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“Name: __________________________________Multiple ChoiceIdentify the choice that best completes the statement or answers the question.____ 1. Which one of the following statements is most CORRECT?a. Very few projects actually have real options. They are theoretically interesting but of little practical importance. b. Real options change the risk, but not the size, of projects’ expected NPVs. c. Real options are more valuable when there is very little uncertainty about the true values of future sales and costs. d. Real options change the size, but not the risk, of projects’ expected NPVs. e. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows. ____ 2. Lindley Corp. is considering a new product that would require an investment of $10 million now, at t = 0. If the new product is well received, then the project would produce after-tax cash flows of $5 million at the end of each of the next 3 years (t = 1, 2, 3), but if the market does not like the product, then the cash flows would be only $2 million per year. There is a 50% probability that the market will be good. The firm could delay the project for a year while it conducts a test to determine if demand is likely to be strong or weak. The project’s cost and expected annual cash flows would be the same whether the project is delayed or not. The project’s WACC is 13.0%. What is the value (in thousands) of the project after considering the investment timing option?a. $839 b. $799 c. $703 d. $655 e. $607 ____ 3. Carlson Inc. is evaluating a project in India that would require a $6.2 million investment today (t = 0). The after-tax cash flows would depend on whether India imposes a new property tax. There is a 50-50 chance that the tax will pass, in which case the project will produce after-tax cash flows of $1,350,000 at the end of each of the next 5 years. If the tax doesn’t pass, the after-tax cash flows will be $2,000,000 for 5 years. The project has a WACC of 12.9%. The firm would have the option to abandon the project 1 year from now, and if it is abandoned, the firm would receive the expected $1.35 million cash flow at t = 1 and would also sell the property for $4.75 million at t = 1. If the project is abandoned, the company would receive no further cash inflows from it. What is the difference (in thousands) in the NPVs of this project with and without the abandonment option?a. $270 b. $322 c. $302 d. $379 e. $399 Norris Production Company (NPC) is considering a project that has an up-front cost at t = 0 of $2,500. (All dollars in this problem are in thousands.) The project’s subsequent cash flows are critically dependent on whether a competitor’s product is approved by the Food and Drug Administration. If the FDA rejects the competitive product, NPC’s product will have high sales and cash flows, but if the competitive product is approved, that will negatively impact NPC. There is a 75% chance that the competitive product will be rejected, in which case NPC’s expected cash flows will be $750 at the end of each of the next seven years (t = 1 to 7). There is a 25% chance that the competitor’s product will be approved, in which case the expected cash flows will be only $50 at the end of each of the next seven years (t = 1 to 7). NPC will know for sure one year from today whether the competitor’s product has been approved.NPC is considering whether to make the investment today or to wait a year to find out about the FDA’s decision. If it waits a year, the project’s up-front cost at t = 1 will remain at $2,500, the subsequent cash flows will remain at $750 per year if the competitor’s product is rejected and $50 per year if the alternative product is approved. However, if NPC decides to wait, the subsequent cash flows will be received only for six years (t = 2 … 7). In addition, once NPC knows the outcome of the FDA’s decision, it will not take on the project if its NPV is negative.____ 4. This is a risky project, so a WACC of 16.0% is to be used. If NPC chooses to wait a year before proceeding, how much will this increase or decrease the project’s expected NPV in today’s dollars? (Hint: Find the NPV for “go now” and for “wait,” then discount the wait-NPV back for one year since it will occur one year later, and then find the difference between the two NPVs.)a. $435.28 b. $351.71 c. $302.96 d. $348.22 e. $282.06 ____ 5. Which of the following statements best describes the optimal capital structure?a. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s earnings per share (EPS). b. The optimal capital structure is the mix of debt, equity, and preferred stock that maximizes the company’s stock price. c. