# The objective of a firm's management - Expert Answers

1. The objective of a firm's management should be to only undertake the projects that ________ the market value of shareholders' equity.

a. decrease

b. increase

c. do not change

d. provide zero change to

e. none of the above

2. The decision rule that management should use with net present value (NPV) is to undertake only those projects with a(n) ________ NPV.

a. positive

b. negative

c. indeterminate

d. negative or zero

e. none of the above

3. The net present value (NPV) amount represents the amount by which the project is expected to ________ shareholder wealth (assuming positive NPV for this question).

a. provide zero change to

b. decrease

c. increase

d. provide zero change to or decrease

4. Net cash inflows from operations can be computed in which of the following ways?

a. Cash Flow = Revenues - Cash Expenses - Taxes

b. Cash Flow = Net Income + Noncash Expenses

c. Cash Flow = Revenue - Total Expenses - Taxes + Noncash Expenses

d. all of the above

5. Which of the following is not true?

a. Multiple IRRs for a project may exist when the project's required rate of return is high.

b. IRR implicitly assumes that cash flows can be reinvested at the IRR rate.

c. Ranking projects based on NPV is not always the appropriate way to pick which projects to undertake.

d. When used to compare two projects, ACC assumes that a project with a short live can be repeated at a later date.

6. Which of the following would not be expected to affect the decision of whether to undertake an investment?

a. Income tax rates.

b. Cost of capital.

c. Sales reductions in other products caused by this investment.

d. Cost of the feasibility study which was conducted for a project.

7. The cost of capital does not reflect any market related risk of the project, or “beta.”

a. true

b. false

8. In computing a project's cost of capital the risk to use is:

a. the risk of the financing instruments used to fund the project

b. the risk of the project's cash flows

c. a risk free rate

d. a historical risk rate using T-bills

e. none of the above

9. When a firm has to ration capital, it should:

a. Fund the set of projects within the limits of capital that produces the greatest overall net present value.

b. Fund the set of projects within the limits of capital that produces the greatest overall internal rate of return (IRR).

c. Rank the projects based on net present value and fund as many of them in that order as possible.

d. Rank the projects based on internal rate of return (IRR) and fund as many of them in that order as possible.

10. If a project requires a $50,000 increase in inventory, this increase in inventory . . .

a. represents a cash outflow for the project.

b. represents a cash inflow for the project.

c. represents a cash outflow for the project but must be adjusted for taxes.

d. represents a cash inflow for the project but must be adjusted for taxes.

e. should be ignored in the evaluation of the project.

11. The ________ is the rate that prevails in a zero-inflation scenario. The ________ is the rate that one actually observes.

a. nominal, inflation

b. real rate, expected

c. nominal, real rate

d. real rate, nominal

12. If the nominal cost of capital is 16% per year and the expected rate of inflation is 5% per year, then compute the real cost of capital (rounded to nearest tenth of a %).

a. 11.5%

b. 10.5%

c. 8.5%

d. 9.0%

e. none of the above

13. When a project has multiple internal rates of return:

a. the analyst should choose the highest rate to compare with the firm's cost of equity

b. the analyst should choose the lowest rate to compare with the firm's cost of capital

c. the analyst should choose the rate that seems most "reasonable" given the project's cash flows, to compare with the firm's cost of equity

d. the analyst should compute the project's net present value and accept the project if its NPV is greater than $0.

e. none of the above

14. Which of the following statements is most correct?

a. Sunk costs must be included in the project's cash flow.

b. R&D expenditures cannot be a part of the initial cost of a project.

c. Opportunity costs are sunk costs and therefore should not be included in the cost of the project.

d. Depreciation is not a cash expense.

e. All of the above statements are false.

15. Suppose the firm's cost of capital is stated in nominal terms, but the project's cash flows are expressed in real dollars. If a nominal rate is used to discount real cash flows and there is inflation (assume positive inflation), the calculated NPV would

a. be biased upward

b. be biased downward

c. be correct

d. be possibly biased; either upward or downward

e. none of the above

16. The correct method to handle overhead costs in capital budgeting is to:

a. allocate a portion to each project.

b. allocate them to projects with the highest NPVs.

c. ignore all except identifiable incremental amounts.

d. ignore them in all cases.

