Subject: Business    / Finance
Question
1: The cost of debt is affected by
1.    retained earnings
2.    firm’s tax rate
3.    interest rate

Answer
1. 1 and 3
2. 1 and 2
3. 1, 2, and 3
4. 2 and 3

2. The marginal cost of capital rises
1.    because the cost of retained earnings exceeds the cost of new shares
2.    because the cost of new shares exceeds the cost of retained earnings
3.    if the firm issues secured debt instead of debentures
4.    if the firm issues debentures instead of secured debt
Answer
1. 2 and 4
2. 1 and 3
3. 1 and 4
4. 2 and 3

3.
The cost of debt exceeds the cost of equity.
Answer
1. True
2. False

4. Preferred stock increases common stockholders’ return
Answer
1. more than an equal dollar amount of retained earnings
2. more than an equal dollar amount of debt
3. less than an equal dollar amount of retained earnings
4. less than an equal dollar amount of debt

5. If management substitutes new common stock for retained earnings, that tends to reduce the cost of capital.
Answer
1. True
2. False

6. If equity is negative,
Answer
1. equity exceeds assets
2. equity exceeds debt
3. total assets exceed debt
4. debt exceeds total assets

7. The cost of debt is
Answer
1. less than the cost of equity
2. greater than the cost of preferred stock
3. equal to the firm’s interest rate
4. greater than the cost of equity

8. A firm can initially increase its use of debt financing without increasing the cost of debt.
Answer
1. False
2. True

9. As a firm increases its use of debt, it becomes more financially leveraged and riskier.
Answer
1. True
2. False

10. The cost of capital includes
1.    cost of debt
2.    cost of preferred stock
3.    cost of retained earnings
Answer
1. 1 and 3
2. 1 and 2
3. 2 and 3
4. 1, 2, and 3

11. The internal rate of return will be higher if
Answer
1. the cost of capital is lower
2. the cost of capital is higher
3. the cost of the investment is higher
4. the cost of the investment is lower

12. If the net present value of two mutually exclusive investments is positive, the firm should
Answer
1. make both investments
2. make the investment with the higher net present value
3. make the investment with the higher present value
4. make neither investment

13. If the net present value is positive,
1.    the internal rate of return exceeds the firm’s cost of capital
2.    the internal rate of return is less than the firm’s cost of capital
3.    the present value of cash inflows exceeds the present cost of an investment
4.    the present value of cash inflows is less than the present cost of an investment
Answer
1. 2 and 4
2. 2 and 3
3. 1 and 3
4. 1 and 4

14. A firm should make an investment if the present value of the cash inflows is
Answer
1. less than zero
2. greater than zero
3. greater than the cost of the investment
4. less than the cost of the investment

15. NPV may be preferred to IRR because
Answer
1. NPV makes the more conservative assumption concerning reinvestment
2. NPV includes salvage value
3. IRR excludes salvage value
4. IRR makes the more conservative assumption concerning reinvestment

16. The internal rate of return and net present value methods of capital budgeting assume the cash flows are reinvested at
Answer
1. the cost of capital for NPV and the internal rate of return for IRR
2. the cost of capital for IRR and the internal rate of return for NPV
3. the cost of capital
4. the internal rate of return

17. The net present value method considers
1.    the timing of the cash inflows from an investment
2.    the cost of an investment
3.    the firm’s cost of capital
Answer
1. 1, 2, and 3
2. 1 and 2
3. 2 and 3
4. 1 and 3

18. An increase in the cost of capital will
Answer
1. increase an investment’s internal rate of return
2. increase an investment’s net present value
3. decrease an investment’s internal rate of return
4. decrease an investment’s net present value

19. If the internal rate of return of two mutually exclusive investments is less than the firm’s cost of capital, the firm should make
Answer
1. both investments
2. the investment with the lower net present value
3. the investment with the higher internal rate of return
4. neither investment

20. A firm should not make an investment if
1.    its net present value is positive
2.    its net present value is negative
3.    the internal rate of return exceeds the cost of capital
4.    the internal rate of return is less than the cost of capital
Answer
1. 2 and 3
2. 2 and 4
3. 1 and 3
4. 1 and 4

21. Given the following information:
interest rate 8%
tax rate 30%
dividend $1
price of the common stock $50
growth rate of dividends 7%
debt ratio 40%
a. Determine the firm’s cost of capital.

b.    If the debt ratio rises to 50 percent and the cost of funds remains the same, what is the new cost of capital?

c.    If the debt ratio rises to 60 percent, the interest rate rises to 9 percent, and the price of the stock falls to $30, what is the cost of capital? Why is this cost different?

22. A firm with the following investment opportunities has a capital budget of $10,000. According to the net present value technique, which investment(s) should the firm make if the firm’s cost of capital is 10%?

Investment A B C

Cost: $10,000 $7,000 $3,000
Cash inflow: $12,000 $8,600 $4,000

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