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Accounting Risk in Capital Budgeting

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1. Which of the following is NOT an acceptable method of accounting for risk in capital budgeting?
A) Certainty equivalent approach
B) Beta distribution analysis
C) Probability trees
D) Scenario analysis

2. Famous Danish Corp. is replacing an old cookie cutter with a new one. The cookie cutter is being sold for $25,000 and it has a net book value of $75,000. Assume that Famous Danish is in the 34% income tax bracket. How much will Famous Danish net from the sale?
A) $61,000 B) $55,000 C) $75,000 D) $42,000
3. When selecting the best project from a group of mutually exclusive projects, you should choose the project with the highest:
A) net present value.
B) internal rate of return.
C) accounting rate of return.
D) payback.

4. The financial manager selecting one of two projects of differing risk should select the project with the:
A) largest risk-adjusted net present value.
B) least relative risk.
C) greatest return even if that project has greater risk.
D) least risk even though that project has less return.

5. All of the following variables are used in the calculation of the certainty equivalent approach EXCEPT:
A) number of possible outcomes.
B) project's expected life.
C) risk-free interest rate.
D) initial cash outlay.

6. What method is used for calculation of the accounting beta?
A) Simulation
B) Regression analysis
C) Sensitivity analysis
D) Correlation trees

7. A firm purchases an asset with a five year life for $90,000, and it costs $10,000 for shipping and installation. According to the current tax laws the cost basis of the asset is:
A) $100,000. B) $95,000. C) $80,000. D) $70,000.
8. Which of the following is considered the major risk when analyzing projects in a multinational environment?
A) Inflation
B) Political risk
C) Currency fluctuation
D) Lack of available betas

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Solution Preview

1. Which of the following is NOT an acceptable method of accounting for risk in capital budgeting?
A) Certainty equivalent approach
B) Beta distribution analysis
C) Probability trees
D) Scenario analysis

B) Beta distribution analysis

2. Famous Danish Corp. is replacing an old cookie cutter with a new one. The cookie cutter is being sold for $25,000 and it has a net book value of $75,000. Assume that Famous Danish is in the 34% income tax bracket. How much will Famous Danish net from the sale?
A) $61,000 B) $55,000 C) $75,000 D) $42,000

Net from sale= Sales value+ Taxes saved ...

Solution Summary

Solution discusses Accounting Risk in Capital Budgeting

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Cash Flows vs. Accounting Profits for Capital-Budgeting Focus

Mini Case :

It's been 2 months since you took a position as an assistant financial analyst at Caledonia Products. Although your boss has been pleased with your work, he is still a bit hesitant about unleashing you without supervision. Your next assignment involves both the calculation of the cash flows associated with a new investment under consideration and the evaluation of several mutually exclusive projects. Given your lack of tenure at Caledonia, you have been asked not only to provide a recommendation but also to respond to a number of questions aimed at judging your understanding of the capital-budgeting process. The memorandum you received outlining your assignment follows:

To: The Assistant Financial Analyst
From: Mr. V. Morrison, CEO, Caledonia Products
Re: Cash Flow Analysis and Capital Rationing
We are considering the introduction of a new product. Currently we are in the 34 percent marginal tax bracket with a 15 percent required rate of return or cost of capital. This project is expected to last 5 years and then, because this is somewhat of a fad product, be terminated. The following information describes the new project:

Cost of new plant and equipment $7,900,000
Shipping and installation costs $ 100,000

Unit sales
YEAR UNITS SOLD
________________________________________
1 70,000
2 120,000
3 140,000
4 80,000
5 60,000

Sales price per unit $300/unit in years 1 through 4, $260/unit in year 5
Variable cost per unit $180/unit
Annual fixed costs $200,000

Working-capital requirements There will be an initial working-capital requirement of $100,000 just to get production started. For each year, the total investment in net working capital will be equal to 10 percent of the dollar value of sales for that year. Thus, the investment in working capital will increase during years 1 through 3, then decrease in year 4. Finally, all working capital is liquidated at the termination of the project at the end of year 5.

The depreciation method

- a. Should Caledonia focus on cash flows or accounting profits in making its capital-budgeting decisions? Should the company be interested in incremental cash flows, incremental profits, total free cash flows, or total profits?
- b. How does depreciation affect free cash flows?
- c. How do sunk costs affect the determination of cash flows?
- d. What is the project's initial outlay?
- e. What are the differential cash flows over the project's life?
- f. What is the terminal cash flow?
- g. Draw a cash flow diagram for this project.
- h. What is its net present value?
- i. What is its internal rate of return?
- j. Should the project be accepted? Why or why not?
- k. In capital budgeting, risk can be measured from three perspectives. What are those three measures of a project's risk?
- l. According to the CAPM, which measurement of a project's risk is relevant? What complications does reality introduce into the CAPM view of risk, and what does that mean for our view of the relevant measure of a project's risk?
- m. Explain how simulation works. What is the value in using a simulation approach?
- n. What is sensitivity analysis and what is its purpose?

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