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Chpt 12

1. Which of the following statements is CORRECT? a. Perhaps the most important step when developing forecasted financial statements is to determine the breakdown of common equity between common stock and retained earnings. b. The first, and perhaps the most critical, step in forecasting financial requirements is to forecast future sales. c. Forecasted financial statements, as discussed in the text, are used primarily as a part of the managerial compensation program, where managements historical performance is evaluated. d. The capital intensity ratio gives us an idea of the physical condition of the firms fixed assets. e. The AFN equation produces more accurate forecasts than the forecasted financial statement method, especially if fixed assets are lumpy, economies of scale exist, or if excess capacity exists. 2. Which of the following statements is CORRECT? a. The sustainable growth rate is the maximum achievable growth rate without the firm having to raise external funds. In other words, it is the growth rate at which the firm's AFN equals zero. b. If a firms assets are growing at a positive rate, but its retained earnings are not increasing, then it would be impossible for the firms AFN to be negative. c. If a firm increases its dividend payout ratio in anticipation of higher earnings, but sales and earnings actually decrease, then the firms actual AFN must, mathematically, exceed the previously calculated AFN. d. Higher sales usually require higher asset levels, and this leads to what we call AFN. However, the AFN will be zero if the firm chooses to retain all of its profits, i.e., to have a zero dividend payout ratio. e. Dividend policy does not affect the requirement for external funds based on the AFN equation. 3. Which of the following statements is CORRECT? a. When we use the AFN equation, we assume that the ratios of assets and liabilities to sales (A0*/S0 and L0*/S0) vary from year to year in a stable, predictable manner. b. When fixed assets are added in large, discrete units as a company grows, the assumption of constant ratios is more appropriate than if assets are relatively small and can be added in small increments as sales grow. c. Firms whose fixed assets are lumpy frequently have excess capacity, and this should be accounted for in the financial forecasting process. d. For a firm that uses lumpy assets, it is impossible to have small increases in sales without expanding fixed assets. e. There are economies of scale in the use of many kinds of assets. When economies occur the ratios are likely to remain constant over time as the size of the firm increases.

Economic Ordering Quantity model for establishing inventory levels demonstrates this relationship. 4. Last year Jain Technologies had $250 million of sales and $100 million of fixed assets, so its FA/Sales ratio was 40%. However, its fixed assets were used at only 75% of capacity. Now the company is developing its financial forecast for the coming year. As part of that process, the company wants to set its target Fixed Assets/Sales ratio at the level it would have had had it been operating at full capacity. What target FA/Sales ratio should the company set? a. 28.5% b. 30.0% c. 31.5% d. 33.1% e. 34.7% 5. Howton & Howton Worldwide (HHW) is planning its operations for the coming year, and the CEO wants you to forecast the firm's additional funds needed (AFN). The firm is operating at full capacity. Data for use in the forecast are shown below. However, the CEO is concerned about the impact of a change in the payout ratio from the 10% that was used in the past to 50%, which the firm's investment bankers have recommended. Based on the AFN equation, by how much would the AFN for the coming year change if HHW increased the payout from 10% to the new and higher level? All dollars are in millions. Last years sales = S0 $300.0 Last years accounts payable $50.0 Sales growth rate = g 40% Last years notes payable $15.0 Last years total assets = A0* $500.0 Last years accruals $20.0 Last years profit margin = PM 20.0% Initial payout ratio 10.0% a. $31.9 b. $33.6 c. $35.3 d. $37.0 e. $38.9 Chpt 13 1. Suppose Leonard, Nixon, & Shull Corporations projected free cash flow for next year is $100,000, and FCF is expected to grow at a constant rate of 6%. If the companys weighted average cost of capital is 11%, what is the value of its operations? a. $1,714,750 b. $1,805,000 c. $1,900,000 d. $2,000,000 e. $2,100,000 2. Leak Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 11% and FCF is expected to grow at a rate of 5% after Year 2, what is the Year 0 value of operations, in millions? Assume that the ROIC is expected to remain constant in Year 2 and beyond (and do not make any half-year adjustments). Year: 1 2 Free cash flow: -$50 $100 a. $1,456 b. $1,529 c. $1,606 d. $1,686 e. $1,770 3. Based on the corporate valuation model, the value of a companys operations is $1,200 million. The companys balance sheet shows $80 million in accounts receivable, $60 million in inventory, and $100 million in short-term investments that are unrelated to operations. The balance sheet also shows $90 million in accounts payable, $120 million in notes payable, $300 million in long-term debt, $50 million in preferred stock, $180 million in retained earnings, and $800 million in total common equity. If the company has 30 million shares of stock outstanding, what is the best estimate of the stocks price per share? a. $24.90

