Answer Options:
a. True
b. False
Answer: A. True
Question: Assuming that their NPVs based on the firm’s cost of capital are equal, the NPV of a project whose cash flows accrue relatively rapidly will be more sensitive to changes in the discount rate than the NPV of a project whose cash flows come in later in its life.
Answer Options:
a. True
b. False
Answer: False
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 regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.
b. A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.
c. If a project’s IRR is smaller than the WACC, then its NPV will be positive.
d. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
e. If a project’s IRR is positive, then its NPV must also be positive.
Answer: D. A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.
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: 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 decrease.
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 decrease.
Question: The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.
Answer Options:
a. True
b. False
Answer: A. True
Question: Sensitivity analysis measures a project’s stand-alone risk by showing how much the project’s NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.
Answer Options:
a. True
b. False
Answer: A. True
Question: Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.
Answer Options:
a. True
b. False
Answer: A. True
Question: The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects.
Answer Options:
a. True
b. False
Answer: B. False
Question: The relative risk of a proposed project is best accounted for by which of the following procedures?
Answer Options:
a. Adjusting the discount rate upward if the project is judged to have above-average risk.
b. Adjusting the discount rate upward if the project is judged to have below-average risk.
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.
Answer: A. Adjusting the discount rate upward if the project is judged to have above-average risk.
Question: Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year’s profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.
Answer Options:
a. True
b. False
Answer: A. True
Question: The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.
Answer Options:
a. True
b. False
Answer: A. True