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FIN 534 Quiz 13

download Question 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 project’s 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 project’s 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 project’s IRR is greater than the WACC, then its NPV must be negative. To find a project’s IRR, we must solve for the discount rate that causes the PV of the inflows to equal the PV of the project’s costs. To find a project’s IRR, we must find a discount rate that is equal to the WACC. Question 2 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. Question 3 Which of the following statements is CORRECT? Answer If a project has “normal” cash flows, then its IRR must be positive. If a project has “normal” cash flows, then its MIRR must be positive. If a project has “normal” cash flows, then it will have exactly two real IRRs. The definition of “normal” 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 project’s life. If a project has “normal” cash flows, then it can have only one real IRR, whereas a project with “nonnormal” cash flows might have more than one real IRR. Question 4 Which of the following statements is CORRECT? Answer One defect of the IRR method is that it does not take account of cash flows over a project’s full life. One defect of the IRR method is that it does not take account of the time value of money. One defect of the IRR method is that it does not take account of the cost of capital. One defect of the IRR method is that it 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 is that it assumes that the cash flows to be received from a project can be reinvested at the IRR itself, and that assumption is often not valid.


Question 5 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. Question 6 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. 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. Question 8 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. Question 9 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. Question 10 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. Question 11 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. Question 12 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. Question 13 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 14 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 15 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. Question 16 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. Question 17 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 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. Question 18 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. Question 19 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. Question 20 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 21 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. 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. Question 23 A company is considering a new project. The CFO plans to calculate the project’s NPV by estimating the relevant cash flows for each year of the project’s life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company’s 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 project’s 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 project’s own direct cash flows. Question 24 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. Question 25 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. Question 26 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. Question 27 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. Question 28 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. Question 29 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 not an 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. 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. Question 30 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.


Fin 534 quiz 13