Which of the following options provides the most information about a projects riskiness?

Chapter 14:   Risk and Managerial Options in Capital Budgeting

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All of the above

Which of the following are steps in a capital investment financial analysis?

Estimate the project's cash flows

Assess the project's riskiness

Estimate the project cost of capital (discount rate)

Measure the financial impact

All of the above

TRUE

True or False: For investor-owned businesses, a capital investment financial analysis identifies those projects that are expected to contribute to owner (shareholder) wealth.

The discount rate decreases.

You have estimated the value of a planned project by finding the present value (PV) of all the cash inflows from that project. Which of the following would cause the project to look more appealing (have a greater NPV)?

The discount rate decreases.

The cash flows are extended over a longer period of time, but the total dollar amount of the cash flows remains the same.

The discount rate increases.

Answers a. and b. are both correct.

Answers b. and c. are both correct.

The project is financially acceptable because its NPV is positive.

Assume that your organization's CFO has just completed a presentation to the board of trustees concerning the analysis of a proposed ambulatory surgery center costing $2 million. During the presentation, the CFO indicated that the project had an NPV of $786,339 and an IRR of 17.3 percent. Based on its risk, the project was judged to have a cost of capital of 13 percent. Which of the following statements is most correct?

The project is financially acceptable because its NPV is positive.

The project is financially acceptable because its IRR is greater than zero.

The project is financially unacceptable because its NPV is less than the project's initial investment cost.

The project is financially unacceptable because its IRR is greater than its cost of capital.

The project is financially unacceptable, but it may have sufficient social value to make it worthwhile.

Must exceed the project cost of capital to make the investment financially acceptable.

The internal rate of return (IRR) of a capital investment:

Changes when the cost of capital changes.

Must exceed the project cost of capital to make the investment financially acceptable.

Measures the dollar profitability of a project.

Must be less than the project cost of capital to make the investment financially acceptable.

Measures the length of time that it takes a business to recover its initial investment in the project.

The calculation of IRR requires the project cost of capital (discount rate).

Return on investment (ROI) can be measured in either dollar or rate of return terms. Which of the following statements about ROI is false?

Net present value (NPV) is a dollar return measure.

IRR is a rate of return (percentage) measure.

ROI measures use time value of money concepts.

The calculation of IRR requires the project cost of capital (discount rate).

The calculation of NPV requires the project cost of capital (discount rate).

Payback measures the length of time it takes to recover the initial investment in the project.

Which of the following statements about capital investment analysis is most correct?

Although a useful accounting concept, breakeven analysis has no role in capital investment analysis.

Net present value (NPV) measures a project's rate of return while internal rate of return (IRR) measures a project's dollar return.

An NPV of zero indicates that the project is expected to return the amount of the initial investment, but it will not provide a return on that investment.

On most projects, the NPV and IRR measures will give conflicting results, so managers must use judgment as to which measure to use.

Payback measures the length of time it takes to recover the initial investment in the project.

Project scoring is a ranking technique that includes both financial and nonfinancial factors.

Which of the following statements about capital investment project scoring is most correct?

Project scoring combines the payback, NPV, and IRR values to create a single measure of financial attractiveness.

Project scoring is a technique that quantifies the social value of a project.

Project scoring is a ranking technique that includes both financial and nonfinancial factors.

Project scoring assigns values to various diseases and then ranks projects according to their effectiveness in treating patients with those diseases.

Project scoring examines the facilities of an organization to determine whether or not the organization can support the project.

The cost of a consultant's report concerning the feasibility of the project that was completed (and paid for) in the previous year

Which of the following is not considered a relevant cash flow when determining incremental cash flows for a new project?

The use of floor space that is currently unused but available for any new project

Revenues from an existing service that would be lost if the new project were initiated

Shipping and installation costs associated with the new project

The cost of a consultant's report concerning the feasibility of the project that was completed (and paid for) in the previous year

An increase in current assets, say, inventories, that would result if the project were undertaken

Sunk costs should be included.

Which of the following statements about project cash flow estimation is false?

Inflation effects should be considered.

The effects on a business's other projects should be included.

Opportunity costs should be considered.

Sunk costs should be included.

Strategic value should be considered.

12.5 percent

Suppose a project having a cost of capital of 10 percent has an internal rate of return (IRR) of 15 percent. What is the project's modified IRR (MIRR)?

5.0 percent

7.5 percent

10.0 percent

12.5 percent

15.0 percent

$194,741

Chronic Pain Clinic has estimated the following cash flows associated with a new project. The project cost of capital (discount rate) is 10 percent.
Year Expected Net Cash Flow
0 ($800,000)
1 400,000
2 400,000
3 400,000

What it the project's NPV?

