Deck 13: Capital Budgeting and Risk

Question 1

In a simulation analysis, a model is simulated on a computer program and run through several iterations. The results of these iterations are used to _____.

A) plot a required rate of return value profile
B) compute a mean and a standard deviation of returns
C) provide the decision maker with a measure of beta risk
D) plot the coefficient of variation of the annual net cash flows

Answer 1

B

Question 2

Total project risk is ______.

A) the contribution a project makes to the risk of the firm
B) measured by the correlation coefficient
C) the chance that a project will perform below expectations
D) measured by the project's beta

Answer 2

C

Question 3

A major disadvantage of the risk-adjusted discount rate approach is that it _____.

A) can lead to selecting only above-average risk projects
B) provides the decision maker with a range of numbers
C) can lead to selecting only below-average risk projects
D) is difficult to estimate the appropriate risk premium for a project

Answer 3

D

Question 4

Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive the ____ is to changes in a particular variable.

A) probability
B) return distribution
C) net present value
D) standard deviation

Question 5

The discount rate used in calculating the certainty equivalent net present value is the ______.

A) risk-adjusted discount rate
B) cost of capital
C) risk-free rate
D) cost of equity capital

Question 6

The subjective approach to determining risk-adjusted discount rates _____.

A) uses the risk-free rate for average-risk projects
B) explicitly considers the probability distribution of a project's cash flows
C) always leads to the correct investment decisions
D) groups projects into risk classes and evaluates all projects in a particular risk class at the same risk-adjusted discount rate

Question 7

The use of sensitivity analysis requires that _____.

A) all variables affecting NPV be defined
B) probability distributions of the determinants of a project's cash flows be estimated
C) the firms have access to a very large computer
D) the firm is greatly interested in the portfolio risk reduction characteristics of a project

Question 8

A firm's leveraged beta will always be ____ its unleveraged beta.

A) less than
B) greater than
C) the same as
D) None of these are correct

Question 9

A major problem with using the risk-adjusted discount rate approach is the determination of _____.

A) the beta value for the firm
B) the firm's weighted cost of capital
C) the firm's required rate of return
D) beta values for individual projects

Question 10

When analyzing a sensitivity curve, the ____ the slope, the more sensitive the net present value is to a change in the computed variable.

A) more negative
B) steeper
C) more general
D) smaller

Question 11

The certainty equivalent factors used to adjust the cash flows for risk can range from _____.

A) -1 to +1
B) 0 to infinity
C) +0.01 to +0.99
D) 0 to +1.0

Question 12

Which of the following techniques can be used to analyze total project risk?

A) net present value/payback approach
B) risk-adjusted discount rate approach
C) simulation analysis
D) All of these are correct

Question 13

The risk-adjusted discount rate approach is preferable to the weighted cost of capital approach when ______.

A) all projects have the same risk characteristics
B) the risk-free rate is known with certainty
C) the projects under consideration have different risk characteristics
D) the firm is unlevered

Question 14

The certainty equivalent approach adjusts the ____ for risk in the ____ of the net present value equation.

A) net cash flows; numerator
B) risk-free rate; numerator
C) required return; numerator
D) net cash flows; denominator

Question 15

Simulation techniques are _____.

A) cheap to apply
B) widely used
C) mostly beneficial for large projects
D) identical to sensitivity analysis

Question 16

The basic capital budgeting decision models (that is NPV and IRR) handle risk by _____.

A) ignoring it
B) assuming all cash flows are known with certainty
C) assuming all projects are of average risk
D) using risk-adjusted discount rates to evaluate projects

Question 17

The ____ the amount of debt in a firm's capital structure, the ____ will be the firm's beta.

A) larger; larger
B) smaller; larger
C) larger; smaller
D) smaller; smaller

Question 18

The net present value/payback approach is a useful approach when _____.

A) screening projects characterized by rapid technological advances
B) cash flow estimates are known with certainty
C) the more risky cash flows occur during the startup period
D) None of these are correct

Question 19

Project C has been classified into risk class II by the analyst of a major firm. The risk premium required for projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%. If the project has an estimated return of 20%, the analyst would recommend _____.

