Macroeconomics exam: business finance, taxes, GPC | BMGT 340, Study notes of Corporate Finance

Download Macroeconomics exam: business finance, taxes, GPC | BMGT 340 and more Study notes Corporate Finance in PDF only on Docsity! Exam 3 Review — BMGT 340 Chapter 9 Problems 1. Which of the following could be true concerning the costs of debt and equity? a, The cost of debt for Firm A is greater than the cost of equity for Firm A b. The cost of debt for Firm A is greater than the cost of equity for Firm B. b. c. The cost of retained earnings for Firm A is less than the cost of debi for Firm A. d. The cost of retained earnings for Firm A is more than its cost of new outside equity. . 2. Which of the following statements is true? a. If Congress raised the corporate tax rate, this would lower the effective cost of debt. ‘ b. IfCongress raised the personal income tax rate, investors would demand more corporate debi financing, and companies’ debt ratios would increase. c. The calculation for a firm’s WACC includes an adjustment to the cost of debt for OO. taxes, since interest is deductible, and includes the cost of ail current liabilities. d. Since the money is readily available, the cost of retained earnings is usually a lot cheaper than the cost of debt financing ‘ Roland Corp.’s next expected dividend (Dj) is $2.50, The firm has maintained a constant payout ratio of 50% during the past 7 years. Seven years ago its EPS was $1.50. The firm’s beta is 1.2. The required return on an average stock in the market is 13%, and the tisk free rate is 7%. Roland’s A rated bonds are yielding 10% and its current stock price on is $30. Which of the following values is the most reasonable estimate of Roland’s cost of common stock? a, 10% b. 12% c. 14% d. 20% e. 26% we 4. The director of capital budgeting for See-Saw Inc., manufacturers of playground equipment, is considering a plan to expand production facilities in order to meet an increase in demand. He estimates that this expansion will produce a rate of return of 11%. The firm’s target capital structure calls for a debt/equity ratio of 0.8. See-Saw currenily has a bond issue outstanding thai will mature in 25 years and has a 7% annual coupon rate. The bonds currently are selling for $804. The firm has maintained a constant growth rate of 6%, See-Saw’s next expected dividend is $2 (D)) and its current stock price is $40. Its tax rate is 40%. Should it undertake the expansion? (Assume that there is no preferred stock outstanding and that any new debt will have a 25-year maturity.) No, the expected return is 2.5 percentage points lower than the cost of capital. c No; the expected return is 1 percentage point lower than the cost of capital. Yes; the expected return is 0.5 percentage points higher than the cost of capital. Yes; the expected return is | percentage point higher than the cost of capital. Yes; the expected return is 2.5 percentage points higher than the cost of capital pao oe 5, Gator Products Co. (GPC) is at its optimal capital structure of 70% common equity and 30% debt. GPC’s WACC is 14%. GPC has a marginal tax rate of 40%. Next year’s dividend is expected to be $2 per share, and GPC has a constant growth in earnings and dividends of 6%. The after-tax cost of common stock used in the WACC is based on new outside equity with a flotation cost of 10%, while the before-tax cost of debt is 12%. What is GPC’s current equilibrium stock price? a $12.73 b. $17.23 ¢, $20.37 do $23.79 2, $37.20 Sun Products Company (SPC) uses only debt and equity. It can borrow unlimited amounts at an interest rate of 12% so long as it finances at its target capital structure, which calls for 48% de 55% common equity. Its last dividend was $2.40, its expected constant growth tate is 5% and its stock sells for $24. SPC’s tax rate is 40%. Four projects are available: Pioject A has a cost of $240 million aud a aie of return of 13%, Project B has a cusi of $125 million and a rate of retum of 12%; Project C has a cost of $200 million and a rate of return of 11%, and Project D has a cost of $150 million and a rate of return of 10%, All of the company’s potential projects are independent and equally risky, 6. What is SPC’s cost of common stock? a. 155% b. 134% ©. 7.2% d 12% e. 16% 7, What is SPC’s weighted average cost of capital? In other words, what WACC cost rate should it use to evaluate capital budgeting projects (these four projects, plus any others that might arise during the year, provided the WACC remains as it a. 12.05% b. 13.4% c. 11.77% d. 12.5% e. 10.61% ty? athy’? 8. What is SPC’s optimal capital budget (in millions)? $240 b. $325 c. $365 d. $565 e. $715 9, Assume now that all four projects are independent; however, Project A has been judged a very risky project, while Projects C and D have been judged low-risk projects. Project B remains an average-risk project. If SPC adjusts its WACC by 2 percentage points up or down to account for risk, what is its optimal capital budget (in millions) now? a. $365 b. $390 . $440 d. $475 e. $715 Chapter 10 Problems x 10, Projects A and B each have an initial cost of $5,000, followed by a series of positive cash inflows. Project A has total undiscounted cash inflows of $12,000, while B has total undiscounted inflows of $10,000. Further, at a discount rate of 10%, the two projects have identical NPVs. Which project’s NPV will be more sensitive to changes in the discount rate? Noie thai projecis with sleeper NPV profiles are more sensitive to discount rate changes. a. Project A b. Project B c. Both projects are equally sensitive to change in the discount rate since their NPVs are equal at all costs of capital. d. The solution cannot be determined unless the timing of the cash flows is known O, Chapter 11 Problems 16. Adams Audio is considering whether to make an investment in a new type of technology Which of the following factors should the company consider when it decides to undertake the investment? a. db. c, d. The investment will increase operating cash flows by $1 million. The new technology will affect the cash flows produced by its other operations. Ifthis investment is not made, then the company will be able to sell one of its laboratories for $2 million. All of these statements are correct. 