Question 1

What are the primary advantages and disadvantages of applying simulation to capital budgeting risk analysis?

Accepted Answer

The answer of What are the primary advantages and disadvantages...

Question 2

The risk-adjusted discount rate approach is preferable to the weighted cost of capital approach when ______.

Accepted Answer

A)  all projects have the same risk characteristics 
B)  the risk-free rate is known with certainty 
C)  the projects under consideration have different risk characteristics 
D)  the firm is unlevered

Question 3

Which of the following techniques can be used to analyze total project risk?

Accepted Answer

A)  net present value/payback approach 
B)  risk-adjusted discount rate approach 
C)  simulation analysis 
D)  All of these are correct

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 leveraged 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%

Question 5

With the risk-adjusted discount rate approach, in the context of total risk, the discount rates used in evaluating cash flows are determined ____.

Accepted Answer

A)  objectively 
B)  subjectively 
C)  using regression analysis 
D)  objectively and by using regression analysis

Question 6

The DMT Company is financed entirely with equity. DMT has a beta of 1.20 and the current risk-free rate is 9.5 percent. If the expected market return is 14 percent, what rate of return should DMT require on a project of average risk?

Accepted Answer

A)  14.9% 
B)  15.4% 
C)  14.0% 
D)  12.0%

Question 7

Determine the pure project beta of a project that has 30% debt and 70% equity. The beta for the company is 1.4, and it has a tax rate of 40%.

Accepted Answer

A)  1.11 
B)  1.56 
C)  1.83 
D)  1.05

Question 8

The type of analysis that models some event and requires that estimates be made of the probability distribution of each cash flow element is _____.

Accepted Answer

A)  scenario 
B)  sensitivity 
C)  simulation 
D)  net present value/payback approach

Question 9

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? ? $$\begin{array} { | l | l | } 
\hline \text { Cash Flows } & \text { Certainty Equivalents } \
\hline \$ 45,000 & 0.85 \
\hline \$ 45,000 & 0.80 \
\hline \$ 75,000 & 0.75 \
\hline 110,000 & 0.70 \
\hline \$ 110,000 & 0.60 \
\hline 110,000 & 0.50 \
\hline
\end{array}$$

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.

Question 10

The net present value/payback approach is a useful approach when _____.

Accepted Answer

A)  screening projects characterized by rapid technological advances 
B)  cash flow estimates are known with certainty 
C)  the more risky cash flows occur during the startup period 
D)  None of these are correct

Question 11

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

Accepted Answer

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

Question 12

All of the following are methods of adjusting a project for total risk EXCEPT _____.

Accepted Answer

A)  sensitivity analysis 
B)  the carpe diem approach 
C)  the certainty equivalent approach 
D)  simulation analysis

Question 13

Haulin' It Towing Company is considering adding more tow trucks to its fleet. The cost of the new trucks is $150,000. The project will utilize the risk adjusted discount, the firm has a beta of 1.3, the risk-free rate is 7%, and the return in the market is 15%. Should Haulin' It add the additional trucks if the expected increased revenues will be as follows? ? $$\begin{array} { | l | l | } 
\hline \text { Years } & \text { Cash Flows } \
\hline \hline 1 & \$ 80,000 \
\hline \hline 2 & \$ 95,000 \
\hline \hline 3 & \$ 110,000 \
\hline
\end{array}$$

Accepted Answer

A)  No, the NPV of the project is -$15,175.19. 
B)  Yes, the NPV of the project is $75,275.16. 
C)  No, the NPV of the project is -$9,765.12. 
D)  Yes, the NPV of the project is $55,050.92.

Question 14

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

Accepted Answer

A)  99.38% 
B)  0.62% 
C)  34.5% 
D)  49.38%

Question 15

The risk of an investment project is defined in terms of the potential ____ of its returns.

Accepted Answer

A)  certainty 
B)  size 
C)  variability 
D)  timing

Question 16

DKA uses the certainty equivalent approach to deal with total project risk and is considering a project with the following: $$\begin{array} { l l l } 
\text { Year } & \text { Expec. NCF } & \text { Certainty Equivalent Factor } \
0 & - \$ 60,000 & 1.0 \
1 & \$ 20,000 & 0.95 \
2 & \$ 20,000 & 0.90 \
3 & \$ 25,000 & 0.80 \
4 & \$ 30,000 & 0.65
\end{array}$$ ? What is the certainty equivalent NPV for this project if the risk-free rate is 8% and the required return on the market portfolio is 15%?

Accepted Answer

A)  $3,233 
B)  $17,743 
C)  -$15,243 
D)  $13,233

Question 17

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

Question 18

The hurdle rate approach in determining the acceptability of projects is _____.

Accepted Answer

A)  an improvement over the risk-adjusted discount rate approach because it provides for an objective basis to determine risk premiums for individual projects 
B)  a modification of the internal rate of return approach 
C)  inconsistent with the principle of project risk balancing 
D)  a method used with the certainty equivalent approach

Question 19

The subjective approach to determining risk-adjusted discount rates _____.

Accepted Answer

A)  uses the risk-free rate for average-risk projects 
B)  explicitly considers the probability distribution of a project's cash flows 
C)  always leads to the correct investment decisions 
D)  groups projects into risk classes and evaluates all projects in a particular risk class at the same risk-adjusted discount rate

Question 20

Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the ____ is to changes in a particular variable.

Accepted Answer

A)  probability 
B)  return distribution 
C)  net present value 
D)  standard deviation

Exam 13: Capital Budgeting and Risk