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of equity. d. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of debt. e. The optimal capital structure is the mix of debt, equity, and preferred stock that minimizes the company’s cost of preferred stock. ____ 6. Which of the following events is likely to encourage a company to raise its target debt ratio, other things held constant?a. An increase in the corporate tax rate. b. An increase in the personal tax rate. c. An increase in the company’s operating leverage. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company’s stock price hits a new high. ____ 7. Which of the following would tend to increase a firm’s target debt ratio, other things held constant?a. The costs associated with filing for bankruptcy increase. b. The corporate tax rate is increased. c. The personal tax rate is increased. d. The Federal Reserve tightens interest rates in an effort to fight inflation. e. The company’s stock price hits a new low. ____ 8. Your firm is currently 100% equity financed. The CFO is considering a recapitalization plan under which the firm would issue long-term debt with a yield of 9% and use the proceeds to repurchase some of its common stock. The recapitalization would not change the company’s total assets, nor would it affect the firm’s basic earning power, which is 15%. The CFO believes that this recapitalization would reduce the firm’s WACC and increase its stock price. Which of the following would be likely to occur if the company goes ahead with the recapitalization plan?a. The company’s net income would increase. b. The company’s earnings per share would decline. c. The company’s cost of equity would increase. d. The company’s ROA would increase. e. The company’s ROE would decline. ____ 9. Your firm has $500 million of total assets, its basic earning power is 15%, and it currently has no debt in its capital structure. The CFO is contemplating a recapitalization where it would issue debt at a cost of 10% and use the proceeds to buy back some of its common stock, paying book value. If the company goes ahead with the recapitalization, its operating income, total assets, and tax rate would remain unchanged. Which of the following is most likely to occur as a result of the recapitalization?a. The ROA would increase. b. The ROA would remain unchanged. c. The basic earning power ratio would decline. d. The basic earning power ratio would increase. e. The ROE would increase. ____ 10. Companies HD and LD have the same total assets, operating income (EBIT), tax rate, and business risk. Company HD, however, has a much higher debt ratio than LD. Also, both companies’ basic earning power (BEP) ratios exceed their cost of debt (r). Which of the following statements is CORRECT?a. HD should have a higher return on assets (ROA) than LD. b. HD should have a higher times interest earned (TIE) ratio than LD. c. HD should have a higher return on equity (ROE) than LD, but its risk, as measured by the standard deviation of ROE, should also be higher than LD’s. d. Given that BEP > r, HD’s stock price must exceed that of LD. e. Given that BEP > r, LD’s stock price must exceed that of HD. ____ 11. Other things held constant, which of the following events would be most likely to encourage a firm to increase the amount of debt in its capital structure?a. Its sales are projected to become less stable in the future. b. The bankruptcy laws are changed in a way that would make bankruptcy more costly to the firm and its stockholders. c. Management believes that the firm’s stock is currently overvalued. d. The firm decides to automate its factory with specialized equipment and thus increase its use of operating leverage. e. The corporate tax rate is increased. ____ 12. Which of the following statements is CORRECT?a. A firm can use retained earnings without paying a flotation cost. Therefore, while the cost of retained earnings is not zero, its cost is generally lower than the after-tax cost of debt. b. The capital structure that minimizes a firm’s weighted average cost of capital is also the capital structure that maximizes its stock price. c. The capital structure that minimizes the firm’s weighted average cost of capital is also the capital structure that maximizes its earnings per share. d. If a firm finds that the cost of debt is less than the cost of equity, increasing its debt ratio must reduce its WACC. e. Other things held constant, if corporate tax rates declined, then the Modigliani-Miller tax-adjusted theory would suggest that firms should increase their use of debt. ____ 13. Which of the following statements is CORRECT?a. The capital structure that maximizes the stock price is also the capital