Question 1

A weakness of the net present value/payback method is that _____.

Accepted Answer

A)   it is a complicated calculation
B)   it is subjective
C)   it is directly related to the variability of returns from a project
D)   because it recognizes the riskiness of various projects, it can develop multiple outcomes B

Question 2

Which of the following is (are) a risk associated with projects that must be considered when determining the net present value? 
I. Financial risk
II. Pure project risk

Accepted Answer

A)   Only statement I is correct.
B)   Only statement II is correct.
C)   Both statements I and II are correct.
D)   Neither statement I nor II is correct. C

Question 3

The net present value of a project is normally distributed with an expected value of $52,000 and a standard deviation of $31,515. Determine the probability that the project will have a net present value of less than zero.

Accepted Answer

A)   1.65%
B)   95.1%
C)   4.95%
D)   Cannot be determined C

Question 4

Billy Bob is considering building a water slide park that will require a net investment of $200,000 and yield the following net cash flows: $$\begin{array} { l l l } 
\text { Year } & \text { Net Cash Flows } & \text { Cert. Equiv. Factor } \
1 & \$ 120,000 & 0.90 \
2 & \$ 90,000 & 0.80 \
3 & \$ 60,000 & 0.65 \
4 & \$ 30,000 & 0.50 \
5 & \$ 10,000 & 0.30
\end{array}$$ ? If the risk-free rate is 8 percent and the market risk premium is 6 percent, what is the certainty equivalent NPV for this project?

Accepted Answer

A)   $12,805
B)   $5,746
C)   $3,703
D)   $11,025

Question 5

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.)

Accepted Answer

A)   $249,685
B)   -$371,484
C)   $238,700
D)   -$352,800

Question 6

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%

Question 7

____ are needed for sensitivity analysis and have made the application simple and inexpensive.

Accepted Answer

A)   Risk tolerance tables
B)   Financial statements
C)   Financial calculators
D)   Computer spreadsheets

Question 8

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: $$\begin{array} { l l l } 
\text { Year } & \text { Net Cash Flow } & \text { Certainty-equival ent } \
1 & \$ 15 \text { million } & 0.90 \
2 & 13 \text { million } & 0.75 \
3 & 11 \text { million } & 0.55 \
4 & 9 \text { million } & 0.30
\end{array}$$ ? 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

Question 9

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%

Question 10

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

Accepted Answer

A)   risk-adjusted discount rate
B)   cost of capital
C)   risk-free rate
D)   cost of equity capital

Question 11

Simulation techniques are _____.

Accepted Answer

A)   cheap to apply
B)   widely used
C)   mostly beneficial for large projects
D)   identical to sensitivity analysis

Question 12

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.

Question 13

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?

Accepted Answer

A)   Yes, since NPV = $5,726
B)   Yes, since NPV = $75,726
C)   No, since NPV = -$10,934
D)   No, since NPV = -$5,726

Question 14

The certainty equivalent factors used to adjust the cash flows for risk can range from _____.

Accepted Answer

A)   -1 to +1
B)   0 to infinity
C)   +0.01 to +0.99
D)   0 to +1.0

Question 15

A firm's leveraged beta will always be ____ its unleveraged beta.

Accepted Answer

A)   less than
B)   greater than
C)   the same as
D)   None of these are correct

Question 16

A major problem with using the risk-adjusted discount rate approach is the determination of _____.

Accepted Answer

A)   the beta value for the firm
B)   the firm's weighted cost of capital
C)   the firm's required rate of return
D)   beta values for individual projects

Question 17

Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted discount rate for its can division of 17 percent. A planned expansion in the can division requires a net investment of $170,000 and results in expected cash inflows of $42,000 a year for seven years. Should Calco invest in this expansion?

Accepted Answer

A)   Yes, since NPV = $10,096
B)   Yes, since NPV = $9,896
C)   No, since NPV = -$5,276
D)   No, since NPV = -$9,896

Question 18

SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions of the firm's total assets: ? $\begin{array}{lcc}
\text { Division } & \text { Beta } & \% \text { of Assets } \
\text { Electric \& Gas } & 0.85 & 60 \
\text { Bus transportation } & 0.95 & 10 \
\text { Real estate } & 1.40 & 25 \
\text { Recreation } & 1.15 & 5
\end{array}$ ?
What is the firm's weighted average beta?

Accepted Answer

A)   1.01
B)   1.53
C)   0.93
D)   1.13

Question 19

The certainty equivalent approach is a risk evaluation technique. Which of the following statements is (are) correct?
 I. Certainty equivalents adjust the cash flows in the numerator of the NPV equation.
II. Using the RADR involves adjustments to the denominator of the NPV equation.

Accepted Answer

A)   Only statement I is correct.
B)   Only statement II is correct.
C)   Both statements I and II are correct.
D)   Neither statement I nor II is correct.

Question 20

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

Accepted Answer

A)   risk-adjusted discount rate
B)   NPV/payback
C)   certainty equivalent
D)   economic life

Exam 13: Capital Budgeting and Risk