Keown Fof10 TB 09

Exam 3 The one that was given
1. All else being equal, if a company’s transaction (flotation) costs associated with selling
corporate securities decrease, the company’s cost of capital will:
Answer: decrease.
2. Siegmeyer Corporation is considering a new inventory system that will cost $750,000.
The system is expected to generate positive cash flows over the next four years in the
amounts of $350,000 in year one, $325,000 in year two, $150,000 in year three, and
$180,000 in year four. Siegmeyer’s required rate of return is 8%.
Suppose Siegmeyer identifies another independent project with a net present value of
$98,525.50. If neither project can be replaced, compared to the value calculated
previously Siegmeyer should accept:
Answer: Both projects because NPV is greater than 0 in both cases.
3. Project Boyaz is expected to generate $24,000 each year for the next four years. It will
cost $60,000 to implement the project tofay. If the project required rate of return is 12%,
what is the profitability index?
Answer: NPV= Excel NPV(.12, 24,000)/60,000=1.21
4. Even if no new shares of the stocks or issues of bonds are sold, corporation still incurs a
“cost” of internal equity of existing debt due to:
Answer: opportunity cost.
5. The rate at which a project’s Net Present Value is exactly equal to zero is known as:
Answer: Internal Rate of return.
What is the payback period?
Answer:2.5
7. The Net Present Value criteria for capital budgeting decisions assumes that expected
future cash flows are reinvested at ___________ and Internal Rate of Return criteria
assumes that expected future cash flows are reinvested at ___________
Answer: The firm’s discount rate, the internal rate of return.
Based on the NPV calculated previously, Siegmeyer should _________ the project
because its NPV is greater than __________
Answer: Accept, zero.
9. Aphid Corporation will finance its next major expansion with 20% debt, 30% preferred
stock, and 50% retained earnings. Aphid after-tax cost of debt is 4.4%, cost of preferred
stock is 8.2%, and cost of retained earnings is 13.2%. What is the corporation’s weighted
average cost of capital?
Answer: WACC=0.2*4.4%+.3*8.2%+.5*13.2=9.94%
10. Shanos Inc. would like to finance an experimental cost-saving procedure by issuing new
common stock. The corporation’s existing common stock currently sells for $49.86.
Management believes that they can issue new common stock at this price, incurring
flotation costs of 7.27% of the current market price. What is the stock’s net market price
(net proceeds)?
Po=49.86*(1-7.27%)=46.24
11. Holt Corp. is considering two independent projects. Project Santiago and Peralta:
Santiago Peralta
NPV $250,000 $225,000
PI 1.20 1.40
IRR 11.40% 12.20%
PB 3.4 years 3.8 years
Assuming Holt Corp. wants to maximize shareholder wealth and can afford either project, which
project should be invested in?
Answer: Both Projects
What is the internal rate of return?
Answer: IRR(-750,000, CF1-CF4)=15.13%
13. Reuven Corporation is undergoing a major expansion. The expansion will be financed by
issuing new 12-year, $1,000 par, 7% semiannual coupon funds. The market price of the
bonds is $940 each. Reuven’s expense on the new bonds will be 70$ per bond. What is
the pre-tax cost of debt for the newly-issued bonds.
Answer: kd= I/Y(N=12*2, FV=1000, PMT=35$, PV=940-70=870, no flotation) =3.3867
Multiply by 2 I/Y=8.77%
14. Triplin Corporation’s marginal tax rate is 35%. It can issue 10-year bonds with an annual
coupon rate of 7% and a par value of 1,000. After $12 per bond flotation costs, new
bonds will net the company $966 in proceeds. Determine the appropriate after-tax cost of
new debt for Triplin to use in capital budgeting process.
Answer: YTM=7.4952*(1-35%)=4.87%
15. A company has common stock that can be sold for $50.67 per share. The stock paid a
dividend at the end of last year of $3.93. Dividends are expected to grow at an annual rate
of 5% indefinitely. Flotation costs associated with the sale of stock equal $2.06 per share.
What is the corporation’s cost of external equity?
Kex.eq=3.93*(1.05)/(50.67-2.06)+0.05=13.49
What is the present value of this project?
Answer: NPV(0.08, CF1-CF4)-$750,000=$104,089.40
17. For independent projects, a corporation should accept the project as long as its_____ is
greater than or equal to zero or it _____ is greater than or equal to the corporation’s
WACC.
Answer: NPV, IRR.
18. Two considerations that cause a corporation’s cost of capital to be different than its
investor’s required returns are:
Answer: corporate taxes and floatation costs.
19. Jiffy Co. expects to pay a dividend of $4.12 per share in one year. The current place of
Jiffy common stock is $30.21 per share. Flotation costs are $3.59 per share when Jiffy
issues new stock. What is the cost of internal common equity(retained earnings) if the
long-term growth is projected to be 5% indefinitely?
Answer: Kre=4.14/30.21+0.05=18.64%
20. Kharnila Corporation is considering the purchase of a new factory and would like to
finance the purchase with a combination of debt and equity. The factory will cost
$101,691 total, of which $32,385 will be financed by new common stock. The remainder
will be financed by debt. What is the proportion of debt financing for use in WACC
calculation?
Answer: 101,691-32,385/101,691=68.15%
Chapter 9 The Cost of Capital

In order to create value, a corporation must earn a rate of return on its invested capital that is
higher than the market's required rate of return on that invested capital.
2) The cost of capital is the rate that must be earned on an investment project if the project is to
increase the value of the common shareholders' investment.
3) The firm's cost of capital may also be referred to as the firm's opportunity cost of capital.
4) The cost of debt increases relative to the investor's required return due to flotation costs, but
decreases relative to the investor's required return due to the tax deductibility of interest.
5) The firm financed completely with equity capital has a cost of capital equal to the required
return on common stock.
7) If a firm were to earn exactly its cost of capital, we would expect the price of its common
stock to remain unchanged.
8) Higher flotation costs will result in all of the following EXCEPT
C) higher cost of retained earnings.
9) Two considerations that cause a corporation's cost of capital to be different than its investors'
required returns are
A) corporate taxes and flotation costs.
10) A firm's cost of capital is influenced by
C) capital structure.
11) Which of the following statements is MOST correct?
D) The cost of a particular source of capital is equal to the investor's required rate of return after
adjusting for the effects of both flotation costs and corporate taxes.
12) Cost of capital is
C) the rate of return that must be earned on additional investment if firm value is to remain
unchanged.
13) Which of the following causes a firm's cost of capital (WACC) to differ from an investor's
required rate of return on the company's common stock?
B) the incurrence of flotation costs when new securities are issued
2) The cost of a particular source of capital (debt, preferred stock, common stock) is equal to the
investor's required rate of return after adjusting for the effects of both flotation costs and
corporate taxes.
3) The cost of debt capital is obtained by substituting the net proceeds per bond for the bond
price in the bond valuation equation and solving for the required return.
4) The cost of preferred stock is equal to the preferred stock dividend divided by the net proceeds
per preferred share.
5) A corporation's cost of common equity may be estimated using either a dividend valuation
model or the capital asset pricing model.
6) Corporations have two costs of common equity, one for retained earnings and one if the
company issues new common stock.
7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.
8) A reasonable estimate of the market risk premium based on historical data and expert opinion
is between 5% and 7%.
12) Other things equal, management should retain profits only if the company's investments
within the firm are at least as attractive as the stockholders' other investment opportunities.
15) A security with a reasonably stable price will have a lower required rate of return than a
security with an unstable price.
16) The cost of internal common equity is already on an after-tax basis since dividends paid to
common stockholders are not tax deductible.
18) The capital asset pricing model uses three variables to evaluate required returns on common
equity: the risk-free rate, the beta coefficient, and the market risk premium.
23) An increase in a corporation's marginal tax rate will decrease the corporation's cost of debt,
but have no impact on its cost of preferred stock or cost of common equity.
24) The after-tax cost of debt is equal to one minus the marginal tax rate times the yield to
maturity on the firm's outstanding debt.
26) Due to changes in regulatory requirements, the transactions costs associated with selling
corporate securities increased by $1 per share. This change will
B) cause the cost of capital to increase.
NB: Transaction Costs are considered flotation costs
27) Adventure Outfitter Corp. can sell common stock for $27 per share and its investors require a
17% return with no expectations of growth. However, the administrative or flotation costs
associated with selling the stock amount to $2.70 per share. What is the cost of capital for
Adventure Outfitter if the corporation raises money by selling common stock?
B) 18.89%
Required back=$27*17%=$4.59
Net cost=27-2.70=$24.30
Cost of capital=required return(preferred stock dividend)/net proceeds from
capital=4.59/24.30=18.89%
28) A company has preferred stock that can be sold for $21 per share. The preferred stock pays
an annual dividend of 3.5% based on a par value of $100. Flotation costs associated with the sale
of preferred stock equal $1.25 per share. The company's marginal tax rate is 35%. Therefore, the
cost of preferred stock is
B) 17.27%.
Cost of preferred stock=Preferred stock dividend/Net proceeds
Ignore the tax!
Dividend=3.5%*100$=3.5$
Net proceeds=Price-Flotation cost=$21-$1.25=$19.75
Cost of preferred stock=3.5$/19.75$=17.72%
29) Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5). The dividend is
expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock
today is $29 per share. If Sentry Manufacturing decides to issue new common stock, flotation
costs will equal $2.50 per share. Sentry Manufacturing's marginal tax rate is 35%. Based on the
above information, the cost of retained earnings is
Kre=5*(1.08)/29+0.08=26.62%
30) Sentry Manufacturing paid a dividend yesterday of $5 per share (D0 = $5). The dividend is
expected to grow at a constant rate of 8% per year. The price of Sentry Manufacturing's stock
today is $29 per share. If Sentry Manufacturing decides to issue new common stock, flotation
costs will equal $2.50 per share. Sentry Manufacturing's marginal tax rate is 35%. Based on the
above information, the cost of new common stock is
D0=$5
D1=D0(1+g)=5(1+0.08)=$4.32
NP0=P0(1-floatation cost in %)=26.50
K=28.38
31) In general, which of the following rankings, from highest to lowest cost, is most accurate?
C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt
Answer: C
32) The risk-free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has
a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport's marginal tax rate is
35%. Analysts expect Rogue Transport's dividends to grow by 6% per year for the foreseeable
future. Using the capital asset pricing model, what is Rogue Transport's cost of retained
earnings?
Rf=2.5%
Market risk premium=8% Beta=2.2 K=2.5+2.2*8=20.1%
33) A company has preferred stock with a current market price of $18 per share. The preferred stock
pays an annual dividend of 4% based on a par value of $100. Flotation costs associated with the sale of
preferred stock equal $1.50 per share. The company's marginal tax rate is 40%. Therefore, the cost of
preferred stock is
Pm=$18
Div=4%=4$
Float=1.50
Ignore tax
Cost of stock=4(18-1.5)=24.24
34) Johnson Production Company paid a dividend yesterday of $3.50 per share. The dividend is
expected to grow at a constant rate of 10% per year. The price of KayCee's common stock today
is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal $4.00
per share. KayCee's marginal tax rate is 35%. Based on the above information, the cost of
retained earnings is
Answer: C
Ignore the tax!
Ignore the flotation costs!
RE=19.63%.
35) Johnson Production Company paid a dividend yesterday of $3.50 per share. The dividend is
expected to grow at a constant rate of 10% per year. The price of KayCee's common stock today
is $40 per share. If KayCee decides to issue new common stock, flotation costs will equal $4.00
per share. KayCee's marginal tax rate is 35%. Based on the above information, the cost of new
common stock is
NP0=P0*(1-Floatation Cost in %)
K=20.69%
36) The risk-free rate of return is 3% and the expected return on the market portfolio is 14%.
Oklahoma Oilco has a beta of 2.0 and a standard deviation of returns of 26%. Oilco's marginal
tax rate is 35%. Analysts expect Oilco's net income to grow by 12% per year for the next 5 years.
Using the capital asset pricing model, what is Oklahoma Oilco's cost of retained earnings?
Expected return on market portfolio = Rm

