Deck 12: Risk Topics and Real Options in Capital Budgeting

Question 1

Since a firm can be viewed as a collection of projects, taking on projects without consideration of their risk can in the long term:

A) change the firm's risk character.
B) systematically degrade the firm's profitability.
C) make the firm's financial results more volatile.
D) a and c

Answer 1

D

Question 2

The cost of capital is the appropriate discount rate in capital budgeting when:

A) all the projects are equally risky.
B) all the projects have the same risk as the current firm.
C) the projects can be ranked from riskiest to least risky.
D) all the projects have less risk than the risk of the current firm.

Answer 2

B

Question 3

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

A) probability simulation.
B) scenario analysis.
C) sensitivity analysis.
D) Monte Carlo simulation.

Answer 3

D

Question 4

Project Alpha has an NPV of $10 million and a standard deviation based on risk analysis of $3 million. Project Beta has an NPV of $8 million and a standard deviation based on risk of $2 million. Which project should be selected and why?

A) Select Alpha because it has the higher NPV.
B) Select Beta because it has the lower risk as represented by standard deviation.
C) Select either project because both have positive NPVs and relatively low risk compared to their NPVs.
D) Don't select either project because there is too much risk associated with both projects.
E) There is no clear decision rule, the choice depends on management's degree of risk aversion.

Question 5

Risk in cash flow estimating for capital budgeting can be defined as:

A) the chance that a cash flow will turn out to be worse than the estimate.
B) the chance that a cash flow will turn out to be different than the estimate, either better or worse.
C) the chance that the cash flows that turn out to be more favorable than the estimate won't totally offset the cash flows that turn out to be worse than the estimate.
D) the chance that the NPV and/or IRR will turn out to be worse than the estimate.
E) All of the above describe the risk in cash flow estimating.

Question 6

Decision tree analysis:

A) provides a relatively quick and easy way to get a rough idea of the probability distribution of NPV outcomes in a capital budgeting project.
B) may prompt management to reject a project with a positive NPV (point estimate).
C) does not apply to IRR analysis.
D) a and b are both correct.

Question 7

Which of the following is not a method for incorporating risk analysis into capital budgeting?

A) Positive/Negative analysis
B) Monte Carlo simulations
C) Scenario analysis
D) Sensitivity analysis
E) Decision tree models

Question 8

Consideration of risk is essential to the capital budgeting process. Which of the following statements is true?

A) Recognizing risk is a major step toward bringing theory in line with the real world.
B) Business managers do recognize risk, but they do it through judgments based on the results of analyses when decisions are finally made.
C) Although we are unable to put the idea that cash flows are subject to probability distributions into our analysis, better capital budget decisions can be made when the relevance of risk is acknowledged.
D) All of the above

Question 9

If a firm adopts a large proportion of above-average-risk projects that are not offset by below-average-risk projects:

A) its cost of capital will rise.
B) its risk premium will decline.
C) the risk-free rate will increase as more risk is added.
D) None of the above

Question 10

The sensitivity/scenario analysis:

A) provides a quantitative measure of project risk.
B) requires as input a probability distribution for each variable affecting project NPV.
C) indicates the variability of project NPV with fluctuations in the value of variables.
D) All of the above
E) None of the above

Question 11

The probability of a path is the product of all the branch probabilities along it and is called a:

A) joint probability.
B) conditional probability.
C) basic probability.
D) None of the above

Question 12

Monte Carlo simulations are so named because it is the name of:

A) a famous European gambling casino.
B) a popular brand of automobile.
C) the first individual to develop an automated simulation machine.
D) the person who discovered the necessary algebraic computations.

Question 13

Scenario/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.

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

Question 14

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

A) The probabilities emerging from any node must sum to 1.
B) The ultimate probabilities assigned to each of the branches (looking at the right hand side of the tree) must sum to 1.
C) The probability assigned to any given branch (looking at the right hand side of the tree) can be no greater than 0.5.
D) Both a. and b. are correct.
E) All of the above are correct.

Question 15

Which of the following is not a drawback of the simulation approach?

A) The probability distributions of the cash flows are subjective estimates.
B) It can be very difficult to access and use a simulation program.
C) Cash flows in successive periods tend not to be independent.
D) There are no clear guidelines on how to interpret the results.

Question 16

The probabilities along a path are called ____ probabilities.

