Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?.
NPV and IRR
20). Which of the following statements is CORRECT?
a. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.
b. The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.
c. The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.
d. The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
e. The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.
(Comp.) Miscellaneous concepts
21). Which of the following statements is CORRECT?
a. 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.
b. The discounted payback method eliminates all of the problems associated with the payback method.
c. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project’s acceptability.
d. To find the MIRR, we discount the TV at the IRR.
e. A project’s NPV profile must intersect the X-axis at the project’s WACC.
(11-7) NPV profiles
22). Which of the following statements is CORRECT? Assume that all projects being considered have normal cash flows and are equally risky.
a. If a project’s IRR is equal to its WACC, then, under all reasonable conditions, the project’s NPV must be negative.
b. If a project’s IRR is equal to its WACC, then under all reasonable conditions, the project’s IRR must be negative.
c. If a project’s IRR is equal to its WACC, then under all reasonable conditions the project’s NPV must be zero.
d. There is no necessary relationship between a project’s IRR, its WACC, and its NPV.
e. When evaluating mutually exclusive projects, those projects with relatively long lives will tend to have relatively high NPVs when the cost of capital is relatively high.
Chapter 12 Multiple choice
(12-1) Sunk costs
23). Which of the following statements is CORRECT?
a. A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
b. A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
c. A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
d. Sunk costs were formerly hard to deal with, but once the NPV method came into wide use, it became possible to simply include sunk costs in the cash flows and then calculate the project’s NPV.
e. A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.
(12-1) Relevant cash flows
24). Which of the following factors should be included in the cash flows used to estimate a project’s NPV?
a. All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
b. Interest on funds borrowed to help finance the project.
c. The end-of-project recovery of any additional net operating working capital required to operate the project.
d. Cannibalization effects, but only if those effects increase the project’s projected cash flows.
e. Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.
(12-1) Incremental cash flows
25). Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
a. A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.
b. A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.
c. A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
d. 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.
e. A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.
(12-4) Risk analysis
26). Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’ risks, the company estimated the beta of each project versus both the company’s other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data:
Project X Project Y
Expected NPV $350,000 $350,000
Standard deviation (?NPV) $100,000 $150,000
Project beta (vs. market) 1.4 0.8
Correlation of the
project cash flows with
cash flows from currently
existing projects Cash flows are not
correlated with the
cash flows from
existing projects Cash flows are highly
correlated with the
cash flows from
existing projects
Which of the following statements is CORRECT?
a. Project X has more stand-alone risk than Project Y.
b. Project X has more corporate (or within-firm) risk than Project Y.
c. Project X has more market risk than Project Y.
d. Project X has the same level of corporate risk as Project Y.
e. Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.
(12-4) Project’s effect on firm risk
27). A firm is considering a new project whose risk is greater than the risk of the firm’s average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
a. Increase the estimated IRR of the project to reflect its greater risk.
b. Increase the estimated NPV of the project to reflect its greater risk.
c. Reject the project, since its acceptance would increase the firm’s risk.
d. Ignore the risk differential if the project would amount to only a small fraction of the firm’s total assets.
e. Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
(12-2) Annual CF
28). As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?
Sales revenues $13,000
Depreciation $4,000
Other operating costs $6,000
Tax rate 35.0%
a. $5,950
b. $6,099
c. $6,251
d. $6,407
e. $6,568
Chapter 13 – Multiple Choice
(13-5) Flexibility option
29). Which one of the following is an example of a “flexibility” option?
a. A company has an option to invest in a project today or to wait for a year before making the commitment.
b. A company has an option to close down an operation if it turns out to be unprofitable.
c. A company agrees to pay more to build a plant in order to be able to change the plant’s inputs and/or outputs at a later date if conditions change.
d. A company invests in a project today to gain knowledge that may enable it to expand into different markets at a later date.
e. A company invests in a jet aircraft so that its CEO, who must travel frequently, can arrive for distant meetings feeling less tired than if he had to fly a commercial airline.
(13-6) Risk and project selection
30). Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:
Project Risk Expected Return
A High 15%
B Average 12%
C High 11%
D Low 9%
E Low 6%
Which set of projects would maximize shareholder wealth?
a. A and B.
b. A, B, and C.
c. A, B, and D.
d. A, B, C, and D.
e. A, B, C, D, and E.
(Comp.) Real options
31). Which one of the following will NOT increase the value of a real option?
a. Lengthening the time during which a real option must be exercised.
b. An increase in the volatility of the underlying source of risk.
c. An increase in the risk-free rate.
d. An increase in the cost of obtaining the real option.
e. A decrease in the probability that a competitor will enter the market of the project in question.
(Comp.) Real options
32). Gleason Research regularly takes real options into account when evaluating its proposed projects. Specifically, it considers the option to abandon a project whenever it turns out to be unsuccessful (the abandonment option), and it evaluates whether it is better to invest in a project today or to wait and collect more information (the investment timing option). Assume the proposed projects can be abandoned at any time without penalty. Which of the following statements is CORRECT?
a. The abandonment option tends to reduce a project’s NPV.
b. The abandonment option tends to reduce a project’s risk.
c. If there are important first-mover advantages, this tends to increase the value of waiting a year to collect more information before proceeding with a proposed project.
d. A project can either have an abandonment option or an investment timing option, but never both.
e. Investment timing options always increase the value of a project.
(13-2) Growth option: NPV
33). Tutor.com is considering a plan to develop an online finance tutoring package that has the cost and revenue projections shown below. One of Tutor’s larger competitors, Online Professor (OP), is expected to do one of two things in Year 5: (1) develop its own competing program, which will put Tutor’s program out of business, or (2) offer to buy Tutor’s program if it decides that this would be less expensive than developing its own program. Tutor thinks there is a 35% probability that its program will be purchased for $6 million and a 65% probability that it won’t be bought, and thus the program will simply be closed down with no salvage value. What is the estimated net present value of the project (in thousands) at a WACC = 10%, giving consideration to the potential future purchase?
WACC = 10.0% 0 1 2 3 4 5
Original project: -$3,000 $500 $500 $500 $500 $500
Future Prob.
Buys 35% $6,000
Doesn’t buy 65% $0
a. $161.46
b. $179.40
c. $199.33
d. $219.26
e. $241.19
