#### Final Finance Test 4

Chapter 10

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T/F One problem with Monte Carlo simulation analysis is that while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.?

True
The Monte Carlo simulation method provides with various outcomes that are possible for changes in the variables that affect the net present values (NPV). But, it does not provide any clear-cut accept versus reject decision.

Which of the following statements concerning cash flow evaluation in capital budgeting is correct??

?Any change in depreciation expense must be computed as it affects the cash flow of a project.
The change in depreciation expense must be computed because when depreciation changes, taxable income changes, and so does the amount of income taxes paid; the

Which of the following statements is true regarding a replacement decision??

The benefits resulting from the new investment is treated as an inflow.

Zinc Corp is planning to purchase new machinery. The initial cash outlay is expected to be $40,000 and the expected return on investment is 9%. The cash flows for the next 3 years are$9,800, $11,720 and$9,640. Based on net present value (NPV) analysis,

reject the project as the NPV is $(13,700.84). Zinc Corp. should reject the project as the project has a negative NPV. NPV can be calculated using a financial calculator. Enter CF0 = -40,000; CF1 = 9,800; CF2 = 11,720; CF3= 9,640; I = 9; CPT NPV; NPV =$(

Tech Engineering Company is considering the purchase of a new machine to replace an existing one. The current market value of the old machine is $14,000 and its book value is$5,000. The new machine's cost is $30,000. If the tax rate is 40%, the initial i ?$24,600
Initial investment outlay = Cost of new asset - Net cash flow from sale of old asset; Net cash flow from the sale of the old (replaced) asset = Selling price (market value) - Book value - Tax = $14,000 -$5,000 - [($14,000 -$5,000) � 0.4] = $9,0 A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should:? ?increase the required rate of return from the project to reflect the higher risk of the project. The decision maker should increase the required rate of return used to evaluate the project to reflect the higher risk of the project. Most corporates use ri Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?? Pure play method Ziker Golf Company evaluated a project as a risky project. Ziker generally evaluates projects that are riskier than average by adjusting its required rate of return by 4 percent. If Ziker expects 12% return on average risk projects, then it should expect 16% Return from risky projects = Return from average-risk projects + Adjusting required rate of return = 12% + 4% = 16%. Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance company. The fire insurance company is expected to generate a return of 20 percent with a beta of 2.5. If the risk-free rate is 8 percent and th 23% Expected return (rproj) = Risk-free rate (rRF) + (Market return (rM) - Risk-free rate (rRF)) � Beta = 0.08 + (0.06) � 2.5 = 0.23 = 23%. The process of sending cash flows from a foreign subsidiary back to the parent company is known as _____.? ?repatriation of earnings The process of sending cash flows from a foreign subsidiary back to the parent company is known as repatriation of earnings. Repatriation of earnings adds complexities to the cash flow analysis and thus, affects the returns expec Chapter 11 ... T/F The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors. False The cost of external equity capital is similar to the cost of retained earnings except it is higher because the firm incurs flotation costs when it issues new common stock. T/F The firm's cost of capital represents the maximum rate of return that a firm can earn from its capital budgeting projects to ensure that the value of the firm increases. False The cost of capital is used in the capital budgeting process so that a firm makes correct accept/reject decisions and its level of financing is optimal. If it uses any other rate, its capital budget will not be optimal. As per the Bond-Yield-Plus-Risk-Premium Approach, analysts estimate the cost of common equity by adding a risk premium of 3 to 5 percentage points to:? the interest rate on the long term debt of the firm. Empirical work suggests that the cost of retained earnings, rs, can also be estimated by adding a risk premium of 3 to 5 percentage points to the before-tax interest rate on the firm's own long-term deb Which of the following statements is true of the impact of tax on the cost of capital of a firm?? ?All else being equal, an increase in the corporate tax rate results in a decrease in the weighted average cost of capital. The after-tax cost of debt, which represents the actual cost to the firm, is the before-tax interest rate (yield) on debt less the Diggin Tools just issued new preferred stock, which sold for$85 in the stock markets. Holders of the stock will receive an annual dividend equal to $9.35. The flotation costs associated with the new issue were 6 percent and Diggin's marginal tax rate is 11.70 percent Component cost of preferred stock = Preferred stock dividend / (Current market price of the preferred stock � (1 - Percentage cost of issue of preferred stock) =$9.35 / $85 � (1 - 6%) = 11.70 percent. Alpha Inc.'s beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Which of the following is Alpha's cost of retained earnings using the capital asset pricing model (CAPM) approach?? 16 percent Cost of retained earnings using CAPM approach = Risk-free rate + (Market return - Risk-free rate) � Beta coefficient = 10% + [(10% - 5%) � 1.2] = 10% + 6% = 16%. J. Ross and Sons Inc. has a target capital structure that calls for 40 percent debt, 10 percent preferred stock, and 50 percent common equity. Ross' common stock currently sells for$40 per share. The firm recently paid a dividend of $2 per share on its c ?15.50 percent Cost of retained earnings = (Dividend expected to be paid at the end of year 1 / Current market price of stock) + Growth rate = {[$2 � (1 + 10%)] / $40.00} + 10% = ($2.20 / $40) + 10% = 15.50%. The _____ of the bond is a cost to the firm for using investors' funds.? Yield to maturity (YTM) Which of the following statements is true of marginal cost of capital?? All else equal, an increase in the tax rate would decrease the marginal cost of debt capital.? The weighted average cost of capital is the sum of the after-tax cost of debt, the cost of preferred stock, and the cost of common equity. As the cost of debt c Alpha Inc. combines the marginal cost of capital (MCC) and the investment opportunity schedules (IOS) on a graph. Which of the following areas on the graph shows the maximum excess of returns over costs?? ?The area that is above the WACC but below the IOS. T/F The cost of issuing preferred stock by a corporation must be adjusted to an after-tax figure because of the 70 percent dividend exclusion provision for corporations holding other corporations' preferred stock. False T/F The correct discount rate for a firm to use in capital budgeting, assuming that new investments are as risky as the firm's existing assets, is its marginal cost of capital. True Bouchard Company's stock sells for$20 per share, its last dividend (D0) was $1.00, its growth rate is a constant 6 percent, and the company would incur a flotation cost of 20 percent if it sold new common stock. Which of the following is the cost of issu 12.63 percent Cost of new equity = (Expected dividend / Net price per share received) + Constant growth rate of the firm = {[($1.00 � (1 + 6%)] / $20 � (1 - 20%)} + 6% = [($1.06) / ($16)] + 6% = 12.63 percent Rollins Corporation is constructing its MCC schedule. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sel 7.2%. Since the bond sells at the par value of$1,000, its YTM and coupon rate (12%) are equal. Thus, the before-tax cost of debt to Rollins is 12.0%. The after-tax cost of debt equals: rdT = 12.0% � (1 ? 0.40) = 7.2%.

Tangerine Inc.'s target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for \$1,000. The firm's marginal tax rat

16 percent
Cost of retained earnings as per bond-yield-plus-risk-premium approach = Bond YTM + Risk premium = 12% + 4% = 16%.

The MCC schedule is either horizontal or rising, which implies that the cost of capital to a firm increases as it raises larger and larger amounts of capital. The rising section of the MCC schedule:?

?results from flotation costs associated with the sale of new common and preferred stock, along with higher debt costs, as the firm's rate of expansion increases.
a company raises larger and larger amounts of funds during a given time period, the costs of

The investment opportunity schedule (IOS) plotted on a graph shows:?

he amount of investment at different rates of return for a firm.