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Exam 10: Project Cash Flows and Risk

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Question 1

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When determining the marginal cash flows associated with an expansion capital budgeting project, which of the following would be included as an incremental operating cash flow?

A) depreciation
B) shipping and installation
C) increase in working capital
D) salvage value
E) decrease in sales

F) A) and D)
G) D) and E)

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Question 2

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The change in net working capital associated with a capital project may actually result in a decrease in the firm's current funding requirement, which frees up cash flows for investment.

A) True
B) False

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Question 3

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Dick Boe Enterprises, an all-equity firm, has a corporate beta coefficient of 1.5.The financial manager is evaluating a project with an IRR of 21 percent, before any risk adjustment.The risk-free rate is 10 percent, and the required rate of return on the market is 16 percent.The project being evaluated is riskier than Boe's average project, in terms of both beta risk and total risk.Which of the following statements is correct?

How do most firms deal with the risks of projects when making capital budgeting decisions?

Sun State Mining Inc., an all-equity firm, is considering the formation of a new division which will increase the assets of the firm by 50 percent.Sun State currently has a required rate of return of 18 percent, S.A.Treasury bonds yield 7 percent, and the market risk premium is 5 percent.If Sun State wants to reduce its required rate of return to 16 percent, what is the maximum beta coefficient the new division could have?

Expansion project analysis requires determining the amount of incremental cash as a result of the expansion relative to the cash flows if the expansion project was not accepted.The incremental cash flows will always be discounted at the same rate as the firm's original cash flows sine we are simply expanding the firm and not changing the risk of the firm.

Which of the following statements is most correct?

Which of the following rules are essential to successful cash flow estimates, and ultimately, to successful capital budgeting?

Risk in a revenue producing project can best be adjusted for by

Carolina Insurance Company, an all-equity life insurance firm, is considering the purchase of a fire insurance company.If the purchase is made, Carolina will be 50 percent larger than before.Currently, Carolina's share has a beta of 1.2 and the return required is 15.2 percent.The fire insurance company is expected to generate a return of 20 percent with a beta of 2.5.If the risk-free rate is 8 percent and the market risk premium is 6 percent, should Carolina make the investment?

If an asset being considered for acquisition has beta of zero, its purchase will have no effect on the firm's market risk.

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR is greater than the firm's average required rate of return.

The cost of capital may be different for a foreign project than for an equivalent domestic project because foreign projects may be more or less risky.

Your company is considering a machine that will cost R1,000 at Time 0 and which can be sold after 3 years for R100.To operate the machine, R200 must be invested at Time 0 in inventories; these funds will be recovered when the machine is retired at the end of Year 3.The machine will produce sales revenues of R900/year for 3 years; variable operating costs (excluding depreciation) will be 50 percent of sales.Operating cash inflows will begin 1 year from today (at Time 1) .The machine will have depreciation expenses of R500, R300, and R200 in Years 1, 2, and 3, respectively.The company has a 40 percent tax rate, enough taxable income from other assets to enable it to get a tax refund from this project if the project's income is negative, and a 10 percent required rate of return.Inflation is zero.What is the project's NPV?

Which of the following methods involves calculating an average beta for firms in a similar business and then applying that beta to determine the beta of its own project?

When calculating the cash flows for a project, you should include interest payments.

Suppose the firm's required rate of return is stated in nominal terms, but the project's expected cash flows are expressed in real rands.In this situation, other things held constant, the calculated NPV would

The cash flows relevant for the analysis of a foreign investment should, from the parent company's perspective, include the financial cash flows that the subsidiary can legally send back to the parent company and the cash flows which must remain in the foreign country.

Exhibit 10-1 You have been asked by the president of your company to evaluate the proposed acquisition of a new special-purpose truck.The truck's basic price is R50,000, and it will cost another R10,000 to modify it for special use by your firm.The truck falls into the MACRS three-year class, and it will be sold after three years for R20,000.Use of the truck will require an increase in net working capital (spare parts inventory) of R2,000.The truck will have no effect on revenues, but it is expected to save the firm R20,000 per year in before-tax operating costs, mainly labor.The firm's marginal tax rate is 40 percent. [MACRS table required] -Refer to Exhibit 10-1.The truck's required rate of return is 10 percent.What is its NPV?

Rucker Truck Line (RTL) is evaluating whether the fleet of trucks it owns should be replaced.If the trucks are replaced, current operating revenues and expenses will not change, except for depreciation expenses.Annual depreciation will increase from R150,000 to R175,000.Based on this information, how will the change in depreciation expense affect the incremental operating cash flows RTL examines when making its capital budgeting decision about replacing the trucks? RTL's marginal tax rate is 40 percent.