Deck 10: Project Cash Flows and Risk

Question 1

Hill Top Lumber Company is considering building a sawmill in the state of Washington because the company doesn't have such a facility to service its growing customer base located on the west coast. When evaluating the acceptability of the project, which of the following would be considered a relevant cash flow that should be included when determining the sawmill's initial investment outlay?

A)Last year, Hill Top spent $75,000 preparing a feasibility study on whether the project should be pursued further; that is, whether the firm should conduct a complete capital budgeting analysis, which is extremely costly.
B)Hill Top estimates that the new sawmill will generate $3 million of new business each year it operates.
C)To raise the funds needed to build the sawmill, Hill Top must issue new bonds.
D)It will cost Hill Top $3 million to clear the land on which the sawmill will be built.
E)It is estimated that $20 million of business from Hill Top's current customers will transfer from existing sawmills to the new sawmill.

Answer 1

  D

Question 2

When evaluating the cash flows associated with a capital budgeting project, the shipping and installation costs associated with the purchase of an asset are included in the computation of the:

A)initial investment outlay, because these expenses are part of the project's depreciable basis.
B)incremental operating cash flows, because shipping and installation costs represent expenses that must be written off annually over the life of the project.
C)terminal cash flows, because these expenses are not paid until the end of the project's life.
D)sunk costs, because these expenses do not affect any cash flows associated with purchasing the project.
E)project's opportunity cost, because these costs increase the potential of the project.

Answer 2

  A

Question 3

Zinc Corp. is planning to purchase a new machine. The initial investment outlay is expected to be $40,000, and the annual supplemental operating cash flows that the machine is expected to generate during its three-year life are $11,000, $15,000, and $18,000, respectively. The company's required rate of return is 9 percent. Which of the following statements is correct about the machine's net present value (NPV) and the decision of Zinc Corp. should make?

A)Accept the project because NPV = $4,000
B)Reject the project because NPV = -$3,384
C)Accept the project because NPV = -$4,382
D)Reject the project because NPV = $16,981
E)Accept the project because NPV = $76,616

Answer 3

  B

Question 4

Which of the following statements is correct?

A)A firm has estimated that it will save $40,000 in utility expenses annually if it replaces an old machine with a new, more technologically advanced machine. The $40,000 is a relevant cash flow that should be included in the computation of the machine's supplemental operating cash flows.
B)Inflation does not need to be considered in capital budgeting analyses.
C)The tax deduction associated with a project's depreciation expense is not a relevant cash flow in capital budgeting analyses.
D)The sunk costs associated with a project are relevant cash flows that should be included in capital budgeting analyses.
E)The cost of advertising a product that the firm currently produces and sells is a relevant cash flow that should be included in the evaluation of a new capital budgeting project.

Question 5

Which of the following statements about capital budgeting analyses is correct?

A)The externalities associated with a project represent important marginal cash flows that should be included in the capital budgeting analysis.
B)Only incremental cash flows, which are the cash flows that will change if a project is purchased, should be included in capital budgeting analyses.
C)The term incremental cash flows refers to only the marginal expected cash inflows, not the outflows, associated with a capital budgeting project.
D)Sunk costs often affect accept/reject decisions and, therefore, they should be included in the estimation of the projects' incremental cash flows.
E)A project's opportunity cost does not affect its expected cash flows, and, therefore, should not be included in the estimation of the incremental cash flows.

Question 6

The incremental cash flows associated with a capital budgeting project that occur only at the start of a project's life are included in the computation of the project's _____. 

A)initial investment outlay
B)terminal cash flows
C)sunk costs
D)supplemental operating cash flows
E)externalities

Question 7

Stanton Inc. is considering the purchase of a new machine that will reduce manufacturing costs by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually. Stanton will use the Modified Accelerated Cost Recovery System (MACRS) method to depreciate the machine, and it has estimated the depreciation expense for the first year as $8,000. Which of the following is the supplemental operating cash flow for the first year? Stanton's marginal tax rate is 40 percent. 

