Question 1

The DMT Company is financed entirely with equity. DMT has a beta of 1.20 and the current risk-free rate is 9.5 percent. If the expected market return is 14 percent, what rate of return should DMT require on a project of average risk?

Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the expected return is calculated as: Risk-free rate + Beta * (Market return - Risk-free rate). Plugging in the values: 9.5% + 1.20 * (14% - 9.5%) = 14.9%.

Question 2

The certainty equivalent factors used in capital budgeting analysis are equal to the ____ divided by ____.

Accepted Answer

The certainty equivalent factor is the amount of certain return that an investment must generate in order for investors to be indifferent between that return and the risky return being considered. Therefore, the certainty equivalent factor is equal to the certain return (what investors would be guaranteed to receive) divided by the risky return (what investors may actually receive).

Question 3

A project has an expected net present value of $50,000 with a standard deviation of the net present value of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a negative NPV?

Accepted Answer

To find the probability of negative NPV, we need to find the area under the normal curve to the left of zero. Using normal distribution tables or a calculator, we can find that the probability is approximately 0.3085. However, since we are dealing with a continuous distribution, we need to subtract 0.5*(probability of zero NPV) from this result. That is, we need to subtract 0.5*(probability density at zero NPV), which is (0.3989/20000)*exp(-(0/50000)^2/2) = 0.0000064. Therefore, the final answer is 0.3085 - 0.0000064 = 0.3084936 or 0.62%.

Question 4

The ____ approach is widely used by firms that attempt to consider differential project risk in their capital budgeting procedures.

Accepted Answer

The risk-adjusted discount rate approach is the most appropriate for firms that consider differential project risk in their capital budgeting procedures. This approach adjusts the discount rate for each project based on its level of risk, with higher-risk projects assigned higher discount rates. The net present value and internal rate of return methods do not directly account for project risk in their calculations, while the certainty equivalent approach is typically used by risk-averse investors to determine the guaranteed return needed to accept a risky investment.

Question 5

SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions of the firm's total assets: ? $\begin{array}{lcc}
\text { Division } & \text { Beta } & \% \text { of Assets } \
\text { Electric \& Gas } & 0.85 & 60 \
\text { Bus transportation } & 0.95 & 10 \
\text { Real estate } & 1.40 & 25 \
\text { Recreation } & 1.15 & 5
\end{array}$ ?
The risk-free rate is 8 percent, and the market risk premium is 5 percent. If SCAN is considering a residential development, what should the firm use as its cost of equity in evaluating this project?

Accepted Answer

The answer of SCAN is a multi-divisional utility company. SCAN...

Question 6

The net present value of a project is normally distributed with an expected value of $52,000 and a standard deviation of $31,515. Determine the probability that the project will have a net present value of less than zero.

Accepted Answer

To find the probability that the net present value will be less than zero, we need to standardize the distribution by converting it to a standard normal distribution. We can do this using the formula:

z = (X - μ) / σ

where X is the net present value, μ is the expected value, and σ is the standard deviation.

Plugging in the values, we get:

z = (0 - 52000) / 31515
z = -1.65

Using a standard normal distribution table or calculator, we can find that the probability of getting a z-score less than -1.65 is 0.0495 or 4.95%. Therefore, the probability that the project will have a net present value of less than zero is 4.95%, which corresponds to choice C.

Question 7

The ____ risk of a firm is a weighted average of the ____ risk of the individual assets in the firm.

Accepted Answer

The systematic risk of a firm is a weighted average of the systematic risk of the individual assets in the firm, as it reflects the impact of external factors that affect all assets similarly.

Question 8

With the risk-adjusted discount rate approach, in the context of total risk, the discount rates used in evaluating cash flows are determined ____.

Accepted Answer

The risk-adjusted discount rate approach involves adjusting the discount rate based on the level of risk associated with the cash flows. The determination of the discount rate involves subjective judgments by the analyst or the management team, taking into consideration the perceived level of risk associated with the investment. While objective factors such as market data or historical experience may be used to inform this judgment, ultimately the discount rate is subjectively determined. Regression analysis may be used to establish the appropriate adjustments to the discount rate based on the level of risk, but it does not determine the discount rate itself.

