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# Multiple Choice Questions on Capital Budgeting - Finance

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Question 1
1. A project has an initial investment of 100. You have come up with the following estimates of the project's cash flows: Suppose the cash flows are perpetuities and the cost of capital is 10%. What does a sensitivity analysis of NPV (no taxes) show? (Answers appear in order: [Pessimistic, Most Likely, Optimistic].)
-50, 20, +100.
-100, -50, +80.
-50, +50, +70.
+5, +11, +18.
0.6757 points
Question 2
1. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3 = 100,000. If the discount rate changes from 12% to 15%, what is the CHANGE in the NPV of the project (approximately)?
12,750 increase
12,750 decrease
14,240 increase
14,240 decrease
0.6757 points
Question 3
1. A project requires an initial investment in equipment of \$90,000 and then requires an initial investment in working capital of \$10,000 (at t = 0). You expect the project to produce sales revenue of \$120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e.,t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for \$10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project are:
CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600.
CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 49,600.
0.6757 points
Question 4
1. A project requires an initial investment in equipment of \$90,000 and then requires an initial investment in working capital of \$10,000 (at t = 0). You expect the project to produce sales revenue of \$120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for \$10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. Calculate the NPV of the project:
\$3,840.
\$8,443.
\$-2,735.
\$7,342.
0.6757 points
Question 5
1. A project requires an initial investment in equipment of \$90,000 and then requires an initial investment in working capital of \$10,000 (at t = 0). You expect the project to produce sales revenue of \$120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e., t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for \$10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. What is the NPV of the project if the revenues were higher by 10% and the costs were 65% of the revenues?
\$8,443
\$964
\$5,566
\$4,840
0.6757 points
Question 6
1. Companies with high ratios of fixed costs to project values tend to have high betas.
True
False
0.6757 points
Question 7
1. Company A's historical returns for the past three years are: 6%, 15%, and 15%. Similarly, the market portfolio's returns were: 10%, 10%, and 16%. Calculate the beta for Stock A.
1.75
1.0
0.57
0.75
0.6757 points
Question 8
1. Company A's historical returns for the past three years are: 6.0%, 15%, and 15%. Similarly, the market portfolio's returns were: 10%, 10%, and 16%. Suppose the risk-free rate of return is 4%. What is the cost of equity capital (required rate of return of company A's common stock), computed with the CAPM?
18%
14%
12%
10%
0.6757 points
Question 9
1. Company A's historical returns for the past three years were: 6%, 15%, and 15%. Similarly, the market portfolio's returns were: 10%, 10%, and 16%. According to the security market line (SML), Stock A was:
overpriced.
underpriced.
correctly priced.
need more information.
0.6757 points
Question 10
1. Cyclical firms tend to have high betas.
True
False
0.6757 points
Question 11
1. Firms with high operating leverage tend to have higher asset betas.
True
False
0.6757 points
Question 12
1. If a firm uses a project-specific cost of capital for evaluating all projects, which situation(s) will likely occur?I) The firm will accept poor low-risk projects.II) The firm will reject good high-risk projects.III) The firm will correctly accept projects with average risk.
I only
II only
III only
I, II, and III
0.6757 points
Question 13
1. If a firm uses the same company cost of capital for evaluating all projects, which situation(s) will likely occur?I) The firm will reject good low-risk projects;II) The firm will accept poor high-risk projects;III) The firm will correctly accept projects with average risk
I only
I and II only
I, II, and III
II only.

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#### Solution Preview

Please see the attached file:
Question 1
1. A project has an initial investment of 100. You have come up with the following estimates of the project's cash flows: Suppose the cash flows are perpetuities and the cost of capital is 10%. What does a sensitivity analysis of NPV (no taxes) show? (Answers appear in order: [Pessimistic, Most Likely, Optimistic].)

-50, 20, +100.
-100, -50, +80.
-50, +50, +70.
+5, +11, +18.

Answer: -50, 20, +100.

Discount rate= 10%
PV of perpetuity = cash flow/ discount rate

Revenue Cost Net Cash Flow PV of perpetuity Initial investment NPV
Pessimistic 15 10 5 50 =5/0.1 100 -50
Most Likely 20 8 12 120 =12/0.1 100 20
Optimistic 25 5 20 200 =20/0.1 100 100

Question 2
1. A project has the following cash flows: C0 = -100,000; C1 = 50,000; C2 = 150,000; C3 = 100,000. If the discount rate changes from 12% to 15%, what is the CHANGE in the NPV of the project (approximately)?
12,750 increase
12,750 decrease
14,240 increase
14,240 decrease

Answer: 12,750 decrease

Year Cash flow Discount rate @ Discount rate @ PV @ PV @
12% 15% 12% 15%
0 -100,000 1.0000 1.0000 -100,000 -100,000
1 50,000 0.8929 0.8696 44,645 43,480
2 150,000 0.7972 0.7561 119,580 113,415
3 100,000 0.7118 0.6575 71,180 65,750
NPV= Total= 135,405 122,645

Difference= -12,760 =122,645 - 135,405
Question 3
1. A project requires an initial investment in equipment of \$90,000 and then requires an initial investment in working capital of \$10,000 (at t = 0). You expect the project to produce sales revenue of \$120,000 per year for three years. You estimate manufacturing costs at 60% of revenues. (Assume all revenues and costs occur at year-end, i.e.,t = 1, t = 2, and t = 3.) The equipment depreciates using straight-line depreciation over three years. At the end of the project, the firm can sell the equipment for \$10,000 and also recover the investment in net working capital. The corporate tax rate is 30% and the cost of capital is 15%. Cash flows from the project are:

CF0: -90,000; CF1: 12,600; CF2: 12,600; CF3: 29,600.

CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600.

CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 42,600.

CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 49,600.

Answer: CF0: -100,000; CF1: 42,600; CF2: 42,600; CF3: 59,600
Time 0 1 2 3
Revenue 120,000 120,000 120,000
Manufacturing cost @ 60% 72,000 72,000 72,000 ...

#### Solution Summary

13 multiple choice questions on capital budgeting, beta, CAPM, SML etc. are solved with step-by-step answers.

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