Exam 13: Capital Budgeting

Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which will increase the assets of the firm by 50 percent.Sun State currently has a required rate of return of 18 percent, U.S.Treasury bonds yield 7 percent, and the market risk premium is 5 percent.If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

One of the disadvantages of the payback method for evaluating capital budgeting projects is that it does not adjust for the riskiness of different projects.

Risky projects can be evaluated by discounting expected cash flows using a risk-adjusted discount rate.

Which of the following decision measures should capital budgeting decision makers consider?

Exchange rate risk is the risk that the cash flows from a foreign project will be worth less than those same cash flows denominated in the parent company's home currency.

The situation where a firm accepts projects to the point where the return on the last project accepted is just equal to or greater than the firm's required rate of return (IRR ≥ r at the margin) is called capital rationing.

When considering two mutually exclusive projects, the financial manager should always select that project whose internal rate of return is the highest provided the projects have the same initial cost.

Suppose a firm is considering production of a new product whose projected sales include sales that will be taken away from another product the firm also produces.The lost sales on the existing product are a sunk cost and are not a relevant cost to the new product.

Given the following information, calculate the NPV of a proposed project: Cost = $4,000; estimated life = 3 years; initial decrease in accounts receivable = $1000, which must be restored at the end of the project's life; estimated salvage value = $1,000; net income before taxes and depreciation = $2,000 per year; method of depreciation = MACRS; tax rate = 40 percent; required rate of return = 18 percent.

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are riskier.

Which of the following is not discussed in the text as a method for analyzing risk in capital budgeting?

As a practical matter, it is much easier to use market risk analysis at the project level than at the divisional level because it is easier to estimate the beta of a single project such as a machine tool die maker than the beta of an entire division (or subsidiary) such as Phillip Morris' Kraft foods unit.

If a company uses the same discount rate for evaluating all projects, which of the following results is likely?

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables, such as sales.Other things held constant, with the independent variable graphed on the horizontal axis, the steeper the graph of the relationship line, the less risky the project.

Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance company.If the purchase is made, Carolina will be 50 percent larger than before.Currently, Carolina's stock has a beta of 1.2 and the return required is 15.2 percent.The fire insurance company is expected to generate a return of 20 percent with a beta of 2.5.If the risk-free rate is 8 percent and the market risk premium is 6 percent, should Carolina make the investment?

Assume the following: (1) A firm is considering two projects, one with a 5-year life and the other with a 10-year life; (2) the cash flows of the two projects are equally risky by all definitions of the word "risky"; (3) the company uses 40 percent debt and 60 percent equity to finance the projects; (4) the debt used to finance any given project has a maturity equal to the life of the project; and (5) the term structure of interest rates has a sharp upward slope.This would suggest, other things held constant, that a lower discount rate should be used to find the NPV for the 5-year project than for the 10-year project.

Estimating the cash flows in a capital project is the easiest and least important part of the capital budgeting process.

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

Two mutually exclusive projects each have a cost of $10,000.The total, undiscounted cash flows from Project L are $15,000, while the undiscounted cash flows from Project S total $13,000.Their NPV profiles cross at a discount rate of 10 percent.Which of the following statements best describes this situation?

The post-audit is used to