Kcs=3%+2.0*(14%-3%)=0.25=25%
37) Jiffy Co. expects to pay a dividend of $3.00 per share in one year. The current price of Jiffy
common stock is $60 per share. Flotation costs are $3.00 per share when Jiffy issues new stock.
What is the cost of internal common equity (retained earnings) if the long-term growth in
dividends is projected to be 8 percent indefinitely?
RE=3/60$+0.08=13%
No flotation costs
38) JPR Company is financed 75 percent by equity and 25 percent by debt. If the firm expects to
earn $30 million in net income next year and retain 40% of it, how large can the capital budget
be before common stock must be sold?
C) $15.5 million
Answer: C
Retaining=40%*$30=$12
Left-over=30-12=18million
Stock=18million*75%=13.5
39) The cost of new preferred stock is equal to
D) preferred stock dividend divided by the net selling price of preferred.
Answer: D
36) In general, which of the following rankings, from highest to lowest cost, is most accurate?
C) cost of new common stock, cost of retained earnings, cost of preferred stock, cost of debt
40) In general, the least expensive source of capital is
A) debt.
41) The cost of external equity capital is greater than the cost of retained earnings because of
A) flotation costs on new equity.
42) Phillips Enterprises Inc. is expected to pay a dividend of $2.60 next year. Dividends are
expected to grow at a constant rate of 8% per year, and the stock price is currently $20.00. New
stock can be sold at this price subject to flotation costs of 15%. The company's marginal tax rate
is 35%. Compute the cost of internal equity (retained earnings) and the cost of external equity
(new common stock), respectively.
D1=$2.60
G=0.08
P=20.00
Flotation=15%
Kre=2.60/20.00+0.08=21.00%
Kns=2.60/(20.00*(1-15%))+0.08=23.29%
43) JPR Company's preferred stock is currently selling for $28.00, and pays a perpetual annual
dividend of $2.00 per share. Underwriters of a new issue of preferred stock would charge $3 per
share in flotation costs. The firm's tax rate is 40%. Compute the cost of new preferred stock for
JPR.
Knp=2.00/(28.00-3.00)=8.00%
44) GPS Inc. wishes to estimate its cost of retained earnings. The firm's beta is 1.3. The rate on
6-month T-bills is 2%, and the return on the S&P 500 index is 15%. What is the appropriate cost
for retained earnings in determining the firm's cost of capital?
Kre=2%+1.3(15%-2%)=18.9%
45) In capital budgeting analysis, when computing the weighted average cost of capital, the
CAPM approach is typically used to find which of the following?
D) component cost of internal equity
46) The cost of retained earnings is less than the cost of new common stock because
B) flotation costs are incurred when new stock is issued.
47) Which of the following differentiates the cost of retained earnings from the cost of newly-
issued common stock?
C) the flotation costs incurred when issuing new securities
48) Crandal Dockworks is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Five Rivers flotation expense on the new bonds will be $50 per bond. Crandal's
marginal tax rate is 35%. What is the yield to maturity on the newly-issued bonds?
Using Calculator: YTM=8.17%
Do not take flotation into consideration because YTM does not consider flotation cost.
49) Crandal Dockworks is undergoing a major expansion. The expansion will be financed by
issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the bonds is
$1,070 each. Crandal's flotation expense on the new bonds will be $50 per bond. Crandal's
marginal tax rate is 35%. What is the pre-tax cost of debt for the newly-issued bonds?
Net Markt Price = Market Price ($) – Floatation Cost ($)=$1,070-50=1,020.
Now, use the calculator to find I/Y= pre-tax-cost=8.76%
50) Tempo Corp. will issue preferred stock to finance a new artillery line. The firm's existing
preferred stock pays a dividend of $4.00 per share and is selling for $40 per share. Investment
bankers have advised Tempo that flotation costs on the new preferred issue would be 5% of the
selling price. Tempo's marginal tax rate is 30%. What is the relevant cost of new preferred stock?
D0=4.00
P0=$40
Flotation=5%
Ignore the tax.
Kns=4/(40*0.95)=10.53%
51) Keystone Corporation will issue new common stock to finance an expansion. The existing
common stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate
8% indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of new common stock be for Keystone Corp.?
Knc=($1.5*1.08)/45*0.95)+0.08=11.79%
52) Grandview Inc. will issue new common stock to finance an expansion. The existing common
stock just paid a $1.50 dividend, and dividends are expected to grow at a constant rate 8%
indefinitely. The stock sells for $45, and flotation expenses of 5% of the selling price will be
incurred on new shares. What is the cost of retained earnings for Grandview?
Kre=1.50*(1.08)45+0.08=11.60%
53) All else equal, an increase in beta results in
D) an increase in the cost of common equity, whether or not the funds come from retained
earnings or newly issued common stock.
54) Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and
dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of
the selling price. What is the cost of Haroldson's retained earnings?
Ignore tax and ignore flotation cost
Kre=1.2*1.06/22+0.06=11.78%
55) Haroldson Inc. common stock is selling for $22 per share. The last dividend was $1.20, and
dividends are expected to grow at a 6% annual rate. Flotation costs on new stock sales are 5% of
the selling price. What is the cost of Haroldson Inc.'s new common stock?
Kre=1.2*1.06/22*0.95+0.06=12.09%
56) Which of the following should NOT be considered when calculating a firm's WACC?
D) cost of carrying inventory
57) Which of the following should NOT be considered when calculating a firm's WACC?
B) after-tax cost of accounts payable
58) A corporate bond has a face value of $1,000 and a coupon rate of 5%. The bond matures in
15 years and has a current market price of $925. If the corporation sells more bonds, it will incur
flotation costs of $25 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
Using calculator: YTM (FV=1,000, PMT=50$,N=15 years,MP=925) no flotation=5.76
After-tax: YTM (1-0.35)=3.74%.
59) A corporate bond has a face value of $1,000 and a coupon rate of 9%. The bond matures in
14 years and has a current market price of $946. If the corporation sells more bonds, it will incur
flotation costs of $26 per bond. If the corporate tax rate is 35%, what is the after-tax cost of debt
capital?
B) 6.56%
60) TC, Inc. has $15 million of outstanding bonds with a coupon rate of 10 percent. The yield to
maturity on these bonds is 12.5 percent. If the firm's tax rate is 30 percent, what is relevant cost
of debt financing to TC, Inc.?
YTM (1-30%)=12.5*0.7=8.75
61) XRT, Inc. is issuing a $1,000 par value bond that pays 8.5% interest annually. Investors are
expected to pay $1,100 for the 12-year bond. The firm will pay $50 per bond in flotation costs.
What is the after-tax cost of new debt if the firm is in the 35% tax bracket?
C) 4.70%
Answer: C
Calculator: YTM(FV=1,000, PV=1,100), PMT=8.5%*100=85$, N=12)=7.8419
YTM*(1-35%)=7.8419*0.65=5.097.
62) All the following variables are used in computing the cost of debt EXCEPT
D) risk-free rate.
Answer: D
63) Blammo, Inc. has a target capital structure of 30% debt and 70% equity. The firm is planning
to invest in a project that will necessitate raising new capital. New debt will be issued at a
before-tax yield of 14%, with a coupon rate of 10%. The equity will be provided by internally
generated funds so no new outside equity will be issued. If the required rate of return on the
firm's stock is 22% and its marginal tax rate is 35%, compute the firm's cost of capital.
WACC=cost of debt+cost of equity
Cost of debt: 14%(1-35%)=9.1%
Cost of equity=required rate of return
WACC=9.1%*0.3+22%*0.7=2.73+15.4=18.13%
64) QRM, Inc.'s marginal tax rate is 35%. It can issue 10-year bonds with an annual coupon rate
of 7% and a par value of $1,000. After $12 per bond flotation costs, new bonds will net the
company $966 in proceeds. Determine the appropriate after-tax cost of new debt for the firm to
use in a capital budgeting analysis.
Answer: B
CPT YTM=7.49*0.65=4.86%
65) Mountain Retreat and Resort is undergoing a major expansion. The expansion will be
financed by issuing new 15-year, $1,000 par, 9% annual coupon bonds. The market price of the
bonds is $1,070 each. The firm's flotation expense on the new bonds will be $50 per bond. The
firm's marginal tax rate is 35%. What is the relevant cost of the new bonds for capital budgeting
purposes?
Knd=CPT YTM=8.7555*(1-35%)=5.69%
66) New Jet Airlines plans to issue 14-year bonds with a par value of $1,000 that will pay $60
every six months. The bonds have a market price of $1,220. Flotation costs on new debt will be
4% of the selling price. If the firm has a 35% marginal tax bracket, compute the following:
a. YTM = 9.18%
b. After-tax cost of debt = 9.18% × (1-.35) = 5.97%
c. After-tax cost of new debt = 9.73% × (1-.35) = 6.33% (The pre-tax cost is determined as in
part a, except the Pr is 117.12, based on a net price of $1,220 less flotation costs of $48.80.)
67) Alarm Systems Corporation's preferred stock pays a dividend of $3.60 and sells for $28.00.
Alarm Systems Corporation has a marginal tax rate of 35%. What is the cost of preferred
financing?
Answer: $3.60/$28 = .12857 =12.857%%
68) NewLinePhone Corp. is very risky, with a beta equal to 2.8 and a standard deviation of
returns of 32%. The risk-free rate of return is 3% and the market risk premium is 8%.
NewLinePhone's marginal tax rate is 35%. Use the capital asset pricing model to estimate
NewLinePhone's cost of retained earnings.
Answer: 3% + (8%)(2.8) = 25.4%
69) Dickerson Corporation's common stock is currently selling for $38. Last year's dividend was
$4.00 per share. Investors expect dividends to grow at an annual rate of 7 percent indefinitely.
Flotation costs of 4% will be incurred when new stock is sold.
a. D1 = $4.00 × 1.07 = $4.28
Cost of internal common equity = $4.28/$38 + .07 = 18.26%
b. Cost of new common equity = $4.28/($38 × .96) + .07 = 18.73%
70) The common stock for El Viss Company currently sells for $20 per share. The firm just paid
a dividend of $1.50, and the dividend three years ago was $1.30. Dividends per share are
anticipated to grow at the same rate in the future as they have over the past three years. Flotation
costs for new shares will be 6% of the selling price. Calculate the following:
a. To find g, you need to discount
CPT I/Y (PV=-1.30, FV=1.50, N=3, PMT=0)
g = 4.89% D1 = $1.50 × 1.049 = $1.57
Cost of retained earnings = $1.57/$20 + .049 = 12.75%
b. Cost of external equity = $1.57/($20 × .94) + .049 = 13.25%
71) A company is going to issue a $1,000 par value bond that pays a 7% annual coupon. The
company expects investors to pay $942 for the 20-year bond. The expected flotation cost per
bond is $42, and the firm is in the 34% tax bracket. Compute the following:
a. YTM = 7.57%
b. After-tax cost of existing debt = 7.57% × (1 - .34) = 5%
c. After-tax cost of new debt = 8.02% × (1 - .34) = 5.29%
72) Toto and Associates' preferred stock is selling for $27.50 a share. The firm nets $25.60 after
issuance costs. The stock pays an annual dividend of $3.00 per share. What is the cost of
existing, and new, preferred stock respectively?
Answer: Cost of existing preferred stock = $3.00/$27.50 = 10.91%
Cost of new preferred stock = $3.00/$25.60 = 11.72%
73) Sutter Corporation's common stock is selling for $16.80 a share. Last year Sutter paid a
dividend of $.80. Investors are expecting Sutter's dividends to grow at an annual rate of 5% per
year. What is the cost of internal equity?
Answer: D1 = $.80 × 1.05 = $.84
Cost of internal equity = $.84/$16.80 + .05 = 10%
74) Gibson Industries is issuing a $1,000 par value bond with an 8% annual interest coupon rate
that matures in 11 years. Investors are willing to pay $972, and flotation costs will be 9%.
Gibson is in the 34% tax bracket. What will be the after-tax cost of new debt for the bond?
Answer: 9.76% × (1 - .34) = 6.44%
75) The preferred stock of Wells Co. sells for $17 and pays a $1.75 dividend. The net price of the
stock after issuance costs is $15.30. What is the cost of capital for new preferred stock?
Answer: $1.75/$15.30 = 11.44%
76) Glenna Gayle common stock sells for $55, and dividends paid last year were $1.35. Flotation
costs on issuing stock will be 8% of the market price. The dividends are predicted to have a 10%
growth rate. What is the cost of internal equity, and new equity, respectively for Glenna Gayle?
Answer: D1 = $1.35 × 1.1 = $1.49
Cost of internal equity = $1.49/$55 + .1 = 12.71%
Cost of new equity = $1.49/($55 × .92) + .1 = 12.94%
77) Toombes, Inc. is issuing new common stock at a market price of $55. Dividends last year
were $3.30 per share and are expected to grow at a rate of 6%. Flotation costs will be 5% of the
market price. What is Toombes' cost of retained earnings, and new equity, respectively?
Answer: D1 = $3.30 × 1.06 = $3.50
Cost of retained earnings = $3.50/$55 + .06 = 12.36%
Cost of new equity = $3.50/($55 × .95) + .06 = 12.70%
2) A corporation may lower its cost of capital by shifting a portion of its total financing from a
higher cost source of capital, such as common equity, to a lower cost source of capital, such as
debt.
7) The mixture of financing sources used by a firm will vary from year to year, so many firms
use target capital structure proportions when calculating the firm's weighted average cost of
capital.
8) Using the weighted cost of capital as a cutoff rate assumes that the riskiness of the project
being evaluated is similar to the riskiness of the company's existing assets.
9) Using the weighted cost of capital as a cutoff rate assumes that future investments will be
financed so as to maintain the firm's target degree of financial leverage.
10) The market value weights are preferred when calculating a firm's weighted average cost of
capital.
11) A firm's weighted average cost of capital is a function of (1) the individual costs of capital,
(2) the capital structure mix, and (3) the level of financing necessary to make the investment.
13) The firm's best financial structure is determined by finding the capital structure that
minimizes the firm's cost of capital.
14) A firm's weighted average cost of capital is determined using all of the following inputs
EXCEPT
A) the firm's capital structure.
B) the amount of capital necessary to make the investment.
C) the firm's after-tax cost of debt.
D) the probability distribution of expected returns.
Answer: D
15) Cost of capital is commonly used interchangeably with all of the following terms EXCEPT
A) the firm's required rate of return.
B) the hurdle rate for new investments.
C) the internal rate of return for new investments.
D) the firm's opportunity cost of funds.
Answer: C
16) Baxter Inc. has a target capital structure of 30% debt, 15% preferred stock, and 55% common
equity. The company's after-tax cost of debt is 7%, its cost of preferred stock is 11%, its cost of
retained earnings is 15%, and its cost of new common stock is 16%. The company stock has a
beta of 1.5 and the company's marginal tax rate is 35%. What is the company's weighted average
cost of capital if retained earnings are used to fund the common equity portion?
WACC=.3*7%+.15*11%+.55*15%=2.1+1.65+8.25=12%
Common equity=retained earnings
17) GHJ Inc. is investing in a major capital budgeting project that will require the expenditure of
$16 million. The money will be raised by issuing $2 million of bonds, $4 million of preferred
stock, and $10 million of new common stock. The company estimates is after-tax cost of debt to
be 7%, its cost of preferred stock to be 9%, the cost of retained earnings to be 14%, and the cost
of new common stock to be 17%. What is the weighted average cost of capital for this project?
2/16*7%+4/16*9%+10/16*17%=0.875+2.25+10.625=13.75
18) Coyote Inc. operates three divisions. One division involves significant research and
development, and thus has a high-risk cost of capital of 15%. The second division operates in
business segments related to Coyote's core business, and this division has a cost of capital of
10% based upon its risk. Coyote's core business is the least risky segment, with a cost of capital
of 8%. The firm's overall weighted average cost of capital of 11% has been used to evaluate
capital budgeting projects for all three divisions. This approach will
C) favor projects in the research and development division because the higher risk projects look
more favorable if a lower cost of capital is used to evaluate them.
19) WineCellars Inc. currently has a weighted average cost of capital of 12%. WineCellars has
been growing rapidly over the past several years, selling common stock in each year to finance
its growth. However, due to difficult economic times this year, WineCellars decides to cut its
dividend and increase its retained earnings so that the common equity portion of its capital
structure will include only retained earnings and no new common stock will be sold.
WineCellars' weighted average cost of capital this year should be
B) less than 12%.
20) Beauty Inc. plans to maintain its optimal capital structure of 40 percent debt, 10 percent
preferred stock, and 50 percent common equity indefinitely. The required return on each
component source of capital is as follows: debt–8 percent; preferred stock–12 percent; common
equity–16 percent. Assuming a 40 percent marginal tax rate, what after-tax rate of return must
the firm earn on its investments if the value of the firm is to remain unchanged?
A) 12.40 percent
B) 12.00 percent
C) 11.12 percent
D) 10.64 percent
Answer: C
Diff: 2 Page Ref: 299-300
Keywords: Weighted Average Cost of Capital
Learning Obj.: L.O. 9.3
AACSB: Analytical Thinking
21) The DEF Company is planning a $64 million expansion. The expansion is to be financed by
selling $25.6 million in new debt and $38.4 million in new common stock. The before-tax
required rate of return on debt is 9 percent and the required rate of return on equity is 14 percent.
If the company is in the 35 percent tax bracket, what is the firm's cost of capital?
A) 8.92%
B) 9.89%
C) 11.50%
D) 10.74%
Answer: D
22) CrochetCo is considering an investment in a project which would require an initial outlay of
$350,000 and produce expected cash flows in years 1-5 of $95,450 per year. You have
determined that the current after-tax cost of the firm's capital (required rate of return) for each
source of financing is as follows:
Cost of Long-Term Debt 7%

Cost of Preferred Stock 11%
Cost of CommonStock 15%
Long-term debt currently makes up 25% of the capital structure, preferred stock 15%, and
common stock 60%. What is the net present value of this project?
A) -$9,306
B) $2,149
C) $5,983
D) $11,568
Answer: A
Keywords: Net Present Value, Weighted Average Cost of Capital
23) For a typical corporation, which of the following capital structures will result in the lowest
weighted average cost of capital?
D) 60% debt, 15% preferred stock, 25% common equity
Answer: D
24) Given the following information on S & G Inc.'s capital structure, compute the company's
weighted average cost of capital.
Percent of
Before-Tax
Type of Capital Capital
Component Cost
Structure
Bonds 40% 7.5%
Preferred Stock 5% 11%
Common Stock (Internal
55% 15%
Only)
The company's marginal tax rate is 40%.

A) 13.3%
B) 7.1%
C) 10.6%
D) 10%
Answer: C
25) Kokapeli, Inc. has a target capital structure of 40% debt and 60% common equity, and has a
40% marginal tax rate. If the firm's yield to maturity on bonds is 7.5% and investors require a
15% return on the firm's common stock, what is the firm's weighted average cost of capital?
A) 7.20%
B) 10.80%
C) 12.00%
D) 12.25%
Answer: B
26) PrimaCare has a capital structure that consists of $7 million of debt, $2 million of preferred
stock, and $11 million of common equity, based upon current market values. The firm's yield to
maturity on its bonds is 7.4%, and investors require an 8% return on the firm's preferred and a
14% return on PrimaCare's common stock. If the tax rate is 35%, what is PrimaCare's WACC?
A) 7.21%
B) 8.12%
C) 10.18%
D) 12.25%
Answer: C
Keywords: Weighted Average Cost of Capital, Capital Structure
27) The average cost associated with each additional dollar of financing for investment projects
is
A) the incremental return.
B) the marginal cost of capital.
C) CAPM required return.
D) the component cost of capital.
Answer: B
Keywords: Marginal Cost of Capital
AACSB: Reflective Thinking
28) Donner, Inc. will finance a proposed investment by issuing new securities while maintaining
its optimal capital structure of 60% debt and 40% equity. The firm can issue bonds at a price of
$950.00 before $15 flotation costs. The 10-year bonds will have an annual coupon rate of 8%
and a face value of $1,000. The company can issue new equity at a before-tax cost of 16% and its
marginal tax rate is 34%. What is the appropriate cost of capital to use in analyzing this project?
A) 3.63%
B) 8.77%
C) 9.97%
D) 11.81%
Answer: C
Diff: 2 Page Ref: 299, 300
Keywords: After-tax Cost of Debt, Cost of New Common Stock, Weighted Average Cost of
Capital
29) Valley Flights, Inc. has a capital structure made up of 40% debt and 60% equity and a tax
rate of 30%. A new issue of $1,000 par bonds maturing in 20 years can be issued with a coupon
of 9% at a price of $1,098.18 with no flotation costs. The firm has no internal equity available for
investment at this time, but can issue new common stock at a price of $45. The next expected
dividend on the stock is $2.70. The dividend for the firm is expected to grow at a constant annual
rate of 5% per year indefinitely. Flotation costs on new equity will be $7.00 per share. The
company has the following independent investment projects available:
Project Initial Outlay IRR

1 $100,000 10%
2 $10,00 8.5%
3 $50,000 12.5%
Which of the above projects should the company take on?

