Question 1

Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30 percent equity.The levered beta for this division has been estimated to be 2.02.What will be Technico's weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent?

Accepted Answer

kₑ = 0.08 + 2.02(0.05) = 0.181
k* = 0.7(0.07) + 0.3(0.181) = 0.1033 or 10.33%

Question 2

A simulation analysis for a new acquisition has indicated that the expected NPV is $50 million with a standard deviation of $40 million.Assume that NPV is normally distributed.What is the probability that the project will be unacceptable?

Accepted Answer

z = ($0 - $50,000)/$40,000 = -1.25
From Table V, p(z < -1.25) = .1056 or 10.56%

Question 3

With the risk adjusted discount rate approach, in the context of total risk, the discount rates used in evaluating cash flows are determined .

Accepted Answer

The risk adjusted discount rate approach takes into account the subjective assessment of risk by the decision maker. The discount rate used to evaluate cash flows is based on the perceived level of risk associated with the investment, which is a subjective estimation. Therefore, the choice is subjective (B). Regression analysis may be used to estimate the discount rate, but it can only provide an objective estimate of the discount rate based on historical data.

Question 4

When evaluating a capital expenditure to be made in a foreign country, the parent firm must be concerned with the

Accepted Answer

When evaluating a capital expenditure to be made in a foreign country, the parent firm must consider all of these factors. Exchange rate risk can affect the returns on the investment, cash flows that can be expected to be received by the parent are important for evaluating the profitability of the investment, and tax rates in the host country can affect the overall cost of the investment. Therefore, the best choice is D, all of these.

Question 5

The DMT Company is financed entirely with equity.DMT has a beta of 1.20 and the current risk-free rate is 9.5 percent.If the expected market return is 14 percent, what rate of return should DMT require on a project of average risk?

Accepted Answer

kₑ = 0.095 + 1.20(0.14 - 0.095) = 0.149 or 14.9%

Question 6

The risk-adjusted discount rate approach is used in the analysis of projects for which is the applicable risk measure.

Accepted Answer

The risk-adjusted discount rate approach takes into account both the total project risk and the beta (systematic) risk, as these are the factors that can impact the project's cash flows and ultimately its profitability. The approach adjusts the discount rate based on the level of risk involved, which is influenced by both total project and beta risk. Unsystematic risk, on the other hand, can be diversified away and is not considered in the risk-adjusted discount rate approach.

Question 7

A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000.Assume that NPV is normally distributed.What is the probability that the project will have a net present value greater than $60,000?

Accepted Answer

z = ($60,000 - $50,000)/$20,000 = +0.50
From Table V p(z > +0.5) = 0.3085 or 30.85%

Question 8

SCAN is a multi-divisional utility company.SCAN has four divisions with the following betas and proportions of the firm's total assets:

The risk-free rate is 8 percent and the market risk premium is 5 percent.If SCAN is considering a residential development, what should the firm use as its cost of equity in evaluating this project?

Accepted Answer

kₑ = 0.08 + 1.40(0.05) = 0.15 or 15%

Question 9

The Chris-Kraft Co.is financed entirely with equity and the firm has a beta of 1.6.The current risk-free rate is 9.5 percent and the expected market return is 16 percent.What rate of return should Chris-Kraft require on a project of average risk?

Accepted Answer

kₑ = 0.095 + 1.6(0.16 - 0.095) = 0.199 or 19.9%

Question 10

SCAN is a multi-divisional utility company.SCAN has four divisions with the following betas and proportions of the firm's total assets:
$\begin{array}{llc}
\frac{\text { Division }}{\text { Electric \& Gas }} & \frac{\text { Beta }}{0.85} & \frac{\% \text { of Assets }}{60} \
\text { Bus transportation } & 0.95 & 10 \
\text { Real estate } & 1.40 & 25 \
\text { Recreation } & 1.15 & 5
\end{array}$
What is the firm's weighted average beta?

Accepted Answer

Beta = 0.6(0.85) + 0.10(0.95) + 0.25(1.40) + 0.05(1.15) = 1.01

Question 11

The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is the

Accepted Answer

The simulation approach, often involving complex computer models to simulate a wide range of possible outcomes, is typically the most expensive method for adjusting for total project risk in capital budgeting evaluations due to its need for extensive data, computational resources, and time.

Question 12

Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division.The new division will have a capital structure of 70 percent debt and 30 percent equity.Faris has a current beta of 1.1, but is not sure what the beta for the new division will be.AMX is a firm that produces a product similar to the product under consideration by Faris.AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax rate of 40 percent.If Faris' tax rate is 40 percent, estimate the levered beta for the new product division?

Accepted Answer

βᵤ = 1.6/[1 + .6(0.4/0.6)] = 1.14
βl = 1.14[1 + .6(0.7/0.3)] = 2.74

Question 13

The approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures.

Accepted Answer

The approach being referred to here involves adjusting the discount rate used in the net present value calculation to reflect the level of risk associated with a particular project. This is known as the risk-adjusted discount rate method. The other options (A, B, D) do not involve explicitly adjusting for project risk in this way.

Question 14

The risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project is .

Accepted Answer

The risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project is scenario analysis. Sensitivity analysis only considers the impact of changes in one variable at a time, while simultaneous equations and RADR analysis are not commonly used in risk assessment techniques.

Question 15

A project has an expected net present value of $50,000 with a standard deviation of the net present value of $20,000.Assume that NPV is normally distributed.What is the probability that the project will have a negative NPV?

Accepted Answer

z = ($0 - $50,000)/$20,000 = - 2.50
From Table V, p(z < -2.5) = .0062 or 0.62%

Question 16

The certainty equivalent factors used in capital budgeting analysis are equal to the divided by .

Accepted Answer

The certainty equivalent factor is the amount of certain return that an investment must generate in order for investors to be indifferent between that return and the risky return being considered. Therefore, the certainty equivalent factor is equal to the certain return (what investors would be guaranteed to receive) divided by the risky return (what investors may actually receive).

Question 17

The of a firm is a weighted average of the of the individual assets in the firm.

Accepted Answer

The systematic risk of a firm is a weighted average of the systematic risk of the individual assets in the firm, as systematic risk is the portion of total risk that is inherent to the entire market or market segment.

Question 18

The net present value of a project is normally distributed with an expected value of $52,000 and a standard deviation of $31,515.Determine the probability that the project will have a net present value of less than zero.

Accepted Answer

P(NPV < $0) = P(Z < ($0 - $52,000)/$31,515)
= P(Z < - 1.65) = 4.95% from Table V

Question 19

Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted discount rate for its can division of 17 percent.A planned expansion in the can division requires a net investment of $170,000 and results in expected cash inflows of $42,000 a year for seven years.Should Calco invest in this expansion?

Accepted Answer

NPV = $42,000(3.922) - $170,000 = -$5,276

Question 20

With the approach, the decision maker adjusts separately each period's cash flows to account for the specific risk of those cash flows.

Accepted Answer

The certainty equivalent approach involves adjusting the cash flows themselves to reflect their risk, rather than adjusting the discount rate. This method directly modifies each period's cash flows to a "certain" equivalent value that the decision maker would be indifferent to receiving instead of the risky cash flow.

Quiz 11: Capital Budgeting and Risk