CHAPTER 10—PROJECT CASH FLOWS AND RISK
TRUE/FALSE
1. If an investment project would make use of land which the firm currently owns, the project
should be charged with the opportunity cost of the land.
2. When calculating the cash flows for a project, you should include interest payments.
3. With the current techniques available, estimating cash flows has become the easiest step in the
analysis of a capital budgeting project.
4. Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large
projects are forecast with great accuracy, but revenues are more uncertain and large errors are not
uncommon.
5. Net incremental operating cash flow is calculated by adding back the change in depreciation to
the change in income after taxes.
6. In cash flow estimation, the presence of externalities has no direct cash flow effects.
7. A key difference between replacement and expansion project analyses is that with replacement,
the incremental cash flows are measured as the net difference between projected cash flows from
the current productive assets and cash flows of the proposed new productive assets.
8. If an asset being considered for acquisition has beta of zero, its purchase will have no effect on
the firm’s market risk.
9. A particular project might have very uncertain cash flows, hence a highly uncertain NPV and
IRR, yet it may not have high market risk.
10. When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if
its IRR is greater than the firm’s average required rate of return.
11. One problem with Monte Carlo simulation analysis is that, while the simulation may provide
some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus
reject decision.
214 Chapter 10 Project Cash Flows and Risk
12. Empirical studies of risk strongly support the contention that investors who are well diversified
focus exclusively on market risk when they establish required returns.
13. Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of
that calculated risk measure is more difficult.
14. If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm,
it should use a discount rate greater than the firm’s average required rate of return to evaluate the
possible investment.
15. Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the
more distant cash flows are riskier.
16. The situation where a firm accepts projects to the point where the return on the last project
accepted is just equal to or greater than the firm’s required rate of return (IRR k at the margin) is
called capital rationing.
17. Capital budgeting decisions must be based on the accounting income the project generates since
stockholders are concerned with the reported net income the firm generates.
18. A sunk is a cash outlay that has already been incurred and that cannot be recovered regardless of
whether the project is accepted or rejected. These sunk costs are extremely important in capital
budgeting decisions.
19. Inflation does not need to be built into expected cash flows; the discount rate used in net present
value calculations captures the effect of inflation. If you were to include expected inflation into
cash flows, all net present value calculations would be incorrect.
20. Replacement analysis involves the decision of whether to replace an existing asset that is still
productive with a new asset.
21. The stand-alone risk is the risk an asset would have if it were a firm’s only asset and it is
measured by the variability of the asset’s expected returns.
22. Corporate risk does not take into consideration the effects of stockholder’s diversification; it is
measured by a project’s effect on the firm’s earnings variability.
Chapter 10 Project Cash Flows and Risk 215
23. The beta risk of a project is that part of the project’s that cannot be eliminated by diversification.
Investors are not concerned about this type of since it can not be diversified.
24. Sensitivity analysis is a risk analysis technique in which key variables are changed and the
resulting changes in the NPV and IRR are observed.
25. The two cardinal rules which financial analysts follow to avoid capital budgeting errors are: (1)
capital budgeting decisions must be based on accounting income, and (2) only incremental cash
flows are relevant to accept/reject decisions.
26. Suppose a firm is considering production of a new product whose projected sales include sales
that will be taken away from another product the firm also produces. The lost sales on the existing
product are a sunk cost and are not a relevant cost to the new product.
27. Superior analytical techniques, such as NPV, used in combination with adjustments to the
average required rate of return, can overcome the problem of poor cash flow estimation in
decision making.
28. It is extremely difficult to estimate the revenues and costs associated with large complex projects
that take several years to develop. This is why subjective judgment is recommended for such
projects instead of cash flow analysis.
29. It is possible with a replacement project that the incremental depreciation cash flows will be
negative even if the actual depreciation on the new asset is positive.
30. Sensitivity analysis measures the stand-alone risk of a project by showing how much the project’s
NPV is affected by a small change in one of the input variables, such as sales. Other things held
constant, with the independent variable graphed on the horizontal axis, the steeper the graph of
the relationship line, the less risky the project.
