Answer Options:
a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.
c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.
d. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is identified will be higher than the NPV if this effect is not recognized.
e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
Answer: E. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
Question: Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?
Answer Options:
a. Project D probably has a higher IRR.
b. Project D is probably larger in scale than Project C.
c. Project C probably has a faster payback.
d. Project C probably has a higher IRR.
e. The crossover rate between the two projects is below 12%.
Answer: D. Project C probably has a higher IRR.
Question: Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer Options:
a. You should reject both projects because they will both have negative NPVs under the new conditions.
b. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
Answer: B. You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.
Question: The IRR method is based on the assumption that projects’ cash flows are reinvested at the project’s risk-adjusted cost of capital.
Answer Options:
a. True
b. False
Answer: False
Question: Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer Options:
a. Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
b. Revenues from an existing product would be lost as a result of customers switching to the new product.
c. Shipping and installation costs associated with a machine that would be used to produce the new product.
d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.
Answer: D. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
Question: When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer Options:
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product, provided that decline is directly attributable to this project.
e. The salvage value of assets used for the project that will be recovered at the end of the project’s life.
Answer: B. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
Question: Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer Options:
a. A project’s NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.
b. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
c. If a project’s NPV is greater than zero, then its IRR must be less than the WACC.
d. If a project’s NPV is greater than zero, then its IRR must be more than zero.
e. The NPVs of relatively risky projects should be found using relatively low WACCs.
Answer: B. The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.
Question: Which of the following statements is CORRECT?
Answer Options:
a. An NPV profile graph shows how a project’s payback varies as the cost of capital changes.
b. The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.
c. An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.
d. An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.
e. We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV.
Answer: D. An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.
Question: The internal rate of return is that discount rate that equates the present value of the cash outflows (or costs) with the present value of the cash inflows.
Answer Options:
a. True
b. False
Answer: True
Question: A basic rule in capital budgeting is that if a project’s NPV exceeds its IRR, then the project should be accepted.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer Options:
a. The new project is expected to capture sales of one of the company’s existing products by 5%.
b. Since the firm’s director of capital budgeting spent some of their time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost.
c. The company has spent and expensed $1 million on research and development costs associated with the new project.
d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
Answer: A. The new project is expected to capture sales of one of the company’s existing products by 5%.
Question: Which of the following statements is CORRECT?
Answer Options:
a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project’s NPV.
e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
Answer: C. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
Question: Which of the following statements is CORRECT?
Answer Options:
a. An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is not an externality.
b. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase.
c. The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
e. Identifying an externality can never lead to an increase in the calculated NPV.
Answer: B. An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase.
Question: Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?
Answer Options:
a. Changes in net operating working capital.
b. Shipping and installation costs for machinery acquired.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.
Answer: E. Sunk costs that have been expensed for tax purposes.
Question: Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects’ initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.
Answer Options:
a. True
b. False
Answer: B. False
Question: Small businesses make less use of DCF capital budgeting techniques than large businesses. This may reflect a lack of knowledge on the part of small firms’ managers, but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for very small firms.
Answer Options:
a. True
b. False
Answer: True
Question: Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
Answer Options:
a. A project’s IRR increases as the WACC declines.
b. A project’s NPV increases as the WACC declines.
c. A project’s MIRR is unaffected by changes in the WACC.
d. A project’s regular payback increases as the WACC declines.
e. A project’s discounted payback increases as the WACC declines.
Answer: B. A project’s NPV increases as the WACC declines.
Question: Which of the following rules is CORRECT for capital budgeting analysis?
Answer Options:
a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.
c. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.
d. A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.
e. If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.
Answer: B. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.