A cost that should be ignored when evaluating a project

Question 1

Which of the following statements is CORRECT?

Answer

For a project with normal cash flows, any change in the WACC will change both the NPV and the IRR.

To find the MIRR, we first compound cash flows at the regular IRR to find the TV, and then we discount the TV at the WACC to find the PV.

The NPV and IRR methods both assume that cash flows can be reinvested at the WACC. However, the MIRR method assumes reinvestment at the MIRR itself.

If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the higher IRR probably has more of its cash flows coming in the later years.

If two projects have the same cost, and if their NPV profiles cross in the upper right quadrant, then the project with the lower IRR probably has more of its cash flows coming in the later years.

2 points

Question 2

Which of the following statements is CORRECT?

Answer

If a project with normal cash flows has an IRR greater than the WACC, the project must also have a positive NPV.

If Project A’s IRR exceeds Project B’s, then A must have the higher NPV.

A project’s MIRR can never exceed its IRR.

If a project with normal cash flows has an IRR less than the WACC, the project must have a positive NPV.

If the NPV is negative, the IRR must also be negative.

2 points

Question 3

Which of the following statements is CORRECT?

Answer

The regular payback method recognizes all cash flows over a project’s life.

The discounted payback method recognizes all cash flows over a project’s life, and it also adjusts these cash flows to account for the time value of money.

The regular payback method was, years ago, widely used, but virtually no companies even calculate the payback today.

The regular payback is useful as an indicator of a project’s liquidity because it gives managers an idea of how long it will take to recover the funds invested in a project.

The regular payback does not consider cash flows beyond the payback year, but the discounted payback overcomes this defect.

2 points

Question 4

Projects S and L both have an initial cost of $10,000, followed by a series of positive cash inflows. Project S’s undiscounted net cash flows total $20,000, while L’s total undiscounted flows are $30,000. At a WACC of 10%, the two projects have identical NPVs. Which project’s 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 projects’ relative IRRs.

2 points

Question 5

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 project’s 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 project’s NPV, the lower the calculated NPV will be.

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

If a project’s 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.

2 points

Question 6

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.

2 points

Question 7

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

The longer a project’s payback period, the more desirable the project is normally considered to be by this criterion.

One drawback of the regular payback for evaluating projects is that this method does not properly account for the time value of money.

If a project’s payback is positive, then the project should be rejected because it must have a negative NPV.

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

If a company uses the same payback requirement to evaluate all projects, say it requires a payback of 4 years or less, then the company will tend to reject projects with relatively short lives and accept long-lived projects, and this will cause its risk to increase over time.

2 points

Question 8

Which of the following statements is CORRECT?

Answer

The NPV, IRR, MIRR, and discounted payback (using a payback requirement of 3 years or less) methods always lead to the same accept/reject decisions for independent projects.

For mutually exclusive projects with normal cash flows, the NPV and MIRR methods can never conflict, but their results could conflict with the discounted payback and the regular IRR methods.

Multiple IRRs can exist, but not multiple MIRRs. This is one reason some people favor the MIRR over the regular IRR.

If a firm uses the discounted payback method with a required payback of 4 years, then it will accept more projects than if it used a regular payback of 4 years.

The percentage difference between the MIRR and the IRR is equal to the project’s WACC.

2 points

Question 9

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 project’s 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 project’s NPV is greater than zero, then its IRR must be less than the WACC.

If a project’s 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.

2 points

Question 10

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.

2 points

Question 11

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 project’s regular IRR is found by compounding the initial cost at the WACC to find the terminal value (TV), then discounting the TV at the WACC.

A project’s regular IRR is found by compounding the cash inflows at the WACC to find the present value (PV), then discounting the TV to find the IRR.

If a project’s IRR is smaller than the WACC, then its NPV will be positive.

A project’s IRR is the discount rate that causes the PV of the inflows to equal the project’s cost.

If a project’s IRR is positive, then its NPV must also be positive.

2 points

Question 12

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%.

2 points

Question 13

Projects S and L are equally risky, mutually exclusive, and have normal cash flows. Project S has an IRR of 15%, while Project L’s IRR is 12%. The two projects have the same NPV when the WACC is 7%. Which of the following statements is CORRECT?

Answer

If the WACC is 10%, both projects will have positive NPVs.

If the WACC is 6%, Project S will have the higher NPV.

