Deck 12: Risk and Refinements in Capital Budgeting

Question 1

Behavioral approaches for dealing with risk include adjusted net present value and risk-adjusted discount rates.

Answer 1

False

Question 2

Scenario analysis is a behavioral approach that evaluates the impact on the firm's return of simultaneous changes in a number of variables.

Answer 2

True

Question 3

In capital budgeting, risk refers to the chance that a project has a high degree of variability of the initial investment.

Answer 3

False

Question 4

Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

Question 5

In a capital budgeting context, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

Question 6

In the real world, different projects have different levels of risk. As a result, the acceptance of a particular project usually has an enormous impact on the firm's overall risk.

Question 7

In the context of capital budgeting, risk generally refers to

A) the degree of variability of the cash inflows.
B) the degree of variability of the initial investment.
C) the chance that the net present value will be greater than zero.
D) the chance that the internal rate of return will exceed the cost of capital.

Question 8

Simulation is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

Question 9

All projects should always use the WACC as the required return for capital budgeting purposes.

Question 10

In the real world, different projects have different levels of risk. As a result, the acceptance of a particular project generally has an impact on the firm's overall risk, although usually in a minor way (depending on size).

Question 11

The breakeven cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

Question 12

In a capital budgeting context, risk is the chance that a project will prove unacceptable or, more formally, the degree of variability of cash flows.

Question 13

The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.

Question 14

Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

Question 15

Sensitivity analysis is a statistically based approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

Question 16

In a capital budgeting context, risk refers to

A) the chance that a project will prove unacceptable.
B) the degree of variability of cash flows.
C) neither A nor B is correct.
D) both A and B are correct.

Question 17

Behavioral approaches for dealing with risk include scenario analysis and simulation.

Question 18

Projects with a small chance of being acceptable and a broad range of expected cash flows are more risky than projects having a high chance of being acceptable and a narrow range of expected cash flows.

Question 19

Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm's return.

Question 20

Scenario analysis is an approach that uses a number of possible values for a given variable in order to assess its impact on a firm's return.

Question 21

In general, exchange rate risk is easier to protect against than political risk.

Question 22

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated can increase the market value of that project's cash flow.

Question 23

The importance and widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices used accurately reflect actual costs and incremental cash flows.

Question 24

In case of international capital budgeting, a U.S. company can minimize its political risk by creating a joint venture with a competent and well-connected local partner.

Question 25

In international trade, transfer prices are prices that subsidiaries charge each other for the goods and services traded between them.

Question 26

Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the project is

A) $1,000,000.
B) $131,474.
C) $100,000.
D) none of the above.

Question 27

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
The range of the annual cash inflows for Project A is ________. (See Table 12.1)

A) $30,000
B) $10,000
C) $5,000
D) $0

Question 28

One type of simulation program made popular by the widespread use of personal computers is called

A) Monaco Simulation.
B) Lemans Simulation.
C) Cannes Simulation.
D) Monte Carlo Simulation.

Question 29

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
The expected net present value of project A if the outcomes are equally probable and the project has five-year life is ________. (See Table 12.1)

A) -$1,045
B) $17,910
C) $36,865
D) $93,730

Question 30

The three basic types of risk associated with international cash flows are 1) business and financial risks, 2) inflation and foreign exchange risks, and 3) political risks.

Question 31

International capital budgeting differs from domestic capital budgeting because (1) cash inflows and outflows occur in a foreign currency, and (2) foreign investments potentially face significant political risk.

Question 32

Exchange rate risk is the the risk that an unexpected change in exchange rates will reduce the market value of a project's cash flows.

Question 33

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
If the projects have five-year lives, the range of the net present value for Project B is approximately ________. (See Table 12.1)

A) $80,560
B) $201,000
C) $255,410
D) $303,280

Question 34

Simulation analysis is a behavioral approach that evaluates the impact on the firm's return of simultaneous changes in a number of variables.

Question 35

Breakeven cash inflow refers to

A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV > $0.
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV < $0.
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR < cost of capital.
D) none of the above is correct.

Question 36

In case of international capital budgeting, long-term currency risk can be minimized by at least partly financing the foreign investment with a dollar-denominated capital contribution from the parent company rather than in the local capital markets.

Question 37

Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign country.

Question 38

The advantage of using simulation in the capital budgeting process is

A) ease of calculation.
B) the availability of a continuum of risk-return trade-offs which may be used as the basis for decision-making.
C) dependability of predetermined probability distributions.
D) that it generates a continuum of risk-return trade-offs rather than a single-point estimate.

Question 39

A behavioral approach that evaluates the impact on the firm's return of simultaneous changes in a number of project variables is called

A) sensitivity analysis.
B) scenario analysis.
C) simulation analysis.
D) none of the above.

Question 40

Behavioral approaches for dealing with project risk

A) explicitly recognize project risk.
B) are used to get a feel for project risk.
C) are used both to get a feel for project risk and also explicitly recognize project risk.
D) none of the above.

