Questions and Answers of Fundamentals Of Financial Management

What are the three types of project risk?
Which type is theoretically the most relevant? Why?
What is one classification scheme that firms often use to obtain risk-adjusted costs of capital?
Explain briefly how a sensitivity analysis is done and what the analysis is designed to show.
What is a scenario analysis? What is it designed to show, and how does it differ from a sensitivity analysis?
What is Monte Carlo simulation? How does a simulation analysis differ from a regular scenario analysis?
Is it easier to measure the stand-alone, within-firm, or beta risk for projects such as a new delivery truck or a Home Depot warehouse?
If a firm cannot measure a potential project’s risk with precision, should it abandon the project? Explain your answer.
Briefly describe the replacement chain (common life) and the EAA approaches to the unequal life problem.
Is it always necessary to adjust projects’ cash flows when different projects have unequal lives? Explain.
Your company must choose one of two mutually exclusive projects. Project A has an after-tax cost of $2,000 today and has after-tax cash flows of $1,500 per year for 4 years. Project B has an
Define the following terms:a. Incremental cash flow; sunk cost; opportunity cost; externality; cannibalizationb. Stand-alone risk; corporate (within-firm) risk; market (beta) riskc. Risk-adjusted
As a financial analyst, you must evaluate a proposed project to produce printer cartridges. The purchase price of the equipment, including installation, is $65,000, and the equipment will be fully
Tannen Industries is considering an expansion. The necessary equipment would be purchased for $18 million and will be fully depreciated at the time of purchase, and the expansion would require an
Colsen Communications is trying to estimate the first-year cash flow(at Year 1) for a proposed project. The assets required for the project were fully depreciated at the time of purchase. The
Karsted Air Services is now in the final year of a project. The equipment originally cost $29 million, of which 100% has been depreciated. Karsted can sell the used equipment today for $8 million,
The Oviedo Company is considering the purchase of a new machine to replace an obsolete one. The machine being used for the operation has a book value and a market value of zero. However, the machine
Charlene is evaluating a capital budgeting project that should last for 4 years. The project requires $800,000 of equipment and is eligible for 100% bonus depreciation. She is unsure whether
You must evaluate the purchase of a proposed spectrometer for the R&D department. The purchase price of the spectrometer including modifications is$170,000, and the equipment will be fully
You must evaluate a proposal to buy a new milling machine. The purchase price of the milling machine, including shipping and installation costs, is $143,000, and the equipment will be fully
The Dauten Toy Corporation currently uses an injection molding machine that was purchased prior to the TCJA. This machine is being depreciated on a straight-line basis, and it has 6 years of
St. Johns River Shipyards is considering the replacement of an 8-year-old riveting machine with a new one that will increase earnings from $24,000 to$46,000 per year. The new machine will cost
Overton Clothes Inc. is considering the replacement of its old, fully depreciated knitting machine. Two new models are available: (a) Machine 171-3, which has an after-tax cost of $171,000, a 3-year
Holmes Manufacturing is considering a new machine that costs $285,000 and would reduce pretax manufacturing costs by $90,000 annually. The new machine will be fully depreciated at the time of
The Darlington Equipment Company purchased a machine 5 years ago, prior to the TCJA, at a cost of $85,000. The machine had an expected life of 10 years at the time of purchase, and it is being
You must analyze a potential new product—a caulking compound that Cory Materials’ R&D people developed for use in the residential construction industry. Cory’s marketing manager thinks the
Allied Food Products is considering expanding into the fruit juice business with a new fresh lemon juice product. Assume that you were recently hired as assistant to the director of capital
Why might DCF techniques not lead to proper capital budgeting decisions?
Why might recognizing the existence of a real option raise, but not lower, a project’s NPV as found in the traditional manner?
Name the five types of real options. Which one best describes the Anheuser-Busch situation discussed in the preceding section?
If a firm fails to consider growth options, would this cause it to underestimate or overestimate projects’ NPVs? Explain.
Would you expect an abandonment option to increase or decrease a project’s expected NPV and risk (as measured by the coefficient of variation)? Explain.
Suppose a project’s expected “cannot abandon” NPV is −$14 and its “can abandon”expected NPV is $214. How much is the abandonment option worth?
Briefly describe what an investment timing option is and why such options are valuable.
Explain why the following statement is true: In general, the more uncertainty there is about future market conditions, the more attractive an investment timing option will be, other things held
What are input flexibility options and output flexibility options?
How do flexibility options affect projects’ NPVs and risk?
Why is a firm’s value maximized if it invests to the point where its marginal return on new investment is equal to its marginal cost of capital?
Explain how a financial manager might estimate his or her firm’s optimal capital budget.
What is capital rationing? What types of firms might encounter capital rationing?
In terms of Figure 13.5, how would an event such as the credit crisis of 2008, where interest rates for many corporate borrowers climbed quite high, affect the size of the capital budget?Figure 13.5
What is done in the post-audit?
Identify several benefits of the post-audit.
What are some factors that complicate the post-audit process?