$126,897

$194,741

$207,223

$224,538

$246,992

23.4 percent

hronic Pain Clinic has estimated the following cash flows associated with a new project. The project cost of capital (discount rate) is 10 percent.
Year Expected Net Cash Flow
0 ($800,000)
1 400,000
2 400,000
3 400,000

What is the project's IRR?

18.5 percent

19.9 percent

20.4 percent

21.8 percent

23.4 percent

Statements c. and d. are both correct.

Which of the following statements about capital budgeting cash flow estimation is most correct?

Interest expense on any loans used to acquire the equipment must be included in the project's cash flows.

Money spent last year on a consulting report must be included in the project's cash flows.

Opportunity costs associated with land usage must be included in the project's cash flows.

Any impact on the cash flows of existing (current) projects must be included in the project's cash flows.

Statements c. and d. are both correct.

2.75 years

Assume a project has the following expected cash flows:
Year Expected Net Cash Flow
0 ($400,000)
1 100,000
2 150,000
3 200,000
4 250,000

What is the project's payback (payback period)?

2.00 years

2.25 years

2.50 years

2.75 years

3.15 years

$650,000

Mercy Hospital is considering a project that is expected to reduce the hospital's annual operating costs by $250,000 per year beginning in Year 1. In addition, the project is expected to generate $400,000 in revenue per year beginning in Year 1. All else held constant, what is the project's expected net cash flow in Year 1?

$150,000

$250,000

$400,000

$650,000

-$250,000

The risk-adjusted opportunity cost of capital is 10 percent.

Concord Clinic is considering an investment project with an estimated internal rate of return equal to 12 percent. Under what conditions should Concord accept the project? Choose the best answer.

The risk-adjusted opportunity cost of capital is 15 percent.

The project's payback period is greater than the required payback period.

The net present value of the project is zero.

The risk-adjusted opportunity cost of capital is 10 percent.

The internal rate of return is positive.

-$100,000

A skilled nursing facility chain is considering building a new facility on a piece of property that it currently owns. The property was purchased five years ago for $250,000 and could be sold now at a current market value of $100,000. When estimating the cash flows for the new facility, what amount should be included to recognize the opportunity cost of using the land for the proposed project?

$0 (the land is a sunk cost)

-$150,000

$250,000

$100,000

-$100,000

$72,000

Chronic Pain Clinic is considering a capital investment project that is expected to generate $150,000 per year in cash revenues and $78,000 per year in cash operating costs. Additionally, $10,000 of existing overhead costs will be allocated to the project each year. What is the project's expected net cash flow in Year 1?

$72,000

$62,000

$150,000

-$78,000

-$88,000

The project's IRR is greater than 15 percent

A project is estimated to have an NPV equal to $85,000. The risk-adjusted opportunity cost of capital is 15 percent. Which of the following statements is most correct?

The project's IRR is less than 15 percent.

The project's IRR is zero.

The project's IRR is greater than 15 percent.

The project's IRR is equal to 15 percent.

The project should be rejected because its IRR cannot be calculated.

TRUE

True or False: Sensitivity analysis measures how much a project's NPV is affected by changes in input variables such as volume and labor costs. Other things held constant, the steeper the plotted sensitivity line, the more sensitive the project's profitability is to the changes in the input variable.

Increase the cost of capital applied to the project to make it greater than the business's corporate cost of capital.

A medical group practice is considering offering a new service with risk that is greater than the current risk of the business. In evaluating this investment, the decision maker should:

Increase the IRR of the project to reflect the greater risk.

Increase the NPV of the project to reflect the greater risk.

Reject the project, because its acceptance would increase the risk of the business.

Ignore the risk differential if the project represents only a small fraction of the total assets of the firm.

Increase the cost of capital applied to the project to make it greater than the business's corporate cost of capital.

Scenario analysis considers the joint (combined) impact of changes in uncertain input variables on profitability.

Which of the following statements about project risk analysis techniques is most correct?

Sensitivity analysis considers the joint (combined) impact of changes in uncertain input variables on profitability.

Scenario analysis considers the joint (combined) impact of changes in uncertain input variables on profitability.

Scenario analysis, as it is done in practice, usually involves four scenarios.

When standard deviation of NPV is used to measure risk, the smaller the value, the greater the risk.

In a sensitivity analysis graph, the steeper the plot lines, the lower the risk

13%

WeCare HMO is evaluating a new project. It has a coefficient of variation (CV) of 5, while the HMO's average project has a CV of 2 to 3. The business's corporate cost of capital is 10 percent, and the typical adjustment for project risk is three percentage points. What is the appropriate project cost of capital?

7%

10%

13%

16%

19%

All of the above statements are correct.

Which of the following statements about the qualitative approach to project risk assessment is most correct?