A) accepting project C
B) rejecting project C
C) re-estimating the risk premiums for class II projects
D) None of these are correct

Question 20

All of the following are advantages of the NPV/payback approach to risk analysis EXCEPT it ______.

A) is easy and inexpensive to apply
B) considers a project's liquidity
C) explicitly considers the variability of a project's return
D) is consistent with the notion that risk increases with futurity

Question 21

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?

A) 14.9%
B) 15.4%
C) 14.0%
D) 12.0%

Question 22

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

A) certain return; risky return
B) risky return; certain return
C) certain return; beta
D) beta, risky return

Question 23

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?

A) 99.38%
B) 0.62%
C) 34.5%
D) 49.38%

Question 24

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

A) net present value
B) internal rate of return
C) risk-adjusted discount rate
D) certainty equivalent

Question 25

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

A) 13.05%
B) 16.20%
C) 12.25%
D) 15.00%

Question 26

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.

A) 1.65%
B) 95.1%
C) 4.95%
D) Cannot be determined

Question 27

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

A) systematic; systematic
B) unsystematic; unsystematic
C) total; total
D) systematic, total

Question 28

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

A) objectively
B) subjectively
C) using regression analysis
D) objectively and by using regression analysis

Question 29

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

A) risk-adjusted discount rate
B) NPV/payback
C) certainty equivalent
D) economic life

Question 30

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?

A) 1915%
B) 69.15%
C) 0.13%
D) 30.85%

Question 31

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. Assuming Faris's tax rate is 40 percent, estimate the levered beta for the new product division.

A) 2.44
B) 1.14
C) 2.74
D) 3.88

Question 32

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

A) 1.01
B) 1.53
C) 0.93
D) 1.13

Question 33

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

A) total project risk
B) beta (systematic) risk
C) unsystematic risk
D) both total project and beta risk

Question 34

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

A) exchange rate risk
B) cash flows that can be expected to be received by the parent
C) greater uncertainty associated with tax rates in the host country
D) All of these are correct

Question 35

Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30 percent equity. The leveraged 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?

A) 14.77%
B) 10.33%
C) 18.1%
D) 1.03%

Question 36

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?

A) Yes, since NPV = $10,096
B) Yes, since NPV = $9,896
C) No, since NPV = -$5,276
D) No, since NPV = -$9,896

Question 37

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

A) sensitivity analysis method
B) simulation approach
C) net present value/payback method
D) risk-adjusted discount rate approach

Question 38

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

A) sensitivity analysis
B) simultaneous equations
C) scenario analysis
D) RADR analysis

Question 39

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?

A) 89.44%
B) 10.56%
C) 39.44%
D) 21.19%

Question 40

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?

A) 25.6%
B) 14.9%
C) 10.4%
D) 19.9%

Question 41

The Bull Company, a lawn mower manufacturer, is considering the introduction of a new model. The initial outlay required is $22 million. Net cash flows over the 4-year life cycle and the corresponding certainty-equivalents of the new model are as follows: $$\begin{array} { l l l } \text { Year } & \text { Net Cash Flow } & \text { Certainty-equival ent } \\1 & \$ 15 \text { million } & 0.90 \\2 & 13 \text { million } & 0.75 \\3 & 11 \text { million } & 0.55 \\4 & 9 \text { million } & 0.30\end{array}$$ ? The firm's cost of capital is 14%, and the risk-free rate is 6%. Bull uses the certainty-equivalent approach in evaluating above-average risk investments such as this one. What is the project's certainty-equivalent NPV?

A) $20,083,000
B) $6,628,400
C) $13,905,000
D) $3,019,400

Question 42

The type of analysis that models some event and requires that estimates be made of the probability distribution of each cash flow element is _____.

A) scenario
B) sensitivity
C) simulation
D) net present value/payback approach

Question 43

The certainty equivalent approach is a risk evaluation technique. Which of the following statements is (are) correct?
I. Certainty equivalents adjust the cash flows in the numerator of the NPV equation.
II. Using the RADR involves adjustments to the denominator of the NPV equation.

