Multiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) The first step in the capital budgeting process is decision-making. proposal generation. implementation. review and analysis. 2) All of the following are steps in the capital budgeting process EXCEPT transformation. decision-making. implementation. follow-up. Cash flows that could be realized from the best alternative use of an owned asset are called opportunity costs. incremental costs. lost resale opportunities. sunk costs. An important cash inflow in the analysis of initial cash flows for a replacement project is installation cost. the cost of the new asset. the sale value of the old asset. taxes. A corporation is considering expanding operations to meet growing demand. With the capital expansion, the current accounts are expected to change. Management expects cash to increase by $20,000, accounts receivable by $40,000, and invento- ries by $60,000. At the same time accounts payable will increase by $50,000, ac- cruals by $10,000, and long-term debt by $100,000. The change in net working capital is a decrease of $40,000. a decrease of $120,000. an increase of $120,000. an increase of $60,000. A loss on the sale of an asset that is depreciable and used in business is; a loss on the sale of a non-depreciable asset is _not deductible; deductible only against capital gains deductible from ordinary income; deductible only against capital gains a credit against the tax liability; not deductible deductible from capital gains income; deductible from ordinary income A corporation has decided to replace an existing asset with a newer model. Two years ago, the existing asset originally cost $30,000 and was being depreciated under MACRS using a five-year recovery period. The existing asset can be sold for $25,000. The new asset will cost $75,000 and will also be depreciated under MACRS using a five-year recovery period. If the assumed tax rate is 40 percent on ordinary income and capital gains, the initial investment is _ $42,000 $54,240 $52,440 $50,000 A corporation is evaluating the relevant cash flows for a capital budgeting decision and must estimate the terminal cash flow. The proposed machine will be disposed of at the end of its usable life of five years at an estimated sale price of $15,000. The machine has an original purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent tax rate on ordinary in- come and long-term capital gain. The terminal cash flow is $24,000. $14,000. $26,000. $16,000. 9) All of the following are weaknesses of the payback period EXCEPT only an implicit consideration of the timing of cash flows. the difficulty of specifying the appropriate payback period. a disregard for cash flows after the payback period. it uses cash flows, not accounting profits. 10) Payback is considered an unsophisticated capital budgeting because it gives explicit consideration to risk exposure due to the use of the cost of capital as a discount rate. gives explicit consideration to the timing of cash flows and therefore the time value of money. gives consideration to cash flows that occur before the payback period. none of the aboveWhat is the payback period for Tangshan Mining company’s new project if its initial after tax cost is $5,000,000 and it is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $700,000 in year 3 and $1,800,000 in year 4? 3.33 years. 4.33 years. 2.33 years. None of the above Should Tangshan Mining company accept a new project if its maximum payback is 3.5 years and its initial after tax cost is $5,000,000 and it is expected to provide af- ter-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $700,000 in year 3 and $1,800,000 in year 4? No. Yes. It depends. None of the above What is the N PV for the followi ng project if its cost of capital is 0 percent and its initial after tax cost is $5,000,000 and it is expected to provide after-tax operating cash inflows of $1,800,000 in year 1, $1,900,000 in year 2, $1,700,000 in year 3 and $1,300,000 in year 4? $371,764. $137,053. $1,700,000. None of the above What is the IRR for the following project if its initial after tax cost is $5,000,000 and it is expected to provide after-tax operati ng cash flows of ($1,800,000) in year 1, $2,900,000 in year 2, $2,700,000 in year 3 and $2,300,000 in year 4? 11.44. 9.67. 5.83. None of the above Consider the following projects, X and Y where the firm can only choose one. Project X costs $600 and has cash flows of $400 in each of the next 2 years. Project Y also costs $600, and generates cash flows of $500 and $275 for the next 2 years, respec- tively. Which investment should the firm choose if the cost of capital is 25 percent? Project Y. Project X. Neither. Not enough information to tell. The is the compound annual rate of return that the firm will earn if it invests in the project and receives the given cash inflows. discount rate opportunity cost cost of capital internal rate of return 17) In comparing the internal rate of return and net present value methods of evaluation, net present value is theoretically superior, but financial managers prefer to use inter- nal rate of return. financial managers prefer net present value, because it measures benefits relative to the amount invested. financial managers prefer net present value, because it is presented as a rate of re- turn. internal rate of return is theoretically superior, but financial managers prefer net pres- ent value. 18) In the context of capital budgeting, risk generally refers to the chance that the net present value will be greater than zero. the degree of variability of the initial investment. the chance that the internal rate of return will exceed the cost of capital. the degree of variabiIity of the cash inflows. Two approaches for dealing with project risk to capture the variability of cash inflows and NPVs are scenario analysis and simulation. sensitivity analysis and scenario analysis. sensitivity analysis and simulation. none of the above. A behavioral approach for dealing with project risk that uses several possible values for a given variable such as cash inflows to assess that variable’s impact on NPV is called sensitivity analysis. simulation analysis. scenario analysis none of the above.The reflects the return that must be earned on the given project to compen- sate the firm’s owners adequately according to the project’s variability of cash flows. cost of capital internal rate of return risk-adjusted discount rate average rate of return The theoretical basis from which the concept of risk-adjusted discount rates is derived is simulation theory. the Gordon model. the capital asset pricing model. the basic cost of money. The approach is used to convert the net present value of unequal-lived projects into an equivalent annual amount (in net present value terms). investment opportunities schedule annualized net present value internal rate of return risk-adjusted discount rate 24) Major types of real options include all of the following