Question 1

Monte Carlo simulation

Accepted Answer

A)  Can be useful for estimating a project's stand-alone risk. 
B)  Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable. 
C)  Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR. 
D)  All of the above. 
E)  Only answers a and b are correct. 
A)  Can be useful for estimating a project's stand-alone risk. 
B)  Is capable of using probability distributions for variables as input data instead of a single numerical estimate for each variable. 
C)  Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR. 
D)  All of the above. 
E)  Only answers a and b are correct.

Question 2

Assuming that the total cash flows are equal, the NPV of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly.

Accepted Answer

A) True 
 B)False

Question 3

Which of the following statements is correct?

Accepted Answer

A)  Neither "stand-alone" nor "within-firm" risk takes account of diversification, either by stockholders or by the firm. 
B)  If a project's expected returns are highly correlated with returns on the market, this will tend to reduce the project's market risk. 
C)  Monte Carlo simulation analysis and sensitivity analysis are similar, but sensitivity analysis is generally harder to use because it requires knowledge of the probability distributions associated with the input variables. 
D)  Sensitivity analysis requires a project's beta coefficient, which can be obtained by either the "pure play" or the "accounting beta" method. 
E)  If we are choosing between two mutually exclusive projects which have only costs (no revenues), the riskier one should be evaluated with a lower required rate of return. 
A)  Neither "stand-alone" nor "within-firm" risk takes account of diversification, either by stockholders or by the firm. 
B)  If a project's expected returns are highly correlated with returns on the market, this will tend to reduce the project's market risk. 
C)  Monte Carlo simulation analysis and sensitivity analysis are similar, but sensitivity analysis is generally harder to use because it requires knowledge of the probability distributions associated with the input variables. 
D)  Sensitivity analysis requires a project's beta coefficient, which can be obtained by either the "pure play" or the "accounting beta" method. 
E)  If we are choosing between two mutually exclusive projects which have only costs (no revenues), the riskier one should be evaluated with a lower required rate of return.

Question 4

Given two mutually exclusive projects and a zero required rate of return, the payback period and NPV method of selecting investments will always lead to the same decision on which project to undertake.

Accepted Answer

A) True 
 B)False

Question 5

Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

Accepted Answer

A)  Risk premium method. 
B)  Pure play method. 
C)  Accounting beta method. 
D)  CAPM method. 
E)  Answers b and c are both correct. 
A)  Risk premium method. 
B)  Pure play method. 
C)  Accounting beta method. 
D)  CAPM method. 
E)  Answers b and c are both correct.

Question 6

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in the analysis.

Accepted Answer

A) True 
 B)False

Question 7

Two projects being considered are mutually exclusive and have the following projected cash flows:   At what rate (approximately) do the NPV profiles of Projects A and B cross?

Accepted Answer

A)  6.5% 
B)  11.5% 
C)  16.5% 
D)  20.0% 
E)  The NPV profiles of these two projects do not cross. 
A)  6.5% 
B)  11.5% 
C)  16.5% 
D)  20.0% 
E)  The NPV profiles of these two projects do not cross.

Question 8

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 9

The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10.This investment will cost the firm $150,000 today, and the firm's required rate of return is 10 percent.Assume cash flows occur evenly during the year, 1/365th each day.What is the payback period for this investment?

Accepted Answer

A)  5.23 years 
B)  4.86 years 
C)  4.00 years 
D)  6.12 years 
E)  4.35 years 
A)  5.23 years 
B)  4.86 years 
C)  4.00 years 
D)  6.12 years 
E)  4.35 years

Question 10

A(n) ____ is the return on the best alternative use of an asset, the highest return that will not be earned if funds are not invested in a particular project.

Accepted Answer

A)  opportunity cost 
B)  sunk cost 
C)  incremental cash flow 
D)  externality 
A)  opportunity cost 
B)  sunk cost 
C)  incremental cash flow 
D)  externality

Question 11

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 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' marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate projects of this nature.If the machine costs $60,000, what is the NPV of the project?

