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Title: FIN 534 Quiz 6

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Question 1
1.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer

If Project A has a higher IRR than Project B, then Project A must have the lower NPV.

If Project A has a higher IRR than Project B, then Project A must also have a higher NPV.

The IRR calculation implicitly assumes that all cash flows are reinvested at the WACC.

The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.

If a project has normal cash flows and its IRR exceeds its WACC, then the projectís NPV must be positive.

Question 2
1.
Assume that the economy is enjoying a strong boom, and as a result interest rates and money costs generally are relatively high. The WACC for two mutually exclusive projects that are being considered is 12%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 12% current WACC. However, you believe that the economy will soon fall into a mild recession, and money costs and thus your WACC will soon decline. You also think that the projects will not be funded until the WACC has decreased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer

You should reject both projects because they will both have negative NPVs under the new conditions.

You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.

You should recommend Project L, because at the new WACC it will have the higher NPV.

You should recommend Project S, because at the new WACC it will have the higher NPV.

You should recommend Project L because it will have both a higher IRR and a higher NPV under the new conditions.

Question 3
1.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer

A projectís NPV is found by compounding the cash inflows at the IRR to find the terminal value (TV), then discounting the TV at the WACC.

The lower the WACC used to calculate a projectís NPV, the lower the calculated NPV will be.

If a projectís NPV is less than zero, then its IRR must be less than the WACC.

If a projectís NPV is greater than zero, then its IRR must be less than zero.

The NPV of a relatively low-risk project should be found using a relatively high WACC.

Question 4
1.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer

A projectís NPV is generally found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting the TV at the IRR to find its PV.

The higher the WACC used to calculate the NPV, the lower the calculated NPV will be.

If a projectís NPV is greater than zero, then its IRR must be less than the WACC.

If a projectís NPV is greater than zero, then its IRR must be less than zero.

The NPVs of relatively risky projects should be found using relatively low WACCs.

Question 5
1.
Assume a project has normal cash flows. All else equal, which of the following statements is CORRECT?
Answer

A projectís IRR increases as the WACC declines.

A projectís NPV increases as the WACC declines.

A projectís MIRR is unaffected by changes in the WACC.

A projectís regular payback increases as the WACC declines.

A projectís discounted payback increases as the WACC declines.

Question 6
1.
Which of the following statements is CORRECT?
Answer

If a project has ďnormalĒ cash flows, then its IRR must be positive.

If a project has ďnormalĒ cash flows, then its MIRR must be positive.

If a project has ďnormalĒ cash flows, then it will have exactly two real IRRs.

The definition of ďnormalĒ cash flows is that the cash flow stream has one or more negative cash flows followed by a stream of positive cash flows and then one negative cash flow at the end of the projectís life.

If a project has ďnormalĒ cash flows, then it can have only one real IRR, whereas a project with ďnonnormalĒ cash flows might have more than one real IRR.

Question 7
1.
Assume that the economy is in a mild recession, and as a result interest rates and money costs generally are relatively low. The WACC for two mutually exclusive projects that are being considered is 8%. Project S has an IRR of 20% while Project L's IRR is 15%. The projects have the same NPV at the 8% current WACC. However, you believe that the economy is about to recover, and money costs and thus your WACC will also increase. You also think that the projects will not be funded until the WACC has increased, and their cash flows will not be affected by the change in economic conditions. Under these conditions, which of the following statements is CORRECT?
Answer

You should reject both projects because they will both have negative NPVs under the new conditions.

You should delay a decision until you have more information on the projects, even if this means that a competitor might come in and capture this market.

You should recommend Project L, because at the new WACC it will have the higher NPV.

You should recommend Project S, because at the new WACC it will have the higher NPV.

You should recommend Project S because it has the higher IRR and will continue to have the higher IRR even at the new WACC.

Question 8
1.
Which of the following statements is CORRECT?
Answer

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the risk-free rate, while the IRR method assumes reinvestment at the IRR.

The NPV method assumes that cash flows will be reinvested at the WACC, while the IRR method assumes reinvestment at the risk-free rate.

The NPV method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

The IRR method does not consider all relevant cash flows, particularly cash flows beyond the payback period.

Question 9
1.
Which of the following statements is CORRECT? Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows.
Answer

A projectís regular IRR is found by compounding the cash inflows at the WACC to find the terminal value (TV), then discounting this TV at the WACC.

A projectís regular IRR is found by discounting the cash inflows at the WACC to find the present value (PV), then compounding this PV to find the IRR.

