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1. Which of the following
statements is CORRECT?
a. An externality is a situation
where a project would have an adverse effect on some other part of the firm’s
overall operations. If the project would have a favorable effect on other
operations, then this is not an externality.
b. An example of an externality
is a situation where a bank opens a new office, and that new office causes
deposits in the bank’s other offices to decline.
c. The NPV method automatically
deals correctly with externalities, even if the externalities are not
specifically identified, but the IRR method does not. This is another reason to
favor the NPV.
d. Both the NPV and IRR methods
deal correctly with externalities, even if the externalities are not
specifically identified. However, the payback method does not.
e. Identifying an externality can
never lead to an increase in the calculated NPV.
2. Taussig Technologies is
considering two potential projects, X and Y. In assessing the projects’ risks,
the company estimated the beta of each project versus both the company’s other
assets and the stock market, and it also conducted thorough scenario and
simulation analyses. This research produced the following data:
Project X Project Y
Expected NPV $350,000 $350,000
Standard deviation (σNPV) $100,000 $150,000
Project beta (vs. market) 1.4 0.8
Correlation of the project cash
flows with cash flows from currently existing projects. Cash flows are not
correlated with the cash flows from existing projects. Cash flows are highly
correlated with the cash flows from existing projects.
Which of the following statements
is CORRECT?
a. Project X has more stand-alone
risk than Project Y.
b. Project X has more corporate
(or within-firm) risk than Project Y.
c. Project X has more market risk
than Project Y.
d. Project X has the same level
of corporate risk as Project Y.
e. Project X has less market risk
than Project Y.
3. Which of the following
statements is CORRECT?
a. If an asset is sold for less
than its book value at the end of a project’s life, it will generate a loss for
the firm, hence its terminal cash flow will be negative.
b. Only incremental cash flows
are relevant in project analysis, the proper incremental cash flows are the
reported accounting profits, and thus reported accounting income should be used
as the basis for investor and managerial decisions.
c. It is unrealistic to believe
that any increases in net working capital required at the start of an expansion
project can be recovered at the project’s completion. Working capital like
inventory is almost always used up in operations. Thus, cash flows associated
with working capital should be included only at the start of a project’s life.
d. If equipment is expected to be
sold for more than its book value at the end of a project’s life, this will
result in a profit. In this case, despite taxes on the profit, the
end-of-project cash flow will be greater than if the asset had been sold at
book value, other things held constant.
e. Changes in net working capital
refer to changes in current assets and current liabilities, not to changes in
long-term assets and liabilities. Therefore, changes in net working capital
should not be considered in a capital budgeting analysis.
4. Temple Corp. is considering a
new project whose data are shown below. The equipment that would be used has a
3-year tax life, would be depreciated by the straight-line method over its
3-year life, and would have a zero salvage value. No new working capital would
be required. Revenues and other operating costs are expected to be constant
over the project’s 3-year life. What is the project’s NPV?
Risk-adjusted WACC 10.0%
Net investment cost (depreciable
basis) $65,000
Straight-line deprec. rate
33.3333%
Sales revenues, each year $65,500
Operating costs (excl. deprec.),
each year $25,000
Tax rate 35.0%
a. $15,740
b. $16,569
c. $17,441
d. $18,359
e. $19,325
5. Florida Car Wash is
considering a new project whose data are shown below. The equipment to be used
has a 3-year tax life, would be depreciated on a straight-line basis over the
project’s 3-year life, and would have a zero salvage value after Year 3. No new
working capital would be required. Revenues and other operating costs will be
constant over the project’s life, and this is just one of the firm’s many
projects, so any losses on it can be used to offset profits in other units. If
the number of cars washed declined by 40% from the expected level, by how much
would the project’s NPV decline? (Hint: Note that cash flows are constant at
the Year 1 level, whatever that level is.)
WACC 10.0%
Net investment cost (depreciable
basis) $60,000
Number of cars washed 2,800
Average price per car $25.00
Fixed op. cost (excl. deprec.)
$10,000
Variable op. cost/unit (i.e., VC
per car washed) $5.375
Annual depreciation $20,000
Tax rate 35.0%
a. $28,939
b. $30,462
c. $32,066
d. $33,753
e. $35,530
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