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Capital Budgeting

1) Simpson corporation is considering a proposed expansion to its facilities. Which of the following statements is most correct?

a. In calculating the project's operating cash flows, the firm should not subtract out financing costs such as interest expense, since these costs are already included in the WACC, which is used to discount the project?s net cash flows.

b. Since depreciation is a non-cash expense, the firm does not need to know the depreciation rate when calculating the operating cash flows.

c. When estimating the project?s operating cash flows, it is important to include any opportunity costs and sunk costs, but the firm should ignore cash flows from externalities since they are accounted for elsewhere.

d. Statements a and c are correct.

e. None of the statements above is correct

2) Which of the following statements is correct?

a. Well-diversified stockholders do not consider corporate risk when determining required rates of return.

b. Undiversified stockholders, including the owners of small businesses, are more concerned about corporate risk than market risk.

c. Empirical studies of the determinants of required rates of return (k) have found that only market risk affects stock prices.

d. Market risk is important but does not have a direct effect on stock price because it only affects beta.

e. All of the statements above are correct.

3) Simpson corporation is considering the purchase of an asset whose risk is greater than the current risk of the firm, based on any method for assessing risk. In evaluating this asset, the decision maker should

a. Increase the IRR of the asset to reflect the greater risk.

b. Increase the NPV of the asset to reflect the greater risk.

c. Reject the asset, since its acceptance would increase the firm?s risk.

d. Ignore the risk differential, if the asset to be accepted would comprise only a small fraction of the firm?s total assets.

e. Increase the cost of capital used to evaluate the project to reflect the project?s higher risk.

Solution Preview

1. a is correct since financing costs as included in the discounting rate
b. is not correct since depreciation is needed for depreciation tax shield
c. is not correct as sunk costs should not be included
Answer is a.

2. a is not correct as ...

Solution Summary

The solution explains various multiple choice questions relating to capital budgeting