b. $27.67 c. $30.43 d. $33.48 e. $36.82 4. Based on the corporate valuation model, the value of a companys operations is $900 million. Its balance sheet shows $70 million in accounts receivable, $50 million in inventory, $30 million in short-term investments that are unrelated to operations, $20 million in accounts payable, $110 million in notes payable, $90 million in long-term debt, $20 million in preferred stock, $140 million in retained earnings, and $280 million in total common equity. If the company has 25 million shares of stock outstanding, what is the best estimate of the stocks price per share? a. $23.00 b. $25.56 c. $28.40 d. $31.24 e. $34.36 5. Vasudevan Inc. forecasts the free cash flows (in millions) shown below. If the weighted average cost of capital is 13% and the free cash flows are expected to continue growing at the same rate after Year 3 as from Year 2 to Year 3, what is the Year 0 value of operations, in millions? Year: 1 2 3 Free cash flow: -$20 $42 $45 a. $586 b. $617 c. $648 d. $680 e. $714 Quiz 30 questions

Question 1

Which of the following statements is CORRECT? Answer One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a projects full life. One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money. One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital. One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.

One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects. 2 points Question 2

Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT? Answer You should reject both projects because they will both have negative NPVs under the new conditions. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market. You should recommend Project L, because at the new WACC it will have the higher NPV. You should recommend Project S, because at the new WACC it will have the higher NPV. You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC. 2 points Question 3

Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method? Answer Lacks an objective, market-determined benchmark for making decisions.

Ignores cash flows beyond the payback period. Does not directly account for the time value of money. Does not provide any indication regarding a projects liquidity or risk. Does not take account of differences in size among projects. 2 points Question 4

Which of the following statements is CORRECT? Answer For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years. 2 points Question 5

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. Answer

A projects regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC. A projects regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR. If a projects IRR is smaller than the WACC, then its NPV will be positive. A projects IRR is the discount rate that causes the PV of the inflows to equal the projects cost. If a projects IRR is positive, then its NPV must also be positive. 2 points Question 6

Which of the following statements is CORRECT? Answer One advantage of the NPV over the IRR is that NPV takes account of cash flows over a projects full life whereas IRR does not. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a projects full life whereas MIRR does not. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order. 2 points Question 7

Which of the following statements is CORRECT?

Answer The shorter a projects payback period, the less desirable the project is normally considered to be by this criterion. One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period. If a projects payback is positive, then the project should be accepted because it must have a positive NPV. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback. 2 points Question 8

Which of the following statements is CORRECT? Answer The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period. 2 points Question 9

Which of the following statements is CORRECT? Answer The MIRR and NPV decision criteria can never conflict. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption. The higher the WACC, the shorter the discounted payback period. The MIRR method assumes that cash flows are reinvested at the crossover rate. 2 points Question 10

Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT? Answer Project D probably has a higher IRR. Project D is probably larger in scale than Project C. Project C probably has a faster payback. Project C probably has a higher IRR. The crossover rate between the two projects is below 12%. 2 points Question 11

Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.

Answer If Project A has a higher IRR than Project B, then Project A must have the lower NPV. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV. The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC. The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business. If a project has normal cash flows and its IRR exceeds its WACC, then the projects NPV must be positive. 2 points Question 12

Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT? Answer If the WACC is 13%, Project As NPV will be higher than Project Bs. If the WACC is 9%, Project As NPV will be higher than Project Bs. If the WACC is 6%, Project Bs NPV will be higher than Project As. If the WACC is greater than 14%, Project As IRR will exceed Project Bs. If the WACC is 9%, Project Bs NPV will be higher than Project As. 2 points Question 13

Which of the following statements is CORRECT? Answer

The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects. For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods. Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR. If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years. The percentage difference between the MIRR and the IRR is equal to the projects WACC. 2 points Question 14

