Corporate Finance - Assignment and Answer Key Part 5

Which of the following is a part of capital budgeting? - Deciding which fixed assets to buy The difference between an investment's market value and its cost is known as its _____. - net present value Capital budgeting ______ when we cannot observe the market price for comparable investments. - becomes more difficult The process of valuing an investment by discounting its future cash flows is called valuation. - discounted - Blank 2: cash - Blank 3: flow What is the net present value (NPV) of a project whose initial investment is $100, cash flow in one year is $107, and discount rate is 6%? (Round your answer to two decimal places) - 0.94 - NPV = –100 + (107 / (1 + 0.06)) = $0.94 Capital budgeting can also be referred to as _____. - strategic asset allocation _____ is a measure of how much value is created or added today by undertaking an investment. - Net present value Difficulties are faced while using net present value method for capital budgeting when the _____. - market price of comparable investment is not availablw In the discounted cash flow (DCF) valuation method, the NPV of a project is calculated as the _____. - difference between the present value of the future cash flows and the cost of the investment A project has an initial setup cost of $10,000 and is expected to deliver an annual cash flow of $4,700 for three years. If the discount rate is 8%, find the NPV of the project. - $2,112.36 Which of the following is a part of capital budgeting? - Deciding which fixed assets to buy When calculating net present value (NPV), the present value of the nth cash flow is found by dividing the nth cash flow by 1 plus the _____ rate raised to the power of n- discount What is the basic net present value (NPV) investment rule? (Select all that apply.) - Accept a project if its NPV is greater than zero - Reject a project if its NPV is less than zero - If a project's NPV is equal to zero, a firm would be indifferent to accepting or rejecting the project The NPV figure tells us ______. - how much value will be created with the investment What is the formula entered in the spreadsheet while calculating net present value (NPV)? - =NPV(rate, value 1, value2,...) − initial cash outflow Based on the payback rule, an investment is acceptable if its calculated payback is less than some prespecified number of years. - True The initial investment of a project is $80,000, and the cash flows are $30,000 in the first year and $100,000 in the second year, Calculate the payback period of the project - 1.50 A project should be _____ if its NPV is greater than zero- Accepted Identify the benefits of the NPV method - It helps rank projects based on their capacity to create value - It adjusts the cash flows for the risk associated with the project. - It helps select the projects that increase shareholders' wealth. The spreadsheet function for calculating net present value is ____. - =NPV() The amount of time required for an investment to generate cash flows to recover its initial cost is called its - payback - Blank 2: period The initial setup cost of a project is $10,000 and the project is expected to have an annual cash flow of $4,000 for seven years. Calculate the payback period of the project. - 2.5 years The biggest problem with the payback rule is coming up with the right - cutoff period One of the flaws of the payback period method is that cash flows after the cutoff date are - not considered in the analysis By ignoring cash flows beyond the cutoff, the payback period rule may ______ profitable long-term investments. - reject One of the challenges of the payback period is that the cutoff date is a(n) _____ figure - arbitrary As a practical matter, an investment that pays back rapidly and has benefits extending beyond the cutoff period probably has a(n) - positive NPV The _____ method is both intuitive and easy to understand. - payback period Compared to the net present value (NPV) method, which of the following statements are true about the payback period method? (Select all that apply.) - NPV takes into account the risk associated with the project, whereas the payback period ignores the risk associated - NPV takes into account all cash flows, whereas the payback period ignores the cash flows after the payback period. Which of the following capital budgeting methods is used by large and sophisticated companies when making relatively small decisions that do not warrant detailed analysis? - The payback period method Identify the true statements about the payback period method - It is biased toward liquidity. - It adjusts for uncertainty of later cash flows Place the steps involved in the discounted payback period in order. - Discount - Add - Determine - Accept A major problem with the discounted payback period is that _____. - the cash flows beyond the cutoff date are ignored The _____ method is both intuitive and easy to understand. - payback period The advantage of the discounted payback period over the ordinary payback period is that the discounted payback period method considers the _ _ _ whereas the ordinary payback period does not. time - Blank 2: value - Blank 3: of - Blank 4: money The capital budgeting method used to find the length of time required for an investment’s discounted cash flows to equal its initial cost is called the _____ method. - discounted payback period Which of the following is an advantage of the discounted payback period? - It does not accept negative estimated NPV investments. A project has an initial setup cost of $10,000 and is expected to deliver an annual cash flow of $2,200 for ten