17. Which of the following statements is normally correct for a project with a positive NPV?

a. IRR exceeds the cost of capital.

b. Accepting the project has an indeterminate effect on shareholders.

c. The traditional payback period exceeds the life of the project.

d. The present value index equals one.

18. Capital budgeting proposals for investment projects should be evaluated as if the project were financed:

a. entirely by debt.

b. entirely by debt, adjusting for taxes.

c. half by debt and half by equity.

d. with the highest cost source of funds, to be safe.

e. the financing and investment decisions should be viewed separately.

19. When projects are mutually exclusive, can be undertaken only once, and capital is unconstrained, selection should be made according to the project with the:

a. longer life.

b. larger initial size.

c. highest IRR.

d. highest NPV.

e. highest PVI (present value index).

20. Which of the following can be deduced about a three-year investment project that has a two year traditional payback period?

a. The NPV is positive.

b. The IRR is greater than the cost of capital.

c. Both 'a' and 'b' can be deduced.

d. Neither 'a' nor 'b' can be deduced.

21. If a project has a cost of $50,000 and a present value index of 1.4, then:

a. its cash inflows are $70,000.

b. the present value of its cash inflows is $30,000.

c. its IRR is 20%.

d. its NPV is $20,000.

22. If two projects offer the same, positive NPV, then:

a. they also have the same IRR.

b. they have the same traditional payback period.

c. they are mutually exclusive projects.

d. they add the same amount to the value of the firm.

e. all the above

23. The likely effect of discounting nominal cash flows with real interest rates (assuming positive NPV) will be to:

a. make an investment's NPV appear more attractive.

b. make an investment's NPV appear less attractive.

c. correctly calculate an investment's NPV if inflation is expected.

d. correctly calculate an investment's NPV, regardless of expected inflation.

24. Which of the following is representative of how depreciation expense is handled in the face of inflation?

a. It increases annually with the rate of inflation.

b. It decreases annually in nominal terms.

c. The depreciable base is not altered by inflation.

d. The real value of the depreciation is fixed.

25. When analyzing a capital project, an increase in net working capital associated with the project:

a. is not a relevant cash flow.

b. is a relevant cash outflow.

c. is a relevant cash inflow.

d. is a relevant cash outflow that must be adjusted for taxes.

e. is a relevant cash inflow that must be adjusted for taxes.

26. What is Plato’s Inc.’s weighted average cost of capital (WACC) given the following information? Dollar amounts are in millions. There are two debt components and YTM (yield to maturity) for these two components are: 4% for notes due in May 2015, and 6% for notes due in January 2020. The risk-free rate is 3%, and market risk premium is 8%. The company has a beta of 1.5. The firm’s tax rate is 35%. (7 points)

27. Calculate the traditional payback period, IRR, NPV, and PVI (present value index) for the project with the following cash flows. The opportunity cost of capital for the project is 14%. (8 points)

28. Calculate the relevant cash flows (for each year) for the following capital budgeting proposal. Enter the total net cash flows for each year in the answer sheet. (10 points)

• $90,000 initial cost for machinery;

• depreciated straight-line over 4 years to a book value of $10,000;

• 35% marginal tax rate;

• $55,000 additional annual revenues;

• $25,000 additional annual cash expense;

• annual expense for debt financing is $7,500.

• $3,500 previously spent for engineering study;

• The project requires inventory increase by $32,000 and accounts payable increase by $14,000 at the beginning of the project;

• The investment in working capital occurs one time at the beginning of the project and it requires working capital return to the original level when the project ends in 4 years;

• 11% cost of capital;

• life of the project is 4 years; and

• The new equipment will be sold at the end of 4 years; expected market value of the new equipment at the end of 4 years is $15,000;

29. You are analyzing a capital budgeting project and, as shown by ???, some numbers are unreadable. You can read the following information:

Cash Flows at the end of:

Year 0 = -$25,000

Year 1 = +$8,000

Year 2 = +$ 6,000

Year 3 = +$ 2,600

Year 4 = $ ???

