MAS 5 THEORY – Cost of Capital
1. All of the following statements are correct except:
a. The matching of asset and liability maturities is considered desirable because this
strategy minimizes interest rate risk.
b. Default risk refers to the inability of the firm to pay off its maturing obligations.
c. The matching of assets and liability maturities lowers default risk.
d. An increase in the payables deferral period will lead to a reduction in the need to nonspontaneous funding.
2. Which of the following would increase risk?
a. Increase the level of working capital.
b. Change the composition of working capital to include more liquid assets.
c. Increase the amount of short-term borrowing.
d. Increase the amount of equity financing.
3. A firm’s financial risk is a function of how it manages and maintains its debt. Which one of
the following sets of ratios characterizes the firm with the greatest amount of financial risk?
A. High debt-to-equity ratio, high interest coverage ratio, stable return on equity.
B. Low debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
C. High debt-to-equity ratio, low interest coverage ratio, volatile return on equity.
D. Low debt-to-equity ratio, high interest coverage ratio, stable return on equity.
4. Which of the following classes of securities are listed in order from lowest risk/opportunity
for return to highest risk/opportunity for return? (E)
A. U.S. Treasury bonds; corporate first mortgage bonds; corporate income bonds; preferred
stock.
B. Corporate income bonds; corporate mortgage bonds; convertible preferred stock;
subordinated debentures.
C. Common stock; corporate first mortgage bonds; corporate second mortgage bonds;
corporate income bonds.
D. Preferred stock; common stock; corporate mortgage bonds; corporate debentures.
5. If the return on the market portfolio is 10% and the risk-free rate is 5%, what is the effect on
a company's required rate of return on its stock of an increase in the beta coefficient from
1.2 to 1.5?
A. 3% increase
B. 1.5% increase
C. No change
D. 1.5% decrease.
6. Cost of capital is
a. The amount the company must pay for its plant assets.
b. The dividends a company must pay on its equity securities.
c. The cost the company must incur to obtain its capital resources.
d. The cost the company is charged by investment bankers who handle the issuance of
equity or long-term debt securities.
7. All
a.
b.
c.
d.
of the following are examples of imputed costs except
The stated interest paid on a bank loan.
Assets that are considered obsolete that maintain a net book value.
Decelerated depreciation.
Lending funds to a supplier at a lower-than-market rate in exchange for receiving the
supplier’s products at a discount.
8. The theory underlying the cost of capital is primarily concerned with the cost of
A. Long-term funds and old funds.
B. Short-term funds and new funds.
C. Long-term funds and new funds.
D. Any combination of old or new, short-term or long-term funds.
9. Management knowledge of the cost of capital is useful for each of the following except
a. Making capital investment decisions.
b. Managing working capital.
c. Setting the maximum rate of return on new investments.
d. Evaluating performance.
10. The pre-tax cost of capital is higher than the after-tax cost of capital because
a. interest expense is deductible for tax purposes.
b. principal payments on debt are deductible for tax purposes.
c. the cost of capital is a deductible expense for tax purposes.
d. dividend payments to stockholders are deductible for tax purposes.
MAS 5 THEORY – Capital Budgeting
11. The long-term planning process for making and financing investments that affect a
company’s financial results over a number of years is referred to as
A. capital budgeting
C. master budgeting
B. strategic planning
D. long-range planning
12. Capital budgeting is the process
A. used in sell or process further decisions.
B. of determining how much capital stock to issue
C. of making capital expenditure decisions
D. of eliminating unprofitable product line
13. A capital investment decision is essentially a decision to:
A. exchange current assets for current liabilities.
B. exchange current cash outflows for the promise of receiving future cash inflows.
C. exchange current cash flow from operating activities for future cash inflows from
investing activities.
D. exchange current cash inflows for future cash outflows.
14. The normal methods of analyzing investments
A. cannot be used by not-for-profit entities.
B. do not apply if the project will not produce revenues.
C. cannot be used if the company plans to finance the project with funds already available
internally.
D. require forecasts of cash flows expected from the project.
15. There are several capital budgeting decision models that do not use discounted cash flows.
What is the name of the simple technique that calculates the total time it will take to recover,
using cash inflows from operations, the amount of cash invested in a project?
A. Recovery period
C. External rate of return
B. Payback model
D. Accounting rate of return
16. The technique most concerned with liquidity is
A. Payback method.
B. Net present value technique.
C. Internal rate of return.
D. book rate of return.
17. Which of the following is a potential use of the payback method?
A. Help managers control the risks of estimating cash flows
B. Help minimize the impact of the investment on liquidity
C. Help control the risk of obsolescence
D. All of the answers are correct
18. Discounted cash flow analysis is used in which of the following techniques?
A. Net present value
C. Cost of capital
B. Payback period
D. All of the above
19. The primary capital budgeting method that uses discounted cash flow techniques is the
A. net present value method.
B. cash payback technique.
C. annual rate of return method.
D. profitability index method.
20. The net present value (NPV) model can be used to evaluate and rank two or more proposed
projects. The approach that computes the total impact on cash flows for each option and
then converts these total cash flows to their present values is called the
A. differential approach
C. contribution approach
B. incremental approach.
D. total project approach.
21. The discount rate commonly used in present value calculations is the
A. treasury bill rate
B. weighted average return on assets adjusted for risk
C. risk free rate plus inflation rate
D. shareholders’ expected return on equity
22. According to the reinvestment rate assumption, which method of capital budgeting assumes
cash flows are reinvested at the project’s rate of return?
