CHAPTER 11: CAPITAL BUDGETING AND RISK
1. The discount rate used in calculating the certainty equivalent net present value is the
a. risk-adjusted discount rate
b. cost of capital
c. risk-free rate
d. cost of equity capital
2. The certainty equivalent factors used to adjust the cash flows for risk can range from
a. –1 to +1
b. 0 to infinity
c. +.01 to +.99
d. 0 to +1.0
3. The basic capital budgeting decision models, that is, NPV and IRR, handle risk by
a. ignoring it
b. assuming all cash flows are known with certainty
c. assuming all projects are of average risk and evaluating them based on expected values
d. using risk-adjusted discount rates to evaluate projects
4. All of the following are advantages of the NPV-payback approach to risk analysis except
a. it is easy and inexpensive to apply
b. it considers a project’s liquidity
c. it explicitly considers the variability of a project’s return
d. it is consistent with the notion that risk increases with futurity
5. The subjective approach to determining risk-adjusted discount rates
a. uses the risk-free rate for average-risk projects
b. explicitly considers the probability distribution of a project’s cash flows
c. always leads to the correct investment decisions
d. groups projects into risk classes and evaluates all projects in a particular risk class at the same risk-adjusted
discount rate
Chapter 11: Capital Budgeting and Risk
6. Simulation techniques are
a. cheap to apply
b. widely used
c. mostly beneficial for large projects
d. identical to sensitivity analysis
7. The use of sensitivity analysis requires that
a. a model of a project’s cash flows be developed
b. probability distributions of the determinants of a project’s cash flows be estimated
c. the firms have access to a very large computer
d. the firm is greatly interested in the portfolio risk reduction characteristics of a project
8. Project C has been classified into risk class II by the analyst of a major firm. The risk premium required for
projects in this risk class is 8%. The current risk-free rate measured by the analyst is 10%. If the project has an
estimated return of 20%, the analyst would recommend
a. accepting project C
b. rejecting project C
c. re-estimating the risk premiums for class II projects
d. none of these
9. Total project risk is
a. the contribution a project makes to the risk of the firm
b. measured by the correlation coefficient
c. the chance that a project will perform different from expectations
d. measured by the project’s beta
10. A firm’s leveraged beta will always be its unleveraged beta.
a. less than
b. greater than
c. the same as
d. could be all of these
Chapter 11: Capital Budgeting and Risk
11. The the amount of debt in a firm’s capital structure, the will be the firm’s beta.
a. larger, larger
b. smaller, larger
c. larger, smaller
d. smaller, smaller
12. The risk-adjusted discount rate approach is preferable to the weighted cost of capital approach when
a. all projects have the same risk characteristics
b. the risk-free rate is known with certainty
c. the projects under consideration have different risk characteristics
d. the firm is unlevered
13. A major problem with using the risk-adjusted discount rate approach is the determination of
a. the beta value for the firm
b. the firm’s weighted cost of capital
c. the firm’s required rate of return
d. beta values for individual projects
14. Which of the following techniques can be used to analyze total project risk?
a. net present value/payback approach
b. risk-adjusted discount rate approach
c. simulation analysis
d. all of these
15. The net present value/payback approach is a useful approach when
a. screening projects characterized by rapid technological advances
b. cash flow estimates are known with certainty
c. the more risky cash flows occur during the startup period
d. None of these
Chapter 11: Capital Budgeting and Risk
16. In a simulation analysis, a model is simulated on a computer program and run through several iterations. The
results of these iterations are used to
a. plot a required rate of return value profile
b. compute a mean and a standard deviation of returns
c. provide the decision maker with a measure of beta risk
d. plot the coefficient of variation of the annual net cash flows
17. Sensitivity analysis is a procedure that can be used in the capital budgeting process to indicate how sensitive
the
is to changes in a particular variable.
a. probability
b. return distribution
c. net present value
d. standard deviation
18. When analyzing a sensitivity curve, the the slope, the more sensitive the net present value is to a change in
the computed variable.
