FINANCE - Exam FINAL (Example QUIZ Problems)
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?
True
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?
True
A project's payback gives us an idea of the project's liquidity because it indicates how long funds will be tied up in the project. True or false?
True
A project's payback gives us an idea of the project's liquidity because it indicates how long funds will be tied up in the project. True or false?
True
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?
True
An NPV profile is a graph that shows a project's NPV on the vertical axis, the cost of capital on the horizontal axis, and a line that shows the project's NPV at each cost of capital. The point on the horizontal axis where the NPV crosses the axis—i.e., where the NPV is zero—is the IRR. True or false?
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. True or false?
True
Barlett Co. has two divisions. Its risky division, Division R, has a WACC = 12%, while its safer division, Division S, has a WACC = 8%. Since the two divisions are the same size, the company's composite WACC is 10%. A Division S project has a 9% expected return. Since this project's return exceeds the division's WACC, the company should accept the project even though its return is less than the company's composite WACC. True or false?
True
Conflicts such as those between mutually exclusive projects can never occur between independent projects. One project might have the higher IRR and the other the higher NPV, but this does not lead to problems in deciding whether to invest in either, neither, or both of the projects. True or false?
True
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?
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. True or false?
True
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?
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. True or false?
True
Is this statement true or false? "The primary difference between the MIRR and the regular IRR is that MIRR assumes that cash inflows are reinvested at the WACC, whereas the regular IRR assumes reinvestment at the IRR. Since reinvestment is generally at a rate close to the WACC, the MIRR is generally closer to the "true" rate of return a project will provide."
True
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?
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. True or false?
True
One important difference between capital budgeting and security analysis is that in security analysis the analyst must generally take the projected cash flows as given rather than something the analyst can influence, whereas firms can often influence the cash flows from projects by making operating changes. True or false?
True
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?
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. True or false?
True
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?
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. True or false?
True
The cost of depreciation-generated funds is approximately equal to the WACC calculated from retained earnings, preferred stock, and debt. True or false?
True
The inputs used in most capital budgeting analyses are not known with certainty; hence, the results of quantitative analysis may be quite different from the actual, after-the-fact results. Also, five capital budgeting criteria are commonly used, and each provides a somewhat different bit of information. Therefore, it is rational for a firm to calculate and give some consideration to each of the five criteria. For most decisions, the greatest weight should be given to the NPV, but it would be foolish to ignore the information provided by the other criteria. True or false?
True
The investor-supplied items—debt, preferred stock, and common equity—are called capital components. Increases in assets must be financed by increases in these capital components. True or false?
True
The rate at which the NPV profile lines of two mutually exclusive projects cross is called the "crossover rate." If the cost of capital is greater than the crossover rate, then no conflict will occur because the project with the higher NPV will also have the higher IRR. True or false?
True
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?
True
The target capital structure is the mix of debt, preferred stock, and common equity the firm plans to raise to fund its future projects. True or false?
True
There has been a strong trend in recent years toward the use of the NPV and IRR methods as the primary criteria, and away from the regular payback as the primary criterion for selecting capital budgeting projects. True or false?
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. True or false?
True
Assume that Project 2's cost of capital is 12% and analyze the following statement: "Even though Project 2's IRRs are both greater than the cost of capital, the project should still be rejected because its NPV is negative at the project's cost of capital, and consequently, the firm's value will be reduced if it is accepted." True or false?
True - any NPV thats negative should be rejected
Which of the following statements is correct? More than one statement may be correct.
a. A project's IRR is conceptually similar to a bond's YTM. b. A project's IRR is the discount rate that causes the project's NPV to equal zero. c. If an independent project's IRR exceeds its cost of capital, then the project should be accepted. d. If an independent project's IRR is less than its cost of capital, then the project should be rejected. e. all of these are correct
Which of the following statements best describes capital rationing?
a. Capital rationing occurs when the firm invests to the point where the marginal internal rate of return equals the marginal cost of capital. b. Capital rationing occurs when a firm invests less than the optimal amount (the point where the marginal rate of return equals the marginal cost of capital) because the firm might be small and it doesn't have the ability to take on as many projects as the optimal amount might indicate. c. Capital rationing indicates that the firm is investing less than the optimal amount. This should never happen and rarely occurs in the real world. d. Capital rationing is the term used to describe when a multidivisional company distributes capital among its various divisions. e. None of the statement above correctly describes capital rationing.
