Chapter 12

10) The objective of ________ is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted. A) capital rationing B) scenario analysis C) real options D) sensitivity analysis

A

18) Breakeven cash inflow refers to ________. A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV greater than zero B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less than zero C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less than zero cost of capital D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals zero

A

20) In capital budgeting, risk refers to ________. A) the degree of variability of the cash inflows B) the degree of variability of the initial investment C) the chance that the net present value will be greater than zero D) the chance that the internal rate of return will exceed the cost of capital

A

6) The option to develop follow-on projects, expand markets, expand or retool plants, and so on that would not be possible without implementation of the project that is being evaluated is called ________. A) growth option B) timing option C) flexibility option D) abandonment option

A

7) A(n) ________ allows management to avoid or minimize losses on projects that turn bad. A) abandonment option B) growth option C) timing option D) put option

A

13) An approach to capital rationing that involves graphing project returns in descending order against the total dollar investment to determine the group of acceptable projects is called the ________. A) net present value approach B) internal rate of return approach C) payback approach D) profitability index approach

B

13) Which of the following is an important type of risk in an international capital budgeting context? A) business cycle risk B) political risk C) appropriation risk D) default risk

B

17) Behavioral approaches ________. A) are used to explicitly recognize project risk B) are used to get a feel for project risk C) are not used by rational financial managers D) are used to quantify the risk

B

18) The difference by which the required discount rate exceeds the risk-free rate is called the ________. A) excess return B) risk premium C) inflation premium D) maturity premium

B

20) The theoretical basis from which the concept of risk-adjusted discount rates is derived is ________. A) the Gordon model B) the capital asset pricing model C) simulation theory D) the basic cost of money

B

21) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the project is ________. A) $1,000,000 B) $131,474 C) $100,000 D) $66,667

B

25) A behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number variables of a project is called ________. A) sensitivity analysis B) scenario analysis C) simulation analysis D) Monte Carlo simulation

B

26) The advantage of using simulation in the capital budgeting process is the ________. A) ease of calculation over scenario analysis B) continuum of risk-return trade-offs for decision making C) single point estimate that helps the decision maker to choose the most accurate alternative D) use of several possible outcomes to asses risk

B

12) If a firm has a limited capital budget to fund its capital projects, it is said to be facing the problem of ________. A) constrained capital B) wealth optimization C) capital rationing D) profitability

C

12) Which of the following strategies will help in minimizing political risk in international capital budgeting decisions? A) by hedging the cash flows using currency futures and options B) structuring the financing of such investments as equity rather than as debt C) structuring the financing of such investments as debt rather than as equity D) financing the project, in whole or in part, in domestic currency

C

17) ________ reflects the return that must be earned on the given project to compensate the firm's owners adequately. A) Internal rate of return B) Cost of capital C) Risk-adjusted discount rate D) Average rate of return

C

28) The shares traded publicly in an efficient market are ________. A) generally positively affected by diversification, because of the reduction in risk B) generally negatively affected by diversification, because of the increase in risk C) generally not affected by diversification, unless greater returns are expected D) generally negatively affected by diversification, because of the increase in the required rate of return

C

29) Firms do not usually get rewarded by diversifying investments in different lines of business because ________. A) the capital markets are efficient and they quickly respond to change in economic conditions B) cash flows from such projects tend to respond less to changing economic conditions C) investors themselves can diversify by holding securities in a variety of firms

C

they do not need the firm to do it for them D) it is not possible for a firm to diversify its risk as the inflation premium is different for different projects

C

11) An IRR approach to capital rationing involves graphically plotting project IRRs in descending order against total dollar investment on an ________ graph. A) ANPV B) NPV C) RADR D) IOS

D

19) A preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint, is ________. A) sensitivity analysis B) simulation analysis C) scenario analysis D) risk-adjusted discount rates

D

19) In capital budgeting, risk refers to ________. A) the chance that a project will prove acceptable B) the conflicting IRR and NPV in a project C) the degree of variability of initial outlay D) the uncertainty of cash inflows

D

27) One type of simulation program made popular by the widespread use of personal computers is called ________. A) Monaco Simulation B) Lemans Simulation C) Cannes Simulation D) Monte Carlo Simulation

D

8) The ________ approach is used to convert the net present value of unequal-lived projects into an equivalent annual amount (in net present value terms). A) internal rate of return B) investment opportunities schedule C) risk-adjusted discount rate D) annualized net present value

D

1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

FALSE

11) In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

FALSE

11) Political risk is easier to protect as compared to exchange rate risk.

