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Exam 11: The Cost of Capital

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Question 21

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Which of the following statements is correct?

A) Sensitivity analysis is used frequently in capital budgeting analysis.Its big advantage is that because it shows correlations between changes in input variables and NPV, it accounts for within-firm risk.
B) Other things held constant, the lower the correlation between a project's returns and returns on the market, the less risky the project.
C) In judging the relative stand-along risks of a set of projects, the projects' standard deviations of NPV are a better measure than their coefficients of variation.
D) One can run a regression of returns on a project versus returns on the firm's other assets, get a beta coefficient, and use this beta as a measure of the project's market risk.
E) One can run a regression of returns on a project versus returns on the stock market, get a beta coefficient, and use this beta as a measure of the project's within-firm risk.

F) A) and D)
G) All of the above

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Question 22

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A firm is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk.In evaluating this asset, the decision maker should

A) Increase the IRR of the asset to reflect the greater risk.
B) Increase the NPV of the asset to reflect the greater risk.
C) Reject the asset, since its acceptance would increase the risk of the firm.
D) Ignore the risk differential if the asset to be accepted would comprise only a small fraction of the total assets of the firm.
E) Increase the required rate of return used to evaluate the project to reflect the higher risk of the project.

F) A) and B)
G) D) and E)

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Question 23

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In cash flow estimation, the presence of externalities has no direct cash flow effects.

When determining the marginal cash flows associated with an expansion capital budgeting project, which of the following would be included as an incremental operating cash flow?

The Oneonta Chemical Company is evaluating two mutually exclusive pollution control systems.Since the company's revenue stream will not be affected by the choice of control systems, the projects are being evaluated by finding the PV of each set of costs.The firm's required rate of return is 13 percent, and it adds or subtracts 3 percentage points to adjust for project risk differences.System A is judged to be a high-risk project (it might end up costing much more to operate than is expected) .The appropriate risk-adjusted discount rate that should be used to evaluate System A is

When calculating the cash flows for a project, you should include interest payments.

If a company uses the same discount rate for evaluating all projects, which of the following results is likely?

Using the same risk-adjusted discount rate to discount all cash flows ignores the fact that the more distant cash flows are riskier.

According to the text, the financial staff's role in the forecasting process centers on

Whitney Crane Inc.has the following independent investment opportunities for the coming year: $\quad$ $\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\quad$$\text { Annual Cash }$ $\begin{array}{ccccc} \underline{\text { Project }} & \underline{\text { Cost }}& \underline{\text { Inflows }} & \underline{ \text { Life(years) }}& \underline{ \text { IRR}}\\\mathrm{A} & \$ 10,000 & \$ 11,800&1& \\\mathrm{~B} & 5,000 & 3,075&2&15 \\\mathrm{C} & 12,000 & 5,696&3& \\\mathrm{D} & 3,000 & 1,009&4&13\end{array}$ The IRRs for Project A and C, respectively, are:

A firm is evaluating a new machine to replace an existing, older machine.The old (existing) machine is being depreciated at $20,000 per year, whereas the new machine's depreciation will be $18,000.The firm's marginal tax rate is 30 percent.Everything else equal, if the new machine is purchased, what effect will the change in depreciation have on the firm's incremental operating cash flows?

The situation where a firm accepts projects to the point where the return on the last project accepted is just equal to or greater than the firm's required rate of return (IRR ≥ r at the margin) is called capital rationing.

Regarding the net present value of a replacement decision, which of the following statements is false?

Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because

The Unlimited, a national retailing chain, is considering an investment in one of two mutually exclusive projects.The discount rate used for Project A is 12 percent.Further, Project A costs $15,000, and it would be depreciated using MACRS.It is expected to have an after-tax salvage value of $5,000 at the end of 6 years and to produce after-tax cash flows (including depreciation) of $4,000 for each of the 6 years.Project B costs $14,815 and would also be depreciated using MACRS.B is expected to have a zero salvage value at the end of its 6-year life and to produce after-tax cash flows (including depreciation) of $5,100 each year for 6 years.The Unlimited's marginal tax rate is 40 percent.What risk-adjusted discount rate will equate the NPV of Project B to that of Project A?

Tech Engineering Company is considering the purchase of a new machine to replace an existing one.The old machine was purchased 5 years ago at a cost of $20,000, and it is being depreciated on a straight line basis to a zero salvage value over a 10-year life.The current market value of the old machine is $14,000.The new machine, which falls into the MACRS 5-year class, has an estimated life of 5 years, it costs $30,000, and Tech plans to sell the machine at the end of the 5th year for $1,000.The new machine is expected to generate before-tax cash savings of $3,000 per year.The company's tax rate is 40 percent.What is the IRR of the proposed project?

Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates.

Risk in a revenue producing project can best be adjusted for by

Mars Inc.is considering the purchase of a new machine which will reduce manufacturing costs by $5,000 annually. Mars will use the MACRS accelerated method to depreciate the machine, and it expects to sell the machine at the end of its 5-year operating life for $10,000.The firm expects to be able to reduce net working capital by $15,000 when the machine is installed, but required working capital will return to the original level when the machine is sold after 5 years.Mars' marginal tax rate is 40 percent, and it uses a 12 percent required rate of return to evaluate projects of this nature.If the machine costs $60,000, what is the NPV of the project?

Inflation does not need to be built into expected cash flows; the discount rate used in net present value calculations captures the effect of inflation.If you were to include expected inflation into cash flows, all net present value calculations would be incorrect.