intermediate accounting questions

intermediate accounting questions

Question

1. Which of the following statements is most correct?

a.The cost of capital used to evaluate a project should be the cost of the specific type of financing used to fund that project.

b.The cost of debt used to calculate the weighted average cost of capital is based on an average of the cost of debt already issued by the firm and the cost of new debt.

c.For a given firm the cost of equity will always be greater than the cost of debt

d.The bond-yield-plus-risk-premium approach is the most sophisticated and objective method of estimating a firm's cost of equity capital.

e.The cost of equity capital is generally easier to measure than the cost of debt, which varies daily with interest rates, or the cost of preferred stock since preferred stock is issued infrequently.

2. Which of the following statements about the cost of capital is incorrect?

a.A company's target capital structure affects its weighted average cost of capital.

b.Weighted average cost of capital calculations should be based on the after-tax-costs of all the individual capital components.

c.If a company's tax rate increases, then, all else equal, its weighted average cost of capital will increase.

d.The cost of retained earnings is equal to the return stockholders could earn on alternative investments of equal risk.

e.Flotation costs can increase the cost of preferred stock.

3. Ball Inc. is evaluating two mutually exclusive projects with the following cash flows. Project A will cost $5000 and generate $3000 in each year of its 3 year life. Project B will cost $10000 and generate $3500 in each year of its 6 year life. The cost of capital is 10% which project should they accept and why?

a. Project A, because it has an NPV of 2461

b. B because it has a chained NPV of 5243

c. A because it has a chained NPV of 4310

d. A because it has an equivalent annual annuity of 990

e. B because it has an equivalent annual annuity of 990

4. Which of the following statements about capital budgeting cash flows is false?

a. Sunk costs are not incremental flows and hence should not be included in capital budgeting analysis.

b. Net working capital changes affect both the initial investment and the terminal or end of project cash flow.

c. If the salvage value is less than the book value at the end of the project, then the salvage value tax is a cash inflow.

d. Operating cash flow in each year equals net income plus the depreciation shield, which is the tax rate times the depreciation expense.

e. Under current tax laws, depreciation is taken over n+1 years where n=MACRS class life.

5. Heavy use of off-balance sheet lease financing will tend to

a.make a company appear more risky than it actually is because its stated debt ratio will be increased.

b.make a company appear less risky than it actually is because its stated debt ratio will appear lower.

c.affect a company's cash flows but not its degree of risk.

d.have no effect on either cash flows or risk because the cash flows are already reflected in the income statement.

e. affect the lessee’s cash flows but only due to tax effects.

6. You have the following data on (1) the average annual returns of the market for the past 5 years and (2) similar information on Stocks A and B. Which of the possible answers best describes the historical betas for A and B?

1 0.03 0.16 0.05

2 -0.05 0.20 0.05

3 0.01 0.18 0.05

4 -0.10 0.25 0.05

5 0.06 0.14 0.05

a.bA > 0; bB = 1.

b.bA > +1; bB = 0.

c.bA = 0; bB = -1.

d.bA < 0; bB = 0.

e.bA < -1; bB = 1.

7. Lighthouse Corporation uses the NPV method for selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers real options that might be associated with projects. Which of the following statements is most likely to describe its situation?

a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.

b. Its estimated capital budget is probably too large due to its failure to consider abandonment and growth options.

c. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too large, but failing to consider growth and timing options probably makes the optimal capital budget too small, so it is unclear what impact not considering real options has on the overall capital budget.

d. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget.

e. Real options should not have any effect on the size of the optimal capital budget.


8. Which of the following statements is incorrect?

a.Assuming a project has normal cash flows, the NPV will be positive if the IRR is less than the cost of capital.

b.If the multiple IRR problem does not exist, any independent project acceptable by the NPV method will also be acceptable by the IRR method.

c.If IRR = r (the cost of capital), then NPV = 0.

d.NPV can be negative if the IRR is positive.

e.The NPV method is not affected by the multiple IRR problem.

9. A company is considering an expansion project. The company’s CFO plans to calculate the project’s NPV by discounting the relevant cash flows (which include the initial up-front costs, the operating cash flows, and the terminal cash flows) at the company’s cost of capital (WACC). Which of the following factors should the CFO include when estimating the relevant cash flows?

a.Any sunk costs associated with the project.

b.Any interest expenses associated with the project.

c.Any opportunity costs associated with the project.

d.Answers b and c are correct.

e.All of the answers above are correct.