A) joint
B) conditional
C) complex
D) None of the above

Question 17

The NPV and IRR derived from estimated cash flows for a capital budgeting project are:

A) essentially expected values or means.
B) likely to differ from the actual results of the project.
C) random variables with their own probability distributions.
D) All of the above

Question 18

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) Computer simulation
B) Sensitivity/scenario analysis
C) Decision tree analysis
D) Both a and c
E) All of the above

Question 19

Portfolio theory makes it possible to incorporate Risk into capital budgeting through risk adjusted returns. However, portfolio theory omits an important element of risk that is relevant in capital budgeting. That missing element is:

A) systematic risk.
B) unsystematic risk.
C) market risk.
D) liquidity risk.

Question 20

Which of the following is/are included in the list of drawbacks to using the Monte Carlo simulation for dealing with risk in capital budgeting?

A) Cash flows still have to be estimated subjectively.
B) Individual cash flows generally don't behave independently. If one cash flow turns out to be less than expected, several other may behave the same way.
C) Even after creating a distribution of probably outcomes, it is difficult to know exactly how to interpret the data.
D) Both a. and c. are drawbacks.
E) All of the above are drawbacks.

Question 21

A land option contract is considered what type of option?

A) Expansion option
B) Investment timing option
C) Flexibility option
D) Abandonment option

Question 22

____ branches may emanate from a node.

A) Two
B) Three
C) Up to four
D) Any number of

Question 23

Which of the following is not a real option?

A) Abandonment option
B) Expansion option
C) Investment timing option
D) Flexibility option
E) All of the above are real options.

Question 24

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) regressing the division's projected return on equity against the return on a major company in a similar business.
B) regressing the division's accounting return on equity in previous years against the return on a major stock market index.
C) regressing the division's projected return on equity against the historic return on a major stock market index.
D) None of the above

Question 25

Which of the following would not be an appropriate guideline for determining the interest rate to use in discounting project cash flows in capital budgeting?

A) For replacement projects, given that their risk is consistent with that of the present business, use the cost of capital.
B) For expansion projects of moderate size, given that their risk is slightly greater than that of the present business, use the cost of capital, plus a small risk premium of one to three percent.
C) For new ventures, given that their risk can be far greater than current operations, use the cost of capital plus a risk premium of at most five percent since using anything higher usually guarantees rejection.
D) All of the above are appropriate guidelines.

Question 26

Decision tree analysis shows a project to have several possible outcomes the best of which has an NPV of $10M calculated over a five year life. This best case path has an overall probability of occurring of 25%. A real option is available at an initial cost of $750,000 which will add a single $5M cash inflow to this best case path at its end. The option doesn't have a significant effect on the project's risk. The company's cost of capital is 11%. What is the option's value (to the nearest $1,000)?

A) ($8,000)
B) $2,218,000
C) $23,000
D) $56,000

Question 27

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

A) accounting beta model
B) CAPM
C) overlay
D) pure play

Question 28

A real option's value may be more than the amount by which its inclusion in a capital budgeting project increases the project's expected NPV because the real option may:

A) reduce the project's risk.
B) increase the amount the firm makes if the project turns out really well.
C) reduce the loss if the project fails badly.
D) a and c

Question 29

An automatic bias against high-risk projects is created by:

A) using the IRR technique, which produces an intrinsic return which is risk adjusted.
B) using a higher rate than the cost of capital when applying NPV and IRR to risky projects.
C) adjust NPVs and IRRs up when evaluating risky projects.
D) make an intuitive judgment about risk after the analysis is done.

Question 30

Multidivisional companies with diverse operations should use an interest rate for discounting a specific division's estimated cash flows in capital budgeting that is representative of:

A) the entire firm's cost of capital.
B) the riskiness of the specific division's cash flows.
C) the cost of capital obtained through the application of the pure play method.
D) Either b or c

Question 31

What type of option is the right to purchase stock at a fixed price for a specified period?

A) Flexibility option
B) Financial option
C) Legal option
D) Timing option

Question 32

Which of the following is likely to be true of a valuable abandonment option?

A) It makes the NPV of all of the possible outcomes at least equal to zero.
B) It reduces the project's risk.
C) It improves the project's expected NPV.
D) Both a. and c. are correct.
E) Both b. and c. are correct.

Question 33

Which of the following can be a benefit of an abandonment option?