Which of the following factors could lead to a conflict between the NPV and IRR methods for two mutually exclusive projects?
a. Differences in the timing of the projects' cash flows. b. Differences in the projects' sizes. c. both statements are true.
Which of the following statements is CORRECT?
a. Effects of a project on other parts of the firm or the environment are called externalities. b. Externalities can be either negative or positive but they should be correctly accounted for in a project's cash flows when evaluating that project. c. Positive externalities on a project are called complements. d. Cannibalization is a negative externality that reduces the cash flow in another part of the same company. e. All the statements above are correct.
Which of the following statements regarding the abandonment option is CORRECT?
a. Having the ability to abandon a project can increase a project's expected net present value. b. Having the ability to abandon a project can reduce a project's risk. c. Having the ability to abandon a project must reduce a project's expected net present value. d. Having the ability to abandon a project must increase a project's risk. e. Statements a and b are both correct.
Which of the following statements suggests that assuming reinvestment at the WACC is a more reasonable reinvestment rate assumption?
a. If firms use internally generated cash flows from past projects rather than external capital, then they will save their costs of capital. Thus, their costs of capital represent the opportunity costs of their cash flows; thus, the effective returns on their reinvested funds. b. If firms have reinvestment opportunities with positive NPVs, they will be constrained in accepting them and financing them at their costs of capital. c. Firms do not have reasonably good access to the capital markets, so firms cannot raise all the capital they need at the going interest rate.
Which of the following statements is correct?
a. If two projects are mutually exclusive, then the one with the higher IRR should be accepted. b. Mutually exclusive projects generally have higher NPVs than independent projects. c. If a firm is considering 5 independent projects, then as a general rule it should invest in all 5 of them if the analysis shows that each of them has a positive NPV. If it were considering 5 mutually exclusive projects (i.e., 5 ways of performing a given task), then as a general rule it should not invest in all 5 of them even if they all have positive NPVs.
Which of the following statements is NOT CORRECT?
a. Opportunity costs and sunk costs are tricky when analyzing capital budgeting projects. In summary, for a correct capital budgeting analysis, opportunity costs must be included in the analysis while sunk costs should be ignored—the money is gone whether the project is undertaken or not. b. Sunk costs are the costs associated with "the road not taken". They represent the alternative cost of an asset if that asset were not already owned by the firm; therefore, these costs should be included in the capital budgeting analysis. c. Sunk costs are cash outlays a company has made in the past, and they can't be recovered whether the new project goes forward or not. Thus, you don't include these costs in the project's capital budgeting analysis. d. While an opportunity cost is not an actual cash outlay, this cost must be added to the project's costs when you calculate its net present value. e. An opportunity cost represents the best return a company could get on an asset it already owns. It is the cost of losing out on something if you greenlight the project, so you want to include this cost in the capital budgeting analysis.
Which of the following statements is CORRECT?
a. The Internal Rate of Return is one of the measures that companies look at when they're trying to decide on projects to undertake. The Internal Rate of Return measures the absolute dollars that the project is expected to generate for shareholders. b. The Net Present Value is one of the measures that companies look at when they're trying to decide on projects to undertake. The Net Present Value measure the percentage, or rate of return, we can expect from a project relative to its cost. c. When a company is deciding between two mutually exclusive projects, it's possible that the better decision for the firm is to accept the project that has a higher Net Present Value but a lower Internal Rate of Return rather than the project with a lower Net Present Value but a higher Internal Rate of Return. This is because the Net Present Value shows directly how much dollar value a project adds to the firm. d. Statements a, b, and c are correct. e. None of the statements is correct.
Corporate Risk, assumes which of the following:
a. The corporation faces no competition. b. The interest rate for the firm is zero. c. The cash flows of the project are not separate from the firm's other assets. d. All costs the firm faces are zero
Which of the following statements about the modified internal rate of return is CORRECT?
a. The modified internal rate of return overstates a project's true return, so that's why the internal rate of return is a better measure of a project's return. b. The modified internal rate of return (MIRR) is a better measure of a project's return than the internal rate of return (IRR) because MIRR assumes that the project's cash flows can be reinvested at the project's internal rate of return. c. The internal rate of return (IRR) is not a good measure of a project's true return. The IRR overstates a project's true return because it assumes that a project's cash flows can be reinvested at the project's internal rate of return. The Modified Internal Rate of Return, however, is a better measure of a project's return because it assumes that a project's cash flows are reinvested at the firm's weighted average cost of capital. d. Due to the mathematics involved in the equations used to solve for both the internal rate of return and the modified internal rate of return, the solutions for the returns are identical—the answers will always be the same. e. None of the statements is correct.