31. As a practical matter, it is much easier to use market risk analysis at the project level than at the
divisional level because it is easier to estimate the beta of a single project such as a machine tool
die maker than the beta of an entire division (or subsidiary) such as Phillip Morris’ Kraft foods
unit.
32. If a project is small relative to the total firm, and if its returns are not highly correlated with the
returns on the firm’s other assets, then the project may not be very risky in either the within-firm
(corporate) or the market risk sense, even if the returns on the project are highly uncertain and
thus the project has a high degree of stand-alone risk.
216 Chapter 10 Project Cash Flows and Risk
33. Assume the following: (1) A firm is considering two projects, one with a 5-year life and the other
with a 10-year life; (2) the cash flows of the two projects are equally risky by all definitions of the
word “risky”; (3) the company uses 40 percent debt and 60 percent equity to finance the projects;
(4) the debt used to finance any given project has a maturity equal to the life of the project; and
(5) the term structure of interest rates has a sharp upward slope. This would suggest, other things
held constant, that a lower discount rate should be used to find the NPV for the 5-year project
than for the 10-year project.
34. The cash flows relevant for the analysis of a foreign investment should, from the parent
company’s perspective, include the financial cash flows that the subsidiary can legally send back
to the parent company and the cash flows which must remain in the foreign country.
35. The cost of capital may be different for a foreign project than for an equivalent domestic project
because foreign projects may be more or less risky.
36. When considering the risk of foreign investment, higher risk could arise from exchange rate risk
and political risk while lower risk might result from international diversification.
37. The change in net working capital associated with a capital project may actually result in a
decrease in the firm’s current funding requirement, which frees up cash flows for investment.
38. Expansion project analysis requires determining the amount of incremental cash as a result of the
expansion relative to the cash flows if the expansion project was not accepted. The incremental
cash flows will always be discounted at the same rate as the firm’s original cash flows sine we are
simply expanding the firm and not changing the risk of the firm.
MULTIPLE CHOICE
1. 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.
Chapter 10 Project Cash Flows and Risk 217
2. 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.
3. Which of the following statements is correct?
a.
If a firm’s stockholders are well diversified, we know from theory and from studies of
market behavior that corporate risk is not important.
b.
Undiversified stockholders, including the owners of small businesses, are more concerned
about corporate risk than market risk.
c.
Empirical studies of the determinants of required rates of return (k) have found that only
market risk affects stock prices.
d.
Market risk is important but does not have a direct effect on stock price because it only
affects beta.
4. Which of the following is not discussed in the text as a method for analyzing risk in capital
budgeting?
a.
Sensitivity analysis.
b.
Beta, or CAPM, analysis.
c.
Monte Carlo simulation.
d.
Scenario analysis.
e.
All of the above are discussed in the text as methods of analyzing risk in capital budgeting.
5. A firm is considering the purchase of an asset whose risk is greater than the current risk of the
firm, based on any 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.
6. 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.
218 Chapter 10 Project Cash Flows and Risk
7. Which of the following statements concerning cash flow evaluation in capital budgeting is
incorrect?
a.
When determining a project’s terminal cash flows, it is generally assumed that the firm’s
operations return to the same level as they were before the project was purchased.
b.
If a depreciable asset is sold at a price different than its book value, taxes will affect the
net cash received from the disposal of the asset at the end of its life.
c.
The relevant marginal cash flows associated with a project should always include
depreciation, because depreciation is an annual operating expense that requires a cash
payment.
d.
If an asset is depreciated using the Modified Accelerated Cost Recovery System
(MACRS), its depreciable basis is the amount that can be depreciated over the asset’s
useful life, which generally includes the purchase price plus any shipping and installation
charges or other costs that are incurred in order to prepare the asset for use.
e.
The sunk costs associated with an investment proposal are not relevant cash flows for
capital budgeting analysis, so they should not be included in the computation of the
marginal cash flows.
8. Which of the following statements is correct?
a.
An asset that is sold for less than book value at the end of a project’s life will generate a
loss for the firm and will cause an actual cash outflow attributable to the project.
b.
