Finance T/F

“Capital” is sometimes defined as funds supplied to a firm by investors. T/F T
The cost of capital used in capital budgeting should reflect the average cost of the various sources of investor-supplied funds a firm uses to acquire assets. T/F T
Suppose you are the president of a small, publicly-traded corporation. Since you believe that your firm’s stock price is temporarily depressed, all additional capital funds required during the current year will be raised using debt. In this case, the appropriate marginal cost of capital budgeting during the current year is the after-tax cost of debt. T/F F
The component costs of capital are market-determined variables in the sense that they are based on investors’ required returns. T/F T
The before-tax cost of debt, which is lower than the after-tax cost, is used as the component cost of debt for purposes of developing the firm’s WACC. T/F F
The cost of debt is equal to one minus the marginal tax rate multiplied by the average coupon rate on all outstanding debt. T/F F
The cost of debt is equal to one minus the marginal tax rate multiplied by the interest rate on new debt. T/F T
The cost of preferred stock to a firm must be adjusted to an after-tax figure because 70% of dividends received by a corporation may be excluded from the receiving corporation’s taxable income. T/F F
The cost of perpetual preferred stock is found as the preferred’s annual dividend divided by the market price of the preferred stock. No adjustment is needed for taxes because preferred dividends, unlike interest on debt, are not deductible by the issuing firm. T/F T
The cost of common equity obtained by retained earnings is the rate of return the marginal stockholder requires on the firm’s common stock. T/F T
For capital budgeting and cost of capital purposes, the firm should always consider retained earnings as the first source of capital (i.e., use these funds first) because retained earnings have no cost to the firm. T/F F
Funds acquired by the firm through retained earnings have no cost because there are no dividend or interest payments associated with them, and no floatation costs are required to raise them, but capital raised by selling new stock or bonds does. T/F F
The cost of equity raised by retained earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, floatation costs, the attitude of investors, and other factors. T/F F
The firm’s cost of external equity raised by issuing new stock is the same as the required rate of return on the firm’s outstanding common stock. T/F F
For capital budgeting and cost of capital purposes, the firm should assume that each dollar of capital is obtained in accordance with its target capital structure, which for many firms means partly as debt, partly as preferred stock, and partly retained earnings. T/F T
The higher the firm’s floatation cost for new common equity, the more likely the firm is to use preferred stock, which has no floatation cost, and retained earnings, whose cost is the average return on the assets that are acquired. T/F F
A firm should never accept a project if its acceptance would lead to an increase in the firm’s cost of capital (its WACC). T/F F
Because “present value” refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project. T/F F
Assuming that their NPVs based on the firm’s cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life. T/F F
A basic rule in capital budgeting is that if a project’s NPV exceeds its IRR, then the project should be accepted. T/F F
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher NPV. T/F T
Conflicts between two mutually exclusive projects occasionally occur, where the NPV method ranks one project higher but the IRR method puts the other one first. In theory, such conflicts should be resolved in favor of the project with the higher IRR. T/F F
The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows. T/F T
Other things held constant, an increase in the cost of capital will result in a decrease in a project’s IRR. T/F F
Under certain conditions, a project may have more than one IRR. One such condition is when, in addition to the initial investment at time = 0, a negative cash flow (or cost) occurs at the end of the project’s life. T/F T
The phenomenon called “multiple internal rates of return” arises when two or more mutually exclusive projects that have different lives are being compared. T/F F
The NPV method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital. T/F T
The IRR method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital. T/F F
The NPV method’s assumption that cash inflows are reinvested at the cost of capital is generally more reasonable than the IRR’s assumption that cash flows are reinvested at the IRR. This is an important reason why the NPV method is generally preferred over the IRR method. T/F T
For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project’s life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project’s cost. T/F T
Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods. T/F F
When evaluating mutually exclusive projects, the modified IRR (MIRR) always leads to the same capital budgeting decisions as the NPV method, regardless of the relative lives or sizes of the projects being evaluated. T/F F
One advantage of the payback method for evaluating potential investments is that it provides information about a project’s liquidity and risk. T/F T
Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process. T/F F
Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects’ cash flows. T/F T
Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects’ initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects. T/F F
Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis. T/F F
If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. T/F T
If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis. T/F F
Any cash flows that can be classified as incremental to a particular project—i.e., results directly from the decision to undertake the project—should be reflected in the capital budgeting analysis. T/F T
We can identify the cash costs and cash inflows to a company that will result from a project. These could be called “direct inflows and outflows,” and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis. T/F F
In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm’s long-run cash flows. T/F T
Suppose a firm’s CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision—estimates of its effect would really just be guesses. In this case, the externality should be ignored—i.e., not considered at all—because if it were considered it would make the analysis appear more precise than it really is. T/F F
Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. T/F F
The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater. T/F F
The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant. T/F T
Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project’s life will be higher if accelerated depreciation is used, other things held constant. T/F F
A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal. T/F T
Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year’s profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes. T/F T
If a firm’s projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate. T/F T

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