Answer Options:
a. True
b. False
Answer: B. False
Question: Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X: Expected NPV $350,000, Standard deviation (σNPV) $100,000, Project beta (vs. market) 1.4, Correlation of the project cash flows with cash flows from currently existing projects Cash flows are not correlated with the cash flows from existing projects Project Y: Expected NPV $350,000, Standard deviation (σNPV) $150,000, Project beta (vs. market) 0.8, Correlation of the project cash flows with cash flows from currently existing projects Cash flows are highly correlated with the cash flows from existing projects Which of the following statements is CORRECT?
Answer Options:
a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.
Answer: C. Project X has more market risk than Project Y.
Question: Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker’s books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
Answer Options:
a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any additional net operating working capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the project’s projected cash flows.
e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
Answer: C. The end-of-project recovery of any additional net operating working capital required to operate the project.
Question: The NPV and IRR methods, when used to evaluate two independent and equally risky projects, will lead to different accept/reject decisions and thus capital budgets if the projects’ IRRs are greater than their costs of capital.
Answer Options:
a. True
b. False
Answer: False
Question: The option to abandon a project is a real option, but a call option on a stock is not a real option.
Answer Options:
a. True
b. False
Answer: B. False
Question: In theory, capital budgeting decisions should depend solely on forecasted cash flows and the opportunity cost of capital. The decision criterion should not be affected by managers’ tastes, choice of accounting method, or the profitability of other independent projects.
Answer Options:
a. True
b. False
Answer: True
Question: Other things held constant, an increase in the cost of capital will result in a decrease in a project’s IRR.
Answer Options:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Options:
a. The shorter a project’s payback period, the less desirable the project is normally considered to be by this criterion.
b. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.
c. If a project’s payback is positive, then the project should be accepted because it must have a positive NPV.
d. The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.
e. One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.
Answer: B. One drawback of the payback criterion is that this method does not take account of cash flows beyond the payback period.
Question: Which of the following statements is CORRECT?
Answer Options:
a. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount.
b. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.
c. The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.
d. If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.
e. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than the NPV, which is a dollar amount.
Answer: A. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount.
Question: 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.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following statements is CORRECT?
Answer Options:
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. For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.
Question: A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?
Answer Options:
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. 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.
Question: The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.
Answer Options:
a. True
b. False
Answer: B. False
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 Options:
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. 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.
Question: Suppose a firm’s CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision—estimates of its effect would really just be guesses. In this case, the externality should be ignored—i.e., not considered at all—because if it were considered it would make the analysis appear more precise than it really is.
Answer Options:
a. True
b. False
Answer: B. False
Question: Which of the following statements is CORRECT?
Answer Options:
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 aims to generally more appropriate.
c. One advantage of the MIRR over the IRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.
d. 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.
e. None of the above statements is correct.
Answer: 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 aims to generally more appropriate.
Question: Which of the following statements is CORRECT?
Answer Options:
a. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
b. If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.
c. If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.
d. If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is identified will be higher than the NPV if this effect is not recognized.
e. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
Answer: E. Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.