Question 1

Other things held constant,if a firm takes on a project that increases its beta coefficient,unless the increased beta is offset by a higher expected return,the firm's stock price will decline.

Accepted Answer

If a firm takes on a project that increases its beta coefficient, it means that the firm is taking on more systematic risk. Investors generally require a higher return for holding such risky assets. If the firm does not offset the increased beta with a higher expected return, investors may sell off their shares, causing the stock price to decline.

Question 2

If a project is small relative to the total firm,and if its returns are not highly correlated with the returns on the firm's other assets,then the project may not be very risky in either the within-firm (corporate)or the market risk sense,even if the returns on the project are highly uncertain and thus the project has a high degree of stand-alone risk.

Accepted Answer

Since the project is small relative to the total firm and its returns are not highly correlated with the returns on the firm's other assets, the project may not contribute significantly to the overall risk of the firm. Therefore, while the project may have a high degree of stand-alone risk (uncertainty of returns), it may not be very risky in the within-firm (corporate) or market risk sense.

Question 3

As a practical matter,it is much easier to use market risk analysis at the project level than at the divisional level because it is easier to estimate the beta of a single project such as a machine tool die maker than the beta of an entire division (or subsidiary)such as Phillip Morris' Kraft foods unit.

Accepted Answer

Market risk analysis can be more complex at the project level because estimating the beta of a single project requires isolating its specific risks and how it correlates with the market, which can be challenging. At the divisional level, such as Phillip Morris' Kraft Foods unit, the diversification of projects and activities can make it easier to estimate beta as it reflects a broader range of operations and their combined market risks.

Question 4

Opportunity costs include those cash inflows that could be generated from assets the firm already owns,if those assets are not used for the project being evaluated.

Accepted Answer

Opportunity costs refer to the potential benefits that are lost when choosing one alternative over another. In the context of a business project, opportunity costs could include the cash inflows that the firm could receive if they choose not to invest their assets in the project under evaluation. Therefore, the statement is true.

Question 5

The NPV and IRR methods,when used to evaluate an independent project,will lead to different accept/reject decisions unless the IRR is greater than the required rate of return.

Accepted Answer

The NPV and IRR methods, when used to evaluate an independent project, will always lead to the same accept/reject decision regardless of the size or timing of cash flows. Therefore, the statement is false. However, if the IRR is greater than the required rate of return, it would still be a favorable investment according to both methods.

Question 6

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1)capital budgeting decisions must be based on accounting income,and (2)only incremental cash flows are relevant to accept/reject decisions.

Accepted Answer

The two cardinal rules which financial analysts follow to avoid capital budgeting errors are actually: (1)capital budgeting decisions must be based on cash flows, not accounting income, and (2)only incremental cash flows are relevant to accept/reject decisions.

Question 7

In capital budgeting analyses,it is possible that NPV and IRR will both involve assuming reinvestment of the project's cash flows at the same rate.

Accepted Answer

When calculating NPV and IRR, it is assumed that any cash flows generated by the project will be reinvested at the same rate. This is because both NPV and IRR are based on the concept of time value of money, which assumes that the value of money changes over time due to factors such as inflation, interest rates, and opportunity cost. Therefore, in order to accurately determine the profitability of a project, both NPV and IRR need to assume a consistent reinvestment rate.

Question 8

The main reason that the NPV method is regarded as being conceptually superior to the IRR method for evaluating mutually exclusive investments is that multiple IRRs may exist.

Accepted Answer

The main reason is that NPV directly measures the increase in value to the firm, taking into account the scale of the investment and the time value of money, whereas IRR does not always provide a clear comparison when projects have different scales or cash flow patterns. Multiple IRRs can be an issue but are not the primary reason for NPV's conceptual superiority.

Question 9

Superior analytical techniques,such as NPV,used in combination with adjustments to the average required rate of return,can overcome the problem of poor cash flow estimation in decision making.

Accepted Answer

Superior analytical techniques and adjustments to the average required rate of return can improve decision-making but cannot fully overcome the fundamental problem of poor cash flow estimation, as the accuracy of the analysis is heavily dependent on the quality of the cash flow projections.

Question 10

Capital budgeting is process of planning expenditures on assets whose cash flows are expected to end in less than one year.

Accepted Answer

Capital budgeting is actually the process of planning and evaluating long-term investments or expenditures on assets whose cash flows are expected to be received over a period of more than one year.