years. If the appropriate discount rate is 10%, find the discounted payback period. (Round your answer to the nearest whole number.) - 6 years The average accounting return is calculated as __. - an investment's average net income divided by its average book value The discounted payback is better than the ordinary payback because it ______. - considers time value of money The discounted payback period is the length of time until the sum of the discounted cash flows equals _____. - the initial investment Which of the following are disadvantages of the discounted payback period? (Select all that apply.) - Biased against long-term projects. - May reject positive NPV investments. - Ignores cash flows beyond the cutoff date. - Requires an arbitrary cutoff point A project's net income is $80,000 for Year 1 and $100,000 for Year 2. The investment is $500,000, which would be 100% depreciated over the two years. Find the average accounting return of the project. - 36 According to the average accounting return rule, a project is acceptable if its average accounting return exceeds - a target average accounting return Which of the following is an advantage of the average accounting return (AAR)? - Its input data is easily available. In the capital budgeting, the IRR stands for ______. - internal rate of return Which of the following is true of the average accounting return (ARR)? - A project is acceptable if its ARR exceeds a target average accounting return. The internal rate of return of a project is a function of the _____ of the project. - Cash flows Which of the following are disadvantages of the average accounting return (AAR)? (Select all that apply.) - It ignores the time value of money. - It uses an arbitrary benchmark cutoff rate. A company's net income is $50,000 for Year 1 and $80,000 for Year 2. If the book value for Year 1 is $325,000 and that for Year 2 is $390,000, respectively, find the average accounting return. (Round your answer to two decimal places.) - 18.18% The most important alternative to the NPV method is the ______ method. - internal rate of return The internal rate of return (IRR) of a project must be compared to its _____ in order to determine the acceptability of the project. - required rate of return - required return What is the internal rate of return (IRR) of a project with an initial investment of $250 and subsequent cash inflows of $100 per year for 3 years? (Round your answer to two decimal places.) - 9.70% According to the internal rate of return (IRR) rule, we should _____. - reject a project if the IRR is less than the required return When cash flows are conventional, net present value (NPV) is _____ if the discount rate is above the internal rate of return (IRR). - negative The internal rate of return (IRR) of a project is the discount rate that makes the project's net present value (NPV) equal to __. - zero Which of the following conditions should be met for the IRR and the NPV methods to lead to the same capital budgeting decisions for a project? (Select all that apply.) - The project cash flows must be conventional. - The project must be independent. What is the problem of multiple rates of return? (IRR denotes internal rate of return and NPV denotes net present value.) - More than one discount rate makes the NPV of an investment zero. Net present value (NPV) is _____ if the required return is less than the internal rate of return (IRR), and it is _____ if the required return is greater than the IRR. - positive, negative\ The project’s cash flows are conventional, when the first cash flow (the initial investment) is negative and all the rest are ______. - positive True or false: Some projects have cash outflows followed by cash inflows and then cash outflows again, giving the projects multiple rates of return. - true If two investments are then taking one of them means we cannot take the other. - mutually - Blank 2: exclusive Which of the following are true of the relationship between net present value and the internal rate of return (IRR)? (Select all that apply.) - NPV is negative for discount rates above the internal rate of return (IRR). - NPV is positive for discount rates below the internal rate of return (IRR). - NPV is equal to zero when the discount rate equals the internal rate of return (IRR). When the net present value (NPV) and the internal rate of return (IRR) rankings conflict for mutually exclusive projects _____. - accept the project with the higher NPV The discount rate that makes the NPVs of two projects equal is called the ______ rate. - crossover The decision to accept or reject a(n) _____ project affects the acceptance or rejection of another project. - mutually exclusive The _____ function in MS Excel addresses the multiple internal rate of return (IRR) problem. - MIRR Given two or more mutually exclusive investments, which one is unambiguously the best? - The investment with the largest NPV. Which of the following best describes why the internal rate of return (IRR) method is more popular than the net present value (NPV) method? - It gives a return in terms of percentage rather than dollar values. Which of the following is a disadvantage of the internal rate of return (IRR) rule? - It may lead to incorrect decisions when comparing mutually exclusive investments True or false: The crossover rate is the rate at which the net present values of two projects are equal. - True The IRR is very popular in practice, because financial analysts seem to prefer talking about ______ rather than ______. - rates of return; dollar values Which of the following is an advantage of the internal rate of return (IRR) rule? - It