial cost of $100,000 and is expected to produce cash flows of $40,000 per year for the next four years. Both projects should be financed at Torch’s weighted average cost of capital. Torch’s current stock price is $40 per share, and next year’s expected dividend is $1.80. The firm’s growth rate is 5%, the current tax rate is 30%, and the pre-tax cost of debt is 8%. Torch has a target capital structure of 50% equity and 50% debt. If Torch takes on either project, it will need to be financed with externally generated equity which has flotation costs of 4%.

Suresh is aware that there are two common methods for accounting for flotation costs. The first method, commonly used in textbooks, is to incorporate flotation costs directly into the cost of equity. The second, and more correct approach, is to subtract the dollar value of the flotation costs from the project NPV. If Suresh uses the cost of equity adjustment approach to account for flotation costs rather than the correct cash flow adjustment approach, will the NPV for each project be overstated or understated?

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Project 1 NPV Project 2 NPV

A) Overstated Overstated

B) Understated Overstated

C) Understated Understated

Answer: A)

Overstated Overstated

The incorrect method of accounting for flotation costs spreads the flotation cost out over the life of the

project by a fixed percentage that does not necessarily reflect the present value of the flotation costs. The

impact on project evaluation depends on the length of the project and magnitude of the flotation costs,

however, for most projects that are shorter, the incorrect method will overstate NPV, and that is exactly

what we see in this problem.

Correct method of accounting for flotation costs:

After-tax cost of debt = 8.0% (1-0.30) = 5.60%

Cost of equity = ($1.80 / $40.00) + 0.05 = 0.045 + 0.05 = 9.50%

WACC = 0.50(5.60%) + 0.50(9.50%) = 7.55%

Flotation costs Project 1 = $200,000 × 0.5 × 0.04 = $4,000

Flotation costs Project 2 = $100,000 × 0.5 × 0.04 = $2,000

NPV Project 1 = -$200,000 - $4,000 + (N = 8, I = 7.55%, PMT = $55,000, FV = 0 →CPT PV = $321,535)

= $117,535

NPV Project 2 = -$100,000 - $2,000 + (N = 4, I = 7.55%, PMT = $40,000, FV = 0 →CPT PV = $133,823)

= $31,823

Incorrect Adjustment for cost of equity method for accounting for flotation costs:

After-tax cost of debt = 8.0% (1-0.30) = 5.60%

Cost of equity = [$1.80 / $40.00(1-0.04)] + 0.05 = 0.0469 + 0.05 = 9.69%

WACC = 0.50(5.60%) + 0.50(9.69%) = 7.65%

NPV Project 1 = -$200,000 + (N = 8, I = 7.65%, PMT = $55,000, FV = 0 →CPT PV = $320,327) =

$120,327

NPV Project 2 = -$100,000+ (N = 4, I = 7.65%, PMT = $40,000, FV = 0 →CPT PV = $133,523) = $33,523

Question 4 Cullen Casket Company is considering a project that requires a $175,000 cash outlay and is expected to produce cash flows of $65,000 per year for the next four years. Cullen’s tax rate is 40% and the before-tax cost of debt is 9%. The current share price for Cullen stock is $32 per share and the expected dividend next year is $1.50 per share. Cullen’s expected growth rate is 5%. Cullen finances the project with 70% newly issued equity and 30% debt, and the flotation costs for equity are 4.5%. What is the dollar amount of the flotation costs attributable to the project, and that is the NPV for the project, assuming that flotation costs are accounted for correctly?

Dollar amount of floatation costs

NPV of project

A) $7,875 $30,510

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B) $5,513 $30,510

C) $5,513 $32,872

Answer: C)

$5,513 $32,872

In order to determine the discount rate, we need to calculate the WACC.

After-tax cost of debt = 9.0% (1 – 0.40) = 5.40%

Cost of equity = ($1.50 / $32.00) + 0.05 = 0.0469 + 0.05 = 0.0969, or 9.69%

WACC = 0.70(9.69%) + 0.30(5.40%) = 8.40%

Since the project is financed with 70% newly issued equity, the amount of equity capital raised is 0.70 ×

$175,000 = $122,500

Flotation costs are 4.5 percent, which equates to a dollar flotation cost of $122,500 × 0.045 = $5,512.50.

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MEASURES OF LEVERAGE

LOS A: Define and explain leverage, business risk, sale risk, operating risk, and financial risk and

classify a risk, given a description.

Question 1 Financial risk is borne by:

A) Common shareholders.

B) Creditors.

C) Managers.

Answer: A) common shareholders.

Common shareholders are the residual owners of the company. As such, they experience the benefits of above-normal gains in good times and the pain of losses when the business is in a slow period. Financial leverage magnifies the variability of earnings per share due to the existence of the required interest payments.

Question 2 The uncertainty in return on assets due to the nature of a firm’s operations is known as:

A) Financial leverage.

B) Tax efficiency.

C) Business risk.

Answer: C) business risk.

Business risk is a function of the firm's revenue and expenses, resulting in operating income, or earnings before interest and taxes (EBIT). The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Tax efficiency is tied to mutual fund investing, while financial leverage requires the existence of debt.

Question 3 Hughes Continental is assessing its business risk. Which of the following factors would least likely be considered in the analysis?

A) Input price variability.

B) Unit sales levels.

C) Debt-equity ratio.

Answer: C) Debt-equity ratio.

The main factors affecting business risk are demand variability, sales price variability, input price variability, ability to adjust output prices, and operating leverage. Debt levels affect financial risk, not business (operating) risk.

Question 4 Variability in a firm’s operating income is most closely related to its:

A) Internal risk.

B) Financial risk.

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C) Business risk.

Answer: C) business risk.

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Question 5 Which of the following statements about business risk and financial risk is least accurate?

A) Business risk is the riskiness of the company's assets if it uses no debt.

B) Factors that affect business risk are demand, sales price, and input price variability.

C) The greater a company's business risk, the higher its optimal debt ratio.

Answer: C) The greater a company's business risk, the higher its optimal debt ratio.

The greater a company’s business risk, the lower its optimal debt ratio.

Question 6 The two major types of risk affecting a firm are:

A) Financial risk and cash flow risk.

B) Business risk and financial risk.

C) Business risk and collection risk.

Answer: B

Business risk is the uncertainty regarding the operating income of a company. Financial risk refers to the uncertainty caused by the fixed cost associated with borrowed money.

Question 7 Which of the following factors is least likely to affect business risk?

A) Demand variability.

B) Operating leverage.

C) Interest rate variability.

Answer: C) Interest rate variability.

Business risk can be defined as the uncertainty inherent in a firm’s return on assets (ROA). While changes in interest rates may impact the demand or input prices, there is a more direct impact on business risk with the other three choices.

Question 8 All else equal, a firm's business risk is higher when:

A) Fixed costs are the highest portion of its expense.

B) The firm has low operating leverage.

C) Variable costs are the highest portion of its expense.

Answer: A) fixed costs are the highest portion of its expense.

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The higher the percentage of a firm's costs that are fixed, the higher the operating leverage, and the greater the firm's business risk and the more susceptible it is to business cycle fluctuations.

LOS B: Calculate and interpret the degree of operating leverage, the degree of financial leverage and the degree of total leverage. Question 1 As financial leverage increases, what will be the impact on the expected rate of return and financial risk?

A) Both will fall.

B) One will rise while the other falls.

C) Both will rise.

Answer: C) Both will rise.

A higher breakeven point resulting from increased interest costs associated with debt financing increases the risk of the company. Since the risk is tied to firm financing, it is referred to as financial risk. Given the positive risk-return relationship, the expected return of the company’s common stock also rises.

Question 2 Which of the following statements regarding leverage is most accurate?

A) A firm with high business risk is more likely to increase its use of financial leverage than a firm with low business risk.

B) A firm with low operating leverage has a small proportion of its total costs in fixed costs.

C) High levels of financial leverage increase business risk while high levels of operating leverage will decrease business risk.

Answer: B

A firm with high operating leverage has a high percentage of its total costs in fixed costs.

Question 3 FCO, Inc. (FCO) is comparing EBIT forecasts to help determine the impact its capital structure has on net income.

Expected EBIT EBIT + 10%

EBIT $80,000 $88,000

Interest expense 15,000 15,000

EBT 65,000 73,000

Taxes 26,000 29,200

Net income 39,000 43,800

Liabilities 200,000

Shareholder equity 250,000

Return on equity 15.60%

FCO’s degree of financial leverage is closest to:

A) 1.25.

B) 0.80.

C) 0.60.

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Answer: A) 1.25.

The degree of financial leverage (DFL) is interpreted as the ratio of the percentage change in net income

to the percentage change in EBIT. FCO can compare two EBIT forecasts to determine how net income is

being driven by financial leverage.

Question 4 Given the following information on the annual operating results for ArtFrames, a producer of quality metal picture frames, what is the degree of operating leverage (DOL) and the degree of financial leverage (DFL)?

Sales of $3.5 million Variable Costs at 45% of sales Fixed Costs of $1.05 million Debt interest payments on $750,000 issued at par with an annual 9.0% coupon (current yield is

7.0%)

Which of the following choices is closest to the correct answer? Art Frame’s DOL and DFL are:

DOL DFL

A) 2.20 1.08

B) 3.00 1.50

C) 2.20 1.50

Answer: A)

The calculations are as follows:

First, calculate the operating results:

Art Frames Annual Operating Results

Sales $3,500,000

Variable Costs1 1,575,000

1,925,000

Fixed Costs 1,050,000

Earnings before interest and taxes

(EBIT) 875,000

Interest Expense2 67,500

807,500 1Variable costs = 0.45 × 3,500,000

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2Interest Expense = 0.09 × 750,000

Second, calculate DOL:

DOL = (Sales – Variable Costs) / (Sales – Variable Costs – Fixed Costs) = (3,500,000 – 1,575,000) / (3,500,000 – 1,575,000 – 1,050,000) = 2.20

Third, calculate DFL:

DFL = EBIT / (EBIT – I) = 875,000 / 807,500 = 1.08

Question 5 The management of Strings & All, Inc., a small, highly leveraged, electric guitar manufacturer, wants to reduce the company’s degree of total leverage (DTL) to 2.0. Currently, the company’s expected operating performance is as follows:

Sales of $500,000. Variable Costs at 60% of sales. Fixed Costs of $120,000. Fixed-Interest Debt with annual interest payments of $25,000.

