Deck 12: Capital Budgeting and Risk

Question 1

If a risky cash flow of $10,000 is equivalent to a riskless cash flow of $9,300,the certainty equivalent factor is

A)0)93.
B)0)07.
C)1)07.
D)1)93.

Answer 1

A

Question 2

The internal rate of return equals the cost of capital when

A)NPV = 0.
B)NPV > 0.
C)NPV < 0.
D)None of the above

Answer 2

A

Question 3

A project whose acceptance eliminates another project from consideration is called

A)independent.
B)mutually exclusive.
C)replacement.
D)complementary.

Answer 3

B

Question 4

Probabilities,which can be obtained by repetition or are based on general mathematical principles,are called

A)statistical.
B)empirical.
C)a priori.
D)subjective.

Question 5

In finance,risk is most commonly measured by

A)the probability distribution.
B)the standard deviation.
C)the average deviation.
D)the square root of the standard deviation.

Question 6

A proposed project should be accepted if the net present value is

A)positive.
B)negative.
C)larger than the internal rate of return.
D)smaller than the internal rate of return.

Question 7

The payback period for a project,requiring an initial outlay of $10,000 and producing ten uniform annual cash inflows of $1,500,is

A)six years.
B)six years and eight months.
C)six years and six months.
D)seven years.

Question 8

Capital budgeting projects include all of the following except

A)the purchase of a six-month treasury bill.
B)the expansion of a plant.
C)the development of a new product.
D)the replacement of a piece of equipment.

Question 9

If,at the end of the project life,a piece of equipment having a book value of $4,000 is expected to bring $3,000 upon resale,and the income tax rate is 40%,how much will be the cash flow?

A)$2,800
B)$3,000
C)$3,400
D)$4,000

Question 10

If $1,000 is placed in an account earning 8% annually,the balance at the end of seven years will be

A)$1,080.
B)$1,560.
C)$2,000.
D)$1,714.

Question 11

The term capital budgeting refers to decisions

A)which are made in the short run.
B)which concern the spreading of expenditures over a period lasting less than one year.
C)where expenditures and receipts for a particular undertaking will continue over a relatively long period of time.
D)where a receipt of cash will occur simultaneously with an outflow of cash.

Question 12

When analyzing a capital budgeting project,the analyst must include in his calculation all of the following except

A)all revenues and costs in terms of cash flows.
B)only those cash flows that will change if the proposal is accepted (i.e.,incremental cash flows).
C)interest payments on debt financing connected with the project.
D)any effect (impact)the acceptance of the project under consideration will have on other projects now in operation.

Question 13

When two mutually exclusive projects are considered,the NPV calculations and the IRR calculations may,under certain circumstances,give conflicting recommendations as to which project to accept.The reason for this result is that in the NPV calculation,cash inflows are assumed to be reinvested at the cost of capital,while in the IRR solution,reinvestment takes place at

A)the hurdle rate.
B)the accounting rate of return.
C)the prime rate.
D)the project's internal rate of return.

Question 14

The internal rate of return of a project can be found by

A)discounting all cash flows at the cost of capital.
B)averaging all cash inflows,and calculating the interest rate,which will make them equal to the average investment.
C)calculating the interest rate,which will equate the present value of all cash inflows to the present value of all cash outflows.
D)None of the above

Question 15

When future events cannot be assigned probabilities,we are talking about

A)risk.
B)uncertainty.
C)a clouded future.
D)financial risk.

Question 16

Other things being equal,the higher the cost of capital

A)the higher the NPV of a project.
B)the higher the IRR of the project.
C)the lower the NPV of the project.
D)The cost of capital has no effect on the NPV of the project.

Question 17

The use of the same cost of capital (risk adjusted discount rate)for all capital projects in a corporation

A)is usually the correct procedure.
B)is incorrect since different divisions of the corporation may be faced with different levels of risk.
C)is incorrect since different capital projects,even in the same division,may be faced with different levels of risk.
D)Both B and C

Question 18

Two projects have the following NPVs and standard deviations: $$\begin{array} { | r | c | c | } \hline & \text { Project } A & \text { Project } B \\\hline \text { NPV } & 200 & 200 \\\hline \text { Standard deviation } & 75 & 100 \\\hline\end{array}$$ A person who selects project A over project B is

A)risk seeking.
B)risk indifferent.
C)risk averse.
D)None of the above

Question 19

If the risk adjusted discount rate method and the certainty equivalent methods are to give the same results,then the certainty equivalent factor (at)must equal (where rf is the risk-free interest rate,and "k" is the risk adjusted cost of capital)

A)(1 + r_f)^t times (1 + k)^t.
B)(1 + k)^t divided by (1 + r_f)^t.
C)(1 + r_f)^t divided by (1 + k)^t.
D)(1 + k)^t minus (1 + r_f)^t.