If a projectís IRR is greater than the WACC, then its NPV must be negative.

To find a projectís IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the projectís costs.

To find a projectís IRR, we must find a discount rate that is equal to the WACC.

Question 10
1.
Which of the following statements is CORRECT?
Answer

The MIRR and NPV decision criteria can never conflict.

The IRR method can never be subject to the multiple IRR problem, while the MIRR method can be.

One reason some people prefer the MIRR to the regular IRR is that the MIRR is based on a generally more reasonable reinvestment rate assumption.

The higher the WACC, the shorter the discounted payback period.

The MIRR method assumes that cash flows are reinvested at the crossover rate.

Question 11
1.
Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project Sís undiscounted net cash flows total $20,000, while Lís total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which projectís NPV is more sensitive to changes in the WACC?
Answer

Project S.

Project L.

Both projects are equally sensitive to changes in the WACC since their NPVs are equal at all costs of capital.

Neither project is sensitive to changes in the discount rate, since both have NPV profiles that are horizontal.

The solution cannot be determined because the problem gives us no information that can be used to determine the projectsí relative IRRs.

Question 12
1.
Which of the following statements is CORRECT?
Answer

The NPV method was once the favorite of academics and business executives, but today most authorities regard the MIRR as being the best indicator of a projectís profitability.

If the cost of capital declines, this lowers a projectís NPV.

The NPV method is regarded by most academics as being the best indicator of a projectís profitability; hence, most academics recommend that firms use only this one method.

A projectís NPV depends on the total amount of cash flows the project produces, but because the cash flows are discounted at the WACC, it does not matter if the cash flows occur early or late in the projectís life.

The NPV and IRR methods may give different recommendations regarding which of two mutually exclusive projects should be accepted, but they always give the same recommendation regarding the acceptability of a normal, independent project.

Question 13
1.
Westchester Corp. is considering two equally risky, mutually exclusive projects, both of which have normal cash flows. Project A has an IRR of 11%, while Project B's IRR is 14%. When the WACC is 8%, the projects have the same NPV. Given this information, which of the following statements is CORRECT?
Answer

If the WACC is 13%, Project Aís NPV will be higher than Project Bís.

If the WACC is 9%, Project Aís NPV will be higher than Project Bís.

If the WACC is 6%, Project Bís NPV will be higher than Project Aís.

If the WACC is greater than 14%, Project Aís IRR will exceed Project Bís.

If the WACC is 9%, Project Bís NPV will be higher than Project Aís.

Question 14
1.
Which of the following statements is CORRECT?
Answer

The shorter a projectís payback period, the less desirable the project is normally considered to be by this criterion.

One drawback of the regular payback is that this method does not take account of cash flows beyond the payback period.

If a projectís payback is positive, then the project should be accepted because it must have a positive NPV.

The regular payback ignores cash flows beyond the payback period, but the discounted payback method overcomes this problem.

One drawback of the discounted payback is that this method does not consider the time value of money, while the regular payback overcomes this drawback.

Question 15
1.
Projects C and D are mutually exclusive and have normal cash flows. Project C has a higher NPV if the WACC is less than 12%, whereas Project D has a higher NPV if the WACC exceeds 12%. Which of the following statements is CORRECT?
Answer

Project D probably has a higher IRR.

Project D is probably larger in scale than Project C.

Project C probably has a faster payback.

Project C probably has a higher IRR.

The crossover rate between the two projects is below 12%.

Question 16
1.
Which of the following statements is CORRECT?
Answer

In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the projectís cash flows will lead to an upward
bias in the NPV.

In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the projectís cash flows will lead to a downward
bias in the NPV.

The existence of any type of ďexternalityĒ will reduce the calculated NPV versus the NPV that would exist without the externality.

If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.

If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.

Question 17
1.
Which of the following statements is CORRECT?
Answer

Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

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 projectís NPV.

The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.

Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variablesí values.

As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.

Question 18
1.
A company is considering a new project. The CFO plans to calculate the projectís NPV by estimating the relevant cash flows for each year of the projectís life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the companyís overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
Answer

All sunk costs that have been incurred relating to the project.

All interest expenses on debt used to help finance the project.

The investment in working capital required to operate the project, even if that investment will be recovered at the end of the projectís life.

Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.

Effects of the project on other divisions of the firm, but only if those effects lower the projectís own direct cash flows.

Question 19
1.
Which of the following statements is CORRECT?
Answer

Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.

Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.

Corporations must use the same depreciation method for both stockholder reporting and tax purposes.

