Capital Budgeting (HW Questions)
Select all the answers that are true about the Certainty Equivalent (CE) method:
A CE cash flow is a risky cash flow that has been converted so it can be accepted with certainty. CE is a technique to establish cash flow that can be accepted with certainty. The further into the future a forecast needs to be, the more difficult in obtaining correct amounts.
Which statement is not true about Beta:
A beta of 1 shows higher volatility than the market.
Investments should align with:
A company's strategy.
The NPV concept only captures the shareholder's value and is:
A fraction of the project's added value
A Well- Designed Strategy includes all of the following except:
External environment is not important
A PCA program is inexpensive to implement and conduct
False
A competitive advantage will always deliver a superior performance
False
All cash flows generated by the project are reinvested in the business.
False
By projecting price over 5 periods with the probability of an increase and decrease, projects that have a positive NPV, could be viable.
False
Capital budgeting for an SPV is very different than standard capital budgeting.
False
Capital rationing is only a theory and rarely used in most organizations.
False
Cost of capital focuses on looking at the past expected cash flows in current dollar terms.
False
IRR assumes that cash flows depreciate at the IRR until the end of the project
False
IRR will never yield a different selection than NPV
False
Modified IRR will not always agree with NPV so it is used often
False
NPV or IRR calculation can not use CE value cash flows
False
Overall, capital rationing is not an efficient way to control and limit agency costs in the process of capital budgeting.
False
PCA reports need to be stored in a secured database with limited access
False
Project evaluation is more difficult to understand than the complexity of the actual practice
False
Project sponsors can not also be contractual counterparties.
False
Successful capital investments has little impact on the success of a company meeting their strategic objectives.
False
The SPV carries out many investments projects
False
The firm's WACC needs to be adjusted to be used as the discount rate for projects of average or normal risk.
False
The initial investment of a capital budget has the largest income tax burden.
False
The option to abandon is always due to the need to close the doors due to lack of the ability to financially support the company.
False
The option to abandon is very different than an option to wait.
False
The proceeds from the sale of a retired asset should be added to the cash inflows for the project for the year of disposal
False
The typical approach to industry analysis puts little emphasis on value capture.
False
WACC is always the best option for discount rate when evaluating projects.
False
When estimating annual cash flows for a future capital project, you should consult individuals in the following departments (select all that apply)
Legal department Marketing department Human resources
Which of the following is not an aspect of PCA:
Long term investments are great ways to reward personnel in the yearly evaluation process
What are examples of the agency problem (select all that apply)
Management chooses to operate the firm that benefits management at the expense of shareholders Managers are motivated to meet short term goals Managers are short term oriented
Which is not a way that firms use DCF and promote under investment:
Managers ability to make decisions throughout the project to reduce risk through time.
Which of the following are true about Real Options Analysis: (select all that apply)
Managers are active participants through-out a project's life Whenever more opportunities exist to have choices, the possibility of recognizing more value exists.
What creates over investment (select all that apply)?
Managers like to build empires Managers like to control more assets
Which is not a characteristic of PCA:
Managers underestimate project cash flows
Examples of the agency issues in capital rationing are (select all that apply)
Managers understating future performance targets Over investment in low-return projects A divisional leader promoting a project that only provides short-term increase to improve their year end bonus
Select all the examples of managers not working in the best interest of shareholders?
Managers who shirk their responsibilities. Managers building empires. Managers maximizing their compensation.
Select all the categories of Capital Budgeting (select all that apply)
Mandatory replacement of assets Investments to expand existing product lines New business and market expansion projects
Which is not part of WACC calculation:
Market Value of Short Term Liablities
Select the true statement:
Market risk premium is the additional return required by investors over the risk-free rate to compensate for the risk associated with investment.
An initial investment cost will include all of the following except:
Marketing costs
PCA has the following managerial uses (select all that apply)
Measure performance Enhances organizational learning Enhances integrity of investment appraisals
What are the key agency problems with Capital Rationing (Select all that apply)
Moral Hazard Information Asymmetry
Which is NOT a type of real option:
No Growth
Which statement is true?