is easy to understand and communicate. The profitability index is defined as the present value of an investment's future cash flows divided by its _____. - initial investment The profitability index (PI) rule for independent projects is to accept a project if its PI is ______. - greater than 1 With mutually exclusive projects, the profitability index suffers from the same problem that the IRR rule does in that it fails to consider ____. - the size or scale of projects Which of the following are the advantages of the profitability index (PI)? (Select all that apply.) - It is useful when available investment funds are limited. - It accounts for the time value of money. The profitability index is calculated by _____. - dividing the PV of the future cash flows by the initial investment The profitability index (PI) rule for independent projects is to _____ a project if its PI is greater than 1. - accept The profitability index may lead to incorrect decisions in comparisons of ______ investments. - mutually exclusive Which of the following is the disadvantage of the profitability index (PI)? - May lead to incorrect decisions in comparisons of mutually exclusive investments. Which methods are more frequently used in large firms than in small firms? (Select all that apply.) - The payback period method - The internal rate of return method The profitability index of a project is also referred to as the project's _____. - benefit/cost ratio Capital rationing exists when we have positive NPV investments available but we ______. - cannot get the needed funds to undertake them. A situation when different units in a business are allocated some fixed amount of money each year for capital spending is called ______. - soft rationing A situation when a business cannot raise capital for a project under any circumstances is called - hard - Blank 2: rationing The method considers the time value of money yet its usage is far less frequent than regular the payback method Discounted - Blank 2: payback Although a firm's new project has a positive net present value, the firm is unable to raise capital without violating a pre-existing contractual agreement. Which type of capital rationing does this scenario depict? - hard rationing Capital rationing exists when we have ____ NPV investments available but we cannot get the needed funds to undertake them - positive Soft rationing is a type of capital rationing that occurs _____. - when units in a business are allocated a certain amount of financing for capital budgeting _____ is a situation that arises when a business cannot raise capital for a project under any circumstances. - Hard rationing Even though a firm's new project has a positive net present value, the firm is unable to raise capital due to financial distress. Which type of capital rationing does this scenario depict? - Hard rationing Capital rationing exists when we have positive NPV investments available but we ______. - cannot get the needed funds to undertake them. A Modified Internal Rate of Return (MIRR) is a rate of return on the ______, not the ______. - modified set of cash flows; project's actual cash flows True or false: The MIRR function eliminates the problem of multiple internal rates of return (IRR) and is better than the NPV method. - False Match the following terms relating to the stock valuation formula P0 = (D1 + P1)/(1 + r). - P1: Stock price in one year - D1: Cash dividend paid at the end of the period - R: Required rate of return in the market - P0: Current price of the stock If D0 is the dividend just paid, D1 is the next dividend, and g is the constant growth rate, then Dt, the dividend t periods in the future, is given by _____. - Dt = D0 × (1 + g)^t Which of the following statements is true of the dividend growth model? - It determines the current price of a stock as its dividend next period, divided by the discount rate, less the dividend growth rate. Identify the special case patterns of dividend growth. (Select all that apply.) - Zero growth - Non-constant growth - Constant growth What is the formula for the required return on a stock? - r = D1/P0 + g The ______ may decide not to pay the dividends on preferred shares. - Board of directors According to the cash flow identity, the cash flow from assets equals the total cash flow to - creditors and shareholders Operating cash flow, capital spending, and additions to net working capital are the three components of - cash flow from assets Which of the following are included when calculating the operating cash flow of a firm? - Revenue - Cost of goods sold - To calculate operating cash flow, we want to calculate revenues minus costs, but we do not want to include depreciation since it’s not a cash outflow, and we do not want to include interest because it’s a financing expense. Selling plant and equipment results in a change in - fixed assets Change in net working capital represents - the net increase in current assets over current liabilities According to the cash flow identity, the cash flow from _____ equals the total cash flow to creditors and shareholders. - Assets Net capital spending is equal to ending net fixed assets - minus beginning net fixed assets plus depreciation Which of the following are the components of cash flow from assets? - Operating cash flow - Additions to net working capital - Capital spending Net capital spending is negative when the amount of assets purchased is _____ the amount of assets sold. - less than ____ cash flow refers to the cash flow resulting from a firm's day-to-day activities of producing and selling. - Operating _____ is money spent on fixed assets less money