NET PRESENT VALUE AND OTHER INVESTMENT RULES

Chapter Quiz
(See related pages)

1
The dollar value a project adds to a firm can be computed using which one of the
following analytical methods?
A) Payback
B) Profitability index
C) Net present value
D) Internal rate of return
E) Average accounting return

2
Eastern Express is considering a project with an initial investment of $218,400.
Clyde, the general manager, estimates the project will generate additional revenues
of $76,200 a year for the next 4 years. How much value will this project add to the
firm if the required rate of return is 15.4 percent?
A) -$2,599.18
B) $1,406.19
C) $9,008.74
D) $23,406.08
E) $38,117.13

3
You need to borrow $2,500 quickly and Slimey Joe, the neighborhood loan shark,
will give it to you if you promise to repay him $300 a month for the next year.
Suppose that Joe's cost of funds is 2 percent per month. From Joe's point of view,
what is the net present value of this deal?
A) $429.18
B) $487.08
C) $542.16
D) $672.60
E) $708.34

4
What is the net present value of the following set of cash flows if the required
return is 12.3 percent?

Yr0 = -$244,900; Yr1 = $16,300; Yr2 = $102,900; Yr3 = $141,700; and Yr4 =
$137,500
A) -$21,407.18
B) -$2,619.03
C) $22,407.01
D) $37,715.07
E) $54,116.23
5
California Squeaker is considering creating a new website at a cost of $526,000.
The website will provide the latest news and gossip from around the state for an
annual fee per subscriber of $8.95 a year. The company expects to collect fees
totaling $44,750 in year 1, $89,500 in year 2, and $304,300 per year for years 3
through 5. After year 5, the company believes the website will be worthless due to
technological advancements. What is the potential value to the firm from this
project given a 16 percent discount rate?
A) $62,406.91
B) $86,986.17
C) $102,008.49
D) $121,603.13
E) $146,900.03

6
Would you accept a project which is expected to pay $8,600 a year for 7 years if
the initial investment is $39,800 and your required return is 13.65 percent? Why or
why not?
A) No; The NPV is -$2,523.
B) No; The NPV is -$989.
C) No; The NPV is -$413.
D) Yes; The NPV is $3,011.
E) Yes; The NPV is $3,336.

7
Which of the following are strengths of the NPV method of analysis?
I. The consideration of every cash flow related to a project.
II. The analysis is based on cash flows.
III. The profits and losses expected over the life of a project are considered.
IV. Time value of money is considered.
A) I and II only
B) II and IV only
C) I, III, and IV only
D) II, III, and IV only
E) I, II, and IV only

8
Which of the following statements are correct?
I. The NPV of a project will increase if the required discount rate is decreased.
II. A financial manager acts in the shareholders' best interests by identifying and
implementing positive NPV projects.
III. The discount rate used in the NPV computation is the opportunity cost of the
project.
IV. A project with an NPV equal to zero is earning a return exactly equal to its
required return.
A) I and II only
B) II and III only
 C) II, III, and IV only
D) I, II, and IV only
E) I, II, III, and IV

9
You are considering a project that costs $156,700 and has expected cash flows of
$31,000, $58,300, and $113,600 per year over the next three years, respectively.
What is the net present value of the project if the appropriate discount rate is 14.7
percent?
A) -$10,077.43
B) -$7,251.43
C) $4,616.08
D) $13,909.18
E) $14,141.41

10
Net present value:
A) is equal to the initial investment in a project.
B) is a dollar comparison of a project's cost to the present value of the project's
benefits.
C) is equal to zero when the discount rate applied is less than the internal rate of
return (IRR).
D) is simplified by the fact that the discount rate applicable to an individual
project is easy to determine.
E) requires a firm to set an arbitrary cutoff point in time for determining whether
or not a project should be accepted.
 MAKING CAPITAL INVESTMENT DECISIONS
Chapter Quiz
(See related pages)

1
The manager of Home Food Sales is trying to decide whether or not the firm
should repair one of its delivery trucks. The chief mechanic has stated that "It
would be a waste of money not to repair it because we just spent $2,200 on repairs
last month." What is the major problem with this argument?
A) It ignores the opportunity cost of the money that has been spent.
B) It includes sunk costs in the decision.
C) It includes opportunity costs in the decision.
D) It includes changes in net working capital.
E) It includes financing costs in the decision.