10. Which of the following statements concerning abandonment value is false?

a. The ability to abandon a project can increase its expected value.

b. The ability to abandon a project can reduce its riskiness.

c. A project should be abandoned when the abandonment value is less than the present value of the cash flows beyond the abandonment point discounted to the abandonment point.

d. The economic life of a project is that life which produces the highest NPV.

11. R.C.Inc. is estimating its WACC. Its target capital structure is 20 percent debt, 20 percent preferred stock, and 60 percent common equity. Its bonds have a 12 percent coupon, paid semiannually, a current maturity of 20 years, and sell for $1,000. The firm could sell, at par, $100 preferred stock which pays a 12 percent annual dividend, but flotation costs of 5 percent would be incurred. Rollins' beta is 1.2, the risk-free rate is 10 percent, and the market risk premium is 5 percent. Rollins is a constant-growth firm which just paid a dividend of $2.00, sells for $27.00 per share, and has a growth rate of 8 percent. The firm's policy is to use a risk premium of 4 percentage points when using the bond-yield-plus-risk-premium method to find rs. The firm's marginal tax rate is 40 percent. What is the WACC for the firm. Show the cost of each component, weights used, etc. for full credit.

12. After a long drought, the manager of Long Branch Farm is considering the installation of an irrigation system which will cost $100,000. It is estimated that the irrigation system will increase revenues by $20,500 annually, although operating expenses other than depreciation will also increase by $5,000. The system will be depreciated using MACRS over its depreciable life (5 years) to a zero salvage value. If the tax rate on ordinary income is 40 percent, what is the project's IRR?

13. Green Grocers is deciding among two mutually exclusive projects. The two projects have the following cash flows:

Project A Project B

Year Cash Flow Cash Flow

0 -$50,000 -$30,000

1 10,000 6,000

2 15,000 12,000

3 40,000 18,000

4 20,000 12,000

The company’s cost of capital is 10 percent (WACC = 10%). What is the net present value (NPV) of the project with the highest MIRR? Which should they select and why?

14. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to be able to reduce net operating working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years. Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects of this nature. If the machine costs $60,000, what is the project’s NPV, and MIRR?

15. Consider the following project data:

(1) A $500 feasibility study will be conducted at t = 0.

(2) If the study indicates potential, the firm will spend $1,000 at t = 1 to build a prototype. The best estimate now is that there is an 80 percent chance that the study will indicate potential, and a 20 percent chance that it will not.

(3) If reaction to the prototype is good, the firm will spend $10,000 to build a production plant at t = 2. The best estimate now is that there is a 60 percent chance that the reaction to the prototype will be good, and a 40 percent chance that it will be poor.

(4) If the plant is built, there is a 50 percent chance of a t = 3 cash inflow of $16,000 and a 50 percent chance of a $13,000 cash inflow.

If the appropriate cost of capital is 10 percent, what is the project's expected NPV and IRR?

16. Austin has got in a tough spot and has to come up with some money quickly to pay off his old girlfriend. The local loan shark has agreed to give him a loan of $10,000 at an agreed on rate of 13%. The shark reminded him that he uses continuous compounding on all loans and since he was desperate he took the loan but now is concerned. What is the effective rate he will be paying and if the loan is amortized over a four year period what is the annual loan payment?

17. You are asked to determine the optimal economic life of the following project. It has an engineering or physical life of 4 years. The cost of capital is 10% and all cash flows except the initial cost are end of year cash flows.

Year Net operating cash flow Net terminal cash flow

0 (50,000)

1 20,000 35,000

2 15,000 25,000

3 10,000 15,000

4 5,000 5,000

18. The Jasper County Waste Water Board has asked for your assistance in the following problem. They are considering two new methane digesters and need your input on which machine they should select. Project TEX is a similar to a machine they have used in the past that is manufactured in Texas. Since they are so familiar with the technology they consider this method to have little to no risk. Project NZ is a new technology from New Zealand. Due to some uncertainty with the adaptability of this process that was originally developed for an agricultural application, the JCWWB has asked you to use a risk adjusted technique. You have decided to use the RADR technique and will increase/decrease the discount 3 percent for projects with other than average risk. For average risk projects they use a 10% cost. Also, the Texas project will last 4 years and the NZ project has a life of only 3 years and the process is one that will need to be continued on in the future. Assume inflation effects are neutral and can be ignored and that the CFs are end of year CFs. Which project would you recommend and why?

