Deck 12: Risk and Refinements in Capital Budgeting

Question 1

Behavioral approaches for dealing with risk include scenario analysis and simulation.

Answer 1

True

Question 2

Scenario analysis is a behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number of variables.

Answer 2

True

Question 3

Projects with a small chance of being acceptable and a broad range of possible cash flows are riskier than projects having a high chance of being acceptable and a narrow range of possible cash flows.

Answer 3

True

Question 4

In capital budgeting, risk refers to a high degree of variability of the initial investment of a project.

Question 5

Simulation is a statistics-based approach used in capital budgeting to get a feel for risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

Question 6

Behavioral approaches for dealing with risk include annualized net present values and risk-adjusted discount rates.

Question 7

Sensitivity analysis is a statistics-based approach used in capital budgeting to asses risk by applying predetermined probability distributions and random numbers to estimate risky outcomes.

Question 8

All projects should always use the WACC as the required return for capital budgeting purposes.

Question 9

Scenario analysis is a behavioral approach that uses a number of possible outcomes to asses the variability of returns.

Question 10

The break even cash inflow is the minimum level of cash inflow necessary for a project to be acceptable.

Question 11

The output of simulation provides an excellent basis for decision making since it allows the decision maker to view a continuum of risk-return trade-offs rather than a single-point estimate.

Question 12

Scenario analysis is a statistics-based behavioral approach that applies predetermined probability distributions and random numbers to estimate risky outcomes.

Question 13

The acceptance of a particular project usually has no impact on a firm's overall risk.

Question 14

Simulation is an approach that evaluates the impact on return of simultaneous changes in a number of variables.

Question 15

Monte Carlo simulation programs usually build a histogram of the results.

Question 16

Behavioral approaches ________.

A) are used to explicitly recognize project risk
B) are used to get a feel for project risk
C) are not used by rational financial managers
D) are used to quantify the risk

Question 17

Different projects have different levels of risk. As a result, the acceptance of a particular project generally has an impact on a firm's overall risk.

Question 18

In capital budgeting, risk is generally thought of as the chance that NPV and IRR will provide conflicting recommendations to management.

Question 19

In capital budgeting, one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst), most likely (expected), and optimistic (best) estimates of cash inflow.

Question 20

In capital budgeting, risk is the degree of variability of cash flows.

Question 21

The importance and widespread use of transfer pricing in international trade makes capital budgeting in MNCs very difficult unless the transfer prices that are used accurately reflect actual costs and incremental cash flows.

Question 22

Tangshan Mining Company, with a cost of capital of 10 percent, is considering investing in project A, with an initial investment of $1,000,000. Project A is expected to provide equal cash inflows over its 15 year useful life. Based on this information, the breakeven cash inflow for the project is ________.

A) $1,000,000
B) $131,474
C) $100,000
D) $66,667

Question 23

Exchange rate risk is the risk that an unexpected change in exchange rates will reduce the market value of a project's cash flows.

Question 24

In case of international capital budgeting, long-term exchange rate risk can be minimized by financing the project, in whole or in part, in local currency.

Question 25

In international trade, transfer prices are prices that subsidiaries charge each other for the goods and services traded between them.

Question 26

Breakeven cash inflow refers to ________.

A) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV greater than zero
B) the minimum level of cash inflow necessary for a project to be acceptable, that is, NPV less than zero
C) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR less than zero cost of capital
D) the minimum level of cash inflow necessary for a project to be acceptable, that is, IRR equals zero

Question 27

Exchange rate risk is easier to protect as compared to political risk.

Question 28

In case of international capital budgeting, a U.S. company can minimize its political risk by creating a joint venture with a competent and well-connected local partner.

Question 29

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
If the projects have five-year lives, the range of the net present value for Project B is approximately ________. (See Table 12.1)

A) $80,563
B) $201,000
C) $255,444
D) $303,263

Question 30

In capital budgeting, risk refers to ________.

A) the degree of variability of the cash inflows
B) the degree of variability of the initial investment
C) the chance that the net present value will be greater than zero
D) the chance that the internal rate of return will exceed the cost of capital

Question 31

A behavioral approach that evaluates the impact on a firm's return through simultaneous changes in a number variables of a project is called ________.

A) sensitivity analysis
B) scenario analysis
C) simulation analysis
D) Monte Carlo simulation

Question 32

The two basic types of risk associated with international cash flows are inflation and foreign exchange risks and political risks.

