CFIN4
Chapter 10 – Project Cash Flows and Risk
64. 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.
65. 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.
66. 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.
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.
67. 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.
68. 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.
69. 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.
70. 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.
71. 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
72. 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
73. 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.
74. An evaluation of four independent capital budgeting projects by the director of capital budgeting for Ziker Golf
Company yielded the following results:
Internal rate of
Project
of return, IRR
Risk level
L
19.0%
Average
E
15.0
High
M
12.0
Low
Q
11.0
Average
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.
75. 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.
76. 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.
77. 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.
CFIN4
Chapter 10 – Project Cash Flows and Risk
78. 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
79. 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
80. 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
CFIN4
Chapter 10 – Project Cash Flows and Risk
81. Whitney Crane Inc. has the following independent investment opportunities for the coming year:
Annual Cash
Project
Cost
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%
d. 18% and 13%
e. 16% and 13%
82. 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
83. 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
e. −$12,879
84. Real Time Systems Inc. is considering the development of one of two mutually exclusive new computer models.
Each will require a net investment of $5,000. The cash flow figures for each project are shown below:
Period
Project A
Project B
1
$2,000
$3,000
2
2,500
2,600
3
2,250
2,900
Model B, which will use a new type of laser disk drive, is considered a high-risk project, while Model A is of
average risk. Real Time adds 2 percentage points to arrive at a risk-adjusted discount rate when evaluating a high-
risk project. The rate used for average risk projects is 12 percent. Which of the following statements regarding the
NPVs for Models A and B is most correct?
a. NPVA = $380; NPVB = $1,815.
b. NPVA = $197; NPVB = $1,590.
c. NPVA = $380; NPVB = $1,590.
d. NPVA = $5,380; NPVB = $6,590.
e. None of the above statements is correct.
85. The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive projects. The
discount rate used for Project A is 12 percent. Further, Project A costs $15,000, and it would be depreciated using
MACRS. It is expected to have an after-tax salvage value of $5,000 at the end of 6 years and to produce after-tax
cash flows (including depreciation) of $4,000 for each of the 6 years. Project B costs $14,815 and would also be
depreciated using MACRS. B is expected to have a zero salvage value at the end of its 6-year life and to produce
after-tax cash flows (including depreciation) of $5,100 each year for 6 years. The Unlimited’s marginal tax rate is
40 percent. What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?
a. 15%
b. 16%
c. 18%
d. 20%
e. 12%
86. Alabama Pulp Company (APC) can control its environmental pollution using either “Project Old Tech” or “Project
New Tech.” Both will do the job, but the actual costs involved with Project New Tech, which uses unproved, new
state-of-the–art technology, could be much higher than the expected cost levels. The cash outflows associated with
Project Old Tech, which uses standard proven technology, are less risky they are about as uncertain as the cash
flows associated with an average project. APC’s required rate of return for average risk projects normally is set at
12 percent, and the company adds 3 percent for high risk projects but subtracts 3 percent for low risk projects. The
two projects in question meet the criteria for high and average risk, but the financial manager is concerned about
applying the normal rule to such cost-only projects. You must decide which project to recommend, and you should
recommend the one with the lower PV of costs. What is the PV of costs of the better project?
Cash Outflows
Years
0
1
2
3
4
Project New Tech
1,500
315
315
315
315
Project Old Tech
600
600
600
600
600
a.
2,521
b.
2,399
c.
2,457
d.
2,543
e.
2,422
87. Arizona Rock, an all-equity firm, currently has a beta of 1.25, and rRF = 7 percent and rM = 14 percent. Suppose
the firm sells 10 percent of its assets (beta = 1.25) and purchases the same proportion of new assets with a beta of
1.1. What will be the firm’s new overall required rate of return, and what rate of return must the new assets
produce in order to leave the stock price unchanged?
a. 15.645%; 15.645%
b. 15.75%; 14.7% c.
15.645%; 14.7% d.
15.75%; 15.645% e.
14.75%; 15.75%
88. Klott Company encounters significant uncertainty with its sales volume and price in its primary product. The firm
uses scenario analysis in order to determine an expected NPV, which it then uses in its budget. The base case, best
case, and worst case scenarios and probabilities are provided in the table below. What is Klott’s expected NPV,
standard deviation of NPV, and coefficient of variation of NPV?
Probability of
Outcome
Unit Sales
Volume
Sales
Price
NPV
(In Thousands)
Worst case
0.30
6,000
$3,600
-$6,000
Base case
0.50
10,000
4,200
+13,000
Best case
0.20
13,000
4,400
+28,000
a.
Expected NPV = $35,000; NPV = 17,500; CVNPV = 2.0.
b.
Expected NPV = $35,000; NPV = 11,667; CVNPV = 0.33.
c.
Expected NPV = $10,300; NPV = 12,083; CVNPV = 1.17.
d.
Expected NPV = $13,900; NPV = 8,476; CVNPV = 0.61.
e.
Expected NPV = $10,300; NPV = 13,900; CVNPV = 1.35.
Worst case
0.3(-6,000) = -1,800
Base case
0.50
Best case
Worst case
Base case
Best case
146.01
89. Rucker Truck Line (RTL) is evaluating whether the fleet of trucks it owns should be replaced. If the trucks are
replaced, current operating revenues and expenses will not change, except for depreciation expenses. Annual
depreciation will increase from $150,000 to $175,000. Based on this information, how will the change in depreciation
expense affect the incremental operating cash flows RTL examines when making its capital budgeting decision
about replacing the trucks? RTL‘s marginal tax rate is 40 percent.
a. After-tax operating cash flows will increase by $15,000.