Using accelerated depreciation rather than straight line normally has the effect of speeding
up cash flows and thus increasing a projectís forecasted NPV.

Using accelerated depreciation rather than straight line normally has no effect on a projectís total projected cash flows nor would it affect the timing of those cash flows or the resulting NPV of the project.

Question 20
1.
Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
Answer

The new project is expected to reduce sales of one of the companyís existing products by 5%.

Since the firmís director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the projectís initial cost.

The company has spent and expensed $1 million on R&D associated with the new project.

The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.

The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year.

Question 21
1.
Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?
Answer

Using some of the firmís high-quality factory floor space that is currently unused to produce the proposed new product. This space could be used for other products if it is not used for the project under consideration.

Revenues from an existing product would be lost as a result of customers switching to the new product.

Shipping and installation costs associated with a machine that would be used to produce the new product.

The cost of a study relating to the market for the new product that was completed last year. The results of this research were positive, and they led to the tentative decision to go ahead with the new product. The cost of the research was incurred and expensed for tax purposes last year.

It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.

Question 22
1.
Which of the following factors should be included in the cash flows used to estimate a projectís NPV?
Answer

All costs associated with the project that have been incurred prior to the time the analysis is being conducted.

Interest on funds borrowed to help finance the project.

The end-of-project recovery of any working capital required to operate the project.

Cannibalization effects, but only if those effects increase the projectís projected cash flows.

Expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes.

Question 23
1.
Dalrymple Inc. is considering production of a new product. In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
Answer

The company will produce the new product in a vacant building that was used to produce another product until last year. The building could be sold, leased to another company, or used in the future to produce another of the firmís products.

The project will utilize some equipment the company currently owns but is not now using. A used equipment dealer has offered to buy the equipment.

The company has spent and expensed for tax purposes $3 million on research related to the new detergent. These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.

The new product will cut into sales of some of the firmís other products.

If the project is accepted, the company must invest $2 million in working capital. However, all of these funds will be recovered at the end of the projectís life.

Question 24
1.
A firm is considering a new project whose risk is greater than the risk of the firmís average project, based on all methods for assessing risk. In evaluating this project, it would be reasonable for management to do which of the following?
Answer

Increase the estimated IRR of the project to reflect its greater risk.

Increase the estimated NPV of the project to reflect its greater risk.

Reject the project, since its acceptance would increase the firmís risk.

Ignore the risk differential if the project would amount to only a small fraction of the firmís total assets.

Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

Question 25
1.
Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?
Answer

The firmís corporate, or overall, WACC is used to discount all project cash flows to find the projectsí NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

Differential project risk cannot be accounted for by using ďrisk-adjusted discount ratesĒ because it is highly subjective and difficult to justify. It is better to not risk adjust at all.

Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the projectís NPV will be found using a lower discount rate than would be appropriate if the projectís returns were negatively correlated.

Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the projectís expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure.

DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a projectís real options must be considered separately.

Question 26
1.
Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the followingindependent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
Answer

Project A, which has average risk and an IRR = 9%.

Project B, which has below-average risk and an IRR = 8.5%.

Project C, which has above-average risk and an IRR = 11%.

Without information about the projectsí NPVs we cannot determine which project(s) should be accepted.

All of these projects should be accepted.

Question 27
1.
Rowell Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Rowell owns the building free and clear--there is no mortgage on it. Which of the following statements is CORRECT?
Answer

Since the building has been paid for, it can be used by another project with no additional cost. Therefore, it should not be reflected in the cash flows for any new project.

If the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it.

This is an example of an externality, because the very existence of the building affects the cash flows for any new project that Rowell might consider.

Since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects.

If there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building.

Question 28
1.
Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
Answer

Changes in net working capital.

Shipping and installation costs.

Cannibalization effects.

Opportunity costs.

Sunk costs that have been expensed for tax purposes.

Question 29
1.
Which of the following statements is CORRECT?
Answer

Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.

Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.

If firms use accelerated depreciation, they will write off assets slower than they would under straight-line depreciation, and as a result projectsí forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projectsí forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.

If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projectsí forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Question 30
1.
The relative risk of a proposed project is best accounted for by which of the following procedures?
Answer

Adjusting the discount rate upward if the project is judged to have above-average risk.

Adjusting the discount rate downward if the project is judged to have above-average risk.

Reducing the NPV by 10% for risky projects.

Picking a risk factor equal to the average discount rate.

Ignoring risk because project risk cannot be measured accurately.


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