Question 1

A major difference between capital budgeting for domestic operations and foreign operations is that:

Accepted Answer

Estimating cash flows generated from foreign operations is more complex due to fluctuating exchange rates. This is because the conversion of foreign currency back to the domestic currency can create volatility in cash flows, making it challenging for companies to accurately estimate the future cash flows generated by their foreign operations.

Question 2

A sunk cost is a cash outlay that has already been incurred. But, it is a cost that can be recovered if a capital budgeting project is purchased. Consequently, these sunk costs are extremely important in capital budgeting analyses.

Accepted Answer

Sunk costs are costs that have already been incurred and cannot be recovered, and therefore, should not be considered in capital budgeting analyses.

Question 3

Investment in foreign subsidiaries is less risky when:

Accepted Answer

Geographical or global diversification spreads the risk across different countries and can reduce the impact of political instability, exchange rate fluctuations, and other risks specific to one location. It also allows for a more balanced portfolio and the potential to benefit from growth opportunities in multiple markets. Therefore, investment in foreign subsidiaries is less risky when the subsidiaries are globally diversified. The other options all pose significant risks and can increase the overall risk of investing in foreign subsidiaries.

Question 4

Multinational companies can reduce the chance of a loss from expropriation by:

Accepted Answer

Obtaining insurance against economic losses associated with expropriation can provide multinational companies with protection against the potential loss of their investments due to expropriation. This can provide a sense of security for the company and its investors, and may also provide investment incentives for the host country. The other choices (increasing required rate of return, establishing subsidiaries in restrictive countries, financing with host country funds, and investing all funds in a single subsidiary) are not effective strategies for reducing the risk of expropriation.

Question 5

The process of sending cash from a foreign subsidiary back to the parent company is known as _____.

Accepted Answer

The process of sending cash from a foreign subsidiary back to the parent company is known as repatriation of earnings. Option A refers to a financial analysis technique used to determine the value of an investment. Option B refers to the exchange of political favors between governments or political parties. Option C refers to the shifting of earnings from one country to another to minimize taxes. Option D refers to the process of allocating financial resources within a company.

Question 6

Because stockholders are very concerned with the "bottom-line" net income that the firm generates, capital budgeting decisions should be based on the accounting income a project generates.

Accepted Answer

Capital budgeting decisions should not solely be based on accounting income as it does not fully reflect the cash flows and timing of the project's costs and benefits. Cash flows and their timing should be the primary basis for these decisions.

Question 7

A firm that is considering purchasing a capital budgeting project with a beta coefficient greater than the firm's current beta coefficient should evaluate the project using a risk-adjusted required rate of return that is greater than the firm's existing (average) required rate of return.

Accepted Answer

This is because the capital budgeting project with a higher beta coefficient is considered to be riskier than the firm's existing portfolio of assets. Therefore, the firm should account for this additional risk by using a higher risk-adjusted required rate of return when evaluating the project.

Question 8

A key difference between a replacement project analysis and an expansion project analysis is that the net present value (NPV) technique that is used to evaluate capital budgeting projects should only be used to evaluate expansion projects, whereas either the NPV technique or the internal rate of return (IRR) technique can be used to evaluate replacement projects.

Accepted Answer

This statement is incorrect. Both the NPV and IRR techniques can be used to evaluate both replacement and expansion projects. The choice of technique will depend on the specific circumstances of each project.

Question 9

If a capital budgeting project has very uncertain cash flows, the Monte Carlo simulation technique can be used to measure its net present value (NPV) for a worst-case scenario, a best-case scenario, and a base-case scenario.

Accepted Answer

The answer of If a capital budgeting project has very...

Question 10

Quantification of risk is difficult, and there are different types of risks, such as stand-alone risk, market risk, and political risk, associated with capital budgeting projects. Sensitivity analysis is a good technique to use when measuring market risk, but not when measuring stand-alone risk.

Accepted Answer

Sensitivity analysis is a useful technique for measuring both stand-alone risk and market risk, as it helps in understanding how changes in one variable affect the project's outcome, applicable to various types of risks.

Question 11

A major problem with Monte Carlo simulation analysis is that while the analysis provides insights into the riskiness of a project, it does not lead to a clear-cut accept/reject decision.

Accepted Answer

Monte Carlo simulation can provide information on the range of possible outcomes and their probabilities but ultimately, the decision to accept or reject a project involves various other factors such as the organization's risk appetite and strategic objectives.

Question 12

According to the capital asset pricing model (CAPM), a capital budgeting project that has a beta equal to zero should be evaluated using a required rate of return equal to the risk-free rate.

Accepted Answer

According to CAPM, the required rate of return for a security or project is equal to the risk-free rate plus a premium equal to the product of the security's beta (systematic risk) and the market risk premium. However, if the project's beta is zero (which would indicate no systematic risk), then the project would have no additional required return beyond the risk-free rate. Therefore, the answer is A.

Quiz 10: Project Cash Flows and Risk