Principles of Finance, 6e
Besley/Brigham
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1. Which of the following capital budgeting methods might not consider the salvage value of a machine being considered
for purchase?
a.
Internal rate of return.
b.
Net present value.
c.
Payback.
d.
Discounted payback.
e.
Answers c and d are both correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Ranking Methods
2. When a project’s NPV exceeds zero,
a.
The project will also be acceptable using payback criteria.
b.
The IRR should be calculated to insure that the project’s projected rate of return exceeds the required rate of
return.
c.
The project should be accepted without any further consideration, assuming we are confident that the cash
flows and the required rate of return have been properly estimated.
d.
Only answers a and c are correct.
e.
None of the above is correct.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Ranking Methods
3. Assume a project has normal cash flows (i.e., the initial cash flow is negative, and all other cash flows are positive).
Which of the following statements is most correct?
a.
b.
c.
d.
e.
ANSWER:
e
RATIONALE:
A project’s NPV increases as the required rate of return declines. A project’s IRR is
independent of its required rate of return.
Principles of Finance, 6e
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e.
All of the above comprise the underlying cause of ranking conflicts.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Ranking Conflicts
7. The post-audit is used to
a.
Improve cash flow forecasts.
b.
Stimulate management to improve operations and bring results into line with forecasts.
c.
Eliminate potentially profitable but risky projects.
d.
All of the above are correct.
e.
Only answers a and b are correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Post-Audit
8. Which of the following statements is correct?
a.
The NPV method assumes that cash flows will be reinvested at the required rate of return 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 required rate of return while the IRR
method assumes reinvestment at the risk-free rate.
d.
The NPV method does not consider the inflation premium.
e.
The IRR method does not consider all relevant cash flows, and particularly cash flows beyond the payback
period.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Ranking Conflicts
Principles of Finance, 6e
Besley/Brigham
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9. When evaluating a new project, the firm should consider all of the following factors except:
a.
Changes in working capital attributable to the project.
b.
Previous expenditures associated with a market test to determine the feasibility of the project, if the
expenditures have been expensed for tax purposes.
c.
The current market value of any equipment to be replaced.
d.
The resulting difference in depreciation expense if the project involves replacement.
e.
All of the above should be considered.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Relevant Cash Flows
10. Which of the following statements is most correct?
a.
Sunk costs should be ignored in capital budgeting.
b.
Opportunity costs should be ignored in capital budgeting.
c.
Externalities should be ignored in capital budgeting.
d.
Answers a, b, and c are all correct.
e.
Answers a, b, and c are all incorrect.
ANSWER:
a
RATIONALE:
Statement a is correct; the other statements are simply false.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Relevant Cash Flows
11. Which of the following is not a cash flow that results from the decision to accept a project?
a.
Changes in working capital.
b.
Shipping and installation costs.
c.
Sunk costs.
d.
Opportunity costs.
e.
Externalities.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Easy
Principles of Finance, 6e
Besley/Brigham
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method for assessing risk. In evaluating this asset, the decision maker should
a.
Increase the IRR of the asset to reflect the greater risk.
b.
Increase the NPV of the asset to reflect the greater risk.
c.
Reject the asset, since its acceptance would increase the risk of the firm.
d.
Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of
the firm.
e.
Increase the required rate of return used to evaluate the project to reflect the higher risk of the project.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Accepting Risky Projects
17. Risk in a revenue producing project can best be adjusted for by
a.
Ignoring it.
b.
Adjusting the discount rate upward for increasing risk.
c.
Adjusting the discount rate downward for increasing risk.
d.
Picking a risk factor equal to the average discount rate.
e.
Reducing the NPV by 10 percent for risky projects.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Risk Adjustment
18. The present value of the expected net cash inflows for a project will most likely exceed the present value of the
expected net profit after tax for the same project because
a.
Income is reduced by taxes paid, but cash flow is not.
b.
There is a greater probability of realizing the projected cash flow than the forecasted income.
c.
