Chapter 9

23. Corporate income statements are designed primarily to show:

A. cash flows during a period.
B. account balances at the end of a period.
C. performance during a period.
D. market values of assets and liabilities.
24. Projects that are calculated as having negative NPVs should be:
A. depreciated over a longer time period.
B. charged less in overhead costs.
C. discounted using lower rates.
D. rejected or abandoned.
25. If the adoption of a new product will reduce the sales of an existing product,
then the:
A. new product should not be undertaken.
B. old product should be abandoned.
C. incremental benefits of the new product may be over-estimated.
D. incremental benefits of the new product may be under-estimated.

26. The value of a proposed capital budgeting project depends upon the:
A. total cash flows produced.
B. incremental cash flows produced.
C. accounting profits produced.
D. increase in total sales produced.
27. The rationale for not including sunk costs in capital budgeting decisions is
that they:
A. are usually small in magnitude.
B. revert at the end of the investment.
C. have no incremental effect.
D. reduce the estimated NPV.
28. If a project's cash flows exceed the project's incremental cash flows, it is likely
that the:
A. project interacts with other aspects of the firm.
B. project must have high depreciation expense.
C. opportunity cost of capital must be high.
D. project will have a negative NPV.
29. When is it appropriate to include sunk costs in the evaluation of a project?
A. Include sunk costs when they are relatively large.
B. Include sunk costs if it improves the project's NPV.
C. Include sunk costs if they are considered to be overhead costs.
D. It is never appropriate to include sunk costs.
30. A cost should be considered sunk when it:
A. is fully depreciated.
B. produces no additional sales revenues.
C. has no effect on future flows.
D. is replaced by costs that are not yet sunk.
31. The opportunity cost of an asset:
A. should be depreciated annually.
B. can differ depending on market conditions.
C. is typically ignored in capital budgeting.
D. is important only for parcels of land.

Chapter 10

24. What level of management is responsible for originating capital budgeting

proposals?
A. Senior management
B. Divisional management
C. Lower management
D. All levels of management
25. The capital budget should be consistent with the firm's:
A. growth in sales.
B. strategic plans.
C. current level of funds.
D. dividend policy.
26. Which of the following would not be judged a traditional category of capital
budgeting project?
A. Machine replacement proposals
B. Salary adjustment proposals
C. New product proposals
D. Plant expansion proposals
27. Which of the following industry has low operating leverage?
A. Steel.
B. Railroads.
C. Electric utilities.
D. Autos.
28. Which of the following capital budgeting proposals is most likely to display a
conflict of interests?
A. The proposal with highest NPV.
B. The proposal with the longest payback period.
C. The proposal with highest IRR and quickest payback.
D. The proposal to solve pollution problems.
29. Which of the following is least likely to be responsible for a regional
manager's conflict of interest in promoting a capital budgeting proposal?
A. Desire for professional advancement
B. Thorough knowledge of the region
C. Overly optimistic economic forecasts
D. The need for quick profitability
30. Soft capital rationing may be beneficial to a firm if it:
A. reduces a firm's interest expense.
B. weeds out proposals with weaker or biased NPVs.
C. allows managers to select their favorite projects.
D. increases funds to be used for other purposes.

31. The purpose of sensitivity analysis is to show:

A. the optimal level of the capital budget.
B. how price changes affect break-even volume.
C. seasonal variation in product demand.
D. how variables in a project affect profitability.
32. Sensitivity analysis evaluates projects by:
A. forecasting changes in interest rates that would increase financing costs.
B. recording profitability changes while changing one variable at a time.
C. insuring that the project sponsor has proper incentives.
D. testing for interrelated variables.
33. What happens to the NPV of a one-year project if fixed costs are increased
from $400 to $600, the firm is profitable, has a 15% tax rate and employs a 12%
cost of capital?
A. NPV decreases by $200.00.
B. NPV decreases by $173.91.
C. NPV decreases by $130.00.
D. NPV decreases by $113.04.

change in cash flow = (200) + 70 = (130),

which discounts to $113.04
34. What happens to the NPV of a one-year project if fixed costs are increased
from $400 to $600, the firm is not profitable, has a 15% tax rate and employs a
12% cost of capital?
A. NPV decreases by $200.00.
B. NPV decreases by $178.57.
C. NPV decreases by $130.00.
D. NPV decreases by $113.04.

change in cash flow = (200),

which discounts to $178.57
35. Which of the following appears to be a more likely result from using
sensitivity analysis?
A. Agreement on the appropriate discount rate
B. Determine whether to finance with debt or equity.
C. Isolation of pivotal factor in project profitability
D. Select the best capital budgeting project.

36. If a 20% reduction in forecast sales would not extinguish a project's

profitability, then sensitivity analysis would suggest:
A. deemphasizing that variable as a critical factor.
B. requiring a more detailed sales forecast.
C. the initial sales forecasts were inflated.
D. a reallocation of fixed costs to this product.
37. If sensitivity analysis concludes that the largest impact on profits would come
from changes in the sales level, then:
A. fixed costs should be traded for variable costs.
B. variable costs should be traded for fixed costs.
C. the project should not be undertaken.
D. additional marketing analysis may be beneficial before proceeding.

