Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. 
B)  The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not.This is another reason to favor the NPV. 
C)  Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not. 
D)  Identifying an externality can never lead to an increase in the calculated NPV. 
E)  An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality. 
A)  An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline. 
B)  The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not.This is another reason to favor the NPV. 
C)  Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not. 
D)  Identifying an externality can never lead to an increase in the calculated NPV. 
E)  An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality. A

Question 2

While developing a new product line, Cook Company spent $3 million two years ago to build a plant for a new product.It then decided not to go forward with the project, so the building is available for sale or for a new product.Cook owns the building free and clear⎯there is no mortgage on it.Which of the following statements is CORRECT?

Accepted Answer

A)  If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. 
B)  This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. 
C)  Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. 
D)  If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. 
E)  Since the building has been paid for, it can be used by another project with no additional cost.Therefore, it should not be reflected in the cash flows for any new project. 
A)  If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. 
B)  This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider. 
C)  Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. 
D)  If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. 
E)  Since the building has been paid for, it can be used by another project with no additional cost.Therefore, it should not be reflected in the cash flows for any new project. A

Question 3

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.

Accepted Answer

A) True 
 B)False  True

Question 4

You have just landed an internship in the CFO's office of Hawkesworth Inc.Your first task is to estimate the Year 1 cash flow for a project with the following data.What is the Year 1 cash flow? $\begin{array}{lr}
\text { Sales revenues } & \$ 13,000 \
\text { Depreciation } & \$ 4,000 \
\text { Other operating costs } & \$ 6,000 \
\text { Tax rate } & 25.0 \%
\end{array}$

Accepted Answer

A)  $6,250 
B)  $6,406 
C)  $6,566 
D)  $6,731 
E)  $6,899 
A)  $6,250 
B)  $6,406 
C)  $6,566 
D)  $6,731 
E)  $6,899

Question 5

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

Accepted Answer

A) True 
 B)False

Question 6

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

A) True 
 B)False

Question 7

McLeod Inc.is considering an investment that has an expected return of 15% and a standard deviation of 10%.What is the investment's coefficient of variation?

Accepted Answer

A)  0.67 
B)  0.73 
C)  0.81 
D)  0.89 
E)  0.98 
A)  0.67 
B)  0.73 
C)  0.81 
D)  0.89 
E)  0.98

Question 8

It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop.This is why subjective judgment is often used for such projects along with discounted cash flow analysis.

Accepted Answer

A) True 
 B)False

Question 9

McPherson Company must purchase a new milling machine.The purchase price is $50,000, including installation.The machine has a tax life of 5 years, and it can be depreciated according to the following rates.The firm expects to operate the machine for 4 years and then to sell it for $12,500.If the marginal tax rate is 25%, what will the after-tax salvage value be when the machine is sold at the end of Year 4? $$\begin{array} { c c } 
\text { Year } & \text { Depreciation Rate } \
1 & 0.20 \
2 & 0.32 \
3 & 0.19 \
4 & 0.12 \
5 & 0.11 \
6 & 0.06
\end{array}$$

Accepted Answer

A)  $9,367 
B)  $9,860 
C)  $10,379 
D)  $10,925 
E)  $11,500 
A)  $9,367 
B)  $9,860 
C)  $10,379 
D)  $10,925 
E)  $11,500

Question 10

The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC.Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

Accepted Answer

A)  All sunk costs that have been incurred relating to the project. 
B)  All interest expenses on debt used to help finance the project. 
C)  The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life. 
D)  Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. 
E)  Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows. 
A)  All sunk costs that have been incurred relating to the project. 
B)  All interest expenses on debt used to help finance the project. 
C)  The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life. 
D)  Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. 
E)  Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

Question 11

If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

Accepted Answer

A) True 
 B)False

Question 12

In your first job with TBL Inc.your task is to consider a new project whose data are shown below.What is the project's Year 1 cash flow? $$\begin{array} { l r } 
\text { Sales revenues } & \$ 22,250 \
\text { Depreciation } & \$ 8,000 \
\text { Other operating costs } & \$ 12,000 \
\text { Tax rate } & 25.0 \%
\end{array}$$

Accepted Answer

A)  $9,115 
B)  $9,397 
C)  $9,688 
D)  $9,978 
E)  $10,277 
A)  $9,115 
B)  $9,397 
C)  $9,688 
D)  $9,978 
E)  $10,277

Question 13

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Accepted Answer

A) True 
 B)False

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)  One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. 
B)  Well-diversified stockholders do not need to consider market risk when determining required rates of return. 
C)  Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. 
D)  Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. 
E)  Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects. 
A)  One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities. 
B)  Well-diversified stockholders do not need to consider market risk when determining required rates of return. 
C)  Market risk is important, but it does not have a direct effect on stock prices because it only affects beta. 
D)  Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. 
E)  Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

