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.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
c. Corporations must use the same depreciation method for both stockholder reporting and tax purposes.
d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.
e. Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project’s forecasted NPV.
Answer: d. Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project’s forecasted NPV.
Question: Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer Choices:
a. The new project is expected to reduce sales of one of the company’s existing products by 5%.
b. Since the firm’s director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project’s initial cost.
c. The company has spent and expensed $1 million on research and development costs associated with the new project.
d. The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
e. The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.
Answer: a. The new project is expected to reduce sales of one of the company’s existing products by 5%.
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.
Answer Choices:
a. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to an upward bias in the NPV.
b. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project’s cash flows will lead to a downward bias in the NPV.
c. The existence of any type of “externality” will reduce the calculated NPV versus the NPV that would exist without the externality.
d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
e. If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
Answer: d. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.
Question: Sensitivity analysis measures a project’s stand-alone risk by showing how much the project’s NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.
Answer Choices:
a. True
b. False
Answer: True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project’s NPV.
e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
Answer: A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
Question: When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
Answer Choices:
a. Changes in net operating working capital attributable to the project.
b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
c. The value of a building owned by the firm that will be used for this project.
d. A decline in the sales of an existing product, provided that decline is directly attributable to this project.
e. The salvage value of assets used for the project that will be recovered at the end of the project’s life.
Answer: b. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
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.
Answer Choices:
a. True
b. False
Answer: True
Question: Other things held constant, which of the following would increase the NPV of a project being considered?
Answer Choices:
a. A shift from straight-line to MACRS depreciation.
b. Making the initial investment in the first year rather than spreading it over the first three years.
c. An increase in the discount rate associated with the project.
d. An increase in required net operating working capital.
e. The project would decrease sales of another product line.
Answer: a. A shift from straight-line to MACRS depreciation.
Question: A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?
Answer Choices:
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: 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 current 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 Choices:
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 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 Choices:
a. True
b. False
Answer: False
Question: Dalyrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
Answer Choices:
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.
Answer: 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.
Question: Which one of the following will NOT increase the value of a real option?
Answer Choices:
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: d. An increase in the cost of obtaining the real option.
Question: A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.
Answer Choices:
a. True
b. False
Answer: 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 Choices:
a. True
b. False
Answer: True
Question: 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?
Answer Choices:
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: b. The abandonment option tends to reduce a project’s risk.
Question: Which of the following statements is CORRECT?
Answer Choices:
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. In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a 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.
Answer: 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.