Finance – Exam 2 Study Guide

Chapter 8 Net Present Value and Other Investment Criteria
The net present value is best defined as the difference between an investment’s: market value and its cost.
The process of valuing an investment by discounting its future cash flows is called: discounted cash flow valuation.
The period of time it takes an investment to generate sufficient cash flows to recover its initial cost is called the: payback period.
Which one of the following correctly defines the average accounting return? average net income divided by average book value.
The internal rate of return is the: discount rate that causes the net present value of a project to equal zero.
The net present value profile is a graphical relationship of an investment’s: discount rate and its net present value.
The possibility that more than one discount rate can cause the net present value of a project to equal zero is referred to as: multiple rates of return.
A mutually exclusive investment decision is defined as a situation where: an investment in project A prohibits you from investing in project B.
The present value of an investment’s cash inflows divided by the investment’s initial cost is called the: profitability index.
Which of the following indicate that a project will produce a return equal to or greater than the required rate of return for that project? I and II only;I. a positive NPVII. an NPV of zero
The net present value rule states that you should accept a project if the NPV: is positive.
The net present value: I and III only;I. is highly dependent upon the discount rate applied to an investment.III. is a measure of the value created by undertaking an investment.
Of the following methods used to evaluate investments, the overall best method is the: net present value.
Net present value is: equal to zero when the discount rate used is the IRR.
A net present value of zero implies that an investment: has no expected impact on shareholders.
A project has a net present value of $2,500 and an initial cash outlay of $2,500. This project’s: required return is less than its internal rate of return.
The president of a firm is most concerned with creating value for the firm’s shareholders. Given this concern, the best method he or she should use to evaluate all proposed projects is: net present value.
Which one of the following statements is correct concerning the payback rule? The rule is flawed because it ignores all cash flows after some arbitrary point in time.
The payback rule works best in evaluating which one of the following? low cost project which pays back rapidly.
The payback rule: I, II, and IV only;I. is biased towards short-term projects.II. helps limit possible losses.IV. is biased towards liquidity.
Payback ignores the: time value of money.
Which one of the following methods can be applied without the use of an interest rate? payback
Which one of the following methods is biased towards liquidity and requires an arbitrary cutoff date? payback
Which one of the following methods has the least value from a financial point of view? average accounting return
Angie is evaluating a proposed project and wants to answer two questions. First, what is the market value of the project? Second, how much profit will the project produce in relation to its book value? To answer these two questions, Angie should use which one of the following sets of investment analysis methods? net present value and average accounting return
The average accounting return: II only;II. ignores time value.
Which one of the following methods is based on net income rather than cash flows? accounting rate of return
The _________ can be interpreted as the breakeven financing rate that leads to a profitable project. internal rate of return
The internal rate of return can lead to faulty decisions: IV only;IV. if two projects are mutually exclusive.
You are considering a project which has an internal rate of return that is equal to the required return. This means that the: project is returning the minimal amount that is acceptable to you.
The internal rate of return is: the minimal rate that produces an accept decision given the net present value rule.
If a project has an internal rate of return that exceeds the required discount rate, then the project: should be accepted because the net present value is positive.
The internal rate of return is best used to evaluate: a project with all positive cash inflows after the initial cash outlay.
If a project has conventional cash flows and a net present value equal to 1.0, then the internal rate of return ______ the required rate of return. must be greater than
Which one of the following best expresses two mutually exclusive investments? building either a gas station or a restaurant on a corner lot
When evaluating two mutually exclusive investments, the best method to use is the: net present value.
You are using a net present value profile to compare two projects. At the point where the net present value of the two projects intersect, the: relevant discount rate is called the crossover rate.
For a project with conventional cash flows, a profitability index greater than 1.0 means that the: net present value is positive.
If managers only invest in projects that have a profitability index greater than 1.0, the: firm will increase in value.
If a project with conventional cash flows has a profitability index equal to 1.0, the project: I and II only; I. will pay back during the life of the project.II. will have an internal rate of return that equals the project’s required rate of return.