Only incremental cash flows are relevant in project analysis and the proper incremental
cash flows are the reported accounting profits because they form the true basis for investor
and managerial decisions.
c.
It is unrealistic to expect that increases in net working capital that are required at the start
of an expansion project are simply recovered at the project’s completion. Thus, these cash
flows are included only at the start of a project.
d.
Equipment sold for more than its book value at the end of a project’s life will increase
income and, despite increasing taxes, will generate a greater cash flow than if the same
asset is sold at book value.
e.
All of the above are false.
9. Regarding the net present value of a replacement decision, which of the following statements is
false?
a.
The present value of the after-tax cost reduction benefits resulting from the new
investment is treated as an inflow.
b.
The after-tax market value of the old equipment is treated as an inflow at t = 0 (initial
investment outlay).
c.
The present value of depreciation expenses on the new equipment, multiplied by the tax
rate, is treated as an inflow.
d.
Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an
outflow at t = 0 (initial investment outlay).
e.
An increase in net working capital is treated as an outflow when the project begins (initial
investment outlay) and as an inflow when the project ends (terminal cash flow).
Chapter 10 Project Cash Flows and Risk 219
10. 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.
11. According to the text, the financial staff’s role in the forecasting process centers on
a.
Developing the original assumptions used in estimating each project’s cash flows.
b.
Making sure that no biases are inherent in the forecasts.
c.
Deciding which projects are strategically important to the firm.
d.
Setting the sales price and quantity estimates for use by other departments.
e.
All of the above.
12. Which of the following is not considered a relevant concern in determining incremental cash
flows for a new product?
a.
The use of factory floor space which is currently unused but available for production of
any product.
b.
Revenues from the existing product that would be lost as a result of some customers
switching to the new product.
c.
Shipping and installation costs associated with preparing the machine to be used to
produce the new product.
d.
The cost of a product analysis completed in the previous tax year and specific to the new
product.
e.
None of the above (All are relevant concerns in estimating relevant cash flows attributable
to a new product project.)
13. Suppose the firm’s required rate of return is stated in nominal terms, but the project’s expected
cash flows are expressed in real dollars. In this situation, other things held constant, the calculated
NPV would
a.
Be correct.
b.
Be biased downward.
c.
Be biased upward.
d.
Possibly have a bias, but it could be upward or downward.
e.
More information is needed; otherwise, we can make no reasonable statement.
220 Chapter 10 Project Cash Flows and Risk
14. In theory, the decision maker should view market risk as being of primary importance. However,
within-firm, or corporate, risk is relevant to a firm’s
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.
15. 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.
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.
16. 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.
17. 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.
18. If the firm is being operated so as to maximize shareholder wealth, and if our basic assumptions
concerning the relationship between risk and return are true, then which of the following should
be true?
a.
If the beta of the asset is larger than the firm’s beta, then the required return on the asset is
less than the required return on the firm.
b.
If the beta of the asset is smaller than the firm’s beta, then the required return on the asset
is greater than the required return on the firm.
c.
If the beta of the asset is greater than the corporate beta prior to the addition of that asset,
then the corporate beta after the purchase of the asset will be smaller than the original
corporate beta.
d.
If the beta of an asset is larger than the corporate beta prior to the addition of that asset,
then the required return on the firm will be greater after the purchase of that asset than
prior to its purchase.
e.
None of the above is a true statement.
19. Which of the following statements is correct?
a.
A relatively risky future cash outflow should be evaluated using a relatively low discount
rate.
b.
If a firm’s managers want to maximize the value of the stock, they should concentrate
exclusively on projects’ market, or beta, risk.
c.
If a firm evaluates all projects using the same required rate of return to determine NPVs,
then the riskiness of the firm as measured by its beta will probably decline over time.
d.
If a firm has a beta which is less than 1.0, say 0.9, this would suggest that its assets’ returns
are negatively correlated with the returns of most other firms‘ assets.
e.
The above statements are all false.
20. Using the Security Market Line concept in capital budgeting, which of the following is correct?
a.
