94) A corporation is evaluating the relevant cash flows for a capital budgeting decision and must
estimate the terminal cash flow. The proposed machine will be disposed of at the end of its
usable life of five years at an estimated sale price of $2,000. The machine has an original
purchase price of $80,000, installation cost of $20,000, and will be depreciated under the five-
year MACRS. Net working capital is expected to decline by $5,000. The firm has a 40 percent
tax rate on ordinary income and long-term capital gain. The terminal cash flow is ________.
A) $5,800
B) $7,800
C) $8,200
D) $6,200
95) Which of the following must be considered in computing the terminal value of a replacement
project?
A) operating cash flow for the final year
B) after-tax proceeds from the sale of a new asset
C) before-tax proceeds from the sale of an old asset
D) before-tax proceeds from the sale of a new asset
11.4 Understand the importance of recognizing risk in the analysis of capital budgeting
projects, and discuss risk and cash flows, scenario analysis, and simulation as behavioral
approaches for dealing with risk.
1) Different projects have different levels of risk. As a result, the acceptance of a particular
project generally has an impact on a firm’s overall risk.
2) The acceptance of a particular project usually has no impact on a firm’s overall risk.
3) All projects should always use the WACC as the required return for capital budgeting
purposes.
4) Behavioral approaches for dealing with risk include scenario analysis and simulation.
5) Behavioral approaches for dealing with risk include annualized net present values and risk-
adjusted discount rates.
6) In capital budgeting, risk is the degree of variability of cash flows.
7) In capital budgeting, risk is generally thought of as the chance that NPV and IRR will provide
conflicting recommendations to management.
8) The break even cash inflow is the minimum level of cash inflow necessary for a project to be
acceptable.
9) Projects with a small chance of being acceptable and a broad range of possible cash flows are
riskier than projects having a high chance of being acceptable and a narrow range of possible
cash flows.
10) In capital budgeting, risk refers to a high degree of variability of the initial investment of a
project.
11) Scenario analysis is a statistics-based behavioral approach that applies predetermined
probability distributions and random numbers to estimate risky outcomes.
12) In capital budgeting, one of the most common scenario approaches is to estimate the NPVs
associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of
cash inflow.
13) Scenario analysis is a behavioral approach that evaluates the impact on a firm’s return
through simultaneous changes in a number of variables.
14) Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses
the variability of returns.
15) Sensitivity analysis is a statistics-based approach used in capital budgeting to asses risk by
applying predetermined probability distributions and random numbers to estimate risky
outcomes.
16) Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by
applying predetermined probability distributions and random numbers to estimate risky
outcomes.
17) Simulation is an approach that evaluates the impact on return of simultaneous changes in a
number of variables.
18) The output of simulation provides an excellent basis for decision making since it allows the
decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.
19) Monte Carlo simulation programs usually build a histogram of the results.
20) Behavioral approaches ________.
A) are used to explicitly recognize project risk
B) are used to get a feel for project risk
C) are not used by rational financial managers
D) are used to quantify the risk
21) Breakeven cash inflow refers to ________.
A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV
greater than zero
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less
than zero
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less
than zero cost of capital
D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals
zero
22) In capital budgeting, risk refers to ________.
A) the chance that a project will prove acceptable
B) the conflicting IRR and NPV in a project
C) the degree of variability of initial outlay
D) the uncertainty of cash inflows
23) In capital budgeting, risk refers to ________.
A) the degree of variability of the cash inflows
B) the degree of variability of the initial investment
C) the chance that the net present value will be greater than zero
D) the chance that the internal rate of return will exceed the cost of capital
24) Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in
project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash
inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the
project is ________.
A) $1,000,000
B) $131,474
C) $100,000
D) $66,667
Table 11.6
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts
have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows
which are given in the following table. The firm’s cost of capital is 10 percent.