A)$19,000
B)$7,800
C)$6,600
D)$9,800
E)$3,000

Question 8

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

A)When determining a project's terminal cash flows, it is generally assumed that the firm's operations do not return to the same level as they were before the project was purchased.
B)Even though it is a noncash expense, a capital budgeting project's depreciation expense must be computed because it affects the after-tax cash flows of the project.
C)The relevant marginal cash flows associated with a project include depreciation, because it is an annual operating expense that requires a cash payment.
D)Shipping and installation charges are deducted from the purchase price of an asset to compute its depreciable basis.
E)The sunk costs associated with an investment proposal are relevant cash flows for capital budgeting analysis that should be included in the computation of the project's initial investment outlay.

Question 9

A project's depreciation expense must be considered when evaluating its incremental operating cash flows because:

A)depreciation represents a tax-deductible cash expense.
B)the firm incurs a cash payment equal to the depreciation expense each year.
C)depreciation has an impact on the taxes paid by the firm, which is a cash flow.
D)depreciation is a sunk cost.
E)depreciation is a fixed cash payment that the firm receives each year.

Question 10

Which of the following mathematical expressions can be used to compute the supplemental operating cash flows? (Δ = delta, which indicates the change in something; t = Period t)

A)Supplemental operating cash flows = ΔCash revenuest − ΔCash expensest − ΔTaxest
B)Supplemental operating cash flows = ΔCash revenuest − ΔCash expensest − ΔDepreciationt
C)Supplemental operating cash flows = ΔCash revenuest − ΔCash expensest + ΔDepreciationt
D)Supplemental operating cash flows = ΔCash revenuest − ΔTaxest
E)Supplemental operating cash flows = ΔCash revenuest − ΔDepreciationt + ΔTaxest

Question 11

Chovita Motors Corp. is evaluating a machine that costs $100,000. The machine is expected to generate net income equal to $30,000, $90,000, and $50,000, respectively, during the next three years. The machine's annual depreciation expense will be $5,000, $3,000, and $2,000, respectively. In three years, the machine will have a salvage value equal to zero. What is the machine's net present value (NPV) if the Chovita's required rate of return is 10 percent?

A)$63,550
B)$80,000
C)$247,746
D)$47,746
E)$186,135

Question 12

Tech Engineering Company is considering the purchase of a new machine to replace an existing one. The current market value of the old machine is $14,000 and its book value is $5,000. The new machine's cost is $30,000. If the firm's marginal tax rate is 40%, the initial investment outlay for the new machine is _____. 

A)$19,600
B)$30,000
C)$33,600
D)$21,000
E)$44,000

Question 13

Trust Engineering Company is considering the purchase of a new machine to replace an existing, worn machine. The old machine was purchased five years ago at a cost of $20,000, and it is being depreciated on a straight line basis to a salvage value of zero over its 10-year life. The new machine, which costs $30,000, falls into the Modified Accelerated Cost Recovery System (MACRS) 5-year class, and it has an estimated life of five years. If the old machine is replaced with the new machine, the change in depreciation expense that will occur in Year 3 of the new machine's life will be _____. The MACRS rates for 5-year class are Year 1 - 20%, Year 2 - 32%, Year 3 - 19%, Year 4 - 12%, Year 5 - 11%, Year 6 - 6%. 

A)$2,000
B)$7,600
C)$3,700
D)$5,700
E)$18,200

Question 14

A firm is evaluating a new machine to replace one of its existing, older machines. If the old machine is replaced, the change in the annual depreciation expense will be $3,000. The firm's marginal tax rate is 30 percent. Which of the following statements is correct?