Income is reduced by dividends paid, but cash flow is not.
d.
Income is reduced by depreciation charges, but cash flow is not.
e.
Cash flow reflects any change in net working capital, but sales do not.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
Principles of Finance, 6e
Besley/Brigham
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a.
The NPV and IRR rules will always lead to the same decision unless one or both of the projects are “non-
conventional” in the sense of having only one change of sign in the cash flow stream, i.e., one or more initial
cash outflows (the investment) followed by a series of cash inflows.
b.
If a conflict exists between the NPV and the IRR, the conflict can always be eliminated by dropping the IRR
and replacing it with the payback period.
c.
There will be a meaningful (as opposed to irrelevant) conflict only if the projects’ NPV profiles cross, and
even then, only if the required rate of return is to the left of (or lower than) the discount rate at which the
crossover occurs.
d.
Statements a, b, and c are all true.
e.
None of the above is a correct statement.
ANSWER:
c
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
NPV and IRR
24. The internal rate of return of a capital investment
a.
Changes when the required rate of return changes.
b.
Is equal to the annual net cash flows divided by one half of the project’s cost when the cash flows are an
annuity.
c.
Must exceed the required rate of return in order for the firm to accept the investment.
d.
Is similar to the yield to maturity on a bond.
e.
Answers c and d are both correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
IRR
25. Projects L and S each have an initial cost of $10,000, followed by a series of positive cash inflows. Project L has total,
undiscounted cash inflows of $16,000, while S has total undiscounted inflows of $15,000. Further, at a discount rate of 10
percent, the two projects have identical NPVs. Which project’s NPV will be more sensitive to changes in the discount
rate? (Hint: Projects with steeper NPV profiles are more sensitive to discount rate changes.)
a.
Project S.
b.
Project L.
c.
Both projects are equally sensitive to changes in the discount rate since their NPVs are equal at all required
Principles of Finance, 6e
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rates of return.
d.
Neither project is sensitive to changes in the discount rate, since both have NPV profiles which are horizontal.
e.
The solution cannot be determined unless the timing of the cash flows is known.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
NPV Profiles
26. Two mutually exclusive projects each have a cost of $10,000. The total, undiscounted cash flows from Project L are
$15,000, while the undiscounted cash flows from Project S total $13,000. Their NPV profiles cross at a discount rate of 10
percent. Which of the following statements best describes this situation?
a.
The NPV and IRR methods will select the same project if the required rate of return is greater than 10 percent;
for example, 18 percent.
b.
The NPV and IRR methods will select the same project if the required rate of return is less than 10 percent; for
example, 8 percent.
c.
To determine if a ranking conflict will occur between the two projects the required rate of return is needed as
well as an additional piece of information.
d.
Project L should be selected at any required rate of return, because it has a higher IRR.
e.
Project S should be selected at any required rate of return, because it has a higher IRR.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
NPV Profiles
27. Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital
budgeting?
a.
The return on invested capital is the only relevant cash flow.
b.
Only incremental cash flows are relevant to the accept/reject decision.
c.
Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
d.
All of the above are correct.
e.
Only answers a and b are correct.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
Principles of Finance, 6e
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a.
Well-diversified stockholders, because it may affect debt capacity and operating income.
b.
Management, because it affects job stability.
c.
Creditors, because it affects the firm’s credit worthiness.
d.
All of the above are correct.
e.
Only answers a and c are correct.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Corporate Risk
35. Which of the following statements is correct?
a.
Neither “stand-alone” nor “within-firm” risk takes account of diversification, either by stockholders or by the
firm.
b.
If a project’s expected returns are highly correlated with returns on the market, this will tend to reduce the
project’s market risk.
c.
Monte Carlo simulation analysis and sensitivity analysis are similar, but sensitivity analysis is generally harder
to use because it requires knowledge of the probability distributions associated with the input variables.
d.
Sensitivity analysis requires a project’s beta coefficient, which can be obtained by either the “pure play” or the
“accounting beta” method.
e.