structure that minimizes the cost of equity from retained earnings (r). b. The capital structure that maximizes the stock price is also the capital structure that maximizes earnings per share. c. The capital structure that maximizes the stock price is also the capital structure that maximizes the firm’s times interest earned (TIE) ratio. d. If a company increases its debt ratio, this will typically increase the marginal costs of both debt and equity, but it still may reduce the company’s WACC. e. If Congress were to pass legislation that increases the personal tax rate but decreases the corporate tax rate, this would encourage companies to increase their debt ratios. ____ 14. Which of the following statements is CORRECT?a. When a company increases its debt ratio, the costs of equity and debt both increase. Therefore, the WACC must also increase. b. The capital structure that maximizes the stock price is generally the capital structure that also maximizes earnings per share. c. All else equal, an increase in the corporate tax rate would tend to encourage companies to increase their debt ratios. d. Since debt financing raises the firm’s financial risk, increasing a company’s debt ratio will always increase its WACC. e. Since the cost of debt is generally fixed, increasing the debt ratio tends to stabilize net income. ____ 15. You work for the CEO of a new company that plans to manufacture and sell a new product, a watch that has an embedded TV set and a magnifying glass crystal. The issue now is how to finance the company, with only equity or with a mix of debt and equity. Expected operating income is $240,000. Other data for the firm are shown below. How much higher or lower will the firm’s expected ROE be if it uses some debt rather than all equity, i.e., what is ROE – ROE?0% Debt, U 60% Debt, L Oper. income (EBIT) $240,000 $240,000 Required investment $2,500,000 $2,500,000 % Debt 0.0% 60.0% $ of Debt $0.00 $1,500,000 $ of Common equity $2,500,000 $1,000,000 Interest rate NA 10.00% Tax rate 35% 35% a. Ã¢â‚¬â€œ0.44% b. Ã¢â‚¬â€œ0.45% c. Ã¢â‚¬â€œ0.39% d. Ã¢â‚¬â€œ0.37% e. Ã¢â‚¬â€œ0.34% ____ 16. El Capitan Foods has a capital structure of 40% debt and 60% equity, its tax rate is 35%, and its beta (leveraged) is 1.15. Based on the Hamada equation, what would the firm’s beta be if it used no debt, i.e., what is its unlevered beta?a. 0.94 b. 0.80 c. 1.00 d. 0.87 e. 0.78 ____ 17. Firms HD and LD are identical except for their use of debt and the interest rates they pay–HD has more debt and thus must pay a higher interest rate. Based on the data given below, how much higher or lower will HD’s ROE be versus that of LD, i.e., what is ROE – ROE?Applicable to Both Firms Firm HD’s Data Firm LD’s Data Assets $3,000,000 Debt ratio 70% Debt ratio 20% EBIT $620,000 Int. rate 12% Int. rate 10% Tax rate 35% a. 10.73% b. 11.41% c. 13.35% d. 11.07% e. 9.93% ____ 18. Your firm’s debt ratio is only 5.00%, but the new CFO thinks that more debt should be employed. She wants to sell bonds and use the proceeds to buy back and retire some stock, which sells at its book value. Other things held constant, and based on the data below, if the firm increases its debt ratio to 60.0%, by how much would the ROE change, i.e., what is ROE – ROE?Operating Data Other Data Assets $150,000 New debt ratio 60% EBIT/Assets = BEP 13.00% Old debt ratio 5% Tax rate 35% New interest rate 12% Old interest rate 10% a. 0.98% b. 0.87% c. 0.75% d. 0.92% e. 0.72% ____ 19. You have been hired by a new firm that is just being started. The CFO wants to finance with 60% debt, but the president thinks it would be better to hold the debt ratio to only 10%. Other things held constant, and based on the data below, if the firm uses the higher debt ratio, by how much would the ROE change, i.e., what is ROE – ROE?Operating Data Other Data Assets $4,000 Higher debt ratio 60% EBIT/Assets = BEP 27.00% Lower debt ratio 10% Tax rate 35% Higher interest rate 13% Lower interest rate 9% a. 11.24% b. 14.45% c. 11.98% d. 12.35% e. 10.37% ____ 20. Dyson Inc. currently finances with 20.0% debt, but its new CFO is considering changing the capital structure to 70.0% debt by issuing additional bonds and using the proceeds to repurchase and retire some common stock at book value. Given the data shown below, by how much would this recapitalization change the firm’s cost of equity? (Hint: You must unlever the current beta and then use the unlevered beta to solve the problem.)Risk-free rate, rRF 5.00% Tax rate, T 40% Market risk prem, RPM 6.00% Current debt ratio 20% Current beta, bL1 1.15 Target debt ratio 70% a. 7.35% b. 6.45% c. 7.50% d. 8.93% e. 8.85%
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