QUESTION 1Debt can be used to constrain managers because it:Provides additional cash flow for their use.Precommits a firm’s excess cash flow to debt servicing.Allows the management to issue more shares.Eliminates a CEO’s tendency to acquire other firms without a sound economic rationale.Makes a CEO more likely to accept positive NPV projects.10 points QUESTION 2The CFO of Cicero Industries plans to calculate a new project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e. the initial investment cost the annual operating cash flows and the terminal cash flow) then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?All sunk costs that have been incurred relating to the project.All interest expenses on debt used to help finance the project.The investment in working capital required to operate the project even if that investment will be recovered at the end of the project’s life.Sunk costs that have been incurred relating to the project but only if those costs were incurred prior to the current year.Effects of the project on other divisions of the firm but only if those effects lower the project’s own direct cash flows.10 points QUESTION 3While developing a new product line Cook Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project so the building is available for sale or for a new product. Cook owns the building free and clear¾there is no mortgage on it. Which of the following statements is CORRECT?If the building could be sold then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.This is an example of an externality because the very existence of the building affects the cash flows for any new project that Rowell might consider.Since the building was built in the past its cost is a sunk cost and thus need not be considered when new projects are being evaluated even if it would be used by those new projects.If there is a mortgage loan on the building then the interest on that loan would have to be charged to any new project that used the building.Since the building has been paid for it can be used by another project with no additional cost. Therefore it should not be reflected in the cash flows for any new project.10 points QUESTION 4Century Roofing is thinking of opening a new warehouse and the key data are shown below. The company owns the building that would be used and it could sell it for $100 000 after taxes if it decides not to open the new warehouse. The equipment for the project would be depreciated by the straight-line method over the project’s 3-year life after which it would be worth nothing and thus it would have a zero salvage value. No new working capital would be required and revenues and other operating costs would be constant over the project’s 3-year life. What is the project’s NPV? (Hint: Cash flows are constant in Years 1-3.)WACC10.0%Opportunity cost$100 000Net equipment cost (depreciable basis)$60 000Straight-line deprec. rate for equipment33.333%Sales revenues each year$121 000Operating costs (excl. deprec.) each year$20 000Tax rate40%$10 598$11 256$11 658$12 271$12 88510 points QUESTION 5The capital budget of Serious Products Company is $1 000 000. The company wants to maintain a target capital structure that is 40% debt and 60% equity. The company forecasts that its net income this year will be $800 000. If the company follows a residual dividend policy what will be its total dividend payment?$100 000$200 000$300 000$400 000$500 00010 points QUESTION 6According to the Trade-off Theory of Capital Structure:A firm should have no debt because of the expected bankruptcy costs.There is a trade-off between interest payments and tax savings of debt.There is a trade-off between expected bankruptcy costs and business risk.There is a trade-off between tax savings of debt and expected bankruptcy costs.There is no optimal capital structure.10 points QUESTION 7Which of the following statements is correct about dividend policies?According to the current tax code dividend payments are taxed at a lower rate than long-term capital gains on stock.Dividend reinvestment plans (DRIPs) allow shareholders to avoid paying taxes on the dividends that they choose to reinvest.Residual dividend policy enables a company to follow a stable dividend policy.The clientele effect suggests that companies should follow a stable dividend policy.Modigliani and Miller argue that investors prefer dividends to capital gains because dividends are more certain than capital gains.10 points QUESTION 8Black Keys Manufacturing is considering making a change to its capital structure in hopes of increasing its value. The company’s capital structure consists of debt and common stock. In order to estimate the cost of debt the company has produced the following table:Percent financedPercent financedBondBefore-tax Levered Cost of equitywith debt (wd)with equity (we)Ratingcost of debtBetareWACC0.10.9AAA7.00%0.20.8AA7.20%0.30.7A8%0.40.6BBB9.60%0.50.5BB10.75%The company uses the CAPM to estimate its cost of common equity rs. The risk-free rate is 5% and the market risk premium is 6%. Black Keys estimates that if it had no debt its beta would be 1.1. (Its “unlevered beta ” bU equals 1.1.) The company’s tax rate T is 40%.On the basis of this information what is Black Keys’ optimal capital structure and what is the firm’s cost of capital at this optimal capital structure?we = 0.9; wd = 0.1; WACC = 11.01%we = 0.8; wd = 0.2; WACC = 10.96%we = 0.7; wd = 0.3; WACC = 10.75%we = 0.6; wd = 0.4; WACC = 10.15%we = 0.5; wd = 0.5; WACC = 10.18 points QUESTION 9Imagine a firm that follows the residual dividend policy very strictly. If its optimal capital budget requires the use of all earnings for a given year (along with new debt according to the optimal debt/total assets ratio) then the firm should payno dividends to common stockholders.dividends only out of funds raised by the sale of new common stock.dividends only out of funds raised by borrowing money (i.e. issue debt).dividends only out of funds raised by selling off fixed assets.no dividends except out of past retained earnings.10 points QUESTION 10Firms that operate in industries with high business risk also choose to finance more of their assets with debt thereby balancing business and financial risk. True False10 points QUESTION 11Your firm follows a strict residual dividend policy. All else equal which of the following factors would be most likely to lead to an increase in your firm’s dividend per share?The company reduces the percentage of equity in its target capital structure.The number of profitable potential projects increases.Congress lowers the tax