Proj TEX PROJ NZ

Yr 1 ($140,000) ($170,000)

Yr 2 ($140,000) ($170,000)

Yr 3 ($140,000) ($170,000)

Yr 4 ($140,000)


19. You are employed by CGT, a Fortune 500 firm that is a major producer of chemicals and plastic goods: plastic grocery bags, styrofoam cups, and fertilizers. You are on the corporate staff as an assistant to the Vice-President of Finance. This is a position with high visibility and the opportunity for rapid advancement, providing you make the right decisions. Your boss has asked you to estimate the weighted average cost of capital for the company. Following are balance sheets and some information about CGT.

Assets

Current assets $38,000,000

Net plant, property, and equipment $101,000,000

Total Assets $139,000,000

Liabilities and Equity

Accounts payable $10,000,000

Accruals $9,000,000

Current liabilities $19,000,000

Long term debt (40,000 bonds, $1,000 face value) $40,000,000

Total liabilities $59,000,000

Common Stock 10,000,000 shares) $30,000,000

Retained Earnings $50,000,000

Total shareholders equity $80,000,000

Total liabilities and shareholders equity $139,000,000

You check The Wall Street Journal and see that CGT stock is currently selling for $7.50 per share and that CGT bonds are selling for $889.50 per bond. These bonds have a 7.25 percent annual coupon rate, with semi-annual payments. The bonds mature in twenty years. The beta for your company is approximately equal to 1.1. The yield on a 6-month Treasury bill is 3.5 percent and the yield on a 20-year Treasury bond is 5.5 percent. The expected return on the stock market is 11.5 percent, but the stock market has had an average annual return of 14.5 percent during the past five years. CGT is in the 40 percent tax bracket. Floatation costs on new equity are estimated to be $0.68 per share and the expected dividend is $0.75 per share. Dividends have been growing at about 6 percent per year for the past several years. Preferred stock pays a dividend of $0.45 and is currently valued at $4.50 per share. The company projects earnings available to common shareholders to be 10 million and depreciation expense to be 2 million dollars. They plan to pay the dividend mentioned above. Using market values as an estimate for the target weights what is the cost of capital and what range(s)of capital spending does the cost of capital computed apply to?


20. Parker Products manufactures a variety of household products. The company is considering introducing a new detergent. The company’s CFO has collected the following information about the proposed product. (Note: You may or may not need to use all of this information, use only the information that is relevant.)

· The project has an anticipated economic life of 4 years.

· The company will have to purchase a new machine to produce the detergent. The machine has an up-front cost (t = 0) of $2 million. The machine will be depreciated on a straight-line basis over 4 years (that is, the company’s depreciation expense will be $500,000 in each of the first four years (t = 1, 2, 3, and 4). The company anticipates that the machine will last for four years, and that after four years, its salvage value will equal zero.

· If the company goes ahead with the proposed product, it will have an effect on the company’s net operating working capital. At the outset, t = 0, inventory will increase by $140,000 and accounts payable will increase by $40,000. At t = 4, the net operating working capital will be recovered after the project is completed.

  • The detergent is expected to generate sales revenue of $1 million the first year (t = 1), $2 million the second year (t = 2), $2 million the third year (t = 3), and $1 million the final year (t = 4). Each year the operating costs (not including depreciation) are expected to equal 50 percent of sales revenue.
  • The company’s interest expense each year will be $100,000.
  • The new detergent is expected to reduce the after-tax cash flows of the company’s existing products by $250,000 a year (t = 1, 2, 3, and 4).
  • The company’s overall WACC is 10 percent. However, the proposed project is riskier than the average project for Parker; the project’s WACC is estimated to be 12 percent.
  • The company’s tax rate is 40 percent.

· What is the net present value of the proposed project?

