FINAL EXAM 7: Capital Budgeting, Risk, & Uncertainty

Multiple-Choice Questions

1) An increase in net working capital required at the beginning of an expansion project must be considered to be

A) a cash inflow. B) a reallocation of assets.C) a cash outflow. D) None of the above.

2) Usually, the cost of capital for newly issued stock is ________ the cost of retained earnings.A) lower than B) higher thanC) same as D) either higher or lower than

3) A stock whose rate of return fluctuates less than the rate of return of a market portfolio will have a beta that equals

A) 1. B) less than 1.C) more than 1. D) Either A or C above.

4) A company's capital structure is made up of 40% debt and 60% common equity (both at market values). The interest rate on bonds similar to those issued by the company is 8%. The cost of equity is estimated to be 15%. The income tax rate is 40%. The company's weighted cost of capital is

A) 11.5%. B) 12.2%. C) 10.9%. D) 8.9%.

5) Capital rationingA) exists when a company sets an arbitrary limit on the amount of investment it is

willing to undertake, so that not all projects with an NPV higher than the cost of capital will be accepted.

B) generally does not permit a company to achieve maximum value.C) seems to occur quite frequently among corporations.D) All of the above.

6) The time value of money can be best described asA) a dollar to day is worth more than a dollar tomorrow.B) the basis on which net present values are calculated.C) the basis on which internal rates of return are calculated.D) All of the above.

7) Net present value and internal rate of return capital budgeting decisions can differ because

A) the initial costs of the capital outlays differ.B) the cash flow streams differ.C) the discount rates differ for different time periods.D) All of the above.

8) Simulation analysisA) permits the calculation of expected value and standard deviation.B) does not permit the calculation of expected value and standard deviation.C) is too complex to ever be used in actual business situations.D) does not consider probabilities.

9) The expected value isA) the total of all possible outcomes.B) the arithmetic average of all possible outcomes.C) the average of all possible outcomes weighted by their respective probabilities.D) the total of all possible outcomes divided by the number of different possible outcomes.

10) An advantage of the decision tree is thatA) it eliminates the need for calculating the cost of capital.B) it eliminates the need for calculating probabilities.C) it causes the analyst to consider important events that may occur in the course of the project, and decisions and actions that may have to be undertaken.D) All of the above.

11) A real option can present management with the opportunity toA) vary output. B) abandon a project.C) postpone a project. D) All of the above.

12) A source of business risk is a change inA) technology. B) consumer preferences.C) input prices. D) All of the above.

13) The certainty equivalent approach to accounting for risk in capital budgeting involvesA) adjusting the discount rate used to calculate net present values.B) adjusting the expected cash flows.C) estimating the coefficient of variation.D) estimating the standard deviation of the net present values.

14) The following is an example of risk in capital budgeting on a global basis:A) exchange rate changes B) tariff changesC) expropriation D) All of the above.

15) The risk adjusted discount rateA) is the sum of the risk-free rate and the risk premium.B) includes risk in the denominator of the present value calculation.C) includes risk in the numerator of the present value calculation.D) All of the above.

16) A drawback in using the payback approach to capital budgeting decisions isA) it doesn't account for the time value of money.B) it ignores cash flows beyond the payback period.C) it doesn't adjust for differences in the stream of cash flows.D) All of the above.

17) The cost of capital is best described as theA) opportunity cost of financing a capital outlay.B) funds that must be acquired to finance a capital outlay.C) decrease in stockholder equity due to a capital outlay.D) All of the above.

18) Capital rationing refers toA) setting a minimum acceptable rate of return for a capital outlay.B) selecting among profitable capital outlays when there are constraints on the funds available.C) determining the maximum price to pay for a capital product.D) None of the above.

19) Probabilities, which are based on past data or experience, are calledA) a priori. B) objective. C) uncertain. D) statistical.

20) The use of real options in capital budgetingA) may raise the NPV of a capital project.B) makes the analysis of the project considerably easier.C) allows management to make decisions more quickly.D) eliminates the need for calculating the project's risk adjusted discount rate.

Analytical Question

An aircraft company has signed a contract to deliver a plane 3 years from now. The price they will receive at the end of 3 years is $20 million. If the firm's cost of capital is 6%, what is the present value of this payment?

Reference:Chapter 12 - Capital Budgeting, Risk, & UncertaintyKeat, Paul and Philip K.Y. Young (2003). Managerial Economics: Economic Tools for Today’s Decision Makers.