All else constant, to obtain a DTL of 2.0, management must:

A) Reduce variable expenses by 30%.

B) Increase variable expenses by 30%.

C) Reduce variable expenses by 38.5%.

Answer: A) reduce variable expenses by 30%.

To obtain this result, we need to calculate the current variable costs, determine the variable costs that will

result in a DTL ratio of 2.00, and calculate the percentage change.

Step 1: Calculate current variable costs (VC): VC = 0.6 × 500,000 = 300,000

Step 2: Calculate Variable costs needed to decrease the DTL to 2.0:

Rearranging the formula for DTL:

(Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs − Interest Expense)

results in:

Variable Costs (VC) = Sales − (2 × Fixed Costs) − (2 × Interest Expense)

= 500,000 − (2 × 120,000) − (2 × 25,000) = 210,000

Step 3: Calculate percentage change:

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Question 6 Jayco, Inc. sells 10,000 units at a price of $5 per unit. Jayco's fixed costs are $8,000, interest expense is $2,000, variable costs are $3 per unit, and earnings before interest and taxes (EBIT) is $12,000. What is Jayco’s degree of financial leverage (DFL) and total leverage (DTL)?

DFL DTL

A) 1.20 2.00

B) 1.33 1.75

C) 1.33 2.00

Answer: A)

DOL = [Q(P − V)] / [Q(P − V) − F] = [10,000(5 − 3)] / [10,000(5 − 3) − 8,000] = 1.67

DFL = EBIT / (EBIT − I) = 12,000 / (12,000 − 2,000) = 1.2

DTL = DOL × DFL = 1.67 × 1.2 = 2.0

Question 7 Which of the following best describes a firm with low operating leverage? A large change in:

A) Earnings before interest and taxes result in a small change in net income.

B) Sales result in a small change in net income.

C) The number of units a firm produces and sells result in a similar change in the firm’s earnings before interest and taxes.

Answer: C) the number of units a firm produces and sells result in a similar change in the firm’s earnings before interest and taxes.

Operating leverage is the result of a greater proportion of fixed costs compared to variable costs in a firm’s capital structure and is characterized by the sensitivity in operating income (earnings before interest and taxes) to change in sales. A firm that has equal changes in sales and operating income would have low operating leverage (the least it can be is one). Note that the relationship between operating income and net income is impacted by the degree of financial leverage, and the relationship between sales and net income is impacted by the degree of total leverage.

Question 8 If a 10% increase in sales causes EPS to increase from $1.00 to $1.50, and if the firm uses no debt, then what is its degree of operating leverage?

A) 5.0.

B) 4.7.

C) 4.2.

Answer: A) 5.0.

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Upon first glance, it appears there is not enough information to complete the problem. However when one

realizes DTL = (DOL)(DFL) it is possible to complete this problem.

DTL = %∆EPS/%∆Sales = 5

DFL = EBIT/(EBIT-I) = 1.

(DOL)(1) =5

DOL= 5.

Question 9 A firm expects to produce 200,000 units of flour that can be sold for $3.00 per bag. The variable costs per unit are $2.00, the fixed costs are $75,000, and interest expense is $25,000. The degree of operating leverage (DOL) and the degree of total leverage (DTL) is closest to:

DOL DTL

A) 1.3 1.3

B) 1.6 2.0

C) 1.6 1.3

Answer: B

DOL = Q(P – V) / [Q(P – V) – F]

DOL = 200,000 (3 – 2) / [200,000(3 – 2) – 75,000] = 1.6

DTL = [Q(P - V) / Q(P - V) - F - I]

DTL = 200,000 (3 - 2) / [200,000 (3 - 2) - 75,000 - 25,000] = 2

Question 10 Stromburg Corporation's sales are $75,000,000. Fixed costs, including research and development, are $40,000,000, while variable costs amount to 30% of sales. Stromburg plans an expansion which will generate additional fixed costs of $15,000,000, decrease variable costs to 25% of sales, and permit sales to increase to $100,000,000. What is Stromburg's degree of operating leverage at the new projected sales level?

A) 4.20.

B) 3.50.

C) 3.75.

Answer: C) 3.75.

Sales = $100,000,000

VC of 25% of sales = 25,000,000

FC of 40,000,000 + 15,000,000 = 55,000,000

DOL= [100,000,000 – 25,000,000] / [100,000,000 – 25,000,000 – 55,000,000] = 3.75

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Question 11 An analyst has gathered the following expenditure information for three different firms, each of which has a sales level of $4 million.

Costs for firms under consideration (in millions)

Firm A Firm B Firm C

Variable Costs $2.00 $2.60 $2.40

Fixed Costs $1.00 $1.30 $1.40

Interest Expense $0.20 $0.00 $0.20

Which firm has the highest degree of operating leverage (DOL)?

A) Firm B.

B) Firm A.

C) Firm C.

Answer: A) Firm B.

The DOL for the three companies is as follows:

DOL = (Total Revenue - Total Variable Costs) / (TR − TVC − Total Fixed Costs)

Firm A: ($4.00 − $2.00) / ($4.00 − $2.00 − $1.00) = 2

Firm B: ($4.00 − $2.60) / ($4.00 − $2.60 − $1.30) = 14

Firm C: ($4.00 − $2.40) / ($4.00 − $2.40 − $1.40) = 8

(Note: Interest expense does not affect operating leverage.)

Question 12 During a period of expansion in the economy, compared to firms with lower operating expense levels, earnings growth for firms with high operating leverage will be:

A) Lower.

B) Unaffected.

C) Higher.

Answer: C) higher.

If a high percentage of a firm's total costs are fixed, the firm is said to have high operating leverage. High operating leverage, other things held constant, means that a relatively small change in sales will result in a large change in operating income. Therefore, during an expansionary phase in the economy a highly leveraged firm will have higher earnings growth than a lesser leveraged firm. The opposite will happen during an economic contraction.

Question 13 The following information reflects the projected operating results for Opstalan, a catalog printer.

Sales of $5.0 million. Variable Costs at 40% of sales.

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Fixed Costs of $1.0 million. Debt interest payments on $1.5 million issued with an annual 7.0% coupon (current yield is

8.0%). Tax Rate of 0.0%.

Opstalan’s degree of total leverage (DTL) is closest to:

A) 2.58.

B) 1.41.

C) 1.59.

Answer: C) 1.59.

First, calculate the operating results:

Opstalan Annual Operating Results

Sales $5,000,000

Variable Costs1 2,000,000

3,000,000

Fixed Costs 1,000,000

EBIT 2,000,000

Interest Expense2 105,000

1,895,000 1Variable costs = 0.40 × 5,000,000 2Interest Expense = 0.07 × 1,500,000

Second, calculate DOL = (Sales − Variable Costs) / (Sales − Variable Costs − Fixed Costs) = 3,000,000 /

2,000,000 = 1.50

Third, calculate DFL = EBIT / (EBIT − I) = 2,000,000 / 1,895,000 = 1.06.

Finally, calculate DTL = DOL × DFL = 1.50 × 1.06 = 1.59.

Question 14 All else equal, which of the following statements about operating leverage is least accurate?

A) Lower operating leverage generally results in a higher expected rate of return.

B) Operating leverage reflects the tradeoff between variable costs and fixed costs.

C) Firms with high operating leverage experience greater variance in operating income.

Answer: A) Lower operating leverage generally results in a higher expected rate of return.

Operating leverage is the trade off between fixed and variable costs. Higher operating leverage typically is indicative of a firm with higher levels of risk (greater income variance). Given the positive risk/return relationship, higher operating leverage firms are expected to have a higher rate of return. And, lower operating leverage firms are expected to have a lower rate of return.

Question 15 Which of the following statements about leverage is most accurate?

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A) An increase in fixed costs (holding sales and variable costs constant) will reduce the company's degree of operating leverage.

B) If the company has no debt outstanding, then its degree of total leverage equals its degree of operating leverage.

C) A decrease in interest expense will increase the company's degree of total leverage.

Answer: B

If debt = 0 then DFL = 1 because DFL = EBIT/(EBIT - I)

If debt = 0 then I = 0 and DFL = EBIT/(EBIT - 0) = EBIT/EBIT = 1

DTL = (DOL)(DFL)

If DFL = 1 then DTL = (DOL)(1) which complies to DTL = DOL

A decrease in interest expense will decrease DFL, which will decrease DTL. An increase in fixed costs

will increase the company’s DOL.

LOS C: Describe the effect of financial leverage on a company’s net income and return on equity Question 1 Which of the following is a key determinant of operating leverage?

A) The tradeoff between fixed and variable costs.

B) The competitive nature of the business.

C) Level and cost of debt.

Answer: A) The tradeoff between fixed and variable costs.

Operating leverage can be defined as the tradeoff between variable and fixed costs.

Question 2 Additional debt should be used in the firm’s capital structure if it increases:

A) Firm earnings.

B) The value of the firm.

C) Earnings per share.

Answer: B

The key to finding the optimal capital structure is identifying the level of debt that will maximize firm value. Earnings and earnings per share are not critical in and of themselves when assessing firm value, because they do not consider risk.