A) Project 3 only
B) Projects 1 and 2
C) Projects 1 and 3
D) Projects 1, 2 and 3
Answer: C
Keywords: Optimal Capital Budget, After-tax Cost of Debt, Cost of New Common Stock
30) Texas Transport has five possible investment projects for the coming year. Each project is
indivisible. They are:
Project Investment (million) IRR

A $6 18%
B $10 15%
C $9 20%
D $4 12%
E $3 24%
The firm's weighted marginal cost of capital schedule is 12 percent for up to $6 million of
investment; 16 percent for between $6 million and $18 million of investment; and above $18
million the weighted cost of capital is 18 percent. The optimal capital budget is
A) $12 million.
B) $18 million.
C) $23 million.
D) $28 million.
Answer: B
Keywords: Weighted Average Cost of Capital, Optimal Capital Budget
31) Meacham Corp. wants to issue bonds with a 9% coupon rate, a face value of $1,000, and 12
years to maturity. Meacham estimates that the bonds will sell for $1,090 and that flotation costs
will equal $15 per bond. Meacham Corp. common stock currently sells for $30 per share.
Meacham can sell additional shares by incurring flotation costs of $3 per share. Meacham paid a
dividend yesterday of $4.00 per share and expects the dividend to grow at a constant rate of 5%
per year. Meacham also expects to have $12 million of retained earnings available for use in
capital budgeting projects during the coming year. Meacham's capital structure is 40% debt and
60% common equity. Meacham's marginal tax rate is 35%.
a. Calculate the after-tax cost of debt assuming Meacham's bonds are its only debt.
b. Calculate the cost of retained earnings.
c. Calculate the cost of new common stock.
d. Calculate the weighted average cost of capital assuming Meacham's total capital budget is
$30 million.
Answer:
a. YTM with Net Proceeds = $1,075 is 8.0%. After-tax cost of debt = 8.0%(1 - .35) = 5.2%
b. (($4.00(1.05))/$30) + 5% = 19%
c. (($4.00(1.05))/($30 - $3)) + 5% = 20.56%
d. At $30 million, debt = $12 million and common equity = $18 million. Available retained
earnings are $12 million, so new common stock will equal $6 million.
WACC = (.4)(5.2%) + (.4)(19%) + (.2)(20.56%) = 13.79%
Keywords: Weighted Average Cost of Capital, Cost of Debt, Cost of Retained Earnings, Cost of
New Common Stock, Capital Structure
32) Office Clean Corporation has a capital structure consisting of 30 percent debt and 70 percent
common equity. Assuming the capital structure is optimal, what amount of total investment can
be financed by a $35 million addition to retained earnings without selling new common stock?
Answer: Capital budget = $35 million/.7 = $50 million
Keywords: Optimal Capital Structure, Total Capital Budget
33) Last year Gator Getters, Inc. had $50 million in total assets. Management desires to increase
its plant and equipment during the coming year by $12 million. The company plans to finance 40
percent of the expansion with debt and the remaining 60 percent with equity capital. Bond
financing will be at a 9 percent rate and will be sold at its par value. Common stock is currently
selling for $50 per share, and flotation costs for new common stock will amount to $5 per share.
The expected dividend next year for Gator is $2.50. Furthermore, dividends are expected to grow
at a 6 percent rate far into the future. The marginal corporate tax rate is 34 percent. Internal
funding available from additions to retained earnings is $4,000,000.
a. What amount of new common stock must be sold if the existing capital structure is to be
maintained?
b. Calculate the weighted marginal cost of capital at an investment level of $12 million.
Answer:
a.
Equity needed = $12 million × 0.6 = $7.2 million
Less additions to R/E 4.0 million
New common stock $3.2 million
b.
Kd = 9(1 - .34) = 5.94%
Knc = $2.50/$45 + 0.06 = 11.56%
MCC = 0.4 × 5.94% + 0.6 × 11.56% = 9.31%
Keywords: After-tax Cost of Debt, Cost of New Common Stock, Marginal Cost of Capital
2) A firm's cost of capital is the required rate of return on the firm's average project.
3) The firm's overall cost of capital is important when evaluating the firm's value, but it should
not be used to evaluate individual projects which have their own unique characteristics.
4) Using the weighted average cost of capital as the required rate of return for every project will
A) cause a firm to reject projects that should have been accepted.
B) cause a firm to accept projects that were too risky.
5) Why should firms that own and operate multiple businesses that have different risk
characteristics use business-specific, or divisional costs of capital?
C) Not all lines of business have equal risk and it is likely that the firm will accept projects
whose returns are unacceptably low in relation to the risk involved.
Chapter 10 Capital-Budgeting Techniques and Practice

1) Free cash flows represent the benefits generated from accepting a capital-budgeting proposal.
2) Advantages of the payback period include that it is easy to calculate, easy to understand, and
that it is based on cash flows rather than on accounting profits.
4) A project with a payback period of four years is acceptable as long as the company's target
payback period is greater than or equal to four years.
8) An acceptable project should have a net present value greater than or equal to zero and a
profitability index greater than or equal to one.
9) If a project's internal rate of return is greater than the project's required return, then the
project's profitability index will be greater than one.
11) The modified internal rate of return represents the project's internal rate of return assuming
that intermediate cash flows from the project can be reinvested at the project's required return.
12) One drawback of the payback method is that some cash flows may be ignored.
13) The required rate of return reflects the costs of funds needed to finance a project.
14) The profitability index provides an advantage over the net present value method by reporting
the present value of benefits per dollar invested.
15) The net present value of a project will increase as the required rate of return is decreased
(assume only one sign reversal).
16) Whenever the internal rate of return on a project equals that project's required rate of return,
the net present value equals zero.
17) One of the disadvantages of the payback method is that it ignores time value of money.
18) The capital budgeting decision-making process involves measuring the incremental cash
flows of an investment proposal and evaluating the attractiveness of these cash flows relative to
the project's cost.
19) When several sign reversals in the cash flow stream occur, a project can have more than one
IRR.
20) Many firms today continue to use the payback method but also employ the NPV or IRR
methods, especially when large projects are being analyzed.
21) NPV is the most theoretically correct capital budgeting decision tool examined in the
text.
22) If the net present value of a project is zero, then the profitability index will equal one.
23) The internal rate of return will equal the discount rate when the net present value equals zero.
25) For a project with multiple sign reversals in its cash flows, the net present value can be the
same for two entirely different discount rates.
26) The internal rate of return is the discount rate that equates the present value of the project's
future free cash flows with the project's initial outlay.
Answer: TRUE
Diff: 1 Page Ref: 330
Keywords: Internal Rate of Return
27) If a project's profitability index is less than one, then the project should be rejected.
Answer: TRUE
Keywords: Profitability Index
28) If a project is acceptable using the NPV criteria, it will also be acceptable when using the
profitability index and IRR criteria.
Answer: TRUE
Keywords: NPV, PI, IRR
29) For any individual project, if the project is acceptable based on its internal rate of return, then
the project will also be acceptable based on its modified internal rate of return.
Answer: TRUE
Keywords: Internal Rate of Return, Modified Internal Rate of Return
30) One positive feature of the payback period is it emphasizes the earliest forecasted free cash
flows, which are less uncertain than later cash flows and provide for the liquidity needs of the
firm.
Answer: TRUE
Keywords: Payback Period
31) The main disadvantage of the NPV method is the need for detailed, long-term forecasts of
free cash flows generated by prospective projects.
Answer: TRUE
Keywords: NPV, Free Cash Flow
32) The profitability index is the ratio of the present value of the future free cash flows to the
initial investment.
Answer: TRUE
33) Marketing is crucial to capital budgeting success because the goal of a good capital
budgeting project is to maximize the company's sales.
Answer: FALSE
Keywords: Capital Budgeting, Shareholder Wealth Maximization
34) Because the NPV and PI methods both yield the same accept/reject decision, a company
attempting to rank capital budgeting projects for funding consideration can use either method
and get the same results.
Answer: FALSE
Keywords: NPV, PI
35) A project's IRR is analogous to the concept of the yield to maturity for bonds.
Answer: TRUE
Keywords: IRR, Yield to Maturity
36) NPV assumes reinvestment of intermediate free cash flows at the cost of capital, while IRR
assumes reinvestment of intermediate free cash flows at the IRR.
Answer: TRUE
Keywords: NPV, IRR, Reinvestment Rate
37) A project's net present value profile shows how sensitive the project is to the choice of a
discount rate.
Answer: TRUE
Keywords: Net Present Value Profile, Discount Rate
38) If a project has multiple internal rates of return, the lowest rate should be used for decision-
making purposes.
Answer: FALSE
Keywords: Internal Rate of Return, Multiple IRRs
39) The payback period ignores the time value of money and therefore should not be used as a
screening device for the selection of capital budgeting projects.
Answer: FALSE
Keywords: Payback Period, Time Value of Money
40) Many financial managers believe the payback period is of limited usefulness because it
ignores the time value of money; hence, it is referred to as the discounted payback period.
Answer: FALSE
Keywords: Discounted Payback Period, Payback Period, Time Value of Money
41) The discounted payback period takes the time value of money into account in that it uses
discounted free cash flows rather than actual undiscounted free cash flows in calculating the
payback period.
Answer: TRUE
Keywords: Discounted Payback Period, Time Value of Money
42) Any project deemed acceptable using the discounted payback period will also be acceptable
if using the traditional payback period.
Answer: TRUE
Keywords: Discounted Payback Period, Payback Period
43) A major disadvantage of the discounted payback period is the arbitrariness of the process
used to select the maximum desired payback period.
Answer: TRUE
Keywords: Discounted Payback Period, Arbitrary Decision Rule
44) A project with a NPV of zero should be rejected since even the returns on U.S. Treasury bills
are greater than zero.
Answer: FALSE
Keywords: NPV, Decision Rule
45) NPV may be calculated on an Excel spreadsheet simply by entering the project's free cash
flows into Excel's NPV function.
Answer: FALSE
Keywords: NPV, Excel
46) The internal rate of return is the discount rate that equates the present value of the project's
free cash flows with the project's initial cash outlay.
Answer: TRUE
47) A project that is very sensitive to the selection of a discount rate will have a steep net present
value profile.
Answer: TRUE
Keywords: Net Present Value Profile
48) Because the MIRR assumes reinvestment at the cost of capital while IRR assumes
reinvestment at the project's IRR, the MIRR will always be less than the IRR.
Answer: FALSE
Keywords: IRR, MIRR, Reinvestment Rate
49) Calculating the modified internal rate of return on an Excel spreadsheet involves the use of
the IRR function multiple times, once using the financing rate, and once using the reinvestment
rate.
Answer: FALSE
Keywords: MIRR, Excel, Reinvestment Rate
50) If a project is acceptable using the NPV criterion, then it will also be acceptable using the
discounted payback period since both methods use discounted cash flows to make the
accept/reject decision.
Answer: FALSE
Keywords: NPV, Discounted Payback Period
51) If a project is acceptable using the IRR criterion, it will also be acceptable using the MIRR
criterion.
Answer: TRUE
Keywords: IRR, MIRR
52) The capital budgeting manager for XYZ Corporation, a very profitable high technology
company, completed her analysis of Project A assuming 5-year depreciation. Her accountant
reviews the analysis and changes the depreciation method to 3-year depreciation. This change
will
A) increase the present value of the NCFs.
B) decrease the present value of the NCFs.
C) have no effect on the NCFs because depreciation is a non-cash expense.
D) only change the NCFs if the useful life of the depreciable asset is greater than 5 years.
Answer: A
Keywords: Net Present Value, Depreciation Expense
53) Project W requires a net investment of $1,000,000 and has a payback period of 5.6 years.
You analyze Project W and decide that Year 1 free cash flow is $100,000 too low, and Year 3 free
cash flow is $100,000 too high. After making the necessary adjustments,
A) the payback period for Project W will be longer than 5.6 years.
B) the payback period for Project W will be shorter than 5.6 years.
C) the IRR of Project W will increase.
D) the NPV of Project W will decrease.
Answer: C
Diff: 2 Page Ref: 320, 324, 330
Keywords: Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR)
54) Project Alpha has an internal rate of return (IRR) of 15 percent. Project Beta has an IRR of
14 percent. Both projects have a required return of 12 percent. Which of the following statements
is MOST correct?
A) Both projects have a positive net present value (NPV).
B) Project Alpha must have a higher NPV than Project Beta.
C) If the required return were less than 12 percent, Project Beta would have a higher IRR than
Project Alpha.
D) Project Beta has a higher profitability index than Project Alpha.
Answer: A
Diff: 2 Page Ref: 320, 324, 330
Keywords: Internal Rate of Return, Net Present Value, Required Return
55) Which of the following statements is MOST correct?
A) If a project's internal rate of return (IRR) exceeds the required return, then the project's net
present value (NPV) must be negative.
B) If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
C) The IRR calculation implicitly assumes that all cash flows are reinvested at a rate of return
equal to the IRR.
D) A project with a NPV = 0 is not acceptable.
Answer: C
Keywords: Internal Rate of Return, Net Present Value, Reinvestment Rate
56) DYI Construction Co. is considering a new inventory system that will cost $750,000. The
system is expected to generate positive cash flows over the next four years in the amounts of
$350,000 in year one, $325,000 in year two, $150,000 in year three, and $180,000 in year four.
DYI's required rate of return is 8%. What is the payback period of this project?
A) 4.00 years
B) 3.09 years
C) 2.91 years
D) 2.50 years
Answer: D
DYI's required rate of return is 8%. What is the net present value of this project?
A) $104,089
B) $100,328
C) $96,320
D) $87,417
Answer: A
Keywords: Net Present Value
DYI's required rate of return is 8%. What is the internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
Answer: D
DYI's required rate of return is 8%. What is the modified internal rate of return of this project?
A) 10.87%
B) 11.57%
C) 13.68%
D) 15.13%
Answer: B
Keywords: Modified Internal Rate of Return
60) Project LMK requires an initial outlay of $400,000 and has a profitability index of 1.5. The
project is expected to generate equal annual cash flows over the next twelve years. The required
return for this project is 20%. What is project LMK's net present value?
A) $600,000
B) $200,000
C) $120,000
D) $80,000
Answer: B
Keywords: Net Present Value, Profitability Index
61) Project LMK requires an initial outlay of $500,000 and has a profitability index of 1.4. The
project is expected to generate equal annual cash flows over the next ten years. The required
return for this project is 16%. What is project LMK's internal rate of return?
A) 19.88%
B) 22.69%
C) 24.78%
D) 26.12%
Answer: D
Keywords: Internal Rate of Return, Profitability Index, Ordinary Annuity
62) A capital budgeting project has a net present value of $30,000 and a modified internal rate of
return of 15%. The project's required rate of return is 13%. The internal rate of return is
A) greater than $30,000.
B) less than 13%.
C) between 13% and 15%.
D) greater than 15%.
Answer: D
Keywords: Modified Internal Rate of Return, Net Present Value, Internal Rate of Return,
Required Return
63) Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs
$95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs
$120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year
three, and $45,000 in year four. The firm's required rate of return for these projects is 10%. The
net present value for Project A is
A) $12,358.
B) $16,947.
C) $19,458.
D) $26,074.
Answer: D
three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is 10%.
The net present value for Project B is
A) $58,097.
B) $66,363.
C) $74,538.
D) $112,000.
Answer: B
The profitability index for Project A is
A) 1.27.
B) 1.22.
C) 1.17.
D) 1.12.
Answer: A
The profitability index for Project B is
A) 1.55.
B) 1.48.
C) 1.39.
D) 1.33.
Answer: A
The internal rate of return for Project A is
A) 31.43%.
B) 29.42%.
C) 25.88%.
D) 19.45%.
Answer: B
The internal rate of return for Project B is
A) 29.74%.
B) 30.79%.
C) 35.27%.
D) 36.77%.
Answer: C
three, and $45,000 in year four. Lithium, Inc.'s required rate of return for these projects is
10%.The modified internal rate of return for Project A is
A) 19.19%.
B) 24.18%.
C) 26.89%.
D) 29.63%.
Answer: B
The modified internal rate of return for Project B is
A) 17.84%.
B) 18.52%.
C) 19.75%.
D) 22.80%.
Answer: D
71) The net present value method

