Answer Choices:
a. Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
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 (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
d. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
e. Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV.
Answer: a. Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
Question: Any cash flows that can be classified as incremental to a particular project—i.e., results directly from the decision to undertake the project—should be reflected in the capital budgeting analysis.
Answer Choices:
a. True
b. False
Answer: True
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 Choices:
a. True
b. False
Answer: False
Question: Real options can affect the size of a project’s expected NPV but not project’s risk as measured by the standard deviation or coefficient of variation of the NPV.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?
Answer Choices:
a. Changes in net operating working capital.
b. Shipping and installation costs for machinery acquired.
c. Cannibalization effects.
d. Opportunity costs.
e. Sunk costs that have been expensed for tax purposes.
Answer: Sunk costs that have been expensed for tax purposes.
Question: The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.
Answer Choices:
a. True
b. False
Answer: True
Question: The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.
Answer Choices:
a. True
b. False
Answer: False
Question: Real options are options to buy real assets, especially stocks, rather than interest-bearing assets, like bonds.
Answer Choices:
a. True
b. False
Answer: b. False
Question: 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. True
b. False
Answer: a. True
Question: Which of the following statements is CORRECT?
Answer Choices:
a. An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
b. Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
c. A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices.
d. A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
e. If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would have been had the sunk costs been ignored.
Answer: A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
Question: Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year’s profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.
Answer Choices:
a. True
b. False
Answer: True
Question: Real options exist whenever managers have the opportunity, after a project has been implemented, to make operating changes in response to changed conditions that modify the project’s cash flows.
Answer Choices:
a. True
b. False
Answer: a. True
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 Choices:
a. True
b. False
Answer: b. False
Question: The true expected value of a project with a growth option is the expected NPV of the project (including the value of the option) less the cost of obtaining that option.
Answer Choices:
a. True
b. False
Answer: a. True
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 decline.
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 decline.
Question: We can identify the cash costs and cash inflows to a company that will result from a project. These could be called “direct inflows and outflows,” and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.
Answer Choices:
a. True
b. False
Answer: False
Question: The following are all examples of real options that are discussed in the text: (1) growth options, (2) flexibility options, (3) timing options, and (4) abandonment options.
Answer Choices:
a. True
b. False
Answer: a. True
Question: In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm’s long-run cash flows.
Answer Choices:
a. True
b. False
Answer: True
Question: The relative risk of a proposed project is best accounted for by which of the following procedures?
Answer Choices:
a. Adjusting the discount rate upward if the project is judged to have above-average risk.
b. Adjusting the discount rate upward if the project is judged to have below-average risk.
c. Reducing the NPV by 10% for risky projects.
d. Picking a risk factor equal to the average discount rate.
e. Ignoring risk because project risk cannot be measured accurately.
Answer: Adjusting the discount rate upward if the project is judged to have above-average risk.
Question: Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Answer Choices:
a. Project A, which has average risk and an IRR = 9%.
b. Project B, which has below-average risk and an IRR = 8.5%.
c. Project C, which has above-average risk and an IRR = 11%.
d. Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
e. All of these projects should be accepted as they will produce a positive NPV.
Answer: Without information about the projects’ NPVs we cannot determine which one or ones should be accepted.
Question: Which of the following statements is CORRECT?
Answer Choices:
a. Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.
b. Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.
c. If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
d. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Answer: e. If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.
Question: The following are all examples of real options that are discussed in the text: (1) natural resource options, (2) flexibility options, (3) timing options, and (4) abandonment options.
Answer Choices:
a. True
b. 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 Choices:
a. True
b. False
Answer: False
Question: 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.
Answer Choices:
a. True
b. False
Answer: a. True
Question: The two cardinal rules that financial analysts should follow to avoid errors are: (1) in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2) all incremental cash flows should be considered when making accept/reject decisions for capital budgeting projects.
Answer Choices:
a. True
b. False
Answer: False