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10) If the cash flows of an accepted investment project are negatively correlated with the average cash
flow of the firm’s existing assets, then the company‘s total exposure to risk can decrease.
Keywords: Contribution-To-Firm Risk, Negative Correlation
Learning Obj.: L.O. 11.4
AACSB: Analytical Thinking
11) Financial theory assumes that individuals are risk averse.
Keywords: Risk Aversion
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
12) The risk-adjusted discount rate for a replacement decision will be less than the rate used by the same
firm when considering a new product line.
Keywords: Risk-Adjusted Discount Rate, Replacement Decision
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
13) The less-risky investment is always the more desirable choice.
Keywords: Risk-Return Trade-off
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
14) A method for estimating a project’s beta that attempts to identify publicly traded firms engage solely
in the same business as the project is called the pure play method.
Keywords: Pure Play Method, Beta
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
15) Sensitivity analysis involves changing one variable at a time.
Keywords: Sensitivity Analysis
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
41
16) A typical decision rule used in simulation is to accept the project if the probability is sufficiently high
that the net present value is positive.
Keywords: Simulation
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
17) Reducing the probability of bankruptcy is a benefit of diversification.
Keywords: Diversification, Probability of Bankruptcy
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
18) Using simulation provides the financial manager with a probability distribution of an investment’s
net present value or internal rate of return.
Keywords: Simulation, Probability Distribution
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
19) A wildcat oil driller has enough capital to invest in only one project, that is, to drill one well in an East
Texas oil field. A major oil company is drilling 100 wells in the same field. The probability of successfully
striking oil is 10% for any well drilled in this field. Which of the following statements is MOST correct
concerning the risk involved in these capital budgeting projects?
A) The risk for the wildcat driller is the same as the risk for the major oil company since they are both
drilling in the same oil field.
B) The appropriate risk for the wildcat driller is systematic risk.
C) The appropriate risk for the major oil company is contribution–to-firm risk, if all shareholders of the
firm are well diversified.
D) The best measure of risk for the wildcat oil driller is project standing alone risk.
Keywords: Project Standing Alone Risk, Contribution-to-firm Risk, Systematic Risk
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
42
20) Bill and Mary own a small chain of high fashion boutiques that represent almost 100% of their net
worth. When considering capital budgeting projects for their boutiques, the appropriate measure of risk
is
A) project standing alone risk.
B) systematic risk.
C) contribution–to-firm risk.
D) beta risk.
Keywords: Contribution-To-Firm Risk, Project Standing Alone Risk, Systematic Risk
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
21) If bankruptcy costs and/or shareholder under diversification are an issue, what measure of risk is
relevant when evaluating project risk in capital budgeting?
A) total project risk
B) contribution-to-firm risk
C) systematic risk
D) capital rationing risk
Keywords: Contribution–To-Firm Risk, Bankruptcy, Diversification
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
22) Which of the following is the most relevant measure of risk for capital budgeting purposes?
A) project standing alone risk
B) contribution-to-firm risk
C) symbiotic risk
D) unsystematic risk
Keywords: Contribution-To-Firm Risk
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
23) Which of the following statements about project standing alone risk is true?
A) It ignores the fact that much of the risk of a project will be diversified away as the project is combined
with the firm’s other projects.
B) It ignores the cash flows that are associated with a project that occur beyond the payback period.
C) It takes into consideration the effects of diversification of the firm‘s shareholders.
D) It provides the best measure of project risk for a large, widely-held company.
Keywords: Project Standing Alone Risk, Diversification
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
43
24) A bakery company is considering one capital budgeting project involving the replacement of a
sophisticated brick oven, and another capital budgeting project involving research and development into
synthetic food substitutes. Which of the following statements is MOST correct concerning the risk–
adjusted discount rate(s) for the projects?
A) The rate will likely be higher for the replacement project because the likelihood of success is higher.
B) The rate will likely be higher for the research and development project because of the uncertainty
involved with research and development projects.
C) The rate should be the same for both projects because they are being considered by one company with
the same common shareholders.
D) The rate should be higher for the replacement project because the company is more certain of the
returns from a project similar to their existing business.
Keywords: Risk-Adjusted Discount Rate
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
25) The pure play method
A) calculates beta using only project returns.
B) uses the beta of a firm that is similar to the project being analyzed to determine the required rate of
return for the project.
C) selects a firm similar to the project being analyzed and uses its returns as the market return in
estimating a project beta.
D) selects one of the firm’s existing projects that is similar to the project being analyzed and uses that
project’s required rate of return.
Keywords: Pure Play Method, Beta
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
26) Which of the following is NOT an important consideration in measuring risk for a capital budgeting
project for a well-diversified firm?
A) systematic risk
B) contribution to firm risk
C) total project risk
D) None of the above—all may be important in measuring project risk.