A)The depreciation expense does not affect the calculation of the supplemental operating cash flows, so it should not be considered in the analysis of the machine.
B)The depreciation expense can be added to the machine's after-tax net operating income to determine its supplemental operating cash flows.
C)The depreciation expense should be added to the machine's initial investment outlay.
D)The depreciation expense is included in the computation of the machine's terminal cash flows.
E)The depreciation expense should be included in the analysis only if it exceeds the tax expense associated with the machine.

Question 15

Triblaze Corp. is considering buying a new truck. The cost of the truck is $62,000 (the only initial investment outlay), and the cash savings the new truck is expected to generate during its life are $19,920, $22,800, and $31,280, respectively. Trailblaze's required rate of return is 10 percent. The net present value (NPV) of the truck is _____. 

A)-$2,058.80
B)$12,000.00
C)$122,453.19
D)-$1,546.81
E)$2,543.67

Question 16

Which of the following should be included in the computation of an expansion project's terminal cash flow?

A)Any change in net working capital that was recognized at the time the projectwas purchased
B)The project's externalities
C)The initial cost (purchase price) of the project
D)The opportunity cost of the project
E)The sunk cost associated with the project

Question 17

To expand sales, Sandine Corporation is evaluating whether to purchase a machine to manufacture a new product line. Which of the following statements is correct concerning an expansion analysis like the one Sandine faces?

A)The machine's annual depreciation expenses will be deducted from the firm's net income to calculate its supplemental operating cash flows.
B)The new machine will be acceptable as long as the sum of its net cash flows is positive.
C)The shipping and installation costs associated with purchasing the new machine are included in the computation of its initial investment outlay.
D)The cost of a feasibility study that Sandine conducted last year to determine whether to further evaluate the introduction of the new product line should be included in the calculation of the new machine's initial investment outlay.
E)The salvage value of the new machine should be included in the computation of its initial investment outlay.

Question 18

Which of the following statements about the opportunity cost associated with a capital budgeting project is correct?

A)A project's opportunity cost is a cash outlay that the firm has already paid; therefore, it should not be included in a capital budgeting analysis.
B)The terms sunk cost and opportunity cost generally are used interchangeably.
C)A project's opportunity cost is the return (cash flow) that will not be earned (generated) if funds are invested in a particular capital budgeting project.
D)A project's opportunity cost is not a relevant cash flow, therefore it should not be included in the capital budgeting analysis.
E)A project's opportunity cost reflects the change in a firm's net cash flow that is attributable to purchasing the project.

Question 19

Which of the following is not relevant in a capital budgeting analysis because it is not an incremental cash flow?

A)Changes in the firm's net working capital
B)Externalities
C)Shipping and installation costs associated with the purchase of a capital budgeting project
D)Purchase price of a capital budgeting project
E)Salvage value of a capital budgeting project

Question 20

Stonewood Manufacturing is evaluating whether to replace one of its existing machines with a new, more technologically advanced one. Which of the following statements concerning a replacement decision analysis is correct?

A)When computing the supplemental operating cash flows associated with the purchase of the new machine, only the after-tax cash flows that the new machine is expected to generate each year should be included in the computation.
B)The net cash flow from the sale of old machine should be included as part of the new machine's initial investment outlay.
C)The annual depreciation expense associated with the new machine should be included in the computation of the new machine's terminal cash flow.
D)If the old machine is sold for a loss when it is replaced, the loss is treated as a cash outflow in the computation of the new machine's initial investment outlay.
E)An increase in the net working capital that occurs when the new machine is purchased is treated as a cash inflow when its initial investment outlay is computed.

Question 21

Chovita Sports Company is evaluating a project that has lower-than-average risk. When evaluating projects that have different risks than its existing assets, Chovita normally adjusts its average required rate of return, which is 12 percent, by 2 percent. What required rate of return should Chovita use to compute the net present value (NPV) of the project it is currently evaluating?

A)14%
B)12%
C)6%
D)10%
E)24%

Question 22

When evaluating capital budgeting projects, how do most firms incorporate risk in their decision-making analyses?

