Exam 11: Capital Budgeting and Risk

The type of analysis that models some event and requires that estimates be made of the probability distribution of each cash flow element is:

MedChem has a capital structure of 60% equity and 40% debt and a current beta of 1.2.MedChem is considering an investment project in a new line of business that has an expected internal rate of return of 16%.The typical firm already in the line of business that MedChem is considering expanding into has a beta of 1.5 and a capital structure that has 55% debt and 45% equity.The marginal tax rate for all these firms, including MedChem, is 40%.If the current risk-free rate is 7% and the expected market risk premium is 8%, should MedChem expand into the new line? Assume that MedChem will retain its current capital structure.

Rolling in Dough Cookie Corporation is trying to determine its certainty equivalent NPV.What is the CNPV if the risk free rate is 2% and the initial investment is $19,000 (rounded)?

A weakness of the net present value/payback method is:

Determine the coefficient of variation for the following annual cash in flows from an investment project: $\text { Cash Flow }$ (E20) F0\% Prabability 2,000 .10 2,500 .20 3,000 .30 3,500 .20 4,000 .20

Determine the pure project beta of a project that has 45% debt and 55% equity.The beta for the company is 1.6 and a tax rate of 40%.

With the approach, the decision maker adjusts separately each period's cash flows to account for the specific risk of those cash flows.

American Biodyne (AB) is considering expanding into a new line of business.The expansion will require an investment of $500,000 in new equipment.This equipment which will cost another $300,000 to install, will be depreciated on a straight-line basis over an 8-year period to an estimated salvage value of zero.If the expansion project is accepted, working capital will increase by $100,000 immediately.Revenues for the first 3 years are forecasted at $650,000 per year and at $800,000 in years 4-8.Operating costs exclusive of depreciation are expected to be $310,000 per year for 3 years and increase to $400,000 per year for the following 5 years.AB has a marginal tax rate of 40% and its required rate of return for the project under consideration is 16%.If AB assumes that the new equipment will have an actual market value of $50,000 at the end of the 8th year, should the expansion be undertaken?

How and when should firms consider employing additional risk analysis techniques in judging the suitability of large projects prior to implementation?

The risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project is .

The Chris-Kraft Co.is financed entirely with equity and the firm has a beta of 1.25.The current risk-free rate is 7 percent and the expected market return is 15 percent.Chris-Kraft is considering an investment project with a risk that matches the firm's average risk, requires a net investment of $70,000, and has net cash flows of $18,000 per year for 8 years.Should Chris-Kraft invest in the project?

The certainty equivalent factors used in capital budgeting analysis are equal to the divided by .

A major disadvantage of the risk-adjusted discount rate approach is that it

M-tel is financed entirely with equity and the firm's stock has a beta of 0.85.M-tel is considering investing in a project that is expected to have a beta of 1.3.The project requires an initial outlay of $6 million and is expected to generate after-tax net cash flows of $1.3 million each year for 8 years.Calculate the NPV of the project.Assume the risk-free rate is 7% and the expected market return is 14%.(Note: Problem requires either calculator use or interpolation from the tables.The suggested solutions use calculator accuracy.)

All of the following techniques are used to measure total project risk EXCEPT:

The subjective approach to determining risk-adjusted discount rates

The DMT Company is financed entirely with equity.DMT has a beta of 1.20 and the current risk-free rate is 9.5 percent.If the expected market return is 14 percent, what rate of return should DMT require on a project of average risk?

Many firms combine net present value and payback when analyzing project risk.Which of the following statements is/are correct?

The of a firm is a weighted average of the of the individual assets in the firm.

The discount rate used in calculating the certainty equivalent net present value is the