Which of the following statements is NOT CORRECT?
a. There are two ways to raise common equity. One source is retained earnings that involves bringing in new funds from outside the company, which represents external equity. The second source is new stock issues that involves bringing in new funds from current stockholders of the company, which represents internal equity. b. The cost of retained earnings is less than the cost of new common stock due to flotation costs. While retained earnings may appear to be free money on the surface, there is an opportunity cost to them as these funds could be invested elsewhere and earning a return for shareholders. Due to the lower cost of retained earnings, companies generally prefer to use retained earnings to finance their projects, and only issue new common stock when they absolutely must. c. There are two ways to raise common equity. One source is retained earnings, which means that the firm has set aside some of its annual profits to reinvest in the firm instead of paying a dividend to stockholders. The second source is the issue of new stock, which involves selling stock to the public. d. When new stock is issued, the company pays an investment bank to handle the expenses and fees involved with selling the stock. These expenses are called flotation costs. e. Flotation costs reduce the amount of capital the firm receives from a new stock issue. The company must make each dollar of the new issue work harder, so new investors earn their required rate of return. The new stock has a higher return (a higher cost), which is the stock's base "required rate of return" plus an adjustment for flotation costs.
Which of the following statements is CORRECT? (MIRR)
a. To find the MIRR, we discount the TV at the IRR. b. The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. c. A project's NPV profile must intersect the X-axis at the project's WACC. d. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. e. The discounted payback method eliminates all of the problems associated with the payback method.
In stand alone risk analysis sensitivity analysis involves changing the ________ of the model.
assumptions
Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
e. You should recommend Project S, because at the new WACC it will have the higher NPV.
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
Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value. On the other hand, using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses. However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.
true
Any cash flows that can be classified as incremental to a particular project--i.e., results directly from the decision to undertake the project--should be reflected in the capital budgeting analysis.
true
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 often used for such projects along with discounted cash flow analysis.
true
Stand alone risk in capital budgeting the assumption is:
The cash flow of the project is separate from the firm's other assets.
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.
true
All else equal, which of the following is most likely to increase a company's retained earnings breakpoint?
A decrease in the fraction of equity used in the company's target capital structure
Real options are best described as:
Choices of future actions.
A firm should never accept a project if its acceptance would lead to an increase in the firm's cost of capital (its WACC).
False
An increase in the firm's WACC will decrease projects' NPVs, which could change the accept/reject decision for any potential project. However, such a change would have no impact on projects' IRRs. Therefore, the accept/reject decision under the IRR method is independent of the cost of capital.
False
The cost of equity raised by retaining earnings can be less than, equal to, or greater than the cost of external equity raised by selling new issues of common stock, depending on tax rates, flotation costs, the attitude of investors, and other factors.
False
The optimal capital structure is the one where the percentages of debt, preferred stock, and common equity minimize the firm's value. True or false?
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. True or false?
False **they should be reflected in capital budgeting analysis
Suppose a project has a negative cash flow (a cost), then a series of positive cash inflows, and then another cost at the end of its life. In this situation it would be impossible for the project to have more than one IRR. True or false?
False, it would have more than 1 IRR
A firm must raise capital to build factories and purchase equipment to develop their products to sell. Which of the following is NOT one of the main sources of capital?
Inventory
The NPV should be used as the primary capital budgeting decision criterion because:
It tells us how much the project is expected to add or subtract from a firms value
Which of the following statement completions is NOT CORRECT? For a profitable firm, when MACRS accelerated depreciation is compared to straight-line depreciation, MACRS accelerated allowances produce
Larger total undiscounted profits from the project over the project's life
Among the following factors that affect the cost of capital, which can the firm most directly control?
The firm's capital structure
Market or Beta risk is the point of view of:
The investor in the firm.