No metric or combination of metrics will take all considerations necessary in making a project decision
What are characteristics of mutually exclusive projects (select all that apply):
One project makes the other project impossible to pursue Both projects will attract the same customers
What is the discount rate the most agree to use?
Opportunity Cost
Which option focuses on the value of switching output for the production process?
Option to switch outputs
Which is not an example of a contract structure:
Pay or Play
When considering an industry analysis, you need to consider all of the following (select all that apply):
Substitute products Bargaining power of suppliers and buyers The threat of new firms Intensity of rivalry
What is not a step in calculating CEFs:
The CEF is assigned to each project category except replacement projects
Which is not a stage of the evolution of firms?
The IPA stage
Which of the following is not true about determining the CE factors:
The most difficult aspect to the CE method is determining the risk free rate.
Capital rationing provides (select all that apply):
The negative effects are much less of a problem when managers are concerned about their reputation. Improves capital budgeting It reduces agency costs.
Which is not true when defining the optimal capital structure for an SPV:
The optimal structure can not project whether the SPV will go bankrupt.
The option to alter the scale of operations includes: (select all that apply):
The option to stop and start operations. Ability to decrease operations during poor economic conditions. Ability to increase operations in good economic conditions
Industry analysis puts excessive focus on industry differences rather than differences among companies in the same industry.
True
Insurance coverage is used for items that cannot be managed or controlled.
True
Investors will not be compensated for bearing unsystematic risk because they are assumed to hold diversified portfolios that eliminate such risk.
True
Legal costs should be considered part of the investment costs when they are to gain rights to use a trademarked name
True
Management must make every effort to identify cash flows that would differ between alternatives.
True
Monitoring a projects implementation is not as effective as PCA
True
Organizational learning is the major objective of PCA
True
Project Finance is defined as the financing of a specific economic entity.
True
Real options analysis and rate adjusted discount rate analysis should always provide the same result.
True
The IRR method must have one cash outflow followed by all cash inflows to avoid generating multiple IRRs
True
The beta coefficient of the project focuses on volatility and risk
True
The cost of capital is the rate of return that suppliers of capital require as a compensation for their contribution of capital.
True
The more rigorous the analysis in the decision making process, the more prudent is the firms accept/reject decision on a given capital budgeting project.
True
The way firms apply discounted cash flows models can promote underinvestment
True
Real Options incorporates: (select all that apply)
Uncertainty about future cash flows Irreversibility of investment The time of the project initiation
Which is not part of the content of a PCA report:
Unique format by company
Why do companies not adopt PCA (select all that apply):
Unique projects Weak technology Scarcity of investments
What are sources of funds to fund a new project (select all that apply)?
Use firm's existing resources Sell stock Get a Loan
Which method below does not add rigor to the decision making process:
Using payback method but adding best case-worst case analysis
A judgment approach includes all but:
Using scientific procedures or techniques
Which method could create an unlimited number of projects to accept?
Using the hurdle rate criterion.
Which of the following is true about determining the RADR:
WACC = Risk-free rate plus Normal business risk
Select the true statement about discount rate.
WACC is the best option for projects that are extensions of current operations
Underinvestment emerges when:
When debt enters a firm's capital structure.
Firms under invest when: (select all that apply)
When the firm needs to have liquidity. When firms focus on extensions of existing services already provided by the firm. When short-term and debt repayment obligations require cash outflows
Select all steps in the careful analysis of risks (select all that apply):
a. Risk Analysis b. Allocation of risks c. Risk transfer d. Risk identification
An example of a long term investment is:
an expansion of a current product line.
Capital budgeting has a long term focus that provides a link to:
an organization's strategic plan.
Relevant cash flows are:
incremental cash flows that would not occur if not for the investment being evaluated
Capital budgeting is:
long term focused and links to an organization's strategic plan
The terminal value of productive equipment is usually _______ while real property could _______
nominal, appreciate
The profitability index will:
provide how you can get more for your money
Capital budgeting refers to:
the process that managers use to make a decision about whether long term investments are worth pursuing.