Question 3 Financial leverage magnifies:

A) Taxes.

B) Earnings per share variability.

C) Operating income variability.

Answer: B was correct!

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Financial leverage results in the existence of required interest payments and, hence, increased earnings per share variability. Higher debt ratios, given a fixed asset base, result in a greater earnings per share variability. Operating income is based on the products and assets of the firm and not on the firm’s financing and, hence, has no impact on financial leverage. Greater financial leverage is likely to reduce taxes due to the tax deductibility of interest payments.

Question 4 Which of the following statements regarding the impact of financial leverage on a company’s net income and return on equity (ROE) is most accurate?

A) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

B) If a firm has a positive operating profit margin, using financial leverage will always increase ROE.

C) Increasing financial leverage increases both risk and potential return of existing bondholders.

Answer: A) Using financial leverage increases the volatility of ROE for a level of volatility in operating income.

If a firm is financed with 100% equity, there is a direct relationship between changes in the firm’s ROE and changes in operating income. Adding financial leverage (debt) to the firm’s capital structure will cause ROE to become much more volatile and ROE will change more rapidly for a given change in operating income. The increased volatility in ROE reflects an increase in both risk and potential return for equity holders. Note that financial leverage results in increased default risk, but since existing bond holders are compensated by coupon interest and return of principal, their potential return is unchanged. Although financial leverage will generally increase ROE if a firm has a positive operating margin (EBIT/Sales), if the operating margin were small, the added interest expense could turn the firm’s net profit margin negative, which would in turn make ROE negative.

Question 5 Munn Industrial Components currently finances its operations with 100% equity, but is considering changing its target capital structure to 70% equity and 30% debt. Munn has a large asset base, a 20% operating profit margin, and the average interest rate on debt is expected to be 6.0%. If Munn makes the change to its capital structure and EBIT is unchanged, what is most likely the impact on Munn’s net income and return on equity (ROE) respectively?

Impact on Net Income

Impact on Return on Equity

A) No Change Increase

B) Decrease Increase

C) Decrease Decrease

Answer: B

You should be able to figure out this question with logic (without having to use calculations). The interest expense associated with using debt represents a fixed cost that reduces net income. However, the lower net income value is spread over a smaller base of equity capital, serving to increase the ROE.

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LOS D: Calculate the breakeven quantity of sales and determine the company’s net income at various sales levels. Question 1 Annual fixed costs at King Mattress amount to $325,000. The variable cost of raw materials and labor is $120 for the typical mattress. Sales prices for mattresses average $160. How many units must King Mattress sell to break even?

A) 8,125.

B) 40.

C) 2,708.

Answer: A) 8,125.

QBreakeven = Fixed Cost / (Price – Variable Cost) QBreakeven = $325,000 / (160 – 120) = 8,125

Question 2 Wanton’s San Y’isidro Co. manufactures custom door knobs for international clients. Average Revenue is $35 per unit, variable costs are $15 per unit, and total costs are $200,000. If sales are 10,000 units, what is the firm's breakeven sales quantity?

A) 2,500 units.

B) 1,750 units.

C) 3,000 units.

Answer: A) 2,500 units.

For this problem you need 2 equations.

Break-even quantity = Fixed Costs / (Price - Variable cost)

Q = FC / (P - V)

Fixed Costs = Total Costs - Variable Costs

FC = TC - VC = 200,000 - 150,000 = 50,000

Q = 50,000 / (35 - 15) = 2,500

Question 3 Jayco, Inc., sells blue ink for $4.00 a bottle. The ink's variable cost per bottle is $2.00. Ink has fixed cost of $10,000. What is Jayco's breakeven point in units?

A) 2,500.

B) 5,000.

C) 6,000.

Answer: B

QBE = [FC] / (P - V) QBE = [10,000] / (4.00 - 2.00) = 5,000

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Question 4 Annah Korotkin is the sole proprietor of CoverMeUp, a business that designs and sews outdoor clothing for dogs. Each year, she rents a booth at the regional Pet Expo and sells only blankets. Korotkin views the Expo as primarily a marketing tool and is happy to breakeven (that is, cover her booth rental). For the last 3 years, she has sold exactly enough blankets to cover the $750 booth rental fee. This year, she decided to make all blankets for the Expo out of high-tech waterproof/breathable material that is more expensive to produce, but that she believes she can sell for a higher profit margin. Information on the two types of blankets is as follows:

Per Unit Last Year’s (Basic) Blanket This Year’s (New) Blanket

Sales Price $25 $40

Variable Cost $20 $33

Assuming that Korotkin remains most interested in covering the booth cost (which has increased to $840), how many more or fewer blankets (new style) does she need to sell to cover the booth cost? To cover this year’s booth costs, Korotkin needs to sell:

A) 42 fewer blankets than last year.

B) 30 fewer blankets than last year.

C) 42 more blankets than last year.

Answer: B

To obtain this result, we need to calculate Last Year’s Breakeven Quantity, This Year’s Breakeven

Quantity, and calculate the difference.

Step 1: Determine Last Year’s (Basic Blanket) breakeven quantity:

QBE = (Fixed Costs) / (Sales Price per unit − Variable Cost per unit) = 750 / (25 − 20) = 150

Step 2: Determine This Year’s (New Blanket) breakeven quantity:

QBE = (Fixed Costs) / (Sales Price per unit – Variable Cost per unit) = 840 / (40 − 33) = 120

Step 3: Determine Change in Units:

This Year – QLast Year = 120 − 150 = −30. Korotkin needs to sell 30 fewer blankets.

Question 5 Jayco, Inc. has a division that makes red ink for the accounting industry. The unit has fixed costs of $10,000 per month, and is expected to sell 40,000 bottles of ink per month. If the variable cost per bottle is $2.00 what price must the division charge in order to breakeven?

A) $2.50.

B) $2.75.

C) $2.25.

Answer: C) $2.25.

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40,000 = $10,000/(P - $2) 40,000P – $80,000 = $10,000 P = $90,000/40,000 = $2.25.

LOS E: calculate and interpret the operating breakeven quantity of sales. Question 1 Nelson, Inc. has fixed financing costs of $3 million, fixed operating costs of $5 million, and variable costs of $2.00 per unit. If the price of Nelson’s product is $4.00, Nelson’s operating breakeven quantity of sales is:

A) 1.0 million Units.

B) 4.0 million Units.

C) 2.5 million Units.

Answer: C) 2.5 million units.

Operating breakeven quantity = fixed operating costs / (price – variable cost per unit) = $5 million / ($4.00 – $2.00) = 2,500,000 units.

Question 2 Yangtze Delta High Technology produces multimedia-enabled wireless phones. The factory incurs rent, depreciation, salary, and other fixed costs totaling RMB 10 million per year. Also, the company incurs annual interest of RMB 3 million on debt. Each phone sold by Yangtze Delta sells for RMB 200. The variable cost per phone is RMB 150. Yangtze Delta’s operating breakeven quantity of sales is closest to:

A) 260,000.

B) 200,000.

C) 65,000.

Answer: B

The operating breakeven point is the quantity of product sold at which operating income is zero (revenue

equals operating cost).

F = Fixed operating cost = RMB 10,000,000

P = Price per unit = RMB 200

V = Variable cost per unit = RMB 150

Operating breakeven quantity = F / (P − V) = 10,000,000 / (200 − 150) = 200,000.

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DIVIDENDS AND SHARE REPURCHASES: BASICS

LOS A: Explain regular cash dividends, extra dividends, stock dividends, stock splits and reverse

stock splits, including their expected effect on a shareholders’ wealth and a company’s financial

ratios.

Question 1 Financial managers utilize stock splits and stock dividends because they perceive that:

A) Investors will double the share price if there is a 20% stock dividend.

B) An optimal trading range exists.

C) Brokerage fees paid by shareholders will be reduced.

Answer: B

Although there is little empirical evidence to support the contention, there is nevertheless a widespread belief in financial circles that an optimal price range exists for stocks. “Optimal” means that if the price is within this range, the price/earnings ratio, price/sales and other relevant ratios will be maximized. Hence, the value of the firm will be maximized.

Question 2 A periodic payment to shareholders in the form of additional shares of stock instead of cash is a:

A) dividend reinvestment plan

B) stock repurchase

C) stock dividend

Answer: C) stock dividend

Stock dividends are dividends paid out in new shares of stock instead of cash. Unlike stock dividends, dividend reinvestment plans are at the discretion of individual shareholders. In the case of stock repurchases, the company is buying back shares so the number of shares in the investment public’s hands is declining.

Question 3 Stock splits:

A) Are less common than stock dividends.

B) Increase firm value.

C) Do not in and of themselves affect firm value.

Answer: C) do not in and of themselves affect firm value.

Stock splits divide up each existing share into multiple shares. The price of each share will drop correspondingly to the number of shares created, so there is no change in the owner’s wealth. Empirical research has shown that in the absence of a dividend yield increase, the stock price falls to the stock split ratio of the original price (i.e., to 25% of the original price in a 4-for-1 stock split). This makes sense, given that the investor’s percentage ownership of the company has not changed.

Question 4 Paying a cash dividend is most likely to result in:

A) An increase in liquidity ratios.

B) An increase in financial leverage ratios.

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C) The same impact on liquidity and leverage ratios as a stock dividend.

Answer: B

A cash dividend will increase leverage ratios such as debt-to-equity and debt-to-assets, reflecting a decrease in the denominator. A cash dividend should decrease liquidity ratios such as the current ratio and cash ratio, due to the decrease in cash in the numerator. Unlike a cash dividend, a stock dividend or a stock split has no impact on liquidity or financial leverage ratios.

