19. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? A. It will accept too many long-term projects and reject too many short- term projects (as judged by the NPV). B. The firm will accept too many projects in all economic states because a 4-year payback is too low. C. The firm will accept too few projects in all economic states because a 4-year payback is too high. D. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

19. Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true? A. It will accept too many long-term projects and reject too many short- term projects (as judged by the NPV). B. The firm will accept too many projects in all economic states because a 4-year payback is too low. C. The firm will accept too few projects in all economic states because a 4-year payback is too high. D. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.

Essentials Of Investments

11th Edition

ISBN:9781260013924

Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.

Chapter1: Investments: Background And Issues

Section: Chapter Questions

Problem 1PS

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Which of the following statements is (are) FALSE? Select one or more alternatives: When sales of a new product displace sales of an existing product, the situation is often referred to as cannibalisation. If the IRR of a project is equal to the cost of capital, the NPV will be zero. It is reasonable to assume that a business has a terminal growth rate higher than the long-term growth rate of the economy. The terminal growth rate is the growth rate used to estimate the terminal value of a business. Interest expenses from borrowing should be subtracted from EBIT to estimate free cash flow to firm.
True or False: In solving a capital budgeting problem involving investment opportunities that are divisible (i.e., you can invest in portions of the opportunities instead of “all or nothing”), you rank the opportunities on thebasis of internal rate of return and add to the portfolio opportunities andfractions of opportunities, beginning with the largest internal rate of return,until “the investment bucket is filled.”
6. Solving for the WACC The WACC is used as the discount rate to evaluate various capital budgeting projects. However, it is important to realize that the WACC is an appropriate discount rate only for a project of average risk. Analyze the cost of capital situations of the following company cases, and answer the specific questions that finance professionals need to address. Consider the case of Turnbull Co. Turnbull Co, has a target capital structure of 55% debt, 6% preferred stock, and 36% common equity. It has a before-tax cost of debt of 11.1%, and its cost of preferred stock is 12.2% of Turnbull can raise all of its equity capital from retained earnings, its cost of common equity will be 14.7%. However, if it is necessary to raise new common equity, it will carry a cost of 16.0% its current tax rate is 25%, how much higher will Turnbull's weighted average cost of capital (WACC) be if it has to raise additional common equity capital by issuing new common stock instead of raising the…
3. Inflation in project analysis Aa Aa It is often easy to overlook the impact of inflation on the net present value of the project. Not incorporating the impact of inflation in determining the value of the cash flows of the project can result in erroneous estimations. Consider the following scenario: Extensive Enterprise Inc. is considering opening a new division to make iGadgets that it expects to sell at a price of $12,450 each in the first year of the project. The company expects the cost of producing each iGadget to be $6,450 in the first year; however, it expects the selling price and cost per iGadget to increase by 1% each year. Based on this information, complete the following table: Selling price in year 4: Cost per unit in year 4: If a company does not take inflation into account when analyzing a project, the expected net present value (NPV) of the project will typically be than the true NPV of the project.
[S1] A company has made the decision to finance next year’s capital projects through debt rather than additional equity. The benchmark cost of capital for these projects should be the WACC rather than the after tax cost of debt. [S2] The general rule for using the WACC in long term investment decisions is to accept all projects with rates of return greater than or equal to the WACC.a. both are trueb. both are falsec. S1 is trued. S2 is true
The payback method helps firms establish and identify a maximum acceptable payback period that helps in their capital budgeting decisions. Consider the case of Green Caterpillar Garden Supplies Inc.: Green Caterpillar Garden Supplies Inc. is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Alpha’s expected future cash flows. To answer this question, Green Caterpillar’s CFO has asked that you compute the project’s payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year. Complete the following table and compute the project’s conventional payback period. For full credit, complete the entire table. (Note: Round the conventional payback period to two decimal places. If your answer is negative, be sure to use a minus sign in your answer.) Year 0 Year 1 Year 2 Year 3 Expected cash flow -$4,500,000…
2. Consider the model of Moral Hazard where firms choose between investing one unit of output in a less risky or more risky project. The safer project yields with probability and zero otherwise while the risky project yields 2 with probability and zero otherwise i.e. TG = G = TB B = 2. Suppose firms finance their investment by borrowing 1 unit from a the fiinancial market at interest rate R. The financial market is risk neutral and requires an expected rate of return equal to the risk free rate which is assumed to be zero. Will there be an equilibrium with lending to firms from the financial market A. Yes B. No C. Not enough information D. None of A-C
You are going to allocate capital into safe and risky assets. The risky asset will earn 200% return if the economy is good (with a 55% chance). If, otherwise, it will lose 60% of the investment principal. States of Rate of Prob. nature Return According to the Kelly's criterion, how much do you have to allocate for the risky asset to maximize final wealth? (The safe asset earns zero return.) → (1) 35%; (2) 47%; (3) 59%; (4) 65%; 1 Good 55% 200% your |(5) 69%; (6) 75%; (7) 85%; (8) 97%; (9) 102%; (10) 114%; (11) 115%; Bad 45% -60%
The market for capital Firms require capital to invest in productive opportunities. The best firms with the most profitable opportunities can attract capital away from inefficient firms with less profitable opportunities. Investors supply firms with capital at a cost called the interest rate. The interest rate that investors require is determined by several factors, including the availability of production opportunities, the time preference for current consumption, risk, and inflation. Suppose the Federal Reserve (the Fed) decides to tighten credit by contracting the money supply. Use the following graph by moving the black X to show what happens to the equilibrium level of borrowing and the new equilibrium interest rate. Q1. Which tend to be more volatile, short- or long-term interest rates? Long-term interest rates 2. Short-term interest rates Q2. If the inflation rate was 3.20% and the nominal interest rate was 4.20% over the last year, what was the real rate of interest over…
Suppose a firm uses the WACC as the single hurdle rate in determining the value of capital budgeting projects rather than using risk adjusted hurdle rates. Choose the statement that actually completes the sentence describing the possible outcomes for the firm: the firm will tend to Accept profitable, low risk projects and reject unprofitable, high risk projects Accept profitable, low risk projects and accept unprofitable, high risk projects Reject profitable, low risk projects and reject unprofitable high risk projects Become less risky overtime Reject profitable, low risk projects and accept unprofitable, high risk projects
The payback period The payback method helps firms establish and identify a maximum acceptable payback period that helps in capital budgeting decisions. There are two versions of the payback method: the conventional payback method and the discounted payback method. Consider the following case: Green Caterpillar Garden Supplies Inc. is a small firm, and several of its managers are worried about how soon the firm will be able to recover its initial investment from Project Delta’s expected future cash flows. To answer this question, Green Caterpillar’s CFO has asked that you compute the project’s payback period using the following expected net cash flows and assuming that the cash flows are received evenly throughout each year. Complete the following table and compute the project’s conventional payback period. Round the payback period to the nearest two decimal places. Be sure to complete the entire table—even if the values exceed the point at which the cost of the project is…

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