Keywords: Risk, Total Project Risk, Systematic Risk, Contribution-to–firm Risk
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
44
27) Humongous Corporation is a multidivisional conglomerate. The Food Division is undergoing a
capital budgeting analysis and must estimate the division’s beta. This division has a different level of
systematic risk than is typical for Humongous Corporation as a whole. The most appropriate method for
estimating this beta is
A) the regression coefficient from a time series regression of Humongous Corporation stock returns on a
market index.
B) to multiply the company‘s beta by the ratio of the Food Division’s total assets/Humongous Corporation
total assets.
C) the regression coefficient from a time series regression of Food Division’s net income on the
Humongous Corporation‘s return on assets.
D) the regression coefficient from a time series regression of Food Division‘s return on assets on a market
index.
Keywords: Beta, Time Series Regression
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
28) One method of accounting for systematic risk for a project involves identifying a publicly traded firm
that is engaged in the same business as that project and using its required rate of return to evaluate the
project. This method is referred to as
A) the accounting beta method.
B) scenario analysis.
C) the pure play method.
D) sensitivity analysis.
Keywords: Pure Play Method
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
29) Creighton Industries is considering the purchase of a new strapping machine, which will cost
$150,000, plus an additional $10,500 to ship and install. The new machine will have a 5-year useful life
and will be depreciated to zero using the straight-line method. The machine is expected to generate new
sales of $45,000 per year and is expected to save $16,000 in labor and electrical expenses over the next 5–
years. The machine is expected to have a salvage value of $20,000. Creighton’s income tax rate is 35%.
Creighton uses a 12.5% discount rate for capital budgeting purposes. What is the machine’s NPV?
A) $29,888
B) $25,062
C) $22,153
D) $27,894
Keywords: Incremental After-Tax Cash Flows, Initial Outlay, Net Present Value, Risk-Adjusted Discount Rate
Learning Obj.: L.O. 11.4
AACSB: Analytical Thinking
45
30) Advantages of using simulation include
A) adjustment for risk in the resulting distribution of net present values.
B) a range of possible outcomes presented.
C) is good only for single period investments since discounting is not possible.
D) graphically displays all possible outcomes of the investment.
Keywords: Keywords: Simulation
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
31) What method is used for calculation of the accounting beta?
A) simulation
B) regression analysis
C) sensitivity analysis
D) both A and C
Keywords: Accounting Beta, Regression Analysis
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
32) The simulation approach provides us with
A) a single value for the risk-adjusted net present value.
B) an approximation of the systematic risk level.
C) a probability distribution of the project‘s net present value or internal rate of return.
D) a graphic exposition of the year–by-year sequence of possible outcomes.
Keywords: Simulation, Probability Distribution
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
33) Which of the following is NOT an acceptable method of measuring risk for capital budgeting
purposes?
A) modified internal rate of return
B) sensitivity analysis
C) using a risk-adjusted discount rate
D) proxy, or pure play method for estimating a project’s beta
Keywords: Risk, Sensitivity Analysis, Risk-Adjusted Discount Rate, Pure Play Method
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking
46
34) The financial manager selecting one of two projects of differing risk should
A) select the project with the larger risk-adjusted net present value.
B) choose the project with the least relative risk.
C) choose the project with greater return even if that project has greater risk.
D) choose the project with less risk even though that project has less return.
Keywords: Net Present Value
Learning Obj.: L.O. 11.2
AACSB: Analytical Thinking
35) KLE Holdings is considering a capital budgeting project with a life of 7 years that requires an initial
outlay of $277,400. The probability distribution for annual incremental cash flows is as follows:
Probability
Incremental Free Cash Flow
4%
-$15,000
16%
18,000
55%
65,000
25%
99,000
a. The risk-adjusted required rate of return for this project is 12%. Calculate the risk-adjusted net
present value of the project and the project’s IRR.
b. Should the project be accepted?
Keywords: Risk-Adjusted Net Present Value, IRR
Learning Obj.: L.O. 11.4
AACSB: Analytical Thinking
47
36) John Q. Enterprises is considering two potential investments. The probability distributions of annual
end-of-year cash flows for the respective projects are:
Project A
Project B
Probability
Outcome
Probability
Outcome
0.25
$10,000
0.25
$12,000
0.50
$15,000
0.50
$15,000
0.25
$20,000
0.25
$18,000
Both projects will require an initial outlay of $45,000 and will have an estimated life of 6 years. Project A
is considered a riskier investment and will have to have a risk-adjusted required rate of return of 15%,
while Project B’s risk-adjusted required rate of return is 12%.
a. Determine the expected value of each project’s annual cash flow.
b. Determine each project’s risk-adjusted net present value.
Keywords: Expected Incremental Cash Flows, Risk-adjusted Net Present Value
Learning Obj.: L.O. 11.4
AACSB: Analytical Thinking
37) What is the most commonly used method for incorporating risk into the capital-budgeting decision?
How is this technique related to Principle 3: Risk Requires a Reward?
Keywords: Risk-Adjusted Net Present Value, IRR
Learning Obj.: L.O. 11.4
AACSB: Reflective Thinking