LOS B: Describe dividend payment chronology, including declaration, holder-of-record, ex-dividend and payment dates, and indicate when a dividend is reflected in the share price. Question 1 What is the earliest day on which an investor can currently purchase Amex, Inc., if the investor wants to avoid receiving a dividend and thereby avoid paying tax on the distribution, if the date of record is Thursday, October 31?

A) Monday, October 28.

B) Thursday, October 24.

C) Tuesday, October 29.

Answer: C) Tuesday, October 29.

The ex-dividend date is now two business days prior to the date of record. Counting back two business days identifies Tuesday, October 29 as the date when the shares can be purchased without the dividend.

Question 2 Shareholders selling shares between the ex-dividend date and date of record:

A) Receive the dividend.

B) Forfeit the dividend, with the proceeds staying with the company.

C) Forfeit the dividend, with the proceeds going to the buyer.

Answer: A) receive the dividend.

The date of record is the date on which the shareholders of record are designated to receive the dividend. The ex-dividend date is the cut-off date for receiving the dividend. Shares sold after the ex-dividend date are sold without claim to the dividend, even if they are sold prior to the date of record. The dividend would be paid to the holder as of the close of trading on the day prior to the ex-dividend date.

Question 3 Which of the following shows the key dividend dates in their proper sequence?

A) Declaration date, holder-of-record date, ex-dividend date, payment date.

B) Declaration date, ex-dividend date, holder-of-record date, payment date.

C) Ex-dividend date, holder-of-record date, declaration date, payment date.

Answer: B

The board of directors announce the amount of the dividend, the holder-of-record date, and payment date. The ex-dividend date is two business days prior to the holder-of-record date, giving the firm time to identify the rightful owner of the dividends.

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Question 4 The cut-off date for receiving the dividend is known as the:

A) Holder of record date.

B) Date of payment.

C) Ex-dividend date.

Answer: C) ex-dividend date. The cut-off date for receiving the dividend is known as the ex-dividend date. The holder of record date is the date on which the shareholders of record are designated. The date the checks are mailed out is known as the date of payment. LOS C: Compare and contrast share repurchase methods Question 1 Which of the following statements about a stock repurchase is least accurate?

A) A stock repurchase occurs when a large block of stock is removed from the marketplace.

B) Management can distribute cash to shareholders without signaling about future earnings.

C) Disgruntled stockholders are forced to sell their shares, improving management's position.

Answer: C) A repurchase gives stockholders a choice. They can sell or not sell. Question 2 Jim Davis and Thurgood Owen, two equity analysts at Ferguson Capital Management, were reviewing the financial statements of Peregrine Foodstuffs Ltd. Davis and Owen noticed that Peregrine has been repurchasing its common shares in the market over the past three years. Owen thought this was an important issue to look into in greater detail. Upon completion of his review, Owen made the following two statements:

Statement 1: Peregrine has bought back shares in the open market during its repurchase program. This method of repurchase gave the company the flexibility to choose the timing of the transaction.

Statement 2: Peregrine plans to buy back shares by making tender offers during the coming year. By making tender offers, the company will be able to repurchase shares at a discount to the prevailing market price.

With respect to Owen's statements:

A) Both are correct.

B) Only one is correct.

C) Both are incorrect.

Answer: B

Buying in the open market gives the company the flexibility to choose the timing of the transaction. Thus, Statement 1 is correct. A second way is to buy a fixed number of shares at a fixed price. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is at a premium to the current market price. They would not be willing to tender their shares for less than the

prevailing market price, so Statement 2 is incorrect.

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Question 3 Laura’s Chocolates, Inc. (LC), is a maker of nut-based toffees. LC is considering a share repurchase and prefers the “tender offer” method. Which of the following is also known as a “tender offer”?

A) Buying in the open market.

B) Repurchasing by direct negotiation.

C) Buying a fixed number of shares at a fixed price.

Answer: C) Buying a fixed number of shares at a fixed price.

A tender offer refers to buying a fixed number of shares at a fixed price (usually at a premium to the current market price).

Question 4 Which justification for repurchasing stock is the least valid?

A) Repurchases offer shareholders more choices than cash dividends.

B) Shareholders prefer capital gains to cash dividends.

C) A cash dividend increase, in response to short-term excess cash flows, may confuse investors.

Answer: B

Some shareholders prefer capital gains, while others prefer dividends. Repurchases offer shareholders the choice of tendering or not tendering their stock, while cash dividends represent a payment they cannot refuse. Raising dividends is often seen as a positive signal, but an increase funded by short-term cash flows may not be sustainable, forcing the company to reduce the dividend later.

Question 5 Which of the following is least likely a method by which firms repurchase their shares?

A) Tender offer.

B) Direct negotiation.

C) Exercise a call provision.

Answer: C) Exercise a call provision.

Call provisions are not relevant to common stock and are not considered a repurchase in any case. There are three repurchase methods. The first is to buy in the open market. A company may repurchase stock by making a tender offer to repurchase a specific number of shares at a price that is usually at a premium to the current market price. The third way is to repurchase by direct negotiation. Companies may negotiate directly with a large shareholder to buy back a block of shares, usually at a premium to the market price.

LOS D: Calculate and compare the effects of a share repurchase on earnings per share when 1) the repurchase is financed with the company’s excess cash and 2) the company uses funded debt to finance the repurchase. Question 1 Sinclair Construction Company’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Sinclair assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Sinclair decides to borrow $30 million that it will use to repurchase shares.

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Sinclair’s Chief Executive Officer (CEO) has compiled the following information regarding the repurchase of the firm’s common stock:

Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 8.0% Planned buyback = 600,000 shares

Based on the information above, Sinclair’s earnings per share (EPS) after the repurchase of its common stock will be closest to:

A) $3.18.

B) $3.32.

C) $3.23.

Answer: B

Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the 8.0% after-tax cost of borrowing is greater than the 6.7% earnings yield (E/P) of the shares, the

share repurchase reduces Sinclair’s EPS.

Question 2 Francis Investment Inc’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Francis assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Francis decides to borrow $30 million that it will use to repurchase shares. Francis’ Chief Financial Officer (CFO) has compiled the following information regarding the repurchase of the firm’s common stock:

Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 4%

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Planned buyback = 600,000 shares

Based on the information above, after the repurchase of its common stock, Francis’ EPS will be closest

to:

A) $3.41.

B) $3.39.

C) $3.36.

Answer: C) $3.36.

Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the after-tax cost of borrowing of 4% is less than the 6.7% earnings yield (E/P) of the shares, the

share repurchase will increase Francis’s EPS.

Question 3 Pants R Us Inc.’s Board of Directors is considering repurchasing $30,000,000 worth of common stock. Pants R Us assumes that the stock can be repurchased at the market price of $50 per share. After much discussion Pants R Us decides to borrow $30 million that it will use to repurchase shares. Pants R Us’ Chief Investment Officer (CIO) has compiled the following information regarding the repurchase of the firm’s common stock:

Share price at the time of buyback = $50 Shares outstanding before buyback = 30,600,000 EPS before buyback = $3.33 Earnings yield = $3.33 / $50 = 6.7% After-tax cost of borrowing = 6.7% Planned buyback = 600,000 shares

Based on the information above, what will be Pants R Us’ earnings per share (EPS) after the repurchase of its common stock?

A) $3.33.

B) $3.28.

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C) $3.40.

Answer: A) $3.33.

Total earnings = $3.33 × 30,600,000 = $101,898,000

Since the after-tax cost of borrowing of 6.7%% is equal to the 6.7% earnings yield (E/P) of the shares, the

share repurchase has no effect on Pants R Us’ EPS.

LOS E: calculate and describe the effect of a share repurchase on book value per share. Question 1 The share price of Winnipeg Auto Unlimited is $5 per share. There are 50 million shares outstanding, and Winnipeg has a book value of $900 million. What is the book value per share (BVPS) after the share repurchase of $10 million?

A) $21.24.

B) $14.76.

C) $18.54.

Answer: C) $18.54.

The share buyback is $10 million / $5 per share = 2,000,000 shares.

Remaining shares: 50 million − 2 million = 48 million shares.

Winnipeg Auto Unlimited’s current BVPS = $900 million / 50 million = $18.

Book value after repurchase: $900 million − $10 million = $890 million.

BVPS = $890 million / 48.0 million = $18.54.

BVPS increased by $0.54.

Book value per share (BVPS) increased because the share price is less than the original BVPS. If the

share prices were more than the original BVPS, then the BVPS after the repurchase would have

decreased.

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Question 2 The share prices of Solar Automotive Industries and Winnipeg Auto Unlimited are both $50 per share, and each company has 50 million shares outstanding. On September 30, both companies announced a $10 million stock buyback. Solar has a book value of $500 million, while Winnipeg has a book value of $900 million. How much did the book value per share (BVPS) of each company increase or decrease after the share repurchase?

Solar Automotive Industries Winnipeg Auto Unlimited

A) Decrease by $0.13 Decrease by $0.13

B) Decrease by $0.16 Decrease by $0.13

C) Increase by $0.13 Increase by $0.16

Answer: B

The share buyback for each company is $10 million / $50 per share = 200,000 shares.

Remaining shares for each company = 50 million − 200,000 = 49.8 million shares.

For Solar Automotive Industries:

Solar Automotive Industries’ current BVPS = $500 million / 50 million = $10.

The market price per share of $50 is greater than the BVPS of $10.

Book value after repurchase = $500 million – $10 million = $490 million

BVPS = $490 million / 49.8 million = $9.84

BVPS decreased by $0.16

For Winnipeg Auto Unlimited:

Winnipeg Auto Unlimited’s current BVPS = $900 million / 50 million = $18.

The market price per share of $50 is greater than the BVPS of $18.