If the expected rate of return on a given capital project lies above the SML, the project
should be accepted even if its beta is above the beta of the firm’s average project.
b.
If a project’s return lies below the SML, it should be rejected if it has a beta greater than
the firm’s existing beta but accepted if its beta is below the firm’s beta.
c.
If two mutually exclusive projects’ expected returns are both above the SML, the project
with the lower risk should be accepted.
d.
If a project’s expected rate of return is greater than the expected rate of return on an
average project, it should be accepted.
21. 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.
222 Chapter 10 Project Cash Flows and Risk
22. 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.
23. 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 cost of capital 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.
24. 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 less risky the project.
c.
In judging the relative stand-along 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.
Chapter 10 Project Cash Flows and Risk 223
25. The financial staff’s role in the forecasting process includes all of the following except
a.
coordinating the efforts of other departments, such as engineering and marketing.
b.
ensuring that everyone involved in the forecasts uses a consistent set of economic
assumptions.
c.
making sure that no biases are inherent in the forecasts.
d.
determine the appropriate discount rate for cash flows.
e.
none of the above.
26. Which of the following cash flows are incremental cash flows that need to be considered when
evaluating a capital project?
a.
Interest expenses on the financing of the project.
b.
Sunk costs of engineering study to determine the feasibility of the project.
c.
Opportunity cost of land being used for project that the firm already owns.
d.
Both a and b are correct.
e.
None of the above.
27. Depreciation must be considered when evaluating the incremental operating cash flows
associated with a capital budgeting project because
a.
it represents a tax-deductible cash expense.
b.
the firm has a cash outflow equal to the depreciation expense each year.
c.
although it is a non-cash expense, depreciation has an impact on the taxes paid by the firm,
which is a cash flow.
d.
depreciation is a sunk cost.
e.
None of the above is correct.
28. Hill Top Lumber Company is considering building a sawmill in the state of Washington because
the company doesn’t have such a facility to service its growing customer base that is located on
the west coast. Hill Top’s executives believe that future growth in west coast customers will make
the sawmill project a good investment. When evaluating the acceptability of the project, which of
the following would not be considered a relevant cash flow that should be included when
determining its initial investment outlay?
a.
Hill Top owns acreage that is large enough and would be an ideal location for the sawmill.
The land, which was purchased five years ago, has a current value of $3 million.
b.
It is estimated that the cost of building the sawmill will be $175 million.
c.
It will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
224 Chapter 10 Project Cash Flows and Risk
d.
It is estimated that $20 million of business from existing customers will move to the new
sawmill.
e.
All of these cash flows should be included in the computation of the sawmill’s initial
investment outlay.
29. A firm is evaluating a new machine to replace an existing, older machine. The old (existing)
machine is being depreciated at $20,000 per year, whereas the new machine’s depreciation will be
$18,000. The firm’s marginal tax rate is 30 percent. Everything else equal, if the new machine is
purchased, what effect will the change in depreciation have on the firm’s incremental operating
cash flows?
a.
There should be no effect on the firm’s cash flows, because depreciation is a noncash
expense.
b.
Operating cash flows will increase by $2,000.
c.
Operating cash flows will increase by $1,400.
d.
Operating cash flows will decrease by $600.
e.
None of the above is correct.
30. When evaluating the cash flows associated with a capital budgeting project, shipping and
installation costs associated with the purchase of an asset, such as a lathe, are considered part of
the
a.
initial investment outlay because these expenses effectively are part of the asset’s purchase
price.
b.
incremental operating cash flows because shipping and installation costs represent
expenses that have to be written off over the life of the asset.
c.
terminal cash flows, because these expenses aren’t paid until the end of the asset’s life.
d.
sunk costs because these expenses do not affect any current or future cash flows associated
with investing in the asset.
e.
None of the above is a correct answer.
