Exam 11: The Cost of Capital

A key difference between replacement and expansion project analyses is that with replacement, the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets.

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.

The stand-alone risk is the risk an asset would have if it were a firm's only asset and it is measured by the variability of the asset's expected returns.

The financial staff's role in the forecasting process includes all of the following except

Which of the following is not considered a relevant concern in determining incremental cash flows for a new product?

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

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?

Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in income after taxes.

Which of the following statements concerning cash flow evaluation in capital budgeting is incorrect?

Monte Carlo simulation

Expansion project analysis requires determining the amount of incremental cash as a result of the expansion relative to the cash flows if the expansion project was not accepted.The incremental cash flows will always be discounted at the same rate as the firm's original cash flows sine we are simply expanding the firm and not changing the risk of the firm.

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

Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital budgeting?

Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.

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.

It is extremely difficult to estimate the revenues and costs associated with large complex projects that take several years to develop.This is why subjective judgment is recommended for such projects instead of cash flow analysis.

The cash flows relevant for the analysis of a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company and the cash flows which must remain in the foreign country.

Empirical studies of risk strongly support the contention that investors who are well diversified focus exclusively on market risk when they establish required returns.

Your company must ensure the safety of its work force.Two plans are being considered for the next 10 years: (1) Install a high electrified fence around the property at a cost of $100,000.Maintenance and electricity would then cost $5,000 per year over the 10-year life of the fence.(2) Hire security guards at a cost of $25,000 paid at the end of each year.Because the company plans to build new headquarters with a "state of the art" security system in 10 years, the plan will only be in effect until that time.Your company's required rate of return is 15 percent for average projects, and that rate is normally adjusted up or down by 2 percentage points for high- and low-risk projects.Plan 1 is considered to be of low risk because its costs can be predicted quite accurately.Plan B, on the other hand, is a high-risk project because of the difficulty of predicting wage rates.What is the proper PV of costs for the better project?

Superior analytical techniques, such as NPV, used in combination with adjustments to the average required rate of return, can overcome the problem of poor cash flow estimation in decision making.