A)Most firms do not consider risk when making capital budgeting decisions; that is, they ignore it.
B)Most firms increase the required rate of return used in their capital budgeting analyses when evaluating projects with higher-than-average risks.
C)Most firms decrease the required rate of return used in their capital budgeting analyses when evaluating projects with higher-than-average risks.
D)Most firms use the same required rate of return to evaluate all capital budgeting projects, because the risk associated with an individual capital budgeting project is not important when determining the overall riskiness of the firm.
E)Most firms decrease the required rate of return used in their capital budgeting analyses by 6 percent when evaluating projects with lower-than-average risks.

Question 23

A firm is considering the purchase of an asset whose stand-alone risk is greater than the average risk of its existing portfolio of assets. In evaluating this asset, the decision maker should:

A)increase the internal rate of return (IRR) used to evaluate the asset to reflect its higher risk.
B)increase the asset's net present value (NPV) to reflect its higher risk.
C)reject the asset because its acceptance would clearly decrease the value of the firm.
D)ignore the asset's higher risk if, after purchase, it will make up only a small fraction of the firm's total assets.
E)increase the required rate of return that is used to evaluate the asset to reflect its higher risk.

Question 24

Ziker Golf Company is evaluating a capital budgeting project that has a higher risk than the average risk of its existing assets. When evaluating projects that are riskier than average, Ziker normally adjusts its required rate of return by 4 percent. Ziker requires a 12 percent return on average-risk projects. What required rate of return should Ziker use to compute the net present value (NPV) of the risky project it is currently evaluating?

A)8%
B)12%
C)16%
D)10%
E)48%

Question 25

Carolina Insurance Company is considering the purchase of a fire insurance company. The fire insurance company has a beta of 2.5. If the risk-free rate is 8 percent and the market risk premium is 6 percent, the required rate of return that should be used to evaluate the insurance company is _____. 

A)13%
B)23%
C)18%
D)11%
E)14%

Question 26

Which of the following methods involves calculating an average of the beta coefficients of numerous firms that are in the same (or a quite similar) line of business and then using that average beta coefficient to determine the appropriate required rate of return for a new capital budgeting project?

A)Sensitivity analysis method
B)Pure play method
C)Accounting beta method
D)Risk-adjusted method
E)Net present value (NPV) method

Question 27

Which of the following provides a measure of systematic risk?

A)Sensitivity analysis
B)Net present value analysis
C)Beta coefficient
D)Monte Carlo simulation
E)Accumulated depreciation

Question 28

If a capital budgeting project has a higher corporate risk than the average risk contained in the firm's portfolio of assets, it generally has a:

A)lower political risk.
B)greater beta risk.
C)lower project risk.
D)lower exchange rate risk.
E)greater financial risk.

Question 29

Sensitivity analysis is a technique in which:

A)all key input variables are changed to their most likely values to compute a project's net present value (NPV).
B)all of the input variables are set at their most reasonably expected values to computes a project's internal rate of return (IRR).
C)the values of key input variables are changed to observe the resulting changes in a project's net present value (NPV) and its internal rate of return (IRR).
D)a "bad" set and "good" set of financial circumstances are compared with a most likely, or base case, situation.
E)key input variables are set at their worst reasonably forecasted values to compute a project's net present value (NPV).

Question 30

Monte Carlo simulation:

A)can be used to estimate a project's market risk, but cannot be used to determine its net present value (NPV).
B)uses the probability distributions of variables as inputs to estimate the project's net present value (NPV).
C)produces an expected net present value (NPV), an internal rate of return (IRR), and a measure of the project's risk for different scenarios.
D)gives an exact outcome for a capital budgeting analysis.
E)calculates net present value (NPV) for a change in one key variable.

Question 31

Topsider Inc. is evaluating whether to replace an existing leather-cutting machine with a new machine that has a five-year life. The old machine has current salvage value equal to $3,000; its salvage value in five years is expected to be zero. The net (after-tax) salvage value of the new machine in five years is expected to be $6,000. If the new machine is purchased, Topsider will have to invest $3,520 in its net working capital. Based on this information, what is the new machine's terminal cash?

