Jiffy Co. expects to pay a dividend of $3.00 per share in one year
Q1. 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?
a. 13 percent
b. 14 percent
c. 15 percent
d. 16 percent
Q2. 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.
Q3. 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?
Q4. 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?
Q5. The risk free rate of return is 2.5% and the market risk premium is 8%. Rogue Transport has a beta of 2.2 and a standard deviation of returns of 28%. Rogue Transport’s marginal tax rate is 35%. Analysts expect Rogue Transport’s dividends to grow by 6% per year for the foreseeable future. Using the capital asset pricing model, what is Rogue Transport’s cost of retained earnings?
Q6. The market risk premium remains constant over time because the risk free rate of return moves inversely with beta.
Q7. 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
a. favor projects in the core business division because that division is the least risky.
b. favor projects in the related businesses division because the cost of capital for this division is the closest to the firm’s weighted average cost of capital.
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.
d. not favor any division over the other because they all use the same company-wide weighted average cost of capital.
Q8. 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.
Q9. 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?
Q10. 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.
Q11. Two projects that have the same cost and the same expected cash flows will have the same net present value.
Q12. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects is 10%. The equivalent annual annuity amount for project B, rounded to the nearest dollar, is
Q13. Your firm is considering an investment that will cost $920000 today. The investment will produce cash flows of $450,000 in year 1, $270,000 in years 2 through 4, and $200,000 in year 5. The discount rate that your firm uses for projects of this type is 11.25%. What is the investment’s net present value?
Q14. 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.
Q15. 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.
Q16. 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.
Q17. 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.
Q18. Lithium, Inc. is considering two mutually exclusive projects, A and B. Project A costs $95,000 and is expected to generate $65,000 in year one and $75,000 in year two. Project B costs $120,000 and is expected to generate $64,000 in year one, $67,000 in year two, $56,000 in year three, and $45,000 in year four. Lithium, Inc.’s required rate of return for these projects is 10%. 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.
Q19. 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. cannot be determined without actual cash flows
Q20. 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.
Q21. Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net worth. When considering capital budgeting projects for their boutiques, the appropriate measure of risk is
a. project standing alone risk.
b. systematic risk.
c. contribution-to-firm risk.
d. beta risk.
Q22. Accounting profits, adjusted for taxes and differences in accounting methods, provide the best measure of relevant cash flows for capital budgeting purposes.
Q23. XYZ, Inc. has developed a project which results in additional accounts receivable of $400,000, additional inventory of $180,000, and additional accounts payable of $70,000. What is the additional investment in net working capital?
Q24. One method of accounting for systematic risk for a project involves identifying a publicly traded firm that is engaged in the same business as that project and using its required rate of return to evaluate the project. This method is referred to as
a. the accounting beta method.
b. scenario analysis.
c. the pure play method.
d. sensitivity analysis.
Q25. A new project is expected to generate $800,000 in revenues, $250,000 in cash operating expenses, and depreciation expense of $150,000 in each year of its 10-year life. The corporation’s tax rate is 35%. The project will require an increase in net working capital of $85,000 in year one and a decrease in net working capital of $75,000 in year ten. What is the free cash flow from the project in year one?
Q26. J.B. Enterprises purchased a new molding machine for $85,000. The company paid $8,000 for shipping and another $7,000 to get the machine integrated with the company’s existing assets. J.B. must maintain a supply of special lubricating oil just in case the machine breaks down. The company purchased a supply of oil for $4,000. The machine is to be depreciated on a straight-line basis over its expected useful life of 8 years. Which of the following statements concerning the change in working capital is most accurate?
a. The $4,000 paid for oil is added to the initial outlay, offset by the tax savings $1600.
b. The $4,000 may be expensed each year over the life of the project as part of the incremental free cash flows.
c. The $4,000 is added to the initial outlay and recaptured during the terminal year, hence having no impact on the projects NPV or IRR.
d. Even if the $4,000 is fully recovered at the end of the project, the project’s NPV and IRR will be lower if the change in working capital is included in the analysis.
Q27. The less-risky investment is always the more desirable choice.
Q28. A local restaurant owner is considering expanding into another rural area. The expansion project will be financed through a line of credit with City Bank. The administrative costs of obtaining the line of credit are $500, and the interest payments are expected to be $1,000 per month. The new restaurant will occupy an existing building that can be rented for $2,500 per month. The incremental cash flows for the new restaurant include
a. $500 administrative costs, $1,000 per month interest payments, $2,500 per month rent.
b. $500 administrative costs, $2,500 per month rent.
c. $1,000 per month interest payments, $2,500 per month rent.
d. $2,500 per month rent.
Q29. An asset with an original cost of $100,000 and a current book value of $20,000 is sold for $50,000 as part of a capital budgeting project. The company has a tax rate of 30%. This transaction will have what impact on the project’s initial outlay?
a. reduce it by $20,000
b. reduce it by $50,000
c. reduce it by $6,000
d. reduce it by $15,000
Q30. Tillamook Farms invests in a new kind of frozen dessert called polar cream that becomes very popular. So many new customers come to the store that the sales of existing ice cream products are increased. The extra sales revenue
a. should not be counted as incremental revenue for the polar cream project because the sales come from existing products.
b. are synergistic effects that should be counted as incremental revenues for the polar cream project.
c. are cannibalized sales that should be excluded from the analysis.
d. should be included in the analysis, but not the cost of the ice cream that is sold as that is a recurring expense.
Q31. Which of the following is a fixed cost?
b. direct material
c. direct labor
d. freight costs on products
Q32. Financial leverage is distinct from operating leverage since it accounts for
a. use of debt and preferred stock.
b. variability in fixed operating costs.
c. variability in sales.
d. changes in EBIT.