A) Improve project NPV
B) Allow the company to delay the project
C) Lower project risk
D) Both a and c

Question 34

A real option that allows a company to respond more easily to changes in business conditions is known as a(n):

A) expansion option.
B) investment timing option.
C) flexibility option.
D) None of the above

Question 35

The appropriate interest rate to use in capital budgeting is:

A) always the company's cost of capital.
B) is the company's cost of capital if the project's risk is about the same as the company's.
C) the cost of capital plus any additional risk premium required to compensate for the project's higher risk.
D) b and c.

Question 36

Richmond Graphics is a small company contemplating a project with a $5M initial investment. A traditional capital budgeting analysis shows the project to have an NPV of $3.3M. However, a simple decision tree analysis reveals that the project has a 90% probability of an NPV of $4.0M and a 10 % chance of a ($3.0M) loss NPV. Management should probably:

A) accept the project because its traditional NPV is positive.
B) accept the project even though there is some risk because the overwhelming likelihood is that the outcome will be favorable.
C) reject the project because it has some risk.
D) reject the project because it entails a fairly good chance of a loss that could ruin a small company coupled with a likely gain that isn't very large.

Question 37

Suppose that the cost of a real option is $1 million, and that using the real option will improve the expected NPV of a project by $900,000. How should management react to the use of this real option?

A) Since the real option costs more than it generates in NPV, it should not be considered for implementation.
B) If the real option provides more flexibility in how management reacts to various project outcomes, it should at least be considered for implementation.
C) Management should study whether or not the use of this real option will reduce the risk of the project. They will have to weigh the $100,000 potential loss against the reduced risk.
D) Both b. and c. are correct.

Question 38

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

A) Replacement projects
B) Expansion projects
C) New venture projects
D) Replacement and expansion projects
E) Expansion and new venture projects

Question 39

A project's possible outcomes are summarized as follows. $\begin{array}{lll}& \text { NPV } & \text { Probability } \\\text { Worst case } & (\$ 1,000) & .2 \\\text { Most likely case } & \$ 300 & 3 \\\text { Rest case. } & \$ 600 & 5\end{array}$ The expected NPV for the project is approximately:

A) $190
B) ($190)
C) ($100)
D) None of the above

Question 40

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:

A) pure play.
B) CAPM.
C) accounting beta.
D) financial accounting.

Question 41

If the IRR is 10% APR for two projects, then ____.

A) the projects have equally risky cash flows
B) the projects have the same discount rate
C) the NPVs of the projects are the same
D) the expected cash flows of the projects may be the same despite having different values for variance

Question 42

Which type of project is it most difficult for a firm to find a risk adjusted rate?

A) Replacement projects
B) Small expansion projects
C) New venture related to the firm's existing operations
D) New venture not related to the firm's current operations

Question 43

An abandonment option will have an upfront cost of $1.0 million. There is a 40% chance that the abandonment option would be used, in which case cash outflows of $800,000 in Year 4, $1,400,000 in Year 5 and $1,200,000 in Year 6 will be avoided. If the discount rate is 7.0%, should the abandonment option be exercised?

A) Yes because its impact on expected NPV about $101,000.
B) No because its impact on expected NPV is about ($37,000).
C) Yes because its impact on expected NPV is about $47, 600.
D) No because its impact on expected NPV is about ($23,700).

Question 44

Next year, a cash flow is expected to be $1,000.00 (40% probability) or $2,000.00 (60% probability). The following year, the same cash flow possibilities exist in the same manner as the previous year. What is the probability of the cash flow in the second year being $2,000.00?

A) 36%
B) 60%
C) 24%
D) 16%

Question 45

A(n) ____ is a graphic representation of a business project in which events have multiple outcomes, each of which is assigned a probability.

A) probability distribution
B) decision tree
C) NPV profile
D) real option

Question 46

Because NPV is calculated using expected cash flows, NPV is ____.

A) generally a correct representation of the future for very risky projects
B) a random variable
C) not subject to the riskiness of the cash flows
D) not subject to the variance of the cash flows

Question 47

Decision tree analysis shows a project to have several possible outcomes the best of which has an NPV of $12M calculated over a five-year life. This best case path has an overall probability of occurring of 20%. A real option is available at an initial cost of $800,000 which will add a single $6M cash inflow to this best case path at its end. The option doesn't have a significant effect on the project's risk. What is the option's value? The company's cost of capital is 12%.