A) is consistent with the goal of shareholder wealth maximization.
B) recognizes the time value of money.
C) uses all of a project's cash flows.
D) all of the above.
Answer: D
72) Arguments against using the net present value and internal rate of return methods include that
A) they fail to use accounting profits.
B) they require detailed long-term forecasts of the incremental benefits and costs.
C) they fail to consider how the investment project is to be financed.
D) they fail to use the cash flow of the project.
Answer: B
Keywords: Net Present Value, Internal Rate of Return
73) All of the following are sufficient indications to accept a project EXCEPT (assume that there
is no capital rationing constraint, and no consideration is given to payback as a decision tool)
A) the net present value of an independent project is positive.
B) the profitability index of an independent project exceeds one.
C) the IRR of a mutually exclusive project exceeds the required rate of return.
D) the NPV of a mutually exclusive project is positive and exceeds that of all other projects.
Answer: C
Diff: 2 Page Ref: 324, 327, 330
Keywords: Net Present Value, Profitability Index, Internal Rate of Return, Mutually Exclusive
Projects, Independent Projects
74) When reviewing the net present profile for a project,

A) the higher the discount rate, the higher the NPV.
B) the higher the discount rate, the higher the IRR.
C) the IRR will always be a point on the horizontal axis line where NPV = 0.
D) the IRR will always be a point on the horizontal axis equal to the required return.
Answer: C
Keywords: Net Present Value Profile, IRR, NPV
75) A project requires an initial investment of $389,600. The project generates free cash flow of
$540,000 at the end of year 4. What is the internal rate of return for the project?
A) 138.6%
B) 38.6%
C) 8.5%
D) 6.9%
Answer: C
76) Raindrip Corp. can purchase a new machine for $1,875,000 that will provide an annual net
cash flow of $650,000 per year for five years. The machine will be sold for $120,000 after taxes
at the end of year five. What is the net present value of the machine if the required rate of return
is 13.5%.
A) $558,378
B) $513,859
C) $473,498
D) $447,292
Answer: D
77) Given the following annual net cash flows, determine the internal rate of return to the nearest
whole percent of a project with an initial outlay of $750,000.
Year Net Cash Flow

1 $500,000
2 $150,000
3 $250,000
A) 9%
B) 11%
C) 13%
D) 15%
Answer: B
78) A machine that costs $1,500,000 has a 3-year life. It will generate after-tax annual cash flows
of $700,000 at the end of each year. It will be salvaged for $200,000 at the end of year 3. If your
required rate of return for the project is 13%, what is the NPV of this investment?
A) $291,417
B) $400,000
C) $600,000
D) $338,395
Answer: A
79)
Cash Flow in Cash Flow in Cash Flow in Cash Flow in
Initial Outlay Period 1 Period 2 Period 3 Period 4
$4,000,000 $1,546,170 $1,546,170 $1,546,170 $1,546,170
The Internal Rate of Return (to nearest whole percent) is

A) 10%.
B) 18%.
C) 20%.
D) 24%.
Answer: C
80) We compute the profitability index of a capital budgeting proposal by

A) multiplying the internal rate of return by the cost of capital.
B) dividing the present value of the annual after-tax cash flows by the cost of capital.
C) dividing the present value of the annual after-tax cash flows by the cash investment in the
project.
D) multiplying the cash inflow by the internal rate of return.
Answer: C
81) What is the payback period for a project with an initial investment of $180,000 that provides
an annual cash inflow of $40,000 for the first three years and $25,000 per year for years four and
five, and $50,000 per year for years six through eight?
A) 5.80 years
B) 5.20 years
C) 5.40 years
D) 5.59 years
Answer: B
82) The advantages of NPV are all of the following EXCEPT
A) it can be used as a rough screening device to eliminate those projects whose returns do not
materialize until later years.
B) it provides the amount by which positive NPV projects will increase the value of the firm.
C) it allows the comparison of benefits and costs in a logical manner through the use of time
value of money principles.
D) it recognizes the timing of the benefits resulting from the project.
Answer: A
83) The disadvantage of the IRR method is that

A) the IRR deals with cash flows.
B) the IRR gives equal regard to all returns within a project's life.
C) the IRR will always give the same project accept/reject decision as the NPV.
D) the IRR requires long, detailed cash flow forecasts.
Answer: D
84) The internal rate of return is

A) the discount rate that makes the NPV positive.
B) the discount rate that equates the present value of the cash inflows with the present value of
the cash outflows.
C) the discount rate that makes NPV negative and the PI greater than one.
D) the rate of return that makes the NPV positive.
Answer: B
85) All of the following are criticisms of the payback period criterion EXCEPT
A) time value of money is not accounted for.
B) cash flows occurring after the payback are ignored.
C) it deals with accounting profits as opposed to cash flows.
D) None of the above; they are all criticisms of the payback period criteria.
Answer: C
86) Southeast Compositions, Inc. is considering a project with the following cash flows:
Initial Outlay = $126,000
Cash Flows: Year 1 = $44,000
Year 2 = $59,000
Year 3 = $64,000
Compute the net present value of this project if the company's discount rate is 14%.
A) $1,193
B) $561
C) $209
D) $715
Answer: A
87) Design Quilters is considering a project with the following cash flows:
Initial Outlay = $126,000

Cash Flows: Year 1 = $44,000
Year 2 = $59,000
Year 3 = $64,000
If the appropriate discount rate is 11.5%, compute the NPV of this project.
A) -$14,947
B) $2,892
C) $7,089
D) $41,000
Answer: C
88) Your company is considering a project with the following cash flows:
Initial Outlay = $3,000,000

Cash Flows Year 1-8 = $547,000
Compute the internal rate of return on the project.

A) 6.38%
B) 8.95%
C) 9.25%
D) 12.34%
Answer: C
89) For the net present value (NPV) criteria, a project is acceptable if NPV is ________, while
for the profitability index a project is acceptable if PI is ________.
A) greater than zero; greater than the required return
B) greater than or equal to zero; greater than zero
C) greater than one; greater than or equal to one
D) greater than or equal to zero; greater than or equal to one
Answer: D
Keywords: Net Present Value, Profitability Index
90) Compute the discounted payback period for a project with the following cash flows received
uniformly within each year and with a required return of 8%.
Initial Outlay = $100

Cash Flows: Year 1 = $40
Year 2 = $50
Year 3 = $600
A) 2.10 years
B) 2.21 years
C) 2.42 years
D) 3.00 years
Answer: C
Keywords: Discounted Payback Period
91) Consider a project with the following information:
After-tax After-tax
Accounting Cash Flow
Year Profits from Operations
1 $799 $750
2 150 1,000
3 200 1,200
Initial outlay = $1,500
Compute the profitability index if the company's discount rate is 10%.

A) 15.8
B) 1.61
C) 1.81
D) 0.62
Answer: B
92) If the NPV (Net Present Value) of a project with one sign reversal is positive, then the
project's IRR (Internal Rate of Return) ________ the required rate of return.
A) must be less than
B) must be greater than
C) could be greater or less than
D) The project's IRR cannot be determined without actual cash flows.
Answer: B
Keywords: Net Present Value, Internal Rate of Return
93) You are considering investing in a project with the following year-end after-tax cash flows:
Year 1: $57,000
Year 2: $72,000
Year 3: $78,000
If the initial outlay for the project is $185,000, compute the project's internal rate of return.
A) 3.98%
B) 5.54%
C) 11.89%
D) 14.74%
Answer: B
94) A significant advantage of the payback period is that it

A) places emphasis on time value of money.
B) allows for the proper ranking of projects.
C) tends to reduce firm risk because it favors projects that generate early, less uncertain returns.
D) gives proper weighting to all cash flows.
Answer: C
95) A significant disadvantage of the payback period is that it

A) is complicated to explain.
B) increases firm risk.
C) does not properly consider the time value of money.
D) provides a measure of liquidity.
Answer: C
96) Your firm is considering an investment that will cost $750,000 today. The investment will
produce cash flows of $250,000 in year 1, $300,000 in years 2 through 4, and $100,000 in year 5.
What is the investment's discounted payback period if the required rate of return is 10%?
A) 3.33 years
B) 3.16 years
C) 2.67 years
D) 2.33 years
Answer: B
Keywords: Discounted Payback Period
97) A significant advantage of the internal rate of return is that it

A) provides a means to choose between mutually exclusive projects.
B) provides the most realistic reinvestment assumption.
C) avoids the size disparity problem.
D) considers all of a project's cash flows and their timing.
Answer: D
98) An independent project should be accepted if it

A) produces a net present value that is greater than or equal to zero.
B) produces a net present value that is greater than the equivalent IRR.
C) has only one sign reversal.
D) produces a profitability index greater than or equal to zero.
Answer: A
Keywords: Independent Projects, Net Present Value
The discount rate that your firm uses for projects of this type is 11.25%. What is the investment's
net present value?
A) $540,000
B) $378,458
C) $192,369
D) $112,583
Answer: C
profitability index?
A) 1.21
B) 1.26
C) 1.43
D) 1.69
Answer: A
internal rate of return?
A) 27.28%
B) 21.26%
C) 20.53%
D) 15.98%
Answer: C
102) Which of the following statements about the internal rate of return (IRR) is true?
A) It has the most conservative and realistic reinvestment assumption.
B) It never gives conflicting answers.
C) It fully considers the time value of money.
D) It is greater than the modified internal rate of return if the discount rate is higher than the IRR.
Answer: C
103) A significant disadvantage of the internal rate of return is that it

A) does not fully consider the time value of money.
B) does not give proper weight to all cash flows.
C) can result in multiple rates of return (more than one IRR).
D) is expressed as a percentage.
Answer: C
104) A significant disadvantage of the internal rate of return is that it

A) does not fully consider the time value of money.
B) does not give proper weight to all cash flows.
C) may have an unrealistic reinvestment assumption.
D) is expressed as a percentage.
Answer: C
105) A one-sign-reversal project should be accepted if it

A) generates an internal rate of return that is higher than the profitability index.
B) produces an internal rate of return that is greater than the firm's discount rate.
C) results in an internal rate of return that is above a project's equivalent annual annuity.
D) results in a modified internal rate of return that is higher than the internal rate of return.
Answer: B
106) What is the internal rate of return's assumption about how cash flows are reinvested?
A) They are reinvested at the firm's discount rate.
B) They are reinvested at the required rate of return.
C) They are reinvested at the project's internal rate of return.
D) They are only reinvested at the end of the project.
Answer: C
Keywords: Internal Rate of Return, Reinvestment Rate Assumption
107) If the NPV (Net Present Value) of a project with multiple sign reversals is positive, then the
project's required rate of return ________ its calculated IRR (Internal Rate of Return).
A) must be less than
B) must be greater than
C) could be greater or less than
D) The required rate of return cannot be determined without actual cash flows.
Answer: C
Keywords: Net Present Value, Internal Rate of Return, Multiple Sign Reversals
108) A project would be acceptable if

A) the payback is greater than the discounted equivalent annual annuity.
B) the equivalent annual annuity is greater than or equal to the firm's discount rate.
C) the profitability index is greater than the net present value.
D) the net present value is positive.
Answer: D
Keywords: Net Present Value, Equivalent Annual Annuity
109) The Net Present Value (or NPV) criteria for capital budgeting decisions assumes that
expected future cash flows are reinvested at ________, and the Internal Rate of Return (or IRR)
criteria assumes that expected future cash flows are reinvested at ________.
A) the firm's discount rate; the internal rate of return
B) the internal rate of return; the internal rate of return
C) the internal rate of return; the firm's discount rate
D) Neither criteria assumes reinvestment of future cash flows.
Answer: A
Keywords: Net Present Value, Internal Rate of Return, Reinvestment Rate
110) What is the net present value's assumption about how cash flows are reinvested?
A) They are reinvested at the IRR.
B) They are reinvested at the APR.
C) They are reinvested at the firm's discount rate.
D) They are reinvested only at the end of the project.
Answer: C
Keywords: Net Present Value, Reinvestment Rate Assumption
111) Kingston Corp. is considering a new machine that requires an initial investment of $480,000
installed, and has a useful life of 8 years. The expected annual after-tax cash flows for the
machine are $89,000 for each of the 8 years and nothing thereafter.
a. Calculate the net present value of the machine if the required rate of return is 11 percent.
b. Calculate the IRR of this project.
c. Should Kingston accept the project (assume that it is independent and not subject to any
capital rationing constraint)? Explain your answer.
Answer:
a. NPV = ($21,995) From Excel Spreadsheet NPV function with rate = .11, cash flows as given,
and then subtracting the initial investment of $480,000.
b. IRR = 9.7% From Excel Spreadsheet IRR function, with cash flows as given above.
c No, the projects NPV is negative and the IRR is less than the required rate of return.
Acceptance of this project would reduce shareholder value.
Keywords: NPV, IRR
112) D&B Contracting plans to purchase a new backhoe. The one under consideration costs
$233,000, and has a useful life of 8 years. After-tax cash flows are expected to be $31,384 in
each of the 8 years and nothing thereafter. Calculate the internal rate of return for the grader.
Answer: IRR = 1.69% from Excel Spreadsheet function IRR with cash flows of -233000
followed by eight cash flows of 3384)
Keywords: IRR
113) Consider two mutually exclusive projects X and Y with identical initial outlays of $600,000
and useful lives of 5 years. Project X is expected to produce an after-tax cash flow of $180,000
each year. Project Y is expected to generate a single after-tax net cash flow of $1,200,000 in year
5. The discount rate is 14 percent.
a. Calculate the net present value for each project.
b. Calculate the IRR for each project.
c. What decision should you make regarding these projects?
Answer:
a. NPV of A = $17,955 NPV of B = $23,242
b. IRR of A = 15.24% IRR of B = 14.87%
c. B should be accepted because it is the mutually exclusive project with the highest positive
NPV.
Keywords: NPV, IRR
114) A project that requires an initial investment of $340,000 is expected to have an after-tax
cash flow of $70,000 per year for the first two years, $90,000 per year for the next two years, and
$150,000 for the fifth year? Assume the required return for this project is 10%.
a. What is the NPV of the project%?
b. What is the IRR of the project?
c. What is the MIRR of the project?
d. What is the PI of the project?
e. What decision would you make regarding this project if the required rate of return is 10%?
f. What is the equivalent annual annuity using a 10% required rate of return?
Answer:
a. NPV = $3,715.34
b. IRR = 10.38%
c. MIRR = 10.24%
d. PI = 1.011
e. Accept the project because its NPV is positive, or because its IRR and MIRR are greater than
the required return of 10%, or because the PI is greater than 1.
f. The EAA = $980.10
Diff: 2 Page Ref: 324, 327, 330, 334
Keywords: NPV, IRR, MIRR, PI, Equivalent Annual Annuity
115) The Bolster Company is considering two mutually exclusive projects:
Year Cash Flow A Cash Flow B

0 -$100,000 -$100,000
1 31,250 0
2 31,250 0
3 31,250 0
4 31,250 0
5 31,250 200,000
The required rate of return on these projects is 12 percent.

