A) 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.
B) 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.
C) 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.
D) 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.
E) 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.
G) B) and C)
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A) 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.
B) The company has spent and expensed $1 million on R&D associated with the new project.
C) The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
D) 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.
E) The new project is expected to reduce sales of one of the company's existing products by 5%.
G) None of the above
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A) $20,762
B) $21,854
C) $23,005
D) $24,155
E) $25,363
G) All of the above
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A) 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.
B) 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.
C) The new product will cut into sales of some of the firm's other products.
D) 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.
E) 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.
G) B) and C)
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A) Adjusting the discount rate downward if the project is judged to have above-average risk.
B) Reducing the NPV by 10% for risky projects.
C) Picking a risk factor equal to the average discount rate.
D) Ignoring risk because project risk cannot be measured accurately.
E) Adjusting the discount rate upward if the project is judged to have above-average risk.
G) B) and E)
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A) 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.
B) A firm must obtain new equipment for the project,and $1 million is required for shipping and installing the new machinery.
C) 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.
D) A firm can produce a new product,and the existence of that product will stimulate sales of some of the firm's other products.
E) 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.
G) C) and D)
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A) 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 downward bias in the NPV.
B) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
C) 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.
D) 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.
E) 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 upward bias in the NPV.
G) A) and D)
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A) 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.
B) 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.
C) 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.
D) As computer technology advances,simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.
E) Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
G) C) and E)
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B) False
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A) 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.
B) 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.
C) 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.
D) 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.
E) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
G) All of the above
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A) 1.20
B) 1.26
C) 1.32
D) 1.39
E) 1.46
G) A) and D)
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B) False
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A) 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.
B) 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.
C) 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.
D) 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.
E) 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.
G) None of the above
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B) False
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B) False
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A) Interest on funds borrowed to help finance the project.
B) The end-of-project recovery of any working capital required to operate the project.
C) Cannibalization effects,but only if those effects increase the project's projected cash flows.
D) Expenditures to date on research and development related to the project,provided those costs have already been expensed for tax purposes.
E) All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
G) None of the above
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B) False
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A) 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.
B) 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.
C) Both the NPV and IRR methods deal correctly with externalities,even if the externalities are not specifically identified.However,the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) 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.
G) A) and E)
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B) False
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B) False
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