Cost of capital is critical to capital budgeting, project selection, and feasibility studies. The application of cost of capital to capital budgeting is similar to the application of cost of capital to valuing a company.

MULTIPLE CHOICE QUESTIONS

1. For capital budgeting, project selection, and feasibility studies, the preferred measure of economic income is:

a. Net cash flow.

b. F/RTTDA.

c. HE IT.

d. Net income.

2. For capital budgeting and project selection, the preferred measure of cost of capital is:

a. The company's overall cost of capital.

b. The company's marginal cost of capital.

c. The project's cost of capital.

d. The company's cost of equity capital.

3. According to Tom Copeland, the evidence that the market focuses on cash flows includes which of the following?

a. Accounting earnings are not very well correlated with share prices.

b. Earnings "window dressing" does not improve share prices.

c. The market evaluates management decisions based on their expected long-term cash flow impact, not their short-term earnings impact.

d. All of the above.

OR QUESTIONS

4. When a company invests in a project that is expected to return less than the company's cost of capital, the expected result would he a decrease in shareholder value.

5. The characteristics of a project, cither risk or special financing opportunities unique to the project, may cause the weighted average cost of capital (WACC) for the project to differ from the company's overall WACC.

Many companies have implemented Rconornic Value Added (RV A) as a management tool. This chapter gives particulars on how some companies implement EVA and how cost of capi­tal plays a cento] role.

1. In EVA, the assessment of business risk is based on:

a. The build-up model.

b. The Capital Asset Pricing Model.

c. The DCF model.

d. The Fama-Frencb three-factor model.

2. The recommended criteria for leveraged stock options under EVA are:

a. They are initially "at the money" and are bought, not granted.

b. They are initially "in the money" and are bought, not granted.

c. They are initially "at the money" and are granted, not bought.

d. They are initially "in the money" and are granted, not bought.

3. To compute RV A, !he operating profit for the company and each of its units is charged for capital at a rate that blends the after-tax cost of debt and equity in the target proportions that each would plan to employ rather than the actual mix that each uses year by year.

4. The RVA bonus plan ties bonuses to absolute levels of RVA.

5. What are the three vays of increasing value with EVA?

6. The EVA ownership plan employs w7hat two distinct elements?

A company with a 12% cost of capital thai earns a 20% return on $100 million of net op­erating assets has an EVA of how much1.'