Year 5 = +$ 9,500

The Cost of Capital is 13%, the NPV = -$5,650.01 and the IRR = ???%. Your superior, ignoring the important fact that we should reject the project, is demanding to know the Cash Flow in Year 4.

Calculate the cash flow in Year 4. (5 points)

30. We can continue to use an existing machine at a cost of $22,500 annually (after-tax cash basis, including depreciation tax benefits) for the next 4 years. Alternatively, we can purchase a new machine that has an expected life of 7 years for $45,000. The new machine is expected to cost $11,000 each year to operate (after-tax cash basis, including depreciation tax benefits). The new machine will reduce inventory needs by $5,000 starting immediately. This is a one-time reduction in inventory that will last for the entirety of the new machine’s life. This reduction in inventory will be reversed at the end of 7 years. The cost of capital is 14%. The existing machine has no salvage value and we estimate that the new machine’s salvage value will be 0 in 7 years. Should we purchase the new machine? In the exam answer sheet, indicate your decision to replace or not replace, and provide support for your answer (i.e., indicate the criteria used to make the decision and the values for that criteria). (10 points)

Additional facts for question 31:

• The existing machine has been fully depreciated.

• As stated, the $22,500 and $11,000 are annual after-tax cash operating costs (i.e., after-tax cash operating costs = net income + depreciation), thus no further adjustments need to be made to them for depreciation.

31. For the following project, calculate the NPV break-even level of annual revenue, assuming that the operating cash flows will be stable for an 8 year horizon and that the discount rate is 12%. (10 points)

• The project requires an initial investment of $600,000.

• Expected annual sales are $770,000.

• Annual fixed costs (excluding depreciation and any other non cash expenses) will be $100,000.

• Straight-line depreciation of the initial investment over 8 years to a book value of 0.

• Variable costs (all of which are cash expenses) of 65% of revenues.

• Working capital will not be affected.

• Market values for salvage purposes in 8 years are estimated to be $40,000.

• 35% tax rate.

a. decrease

b. increase

c. do not change

d. provide zero change to

e. none of the above

2. The decision rule that management should use with net present value (NPV) is to undertake only those projects with a(n) ________ NPV.

a. positive

b. negative

c. indeterminate

d. negative or zero

e. none of the above

3. The net present value (NPV) amount represents the amount by which the project is expected to ________ shareholder wealth (assuming positive NPV for this question).

a. provide zero change to

b. decrease

c. increase

d. provide zero change to or decrease

4. Net cash inflows from operations can be computed in which of the following ways?

a. Cash Flow = Revenues - Cash Expenses - Taxes

b. Cash Flow = Net Income + Noncash Expenses

c. Cash Flow = Revenue - Total Expenses - Taxes + Noncash Expenses

d. all of the above

5. Which of the following is not true?

a. Multiple IRRs for a project may exist when the project's required rate of return is high.

b. IRR implicitly assumes that cash flows can be reinvested at the IRR rate.

c. Ranking projects based on NPV is not always the appropriate way to pick which projects to undertake.

d. When used to compare two projects, ACC assumes that a project with a short live can be repeated at a later date.

6. Which of the following would not be expected to affect the decision of whether to undertake an investment?

a. Income tax rates.

b. Cost of capital.

c. Sales reductions in other products caused by this investment.

d. Cost of the feasibility study which was conducted for a project.

7. The cost of capital does not reflect any market related risk of the project, or “beta.”

a. true

b. false

8. In computing a project's cost of capital the risk to use is:

a. the risk of the financing instruments used to fund the project

b. the risk of the project's cash flows

c. a risk free rate

d. a historical risk rate using T-bills

e. none of the above

9. When a firm has to ration capital, it should:

a. Fund the set of projects within the limits of capital that produces the greatest overall net present value.

b. Fund the set of projects within the limits of capital that produces the greatest overall internal rate of return (IRR).

c. Rank the projects based on net present value and fund as many of them in that order as possible.

d. Rank the projects based on internal rate of return (IRR) and fund as many of them in that order as possible.