a. What is each project's payback period?
b. What is each project's discounted payback period?
c. What is each project's net present value?
d. What is each project's internal rate of return?
e. Fully explain the results of your analysis. Which project do you prefer, and why?
Answer:
a. Payback of A = 3.2 years Payback of B = 4.5 years
b. Discounted Payback of A = 4.29 Discounted Payback of B = 4.88
b. NPV of A = $12,649.26 NPV of B = $13,485.37
c. IRR of A = 16.99% IRR of B = 14.87%
d. B is preferred because it has the greatest positive NPV.
Diff: 2 Page Ref: 320, 321, 324, 327, 330
Keywords: Payback Period, Net Present Value (NPV), Internal Rate of Return (IRR)
116) What is the difference between the IRR and the MIRR?
Answer: The internal rate of return (IRR) attempts to answer the question, "What rate of return
does this project earn?" For computational purposes, the internal rate of return is defined as the
discount rate that equates the present value of the project's free cash flows with the project's
initial cash outlay. It is referred to it as the "internal" rate of return because it is dependent solely
upon the project's cash flows, not on rates of return or the opportunity cost of money.
The modified internal rate of return (MIRR), has gained popularity as an alternative to the IRR
method because it avoids multiple IRRs and allows the decision maker to directly specify the
appropriate reinvestment rate. As a result, the MIRR provides the decision maker with the
intuitive appeal of the IRR coupled with a reinvestment rate assumption that prevents the
possibility of multiple rates of return. Is the reinvestment rate assumption really a problem? The
answer is yes. One of the problems of the IRR is that it creates unrealistic expectations for both
the corporation and its shareholders.
There is more than one way to compute the MIRR, and each method can potentially result in a
different value for the MIRR. We used what we consider to be the most common way to compute
the MIRR, which is also the one used by Excel. Specifically, we discounted the project's negative
cash flows back to the present using the project's required rate of return and then compounded all
the positive cash flows to the end of the project's life at the required rate of return before
computing the MIRR. Some analysts compute the MIRR by discounting negative cash flows
back to the present using the project's required rate of return and then computing the MIRR.
Neither method is necessarily better than the other.
Keywords: IRR, MIRR
117) What does a net present value profile tell you, and how is it constructed? How does the IRR
enter into the net present value profile?
Answer: A net present value profile is simply a graph showing how a project's NPV changes as
the discount rate changes. To graph a project's net present value profile, you simply need to
determine the project's NPV, first using a 0 percent discount rate, then slowly increasing the
discount rate until a representative curve has been plotted. Perhaps the easiest way to understand
the relationship between the IRR and the NPV value is to view it graphically through the use of a
net present value profile. The IRR is the discount rate at which the NPV is zero.
Keywords: Net Present Value Profile, IRR, NPV
Learning Objective 10.3
1) The payback period may be more appropriate to use for companies experiencing capital
rationing.
Answer: TRUE
Keywords: Payback Period, Capital Rationing
2) The profitability index can be helpful when a financial manager encounters a situation where
capital rationing is required.
Answer: TRUE
Keywords: Profitability Index, Capital Rationing
3) Positive NPV projects may be rejected when capital must be rationed.

Answer: TRUE
Keywords: Capital Rationing, Net Present Value (NPV)
4) Capital rationing generally leads to higher stock prices as management is doing the best job it
can in selecting only the best capital budgeting projects.
Answer: FALSE
Keywords: Capital Rationing, Firm Value
5) When capital rationing exists, the divisibility of projects is ignored and projects are funded in
order of their PI's or IRR's.
Answer: FALSE
Keywords: Capital Rationing, PI, IRR
6) If a firm imposes a capital constraint on investment projects, the appropriate decision criterion
is to select the set of projects that has the highest positive net present value subject to the capital
constraint.
Answer: TRUE
Keywords: Capital Constraint, Net Present Value
7) The net present value always provides the correct decision provided that
A) cash flows are constant over the asset's life.
B) the required rate of return is greater than the internal rate of return.
C) capital rationing is not imposed.
D) the internal rate of return is positive.
Answer: C
Keywords: Net Present Value, Capital Rationing
8) Capital rationing may be imposed because of all of the following EXCEPT

A) capital market conditions are poor.
B) management has a fear of debt.
C) stockholder control problems prevent issuance of additional stock.
D) the company's stock price is at an historically high level.
Answer: D
Keywords: Capital Rationing
9) You are in charge of one division of Yeti Surplus Inc. Your division is subject to capital
rationing. Your division has 4 indivisible projects available, detailed as follows:
Project Initial Outlay IRR NPV

1 2 million 18% 2,500,000
2 1 million 15% 950,000
3 1 million 10% 600,000
4 3 million 9% 2,000,000
If you must select projects subject to a budget constraint of 5 million dollars, which set of
projects should be accepted so as to maximize firm value?
A) Projects 1, 2 and 3
B) Project 1 only
C) Projects 1 and 4
D) Projects 2, 3 and 4
Answer: C
10) Under what condition would you NOT accept a project that has a positive net present value?
A) If the project has a profitability index less than zero.
B) If two or more projects are mutually inclusive.
C) If the firm is limited in the capital it has available (capital rationing).
D) If a project has more than one sign reversal.
Answer: C
Keywords: Net Present Value, Capital Rationing
11) I301 Motors has several investment projects under consideration, all with positive net present
values. However, due to a shortage of trained personnel, a limit of $500,000 has been placed on
the capital budget for this year. Which of the projects listed below should be included in this
year's capital budget? Explain your answer.
Project Initial Outlay NPV

A $250,000 $325,000
B 250,000 350,000
C 100,000 700,000
D 375,000 112,500
E 375,000 75,000
Answer: Accept B and C because their combined NPV ($1,050,000) is the greatest of any
combination of projects that fit within the capital constraint.
12) How might capital rationing conflict with the goal of maximizing shareholders' wealth?
Answer: The use of our capital-budgeting decision rules implies that the size of the capital
budget is determined by the availability of acceptable investment proposals. However, a firm
may place a limit on the dollar size of the capital budget, they are recognizing that they do not
have the ability to profitably handle more than a certain number of new and/or large projects.
This situation is called capital rationing.
Capital rationing has a negative effect on the firm. To what degree it is negative depends on the
severity of the rationing. If the rationing is minor and short-lived, the firm's share price will not
suffer to any great extent. In this case, capital rationing can probably be excused, although it
should be noted that any capital-rationing action that rejects projects with positive NPVs is
contrary to the firm's goal of maximization of shareholders' wealth. If the capital rationing is a
result of the firm's decision to limit dramatically the number of new projects or to use only
internally generated funds for projects, then this policy will eventually have a significantly
negative effect on the firm's share price. For example, a lower share price will eventually result
from lost competitive advantage if, because of a decision to arbitrarily limit its capital budget, a
firm fails to upgrade its products and manufacturing processes.
Keywords: Capital Rationing
2) IRR should not be used to choose between mutually exclusive projects.

Answer: TRUE
Keywords: IRR, Mutually Exclusive Projects
3) The mutually exclusive project with the highest positive NPV will also have the highest IRR.
Answer: FALSE
Keywords: Mutually Exclusive Projects, NPV, IRR
4) The size disparity problem occurs when mutually exclusive projects of unequal size are being
examined.
Answer: TRUE
Keywords: Size Disparity, Mutually Exclusive Projects
5) A project's equivalent annual annuity (EAA) is the annuity cash flow that yields the same
present value as the project's NPV.
Answer: TRUE
Keywords: Equivalent Annual Annuity
6) An infinite-life replacement chain allows projects of different lengths to be compared.

Answer: TRUE
Keywords: Infinite-life Replacement Chain
9) Both the profitability index (PI) and net present value (NPV) are based on the present value of
all future free cash flows, but the PI is a relative measure while the NPV is an absolute measure
of a project's desirability.
10) If a project's IRR is equal to its required return, then the project's NPV is equal to zero and its
PI is equal to one.
The equivalent annual annuity amount for project A is
A) $12,989.
B) $13,357.
C) $15,024.
D) $18,532.
Answer: C
12) Interstate Appliance Inc. is considering the following 3 mutually exclusive projects.
Projected cash flows for these ventures are as follows:
Plan A Plan B Plan C

Initial Initial Initial
Outlay = $3,600,000 Outlay = $6,000,000 Outlay = $3,500,000
Cash Flow: Cash Flow: Cash Flow:
Yr 1 = $-0- Yr 1 = $4,000,000 Yr 1 = $2,000,000
Yr 2= -0- Yr 2 = 3,000,000 Yr 2 = -0-
Yr 3 = -0- Yr 3 = 2,000,000 Yr 3 = 2,000,000
Yr 4 = -0- Yr 4 = -0- Yr 4 = 2,000,000
Yr 5 = $7,000,000 Yr 5 = -0- Yr 5 = 2,000,000
If Interstate Appliance has a 12% cost of capital, what decision should be made regarding the
projects above?
A) accept plan A
B) accept plan B
C) accept plan C
D) accept Plans A, B and C
Answer: C
Keywords: Net Present Value, Mutually Exclusive Projects
13) Your company is considering an investment in one of two mutually exclusive projects.
Project 1 involves a labor intensive production process. Initial outlay for Project 1 is $1,495 with
expected after-tax cash flows of $500 per year in years 1-5. Project 2 involves a capital intensive
process, requiring an initial outlay of $6,704. After-tax cash flows for Project 2 are expected to
be $2,000 per year for years 1-5. Your firm's discount rate is 10%. If your company is not subject
to capital rationing, which project(s) should you take on?
A) Project 1
B) Project 2
C) Projects 1 and 2
D) Neither project is acceptable.
Answer: B
Keywords: Mutually Exclusive Projects, Net Present Value
14) Your firm is considering investing in one of two mutually exclusive projects. Project A
requires an initial outlay of $3,500 with expected future cash flows of $2,000 per year for the
next three years. Project B requires an initial outlay of $2,500 with expected future cash flows of
$1,500 per year for the next two years. The appropriate discount rate for your firm is 12% and it
is not subject to capital rationing. Assuming both projects can be replaced with a similar
investment at the end of their respective lives, compute the NPV of the two chain cycle for
Project A and three chain cycle for Project B.
A) $2,232 and $85
B) $5,000 and $1,500
C) $2,865 and $94
D) $3,528 and $136
Answer: A
Keywords: Replacement Chain, Net Present Value, Mutually Exclusive Projects
15) Determine the five-year equivalent annual annuity of the following project if the appropriate
discount rate is 16%.
Initial Outflow = $150,000

Cash Flow Year 1 = $40,000
Cash Flow Year 4 = $0
A) $7,058
B) $8,520
C) $9,454
D) $9,872
Answer: B
16) Which of the following statements about the net present value is true?
A) It produces a percentage result that is easy to describe.
B) It has an inadequate reinvestment assumption.
C) It is likely that there will be more than one NPV for a project.
D) It may be used to select among projects of different sizes.
Answer: D
Keywords: Net Present Value, Unequal Size Projects
17) Mutually exclusive projects occur when
A) projects have uneven cash flows.
B) more than one firm can use the projects.
C) a set of investment proposals perform essentially the same task.
D) projects are independent.
Answer: C
Keywords: Mutually Exclusive Projects
18) Which of the following methods of evaluating investment projects can properly evaluate
projects of unequal lives?
A) the net present value
B) the payback
C) the internal rate of return
D) the equivalent annual annuity
Answer: D
equivalent annual annuity?
A) $52,377
B) $42,923
C) $41,387
D) $40,399
Answer: A
Which project would you recommend using the replacement chain method to evaluate the
projects with different lives?
A) Project B because its NPV is higher than Project A's replacement chain NPV of $47,623
B) Project A because its replacement chain NPV is $76,652, which exceeds the NPV for Project
B
C) Project A because its replacement chain NPV is $45,642, which is less than the NPV for
Project B
D) Both projects will be valued the same since they are now both four year projects.
Answer: A
Keywords: Replacement Chain, Net Present Value
The equivalent annual annuity amount for project B, rounded to the nearest dollar, is
A) $17,385.
B) $20,936.
C) $22,789.
D) $26,551.
Answer: B
22) Different discounted cash flow evaluation methods may provide conflicting rankings of
investment projects when
A) the size of investment outlays differ.
B) the projects are mutually exclusive.
C) the accounting policies differ.
D) the internal rate of return equals the cost of capital.
Answer: A
Keywords: Capital Budgeting Decisions, Size, Cash Flows vs Accounting Income
23) Consider the following two projects:
Net Cash Flow Each Period

Initial Outlay 1 2 3 4
Project A $4,000,000 $2,003,000 $2,003,000 $2,003,000 $2,003,000
Project B $4,000,000 0 0 0 $11,000,000
a. Calculate the net present value of each of the above projects, assuming a 14 percent discount
rate.
b. What is the internal rate of return for each of the above projects?
c. Compare and explain the conflicting rankings of the NPVs and IRRs obtained in parts a and
b above.
d. If 14 percent is the required rate of return, and these projects are independent, what decision
should be made?
e. If 14 percent is the required rate of return, and the projects are mutually exclusive, what
decision should be made?
Answer:
a. NPV of A = $1,836,166 NPV of B = $2,512,883
b. IRR of A = 35.0% IRR of B = 28.78%
c. B has more distant cash flows, thus its IRR is less while its NPV is greater. This time
disparity is one of IRR's ranking problems.
d. If these projects are independent, we would accept them both because they each have a
positive NPV.
e. If these projects are mutually exclusive, we would select B because it has the highest positive
NPV.
Keywords: IRR, NPV, Mutually Exclusive Projects, Independent Projects
24) The Meacham Tire Company is considering two mutually exclusive projects with useful lives
of 3 and 6 years. The after-tax cash flows for projects S and L are listed below.
Year Cash Flow S Cash Flow L

0 -$60,000 -$115,000
1 38,000 28,500
2 25,000 49,500
3 35,000 26,850
4 22,600
5 18,750
6 23,500
The required rate of return on these projects is 14 percent. What decision should be made? As
part of your answer, calculate the NPV assuming a replacement chain for Project S, and also
calculate the equivalent annual annuity for each project.
Answer: Accept Project S because its replacement chain NPV of $27,124.53 is positive and is
greater than the NPV of Project L of $37.09. Also, the equivalent annual annuity for Project S is
$6,975.28 while that of Project L is only $9.54.
Keywords: NPV, Replacement Chain, Equivalent Annual Annuity
25) The Dickerson PR Firm is considering two mutually exclusive projects with useful lives of 3
and 6 years. The after-tax cash flows for projects S and L are listed below.
Year Cash Flow S Cash Flow L

0 -$60,000 -$51,500
1 40,000 13,000
2 20,000 19,000
3 17,000 11,000
4 20,000
5 10,000
6 8,000
Calculate the equivalent annual annuity for each project assuming a required return of 15%.
What decision should be made?
Answer: Choose Project S. Although the NPV of Project L (NPV = $1,269.21) is greater than
the NPV of Project S (NPV = $1,083.26), this is due to the longer life of project L. The
equivalent annual annuity for Project S is $474.44, while the equivalent annual annuity for
Project L is only $335.37.
Keywords: NPV, Equivalent Annual Annuity
26) Company K is considering two mutually exclusive projects. The cash flows of the projects
are as follows:
Year Project A Project B

0 -$2,000,000 -$2,000,000
1 500,000
2 500,000
3 500,000
4 500,000
5 500,000
6 500,000
7 500,000 5,650,000
a. Compute the NPV and IRR for the above two projects, assuming a 13% required rate of
return.
b. Discuss the ranking conflict.
c. What decision should be made regarding these two projects?
Answer:
a. NPV of A = $211,305 NPV of B = $401,592.64
IRR of A = 16.33% IRR of B = 15.99%
b. The later cash flow of B causes its lower IRR even though it has the higher NPV.
c. B should be accepted because it is the mutually exclusive project with the highest positive
NPV.
Keywords: NPV, IRR
27) What are mutually exclusive projects? How might they complicate the capital-budgeting
process?
Answer: When two projects are judged acceptable by the discounted cash flow criteria, it may
be necessary to select only one of them because they are mutually exclusive. Mutually exclusive
projects are projects that, if undertaken, would serve the same purpose.
When dealing with mutually exclusive projects, there are three general types of ranking
problems:
• The size-disparity problem occurs when mutually exclusive projects of unequal size are
examined. The project with the largest NPV should be selected, provided there is no capital
rationing. When capital rationing exists, the firm should select the set of projects with the largest
NPV.
• The time-disparity problem and the conflicting rankings that accompany it result from the
differing reinvestment assumptions made by the net present value and internal rate of return
decision criteria. The NPV criterion assumes that cash flows over the life of the project can be
reinvested at the required rate of return or cost of capital, whereas the IRR criterion implicitly
assumes that the cash flows over the life of the project can be reinvested at the IRR. One possible
solution to this problem is to use the MIRR method that allows you to explicitly state the rate at
which cash flows over the life of the project will be reinvested.
• The final ranking problem arises when comparing mutually exclusive projects with different
life spans. The two most common ways of comparing these mutually exclusive projects are by
creating a replacement chain to equalize the life spans of projects or by calculating the equivalent
annual annuity (EAA) of the projects. Using a replacement chain, calls for the creation of a chain
cycle for project A; that is, we assume that project A can be replaced with a similar investment.
One problem with replacement chains is that, depending on the life of each project, it can be
quite difficult to come up with equivalent lives. Calculating the equivalent annual annuity we
determine the project's equivalent annual annuity (EAA). A project's EAA is simply an annuity
cash flow that yields the same present value as the project's NPV. To calculate an EAA, we need
only calculate a project's NPV and then determine what annual annuity (PMT on your financial
calculator) it is equal to. This can be done in two steps as follows: STEP 1 Calculate the project's
NPV. STEP 2 Calculate the EAA.
Keywords: Mutually Exclusive Projects
Foundations of Finance, 10e (Keown/Martin/Petty)

Chapter 15 Working-Capital Management
2) Two advantages of financing with current liabilities are flexibility and lower interest cost.
Answer: TRUE
3) Higher liquidity (holding larger cash and marketable securities balances) generally results in a
lower return on equity.
Answer: TRUE
5) Short-term debt provides a more flexible form of financing than long-term debt.
Answer: TRUE
6) Short-term debt has a greater risk of illiquidity than long-term debt because it must be rolled
over more frequently, and its use creates more uncertainty concerning future interest rates.
Answer: TRUE
7) Working capital refers to investment in current assets, while net working capital is the
difference between current assets and current liabilities.
Answer: TRUE
10) Achieving a lower inventory balance through working capital management can result in
savings from both carrying costs and losses associated with obsolete inventory.
Answer: TRUE
11) Working capital management involves managing a firm's liquidity.

