Question 1

What is the total value of the terminal year non-operating cash flows at the end of Year 3?

Accepted Answer

A)  $18,120 
B)  $19,000 
C)  $21,000 
D)  $25,000 
E)  $27,000 
A)  $18,120 
B)  $19,000 
C)  $21,000 
D)  $25,000 
E)  $27,000 A

Question 2

What is the net investment required at t = 0?

Accepted Answer

A)  -$42,000 
B)  -$40,000 
C)  -$38,600 
D)  -$37,600 
E)  -$36,600 
A)  -$42,000 
B)  -$40,000 
C)  -$38,600 
D)  -$37,600 
E)  -$36,600 A

Question 3

Which of the following statements is most correct?

Accepted Answer

A)  Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same. 
B)  In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital. 
C)  When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment. 
D)  All of the answers above are correct. 
E)  None of the answers above is correct. 
A)  Capital budgeting analysis for expansion and replacement projects is essentially the same because the types of cash flows involved are the same. 
B)  In estimating net cash flows for the purpose of capital budgeting, interest and dividend payments should not be included since the effects of these items are already included in the weighted average cost of capital. 
C)  When equipment is sold, companies receive a tax credit as long as the salvage value is less than the initial cost of the equipment. 
D)  All of the answers above are correct. 
E)  None of the answers above is correct. B

Question 4

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR (or modified IRR) is greater than the firm's weighted average cost of capital.

Accepted Answer

A) True 
 B)False

Question 5

Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

Accepted Answer

A)  Be correct. 
B)  Be biased downward. 
C)  Be biased upward. 
D)  Possibly have a bias, but it could be upward or downward. 
E)  More information is needed; otherwise, we can make no reasonable statement. 
A)  Be correct. 
B)  Be biased downward. 
C)  Be biased upward. 
D)  Possibly have a bias, but it could be upward or downward. 
E)  More information is needed; otherwise, we can make no reasonable statement.

Question 6

A company estimates that an average-risk project has a WACC of 10 percent, a below-average-risk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?

Accepted Answer

A)  Project A has average risk and an IRR = 9 percent. 
B)  Project B has below-average risk and an IRR = 8.5 percent. 
C)  Project C has above-average risk and an IRR = 11 percent. 
D)  All of the projects above should be accepted. 
E)  None of the projects above should be accepted. 
A)  Project A has average risk and an IRR = 9 percent. 
B)  Project B has below-average risk and an IRR = 8.5 percent. 
C)  Project C has above-average risk and an IRR = 11 percent. 
D)  All of the projects above should be accepted. 
E)  None of the projects above should be accepted.

Question 7

Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to be able to reduce net operating working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years. Mars's marginal tax rate is 40 percent, and it uses a 12 percent cost of capital to evaluate projects of this nature. If the machine costs $60,000, what is the project's NPV?

Accepted Answer

A)  -$15,394 
B)  -$14,093 
C)  -$58,512 
D)  -$21,493 
E)  -$46,901 
A)  -$15,394 
B)  -$14,093 
C)  -$58,512 
D)  -$21,493 
E)  -$46,901

Question 8

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1) capital budgeting decisions must be based on accounting income, and (2) only incremental cash flows are relevant to accept/reject decisions.

Accepted Answer

A) True 
 B)False

Question 9

Which of the following statements is most correct?

Accepted Answer

A)  The rate of depreciation will often affect operating cash flows, even though depreciation is not a cash expense. 
B)  Corporations should fully account for sunk costs when making investment decisions. 
C)  Corporations should fully account for opportunity costs when making investment decisions. 
D)  All of the answers above are correct. 
E)  Answers a and c are correct. 
A)  The rate of depreciation will often affect operating cash flows, even though depreciation is not a cash expense. 
B)  Corporations should fully account for sunk costs when making investment decisions. 
C)  Corporations should fully account for opportunity costs when making investment decisions. 
D)  All of the answers above are correct. 
E)  Answers a and c are correct.

Question 10

Which of the following statements is correct?

Accepted Answer

A)  An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project. 
B)  Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions. 
C)  It is unrealistic to expect that increases in net operating working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project. 
D)  Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value. 
E)  All of the statements above are false. 
A)  An asset that is sold for less than book value at the end of a project's life will generate a loss for the firm and will cause an actual cash outflow attributable to the project. 
B)  Only incremental cash flows are relevant in project analysis and the proper incremental cash flows are the reported accounting profits because they form the true basis for investor and managerial decisions. 
C)  It is unrealistic to expect that increases in net operating working capital that are required at the start of an expansion project are simply recovered at the project's completion. Thus, these cash flows are included only at the start of a project. 
D)  Equipment sold for more than its book value at the end of a project's life will increase income and, despite increasing taxes, will generate a greater cash flow than if the same asset is sold at book value. 
E)  All of the statements above are false.

Question 11

If a project is small relative to the total firm, and if its returns are not highly correlated with the returns on the firm's other assets, then the project may not be very risky in either the within-firm (corporate) or the market risk sense, even if the returns on the project are highly uncertain and thus the project has a high degree of stand-alone risk.

Accepted Answer

A) True 
 B)False

Question 12

In cash flow estimation, the presence of externalities has no direct cash flow effects.

Accepted Answer

A) True 
 B)False

Question 13

(3)2). Which of the following statements is correct?