Question 33

In capital budgeting, risk refers to ________.

A) the chance that a project will prove acceptable
B) the conflicting IRR and NPV in a project
C) the degree of variability of initial outlay
D) the uncertainty of cash inflows

Question 34

Foreign direct investment is the transfer of capital, managerial, and technical assets to a foreign country.

Question 35

The advantage of using simulation in the capital budgeting process is the ________.

A) ease of calculation over scenario analysis
B) continuum of risk-return trade-offs for decision making
C) single point estimate that helps the decision maker to choose the most accurate alternative
D) use of several possible outcomes to asses risk

Question 36

One type of simulation program made popular by the widespread use of personal computers is called ________.

A) Monaco Simulation
B) Lemans Simulation
C) Cannes Simulation
D) Monte Carlo Simulation

Question 37

International capital budgeting differs from domestic capital budgeting as cash inflows and outflows occur in a foreign currency and foreign investments potentially face significant political risk.

Question 38

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
The expected net present value of Project A if the outcomes are equally probable and the project has five-year life is ________. (See Table 12.1)

A) -$1,045
B) $17,910
C) $36,865
D) $93,730

Question 39

The danger that an unexpected change in the exchange rate between the dollar and the currency in which a project's cash flows are denominated will reduce the market value of that project's cash flow is called exchange rate risk.

Question 40

Table 12.1
A corporation is assessing the risk of two capital budgeting proposals. The financial analysts have developed pessimistic, most likely, and optimistic estimates of the annual cash inflows which are given in the following table. The firm's cost of capital is 10 percent.
The range of the annual cash inflows for Project A is ________. (See Table 12.1)

A) $30,000
B) $10,000
C) $5,000
D) $0

Question 41

Which of the following strategies will help in minimizing political risk in international capital budgeting decisions?

A) by hedging the cash flows using currency futures and options
B) structuring the financing of such investments as equity rather than as debt
C) structuring the financing of such investments as debt rather than as equity
D) financing the project, in whole or in part, in domestic currency

Question 42

The higher the risk-adjusted net present, the more viable the project.

Question 43

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a positive NPV and those falling below the SML would have a negative NPV.

Question 44

The higher the risk of a project, the higher its risk-adjusted discount rate and thus the lower the net present value for a given stream of cash inflows.

Question 45

Even though a business firm can be viewed as a portfolio of assets, firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify the risk on their own.

Question 46

________ reflects the return that must be earned on the given project to compensate the firm's owners adequately.

A) Internal rate of return
B) Cost of capital
C) Risk-adjusted discount rate
D) Average rate of return

Question 47

A market risk-return function is a graphical presentation of the discount rates associated with each level of project risk.

Question 48

In CAPM, the total risk is defined as the sum of nondiversifiable and diversifiable risk.

Question 49

The risk-adjusted discount rate (RADR) is the rate of return that must be earned on a given project to compensate a firm's owners adequately, that is, to maintain or improve the firm's share price.

Question 50

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the market risk premium.

Question 51

Which of the following is an important type of risk in an international capital budgeting context?

A) business cycle risk
B) political risk
C) appropriation risk
D) default risk

Question 52

Political risk is easier to protect as compared to exchange rate risk.

Question 53

By combining two projects with negatively correlated cash inflows, a firm reduces the combined cash inflow variability and its risk.

Question 54

For assets traded in an efficient market, the diversifiable risk can be eliminated through diversification.

Question 55

RADRs are popular because they are consistent with the general disposition of financial decision makers toward rates of return.

Question 56

The risk-adjusted discount rate (RADR) is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

Question 57

The risk-adjusted discount rate can be computed as the risk free rate plus the product of a project's beta and the credit risk premium.

Question 58

In applying risk-adjusted discount rates to project selection, projects falling above the SML would have a negative NPV and those falling below the SML would have a positive NPV.

Question 59

Because a business firm can be viewed as a portfolio of assets, it is important that the firm maintains a diversified portfolio of assets.

Question 60

Because of the basic mathematics of compounding and discounting, the risk-adjusted discount rate (RADR) approach implicitly assumes that risk is an increasing function of time.