Question 20

The net present value of a project is calculated as

A)the future value of all cash inflows minus the present value of all outflows.
B)the sum of all cash inflows minus the sum of all cash outflows.
C)the present value of all cash inflows minus the present value of all cash outflows.
D)None of the above

Question 21

The expected value is

A)the total of all possible outcomes.
B)the arithmetic average of all possible outcomes.
C)the average of all possible outcomes weighted by their respective probabilities.
D)the total of all possible outcomes divided by the number of different possible outcomes.

Question 22

The certainty equivalent approach to accounting for risk in capital budgeting involves

A)adjusting the discount rate used to calculate net present values.
B)adjusting the expected cash flows.
C)estimating the coefficient of variation.
D)estimating the standard deviation of the net present values.

Question 23

Capital rationing refers to

A)setting a minimum acceptable rate of return for a capital outlay.
B)selecting among profitable capital outlays when there are constraints on the funds available.
C)determining the maximum price to pay for a capital product.
D)None of the above

Question 24

Which of the following is an example of risk in capital budgeting on a global basis?

A)exchange rate changes
B)tariff changes
C)expropriation
D)All of the above

Question 25

Usually,the cost of capital for newly issued stock is ________ the cost of retained earnings.

A)lower than
B)higher than
C)same as
D)either higher or lower than

Question 26

An advantage of the decision tree is that

A)it eliminates the need for calculating the cost of capital.
B)it eliminates the need for calculating probabilities.
C)it causes the analyst to consider important events that may occur in the course of the project,and decisions and actions that may have to be undertaken.
D)All of the above

Question 27

The time value of money can be best described as

A)a dollar today is worth more than a dollar tomorrow.
B)the basis on which net present values are calculated.
C)the basis on which internal rates of return are calculated.
D)All of the above

Question 28

An increase in net working capital required at the beginning of an expansion project must be considered to be

A)a cash inflow.
B)a reallocation of assets.
C)a cash outflow.
D)None of the above

Question 29

The risk adjusted discount rate

A)is the sum of the risk-free rate and the risk premium.
B)includes risk in the denominator of the present value calculation.
C)includes risk in the numerator of the present value calculation.
D)All of the above

Question 30

The cost of capital is best described as the

A)opportunity cost of financing a capital outlay.
B)funds that must be acquired to finance a capital outlay.
C)decrease in stockholder equity due to a capital outlay.
D)All of the above

Question 31

A source of business risk is a change in

A)technology.
B)consumer preferences.
C)input prices.
D)All of the above

Question 32

Capital rationing

A)exists when a company sets an arbitrary limit on the amount of investment it is willing to undertake,so that not all projects with an NPV higher than the cost of capital will be accepted.
B)generally does not permit a company to achieve maximum value.
C)seems to occur quite frequently among corporations.
D)All of the above

Question 33

In evaluating the required rate of return for equity financing of a capital project,the Beta value is

A)the expected rate of growth in a firm's profits.
B)the expected future value of a firm's stock.
C)the volatility in the rate of return on a firm's stock compared with the volatility in the rate of return on a market portfolio of stocks.
D)None of the above

Question 34

A real option can present management with the opportunity to

A)vary output.
B)abandon a project.
C)postpone a project.
D)All of the above

Question 35

Net present value and internal rate of return capital budgeting decisions can differ because

A)the initial costs of the capital outlays differ.
B)the cash flow streams differ.
C)the discount rates differ for different time periods.
D)All of the above

Question 36

A drawback in using the payback approach to capital budgeting decisions is

A)it doesn't account for the time value of money.
B)it ignores cash flows beyond the payback period.
C)it doesn't adjust for differences in the stream of cash flows.
D)All of the above

Question 37

Simulation analysis

A)permits the calculation of expected value and standard deviation.
B)does not permit the calculation of expected value and standard deviation.
C)is too complex to ever be used in actual business situations.
D)does not consider probabilities.

Question 38

A stock whose rate of return fluctuates less than the rate of return of a market portfolio will have a beta that equals

A)1)
B)less than 1.
C)more than 1.
D)Either A or C above

Question 39

Probabilities,which are based on past data or experience,are called

A)a priori.
B)objective.
C)uncertain.
D)statistical.

Question 40

A company's capital structure is made up of 40% debt and 60% common equity (both at market values).The interest rate on bonds similar to those issued by the company is 8%.The cost of equity is estimated to be 15%.The income tax rate is 40%.The company's weighted cost of capital is

A)11.5%.
B)12.2%.
C)10.9%.
D)8)9%.