Book value after repurchase = $900 million – $10 million = $890 million

BVPS = $890 million / 49.8 million = $17.87

BVPS decreased by $0.13.

In the case of both Solar Automotive Industries and Winnipeg Auto Unlimited, book value per share

(BVPS) decreased because the share price is greater than the original BVPS. If the share prices were

less than the original BVPS, then the BVPS after the repurchase for each firm would have increased.

Question 3 The share price of Solar Automotive Industries is $50 per share. It has a book value of $500 million and 50 million shares outstanding. What is the book value per share (BVPS) after a share repurchase of $10 million?

A) $9.84.

B) $10.12

C) $10.00.

Answer: A) $9.84.

The share buyback is $10 million / $50 per share = 200,000 shares.

Remaining shares: 50 million − 200,000 = 49.8 million shares.

Solar Automotive Industries’ current BVPS = $500 million / 50 million = $10.

Book value after repurchase: $500 million − $10 million = $490 million.

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BVPS = $490 million / 49.8 million = $9.84.

BVPS decreased by $0.16.

Book value per share (BVPS) decreased because the share price is greater than the original BVPS. If the

share prices were less than the original BVPS, then the BVPS after the repurchase would have

increased.

LOS F: Explain why a cash dividend and a share repurchase of the same amount are equivalent in terms of the effect on shareholders’ wealth, all else being equal. Question 1 Pearl City Breweries has 8 million shares outstanding that are currently trading at $34 per share. The company is choosing whether to distribute $22 million as dividends or to use the same amount to repurchase its shares. Ignoring tax effects, what will be the amount of total wealth from owning one share of Pearl City Breweries under each of these alternatives?

Cash dividend Share repurchase

A) $34.00 $34.00

B) $31.25 $37.00

C) $31.25 $34.00

Answer: A)

If the company pays a cash dividend, the dividend per share will be $22 million/8 million = $2.75. The

value of its shares will be:

So the total wealth from owning one share will be $31.25 + $2.75 = $34.00.

If the company repurchases shares, it can buy $22 million/$34 = 647,058 shares. The value of one share

would then be:

If you remember that both a cash dividend and a share repurchase for cash leave shareholder wealth

unchanged, this question does not require calculations of the amounts.

Question 2 What is the impact on shareholder wealth of a share repurchase versus cash dividend of equal amount when the tax treatment of the two alternatives is the same?

A) A share repurchase is equivalent to a cash dividend of an equal amount, so total shareholder wealth will be the same.

B) A share repurchase will sometimes lead to higher total shareholder wealth than a cash dividend of an equal amount.

C) A share repurchase will always lead to higher total shareholder wealth than a cash dividend of an equal amount.

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Answer: A)

Assuming that the tax treatment of a share repurchase and a cash dividend of equal amount is the same, a share repurchase is equivalent to a cash dividend payment, and shareholder wealth will be the same.

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WORKING CAPITAL MANAGEMENT

LOS A: Describe primary and secondary sources of liquidity and factors that influence a

company’s liquidity position.

Question 1 An example of a secondary source of liquidity is:

A) Cash flow management.

B) Negotiating debt contracts.

C) Trade credit and bank lines of credit.

Answer: B

Secondary sources of liquidity include negotiating debt contracts, liquidating assets, and filing for bankruptcy protection and reorganization. Primary sources of liquidity include ready cash balances, short-term funds (e.g., trade credit and bank lines of credit), and cash flow management.

Question 2 The condition that occurs when a company disburses cash too quickly, stretching the company’s cash reserves, is best described as a:

A) Drag on liquidity.

B) Pull on liquidity.

C) Liquidity premium.

Answer: B

When cash payments are made too quickly, the condition is known as a pull on liquidity. A drag on liquidity occurs when cash inflows lag.

LOS B: Compare a company’s liquidity measure with those of peer companies. Question 1 The quick ratio is considered a more conservative measure of liquidity than the current ratio because the quick ratio excludes:

A) Short-term marketable securities, which may need to be sold at a significant loss.

B) Accounts receivable, which may not be collectible in the short term.

C) Inventories, which are not necessarily liquid.

Answer: C) inventories, which are not necessarily liquid.

The quick ratio is usually defined as (current assets – inventory) / current liabilities. It is a more restrictive measure of liquidity than the current ratio, which equals current assets / current liabilities. The numerator of the quick ratio includes cash, receivables, and short-term marketable securities.

Question 2

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In a recent staff meeting, David Hurley, stated that analysts should understand that financial ratios mean little by themselves. He advised his colleagues to evaluate financial ratios carefully. During the discussion he made the following statements:

Statement 1: A company can be compared with others in its industry by relating its financial ratios to industry norms. However, care must be taken because many ratios are industry-specific, but not all ratios are important to all industries.

Statement 2: Comparing a company to the overall economy is useless because overall business conditions are constantly changing. Specifically, it is not the case that financial ratios tend to improve when the economy is strong and weaken during recessionary times.

Are statements 1 and 2 as made by Hurley regarding financial ratio analysis CORRECT?

Statement 1 Statement 2

A) Incorrect Correct

B) Correct Correct

C) Correct Incorrect

Answer: C)

Correct Incorrect

Financial ratios are meaningless by themselves. To have meaning an analyst must use them with other information. An analyst should evaluate financial ratios based on industry norms and economic conditions. Statement 1 is correct. However, statement 2 is not because financial ratios tend to improve when the economy is strong and weaken when the economy is in a recession. So, financial ratios should be reviewed in light of the current stage of the business cycle.

Question 3 Which of the following is least likely an indicator of a firm’s liquidity?

A) Inventory turnover.

B) Amount of credit sales.

C) Cash as a percentage of sales.

Answer: B

No inferences about liquidity are warranted based on this measure. A firm may have higher credit sales than another simply because it has more sales overall. Cash as a proportion of sales and inventory turnover are indicators of liquidity.

Question 4 An analyst computes the following ratios for Iridescent Carpeting Inc. and compares the results to the industry averages:

Financial Ratio Iridescent Carpeting Industry Average

Current Ratio 2.3x 1.8x

Net Profit Margin 22% 24%

Return on Equity 17% 20%

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Total Debt / Total Capital 35% 56%

Times Interest Earned 4.7x 4.1x

Based on the above data, which of the following can the analyst conclude? Iridescent Carpeting:

A) Has stronger profitability than its competitors.

B) Is most likely a younger company than its competitors

C) Has better short-term liquidity than its competitors.

Answer: C) has better short-term liquidity than its competitors.

Based on the data provided, the analyst can conclude that Iridescent Carpeting has weaker profitability than its competitors based on the net profit margin and return on equity. The analyst can also conclude that the company has less financial leverage (risk) than the industry average based on the total debt / total capital and the times interest earned ratios. The analyst can conclude that the company has better short-term liquidity than the industry average (i.e., its competitors) based on the current ratio.

Question 5 Alton Industries will have better liquidity than its peer group of companies if its:

A) Receivables turnover is higher.

B) Average trade payables are lower.

C) Quick ratio is lower.

Answer: A) receivables turnover is higher.

Higher receivables turnover is an indicator of better receivables liquidity since receivables are converted to cash more rapidly. A lower quick ratio is an indication of less liquidity. Lower trade payables could be related to better liquidity, but could also be consistent with very poor liquidity and a requirement from its suppliers of cash payment.

Question 6 Which of the following is NOT a limitation to financial ratio analysis?

A) A firm that operates in only one industry.

B) The need to use judgment.

C) Differences in international accounting practices.

Answer: A) A firm that operates in only one industry.

If a firm operates in multiple industries, this would limit the value of financial ratio analysis by making it difficult to find comparable industry ratios.

Question 7 A firm has average days of receivables outstanding of 22 compared to an industry average of 29 days. An analyst would most likely conclude that the firm:

A) May have credit policies that are too strict.

B) Has better credit controls than its peer companies.

C) Has a lower cash conversion cycle than its peer companies.

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Answer: A) may have credit policies that are too strict.

The firm’s average days of receivables should be close to the industry average. A significantly lower average days receivables outstanding, compared to its peers, is an indication that the firm’s credit policy may be too strict and that sales are being lost to peers because of this. We can not assume that stricter credit controls than the average for the industry are “better.” We cannot conclude that credit sales are less, they may be more, but just made on stricter terms. The average days of receivables are only one component of the cash conversion cycle.

LOS C: Evaluate overall working capital effectiveness of a company, using the operating and cash conversion cycles, and compare its effectiveness with other peer companies. Question 1 Compared to the prior year, Chart Industries has reported that its operating cycle has remained relatively stable while its cash conversion cycle has decreased. The most likely explanation for this is that the firm:

A) Has improved its inventory turnover.

B) Is paying its bills for raw materials more rapidly.

C) Is relying more on its suppliers for short-term liquidity.

Answer: C) is relying more on its suppliers for short-term liquidity.

The cash conversion cycle is its operating cycle minus its average days payables outstanding. Therefore, the firm’s average days payables must have increased, a clear indication that the firm is relying more heavily on credit from its suppliers. Improved inventory turnover would tend to increase both the operating and cash conversion cycles. Relaxed credit policies would tend to increase the firm’s operating cycle as receivables turnover would tend to decrease.

Question 2 An analyst who is evaluating a firm’s working capital management would be least likely to be concerned if the firms:

A) Number of days of inventory is higher than that of its peers.

B) Operating cycle is shorter than that of its peers.

C) Total asset turnover is lower than its industry average.

Answer: B

A shorter operating cycle will lead to a shorter cash conversion cycle, other things equal, which is an indication of better working capital management. Higher days inventory on hand, compared to peer company averages, will lengthen the cash conversion cycle, an indication of poorer working capital management. Good working capital management would tend to increase a firm’s total asset turnover since a given amount of sales can be supported with less working capital (less current assets).

