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. Because the analysis extends out at least one additional year from the original analysis, it is unlikely that the firm would ever delay a project—particularly given the loss of the “first mover advantage.” a. True b. False
Answer Choices:
[No answer choices shown in source]
Answer: b
For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC. a. True b. False
Answer Choices:
[No answer choices shown in source]
Answer: b
The optimal capital budget is the size of the capital budget where the rate of return on the marginal project is equal to the marginal cost of capital. a. True b. False
Answer Choices:
[No answer choices shown in source]
Answer: a
Capital rationing is the situation in which a firm can raise only a specified, limited amount of capital regardless of how many good projects it has.
Answer Choices:
a. Trueb. False
Answer: a. True
If a firm practices capital rationing, this means that it is accepting fewer projects than would be theoretically optimal; hence, it is not maximizing its theoretical value.
Answer Choices:
a. Trueb. False
Answer: a. True
A firm’s optimal capital budget consists of all independent projects with positive NPVs plus those mutually exclusive projects that have the highest positive NPVs.
Answer Choices:
a. Trueb. False
Answer: a. True
An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project’s sponsors and explaining why any differences occurred.
Answer Choices:
a. Trueb. False
Answer: a. True
Which one of the following will NOT increase the value of a real option? a. Lengthening the time during which a real option must be exercised. b. An increase in the volatility of the underlying source of risk. c. An increase in the risk-free rate. d. An increase in the cost of obtaining the real option. e. A decrease in the probability that a competitor will enter the market of the project in question.
Answer Choices:
[No answer choices shown in source]
Answer: d. An increase in the cost of obtaining the real option.
Which one of the following statements is most CORRECT? a. Real options change the size, but not the risk, of projects’ expected NPVs. b. Real options change the risk, but not the size, of projects’ expected NPVs. c. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows. d. Very few projects actually have real options. They are theoretically interesting but of little practical importance. e. Real options are more valuable when there is very little uncertainty about the true values of future sales and costs.
Answer Choices:
[No answer choices shown in source]
Answer: c. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows.
Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT? a. The abandonment option tends to reduce a project’s NPV. b. The abandonment option tends to reduce a project’s risk. c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project. d. A project can either have an abandonment option or an investment timing option, but never both. e. Investment timing options always increase the value of a project.
Answer Choices:
[No answer choices shown in source]
Answer: b. The abandonment option tends to reduce a project’s risk.
24. Which of the following statements is CORRECT? a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment. b. In general, the greater the strategic advantages of being the first competitor to enter a given market, the more attractive it probably is to wait before making an investment. c. In general, the higher the discount rate, the more attractive it probably is to wait before making an investment. d. In general, investment timing options are more valuable than abandonment options. e. In general, abandonment options are rarely seen in the real world.
Answer Choices:
[No answer choices shown in source]
Answer: a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment.
25. Weisbach Electronics is considering investing in India. Which of the following factors would make the company less likely to proceed with the investment? a. The company would have the option to withdraw from the investment after 2 years if it turns out to be unprofitable. b. The investment would increase the odds of the company being able to subsequently make a successful entry into China. c. The investment would preclude the company from being able to make a profitable investment in China. d. Competitors are considering similar investments in India, and the firm can discourage them from trying by entering now. e. The new plant could be easily retrofitted to manufacture many of the firm’s other products.
Answer Choices:
[No answer choices shown in source]
Answer: c. The investment would preclude the company from being able to make a profitable investment in China.
26. Wahal Corporation uses the NPV method when selecting projects, and it does a reasonably good job of estimating projects’ sales and costs. However, it never considers any real options that might be associated with projects. Which of the following statements is most likely to describe its situation? a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account. b. Its estimated capital budget is probably too large due to its failure to include abandonment and growth options. c. Omitting real options from the capital budgeting process has no adverse effect on the estimation of the optimal capital budget. d. Failing to consider abandonment and flexibility options probably makes the optimal capital budget too small, but failing to consider growth and timing options probably makes the optimal capital budget too large, so it is unclear what impact not considering real options has on the overall capital budget. e. Real options should not have any effect on the size of the optimal capital budget.
Answer Choices:
[No answer choices shown in source]
Answer: a. Its estimated capital budget is probably too small, because projects’ NPVs are often larger when real options are taken into account.
A firm’s business risk is largely determined by the financial characteristics of its industry, especially by the amount of debt the average firm in the industry uses.
Answer Choices:
a. Trueb. False
Answer: b. False
2. Financial risk refers to the extra risk borne by stockholders as a result of a firm’s use of debt as compared with their risk if the firm had used no debt.
Answer Choices:
a. Trueb. False
Answer: a. True
3. A firm’s capital structure does not affect its free cash flows as discussed in the text, because FCF reflects only operating cash flows, which are available to service debt, to pay dividends to stockholders, and for other purposes.
Answer Choices:
a. Trueb. False
Answer: a. True
4. If a firm borrows money, it is using financial leverage.
Answer Choices:
a. Trueb. False
Answer: a. True
5. Other things held constant, an increase in financial leverage will increase a firm’s market (or systematic) risk as measured by its beta coefficient.
Answer Choices:
a. Trueb. False
Answer: a. True
6. The graphical probability distribution of ROE for a firm that uses financial leverage would tend to be more peaked than the distribution if the firm used no leverage, other things held constant.
Answer Choices:
a. Trueb. False
Answer: b. False