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Capital Budgeting

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1) Simpson corporation is considering a proposed expansion to its facilities. Which of the following statements is most correct?

a. In calculating the project's operating cash flows, the firm should not subtract out financing costs such as interest expense, since these costs are already included in the WACC, which is used to discount the project?s net cash flows.

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

c. When estimating the project?s operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flows from externalities since they are accounted for elsewhere.

d. Statements a and c are correct.

e. None of the statements above is correct

2) Which of the following statements is correct?

a. Well-diversified stockholders do not consider corporate risk when determining required rates of return.

b. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.

c. Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.

d. Market risk is important but does not have a direct effect on stock price because it only affects beta.

e. All of the statements above are correct.

3) Simpson corporation is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

a. Increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.

c. Reject the asset, since its acceptance would increase the firm?s risk.

d. Ignore the risk differential, if the asset to be accepted would comprise only a small fraction of the firm?s total assets.

e. Increase the cost of capital used to evaluate the project to reflect the project?s higher risk.

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Solution Preview

1. a is correct since financing costs as included in the discounting rate
b. is not correct since depreciation is needed for depreciation tax shield
c. is not correct as sunk costs should not be included
Answer is a.

2. a is not correct as ...

Solution Summary

The solution explains various multiple choice questions relating to capital budgeting

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See Also This Related BrainMass Solution

Cost of Capital, Capital Budgeting, Capital Structure, Forecasting, and Working Capital Management

Please see attachment use word or excel but please show how you got the answer.

Question 1: (Cost of Capital)

You are provided the following information on a company. The total market value is $38 million. The company's capital structure, shown here, is considered to be optimal.
(see attached file for data)

a. What is the after-tax cost of debt? (assume the company's effective tax rate = 40%)
b. Assuming a $4 dividend paid annually, what is the required return for preferred shareholders (i.e. component cost of preferred stock)? (assume floatation costs = $0.00)
c. Assuming the risk-free rate is 1%, the expected return on the stock market is 7%, and the company's beta is 1.0, what is the required return for common stockholders (i.e., component cost of common stock)?
d. What is the company's weighted average cost of capital (WACC)?

Question 2: (Capital Budgeting)

It's time to decide how to use the money your firm is expected to make this year. Two investment opportunities are available, with net cash flows as follows:
(See attached file for data)

a. Calculate each project's Net Present Value (NPV), assuming your firm's weighted average cost of capital (WACC) is 7%
b. Calculate each project's Internal rate of Return (IRR).
c. Plot NPV profiles for both projects on a graph).
d. Assuming that your firm's WACC is 7%:
(1) If the projects are independent which one(s) should be accepted?
(2) If the projects are mutually exclusive which one(s) should be accepted?

Question 3: (Capital Structure)

Aaron Athletics is trying to determine its optimal capital structure. The company's capital structure consists of debt and common stock. In order to estimate the cost of debt, the company has produced the following table:
(See attached file for data)

The company's tax rate, T, is 40 percent. The company uses the CAPM to estimate its cost of common equity, Rs. The risk-free rate is 1 percent and the market risk premium is 6 percent. Aaron estimates that if it had no debt its beta would be 1.0. (i.e., its "unlevered beta," bU, equals 1.0.)

On the basis of this information, what is the company's optimal capital structure, and what is the firm's cost of capital at this optimal capital structure?

Question 4: (Forecasting)

A firm has the following balance sheet:
(See attached file for data)

Sales for the year just ended were $6,000, and fixed assets were used at 80 percent of capacity. Current assets and accounts payable vary directly with sales. Sales are expected to grow by 20 percent next year, the expected net profit margin is 5 percent, and the dividend payout ratio is 80 percent.

How much additional funds (AFN) will be needed next year, if any?

Question 5: Working Capital Management

The Chickman Corporation has an inventory conversion period of 60 days, a receivables collection period of 30 days, and a payables deferral period of 30 days. Its annual credit sales are $6,000,000, and its annual cost of goods sold (COGS) is 60% of sales.

a. What is the length of the firm's cash conversion cycle?
b. What is the firm's investment in accounts receivable?
c. What is the company's inventory turnover ratio?
d. Identify three ways in which the company could reduce its cash conversion cycle?
e. What are the possible risks of reducing the cash conversion cycle per your recommendations in part d?

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