FIN 3100 Chapter 12 Reading Review
Refer to Table 12.1 in the text and answer the following question: What WACC is used for the analysis of Expansion Project S?
10%
Real options are best described as:
Choices of future actions.
An opportunity cost is an amount that a firm would receive if it does not/make a given investment. An example would be the purchase price from a building that a firm owns and could sell if it does not make an investment that would call for the use of the building. Opportunity costs should not be reflected in a capital budgeting analysis. True or false?
F
A firm's optimal capital budget consists of all potential independent projects that have positive NPVs when evaluated at the projects' own risk-adjusted costs of capital, plus those mutually exclusive projects with the highest positive NPVs. True or false?
T
A project's incremental cash flow is the difference between the firm's cash flow if it accepts the project versus if it rejects the project. Thus, if a project has an initial cost of $1 million in Year 1 and no other costs or revenues, then the incremental cash flow in that year will be -$1 million. True or false?
T
A sunk cost is a cost that has been incurred and cannot be recovered regardless of whether a project is accepted or rejected. Sunk costs should not/ be reflected in a capital budgeting analysis. True or false?
T
An opportunity to expand if a project is successful is an example of a real option. This particular type of option is called an expansion option. True or false?
T
If a firm accepts less than all of its prospective projects with positive NPVs when evaluated at their own risk-adjusted costs of capital and those mutually exclusive projects with the highest positive NPVs, then it is said to be employing capital rationing. True or false?
T
If a project is negatively correlated with the firm's other projects, it might stabilize the firm's total earnings and thus be relatively safe. True or false?
T
In some instances, replacements add capacity as well as lower operating costs. When this is the case, sales revenues would be increased; and if that led to an increase in net operating working capital, that number would be shown as a Time 0 expenditure along with its recovery at the end of the project's life. These changes would, of course, be reflected in the differential cash flows for the analysis. True or false?
T
Including real options in a capital budgeting analysis can raise, but not lower, a project's expected NPV as found in a traditional analysis. This is true because, by definition, an option can be exercised or not, and if the option has a negative value, it will be rejected. True or false?
T
Monte Carlo simulation is similar to scenario analysis, except in a simulation the computer chooses the values used for the input variables based on probability distributions for the variables. Simulation analysis provides an expected NPV along with information about the range of possibilities, including the standard deviation of the NPV. True or false?
T
Of the three types of risk, market risk is theoretically the most relevant, but it is quite difficult to measure a new project's market risk. Stand-alone risk is easier to estimate, and it is usually positively correlated with market risk. Therefore, the focus of risk analysis for most projects is on stand-alone risk. True or false?
T
Post-audits point out errors in forecasts, and they identify why the errors occurred. This information should help firms obtain better forecasts in the future and improve their capital budgeting process. True or false?
T
Scenario analysis is similar to sensitivity analysis, but here the variables are typically set at "good," "normal," and "bad" levels, and then the NPV is calculated under each situation. This analysis is designed to give management an idea of just how good or bad the results might turn out to be, along with the most likely (or expected) result. The spreadsheet model used to do a sensitivity analysis could be modified slightly and used for the scenario analysis. True or false?
T
Sometimes a cost must be incurred to obtain an abandonment option. This cost should be incurred if and only if the value of the option exceeds its cost. The value of an abandonment option can be estimated by first calculating the value of the project considering the possibility of abandonment, then subtracting the value of the project if it could not be abandoned. The difference in values is the value of the abandonment option. True or false?
T
Table 12.1 divides the project's cash flows into three components: Initial investment outlays, operating cash flows the company receives over the life of the project, and terminal cash flows that are realized when the project is completed. True or false
T
The risk-adjusted cost of capital is the cost of capital appropriate for a given project, given the riskiness of that project. The greater the project's risk, the higher its cost of capital. True or false?
T
To do a sensitivity analysis, one would set up a spreadsheet model that calculates a project's NPV, using as inputs unit sales, sale prices, fixed and variable costs, the tax rate, and the cost of capital. Input variables are then changed one at a time to determine their effects on the NPV. If small changes in the variables could result in a large decline in the NPV, then the project is judged to be relatively risky. True or false?
T
Refer to Table 12.1 in the text and answer the following question: If the IRS shortened the depreciable lives of the assets, thus increasing their depreciation rates, which of the following statements reflects what would happen to the calculated NPV?
The calculated NPV would increase
Academics and businesspeople use the concept of real options because Net Present Value is seen as:
Too Passive