Answer: TRUE
12) Three basic factors that determine which sources of short-term financing a firm uses are the
effective cost of financing, the availability of credit, and the influence of the use of a particular
credit source on the cost and availability of other sources of financing.
Answer: TRUE
13) The trade-off associated with holding large amounts of cash and marketable securities is
increased liquidity offset by a reduction in the overall rate of return.
Answer: TRUE
16) Although interest rates are generally higher on long-term debt, using more long-term debt
rather than short-term debt can reduce the risk of illiquidity and decrease uncertainty related to
interest rate changes.
Answer: TRUE
17) Current assets would usually NOT include
A) plant and equipment.
Answer: A
18) A company that increases its liquidity by holding more cash and marketable securities is
B) likely to achieve a lower return on equity because of the smaller rates of return earned on cash
and marketable securities compared to the firm's other investments.
Answer: B
19) Which of the following statements concerning liquidity and debt is true?
C) A firm can reduce its risk for illiquidity by shifting from short-term debt to long-term debt.
Answer: C
20) Interest costs for short-term debt are generally lower than interest costs for long-term debt
because
A) the term structure of interest rates generally reflects an upward sloping yield curve.
B) short-term debt is more flexible, allowing a match of short-term needs with short-term
financing.
D) both A and B.
Answer: D
21) All of the following are potential disadvantages of short-term debt EXCEPT
A) short-term debt must be paid back more quickly than long-term debt.
B) uncertainty of interest costs because short-term debt must be replaced often.
C) a greater risk of illiquidity than long-term debt.
D) short-term debt generally has a higher interest cost than long-term debt.
Answer: D
22) Which of the following is NOT true regarding the use of short-term debt?
A) It must be rolled over more often than long-term debt.
B) There is uncertainty connected with interest costs on short-term debt from year to year.
C) The firm is subjected to greater liquidity risk when using short-term credit.
D) Interest rates are usually higher on short-term debt.
Answer: D
23) Which of the following is a disadvantage of the use of current liabilities to finance assets?
A) greater risk of illiquidity
Answer: A
24) Which of the following is an advantage of the use of current liabilities to finance assets?
A) less risk of illiquidity
B) more flexibility
C) lower interest costs
D) both B and C
Answer: D
25) Which of the following actions would improve a firm's liquidity?
B) selling bonds and increasing cash
Answer: B
26) Which of the following actions would improve a firm's liquidity?

C) purchasing inventory with long-term debt
Answer: C
27) Which of the following actions would decrease a firm's liquidity?

C) reducing accounts receivable and buying bonds
Answer: C
28) In general, the greater a firm's reliance upon short-term debt or current liabilities,
A) the lower will be its liquidity
Answer: A
29) If a firm relies on short-term debt or current liabilities in financing its asset investments, and
all other things remain the same, what can be said about the firm's liquidity?
B) The firm will be relatively less liquid.
Answer: B
30) Which of the following would normally occur if a firm increases its investment in current
assets?
A) The firm's liquidity would be improved.
Answer: A
31) The risk-return trade-off in managing a firm's working capital involves which of the
following?
C) a trade-off between the firm's liquidity and its profitability
Answer: C
32) Which of the following is an advantage of utilizing short-term debt to finance the acquisition
of short-term assets?
A) Interest rates on short-term debt are usually lower than interest-rates on long-term debt.
Answer: A
33) Net working capital refers to which of the following?

E) current assets minus current liabilities
Answer: E
34) Gross working capital includes all of the following EXCEPT

A) cash.
B) accounts receivable.
C) accounts payable.
D) inventories.
Answer: C
35) Selection of a source of short-term financing should include all of the following EXCEPT
A) the effective cost of credit.
B) the availability of financing in the amount and for the time needed.
C) the floatation costs for debentures.
D) the effect of the use of credit from a particular source on the cost and availability of other
sources of credit.
Answer: C
36) Discuss the risk-return trade-off experienced in working-capital management.

Answer: Working-capital management (involving current asset investment and use of current
liabilities) is in effect evaluating the risk-return trade-off. Investing in current assets reduces the
risk of illiquidity at the expense of lowering its overall rate of return. Using long-term financing
increases liquidity while reducing its rate of return on assets.
37) How does the use of current liabilities enhance profitability and also increase the firm's risk
of default on its financial obligations?
Answer: Other things remaining the same, the greater the firm's reliance on short-term debt or
current liabilities in financing its assets, the greater the risk of illiquidity. However, the use of
current liabilities offers some very real advantages in that they can be less costly than long-term
financing, and they provide the firm with a flexible means of financing its fluctuating needs for
assets. A firm can reduce its risk of illiquidity through the use of long-term debt at the expense of
a reduction in its return on invested funds. Once again, we see that the risk-return trade-off
involves an increased risk of illiquidity versus increased profitability.
4) The hedging principle is used to address the issue of how much short-term financing a firm
should use.
Answer: TRUE
6) Total assets must always equal the sum of temporary, permanent, and spontaneous sources of
financing.
Answer: TRUE
8) The hedging principle involves matching the cash flow from an asset with the cash flow
requirements of the financing used.
Answer: TRUE
14) Sources of spontaneous financing include trade credit, salaries payable, and accrued taxes.
Answer: TRUE
15) The hedging principle implies that permanent asset investments not financed by spontaneous
sources should be financed with permanent sources, and temporary investments not financed by
spontaneous sources should be financed with temporary sources.
Answer: TRUE
17) AFB, Inc. purchases a new delivery van which is expected to increase cash flows for the next
10 years. AFB can finance the purchase with a standard 48-month vehicle loan, or by getting a
10-year loan from the bank. According to the hedging principle, AFB should
A) use the 10-year financing in order to match the cash flow stream from the asset with the
financing repayments.
Answer: A
18) According to the hedging principle, fixed assets should NOT be financed with
B) temporary financing.
Answer: B
19) Accrued wages and accrued taxes are considered to be

B) spontaneous sources of unsecured short-term financing.
Answer: B
20) Spontaneous sources of financing include

B) wages payable.
Answer: B
21) Permanent sources of financing include all but

A) corporate bonds.
B) common stock.
C) preferred stock.
D) commercial paper.
Answer: D
22) According to the hedging principle, plant and equipment should be financed with.
B) long-term funds.
Answer: B
23) A toy manufacturer following the hedging principle will generally finance seasonal inventory
build-up prior to the Christmas season with:
C) trade credit.
Answer: C
24) According to the hedging principle, which of the following assets should be financed with
permanent sources of financing?
C) levels of inventory and accounts receivable the firm maintains throughout the year
Answer: C
25) With regard to the hedging principle, which of the following would be an appropriate method
to finance a minimum level of current assets required for year-round operations?
C) common stock
Answer: C
26) With regard to the hedging principle, which of the following assets should be financed with
current liabilities?
B) expansion of accounts receivable to meet seasonal demand
Answer: B
28) Which of the following is most likely to be a temporary source of financing?

A) commercial paper
Answer: A
29) In the context of managing working capital, the hedging principle refers to which of the
following?
C) matching the maturity of the source of financing to the cash flow generating characteristics of
the asset being financed
Answer: C
30) Which of the following is considered a spontaneous source of financing?

B) accounts payable
Answer: B
31) What is the hedging principle or principle of self-liquidating debt?

Answer: The hedging principle, or principle of self-liquidating debt, involves matching the cash-
flow-generating characteristics of an asset with the maturity of the source of financing used to
fund its acquisition.
For example, a seasonal expansion in inventories, according to the hedging principle, should be
financed with a short-term loan or current liability. The funds are needed for a limited period,
and when that time has passed, the cash needed to repay the loan will be generated by the sale of
the extra inventory items.
Obtaining the needed funds from a long-term source (longer than 1 year) would mean that the
firm would still have the funds after the inventories they helped finance had been sold. In this
case the firm would have "excess" liquidity, which it would either hold in cash or invest in low-
yield marketable securities until the seasonal increase in inventories occurs again and the funds
are needed. The result of all this would be lower profits.
32) What are some examples of permanent and temporary investments in current assets?
Answer: Permanent investments in an asset are investments that the firm expects to hold for a
period longer than 1 year. Note that we are referring to the period the firm plans to hold an
investment, not the useful life of the asset. For example, permanent investments are made in the
firm's minimum level of current assets, as well as in its fixed assets. Temporary investments, by
contrast, consist of current assets that will be liquidated and not replaced within the current year.
Thus, some part of the firm's current assets is permanent and the remainder is temporary. For
example, a seasonal increase in level of inventories is a temporary investment: the buildup in
inventories that will be eliminated when no longer needed. In contrast, the buildup in inventories
to meet a long-term increasing sales trend is a permanent investment.
1) A cash conversion cycle of -5 days is better than a cash conversion cycle of 50 days.
Answer: TRUE
3) The cash conversion cycle is a measure of a firm's effectiveness in managing its working
capital.
Answer: TRUE
8) What three actions can a firm take to minimize its net working capital?
Answer: Working capital is minimized by speeding up the collection of cash from sales,
increasing inventory turns, and slowing down the disbursement of cash. We can incorporate all
of these factors in a single measure called the cash conversion cycle. The cash conversion cycle,
or CCC, is simply the sum of days of sales outstanding and days of sales in inventory less days
of payables outstanding.
1) Compounding effectively raises the cost of short-term credit.

Answer: TRUE
2) Simpson Conglomerates borrows $12,000 for a short-term purpose. The loan will be repaid
after 120 days, with Simpson paying a total of $12,400. What is the approximate cost of credit
using the APR, or annual percentage rate, calculation?
C) 10.00%
Answer: C
APR=Interest/Principal*1/Time=400/12000*1/(120/360)=10%
3) Simpson Conglomerates borrows $12,000 for a short-term purpose. The loan will be repaid
after 120 days, with Simpson paying a total of $12,400. What is the approximate cost of credit
using the APY, or annual percentage yield, calculation?
B) 10.34%
Answer: B
APY=(1+i/m)^m-1=(1+0.10/3)^3-1=10.34%
M=1/time=1/(120/360)=3
4) Your company is able to arrange financing at either a rate of 12.75% annually, or at a rate of
12% compounded monthly. Assuming financing is needed for one-year, which rate is the best?
A) 12% compounded monthly, because the annual percentage yield is 12.68%.
Answer: A
5) Blastdale Corp. is considering borrowing $15,000 for a 60-day period. The firm will repay the
$15,000 principal amount plus $200 in interest. What is the effective annual rate of interest? Use
a 360-day year.
B) 8.3%
Answer: B
APY=(1+i/m)^m-1=(1+.08/6)^6-1=8.27%
M=1/(60/360)=6
6) Blastdale Corp. is considering borrowing $15,000 for a 60-day period. The firm will repay the
$15,000 principal amount plus $200 in interest. What is the nominal annual rate of interest? Use
a 360-day year.
C) 8.0%
Answer: C
APR=200/15000*1/(60/360)=8%
7) Assume that Montana Mining, Inc. borrows $5,000,000 for 120 days. The total interest paid is
$150,000. What is the APY, or Effective Annual Rate of interest that Billings pays?
C) 9.27%
Answer: C
APY=(1+i/m)^m-1=(1+9%/3)^3-1=9.27%
M=3
APR=150,000/5,000,000*1(120/360)=9%
1) To ensure that a borrower is not using short-term bank credit to finance a part of its permanent
needs for funds, banks often require borrowers to clean up their short-term loans for a 30-45 day
period during the year.
Answer: TRUE
5) Floating lien agreements are the least secure form of inventory collateral.
Answer: TRUE
6) Factoring accounts receivable is the sale of a firm's receivables while pledging accounts
receivable is the use of accounts receivable as collateral for a loan.
Answer: TRUE
8) Major sources of secured credit include commercial banks, finance companies, and factors.
Answer: TRUE
9) The cost of trade credit varies directly with the size of the cash discount and inversely with the
length of time between the end of the discount period and the final due date.
Answer: TRUE
10) The effective cost to the borrower of an unsecured bank loan is increased if a compensating
balance is required.
Answer: TRUE
11) A major risk in using commercial paper for short-term financing is the inflexible repayment
schedule.
Answer: TRUE
12) The amount that can be obtained on an inventory loan depends on both the marketability and
perishability of the items in the inventory.
Answer: TRUE
15) Trade credit appears on a company's balance sheet as accounts payable.

Answer: TRUE
16) A revolving credit agreement is a legally binding agreement between a borrower and lender.
Answer: TRUE
17) Issuers of commercial paper usually maintain lines of credit with banks to back up their
short-term financing needs.
Answer: TRUE
18) The primary sources of collateral for secured loans are accounts receivable and inventory.
Answer: TRUE
19) Commercial paper is an unsecured form of credit.