If the WACC is 13%, Project S will have the lower NPV.

If the WACC is 10%, both projects will have a negative NPV.

Project S’s NPV is more sensitive to changes in WACC than Project L's.

2 points

Question 14

Which of the following statements is CORRECT?

Answer

An NPV profile graph shows how a project’s payback varies as the cost of capital changes.

The NPV profile graph for a normal project will generally have a positive (upward) slope as the life of the project increases.

An NPV profile graph is designed to give decision makers an idea about how a project’s risk varies with its life.

An NPV profile graph is designed to give decision makers an idea about how a project’s contribution to the firm’s value varies with the cost of capital.

We cannot draw a project’s NPV profile unless we know the appropriate WACC for use in evaluating the project’s NPV.

2 points

Question 15

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 A’s NPV will be higher than Project B’s.

If the WACC is 9%, Project A’s NPV will be higher than Project B’s.

If the WACC is 6%, Project B’s NPV will be higher than Project A’s.

If the WACC is greater than 14%, Project A’s IRR will exceed Project B’s.

If the WACC is 9%, Project B’s NPV will be higher than Project A’s.

2 points

Question 16

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.

2 points

Question 17

Which of the following rules is CORRECT for capital budgeting analysis?

Answer

The interest paid on funds borrowed to finance a project must be included in estimates of the project’s cash flows.

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.

Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project’s other costs when reaching the accept/reject decision.

A proposed project’s estimated net income as determined by the firm’s accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project’s cost, the project should be accepted.

If a product is competitive with some of the firm’s other products, this fact should be incorporated into the estimate of the relevant cash flows. However, if the new product is complementary to some of the firm’s other products, this fact need not be reflected in the analysis.

2 points

Question 18

A firm is considering a new project whose risk is greater than the risk of the firm’s 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 firm’s risk.

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

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

2 points

Question 19

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 firm’s 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 firm’s 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 project’s life.

2 points

Question 20

Which of the following statements is CORRECT?

Answer

Using accelerated depreciation rather than straight line would normally have no effect on a project’s total projected cash flows but it would affect the timing of the cash flows and thus the NPV.

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 (e.g., straight line or accelerated) for stockholder reporting and tax purposes.

Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.

Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project’s projected NPV.

2 points

Question 21

A company is considering a proposed new plant that would increase productive capacity. Which of the following statements is CORRECT?

Answer

In calculating the project’s operating cash flows, the firm should not

deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, “double count” it.

Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.

When estimating the project’s operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.

Capital budgeting decisions should be based on before-tax cash flows.

The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.

2 points

Question 22

Which of the following statements is CORRECT?

Answer

A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.

A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.

Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.

A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm’s existing stores.

2 points

Question 23

Currently, Powell Products has a beta of 1.0, and its sales and profits are positively correlated with the overall economy. The company estimates that a proposed new project would have a higher standard deviation and coefficient of variation than an average company project. Also, the new project’s sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong. On the basis of this information, which of the following statements is CORRECT?

Answer

The proposed new project would have more stand-alone risk than the firm’s typical project.

The proposed new project would increase the firm’s corporate risk.

The proposed new project would increase the firm’s market risk.

The proposed new project would not affect the firm’s risk at all.

The proposed new project would have less stand-alone risk than the firm’s typical project.

2 points

Question 24

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 company’s existing products by 5%.

Since the firm’s 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 project’s 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.

2 points

Question 25

Which of the following statements is CORRECT?

Answer

Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.

Well-diversified stockholders do not need to consider market risk when determining required rates of return.

Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.

Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

2 points

Question 26

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 project’s 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 variables’ values.

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

2 points

Question 27

Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:

Project Risk Expected Return

A High 15%

B Average 12%

C High 11%

D Low 9%

E Low 6%

Which set of projects would maximize shareholder wealth?

Answer

A and B.

A, B, and C.

A, B, and D.

A, B, C, and D.

A, B, C, D, and E.

2 points

Question 28

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.

2 points

Question 29

Which of the following statements is CORRECT?

Answer

If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.

If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.

If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.

If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.

Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

2 points

Question 30

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

Answer

Changes in net working capital attributable to the project.

Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.

The value of a building owned by the firm that will be used for this project.

A decline in the sales of an existing product, provided that decline is directly attributable to this project.

The salvage value of assets used for the project that will be recovered at the end of the project’s life.