Questions and Answers of Fundamentals Of Financial Management

Does the Fed have complete control over U.S. interest rates? That is, can it set rates at any level it chooses? Why or why not?
If short-term interest rates are lower than long-term rates, why might a borrower still choose to finance with long-term debt?
Explain the following statement: The optimal financial policy depends in an important way on the nature of the firm’s assets.
Define each of the following terms:a. Production opportunities; time preferences for consumption; risk; inflationb. Real risk-free rate of interest, r*; nominal (quoted) risk-free rate of interest,
The real risk-free rate of interest, r*, is 3%, and it is expected to remain constant over time. Inflation is expected to be 2% per year for the next 3 years and 4% per year for the next 5 years. The
The yield on 1-year Treasury securities is 6%, 2-year securities yield 6.2%, 3-year securities yield 6.3%, and 4-year securities yield 6.5%. There is no maturity risk premium. Using expectations
An analyst is evaluating securities in a developing nation where the inflation rate is very high. As a result, the analyst has been warned not to ignore the cross-product between the real rate and
The real risk-free rate is 2.05%. Inflation is expected to be 3.05% this year, 4.75% next year, and 2.3% thereafter. The maturity risk premium is estimated to be 0.05 × (t - 1)%, where t = number of
Holt Enterprises recently paid a dividend, D0, of$2.75. It expects to have nonconstant growth of 18% for 2 years followed by a constant rate of 6% thereafter. The firm’s required return is 12%. a.
Investors require an 8% rate of return on Mather Company’s stock (i.e., rs = 8%). a. What is its value if the previous dividend was D = $1.25 and investors expect divi- dends to grow at a constant
Assume that today is December 31, 2021, and that the following information applies to Abner Airlines:● After-tax operating income [EBIT(1 2 T)] for 2022 is expected to be $400 million.● The
Assume that it is now January 1, 2022. Wayne-Martin Electric Inc. (WME) has developed a solar panel capable of generating 200% more electricity than any other solar panel currently on the market. As
In this chapter, we described the various factors that influence stock prices and the approaches that analysts use to estimate a stock’s intrinsic value. By comparing these intrinsic value
When calculating WACC, what capital is excluded and why?
When calculating a company’s WACC, should book value, market value, or target weights be used? Explain.
Why might the weights of capital be different depending on whether book values, market values, or target values are used?
Identify the firm’s three major capital structure components, and give their respective component cost and weight symbols.
Why might there be two different component costs for common equity? Which one is generally relevant, and for what type of firm is the second one likely to be relevant?
If a firm now has a debt ratio of 50% but plans to finance with only 40% debt in the future, what should it use as wd when it calculates its WACC? Explain.
Why is the after-tax cost of debt rather than the before-tax cost used to calculate the WACC?
Why is the relevant cost of debt the interest rate on new debt, not that on already outstanding, or old, debt?
How can the yield to maturity on a firm’s outstanding debt be used to estimate its before-tax cost of debt?
A company has outstanding 20-year noncallable bonds with a face value of $1,000, an 11% annual coupon, and a market price of $1,294.54. If the company was to issue new debt, what would be a
Is a tax adjustment made to the cost of preferred stock? Why or why not?
A company’s preferred stock currently trades at $80 per share and pays a $6 annual dividend per share. Ignoring flotation costs, what is the firm’s cost of preferred stock?
Why must a cost be assigned to retained earnings?
What three approaches are used to estimate the cost of common equity? Which approach is most commonly used in practice?
Identify some potential problems with the CAPM.
Which of the two components of the DCF formula, the dividend yield or the growth rate, do you think is more difficult to estimate? Why?
What’s the logic behind the bond-yield-plus-risk-premium approach?
Suppose you are an analyst with the following data: rRF = 5.5%, rM - rRF = 6%, b = 0.8, D1 = $1.00, P0 = $25.00, g = 6%, and rd = firm’s bond yield = 6.5%. What is this firm’s cost of equity
What are the two approaches that can be used to adjust for flotation costs?
Would a firm that has many good investment opportunities be likely to have a higher or a lower dividend payout ratio than a firm with few good investment opportunities?Explain.
A firm’s common stock has D1 = $1.50, P0 = $30.00, g = 5%, and F = 4%. If the firm must issue new stock, what is its cost of new external equity?
