Chapter 9 & 11 Second Assignment

Corporate Finance
Prof. Hayam Wahba
TA. Aya Elmahdy
True or false

1. The cost of capital is the rate of return a firm must meet or exceed on investments
to increase the firm's value.

2. The cost of capital acts as a major link between a firm's long-term investment
decisions and the wealth of the firm's owners as determined by the market value of
their shares.

3. Incremental cash flows represent the additional cash flows expected as a direct
result of the proposed project.

4. The three major cash flow components include the initial investment, nonoperating
cash flows, and terminal cash flow.
5. Sunk costs are cash outlays that have already been made and therefore have no
effect on the cash flows relevant to the current decision.

6. All other factors held constant, the higher the tax rate that firms must pay, the more
valuable are depreciation deductions.

7. Recaptured depreciation is the portion of the sale price that is below the book value.

8. Capital gain is the portion of the sale price that is in excess of the initial purchase
price.

9. Use of the capital asset pricing model (CAPM) in measuring the cost of common
stock equity differs from the constant-growth valuation model in that it directly
considers the firm's risk as reflected by beta.

10. Weights that use accounting values to measure the proportion of each type of capital
in a firm's financial structure are called market value weights.

1
 Please choose the correct answer
11. In order to recognize the interrelationship between financing and investments, a firm
should use ________ when evaluating an investment.
A) the least costly source of financing
B) the most costly source of financing
C) the weighted average cost of all financing sources
D) the current opportunity cost
12. Generally the least expensive source of long-term capital is ________.
A) retained earnings
B) preferred stock
C) long-term debt
D) common stock
13. ) A tax adjustment must be made in determining the cost of ________.
A) long-term debt
B) common stock
C) preferred stock
D) retained earnings
14. If a corporation pays a tax rate of 21 percent, the after-tax cost of debt for a 10-year,
8 percent, $1,000 par value bond selling at $1,150 is ________.
A) 4.71 percent
B) 3.58 percent
C) 1.25 percent
D) 6.32 percent
15. What is the dividend on an 8 percent preferred stock that currently sells for $45 and
has a face value of $50 per share?
A) $3.33
B) $3.60
C) $4.00
D) $5.00

2
 16. A firm has a beta of 1.2. The market return equals 14 percent and the risk-free rate
of return equals 6 percent. The estimated cost of common stock equity is ________.
A) 6 percent
B) 7.2 percent
C) 14 percent
D) 15.6 percent

17. A firm has common stock with a market price of $25 per share and an expected
dividend of $2 per share at the end of the coming year. The growth rate in dividends
has been 5 percent. The cost of the firm's common stock equity is ________.
A) 5 percent
B) 8 percent
C) 10 percent
D) 13 percent
A firm has determined its cost of each source of capital and the percentage of each source
making up the firm's capital structure:

18. The weighted average cost of capital is ________.

A) 6 percent
B) 10.7 percent
C) 11 percent
D) 15 percent

19. Relevant cash flows for a project are best described as ________.
A) incidental cash flows
B) incremental cash flows
C) sunk cash flows
D) contingent cash flows

3
 20. When making replacement decisions, the development of relevant cash flows is
complicated when compared to expansion decisions, due to the need to calculate
________ cash inflows.
A) conventional
B) opportunity
C) incremental
D) sunk

21. In developing the cash flows for an expansion project, the analysis is the same as
the analysis for replacement projects where ________.
A) all cash flows from the old assets are equal
B) prior cash flows are irrelevant
C) all cash flows from the old asset are zero
D) cash inflows equal cash outflows

22. An important cash inflow in the analysis of initial cash flows for a replacement project
is ________.
A) taxes
B) the cost of the new asset
C) installation cost
D) the sale value of the old asset

23. A corporation is considering expanding operations to meet growing demand. With

the capital expansion, the current accounts are expected to change. Management
expects cash to increase by $20,000, accounts receivable by $40,000, and
inventories by $60,000. At the same time accounts payable will increase by $50,000,
accruals by $10,000, and long-term debt by $100,000. The change in net working
capital is ________.
A) an increase of $120,000
B) a decrease of $60,000
C) a decrease of $120,000
D) an increase of $60,000

24. A corporation has decided to replace an existing asset with a newer model. Two
years ago, the existing asset originally cost $30,000 and was being depreciated
under MACRS using a five-year recovery period. The existing asset can be sold for
$25,000. The new asset will cost $75,000 and will also be depreciated under
MACRS using a five-year recovery period. If the assumed tax rate is 40 percent on
ordinary income and capital gains, the initial investment is ________.
A) $42,000
B) $52,440
C) $54,240
D) $50,000

