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1 FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored Find needed answers here - FIN 534 Quiz 8 (30 questions with answers) 99,99 % Scored Top of Form Question 1В 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. 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. Question 2В 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. Question 3В Westchester Corp. is considering two equally risky, mutually exclusive projects, both of

2 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? 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 4В Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. 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. Question 5В Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. 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 6В Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. A project's NPV is found by compounding the cash inflows at the IRR to find the

3 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. Question 7В The IRR method appeals to some managers because it gives an estimate of the rate of return on projects rather than a dollar amount, which the NPV method provides. The discounted payback method eliminates all of the problems associated with the payback method. When evaluating independent projects, the NPV and IRR methods often yield conflicting results regarding a project's acceptability. To find the MIRR, we discount the TV at the IRR. A project's NPV profile must intersect the X-axis at the project's WACC. Question 8В 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 9В 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? Project S. Project L.

4 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. Question 10В 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%. 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 11В 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 12В 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

5 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 13В 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? 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 14В Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. 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.

6 Question 15В Assume that the project being considered has normal cash flows, with one outflow followed by a series of inflows. 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. Question 16В Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project? 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 17В 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

7 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 18В 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? 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-thanaverage risk. Question 19В 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. Question 20В The relative risk of a proposed project is best accounted for by which of the following procedures? 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.

8 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 21В 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 22В 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? 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. Question 23В 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

9 following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows? 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 24В Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project? Changes in net working capital. Shipping and installation costs. Cannibalization effects. Opportunity costs. Sunk costs that have been expensed for tax purposes. Question 25В 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. Question 26В

10 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 project's cash flows will lead to an upwardвbias 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 project's cash flows will lead to a downwardвbias in the NPV. The existence of any type of "externality" 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 27В 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 lowrisk 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? A and B. A, B, and C. A, B, and D. A, B, C, and D. A, B, C, D, and E. Question 28В A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

11 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 29В 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. 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 30В 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? Using some of the firm's 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

12 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. Sitemap

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