If we are choosing between two mutually exclusive projects which have only costs (no revenues), the riskier
one should be evaluated with a lower required rate of return.
ANSWER:
e
RATIONALE:
If we found the PV of costs for the riskier project using a higher discount rate, the PV of
costs would get lower the riskier the project. This would be illogical. The way to correct
the problem is to discount riskier cash outflows with a lower discount rate.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Risk Analysis
36. Which of the following statements is most correct?
a.
Sensitivity analysis is incomplete because it fails to consider the range of likely values of key variables as
reflected in their probability distributions.
b.
In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less
risky, because a small error in estimating a variable, such as unit sales, would produce only a small error in the
project’s NPV.
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c.
The primary advantage of simulation is that it provides a very accurate point estimate of a project’s NPV.
d.
One important benefit of simulation analysis as compared to scenario analysis, is that once the analysis is
complete, it provides a clear accept/reject decision rule.
e.
Answers c and d are both correct.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Methods of Analysis
37. Monte Carlo simulation
a.
Can be useful for estimating a project’s stand-alone risk.
b.
Is capable of using probability distributions for variables as input data instead of a single numerical estimate
for each variable.
c.
Produces both an expected NPV (or IRR) and a measure of the riskiness of the NPV or IRR.
d.
All of the above.
e.
Only answers a and b are correct.
ANSWER:
d
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
DISC-FIN-05 – Financial Analysis and Cash Flows
Time Estimate-a – 5 min.
TOPICS:
Monte Carlo Simulation
38. Which of the following methods involves calculating an average beta for firms in a similar business and then applying
that beta to determine the beta of its own project?
a.
Risk premium method.
b.
Pure play method.
c.
Accounting beta method.
d.
CAPM method.
e.
Answers b and c are both correct.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
Principles of Finance, 6e
Besley/Brigham
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41. If a company uses the same discount rate for evaluating all projects, which of the following results is likely?
a.
Accepting poor, high-risk projects.
b.
Rejecting good, low-risk projects.
c.
Accepting only good, low risk projects.
d.
Accepting no projects.
e.
Answers a and b are both correct.
ANSWER:
e
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Risk-Adjusted Discount Rate
42. The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems. Since the company’s
revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of
each set of costs. The firm’s required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for
project risk differences. System A is judged to be a high-risk project (it might end up costing much more to operate than is
expected). The appropriate risk-adjusted discount rate that should be used to evaluate System A is
a.
10%; this might seem illogical at first, but it correctly adjusts for risk where outflows, rather than inflows, are
being discounted.
b.
13%; the firm’s required rate of return should not be adjusted when evaluating outflow only projects.
c.
16%; since A is more risky, its cash flows should be discounted at a higher rate, because this correctly
penalizes the project for its high risk.
d.
Somewhere between 10% and 16%, with the answer depending on the riskiness of the relevant inflows.
e.
Indeterminate, or, more accurately, irrelevant, because for such projects we would simply select the process
that meets the requirements with the lowest required investment.
ANSWER:
a
RATIONALE:
rA = 13% − 3% = 10%. If the cash flows are cost only outflows, and the analyst wants to
correctly reflect their risk, the discount rate should be adjusted downward (in this case by
subtracting 3 percentage points) to make the discounted flows comparatively larger.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Risk Adjustment
43. Which of the following statements is correct?
a.
Sensitivity analysis is used frequently in capital budgeting analysis. Its big advantage is that because it shows
correlations between changes in input variables and NPV, it accounts for within-firm risk.
b.
Other things held constant, the lower the correlation between a project’s returns and returns on the market, the
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less risky the project.
c.
In judging the relative stand-alone risks of a set of projects, the projects’ standard deviations of NPV are a
better measure than their coefficients of variation.
d.
One can run a regression of returns on a project versus returns on the firm’s other assets, get a beta coefficient,
and use this beta as a measure of the project’s market risk.
e.
One can run a regression of returns on a project versus returns on the stock market, get a beta coefficient, and
use this beta as a measure of the project’s within-firm risk.