except the growth option. conversion option. timing option. abandonment option. The is the rate of return a firm must earn on its investments in projects in order to maintain the market value of its stock. cost of capital internal rate of return gross profit margin net present valueMultiple Choice Questions (Enter your answers on the enclosed answer sheet) 1) At the operating breakeven point, equals zero. variable operating costs sales revenue earnings before interest and taxes fixed operati ng costs 2) Breakeven analysis is used by the firm to determine the level of operations necessary to cover all operating costs. to evaluate the profitability associated with various levels of sales. Both A and B. none of the above 3) If a firm’s variable costs per unit increase, the firm’s operating breakeven point will decrease. remain unchanged. change in an undetermined direction. increase. Noncash charges such as depreciation and amortization the firm’s breakev- en point. decrease understate overstate do not affect 5) leverage is concerned with the relationship between sales revenues and earnings before interest and taxes. Total Financial Variable Operating 6) The three basic types of leverage are operating, production, and total. operating, financial, and total. production, financial, and total. operating, production, and financial. 7) is the potential use of fixed costs, both operating and financial, to magnify the effect of changes in sales on the firm’s earnings per share. Total leverage Debt service Operating leverage Financial leverage With the existence of fixed operating costs, an increase in sales will result in ___ increase in EBIT. a less than proportional a proportional an equal a more than proportional 9) All of the following affect business risk EXCEPT cost stability. interest rate stability. revenue stability. operati ng leverage. A corporation has $5,000,000 of 10 percent bonds and $3,000,000 of 12 percent preferred stock outstanding. The firm’s financial breakeven (assuming a 40 percent tax rate) is $860,000. $716,000. $1,400,000. $1,100,000. 11) Operating and financial constraints placed on a corporation by loan provision are agency cost imposed by the lendersinterest rate costs to the firm. necessary to control the risk of the firm. agency costs to the firm. In order to enhance the wealth of stockholders and to send positive signals to the market, corporations generally raise funds using the following order: Equity, retained earnings, debt. Debt, retained earnings, equity. Retained earnings, equity, debt. Retained earnings, debt, equity. According to the traditional approach to capital structure, the value of the firm will be maximized when the financial leverage is maximized. the weighted average cost of capital is minimized. the cost of debt is minimized. the dividend payout is maximized. 14) In the EBIT-EPS approach to capital structure, risk is represented by shifts in the times-interest-earned ratio. shifts in the cost of debt capital. the slope of the capital structure line. shifts in the cost of equity capital. Nico Trading Company must choose its optimal capital structure. Currently, the firm has a 20 percent debt ratio and the firm expects to generate a dividend next year of $5.44 per share. Dividends are expected to remain at this level indefinitely. Stock- holders currently require a 12.1 percent return on their investment. Nico is consider- ing changing its capital structure if it would benefit shareholders. The firm estimates that if it increases the debt ratio to 30 percent, it wi II increase its expected dividend to $5.82 per share. Again, dividends are expected to remain at this new level indefi- nitely. However, because of the added risk, the required return demanded by stock holders will increase to 12.6 percent. Based on this information, should Nico make the change? Yes No It’s irrelevant Not enough information At the quarterly meeting of Tangshan Mining Corporation, held on September 10th, the directors declared a $1.00 per share dividend for the firm’s 100,000 shares of common stock outstanding. The net effect of declaring and paying this dividend would be to increase total assets by $100,000 and decrease stockholders equity by $100,000. increase total assets by $100,000 and increase stockholders equity by $100,000. decrease total assets by $100,000 and decrease stockholders equity by $100,000. decrease total assets by $100,000 and increase stockholders equity by $100,000. Tangshan Mining has common stock at par of $200,000, paid in capital in excess of par of $400,000, and retained earnings of $280,000. In states where the firm’s legal capital is defined as the par value of common stock, the firm could payout ___ in cash dividends without impairing its capital. $200,000 $880,000 $600,000 $680,000 Shareholder wealth considerations in the payment of dividends include all of the following EXCEPT the criminal status of the firm’s owners. the tax status of the firm’s owners. the investment opportunities of the firm’s owners. the potential dilution of ownership on behalf of the firm’s owners. 19) Gordon’s “bird-in-the-hand” argument suggests that shareholders are generally risk averse and attach less risk to current dividends. dividends are irrelevant. firms should have a 100 percent payout policy. the market value of the firm is unaffected by dividend policy. A firm that has a large percentage of investors may payout a lower percent- age of its earnings as dividends. wealthy business middle-income pension fund A firm has current after-tax earnings of $1,000,000 and has declared a cash dividend of $400,000. The firm’s dividend payout ratio is 4.0 percent. 2.0 percent. 2.5 percent. 40 percent. 22) The advantage of using the low-regular-and-extra dividend policy is that cyclical shifts in earnings may be avoided. the extra dividend may become a regular event. the firm avoids giving the shareholders false hopes. if the firm’s earnings drop, so does the dividend payment. Mr. R. owns 20,000 shares of ABC Corporation stock. The company is planning to issue a stock dividend. Before the dividend Mr. R. owned 10 percent of the outstand- ing stock, which had a market value of $200,000, or $10 per share. Upon receiving the 10 percent stock dividend the value of his shares is $210,000. $200,000. $220,000. greater, but cannot be determined. 24) The accounting in a stock split will transfer funds from the Retained Earnings account to the Paid in Capital account. from the Common Stock and Paid in Capital accounts to the Retained Earnings ac- count. from the Paid in Capital account to the Retained Earnings account. from the Retained Earnings account to the Preferred Stock account. none of the above When purchasing outstanding shares of common stock a firm can utilize all of the fol- lowing methods EXCEPT a tender offer at a specified price. a purchase on the open market at market prices. a tender offer at varying prices. by purchasing a large block on a negotiated basis.