31. Express Press evaluates many different capital budgeting projects each year. The risks of the
projects often differ significantly, from very little risk to risks that are substantially greater than
the average risk associated with the firm. If Express Press always uses its weighted average cost
of capital, or average required rate of return, to evaluate all of these capital budgeting projects,
then the company might make an incorrect decision, or a mistake, by
a.
accepting projects that actually should be rejected.
b.
accepting projects with internal rates of return that are too high.
c.
rejecting projects that actually should be rejected.
d.
rejecting projects with internal rates of return that are lower than the appropriate risk-
adjusted required rate of return.
e.
accepting project that actually should be accepted.
Chapter 10 Project Cash Flows and Risk 225
32. Cyrus Cypress evaluates all capital budgeting projects with its normal, or average, required rate
of return (k), regardless of the risk associated with the projects. If Cyrus is currently examining
projects that are significantly riskier than the existing assets of the firm, the capital budgeting
decisions that the firm makes could be
a.
correct.
b.
incorrect because acceptable projects might be rejected when they should be accepted.
c.
incorrect because unacceptable projects might be accepted when they should be rejected.
d.
Both a and b are correct answers.
e.
Both a and c are correct answers.
33. Which of the following items should not be considered when computing the terminal cash flow
for an expansion project?
a.
a change in net working capital associated with the purchase of the project
b.
the selling price of the asset at the end of its life
c.
increases in cash sales that occur because the project is purchased
d.
taxes on the sale of the asset at the end of its life
e.
none of the above
34. When determining the marginal cash flows associated with an expansion capital budgeting
project, which of the following would be included as an incremental operating cash flow?
a.
depreciation
b.
shipping and installation
c.
increase in working capital
d.
salvage value
e.
decrease in sales
35. If a firm uses its weighted average cost of capital (WACC) to evaluate all capital budgeting
projects, which of the following could occur?
a.
Projects with little or no risk might be rejected when they actually should be accepted.
b.
Projects with significant risks might be accepted when the actually should be rejected.
c.
Projects with average risk will always be rejected when they actually should be rejected.
d.
All of the above could occur.
e.
None of the above could occur.
36. An evaluation of four independent capital budgeting projects by the director of capital budgeting
for Ziker Golf Company yielded the following results:
Project
Risk level
L
Average
E
High
M
Low
Q
Average
226 Chapter 10 Project Cash Flows and Risk
The firm’s weighted average cost of capital is 12 percent. Ziker Golf generally evaluates projects
that are riskier than average by adjusting its required rate of return by 4 percent, whereas projects
with less-than-average risk are evaluated by adjusting the required rate of return by 2 percent.
Which project(s) should the firm purchase?
a.
Project L
b.
Projects L and E
c.
Projects L and M
d.
Projects L, E, and M
e.
None of the above is a correct answer.
37. How do most firms deal with the risks of projects when making capital budgeting decisions?
a.
Projects risks are not considered directly because the weighted average cost of capital
(WACC) that is used as the required rate of return for capital budgeting decisions is based
on the riskiness of the firm. As a result, all projects, no matter their risks, can be evaluated
using WACC.
b.
Evaluating risk is important only when the projects are similar to the firm’s existing assets.
c.
Most firms adjust the discount rates used to evaluate new projects that have significantly
different risks than the risk associated with the firm’s existing assets.
d.
Firms generally increase the required rate of return used to evaluate projects that have
significantly different risks than the risk associated with the firm’s existing assets,
regardless of whether the new projects’ risks are higher or lower.
e.
None of the above is a correct answer.
38. Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5. The financial
manager is evaluating a project with an IRR of 21 percent, before any risk adjustment. The risk-
free rate is 10 percent, and the required rate of return on the market is 16 percent. The project
being evaluated is riskier than Boe’s average project, in terms of both beta risk and total risk.
Which of the following statements is correct?
a.
The project should be accepted because its IRR (before risk adjustment) is greater than its
required return.
b.
The project should be rejected because its IRR (before risk adjustment) is less than its
required return.
c.
The accept/reject decision depends on the risk-adjustment policy of the firm. If the firm’s
policy were to reduce a riskier-than-average project’s IRR by 1 percentage point, then the
project should be accepted.
d.
Riskier-than-average projects should have their IRRs increased to reflect their added
riskiness. Clearly, this would make the project acceptable regardless of the amount of the
adjustment.
e.