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 44

All of the following are correct statements about a project's total risk EXCEPT _____.

A) undiversified investors are concerned about the company's future outlook
B) it becomes the relevant risk when the project's returns are correlated to the returns from the firm as a whole
C) total project risk can be measured by calculating standard deviation
D) total project risk is irrelevant when forecasting a company's chance of bankruptcy

Question 45

Billy Bob is considering building a water slide park that will require a net investment of $200,000 and yield the following net cash flows: $$\begin{array} { l l l } \text { Year } & \text { Net Cash Flows } & \text { Cert. Equiv. Factor } \\1 & \$ 120,000 & 0.90 \\2 & \$ 90,000 & 0.80 \\3 & \$ 60,000 & 0.65 \\4 & \$ 30,000 & 0.50 \\5 & \$ 10,000 & 0.30\end{array}$$ ? If the risk-free rate is 8 percent and the market risk premium is 6 percent, what is the certainty equivalent NPV for this project?

A) $12,805
B) $5,746
C) $3,703
D) $11,025

Question 46

Given the following cash flows and certainty equivalent factors for an investment project, determine the certainty equivalent net present value. The firm's cost of capital is 14% and the risk-free rate is 6%. $$\begin{array} { l l l } & \text { Cash } & \text { Certainty-Equivalent } \\\text { Year } & \text { Flow } & \text { Factor } \\0 & - \$ 100,000 & 1.00 \\1 & \$ 60,000 & 0.90 \\2 & \$ 60,000 & 0.75 \\3 & \$ 60,000 & 0.55\end{array}$$

A) $32,000
B) $18,692
C) $4,238
D) Cannot be determined

Question 47

The Chris-Kraft Co. is financed entirely with equity, and the firm has a beta of 1.25. The current risk-free rate is 7 percent, and the expected market return is 15 percent. Chris-Kraft is considering an investment project with a risk that matches the firm's average risk, requires a net investment of $70,000, and has net cash flows of $18,000 per year for 8 years. Should Chris-Kraft invest in the project?

A) Yes, since NPV = $5,726
B) Yes, since NPV = $75,726
C) No, since NPV = -$10,934
D) No, since NPV = -$5,726

Question 48

M-tel is financed entirely with equity, and the firm's stock has a beta of 0.85. M-tel is considering investing in a project that is expected to have a beta of 1.3. The project requires an initial outlay of $6 million and is expected to generate after-tax net cash flows of $1.3 million each year for 8 years. Calculate the NPV of the project. Assume the risk-free rate is 7% and the expected market return is 14%. (Note: Problem requires either calculator use or interpolation from the tables. The suggested solutions use calculator accuracy.)

A) $249,685
B) -$371,484
C) $238,700
D) -$352,800

Question 49

Rolling in Dough Cookie Corporation is trying to determine its certainty equivalent NPV. What is the CNPV if the risk free rate is 2% and the initial investment is $19,000 (rounded)? ? $$\begin{array} { l l l } \text { Year } & \text { Cash Flows } & \text { Certainty Equival ents } \\1 & \$ 15,000 & 90 \% \\2 & \$ 15,000 & 60 \% \\3 & \$ 8,000 & 50 \%\end{array}$$

A) $2,575.25
B) $6,655.10
C) $5,261.38
D) $4,215.15

Question 50

Many firms combine net present value and payback when analyzing project risk. Which of the following statements is (are) correct?
I. Both payback and net present value consider the frequency of cash flows.
II. Both payback and net present value can be adjusted for risk.

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 51

Determine the coefficient of variation for the following annual cash inflows from an investment project: $$\begin{array} { l l } \text { Cash Flow } & \\( \$ 000 ) & \text { Probability } \\\$ 2,000 & 0.10 \\\$ 2,500 & 0.20 \\\$ 3,000 & 0.30 \\\$ 3,500 & 0.20 \\\$ 4,000 & 0.20\end{array}$$

A) $624.50
B) 125.8
C) 0.201
D) Cannot be determined

Question 52

Portfolio risk is also known as _____.

