Deck 13: Dealing With Project Risk and Other Topics in Capital Budgeting

Question 1

A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
$$\begin{array} { c c c } & { \text { Project A } } \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \$ 20,000 } & \$ 5,000 & \text { Pessimistic } \\& 10,000 & \text { Most likely } \\& 15,000 & \text { Optimistic } \\\\& \text { Project B } & \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \text { \$100,000 } } & \$ 20,000 & \text { Pessimistic } \\& 40,000 & \text { Most likely } \\& 100,000 & \text { Optimistic }\end{array}$$

-The expected net present value of project A if the outcomes are equally probable and the projecthas five-year life is_________

A) $17,910
B) $36,865
C) $93,730
D) -$1,045

Answer 1

$17,910

Question 2

A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
$$\begin{array} { c c c } & { \text { Project A } } \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \$ 20,000 } & \$ 5,000 & \text { Pessimistic } \\& 10,000 & \text { Most likely } \\& 15,000 & \text { Optimistic } \\\\& \text { Project B } & \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \text { \$100,000 } } & \$ 20,000 & \text { Pessimistic } \\& 40,000 & \text { Most likely } \\& 100,000 & \text { Optimistic }\end{array}$$

-The range of the annual cash inflows for Project A is_________

A) $10,000
B) $0
C) $30,000
D) $5,000

Answer 2

$10,000

Question 3

The IRR approach to capital rationing involves graphically plotting project IRR's in descendingorder against total dollar investment on _________graph.

A) an ANPV
B) an IOS
C) an NPV
D) an RADR

Answer 3

an IOS

Question 4

Which of the following is an example of diversifiable risk.

A) An economic downturn due to overcapacity in many industries worldwide.
B) Geopolitical uncertainty caused by differing government policies.
C) The global threat of terrorism and war.
D) The insider trading activities of the company's executives.

Question 5

A firm is evaluating the relative riskiness of two capital budgeting projects. The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$

$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\\hline 0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$



-The coefficient of variations for projects A and B are

A) 0.6 and 1, respectively.
B) 0.8 and 2, respectively.
C) 1.2 and 1.5, respectively.
D) 1.6 and 1, respectively.

Question 6

____________refers to the chance that the inputs into the analysis of an investment project will prove to be wrong.

A) Forecasting
B) Data entry
C) RADRs
D) Risk

Question 7

If a firm has a project with an IRR_________RADR, the project should be

A) greater than; accepted.
B) less than; accepted.
C) greater than; rejected.
D) Cannot be determined with the information provided.

Question 8

It has been found that the value of the stock of corporations whose shares are traded publicly in anefficient marketplace is

A) generally negatively affected by diversification, because of the increase in risk.
B) generally not affected by diversification, unless greater returns are expected.
C) generally positively affected by diversification, because of the reduction in risk.
D) generally negatively affected by diversification, because of the increase in the required rate of return.

Question 9

When doing capital budgeting, Canadian multi-national corporations need to be concerned with

A) setting transfer prices of goods and services traded between nations.
B) the strategic point of view, not just the financial point of view.
C) tax law differences between Canada and the country the project is located.
D) all of the above

Question 10

The beta of the risk free asset is___________; the beta of the market index is ___________

A) 0.0; 1.0
B) 1.0; 0.0
C) 0.0; 0.1
D) 0.1; 0.0

Question 11

An asset is priced to earned a 10% annual return; the asset has a beta of 0.75. The market risk premium is 8% and the risk free rate is 4%. The asset is

A) cannot be determined with the information provided
B) correctly priced.
C) underpriced.
D) overpriced.

Question 12

In the context of capital budgeting, risk refers to

A) the chance that the internal rate of return will exceed the cost of capital.
B) the chance that the net present value will be greater than zero.
C) the degree of variability of the initial investment.
D) the degree of variability of the cash inflows.

Question 13

An asset is priced to earned an 18% annual return; the asset has a beta of 1.1.premium is 8% and the risk free rate is 6%. The asset is

A) correctly priced.
B) underpriced.
C) overpriced.
D) cannot be determined with the information provided

Question 14

A financial goal of the firm is to

A) accept projects that have negative NPVs.
B) accept all projects that can be funded internally.
C) accept projects that have a cost of capital greater than the IRR.
D) none of the above

Question 15

The amount by which the required discount rate exceeds the risk-free rate is called

A) the opportunity cost.
B) the risk equivalent.
C) the risk premium.
D) the excess risk.

Question 16

The objective of___________ is to select the group of projects that provides the highest overall netpresent value and does not require more dollars than are budgeted.

A) certainty equivalents
B) scenario analysis
C) sensitivity analysis
D) capital rationing

Question 17

A firm is evaluating the relative riskiness of two capital budgeting projects. The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$

$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\\hline 0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$

-The expected net present value for projects A and B are

A) $4,000 and $1,500, respectively.
B) $2,000 and $1,000, respectively.
C) $3,000 and $3,300, respectively.
D) $3,250 and $3,000, respectively.