Which one of the following will reveal the amount of cash in today’s dollars that a project will return for each dollar originally invested? profitability index
Project selection ambiguity can arise if you rely on the internal rate of return instead of the net present value when: there are multiple internal rates of return.
Rank the following decision rules from best to worst in terms of their overall usefulness in capital budgeting analysis for a project with conventional cash flows. IV, I, II, III;IV. net present valueI. internal rate of returnII. paybackIII. average accounting rate of return
Which one of the following methods is most appropriate for a low-level manager, who has no financial training, to use when evaluating small projects? payback
The payback method of analysis is the most beneficial in which one of the following situations? A firm has free cash which can be invested but must be returned in time to meet a bond obligation two years from now.
Which one of the following is correct concerning the rules related to project analysis? The internal rate of return can lead to faulty decisions if two mutually exclusive projects are of different sizes.
Chapter 9 Making Capital Investment Decisions
The incremental cash flows of a project can best be defined as the difference between a firm’s ________ with and without the project. future cash flows
The stand-alone principle is the assumption that the evaluation of a project may be based on the project’s: incremental cash flows.
A cost that has already been incurred and cannot be recouped is referred to as a(n) ______ cost. sunk
An opportunity cost is defined as: the most valuable alternative that is given up if a particular investment is undertaken.
A reduction in the sales of a current product whenever a new product is introduced by a firm is called: erosion.
A pro forma financial statement is a financial statement which: projects future years’ operations.
The depreciation tax shield is defined as: D x T.
A U.S. depreciation system which allows for more rapid depreciation under various classifications is called the _______ system. accelerated cost recovery
Forecasting risk can be defined as the possibility that _________ will lead to incorrect decisions. errors in projected cash flows
The analysis of the effects that what-if questions have on a project is referred to as _______ analysis. scenario
The analysis of the effect that a single variable has on the net present value of a project is called ________ analysis. sensitivity
The opportunities to change the way a product is priced, manufactured, or advertised in the future are referred to as: managerial options.
Contingency planning is the consideration of the: managerial options implicit in a project.
The options that a company has to expand their business into related products are referred to as ________ options. strategic
The situation a firm faces when it has positive net present value projects but cannot obtain financing for those projects is referred to as: capital rationing.
Soft rationing is best defined as the situation that exists when: the units within a business are allotted a fixed amount of money for their annual capital spending.
When a firm cannot raise financing for a project under any circumstances, the firm is facing a situation known as: hard rationing.
The Shoe Co. is considering adding a new line of sandals to their product line-up. Which of the following are relevant cash flows for this project? II and IV only;II. the additional revenue generated from the new line of sandalsIV. the commission paid to a salesperson for selling the new sandals
ABC Plastics currently produces plastic plates. The company is considering expanding their production to include plastic silverware. Payment for which of the following are relevant to this project? I, II, and IV only;I. the plastic used to make the silverwareII. the labor involved in making the silverwareIV. the plastic needed to produce the additional plates they expect to sell if they expand their product offerings
Alfsonso and Sons purchased a new grinding machine 2 years ago at a cost of $390,000. Last year, some revolutionary developments occurred making their machine virtually worthless as it cannot produce products which meet the higher quality standards of the newer machines. If Alfsonso and Sons continues using their current machine, they will lose all their customers. They have not found anyone willing to purchase the machine even at a deeply discounted price. The best description of this machine today is that is a(n) ______ cost. sunk
The Siverly Hill Billies are discussing their old truck. Which one of the following items from their discussion represents a sunk cost? new fuel tank they put on last week
Jeff’s Sporting Goods sells fishing, hunting, and camping equipment. Jeff is contemplating greatly expanding the selection and variety of his hunting equipment. If he does this, he expects his fishing and hunting sales will increase and his camping related sales will decrease. Which one of the following expresses the erosion cost of this expansion project? Only the change in the camping equipment sales is an erosion effect.