21. Your firm is developing the analysis for a new bio-diesel plant in Carthage. This plant will use new technology to convert waste material from local poultry integrators and fast food restaurants into commercial grade diesel fuel. The technology is new and somewhat uncertain. You have developed the following cash flows estimates. The project will only last 3 years after which new technology will make the method obsolete. The firm’s cost of capital for average risk projects is 11%, the risk free rate is 6%, the beta of the project is 2.5 and the market return is 10%. The certainty equivalent factors are provided in the third column. Should the project be accepted, why or why not? Provide as much support for your answer as possible given the information provided.

Yr 0 ($850,000) 100%

Yr 1 $320,000 90%

Yr 2 $420,000 80%

Yr 3 $440,000 80%

22. Texas Wildcatters Inc. (TWI) is in the business of finding and developing oil properties, and then selling the successful ones to major oil refining companies. TWI is now considering a new potential field, and its geologists have developed the following data, in thousands of dollars.

t = 0. A $400 feasibility study would be conducted at t = 0. The results of this study would determine if the company should commence drilling operations or make no further investment and abandon the project.

t = 1. If the feasibility study indicates good potential, the firm would spend $1,000 at t = 1 to drill exploratory wells. The best estimate is that there is an 80% probability that the exploratory wells would indicate good potential and thus that further work would be done, and a 20% probability that the outlook would look bad and the project would be abandoned.

t = 2. If the exploratory wells test positive, TWI would go ahead and spend $10,000 to obtain an accurate estimate of the amount of oil in the field at t = 2. The best estimate now is that there is a 60% probability that the results would be very good and a 40% probability that results would be poor and the field would be abandoned.

t = 3. If the full drilling program is carried out, there is a 50% probability of finding a lot of oil and receiving a $25,000 cash inflow at t = 3, and a 50% probability of finding less oil and then only receiving a $10,000 inflow.

Since the project is considered to be quite risky, a 20% cost of capital is used. What is the project's expected NPV, in thousands of dollars?

Also please find the projects coefficient of variation (Hint: Use the expected NPV to find the standard deviation, etc.)


23. Carolina Trucking Company (CTC) is evaluating a potential lease for a truck with a 4-year life that costs $40,000 and falls into the MACRS 3-year class. If the firm borrows and buys the truck, the loan rate would be 10%, and the loan would be amortized over the truck’s 4-year life, so the interest expense for taxes would decline over time. The loan payments would be made at the end of each year. The truck will be used for 4 years, at the end of which time it will be sold at an estimated residual value of $10,000. If CTC buys the truck, it would purchase a maintenance contract that costs $1,000 per year, payable at the end of each year. The lease terms, which include maintenance, call for a $10,000 lease payment (4 payments total) at the beginning of each year. CTC's tax rate is 40%. Should the firm lease or buy? (Note: MACRS rates for Years 1 to 4 are 0.33, 0.45, 0.15, and 0.07.)


24. The A.B. Defense Co. currently has the following capital amounts. $400,000 of common stock, $500,000 of long-term debt, and $50,000 of preferred stock. Our best estimate is that this is also the target capital structure. If they issue new preferred stock the company can sell 1,000 shares at the par price of $40 less an estimated float of$3.00 per share. If they sell more than 1,000 shares the selling price will be only $32 with the same expected float. In either case the dividend will be set at $5 per year. New debt will have a coupon rate of 9% paid semi-annually with a 30 year maturity. The net price on bonds will be $940 and the par value is $1000. They are in a 40% tax bracket. It is expected that they will be able to issue as much debt as needed without impacting the price. Common stock is currently selling for $28 and the last dividend was $4.50 and dividends are expected to grow at 8% for the future. The company expects to have $360,000 net income in the coming year and follows a strict dividend policy of paying out 50% of earnings. Floatation fees on common stock are estimated to be 5% of the selling price.

Determine the W ACC in each of the appropriate ranges. In order to make this clear you need to determine the cost and weight of RE, new equity, debt and preferred stock and the point(s) that the W ACC increases.

They have five projects they are considering. Based on the WACC constructed on the above information and an IOS should develop from the information below please illustrate which projects should be accepted. Capital rationing is not a constraint.

Project Initial Investment IRR

Alpha $200,000 15%

Beta $250,000 18%

Charlie $150,000 16%

Delta $100,000 14%

Elsie $300,000 19%