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Managerial Economics, 7e (Keat)
Chapter 12 Capital Budgeting and Risk (Appendix 12A)
Multiple-Choice Questions
1) The term capital budgeting refers to decisions
A) which are made in the short run.
B) which concern the spreading of expenditures over a period lasting less than one year.
C) where expenditures and receipts for a particular undertaking will continue over a relatively
long period of time.
D) where a receipt of cash will occur simultaneously with an outflow of cash.
2) Capital budgeting projects include all of the following except
A) the purchase of a six-month treasury bill.
B) the expansion of a plant.
C) the development of a new product.
D) the replacement of a piece of equipment.
3) If $1,000 is placed in an account earning 8% annually, the balance at the end of seven years
will be
A) $1,080.
B) $1,560.
C) $2,000.
D) $1,714.
4) The payback period for a project, requiring an initial outlay of $10,000 and producing ten
uniform annual cash inflows of $1,500, is
A) six years.
B) six years and eight months.
C) six years and six months.
D) seven years.
5) The net present value of a project is calculated as
A) the future value of all cash inflows minus the present value of all outflows.
B) the sum of all cash inflows minus the sum of all cash outflows.
C) the present value of all cash inflows minus the present value of all cash outflows.
D) None of the above
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6) A proposed project should be accepted if the net present value is
A) positive.
B) negative.
C) larger than the internal rate of return.
D) smaller than the internal rate of return.
7) When future events cannot be assigned probabilities, we are talking about
A) risk.
B) uncertainty.
C) a clouded future.
D) financial risk.
8) Probabilities, which can be obtained by repetition or are based on general mathematical
principles, are called
A) statistical.
B) empirical.
C) a priori.
D) subjective.
9) Other things being equal, the higher the cost of capital
A) the higher the NPV of a project.
B) the higher the IRR of the project.
C) the lower the NPV of the project.
D) The cost of capital has no effect on the NPV of the project.
10) The internal rate of return of a project can be found by
A) discounting all cash flows at the cost of capital.
B) averaging all cash inflows, and calculating the interest rate, which will make them equal to
the average investment.
C) calculating the interest rate, which will equate the present value of all cash inflows to the
present value of all cash outflows.
D) None of the above
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11) In finance, risk is most commonly measured by
A) the probability distribution.
B) the standard deviation.
C) the average deviation.
D) the square root of the standard deviation.
12) A project whose acceptance eliminates another project from consideration is called
A) independent.
B) mutually exclusive.
C) replacement.
D) complementary.
13) The internal rate of return equals the cost of capital when
A) NPV = 0.
B) NPV > 0.
C) NPV < 0.
D) None of the above
14) When two mutually exclusive projects are considered, the NPV calculations and the IRR
calculations may, under certain circumstances, give conflicting recommendations as to which
project to accept. The reason for this result is that in the NPV calculation, cash inflows are
assumed to be reinvested at the cost of capital, while in the IRR solution, reinvestment takes
place at
A) the hurdle rate.
B) the accounting rate of return.
C) the prime rate.
D) the project's internal rate of return.
15) When analyzing a capital budgeting project, the analyst must include in his calculation all of
the following except
A) all revenues and costs in terms of cash flows.
B) only those cash flows that will change if the proposal is accepted (i.e., incremental cash
flows).
C) interest payments on debt financing connected with the project.
D) any effect (impact) the acceptance of the project under consideration will have on other
projects now in operation.
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16) The use of the same cost of capital (risk adjusted discount rate) for all capital projects in a
corporation
A) is usually the correct procedure.
B) is incorrect since different divisions of the corporation may be faced with different levels of
risk.
C) is incorrect since different capital projects, even in the same division, may be faced with
different levels of risk.
D) Both B and C
17) If a risky cash flow of $10,000 is equivalent to a riskless cash flow of $9,300, the certainty
equivalent factor is
A) 0.93.
B) 0.07.
C) 1.07.
D) 1.93.
18) If, at the end of the project life, a piece of equipment having a book value of $4,000 is
expected to bring $3,000 upon resale, and the income tax rate is 40%, how much will be the cash
flow?
A) $2,800
B) $3,000
C) $3,400
D) $4,000
19) If the risk adjusted discount rate method and the certainty equivalent methods are to give the
same results, then the certainty equivalent factor (at) must equal (where rf is the risk-free interest
rate, and "k" is the risk adjusted cost of capital)
A) (1 + rf)t times (1 + k)t.