A) ($3,404)
B) $2,604,000
C) ($119,000)
D) $274,000

Question 48

A cash flow is expected to be $500.00 (50% probability) or $1,000.00 (50% probability) next year. Assuming the cash flow next year is $500.00, the cash flow the following year is $400.00 (60% probability) or $600.00 (40% probability). Assuming the cash flow next year is $1,000.00, the cash flow the following year is $1,200.00 (80% probability) or $2,000.00 (20%) probability. What is the probability of a $1,200.00 cash flow two years from today?

A) 40%
B) 30%
C) 20%
D) 10%

Question 49

Scenario analysis for a proposed new project has resulted in the following: $\begin{array}{lll}& \text { NPV } & \text { Probability } \\\text { Worst case } & (\$ 1,000) & .2 \\\text { Most likely case } & \$ 300 & 3 \\\text { Rest case. } & \$ 600 & 5\end{array}$ An abandonment option would change the NPV in the worst case to ($500). The project's expected NPV if the abandonment option is included is:

A) $190.
B) ($290).
C) $290.
D) None of the above

Question 50

Suppose a firm builds a plant with more space than the firm currently needs. What type of real option best describes the firm's behavior?

A) An abandonment option
B) An expansion option
C) A land option contract
D) A contraction option

Question 51

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

A) probability distribution
B) decision tree
C) risk-adjusted option
D) real option

Question 52

Ignoring ____ in capital budgeting can lead to incorrect decisions and change the character of the firm.

A) liability
B) risk
C) working capital
D) opportunity costs

Question 53

If a low cash flow this year makes a low cash flow next year more likely to occur, this means the project cash flows tend to be ____.

A) less predictable
B) independent of each other
C) more volatile
D) correlated

Question 54

Scenario analysis for a proposed new project has resulted in the following: $\begin{array}{lll}& \text { NPV } & \text { Probability } \\\text { Worst case } & (\$ 1,000) & .2 \\\text { Most likely case } & \$ 300 & 3 \\\text { Rest case. } & \$ 600 & 5\end{array}$ An abandonment option would change the NPV in the worst case to ($300). The value of the option is at least:

A) $190.
B) $330.
C) $140.
D) $470.

Question 55

The NPV and IRR of any capital budgeting project are random variables with means that represent their most likely values and variances that reflect:

A) variations in profit.
B) value inconsistencies.
C) risk.
D) unstable expectancies.

Question 56

A company is evaluating a capital project on a new line of business for the firm. The firm's current cost of capital is 12%. However, another firm, whose principal focus is in the same field, is publicly traded and has a beta of 1.6. The market is currently yielding 12% and the yield on short-term treasury bills is 6%. The risk adjusted rate that should be used for this project is:

A) 12%.
B) 18%.
C) 25.2%.
D) 15.6%.

Question 57

The initial cost of a project is $10,000. There is a 30% chance that it will be highly successful, in which case cash inflows of $4,500 are expected for the next four years. There is a 70% chance that the project will be unsuccessful, in which case annual cash inflows of $3,200 are expected for four years. The cost of capital is 12%. What is the project's expected NPV?

A) $3,688
B) ($281)
C) $7,700
D) $904

Question 58

Project A generates $5,000.00 in revenue two years from today and costs $4,000.00. Project B generates $4,000.00 (50% probability) or $6,000.00 (50% probability) one year from today and costs $4,500.00. Assuming a discount rate of 12% for both projects, which project does a risk averse manager prefer?

A) Project A
B) Project B
C) Neither project
D) Cannot be determined

Question 59

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?

A) Project A
B) Project B
C) Neither project
D) Cannot be determined

Question 60

Why should a risk averse manager select one project over another when both projects generate the same NPV?

A) Because the manager prefers the project which has more variance in its cash flows.
B) Because the manager prefers the project with the higher IRR.
C) Because the manager prefers the project with less risky cash flows.
D) Because the manager prefers the project which has higher standard deviation in its cash flows.

Question 61

Which of the following is an advantage of the certainty equivalent approach?

A) It allows decision makers to recognize particularly risky years.
B) It uses the cost of capital as the appropriate discount rate which is easier to calculate.
C) It uses regression analysis which gives a certain estimate of cash flows.
D) It uses computer simulation methods which makes a precise prediction of cash flows.

Question 62

Average stocks are yielding 7.0%, while short term treasuries return 3.0%. Marshall Inc. has a beta of 1.3 and is considering a new venture into an industry with direct competitors who have betas that average 1.8. What discount rate should Marshall use in evaluating the cash flows from this project?

