Answer Choices:
a. The new project is expected to reduce 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
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
b. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV.
c. The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.
d. Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables’ values.
e. As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.
Answer:
a
Question: Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.
Answer Choices:
a. True
b. False
Answer:
b. False
Question: Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce
Answer Choices:
a. Higher depreciation charges in the early years of an asset’s life.
b. Larger cash flows in the earlier years of an asset’s life.
c. Larger total undistributed profits from the project over the project’s life.
d. Smaller accounting profits in the early years, assuming the company uses the same depreciation method for tax and book purposes.
e. Lower tax payments in the earlier years of an asset’s life.
Answer:
c
Question: Traditionally, an NPV analysis assumes that projects will be accepted or rejected, which implies that they will be undertaken now or never. However, in practice, companies sometimes have a third choice—delay the decision until later, when more information will be available.
Answer Choices:
a. True
b. False
Answer:
b. False
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
Question: Which 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 Choices:
a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
Answer:
d
Question: Which of the following statements is CORRECT?
Answer Choices:
a. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.
b. To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.
Answer:
a
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. If a project has normal cash flows and its IRR exceeds its WACC, then the project’s NPV must be positive.
Answer:
a
Question: Suppose a firm relies exclusively on the payback method when making capital budgeting decisions, and it sets a 4-year payback regardless of economic conditions. Other things held constant, which of the following statements is most likely to be true?
Answer Choices:
a. It will accept too many short-term projects and reject too many long-term projects (as judged by the NPV).
b. It will accept too many long-term projects and reject too many short-term projects (as judged by the NPV).
c. The firm will accept too many projects in all economic states because a 4-year payback is too low.
d. The firm will accept too few projects in all economic states because a 4-year payback is too high.
e. If the 4-year payback results in accepting just the right set of projects under average economic conditions, then this payback will result in too few long-term projects when the economy is weak.
Answer:
d
Question: Which of the following statements is CORRECT?
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 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
Question: Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L’s IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, 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 Choices:
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.
c. You should recommend Project L, because at the new WACC it will have the higher NPV.
d. You should recommend Project S, because at the new WACC it will have the higher NPV.
e. You should recommend Project L because it will have the higher IRR at the new WACC.
Answer:
d
Question: Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project’s sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?
Answer Choices:
a. The proposed new project would have more stand-alone risk than the firm’s typical project.
b. The proposed new project would increase the firm’s corporate risk.
c. The proposed new project would increase the firm’s market risk.
d. The proposed new project would not affect the firm’s risk at all.
e. The proposed new project would have less stand-alone risk than the firm’s typical project.
Answer:
a
Question: Which of the following statements is CORRECT?
Answer Choices:
a. For a project to have more than one IRR, then both IRRs must be greater than the WACC.
b. If two projects are mutually exclusive, then they are likely to have multiple IRRs.
c. If a project is independent, then it cannot have multiple IRRs.
d. Multiple IRRs can only occur if the signs of the cash flows change more than once.
e. If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.
Answer:
d
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.
b. If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.
c. A project’s MIRR can never exceed its IRR.
d. If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.
e. If the NPV is negative, the IRR must also be negative.
Answer:
a
Question: A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?
Answer Choices:
a. In calculating the project’s operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.
b. Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
c. When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
d. Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis.
e. The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis. To do otherwise would bias the NPV upward.
Answer:
a
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 Choices:
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
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. If Project A has a higher IRR than Project B, then Project A must have the lower NPV.
b. If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.
Answer:
b
Question: Which of the following statements is CORRECT?
Answer Choices:
a. The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a project’s profitability.
b. If the cost of capital declines, this lowers a project’s NPV.
c. The NPV method is regarded by most academics as being the best indicator of a project’s profitability, hence most academics recommend using only this one method and disregard other methods.
d. A project’s NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the project’s life.
e. The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.
Answer:
e
Question: Which of the following statements is CORRECT?
Answer Choices:
a. One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not.
b. One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. NPV also seems to generally more appropriate.
c. One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life whereas MIRR does not.
d. One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.
e. Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.
Answer:
b
Question: Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear—there is no mortgage on it. Which of the following statements is CORRECT?
Answer Choices:
a. Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows of the capital budgeting analysis for any new project.
b. If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.
c. This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.
d. Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.
e. If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.
Answer:
b
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.
Answer Choices:
a. True
b. False
Answer:
a. True