2. Bloom and Co. has no debt or preferred stockit uses only equity capital, and has two equally- sized divisions. Division X's cost of capital is 10.0%, Division Y's cost is 14.0%, and the corporate (composite) WACC is 12.0%. All of Division X's projects are equally risky, as are all of Division Y's projects. However, the projects of Division X are less risky than those of Division Y. Which of the following projects should the firm accept?
a. A Division Y project with a 12% return.
b. A Division X project with an 11% return.
c. A Division X project with a 9% return.
d. A Division Y project with an 11% return.
e. A Division Y project with a 13% return.
b. A Division X project with an 11% return.
Reason: The 11% return is higher than the Division X's cost of capital ...
The solution explains the projects that can be accepted and rejected.
12 questions on Capital Budgeting, Capital Structure, WACC
1. Billick Brothers is estimating its WACC. The company has collected the following information:
? Its capital structure consists of 40 percent debt and 60 percent common equity.
? The company has 20-year bonds outstanding with a 9 percent annual coupon that are trading at par.
? The company's tax rate is 40 percent.
? The risk-free rate is 5.5 percent.
? The market risk premium is 5 percent.
? The stock's beta is 1.4.
What is the company's WACC?
2. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial manager is evaluating a project with an expected return of 21 percent, before any risk adjustment. The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent. The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk. Which of the following statements is most correct?
A. The project should be accepted since its expected return (before risk adjustment) is greater than its required return.
B. The project should be rejected since its expected return (before risk adjustment) is less than its required return.
C. The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm's policy were to reduce a riskier-than-average project's expected return by 1 percentage point, then the project should be accepted.
D. Riskier-than-average projects should have their expected returns increased to reflect their added riskiness. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
E. Projects should be evaluated on the basis of their total risk alone. Thus, there is insufficient information in the problem to make an accept/reject decision.
3. Heller Airlines is considering two mutually exclusive projects, A and B. The projects have the same risk. Below are the cash flows from each project:
Project A Project B
Year Cash Flow Cash Flow
0 -$2,000 -$1,500
1 700 300
2 700 500
3 1,000 800
4 1,000 1,100
At what cost of capital would the two projects have the same NPV?
4. Tyrell Corporation is considering a project with the following cash flows (in millions of dollars):
Year Cash Flow
The project has a simple payback period of exactly two years. The project's cost of capital is 12 percent. What is the project's modified internal rate of return (MIRR)?
5. Oak Furnishings is considering a project that has an up-front cost and a series of positive cash flows. The project's estimated cash flows are summarized below:
Year Cash Flow
1 $500 million
2 300 million
3 400 million
4 600 million
The project has a payback of 2.25 years. What is the project's internal rate of return (IRR)?
6. Calculate the incremental operating cash flow for year 2 for a new proposed project given the following information:
Machine cost: $ 90000; Installation & delivery: $ 10000; Depreciation expense in year 2: $ 44,500; Tax rate: 40 %; New revenues: $ 145,000 per year; Old revenues: $ 90,000 per year
a. $ 104,800
b. $ 60,300
c. $ 50,800
d. $ 6,300
e. $ 145,000
7. St. John's Paper is considering purchasing equipment today that has a depreciable cost of $1 million. The equipment will be depreciated on a MACRS 5-year basis, which implies the following depreciation schedule:
8. Which of the following statements is most correct?
a. Underlying the MIRR is the assumption that cash flows can be reinvested at the firm's cost of capital
b. Underlying the IRR is the assumption that cash flows can be reinvested at the firm's cost of capital
c. Underlying the NPV is the assumption that cash flows can be reinvested at the firm's cost of capital
d. The discounted payback method always leads to the same accept/reject decisions as the NPV method
e. Statements a and c are correct.
9. Maple Media is considering a proposal to enter a new line of business. In reviewing the proposal, the company's CFO is considering the following facts:
? The new business will require the company to purchase additional fixed assets that will cost $600,000 at t = 0. For tax and accounting purposes, these costs will be depreciated on a straight-line basis over three years. (Annual depreciation will be $200,000 per year at t = 1, 2, and 3.)
? At the end of three years, the company will get out of the business and will sell the fixed assets at a salvage value of $100,000.
? The project will require a $50,000 increase in net operating working capital at t = 0, which will be recovered at t = 3.
? The company's marginal tax rate is 35 percent.
? The new business is expected to generate $2 million in sales each year (at t = 1, 2, and 3). The operating costs excluding deprecia-tion are expected to be $1.4 million per year.
? The project's cost of capital is 12 percent.
What is the project's net present value (NPV)?
B. $ 86,885
C. $ 81,243
D. $ 56,331
10. Klott Company encounters significant uncertainty with its sales volume and price in its primary product. The firm uses scenario analysis in order to determine an expected NPV, which it then uses in its budget. The base-case, best-case, and worst-case scenarios and probabilities are provided in the table below. What is Klott's expected NPV, standard deviation of NPV, and coefficient of variation of NPV?
Probability Unit Sales Sales NPV
of Outcome Volume Price (In Thousands)
Worst case 0.30 6,000 $3,600 -$6,000
Base case 0.50 10,000 4,200 +13,000
Best case 0.20 13,000 4,400 +28,000
A. Expected NPV = $35,000; óNPV = 17,500; CVNPV = 2.00
B. Expected NPV = $35,000; óNPV = 11,667; CVNPV = 0.33
C. Expected NPV = $10,300; óNPV = 12,083; CVNPV = 1.17
D. Expected NPV = $13,900; óNPV = 8,476; CVNPV = 0.61
E. Expected NPV = $10,300; óNPV = 13,900; CVNPV = 1.35
11. A company estimates that an average-risk project has a WACC of 10 percent, a below-average risk project has a WACC of 8 percent, and an above-average risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?
A. Project A has average risk and an IRR = 9 percent.
B. Project B has below-average risk and an IRR = 8.5 percent.
C. Project C has above-average risk and an IRR = 11 percent.
D. All of the projects above should be accepted.
E. None of the projects above should be accepted
12. The costs of a stock-out do not include
a. Disruption of production schedules
b. Loss of customer goodwill
c. Depreciation and obsolescence
d. Loss of Sales
e. Answers c and d above.
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