FINA1003_1310_EF Corporate Finance

Semester 2 2016-2017
HW4 (Part A and B) (Due: 4th May, 2017 Thu 12:30)
Hard copy submission through 9th Floor KKL assignment box only

Student Name:
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Multiple Choice Questions (44 points)

Please choose only ONE answer for each question

1. The depreciation tax shield is best defined as the:

A. amount of tax that is saved when an asset is purchased.
B. tax that is avoided when an asset is sold as salvage.
C. amount of tax that is due when an asset is sold.
D. amount of tax that is saved because of the depreciation expense.
E. amount by which the aftertax depreciation expense lowers net income.

2. Danielle's is a furniture store that is considering adding appliances to its offerings.

Which of the following should be considered incremental cash flows of this project?
I. utilizing the credit offered by a supplier to purchase the appliance inventory
II. benefiting from increased furniture sales to appliance customers
III. borrowing money from a bank to fund the appliance project
IV. purchasing parts for inventory to handle any appliance repairs that might be
necessary
A. I and II only
B. III and IV only
C. I, II, and IV only
D. II, III, and IV only
E. I, II, III, and IV

3. G & L Plastic Molders spent $1,200 last week repairing a machine. This week the
company is trying to decide if the machine could be better utilized if they assigned it
a proposed project. When analyzing the proposed project, the $1,200 should be
treated as which type of cost?
A. opportunity
B. fixed
C. incremental
D. erosion
E. sunk

4. Changes in the net working capital requirements:

A. can affect the cash flows of a project every year of the project's life.
B. only affect the initial cash flows of a project.
C. only affect the cash flow at time zero and the final year of a project.
D. are generally excluded from project analysis due to their irrelevance to the total
 project.
E. reflect only the changes in the current asset accounts.

5. Three years ago, Knox Glass purchased a machine for a 3-year project. The machine
is being depreciated straight-line to zero over a 5-year period. Today, the project
ended and the machine was sold. Which one of the following correctly defines the
aftertax salvage value of that machine? (T represents the relevant tax rate)
A. Sale price + (Sales price - Book value) T
B. Sale price + (Sales price - Book value) (1 - T)
C. Sale price + (Book value - Sale price) T
D. Sale price + (Book value - Sale price) (1 - T)
E. Sale price (1 - T)

6. Scenario analysis is best suited to accomplishing which one of the following when
analyzing a project?
A. determining how fixed costs affect NPV
B. estimating the residual value of fixed assets
C. identifying the potential range of reasonable outcomes
D. determining the minimal level of sales required to break-even on an accounting
basis
E. determining the minimal level of sales required to break-even on a financial basis

7. Which one of the following will be used in the computation of the best-case analysis
of a proposed project?
A. minimal number of units that are expected to be produced and sold
B. the lowest expected salvage value that can be obtained for a project's fixed assets
C. the most anticipated sales price per unit
D. the lowest variable cost per unit that can reasonably be expected
E. the highest level of fixed costs that is actually anticipated

8. Sensitivity analysis determines the:

A. range of possible outcomes given that most variables are reliable only within a
stated range.
B. degree to which the net present value reacts to changes in a single variable.
C. net present value range that can be realized from a proposed project.
D. degree to which a project relies on its fixed costs.
E. ideal ratio of variable costs to fixed costs for profit maximization.

9. Which of the following values will be equal to zero when a firm is producing the
accounting break-even level of output?
I. operating cash flow
II. internal rate of return
III. net income
IV. payback period
A. I only
B. III only
 C. II and III only
D. I and IV only
E. I, II, and III only

10. Which of the following characteristics relate to the cash break-even point for a given
project?
I. The project never pays back.
II. The IRR equals the required rate of return.
III. The NPV is negative and equal to the initial cash outlay.
IV. The operating cash flow is equal to the depreciation expense.
A. I and III only
B. II and IV only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV

11. Brubaker & Goss has received requests for capital investment funds for next year
from each of its five divisions. All requests represent positive net present value
projects. All projects are independent. Senior management has decided to allocate the
available funds based on the profitability index of each project since the company has
insufficient funds to fulfill all of the requests. Management is following a practice
known as:
A. scenario analysis.
B. sensitivity analysis.
C. leveraging.
D. hard rationing.
E. soft rationing.

12. The weighted average cost of capital for a wholesaler:

A. is equivalent to the aftertax cost of the firm's liabilities.
B. should be used as the required return when analyzing a potential acquisition of a
retail outlet.
C. is the return investors require on the total assets of the firm.
D. remains constant when the debt-equity ratio changes.
E. is unaffected by changes in corporate tax rates.

13. The aftertax cost of debt generally increases when:

I. a firm's bond rating increases.
II. the market rate of interest increases.
III. tax rates decrease.
IV. bond prices rise.
A. I and III only
B. II and III only
C. I, II, and III only
D. II, III, and IV only
E. I, II, III, and IV
14. Markley and Stearns is a multi-divisional firm that uses its WACC as the discount rate
for all proposed projects. Each division is in a separate line of business and each
presents risks unique to those lines. Given this, a division within the firm will tend
to:
A. receive less project funding if its line of business is riskier than that of the other
divisions.
B. avoid risky projects so it can receive more project funding.
C. become less risky over time based on the projects that are accepted.
D. have equal probability of receiving funding as compared to the other divisions.
E. prefer higher risk projects over lower risk projects.