rate on capital gains.Earnings are unchanged but the firm issues new shares of common stock.The firm’s net income decreases.10 points QUESTION 12You are analyzing your firm’s dividend policy. Your firm has a capital budget of $650 000 and you want to maintain a target capital structure of 60% debt and 40% equity. The company forecasts a net income of $500 000. If you follow the residual dividend policy what is your firm’s forecasted dividend payout ratio?40.00B.75E.00G.37H.00 points QUESTION 13When evaluating a new project firms should include in the projected cash flows all of the following EXCEPT:Previous expenditures associated with a market test to determine the feasibility of the project provided those costs have been expensed for tax purposes.The value of a building owned by the firm that will be used for this project.A decline in the sales of an existing product provided that decline is directly attributable to this project.The salvage value of assets used for the project that will be recovered at the end of the project’s life.Changes in net working capital attributable to the project.10 points QUESTION 14Kasper Film Co. is selling off some old equipment it no longer needs because its associated project has come to an end. The equipment originally cost $22 500 of which 80% has been depreciated. The firm can sell the used equipment today for $7 500 and its tax rate is 35%. What is the equipment’s after-tax salvage value for use in a capital budgeting analysis? Note that if the equipment’s final market value is less than its book value the firm will receive a tax credit as a result of the sale.$5 558$5 850$6 143$6 450$6 77210 points QUESTION 15Worst Plumbers Inc. wants to maintain a target capital structure with 33% debt and 67% equity. Its forecasted net income is $500 000. If the firm follows the residual dividend policy what is the maximum capital budget that is consistent with maintaining the target capital structure? Note that it is the maximum capital budget the company can fund through debt and internal equity without giving any dividends this year or issuing new equity.$673 652$709 107$746 269$789 720$825 00010 points QUESTION 16Slow Watch Company has a levered beta of 1.10 its capital structure consists of 44% debt and 56% equity and its tax rate is 40%. What would Slow Watch’s beta be if it used no debt i.e. what is its unlevered beta?0.640.670.710.750.7910 points QUESTION 17The main difference between MM II (Modigliani Miller Model with Corporate Taxes) and Miller Model with Corporate and Personal Taxes is:MM II concludes that a capital structure with 100% debt is optimal but the Miller Model states that a capital structure with 100% equity is optimal.MM II concludes that a capital structure with 100% equity is optimal but the Miller Model states that a capital structure with 100% debt is optimal.Both conclude that a levered firm’s value will be higher than an unlevered’s firm but the size of that advantage is bigger in MM II’s model.Both conclude that a levered firm’s value will be higher than an unlevered’s firm but the size of that advantage is smaller in MM II’s model.There is no difference between these two models they both conclude that capital structure is irrelevant but they base their conclusion on different arguments.10 points QUESTION 18Which of the following factors should be included in the cash flows used to estimate a project’s NPV?Tax payment on profits made from selling equipment at the end of the project.Cannibalization effects on competitors’ products in development stage.Tax savings from interest payments.Expenditures that will be incurred for future follow-up product development.Costs incurred on beta version of the product launched last year.10 points QUESTION 19Loud Music Inc recently completed a 3-for-1 stock split. Prior to the split its stock sold for $120 per share. What was the stock price following the split?$20.00$480.00$30.00$120.00$40.0010 points QUESTION 20In theory stock dividends (when shares are given as dividends instead of cash) and stock splits should have the same effect on shareholders’ wealth. True False10 points QUESTION 21If Miller and Modigliani had incorporated the costs of bankruptcy into their model (MM II) it is unlikely that they would have concluded that 100% debt financing is optimal. True False10 points QUESTION 22As a result of many phases of trial and error two methods for producing playing cards have been identified by the Modest Mouse Company. One method involves using a machine having a fixed cost of $10 000 and variable costs of $1.00 per deck of cards. The other method would use a less expensive machine (fixed cost = $2 000) but it would require greater variable costs ($1.40 per deck of cards). If the selling price per deck of cards will be the same under each method at what level of output will the two methods produce the same net operating income (EBIT)?5 000 decks10 000 decks15 000 decks20 000 decks25 000 decks10 points QUESTION 23Which of the following statements is correct?If a company has an established clientele of investors who prefer a high dividend payout and if management wants to keep stockholders happy it should follow the strict residual dividend policy.If a firm follows a strict residual dividend policy then holding all else constant its dividend payout ratio will tend to rise whenever the firm’s investment opportunities decline.If Congress eliminates taxes on capital gains but leaves the personal tax rate on dividends unchanged this would motivate companies to increase their dividend payout ratios.Despite its drawbacks following the residual dividend policy will tend to stabilize actual cash dividends and this will make it easier for firms to attract a clientele that prefers high dividends such as retirees.One advantage of dividend reinvestment plans is that they enable investors to avoid paying taxes on the dividends they receive.10 points QUESTION 24Which of the following is NOT associated with (or does not contribute to) business risk? Recall that business risk is affected by a firm’s operations.Sales price variability.The extent to which operating costs are fixed.The effect of exchange rate changes on its foreign sales.Raw material cost variability.Increase in its interest cost.10 points QUESTION 25Which of the following items should a company report directly in its monthly cash budget?Cash proceeds from selling one of its divisions.Accrued interest on zero coupon bonds that it issued.New shares issued in a stock split.New shares issued in a stock dividend.Its monthly depreciation expense.
