Exam 12: Risk Topics and Real Options in Capital Budgeting

Which of the following techniques gives an estimate of capital budgeting project risk in terms of the standard deviation of a project's NPV or IRR?

A worst case scenario analysis evaluates the potential cash flows for a project that represent the worst possible outcome for the project.

Francis Corp is evaluating a capital budgeting project and has come up with the following two branch decision tree analysis ($000). The firm's cost of capital is 12%. What is the project's NPV? ($000)

Evaluating several possible cash flow scenarios gives a feel for variability of a project's NPV.

In theory, the risk-free rate is more appropriate for the NPV calculation in the certainty equivalent approach since:

The certainty equivalent approach uses the cost of capital as the appropriate discount rate.

When a similar company can't be found to use in estimating a divisional beta, the division's own records can sometimes be used instead. This method is called:

Real options are generally worth more than their expected NPV impact due to the effect real options have on risk.

The certainty equivalent factor can take any value:

Nash, Inc. is looking at a 4-year project that will cost $4 million to initiate. Based on a range of economic forecasts, Nash has forecasted a worst case, best case and most likely case with respect to cash flows that this project will generate and assigned probabilities to these forecasts. The worst case forecast (30% probability) is $1.2 million per year. The best case (20% probability) is $1.8 million per year with an additional $1 million in the fourth year. The most likely forecast (50% probability) is $1.5 million per year with an additional $0.5 million in the fourth year. The cost of capital is 14%. a. What is the NPV ($000) of the worst case scenario? b. What is the NPV ($000) of the best case scenario? c. What is the NPV ($000) of the most likely scenario? d. What should Nash use to approximate the expected NPV ($000) of the project?

Multidivisional firms are often unable to obtain an appropriate surrogate for determining the beta of a division. An acceptable alternative technique is to develop a beta through the division's accounting records. This is accomplished by:

A ____ is a course of action that can be made available, usually at a cost, which improves financial results under certain conditions.

Project A will generate $10,000.00 of revenue next year. Project B will generate $5,000.00 (50% probability) or $15,000.00 (50% probability) of revenue next year. Assuming both projects cost $8,000.00 and have a 10% APR discount rate, which project is preferred by a risk averse manager?

The probabilities along a path are called ____ probabilities.

The existence of an abandonment option raises a project's risk.

A company's cost of capital is the most appropriate discount rate to use when analyzing which type of project(s)?

In calculating probabilities using a decision tree, which of the following is most correct?

The technique for incorporating Risk into capital budgeting that involves the use of numbers drawn randomly from probability distributions is called a:

The ____ makes risky projects less acceptable by simply lowering the cash flow estimates themselves.

The ____ method consists of regressing historical values of a division's return on equity against the return on a major stock market index.