Question 9

With the ____ approach, the decision maker adjusts separately each period's cash flows to account for the specific risk of those cash flows.

Accepted Answer

The certainty equivalent approach involves adjusting the cash flows themselves to reflect their risk, rather than adjusting the discount rate. This method directly modifies each period's cash flows to a "certain" equivalent value that the decision maker would be indifferent to receiving instead of the risky cash flow.

Question 10

A project has an expected NPV of $50,000 with a standard deviation of the NPV of $20,000. Assume that NPV is normally distributed. What is the probability that the project will have a net present value greater than $60,000?

Accepted Answer

First, we need to standardize the NPV using the formula:

z = (X - μ) / σ

where X is the value we want to find the probability for (in this case, $60,000), μ is the expected value ($50,000), and σ is the standard deviation ($20,000).

z = (60,000 - 50,000) / 20,000
z = 0.5

Next, we need to find the probability of getting a z-score of 0.5 or greater using a standard normal distribution table or a calculator. This is equivalent to finding the area to the right of z = 0.5 on a standard normal distribution curve.

Using a calculator, we can find this probability by using the normalcdf function:

normalcdf(0.5, E99)
0.3085375387

Rounding to two decimal places, we get 0.31 or 31%.

Therefore, the probability that the project will have a net present value greater than $60,000 is 30.85%. The correct choice is D.

Question 11

Faris currently has a capital structure of 40 percent debt and 60 percent equity, but is considering a new product that will be produced and marketed by a separate division. The new division will have a capital structure of 70 percent debt and 30 percent equity. Faris has a current beta of 1.1 but is not sure what the beta for the new division will be. AMX is a firm that produces a product similar to the product under consideration by Faris. AMX has a beta of 1.6, a capital structure of 40 percent debt and 60 percent equity, and a marginal tax rate of 40 percent. Assuming Faris's tax rate is 40 percent, estimate the levered beta for the new product division.

Accepted Answer

First, we need to find the unlevered beta of the new division:
Unlevered beta of AMX = 1.6
AMX D/E ratio = 0.40/0.60 = 0.67
Unlevered beta of new division = Unlevered beta of AMX / [1 + (1 - tax rate)*(debt/equity)]
= 1.6 / [1 + (1-0.4)*(0.7/0.3)]
= 1.16

Next, we need to find the levered beta of the new division:
Debt/equity of new division = 0.7/0.3 = 2.33
Levered beta of new division = Unlevered beta of new division * [1 + (1 - tax rate)*(debt/equity)]
= 1.16 * [1 + (1-0.4)*(2.33)]
= 2.74

Therefore, the answer is C) 2.74.

Question 12

SCAN is a multi-divisional utility company. SCAN has four divisions with the following betas and proportions of the firm's total assets: ? $\begin{array}{lcc}
\text { Division } & \text { Beta } & \% \text { of Assets } \
\text { Electric \& Gas } & 0.85 & 60 \
\text { Bus transportation } & 0.95 & 10 \
\text { Real estate } & 1.40 & 25 \
\text { Recreation } & 1.15 & 5
\end{array}$ ?
What is the firm's weighted average beta?

Accepted Answer

The firm's weighted average beta is calculated by multiplying each division's beta by its proportion of total assets and summing the results: (0.85 * 0.60) + (0.95 * 0.10) + (1.40 * 0.25) + (1.15 * 0.05) = 1.01.

Question 13

The risk-adjusted discount rate approach is used in the analysis of projects for which ____ is the applicable risk measure.

Accepted Answer

The answer of The risk-adjusted discount rate approach is used...

Question 14

When evaluating a capital expenditure to be made in a foreign country, the parent firm must be concerned with the _____.

Accepted Answer

All of these factors are important for a parent firm to consider when evaluating a capital expenditure in a foreign country. Exchange rate risk can impact the return on investment, cash flows that can be expected are essential to determine the financial feasibility of the project, and greater uncertainty associated with tax rates in the host country can affect the overall profitability of the investment.