Question 15

Weston Clothing Company is considering manufacturing a new style of shirt, whose data are shown below.The equipment to be used would be depreciated by the straight-line method over its 3-year life and would have a zero salvage value, and no new working capital would be required.Revenues and other operating costs are expected to be constant over the project's 3-year life.However, this project would compete with other Weston's products and would reduce their pre-tax annual cash flows.What is the project's NPV? (Hint: Cash flows are constant in Years 1-3.) $\begin{array}{lr}
\text { Cost of capital } & 10.0 \% \
\text { Pre-tax cash flow reduction for other products (cannibalization) } & \$ 5,000 \
\text { Investment cost (depreciable basis) } & \$ 80,000 \
\text { Straight-line deprec. rate } & 33.333 \% \
\text { Sales revenues, each year for 3 years } & \$ 67,500 \
\text { Annual operating costs (excl. deprec) } & \$ 25,000 \
\text { Tax rate } & 25.0 \%
\end{array}$

Accepted Answer

A)  $6,196 
B)  $6,522 
C)  $6,848 
D)  $7,190 
E)  $7,550 
A)  $6,196 
B)  $6,522 
C)  $6,848 
D)  $7,190 
E)  $7,550

Question 16

Because of differences in the expected returns on different investments, the standard deviation is not always an adequate measure of risk.However, the coefficient of variation adjusts for differences in expected returns and thus allows investors to make better comparisons of investments' stand-alone risk.

Accepted Answer

A) True 
 B)False

Question 17

Garden-Grow Products is considering a new investment whose data are shown below.The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that would be recovered at the end of the project's life.Revenues and other operating costs are expected to be constant over the project's life.What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.) $\begin{array}{lr}
\text { Proj ect cost of capital (r) } & 10.0 \% \
\text { Net investment in fixed assets (basis) } & \$ 75,000 \
\text { Required new working capital } & \$ 15,000 \
\text { Straight-line deprec. rate } & 33.333 \% \
\text { Sal es revenues, each year } & \$ 75,000 \
\text { Operating costs (excl. deprec.), each year } & \$ 25,000 \
\text { Tax rate } & 25.0 \%
\end{array}$

Accepted Answer

A)  $30,069 
B)  $31,573 
C)  $33,152 
D)  $34,809 
E)  $36,550 
A)  $30,069 
B)  $31,573 
C)  $33,152 
D)  $34,809 
E)  $36,550

Question 18

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.

Accepted Answer

A) True 
 B)False

Question 19

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.

Accepted Answer

A) True 
 B)False

Question 20

Wansley Enterprises is considering a new project.The company has a beta of 1.0, and its sales and profits are positively correlated with the overall economy.The company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project.Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong.On the basis of this information, which of the following statements is CORRECT?

Accepted Answer

A)  The proposed new project would increase the firm's corporate risk. 
B)  The proposed new project would increase the firm's market risk. 
C)  The proposed new project would not affect the firm's risk at all. 
D)  The proposed new project would have less stand-alone risk than the firm's typical project. 
E)  The proposed new project would have more stand-alone risk than the firm's typical project. 
A)  The proposed new project would increase the firm's corporate risk. 
B)  The proposed new project would increase the firm's market risk. 
C)  The proposed new project would not affect the firm's risk at all. 
D)  The proposed new project would have less stand-alone risk than the firm's typical project. 
E)  The proposed new project would have more stand-alone risk than the firm's typical project.

Exam 11: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.

You have just landed an internship in the CFO's office of Hawkesworth Inc.Your first task is to estimate the Year 1 cash flow for a project with the following data.What is the Year 1 cash flow? Sales revenues \ 13,000 Depreciation \ 4,000 Other operating costs \ 6,000 Tax rate 25.0\%

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

McLeod Inc.is considering an investment that has an expected return of 15% and a standard deviation of 10%.What is the investment's coefficient of variation?

It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop.This is why subjective judgment is often used for such projects along with discounted cash flow analysis.

If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

In your first job with TBL Inc.your task is to consider a new project whose data are shown below.What is the project's Year 1 cash flow? Sales revenues \ 22,250 Depreciation \ 8,000 Other operating costs \ 12,000 Tax rate 25.0\%

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Which of the following statements is CORRECT?

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.

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Risk and Return

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Corporate Valuation and Financial Planning

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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