The primary function of the capital budget is to forecast the funds required for future investments that must be raised through external funding

True or False: Please indicate whether each statement is true or false. (2 points per question)

1. The primary function of the capital budget is to forecast the funds required for future investments that must be raised through external funding, that is, by selling stock or bonds.

2. When considering two mutually exclusive projects, the financial manager should always select that project whose internal rate of return is the highest provided the projects have the same initial cost.

3. Corporate risk does not take into consideration the effects of stockholder’s diversification; it is measured by a project’s effect on the firm’s earnings variability.

4. The beta risk of a project is that part of the project’s that cannot be eliminated by diversification. Investors are not concerned about this type of since it cannot be diversified.

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

6. The cost of debt, rd, is always less than rs, so rd(1 – T) will certainly be less than rs. Therefore, since a firm cannot be 100% debt financed, the weighted average cost of capital will always be greater than rd(1 – T).

7. The fact that interest is tax deductible makes corporate debt less expensive than common of preferred stock.

8. If the firm’s actual debt ratio is below its target level, expansion capital should be raised by issuing equity in order to preserve the firm’s borrowing capacity.

9. On a 2-for-1 stock split, the shares outstanding are doubled, and the stock’s par value is halved.

10. A firm with a current ratio equal to four will have its current ratio increase if both current assets and current liabilities increase by the same amount.

11. The sale of common stock for cash will increase the current assets for a firm.

12. If you receive some goods on April 1 with the terms 3/20, net 30, June 1 dating, it means that you will receive a 3 percent discount if the bill is paid on or before June 20 and that the full amount must be paid 30 days after receipt of the goods.

13. Collections float offsets disbursement float. If a firm’s collections float is greater than its disbursement float then a firm is said to operate with positive net float.

14. When a firm pledges its accounts receivable, if a customer that purchased goods from the firm does not pay, the selling firm must take the loss.

15. Breakeven analysis can involve determining the magnitude of the firm’s profit or losses at output levels on and around the point where revenues equal costs.

Multiple Choice (2 points per question):

16. Assume a project has normal cash flows (i.e., initial cash flow is negative, and all other cash flows are positive). Which of the following statements is most correct?

a.

All else equal, a project’s IRR increases as the required rate of return declines.

b.

All else equal, a project’s NPV increases as the required rate of return declines.

c.

All else equal, a project’s IRR is unaffected by changes in the required rate of return.

d.

Answers a and b are both correct.

e.

Answers b and c are both correct.

17. Which of the following statements is correct?

a.

Because discounted payback takes account of the required rate of return, a project’s discounted payback is normally shorter than its regular payback.

b.

The NPV and IRR methods use the same basic equation, but in the NPV method the discount rate is specified and the equation is solved for NPV, while in the IRR method the NPV is set equal to zero and the discount rate is found.

c.

If the required rate of return is less than the crossover rate for two mutually exclusive projects’ NPV profiles, a NPV/IRR conflict will not occur.

d.

If you are choosing between two projects which have the same life, and if their NPV profiles cross, then the smaller project will probably be the one with the steeper NPV profile.

e.

If the required rate of return is relatively high, this will favor larger, longer-term projects over smaller, shorter-term alternatives because it is good to earn high rates on larger amounts over longer periods.

18. Which of the following is not a cash flow that results from the decision to accept a project?

a.

Changes in working capital.

b.

Shipping and installation costs.

c.

Sunk costs.

d.

Opportunity costs.

e.

Externalities.

19. According to the text, the financial staff’s role in the forecasting process centers on

a.

Developing the original assumptions used in estimating each project’s cash flows.

b.

Making sure that no biases are inherent in the forecasts.

c.

Deciding which projects are strategically important to the firm.

d.

Setting the sales price and quantity estimates for use by other departments.

e.

All of the above.

20. The firm’s weighted average cost of capital (WACC) is

a.

set by the board of directors of the firm because it is the benchmark they use to evaluate upper management.

b.

regulated by the Internal Revenue Service (IRS) because tax-deductible debt is included in the computation.

c.

determined by the financial markets because investors provide the funds used by firms and these funds have costs, which are the returns demanded by investors.

d.

the same as the firm’s internal rate of return (IRR).

e.

the total net present value (NPV) of all the capital budgeting projects in which the firm invests in any year.

21. Which of the following statements is correct?

a.

Under normal conditions, the CAPM approach to estimating a firm’s cost of retained earnings gives a better estimate than the DCF approach.

b.

The CAPM approach is typically used to estimate a firm’s flotation cost adjustment factor, and this factor is added to the DCF cost estimate.

c.

The risk premium used in the bond-yield-plus-risk-premium method is the same as the one used in the CAPM method.

d.

In practice (as opposed to theory), the DCF method and the CAPM method usually produce exactly the same estimate for r.

e.

The above statements are all false.

22. The firm’s target capital structure is consistent with which of the following?

a.

Maximum earnings per share.

b.

Minimum cost of debt (rd).

c.

Minimum risk.

d.

Minimum cost of equity (rs).

e.

Minimum weighted average cost of capital.

23. Which of the following statements is correct?

a.

The degree of operating leverage (DOL) depends on a company’s fixed costs, variable costs, and sales. The DOL formula assumes (1) that fixed costs are constant and (2) that variable costs are a constant proportion of sales.

b.

The degree of total leverage (DTL) is equal to the DOL plus the degree of financial leverage (DFL).

c.

Arithmetically, financial leverage and operating leverage offset one another so as to keep the degree of total leverage constant.

d.

The above statements are all true.

e.

The above statements are all false.

24. The portion of the firm’s earnings that has been reinvested in the firm rather than paid out in dividends is called

a.

net income.

b.

gross margin.

c.

reinvestment return.

d.

retained earnings.

e.

