Finance Chapter 12 Exam

Of the following new product expansion situations, only one would not result in incremental cash flows so it should not be included in the capital budgeting analysis. Which situation is it? A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery. A firm has a parcel of land that can be used for a new plant site or sold, rented, or used for agricultural purposes. A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected. A new product will generate new sales, but some of those new sales will be to customers who switch from one of the firm's current products.

A firm has spent $2 million on research and development associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

The traditional NPV analysis may yield faulty results when a company chooses between two projects that have significantly different lives, are mutually exclusive, and _____. have a negative correlation with the performance of the company's other projects and with the stock market cannot be repeated have a higher IRR than WACC can be repeated have a higher WACC than IRR

Can be repeated

Given a project's expected cash flows, it is easy to calculate its NPV, IRR, MIRR, payback, and discounted payback. Cash flows are estimated based on information from various sources. There is uncertainty in a project's forecasted cash flows, and some projects are more uncertain and thus riskier than others. In this chapter, we illustrate how project cash flows are estimated, discuss techniques for measuring risk, and discuss how to choose between projects that have significantly different lives, are mutually exclusive, and can be repeated. The most critical step in capital budgeting analysis is ______ estimation. The key is to focus on only _______. Factors that complicate the analysis are sunk costs, opportunity costs, externalities, changes in net operating working capital, and salvage values. Adjustments to the analysis must be made for ________ We concentrate on expansion project analyses here but there are similarities when analyzing replacement projects.

Cash flow Incremental cash flows inflation

Each of the following is a valid assessment of the replacement chain and equivalent annual annuity methods EXCEPT: The equivalent annual annuity method is easier to implement. Neither method should be used for mutually exclusive projects that will not be repeated. Engineers prefer to use both methods in case they yield conflicting results. Neither method should be used for independent projects that will be repeated. The replacement chain method is easier to explain to senior managers.

Engineers prefer to use both methods in case they yield conflicting results.

Which of the following statements about capital budgeting is CORRECT? If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration. In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.

If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net proceeds that could be obtained should be charged as a cost to the project under consideration.

Global Spice Co. is considering a new project, but all methods for assessing risk indicate that the project's risk is greater than the risk of the firm's average project. In evaluating this project, it would be reasonable for Global Spice's management to do which of the following? Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. Reject the project, as its acceptance would increase the firm's risk. Increase the estimated IRR of the project to reflect its greater risk. Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. Increase the estimated NPV of the project to reflect its greater risk.

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

In capital budgeting decisions, corporate risk will be of least interest to: Employees. Creditors. Stockholders with few shares. The local community. Institutional investors.

Institutional investors. (institutional investors are diversified, so they care more about beta risk)

Which of the following items should be included in the capital budgeting analysis? Sunk cost Opportunity cost

Opportunity cost

What is opportunity cost?

Opportunity costs represent the potential benefits an individual, investor, or business misses out on when choosing one alternative over another.

A company's new project evaluation should include all of the following EXCEPT: Changes in net operating working capital attributable to the project. A decline in the sales of an existing product, provided that decline is directly attributable to this project. The value of a building owned by the firm that will be used for this project. The salvage value of assets used for the project that will be recovered at the end of the project's life. Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.

Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.

An outlay that was incurred in the past and cannot be recovered in the future regardless of whether the project under consideration is accepted is known as:

Sunk cost

The CFO of Rambler Retail Concepts is considering a new project, so she plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? All interest expenses on debt used to help finance the project. Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year. All sunk costs that have been incurred relating to the project. Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows. The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

The additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life.

Which of the following is a valid assessment of the replacement chain and equivalent annual annuity methods? The equivalent annual annuity method is easier to implement. The replacement chain method produces better results. The replacement chain method is easier to implement. The equivalent annual annuity method is easier to explain to senior managers. The equivalent annual annuity method produces better results.

The equivalent annual annuity method is easier to implement.

Crawford Mill Products' sales and profits are positively correlated with the overall economy, and the company has a beta of 1.0. Crawford Mill estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT? The proposed new project would have less stand-alone risk than the firm's typical project. The proposed new project would increase the firm's market risk. The proposed new project would have more stand-alone risk than the firm's typical project. The proposed new project would not affect the firm's risk at all. The proposed new project would increase the firm's corporate risk.

The proposed new project would have more stand-alone risk than the firm's typical project.

While reviewing a replacement analysis, a CEO discovers that the yearly depreciation on the old project was incorrectly listed as $50 rather than $100. Correcting the error will have which of the following effects? The outcome of the replacement analysis will not change. The replacement will look less attractive because the differentials between the old and new cash flows will increase. The replacement will look more attractive because the differentials between the old and new cash flows will increase. The replacement will look less attractive because the differentials between the old and new cash flows will decrease. The replacement will look more attractive because the differentials between the old and new cash flows will decrease.

The replacement will look less attractive because the differentials between the old and new cash flows will decrease.

each of the following factors should be considered EXCEPT: Sales revenues. The labor, materials, and other costs per year of the old machine. The salvage value of the old machine at the beginning of the project. The labor, materials, and other costs per year of the new machine. The salvage value of the old machine at the end of the project.

The salvage value of the old machine at the end of the project.

True/False: McDonald's is planning to open a new store across from the student union. Annual revenues are expected to be $5 million. However, opening the new location will cause annual revenues to drop by $3 million at McDonald's existing stadium location. The relevant sales revenues for the capital budgeting analysis are $2 million per year.

True

What is cannibalization?

a loss in sales caused by a company's introduction of a new product that displaces one of its own older products. The cannibalization of existing products leads to no increase in the company's market share despite sales growth for the new product.

When conducting a replacement analysis, the incremental cash flows _____. are derived by subtracting the cash flows for the old project from the cash flows for the new project should not be considered; cash flow differentials between the old and new projects should be used instead are derived by subtracting the cash flows for the new project from the cash flows for the old project should be considered if and only if the IRR is greater than the NPV are derived by adding the cash flows for the new project to the cash flows for the old project

are derived by subtracting the cash flows for the old project from the cash flows for the new project

Which of the following is an example of an opportunity cost? a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks. b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes). c. Apple's investment in the iTunes music store boosted sales of its iPod. d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it. e. Statements a and d are both examples of opportunity costs.

b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes).

Which of the following is an example of cannibalization? a. A publisher introduces a new textbook which reduces sales of one of their existing textbooks. b. A firm has land that can be used in building a new store. If the new store is not built, the firm could sell the land for $2 million (net of taxes). c. Apple's investment in the iTunes music store boosted sales of its iPod. d. The cost of a report done 2 years ago to investigate the potential of a new plant and the permits required to build it.

c. Apple's investment in the iTunes music store boosted sales of its iPod.

The _____ method of comparing projects with unequal lives calculates the NPV of each project over its stated life and then finds the constant annual cash flow that this NPV would provide over the project's initial life. replacement analysis replacement chain expansion analysis traditional NPV equivalent annual annuity

equivalent annual annuity

The _____ method of comparing projects with unequal lives assumes that each project can be repeated as many times as necessary to reach a common life. replacement analysis replacement chain expansion analysis traditional NPV equivalent annual annuity

replacement chain