Question 1

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%.

Accepted Answer

A)  1.82. 
B)  1.82 
C)  1.07 
D)  2.07 
A)  1.82. 
B)  1.82 
C)  1.07 
D)  2.07

Question 2

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

Accepted Answer

A)  systematic risk; systematic risk 
B)  unsystematic risk; unsystematic risk 
C)  total risk; total risk 
D)  systematic risk, total risk 
A)  systematic risk; systematic risk 
B)  unsystematic risk; unsystematic risk 
C)  total risk; total risk 
D)  systematic risk, total risk

Question 3

The certainty equivalent approach adjusts the ____ for risk in the ____ of the net present value equation.

Accepted Answer

A)  net cash flows, numerator 
B)  risk-free rate, numerator 
C)  required return, numerator 
D)  net cash flows, denominator 
A)  net cash flows, numerator 
B)  risk-free rate, numerator 
C)  required return, numerator 
D)  net cash flows, denominator

Question 4

Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30 percent equity. The levered beta for this division has been estimated to be 2.02. What will be Technico's weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent?

Accepted Answer

A)  14.77% 
B)  10.33% 
C)  18.1% 
D)  1.03% 
A)  14.77% 
B)  10.33% 
C)  18.1% 
D)  1.03%

Question 5

Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent. If Faris' tax rate is 40 percent, estimate the levered beta for the new product division?

Accepted Answer

A)  2.44 
B)  1.14 
C)  2.74 
D)  3.88 
A)  2.44 
B)  1.14 
C)  2.74 
D)  3.88

Question 6

What is the reason companies utilize the certainty equivalent approach in evaluating projects?

Accepted Answer

1. It can adjust the cash flows to accou

Question 7

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.

Accepted Answer

A)  expand if after-tax cost of debt is 11.5% or less 
B)  expand if after-tax cost of debt is 15% or less 
C)  expand if after-tax cost of debt is 10.4% or less 
D)  do not expand 
A)  expand if after-tax cost of debt is 11.5% or less 
B)  expand if after-tax cost of debt is 15% or less 
C)  expand if after-tax cost of debt is 10.4% or less 
D)  do not expand

Question 8

The ____ approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures.

Accepted Answer

A)  net present value 
B)  internal rate of return 
C)  risk-adjusted discount rate 
D)  certainty equivalent 
A)  net present value 
B)  internal rate of return 
C)  risk-adjusted discount rate 
D)  certainty equivalent

Question 9

Which of the following statements is correct about adjusting for beta risk in capital budgeting?

Accepted Answer

A)  It measures unsystematic risk. 
B)  It is a guaranteed measure of the success of the project. 
C)  The beta concept can be used to determine RADR. 
D)  It evaluates the efficiency of the management team. 
A)  It measures unsystematic risk. 
B)  It is a guaranteed measure of the success of the project. 
C)  The beta concept can be used to determine RADR. 
D)  It evaluates the efficiency of the management team.

Question 10

IKON is financed entirely with equity and its beta is 1.31. If the current risk-free rate is 6.25% and the expected market return is 12.8%, what is IKON's required rate of return on a project of average risk?

Accepted Answer

A)  8.58% 
B)  14.83% 
C)  17.65% 
D)  12.81% 
A)  8.58% 
B)  14.83% 
C)  17.65% 
D)  12.81%

Question 11

A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a net present value greater than $60,000?

Accepted Answer

A)  1915% 
B)  69.15% 
C)  0.13% 
D)  30.85% 
A)  1915% 
B)  69.15% 
C)  0.13% 
D)  30.85%

Question 12

The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is the

Accepted Answer

A)  sensitivity analysis method 
B)  simulation approach 
C)  net present value/payback method 
D)  risk-adjusted discount rate approach 
A)  sensitivity analysis method 
B)  simulation approach 
C)  net present value/payback method 
D)  risk-adjusted discount rate approach

Question 13

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

Accepted Answer

A)  certain return; risky return 
B)  risky return; certain return 
C)  certain return; beta 
D)  beta, risky return 
A)  certain return; risky return 
B)  risky return; certain return 
C)  certain return; beta 
D)  beta, risky return

Question 14

SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions of the firm's total assets:  
The risk-free rate is 8 percent and the market risk premium is 5 percent. If SCAN is considering a residential development, what should the firm use as its cost of equity in evaluating this project?

