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# Solving Various Capital Budgeting Problems

____ 11. Which of the following statements is CORRECT?
a. The WACC is calculated using before-tax costs for all components.
b. The after-tax cost of debt usually exceeds the after-tax cost of equity.
c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
d. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
e. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.

____ 12. A company's perpetual preferred stock currently sells for \$92.50 per share, and it pays an \$8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?
a. 7.81%
b. 8.22%
c. 8.65%
d. 9.10%
e. 9.56%

____ 13. Rivoli Inc. hired you as a consultant to help estimate its cost of common equity. You have been provided with the following data: D0 = \$0.80; P0 = \$22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from retained earnings?
a. 10.69%
b. 11.25%
c. 11.84%
d. 12.43%
e. 13.05%

____ 14. 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 sometime 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.

____ 15. Taggart Inc. is considering a project that has the following cash flow data. What is the project's payback?

Year 0 1 2 3
Cash flows ï?­\$1,150 \$500 \$500 \$500

a. 1.86 years
b. 2.07 years
c. 2.30 years
d. 2.53 years
e. 2.78 years

____ 16. Ingram Electric Products is considering a project that has the following cash flow and WACC data. What is the project's MIRR? Note that a project's MIRR can be less than the WACC (and even negative), in which case it will be rejected.

WACC: 11.00%
Year 0 1 2 3
Cash flows ï?­\$800 \$350 \$350 \$350

a. 8.86%
b. 9.84%
c. 10.94%
d. 12.15%
e. 13.50%

____ 17. Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
a. Project A, which has average risk and an IRR = 9%.
b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects' NPVs we cannot determine which project(s) should be accepted.
e. All of these projects should be accepted.

____ 18. Which of the following factors should be included in the cash flows used to estimate a project's NPV?
a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any working capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the project's projected cash flows.
e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

____ 19. Which of the following statements is CORRECT?
a. If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.
b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.
c. It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life.
d. If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.
e. Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis.

____ 20. You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues, each year \$62,500
Depreciation \$ 8,000
Other operating costs \$25,000
Interest expense \$ 8,000
Tax rate 35.0%

a. \$25,816
b. \$27,175
c. \$28,534
d. \$29,960
e. \$31,458

#### Solution Preview

Need assistance with problems 11-20
____ 11. Which of the following statements is CORRECT?
a. The WACC is calculated using before-tax costs for all components.
b. The after-tax cost of debt usually exceeds the after-tax cost of equity.
c. For a given firm, the after-tax cost of debt is always more expensive than the after-tax cost of non-convertible preferred stock.
d. Retained earnings that were generated in the past and are reported on the firm's balance sheet are available to finance the firm's capital budget during the coming year.
e. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
e. The WACC that should be used in capital budgeting is the firm's marginal, after-tax cost of capital.
(Yes it's the marginal cost of the funds)

____ 12. A company's perpetual preferred stock currently sells for \$92.50 per share, and it pays an \$8.00 annual dividend. If the company were to sell a new preferred issue, it would incur a flotation cost of 5.00% of the issue price. What is the firm's cost of preferred stock?
a. 7.81%
b. 8.22%
c. 8.65%
d. 9.10%
e. 9.56%

Cost= Annual Dividend/(Share price*(1-flotationcost))
=8/(92.5*(1-5%))
=9.10%

Hence d is the answer

____ 13. Rivoli Inc. hired you as a consultant to help estimate its cost of common equity. You have been provided with the following data: D0 = \$0.80; P0 = \$22.50; and g = 8.00% (constant). Based on the DCF approach, what is the cost of common from retained earnings?
a. 10.69%
b. 11.25%
c. 11.84%
d. 12.43%
e. 13.05%

Cost= D1/P0 +g
=0.8*(1+8%)/22.5+8%
=11.25%
Hence b is the answer

____ 14. Which of the following statements is CORRECT?
a. One defect of ...

#### Solution Summary

The following problem helps with various capital budgeting problems.

\$2.19