2
It is important to identify and use only incremental cash flows in capital investment
decisions:
A) because they are simple to identify.
B) only when allocated costs are present.
C) because ultimately it is the change in a firm's overall future cash flows that
matter.
D) in order to accommodate unforeseen changes that might occur.
E) whenever sunk costs are involved.

3
Incremental cash flows should include the:
I. sunk costs.
II. opportunity costs.
III. erosion effects.
IV. effects of synergy.
A) I and II only
B) I, III, and IV only
C) II and III only
D) II, III, and IV only
E) I, II, III, and IV

4
Boyd and Sons purchased 14.5 acres of industrial property 2 years ago at a cost of
$1.1 million. Since that time, the firm has spent $220,000 on land improvements
such that the current market value of the land is estimated at $1.45 million. The
operations manager has been assigned the task of analyzing the construction of a
new manufacturing plant located on that site. This manager has developed cost
estimates for the building and its contents of $24.6 million along with $1.1 million
for additional land improvements and site preparation. Based on this information,
the financial manager should estimate the initial cash flow for the plant project as
_____ million.
 A) $25.70
B) $25.92
C) $26.05
D) $27.02
E) $27.15

5
A.B. Cooper purchased a piece of land 3 years ago for $124,000 and subsequently
added $68,000 in improvements. There are two options for future use of the land:
1) the land can be sold today for $213,000 aftertax; or 2) your company can
destroy the past improvements and build a factory on the land. When evaluating
the factory option, what amount, if any, should be included for the use of the land?
A) $0
B) $124,000
C) $145,000
D) $192,000
E) $213,000

6
Which one of the following is least likely to cause erosion?
A) A gas station owner expands his building to make room for a convenience
store.
B) You begin selling coffee in single-serving foil pouches along side your
regular-sized cans.
C) You build a Taco Heaven just down the street from the Chili Dog Haven you
own.
D) Your grocery store begins to carry additional flavors of ice cream.
E) The concession stand at the local ball field begins to sell both hot dogs and
hamburgers, rather than just hot dogs.

7
Over the past five years, your company scientists spent $3.6 million developing a
new engine additive which they recently began marketing. Today, those same
scientists have proven that the additive can also be used as a cleaning fluid if
additional chemicals are added to the mixture. As the financial manager of the
firm, you are being assigned the task of determining whether or not the cleaning
fluid should be produced and sold. For your analysis, the original $3.6 million
R&D costs should be treated as:
A) a cash outflow at time T = -5.
B) an annual operating cost of $.72 million for each of the next 5 years.
C) an annual cash outflow of $.72 million for each of the past 5 years.
D) an opportunity cost and included as a cash outflow at time T = 0.
E) a sunk cost, and therefore excluded from the analysis.

8
Your company currently manufactures the "Priced Right" line of golf clubs. The
board of directors wants you to look at replacing that line with a new "Straight Hit"
line of clubs. Which one of the following should NOT be included in your analysis
of the proposed "Straight Hit" project?
 A) $400,000 drop in sales from terminating the "Priced Right" line of clubs
B) $150,000 market value of land currently owned by the firm that will be used
for the project
C) $200,000 already spent on research and development to create the new line of
clubs
D) $350,000 you will pay to Fred Frimstone to promote your new clubs
E) $125,000 you expect to receive from selling the equipment used to produce
the "Priced Right" clubs

9
Brett is deciding whether or not to drop one of the college courses in which he is
currently enrolled. If he drops the course, he will forfeit half of the money spent on
tuition. However, by dropping the course, he can increase the number of hours he
works each week. Which of the following statements is accurate based on Brett's
situation?
I. Remaining in the class incurs an opportunity cost equal to Brett's foregone
wages.
II. The tuition is irrelevant to the decision because it is a sunk cost.
III. The time and energy put into the course thus far is a sunk cost.
A) I only
B) I and II only
C) I and III only
D) II and III only
E) I, II, and III

10
When evaluating a capital budgeting project, you ignore all cash flows of the firm
except those that change when a project is implemented. The cash flows you are
trying to isolate are referred to as:
A) capital expenditures.
B) operating cash flows.
C) incremental cash flows.
D) allocated costs.
E) opportunity costs.
 Risk, Cost of Capital, and Valuation
Chapter Quiz
(See related pages)

1
The appropriate discount rate to be used when analyzing an investment project is
the:
A) rate of return that will result in an NPV of zero.
B) firm's current cost of capital.
C) project's internal rate of return.
D) rate of return financial markets offer on investments of similar risk.
E) rate of interest the firm receives on its excess cash investments.

