Capital Budgeting

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Questions 1 to 20: Select the best answer to each question. Note that a question and its answers may be split across a page break, so be sure that you have seen the entire question and all the answers before choosing an answer.

1. The fact that a proposed project is analyzed based on the project’s incremental cash flows is the assumption behind the A. underlying value principle.

B. fundamental principle.

C. stand-alone principle.

D. equivalent cost principle.

2. Future cash flows require the development of projected financial statements, projecting future years’s operations. These are called _______ statements. A. discounted

B. pro forma

C. projected

D. forward

3. Why is it important to find changes of net working capital (NWC) in developing cash flows? A. Changes in NWC indicate capital expenditures (such as purchase of equipment). They must be subtracted from cash inflows (measured by other cash flow).

B. Changes in NWC indicate cash outflows (measured by change in NWC) must be subtracted from cash inflows (measured by operating cash flow).

C. Changes in NWC have important tax implications (a tax shield), so they must be multiplied by 1 minus the tax rate to find total cash flow.

D. Changes of NWC are unimportant.

4. If a firm accepts Project A, it won’t be feasible to also accept Project B because both projects would require the simultaneous and exclusive use of the same piece of machinery. These projects are considered to be A. mutually exclusive.

B. economically scaled.

C. interdependent.

D. independent.

5. Depreciation is a way to allocate the cost of capital expenditures (equipment) over the useful life of the asset. A method of accelerated depreciation is called A. NPV.

B. straight-line.

C. IRR.

D. MACRS.

6. It will cost $6,000 to acquire an ice cream cart. Cart sales are expected to be $3,600 a year for three years. After three years, the cart is expected to be worthless because the expected life of the refrigeration unit is only three years. What’s the payback period? A. 1.48 years

B. 1.67 years

C. 1.95 years

D. 1.82 years

7. A project has expected sales of 15,000 units plus or minus four percent, variable cost per unit of $120 plus or minus three percent, fixed costs of $311,000 plus or minus two percent, and a sales price per unit of $168 plus or minus two percent. The depreciation expense is $74,000, and the tax rate is 35 percent. What’s the contribution margin per unit for a sensitivity analysis, using a variable cost per unit of $122? A. $42.64

B. $49.36

C. $43.43

D. $46.00

8. If a project has a net present value equal to zero, then A. a decrease in the project’s initial cost will cause the project to have a negative NPV.

B. the project earns a return exactly equal to the discount rate.

C. the project’s PI must also be equal to zero.

D. the total of the cash inflows must equal the initial cost of the project.

9. A project requires an initial investment of $950,000 today. The present value of the cash inflows likely to result from this initial investment is $1,208,293. What’s the net present value of this investment? A. –$258,293

B. $950,000

C. –$950,000

D. $258,293

10. Which of the following methods of project analysis is defined as computing the value of a project based on the present value of the project’s anticipated cash flows? A. Constant dividend growth model

B. Discounted cash flow valuation

C. Expected earnings model

D. Internal rate of return

11. Net present value is based on many estimates and forecasts. What can be done to compensate for the uncertainty of these future variables? A. Using IRR instead

B. Decreasing the discount rate

C. Sensitivity and scenario analysis

D. Nothing

12. Suppose you’re considering making an investment in one of two firms. Firm A has fixed costs that account for 50 percent of total costs, and variable costs account for 50 percent of total costs. Firm B has fixed costs that account for 80 percent of total costs, and variable costs account for 20 percent of total costs. Assuming everything else is equal and that you’re risk adverse, which firm would you invest in and why? A. Firm B because it’s less risky

B. There isn’t enough information.

C. Firm A because it’s less risky

D. It doesn’t matter because both firms have a similar amount of risk.

13. Assume that a firm sells widgets for $30 per unit. Widgets cost $10 per unit to manufacture. Assuming fixed costs are $60,000, how many units would the firm have to sell to hit the cash break even? A. 6,000 units

B. 1,000 units

C. 3,000 units

D. 2,000 units

14. Which cost should not be considered when evaluating a new project? A. Future costs

B. Opportunity costs

C. Erosion costs

D. Sunk costs

15. What’s the investment criteria that sets NPV equal to zero and solves for the discount rate? A. The internal rate of return (IRR) rule

B. The discounted payback rule

C. The net present value (NPV) rule

D. The profitability index (PI) rule

16. The maintenance expenses on a rental house you own average $200 a month. The house cost $219,000 when you purchased it four years ago. A recent appraisal on the house valued it at $239,000. If you sell the house, you’ll incur $14,000 in real estate fees. The annual property taxes are $4,000. You’re trying to decide whether to sell the house or convert it for your own use as a professional office. What value should you place on this house when analyzing the option of using it as a professional office? A. $211,800

B. $225,000

C. $239,000

D. $235,000

17. The profitability index is calculated by

End of exam

A. multiplying NPV weighted by the proportion of project assets to firm assets.

B. dividing cash flows by the initial investment.

C. dividing NPV by the initial investment.

D. setting the NPV to zero and solving for the discount rate.

18. How does scenario analysis differ from sensitivity analysis? A. Scenario analysis changes one variable at a time and determines different NPV estimates; sensitivity analysis determines different NPV estimates based on different what-if questions.

B. Scenario analysis is performed before a project is started; sensitivity analysis is performed after a project is completed.

C. Sensitivity and scenario analysis are synonymous.

D. Scenario analysis determines different NPV estimates based on different what-if questions; sensitivity analysis changes one variable at a time and determines different NPV estimates.

19. Assume that a firm wants to add staplers to their product line and sell each unit for $15. Staplers cost $5 per unit to manufacture. Assuming incremental fixed costs are $10,000, what can we say with certainty about the project? A. The project should be accepted.

B. The project should be rejected.

C. If 1,000 units are sold (cash break even), the project has a negative NPV.

D. If 1,000 units are sold (cash break even), the project has a positive NPV.

20. You’re working on a bid to build two apartment buildings a year for the next three years. This project requires the purchase of $1,089,000 of equipment that will be depreciated using straight-line depreciation to a zero book value over the project’s life. The equipment can be sold at the end of the project for $815,000. You’ll also need $280,000 in net working capital over the life of the project. The fixed costs will be $528,000 a year, and the variable costs will be $1,640,000 per building. Your required rate of return is 18 percent for this project, and your tax rate is 35 percent. What’s the minimal amount, rounded to the nearest $100, you should bid per building? A. $2,780,600

B. $4,233,000

C. $4,489,500

D. $2,116,200

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