Answer: TRUE
20) In a chattel mortgage, specific items of inventory are identified in the security agreement.
Answer: TRUE
21) A bank is legally obligated to provide credit under a revolving credit agreement, but not
under a line of credit.
Answer: TRUE
23) Both compensating balances and discounting interest increase the effective interest rate on a
loan.
Answer: TRUE
24) Because only the largest and most creditworthy companies are able to use commercial paper,
the interest rate on commercial paper is generally lower than the prime rate.
Answer: TRUE
25) Parsons Company has a cash flow problem. The company owes its suppliers $300,000 on
credit terms of 2/10 net 40, but Parsons doesn't have the cash to pay during the discount period.
Parsons, however, can borrow the $300,000 at annual rate of 24%. Should Parsons borrow the
money to pay its accounts payable?
B) Yes, the effective cost of forgoing the discount is greater than 24%.
Answer: B
26) Your company buys supplies on credit terms of 2/10 net 45. Suppose the company makes a
purchase of $20,000 today. Which of the following payment options makes the most sense as a
general rule?
D) Either pay the bill on day 10 to get the discount or wait until day 45.
Answer: D
27) As a company accounts payable manager, which of the following credit terms are most likely
to entice you to take the cash discount?
A) 1/10 net 45
B) 2/10 net 60
C) 1/10 net 30
D) 2/10 net 90
Answer: C
28) You are working on your company's cash budget for the coming year and you believe there
may be short periods of time where financing is required. Which of the following sources of
short-term financing is most certain to be available when needed?
C) revolving credit agreement with a bank
Answer: C
29) All of the following are likely to increase the cost of a company's short-term financing
EXCEPT
A) an increase in the bank's prime lending rate.
B) an increase in the compensating balance required.
C) taking a loan on a discount basis.
D) an increase in the company's debt rating by Moody's or Standard and Poors.
Answer: D
30) Brown Inc. needs to borrow $250,000 for the next 6 months. The company has a line of
credit with a bank that allows the company to borrow funds with an 8% interest rate subject to a
20% of loan compensating balance. Currently, Brown Inc. has no funds on deposit with the bank
and will need the loan to cover the compensating balance as well as their other financing needs.
How much will Brown Inc. need to borrow?
A) $270,000
B) $300,000
C) $312,500
D) $347,222
Answer: C
Keywords: Compensating Balance, Line of Credit
250,000=Principal
Time=6/12=1/2
Compensation=10%*250,000=50,000
Interest=8%*250,000=20,000
APR=20,000/(250,000-25,000=10%
What will be the annual percentage rate, or APR, for this financing?
A) 10.00%
Answer: A
Interest=8%*250,000=20,000
Principal=250,000
Compensating balance=50,000
APR=10,000(250,000-50,000) =10%
What is the annual percentage rate for this financing assuming discounted interest?
A) 14.29%
B) 12.98%
C) 11.67%
D) 10.53%
Answer: D
Discounted Interest=Principle*Interest/Time= 250,000*8%/12*6=9,999=10,000

APR=20,000/(250,000-50,000-10,000)=10,53%
33) All of the following are potential advantages of commercial paper EXCEPT
A) flexible repayment terms.
B) lower interest rates than comparable sources of short-term financing.
C) no compensating balance requirements.
D) ability to borrow very large amounts.
Answer: A
34) Marley Financial plans to sell $50,000,000 of 120-day commercial paper, on which it expects
to pay discounted interest at a rate of 5% per year. Dealer fees are expected to be $30,000. The
effective cost of credit to Marley Financial is
A) 5.27%.
Answer: A
interest = (principal * rate * time) + financing fees=50,000,000*5%*120/365+30,000=851917;
APR=Interest/(Principal-Fees)=851917/(50,000,000-30,000)*365/120=5.27%
35) Which of the following sources of short-term financing is likely to have the lowest interest
rate?
A) accounts receivable loan (pledging of accounts receivable)
B) line of credit
C) line of credit with a compensating balance
D) commercial paper
Answer: D
36) Hyper Retail Outlets sell goods on terms of net 40. The store's average monthly sales (all on
credit) are $70,000. Hyper pledges all of its receivables to the bank, which advances 80% of the
face value of the receivables at a rate of 2.5% above prime. The bank also charges a 1%
processing fee on all receivables pledged. Hyper borrows the full amount possible, and the
current prime rate is 5%. What is the annual percentage rate (APR) of using this source of
financing for one full year?
A) 23.5%
B) 18.75%
C) 21.8%
D) 19.1%
Answer: B
Principal = 70,000
xAnnual percentage rate = (prime rate + premium) x (prime rate + premium)/ premium
= ( 0.05+0.025) x (0.05+0.025)/0.025
= 0.075 x 3
= 22.50%
37) Which of the following sources of short-term financing is likely to have the highest interest
rate?
A) accounts receivable loan (pledging of accounts receivable)
B) line of credit
C) line of credit with a compensating balance
D) commercial paper
Answer: A
38) Which of the following is NOT an advantage of trade credit?

A) The amount of extended credit expands and contracts with the needs of the firm.
B) The cost of forgoing the discount is less than the prime rate.
C) Generally no formal agreements are involved in the extension of trade credit.
D) Trade credit is very flexible.
Answer: B
Keywords: Trade Credit
39) Which of the following statements regarding a line of credit is true?

A) The purpose for which the money is being borrowed must be stated by the borrower.
B) A line of credit agreement usually fixes the interest rate that will be applied to any extensions
of credit.
C) A line of credit agreement is a legal commitment on the part of the bank to provide the stated
credit.
D) Such agreements usually cover the borrower's fiscal year.
Answer: D
Keywords: Line of Credit
40) Which item would constitute poor collateral for an inventory loan?
A) lumber
B) vegetables
C) grain
D) chemicals
Answer: B
Keywords: Inventory Loan, Collateral
41) The inventory loan arrangement in which all of the borrower's inventories are used as
collateral is termed a
A) terminal warehouse agreement.
B) floating lien agreement.
C) chattel mortgage agreement.
D) field warehouse financial agreement.
Answer: B
Keywords: Inventory Loan, Floating Lien Agreement
42) The inventory loan agreement in which the lender can increase his or her security interest by
having specific items of inventory identified in the loan agreement is called
A) a floating lien agreement.
B) a chattel mortgage agreement.
C) a field warehouse agreement.
D) inventory identification agreement.
Answer: B
Keywords: Chattel Mortgage
43) The prime rate of interest is

A) the rate the bank charges its most creditworthy borrowers.
B) the rate the bank charges for money it borrows from the Federal Reserve Board.
C) the rate the bank charges its average borrower.
D) the rate the bank charges on home mortgages.
Answer: A
Keywords: Prime Rate
44) Terminal warehouse agreements

A) are particularly useful where large bulky items are used as collateral.
B) give the lender a lien against all inventories while only removing representative items.
C) remove control of the inventory from the borrower.
D) are less costly than field warehouse agreements.
Answer: C
Keywords: Terminal Warehouse Agreements
45) An inventory loan agreement in which the inventories pledged as collateral are physically
separated from the firm's other inventory and placed under the control of a third-party is called
A) a floating lien agreement.
B) a chattel mortgage agreement.
C) a field warehouse agreement.
D) a securitized inventory loan arrangement.
Answer: C
Keywords: Field Warehouse Financing Agreement
46) A company that forgoes the discount when credit terms are 2/10 net 60 is essentially
borrowing money from his supplier for an additional
A) 10 days.
B) 50 days.
C) 60 days.
D) 70 days.
Answer: B
Keywords: Cash Discount, Credit Terms
47) Which of the following loans provide the least amount of security to the lender?
A) chattel mortgage
B) factoring
C) floating lien
D) terminal warehouse agreement
Answer: C
Keywords: Floating Lien
48) Which of the following is NOT a source of unsecured short-term credit?

A) trade credit
B) a line of credit
C) floating lien
D) commercial paper
Answer: C
Keywords: Unsecured Short-term Credit
49) The Boyles Ceramics, Inc. established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $1,000,000 at an annual rate of
8 percent. A compensating balance averaging 25 percent of the amount borrowed is required.
Prior to the agreement, Boyles had no deposit with the bank. Shortly after signing the agreement,
Boyles needed $240,000 to pay off a note that was due. It borrowed the funds from the bank by
drawing on the line of credit. What is the effective annual cost of credit?
A) 12.50%
B) 11.11%
C) 10.67%
D) 8.85%
Answer: C
Keywords: Effective Cost of Credit, Compensating Balance
Boyles needed $240,000 to pay off a note that was due. Boyles decides to borrow an amount
sufficient to pay the $240,000 note and also to cover the compensating balance. How much must
Boyles Glass borrow?
A) $300,000
B) $320,000
C) $375,000
D) $400,000
Answer: B
Boyles needed $240,000 to pay off a note that was due. Boyles decides to borrow an amount
sufficient to pay the $240,000 note and also to cover the compensating balance. What is the
effective annual cost of credit if the loan is made on a discount basis?
A) 11.94%
B) 11.00%
C) 10.83%
D) 10.57%
Answer: A
52) Crawley, Inc. has a line of credit with HNC Bank that allows the company to borrow up to
$800,000 at an interest rate of 12 percent. However, Crawley, Inc. must keep a compensating
balance of 18 percent of any amount borrowed on deposit at the bank. Crawley, Inc. does not
normally keep a cash balance account with HNC Bank. What is the effective annual cost of
credit?
A) 12.40%
B) 12.83%
C) 14.63%
D) 15.47%
Answer: C
Keywords: Line of Credit, Compensating Balance, Effective Cost of Credit
53) DAS, Inc. has a line of credit with FBT Bank that allows DAS to borrow up to $400,000 at
an annual interest rate of 11 percent. However, DAS must keep a compensating balance of 25
percent of any amount borrowed on deposit at the bank. DAS does not normally have a cash
balance account with the bank. What is the effective annual cost of credit?
A) 11.45%
B) 12.59%
C) 14.67%
D) 16.00%
Answer: C
Keywords: Line of Credit, Compensating Balance, Effective Cost of Credit
54) Which of the following is an unsecured short-term bank loan made for a specific purpose?
A) mortgage bond
B) line of credit
C) revolving credit agreement
D) transaction loan
Answer: D
Keywords: Unsecured Short-term Loan, Transaction Loan
55) The Missouri River Pendant Company uses commercial paper to satisfy part of its short-term
financing requirements. Next week, it intends to sell $18 million in 90-day maturity paper on
which it expects to have to pay discounted interest at an annual rate of 7 percent per annum. In
addition, Stoney River expects to incur a cost of approximately $25,000 in dealer placement fees
and other expenses of issuing the paper. What is the effective annual cost of credit to Missouri
River?
A) 7.7%
B) 7.5%
C) 7.3%
D) 7.1%
Answer: A
Keywords: Effective Annual Cost of Credit, Commercial Paper
56) The Native Industries, Inc. is going to issue 180-day commercial paper to raise $25 million.
It anticipates a discounted interest rate of 13 percent, and dealer placement costs of
approximately $60,000. What is the effective annual cost of credit to Native Industries?
A) 13.46%
B) 14.06%
C) 14.45%
D) 15.38%
Answer: C
Keywords: Commercial Paper, Effective Annual Cost of Credit, Discount Interest
57) The effective annual cost of not taking advantage of the 1/10, net 60 terms offered by a
supplier is
A) 7.50%.
B) 5.37%.
C) 6.69%.
D) 7.27%.
Answer: A
Keywords: Effective Annual Cost of Trade Credit
58) The nominal annual cost of interest of not taking advantage of the 1/10, net 60 terms offered
by a supplier is
A) 1.50%.
B) 5.37%.
C) 6.69%.
D) 7.27%.
Answer: D
Keywords: Effective Annual Cost of Trade Credit
59) A floating lien, chattel mortgage, or terminal warehouse receipt have which of the following
in common?
A) They all pledge accounts receivables as security.
B) They have nothing in common.
C) They are all unsecured forms of financing.
D) They all use inventory to secure a loan.
Answer: D
Keywords: Inventory Loans, Floating Lien, Chattel Mortgage, Terminal Warehouse Receipt
60) The primary advantage that pledging accounts receivable provides is

A) the flexibility it gives to the borrower.
B) that the financial institution bears the risk of collection.
C) the low cost as compared with other sources of short-term financing.
D) that the financial institution services the accounts.
Answer: A
Keywords: Pledging Accounts Receivable
61) The terminal warehouse agreement differs from the field warehouse agreement in that
A) the cost of the terminal warehouse agreement is lower due to the lower degree of risk.
B) the borrower of the field warehouse agreement can sell the collateral without the consent of
the lender.
C) the warehouse procedure differs for both agreements.
D) the terminal agreement transports the collateral to a public warehouse.
Answer: D
Keywords: Terminal Warehouse Agreements, Field Warehouse Agreement, Inventory Loans
62) What is the primary advantage of a firm that is able to issue commercial paper to finance its
short-term assets?
A) Commercial paper provides greater flexibility in terms of repayment.
B) Interest rates on commercial paper are generally lower than rates on bank loans.
C) Commercial paper does not need to be repaid.
D) Commercial paper is guaranteed by the Federal Government.
Answer: B
Keywords: Commercial Paper
63) Nike Corp. buys on 3/10, net 30 days. What is the nominal cost of interest if Nike does not
take advantage of the trade discount offered? Assume a 360-day year.
A) 12.0%
B) 22.3%
C) 55.7%
D) 66.3%
Answer: C
Keywords: Cost of Trade Credit
64) Which of the following statements about factoring is true?
A) The firm, not the factor, bears the risk of collecting bad receivables in a factoring
arrangement.
B) Factoring involves the outright sale of a firm's accounts receivable to the factor.
C) The borrowing firm is able to obtain a greater advance against inventory in a factoring
arrangement than in a typical line of credit secured by accounts receivable.
D) Factoring firms sell the receivables of other firms.
Answer: B
Keywords: Factoring Accounts Receivable
65) All of the following are true EXCEPT

A) Trade credit represents inventories sold to customers.
B) Temporary investments are current assets that will be liquidated and not replaced within the
current year.
C) Permanent investments are assets a firm expects to hold for longer than one year.
D) Compensating balance requirements increase the cost of financing.
Answer: A
Keywords: Trade Credit, Temporary Investments, Permanent Investments, Compensating
Balances
66) A company that forgoes the discount when credit terms are 2/10 net 60 due to insufficient
cash flow would be better off to borrow funds and take the discount as long the company could
borrow the funds at any rate
A) less than 16.33%.
B) less than 15.47%.
C) less than 14.69%.
D) less than 12.00%.
Answer: C
Keywords: Annual Percentage Rate, Cash Discount
67) Idaho Mining, Inc. borrows at prime plus 1.5% on its line of credit. The line requires a 15%
compensating balance. If the prime rate is 9% and Idaho Mining plans on borrowing for a period
of one year, what is the nominal APR of the line of credit?
A) 9.0%
B) 6.0%
C) 10.6%
D) 12.4%
Answer: D
Keywords: Annual Percentage Rate, APR
68) Calculate the effective cost of the following trade credit terms if the discount is forgone and
payment is made on the net due date.
a. 2/10 net 50
b. 2/15 net 60
c. 2/20 net 45
Answer:
a. × = .1837
b. × = .1633
c. × = .2939
The cost of foregoing trade credit decreases as the length of time between the end of the discount
period and the end of the net due period increases.
Keywords: Cost of Trade Credit
69) The Rosewood Corporation established a line of credit with a local bank. The maximum
amount that can be borrowed under the terms of the agreement is $500,000 at a rate of 10
percent. A compensating balance averaging 15 percent of the loan is required. Prior to the
agreement, Rosewood had maintained an account at the bank averaging $25,000. Any additional
funds needed for the compensating balance will also have to be borrowed at the 10 percent rate.
If the firm needs $280,000 for 6 months, what is the annual cost of the loan?
Answer:
Borrowed Funds = - $25,000
Borrowed Funds = $304,411.8
Rate = ×
Rate = .1087 per year

Keywords: Annual Cost of Credit, Compensating Balance
70) Worthington, Inc. is planning to issue $7,500,000 in 120-day maturity notes carrying a rate of
11 percent per year. Worthington's commercial paper will be placed at a cost of $35,000. What is
the effective cost of credit to Worthington?
Answer: Rate = × = .129

Keywords: Commercial Paper, Effective Cost of Credit
71) The Smith Corporation is a maker of fine stereo components and presently has finished
goods inventories of $800,000. They need a short-term bank loan of $400,000 for three months.
The bank has proposed two different financing arrangements. The first is a floating lien
arrangement at a rate of 22 percent. The second proposal is for a terminal warehouse
arrangement at 11 percent. Under the latter proposal, Smith will pay $1,000 a month plus round
trip shipping expense of $6,000. Which source of credit should be selected by the Smith
Corporation? Explain.
Answer: Floating lien arrangement:
Annual rate = 0.2200
Terminal warehouse arrangement:
Annual Rate = ($11,000+$3,000+$6000)/$400,000 × = 0.20
The terminal warehouse arrangement is less costly with an effective rate of 20%.
Keywords: Floating Lien, Terminal Warehouse Arrangement
72) MovieTone, Inc. is a producer and distributor of specialty DVDs. It sells directly to large
retail firms on terms of net 60 and has average monthly sales of $350,000. It has recently decided
to pledge all of its accounts receivable to its bank. The bank advances up to 80 percent of the
face value of these receivables at a rate of 4 percent over the prime rate, while charging 2.5
percent on all receivables pledged for processing to cover billing and collection services. Prior to
this arrangement MovieTone was spending $50,000 a year on its credit department. The prime
rate is 6 percent.
a. What is the average level of accounts receivable?
b. What is the effective cost of using this short-term credit for one year?
Answer:
a. 2 × $350,000 = $700,000
b. Rate = × = 0.1982
Annual interest expense = 0.10 × 0.80 × $700,000 = $56,000
Processing fee = .025 × $350,000 × 12 = $105,000

Keywords: Pledging Accounts Receivable, Effective Cost of Credit
73) The effective interest rate on short-term loans from Bank A is 12.5 percent per year. Bank B
claims that their interest rate is only 11 percent per year. However, Bank B charges interest on a
discount basis. Which bank is charging the lowest effective rate of interest on a one-year loan?
Answer: Effective cost of loan from Bank A = .125
Effective cost of loan from Bank B = = .1236
Bank A is charging the lowest effective rate of interest.

