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##### intermediate accounting questions

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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?;Years;Market Stock A Stock 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%

Paper#50404 | Written in 18-Jul-2015

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