Question 1

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 may be positive or negative, depending on the specific project. Expansion projects may require an increase in working capital, while replacement projects may require less working capital. Negative changes in net working capital may also occur if the project involves more efficient management of inventory or receivables.

Question 2

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

It is possible that NPV and IRR assume reinvestment of cash flows at the same rate, although it is not always the case.

Question 3

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 sufficient knowledge or resources to accurately utilize DCF capital budgeting techniques, and may determine that the costs of using these methods outweigh the potential benefits.

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

This statement is true. Opportunity costs refer to the benefits or cash flows that a company could have received from an alternative option. In this case, the company could generate cash inflows from assets they already own, but if those assets are being used for another project, then the opportunity cost is the potential cash inflows they could have received if those assets were not being used for the current project.

Question 5

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 6

Normal Projects Q and R have the same NPV when the discount rate is zero.However, Project Q has larger early cash flows than R.Therefore, we know that at all discount rates greater than zero, Project R will have a greater NPV than Q.

Accepted Answer

The statement is false. While it's true that Project Q will have larger early cash flows than R, it doesn't necessarily mean that R will have a greater NPV at all discount rates greater than zero. The timing and magnitude of cash flows in both projects will affect their respective NPVs at different discount rates. It's possible that Q could still have a higher NPV at certain discount rates, despite having smaller early cash flows.

Question 7

Exchange rate risk is the risk that the cash flows from a foreign project will be worth less than those same cash flows denominated in the parent company's home currency.

Accepted Answer

Exchange rate risk refers to the possibility of losses due to fluctuations in currency exchange rates when the cash flows from a foreign project are converted into the parent company's home currency. Therefore, the statement is true.

Question 8

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: (1) capital budgeting decisions must be based on cash flows, and (2) all relevant cash flows, both incremental and non-incremental, must be considered in the decision-making process. Therefore, the statement in the question is incorrect, as capital budgeting decisions should not solely be based on accounting income and only incremental cash flows.

Question 9

Project S has a pattern of high cash flows in its early life, while Project L has a longer life, with large cash flows late in its life.At the current required rate of return, normal Projects S and L have identical NPVs.Now suppose interest rates and money costs generally decline.Other things held constant, this change will cause L to become preferred to S.

Accepted Answer

Since the required rate of return is held constant, a decline in interest rates and money costs will increase the present value of future cash flows more for Project L (due to its longer life), making it more attractive than Project S.

Question 10

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 11

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 12

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 risk associated with a foreign project may differ from that of a domestic project due to factors such as political instability, exchange rate fluctuations, and legal issues. As a result, the cost of capital for a foreign project may be higher or lower than that for a comparable domestic project.

Question 13

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 14

If the IRR of normal Project X is greater than the IRR of mutually exclusive Project Y (also normal), we can conclude that the firm will select X rather than Y if X has a NPV > 0.

Accepted Answer

The answer of If the IRR of normal Project X...

Question 15

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 answer of The main reason that the NPV method...

Question 16

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 17

Any capital budgeting investment rule should depend solely on forecasted cash flows and the opportunity rate of return.The rule itself should not be affected by managers' tastes, the choice of accounting method, or the profitability of other independent projects.

Accepted Answer

Capital budgeting investment rules, such as NPV or IRR, should be based on cash flows and the opportunity rate of return, which are objective factors. Other subjective factors such as personal preferences or accounting methods should not influence the decision-making process.

Question 18

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 19

A decrease in the firm's discount rate (r) will increase NPV, which could change the accept/reject decision for a potential project.However, such a change would have no impact on the project's IRR, hence on the accept/reject decision under the IRR method.

Accepted Answer

The answer of A decrease in the firm's discount rate...

Question 20

When considering two mutually exclusive projects, the financial manager should always select that project whose internal rate of return is the highest provided the projects have the same initial cost.

Accepted Answer

The answer of When considering two mutually exclusive projects, the...

Quiz 13: Capital Budgeting