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 12

____ are decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operations.

Accepted Answer

A)  Replacement decisions 
B)  Expansion decisions 
C)  Independent decisions 
D)  Mutually exclusive decisions 
A)  Replacement decisions 
B)  Expansion decisions 
C)  Independent decisions 
D)  Mutually exclusive decisions

Question 13

The change in net working capital is always positive, meaning more working capital is required, for projects considered in capital budgeting because all projects are either expansion projects or replacement projects which have expansion effects.

Accepted Answer

A) True 
 B)False

Question 14

Your company is considering a machine which will cost $50,000 at Time 0 and which can be sold after 3 years for $10,000.$12,000 must be invested at Time 0 in inventories and receivables; these funds will be recovered when the operation is closed at the end of Year 3.The facility will produce sales revenues of $50,000/year for 3 years; variable operating costs (excluding depreciation) will be 40 percent of sales.No fixed costs will be incurred.Operating cash inflows will begin 1 year from today (at t = 1).By an act of Congress, the machine will have depreciation expenses of $40,000, $5,000, and $5,000 in Years 1, 2, and 3, respectively.The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund on this project if the project's income is negative, and a 15 percent required rate of return.Inflation is zero.What is the project's NPV?

Accepted Answer

A)  $7,673.71 
B)  $12,851.75 
C)  $17,436.84 
D)  $24,989.67 
E)  $32,784.25 
A)  $7,673.71 
B)  $12,851.75 
C)  $17,436.84 
D)  $24,989.67 
E)  $32,784.25

Question 15

Which of the following statements is 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 supplemental operating cash flows for the purpose of capital budgeting, interest payments should not be included since the effects of these payments are already included in the rate of return the firm is required to earn from its investments. 
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 above answers are correct. 
E)  None of the above answers 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 supplemental operating cash flows for the purpose of capital budgeting, interest payments should not be included since the effects of these payments are already included in the rate of return the firm is required to earn from its investments. 
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 above answers are correct. 
E)  None of the above answers is correct.

Question 16

The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs.The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences.System A is judged to be a high-risk project (it might end up costing much more to operate than is expected).The appropriate risk-adjusted discount rate that should be used to evaluate System A is

Accepted Answer

A)  10%; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted. 
B)  13%; the firm's required rate of return should not be adjusted when evaluating outflow only projects. 
C)  16%; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk. 
D)  Somewhere between 10% and 16%, with the answer depending on the riskiness of the relevant inflows. 
E)  Indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment. 
A)  10%; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are being discounted. 
B)  13%; the firm's required rate of return should not be adjusted when evaluating outflow only projects. 
C)  16%; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly penalizes the project for its high risk. 
D)  Somewhere between 10% and 16%, with the answer depending on the riskiness of the relevant inflows. 
E)  Indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process that meets the requirements with the lowest required investment.

Question 17

New Project NPV
Truck Acquisition
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 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.
[MACRS table required]
-Refer to Truck Acquisition.What is the initial investment outlay for the truck? (That is, what is the Year 0 net cash flow?)

Accepted Answer

A)  −$50,000 
B)  −$52,600 
C)  −$55,800 
D)  −$62,000 
E)  −$65,000 
A)  −$50,000 
B)  −$52,600 
C)  −$55,800 
D)  −$62,000 
E)  −$65,000

Question 18

Assume you are the director of capital budgeting for an all-equity firm.The firm's current required rate of return is 16 percent; the risk-free rate is 10 percent; and the market risk premium is 5 percent.You are considering a new project that has 50 percent more beta risk than your firm's assets currently have, i.e., its beta is 50 percent larger than the firm's existing beta.The expected return (IRR) on the new project is 18 percent.Should the project be accepted if beta risk is the appropriate risk measure? Choose the most correct statement.

