Which one of the following statements is correct? assume cash flows are conventional.

FIN 534 Quiz 11

Question 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%.

2 points

Question 2

Which of the following statements is CORRECT?

Answer

One defect of the IRR method versus the NPV is that the IRR does not take account of cash flows over a project’s full life.

One defect of the IRR method versus the NPV is that the IRR does not take account of the time value of money.

One defect of the IRR method versus the NPV is that the IRR does not take account of the cost of capital.

One defect of the IRR method versus the NPV is that the IRR values a dollar received today the same as a dollar that will not be received until sometime in the future.

One defect of the IRR method versus the NPV is that the IRR does not take proper account of differences in the sizes of projects.

2 points

Question 3

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The IRR calculation implicitly assumes that cash flows are withdrawn from the business rather than being reinvested in the business.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 project’s NPV must be positive.

2 points

Question 4

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.

2 points

Question 5

Which of the following statements is CORRECT?

Answer

Projects with “normal” cash flows can have only one real IRR.

Projects with “normal” cash flows can have two or more real IRRs.

Projects with “normal” cash flows must have two changes in the sign of the cash flows, e.g., from negative to positive to negative. If there are more than two sign changes, then the cash flow stream is “nonnormal.”

The “multiple IRR problem” can arise if a project’s cash flows are “normal.”

Projects with “nonnormal” cash flows are almost never encountered in the real world.

2 points

Question 6

Which of the following statements is CORRECT?

Answer

For a project to have more than one IRR, then both IRRs must be greater than the WACC.

If two projects are mutually exclusive, then they are likely to have multiple IRRs.

If a project is independent, then it cannot have multiple IRRs.

Multiple IRRs can occur only if the signs of the cash flows change more than once.

If a project has two IRRs, then the smaller one is the one that is most relevant, and it should be accepted and relied upon.

2 points

Question 7

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 8

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 9

Which of the following statements is CORRECT?

Answer

The shorter a project’s 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.[11]

If a project’s 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.

2 points

Question 10

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 11

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 12

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.

2 points

Question 13

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

Answer

A project’s IRR increases as the WACC declines.

A project’s NPV increases as the WACC declines.

A project’s MIRR is unaffected by changes in the WACC.

A project’s regular payback increases as the WACC declines.

A project’s discounted payback increases as the WACC declines.

2 points

Question 14

Which of the following statements is CORRECT?

Answer

One advantage of the NPV over the IRR is that NPV takes account of cash flows over a project’s full life whereas IRR does not.

One advantage of the NPV over the IRR is that NPV assumes that cash flows will be reinvested at the WACC, whereas IRR assumes that cash flows are reinvested at the IRR. The NPV assumption is generally more appropriate.

One advantage of the NPV over the MIRR method is that NPV takes account of cash flows over a project’s full life whereas MIRR does not.

One advantage of the NPV over the MIRR method is that NPV discounts cash flows whereas the MIRR is based on undiscounted cash flows.

Since cash flows under the IRR and MIRR are both discounted at the same rate (the WACC), these two methods always rank mutually exclusive projects in the same order.

2 points

Question 15

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 project’s profitability.

If the cost of capital declines, this lowers a project’s NPV.

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

A project’s 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 project’s 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.

2 points

Question 16

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 projects’ 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 projects’ 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 projects’ forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

2 points

Question 17

Which of the following statements is CORRECT?

Answer

An externality is a situation where a project would have an adverse effect on some other part of the firm’s overall operations. If the project would have a favorable effect on other operations, then this is notan externality.

An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank’s other offices to increase.[12]

The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not. This is another reason to favor the NPV.

Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

Identifying an externality can never lead to an increase in the calculated NPV.

2 points

Question 18

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

Answer

The firm’s corporate, or overall, WACC is used to discount all project cash flows to find the projects’ 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 “risk-adjusted discount rates” 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 project’s NPV will be found using a lower discount rate than would be appropriate if the project’s 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 project’s 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 project’s real options must be considered separately.

2 points

Question 19

Which of the following statements is CORRECT?

Answer

An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.

A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank’s other offices.

A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.

If sunk costs are considered and reflected in a project’s cash flows, then the project’s calculated NPV will be higher than it otherwise would be.

2 points

Question 20

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 following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

Answer

Project A, which has average risk and an %.

Project B, which has below-average risk and an 9 %.IRR

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

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

All of these projects should be accepted.

2 points

Question 21

Which of the following factors should be included in the cash flows used to estimate a project’s 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 project’s projected cash flows.

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

2 points

Question 22

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 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 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 speedingup cash flows and thus increasing a project’s forecasted NPV.

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

2 points

Question 25

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 are existing stores.

2 points

Question 26

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.

2 points

Question 27

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.

2 points

Question 28

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 29

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 30

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

A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm’s current products.

A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.

A firm has spent $2 million on R&D associated with a new product. These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.

A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm’s other products.

2 points

[11]This is also true for discounted payback period

[12]Positive externalities: Synergy and negative externalities: erosion or cannibalization