Question 1

A sunk is a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected.These sunk costs are extremely important in capital budgeting decisions.

Accepted Answer

Sunk costs are not considered in capital budgeting decisions because they do not affect future cash flows and cannot be recovered.

Question 2

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

Accepted Answer

Since the asset's beta is greater than the firm's current beta, it is riskier and therefore requires a higher return to compensate for the additional risk. Using a discount rate greater than the firm's average required rate of return accounts for the increased risk and is a more appropriate way to evaluate the investment's potential returns.

Question 3

Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in income after taxes.

Accepted Answer

Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in income after taxes, making statement A true.

Question 4

With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital budgeting project.

Accepted Answer

While there are various techniques available to estimate cash flows, it still requires significant analysis and assumptions regarding market trends, economic conditions, and other factors that may impact revenue and expenses. Thus, it can be a challenging step in the capital budgeting process.

Question 5

Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of that calculated risk measure is more difficult.

Accepted Answer

Quantification of risk involves complex statistical and financial analysis to accurately measure potential risks, which is often challenging. Treatment of risk, while also complex, follows established strategies once risks are quantified.

Question 6

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

Accepted Answer

If a firm could have earned income by leasing its land, then the investment project should be charged with the opportunity cost of the lease income that could have been earned. This is because by using the land for the investment project, the firm foregoes the opportunity to earn that lease income.

Question 7

Empirical studies of risk strongly support the contention that investors who are well diversified focus exclusively on market risk when they establish required returns.

Accepted Answer

The answer of Empirical studies of risk strongly support the...

Question 8

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are riskier.

Accepted Answer

The answer of Using the same risk-adjusted discount rate to...

Question 9

Inflation does not need to be built into expected cash flows; the discount rate used in net present value calculations captures the effect of inflation.If you were to include expected inflation into cash flows, all net present value calculations would be incorrect.

Accepted Answer

Inflation should be considered when estimating expected cash flows for net present value calculations. Ignoring inflation can lead to inaccurate discount rates and incorrect NPV calculations.

Question 10

Replacement analysis involves the decision of whether to replace an existing asset that is still productive with a new asset.

Accepted Answer

Replacement analysis involves the decision to replace an existing asset that is still productive with a new asset.

Question 11

One problem with Monte Carlo simulation analysis is that, while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.

Accepted Answer

Monte Carlo simulation analysis can provide a range of possible outcomes and their probabilities, but the decision to accept or reject a project based on this analysis ultimately depends on the risk tolerance of the decision maker and other factors such as cost, time, and strategic importance.

Question 12

In cash flow estimation, the presence of externalities has no direct cash flow effects.

Accepted Answer

Externalities can have indirect cash flow effects, such as changes in demand for a product or service as a result of environmental or social factors. For example, a company that produces environmentally friendly products may attract more customers and generate higher cash flow, while a company that produces products with negative environmental effects may experience reduced demand and lower cash flow. Thus, the presence of externalities should be considered when estimating cash flows.

Question 13

When calculating the cash flows for a project, you should include interest payments.

Accepted Answer

The answer of When calculating the cash flows for a...

Question 14

The situation where a firm accepts projects to the point where the return on the last project accepted is just equal to or greater than the firm's required rate of return (IRR ≥ r at the margin) is called capital rationing.

Accepted Answer

Capital rationing refers to a situation where a firm limits its investments or projects due to external financial constraints or internal budgeting controls, not to the point where the return on the last project accepted is just equal to or greater than the firm's required rate of return.

Question 15

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Accepted Answer

Market risk is the risk that the entire market, economy, or a specific industry will decline or experience negative events that will affect all companies in that market, regardless of their individual characteristics. Uncertain cash flows, which lead to uncertain NPV and IRR, are specific to a project and do not necessarily reflect market risk. Therefore, a project may have uncertain cash flows and low market risk.

Question 16

Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.

Accepted Answer

The answer of Although it is difficult to make accurate...

Question 17

A key difference between replacement and expansion project analyses is that with replacement, the incremental cash flows are measured as the net difference between projected cash flows from the current productive assets and cash flows of the proposed new productive assets.

Accepted Answer

This statement accurately describes the key difference between replacement and expansion project analyses.

Question 18

If an asset being considered for acquisition has beta of zero, its purchase will have no effect on the firm's market risk.

Accepted Answer

The answer of If an asset being considered for acquisition...

Question 19

Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates.

Accepted Answer

Capital budgeting decisions should be based on cash flows rather than accounting income since cash is what ultimately affects a company's ability to pay dividends and invest in future projects, not reported net income.

Question 20

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR is greater than the firm's average required rate of return.

Accepted Answer

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its NPV is positive (greater than zero), not based on its IRR being greater than the firm's required rate of return. This is because NPV takes into account the time value of money and the project's riskiness, whereas IRR only considers the project's return.

Quiz 11: The Cost of Capital