True or False

1. The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead
to different accept/reject decisions and thus capital budgets if the projects' IRRs are greater than their cost of
capital. False
2. No conflict will exist between the NPV and IRR methods, when used to evaluate two equally risky but
mutually exclusive projects, if the projects' cost of capital exceeds the rate at which the projects' NPV profiles
cross. True
3. The regular payback method is deficient in that it does not take account of cash flows beyond the payback
period. The discounted payback method corrects this fault. False
4. In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of
capital. The decision criterion should not be affected by managers' tastes, choice of accounting method, or the
profitability of other independent projects. True
5. In general, one should use higher discount rates for longer-term projects. False
6. The cost of equity raised by retaining 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, flotation costs, the attitude
of investors, and other factors. False
7. If a firm's marginal tax rate is increased, this would, other things held constant, lower the cost of debt
used to calculate its WACC. True
8. Depreciation expense acts as a tax shield in reducing taxes. True
9. The two cardinal rules that financial analysts should follow to avoid capital budgeting errors are: (1) in
the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting
principles, and (2) all incremental cash flows should be considered when making accept/reject decisions. False
10. Because of differences in the expected returns on different investments, the coefficient of variation is not
always an adequate measure of risk. However, the standard deviation analysis allows investors to make better
comparisons of investments' stand-alone risk. False
11. Real options are less valuable when there is a lot of uncertainty about the true values future sales and
costs. False
12. A company agrees to pay more to build a plant in order to be able to change the plant's inputs and/or
outputs at a later date if conditions change. This is an example of a real option. True
13. Most large corporations keep two separate sets of books, one for stockholders and one for the
taxation purpose. True
14. For firms with relatively high levels of debt, the company cost of capital is the cost of equity of
the firm. False
15. Risky projects can be evaluated by discounting expected cash flows at a risk-adjusted discount
rate. True
16. Suppose that an analyst incorrectly calculates WACCs using book values of debt and equity
instead of market values. The resulting WACC estimates will generally be too high. False
17. If the IRR of normal Project X is greater than the IRR of mutually exclusive (and also normal) Project Y,
we can conclude that the firm should always select X rather than Y if X has NPV > 0. False
18. When considering two mutually exclusive projects, the firm should always select the project whose
internal rate of return is the highest, provided the projects have the same initial cost. This statement is true
regardless of whether the projects can be repeated or not. False
19. The accept/reject decision under the IRR method is independent of the cost of capital. False
20. Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital
estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject
decisions. False

Multiple Choice Questions

1. One calculates the after-tax weighted average cost of capital (WACC) using which of the
following formulas:
A WACC = (rD) (D/V) + (rE) (E/V), where: V = D + E. B WACC = (rD) (D/E) + (rE) (E/D).
C WACC = (rD) (1 - TC) (D/V) + (rE) (1 - TC) (E/V), where: V = D + E.
D WACC = (rD) (1 - TC) (D/V) + (rE) (E/V), where: V = D + E.
Ans: D

2. When working with the CAPM, which of the following factors can be determined with the most
precision?
A The beta coefficient, bi, of a relatively safe stock. B The most appropriate risk-free rate, rRF.
C The beta coefficient of the market D The market risk premium (RPM).
Ans: C

3. When a firm has the opportunity to add a project that will utilize excess factory capacity (that is
currently not being used), which costs should be used to help determine if the added project should
be undertaken?
A. all of the below B. sunk costs C. incremental costs D. average costs
Ans: C

4. If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will
likely occur?
I The firm will accept poor low-risk projects
II The firm will reject good high-risk projects
III The firm will correctly accept projects with average risk

A I only B II only C III only D I, II, and III

Ans: C
5. Which of the following statements is CORRECT?
A WACC calculations should be based on the before-tax costs of all the individual capital components.
B A change in a company's target capital structure cannot affect its WACC
C An increase in the risk-free rate will normally lower the marginal costs of both debt and equity financing
 D None of the above
Ans: D

6. Which of the following is NOT a real option

A The option to expand into a new geographic region B The option to expand in same geographic region
C The option to abandon a project D None of the above
Ans: D
7. Which of the following will NOT increase the value of a real option?
A An increase in the volatility of the underlying source of risk B An increase in the cost of obtaining
the real option C An increase in the risk-free rate D Lengthening the time in which a real
option must be exercised
Ans: B
8. A reduction in the sales of existing products caused by the introduction of a new product is an
example of:
A. cannibalization B. allocated overhead expenses C. opportunity costs D. sunk cost

Ans: A

9. The cost of a resource that may be relevant to an investment decision even when no cash changes
hand is called a(an):
A. sunk cost B. opportunity cost c. depreciation cost d. insurance cost

Ans: B

10. For the case of an electric car project, which of the following costs or cash flows should be
categorized as incremental when analyzing whether to invest in the project?
A The cost of research and development undertaken for developing the electric car during the past
three years
B Annual depreciation charge
C Tax savings resulting from depreciation charges
D Preferred dividend payments