Project B has: Risk-free rate - 6% Market risk premium - 7% Beta = .9 Calculate the rate using CAPM:
12.3%
If the price is less than expected:
A manager may decide to stop production.
A growth option is also known as:
A pioneer venture.
What issues can influence differences between IRR and NPV (Select all that apply):
A smaller project versus a larger project Mutually exclusive projects
What should be the first thing you should do when evaluating a new capital project?
Actively find a project that generates enough cash flow that compensates for the risky investment
What are risks of capital budgeting (select all that apply):
Actual project cash flows are unlikely to exactly equal estimated cash flows Assumptions for cash flows are based on information available today
Which of the following is not considered an inflow or outflow used to estimate future annual cash flows:
Advertising expenses to sell the new product
Errors in capital budgeting can:
Affect a firm in the long term.
Real Investment Decisions include all of the following except:
All projects recommended by the board must be selected
Which statement is not true:
Capital budgeting refers to process of identifying, evaluating and selecting short-term investment projects.
The typical Capital Budgeting Method includes (select all that apply)
Estimating the initial cost Finding an adequate discount rate Estimating cash flows
Which one is not a technical difficulty of PCA:
Estimation of present cash flows
Which statement is true about Capital Structure.
Every firm has a target or optimal capital structure.
Select all the true statements about project classification:
Expansion is higher risk factors when entering new markets Assign a risk factor to each project type Replacement projects are the lowest risk factor
What is the maximum number of years that expenses can be considered part of an initial investment for a capital project?
As long as the expense is directly related to the project it can be part of the initial investment
Which is not a common source of capital:
Assets
Select which answer is not part of NPV enhancement.
Assign the same probability for the likelihood of changes in competition, equipment repairs and economic factors.
What are aspects of payback method (select all that apply):
Assumes cash is received evenly throughout the year Cash flows are not discounted
Which statement is not true?
Banks provide funds with full recourse.
The option to defer or wait must:
Be a one-time project investment that is irreversible.
Which is not a challenge of using the CAPM:
CAPM is a historical model
Which is not a disadvantage of the Black-Scholes Model:
Can price all the real options in which the manager decides between investing in development costs for the option to produce a product when the price is above the production cost.
Which statement is not true:
Capital budgeting does not focus on risk.
Which statement is not true regarding capital budgeting for the operational phase of an SPV:
Cash can not be swept out of the project at any time.
Financing and Investment decisions should: (Select all that apply)
Cash rich companies can drive financially weak companies out of the market Investment decisions must consider the potential for generating cash flows Must coordinate investment strategies and financing policies
Corporate strategy must consider:
Companies' resources and factors that allow companies to create value
A PCA has the following feature:
Compares pre-investment estimates with the actual results
Select all the statements that are true regarding the affect of capital investments?
Competitive position Firm performance Future direction
Select all of the below that are decision making techniques for risk:
Comprehensive analysis of a project's risk-return. Sensitivity analysis Intuitively adjusting cash flows
The final stage in capital budgeting is:
Conducting a post completion audit.
Which statement is not true about conglomerates
Conglomerates always outperform a comparable portfolio of stand alone companies
What does payback method focus on?
Cost Recovery
What are the examples of inflows or outflows (select all that apply):
Costs of additional staffing as a result of a recent capital project Increased refreshment sales as a result of a capital project
Capital Rationing is (select all that apply)
Creates competition Funds are limited to invest in projects Only some investments get funded.
Net Income includes which non cash expenses:
Depreciation and Amortization
Sustainable competitive advantage must be built on:
Difficult to imitate
What is not true about risk allocation:
Do not worry about risk
When creating a forecasts for capital budgets, what is one of the most important things that you should do:
Document all assumptions
Select all the true statements about discount rates for new projects.
