Safeco Company and Risco Inc are identical in size and capital structure. However, the
riskiness of their assets and cash flows are somewhat different, resulting in Safeco having
a WACC of 10% and Risco a 12% WACC. Safeco is considering Project X, which has an
IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering
Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company, Safeco/Risco Inc.
Moreover, the new company's market risk is an average of the pre-merger companies'
market risks, and the merger has no impact on either the cash flows or the risks of
projects X and Y. Which of the following statements is CORRECT? (Points: 5)
Safeco/Risco's WACC, as a result of the merger, would be 10%. If evaluated using the
correct post-merger WACC, Project X would have a negative NPV. After the merger,
Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project
X but accept Project Y. If the firm evaluates these projects and all other projects at the
new overall corporate WACC, it will become riskier over time. After the merger,
Safeco/Risco should select Project Y but reject Project X.
20. Blanchford Enterprises is considering a project that has the following cash flow data.
What is the project's IRR? Note that a project's projected IRR can be less than the WACC
(and even negative), in which case it will be rejected. Year: 0 1 2 3 Cash flows: -$1,000
$450 $450 $450 (Points: 5) 16.20% 16.65% 17.10% 17.55% 18.00%
21. Swannee Resorts is considering a new project whose data are shown below. The
equipment that would be used has a 3-year tax life, would be depreciated by the straight
line method over the project's 3 year life, and would have zero salvage value. No new
working capital would be required. Revenues and other operating costs are expected to be
constant over the project's 3-year life. What is the project's NPV? If you are working this
problem by hand rather than by computer, ignore small rounding differences between
your answer and the choices given. (Hint: Cash flows are constant in Years 1-3.) WACC
10% Net investment cost (depreciable basis) $65,000 Straight line depr’n rate 33.33%
Sales revenues $70,000 Operating costs excl. depr’n $25,000 Tax rate 35% (Points: 5)
$22,156.24 $23,791.14 $24,354.87 $25,189.71 $26,599.05
22. Harmon Industries is considering adding a new store. As a final step in reviewing the
proposed project, the CFO wants to take into account two real options that are attached to
the proposed project. First, there is a timing option. One year from now, the company
will have a much better idea of whether the county will raise or lower its property taxes.
The firm might want to wait a year to decide whether it makes sense to proceed with their
proposed project because the county taxes could significantly affect the project’s cash
flows. Second, there is an abandonment option. After two years, the company will have
the option to shut down the store if it is determined that the store is losing money and will
continue to lose money. Which of the following statements is most correct? (Points: 5) In
this case, the option to delay the project actually takes value away from the project. The
abandonment option is likely to increase the project’s expected cash flows. The
abandonment option is likely to increase the project’s risk. An abandonment and
investment timing option can not exist for the same project. In this case, the option to
delay the project is likely to increase the project’s risk.
23. Business risk is concerned with the operations of the firm. Which of the following is
NOT associated with (or not a part of) business risk? (Points: 5) demand variability sales
price variability the extent to which operating costs are fixed changes in required
returns due to financing decisions the ability to change prices as costs change
24. Brandi Co. has an unlevered beta of 1.10. The firm currently has no debt, but is
considering changing its capital structure to be 30% debt and 70% equity. If its corporate
tax rate is 40%, what is Brandi's levered beta? (Points: 5) 1.2549 1.3829 1.5764 1.6235
1.7458
25. Ronaldo Inc. has a capital budget of $1,000,000, but it wants to maintain a target
capital structure of 60% debt and 40% equity. The company forecasts this year’s net
income to be $600,000. If the company follows a residual dividend policy, what will be
its dividend payout ratio? (Points: 4)
16.67%
20.00%
25.00%
33.33%
35.00%