Ans: C
 Multiple Choice Questions

Note: Do not assume any preferred stocks issued by the firm, unless
otherwise explicitly mentioned. Corporate taxes are present unless
explicitly mentioned otherwise. MM (Miller-Modigiliani):

1. The use of personal borrowing to change the overall amount of

financial leverage to which an individual is exposed is called:
A. homemade leverage
B. dividend recapture
C. the weighted average cost of capital
D. private debt placement
E. personal offset
Ans: A

2. A high-financial break-even point is most appropriately indicative of:

A. high financial risk
B. high debt-to-equity ratio
C. high tax saving on debt securities
D. negative return on equity
E. All of the above
Ans: A

3. The proposition that the value of the firm is independent of its

capital structure is called:
A. the capital asset pricing model
B. MM Proposition I (no taxes)
C. MM Proposition II (no taxes)
D. the law of one price
E. the efficient markets hypothesis
Ans: B

4. The unlevered cost of capital is:

A. the cost of capital for a firm with no equity in its capital structure
B. the cost of capital for a firm with no debt in its capital structure
C. the interest tax shield times pre-tax net income
D. the cost of preferred stock for an all-equity firm
E. equal to the profit margin for a firm with some debt in its capital
structure
Ans: B

5. Which of the following is not affected by change in capital structure:

A. return on equity
B. financial leverage
C. EBIT
D. operating fixed costs
E. both C & D
Ans: E
6. According to the efficient market hypothesis, it is most likely that
the stock price will:
A. change on the ex-date of share repurchase
B. change when the firm receives cash in its bank account after
restructuring
C. not change due to change in capital structure
D. change when the firm invest the proceeds received from debt for
capital expenditure
E. None of the above
Ans: E

7. The degree of financial leverage directly depends on:

A. the degree of total leverage of a levered firm
B. the operating fixed costs of a levered firm
C. the rate of corporate tax of a levered firm
D. the sales and EBIT level of a levered firm
E. All of the above
Ans: C

8. For an unlevered firm, the degree of financial leverage is equal to:

A. -1
B. +1
C. 0
D. Does not exist
E. Financial break even
Ans: B

9. A key underlying assumption of MM Proposition I without taxes is

that:
A. financial leverage increases risk
B. cost of equity linearly increases as the firm’s debt-to-equity ratio
increases
C. managers always act to maximize the value of the firm
D. corporations are all-equity financed
E. None of the above
Ans: E

10. MM Proposition I with taxes supports the argument that:

A. business risk determines the return on assets
B. it is completely irrelevant how a firm arranges its finances
C. financial risk is determined by the debt-equity ratio
D. the firm’s weighted average cost of capital does not depend on the
capital structure
E. None of the above
Ans: E

True or False
1. MM Proposition I with taxes is the theory that argues that a firm's
weighted average cost of capital increases as the debt-equity ratio of the
firm rises. False
2. The interest tax shield is a key reason why the required rate of
return on assets rises when debt is added to the capital structure. False
3. Under both MM Proposition II i.e. with and without taxes, a firm's
cost of equity capital is a positive linear function of the firm's capital
structure. True
4. MM Proposition II with taxes reveals how the interest tax shield
relates to the value of a firm. False
5. A levered firm will have a higher EPS compared to an unlevered firm
if the level of its EBIT is greater than the EBIT of the unlevered firm. False
6. The degree of total leverage is indicative of both business and
financial risks of the firm. True
7. The EBIT of an unlevered firm is Rs 7.5 million. Its total new
perpetual debt is Rs 400,000 with annual cost of debt of 10% and cost of
equity of the levered firm 15% If corporate tax rate is 35%, the value of
the levered equity is greater than Rs. 33 million. False
8. A firm should select the capital structure which maximizes the
weighted average cost of capital of the firm. False
9. The variability in EBIT is greater in a levered firm compared to a
similar unlevered firm. False
10. According to the MM II proposition (after taxes), the cost of equity of
the levered firm is inversely related to the cost of debt. True
11. The unexpected return on a security is made up of systematic and
non-diversifiable risk. False
12. A security held in a well-diversified portfolio that has a beta of zero
will have an expected return of zero. False
13. Shareholders discount many corporate announcements because of
their prior expectations. If an announcement causes the price to change
that change will mostly be driven by the expected part of the
announcement. False
14. The beta of a portfolio is a linear function of beta of individual stocks
in that portfolio. True
15. The variance of a portfolio comprised of many securities is primarily
dependent upon the covariances between the individual securities. True
16. The Capital Market Line implies that states that an investor will
choose between any efficient portfolio and a riskless asset to generate the
desired expected return. False
17. According to the CAPM, the slope of the SML is security risk
premium. False
18. The beta of a security is a measure of that security’s systematic
risk. True
19. A stock with an actual return that lies above the security market line
has yielded a higher return than expected for the level of risk assumed.
True
20. The standard deviation of a portfolio can often be lowered by
changing the weights of the securities in the portfolio. True
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