Question 61

Table 12.5
Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.
Using the risk-adjusted discount rate method of project evaluation, find the NPV for projects X and Y. Which project should Nico select using this method? (See Table 12.5)

Question 62

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The net present value of the project when adjusting for risk is ________. (See Table 12.2)

A) -$9,300
B) $0
C) $87,000
D) $105,000

Question 63

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the better investment for Tangshan Mining is ________. (See Table 12.3)

A) Project M because it has a higher NPV
B) Project N because it has a higher NPV
C) Project N because it has a higher IRR
D) Project M because it has a higher IRR

Question 64

The shares traded publicly in an efficient market are ________.

A) generally positively affected by diversification, because of the reduction in risk
B) generally negatively affected by diversification, because of the increase in risk
C) generally not affected by diversification, unless greater returns are expected
D) generally negatively affected by diversification, because of the increase in the required rate of return

Question 65

The theoretical basis from which the concept of risk-adjusted discount rates is derived is ________.

A) the Gordon model
B) the capital asset pricing model
C) simulation theory
D) the basic cost of money

Question 66

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The net present value without adjusting the discount rate for risk is ________. (See Table 12.2)

A) $336,000
B) $250,000
C) $179,400
D) $87,000

Question 67

When unequal-lived projects are independent, the length of the project lives is not critical.

Question 68

A preferred approach for risk adjustment of capital budgeting cash flows, from a practical viewpoint, is ________.

A) sensitivity analysis
B) simulation analysis
C) scenario analysis
D) risk-adjusted discount rates

Question 69

Table 12.4
Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects.
Which project do you recommend? (See Table 12.4)

Question 70

Table 12.2
A firm is considering investment in a capital project which is described below. The firm's cost of capital is 18 percent and the risk-free rate is 6 percent. The project has a risk index of 1.5. The firm uses the following equation to determine the risk adjusted discount rate, RADR, for each project: RADR = Rf + Risk Index (Cost of capital - Rf)
The discount rate that should be used in the net present value calculation to compensate for risk is ________. (See Table 12.2)

A) 6 percent
B) 15 percent
C) 18 percent
D) 24 percent

Question 71

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Which project would be preferable if both projects were of average risk as the overall firm and Tangshan Mining has a beta of 1.0? (See Table 12.3)

A) Project M because it has a higher NPV
B) Project N because it has a higher NPV
C) Project N because it has a higher IRR
D) Project M because it has a higher IRR

Question 72

Table 12.5
Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.
What potential biases exist in project selection if Nico Manufacturing did not adjust for the difference in risk between Projects X and Y (See Table 12.5).

Question 73

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the NPV for Project M is ________. (See Table 12.3)

A) $156,494
B) $122,970
C) $85,732
D) $500,000

Question 74

Table 12.3
Tangshan Mining Company is considering investment in one of two mutually exclusive projects M and N which are described below. Tangshan Mining's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Tangshan estimates that the beta for project M is 1.20 and the beta for project N is 1.40.
Using the risk-adjusted discount rate method of project evaluation, the NPV for Project N is ________. (See Table 12.3)

A) $166,132
B) $122,970
C) $85,732
D) $600,000

Question 75

The difference by which the required discount rate exceeds the risk-free rate is called the ________.

A) excess return
B) risk premium
C) inflation premium
D) maturity premium

Question 76

Table 12.4
Johnson Farm Implement is faced with two mutually exclusive projects, P and Q. The following are the data about the two projects.
Evaluate the projects using risk-adjusted discount rates. (See Table 12.4)

Question 77

Table 12.5
Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.
Calculate the NPV of projects X and Y assuming that the firm did not employ the RADR method and instead used the firm's overall cost of capital to evaluate projects X and Y. (See Table 12.5)

Question 78

In case of unequal-lived, mutually exclusive projects, the use of net present value to select the better project results in an incorrect decision.

Question 79

Table 12.5
Nico Manufacturing is considering investment in one of two mutually exclusive projects X and Y which are described below. Nico Manufacturing's overall cost of capital is 15 percent, the market return is 15 percent and the risk-free rate is 5 percent. Nico estimates that the beta for project X is 1.20 and the beta for project Y is 1.40.
Calculate the risk-adjusted discount rates for Project X and Project Y. (See Table 12.5)

Question 80

Firms do not usually get rewarded by diversifying investments in different lines of business because ________.

A) the capital markets are efficient and they quickly respond to change in economic conditions
B) cash flows from such projects tend to respond less to changing economic conditions
C) investors themselves can diversify by holding securities in a variety of firms; they do not need the firm to do it for them
D) it is not possible for a firm to diversify its risk as the inflation premium is different for different projects