10. If a project requires a $50,000 increase in inventory, this increase in inventory . . .

a. represents a cash outflow for the project.

b. represents a cash inflow for the project.

c. represents a cash outflow for the project but must be adjusted for taxes.

d. represents a cash inflow for the project but must be adjusted for taxes.

e. should be ignored in the evaluation of the project.

11. The ________ is the rate that prevails in a zero-inflation scenario. The ________ is the rate that one actually observes.

a. nominal, inflation

b. real rate, expected

c. nominal, real rate

d. real rate, nominal

12. If the nominal cost of capital is 16% per year and the expected rate of inflation is 5% per year, then compute the real cost of capital (rounded to nearest tenth of a %).

a. 11.5%

b. 10.5%

c. 8.5%

d. 9.0%

e. none of the above

13. When a project has multiple internal rates of return:

a. the analyst should choose the highest rate to compare with the firm's cost of equity

b. the analyst should choose the lowest rate to compare with the firm's cost of capital

c. the analyst should choose the rate that seems most "reasonable" given the project's cash flows, to compare with the firm's cost of equity

d. the analyst should compute the project's net present value and accept the project if its NPV is greater than $0.

e. none of the above

14. Which of the following statements is most correct?

a. Sunk costs must be included in the project's cash flow.

b. R&D expenditures cannot be a part of the initial cost of a project.

c. Opportunity costs are sunk costs and therefore should not be included in the cost of the project.

d. Depreciation is not a cash expense.

e. All of the above statements are false.

15. Suppose the firm's cost of capital is stated in nominal terms, but the project's cash flows are expressed in real dollars. If a nominal rate is used to discount real cash flows and there is inflation (assume positive inflation), the calculated NPV would

a. be biased upward

b. be biased downward

c. be correct

d. be possibly biased; either upward or downward

e. none of the above

16. The correct method to handle overhead costs in capital budgeting is to:

a. allocate a portion to each project.

b. allocate them to projects with the highest NPVs.

c. ignore all except identifiable incremental amounts.

d. ignore them in all cases.

17. Which of the following statements is normally correct for a project with a positive NPV?

a. IRR exceeds the cost of capital.

b. Accepting the project has an indeterminate effect on shareholders.

c. The traditional payback period exceeds the life of the project.

d. The present value index equals one.

18. Capital budgeting proposals for investment projects should be evaluated as if the project were financed:

a. entirely by debt.

b. entirely by debt, adjusting for taxes.

c. half by debt and half by equity.

d. with the highest cost source of funds, to be safe.

e. the financing and investment decisions should be viewed separately.

19. When projects are mutually exclusive, can be undertaken only once, and capital is unconstrained, selection should be made according to the project with the:

a. longer life.

b. larger initial size.

c. highest IRR.

d. highest NPV.

e. highest PVI (present value index).

20. Which of the following can be deduced about a three-year investment project that has a two year traditional payback period?

a. The NPV is positive.

b. The IRR is greater than the cost of capital.

c. Both 'a' and 'b' can be deduced.

d. Neither 'a' nor 'b' can be deduced.

21. If a project has a cost of $50,000 and a present value index of 1.4, then:

a. its cash inflows are $70,000.

b. the present value of its cash inflows is $30,000.

c. its IRR is 20%.

d. its NPV is $20,000.

22. If two projects offer the same, positive NPV, then:

a. they also have the same IRR.

b. they have the same traditional payback period.

c. they are mutually exclusive projects.

d. they add the same amount to the value of the firm.

e. all the above

23. The likely effect of discounting nominal cash flows with real interest rates (assuming positive NPV) will be to:

a. make an investment's NPV appear more attractive.

b. make an investment's NPV appear less attractive.

c. correctly calculate an investment's NPV if inflation is expected.

d. correctly calculate an investment's NPV, regardless of expected inflation.

24. Which of the following is representative of how depreciation expense is handled in the face of inflation?

a. It increases annually with the rate of inflation.

b. It decreases annually in nominal terms.

c. The depreciable base is not altered by inflation.

d. The real value of the depreciation is fixed.