Keywords: Discount Interest, Effective Cost of Credit
74) AAC, Inc. is planning to issue $5,000,000 in 180-day maturity notes paying a rate of 12
percent per annum. The company expects to incur costs of approximately $20,000 in dealer
placement fees and other expenses of issuing the commercial paper. The company plans to back
up their commercial paper offering with a line of credit from a bank for $5,000,000. The
compensating balance requirement is 10 percent of the line of credit. The company normally
maintains $450,000 in its accounts with the bank. What is the effective cost of the commercial
paper offering?
Answer: Additional funds tied up with compensating balance requirements equal:
(.10)($5,000,000) - $450,000 = $50,000
Interest on commercial paper = (.12) ($5,000,000) = $300,000
Effect rate = × = × 2 = .1296

Keywords: Commercial Paper, Effective Cost of Credit, Compensating Balance
75) Your company needs to pay $10,000 for the overhaul of five trucks. A bank offers you a loan
at 18 percent per annum with a compensating balance requirement of 15 percent of the loan
amount. You plan to borrow the money for 9 months and currently do not have any account with
this bank. What is the effective cost of the loan?
Answer: (.85)(loan amount) = $10,000
Loan amount = = $11,765
Interest on loan = (.18)($11,765) = $1,588
Rate = × = .2117

Keywords: Compensating Balance, Effective Cost of Credit
76) Crenshaw Inc. has a $400,000 line of credit with a local bank. The bank requires a
compensating balance of 10% of the loan and extends credit to Crenshaw at 1% over the current
prime rate. Crenshaw needs the use of $200,000 for the three-month period. They currently have
no deposits with the lending bank.
a. What will the effective annual cost of this credit be? (Assume a 360-day year and a 9%
prime rate.)
b. Using the above information, what would be the effective interest rate if the firm discounted
the interest on the loan?
Answer:
a. Loan amount to cover compensating balance
.90B = 200,000
B = 222,222
Interest paid on the $222,222:
$222,222 × .10 × 1/4 = $5,555.55
Effective annual cost:
Rate = × = 11.11%
b. Rate = × = 11.43%

Keywords: Effective Cost of Credit, Compensating Balance, Discount Interest
77) Dazzly Diamond Corp. called for credit at the Home Alone Bank of Paris, TX. The terms
included a $35,000 maximum loan with interest of 1 percent over prime, and the agreement also
requires a 15% compensating balance throughout the year. The prime rate is currently 12 percent.
a. If Dazzly Diamond Corp. maintains a balance in its account of $5,250 to $6,000, what is the
effective cost of credit through the line-of-credit agreement where the maximum amount of the
loan is used?
b. Recompute the effective cost of credit to Dazzly Diamond if it will have to borrow the
compensating balance and the maximum amount possible under the agreement.
Answer: 35,000 × 0.13 = $4,550
$379/month -- interest
$5,250 -- compensating balance
a. RATE = × = 0.13 or 13%
b. RATE = × = 0.1529 or 15.29%
Interest expense for the loan is
($35,000) (0.13) = $4,550
However, the firm gets the use of only .85 × $35,000 = $29,750.
Keywords: Compensating Balance, Effective Cost of Credit
78) Quincy Fathows & Co. plans to issue commercial paper for the first time in its 85-year
history. The firm plans to issue $400,000 in 120-day maturity notes. The paper will carry a 13%
quarterly compounded rate with discounted interest and will cost Quincy Fathows $8,000 in
advance to issue.
a. What is the effective cost of credit to Quincy Fathows?

b. What other factors should the firm consider in analyzing whether or not to issue the
commercial paper?
Answer:
a.
RATE = ×
RATE = × = .203 = 20.3%
*Interest = 0.13 × $400,000 × 1/3
b. The risk involved with the issue of commercial paper should be considered. This risk relates
to the fact that the commercial paper market is highly impersonal and denies even the most credit
worthy borrower any flexibility in terms of when repayment is made. In addition, commercial
paper is a viable source of credit to only the most credit worthy borrowers. Thus, it may simply
not be available to the firm.
Keywords: Commercial Paper, Effective Annual Cost of Credit, Discount Interest
79) Richenstein Enterprises is in the business of selling dishwashers. The firm needs $192,000 to
finance an anticipated expansion in receivables due to increased sales. Richenstein's credit terms
are net 40, and its average monthly credit sales are $180,000. In general, the firm's customers pay
within the credit period; thus, the firm's average accounts receivable balance is $240,000.
The comptroller of Richenstein Enterprises, Mr. Gee, approached their bank for the needed
capital, pledging the accounts receivable as collateral. The bank offered to make the loan at a rate
of 2 percent over prime plus a 1 percent processing charge on all receivables pledged. The bank
agreed to loan up to 80 percent of the face value of the receivables pledged.
a. Estimate the cost of the receivables loan to Richenstein where the firm borrows the
$192,000. The prime rate is currently 13%.
b. Gee also requested a line of credit for $192,000 from the bank. The bank agreed to grant the
necessary line of credit at a rate of 4% over prime and required a 12% compensating balance Gee
currently maintains an average demand deposit of $40,000. Estimate the cost of the line of credit
to Richenstein.
c. Which source of credit should Richenstein Enterprises select?

Answer:
a.
RATE = × = .2625 or 26.25%
*$240,000 × 0.15 × 0.8 = $28,800

**$180,000 × 0.01 × 12 = $21,600
b. $192,000 × .12 = $23,040 (compensating balance) Since Richenstein maintains a balance of

$40,000 normally with the bank, the compensating balance requirement will not increase the
effective cost of credit.
× = 0.17 or 17%
Interest = $192,000 × .17 = $32,640.
c. Choose the line of credit since the effective interest is considerably lower. Note, however,
that the pledging arrangement may involve credit services to Richenstein which would reduce
Richenstein's credit department expense. If this were the case then these savings would reduce
the effective cost of that financing arrangement.
Keywords: Pledging Accounts Receivable, Compensating Balance
80) Bonneau Sunglass Co. is considering the factoring of its receivables. The firm has credit
sales of $500,000 per month and has an average receivables balance of $1,000,000 with 60-day
credit terms. The factor has offered to extend credit equal to 85% of the receivables factored less
interest on the loan at a rate of 2% per month. The 15% difference in the advance and face value
of all receivables factored consists of a 2% factoring fee plus a 13% reserve, which the factor
maintains. In addition, if Bonneau decides to factor its receivables, it will sell them all, so that it
can reduce its credit costs by $2,000 a month.
a. What is the cost of borrowing the maximum amount of credit available to Bonneau through
the factoring agreement?
b. What considerations other than cost should be accounted for by Bonneau in determining
whether or not to enter the factoring agreement?
Answer:
a. Maximum advance
Face value of receivables
(2 months credit sales) $1,000,000
Less: factoring fee (2%) (20,000)
Reserve (13%)
Interest (2% per month for 60 days) *(34,000)
Loan advance (less discount interest) $816,000
*Interest is calculated on the 85 percent of the factored accounts that can be borrowed,
(.85 × $1,000,000 × .02 × 2 months) = $34,000 or ($1,000,000 - $20,000 - $130,000) × .02 ×
2 months) = $34,000. Thus, the effective cost of credit to Bonneau's is calculated as follows:
RATE = × = .3676 or 36.76%
**Credit department savings for 60 days equals 2 × $2,000.

Calculated on an annual basis, the cost of credit would be:
RATE = × = .3676 or 36.76%
where interest = .02 × $850,000 × 12 = $204,000

factoring fee = .02 × $500,000 × 12 = $120,000
credit department savings= 12 × $2,000 = $24,000
b. Of particular concern here is the presence of any "stigma" associated with factoring. In some
industries, factoring simply is not used unless the firm's financial condition is critical. This would
appear to be the case here, given the relatively high effective rate of interest on borrowing.
Keywords: Factoring Accounts Receivable
81) Discuss the similarities and differences between a line of credit and a revolving credit
agreement.
Answer: A line of credit and revolving credit agreement are agreements between a borrower and
a bank detailing the maximum amount of credit that the bank will provide the borrower at any
one time. A line of credit agreement is informal and requires no legal commitment on the bank's
part. A legal obligation arises when a revolving credit agreement is used.
Keywords: Line of Credit, Revolving Credit Agreement
82) Symco Corp. needs $500,000 for 90 days to get through a period of unexpectedly high oil
prices. Symco's line of credit with the bank allows the company to borrow at 6% per year with a
compensating balance of 10% of the amount borrowed. Currently, Symco has no money on
deposit with the bank.
a. Calculate the amount Symco must borrow to meets its needs plus the compensating balance.
b. What is the annual percentage rate for this financing?
c. If the bank requires discount interest, what is the annual percentage rate for this financing?
Answer:
a. $500,000/(1-.1) = $555,555.55
b. Interest = (.06 × $555,555.55)/4 = $8,333.33
APR = ($8,333.33/$500,000) × (1/(90/360)) = 6.67%
c. APR = ($8,333.33/($500,000 - $8,333.33)) × (1/(90/360)) = 6.78%
Keywords: Line of Credit, Compensating Balance, Annual Percentage Rate, Discount Interest
83) AJAX Corp. has accounts payable with 2/10 net 40 credit terms. The company could take a
short-term bank loan with an interest rate of 20%. Would you recommend AJAX borrow from
the bank to pay its accounts payable and take the cash discount, or would you recommend the
company forgo the cash discount?
Answer: Cost of Trade Credit: (.02/.98) × (1/(30/360)) = 24.49%
Take the cash discount and borrow the money from the bank. The cost of the bank loan is less
than the cost of trade credit.
Keywords: Cost of Trade Credit, Annual Percentage Yield
84) What are some examples of unsecured and secured sources of short-term credit?
Answer: Short-term credit sources can be classified into two basic groups: unsecured and
secured. Unsecured loans include all those sources that have as their security only the lender's
faith in the ability of the borrower to repay the funds when due. The major sources of unsecured
short-term credit include accrued wages and taxes, trade credit, unsecured bank loans, and
commercial paper. A secured loan involves the pledge of specific assets as collateral in the event
the borrower defaults in payment of principal or interest. Commercial banks, finance companies,
and firms that make loans secured by receivables (factors) are the primary suppliers of secured
credit. The principal sources of collateral include accounts receivable and inventories.
Because most businesses pay their employees only periodically (weekly, biweekly, or monthly),
firms accrue a wages-payable account that is, in essence, a loan from their employees. Similarly,
firms generally make quarterly income tax payments for their estimated quarterly tax liability.
This means that the firm has the use of the tax money it owes based on its quarterly profits
through the end of the quarter. Trade credit provides one of the most flexible sources of short-
term financing available to the firm. Trade credit arises spontaneously with the firm's purchases.
Commercial banks provide unsecured short-term credit
Commercial paper is simply a short-term promise to pay that is sold in the market for short-term
debt securities.
Secured sources of short-term credit have certain assets of the firm pledged as collateral to
secure the loan. Upon default of the loan agreement, the lender has first claim to the pledged
assets in addition to its claim as a general creditor of the firm. Hence, the secured credit
agreement offers an added margin of safety to the lender. Under the pledging accounts receivable
arrangement, the borrower simply pledges accounts receivable as collateral for a loan obtained
from either a commercial bank or a finance company. Inventory loans, or loans secured by
inventories, provide a second source of security for short-term credit. The amount of the loan that
can be obtained depends on both the marketability and perishability of the inventory.
Keywords: Unsecured Short-term Loan, Transaction Loan
85) What is the difference between a line of credit and a revolving credit agreement?
Answer: A line of credit is generally an informal agreement or understanding between the
borrower and the bank about the maximum amount of credit that the bank will provide the
borrower at any one time. Under this type of agreement there is no legal commitment on the part
of the bank to provide the credit. In a revolving credit agreement, which is a variant of this form
of financing, a legal obligation is involved.
Keywords: Revolving Credit Agreement
86) List and describe at least three advantages accrue to the user of commercial paper.
Answer: 1. Interest rate: commercial paper rates are generally lower than rates on bank loans
and comparable sources of short-term financing; 2. Compensating-balance requirement: no
minimum balance requirements are associated with commercial paper. However, issuing firms
usually find it desirable to maintain line-of-credit agreements sufficient to back up their short-
term financing needs in the event that a new issue of commercial paper cannot be sold or an
outstanding issue cannot be repaid when due.
3. Amount of credit: commercial paper offers the firm with very large credit needs a single
source for all its short-term financing. Because of loan amount restrictions placed on the banks
by the regulatory authorities, obtaining the necessary funds from a commercial bank might
require borrowing from a number of institutions; 4. Prestige. Because it is widely recognized that
only the most creditworthy borrowers have access to the commercial paper market, its use
signifies a firm's credit status.
Keywords: Combined Leverage

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Exam 3 The one that was given

Chapter 9 The Cost of Capital

Market risk premium=8% Beta=2.2 K=2.5+2.2*8=20.1%

Expected return on market portfolio = Rm

Now, use the calculator to find I/Y= pre-tax-cost=8.76%

Cost of Long-Term Debt 7%

The company's marginal tax rate is 40%.

Project Initial Outlay IRR

Which of the above projects should the company take on?

Project Investment (million) IRR

Chapter 10 Capital-Budgeting Techniques and Practice

71) The net present value method

74) When reviewing the net present profile for a project,

Year Net Cash Flow

The Internal Rate of Return (to nearest whole percent) is

80) We compute the profitability index of a capital budgeting proposal by

83) The disadvantage of the IRR method is that

84) The internal rate of return is

Initial Outlay = $126,000

Initial Outlay = $3,000,000

Compute the internal rate of return on the project.

Initial Outlay = $100

Initial outlay = $1,500

Compute the profitability index if the company's discount rate is 10%.

94) A significant advantage of the payback period is that it

95) A significant disadvantage of the payback period is that it

97) A significant advantage of the internal rate of return is that it

98) An independent project should be accepted if it

103) A significant disadvantage of the internal rate of return is that it

104) A significant disadvantage of the internal rate of return is that it

105) A one-sign-reversal project should be accepted if it

108) A project would be acceptable if

Year Cash Flow A Cash Flow B

The required rate of return on these projects is 12 percent.

3) Positive NPV projects may be rejected when capital must be rationed.

8) Capital rationing may be imposed because of all of the following EXCEPT

Project Initial Outlay IRR NPV

Project Initial Outlay NPV

2) IRR should not be used to choose between mutually exclusive projects.

6) An infinite-life replacement chain allows projects of different lengths to be compared.

Plan A Plan B Plan C

Initial Outflow = $150,000

Net Cash Flow Each Period

Year Cash Flow S Cash Flow L

Year Cash Flow S Cash Flow L

Year Project A Project B

Foundations of Finance, 10e (Keown/Martin/Petty)

11) Working capital management involves managing a firm's liquidity.

26) Which of the following actions would improve a firm's liquidity?

27) Which of the following actions would decrease a firm's liquidity?

33) Net working capital refers to which of the following?

34) Gross working capital includes all of the following EXCEPT

36) Discuss the risk-return trade-off experienced in working-capital management.

19) Accrued wages and accrued taxes are considered to be

20) Spontaneous sources of financing include

21) Permanent sources of financing include all but

28) Which of the following is most likely to be a temporary source of financing?

30) Which of the following is considered a spontaneous source of financing?

31) What is the hedging principle or principle of self-liquidating debt?

1) Compounding effectively raises the cost of short-term credit.

15) Trade credit appears on a company's balance sheet as accounts payable.

19) Commercial paper is an unsecured form of credit.

Discounted Interest=Principle*Interest/Time= 250,000*8%/12*6=9,999=10,000

Discounted Interest=PrincipleInterest/Time= 250,0008%/12*6=9,999=10,000