Lakeside Amusement Park is adding a new thriller roller coaster to their park. They expect this addition to increase their overall ticket sales. On individual rides, they expect the ridership of their old roller coaster to increase along with the use of their bungee jumping facility. They expect fewer people to ride their creeper ride, but more to eat at their restaurant. Which of these changes represent the effect of erosion? the change in the ridership of the creeper ride
The Brick and Mortar Book Shop has decided to sell books on-line. Currently, their greatest sellers are young children’s books. On-line, they expect to sell primarily fiction to teenagers. Which one of the following would be an erosion cost related to this decision? less in-store sales because of the convenience of on-line shopping
The net working capital invested in a project is generally: recouped at the end of the project.
A proposed project will reduce the amount of inventory a firm must keep on hand. This effect: is an initial cash inflow that should be included in the analysis.
The effects that projects have on the current accounts of a firm are captured in the: net working capital cash flows.
Compiling pro forma income statements for a project can allow the financial managers of a firm to see: I, II, III, and IV;I. the dollar changes in the sales revenue over a period of time.II. the effect that depreciation has on the net income for each time period.III. the difference between EBIT and net income.IV. a comparison of fixed versus variable costs.
Operating cash flow is equal to: EBIT minus taxes plus depreciation.
Operating cash flow includes: all of the cash expenses of a firm except interest expense.
The operating cash flow of a taxable firm: can be computed using the tax shield approach.
The tax shield approach computes the operating cash flow of a firm using the formula: (Sales – Costs) x (1 – T) + (D x T).
Using the tax shield approach, a(n) ________ will increase the operating cash flow. increase in depreciation
Which one of the following can be completely ignored when analyzing a project? sunk cost
Which one of the following statements is correct concerning MACRS? A fixed asset classified as 5-year property is depreciated to a zero book value over 6 years.
Scenario analysis asks questions such as: What is the best outcome that is reasonably possible for this project?
Scenario analysis can be thought of as the: means of answering “What if?” questions that affect multiple variables simultaneously.
Sensitivity analysis: helps identify the variable within a project that presents the greatest forecasting risk.
Which of the following are examples of managerial options? I, II, III, and IV;I. changing the price of a productII. discontinuing the production of a productIII. waiting for a period of time before commencing a projectIV. changing the production process by which a product is manufactured
Ignoring the option to expand: underestimates the net present value of a project.
If a manager ignores the option of scaling back a project, he or she: misses something of value when analyzing a project.
The postponement of a project until conditions are more favorable: I and III only;I. is a valuable option.III. could cause a negative net present value project to become a positive net present value project.
Under soft rationing, it would be common to find that division managers within a firm: compete to increase their capital allocation.
Which one of the following rates of return expresses the required return for a firm facing hard rationing? a rate so large that no project has a positive net present value
Chapter 13 Leverage and Capital Structure
The use of personal borrowing to change the overall amount of financial leverage to which an individual is exposed is called: homemade leverage.
The theory that the value of a firm is independent of its capital structure is referred to as: M&M Proposition I.
The theory that a firm’s cost of equity capital is a positive linear function of its capital structure is referred to as: M&M Proposition II.
Business risk is defined as the: equity risk that comes from the nature of a firm’s operating activities.
Financial risk is defined as the: equity risk that comes from the capital structure of a firm.
The tax savings attained by a firm because of the tax deductibility of the interest expense is called the: interest tax shield.
The legal and administrative costs of bankruptcy are called ______ bankruptcy costs. direct
The costs incurred by a firm in an effort to avoid bankruptcy are called ______ bankruptcy costs. indirect
The direct and indirect costs of bankruptcy are also called ___________ costs. financial distress
The argument that a firm borrows up to the point where the tax benefit of an extra dollar of debt is exactly offset by the increased probability of financial distress is called: the static theory of capital structure.
Bankruptcy is best defined as: a legal proceeding for liquidating or reorganizing a business.
The term which best describes the termination of a firm as a going concern is: liquidation.
The financial restructuring of a firm in an attempt to create a situation in which the firm can continue its operations as a going concern is best described as a(n): reorganization.