Question 18

A firm buys a business with land that can be used for expansion in the future. This would beconsidered a ________option.

A) abandonment
B) growth
C) tax
D) flexibility

Question 19

Forecasting the future with accuracy is problematic in valuation; this creates

A) a need to adjust discount rates downwards.
B) a tendency to avoid valuation when buying capital assets.
C) a need to spend more on software to get it right.
D) problems in predicting future cash inflows from a project.

Question 20

A firm is evaluating the relative riskiness of two capital budgeting projects. The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$

$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\\hline 0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$

-The two projects can best be characterized relative to one another by the statement,13.2)

A) project A is more risky than project B.
B) since project A has a higher expected net present value, it should be chosen.
C) since project B has a higher standard deviation, it is more risky and should not be chosen.
D) project B is more risky than project A.

Question 21

A firm is evaluating the relative riskiness of two capital budgeting projects. The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$
$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$

-The standard deviation for projects A and B are

A) $4,210 and $2,104, respectively.
B) $3,000 and $5,000, respectively.
C) $5,356 and $3,000, respectively.
D) $2,106 and $0, respectively.

Question 22

When comparing mutually exclusive projects using the ANPV approach, you would

A) reject the project with the lowest ANPV.
B) be indifferent if the ANPVs are equal.
C) accept the project with the highest ANPV.
D) all of the above

Question 23

Diagrams that permit the mapping of the various investment decision alternatives and payoffs as well as their probabilities of occurrence are called

A) simulations.
B) multiple regression analysis.
C) sensitivity analysis.
D) decision trees.

Question 24

The security market line plots_________on the x-axis and_________on the y-axis.

A) project risk; required rate of return
B) project risk; beta
C) required rate of return; beta
D) required rate of return; project risk

Question 25

Risk faced by Canadian corporations doing business abroad include

A) currency risk.
B) political risk.
C) exchange rate risk.
D) all of the above

Question 26

A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the riskfree rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
$$\begin{array} { l r } \text { Initial Investment } & \$ 1,000,000 \\\hline \text { Year } & \text { Cash Inflow } \\\hline 1 & \$ 500,000 \\2 & 500,000 \\3 & 500,000\end{array}$$

-The discount rate that should be used in the net present value calculation to compensate for risk is(See Figure 13.3)

A) 24 percent.
B) 18 percent.
C) 15 percent.
D) 6 percent.

Question 27

A project which has a coefficient of variation greater than zero will have a risk-adjusted discount rate

A) less than the risk-free rate of return.
B) greater than the risk-free rate of return.
C) equal to the risk-free rate of return.
D) not related to the risk-free rate of return.

Question 28

The preferred approach for risk adjustment of capital budgeting cash flows, from a practicalviewpoint, is

A) sensitivity analysis.
B) simulation.
C) risk-adjusted discount rates.
D) certainty equivalents.

Question 29

A project which has a coefficient of variation of zero is considered

A) a bad investment.
B) very risky.
C) risk free.
D) slightly risky.

Question 30

A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the riskfree rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
$\text { Net Present Value }\quad\quad\quad\$1,000,000$
$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$

-The net present value without adjusting the discount rate for risk is _

A) $179,400
B) $250,000
C) $336,000
D) $87,000

Question 31

A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
$$\begin{array} { c c c } & { \text { Project A } } \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \$ 20,000 } & \$ 5,000 & \text { Pessimistic } \\& 10,000 & \text { Most likely } \\& 15,000 & \text { Optimistic } \\\\& \text { Project B } & \\\hline \text { Initial Investment } & \text { Annual cash inflow } & \text { Outcome } \\\hline { \text { \$100,000 } } & \$ 20,000 & \text { Pessimistic } \\& 40,000 & \text { Most likely } \\& 100,000 & \text { Optimistic }\end{array}$$

-If the projects have five-year lives, the range of the net present value for Project B is approximately. _____________

A) $303,260
B) $255,410
C) $80,560
D) $201,000

Question 32

If a firm has a limited capital budget and too many good capital projects to fund them all, it is said to be facing the problem of

A) constrained capital.
B) capital rationing.
C) wealth optimization.
D) profitability.

Question 33

The theoretical basis from which the concept of risk-adjusted discount rates is derived is

A) the capital asset pricing model.
B) simulation theory.
C) the basic cost of money.
D) the Gordon model.

Question 34

_________represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows possible from the project.

A) Certainty equivalents
B) Time-anchored cost of capitals
C) Annualized net present values
D) Risk-adjusted discount rates

Question 35

The ___________reflects the return that must be earned on the given project to compensate the firm's owners adequately according to the project's variability of cash flows.