received from the sale of fixed assets. - Net capital spending Additions to net working capital is the amount spent on _____ - net working capital Net capital spending is equal to the change in the net fixed assets during the year plus _____. - Depreciation True or false: Net capital spending cannot be negative. - False Which of the following are included when calculating the operating cash flow of a firm? - Revenue - Cost of goods sold Diamond Corporation's operating cash flow is $24,000, net capital spending is $7,500, and change in net working capital is $11,100. Calculate its cash flow from assets. - $5,400 A firm's current assets increased from $150 in 2017 to $225 in 2018. Its current liabilities increased from $75 to $110 during the same period. The change in the firm's net working capital is _____. - Change in net working capital = ($225 – $110) – ($150 – $75) = $40. True or false: Free cash flow is the total of cash flow to creditors and cash flow to shareholders. - True Cash flow to shareholders equals _____ - dividends paid less net new equity raised If interest paid is $200 and net new borrowing is ‒$120, what is cash flow to creditors? - $320 Zinc Corporation's operating cash flow is $6,500, net capital spending is $2,100, and change in net working capital is $4,100. Calculate its cash flow from assets. - $300 What is the cash flow to shareholders, if dividends paid are $40 and net new equity is $60? - ‒$20 Why is a firm free to distribute free cash to creditors and shareholders? (Select all that apply.) - It is not needed for working capital investment. - It is not needed for fixed asset investments. A positive operating cash flow indicates that the firm is generating enough cash to _____. - pay its operating costs Cash flow to creditors is _____ - interest paid less net new borrowing In determining the economic and financial condition of a firm, cash flow is ______ net income. - more revealing than If ending net fixed assets are $100, beginning fixed assets are $40, and depreciation is $10, then the change in capital spending will be _____. - $70 If dividends paid are $100 and dividends received are $20, net new equity raised is $10. What is the cash flow to shareholders? - $90 Which of the following statements about individual tax rates are true? (Select all that apply.) - They are applicable to income from employment. - Interest income is taxed at the same rates as employment income. True or false: Free cash flow is the total of cash flow to creditors and cash flow to shareholders. - True The operating cash flow of a firm denotes its _____. - earnings before interest and depreciation minus taxes Net income is _____. - not the same as cash flow If ending net fixed assets are $100, beginning net fixed assets are $60, and depreciation is $10, then the change in capital spending will be _____. - $50 Tax rates apply to income from employment (wages and salary) and from unincorporated businesses. - Individual or Personal Which of the following is the correct mathematical expression for the cash flow identity? - Cash flow from assets = Cash flow to bondholders + Cash flow to shareholders If interest paid is $100 and net new borrowing is $150, then cash flow to creditors equals _____. - –$50 If dividends paid are $100 and dividends received are $20, net new equity raised is $10. What is the cash flow to shareholders? - 90 An individual has a taxable income of $150,000. The federal tax rate is 29.00%, and the provincial tax rate is 14.75%. The individual's tax on the next dollar is __. - 43.75 In making financial decisions, it is frequently important to distinguish between average and _____ tax rates. marginal True or false: Marginal tax rates apply to the total income. - False An individual has a taxable income of $100,000. The federal tax rate is 26.00%, and the provincial tax rate is 12.75%. The individual's tax on the next dollar is - 38.75 True or false: With a flat rate tax, there is only one tax rate, and this rate is the same for all income levels. - True Individual taxation in Canada is a _____ tax system. - progressive What is average tax rate? - It equals the total taxes paid divided by the total taxable income. Normally, the _____ tax rate is relevant for decision making. - marginal In making financial decisions, it is frequently important to distinguish between ______. - average and marginal tax rates _____ tax rate is the amount of tax payable on the next dollar earned. - marginal With a flat tax rate, the marginal tax rate _____. - is always the same as the average tax rate Which of the following statements are true of the Canadian tax system? (Select all that apply.) - The tax rate becomes flat at very high income levels. - Individual taxes are progressive, with higher incomes taxed at a higher rate. Which of the following is the most relevant tax rate for financial decisions involving new cash flows or changes in existing cash flows? - Marginal Since new cash flows are taxed at _____ tax rates, those tax rates are the most important. - marginal True or false: Marginal tax rates apply to the total income. - Fasle True or false: With a flat rate tax, there is only one tax rate, and this rate is the same for all income levels. - True Which of the following statements are true of the dividend tax credit? (Select all that apply.) - It applies only to dividends paid by Canadian corporations. - It diminishes double taxation. - It is used to encourage Canadian investors to invest in Canadian firms instead of foreign companies. Which of the following reasons make marginal tax rates the most important tax rates? (Select all that apply.) - Financial