Question 1

The advantage of using simulation in the capital budgeting process is

Accepted Answer

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

Question 2

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.

Accepted Answer

A) True 
 B)False

Question 3

In case of international capital budgeting, the Canadian company can minimize its political risk by subtracting the investment as a joint venture and by selecting a competent and well-connected local partner.

Accepted Answer

A) True 
 B)False

Question 4

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

Accepted Answer

A) True 
 B)False

Question 5

When doing capital budgeting, Canadian multi-national corporations need to be concerned with

Accepted Answer

A)  setting transfer prices of goods and services traded between nations. 
B)  the strategic point of view, not just the financial point of view. 
C)  tax law differences between Canada and the country the project is located. 
D)  all of the above

Question 6

The security market line plots_________on the x-axis and_________on the y-axis.

Accepted Answer

A)  project risk; required rate of return 
B)  project risk; beta 
C)  required rate of return; beta 
D)  required rate of return; project risk

Question 7

When a project being valued is riskier than the average asset in the firm, the firm's cost of capital should be adjusted downwards to reflect this increased risk.

Accepted Answer

A) True 
 B)False

Question 8

Generally, poor forecasts result in poor decisions no matter how thorough the analysis of thenumbers.

Accepted Answer

A) True 
 B)False

Question 9

Risk faced by Canadian corporations doing business abroad include

Accepted Answer

A)  currency risk. 
B)  political risk. 
C)  exchange rate risk. 
D)  all of the above

Question 10

_________represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows possible from the project.

Accepted Answer

A)  Certainty equivalents 
B)  Time-anchored cost of capitals 
C)  Annualized net present values 
D)  Risk-adjusted discount rates

Question 11

An asset is priced to earned an 18% annual return; the asset has a beta of 1.1.premium is 8% and the risk free rate is 6%. The asset is

Accepted Answer

A)  correctly priced. 
B)  underpriced. 
C)  overpriced. 
D)  cannot be determined with the information provided

Question 12

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.

Accepted Answer

A) True 
 B)False

Question 13

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.
$$\begin{array} { c c c } 
& { \text { Project A } } \
\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \
\hline { \$ 20,000 } & \$ 5,000 & \text { Pessimistic } \
& 10,000 & \text { Most likely } \
& 15,000 & \text { Optimistic } \\
& \text { Project B } & \
\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \
\hline  { \text { \$100,000 } } & \$ 20,000 & \text { Pessimistic } \
& 40,000 & \text { Most likely } \
& 100,000 & \text { Optimistic }
\end{array}$$
-The expected net present value of project A if the outcomes are equally probable and the projecthas five-year life is_________

Accepted Answer

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

Question 14

The firm's objective is to use its budget to generate the highest internal rate of return for its cash inflows.

Accepted Answer

A) True 
 B)False

Question 15

The objective to capital rationing is to select the group of projects that provides the highest overallIRR and does not require more dollars than are budgeted.

Accepted Answer

A) True 
 B)False

Question 16

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.

Accepted Answer

A) True 
 B)False

Question 17

The annualized net present value approach converts the net present value of unequal-livedprojects into an equivalent annual amount (in NPV terms) that can be used to select the best project.

Accepted Answer

A) True 
 B)False

Question 18

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.

Accepted Answer

A) True 
 B)False

Question 19

A firm is evaluating the relative riskiness of two capital budgeting projects.  The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$

$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\
\hline 0.25 & -\$ 5,000 & 0 \
0.50 & 4,000 & \$ 2,000 \
0.25 & 10,000 & 8,000
\end{array}$

-The coefficient of variations for projects A and B are

Accepted Answer

A)  0.6 and 1, respectively. 
B)  0.8 and 2, respectively. 
C)  1.2 and 1.5, respectively. 
D)  1.6 and 1, respectively.

Question 20

Diagrams that permit the mapping of the various investment decision alternatives and payoffs as well as their probabilities of occurrence are called

Accepted Answer

A)  simulations. 
B)  multiple regression analysis. 
C)  sensitivity analysis. 
D)  decision trees.

Exam 13: Dealing With Project Risk and Other Topics in Capital Budgeting

The advantage of using simulation in the capital budgeting process is

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.

In case of international capital budgeting, the Canadian company can minimize its political risk by subtracting the investment as a joint venture and by selecting a competent and well-connected local partner.

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

When doing capital budgeting, Canadian multi-national corporations need to be concerned with

The security market line plots_on the x-axis and_on the y-axis.

When a project being valued is riskier than the average asset in the firm, the firm's cost of capital should be adjusted downwards to reflect this increased risk.

Generally, poor forecasts result in poor decisions no matter how thorough the analysis of thenumbers.

Risk faced by Canadian corporations doing business abroad include

_________represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows possible from the project.

An asset is priced to earned an 18% annual return; the asset has a beta of 1.1.premium is 8% and the risk free rate is 6%. The asset is

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.

The firm's objective is to use its budget to generate the highest internal rate of return for its cash inflows.

The objective to capital rationing is to select the group of projects that provides the highest overallIRR and does not require more dollars than are budgeted.

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.

The annualized net present value approach converts the net present value of unequal-livedprojects into an equivalent annual amount (in NPV terms) that can be used to select the best project.

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.

Diagrams that permit the mapping of the various investment decision alternatives and payoffs as well as their probabilities of occurrence are called