Which of the following statements is CORRECT? Answer The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. The discounted payback method eliminates all of the problems associated with the payback method. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. To find the MIRR, we discount the TV at the IRR. A projects NPV profile must intersect the X-axis at the projects WACC. 2 points Question 15

Which of the following statements is CORRECT? Answer

If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV. If Project As IRR exceeds Project Bs, then A must have the higher NPV. A projects MIRR can never exceed its IRR. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV. If the NPV is negative, the IRR must also be negative. 2 points Question 16

Which of the following rules is CORRECT for capital budgeting analysis? Answer The interest paid on funds borrowed to finance a project must be included in estimates of the projects cash flows. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the projects other costs when reaching the accept/reject decision. A proposed projects estimated net income as determined by the firms accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the projects cost, the project should be accepted. If a product is competitive with some of the firms other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firms other products, this fact need not be reflected in the analysis. 2 points Question 17

Which of the following statements is CORRECT? Answer Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. Corporations must use the same depreciation method for both stockholder reporting and tax purposes. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a projects forecasted NPV. Using accelerated depreciation rather than straight line normally has no effect on a projects total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project. 2 points Question 18

Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated? Answer The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firms products. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. The new product will cut into sales of some of the firms other products.

If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the projects life. 2 points Question 19

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new projects sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT? Answer The proposed new project would have more stand-alone risk than the firms typical project. The proposed new project would increase the firms corporate risk. The proposed new project would increase the firms market risk. The proposed new project would not affect the firms risk at all. The proposed new project would have less stand-alone risk than the firms typical project. 2 points Question 20

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses? Answer The firms corporate, or overall, WACC is used to discount all project cash flows to find the projects NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. Differential project risk cannot be accounted for by using risk-adjusted discount rates

because it is highly subjective and difficult to justify. It is better to not risk adjust at all. Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the projects NPV will be found using a lower discount rate than would be appropriate if the projects returns were negatively correlated. Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the projects expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure. DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a projects real options must be considered separately. 2 points Question 21

Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT? Answer Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new

projects. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. 2 points Question 22

A firm is considering a new project whose risk is greater than the risk of the firms average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? Answer Increase the estimated IRR of the project to reflect its greater risk. Increase the estimated NPV of the project to reflect its greater risk. Reject the project, since its acceptance would increase the firms risk. Ignore the risk differential if the project would amount to only a small fraction of the firms total assets. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. 2 points Question 23

Which of the following statements is CORRECT? Answer If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.

If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself. 2 points Question 24

A company is considering a new project. The CFO plans to calculate the projects NPV by estimating the relevant cash flows for each year of the projects life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the companys overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? Answer All sunk costs that have been incurred relating to the project. All interest expenses on debt used to help finance the project. The investment in working capital required to operate the project, even if that investment will be recovered at the end of the projects life. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. Effects of the project on other divisions of the firm, but only if those effects lower the projects own direct cash flows. 2 points Question 25

Which of the following statements is CORRECT? Answer

An externality is a situation where a project would have an adverse effect on some other part of the firms overall operations. If the project would have a favorable effect on other operations, then this is not an externality. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the banks other offices to increase. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not. Identifying an externality can never lead to an increase in the calculated NPV. 2 points Question 26

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT? Answer In calculating the projects operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, double count it. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. When estimating the projects operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. Capital budgeting decisions should be based on before-tax cash flows. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. 2 points

Question 27

Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects: Project A B C D E Risk High Average High Low Low Expected Return 15% 12% 11% 9% 6%

Which set of projects would maximize shareholder wealth? Answer A and B. A, B, and C. A, B, and D. A, B, C, and D. A, B, C, D, and E. 2 points Question 28

Which of the following factors should be included in the cash flows used to estimate a projects NPV? Answer All costs associated with the project that have been incurred prior to the time the analysis is being conducted. Interest on funds borrowed to help finance the project.

The end-of-project recovery of any working capital required to operate the project. Cannibalization effects, but only if those effects increase the projects projected cash flows. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. 2 points Question 29

Which of the following statements is CORRECT? Answer An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the banks other offices. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project. If sunk costs are considered and reflected in a projects cash flows, then the projects calculated NPV will be higher than it otherwise would be. 2 points Question 30

Which of the following statements is CORRECT? Answer A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firms existing stores. 2 points