2
The cost of equity capital for an all-equity firm:
I. depends on the use of the funds, not the source.
II. can be applied only to company project's whose risk level is comparable to that
of the existing firm.
III. will vary directly with the risk-free rate of return assuming that the market risk
premium is constant.
IV. is dependent upon both the firm's beta and the market risk premium.
A) I, II, and III only
B) I, II, and IV only
C) II, III, and IV only
D) I, III, and IV only
E) I, II, III, and IV

3
The common stock of The Holiday Express sells for $46.50. The firm's beta is 1.6,
the risk-free rate is 3.8 percent, and the market risk premium is 8.2 percent. What
is the cost of equity for The Holiday Express?
A) 10.84 percent
B) 12.39 percent
C) 16.92 percent
D) 18.47 percent
E) 13.08 percent

4
Which one of the following formulas correctly describes the cost of equity capital?
A) RS = RM - ß × (RF – RM)
B) RS = RM + ß × (RF – RM)
C) RS = RF - ß × (RM – RF)
D) RS = RF + ß × (RF – RM)
E) RS = RF + ß × (RM - RF)
5
All else constant, which of the following will always decrease a firm's cost of
equity as computed using the capital asset pricing model? Assume beta is positive
and greater than 1.
I. A decrease in the risk-free rate of return
II. A decrease in a firm's level of systematic risk
III. A decrease in the market risk premium
IV. A decrease in the market rate of return
A) I and IV only
B) II and III only
C) I, II, and III only
D) II, III, and IV only
E) I, II, III, and IV

6
U.S. Treasury bills are currently yielding 4.15 percent and the market rate of return
is 13.28 percent. Glasgo Glass has a beta of 1.18. The firm is considering
expanding its current operations. This expansion will not affect the risk level of the
firm. What is the required rate of return on the expansion project if both the firm
and the project are totally financed with equity capital?
A) 19.82 percent
B) 14.92 percent
C) 15.67 percent
D) 16.84 percent
E) 15.39 percent

7
The Carpenter's Hut is considering an all-equity project that is equally as risky as
the firm. The project has an internal rate of return of 14.89 percent. The company
has a beta of 1.34, the risk-free rate is 4.33 percent, and the market risk premium is
8.71 percent. This project _____ be accepted because the cost of equity capital is
_____ percent.
A) should; 10.20
B) should; 14.85
C) should; 16.00
D) should not; 10.20
E) should not; 16.00

8
An all-equity firm should accept any independent all-equity project which has:
A) risk similar to the current operations of the firm.
B) less risk than the firm's current operations.
C) an internal rate of return that is less than the cost of equity capital.
D) an internal rate of return that is greater than the cost of equity capital.
E) a rate of return which exceeds the risk-free rate.

9
The beta of security i is equal to the _____ divided by the:
 A) covariance of the security with the market; variance of the market.
B) covariance of the security with the market; beta of the market.
C) standard deviation of the security; variance of the market.
D) variance of the security; variance of the market.
E) covariance of the security with the market; standard deviation of the market.

10
A firm has a cost of equity of 12.4 percent, a cost of preferred stock of 10.8
percent, and a pre-tax cost of debt of 8.2 percent. The firm is financed with 40
percent common stock, 10 percent preferred stock, and the balance with debt. What
is the firm's weighted average cost of capital if its tax rate is 35 percent?
A) 8.71 percent
B) 6.59 percent
C) 15.86 percent
D) 9.34 percent
E) 8.39 percent

Chapter 16 Capital Structure

1
Katie is the CFO of Baxter International. If she has the best interests of the firm's
shareholders in mind, she will maintain the capital structure for the firm which:
A) minimizes the market value of the firm's debt.
B) maximizes the market value of the firm.
C) minimizes the book value of the firm's debt.
D) maximizes the market value of the firm's debt.
E) maximizes the book value of the firm's debt.

