Question 1

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 answer of Suppose a firm is considering production of...

Question 2

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 is because incremental depreciation is the difference between the initial investment or book value of the old asset and the book value of the new asset. If the initial investment or book value of the old asset is higher than the book value of the new asset, the incremental depreciation will be negative even if the actual depreciation on the new asset is positive.

Question 3

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

Question 4

When considering the risk of foreign investment, higher risk could arise from exchange rate risk and political risk while lower risk might result from international diversification.

Accepted Answer

Exchange rate risk and political risk are common risks associated with foreign investment, while international diversification can help reduce risk. Therefore, higher risk is likely to arise from exchange rate and political risks, while lower risk could result from international diversification.

Question 5

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 6

The stand-alone risk is the risk an asset would have if it were a firm's only asset and it is measured by the variability of the asset's expected returns.

Accepted Answer

The definition of stand-alone risk is accurate. It refers to the risk that an individual asset faces when considered in isolation or as part of a diversified portfolio, rather than in relation to the broader market or economy.

Question 7

The change in net working capital associated with a capital project may actually result in a decrease in the firm's current funding requirement, which frees up cash flows for investment.

Accepted Answer

A decrease in net working capital would mean that the firm has less current assets tied up in operations, which could lead to a decrease in the firm's current funding requirement. This would free up cash flows for investment in other projects.

Question 8

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

The sharp upward slope of the term structure of interest rates means that interest rates are expected to rise in the future. Therefore, the cost of capital for the 10-year project will be higher than that for the 5-year project. This is due to the fact that the company will have to borrow money at higher interest rates to finance the longer-term project, and as a result, the cost of equity will also be higher. Consequently, a lower discount rate should be used to find the NPV for the 5-year project than for the 10-year project.

Question 9

When evaluating a new project, the firm should consider all of the following factors except:
A)Changes in working capital attributable to the project.
B)Previous expenditures associated with a market test to determine the feasibility of the project, if the expenditures have been expensed for tax purposes.
C)The current market value of any equipment to be replaced.
D)The resulting difference in depreciation expense if the project involves replacement.
E)All of the above should be considered.

Accepted Answer

All of the factors listed in choices A, C, and D are important considerations when evaluating a new project. However, choice B - previous expenditures associated with a market test - is not relevant to the evaluation of a new project as it pertains to costs already incurred.

Question 10

Corporate risk does not take into consideration the effects of stockholder's diversification; it is measured by a project's effect on the firm's earnings variability.

Accepted Answer

Corporate risk focuses on the impact of a project's earnings variability on the overall company, regardless of the stockholder's diversification.

Question 11

The beta risk of a project is that part of the project's that cannot be eliminated by diversification.Investors are not concerned about this type of since it can not be diversified.

Accepted Answer

The answer of The beta risk of a project is...

Question 12

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 13

The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky.

Accepted Answer

The cost of capital is determined by the risk associated with the project. Foreign projects may have higher or lower risks due to factors such as political instability, currency exchange rates, and unfamiliar legal systems. Therefore, the cost of capital for a foreign project may be different than for an equivalent domestic project.

Question 14

Expansion project analysis requires determining the amount of incremental cash as a result of the expansion relative to the cash flows if the expansion project was not accepted.The incremental cash flows will always be discounted at the same rate as the firm's original cash flows sine we are simply expanding the firm and not changing the risk of the firm.

Accepted Answer

The discount rate should reflect the risk of the incremental cash flows, which may differ from the firm's original cash flows, especially if the expansion changes the risk profile.

Question 15

Which of the following is not a cash flow that results from the decision to accept a project?
A)Changes in working capital.
B)Shipping and installation costs.
C)Sunk costs.
D)Opportunity costs.
E)Externalities.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered regardless of the project decision. They are not cash flows that result from accepting a project. The other options listed (Changes in working capital, Shipping and installation costs, Opportunity costs, Externalities) are all cash flows that could result from the decision to accept a project.

Question 16

Sensitivity analysis is a risk analysis technique in which key variables are changed and the resulting changes in the
NPV and IRR are observed.

Accepted Answer

This is a correct definition of sensitivity analysis.

Question 17

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 is incorrect. The steeper the graph of the relationship line, the more sensitive the project is to changes in that input variable, and therefore the riskier the project.

Question 18

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

If a project is small relative to the total firm and 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 or the market risk sense, even if the returns on the project are uncertain, and the project has a high degree of stand-alone risk. Therefore, the statement is true.

Question 19

The cash flows relevant for the analysis of a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company and the cash flows which must remain in the foreign country.

Accepted Answer

The answer of The cash flows relevant for the analysis...

Question 20

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.

Quiz 11: The Cost of Capital