15. The value of a firm is maximized when the:

A. cost of equity is maximized.
B. tax rate is zero.
C. levered cost of capital is maximized.
D. weighted average cost of capital is minimized.
E. debt-equity ratio is minimized.

16. M&M Proposition I with no tax supports the argument that:

A. business risk determines the return on assets.
B. the cost of equity rises as leverage rises.
C. the debt-equity ratio of a firm is completely irrelevant.
D. a firm should borrow money to the point where the tax benefit from debt is equal
to the cost of the increased probability of financial distress.
E. homemade leverage is irrelevant.

17. Which of the following statements are correct in relation to M&M Proposition II with
no taxes?
I. The required return on assets is equal to the weighted average cost of capital.
II. Financial risk is determined by the debt-equity ratio.
III. Financial risk determines the return on assets.
IV. The cost of equity declines when the amount of leverage used by a firm rises.
A. I and III only
B. II and IV only
C. I and II only
D. III and IV only
E. I and IV only

18. Which of the following statements related to financial risk are correct?
I. Financial risk is the risk associated with the use of debt financing.
II. As financial risk increases so too does the cost of equity.
III. Financial risk is wholly dependent upon the financial policy of a firm.
IV. Financial risk is the risk that is inherent in a firm's operations.
A. I and III only
B. II and IV only
C. II and III only
 D. I, II, and III only
E. I, II, III, and IV

19. M&M Proposition I with tax supports the theory that:

A. a firm's weighted average cost of capital decreases as the firm's debt-equity ratio
increases.
B. the value of a firm is inversely related to the amount of leverage used by the firm.
C. the value of an unlevered firm is equal to the value of a levered firm plus the value
of the interest tax shield.
D. a firm's cost of capital is the same regardless of the mix of debt and equity used by
the firm.
E. a firm's cost of equity increases as the debt-equity ratio of the firm decreases.

20. M&M Proposition II with taxes:

A. has the same general implications as M&M Proposition II without taxes.
B. states that a firm's capital structure is irrelevant.
C. supports the argument that business risk is determined by the capital structure
decision.
D. supports the argument that the cost of equity decreases as the debt-equity ratio
increases.
E. concludes that the capital structure decision is irrelevant to the value of a firm.

21. The present value of the interest tax shield is expressed as:
A. (TC D)/RA.
B. VU + (TC D).
C. [EBIT (TC D)]/RU.
D. [EBIT (TC D)]/RA.
E. Tc D.

22. Based on M&M Proposition II with taxes, the weighted average cost of capital:
A. is equal to the aftertax cost of debt.
B. has a linear relationship with the cost of equity capital.
C. is unaffected by the tax rate.
D. decreases as the debt-equity ratio increases.
E. is equal to RU (1 - TC).
Calculation Questions (56 Points)
1. Wharton Ltd. is considering a four-year project to improve its production efficiency.
Buying a new equipment for $800,000 is estimated to result in $250,000 pretax cost
savings annually. The equipment will be depreciated equally to zero per year and will
have a salvage value of $80,000. It also requires an initial investment in inventory of
$20,000, along with an additional $4,000 in inventory for each succeeding year of the
project. Tax rate is 16.5% and the discount rate is 10%. Should the company
undertake the project? (15 Points)
2. Toronto Ltd. is considering a new Flying Bus launch. The project will cost
$2,000,000 for capital spending, have a five-year life, and have no salvage value;
depreciation is straight-line to zero. Sales are projected at 250 units per year; price per
unit will be $16,000, variable cost per unit will be $10,000, and fixed costs will be
$450,000 per year. The required return on the project is 15% and the tax rate is 20%.

a. Toronto Ltd. is confident about the sales price, unit sales, variable cost, and fixed cost
projections are accurate to within 20 percent. What are the base-case, worst-case,
and best-case scenarios NPV? (20 Points)
b. What is the sensitivity of NPV to changes in unit sales?
c. What are the accounting break-even quantity, cash break-even quantity, and financial
break-even quantity (ignoring taxes)?
3. Aba House has 11 million shares of common stock outstanding. The current share
price is $68, and the book value per share is $6. It also has two bonds outstanding.
The first bond issue has a face value of $70 million, has a 7 percent coupon rate, and
sell for 93 percent of par. The second issue has a face value of $55 million, has an 8
percent coupon rate, and sells for 104 percent of par. The first issue matures in 21
years, the second one in 6 years. The most recent dividend was $4.10 and the
dividend growth rate is 6%. The first bond has a YTM of 7.68%, the second bond has
a YTM of 7.17%. The tax rate is 35%. What is the companys WACC? (7 Points)
4. British Columbia Ltd. is proposing a rights offering. Currently there are 500,000
shares outstanding at $60 each. The company is considering $5,200,000 new equity
offered to existing shareholders through a rights offering with a subscription price of
$52 per share. How many rights are required to buy one new share? What is the new
share price? What is the value of a right? (5 points)
5. ABC Ltd. expects it EBIT to be $90,000 every year forever. The firm can borrow at
8%. It has no debt and the cost of equity is 16%. If the tax rate is 22%, what is the
value of the firm? What will the value be if it borrows $50,000 and repurchase the
outstanding shares and the cost of equity, WACC after recapitalization? (9 Points)