Projects should be evaluated on the basis of their total risk alone. Thus, there is
insufficient information in the problem to make an accept/reject decision.
Chapter 10 Project Cash Flows and Risk 227
39. Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a
fire insurance company. If the purchase is made, Carolina will be 50 percent larger than before.
Currently, Carolina’s stock has a beta of 1.2 and the return required is 15.2 percent. The fire
insurance company is expected to generate a return of 20 percent with a beta of 2.5. If the risk-
free rate is 8 percent and the market risk premium is 6 percent, should Carolina make the
investment?
a.
No; the expected return is less than the required return.
b.
No; the IRR is less than the appropriate required rate of return.
c.
Yes; the IRR is greater than the appropriate required rate of return.
d.
Yes; the expected return is greater than the required return.
e.
Yes; the project’s risk/return combination lies above the SML.
40. Given the following information, calculate the NPV of a proposed project: Cost = $4,000;
estimated life = 3 years; initial decrease in accounts receivable = $1000, which must be restored
at the end of the project’s life; estimated salvage value = $1,000; net income before taxes and
depreciation = $2,000 per year; method of depreciation = MACRS; tax rate = 40 percent; required
rate of return = 18 percent.
a.
$1,137
b.
-$151
c.
$137
d.
$804
e.
$544
228 Chapter 10 Project Cash Flows and Risk
41. Mars Inc. is considering the purchase of a new machine which will reduce manufacturing costs by
$5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it
expects to sell the machine at the end of its 5-year operating life for $10,000. The firm expects to
be able to reduce net working capital by $15,000 when the machine is installed, but required
working capital will return to the original level when the machine is sold after 5 years. Mars’
marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate projects
of this nature. If the machine costs $60,000, what is the NPV of the project?
a.
-$15,394
b.
-$14,093
c.
-$58,512
d.
-$21,493
e.
-$46,901
Chapter 10 Project Cash Flows and Risk 229
42. Stanton Inc. is considering the purchase of a new machine which will reduce manufacturing costs
by $5,000 annually and increase earnings before depreciation and taxes by $6,000 annually.
Stanton will use the MACRS method to depreciate the machine, and it expects to sell the machine
at the end of its 5-year operating life for $10,000 before taxes. Stanton’s marginal tax rate is 40
percent, and it uses a 9 percent required rate of return to evaluate projects of this type. If the
machine’s cost is $40,000, what is the project’s NPV?
a.
$1,014
b.
$2,292
c.
$7,550
d.
$817
e.
$5,040
230 Chapter 10 Project Cash Flows and Risk
43. Whitney Crane Inc. has the following independent investment opportunities for the coming year:
Project
Cost
Annual Cash
Inflows
Life (years)
IRR
A
$10,000
$11,800
1
B
5,000
3,075
2
15
C
12,000
5,696
3
D
3,000
1,009
4
13
The IRRs for Project A and C, respectively, are:
a.
16% and 14%
b.
18% and 10%
c.
18% and 20%
2
40,000
12,800
3
0.19
40,000
7,600
4
40,000
4,800
5
0.11
40,000
4,400
6
0.06
40,000
2,400
$40,000
Chapter 10 Project Cash Flows and Risk 231
d.
18% and 13%
e.
16% and 13%
44. Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which
will increase the assets of the firm by 50 percent. Sun State currently has a required rate of return
of 18 percent, U.S. Treasury bonds yield 7 percent, and the market risk premium is 5 percent. If
Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta
coefficient the new division could have?
a.
2.2
b.
1.0
c.
1.8
d.
1.6
e.
2.0
45. An all-equity firm is analyzing a potential project which will require an initial, after-tax cash
outlay of $50,000 and after-tax cash inflows of $6,000 per year for 10 years. In addition, this
project will have an after-tax salvage value of $10,000 at the end of Year 10. If the risk-free rate
is 6 percent, the return on an average stock is 10 percent, and the beta of this project is 1.50, then
what is the project’s NPV?
a.
$13,210
b.
$4,905
c.
$7,121
d.
-$6,158