Answer Choices:
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 decline.
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 decline.
Question: Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process. Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects’ cash flows. True False
Answer:
a) True
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 Choices:
a. The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
c. If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.
Answer:
b) One drawback of the payback criterion for evaluating projects is that this method does not properly account for the time value of money.
Question: Norris Enterprises, an all-equity firm, has a beta of 2.0. The chief financial officer is evaluating a project with an expected return of 14%, before any risk adjustment. The risk-free rate is 5%, and the market risk premium is 4%. The project being evaluated is riskier than the firm’s average project, in terms of both its beta risk and its total risk. Which of the following statements is CORRECT?
Answer Choices:
a. The project should definitely be accepted because its expected return (before any risk adjustments) is greater than its required return.
b. The project should definitely be rejected because its expected return (before risk adjustment) is less than its required return.
c. Riskier-than-average projects should have their expected returns increased to reflect their higher risk. Clearly, this would make the project acceptable regardless of the amount of the adjustment.
d. The accept/reject decision depends on the firm’s risk-adjustment policy. If Norris’ policy is to increase the required return on a riskier-than-average project to 3% over rₛ, then it should reject the project.
e. Capital budgeting projects should be evaluated solely on the basis of their total risk. Thus, insufficient information has been provided to make the accept/reject decision.
Answer:
Options:
Question: Four of the following statements are truly disadvantages of the regular payback method, but one is not a disadvantage of this method. Which one is NOT a disadvantage of the payback method?
Answer Choices:
a. Lacks an objective, market-determined benchmark for making decisions.
b. Ignores cash flows beyond the payback period.
c. Does not directly account for the time value of money.
d. Does not provide any indication regarding a project’s liquidity or risk.
e. Does not take account of differences in size among projects.
Answer:
d) Does not provide any indication regarding a project’s liquidity or risk.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes.
d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.
e. Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project’s forecasted NPV.
Answer:
d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.
Question: A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal. True False
Answer:
a) True
Question: Because “present value” refers to the value of cash flows that occur at different points in time, a series of present values of cash flows should not be summed to determine the value of a capital budgeting project. True False
Answer:
b) False
Question: The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options, (3) timing options, and (4) abandonment options. True False
Answer:
a. True
Question: Real options exist whenever managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows. True False
Answer:
a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
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: A firm can change its beta through managerial decisions, including capital budgeting and capital structure decisions.
Answer:
Options:
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
Question: Other things held constant, which of the following would increase the NPV of a project being considered?
Answer Choices:
a. A shift from straight-line to MACRS depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three years.
c. An increase in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. The project would decrease sales of another product line.
Answer:
a. A shift from straight-line to MACRS depreciation.
Question: We can identify the cash costs and cash inflows to a company that will result from a project. These could be called “direct inflows and outflows,” and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis. True False
Answer:
b) False
Question: Traditional discounted cash flow (DCF) analysis–where a project’s cash flows are estimated and then discounted to obtain an expected NPV–has been the cornerstone of capital budgeting since the 1950s. However, in recent years, it has been demonstrated that DCF techniques do not always lead to proper capital budgeting decisions due to the existence of real options. True False
Answer:
b. False
Question: Real options are most valuable when the underlying source of risk–such as uncertainty about unit sales, or the sales price, or input costs–is very low. True False
Answer:
b. False
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 Choices:
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: Which of the following statements is CORRECT?
Answer Choices:
a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.
c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Answer:
e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Question: If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land. True False
Answer:
a) True