Question 41

An aircraft company has signed a contract to sell a plane for $20 million.The firm buying the plane will pay for it in 5 annual payments (at year end)of $4 million.If the firm's cost of capital is 6%,what is the net present value of this payment?

Question 42

What are the major sources of risk for the firm?

Question 43

The Widget Company has estimated the following revenue possibilities for the year:
Sales Probability
100 0.15
150 0.20
220 0.30
290 0.20
310 0.15
a.Find expected revenue.
b.Find the standard deviation.
c.Find the coefficient of variation.

Question 44

Describe the Capital Asset Pricing Model (CAPM)and how it is used in capital budgeting decisions.

Question 45

The difference between sensitivity analysis and scenario analysis is

A)sensitivity analysis is a method for evaluating risk while scenario analysis is not.
B)sensitivity analysis is based on regression analysis while scenario analysis is not.
C)sensitivity analysis examines the impact on the overall results of a change in one variable while scenario analysis examines the impacts on overall results of changes in several variables at the same time.
D)None of the above

Question 46

The use of real options in capital budgeting

A)may raise the NPV of a capital project.
B)makes the analysis of the project considerably easier.
C)allows management to make decisions more quickly.
D)eliminates the need for calculating the project's risk adjusted discount rate.

Question 47

A firm must spend $10 million today on a project that is expected to bring in annual revenues of $1.5 million for the next 10 years (beginning at the end of year 1).
a.If the firm's cost of capital is 5%,what is the NPV of this project?
b.If the firm's cost of capital is 10%,what is the NPV of this project?
c.What is the internal rate of return?

Question 48

You start working at age 20 and you plan to deposit $5,000 in a savings account every year for the next 45 years.
a.At the end of this time,how much money will you have if the interest rate is 5%?
b.You decide that's not enough money.How much will you have to save every year if you wish to have $1,000,000 when you retire?

Question 49

You deposit $10,000 in a savings account today.If the interest rate is 3%,what is the value in 20 years?

Question 50

A drawback in the use of sensitivity analysis in capital budgeting decisions is that it doesn't

A)permit evaluating alternative outcomes.
B)provide estimates of net present values.
C)assign probability values to outcomes.
D)consider different possible rates of discount.

Question 51

Explain what is meant by the "weighted cost of capital" and how it is used in capital budgeting.

Question 52

An aircraft company has signed a contract to deliver a plane 3 years from now.The price they will receive at the end of 3 years is $20 million.If the firm's cost of capital is 6%,what is the present value of this payment?

Question 53

If a company's stock is perceived to be more risky than average,what will happen to their equity cost of capital? Explain using the capital asset pricing model.

Question 54

What additional complexities arise when multinational corporations consider capital projects on a global basis?

Question 55

You buy a lottery ticket for $1.If you win,you receive $3 million.The odds of your numbers coming up are 1:10,000,000.What is the expected value of this gamble?

Question 56

You win the $20 million state lottery,and you have a choice of taking an amount of money per year for the next 20 years or a flat payment now.The flat payment that the state offers you is $9.82 million.
a.What discount rate is the state using?
b.Should you take the money or the annuity?

Question 57

The use of sensitivity analysis will generally result in

A)the calculation of a certainty equivalent NPV.
B)the calculation of a best case,a base case and a worst case.
C)the calculation of the coefficient of variation.
D)the calculation of the probability of the maximum profit.

Question 58

Project C has an expected value of $500 and a standard deviation of 50.Project D has an expected value of $300 and a standard deviation of 10.Comment on the desirability of these projects.

Question 59

If an expansion proposal is accepted,allowing an otherwise idle (and useless)machine with a market value and book value of $2,000 to be utilized,should it be recorded as a cash outflow,and if so,how much?

Question 60

Inc.'s stock is currently $50.The last dividend that they paid was $1.If dividends are expected to increase at a 10% annual rate,what is the firm's equity cost of capital?

Question 61

In terms of capital budgeting,explain the difference between risk and uncertainty.

Question 62

What additional sources of risk come from international investments?

Question 63

The XYZ Company has estimated expected cash flows for 1996 to be as follows:
Calculate:
a.expected value
b.standard deviation
c.coefficient of variation
d.the probability that the cash flow will be less than $100,000

Question 64

Explain why risk can be insured against but uncertainty cannot.

Question 65

Describe the real option approach to risk-adjusted capital budgeting.

Question 66

Two projects have the following NPVs and standard deviations:
Project A Project B
NPV 200 300
Standard deviation 75 100
Which of the two projects is more risky?

Question 67

Savings accounts pay very low rates of interest.The average return on the stock market is about 10-12%,in the long run.Why would anyone put money into a savings account?