25. When analyzing a capital project, an increase in net working capital associated with the project:

a. is not a relevant cash flow.

b. is a relevant cash outflow.

c. is a relevant cash inflow.

d. is a relevant cash outflow that must be adjusted for taxes.

e. is a relevant cash inflow that must be adjusted for taxes.

26. What is Plato’s Inc.’s weighted average cost of capital (WACC) given the following information? Dollar amounts are in millions. There are two debt components and YTM (yield to maturity) for these two components are: 4% for notes due in May 2015, and 6% for notes due in January 2020. The risk-free rate is 3%, and market risk premium is 8%. The company has a beta of 1.5. The firm’s tax rate is 35%. (7 points)

27. Calculate the traditional payback period, IRR, NPV, and PVI (present value index) for the project with the following cash flows. The opportunity cost of capital for the project is 14%. (8 points)

28. Calculate the relevant cash flows (for each year) for the following capital budgeting proposal. Enter the total net cash flows for each year in the answer sheet. (10 points)

• $90,000 initial cost for machinery;

• depreciated straight-line over 4 years to a book value of $10,000;

• 35% marginal tax rate;

• $55,000 additional annual revenues;

• $25,000 additional annual cash expense;

• annual expense for debt financing is $7,500.

• $3,500 previously spent for engineering study;

• The project requires inventory increase by $32,000 and accounts payable increase by $14,000 at the beginning of the project;

• The investment in working capital occurs one time at the beginning of the project and it requires working capital return to the original level when the project ends in 4 years;

• 11% cost of capital;

• life of the project is 4 years; and

• The new equipment will be sold at the end of 4 years; expected market value of the new equipment at the end of 4 years is $15,000;

29. You are analyzing a capital budgeting project and, as shown by ???, some numbers are unreadable. You can read the following information:

Cash Flows at the end of:

Year 0 = -$25,000

Year 1 = +$8,000

Year 2 = +$ 6,000

Year 3 = +$ 2,600

Year 4 = $ ???

Year 5 = +$ 9,500

The Cost of Capital is 13%, the NPV = -$5,650.01 and the IRR = ???%. Your superior, ignoring the important fact that we should reject the project, is demanding to know the Cash Flow in Year 4.

Calculate the cash flow in Year 4. (5 points)

30. We can continue to use an existing machine at a cost of $22,500 annually (after-tax cash basis, including depreciation tax benefits) for the next 4 years. Alternatively, we can purchase a new machine that has an expected life of 7 years for $45,000. The new machine is expected to cost $11,000 each year to operate (after-tax cash basis, including depreciation tax benefits). The new machine will reduce inventory needs by $5,000 starting immediately. This is a one-time reduction in inventory that will last for the entirety of the new machine’s life. This reduction in inventory will be reversed at the end of 7 years. The cost of capital is 14%. The existing machine has no salvage value and we estimate that the new machine’s salvage value will be 0 in 7 years. Should we purchase the new machine? In the exam answer sheet, indicate your decision to replace or not replace, and provide support for your answer (i.e., indicate the criteria used to make the decision and the values for that criteria). (10 points)

Additional facts for question 31:

• The existing machine has been fully depreciated.

• As stated, the $22,500 and $11,000 are annual after-tax cash operating costs (i.e., after-tax cash operating costs = net income + depreciation), thus no further adjustments need to be made to them for depreciation.

31. For the following project, calculate the NPV break-even level of annual revenue, assuming that the operating cash flows will be stable for an 8 year horizon and that the discount rate is 12%. (10 points)

• The project requires an initial investment of $600,000.

• Expected annual sales are $770,000.

• Annual fixed costs (excluding depreciation and any other non cash expenses) will be $100,000.

• Straight-line depreciation of the initial investment over 8 years to a book value of 0.

• Variable costs (all of which are cash expenses) of 65% of revenues.

• Working capital will not be affected.

• Market values for salvage purposes in 8 years are estimated to be $40,000.

• 35% tax rate.

You'll get a 32.1KB .ZIP file.