A. payback period
C. internal rate of return
B. net present value
D. none of the above
23. The rate of interest that produces a zero net present value when a project’s discounted cash
operating advantage is netted against its discounted net investment is the:
A. Cost of capital
C. Cutoff rate
B. Discount rate
D. Internal rate of return
24. A weakness of the internal rate of return method for screening investment projects is that it:
A. Does not consider the time value of money
B. Implicitly assumes that the company is able to reinvest cash flows from the project at
the company’s discount rate
C. Implicitly assumes that the company is able to reinvest cash flows from the project at the
internal rate of return
D. Fails to consider the timing of cash flows
25. If Arbitrary Company wants to use IRR to evaluate long-term decisions and to establish a
cutoff rate of return, it must be sure that the cutoff rate is
A. at least equal to its cost of capital.
B. at least equal to the rate used by similar companies.
C. greater than the IRR on projects accepted in the past.
D. greater than the current book rate of return.
MAS 5 PROBLEM – Cost of Capital
26. Gravy Company expects earnings of P30 million next year. Its dividend payout ratio is 40%,
and its debt/equity ratio is 1.50. Gravy uses no preferred stock.
At what amount of financing will there be a break point in Gravy’s marginal cost of capital?
A. P45 million.
B. P30 million.
C. P20 million.
D. P18 million.
27. Allison Engines Corporation has established a target capital structure of 40 percent debt and
60 percent common equity. The current market price of the firm’s stock is P 0 = $28; its last
dividend was D0 = $2.20, and its expected dividend growth rate is 6 percent. What will
Allison’s marginal cost of retained earnings, ks, be?
a. 15.8%
b. 13.9%
c. 7.9%
d. 14.3%
28. Doris Corporation's stock has a market price of $20.00 and pays a constant dividend of $2.50.
What is the required rate of return on its stock?
A. 13.0%
B. 12.5%
C. 12.0%
D. 11.5%
MAS 5 PROBLEM – Capital Budgeting
i.
Bruell Company is considering to replace its old equipment with a new one. The old equipment had a net
book value of P100,000, 4 remaining useful life with P25,000 depreciation each year. The old equipment can be sold
at P80,000. The new equipment costs P160,000, have a 4-year life. Cash savings on operating expenses before 40%
taxes amount to P50,000 per year. What is the amount of investment in the new equipment?
A. P160,000
C. P 80,000
B. P 72,000
D. P 68,000
i.
If an asset costs P35,000 and is expected to have a P5,000 salvage value at the end of its tenyear life, and generates annual net cash inflows of P5,000 each year, the cash payback period
is
A. 8 years
C. 6 years
B. 7 years
D. 5 years
i.
Consider a project that requires cash outflow of P50,000 with a life of eight years and a
salvage value of P5,000. Annual before-tax cash inflow amounts to P10,000 assuming a tax
rate of 30% and a required rate of return of 8%. Salvage value is ignored in computing
depreciation. The project has a payback period of
A. 5.0 years
C. 6.0 years
B. 5.6 years
D. 6.6 years
i.
It is the start of the year and Agudelo Company plans to replace its old grinding equipment.
The following information are made available by the management:
Old
New
Equipment cost
P70,000
P120,000
Current salvage value
14,000
Salvage value, end of useful life
5,000
16,000
Annual operating costs
44,000
32,000
Accumulated depreciation
55,300
Estimated useful life
10 years
10 years
The company is not subject to tax and its cost of capital is 12%. What is the present value
of all the relevant cash flows at time zero?
A. (P 54,000)
C. (P106,000)
B. (P120,000)
D. (P124,700)
i.
Consider a project that requires an initial cash outflow of P500,000 with a life of eight years
and a salvage value of P20,000 upon its retirement. Annual cash inflow before tax amounts
to P100,000 and a tax rate of 30 percent will be applicable. The required minimum rate of
return for this type of investment is 8 percent. The present value of 1 and the annuity of 1,
discounted at 8 percent for 8 periods are 0.54 and 5.747, respectively. Salvage value is
ignored in computing depreciation. The net present value amounts to
A. P 7,560
C. P 17,606
B. P 10,050
D. P 20,050
i.
The Pambansang Kamao Corporation has to replace its completely damaged boiler machine
with a new one. The old machine has a net book value of P100,000 with zero market value;
therefore it will give a tax shield, based on 35% tax rate if replaced, by P35,000. The company
has a 10 percent cost of capital. Understandably, the new machine, through a uniform
decrease in cash operating costs, will give a positive net present value, because this machine
will provide an internal rate of return of 12 percent.
The present values at 10% and 12%, respectively, are:
10%
12%
Annuity of 1, 6 periods
4.35526
4.11141
1 end of 6 periods
0.56447
0.50663
If the machine were to be depreciated using straight-line method for 6 years without any
salvage value, the estimated profitability index is:
A. 1.20
B. 1.06
C. 1.07
D. Cannot be determined from the information
Use the following information for questions 67 - 70
Pillo Company is considering two capital investment proposals.
Estimates regarding each project are provided below:
Project MA
P2000,000
10,000
50,000
5 years
-0-
Initial investment
Annual net income
Net annual cash inflow
Estimated useful life
Salvage value
Project PA
P300,000
21,000
71,000
6 years
-0-
The company requires a 10% rate of return on all new investments.
Present Value of an Annuity of 1
Period
5
6
9%
3.890
4.486
10%
3.791
4.355
11%
3.696
4.231
i.
The cash payback period for Project MA is
A. 20 years
C. 5 years
B. 10 years
D. 4 years
i.
The net present value for Project PA is
A. P309,204
C. P 50,000
B. P 91,456
D. P 9,205
12%
3.605
4.111
i.
The annual rate of return for Project MA is
A. 5%
C. 25%
B. 10%
D. 50%
i.
The internal rate of return for Project PA is closest to
A. 10%
C. 12%
B. 11%
D.
none of these