Question 3 Compared to the prior period, a firm has greater days of receivables. The effect on the firm’s cash conversion cycle and operating cycle are most likely a(n):

Cash conversion cycle Operating cycle

A) Increase Increase

B) Increase Decrease

C) Decrease Increase

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Answer: A)

Greater days of receivables will increase both the cash conversion cycle and operating cycle, other things equal.

Question 4 Which of the following most accurately represents the cash conversion cycle?

A) Average days of receivables + average days of inventory + average days of payables.

B) Average days of payables + average days of inventory – average days of receivables.

C) Average days of receivables + average days of inventory – average days of payables.

Answer: C) average days of receivables + average days of inventory – average days of payables.

The cash conversion cycle, also called the net operating cycle is:

The cash conversion cycle measures the length of time required to convert a firm’s cash investment in

inventory back into cash resulting from the sale of the inventory. A short cash conversion cycle is good

because it indicates a relatively low investment in working capital.

LOS D: Identify and evaluate the necessary tools to use in managing a company’s net daily cash position Question 1 Which of the following factors is most likely to cause a firm to need short-term financing?

A) Operating cash inflows that fluctuate seasonally.

B) Return of principal from maturing investments.

C) Shorter cash conversion cycle than the industry average.

Answer: A) Operating cash inflows that fluctuate seasonally.

Firms with operating cash inflows that fluctuate seasonally are likely to experience short-term imbalances between cash inflows and cash outflows and must forecast these imbalances to manage their net daily cash positions, for example by arranging short-term borrowing over seasons when operating cash inflows are expected to be relatively low and operating cash outflows are relatively high.

Question 2 Which of the following actions would improve a firm’s net daily cash position in the short term?

A) Increasing the annual dividend on common stock.

B) Stretching accounts payable.

C) Purchasing plant and equipment with financing provided by the seller.

Answer: B

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Increasing a cash inflow or decreasing a cash outflow would improve a firm’s net daily cash position. Stretching accounts payable (i.e., waiting longer to pay suppliers) would decrease cash outflows in the short term. Increasing the annual dividend on common stock would increase a cash outflow. Purchasing plant and equipment with financing provided by the seller is a non-cash transaction.

Question 3 The least appropriate security for investing short-term excess cash balances would be:

A) Bank certificates of deposit.

B) Time deposits.

C) Preferred stock.

Answer: C) preferred stock.

While adjustable-rate preferred is an appropriate security for short-term investment of excess cash balances, other preferred shares are not. Bank certificates of deposit and time deposits can be for appropriately short periods.

Question 4 An appropriate cash management strategy for a company that has a seasonally high need for cash prior to the holiday shopping season would least likely include:

A) Investing in U.S. Treasury notes at other times of the year because they are highly liquid.

B) Allowing short-term securities to mature without reinvestment.

C) Borrowing funds though a bank line of credit.

Answer: A) investing in U.S. Treasury notes at other times of the year because they are highly liquid.

Treasury notes have maturities between 2 and 10 years and, thus, have maturities longer than those of securities suitable for cash management. Allowing short-term securities to mature without reinvesting the cash generated would be one way to meet seasonal cash needs. Short-term bank borrowing or issuing commercial paper that can be paid off when holiday sales generate cash would be appropriate strategies for dealing with a predictable short-term need for cash.

LOS E: Compute and interpret comparable yields on various securities, compare portfolio returns against a standard benchmark, and evaluate a company’s short-term investment policy guidelines. Question 1 An investment policy statement for a firm’s short-term cash management function would least appropriately include:

A) Information on who is allowed to invest corporate cash.

B) A list of permissible securities.

C) Procedures to follow if the investment guidelines are violated.

Answer: B

An investment policy statement typically begins with a statement of the purpose and objective of the investment portfolio, some general guidelines about the strategy to be employed to achieve those objectives, and the types of securities that will be used. A list of permitted securities for investment would be limited and likely too restrictive. A list of permitted security types is appropriate and can provide the necessary flexibility to increase yield within the safety and liquidity constraints appropriate for the firm.

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Question 2 Assume that a 30-day commercial paper security has a holding period yield of 0.80%. The bond equivalent yield of this security is:

A) 9.60%.

B) 10.12%.

C) 9.73%.

Answer: C) 9.73%.

BEY = HPY × (365/days)

BEY = 0.80% × (365/30) = 9.73%

Question 3 A 91-day Treasury bill has a holding period yield of 1.5%. What is the annual yield of this T-bill on a bond-equivalent basis?

A) 6.02%.

B) 6.65%.

C) 6.24%.

Answer: A) 6.02%.

BEY = 1.5% × (365/91) = 6.02%.

Question 4 Which yield measure is the most appropriate for comparing a company’s investments in short-term securities?

A) Bond equivalent yield.

B) Money market yield.

C) Discount basis yield.

Answer: A) Bond equivalent yield.

When evaluating the performance of its short-term securities investments, a company should compare them on a bond equivalent yield basis.

Question 5 Yields on firms’ investments in short-term securities for comparison purposes are best stated as:

A) .

B) .

C) .

Answer: B

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The yields on investments in short-term securities should be stated as bond equivalent yields (BEYs), and returns on portfolios of these securities should be stated as a weighted average of BEYs. The BEY, which

is holding period yield × , allows fixed-income securities whose payments are not annual to be compared with securities with annual yields.

Question 6 A banker’s acceptance that is priced at $99,145 and matures in 72 days at $100,000 has a(n):

A) Discount yield greater than its bond equivalent yield.

B) Money market yield greater than its discount yield.

C) Bond equivalent yield greater than its effective annual yield.

Answer: B

The money market yield is the holding period yield times 360/72 and is always greater than the discount yield which is the actual discount from face value times 360/72, since the holding period yield is always greater than the percentage discount from face value. A security’s discount yield and its money market yield are always less than its bond equivalent yield, and its effective annual yield is always greater than its bond equivalent yield.

Question 7 A firm is choosing among three short-term investment securities:

Security 1: A 30-day U.S. Treasury bill with a discount yield of 3.6%. Security 2: A 30-day banker’s acceptance selling at 99.65% of face value. Security 3: A 30-day time deposit with a bond equivalent yield of 3.65%.

Based only on these securities’ yields, the firm would:

A) Prefer the U.S. Treasury bill.

B) Prefer the time deposit.

C) Prefer the banker’s acceptance.

Answer: C) prefer the banker’s acceptance.

We can compare the yields of these securities on any single basis. The preferred basis is the bond

equivalent yield.

Security 1 = discount is 3.6%(30 / 360) = 0.3%

BEY = (0.3 / 99.7) (365 / 30) = 3.661%

BEY of Security 2 = (0.35 / 99.65) × (365 / 30) = 4.273%

BEY of Security 3 = 3.65%

Question 9 A 30-day bank certificate of deposit has a holding period yield of 1%. What is the annual yield of this CD on a bond-equivalent basis?

A) 11.83%.

B) 12.17%.

C) 12.00%.

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Answer: B

The bond-equivalent yield is calculated as the holding period yield times (365 / number of days in the

holding period). BEY = 1% × (365/30) = 12.17%.

LOS F: Assess the performance of a company’s accounts receivable, inventory, management, and accounts payable functions against historical figures and comparable peer company values. Question 1 Which of the following strategies is most likely to be considered good payables management?

A) Paying invoices on the last possible day to still get the supplier’s discount for early payment.

B) Taking trade discounts only if the firm’s annual return on short-term investments is less than the discount percentage.

C) Paying trade invoices on the day they arrive.

Answer: A) Paying invoices on the last possible day to still get the supplier’s discount for early payment.

Paying invoices on the last day to get a discount (for early payment) is often the most advantageous strategy for a firm. If the annualized percentage cost of not taking advantage of the discount is less than the firm’s short-term cost of funds, it would be advantageous to pay on the due date. However, the discount percentage is not an annualized rate, so it cannot be compared directly to the firm's annual return on short-term investments. Paying prior to the discount cut-off date or prior to the due date sacrifices interest income for no advantage.

Question 2 Pfluger Company’s accounts payable department receives an invoice from a vendor with terms of 2/10 net 30. If Pfluger pays the invoice on its due date, the cost of trade credit is closest to:

A) 27.9%.

B) 43.5%.

C) 44.6%.

Answer: C) 44.6%.

"2/10 net 30" is a discount of 2% of the invoice amount for payment within 10 days, with full payment due

in 30 days. Cost of trade credit on day 30 =

Question 3 With respect to inventory management,:

A) A firm with inventory turnover higher than the industry average can be expected to have better profitability as a result.

B) An increase in days of inventory on hand can be the result of either good or poor inventory management.

C) A decrease in a firm’s days of inventory on hand indicates better inventory management and can lead to increased profits.

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Answer: B

An increase in inventory could indicate poor sales and an accumulation of obsolete items or could be the result of a conscious effort to have adequate supplies to avoid losses from not having items to satisfy customer orders (stock outs). Higher-than-average inventory turnover could indicate better inventory management or could indicate that a less than optimal inventory is being maintained by the company.

Question 4 A result that is most likely to give a financial manager concern that his firm’s credit policy may have become too lenient is:

A) Receivables turnover has increased significantly.

B) Weighted average collection period has increased.

C) Inventory turnover has decreased considerably.

Answer: B

The weighted average collection period is the average number of days it takes to collect a dollar of receivables. A decreased percentage of sales made on credit or an increase in the receivables turnover ratio might result from more strict credit terms. Inventory turnover is not directly affected by credit terms, only though the effect of credit terms on overall sales.

LOS G: Evaluate the choices of short-term funding available to a company and recommend a financing method. Question 1 A large, creditworthy manufacturing firm would most likely get short-term financing by:

A) Factoring its receivables.