Question 15

Technico plans to start a new product division that will have a capital structure of 70 percent debt and 30 percent equity. The leveraged beta for this division has been estimated to be 2.02. What will be Technico's weighted cost of capital for this new division if the after-tax cost of debt is 7 percent, the risk-free rate is 8 percent, and the market risk premium is 5 percent?

Accepted Answer

To calculate the weighted cost of capital (WACC) for Technico's new division, we first need to calculate the cost of equity using the Capital Asset Pricing Model (CAPM). The formula for CAPM is:$$ \text{Cost of Equity} = \text{Risk-Free Rate} + \text{Beta} \times \text{Market Risk Premium} $$Given:- Risk-Free Rate = 8%- Beta = 2.02- Market Risk Premium = 5%$$ \text{Cost of Equity} = 8\% + 2.02 \times 5\% = 8\% + 10.1\% = 18.1\% $$Now, we can calculate the WACC using the formula:$$ \text{WACC} = \text{Weight of Equity} \times \text{Cost of Equity} + \text{Weight of Debt} \times \text{After-Tax Cost of Debt} $$Given:- Weight of Equity = 30% or 0.3- Weight of Debt = 70% or 0.7- After-Tax Cost of Debt = 7%$$ \text{WACC} = 0.3 \times 18.1\% + 0.7 \times 7\% = 5.43\% + 4.9\% = 10.33\% $$Therefore, the weighted cost of capital for Technico's new division is 10.33%.

Question 16

Calco is a multi-divisional firm with a weighted cost of capital of 14 percent and a risk-adjusted discount rate for its can division of 17 percent. A planned expansion in the can division requires a net investment of $170,000 and results in expected cash inflows of $42,000 a year for seven years. Should Calco invest in this expansion?

Accepted Answer

The NPV is calculated using the risk-adjusted discount rate of 17% for the can division. The NPV is negative, indicating that the investment should not be made.

Question 17

The most expensive method of adjusting for total project risk in the evaluation of capital budgeting projects is the _____.

Accepted Answer

The simulation approach, often involving complex computer models to simulate a wide range of possible outcomes, is typically the most expensive method for adjusting for total project risk in capital budgeting evaluations due to its need for extensive data, computational resources, and time.

Question 18

The risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project is ____.

Accepted Answer

Scenario analysis is the risk assessment technique that considers the impact of simultaneous changes in key variables on the desirability of an investment project. Sensitivity analysis only considers the impact of changes in one variable, while simultaneous equations are a mathematical modeling technique that is not directly related to risk assessment. RADR analysis is not a commonly used risk assessment technique.

Question 19

A simulation analysis for a new acquisition has indicated that the expected NPV is $50 million with a standard deviation of $40 million. Assume that NPV is normally distributed. What is the probability that the project will be unacceptable?

Accepted Answer

To determine the probability that the project will be unacceptable, we need to calculate the probability that the NPV is negative. We can do this by standardizing the NPV using the formula z = (x - μ) / σ, where x is the NPV, μ is the mean (expected NPV) and σ is the standard deviation.

z = (0 - 50) / 40 = -1.25

Using a standard normal distribution table or calculator, we find that the probability of getting a z-score of -1.25 or lower is 0.1056 or 10.56%, which is the probability that the project will be unacceptable.

Question 20

The Chris-Kraft Co. is financed entirely with equity, and the firm has a beta of 1.6. The current risk-free rate is 9.5 percent, and the expected market return is 16 percent. What rate of return should Chris-Kraft require on a project of average risk?

Accepted Answer

Using the Capital Asset Pricing Model (CAPM), the required rate of return is calculated as: Risk-Free Rate + Beta * (Market Return - Risk-Free Rate) = 9.5% + 1.6 * (16% - 9.5%) = 9.5% + 1.6 * 6.5% = 9.5% + 10.4% = 19.9%.

Quiz 13: Capital Budgeting and Risk