Question 1

(12A). Other things held constant, which of the following would increase the NPV of a project being considered?

Accepted Answer

A)  A shift from straight-line to MACRS depreciation. 
B)  Making the initial investment in the first year rather than spreading it over the first three years. 
C)  An increase in the discount rate associated with the project. 
D)  An increase in required net operating working capital. 
E)  The project would decrease sales of another product line.

Question 2

Atlas Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project L has an expected life of 4 years with after-tax cash inflows of $4,373 at the end of each of the next 4 years. Each project has a WACC of 9.25%, and Project S can be repeated with no changes in its cash flows. The controller prefers Project S, but the CFO prefers Project L. How much value will the firm gain or lose if Project L is selected over Project S, i.e., what is the value of NPVL - NPVS?

Accepted Answer

A)  $56.50 
B)  $62.15 
C)  $68.37 
D)  $75.21 
E)  $82.73

Question 3

Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $7,900 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,300 at the end of each of the next 4 years. Each project has a WACC of 8%. Using the replacement chain approach, what is the NPV of the most profitable project?

Accepted Answer

A)  $4,242 
B)  $4,246 
C)  $4,286 
D)  $4,325 
E)  $4,433

Question 4

Rowell 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. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?

Accepted Answer

A)  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 of the capital budgeting analysis for any new project. 
B)  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. 
C)  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. 
D)  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. 
E)  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.

Question 5

Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision--estimates of its effect would really just be guesses. In this case, the externality should be ignored--i.e., not considered at all--because if it were considered it would make the analysis appear more precise than it really is.

Accepted Answer

A) True 
 B)False

Question 6

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

Accepted Answer

A) True 
 B)False

Question 7

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

Accepted Answer

A) True 
 B)False

Question 8

The relative risk of a proposed project is best accounted for by which of the following procedures?

Accepted Answer

A)  Adjusting the discount rate upward if the project is judged to have above-average risk. 
B)  Adjusting the discount rate upward if the project is judged to have below-average risk. 
C)  Reducing the NPV by 10% for risky projects. 
D)  Picking a risk factor equal to the average discount rate. 
E)  Ignoring risk because project risk cannot be measured accurately.

Question 9

The two cardinal rules that financial analysts should follow to avoid 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 for capital budgeting projects.

Accepted Answer

A) True 
 B)False

Question 10

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.

Accepted Answer

A) True 
 B)False

Question 11

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

Accepted Answer

A)  In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, "double count" it. 
B)  Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows. 
C)  When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process. 
D)  Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis. 
E)  The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.

Question 12

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

Accepted Answer

A) True 
 B)False

Question 13

Which of the following statements is CORRECT?

Accepted Answer

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

Question 14

Which of the following statements is CORRECT?

Accepted Answer

A)  Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV. 
B)  Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer. 
C)  Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes. 
D)  Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions. 
E)  Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Question 15

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a 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 have more stand-alone risk than the firm's typical project. 
B)  The proposed new project would increase the firm's corporate risk. 
C)  The proposed new project would increase the firm's market risk. 
D)  The proposed new project would not affect the firm's risk at all. 
E)  The proposed new project would have less stand-alone risk than the firm's typical project.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws. 
B)  If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws. 
C)  If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward. 
D)  If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized. 
E)  Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Question 17

Which of the following statements is CORRECT?

Accepted Answer

A)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. 
B)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. 
C)  The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. 
D)  If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration. 
E)  If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

Question 18

Carlyle Inc. is considering two mutually exclusive projects. Both require an initial investment of $15,000 at t = 0. Project S has an expected life of 2 years with after-tax cash inflows of $7,000 and $12,000 at the end of Years 1 and 2, respectively. In addition, Project S can be repeated at the end of Year 2 with no changes in its cash flows. Project L has an expected life of 4 years with after-tax cash inflows of $5,200 at the end of each of the next 4 years. Each project has a WACC of 9.00%. What is the equivalent annual annuity of the most profitable project?

Accepted Answer

A)  $ 569.97 
B)  $ 782.34 
C)  $ 865.31 
D)  $1,522.18 
E)  $1,846.54

Question 19

Which of the following statements is CORRECT?

Accepted Answer

A)  A sunk cost is any cost that must be expended in order to complete a project and bring it into operation. 
B)  A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project. 
C)  A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project. 
D)  Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project's NPV. 
E)  A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.

Question 20

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

Accepted Answer

A)  Project A, which has average risk and an IRR = 9%. 
B)  Project B, which has below-average risk and an IRR = 8.5%. 
C)  Project C, which has above-average risk and an IRR = 11%. 
D)  Without information about the projects' NPVs we cannot determine which one or ones should be accepted. 
E)  All of these projects should be accepted as they will produce a positive NPV.

Exam 12: Cash Flow and Risk

(12A) . Other things held constant, which of the following would increase the NPV of a project being considered?

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

The relative risk of a proposed project is best accounted for by which of the following procedures?

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?