Chapter 14 - Cost of Capital
31. Which one of the following statements is correct?
A. Firms should accept low risk projects prior to funding high risk projects.
B. Making subjective adjustments to a firm's WACC when determining project discount rates unfairly punishes low-risk divisions within a firm.
C. A project that is unacceptable today might be acceptable tomorrow given a change in market returns.
D. The pure play method is most frequently used for projects involving the expansion of a firm's current operations.
E. Firms that elect to use the pure play method for determining a discount rate for a project cannot subjectively adjust the pure play rate. Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Intermediate Learning Objective: 14-5 Section: 14.5
Topic: Cost of capital
32. Phil's is a sit-down restaurant that specializes in home-cooked meals. Theresa's is a walk-in deli that specializes in specialty soups and sandwiches. Both firms are currently considering expanding their operations during the summer months by offering pre-wrapped donuts, sandwiches, and wraps at a local beach. Phil's currently has a WACC of 14 percent while Theresa's WACC is 10 percent. The expansion project has a projected net present value of $12,600 at a 10 percent discount rate and a net present value of -$2,080 at a 14 percent discount rate. Which firm or firms should expand and offer food at the local beach during the summer months? A. Phil's only B. Theresa's only
C. both Phil's and Theresa's D. neither Phil's nor Theresa's
E. cannot be determined from the information provided Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project cost of capital
14-16
Chapter 14 - Cost of Capital
33. Wilderness Adventures specializes in back-country tours and resort management. Travel Excitement specializes in making travel reservations and promoting vacation travel.
Wilderness Adventures has an aftertax cost of capital of 13 percent and Travel Excitement has an aftertax cost of capital of 11 percent. Both firms are considering building wilderness
campgrounds complete with man-made lakes and hiking trails. The estimated net present value of such a project is estimated at $87,000 at a discount rate of 11 percent and -$12,500 at a 13 percent discount rate. Which firm or firms, if either, should accept this project? A. Wilderness Adventures only B. Travel Excitement only
C. both Wilderness Adventures and Travel Excitement D. neither Wilderness Adventures nor Travel Excitement E. cannot be determined without further information Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project cost of capital
34. The subjective approach to project analysis:
A. is used only when a firm has an all-equity capital structure.
B. uses the WACC of firm X as the basis for the discount rate for a project under consideration by firm Y.
C. assigns discount rates to projects based on the discretion of the senior managers of a firm. D. allows managers to randomly adjust the discount rate assigned to a project once the project's beta has been determined.
E. applies a lower discount rate to projects that are financed totally with equity as compared to those that are partially financed with debt. Refer to section 14.5
AACSB: N/A
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Project cost of capital
14-17
Chapter 14 - Cost of Capital
35. Which one of the following statements is correct?
A. The subjective approach assesses the risks of each project and assigns an adjustment factor that is unique just for that project.
B. Overall, a firm makes better decisions when it uses the subjective approach than when it uses its WACC as the discount rate for all projects.
C. Firms will correctly accept or reject every project if they adopt the subjective approach. D. Mandatory projects should only be accepted if they produce a positive NPV when the firm's WACC is used as the discount rate.
E. The pure play approach should only be used with low-risk projects. Refer to section 14.5
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-5 Section: 14.5
Topic: Subjective approach
36. When a firm has flotation costs equal to 7 percent of the funding need, project analysts should:
A. increase the project's discount rate to offset these expenses by multiplying the firm's WACC by 1.07.
B. increase the project's discount rate to offset these expenses by dividing the firm's WACC by (1 - 0.07).
C. add 7 percent to the firm's WACC to get the discount rate for the project. D. increase the initial project cost by multiplying that cost by 1.07. E. increase the initial project cost by dividing that cost by (1 - 0.07). Refer to section 14.6
AACSB: N/A
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-18
Chapter 14 - Cost of Capital
37. The flotation cost for a firm is computed as:
A. the arithmetic average of the flotation costs of both debt and equity.
B. the weighted average of the flotation costs associated with each form of financing. C. the geometric average of the flotation costs associated with each form of financing. D. one-half of the flotation cost of debt plus one-half of the flotation cost of equity. E. a weighted average based on the book values of the firm's debt and equity. Refer to section 14.6
AACSB: N/A
Bloom's: Knowledge Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
38. Incorporating flotation costs into the analysis of a project will: A. cause the project to be improperly evaluated. B. increase the net present value of the project. C. increase the project's rate of return.
D. increase the initial cash outflow of the project. E. have no effect on the present value of the project. Refer to section 14.6
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
14-19
Chapter 14 - Cost of Capital
39. Flotation costs for a levered firm should:
A. be ignored when analyzing a project because they are not an actual project cost.
B. be spread over the life of a project thereby reducing the cash flows for each year of the project.
C. only be considered when two projects are mutually exclusive. D. be weighted and included in the initial cash flow.
E. be totally ignored when internal equity funding is utilized. Refer to section 14.6
AACSB: N/A
Bloom's: Comprehension Difficulty: Basic
Learning Objective: 14-4 Section: 14.6
Topic: Flotation costs
40. Chelsea Fashions is expected to pay an annual dividend of $0.80 a share next year. The market price of the stock is $22.40 and the growth rate is 5 percent. What is the firm's cost of equity?
A. 7.58 percent B. 7.91 percent C. 8.24 percent D. 8.57 percent E. 9.00 percent
AACSB: Analytic Bloom's: Application Difficulty: Basic
Learning Objective: 14-1 Section: 14.2
Topic: Cost of equity
14-20
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