A)$6,000
B)$3,520
C)$9,520
D)$7,000
E)$3,000

Question 32

Using the capital asset pricing model (CAPM), Sun State determined that the required rate of return for a capital budgeting project it is evaluating is equal to 18 percent. If U.S. Treasury bonds yield 7 percent and the market risk premium is 5 percent, what is the project's beta coefficient?

A)5.50
B)2.20
C)5.00
D)12.50
E)0.45

Question 33

Which of the following statements is correct?

A)Well-diversified stockholders do not consider a firm's corporate risk when establishing their required rates of return.
B)Undiversified stockholders, including the owners of small businesses, probably are more concerned about the corporate risk associated with a particular firm than are diversified stockholders.
C)Empirical studies to determine the factors that affect required rates of return (r) have concluded that only market risk affects stock prices; i.e., neither corporate risk nor stand-alone risk has any impact on required rates of return.
D)A firm's market risk is important, but it does not directly affect stock prices because it only affects the firm's beta.
E)A firm's market risk is not an important factor in determining its required rate of return.

Question 34

Allmax is concerned that its subsidiary in Venezuela could be expropriated (seized) by the host government without compensation within the next few years. The type of risk Allmax faces with its Venezuelan subsidiary is termed ______ risk. 

A)pure play
B)political
C)international beta coefficient
D)foreign exchange
E)global business

Question 35

Suppose a firm's senior management is careful to make decisions that contribute to the goal of wealth maximization. If our basic assumptions about the relationship between risk and return are valid, which of the following statements is correct?

A)If thebeta coefficient of a capital budgeting project is greater than the firm's beta coefficient, the required rate of return used to evaluate the project should be less than the firm's existing required rate of return.
B)If the beta coefficient of a capital budgeting project is less than the firm's beta coefficient, the required rate of return used to evaluate the project should be greater than the firm's existing required rate of return.
C)If the beta coefficient of a capital budgeting project is greater than the firm's existing beta coefficient, the firm's beta coefficient will decrease if the project is purchased.
D)If the beta coefficient of a capital budgeting project is greater than the firm's existing beta coefficient, the firm's required rate of return will increase if the project is purchased.
E)If the beta coefficient of a capital budgeting project is greater than the firm's existing beta coefficient, the firm should use required rate of return that is based on its existing beta coefficient to evaluate the project.

Question 36

Which of the following statements is correct?

A)Capital budgeting projects with fairly risky cash flows should be evaluated using relatively high discount rates (required rates of return).
B)If managers want to maximize the firm's stock value, they should not be concerned with risk when making capital budgeting decisions.
C)If a firm evaluates all capital budgeting projects using its existing required rate of return, its overall risk, as measured by its beta coefficient, probably will decline over time.
D)If a firm has a beta coefficient that is less than 1.0, its existing required rate of return will be negatively correlated with the returns on most of the capital budgeting projects it evaluates in the future.
E)A firm should use a different approach to estimate the riskiness of mutually exclusive projects than it uses to estimate the riskiness of independent projects.

Question 37

_____ risk is the uncertainty associated with the price at which the currency from one country can be converted into the currency of another country. 

A)Pure play
B)Political
C)Money
D)Exchange rate
E)International

Question 38

Klott Company used scenario analysis to evaluate a capital budgeting project. The analysis generated a net present value (NPV) equal to $10,500 and a standard deviation (σ) equal to $12,083. The project's coefficient of variation (CVNPV) is _____. 

A)0.25
B)13.90
C)10.50
D)1.15
E)0.87

Question 39

Which of the following statements is correct concerning various techniques used for assessing a capital budgeting project's stand-alone risk?