Accepted Answer

A)  Yes; its IRR is greater than the firm's required rate of return. 
B)  Yes; the project's risk-adjusted required return is less than its IRR. 
C)  No; a 50% increase in beta risk gives a risk-adjusted required return of 24%. 
D)  No; the project's risk-adjusted required return is 2 percentage points above its IRR. 
E)  No; the project's risk-adjusted required return is 1 percentage point above its IRR. 
A)  Yes; its IRR is greater than the firm's required rate of return. 
B)  Yes; the project's risk-adjusted required return is less than its IRR. 
C)  No; a 50% increase in beta risk gives a risk-adjusted required return of 24%. 
D)  No; the project's risk-adjusted required return is 2 percentage points above its IRR. 
E)  No; the project's risk-adjusted required return is 1 percentage point above its IRR.

Question 19

A(n) ____ is a cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.

Accepted Answer

A)  sunk cost 
B)  opportunity cost 
C)  externality 
D)  incremental cash flow 
A)  sunk cost 
B)  opportunity cost 
C)  externality 
D)  incremental cash flow

Question 20

One of the advantages of the payback period (either regular or discounted) is that it considers all cash flows throughout the entire life of a project.

Accepted Answer

A) True 
 B)False

Monte Carlo simulation

Assuming that the total cash flows are equal, the NPV of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly.

Which of the following statements is correct?

Given two mutually exclusive projects and a zero required rate of return, the payback period and NPV method of selecting investments will always lead to the same decision on which project to undertake.

Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in the analysis.

Two projects being considered are mutually exclusive and have the following projected cash flows: At what rate (approximately) do the NPV profiles of Projects A and B cross?

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

A(n) ____ is the return on the best alternative use of an asset, the highest return that will not be earned if funds are not invested in a particular project.

____ are decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operations.

The change in net working capital is always positive, meaning more working capital is required, for projects considered in capital budgeting because all projects are either expansion projects or replacement projects which have expansion effects.

Which of the following statements is correct?

A(n) ____ is a cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.

One of the advantages of the payback period (either regular or discounted) is that it considers all cash flows throughout the entire life of a project.

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

The Cost of Money Interest Rates

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

The Cost of Capital

Capital Structure and Dividend Policy Decisions

Working Capital Management

Investment Concepts

Security Valuation and Selection

Filters

Exam 13: Capital Budgeting

Monte Carlo simulation

Assuming that the total cash flows are equal, the NPV of a project whose cash flows accrue relatively rapidly is more sensitive to changes in the discount rate than is the NPV of a project whose cash flows come in more slowly.

Which of the following statements is correct?

Given two mutually exclusive projects and a zero required rate of return, the payback period and NPV method of selecting investments will always lead to the same decision on which project to undertake.

Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not relevant in the analysis.

Two projects being considered are mutually exclusive and have the following projected cash flows: At what rate (approximately) do the NPV profiles of Projects A and B cross?

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

A(n) ____ is the return on the best alternative use of an asset, the highest return that will not be earned if funds are not invested in a particular project.

____ are decisions about whether to purchase capital projects and add them to existing assets so as to increase existing operations.

The change in net working capital is always positive, meaning more working capital is required, for projects considered in capital budgeting because all projects are either expansion projects or replacement projects which have expansion effects.

Which of the following statements is correct?

A(n) ____ is a cash outlay that already has been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.

One of the advantages of the payback period (either regular or discounted) is that it considers all cash flows throughout the entire life of a project.

An Overview of Finance

Financial Assets Instruments

Financial Markets and the Investment Banking Process

Financial Intermediaries and the Banking System

The Cost of Money Interest Rates

Business Organizations and the Tax Environment

Analysis of Financial Statements

Financial Planning and Control

Time Value of Money

Valuation Concepts

Risk and Rates of Return

The Cost of Capital

Capital Structure and Dividend Policy Decisions

Working Capital Management

Investment Concepts

Security Valuation and Selection

Filters