25) The range of the annual cash inflows for Project A is ________. (See Table 11.6)
A) $30,000
B) $10,000
C) $5,000
D) $0
26) If the projects have five-year lives, the range of the net present value for Project B is
approximately ________. (See Table 11.6)
A) $80,563
B) $201,000
C) $255,444
D) $303,263
27) The expected net present value of Project A if the outcomes are equally probable and the
project has five-year life is ________. (See Table 11.6)
A) -$1,045
B) $17,910
C) $36,865
D) $93,730
28) A behavioral approach that evaluates the impact on a firm’s return through simultaneous
changes in a number variables of a project is called ________.
A) sensitivity analysis
B) scenario analysis
C) simulation analysis
D) Monte Carlo simulation
29) The advantage of using simulation in the capital budgeting process is the ________.
A) ease of calculation over scenario analysis
B) continuum of risk-return trade-offs for decision making
C) single point estimate that helps the decision maker to choose the most accurate alternative
D) use of several possible outcomes to asses risk
30) One type of simulation program made popular by the widespread use of personal computers
is called ________.
A) Monaco Simulation
B) Lemans Simulation
C) Cannes Simulation
D) Monte Carlo Simulation
11.5 Describe the determination and use of risk-adjusted discount rates (RADRs), portfolio
effects, and the practical aspects of RADRs.
1) The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the
percent of estimated cash inflows that investors would be satisfied to receive for certain rather
than the cash inflows that are possible for each year.
2) The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given
project to compensate a firm’s owners adequately, that is, to maintain or improve the firm’s share
price.
3) A market risk-return function is a graphical presentation of the discount rates associated with
each level of project risk.
4) In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.
5) Because of the basic mathematics of compounding and discounting, the risk-adjusted discount
rate (RADR) approach implicitly assumes that risk is an increasing function of time.
6) The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower
the net present value for a given stream of cash inflows.
7) For assets traded in an efficient market, the diversifiable risk can be eliminated through
diversification.
8) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a
project’s beta and the market risk premium.
9) The risk-adjusted discount rate can be computed as the risk free rate plus the product of a
project’s beta and the credit risk premium.
10) In applying risk-adjusted discount rates to project selection, projects falling above the SML
would have a positive NPV and those falling below the SML would have a negative NPV.
11) In applying risk-adjusted discount rates to project selection, projects falling above the SML
would have a negative NPV and those falling below the SML would have a positive NPV.
12) The higher the risk-adjusted net present, the more viable the project.
13) Because a business firm can be viewed as a portfolio of assets, it is important that the firm
maintains a diversified portfolio of assets.
14) Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded
for selecting a diversified portfolio of assets because investors can more efficiently diversify the
risk on their own.
15) By combining two projects with negatively correlated cash inflows, a firm reduces the
combined cash inflow variability and its risk.
16) RADRs are popular because they are consistent with the general disposition of financial
decision makers toward rates of return.
17) ________ reflects the return that must be earned on the given project to compensate the
firm’s owners adequately.
A) Internal rate of return
B) Cost of capital
C) Risk-adjusted discount rate
D) Average rate of return
18) The difference by which the required discount rate exceeds the risk-free rate is called the
________.
A) excess return
B) risk premium
C) inflation premium
D) maturity premium
19) A preferred approach for risk adjustment of capital budgeting cash flows, from a practical
viewpoint, is ________.
A) sensitivity analysis
B) simulation analysis
C) scenario analysis
D) risk-adjusted discount rates
20) The theoretical basis from which the concept of risk-adjusted discount rates is derived is
________.
A) the Gordon model
B) the capital asset pricing model
C) simulation theory
D) the basic cost of money
Table 11.7
A firm is considering investment in a capital project which is described below. The firm’s cost of
capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The
firm uses the following equation to determine the risk adjusted discount rate, RADR, for each
project: RADR = Rf + Risk Index (Cost of capital – Rf).
21) The net present value without adjusting the discount rate for risk is ________. (See Table
11.7)
A) $336,000
B) $250,000
C) $179,400
D) $87,000
22) The discount rate that should be used in the net present value calculation to compensate for
risk is ________. (See Table 11.7)
A) 6 percent
B) 15 percent
C) 18 percent
D) 24 percent
23) The net present value of the project when adjusting for risk is ________. (See Table 11.7)
A) -$9,300
B) $0
C) $87,000
D) $105,000