Accepted Answer

A)  13.05% 
B)  16.20% 
C)  12.25% 
D)  15.00% 
A)  13.05% 
B)  16.20% 
C)  12.25% 
D)  15.00%

Question 15

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

Accepted Answer

A)  simulation analysis 
B)  profitability index 
C)  certainty equivalent approach 
D)  risk adjusted discount rate 
A)  simulation analysis 
B)  profitability index 
C)  certainty equivalent approach 
D)  risk adjusted discount rate

Question 16

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

Accepted Answer

A)  can lead to selecting only above-average risk projects 
B)  provides the decision maker with a range of numbers 
C)  can lead to selecting only below-average risk projects 
D)  is difficult to estimate the appropriate risk premium for a project 
A)  can lead to selecting only above-average risk projects 
B)  provides the decision maker with a range of numbers 
C)  can lead to selecting only below-average risk projects 
D)  is difficult to estimate the appropriate risk premium for a project

Question 17

Smart Bumpkins wants to increase production by adding new equipment. The cost of the upgrade is $190,000 and expected cash flows from the new upgrade are expected to be as follows over the next 6 years and the risk free rate is 5%. Should the company upgrade?

Accepted Answer

A)  Yes, the CNPV is $195,196.06 
B)  Yes, the CNPV is $83,775.16 
C)  No, the CNPV is -$75,522.84 
D)  No, the CNPV is -$42,175.93 
A)  Yes, the CNPV is $195,196.06 
B)  Yes, the CNPV is $83,775.16 
C)  No, the CNPV is -$75,522.84 
D)  No, the CNPV is -$42,175.93

Question 18

The ____ the amount of debt in a firm's capital structure, the ____ will be the firm's beta.

Accepted Answer

A)  larger, larger 
B)  smaller, larger 
C)  larger, smaller 
D)  smaller, smaller 
A)  larger, larger 
B)  smaller, larger 
C)  larger, smaller 
D)  smaller, smaller

Question 19

Project C has been classified into risk class II by the analyst of a major firm. The risk premium required for projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%. If the project has an estimated return of 20%, the analyst would recommend

Accepted Answer

A)  accepting project C 
B)  rejecting project C 
C)  reestimating the risk premiums for class II projects 
D)  none of the above 
A)  accepting project C 
B)  rejecting project C 
C)  reestimating the risk premiums for class II projects 
D)  none of the above

Question 20

The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The initial outlay required is $22 million. Net cash flows over the 4-year life cycle and the corresponding certainty-equivalents of the new model are as follows:  
The firm's cost of capital is 14% and the risk-free rate is 6%. Bull uses the certainty-equivalent approach in evaluating above-average risk investments such as this one. What is the project's certainty-equivalent NPV?

Accepted Answer

A)  $20,083,000 
B)  $ 6,628,400 
C)  $13,905,000 
D)  $ 3,019,400 
A)  $20,083,000 
B)  $ 6,628,400 
C)  $13,905,000 
D)  $ 3,019,400

Exam 11: Capital Budgeting and Risk

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%.

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

The certainty equivalent approach adjusts the ____ for risk in the ____ of the net present value equation.

What is the reason companies utilize the certainty equivalent approach in evaluating projects?

The ____ approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures.

Which of the following statements is correct about adjusting for beta risk in capital budgeting?

IKON is financed entirely with equity and its beta is 1.31. If the current risk-free rate is 6.25% and the expected market return is 12.8%, what is IKON's required rate of return on a project of average risk?

A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a net present value greater than $60,000?

The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is the

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

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

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

Smart Bumpkins wants to increase production by adding new equipment. The cost of the upgrade is $190,000 and expected cash flows from the new upgrade are expected to be as follows over the next 6 years and the risk free rate is 5%. Should the company upgrade?

The ____ the amount of debt in a firm's capital structure, the ____ will be the firm's beta.

Project C has been classified into risk class II by the analyst of a major firm. The risk premium required for projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%. If the project has an estimated return of 20%, the analyst would recommend

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

The certainty equivalent approach adjusts the for risk in the of the net present value equation.

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

The the amount of debt in a firm's capital structure, the will be the firm's beta.