ANSWER:
b
RATIONALE:
Statement a is false. While sensitivity analysis shows the sensitivity of NPV to changes in
key variables, it doesn’t give the range of likely values. A project’s stand–alone risk
depends on both factors. Statement c is false; the coefficient of variation is a better
measure of relative stand-alone risk between a set of projects than standard deviation.
Statements d and e are false. The statements have been reversed. A regression of a
project’s returns versus returns on the firm’s other assets provides a beta which could be
used to measure the project’s within-firm risk. A regression of a project’s returns versus
the returns on the stock market provides a beta which could be used to measure the
project’s market risk.
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Miscellaneous
44. If a typical U.S. company uses the same discount rate to evaluate all projects, the firm will most likely become
a.
Riskier over time, and its value will decline.
b.
Riskier over time, and its value will rise.
c.
Less risky over time, and its value will rise.
d.
Less risky over time, and its value will decline.
e.
There is no reason to expect its risk position or value to change over time as a result of its use of a single
discount rate.
ANSWER:
a
POINTS:
1
DIFFICULTY:
Moderate
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Risk-Adjusted Discount Rate
45. Your assistant has just completed an analysis of two mutually exclusive projects. You must now take her report to a
board of directors meeting and present the alternatives for the board’s consideration. To help you with your presentation,
your assistant also constructed a graph with NPV profiles for the two projects. However, she forgot to label the profiles,
so you do not know which line applies to which project. Of the following statements regarding the profiles, which one is
most reasonable?
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a.
If the two projects have the same investment cost, and if their NPV profiles cross once in the upper right
quadrant, at a discount rate of 40 percent, this suggests that a NPV versus IRR conflict is not likely to exist.
b.
If the two projects’ NPV profiles cross once, in the upper left quadrant, at a discount rate of minus 10 percent,
then there will probably not be a NPV versus IRR conflict, irrespective of the relative sizes of the two projects,
in any meaningful, practical sense (that is, a conflict which will affect the actual investment decision).
c.
If one of the projects has a NPV profile which crosses the X-axis twice, hence the project appears to have two
IRRs, your assistant must have made a mistake.
d.
Whenever a conflict between NPV and IRR exist, then, if the two projects have the same initial cost, the one
with the steeper NPV profile probably has less rapid cash flows. However, if they have identical cash flow
patterns, then the one with the steeper profile probably has the lower initial cost.
e.
If the two projects both have a single outlay at t = 0, followed by a series of positive cash inflows, and if their
NPV profiles cross in the lower left quadrant, then one of the projects should be accepted, and both would be
accepted if they were not mutually exclusive.
ANSWER:
b
POINTS:
1
DIFFICULTY:
Hard
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
NPV Profiles
46. The Ace Company is considering investing in a piece of property which costs $105,000. The property will return a
constant cash flow forever. If the firm’s required rate of return is 9 percent and the corporate tax rate is 40 percent, what is
the minimum after-tax cash flow that would make the investment acceptable to Ace?
a.
$15,942
b.
$10,831
c.
$9,450
d.
$2,375
e.
$5,000
ANSWER:
c
RATIONALE:
Note: MACRS accelerated depreciation rates should be given for some of these
problems. These rates are provided in the text and on the formula pages.
POINTS:
1
DIFFICULTY:
Easy
ACCREDITING STANDARDS:
Blooms Taxonomy-5 – Knowledge
Business Program-6 – Reflective Thinking
DISC-FIN-03 – Capital Budgeting and Cost of Capital
Time Estimate-a – 5 min.
TOPICS:
Perpetual Cash Flow
47. The Seattle Corporation has been presented with an investment opportunity which will yield cash flows of $30,000 per
year in Years 1 through 4, $35,000 per year in Years 5 through 9, and $40,000 in Year 10. This investment will cost the
firm $150,000 today, and the firm’s required rate of return is 10 percent. Assume cash flows occur evenly during the year,
1/365th each day. What is the payback period for this investment?