38. Which of the following statements is correct concerning sensitivity analysis?

A. It ignores interrelationships between variables.
B. Several variables are allowed to change concurrently.
C. It considers all feasible variable combinations.
D. Its results are free from ambiguity.
39. If sensitivity analysis indicates none of the individual variables will cause a
negative NPV under pessimistic conditions, then the:
A. project is assured to be successful.
B. project's discount rate should be reduced.
C. economic forecasts are possibly overly optimistic.
D. interaction of the variables should be considered.

Chapter 11
33. Macro events only are reflected in the performance of the market portfolio
because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
34. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
35. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock.
36. The sensitivity of a stock's returns to the returns on a market portfolio is
referred to as the:
A. stock's market risk premium.
B. stock's beta.
C. market portfolio's systematic risk.
D. stock's unique risk.
37. When the overall market is up by 10%, an investor with a portfolio of
defensive stocks will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
38. When the overall market experiences a decline of 8%, an investor with a
portfolio of aggressive stocks will probably experience:
A. negative portfolio returns of less than 8%.
B. negative portfolio returns of greater than 8%.
C. positive portfolio returns of less than 8%.
D. positive portfolio returns of greater than 8%.
39. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.

40. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
41. The line plotted to fit observations of a stock's returns versus the market's
returns determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
42. If a stock consistently goes down (up) by 1.6% when the market portfolio
goes down (up) by 1.2% then its beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.
43. If the slope of the line measuring a stock's historic returns against the
market's historic returns is positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.

Chapter 12

33. Macro events only are reflected in the performance of the market portfolio
because:
A. the market portfolio has no individual firms.
B. only macro events are tracked by economists.
C. unique risks have been diversified away.
D. firm-specific events would be too numerous to list.
34. In practice, the market portfolio is often represented by:
A. a portfolio of U.S. Treasury securities.
B. a diversified stock market index.
C. an investor's mutual fund portfolio.
D. the historic record of stock market returns.
35. A stock's beta measures the:
A. average return on the stock.
B. variability in the stock's returns compared to that of the market portfolio.
C. difference between the return on the stock and return on the market portfolio.
D. market risk premium on the stock.
36. The sensitivity of a stock's returns to the returns on a market portfolio is
referred to as the:
A. stock's market risk premium.
B. stock's beta.
C. market portfolio's systematic risk.
D. stock's unique risk.
37. When the overall market is up by 10%, an investor with a portfolio of
defensive stocks will probably have:
A. negative portfolio returns less than 10%.
B. negative portfolio returns greater than 10%.
C. positive portfolio returns less than 10%.
D. positive portfolio returns greater than 10%.
38. When the overall market experiences a decline of 8%, an investor with a
portfolio of aggressive stocks will probably experience:
A. negative portfolio returns of less than 8%.
B. negative portfolio returns of greater than 8%.
C. positive portfolio returns of less than 8%.
D. positive portfolio returns of greater than 8%.
39. A stock with a beta greater than 1.0 would be termed:
A. an aggressive stock, expected to increase more than the market increases.
B. a defensive stock, expected to decrease more than the market increases.
C. an aggressive stock, expected to decrease more than the market increases.
D. a defensive stock, expected to increase more than the market decreases.

40. The average of beta values for all individual stocks is:
A. greater than 1.0; most stocks are aggressive.
B. less than 1.0; most stocks are defensive.
C. unknown; betas are continually changing.
D. exactly 1.0; these stocks represent the market.
41. The line plotted to fit observations of a stock's returns versus the market's
returns determines the:
A. security market line.
B. beta of the stock.
C. market risk premium.
D. capital asset pricing model.
42. If a stock consistently goes down (up) by 1.6% when the market portfolio
goes down (up) by 1.2% then its beta:
A. equals 1.04.
B. equals 1.24.
C. equals 1.33.
D. equals 1.40.
43. If the slope of the line measuring a stock's historic returns against the
market's historic returns is positive, then the stock:
A. has a beta greater than 1.0.
B. has no unique risk.
C. has a positive beta.
D. plots above the security market line.

Chapter 13

29. Capital structure decisions refer to the:

A. dividend yield of the firm's stock.
B. blend of equity and debt used by the firm.
C. capital gains available on the firm's stock.
D. maturity date for the firm's securities.
30. What appears to be the targeted debt ratio of a firm that issues $15 million in
bonds and $35 million in equity to finance its new capital projects?
A. 15.00%
B. 30.00%
C. 35.00%
D. 60.00%

31. Proposed assets can be evaluated using the company cost of capital
providing that the:
A. firm does not pay taxes.
B. firm is all equity financed.
C. cost of debt is less than the cost of equity.
D. new assets have the same risk as existing assets.
32. The company cost of capital for a firm with a 65/35 debt/equity split, 8% cost
of debt, 15% cost of equity, and a 35% tax rate would be:
A. 7.02%
B. 9.12%
C. 10.45%
D. 13.80%
0.65x 8% + 0.35 x 15% = 10.45%
33. The company cost of capital, after tax, for a firm with a 65/35 debt/equity
split, 8% cost of debt, 15% cost of equity, and a 35% tax rate would be:
A. 7.02%
B. 8.63%
C. 10.80%
D. 13.80%

0.65x (1-35%) x 8% + 0.35 x 15% = 8.63%

34. Why is debt financing said to include a tax shield for the company?
A. Taxes are reduced by the amount of the debt.
B. Taxes are reduced by the amount of the interest.
C. Taxable income is reduced by the amount of the debt.
D. Taxable income is reduced by the amount of the interest.

