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1. Which of the following statements is CORRECT?

a. The component cost of preferred stock is expressed as rp(1 T). This follows because preferred stock dividends are treated as fixed charges, and as such they can be deducted by the issuer for tax purposes.

b. A cost should be assigned to retained earnings due to the opportunity cost principle, which refers to the fact that the firm’s stockholders would themselves expect to earn a return on earnings that were distributed rather than retained and reinvested.

c. No cost should be assigned to retained earnings because the firm does not have to pay anything to raise them. They are generated as cash flows by operating assets that were raised in the past; hence, they are “free.”

d. Suppose a firm has been losing money and thus is not paying taxes, and this situation is expected to persist into the foreseeable future. In this case, the firm’s before-tax and after-tax costs of debt for purposes of calculating the WACC will both be equal to the interest rate on the firm’s currently outstanding debt, provided that debt was issued during the past 5 years.

e. If a firm has enough retained earnings to fund its capital budget for the coming year, then there is no need to estimate either a cost of equity or a WACC.

2. Which of the following statements is CORRECT?

a. Although some methods used to estimate the cost of equity are subject to severe limitations, the CAPM is a simple, straightforward, and reliable model that consistently produces accurate cost of equity estimates. In particular, academics and corporate finance people generally agree that its key inputsbeta, the risk-free rate, and the market risk premiumcan be estimated with little error.

b. The DCF model is generally preferred by academics and financial executives over other models for estimating the cost of equity. This is because of the DCF model’s logical appeal and also because accurate estimates for its key inputs, the dividend yield and the growth rate, are easy to obtain.

c. The bond-yield-plus-risk-premium approach to estimating the cost of equity may not always be accurate, but it has the advantage that its two key inputs, the firm’s own cost of debt and its risk premium, can be found by using standardized and objective procedures.

d. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision makers confidence in the estimated cost of equity.

e. The DCF model is preferred by academics and finance practitioners over other cost of capital models because it correctly recognizes that the expected return on a stock consists of a dividend yield plus an expected capital gains yield.

3. Eakins Inc.’s common stock currently sells for $45.00 per share, the company expects to earn $2.75 per share during the current year, its expected payout ratio is 70%, and its expected constant growth rate is 6.00%. New stock can be sold to the public at the current price, but a flotation cost of 8% would be incurred. By how much would the cost of new stock exceed the cost of common from retained earnings?

a. 0.09%

b. 0.19%

c. 0.37%

d. 0.56%

e. 0.84%

4. An increase in the firms WACC will decrease projects NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.

a. True

b. False

5. Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

a. If the WACC is 10%, both projects will have positive NPVs.

b. If the WACC is 6%, Project S will have the higher NPV.

c. If the WACC is 13%, Project S will have the lower NPV.

d. If the WACC is 10%, both projects will have a negative NPV.

e. Project S’s NPV is more sensitive to changes in WACC than Project Ls.

6. Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one cash outflow at t = 0 followed by a series of positive cash flows.

a. A project’s MIRR is always greater than its regular IRR.

b. A project’s MIRR is always less than its regular IRR.

c. If a project’s IRR is greater than its WACC, then its MIRR will be greater than the IRR.

d. To find a project’s MIRR, we compound cash inflows at the regular IRR and then find the discount rate that causes the PV of the terminal value to equal the initial cost.

e. To find a project’s MIRR, the textbook procedure compounds cash inflows at the WACC and then finds the discount rate that causes the PV of the terminal value to equal the initial cost.

7. Projects S and L both have normal cash flows, and the projects have the same risk, hence both are evaluated with the same WACC, 10%. However, S has a higher IRR than L. Which of the following statements is CORRECT?

a. Project S must have a higher NPV than Project L.

b. If Project S has a positive NPV, Project L must also have a positive NPV.

c. If the WACC falls, each project’s IRR will increase.

d. If the WACC increases, each project’s IRR will decrease.

e. If Projects S and L have the same NPV at the current WACC, 10%, then Project L, the one with the lower IRR, would have a higher NPV if the WACC used to evaluate the projects declined

8. Which of the following statements is CORRECT?

a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase.

c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

e. Identifying an externality can never lead to an increase in the calculated NPV.

9. A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

a. In calculating the project’s operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.

b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.

c. When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.

d. Capital budgeting decisions should be based on before-tax cash flows.

e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.

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