Question 1

The most relevant measure of risk for capital budgeting is project standing alone risk.

Accepted Answer

The most relevant measure of risk for capital budgeting is not project standing alone risk, but rather the project's contribution to the overall risk of the company. This is known as the project's corporate risk, which takes into account the project's impact on the company's overall risk and diversification. Therefore, the answer is false, and the relevant measure of risk for capital budgeting is corporate risk.

Question 2

A project's contribution to firm risk is relevant for undiversified investors or when bankruptcy costs exist.

Accepted Answer

A project's contribution to firm risk matters for undiversified investors who do not have a sufficiently diversified portfolio to offset the risk of a single project. Additionally, bankruptcy costs may be higher for firms with riskier projects, making the contribution to firm risk even more significant.

Question 3

A wildcat oil driller has enough capital to invest in only one project,that is,to drill one well in an East Texas oil field.A major oil company is drilling 100 wells in the same field.The probability of successfully striking oil is 10% for any well drilled in this field.Which of the following statements is most correct concerning the risk involved in these capital budgeting projects?

Accepted Answer

The best measure of risk for the wildcat oil driller is project standing alone risk because the driller has only one project, and the success of that project will determine the success or failure of the entire venture. The major oil company, on the other hand, is diversified across multiple projects and wells, which would make contribution-to-firm risk more appropriate for measuring their overall risk. Systematic risk is a measure of the risk associated with the overall market and would not be appropriate in this case. Therefore, option D is the most appropriate choice.

Question 4

A project's contribution-to-firm risk does allow for diversification within the firm.

Accepted Answer

Contribution-to-firm risk refers to the risk of a project impacting the overall performance or success of the firm. By diversifying the firm's projects or investments, the contribution-to-firm risk can be reduced, as the failure of one project is offset by the success of others. Therefore, diversification within the firm can help manage contribution-to-firm risk.

Question 5

Which of the following is the most relevant measure of risk for capital budgeting purposes?

Accepted Answer

Contribution-to-firm risk is the most relevant measure of risk for capital budgeting purposes because it considers the impact of the project on the entire firm and takes into account the diversification benefits of the firm's existing portfolio. Project standing alone risk, symbiotic risk, and unsystematic risk are all important factors to consider, but they do not provide a comprehensive view of the risk associated with a specific project.

Question 6

Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net worth.When considering capital budgeting projects for their boutiques,the appropriate measure of risk is

Accepted Answer

Since Bill and Mary's net worth is almost entirely invested in their boutiques, the appropriate measure of risk is contribution-to-firm risk, which considers the impact of a project on the overall risk of the entire company. Options A and D are incorrect because they only consider the risk of the project itself, while option B (systematic risk) is more appropriate for diversified portfolios and not relevant for a company that represents a large proportion of an individual's net worth.

Question 7

The pure play method

Accepted Answer

The pure play method uses the beta of a firm that is similar to the project being analyzed to determine the required rate of return for the project. This firm is often referred to as a "pure play" since it operates exclusively in the same industry or line of business as the project being analyzed. By using the beta of a pure play, the method can better account for the risks and opportunities specific to the project, resulting in a more accurate estimate of the required rate of return.

Question 8

A method for estimating a project's beta that attempts to identify publicly traded firms engage solely in the same business as the project is called the pure play method.

Accepted Answer

The pure play method is a commonly used method for estimating a project's beta. It involves identifying publicly traded firms that operate solely in the same business as the project and using their betas as a proxy for the project's beta. This method is considered more accurate than other methods because it ensures that the companies used for comparison are similar in terms of business operations and risk.

Question 9

Financial theory assumes that individuals are risk averse.

Accepted Answer

Financial theory assumes that individuals are risk averse, meaning that they prefer less risk and greater certainty when making financial decisions. This is why investors typically demand a higher return for taking on greater risk in their investment portfolios.

Question 10

The less-risky investment is always the more desirable choice.