Document all your assumptions when selecting a discount rate Understand the complexities in selecting the discount rate A discount rate can be selected from other publicly traded firms with a similar risk profile
Which of the following are strengths or weaknesses of the CE method (select all that apply):
Each cash flow has a riskiness established before the time value of money is applied, keeping them separate The difficulty of deterring the correct CEFs CE accounts for time value of money and risk separately
What three concepts are included in measuring investment value?
Economic Value Added; Free Cash Flow; New Present Value
Real Options:
Emerged to demonstrate how longer-term projects generate value for a firm.
How do you compensate for risk (Check all that apply)?
Ensure cash flows generated from projects exceeds the cost of risk Determine the risk associated with the project and ensure the inflows exceed the outflows
Which is not used in the investor portion of the risk premium estimation.
Estimate of a Government bond's beta
When performing the DCF Analysis, which gets the most attention?
Estimating discount rates
The most challenging phase in capital budgeting is:
Estimating project cash flows.
The findings of the study on Evolution of firms showed: (Choose all that apply)
Firm scope is important Managers consider unique resources highly important Expertise of managers is less important after the company goes public
Select all of the techniques that can be used to incorporate risk in capital budgeting:
Judgment adjustment based on the perceived risk of the project Do a three point estimation of the project and compute the average. Probability estimates for all of the inputs in the project Calculate the standard deviation of the outcomes
Why is capital rationing difficult for conglomerates (select all that apply):
Lack of comparability The diversity of the conglomerates divisions.
Which method only allows projects to be accepted up to the total amount of funds available?
Fixed investment budget
Underinvestment problems result in:
Focus on predictable imitative design
The monitoring phase includes (select all that apply)
Focused on profit or cost Estimating whether an investment project will achieve targets
Which is not a cost that should be considered for the construction phase of an SPV:
Generation of cash flows
What are some of the types of real options available: (Select all that apply)
Growth Defer Abandon
Why would a manager use Profitability Index (Select all that apply)?
Helps rank projects that all have positive NPV Selection is based on which project generates the most benefit relative to cost Project selection is based on the higher PI
Select the true statement about projecting cash flows.
Higher discount rates should be used for cash flows in the future
Select all the aspects of a post completion audit:
Holds managers accountable for estimates and selections. Enhances organizational learning. Identify systematic biases in making cash flow estimates.
Put the five steps of capital budgeting in order:
Identify and evaluate potential opportunities Estimate operating and implementation costs Estimate cash flow or benefit Assess risk Implement
Select all the true statements below:
If NPV = $0, the project rate is equal to the discount rate
The option to abandon includes: (Select all that apply):
Lack of innovation can ultimately cause a company to abandon. Is generally viewed as applicable under poor economic conditions. Entrepreneurs with the goal of selling their product rights to larger companies.
Select the true statement about adoption of PCA:
Larger companies; High asset turnover; Capital intensity
Indicate which statements are not true (select all that apply)
If the WACC is underestimated, the firm may reject projects that are not value enhancing. If the WACC is overestimated, the firm may accept projects that are value enhancing.
What type of corporate governance do organizations have available to them:
Implementing proper managerial compensation contracts,
A negative effect of capital rationing is:
Increase pressure to report higher cash flows in a project to improve chances for funding.
Which is not a stage in the industry life cycle:
Infancy
Which is not a construct of organizational learning:
Information preparation
When comparing imitate and innovate, which is true:
Innovation integration require new or unfamiliar production and sales policies
What are examples of completion risks (select all that apply)
Interest rate risk Contract enforceability Country risk
Which is not a standard classification of risks:
Interim-completion risks
Select all the true statements;
Investments with positive net present value (NPV) should be considered. Investments with an internal rate of return (IRR) higher than the prescribed hurdle rate should be considered. When managers select the right investments they should enhance a firm's market value.
Which statement is a true assumption of the CAPM?
Investors are single-period price takers
What is the main attraction to use the CAPM:
It is a simply and practical approach
Which is not an example of Systematic Risk:
It is diversifiable
What is not a characteristic of Preferred Stock
Preferred stock is callable
Which is true about construction contracts:
Prices are predefined.