B) (1 + k)t divided by (1 + rf)t.
C) (1 + rf)t divided by (1 + k)t.
D) (1 + k)t minus (1 + rf)t.
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20) Two projects have the following NPVs and standard deviations:
Project A Project B
NPV 200 200
Standard deviation 75 100
A person who selects project A over project B is
A) risk seeking.
B) risk indifferent.
C) risk averse.
D) None of the above
21) An increase in net working capital required at the beginning of an expansion project must be
considered to be
A) a cash inflow.
B) a reallocation of assets.
C) a cash outflow.
D) None of the above
22) Usually, the cost of capital for newly issued stock is ________ the cost of retained earnings.
A) lower than
B) higher than
C) same as
D) either higher or lower than
23) A stock whose rate of return fluctuates less than the rate of return of a market portfolio will
have a beta that equals
A) 1.
B) less than 1.
C) more than 1.
D) Either A or C above
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24) A company's capital structure is made up of 40% debt and 60% common equity (both at
market values). The interest rate on bonds similar to those issued by the company is 8%. The cost
of equity is estimated to be 15%. The income tax rate is 40%. The company's weighted cost of
capital is
A) 11.5%.
B) 12.2%.
C) 10.9%.
D) 8.9%.
25) Capital rationing
A) exists when a company sets an arbitrary limit on the amount of investment it is willing to
undertake, so that not all projects with an NPV higher than the cost of capital will be accepted.
B) generally does not permit a company to achieve maximum value.
C) seems to occur quite frequently among corporations.
D) All of the above
26) The time value of money can be best described as
A) a dollar today is worth more than a dollar tomorrow.
B) the basis on which net present values are calculated.
C) the basis on which internal rates of return are calculated.
D) All of the above
27) Net present value and internal rate of return capital budgeting decisions can differ because
A) the initial costs of the capital outlays differ.
B) the cash flow streams differ.
C) the discount rates differ for different time periods.
D) All of the above
28) Simulation analysis
A) permits the calculation of expected value and standard deviation.
B) does not permit the calculation of expected value and standard deviation.
C) is too complex to ever be used in actual business situations.
D) does not consider probabilities.
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29) The expected value is
A) the total of all possible outcomes.
B) the arithmetic average of all possible outcomes.
C) the average of all possible outcomes weighted by their respective probabilities.
D) the total of all possible outcomes divided by the number of different possible outcomes.
30) An advantage of the decision tree is that
A) it eliminates the need for calculating the cost of capital.
B) it eliminates the need for calculating probabilities.
C) it causes the analyst to consider important events that may occur in the course of the project,
and decisions and actions that may have to be undertaken.
D) All of the above
31) A real option can present management with the opportunity to
A) vary output.
B) abandon a project.
C) postpone a project.
D) All of the above
32) A source of business risk is a change in
A) technology.
B) consumer preferences.
C) input prices.
D) All of the above
33) The certainty equivalent approach to accounting for risk in capital budgeting involves
A) adjusting the discount rate used to calculate net present values.
B) adjusting the expected cash flows.
C) estimating the coefficient of variation.
D) estimating the standard deviation of the net present values.
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34) Which of the following is an example of risk in capital budgeting on a global basis?
A) exchange rate changes
B) tariff changes
C) expropriation
D) All of the above
35) The risk adjusted discount rate
A) is the sum of the risk-free rate and the risk premium.
B) includes risk in the denominator of the present value calculation.
C) includes risk in the numerator of the present value calculation.
D) All of the above
36) A drawback in using the payback approach to capital budgeting decisions is
A) it doesn't account for the time value of money.
B) it ignores cash flows beyond the payback period.
C) it doesn't adjust for differences in the stream of cash flows.
D) All of the above
37) The cost of capital is best described as the
A) opportunity cost of financing a capital outlay.
B) funds that must be acquired to finance a capital outlay.
C) decrease in stockholder equity due to a capital outlay.
D) All of the above
38) Capital rationing refers to
A) setting a minimum acceptable rate of return for a capital outlay.
B) selecting among profitable capital outlays when there are constraints on the funds available.
C) determining the maximum price to pay for a capital product.
D) None of the above
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