Answer Choices:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Choices:
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 considered 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.
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. 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.”
Answer Choices:
a. True
b. False
Answer: b. False
Question: 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.
Answer Choices:
a. True
b. False
Answer: b. False
Question: 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. True
b. False
Answer: a. True
Question: Which one of the following statements is most CORRECT?
Answer Choices:
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: c. Real options can reduce the cost of capital that should be used to discount a project’s expected cash flows.
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 Choices:
a. True
b. False
Answer: False
Question: It is not possible for abandonment options to decrease a project’s risk as measured by the project’s coefficient of variation.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project’s life will be higher if accelerated depreciation is used, other things held constant.
Answer Choices:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.
b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
c. Well-diversified stockholders do not need to consider market risk when determining required rates of return.
d. Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
Answer: e. Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
Question: Which of the following rules is CORRECT for capital budgeting analysis?
Answer Choices:
a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
b. Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects.
c. Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.
d. A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.
e. If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.
Answer: a. The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.
Question: 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.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis.
Answer Choices:
a. True
b. False
Answer: False
Question: If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.
Answer Choices:
a. True
b. False
Answer: False
Question: The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project’s life, other things held constant.
Answer Choices:
a. True
b. False
Answer: False
Question: Which of the following statements is CORRECT?
Answer Choices:
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: a. In general, the more uncertainty there is about market conditions, the more attractive it may be to wait before making an investment.
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 increase.
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. 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 increase.
Question: The change in net operating working capital associated with new projects is always positive, because new projects mean that more operating working capital will be required.
Answer Choices:
a. True
b. False
Answer: False
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. The proposed new project would have more stand-alone risk than the firm’s typical project.
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: 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.
Question: For planning purposes, managers must forecast the total capital budget because the amount of capital raised affects the WACC.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The option to abandon a project is a real option, but a call option on a stock is not a real option.
Answer Choices:
a. True
b. False
Answer: b. False