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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.
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.

#### Solution Preview

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.

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

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.

\$2.19

## Finance Multiple Choice Questions: Capital Budgeting and Valuing

1 The capital budgeting director of Sparrow Corporation is evaluating a project which costs \$200,000, is expected to last for 10 years and produce net after-tax cash flows of \$44,503 per year. If the firm's cost of capital is 14 percent, what is the project's IRR? (Hint: Is the firm's cost of capital relevant to an IRR calculation? )
a. 8%
b. 14%
c. 18%
d. -5%
e. 12%

2) Which of the following financial assets would be most susceptible (vulnerable) to a decline in value if interest rates increased?
a. a short term fixed income financial asset (ex. short term bond)
b. a long term fixed income financial asset (ex. long term bond)
c. a long term variable interest rate income financial asset
d. they would all be approximately equally susceptible to a decline in value.
e. None of the above or insufficient information

3 Assume that you can buy a bond for \$555 today. The bond will pay you \$75 in annual coupon payments (i.e. interest payments) at the end of each of the next 12 years, plus repay the original \$1000 par value of the bond at the end of the 12th year. What annual rate of return would you expect to earn on the investment (i.e., what is the bond's YTM?)? (Hint: use your basic TVM keys)
a. 15.7 %
b. 16.1 %
c. 17.6 %
d. 16.5 %
e. None of the above or insufficient information

4 If a firm's current ratio is 4, the firm could liquidate its current assets at only ______ percent of their book value and just have enough (nothing extra from current assets) to still pay off the current liabilities in full.
a. insufficient information to answer; need the inventory amount
b. insufficient information to answer; need the dollar amounts of CA and CL
c. 40%
d. 25%
e. A current ratio has nothing to do with the question being asked

5) Which of the following would least likely be considered as signaling a potential problem regarding the "quality of earnings" for a firm?
a. the firm has experienced a significant increase in earnings relative to the industry overall
b. the firm's accounts receivable account is increasing at a rate faster than the firm's increase in sales.
c. the firm has announced a delay in their release of financial statements due to a change in auditors
d. the firm's accounts receivable account is increasing, but at a rate slower than the firm's increase in sales.
e. all of the above would be considered signals of potential problems regarding he firms' quality of earnings
6) Which of the following is most directly related to value creation?
a. sales
b. Cash inflow
c. Market share
d. Net income

7 Which of the following assets' book values would, in general, most accurately represent the assets' true market value?
A. Specialized inventory that can only be used for specific projects
b. Inventory that is widely used in many common manufacturing activities
c. real estate assets of the firm
d. equipment assets of the firm used in production activities.

8 The total economic (true, i.e. true financial value) value of the firm is (Please READ ALL alternatives before answering):
a. Found on the balance sheet
b. Equal to the total market value of the stockholders' equity
c. equal to the total market value of the all of the firm's assets
d. Equal to the total market value of the owners and creditors' claim on the firm, by the balance sheet equation( aka accounting equation)
e. both c and d are correct

9 Because of the limited diversification potential of human capital, managers have an incentive to seek:
a. Higher risk projects because they offer the potential for higher returns (payoffs) for the managers
b. higher return projects because they are less risky
c. lower risk projects, because these projects are in the best interest of all stakeholders
d. lower risk projects, because these projects are in the best interest of stockholders
e. lower risk projects, because these projects reduce the probability of the firm going bankrupt.

10 Managerial stock options are an incentive for managers to act in the best interest of:
a. stockholders
b. bondholders
c. employees