Test 4 FIN3320 Review

Chapter 10 Review
The cost of capital for a firm is a weighted average of the required returns of the securities that are used to
finance the firm. If a firm has multiple divisions with different risk level, the weighted-average cost of
capital is adjusted to reflect the risk characteristics of each particular unit.

Key Terms
Cost of capital
Cost of common equity
Cost of debt
Risk Premium
Weighted Average Cost of Capital
Capital Structure

1. What is a firm’s WACC (class review)

2. What are the basic sources of financing included in a firm’s capital structure?

3. What does the cost of debt and cost of equity represent?

4. Recently, Flowers Food had a Beta of 0.79. What can you conclude from this information?

5. If the company has 40% debt and the cost of debt is 6%, cost of equity is 6%, and the tax
rate is 20%, what is the weighted average cost of capital? (class review)

6. This is the Way Companies has common stock with a beta of 0.85. If the risk free rate of
return is expected to be 5.2% and the market rate of return is 14%, what is the required
return on This is the Way's common stock? (class review)

7. The Holmes Company’s currently outstanding bonds have an 8% coupon and a 10% yield
to maturity. Holmes believed it could issue new bonds at par that would provide a similar
yield to maturity. If its marginal tax rate is 40%, what is Holmes’ after-tax cost of debt?
(class review)

8. A company is considering expansion into a new market. This will cost $500,000. The company
has 30% debt and 70% equity in its capital structure. The firm’s cost of debt is 7% and its cost of
equity is 12%. The firm’s tax rate is 30%. What is the firm’s cost of capital?

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
Chapter 11 Review
Capital Budgeting is the term used to refer to the process used to evaluate a firm’s long-term investment
opportunities. A number of steps are involved in the capital budgeting process. These include identifying
promising investment opportunities and evaluating the value-creating potential of these opportunities. Net
Present Value (NPV) is the “holy grail” of criteria for evaluating new investment opportunities. It
incorporates the four principles of finance: 1) cash flows are a course of value; 2) money has time value;
3) there is a risk-reward tradeoff; and 4) market prices reflect information.

Key Terms
Independent investment project
Internal rate of return (IRR)
Mutually exclusive projects
Net present value (NPV)
Payback period

1. Distinguish between revenue enhancement investments, cost-reduction investments, and

2. What does it mean to say that two or more investment projects are mutually exclusive?
(class review)

3. Why is NPV considered the best method for capital budgeting? What does NPV tell you?

4. Compare and contrast the NPV, PI, and IRR criteria. What are the advantages and disadvantages
of using each method?

5. When is it possible to have multiple IRRs?

6. Your storage firm has been offered $100,000 in one year to store some goods for one year.
Assume your costs are $95,000 payable immediately, and the cost of capital is 8%. Should you
take the contract?

7. You have an opportunity to invest $100,000 now in return for $80,000 in one year and $30,000 in
two years. If your cost of capital is 9%, what is the NPV of the investment?

8. Project L cots $65,000 and its expected cash inflows are $12,000 per year for 4 years and its
WACC is 9%, what is the projects NPV? (class review)
a. Refer to the problem above, what is the project’s IRR
b. Refer to the problem above, what is the project’s payback period

9. Project S costs $17,000 and its expected cash flows would be $5,000 per year for 5 years.
Mutually exclusive Project L costs $30,000 and its expected cash flows would be $8,750 per year
for 5 years. If both projects have a WACC of 12%, which project would you recommend?
Explain.

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
 10. You have the opportunity to purchase an office building. You have a tenant lined up that will
generate $16,000 per year in cash flows for three years. At the end of three years you anticipate
selling the building for $450,000. How much would you be willing to pay for the building if the
opportunity cost is 7%?
a. If the building is being offered for sale at a price of $350,000, would you buy the building
and what is the added value generated by your purchase and management of the building?

11. A taxi company is considering buying electric/hybrid cars in order to save on gas and maintenance.
This will cost $200,000. It will save the following:
Year 1: $70,000
Year 2: $80,000
Year 3: $80,000
Year 4: $24,000
If they can purchase these cars at 3% interest, what is NPV?

12. An uber driver is considering buying a new electric car for $35,000 that will save the following if IR
is 3%
Year 1: $10,000
Year 2: $8,000
Year 3: $5,000
Year 4: 11,000
What is NPV?
What is IRR?
What is Payback Period?

13. A company wishes to do a $1,500,000 expansion that will yield the following cash flows:
Year 1: $500,000
Year 2: $500,000
Year 3: $500,000
Year 4: 200,000
If they have an IR of 6%, what are:
NPV
IRR
Payback Period

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.
Chapter 12 Review
This chapter describes and discusses the methods that can be used to develop cash flow forecasts.
Incremental cash flows reflect the additional cash flow a firm receives from taking on a new project. This is
the relevant cash flow when assessing a project for investment purposes. There are four steps in the
procedure for calculating project cash flows. First, estimate a project’s operating cash flows. Second,
calculate a project’s working capital requirements. Third, calculate a project’s capital expenditure
requirements. Fourth, calculate a project’s free cash flow. Once all relevant cash flows are determined, one
can compute the project’s NPV and determine if the project should be accepted.

Key Terms
Expansion project
Incremental cash flow
Sunk cost
Synergy
Opportunity Cost
Working Capital
Overhead Cost
Capital Expenditure
Operating Cash Flow
Initial Outlay

1. If depreciation is not a cash flow item, why does it affect the level of cash flows from a projects?

2. What are sunk costs and how should they be considered when evaluating and investment’s cash
flows?

3. What are opportunity costs, and how should they affect an investment’s cash flows? Give an
example

4. Morten Food Products, Inc. is a regional manufacturer of salty food snack. Last year Morten sold
$300 million of its various chip products and hopes to increase its sales in the coming year by
offering a new line of baked chips. However, the firm’s analysts estimate that about 60% of these
revenues will come from existing customers who switch their purchases from one of the firm’s
existing products to the new healthier baked chips. What level of incremental sales should the
company analyst attribute to the new line of baked chips?

5. Mystic Beverage Company is considering purchasing a new bottling machine. The new machine
costs $125,000, plus installation fees of $15,000 and will generate earning before interest and
taxes of $50,000 per year over its 6-year life. The machine will be depreciated on a straight-line
basis over its 6-year life to an estimated salvage value of 0. Mystic’s marginal tax rate is 40%.
Mystic will require $40,000 in NWC if the machine is purchased.
(a) determine the initial outlay
(b) determine the annual cash flows in years 1-6
(c) determine the terminal cash flow

© 2021 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part,
except for use as permitted in a license distributed with a certain product or service or otherwise on a password-
protected website for classroom use.