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? 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.
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Answer: a
A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following? a. Increase the estimated IRR of the project to reflect its greater risk. b. Increase the estimated NPV of the project to reflect its greater risk. c. Reject the project, since its acceptance would increase the firm’s risk. d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets. e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
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Answer: e
Which of the following statements is CORRECT? a. The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firm’s products. b. The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment. c. The company has spent and expensed for tax purposes $3 million on research related to the new product. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. d. The new product will cut into sales of some of the firm’s other products. e. If the project is accepted, the company must invest an additional $2 million in net operating working capital. However, all of these funds will be recovered at the end of the project’s life.
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Answer: e
Which of the following statements is CORRECT? 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. Constructing a NPV sensitivity analysis involves the one with the steeper lines would be considered less risky, because two 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.
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Answer: a
Which of the following statements is CORRECT? a. If an asset is sold for less than its book value at the end of a project’s life, it will generate a loss for the firm, hence its terminal cash flow will be negative. b. Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions. c. It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the project’s completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating working capital should be included only at the start of a project’s life. d. If equipment is expected to be sold for more than its book value at the end of a project’s life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant. e. Changes in net operating working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities, hence they should not be considered in a capital budgeting analysis.
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Answer: d
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 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 undiscounted 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.
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Answer: c
Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no reason to consider real options separately from the NPV analysis. a. True b. False
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Answer: b
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. a. True b. False
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Answer: b
Real options can affect the size of a project’s expected NPV but not project’s risk as measured by the standard deviation or coefficient of variation of the NPV. a. True b. False
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Answer: b
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. a. True b. False
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Answer: a
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. a. True b. False
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Answer: b
Real options are options to buy real assets, especially stocks, rather than interest-bearing assets, like bonds. a. True b. False
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Answer: b
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. a. True b. False
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Answer: a
The following are all examples of real options that are discussed in the text: (1) protection options, (2) flexibility options, (3) timing options, and (4) abandonment options. a. True b. False
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Answer: b
The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options. a. True b. False
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Answer: b
The option to abandon a project is a real option, but a call option on a stock is not a real option. a. True b. False
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Answer: a
The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option. a. True b. False
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Answer: a
It is not possible for abandonment options to decrease a project’s risk as measured by the project’s coefficient of variation. a. True b. False
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Answer: b
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. a. True b. False
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Answer: b