Midterm Makeup for Week 6 – Taken in Week 8
Name: __Iago Oliveira _________________ Date: _________________________
1. 1) In order to create value, a corporation must earn a rate of return on its invested capital
that is higher than the market’s required rate of return on that invested capital.
2. 4) The cost of debt increases relative to the investor’s required return due to flotation
costs, but decreases relative to the investor’s required return due to the tax deductibility of
3. 3) The cost of debt capital is obtained by substituting the net proceeds per bond for the
bond price in the bond valuation equation and solving for the required return.
4. 4) The cost of preferred stock is equal to the preferred stock dividend divided by the net
proceeds per preferred share.
5. 7) The Capital Asset Pricing Model may be used to estimate the cost of retained earnings.
6. 10) The after-tax cost of equity equals one minus the marginal tax rate times the required
rate of return on common stock.
7. 11) If preferred stock pays a $5 annual dividend and sells for $50, the cost of preferred
stock financing is 10% since dividends are not tax deductible and preferred stock is sold
without flotation costs.
8. 14) The required return of a preferred stockholder, rps, is higher than the cost of preferred
stock for the corporation because stockholders must pay federal taxes on their dividend
9. 15) A security with a reasonably stable price will have a lower required rate of return
than a security with an unstable price.
10. 17) A short-term T-bill’s rate of return should be used in the CAPM formula to determine
the cost of equity capital regardless of the length of the project under consideration.
11. 19) The cost of debt measures the cost of a bank loan, while the cost of preferred stock is
used as a proxy for the cost of a new bond issue.
12. 2) A corporation may lower its cost of capital by shifting a portion of its total financing
from a higher cost source of capital, such as common equity, to a lower cost source of
capital, such as debt.
13. 5) The average cost of capital is the appropriate rate to use when evaluating new
investments, even though the new investments may be in a higher risk class.
14. 7) The mixture of financing sources used by a firm will vary from year to year, so many
firms use target capital structure proportions when calculating the firm’s weighted
average cost of capital.
15. 11) A firm’s weighted average cost of capital is a function of (1) the individual costs of
capital, (2) the capital structure mix, and (3) the level of financing necessary to make the
16. 3) The firm’s overall cost of capital is important when evaluating the firm’s value, but it
should not be used to evaluate individual projects which have their own unique
17. 2) Advantages of the payback period include that it is easy to calculate, easy to
understand, and that it is based on cash flows rather than on accounting profits.
18. 3) If project A generates a total of $10 million of free cash flow over its five year useful
life and project B generates $8 million of free cash flow over its five year useful life, then
Project A will have a shorter payback period than Project B, assuming both projects
require the same initial investment.
19. 4) A project with a payback period of four years is acceptable as long as the company’s
target payback period is greater than or equal to four years.
20. 7) If a project is acceptable using the net present value criteria, then it will also be
acceptable under the less stringent criteria of the payback period.
21. 8) An acceptable project should have a net present value greater than or equal to zero and
a profitability index greater than or equal to one.
22. 9) If a project’s internal rate of return is greater than the project’s required return, then the
project’s profitability index will be greater than one.
23. 12) One drawback of the payback method is that some cash flows may be ignored.
24. 13) The required rate of return reflects the costs of funds needed to finance a project.
25. 16) Whenever the internal rate of return on a project equals that project’s required rate of
return, the net present value equals zero.
AACSB: Analytical Thinking
26. 19) When several sign reversals in the cash flow stream occur, a project can have more
than one IRR.
27. 21) NPV is the most theoretically correct capital budgeting decision tool examined in the
28. 21) NPV is the most theoretically correct capital budgeting decision tool examined in the
29. 3) Positive NPV projects may be rejected when capital must be rationed.
30. 3) The mutually exclusive project with the highest positive NPV will also have the
31. 6) An infinite-life replacement chain allows projects of different lengths to be compared.
32. 1) Accounting profits are used to make capital budgeting decisions because generally
accepted accounting principles ensure that profits are the best measure of a company’s
33. 6) Sunk costs are cash outflows that will occur regardless of the current accept/reject
decision, and therefore should be excluded from the analysis.
34. 9) To be included in a capital budgeting analysis, all incremental free cash flows must be
expensed on the company’s books, otherwise generally accepted accounting principles
will be violated.
35. 3) If an old asset is sold for its depreciated, or book, value, then no taxes result and there
is no tax effect from the sale.
36. 4) One example of a terminal cash flow is the recapture of the net working capital
associated with the project.
37. 8) If the increase in net working capital is recovered entirely at the end of the project,
then it may be ignored.
38. 13) Terminal cash flows are always positive because they result from the shutting down
of a project with the sale of any assets with remaining value.
39. 17) Depreciation expense produces a cash inflow equal to the depreciation expense
multiplied by the firm’s marginal tax rate.
40. 21) In general, a project’s free cash flows will fall into one of three categories: (1)
incremental costs, (2) sunk costs, and (3) opportunity costs.
41. 22) The initial outlay includes the cost of purchasing the asset and getting it operational,
including the purchase price, shipping and installation, and any training costs for
employees who will be operating the equipment, and any increases in working capital
42. 23) The initial outlay includes the cost of purchasing the asset and getting is operational,
but this excludes any training costs for employees which should be included as part of
differential cash flows over the life of the project.
43. 1) Three of the most common options that can add value to a capital budgeting project are
the option to delay the project, the option to expand the project, and the option to
abandon the project.
44. 3) According to the CAPM, systematic risk is the only relevant risk for capital budgeting
45. 6) The most relevant measure of risk for capital budgeting is project standing alone risk.
46. 9) The risk-adjusted discount rate method implicitly assumes that distant cash flows have
the same risk as near cash flows.
47. 3) The three major components responsible for variation in a company’s income stream
are business risk, operating risk, and financial risk.
48. 3) Break-even analysis is a short-term concept because, in the long run, all costs are
49. 9) If sales double, the break-even model assumes that total variable costs will double.
50. 10) The break-even model assumes that selling price per unit and variable cost per unit of
output are constant over the relevant range of output.
51. 15) Depreciation is considered a fixed cost.
52. 18) Break-even analysis assumes that a multiproduct firm maintains a constant
production and sales mix.
53. 2) A company that sells common stock and uses the money to pay off a loan is increasing
its use of financial leverage.
54. 3) A company that sells preferred stock and uses the money to pay off a loan is
decreasing its amount of financial leverage.
55. 7) Operating leverage contributes ultimately to the variability of a firm’s earnings per
56. 3) The optimal capital structure occurs when operating leverage equals financial leverage.
57. 6) According to the moderate view of capital structure theory, the cost of common equity
is constant regardless of the debt financing level.
58. 7) The objective of capital structure management is to maximize the market value of the
firm’s common stock.
59. 13) Financial structure is another term for capital structure.
60. 18) A saucer-shaped or U-shaped weighted average cost of capital curve results from the
tax deductibility of interest, which results in the downward slope, followed by the
recognition of potential financial distress costs, that cause the upward slope as the amount
of debt ratio increases.
61. 3) Because there are no fixed financing costs, a common stock plan line in an EBIT-EPS
analysis chart will have a less-steep slope than will a bond plan line.
62. 4) One danger of EBIT-EPS analysis is that it ignores the implicit cost of debt financing.