Question 11

Sensitivity analysis measures the stand-alone risk of a project by showing how much the project's NPV is affected by a small change in one of the input variables,such as sales.Other things held constant,with the independent variable graphed on the horizontal axis,the steeper the graph of the relationship line,the less risky the project.

Accepted Answer

The statement in the first sentence about sensitivity analysis measuring stand-alone risk and showing how much the project's NPV is affected by a small change in one input variable is true. However, the statement in the second sentence about the steepness of the relationship line being related to project risk is false. In fact, the opposite is true - the less steep the line, the less risky the project, because it means that a small change in the input variable has less impact on the project's NPV.

Question 12

Many firms use more than one technique to evaluate capital budgeting projects because multiple measures can provide decision makers with somewhat different pieces of relevant information.

Accepted Answer

This statement is true. Different capital budgeting techniques can provide decision makers with different types of information, such as a project's profitability, risk, liquidity, and payback period. By using multiple measures, firms can get a more comprehensive picture of a project's potential value and make a more informed decision.

Question 13

Suppose a firm is considering production of a new product whose projected sales include sales that will be taken away from another product the firm also produces.The lost sales on the existing product are a sunk cost and are not a relevant cost to the new product.

Accepted Answer

The lost sales on the existing product are considered an opportunity cost, not a sunk cost, and are relevant to the decision about producing the new product because they represent the cost of the foregone opportunity to make sales from the existing product.

Question 14

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 recommended for such projects instead of cash flow analysis.

Accepted Answer

While estimating revenues and costs for large, complex projects is indeed challenging, cash flow analysis, along with other objective financial models, is crucial for making informed decisions. Subjective judgment can complement these analyses but should not replace them.

Question 15

Small businesses probably make less use of the DCF capital budgeting techniques than large businesses.This may reflect a lack of knowledge on the part of small firms' managers,but it may also reflect a rational conclusion that the costs of using DCF analysis outweigh the benefits of these methods for those firms.

Accepted Answer

Small businesses may not have the resources or knowledge to effectively use DCF capital budgeting techniques, and they may not see the benefits of investing in these methods for their smaller projects.

Question 16

The change in net working capital is always positive,meaning more working capital is required,for projects considered in capital budgeting because all projects are either expansion projects or replacement projects which have expansion effects.

Accepted Answer

The change in net working capital can be positive or negative depending on the nature of the project. Expansion projects may require an increase in working capital, leading to a positive change, while replacement projects may not require additional working capital, leading to a negative change or no change at all.

Question 17

The net present value of a replacement item of equipment will decrease if the current market value of the equipment to be replaced is increased,other things held constant.

Accepted Answer

The answer of The net present value of a replacement...

Question 18

Assume the following: (1)A firm is considering two projects,one with a 5-year life and the other with a 10-year life;(2)the cash flows of the two projects are equally risky by all definitions of the word "risky";(3)the company uses 40 percent debt and 60 percent equity to finance the projects;(4)the debt used to finance any given project has a maturity equal to the life of the project;and (5)the term structure of interest rates has a sharp upward slope.This would suggest,other things held constant,that a lower discount rate should be used to find the NPV for the 5-year project than for the 10-year project.

Accepted Answer

Given the sharp upward slope in the term structure of interest rates, longer-term debt (for the 10-year project) would have a higher interest rate compared to shorter-term debt (for the 5-year project). However, the discount rate for a project is influenced by the cost of capital, which includes the cost of debt. Since the cost of debt for the 10-year project would be higher due to higher interest rates associated with longer maturities, the discount rate applied to the 10-year project should be higher, not lower, compared to the 5-year project.

Question 19

The IRR of normal Project X is greater than the IRR of normal Project Y,and both IRRs are greater than zero.Also,the NPV of X is greater than the NPV of Y at the required rate of return.If the two projects are mutually exclusive,Project X should definitely be selected,and the investment made,provided we have confidence in the data.Put another way,it is impossible to draw NPV profiles that would suggest not accepting Project X.

Accepted Answer

While Project X has a higher IRR and NPV at a specific discount rate, NPV profiles could intersect, meaning that at different discount rates, Project Y could have a higher NPV. The decision depends on the discount rate relative to the IRRs.

Question 20

It is possible with a replacement project that the incremental depreciation cash flows will be negative even if the actual depreciation on the new asset is positive.

Accepted Answer

This can happen if the incremental increase in operating cash flows from the new asset is not sufficient to cover the higher depreciation expense. In other words, the additional revenue or cost savings from the replacement project may not be enough to offset the higher depreciation expense, resulting in a negative net cash flow from depreciation.

Quiz 13: Capital Budgeting