17. Downington Industries has an overall WACC of 10%. ‘The cost of capital reflects the cost of capital for a Downington project with average risk, however, there are large differences among the projects. The company estimates that low-risk projects have a cost of capital of 8% and high-risk projects have a cost of capital of 12%. The company is considering the following projects: Project Expected Return Risk A 15% High B 12 Average c 1 High D 9 Low EB 6 Loiw C. Which of the projects will the company select? a. AandB b. A, BandC ce, A,BandD d. A,B,C, DandE 18. Franklin Corp. is considering an expansion project. The necessary equipment could be purchased for $15 million and shipping and installation costs are another $500,000. The project will also require an initial $2 million investment in net operating working capital é.. If the company’s tax rate is 40%, what is the project’s initial investment outlay? ” a. $15 million b. $15.5 c. $16.5 d. $17 e $17.5 19. Franklin is trying to estimate its first-year operating cash flow (at t = 1) for a proposed project. The financial staff has collected the following information: Projected Sales $3,000,000 Operating Costs 1,200,000 Tnierest Expense 350,000 The company has a 40% tax rate. The equipment costs $15,000,006 and is depreciated over a 30 year period to a salvage value of $1,500,000. The equipment can be sold in year 30 for $3,000,000. What is the project’s operating cash flow for the first year (t = 1)? Q a. $1,260,000 b. $810,000 oc, $3,080,000 d, $1,500,000 e, $1,800,000 ’ USOWOo Be eos (100 ood) Vie’ gee yaw yale yor? 20. Consolidated Inc. uses a weighted average cost of capital of 12% to evaluate average risk projects and adds/subtracts two percentage points to evaluate projects of greater/lesser risk. Currently, two mutually exclusive projects are under consideration, cost of $200,000 and last 4 years. Project A, which is riskier than average will produce annual afler-tax uvi cash flows of $71,000, Project B, which lias less Ula average vss, will produce an after-tax net cash flow of $146,000 in years 3 and 4 only, What should Consolidated do? Accept Project B with an NPV of $9,412 Accept both projects since both NPVs are greater than zero. GQ Accept Project A with an NPV of $6,874 . Accept neither project since both NPVs are less than zero. Accept Projecig A with an NPV of $15,652 Da sao se Chapter 12 21. As a general rule, the capital structure that maximizes stock price also a. Maximizes the weighted average cost of capital nizeg EPS c. Minimizes the required rate of return on equity a Gd. Miniwizes the weighted average cost of capital . 22. A decrease in the debt ratio will normally have no effect on a. Financial risk 6. Total risk c. Business risk . d, Firm unique risk Ce 23. Which of the following is true? a. Ifa firm is exposed to a high degree of business risk as a result of its high operating leverage, th probably sh: ) average amount of financial leverage. This follows because debt has a lower after iax cust ihan equity. . Financial risk can be reduced by replacing common equity with preferred stock c. The Hamada equation specities the effect of financial leverage on beta. Jt shows how increases in the debt/equity ratio lowers beta. a d. The capital structure that minimizes the WACC also maximizes the firm’s stock . price and its total value, but generally not its expected EPS. One reason given for why debt is beneficial is that it shelters operating income from taxes, while it was staied that a disadvaniage of excessive debi has tu do wiih cosis associated with bankruptcy and financial distress generally. 24, The Fisher Company will produce 50,000 10-gallon aquariums next year. Variable costs will equal 40% of dollar sales, while fixed costs total $100,000. At what price must each ium be sold for the firm’s HRIT to be $90,000? a. $5.00 b. $5.33 c. $5.50 d $6.00 e $6.33 90 000 * PA .4 Pe = foosou AO,ooo ™ $0,000 # ~ 19, D000 JA, OOD 25. Hairston Industries has $25 million in assets, which is financed with $5 million of debt and $20 million in equity. If Hairston’s beta is currently 1.75 and its tax rate is 40%, what is its unlevered beta? . . a. 0.7564 b. 1.0 © 12525 d 1.5217 e 2.0125 L1S* ya Chew] 26. The Hampton Hardware Co. is trying to estimate its optimal capital structure. Hampton’s ’ current capital structure consists of 20% debt and 80% equity; however, management aw believes the firm should use more debt. The risk free rate is 7%, the market risk premium is 5% and the firm’s tax rate is 35%. Currently, Hampton’s cost of equity is 16%. What would be Hampton’s estimated cost of equity if it were to change its capital structure from its present capital structure to 40% debt and 60% equity? a. 14.93% b. 15.45% ¢. 18.10% d. 19.25% e. 20.33% Lose} _ 1 Basery Kees OF hee os va, By we Kaw Ve Hips WT 4.0%b p~ 1.8 1.8 bu fy ¥buss) \ Your VSN by, hSHR CLE GU Ce) Le ber Qa ak, Co