Q33. A plant may remain operating when sales are depressed
a. if the selling price per unit exceeds the variable cost per unit.
b. to help the local economy.
c. in an effort to cover at least some of the variable cost.
d. unless variable costs are zero when production is zero.
Q34. Depreciation is considered a fixed cost.
Q35. Which of the following transactions will lower a company’s financial leverage?
a. A mortgage loan is obtained and the proceeds are used to pay off existing short-term debt.
b. Preferred stock is sold and the proceeds are used to pay off existing short-term debt.
c. Common stock is sold and the proceeds are used to pay off existing short-term debt.
d. Short-term debt is obtained to get the company through a period of negative net income and cash flow.
Q36. Business risk refers to the relative dispersion (variability) of a company’s net income.
Q37. Because financial markets can be extremely volatile, with bond and stock prices changing significantly from day to day, a firm’s management has much greater control over the firm’s operating leverage than over its financial leverage.
Q38. HomeCraft makes wooden play sets. The company pays annual rent of $400,000 per year and pays administrative salaries totaling $150,000 per year. Each play set requires $400 of wood, ten hours of labor at $70 per hour, and variable overhead costs of $100. Fixed advertising expenses equal $100,000 per year. Each play set sells for $3,200. What is Homecraft’s break-even output level?
a. 340 play sets
b. 325 play sets
c. 297 play sets
d. 258 play sets
Q39. The EBIT-EPS indifference point
a. identifies the EBIT level at which the EPS will be the same regardless of the financing plan.
b. identifies the point at which the analysis can use EBIT and EPS interchangeably.
c. identifies the level of earnings at which the management is indifferent about the payments of dividends.
d. identifies the sales level at which EBIT equals EPS.
Q40. The optimal capital structure is the funds mix that will
a. minimize the use of debt.
b. achieve an equal proportion of debt, preferred stock, and common equity.
c. minimize the firm’s composite cost of capital.
d. maximize total leverage.
Q41. Stock repurchases do not alter a company’s capital structure since all of the purchased shares are retired and no longer outstanding.
Q42. One potential reason for a share repurchase is
a. to increase the power of a minority group of shareholders.
b. maximize the dilution in earnings associated with a merger.
c. a reduction in the firm’s cost associated with servicing small stockholders.
d. to signal the market that the firm’s stock price is too high.
Q43. The residual dividend theory suggests that dividends will only be paid
a. if the tax rate on capital gains is higher than the tax rate on dividends.
b. if the corporation has more positive NPV projects than it can fund.
c. if interest rates available to shareholders are higher than the required return on the company’s stock.
d. if current retained earnings exceed the equity portion of the firm’s capital budget.
Q44. Concentric Corporation has 10 million shares of stock outstanding. Concentric’s after-tax profits are $140 million and the corporation’s stock is selling at a price-earnings multiple of 18, for a stock price of $252 per share. Concentric’s management issues a 40% stock dividend. What is the effect on an investor who owns 100 shares of Concentric before the dividend if Concentric’s price-earnings multiple remains the same after the dividend is paid?
a. The investor will own 140 shares worth $25,200.
b. The investor will own 140 shares worth $35,280.
c. The investor will own 100 shares worth $25,200.
d. The investor will own 100 shares worth $35,280.
Q45. AFB, Inc.’s dividend policy is to maintain a constant payout ratio. This year AFB, Inc. paid out a total of $2 million in dividends. Next year, AFB, Inc.’s sales and earnings per share are expected to increase. Dividend payments are expected to
a. remain at $2 million.
b. increase above $2 million.
c. decrease below $2 million.
d. increase above $2 million only if the company issues additional shares of common stock.
Q46. Assume that a firm has a steady record of paying stable dividends for years. Market analysts had expected management to increase the dividend by 7.5% in the latest quarter. However, management announced a 15% increase in the current year’s dividend. The market value of the stock rose 20% on the day of the announcement. Which of the following would best explain the stock market’s reaction to the announcement?
a. expectations theory
b. dividend irrelevance theory
c. residual dividend theory
d. agency theory
Q47. A firm’s dividend payout ratio is
a. the ratio of dividends to sales.
b. the ratio of dividends to market equity.
c. the ratio of dividends to earnings.
d. the ratio of dividends to book equity.
Q48. The president of Smith Brothers, Inc. wants a dividend policy that minimizes the likelihood of decreasing the company’s dividend per share. Which of the following policies should the CEO select?
a. constant dividend payout ratio
b. stable dollar dividend per share
c. regular dividend plus a year-end extra
d. All policies have the same likelihood of a dividend decrease because dividend changes are dependent on changes in earnings.
Q49. Grainery Distillers, Inc. is experiencing high demand for its products and high growth rates. The company just reported earnings per share of $5 for the most recent year and has many positive NPV projects to fund. One vice president wants to pay a dividend of $5 per share, arguing that this will maximize shareholder value. You argue that a much smaller dividend will maximize value. Your argument may be based on
a. the bird-in-the-hand theory.
b. the residual dividend theory.
c. the information effect.
d. the very high agency costs of the corporation.
Q50. EveningFall, Inc. pays a quarterly dividend of $3.40 per share. Which of the following statements is most accurate concerning which shareholders will receive the dividend payment?
a. The shareholders who own the stock on the date the dividend is declared will receive the dividend, even if they sell their stock before the dividend checks are mailed.
b. The shareholders who are identified as owning the stock on the record date will receive the dividend, even if they sell their stock before the dividend checks are mailed.
c. The shareholders who own the stock the day the dividend is paid will receive the dividend.
d. All shareholders who own the stock on the record date, but sell the stock before the dividend checks are mailed, forfeit their right to receive the dividend and the money reverts back to the corporation.