Define each of the following terms:a. Real option; option valueb. Growth option; abandonment optionc. Investment timing option; flexibility optiond. Marginal cost of capital; IRR schedulee. Optimal
firm is considering a project with the following after-tax cash flows:You learn that the firm can abandon the project, if it so chooses, after 1 year of operation, in which case it can sell the asset
Harmon Corporation has four potential projects: M, N, O, and P.Projects O and P are mutually exclusive. The table provides the required investment and NPV for each project.Using the information in
Use a spreadsheet model to evaluate the project analyzed in Problem 13-8.Problem 13-8Enterprises is considering buying a vacant lot for an after-tax cost of $1.4 million. If the property is
Define the terms “book-value capital structure,” “market-value capital structure,” and“target capital structure,” and explain why they differ from one another.
Would the market-value debt ratio tend to be higher than the book-value debt ratio during a stock market boom or a recession? Explain.
Why would the WACC based on market values tend to be higher than the one based on book values if the stock price exceeded its book value?
Which would you expect to be more stable over time, a firm’s book-value or marketvalue capital structure? Explain.
What is business risk, and how can it be measured?
Why does business risk vary from industry to industry?
How does operating leverage affect business risk?
What is financial risk, and how does it arise?
Explain this statement: Using financial leverage has both good and bad effects.
What happens to the component costs of debt and equity when the debt ratio is increased? Why does this occur?
Using the Hamada equation, explain the effects of financial leverage on beta.
What is the equation for calculating a firm’s unlevered beta?
What would be the cost of equity for Firm X at Equity/Capital ratios of 1.0 (no debt)and 0.58 assuming that rRF = 5% and RPM = 4%?Use the Hamada equation to calculate the unlevered beta for Firm X
Using a graph and illustrative data, discuss the premiums for financial risk and business risk at different debt levels. Do these premiums vary depending on the debt level? Explain.Is expected EPS
Why does MM’s theory with taxes lead to 100% debt?
How would an increase in corporate taxes tend to affect an average firm’s capital structure? What about an increase in the personal tax rate?
Explain what asymmetric information means, and how signals affect capital structure decisions.
What is meant by reserve borrowing capacity, and why is it important to firms?
How can the use of debt serve to discipline managers?
What is the pecking order hypothesis, and how does it influence firms’ capital structures?
How do “windows of opportunity” impact a firm’s capital structure?
How does sales stability affect the target capital structure?
How do the types of assets used affect a firm’s capital structure?
How do taxes affect the target capital structure?
How do the attitudes of lenders and rating agencies affect capital structure?
How does the firm’s internal condition affect its actual capital structure?
What is financial flexibility, and is it increased or decreased by a high debt ratio?Explain.
Why do wide variations in the use of financial leverage occur across industries and among individual firms in each industry?
What is the likely impact of the TCJA on the average company’ capital structure?
Define each of the following terms:a. Capital; capital structure; optimal capital structureb. Business risk; financial riskc. Financial leverage; operating leverage; operating breakevend. Hamada
Olinde Electronics Inc. produces stereo components that sell at P = $100 per unit. Olinde’s fixed costs are $200,000, variable costs are $50 per unit, 5,000 components are produced and sold each
Carlisle Industries is trying to determine its optimal capital structure, which now consists of only common equity. The firm will add debt to its capital structure if it minimizes its WACC, but the
a. Given the following information, calculate the expected value for Firm C’s EPS. Data for Firms A and B are as follows: E(EPSA) = $5.10, σA = $3.61, E(EPSB) 5 $4.20, andσB = $2.96. Firm A: EPS
Hartman Motors has $18 million in assets, which were financed with$6 million of debt and $12 million in equity. Hartman’s beta is currently 1.3, and its tax rate is 25%. Use the Hamada equation to
Firms HL and LL are identical except for their financial leverage ratios and the interest rates they pay on debt. Each has $20 million in invested capital, has $4 million of EBIT, and is in the 25%
The Neal Company wants to estimate next year’s return on equity (ROE) under different financial leverage ratios. Neal’s total capital is $14 million, it currently uses only common equity, it has
Situational Software Co. (SSC) is trying to establish its optimal capital structure. Its current capital structure consists of 25% debt and 75% equity; however, the CEO believes that the firm should
The Severn Company plans to raise a net amount of $270 million to finance new equipment in early 2022. Two alternatives are being considered: Common stock may be sold to net $60 per share, or bonds
WaCC aND OptIMaL CapItaL strUCtUre Elliott Athletics is trying to determine its optimal capital structure, which now consists of only debt and common equity. The firm does not currently use preferred
OptIMaL CapItaL strUCtUre Assume that you have just been hired as business manager of Campus Deli (CD), which is located adjacent to the campus. Sales were $1,100,000 last year, variable costs were
This chapter provides an overview of the effects of leverage and describes the process that firms use to determine their optimal capital structure. The chapter also indicates that capital structures
Explain briefly the ideas behind the dividend irrelevance theory.
What did Modigliani and Miller assume about taxes and brokerage costs when they developed their dividend irrelevance theory?
Why did MM refer to the Gordon–Lintner dividend argument as the bird-in-the-hand fallacy?
Why do some investors prefer high-dividend-paying stocks?
Why might other investors prefer low-dividend-paying stocks?
Define (1) information content and (2) the clientele effect, and explain how they affect dividend policy.
What is catering theory, and how does it impact a firm’s dividend policy?
Explain the logic of the residual dividend model, the steps a firm would take to implement it, and the reason it is more likely to be used to establish a long-run payout target than to set the actual
How do firms use long-run planning models to help set dividend policy?
Which are more critical to the dividend decision, earnings or cash flow? Explain.
Explain the procedures used to actually pay the dividend.

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