decisions are usually based on new cash flows. - Incremental cash flows are taxed at marginal tax rates. Capital gains arise when _____. - an investment increases in value above its purchase price The increase in value of an investment, when converted to cash, is referred to as _____. - realized capital gains Corporate taxes are passed on to investors through _____. - Lower returns The tax formula that reduces the effective tax rate on dividends is known as _____. - dividend tax credit The increase in value of an investment over its purchase price is called - Capital, gains Which of the following is true of realized capital gains? - The time value of money reduces the effective tax rate on realized capital gains when investors hold shares for a long time. Corporate taxes are passed on to consumers through _____. - higher prices A firm's tax rate is 40%. As interest is fully tax deductible, the firm needs to earn ______ more in EBIT to be able to pay $1 in added interest. - $1 Which of the following is true of the tax system in Canada? - Dividends are taxed only marginally more than capital gains. Which one of the following statements is true about the relationship between taxable income, dividends paid, and interest expense? - Interest paid is deducted from EBIT in calculating income. Using a year's capital losses to offset capital gains of future years is called _____. - loss carry-forward Capital losses can be carried forward ______. - indefinitely Which of the following is true regarding the tax system in Canada? - Canada does not have a tiered capital gains tax system. Which of the following statements are true of the carry-back feature of net capital losses? (Select all that apply.) - A firm can file a revised tax return and receive a refund of prior years' taxes. - The capital losses of one year can be used to offset capital gains in the past years. The loss carry-forward period for non-capital losses is ______. - not fixed as different rules apply for different types of losses Which of the following statements are true of capital cost allowance (CCA)? (Select all that apply.) - It is the depreciation for tax purposes in Canada. - It is deducted in determining income Using a year's capital losses to offset capital gains of previous years is called _____. - loss carry-back Intangible assets like leasehold improvements follow the _____ depreciation method for capital cost allowance. - straight-line Depreciation for tax purposes in Canada is known as _____. - capital cost allowance What does UCC stand for in accounting terms? - Undepreciated Capital Cost Which of the following is true of capital cost allowance (CCA) calculation? - It begins by assigning every capital asset to a particular class. The half-year rule allows you _____. - to figure capital cost allowance on only half of the asset's installed cost in the first year it is put in use When an asset is sold, the undepreciated capital cost in its asset class (or pool) is reduced by what is realized on the asset or by its original cost, whichever is less. This amount is called the - Adjusted cost disposal Net acquisition is defined as the total installed cost of capital acquisitions _____. - minus the adjusted cost of any disposals within an asset pool An asset's book value for tax purposes is called _____. - undepreciated capital cost Terminal loss is calculated as the _____. - difference between the undepreciated capital cost (UCC) and the adjusted cost of disposal when the UCC is greater A firm has recently purchased a Class 8 asset for $50,000 with a CCA rate of 20%. Under the half-year rule, what is the amount of depreciation that the firm can claim as a tax-deductible expense in the first year? - $5,000 When an asset is sold, the undepreciated capital cost in its asset class (or pool) is reduced by what is realized on the asset or by its original cost, whichever is ______. - less True or false: If net acquisitions are positive, there is no adjustment for the half-year rule. - False Recaptured depreciation is the _____. - taxable difference between the adjusted cost of disposal and the undepreciated capital cost (UCC) when the UCC is smaller Terminal loss is deducted from ______. - income The taxable difference between adjusted cost of disposal and UCC when UCC is smaller is called - Recaptured depreciation When an asset is sold, the undepreciated capital cost in its asset class (or pool) is reduced by what is realized on the asset or by its original cost, whichever is less. This amount is called the _____. - adjusted cost of disposal If your tax bill is $200 and your taxable income is $2000, then your average tax rate will be _____. - 10% The loss carry-back period for capital losses is _____ years. - three The loss carry-back period for non-capital losses is ______ years. - Three The difference between a firm’s future cash flows with a project and without the project is called _____ cash flows. - Incremental According to the _____ principle, once the incremental cash flows from a project have been identified, the project can be viewed as a minifirm with its own future revenues and costs, its own assets, and its own cash flows. - Stand-alone Which of the following is an example of a sunk cost? - Research and development expense incurred in the past - The test marketing expenses of a new product True or false: A sunk cost is an example of a relevant incremental cash flow. - False What is a sunk cost? - A cost incurred in the past that is irrelevant for any decision making The portion of cash flows of a new project that come at the expense of a firm’s existing operations is called _____.