Operations should have input for a capital budgeting project for (select all that apply)
Production capacity Potential operational constraints
The most difficult stage of capital budgeting is (select all that apply)?
Project definition Cash flow estimation
Which statement is not true:
Projects do not need to be adjusted to compensate for the level of risk
The marketing department is the best source for cost estimates related to:
Promotion, market research and distribution
Which of the following are aspects of the PCA (select all that apply):
Provides early warning to help make changes Helps identify potential under performing investment projects
All are aspects of organizational learning except:
Quick and efficient transfer of learning does not build competitive advantage
Which is not a strength or weakness of the CAPM:
Rarely used due to the difficulty of determining beta
Which is not part of the real options theory:
Real options analysis does not permit strategic thinking.
Select all the answers that are part of the best methods for capital budgeting.
Recognize the time value of money Recognize the amount
Which is NOT an assumption of CAPM"
Risk-free asset do not exist
Which statement is a true use of the adjusted payback period:
Serves as a control measure and indicates a project's liquidity
One way to implement capital rationing is:
Set a hurdle rate higher than the cost of capital
Organization learning is a process of (select all that apply):
Sharing knowledge Detecting errors and correcting them Responding to environment changes
Investment decisions are not:
Short term predictions
Which one is not true:
The SPV can use the sponsor companies resources to design, build and manage the project.
A staged investment option is:
The ability to implement a project through a series of investments rather than all at once.
What is not an example of a competitive advantage?
The company's industry
Which statement is true:
The core of the discount rate is the cost of capital.
What are issues with Payback method (select all that apply):
The decision rule is based on management's perception The amount of money made in excess of cost is ingnored The calculation does not consider the time value of money
When resources are scare or rationed:
The decisions are more difficult.
Which is not a technical problem associated with PCA:
The ease of planning material
Which of the following is true about RADR method:
The higher discount rate lowers the NPV of the project
Identify the categories of relevant cash flows (select all that apply)
The initial investment The expected incremental future net cash flows resulting from the investment The expected terminal value of the investment
Which of the following is not true about CAPM:
The model focuses only on diversified risk
What are the weaknesses of the NPV method (Select all that apply)
The project will be executed for the entire life span Once a project is accepted, management never re-evaluates
Select the component costs in WACC (Select all that apply)
The target market weights should be employed Cost of capital should measure the market cost of the securities included in the capital structure Market weights reflect current conditions of the market
What is not part of the Knowledge Acquisition section of the PCA design:
The timing of a PCA allows a company to respond to lessons learned
Decisions on capital budgeting are among the most important decision of management, why?
They usually involve large amounts of money and can result in large financial consequences if the incorrect project is selected.
Companies should only use their overall cost of capital for projects with risk similar to the firm.
True
Decision makers should realize that project evaluation techniques are only tools to assist in the decision making process`
True
Dynamic NPV allows for multiple discount rates to be used for predicted cash flows
True
Evaluating a completed investment is a core function of PCA
True
For the Arbitrage Pricing Theory to work, the number of factors should be reasonable small.
True
IRR is the rate that will create a $0 NPV
True
Which one is not a consequence of an SPV:
This structure does not allow sponsors to exploit higher leverage ratios.
What is the objective in making long term investment decisions?
To maximize owner's wealth.
Select the organizational problems associated with PCA (Select all that apply)
Top management's lack of interest Reluctance of people
A positive added value is a necessary condition for a sustainable competitive advantage
True
Although EVA focuses on several adjustments to cost of capital and operating capital used, NPV still has more substance in project valuation.
True
An SPV is created with the sole purpose of managing one project
True
Capital rationing discourages biased cash flow forecasts.
True
Cash Flow is not Net Income
True
Changes in cash inflows for a project has influence on IRR
True
What is considered for the Cost of Debt:
Yield To Maturity is a common method of estimating cost of debt
Select all the False statements below:
You do not need to exclude any expenses when calculating cash flow Cash flows are not complicated to calculate
Select the false statement regarding dynamic NPV
You do not need to use different discount rates for cash flows with different risk profiles