B) Entering into an agreement for a committed line of credit.

C) Issuing commercial paper.

Answer: C) issuing commercial paper.

Large, creditworthy firms can get the lowest cost of financing by issuing commercial paper. Selling receivables to a factor is a higher cost source of funds used by firms with poor credit quality. A committed line of credit requires payment of a fee and represents bank borrowing, which would be attractive to a firm that did not have the size or creditworthiness to issue commercial paper.

Question 2 Which of the following sources of short-term liquidity is considered reliable enough that it can be listed in the footnotes to a firm’s financial statements as a source of liquidity?

A) Factoring agreement.

B) Revolving line of credit.

C) Uncommitted line of credit.

Answer: B

With an uncommitted line of credit, the lender is not committed to make loans in any amount. A revolving line of credit is typically for a longer period and involves an agreement to lend funds in the future up to

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some maximum amount. Factoring does not typically involve an agreement for future receivables purchases.

Question 3 Which of the following sources of credit would an analyst most likely associate with a borrower of the lowest credit quality?

A) Committed line of credit.

B) Revolving line of credit.

C) Uncommitted line of credit.

Answer: C) Uncommitted line of credit.

Committed lines and revolving lines of credit all contain a commitment by a lender to lend up to a maximum amount, at the borrower’s option for some period of time. A firm with lower credit quality may have an uncommitted line of credit which offers no guarantee from the lender to provide any specific amount of funds in the future.

Question 4 Which of the following sources of liquidity is the most reliable?

A) Revolving line of credit.

B) Committed line of credit.

C) Uncommitted line of credit.

Answer: A) Revolving line of credit.

A revolving line of credit is typically for a longer term than an uncommitted or committed line of credit and thus is considered a more reliable source of liquidity. With an uncommitted line of credit, the issuing bank may refuse to lend if conditions of the firm change. An overdraft line of credit is similar to a committed line of credit agreement between banks and firms outside of the U.S. Both committed and revolving lines of credit can be verified and can be listed in the footnotes to a firm’s financial statements as sources of liquidity.

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THE COPORATE GOVERNANCE OF LISTED COMPANIES: A

MANUAL FOR INVESTORS

LOS A: Define and describe Corporate Governance.

Question 1 Which of the following statements regarding corporate governance practices is least accurate?

A) Corporate governance is not as important for firms with largely dispersed minority shareholders.

B) Good corporate governance practices ensure that the firm’s financial and operating activities are reported to shareholders in a verifiable manner.

C) Corporate governance is the system of internal controls/procedures by which firms are managed.

Answer: A).

Good corporate governance practices are extremely important in the case of firms with largely dispersed minority shareholders. Both remaining statements are accurate.

Question 2 Corporate governance is the set of internal controls, processes and procedures defining how a firm is managed. Which of the following statements concerning corporate governance is least accurate?

A) Good corporate governance dictates that the firm’s financial, operating and governance activities are reported to stakeholders in a fair, accurate and timely manner.

B) Corporate governance defines the appropriate rights, roles and responsibilities of management, the board, and stakeholders within a firm.

C) Good corporate governance means that the board can work effectively with management.

Answer: C) Good corporate governance means that the board can work effectively with management.

The board of directors must be able to act independently from management. Both remaining statements concerning corporate governance are accurate.

Question 3 During a recent luncheon, Angus Rahamut and Dan Riding became engaged in a discussion of issues related to corporate governance. Neither of these individuals is an expert in the field of corporate governance and either of them may have made an inaccurate statement. Which of the following is most likely to be an inaccurate statement?

Answer: B

A) “Board members must have the experience and qualifications necessary for them to be able to make decisions independently from the firm’s management.”

B) “In order to avoid conflicts of interest, board members should seek management approval prior to hiring external advisors.”

C) “To be independent, a board member must not have any material relationship with the firm’s executive management or their families.”

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Ideally, independent board members can hire external consultants without management’s approval. This enables the board to obtain advice on specialized issues that is not biased by the interests of management.

Question 4 Which of the following activities would least likely be an example of good corporate governance?

A) The board has decided to eliminate finders’ fees for its members for any potential acquisitions that are brought to management’s attention.

B) Management is allowed to act independently of board of directors.

C) The board of directors has decided to conduct a self-assessment.

Answer: B

The board of directors should be allowed to act independently of management. Management should not be allowed to act independently from the board.

Question 5 All of the following practices constitute good corporate governance, EXCEPT:

A) There are proper procedures and controls covering management’s day-to-day operations and the firm acts lawfully in dealings with shareholders.

B) The firm’s financial, operating, and governance activities are reported to shareholders in a fair, accurate, and timely manner, and management acts independent of the board of directors.

C) The board of directors protects shareholder interests, and the shareholders have a voice in governance.

Answer: B

The board of directors must be able to act independent of management, not vice versa. Both of the remaining practices are examples of good corporate governance.

Question 6 Corporate governance defines the appropriate rights, role, and responsibilities of:

A) Management only.

B) Management, the board of directors, and shareholders.

C) Management and the board of directors.

Answer: B

Corporate governance defines the appropriate rights, roles, and responsibilities of a corporation’s management, the board of directors, and shareholders.

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LOS B: Discuss and critique characteristics and practices related to board and committee independence, experience, compensation, external consultants, and frequency of elections, and determine whether they are supportive of shareowner protection. Question 1 Rochelle Dixon is delivering a presentation on best practices for corporate governance. Two of her recommendations are as follows:

Statement 1: To avoid the potential for harming shareholders’ interests by wasting company resources, the Board of Directors should get management’s approval before it hires outside consultants.

Statement 2: The more members a Board of Directors has, the more likely it is to represent shareholders’ interests fairly.

Are Dixon’s statements CORRECT?

Statement 1 Statement 2

A) Incorrect Correct

B) Incorrect Incorrect

C) Correct Correct

Answer: B

Both statements are incorrect. An independent board should have the ability to seek specialized advice by hiring outside consultants without management approval. The size of the board should be appropriate for the facts and circumstances of the firm; having more members does not imply that the board will be more independent if the additional members are aligned closely with management or are less well qualified.

Question 2 A board of directors is most likely to protect the shareholders’ interests when:

A) The board requires that management attend all meetings.

B) One individual can be identified as the leading board member from outside the firm.

C) The board includes representatives from the firm’s key customers and suppliers.

Answer: B

Especially in cases where the chairman of the board is closely aligned with the firm, independent board members are more able to protect shareholders’ interests when they have a leading or primary independent member. The board should meet regularly outside the presence of management. Board members who represent the firm’s customers and suppliers may have interests that conflict with those of shareholders.

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LOS C: Describe board independence and explain the importance of independent board members in corporate governance. Question 3 Which of the following statements related to corporate governance is least accurate?

A) It is desirable for the chairman of the board to be the firm’s current CEO or former CEO.

B) Board members should not have any material relationships with the firm’s advisers, auditors, and their families.

C) It is desirable for board members to have board experience with other boards.

Answer: A) It is desirable for the chairman of the board to be the firm’s current CEO or former CEO.

The willingness of independent board members to express opinions that are not aligned with managements’ may be impaired when the chairman is the firm’s current CEO or a former CEO.

Question 4 There are a lot of issues to consider in determining board independence. What would be the best definition of true “independence”? Independence, as it relates to board members, refers to: Answer: C)

Avoiding material conflicts of interest is important, but this is not a true definition of independence. Independent board members should be independent from the outside audit group, but this is not part of the actual definition. Benefiting management interests should not be a board priority.

LOS D: Identify factors that indicate a board and its members possess the experience required to govern the company for the benefit of its shareowners. Question 1 A properly qualified board member is of vital importance to proper corporate governance within a firm. Board members who lack the requisite skills, knowledge and expertise to conduct a thorough review of the firm’s activities are:

A) Less likely to participate fully in decision-making matters during board meetings.

B) More likely to defer to management when making decisions.

C) More likely to consult with outside interests to assist in decision-making.

Answer: B

Board members must be properly qualified, having the knowledge and experience which is required to advise management in light of the firm’s specific situations encountered. Both remaining answers are incorrect.

Question 2 A critical corporate governance issue is ensuring that the board and its members have the requisite experience needed to properly govern the firm for the shareholders’ benefit. When considering board member qualifications, investors and shareholders should consider whether board members can act with care and competence as a result of their experience with all of the following EXCEPT:

A) The competitive landscape the firm faces.

B) Legal issues.

C) Technologies, products, services which the firm offers.

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Answer: A) the competitive landscape the firm faces.

Knowledge of the firm’s competitive landscape is likely beyond what a board member should have intimate knowledge about. The other items are all issues a board member should be knowledgeable about. Other issues board members should have experience with include financial operations, accounting

and auditing topics, and business risks the firm faces.

Question 3 Which of the following might be an undesirable trait of a member of the board of directors?

A) Lack of legal or regulatory problems as a result of working with other firms.

B) Experience with the technologies, products, and services the firm offers.

C) Service on the board for more than 10 years.

Answer: C) Service on the board for more than 10 years.

Service on the board for more than 10 years may indicate knowledge and experience, but may result in a member becoming too close to management.

LOS E: Explain the provisions that should be included in a strong corporate code of ethics and the implications of a weak code of ethics with regard to related-party transactions and personal use of company assets. Question 1 The audit committee of a company’s Board of Directors is most likely to act in the interests of shareholders when:

A) A company officer other than the CEO controls the audit budget.

B) A reliable communication “firewall” is in place between the committee and the company’s internal auditors.

C) The committee has authority to prevent the company from engaging in non-audit business relationships with its external auditors.

Answer: C)

The audit committee is responsible for evaluating the financial information that the company provides to shareholders. This committee should be able to approve or reject the company’s proposed non-audit engagements with its external auditing firm. The audit committee, not management, should control the audit budget, and there should be no restrictions on communication between the committee and the company’s internal auditors.