4
 25. This year a certain investment project generated revenue of $200,000. Other
expenses (excluding depreciation and interest expense) totaled $100,000.
Depreciation expense was $50,000 and interest expense was $10,000. The firm
faces a tax rate of 21%. What is the project's after-tax operating cash flow this year?
A) $89,500
B) $81,600
C) $129,000
D) $79,000

26. A corporation is evaluating the relevant cash flows for a capital budgeting decision
and must estimate the terminal cash flow. The proposed machine will be disposed
of at the end of its usable life of five years at an estimated sale price of $15,000. The
machine has an original purchase price of $80,000, installation cost of $20,000, and
will be depreciated under the five-year MACRS. Net working capital is expected to
decline by $5,000. The firm has a 40 percent tax rate on ordinary income and long-
term capital gain. The terminal cash flow is ________.
A) $24,000
B) $16,000
C) $14,000
D) $26,000

Answer the following questions from 27 -33

A firm has determined its optimal capital structure which is composed of the following
sources and target market value proportions.
Table 9.1

Debt: The firm can sell a 12-year, $1,000 par value, 7 percent bond for $960. A flotation
cost of
2 percent of the face value would be required in addition to the discount of $40.
Preferred Stock: The firm has determined it can issue preferred stock at $75 per share
par value. The stock will pay a $10 annual dividend. The cost of issuing and selling the
stock is $3 per share.
Common Stock: A firm's common stock is currently selling for $18 per share. The dividend
expected to be paid at the end of the coming year is $1.74. Its dividend payments have
been growing at a constant rate for the last four years. Four years ago, the dividend was
$1.50. It is expected that to sell, a new common stock issue must be underpriced $1 per
share in floatation costs. Additionally, the firm's marginal tax rate is 40 percent.

5
 27. The firm's before-tax cost of debt is ________. (See Table 9.1)
A) 7.8 percent
B) 10.6 percent
C) 11.2 percent
D) 12.7 percent

28. The firm's after-tax cost of debt is ________. (See Table 9.1)
A) 3.25 percent
B) 4.67 percent
C) 8 percent
D) 8.13 percent

29. The firm's cost of preferred stock is ________. (See Table 9.1)
A) 7.2 percent
B) 8.3 percent
C) 13.3 percent
D) 13.9 percent

30. The firm's cost of a new issue of common stock is ________. (See Table 9.1)
A) 7 percent
B) 9.08 percent
C) 14.2 percent
D) 13.4 percent

31. The firm's cost of retained earnings is ________. (See Table 9.1)
A) 10.2 percent
B) 13.9 percent
C) 12.7 percent
D) 13.6 percent

32. The weighted average cost of capital up to the point when retained earnings are
exhausted is ________. (See Table 9.1)
A) 7.5 percent
B) 8.65 percent
C) 10.4 percent
D) 11.9 percent

33. If the target market proportion of long-term debt is reduced to 15 percent – increasing
the proportion of common stock equity to 75 percent, what will be the revised
weighted average cost of capital? (See Table 9.1)
A) 13.6 percent
B) 11.0 percent
C) 12.34 percent
D) 10.4 percent

6
Answer the following question from 34 -40
Cuda Marine Engines, Inc. must develop the relevant cash flows for a replacement capital
investment proposal. The proposed asset costs $50,000 and has installation costs of
$3,000. The asset will be depreciated using a five-year recovery schedule. The existing
equipment, which originally cost $25,000 and will be sold for $10,000, has been
depreciated using an MACRS five-year recovery schedule and three years of depreciation
has already been taken. The new equipment is expected to result in incremental before-
tax net profits of $15,000 per year. The firm has a 40 percent tax rate.

34. The cash flow pattern for the capital investment proposal is ________.
A) a mixed stream and conventional
B) a mixed stream and nonconventional
C) a perpetuity and conventional
D) an annuity and nonconventional

35. The book value of the existing asset is ________.

A) $7,250
B) $15,000
C) $21,250
D) $25,000

36. The tax effect on the sale of the existing asset results in ________.
A) $800 tax benefit
B) $1,000 tax liability
C) $1,100 tax liability
D) $6,000 tax liability

37. The initial outlay equals ________.

A) $41,100
B) $44,100
C) $38,800
D) $38,960

38. The incremental depreciation expense for year 1 is ________.

A) $2,250
B) $7,600
C) $7,000
D) $7,950

39. The incremental depreciation expense for year 5 is ________.

A) $2,250
B) $5,110
C) $7,950
D) $6,360

7
 40. The annual incremental after-tax cash flow from operations for year 1 is ________.
A) $13,950
B) $16,600
C) $25,600
D) $30,000