DRIP.

25. The average length of time required to convert a firm’s receivables into cash is called the __________.

a.

cash conversion cycle

b.

inventory conversion period

c.

receivables collection period

d.

payables deferral period

e.

days sales outstanding

26. Golden Fritter Corporation has a current ratio equal to three. If Golden Fritter issues $1,000,000 in long term bonds and uses the proceeds to purchase inventory, what will happen to the current ratio?

a.

Increase

b.

Decrease

c.

Stay the same

d.

Change, but more information is required to determine the direction of the change.

e.

None of the above.

27. Which of the following would cause average inventory holdings to decrease, other things held constant?

a.

Fixed order costs double.

b.

The purchase price of inventory items decreases by 50 percent.

c.

The carrying cost of an item decreases (as a percent of purchase price).

d.

The sales forecast is revised downward by 10 percent.

e.

None of the above (all would cause average inventory to increase).

28. The Danser Company expects to have sales of $30,000 in January, $33,000 in February, and $38,000 in March. If 20 percent of sales are for cash, 40 percent are credit sales paid in the month following the sale, and 40 percent are credit sales paid 2 months following the sale, what are the cash receipts from sales in March?

a.

$55,000

b.

$47,400

c.

$38,000

d.

$32,800

e.

$30,000

29. A firm is offered trade credit terms of 3/15, net 45. The firm does not take the discount, and it pays after 67 days. What is the approximate annual cost of not taking the discount?

a.

21.41%

b.

22.07%

c.

22.95%

d.

23.48%

e.

24.52%

30. The degree of financial leverage for ABC Inc. is 2.5, and the degree of financial leverage for XYZ Corporation is 1.5. According to this information, which firm is considered to have greater financial risk?

a.

ABC Inc.

b.

XYZ Corporation.

c.

The degree of financial leverage is not a measure of financial risk, so it is not possible to tell which firm has the greater financial risk given the above information.

d.

To determine which firm has the greater financial risk, we need to know the operating income (NOI or EBIT) of each firm. XYZ Corporation would have less financial risk if its operating income is at least twice that of ABC Inc.

e.

None of the above is a correct answer.

Problems:

31. Given the following net cash flows, determine the IRR of the project (5 points):

Time

Net cash flow

0

$1,520

1

-1,000

2

-1,500

3

500

32. Your company is considering a machine that will cost $1,000 at Time 0 and which can be sold after 3 years for $100. To operate the machine, $200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3. The machine will produce sales revenues of $900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales. Operating cash inflows will begin 1 year from today (at Time 1). The machine will have depreciation expenses of $500, $300, and $200 in Years 1, 2, and 3, respectively. The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project’s income is negative, and a 10 percent required rate of return. Inflation is zero. What is the project’s NPV? (5 points)

33. Hamilton Company’s 8 percent coupon rate, quarterly payment, $1,000 par value bond, which matures in 20 years, currently sells at a price of $686.86. The company’s tax rate is 40 percent. Based on the simple interest rate, not the EAR, what is the firm’s component cost of debt for purposes of calculating the WACC? (5 points)

34. Copybold Corporation is a start-up firm considering two alternative capital structures–one is conservative and the other aggressive. The conservative capital structure calls for a D/A ratio = 0.25, while the aggressive strategy call for D/A = 0.75. Once the firm selects its target capital structure it envisions two possible scenarios for its operations: Feast or Famine. The Feast scenario has a 60 percent probability of occurring and forecast EBIT in this state is $60,000. The Famine state has a 40 percent chance of occurring and the EBIT is expected to be $20,000. Further, if the firm selects the conservative capital structure its cost of debt will be 10 percent, while with the aggressive capital structure its debt cost will be 12 percent. The firm will have $400,000 in total assets, it will face a 40 percent marginal tax rate, and the book value of equity per share under either scenario is $10.00 per share. What is the coefficient of variation of expected EPS under the aggressive capital structure plan? (5 points)

35. Flavortech Inc. expects EBIT of $2,000,000 for the coming year. The firm’s capital structure consists of 40 percent debt and 60 percent equity, and its marginal tax rate is 40 percent. The cost of equity is 14 percent, and the company pays a 10 percent rate on its $5,000,000 of long-term debt. One million shares of common stock are outstanding. In its next capital budgeting cycle, the firm expects to fund one large positive NPV project costing $1,200,000, and it will fund this project in accordance with its target capital structure. If the firm follows a residual dividend policy and has no other projects, what is its expected dividend payout ratio? (5 points)

36. On average, a firm sells $2,500,000 in merchandise a month. Its cost of goods sold equals 80 percent of sales, and it keeps inventory equal to one-half of its monthly cost of goods on hand at all times. If the firm analyzes its accounts using a 360-day year, what is the firm’s inventory conversion period? (5 points)

37. You need to borrow $25,000 for one year. Your bank offers to make the loan, and it offers you three choices: (1) 15 percent simple interest, annual compounding; (2) 13 percent simple interest, daily compounding (360-day year); (3) 9 percent add-on interest, 12 end-of-month payments. The first two loans would require a single payment at the end of the year, the third would require 12 equal monthly payments beginning at the end of the first month. What is the difference between the highest and lowest effective annual rate? (5 points)

38. Trident Food Corporation

Trident Food Corporation generated the following income statement for the most recent fiscal year, which ended December 31, 2010:

Sales revenues

$150,000

Variable cost of sales

(112,500)

Gross profit

37,500

Fixed operating costs

(24,000)

Net operating income (EBIT)

13,500

Interest

(10,000)

Earnings before taxes

3,500

Taxes (40%)

(1,400)

Net income

2,100