Answer:
b) False
Question: A basic rule in capital budgeting is that if a project’s NPV exceeds its IRR, then the project should be accepted. True False
Answer:
b) False
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
Question: Modigliani and Miller’s first article led to the conclusion that capital structure is “irrelevant” because it has no effect on a firm’s value. However, that article was criticized because it assumed that no taxes existed. MM then revised their original article to include corporate taxes, and this model led to the conclusion that a firm’s value would be maximized if it used (almost) 100% debt.
Answer:
Options:
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. True 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 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. 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: Both the regular and the modified IRR (MIRR) methods have wide appeal to professors, but most business executives prefer the NPV method to either of the IRR methods. True False
Answer:
b) False
Question: Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital. True False
Answer:
b) False
Question: Which of the following statements is CORRECT?
Answer Choices:
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.
Answer:
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.
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) The firm will accept too few projects in all economic states because a 4-year payback is too high.
Question: Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.
Answer:
Options
Question: For a project with one initial cash outflow followed by a series of positive cash inflows, the modified IRR (MIRR) method involves compounding the cash inflows out to the end of the project’s life, summing those compounded cash flows to form a terminal value (TV), and then finding the discount rate that causes the PV of the TV to equal the project’s cost. True False
Answer:
a) True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. If a project has “normal” cash flows, then its IRR must be positive.
b. If a project has “normal” cash flows, then its MIRR must be positive.
c. If a project has “normal” cash flows, then it will have exactly two real IRRs.
d. The definition of “normal” cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the project’s life.
e. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.
Answer:
e) If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR.
Question: If a firm’s projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate. True False
Answer:
a) True
Question: Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.
Answer:
Options
Question: Which one 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. 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.