A) average rate of return
B) risk-adjusted discount rate
C) internal rate of return
D) cost of capital

Question 36

A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the riskfree rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
$$\begin{array} { l r } \text { Initial Investment } & \$ 1,000,000 \\\hline \text { Year } & \text { Cash Inflow } \\\hline 1 & \$ 500,000 \\2 & 500,000 \\3 & 500,000\end{array}$$

-The net present value of the project when adjusting for risk is____________

A) $105,000
B) $87,000
C) $0
D) -$9,500

Question 37

The advantage of using simulation in the capital budgeting process is

A) that it generates a continuum of risk-return tradeoffs rather than a single-point estimate.
B) the availability of a continuum of risk-return tradeoffs which may be used as the basis for decision making.
C) ease of calculation.
D) dependability of predetermined probability distributions.

Question 38

A firm is evaluating the relative riskiness of two capital budgeting projects. The following table summarizes the net present values and associated probabilities for various outcomes for the two projects.
$\text { Net Present Value }$
$\begin{array}{rrr}\text { Probability }&\text { Project A }&\text { Project B }\\0.25 & -\$ 5,000 & 0 \\0.50 & 4,000 & \$ 2,000 \\0.25 & 10,000 & 8,000\end{array}$

-The firm should

A) choose project B since it has a lower standard deviation.
B) choose project A since it has a lower relative risk.
C) choose project B since it has a lower relative risk.
D) choose project A since it has a higher net present value potential.

Question 39

An asset is priced to earned a 14% annual return; the asset has a beta of 1.4. The market risk premium is 7% and the risk free rate is 6%. The asset is

A) underpriced.
B) correctly priced.
C) overpriced.
D) cannot be determined with the information provided

Question 40

__________measure(s) the risk of a capital budgeting project by estimating the NPVs associated with the optimistic, most likely, and pessimistic cash flow estimates.

A) Multiple regression analysis
B) Simulations
C) Risk-adjusted discount rates
D) Sensitivity analysis

Question 41

The investment opportunities schedule (IOS) is the graphical presentation of IRRs in descending order against the total dollar investment.

Question 42

The incremental cost of a project is known with virtual certainty since the cash flow occurs now, at time 0.

Question 43

Sensitivity analysis is a behavioral approach that uses a number of possible values for a given variable to assess its impact on a firm's return.

Question 44

Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate(RADR) approach implicitly assumes that risk is an increasing function of time.

Question 45

Sensitivity analysis is a statistically based approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

Question 46

The three basic types of risk associated with international cash flows are 1) business and financial risks, 2) inflation and foreign exchange risks, and 3) political risks.

Question 47

In CAPM, the required return is calculated by adding the risk free rate to beta multiplied by the market risk premium.

Question 48

When a project being valued is riskier than the average asset in the firm, the firm's cost of capital should be adjusted downwards to reflect this increased risk.

Question 49

Generally, the market value of a firm's stock, whose shares are traded publicly in an efficient market, is not affected by diversification.

Question 50

The market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

Question 51

The importance and widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices used accurately reflect actual costs and incremental cash flows.

Question 52

In capital budgeting, risk refers to the chance that a project has a high degree of variability in the initial investment.

Question 53

The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

Question 54

In case of international capital budgeting, long-term currency risk can be minimized by at least partly financing the foreign investment with a dollar-denominated capital contribution from the parent company rather than in the local capital markets.

Question 55

The objective to capital rationing is to select the group of projects that provides the highest overallIRR and does not require more dollars than are budgeted.

Question 56

International capital budgeting differs from the domestic version because (1) cash inflows and outflows occur in a foreign currency, and (2) foreign investments potentially face significant political risk.

Question 57

When unequal-lived projects are independent, the length of the projects' lives is not critical.

Question 58

In the case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project could result in an incorrect decision.

Question 59

In case of international capital budgeting, the Canadian company can minimize its political risk by subtracting the investment as a joint venture and by selecting a competent and well-connected local partner.

Question 60

Generally, poor forecasts result in poor decisions no matter how thorough the analysis of thenumbers.

Question 61

The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given projectto compensate the firm's owners adequately, thereby resulting in the maintenance or improvementof share price.

Question 62

The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single point estimate.

Question 63

In international trade, transfer prices are prices that subsidiaries charge each other for the goods and services traded between them.

Question 64

Scenario analysis is an approach that uses a number of possible values for a given variable in order to assess its impact on a firm's return.

Question 65

Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

Question 66

When unequal-lived projects are independent, the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

Question 67

The risk-adjusted discount rate (RADRs) are the risk-adjustment factors that represent the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

Question 68

The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

Question 69

The annualized net present value approach converts the net present value of unequal-livedprojects into an equivalent annual amount (in NPV terms) that can be used to select the best project.

Question 70

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated can increase the market value of that project's cash flow.

Question 71

Projects with a small chance of being acceptable and a broad range of expected cash flows are more risky than projects having a high chance of being acceptable and a narrow range of expected cash flows.

Question 72

The firm's objective is to use its budget to generate the highest internal rate of return for its cash inflows.

Question 73

Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign country.

Question 74

When firms ignore real options in the capital budgeting process, they undervalue capital projects.

Question 75

The breakeven cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

Question 76

Forecasting the future can be done with relative certainty if a person makes the effort.