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Question :
[51].Which of the following statements CORRECT?
a.Sensitivity analysis a good way : 1416415

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^{[51]}.Which of the following statements is CORRECT?

a.Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

b.One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.

c.Well-diversified stockholders do not need to consider market risk when determining required rates of return.

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

e.Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.

^{[52]}.Which of the following statements is CORRECT?

a.Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

b.In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project’s NPV.

c.The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.

d.Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values.

e.As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

^{[53]}.Langston Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Langston evaluates low-risk projects with a WACC of 8%, average-risk projects at 10%, and high-risk projects at 12%. The company is considering the following projects:

__Project____Risk____Expected Return__

AHigh15%

BAverage12%

CHigh11%

DLow9%

ELow6%

Which set of projects would maximize shareholder wealth?

a.A and B.

b.A, B, and C.

c.A, B, and D.

d.A, B, C, and D.

e.A, B, C, D, and E.

^{[54]}.Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

a.The firm’s corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs. Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

b.Differential project risk cannot be accounted for by using “risk-adjusted discount rates” because it is highly subjective and difficult to justify. It is better to not risk adjust at all.

c.Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project’s NPV will be found using a __lower__ discount rate than would be appropriate if the project’s returns were negatively correlated.

d.Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV. Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables. This makes it easier to implement a simulation analysis than a scenario or sensitivity analysis, hence simulation is the most frequently used procedure.

e.DCF techniques were originally developed to value passive investments (stocks and bonds). However, capital budgeting projects are not passive investments--managers can often take positive actions after the investment has been made that alter the cash flow stream. Opportunities for such actions are called real options. Real options are valuable, but this value is not captured by conventional NPV analysis. Therefore, a project's real options must be considered separately.

^{[55]}.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 operating working capital required at the start of an expansion project can be recovered at the project’s completion. Operating working capital like inventory is almost always used up in operations. Thus, cash flows associated with operating 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 operating working capital refer to changes in __current__ assets and current liabilities, not to changes in __long-term__ assets and liabilities, hence they should not be considered in a capital budgeting analysis.

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**Multiple Choice: Problems**

*We designated many of these questions EASY or MEDIUM. This indicates that they are not conceptually hard. However, some of them require a good bit of arithmetic, which will lengthen the time it takes students to work them. We tried to use constant cash flows, straight-line depreciation (except where we wanted to illustrate accelerated depreciation), and short project lives, but completing the cash flow estimation process still requires a good bit of arithmetic. This should not be important for take-home tests, but it should be considered when making up timed tests.*

^{[56]}.As assistant to the CFO of Boulder Inc., you must estimate the Year 1 cash flow for a project with the following data. What is the Year 1 cash flow?

Sales revenues$13,000

Depreciation$4,000

Other operating costs$6,000

Tax rate35.0%

a.$5,950

b.$6,099

c.$6,251

d.$6,407

e.$6,568

^{[57]}.Your company, RMU Inc., is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues$22,250

Depreciation$8,000

Other operating costs$12,000

Tax rate35.0%

a.$ 8,903

b.$ 9,179

c.$ 9,463

d.$ 9,746

e.$10,039

^{[58]}.Clemson Software is considering a new project whose data are shown below. The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's Year 1 cash flow?

Equipment cost (depreciable basis)$65,000

Straight-line depreciation rate33.333%

Sales revenues, each year$60,000

Operating costs (excl. depreciation)$25,000

Tax rate35.0%

a.$28,115

b.$28,836

c.$29,575

d.$30,333

e.$31,092

^{[59]}.As a member of UA Corporation's financial staff, you must estimate the Year 1 cash flow for a proposed project with the following data. What is the Year 1 cash flow?

Sales revenues, each year$42,500

Depreciation$10,000

Other operating costs $17,000

Interest expense$4,000

Tax rate35.0%

a.$16,351

b.$17,212

c.$18,118

d.$19,071

e.$20,075

^{[60]}.You work for Whittenerg Inc., which is considering a new project whose data are shown below. What is the project's Year 1 cash flow?

Sales revenues, each year$62,500

Depreciation$8,000

Other operating costs $25,000

Interest expense$8,000

Tax rate35.0%

a.$25,816

b.$27,175

c.$28,534

d.$29,960

e.$31,458

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