2
The president of Cyber Tech wants to restructure the firm for the shareholders
benefit. The shareholders will benefit from the restructuring only if the:
A) debt level of the firm is reduced.
B) changes increase the firm's annual sales.
C) changes increase the overall value of the firm.
D) firm's debt is completely eliminated.
E) changes increase the contribution margin on all products sold.

3
The Midnite Express is an all-equity trucking firm which has 1,200 shares of stock
outstanding. The stock is valued at $24 a share. The financial manager has decided
to borrow $4,000 to fund a one-time dividend distribution of $4,000. It is expected
that this action will increase the value of the firm by $800. The value of the firm's
equity after the dividend has been paid will be _____ and the payoff to the
shareholders' from the restructuring will be _____.
 A) $20,500; $1,750
B) $22,500; $0
C) $22,500; $950
D) $25,600; $800
E) $25,600; $3,200

4
The president of Capital Unlimited is analyzing two capital structures to determine
which structure is best for the firm at this time. The first structure consists of
25,000 shares of stock valued at $36 each. The second structure consists of 12,500
shares of stock valued at $36 each plus $450,000 of debt. The interest rate on the
debt is 8 percent and the expected earnings before interest are $88,000. Assume
there are no taxes. The firm should select the _____ structure because the break-
even earnings before interest are _____.
A) all equity; $16,000
B) all equity; $72,000
C) debt and equity; $16,000
D) debt and equity; $72,000
E) debt and equity; $88,000

5
Ziegler Transportation currently has 40,000 shares of stock outstanding. The firm
is considering borrowing $800,000 and using the funds to repurchase 15,000 shares
of stock. The interest rate on the debt is 8.75 percent and there are no taxes. What
is the break-even level of earnings before interest between these two capital
structures?
A) $128,282
B) $141,414
C) $158,400
D) $166,667
E) $186,667

6
Taylor's Men's Wear is comparing a debt and equity capital structure to an all-
equity capital structure. The debt and equity structure consists of 2,400 shares of
stock plus $25,000 of debt at an interest rate of 8 percent. How many shares of
stock comprise the all-equity option if the break-even level of earnings before
interest between these two options is $11,600? Assume there are no taxes.
A) 2,900 shares
B) 3,150 shares
C) 3,333 shares
D) 3,650 shares
E) 3,800 shares

7
Suppose you draw a graph with earnings before interest on the horizontal axis and
earnings per share on the vertical axis. Which one of the following statements is
true if you compare a levered firm versus an unlevered firm using this graph?
 Assume there are no taxes.
A) The levered firm has a lower vertical intercept than the unlevered firm and the
slope of their functions are equal.
B) The levered firm has a lower vertical intercept and a steeper slope than does
the unlevered firm.
C) The levered firm has a higher vertical intercept and a flatter slope than does
the unlevered firm.
D) The unlevered firm has a higher vertical intercept than the levered firm and
the slope of their functions are equal.
E) The unlevered firm has a lower vertical intercept and a steeper slope than does
the levered firm.

8
Which of the following statements regarding leverage are correct?
I. The ultimate effect of leverage depends on a firm's level of earnings before
interest.
II. The risk to the shareholders increases as the amount of leverage employed by a
firm increases.
III. Firms with minimal earnings are generally better off being all-equity firms.
IV. The disadvantages of debt increase as the earnings before interest increase.
A) I and III only
B) II and IV only
C) II, III, and IV only
D) I, II, and III only
E) I, II, III, and IV

9
Marley Industries has $950,000 of perpetual debt with an interest rate of 7.5
percent. What is the present value of the tax shield if the firm's tax rate is 34
percent?
A) $323,000
B) $24,225
C) $71,250
D) $347,225
E) $95,475

10
Braxton Corp. has a weighted average cost of capital of 10.2 percent and a tax rate
of 34 percent. The firm has sales of $986,000, debt of $482,000, and earnings
before interest and taxes of $128,500. What is the value of the levered firm?
A) $3,286,667
B) $831,471
C) $1,259,804
D) $349,470
E) $1,313,470