Suppose Firm A plans to retain $100 million of earnings for the year. It wants to finance its capital budget using a target capital structure of 46% debt, 3% preferred, and 51% common equity. How
Write the equation for the WACC.
Firm A has the following data: Target capital structure of 46% debt, 3% preferred, and 51% common equity; tax rate = 25%; rd = 7%; rp = 7.5%; rs = 11.5%; and re = 12.5%.What is the firm’s WACC if
Name three factors that affect the cost of capital and are beyond the firm’s control.
What are three factors under the firm’s control that can affect its cost of capital?
Suppose interest rates in the economy increase. How would such a change affect the costs of both debt and common equity based on the CAPM?
Why is the cost of capital sometimes referred to as a “hurdle rate”?
How should firms evaluate projects with different risks?
Should all divisions within the same firm use the firm’s composite WACC for evaluating all capital budgeting projects? Explain.
Identify some problem areas in cost of capital analysis. Do these problems invalidate the cost of capital procedures discussed in this chapter? Explain.
Define each of the following terms:a. Target capital structure; capital componentsb. Before-tax cost of debt, rd; after-tax cost of debt, rd(1 - T)c. Cost of preferred stock, rpd. Cost of retained
Lancaster Engineering Inc. (LEI) has the following capital structure, which it considers to be optimal:LEI’s expected net income this year is $34,285.72, its established dividend payout ratio is
The Holmes Company’s currently outstanding bonds have an 8% coupon and a 10% yield to maturity. Holmes believes it could issue new bonds at par that would provide a similar yield to maturity. If
Pearson Motors has a target capital structure of 30% debt and 70% common equity, with no preferred stock. The yield to maturity on the company’s outstanding bonds is 9%, and its tax rate is 25%.
Palencia Paints Corporation has a target capital structure of 35% debt and 65% common equity, with no preferred stock. Its before-tax cost of debt is 8%, and its marginal tax rate is 25%. The current
The Paulson Company’s year-end balance sheet is shown here. Its cost of common equity is 14%, its before-tax cost of debt is 10%, and its marginal tax rate is 25%. Assume that the firm’s
Olsen Outfitters Inc. believes that its optimal capital structure consists of 55%common equity and 45% debt, and its tax rate is 25%. Olsen must raise additional capital to fund its upcoming
Hook Industries’s capital structure consists solely of debt and common equity. It can issue debt at rd = 11%, and its common stock currently pays a $2.00 dividend per share (D0 = $2.00). The
Empire Electric Company (EEC) uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd = 9% as long as it finances at its target capital structure, which calls for
Kahn Inc. has a target capital structure of 60%common equity and 40% debt to fund its $10 billion in operating assets. Furthermore, Kahn Inc. has a WACC of 13%, a before-tax cost of debt of 10%, and
The Bouchard Company’s EPS was $6.50 in 2021, up from $4.42 in 2016. The company pays out 40% of its earnings as dividends, and its common stock sells for $36.00.a. Calculate the past growth rate
Adamson Corporation is considering four average-risk projects with the following costs and rates of return:The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 25%.
The following table gives Foust Company’s earnings per share for the last 10 years.The common stock, 7.8 million shares outstanding, is now (1/1/22) selling for $65.00 per share. The expected
Here is the condensed 2021 balance sheet for Skye Computer Company (in thousands of dollars):Skye’s earnings per share last year were $3.20. The common stock sells for $55.00, last year’s
Coleman Technologies is considering a major expansion program that has been proposed by the company’s information technology group. Before proceeding with the expansion, the company must estimate
In this chapter, we described how to estimate a company’s WACC, which is the weighted average of its costs of debt, preferred stock, and common equity. Most of the data we need to do this can be
How is capital budgeting similar to security valuation? How is it different?
What are some ways that firms generate ideas for capital projects?
Identify the major project classification categories, and explain how and why they are used.
What is the single best capital budgeting decision criterion? Explain.
Why is the NPV the primary capital budgeting decision criterion?
Differentiate between independent and mutually exclusive projects.
In what sense is a project’s IRR similar to the YTM on a bond?
What condition regarding cash flows would cause more than one IRR to exist? Project MM has the following cash flows: 0 - $1,000 End-of-Year Cash Flows 1 2 $2,000 $2,000 3 - $3,350
Calculate MM’s NPV at discount rates of 0%, 10%, 12.2258%, 25%, 122.1470%, and 150%. What are MM’s IRRs? If the cost of capital is 10%, should the project be accepted or rejected?