Accepted Answer

The desirability of an investment depends on the investor's risk tolerance, investment goals, and the potential return. Higher-risk investments often offer the possibility of higher returns, making them more desirable for some investors.

Question 11

Interest expenses are not included as incremental free cash flows because the cost of funds is recognized as cash flows are discounted back to present value.

Accepted Answer

Interest expenses are already accounted for in the discount rate used to calculate the present value of future cash flows.

Question 12

A bakery company is considering one capital budgeting project involving the replacement of a sophisticated brick oven,and another capital budgeting project involving research and development into synthetic food substitutes.Which of the following statements is most correct concerning the risk-adjusted discount rate(s)for the projects?

Accepted Answer

The risk-adjusted discount rate is higher for the research and development project because of the uncertainty involved with such projects. These types of projects are inherently riskier because there is no guarantee that the research will lead to a successful product or technology. On the other hand, replacing an existing oven is a relatively straightforward project with a higher likelihood of success, and the returns are more certain. Thus, the risk-adjusted discount rate for the replacement project may be lower. The fact that both projects are being considered by the same company with the same shareholders is not relevant to the determination of the risk-adjusted discount rate.

Question 13

If bankruptcy costs and/or shareholder underdiversification are an issue,what measure of risk is relevant when evaluating project risk in capital budgeting?

Accepted Answer

Contribution-to-firm risk is the most relevant measure of risk in this case as it takes into account the impact of the project on the overall risk of the company, including the potential bankruptcy costs and shareholder underdiversification. Total project risk and systematic risk are useful measures but do not specifically address these concerns. Capital rationing risk is not directly related to the issue at hand.

Question 14

The use of risk-adjusted discount rates is based on the concept that investors require a higher rate of return for more risky projects.

Accepted Answer

Risk-adjusted discount rates take into account the level of risk associated with a project and adjust the discount rate accordingly to compensate investors for taking on more risk. This concept recognizes the fact that investors generally require a higher return for more risky investments.

Question 15

Which of the following statements about project standing alone risk is true?

Accepted Answer

Project standing alone risk only focuses on the risk of a single project and ignores the possible diversification benefits that could occur when the project is combined with the firm's other projects. Therefore, statement A is true. Statement B refers to payback period risk, which is different from project standing alone risk. Statement C and D are both incorrect.

Question 16

The risk-adjusted discount rate method implicitly assumes that distant cash flows have the same risk as near cash flows.

Accepted Answer

The risk-adjusted discount rate method takes into account the risk of cash flows over time, assuming that distant cash flows may have a different level of risk compared to near cash flows. Therefore, the statement is false.

Question 17

The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same firm when considering a new product line.

Accepted Answer

The risk-adjusted discount rate for a replacement decision will be lower because it involves less risk than launching a completely new product line.

Question 18

If the cash flows of an accepted investment project are negatively correlated with the average cash flow of the firm's existing assets,then the company's total exposure to risk can decrease.

Accepted Answer

Negative correlation means that when the cash flows of the investment project increase, the cash flows of the existing assets decrease and vice versa. This reduces the overall risk of the company as the fluctuations in cash flows of different assets offset each other.

Question 19

According to the CAPM,systematic risk is the only relevant risk for capital budgeting purposes.

Accepted Answer

According to the Capital Asset Pricing Model (CAPM), systematic risk (beta) is the only relevant risk for capital budgeting because it cannot be diversified away through portfolio diversification. Therefore, only systematic risk affects the required rate of return on a project or investment.

Question 20

A project's standing alone risk allows for diversification within a sole firm.

Accepted Answer

Standing alone risk refers to the risk an investment poses on its own, without considering the effects of diversification within a portfolio or across different projects within a firm. Diversification involves spreading investments across various assets to reduce risk, which is not captured by the concept of standing alone risk.

Quiz 11: Cash Flows and Other Topics in Capital Budgeting