Question 41

The risk-adjusted net present value is the rate of return that a project must earn to maintain or improve the firm's share price.

Question 42

The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

Question 43

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market risk premium.

Question 44

Despite their focus on total risk, RADRs are often used in practice.

Question 45

In general, political risk is easier to protect against than exchange rate risk.

Question 46

Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintain a diversified portfolio of assets.

Question 47

Because of their focus on total risk, RADRs are the best theoretical method for adjusting for project risk and are therefore used most often in practice.

Question 48

Important types of risk in an international capital budgeting context include all of the following EXCEPT

A) exchange rate risk.
B) political risk.
C) appropriation risk.
D) all of the above are correct.

Question 49

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

Question 50

Risk-adjusted discount rates (RADRs) are the risk-adjustment factors that represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

Question 51

In international capital budgeting decisions, political risks can be minimized using all of the following strategies EXCEPT

A) structuring the investment as a joint venture and selecting well-connected local partner.
B) structuring the financing of such investments as equity rather than as debt.
C) structuring the financing of such investments as debt rather than as equity.
D) none of the above.

Question 52

The risk-adjusted discount rate is the rate of return that a project must earn to maintain or improve the firm's share price.

Question 53

The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

Question 54

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a positive NPV and those falling below the SML would have a negative NPV.

Question 55

A market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

Question 56

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market return.

Question 57

The amount by which the required discount rate exceeds the risk-free rate is called

A) the opportunity cost.
B) the risk premium.
C) the risk equivalent.
D) the excess risk.

Question 58

Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate (RADR) approach implicitly assumes that risk is an increasing function of time.

Question 59

Even though a business firms can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify away unsystematic risk on their own.

Question 60

The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate the firm's owners adequately, thereby resulting in the maintenance or improvement of share price.

Question 61

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The discount rate that should be used in the net present value calculation to compensate for risk is ________. (See Table 12.2)

A) 6 percent
B) 15 percent
C) 18 percent
D) 24 percent

Question 62

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Which project, M or N, would be preferable if both projects were of average risk as the overall firm and Tangshan Mining has a beta of 1.0? (See Table 12.3)

A) Project M.
B) Project N.
C) They are equivalent.
D) none of the above.

Question 63

When unequal-lived projects are independent, the length of the projects' lives is not critical.

Question 64

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The net present value of the project when adjusting for risk is ________. (See Table 12.2)

A) -$9,500
B) $0
C) $87,000
D) $105,000

Question 65

What potential biases exist in project selection if Nico Manufacturing did not adjust for the difference in risk between projects X and Y (See Table 12.5).

Question 66

The preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint, is

A) sensitivity analysis.
B) simulation.
C) certainty equivalents.
D) risk-adjusted discount rates.

Question 67

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Which of the following statements is most correct?

A) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintain a diversified portfolio of investments in order to reduce firm diversifiable risk.
B) Firm's are rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock values.
C) Firms generally are not rewarded for choosing and implementing from among a diversifiable collection of projects through higher stock prices.
D) Two of the above are true.

Question 68

Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm's overall cost of capital to evaluate projects X and Y. (See Table 12.5)

Question 69

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the better investment for Tangshan Mining is ________. (See Table 12.3)

A) Project M.
B) Project N.
C) they are equivalent.
D) none of the above.

Question 70

The ________ reflects the return that must be earned on the given project to compensate the firm's owners adequately according to the project's variability of cash flows.

A) internal rate of return
B) cost of capital
C) risk-adjusted discount rate
D) average rate of return

Question 71

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
It has been found that the value of the stock of corporations whose shares are traded publicly in an efficient marketplace is

A) generally positively affected by diversification, because of the reduction in risk.
B) generally negatively affected by diversification, because of the increase in risk.
C) generally not affected by diversification, unless greater returns are expected.
D) generally negatively affected by diversification, because of the increase in the required rate of return.

Question 72

Table 12.4
Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects.
Which project do you recommend? (See Table 12.4)

Question 73

The theoretical basis from which the concept of risk-adjusted discount rates is derived is

A) the Gordon model.
B) the capital asset pricing model.
C) simulation theory.
D) the basic cost of money.

Question 74

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The net present value without adjusting the discount rate for risk is ________. (See Table 12.2)

A) $336,000
B) $250,000
C) $179,400
D) $87,000

Question 75

Table 12.4
Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects.
Evaluate the projects using risk-adjusted discount rates. (See Table 12.4)

Question 76

In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project could result in an incorrect decision.

Question 77

Table 12.5
Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.
Calculate the risk-adjusted discount rates for project X and project Y. (See Table 12.5)

Question 78

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the NPV for project M is ________. (See Table 12.3)

A) $156,494.
B) $122,970.
C) $85,732.
D) none of the above.

Question 79

Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Nico select using this method? (See Table 12.5)

Question 80

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the NPV for project N is ________. (See Table 12.3)

A) $166,132.
B) $122,970.
C) $85,732.
D) none of the above.