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FINAL EXAM 6: Capital Budgeting, Risk, & Uncertainty

Multiple-Choice Questions

1) The term "capital budgeting" refers to decisions

A) which are made in the short run.
B) which concern the spreading of expenditures over a period lasting less than
one year.
C) where expenditures and receipts for a particular undertaking will continue
over a
relatively long period of time.
D) where a receipt of cash will occur simultaneously with an outflow of cash.

2) Capital budgeting projects include all of the following with the exception of
A) the purchase of a six-month treasury bill.
B) the expansion of a plant.
C) the development of a new product.
D) the replacement of a piece of equipment.

3) If \$1,000 is placed in an account earning 8% annually, the balance at the end of

seven years will be
A) \$1,080. B) \$1,560. C) \$2,000. D) \$1,714.

4) The payback period for a project, requiring an initial outlay of \$10,000 and
producing ten
uniform annual cash inflows of \$1,500, is
A) six years. B) six years and eight months.
C) six years and six months. D) seven years.

5) The net present value of a project is calculated as follows:

A) The future value of all cash inflows minus the present value of all outflows.
B) The sum of all cash inflows minus the sum of all cash outflows.
C) The present value of all cash inflows minus the present value of all cash
outflows.
D) None of the above.

6) A proposed project should be accepted if the net present value is

A) positive. B) negative.
C) larger than the internal rate of return. D) smaller than the internal rate of
return.

7) When future events cannot be assigned probabilities, we are talking about

A) risk. B) uncertainty.
C) a clouded future. D) financial risk.

8) Probabilities, which can be obtained by repetition or are based on general

mathematical
principles are called
A) statistical. B) empirical. C) a priori. D) subjective.
9) Other things being equal, the higher the cost of capital,
A) the higher the NPV of a project.
B) the higher the IRR of the project.
C) the lower the NPV of the project.
D) the cost of capital has no effect on the NPV of the project.

10) The internal rate of return of a project can be found

A) by discounting all cash flows at the cost of capital.
B) by averaging all cash inflows, and calculating the interest rate, which will
make them
equal to the average investment.
C) by calculating the interest rate, which will equate the present value of all cash
inflows to
the present value of all cash outflows.
D) None of the above.

11) In finance, risk is most commonly measured by

A) the probability distribution.
B) the standard deviation.
C) the average deviation.
D) the square root of the standard deviation.

12) A project whose acceptance eliminates another project from consideration is

called
A) independent. B) mutually exclusive.
C) replacement D) complementary.

13) The internal rate of return equals the cost of capital when
A) NPV = 0. B) NPV > 0.
C) NPV < 0. D) None of the above.

14) When two mutually exclusive projects are considered, the NPV calculations and
the IRR
calculations may, under certain circumstances, give conflicting
recommendations as to
which project to accept. The reason for this result is that in the NPV calculation,
cash
inflows are assumed to be reinvested at the cost of capital, while in the IRR
solution,
reinvestment takes place at
A) the hurdle rate. B) the accounting rate of return.
C) the prime rate. D) the project's internal rate of return.

15) When analyzing a capital budgeting project, the analyst must include in his
calculation all of
the following except
A) all revenues and costs in terms of cash flows.
B) only those cash flows that will change if the proposal is accepted (i.e.,
incremental cash
flows).
C) interest payments on debt financing connected with the project.
D) any effect (impact) the acceptance of the project under consideration will
have on other
projects now in operation.

16) The use of the same cost of capital (risk adjusted discount rate) for all capital
projects in a
corporation
A) is usually the correct procedure.
B) is incorrect since different divisions of the corporation may be faced with
different levels
of risk.
C) is incorrect since different capital projects, even in the same division, may be
faced with
different levels of risk.
D) Both B and C.

17) If a risky cash flow of \$10,000 is equivalent to a riskless cash flow of \$9,300, the
certainty
equivalent factor is
A) 0.93. B) 0.07. C) 1.07. D) 1.93.

18) If, at the end of the project life, a piece of equipment having a book value of
\$4,000 is
expected to bring \$3,000 upon resale, and the income tax rate is 40%, how
much will be the
cash flow?

A) \$2,800 B) \$3,000 C) \$3,400 D) \$4,000

19) If the risk adjusted discount rate method and the certainty equivalent methods
are to give the
same results, then the certainty equivalent factor (at) must equal (where rf is
the risk-free
interest rate, and ‘k’ is the risk adjusted cost of capital)

A) (1 + rf)t times (1 + k) t B) (1 + k) t divided by (1 + rf) t

C) (1 + rf) t divided by (1 + k) t D) (1 + k) t minus (1 + rf) t

20) Two projects have the following NPV's and standard deviations:

Project A Project B
NPV
200 200 200
Standard 75 100
deviation

A) risk seeking. B) risk indifferent.

C) risk averse. D) None of the above.

Analytical Question

You deposit \$10,000 in a savings account today. If the interest rate is 3%,
what is the value in 20 years?

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