A) 10.0%
B) 8.2%
C) 4.8%
D) 10.2%

Question 63

The certainty equivalent factor can take any value:

A) between -1 and 1.
B) between 0 and 1.
C) between 0 and 100.
D) between -100 and 0.

Question 64

Zeta Inc.'s cost of capital is 12% and the risk-free rate is 5%. It plans to invest in a new project. The cash flow projections ($000) for the project are given below. Calculate the difference in the traditional NPV and the certainty equivalent NPV. $\begin{array}{llllll}\text { Year } & \mathbf{0} & \mathbf{1} & \mathbf{2} & \mathbf{3} & \mathbf{4} \\\text { Cash Flow } & -240 & 75 & 75 & 75 & 75 \\\text { CE factor } & 1 & 0.9 & 0.85 & 0.8 & 0.75\end{array}$

A) $9.43
B) $7.59
C) $30.35
D) $20.92

Question 65

A company is considering a project in which the risk associated with annual cash flows varies considerably from year to year. Which of the following methods will best allow management to include consideration of risk in the analysis?

A) Pure play method
B) Accounting beta method
C) Certainty approach method
D) Overlay approach

Question 66

The various capital budgeting risk analysis techniques all estimate the standard deviation of an investment's cash flows.

Question 67

Zeta Inc.'s cost of capital is 12% and the risk-free rate is 5%. It plans to invest in a new project. The cash flow projections ($000) for the project are given below. Calculate the certainty equivalent NPV ($000). $\begin{array}{llllll}\text { Year } & \mathbf{0} & \mathbf{1} & \mathbf{2} & \mathbf{3} & \mathbf{4} \\\text { Cash Flow } & -240 & 75 & 75 & 75 & 75 \\\text { CE factor } & 1 & 0.9 & 0.85 & 0.8 & 0.75\end{array}$

A) ($19.78)
B) $19.78
C) $12.20
D) ($12.20)

Question 68

Modern techniques are very good at incorporating risk into capital budgeting.

Question 69

A company is a portfolio of projects.

Question 70

Smith Inc.'s cost of capital is 11% and the risk-free rate is 5%. The company plans to invest in a new project. The cash flow projections ($000) for the project are given below. Calculate the certainty equivalent NPV ($000). $\begin{array}{lllllll}\text { Year } & \mathbf{0} & \mathbf{1} & \mathbf{2} & \mathbf{3} & \mathbf{4} & \mathbf{5} \\\text { Cash Flow } & -500 & 150 & 150 & 150 & 150 & 150 \\\text { CE factor } & 1 & 0.9 & 0.85 & 0.8 & 0.75 & 0.7\end{array}$

A) ($51.22)
B) ($54.38)
C) $51.22
D) $22.41

Question 71

As is true of financial investments, the cash flow patterns on different capital budgeting projects tend to be very similar.

Question 72

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

Question 73

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

A) overlay approach
B) pure play method
C) certainty equivalent approach
D) accounting beta method

Question 74

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

A) it is assumed that there is no business-specific risk associated with the projects.
B) certainty equivalent factors cannot take negative values.
C) certainty equivalents imply zero risk.
D) certainty equivalents consider unsystematic risk only.

Question 75

Ignoring risk in capital budgeting can lead to incorrect decisions and change the risk character of the firm.

Question 76

When incorporating risk into capital budgeting through the interest rate used in NPV or IRR calculations, the rates used are called:

A) inflation adjusted rates.
B) market risk premium.
C) risk-free rates.
D) risk-adjusted rates.

Question 77

Which of the following is the appropriate discount rate to be used when calculating NPV in the certainty equivalent approach?

A) Cost of capital
B) Risk-free rate
C) Cost of equity
D) Market risk premium

Question 78

Scenario analysis involves developing an NPV for each of several potential project outcomes along with an estimate of the probability of the outcomes.

Question 79

Which of the following is true of certainty equivalent factors?

A) Certainty equivalent factors cannot be fractions.
B) They can either be positive or negative based on the risks of the project.
C) They are constant across the life span of the business.
D) They usually decline as they proceed into the future.

Question 80

Which of the following is true of the certainty equivalent approach?

A) It asks the decision makers to consider each forecast cash flow individually and come up with a lower, risk free cash flow that is equally acceptable.
B) It is accomplished by regressing the division's accounting return on equity in previous years against the return on a major stock market index.
C) It selects worst, middle, and best outcomes for each cash flow and computes NPV for a variety of combinations.
D) It models cash flows as random variables and repeatedly calculates NPV.