A) total project risk
B) beta risk
C) market risk
D) scenario risk

Question 53

A weakness of the net present value/payback method is that _____.

A) it is a complicated calculation
B) it is subjective
C) it is directly related to the variability of returns from a project
D) because it recognizes the riskiness of various projects, it can develop multiple outcomes

Question 54

DKA uses the certainty equivalent approach to deal with total project risk and is considering a project with the following: $$\begin{array} { l l l } \text { Year } & \text { Expec. NCF } & \text { Certainty Equivalent Factor } \\0 & - \$ 60,000 & 1.0 \\1 & \$ 20,000 & 0.95 \\2 & \$ 20,000 & 0.90 \\3 & \$ 25,000 & 0.80 \\4 & \$ 30,000 & 0.65\end{array}$$ ? What is the certainty equivalent NPV for this project if the risk-free rate is 8% and the required return on the market portfolio is 15%?

A) $3,233
B) $17,743
C) -$15,243
D) $13,233

Question 55

IKON is financed entirely with equity, and its beta is 1.31. If the current risk-free rate is 6.25% and the expected market return is 12.8%, what is IKON's required rate of return on a project of average risk?

A) 8.58%
B) 14.83%
C) 17.65%
D) 12.81%

Question 56

Which of the following statements is correct about adjusting for beta risk in capital budgeting?

A) It measures unsystematic risk.
B) It is a guaranteed measure of the success of the project.
C) The beta concept can be used to determine RADR.
D) It evaluates the efficiency of the management team.

Question 57

All of the following techniques are used to measure total project risk EXCEPT _____.

A) simulation analysis
B) the profitability index
C) the certainty equivalent approach
D) the risk-adjusted discount rate

Question 58

Quick Flick is considering two investments. Both require a net investment of $120,000 and have the following net cash flows: $$\begin{array} { l l l } \text { Year } & \text { Project } \mathrm { X } & \text { Project Y } \\1 & \$ 50,000 & \$ 25,000 \\2 & \$ 40,000 & \$ 45,000 \\3 & \$ 30,000 & \$ 50,000 \\4 & \$ 25,000 & \$ 60,000 \\5 & \$ 20,000 & \$ 70,000\end{array}$$ ? Quick uses a combination of the net present value approach and the payback approach to evaluate investment alternatives. The firm uses a discount rate of 14 percent and requires that all projects have a payback period no longer than 3 years. Which investment or investments should Quick accept?

A) only Project X
B) only Project Y
C) both projects X and Y
D) reject both projects

Question 59

MedChem has a capital structure of 60% equity and 40% debt and a current beta of 1.2. MedChem is considering an investment project in a new line of business that has an expected internal rate of return of 16%. The typical firm already in the line of business that MedChem is considering expanding into has a beta of 1.5 and a capital structure that has 55% debt and 45% equity. The marginal tax rate for all these firms, including MedChem, is 40%. If the current risk-free rate is 7% and the expected market risk premium is 8%, should MedChem expand into the new line? Assume that MedChem will retain its current capital structure.

A) expand if after-tax cost of debt is 11.5% or less
B) expand if after-tax cost of debt is 15% or less
C) expand if after-tax cost of debt is 10.4% or less
D) do not expand

Question 60

American Biodyne (AB) is considering expanding into a new line of business. The expansion will require an investment of $500,000 in new equipment. This equipment, which will cost another $300,000 to install, will be depreciated on a straight-line basis over an 8-year period to an estimated salvage value of zero. If the expansion project is accepted, working capital will increase by $100,000 immediately. Revenues for the first 3 years are forecasted at $650,000 per year and at $800,000 in years 4-8. Operating costs exclusive of depreciation are expected to be $310,000 per year for 3 years and increase to $400,000 per year for the following 5 years. AB has a marginal tax rate of 40%, and its required rate of return for the project under consideration is 16%. If AB assumes that the new equipment will have an actual market value of $50,000 at the end of the 8th year, should the expansion be undertaken?

A) Yes, as NPV = $275,114
B) Yes, as NPV = $265,964
C) Yes, as NPV = $302,934
D) Yes, as NPV = $272,434

Question 61

All of the following are methods of adjusting a project for total risk EXCEPT _____.