A)Sensitivity analysis fails to consider the range of likely values for the key input variables that are used to evaluate a capital budgeting project.
B)When using sensitivity analysis, the sensitivity of input variables can be compared by graphing their relationships with such measures as net present value (NPV) and internal rate of return (IRR). When comparing two of the variables, the variable that has the graph with the steeper line (slope) is considered less risky than the graph with the flatter line.
C)The primary advantage of using simulation analysis to evaluate a capital budgeting project is that it provides an accurate point (single) estimate of the project's net present value (NPV).
D)Compared to scenario analysis, one important benefit of using simulation analysis to evaluate a capital budgeting project is that once the analysis is complete, simulation provides a clear accept/reject decision rule.
E)When using simulation analysis to evaluate a capital budgeting project, only a few discrete alternative scenarios are included.

Question 40

If the risk-free rate is 6 percent, the return on an average stock is 10 percent, and the beta of a capital budgeting project is 1.50, the project's required rate of return from the project is _____. 

A)12%
B)24%
C)4%
D)19%
E)21%

Question 41

A major difference between capital budgeting for domestic operations and foreign operations is that:

A)cash flow estimation is easier (less complex) for foreign operations.
B)repatriation of earnings does not occur in foreign operations of multinational firms that are headquartered in the United States.
C)estimating cash flows generated from foreign operations is more complex due to fluctuating exchange rates.
D)foreign operations are not taxed by both the home country and the host country.
E)foreign operations rarely are not as risky as domestic operations.

Question 42

A sunk cost is a cash outlay that has already been incurred. But, it is a cost that can be recovered if a capital budgeting project is purchased. Consequently, these sunk costs are extremely important in capital budgeting analyses. 

Question 43

Investment in foreign subsidiaries is less risky when:

A)laws in the host country that apply to repatriate earnings are complex.
B)the host country has higher tax rates.
C)the host country is politically unstable.
D)exchange rates are volatile.
E)the subsidiaries are geographically (globally) diversified.

Question 44

Multinational companies can reduce the chance of a loss from expropriation by:

A)increasing the required rate of return a foreign subsidiary is expected to earn.
B)establishing foreign subsidiaries in countries that have restrictive policies on repatriation of earnings.
C)financing the foreign subsidiary using fund raised in the host country.
D)obtaining insurance against economic losses associated with expropriation.
E)investing all the funds in a single foreign subsidiary.

Question 45

The process of sending cash from a foreign subsidiary back to the parent company is known as _____. 

A)net present value analysis
B)political exchange
C)international earnings shifts
D)capital allocation
E)repatriation of earnings

Question 46

Because stockholders are very concerned with the "bottom-line" net income that the firm generates, capital budgeting decisions should be based on the accounting income a project generates. 

Question 47

A firm that is considering purchasing a capital budgeting project with a beta coefficient greater than the firm's current beta coefficient should evaluate the project using a risk-adjusted required rate of return that is greater than the firm's existing (average) required rate of return. 

Question 48

A key difference between a replacement project analysis and an expansion project analysis is that the net present value (NPV) technique that is used to evaluate capital budgeting projects should only be used to evaluate expansion projects, whereas either the NPV technique or the internal rate of return (IRR) technique can be used to evaluate replacement projects. 

Question 49

If a capital budgeting project has very uncertain cash flows, the Monte Carlo simulation technique can be used to measure its net present value (NPV) for a worst-case scenario, a best-case scenario, and a base-case scenario. 

Question 50

Quantification of risk is difficult, and there are different types of risks, such as stand-alone risk, market risk, and political risk, associated with capital budgeting projects. Sensitivity analysis is a good technique to use when measuring market risk, but not when measuring stand-alone risk. 

Question 51

A major problem with Monte Carlo simulation analysis is that while the analysis provides insights into the riskiness of a project, it does not lead to a clear-cut accept/reject decision. 

Question 52

According to the capital asset pricing model (CAPM), a capital budgeting project that has a beta equal to zero should be evaluated using a required rate of return equal to the risk-free rate.