# Multiple choice

3. The McCue Company has equal amounts of low-risk, average-risk, and high-risk projects. McCue estimates that its overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower risk projects and a higher rate for higher risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?

A. The company will take on too many high-risk projects and reject too many low-risk projects.

B. The company will take on too many low-risk projects and reject too many high-risk projects.

C. Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.

D. The company's overall WACC should decrease over time because its stock price should be increasing.

E. The CEO's recommendation would maximize the firm's intrinsic value.

4. Which of the following statements is CORRECT?

a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

b. When calculating the cost of preferred stock, companies must adjust for taxes, because dividends paid on preferred stock are deductible by the paying corporation.

c. Because of tax effects, an increase in the risk-free rate will have a greater effect on the after-tax cost of debt than on the cost of common stock.

d. If a company's beta increases, this will increase the cost of equity used to calculate the WACC, but only if the company does not have enough retained earnings to take care of its equity financing and hence needs to issue new stock.

e. Higher flotation costs reduce investor returns, and that leads to a reduction in a company's WACC.

6. Which of the following statements is CORRECT?

a. The discounted cash flow method of estimating the cost of equity cannot be used unless the growth rate, g, is expected to be constant forever.

b. If the calculated beta underestimates the firm's true investment risk, i.e., if the forward-looking beta that investors think exists exceeds the historical beta, then the CAPM method based on the historical beta will produce an estimate of rs and thus WACC that is too high.

c. Beta measures market risk, which is the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.

d. An advantage shared by both the DCF and CAPM methods when they are used to estimate the cost of equity is that little or no judgment is required.

e. The specific risk premium used in the CAPM is the same as the risk premium used in the bond-yield-plus-risk-premium approach.

7. Which of the following statements is CORRECT? Assume that the firm is a publicly-owned corporation and is seeking to maximize shareholder wealth.

a. If a firm has a beta that is less than 1.0, say 0.9, this would suggest that the expected returns on its assets are negatively correlated with the returns on most other firms' assets.

b. If a firm's managers want to maximize the value of the stock, they should, in theory, concentrate on project risk as measured by the standard deviation of the project's expected future cash flows.

c. If a firm evaluates all projects using the same cost of capital, and the CAPM is used to help determine that cost, then its risk as measured by beta will probably decline over time.

d. Projects with above-average risk typically have higher than average expected returns. Therefore, to maximize a firm's intrinsic value, its managers should favor high-beta projects over those with lower betas.

e. Project A has a standard deviation of expected returns of 20%, while Project B's standard deviation is only 10%. A's returns are negatively correlated with both the firm's other assets and the returns on most stocks in the economy, while B's returns are positively correlated. Therefore, Project A is less risky to a firm and should be evaluated with a lower cost of capital.

10. Which of the following statements is CORRECT?

a. One defect of the IRR method is that it does not take account of cash flows over a project's full life.

b. One defect of the IRR method is that it does not take account of the time value of money.

c. One defect of the IRR method is that it does not take account of the cost of capital.

d. One defect of the IRR method is that it values a dollar received today the same as a dollar that will not be received until some time in the future.

e. One defect of the IRR method is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.

13. Which of the following statements is CORRECT?

a. The internal rate of return method (IRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

b. The payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

c. The discounted payback method is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

d. The net present value method (NPV) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

e. The modified internal rate of return method (MIRR) is generally regarded by academics as being the best single method for evaluating capital budgeting projects.

14. Which of the following statements is CORRECT?

a. An NPV profile graph shows how a project's payback varies as the cost of capital changes.

b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.

c. An NPV profile graph is designed to give decision makers an idea about how a project's risk varies with its life.

d. An NPV profile graph is designed to give decision makers an idea about how a project's contribution to the firm's value varies with the cost of capital.

e. We cannot draw a project's NPV profile unless we know the appropriate WACC for use in evaluating the project's NPV.

15. Which of the following statements is CORRECT?

a. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project's profitability.

b. If the cost of capital declines, this lowers a project's NPV.

c. The NPV method is regarded by most academics as being the best indicator of a project's profitability, hence most academics recommend that firms use only this one method.

d. A project's NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project's life.

e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

17. Which of the following statements is CORRECT?

a. The MIRR and NPV decision criteria can never conflict.

b. The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.

c. One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on what is generally a more reasonable assumption about the reinvestment rate than the regular IRR.

d. The higher the WACC, the shorter the discounted payback period.

e. The MIRR method assumes that cash flows are reinvested at the crossover rate.

18. Which of the following statements is CORRECT?

a. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

b. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.

c. The NPV and IRR methods both assume cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.

d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.

e. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

#### Solution Preview

3. A. The company will take on too many high-risk projects and reject too many low-risk projects.

High risk projects which should be evaluated using a higher rate are evaluated using the lower average rate while low risk projects which should be evaluated using a lower rate are evaluated using a higher average rate

4. a. When calculating the cost of debt, a company needs to adjust for taxes, because interest payments are deductible by the paying corporation.

Since interest is tax deductible, the actual cost is the after tax cost

6. c. Beta measures market risk, which is the most relevant risk measure for a publicly-owned firm that seeks to maximize its intrinsic value. This is true even if not all of the firm's stockholders are well diversified.

Beta is a measure of market risk which is most relevant for stocks

7. e. Project A has ...

#### Solution Summary

The solution explains some multiple choice questions in corporate finance