Why is it true that a reinvestment rate is implicitly assumed whenever we find the present value of a future cash flow? Would it be possible to find the PV of a FV without specifying an implicit
What reinvestment rate is built into the NPV calculation? The IRR calculation?
For a firm that has adequate access to capital markets, is it more reasonable to assume reinvestment at the WACC or the IRR? Explain.
What’s the primary difference between the MIRR and the regular IRR?
Which provides a better estimate of a project’s “true” rate of return, the MIRR or the regular IRR? Explain.
Describe in words how an NPV profile is constructed. How are the intercepts of the x- and y-axes determined?
What is the crossover rate, and how does its value relative to the cost of capital determine whether a conflict exists between NPV and IRR?
What two conditions can lead to conflicts between the NPV and the IRR when evaluating mutually exclusive projects?
What information does the payback convey that is absent from the other capital budgeting decision methods?
What three flaws does the regular payback have? Does the discounted payback correct all of these flaws? Explain.
Project P has a cost of $1,000 and cash flows of $300 per year for 3 years plus another $1,000 in Year 4. The project’s cost of capital is 15%. What are Project P’s regular and discounted
The project’s cost of capital is 15%. What are Project P’s regular and discounted paybacks? (3.10, 3.55) If the company requires a payback of 3 years or less, would the project be accepted? Would
Describe the advantages and disadvantages of the five capital budgeting methods discussed in this chapter.
Should capital budgeting decisions be made solely on the basis of a project’s NPV?Explain.
What trends in capital budgeting methodology can be seen from Table 11.2? NPV IRR Payback Discounted Payback Other Methods Totals 1960 0% 20 35 45 100% Capital Budgeting Methods Used in Practice
Define the following terms:a. Capital budgeting; strategic business planb. Net present value (NPV)c. Internal rate of return (IRR)d. NPV profile; crossover ratee. Mutually exclusive projects;
Project L requires an initial outlay at t = 0 of $65,000, its expected cash inflows are$12,000 per year for 9 years, and its WACC is 9%. What is the project’s NPV?
Refer to problem 11-1. What is the project’s IRR?Problem 11-1Project L requires an initial outlay at t = 0 of $65,000, its expected cash inflows are $12,000 per year for 9 years, and its WACC is
Refer to problem 11-1. What is the project’s MIRR?Problem 11-1Project L requires an initial outlay at t = 0 of $65,000, its expected cash inflows are$12,000 per year for 9 years, and its WACC is
A firm with a 14% WACC is evaluating two projects for this year’s capital budget. After-tax cash flows are as follows:a. Calculate NPV, IRR, MIRR, payback, and discounted payback for each
A company has an 11% WACC and is considering two mutually exclusive investments (that cannot be repeated) with the following cash flows:a. What is each project’s NPV?b. What is each project’s
Why should companies use a project’s free cash flows rather than accounting income when determining a project’s NPV?
Explain the following terms: incremental cash flow, sunk cost, opportunity cost, externality, and cannibalization.
Provide an example of a “good” externality, that is, one that increases a project’s true NPV.
In what ways is the setup for finding a project’s cash flows similar to the projected income statements for a new single-product firm? In what ways would the two statements be different?
Would a project’s NPV for a typical firm be higher or lower if the firm used bonus depreciation rather than straight-line depreciation? Explain.
How could the analysis in Table 12.1 be modified to consider cannibalization, opportunity costs, and sunk costs?Table 12.1 12 13 Investment Outlays at Time = 0 14 CAPEX = Equipment Cost (1-T) ANOWC=
Why does NOWC appear as both a negative and a positive number in Table 12.1?Table 12.1 24 Total operating costs 25 EBIT (or Operating Income) 26 Taxes on operating Income B 12 13 Investment Outlays
What role do incremental cash flows play in a replacement analysis?
If you were analyzing a replacement project and you suddenly learned that the old equipment could be sold for $1,000 rather than $100, would this new information make the replacement look better or
In Table 12.2, we assumed that output would not change if the old machine was replaced. Suppose output would actually double. How would this change be dealt with in the framework of Table 12.2?Table

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