a. more negative
b. steeper
c. more general
d. smaller
19. A major disadvantage of the risk-adjusted discount rate approach is that it
a. can lead to selecting only above-average risk projects
b. provides the decision maker with a range of numbers
c. can lead to selecting only below-average risk projects
d. is difficult to estimate the appropriate risk premium for a project
20. The certainty equivalent approach adjusts the for risk in the of the net present value equation.
a. net cash flows, numerator
b. risk-free rate, numerator
c. required return, numerator
d. net cash flows, denominator
Chapter 11: Capital Budgeting and Risk
21. When evaluating a capital expenditure to be made in a foreign country, the parent firm must be concerned with
the
a. exchange rate risk
b. cash flows that can be expected to be received by the parent
c. greater uncertainty associated with tax rates in the host country
d. all these
22. The approach is widely used by firms that attempt to consider differential project risk in their capital
budgeting procedures.
a. net present value
b. internal rate of return
c. risk-adjusted discount rate
d. certainty equivalent
23. The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is
the
a. sensitivity analysis method
b. simulation approach
c. net present value/payback method
d. risk-adjusted discount rate approach
24. The risk-adjusted discount rate approach is used in the analysis of projects for which is the applicable risk
measure.
a. total project risk
b. beta (systematic) risk
c. unsystematic risk
d. both total project and beta risk
25. The certainty equivalent factors used in capital budgeting analysis are equal to the divided by .
a. certain return; risky return
b. risky return; certain return
c. certain return; beta
d. beta, risky return
Chapter 11: Capital Budgeting and Risk
26. With the approach, the decision maker adjusts separately each period’s cash flows to account for the
specific risk of those cash flows.
a. risk-adjusted discount rate
b. NPV/payback
c. certainty equivalent
d. economic life
27. With the risk adjusted discount rate approach, in the context of total risk, the discount rates used in evaluating
cash flows are determined .
a. objectively
b. subjectively
c. using regression analysis
d. objectively and by using regression analysis
28. The of a firm is a weighted average of the of the individual assets in the firm.
a. systematic risk; systematic risk
b. unsystematic risk; unsystematic risk
c. total risk; total risk
d. systematic risk, total risk
29. The risk assessment technique that considers the impact of simultaneous changes in key variables on the
desirability of an investment project is .
a. sensitivity analysis
b. simultaneous equations
c. scenario analysis
d. RADR analysis
30. A project has an expected net present value of $50,000 with a standard deviation of the net present value of
$20,000. Assume that NPV is normally distributed. What is the probability that the project will have a negative
NPV?
a. 99.38%
b. 0.62%
c. 34.5%
d. 49.38%
Chapter 11: Capital Budgeting and Risk
31. A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000. Assume that NPV
is normally distributed. What is the probability that the project will have a net present value greater than
$60,000?
a. 1915%
b. 69.15%
c. 0.13%
d. 30.85%
32. A simulation analysis for a new acquisition has indicated that the expected NPV is $50 million with a standard
deviation of $40 million. Assume that NPV is normally distributed. What is the probability that the project will
be unacceptable?
a. 89.44%
b. 10.56%
c. 39.44%
d. 21.19%
33. The DMT Company is financed entirely with equity. DMT has a beta of 1.20 and the current risk-free rate is
9.5 percent. If the expected market return is 14 percent, what rate of return should DMT require on a project of
average risk?
a. 14.9%
b. 15.4%
c. 14.0%
d. 12.0%
Chapter 11: Capital Budgeting and Risk
34. Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new
product that will be produced and marketed by a separate division. The new division will have a capital
structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1, but is not sure what the beta
for the new division will be. AMX is a firm that produces a product similar to the product under consideration
by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity and a marginal tax
rate of 40 percent. If Faris’ tax rate is 40 percent, estimate the levered beta for the new product division?