35. What is the pretax cost of debt for a firm in the 35% tax bracket that has a
10% after-tax cost of debt?
A. 5.85%
B. 12.15%
C. 15.38%
D. 25.71%
after-tax cost of debt = pretax cost x (1 - tax rate)
10% = pretax cost x .65
15.38% = pretax cost of debt
36. How much is added to a firm's weighted average cost of capital for 45% debt
financing with a required rate of return of 10% and a tax rate of 35%?
A. 1.29%
B. 2.93%
C. 3.50%
D. 4.50%

Component cost of debt = .45 x (1 - .35).10

= .45 x (.65 x .10)
= .45 x .065
= 2.925%
37. What is the WACC for a firm with 50% debt and 50% equity that pays 12% on
its debt, 20% on its equity, and has a 40% tax rate?
A. 9.6%
B. 12.0%
C. 13.6%
D. 16.0%
WACC = (.5 x (.12 x .6)) + (.5 x .2)
= 3.6% + 10% = 13.60%
38. Company X has 2 million shares of common stock outstanding at a book
value of $2 per share. The stock trades for $3.00 per share. It also has $2 million
in face value of debt that trades at 90% of par. What is its ratio of debt to value
for WACC purposes?
A. 15.38%
B. 28.6%
C. 31.0%
D. 33.3%
2 million shares x $3.00 = $6,000,000
$2 million debt x 90% = $1,800,000
Total value = $7,800,000
$1.2 million/$7.8 million = 15.38%
39. What is the after-tax cost of preferred stock that sells for $10 per share and
offers a $1.20 dividend when the tax rate is 35%?
A. 4.20%
B. 7.80%
C. 8.33%
D. 12.00%
$1.20/$10.00 = 12%
40. What is the WACC for a firm using 55% equity with a required return of 15%,
35% debt with a required return of 8%, 10% preferred stock with a required
return of 10%, and a tax rate of 35%?
A. 10.72%
B. 11.07%
C. 11.70%
D. 12.05%
WACC = (.35 x (1 - .35).08) + (.1 x .1) + (.55 x .15)
= 1.82% + 1.0% + 8.25%
= 11.07%

41. Should a project be accepted if it offers an annual after-tax cash flow of

$1,250,000 indefinitely, costs $10 million, is riskier than the firm's average
projects, and the firm uses a 12.5% WACC?
A. Yes, since NPV is positive.
B. Yes, since a zero NPV indicates marginal acceptability.
C. No, since NPV is zero.
D. No, since NPV is negative.
NPV = -10 million + $2 million/.20 = -10 + 10 = 0
However, the 20% rate does not reflect the projects' greater risk; thus NPV is
negative.
42. How much will a firm need in cash flow before tax and interest to satisfy
debtholders and equityholders if: the tax rate is 40%, there is $10 million in
common stock requiring a 12% return, and $6 million in bonds requiring an 8%
return?
A. $1,392,000
B. $1,488,000
C. $2,480,000
D. $2,800,000

43. How much will a firm need in cash flow before tax and interest to satisfy
debtholders and equityholders if: the tax rate is 35%, there is $13 million in
common stock requiring a 10% return, and $6 million in bonds requiring an 6%
return?
A. $1,392,000
B. $1,488,000
C. $2,360,000
D. $2,480,000

44. Which of the following statements is incorrect concerning the equity

component of the WACC?
A. The value of retained earnings is not included.
B. Market values should be used in the calculations.
C. Preferred equity has a separate component.
D. There is a tax shield such as with debt.

45. What will be the effect of using book value of debt in WACC decisions if
interest rates have decreased substantially since a firm's long-term bonds were
issued?
A. The debt-to-value ratio will be overstated.
B. The debt-to-value ratio will be understated.
C. There will be no effect on WACC decisions.
D. Cannot be determined without knowing interest rates.

Thus, the debt-to-value ratio is .286. However, if the market value of debt is $2.5
million due to increased interest rates, the value of the firm is $7.5 million and
the debt-to-value ratio is .333. The key is that the numerator of the ratio changes
proportionately more than the denominator.
46. Which component is more likely to be biased if book values are used in the
calculation of WACC rather than market values?
A. Debt
B. Preferred stock
C. Common stock
D. All categories should be equally biased.
47. What would you estimate to be the required rate of return for equity investors
if a stock sells for $40 and will pay a $4.40 dividend that is expected to grow at a
constant rate of 5%?
A. 7.6%
B. 12.0%
C. 12.6%
D. 16.0%

Chapter 16