Accepted Answer

A)  In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV. 
B)  The preceding statement would be true if "upward" were replaced with "downward." 
C)  The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities. 
D)  If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration. 
E)  The rent referred to in statement d is a sunk cost, and as such it should be ignored. 
A)  In a capital budgeting analysis where part of the funds used to finance the project are raised as debt, failure to include interest expense as a cost in the cash flow statement when determining the project's cash flows will lead to an upward bias in the NPV. 
B)  The preceding statement would be true if "upward" were replaced with "downward." 
C)  The existence of "externalities" reduces the NPV to a level below the value that would exist in the absence of externalities. 
D)  If one of the assets that would be used by a potential project is already owned by the firm, and if that asset could be leased to another firm if the project is not undertaken, then the net rent that could be obtained should be charged as a cost to the project under consideration. 
E)  The rent referred to in statement d is a sunk cost, and as such it should be ignored.

Question 14

What is the operating cash flow in Year 2?

Accepted Answer

A)  $ 9,000 
B)  $10,240 
C)  $11,687 
D)  $13,453 
E)  $16,200 
A)  $ 9,000 
B)  $10,240 
C)  $11,687 
D)  $13,453 
E)  $16,200

Question 15

You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck. The truck's basic price is $50,000, and it will cost another $10,000 to modify it for special use by your firm. The truck falls into the MACRS three-year class, and it will be sold after three years for $20,000. Use of the truck will require an increase in net operating working capital (spare parts inventory) of $2,000. The truck will have no effect on revenues, but it is expected to save the firm $20,000 per year in before-tax operating costs, mainly labor. The firm's marginal tax rate is 40 percent.
-What is the operating cash flow in Year 1?

Accepted Answer

A)  $17,820 
B)  $18,254 
C)  $19,920 
D)  $20,121 
E)  $21,737 
A)  $17,820 
B)  $18,254 
C)  $19,920 
D)  $20,121 
E)  $21,737

Question 16

Which of the following is not a cash flow that results from the decision to accept a project?

Accepted Answer

A)  Changes in working capital. 
B)  Shipping and installation costs. 
C)  Sunk costs. 
D)  Opportunity costs. 
E)  Externalities. 
A)  Changes in working capital. 
B)  Shipping and installation costs. 
C)  Sunk costs. 
D)  Opportunity costs. 
E)  Externalities.

Question 17

Opportunity costs include those cash inflows that could be generated from assets the firm already owns, if those assets are not used for the project being evaluated.

Accepted Answer

A) True 
 B)False

Question 18

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Accepted Answer

A) True 
 B)False

Question 19

Quantification of risk is the easiest part of incorporating risk into capital budgeting.

Accepted Answer

A) True 
 B)False

Question 20

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

Accepted Answer

A)  Increase the IRR of the asset to reflect the greater risk. 
B)  Increase the NPV of the asset to reflect the greater risk. 
C)  Reject the asset, since its acceptance would increase the risk of the firm. 
D)  Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm. 
E)  Increase the cost of capital used to evaluate the project to reflect the higher risk of the proj¬ect. 
A)  Increase the IRR of the asset to reflect the greater risk. 
B)  Increase the NPV of the asset to reflect the greater risk. 
C)  Reject the asset, since its acceptance would increase the risk of the firm. 
D)  Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm. 
E)  Increase the cost of capital used to evaluate the project to reflect the higher risk of the proj¬ect.

Exam 13: Capital Budgeting: Cash Flows and Risk

What is the total value of the terminal year non-operating cash flows at the end of Year 3?

What is the net investment required at t = 0?

Which of the following statements is most correct?

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR (or modified IRR) is greater than the firm's weighted average cost of capital.

Suppose the firm's WACC is stated in nominal terms, but the project's expected cash flows are expressed in real dollars. In this situation, other things held constant, the calculated NPV would

A company estimates that an average-risk project has a WACC of 10 percent, a below-average-risk project has a WACC of 8 percent, and an above-average-risk project has a WACC of 12 percent. Which of the following independent projects should the company accept?

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1) capital budgeting decisions must be based on accounting income, and (2) only incremental cash flows are relevant to accept/reject decisions.

Which of the following statements is most correct?

Which of the following statements is correct?

In cash flow estimation, the presence of externalities has no direct cash flow effects.

(3)2). Which of the following statements is correct?

What is the operating cash flow in Year 2?

Which of the following is not a cash flow that results from the decision to accept a project?

Opportunity costs include those cash inflows that could be generated from assets the firm already owns, if those assets are not used for the project being evaluated.

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Quantification of risk is the easiest part of incorporating risk into capital budgeting.

A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

An Overview of Financial Management

Risk and Return: Part I

Risk and Return: Part II

Bond Valuation

Basic Stock Valuation

Financial Options

Accounting for Financial Management

Analysis of Financial Statements

Financial Planning and Forecasting Financial Statements

Determining the Cost of Capital

Corporate Valuation and Value-Based Management

Capital Budgeting: Decision Criteria

Real Options

Capital Structure Decisions: Part I

Capital Structure Decisions: Part II

Distributions to Shareholders

Ipos, Investment Banking, and Financial Restructuring

Lease Financing

Hybrid Financing

Working Capital Management

Providing and Obtaining Credit

Other Topics in Working Capital Management

Derivatives and Risk Management

Bankruptcy, Reorganization, and Liquidation

Mergers, Lbos, Divestitures, and Holding Companies

Multinational Financial Management

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