Reference no: EM132368643

Business Finance Questions -

Question One: Multiple Choice Questions - Choose the best answer

1. When we are comparing projects with cash outflows and unequal lives, we can use the:

(a) IRR

(b) Present value

(c) Net present value

(d) Annual equivalent cost

(e) None of the above

2. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000. Their NPV profiles cross at a discount rate of 10 percent. Which of the following statements best describes this situation?

(a) The NPV and IRR methods will select the same project if the cost of capital is greater than 10 percent; for example, 18 percent.

(b) The NPV and IRR methods will select the same project if the cost of capital is less than 10 percent; for example, 8 percent.

(c) To determine if a ranking conflict will occur between the two projects the cost of capital is needed as well as an additional piece of information.

(d) Project L should be selected at any cost of capital, because it has a higher IRR.

(e) Project S should be selected at any cost of capital, because it has a higher IRR.

3. A cost that has been incurred and cannot be removed, and hence should not be considered in an investment decision is known as:

(a) opportunity cost

(b) erosion

(c) sunk cost

(d) irrelevant cost

(e) none of the above

4. The MM theory with taxes implies that firms should issue maximum debt. In practice, this is not true because:

(a) debt is more risky than equity.

(b) bankruptcy is a disadvantage to debt.

(c) firms will incur large agency costs of short term debt by issuing long term debt.

(d) Both debt is more risky than equity; and bankruptcy is a disadvantage to debt.

(e) Both bankruptcy is a disadvantage to debt; and firms will incur large agency costs of short term debt by issuing long term debt.

5. Indirect costs of financial distress:

(a) effectively limit the amount of equity a firm issues.

(b) serve as an incentive to increase the financial leverage of a firm.

(c) include direct costs such as legal and accounting fees.

(d) tend to increase as the debt-equity ratio decreases.

(e) include the costs incurred by a firm as it tries to avoid seeking bankruptcy protection.

6. Given realistic estimates of the probability and cost of bankruptcy, the future costs of a possible bankruptcy are borne by:

(a) all investors in the firm.

(b) debtholders only because if default occurs interest and principal payments are not made.

(c) shareholders because debtholders will pay less for the debt providing less cash for the shareholders.

(d) management because if the firm defaults they will lose their jobs.

e) None of these.

Question Two - (a) Briefly discuss the circumstances in which you would use the equivalent cost approach method to evaluate investment decision.

(b) A machine costs $60,000 and requires $5,000 maintenance for each year of its three year life. The maintenance costs are paid at the end of each year. After three years, the machine will be replaced. The company tax rate is 30%. Cost of capital is 14%. The machine will be depreciated over three years using straight-line method. Calculate the equivalent annual costs (EAC).

Question Three - Explain the implications of MM (1958) propositions I, II and III in a no tax world using appropriate diagrams. Discuss and show how these propositions change with the introduction of corporate taxation.