Finance Ch. 12

The primary purpose of the post-audit is to check on the speed at which information, especially post office mail, is processed within the firm. T or F

False

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

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. T or F

True

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. T or F

True

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. T or F

True

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. T or F

True

Three separate types of risk should be considered in capital budgeting. Which of the following is NOT one of those risks? a. Corporate risk b. Consumer price risk c. Market risk d. Stand-alone risk

b. consumer price risk

A firm's optimal capital budget consists of all potential independent projects that have positive NPVs when evaluated at the firm's overall composite WACC, plus those mutually exclusive projects with the highest positive NPVs. Differential project risk is not reflected in the optimal capital budget. T or F

false

Although free cash flows rather than accounting income are useful for some purposes, in a capital budgeting analysis it is accounting income that should be discounted to find the NPV. T or F

false

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. T or F

false

If a firm accepts all independent projects that have positive NPVs when evaluated at the projects' own risk-adjusted costs of capital, then it is said to be employing capital rationing. T or F

false

The after-tax salvage value, shown in the terminal cash flow section of the Excel worksheet, reflects a tax credit in Year 4 because the equipment was sold for less than book value. T or F

false

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. T or F

true

For replacement projects, we must find cash flow differentials between the new and old projects. These differentials are the incremental cash flows that we analyze in determining whether the replacement project should be done or not. T or F

true

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. T or F

true

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. T or F

true

Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately. T or F

true

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. T or F

true

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. T or F

true

Taking an abandonment option into account could only increase a project's expected NPV, because if the option had a negative value, it would be rejected.

true

Three procedures are used to evaluate a project's stand-alone risk: sensitivity analysis, scenario analysis, and Monte Carlo simulation. T or F

true