Question 2 Investors have a duty to determine whether the board has properly established committees of independent board members to help carry out various board functions. Which of the following statements about the “audit committee” is least accurate?

A) The audit committee should ensure that the audit is conducted consistent with generally accepted auditing standards (GAAS).

B) The audit committee should ensure that the independent auditors have authority over the audit of the entire corporate group, which includes foreign subs and affiliates.

C) Firm management is responsible for hiring and supervising the independent external auditors, but the audit committee has strict oversight responsibilities.

Answer: C) Firm management is responsible for hiring and supervising the independent external auditors, but the audit committee has strict oversight responsibilities.

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The audit committee is responsible for hiring and supervising the independent external auditors, in order to ensure that the auditors’ priorities are consistent with the best interests of shareholders. Both remaining statements are correct.

Question 3 A special-purpose board committee with which of the following responsibilities would be least likely to act in the best interests of the shareholders?

A) Corporate governance.

B) Mergers and acquisitions.

C) Takeover defense.

Answer: C) Takeover defense.

A committee responsible for takeover defense would most likely be acting in the interests of the company's current management rather than in the interests of shareholders.

Question 4 Which of the following statements concerning Board committees is least accurate?

A) The nominations committee is responsible for recruiting qualified board members and preparing an executive management succession plan.

B) The audit committee has authority over the procedures used to audit the entire corporate group including subsidiaries and affiliates.

C) Members of the audit committee should be independent experts in accounting and finance.

Answer: B

The independent auditor has authority over the audit procedures. The audit committee is responsible for hiring and supervising the independent auditor.

LOS F: State the key areas of responsibility for which board committees are typically created and explain the criteria for assessing whether each committee is able to adequately represent shareowner interests. Question 1 A strong corporate code of ethics is vitally important. Which of the following statements concerning a firm’s code of ethics is least likely accurate?

A) A firm’s code of ethics sets standards for ethical conduct based on basic principles of integrity, trust and honesty.

B) A firm’s code of ethics should require clear disclosure of any advantages given to the firm’s insiders that are not also offered to shareholders.

C) As part of investor review of the firm’s ethical climate, investors should determine whether the firm gives the board access to relevant corporate information in a timely manner.

Answer: B

The firm’s code of ethics should prohibit practices that give advantages to company insiders that are not also offered to shareholders.

Question 2 Which of the following practices should be included in a firm’s code of ethics? Answer: C)

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The firm’s code of ethics establishes the basic principles of integrity, trust, and honesty. Two of the practices listed in the reading discuss providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.

LOS G: Evaluate from a shareowner’s perspective, company policies related to voting rules, shareowner-sponsored proposals, common stock classes and takeover defenses. Question 1 Shareholder-sponsored resolutions are something investors can consider in order to be “heard”. These resolutions do have implications for investors. Which of the following statements regarding shareholder-sponsored resolutions is least accurate?

A) The right to propose initiatives for consideration at the firm’s annual meeting is one way for shareholders to send a message that they are dissatisfied with the way the board is handling one or more firm matters.

B) The ability shareholders have to propose needed changes in a firm can serve to erode shareholder value.

C) The right to propose initiatives for consideration at the firm’s annual meeting is one way for shareholders to send a message that they are dissatisfied with the way management is handling one or more firm matters.

Answer: B

The ability to bring issues in front of the board and/or management can serve to prevent erosion of shareholder value.

Question 2 Which of the following is least likely to be considered a “best practice” regarding corporate governance?

A) Use of a third party to tabulate votes and retain voting records.

B) A code of ethics that is audited and improved periodically.

C) Board members are limited to a six-year term.

Answer: C) Board members are limited to a six-year term.

Anything beyond 2- or 3-year term limits on board membership has the potential to restrict the ability for shareholders to change the composition of the board if its members are not acting in the shareholders’ best interest.

Question 3 Which of the following firms is most likely to have a board of directors that considers the best interest of all shareholders?

A) Prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.

B) Providing the board with relevant corporate information in a timely manner and allowing board members or other insiders to purchase stock before shareholders can make purchases.

C) Providing the board with relevant corporate information in a timely manner and prohibiting board members or other insiders from purchasing stock before shareholders can make purchases.

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A) Firms that assign a single vote to each share, and firms with different classes of common equity with supermajority rights given to one class.

B) Neither firms with different classes of common equity with supermajority rights given to one class, nor firms that assign a single vote to each share.

C) Firms that assign a single vote to each share, but not firms with different classes of common equity with supermajority rights given to one class.

Answer: C)

Firms that assign one vote to each share are more likely to have a board that considers the best interest of all shareholders. Firms with dual classes of common equity where supermajority rights are given to one class are likely to have boards that focus on the interests of the supermajority shareholders.

Question 4 Which of the following rights concerning shareholder-sponsored board nominations and shareholder-sponsored resolutions would be advantageous to an investor?

A) The right to nominate or remove board members in certain circumstances, and the right to propose initiatives for consideration at the annual meeting.

B) The right to propose initiatives for consideration at the annual meeting, but not the right to nominate or remove board members in certain circumstances.

C) The right to nominate or remove board members in certain circumstances, but not the right to propose initiatives for consideration at the annual meeting.

Answer: A) Investors need the power to put forth an independent board nominee. In addition, the right to propose initiatives for consideration at the annual meeting is an important method to send a message to management. Question 5 When examining a firm’s ownership structure, it is imperative to examine any super-voting rights by certain classes of shareholders. Which of the following statements concerning these voting rights is most accurate?

A) If a company has a significant minority shareowner group, such as a founding family, cumulative voting to elect board members can be a positive factor for shareholders.

B) Firms with a single class of common equity could encourage prospective acquirers to only deal directly with shareholders with the supermajority rights.

C) Super-voting rights by certain classes of shareholders impair the firm’s ability to raise capital for the future.

Answer: C) Super-voting rights by certain classes of shareholders impair the firm’s ability to raise capital for the future.

Firms with dual classes of common equity could encourage prospective acquirers to only deal directly with shareholders with the supermajority rights. If the firm has a significant minority ownership group, such as a founding family, use of cumulative voting to elect board members can favor specific interests at the expense of the interests of other shareholders.

Question 6 Which of the following would NOT be a good source for information about a company’s proxy voting rules?

A) Company’s articles of organization and by-laws.

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B) Firm’s annual report.

C) Firm’s corporate governance statement.

Answer: B

The annual report would typically not contain this detailed information.

Question 7 Which of the following policies regarding shareowner rights for equity investors is most likely detrimental to the shareowners’ interests?

A) The company uses a third-party entity to tabulate shareowner votes.

B) Shareowners can approve changes to the corporate structure only with a supermajority vote.

C) Shareowners are permitted to vote either by paper ballot or a proxy voting service.

Answer: B

Provisions that require a supermajority can even make changes strongly supported by shareowners more difficult to enact.

Question 8 The most likely outcome of adopting a golden parachute, poison pill, or greenmail is a:

A) Reduced possibility for a successful takeover bid and a negative impact on the stock price.

B) Negative impact on the stock price and a greater possibility for a successful takeover bid.

C) Reduced possibility for a successful takeover bid and a positive impact on the stock price.

Answer: A)

Adopting a golden parachute, poison pill, or greenmail are all take-over defenses used to frustrate an acquisition attempt. The barriers created by such defenses are likely to decrease the value of the stock.

Question 9 Which of the following actions would most likely have a positive influence on shareholder value?

A) Executive board members regularly attend the board meetings.

B) Adopting a poison pill.

C) Only one class of common equity has been issued.

Answer: C) Only one class of common equity has been issued.

Firms with dual classes of equity can have a negative effect on shareholder value as the shareholder may have inferior voting rights. Takeover measures such as poison pills, golden parachutes, and greenmail typically have a negative effect on shareholder value. Annual elections are preferred for board members as it increases accountability. Executive board members regularly attending the meetings can potentially prevent free discussion among the independent members.

Question 10 One of the issues shareholders should consider is the issue of confidential voting of proxies. Which of the following statements would be considered most accurate in regard to proxy voting and confidential votes?

A) Shareholders are more likely to vote conscientiously if allowed to do so confidentially.

B) It is an SEC requirement that the proxy voting process be confidential.

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C) Confidentiality of voting does not ensure that all votes are counted equally.

Answer: A) Shareholders are more likely to vote conscientiously if allowed to do so confidentially.

Shareholders will be more likely to vote and vote conscientiously if they are sure that board members and/or management will not find out how they voted. There is no SEC requirement of confidentiality regarding proxy voting. Confidentiality of voting does insure that all votes are counted equally.

Question 11 Which of the following statements regarding company takeover defenses is CORRECT?

A) The firm’s annual report contains pertinent details concerning takeover defenses.

B) Newly created anti-takeover provisions may or may not require stakeholder authorization/approval.

C) A firm’s proxy is the most likely place to find information about present takeover defenses.

Answer: B

These provisions may or may not require such approval. In either case, the firm may have to, at a minimum, provide information to its shareholders about any amendments to existing takeover defenses. A firm’s articles of organization are the most likely places to locate information about present takeover defenses.

Question 12 All of the following negatively affect shareholders’ proxy voting rights, EXCEPT:

A) Allowing proxy voting by means other than a paper ballot.

B) Preventing investors who wish to vote their shares from trading during a period prior to the annual meeting.

C) Requiring attendance at the annual meeting.

Answer: A) allowing proxy voting by means other than a paper ballot.

Allowing proxy voting by means other than a paper ballot has a positive impact on shareholders’ proxy voting rights. Both of the remaining choices negatively affect shareholders’ proxy voting rights.