A) sensitivity analysis
B) the carpe diem approach
C) the certainty equivalent approach
D) simulation analysis

Question 62

How can beta, a measure of systematic risk of a portfolio of securities, be used to judge the risk of a firm?

Question 63

____ are needed for sensitivity analysis and have made the application simple and inexpensive.

A) Risk tolerance tables
B) Financial statements
C) Financial calculators
D) Computer spreadsheets

Question 64

Which of the following is (are) a risk associated with projects that must be considered when determining the net present value?
I. Financial risk
II. Pure project risk

A) Only statement I is correct.
B) Only statement II is correct.
C) Both statements I and II are correct.
D) Neither statement I nor II is correct.

Question 65

Determine the pure project beta of a project that has 45% debt and 55% equity. The beta for the company is 1.6, and it has a tax rate of 40%.

A) 1.82
B) 1.82
C) 1.07
D) 2.07

Question 66

What item has made sensitivity analysis simple and inexpensive?

A) computer accounting software
B) computer spreadsheet software
C) computer webinars
D) computer video and presentation software

Question 67

Determine the pure project beta of a project that has 30% debt and 70% equity. The beta for the company is 1.4, and it has a tax rate of 40%.

A) 1.11
B) 1.56
C) 1.83
D) 1.05

Question 68

The risk-adjusted discount rate approach is considered preferable to the weighted cost of capital approach in determining the net present value of a project when the projects under consideration differ significantly in _____.

A) the number of cash flows generated by the projects
B) their total return
C) their cash inflows
D) their risk characteristics

Question 69

The risk of an investment project is defined in terms of the potential ____ of its returns.

A) certainty
B) size
C) variability
D) timing

Question 70

What are the primary advantages and disadvantages of applying simulation to capital budgeting risk analysis?

Question 71

How and when should firms consider employing additional risk analysis techniques in judging the suitability of large projects prior to implementation?

Question 72

Haulin' It Towing Company is considering adding more tow trucks to its fleet. The cost of the new trucks is $150,000. The project will utilize the risk adjusted discount, the firm has a beta of 1.3, the risk-free rate is 7%, and the return in the market is 15%. Should Haulin' It add the additional trucks if the expected increased revenues will be as follows? ? $$\begin{array} { | l | l | } \hline \text { Years } & \text { Cash Flows } \\\hline \hline 1 & \$ 80,000 \\\hline \hline 2 & \$ 95,000 \\\hline \hline 3 & \$ 110,000 \\\hline\end{array}$$

A) No, the NPV of the project is -$15,175.19.
B) Yes, the NPV of the project is $75,275.16.
C) No, the NPV of the project is -$9,765.12.
D) Yes, the NPV of the project is $55,050.92.

Question 73

Smart Bumpkins wants to increase production by adding new equipment. The cost of the upgrade is $190,000, and expected cash flows from the new upgrade are expected to be as follows over the next 6 years, and the risk-free rate is 5%. Should the company upgrade? ? $$\begin{array} { | l | l | } \hline \text { Cash Flows } & \text { Certainty Equivalents } \\\hline \$ 45,000 & 0.85 \\\hline \$ 45,000 & 0.80 \\\hline \$ 75,000 & 0.75 \\\hline 110,000 & 0.70 \\\hline \$ 110,000 & 0.60 \\\hline 110,000 & 0.50 \\\hline\end{array}$$

A) Yes, the CNPV is $195,196.06.
B) Yes, the CNPV is $83,775.16.
C) No, the CNPV is -$75,522.84.
D) No, the CNPV is -$42,175.93.

Question 74

The hurdle rate approach in determining the acceptability of projects is _____.

A) an improvement over the risk-adjusted discount rate approach because it provides for an objective basis to determine risk premiums for individual projects
B) a modification of the internal rate of return approach
C) inconsistent with the principle of project risk balancing
D) a method used with the certainty equivalent approach

Question 75

The hurdle rate is best described as the _____.

A) required rate of return
B) risk adjusted discount rate
C) net present value
D) risk free rate