The list which establishes the order of claims in a liquidation is referred to as: the absolute priority rule.
A firm’s optimal capital structure: is the debt-equity ratio that results in the lowest possible weighted average cost of capital.
Assume that you are comparing two firms which are identical, with one exception. Firm A is an all-equity firm and firm B has a debt-equity ratio of .6. All else equal, firm A will: earn less than firm B when the level of earnings before interest and taxes (EBIT) is relatively high.
Which one of the following statements concerning financial leverage is correct? Financial leverage magnifies both profits and losses.
You are comparing two financial policies. The first is all equity. The second involves the use of $2 million of debt. The break-even point between these two policies occurs when the earnings before interest and taxes (EBIT) is $450,000. Given this, it is accurate to say that leverage ___ beneficial to the firm when EBIT is $325,000 and ___ beneficial when EBIT is $625,000. is not; is
Which one of the following statements concerning financial leverage is correct? If a firm employs financial leverage, the shareholders will be exposed to greater risk.
Less Debt, Inc., just revised its capital structure such that the firm’s debt-equity ratio decreased from .80 to .40. Those individual investors who prefer the old capital structure: can replicate that structure by increasing their use of homemade leverage.
M&M Proposition I, without taxes, states that: it is completely irrelevant how a firm arranges its finances.
Which one of the following suggests that a firm should be indifferent between a debt-equity ratio of .40 and a ratio of .75 if the firm’s goal is to maximize firm value? M&M Proposition I, without taxes
According to M&M Proposition II, without taxes, the cost of equity depends on the firm’s: II, III, and IV only;II. cost of debt.III. debt-equity ratio.IV. required rate of return on its assets.
M&M Proposition II, without taxes, states that: RE rises as a firm increases its use of financial leverage.
Financial risk: increases as a firm’s debt-equity ratio increases.
Taylor & Taylor has positive earnings before interest and taxes (EBIT). Given this, which one of the following statements related to the interest tax shield is correct? The present value of the tax shield is equal to TC x D.
M&M Proposition I, with taxes, states that the value of a levered (VL) firm is equal to: VU + (TC x D).
Which of the following statements correctly relate to M&M Proposition I, with taxes? I only;I. Debt financing is advantageous to a firm.
Which one of the following is an example of a direct bankruptcy cost? A firm engages an attorney to draft a prepack.
The assumption that a firm is fixed in terms of its operations and assets is most related to: the static theory of capital structure.
The maximum firm value, according to the static theory of capital structure, occurs at a point where the: value of the firm equalizes the costs of financial distress with the present value of the tax shield on debt.
The maximum firm value, as defined by the static theory of capital structure, demonstrates that a firm: benefits from leverage, net of financial distress costs.
Which of the following are correct assumptions based on the static theory of capital structure? II and IV only;II. There is an inverse relationship between the amount that a firm should borrow and the volatility of its earnings before interest and taxes (EBIT).IV. The higher a firm’s tax rate, the greater the firm’s incentive to borrow.
U.S. firms, in general: have debt-equity ratios that vary by industry.
A firm is technically insolvent: when it is unable to meet its financial obligations.
Which one of the following relates to a bankruptcy liquidation, but not to a reorganization? termination of the firm as a going concern
Which one of the following will generally receive the highest priority in a bankruptcy liquidation, assuming that the absolute priority rule applies? bankruptcy administrative expenses
A secured creditor in a bankruptcy liquidation is entitled to the proceeds from the underlying security: up to the amount they are due.
Which one of the following statements is true concerning a bankruptcy? A federal judge has the authority to deny a Chapter 11 bankruptcy petition filed by a firm.
A prepackaged bankruptcy: has been approved by a firm’s creditors prior to the bankruptcy petition being filed with the court.
The bankruptcy process has been utilized in the past by firms to: I, II, III, and IV;I. renegotiate labor contracts.II. reduce their labor costs.III. avoid paying a legal judgment.IV. improve their competitive position.

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