Answer Choices:
a. Increase the estimated IRR of the project to reflect its greater risk.
b. Increase the estimated NPV of the project to reflect its greater risk.
c. Reject the project, since its acceptance would increase the firm’s risk.
d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
Answer: e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
Question: An important part of the capital budgeting process is the post-audit, which involves comparing the actual results with those predicted by the project’s sponsors and explaining why any differences occurred.
Answer Choices:
a. True
b. False
Answer: a. True
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. Using some of the firm’s high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.
b. Revenues from an existing product would be lost as a result of customers switching to the new product.
c. Shipping and installation costs associated with a machine that would be used to produce the new product.
d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
e. It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.
Answer: d. The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.
Question: Real options are valuable, and that value is correctly captured by a traditional NPV analysis. Therefore, there is no reason to consider real options separately from the NPV analysis.
Answer Choices:
a. True
b. False
Answer: b. False
Question: Weisbach Electronics is considering investing in India. Which of the following factors would make the company less likely to proceed with the investment?
Answer Choices:
a. The company would have the option to withdraw from the investment after 2 years if it turns out to be unprofitable.
b. The investment would increase the odds of the company being able to subsequently make a successful entry into China.
c. The investment would preclude the company from being able to make a profitable investment in China.
d. Competitors are considering similar investments in India, and the firm can discourage them from trying by entering now.
e. The new plant could be easily retrofitted to manufacture many of the firm’s other products.
Answer: c. The investment would preclude the company from being able to make a profitable investment in China.
Question: The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the equivalent annual annuity (EAA) approach.
Answer Choices:
a. True
b. False
Answer: True
Question: Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because not projects meet the assumptions the method requires.
Answer Choices:
a. True
b. False
Answer: False
Question: Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions for capital budgeting projects.
Answer Choices:
a. True
b. False
Answer: False
Question: A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company’s overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
Answer Choices:
a. All sunk costs that have been incurred relating to the project.
b. All interest expenses on debt used to help finance the project.
c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
d. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
e. Effects of the project on other divisions of the firm, but only if those effects lower the project’s own direct cash flows.
Answer: c. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project’s life.
Question: Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
Answer Choices:
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: Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their initial lives.
Answer Choices:
a. True
b. False
Answer: True
Question: If a firm practices capital rationing, this means that it is accepting fewer projects than would be theoretically optimal; hence, it is not maximizing its theoretical value.
Answer Choices:
a. True
b. False
Answer: a. True
Question: It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis.
Answer Choices:
a. True
b. False
Answer: True
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.
Answer Choices:
a. True
b. False
Answer: False