FALSE

12) Sensitivity analysis is a statistics-based approach used in capital budgeting to asses risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

FALSE

13) Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintains a diversified portfolio of assets.

FALSE

14) Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

FALSE

15) By combining two projects with negatively correlated cash inflows, a firm reduces the combined cash inflow variability and its risk.

FALSE

2) Behavioral approaches for dealing with risk include annualized net present values and risk-adjusted discount rates.

FALSE

2) Futures and options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability.

FALSE

2) The acceptance of a particular project usually has no impact on a firm's overall risk.

FALSE

3) All projects should always use the WACC as the required return for capital budgeting purposes.

FALSE

3) When unequal-lived projects are independent, the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

FALSE

4) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

FALSE

5) In selecting the best group of unequal-lived projects, if the projects are mutually exclusive, the length of the projects lives is not critical.

FALSE

5) The objective of capital rationing is to select the group of projects that provides the quickest overall payback and does not require more dollars than are budgeted.

FALSE

7) In capital budgeting, risk refers to a high degree of variability of the initial investment of a project.

FALSE

7) The risk-adjusted discount rate approach to evaluating projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

FALSE

8) Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

FALSE

9) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the credit risk premium.

FALSE

1) Behavioral approaches for dealing with risk include scenario analysis and simulation.

TRUE

1) Different projects have different levels of risk. As a result, the acceptance of a particular project generally has an impact on a firm's overall risk.

TRUE

1) In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project results in an incorrect decision.

TRUE

1) In international trade, transfer prices are prices that subsidiaries charge each other for the goods and services traded between them.

TRUE

1) Real options are opportunities that are embedded in capital budgeting projects that enable managers to alter their cash flows and risks in a way that affects project acceptability.

TRUE

10) Exchange rate risk is easier to protect as compared to political risk.

TRUE

10) In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a positive NPV and those falling below the SML would have a negative NPV.

TRUE

10) Scenario analysis is a behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number of variables.

TRUE

11) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses the variability of returns.

TRUE

12) The higher the risk-adjusted net present, the more viable the project.

TRUE

13) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

TRUE

14) Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify the risk on their own.

TRUE

15) The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.

TRUE

16) Monte Carlo simulation programs usually build a histogram of the results.

TRUE

16) RADRs are popular because they are consistent with the general disposition of financial decision makers toward rates of return.

TRUE

2) Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign country.

TRUE

2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate a firm's owners adequately, that is, to maintain or improve the firm's share price.

TRUE

2) When unequal-lived projects are independent, the length of the project lives is not critical.

TRUE

3) A market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

TRUE

3) In capital budgeting, risk is the degree of variability of cash flows.

TRUE

3) The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated will reduce the market value of that project's cash flow is called exchange rate risk.

TRUE

3) The objective of capital rationing is to select the group of projects that provides the highest overall net present value and does not require more dollars than are budgeted.

TRUE

4) A firm with limited funds for investment in capital assets must ration those funds by allocating them to projects that will maximize share value.

TRUE

4) Annualized net present value approach is the most efficient technique for dealing with projects of unequal lives.

TRUE

4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.

TRUE

4) International capital budgeting differs from domestic capital budgeting as cash inflows and outflows occur in a foreign currency and foreign investments potentially face significant political risk.

TRUE

5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate (RADR) approach implicitly assumes that risk is an increasing function of time.

TRUE

5) In case of international capital budgeting, a U.S. company can minimize its political risk by creating a joint venture with a competent and well-connected local partner.

TRUE

5) The break even cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

TRUE

6) In case of international capital budgeting, long-term exchange rate risk can be minimized by financing the project, in whole or in part, in local currency.

TRUE

6) Projects with a small chance of being acceptable and a broad range of possible cash flows are riskier than projects having a high chance of being acceptable and a narrow range of possible cash flows.

TRUE

6) The annualized net present value approach used to evaluate projects with unequal lives converts the net present value of unequal-lived, mutually exclusive projects into an equivalent annual amount.

TRUE

6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

TRUE

7) For assets traded in an efficient market, the diversifiable risk can be eliminated through diversification.

TRUE

7) The importance and widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and incremental cash flows.

TRUE

8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market risk premium.

TRUE

8) The two basic types of risk associated with international cash flows are inflation and foreign exchange risks and political risks.

TRUE

9) Exchange rate risk is the risk that an unexpected change in exchange rates will reduce the market value of a project's cash flows.

TRUE

9) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.

TRUE