a. 2.44
b. 1.14
c. 2.74
d. 3.88
35. Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30
percent equity. The levered beta for this division has been estimated to be 2.02. What will be Technico’s
weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8
percent, and the market risk premium is 5 percent?
a. 14.77%
b. 10.33%
c. 18.1%
d. 1.03%
36. Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted discount rate
for its can division of 17 percent. A planned expansion in the can division requires a net investment of
$170,000 and results in expected cash inflows of $42,000 a year for seven years. Should Calco invest in this
expansion?
a. Yes, NPV = $10,096
b. Yes, NPV = $9,896
c. No, NPV = –$5,276
d. No, NPV = –$9,896
Chapter 11: Capital Budgeting and Risk
37. SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions
of the firm’s total assets:
Division
Beta
% of Assets
Electric & Gas
0.85
60
Bus transportation
0.95
10
Real estate
1.40
25
Recreation
1.15
5
What is the firm’s weighted average beta?
a. 1.01
b. 1.53
c. 0.93
d. 1.13
38. SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions
of the firm’s total assets:
Division
Beta
% of Assets
Electric & Gas
0.85
60
Bus transportation
0.95
10
Real estate
1.40
25
Recreation
1.15
5
The risk-free rate is 8 percent and the market risk premium is 5 percent. If SCAN is considering a residential
development, what should the firm use as its cost of equity in evaluating this project?
a. 13.05%
b. 16.20%
c. 12.25%
d. 15.00%
39. The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.6. The current risk-free rate is
9.5 percent and the expected market return is 16 percent. What rate of return should Chris-Kraft require on a
project of average risk?
a. 25.6%
b. 14.9%
c. 10.4%
d. 19.9%
Chapter 11: Capital Budgeting and Risk
40. The net present value of a project is normally distributed with an expected value of $52,000 and a standard
deviation of $31,515. Determine the probability that the project will have a net present value of less than zero.
a. 1.65%
b. 95.1%
c. 4.95%
d. cannot be determined
41. IKON is financed entirely with equity and its beta is 1.31. If the current risk-free rate is 6.25% and the
expected market return is 12.8%, what is IKON’s required rate of return on a project of average risk?
a. 8.58%
b. 14.83%
c. 17.65%
d. 12.81%
42. The Chris-Kraft Co. is financed entirely with equity and the firm has a beta of 1.25. The current risk-free rate is
7 percent and the expected market return is 15 percent. Chris-Kraft is considering an investment project with a
risk that matches the firm’s average risk, requires a net investment of $70,000, and has net cash flows of
$18,000 per year for 8 years. Should Chris-Kraft invest in the project?
a. Yes, NPV = $5,726
b. Yes, NPV = $75,726
c. No, NPV = –$10,934
d. No, NPV = –$5,726
Chapter 11: Capital Budgeting and Risk
43. Quick Flick is considering two investments. Both require a net investment of $120,000 and have the following
net cash flows:
Year
Project X
Project Y
1
$50,000
$25,000
2
40,000
45,000
3
30,000
50,000
4
25,000
60,000
5
20,000
70,000
Quick uses a combination of the net present value approach and the payback approach to evaluate investment
alternatives. The firm uses a discount rate of 14 percent and requires that all projects have a payback period no
longer than 3 years. Which investment or investments should Quick accept?
a. only Project X
b. only Project Y
c. both projects X and Y
d. reject both projects
1
$50,000
$ 43,850
$ 21,925
3
5
10,380
36,330
Chapter 11: Capital Budgeting and Risk
44. Billy Bob is considering building a water slide park that will require a net investment of $200,000 and yield the
following net cash flows:
Year
Net Cash Flows
Cert. Equiv. Factor
1
$120,000
.90
2
90,000
.80
3
60,000
.65
4
30,000
.50
5
10,000
.30
If the risk-free rate is 8 percent and the market risk premium is 6 percent, what is the certainty equivalent NPV
for this project?
a. $12,805
b. $5,746
c. $3,703
d. $11,025
1
$108,000
3
39,000
5