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CFIN4
Chapter 10 – Project Cash Flows and Risk
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.
a. True
b. False
2. When calculating the cash flows for a project, you should include interest payments.
a. True
b. False
3. With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital
budgeting project.
a. True
b. False
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.
a. True
b. False
CFIN4
Chapter 10 – Project Cash Flows and Risk
5. Net incremental operating cash flow is calculated by adding back the change in depreciation to the change in
income after taxes.
a. True
b. False
6. In cash flow estimation, the presence of externalities has no direct cash flow effects.
a. True
b. False
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.
a. True
b. False
8. If an asset being considered for acquisition has beta of zero, its purchase will have no effect on the firm's market
risk.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
13. Quantification of risk is the easiest part of incorporating risk into capital budgeting; treatment of that calculated risk
measure is more difficult.
a. True
b. False
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.
a. True
b. False
15. Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash
flows are riskier.
a. True
b. False
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 ≥ r at the margin) is called capital rationing.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
20. Replacement analysis involves the decision of whether to replace an existing asset that is still productive with a new
asset.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
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.
a. True
b. False
39. 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.
40. 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.
41. 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.
42. 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.
43. 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.
44. 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.
45. 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.
46. 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.
47. 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).
48. 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.
49. 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.
50. 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.)
51. 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.
52. 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.
53. 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.
54. 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.
55. 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.
56. 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.
57. 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.
58. 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.
59. 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.
60. 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.
61. 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.
62. 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.
63. 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.