Qualitative risk assessment involves assessing the validity of a series of statements.

Typically, each statement is assigned a score, such as 0, 1, or 2.

The higher the score, the greater the risk.

Typically, qualitative risk assessment is used in conjunction with a quantitative risk assessment (as opposed to in place of a quantitative risk assessment).

All of the above statements are correct.

TRUE

True or False: Large businesses with multiple divisions typically estimate divisional costs of capital along with the corporate cost of capital.

Capital rationing occurs when a business does not have the capital necessary to fund all acceptable projects.

Which of the following statements about capital rationing is most correct?

Capital rationing occurs when a business does not have the capital necessary to fund all acceptable projects.

Capital rationing occurs when a business has more capital available than needed to fund all acceptable projects.

Under capital rationing, the typical approach is to accept all projects with negative NPVs.

Statements a. and b. are both correct.

Statements a., b., and c. are all correct.

FALSE

True or False: In a thorough capital budgeting analysis, once a project cost of capital has been assigned that incorporates any differential project risk, the analyst should rerun the risk analysis to ensure that the new (adjusted) discount rate does not change the results.

Scenario analysis usually is based on two scenarios.

Which of the following statements about capital budgeting risk analysis techniques is false?

Payback period provides a rough measure of a project's liquidity.

Scenario analysis gives managers an idea of the worst possible outcome.

Scenario analysis usually is based on two scenarios.

Scenario analysis can provide a quantitative measure of a project's risk.

Payback period provides a rough measure of a project's risk.

The inputs required to perform a Monte Carlo simulation are as easy to develop as in a traditional scenario analysis.

Which of the following statements concerning Monte Carlo simulation is false?

Monte Carlo simulation can be performed on personal computers.

Monte Carlo simulation uses continuous distributions to proxy input variable uncertainty.

Monte Carlo simulation can produce a very large number (tens of thousands or more) of project scenarios.

The inputs required to perform a Monte Carlo simulation are as easy to develop as in a traditional scenario analysis.

The output of a Monte Carlo simulation contains several useful measures such as expected NPV, probability of a positive NPV, and maximum and minimum NPVs.

The rate of return available on alternative investment opportunities of similar risk to the project being considered

Assume a healthcare organization is analyzing a capital investment project with greater risk than that of the organization's average project. Which of the following cost of capital alternatives would be most appropriate for analyzing the project's net present value?

The rate of return available on a standard savings account, because it is known with certainty

The corporate cost of capital

The rate of return available on a money market fund where the firm invests its short-term cash reserves

The rate of return available on alternative investment opportunities of similar risk to the project being considered

The expected rate of inflation

FALSE

True or False: The ultimate goal in project risk analysis is to ensure that the cost of capital used as the discount rate in a project's ROI analysis is as high as possible.

Market-risk

The type of risk most relevant for projects being evaluated by investor-owned businesses is:

Stand-alone risk

Corporate risk

Market risk

Answers a. and c. are both correct

Answers a., b., and c. are all correct

FALSE

True or False: When a project's returns are expected to be negatively correlated with market returns, stand-alone risk is a good proxy for market risk.

Stand-alone risk

The nature of a project's component cash flow distributions and their correlation with one another determine a project's:

Stand-alone risk

Corporate risk

Market risk

Answers a., b., and c. are all correct

None of these answers is correct

Statements a. and b. are both correct.

Strengths of scenario analysis as compared to sensitivity analysis include which of the following?

Scenario analysis considers the sensitivity of NPV to changes in key variables, the likely range of variable values, and the interactions among variables.

Scenario analysis allows for the calculation of a project's coefficient of variation so that the riskiness of projects can be compared to the firm's average project.

Scenario analysis provides all necessary information about both a project's risk and profitability in a single step.

Statements a. and b. are both correct.

Statements a., b., and c. are all correct.

The certainty equivalent value of a net cash outflow will be higher (in absolute value) than the expected value if the cash outflow has greater-than-average risk.

Which of the following statements is most correct?

When calculating NPV for cash flows of higher-than-average risk, the discount rate should always be adjusted upward to reflect the corporate cost of capital plus a risk premium.

A weakness of the certainty equivalent method of adjusting project cash flows for risk is that it does not allow individual cash flows to be adjusted to reflect their own unique risk.

The risk-adjusted discount rate method of valuation assigns equal risk to all project cash flows since a constant discount rate is applied over the life of the project.

The certainty equivalent value of a net cash outflow will be higher (in absolute value) than the expected value if the cash outflow has greater-than-average risk.

None of these statements is correct.

FALSE

True or False: As long as a business is confident that risk has been adequately incorporated in the capital budgeting process, only positive NPV projects should be accepted.

TRUE

True or False: In a capital rationing situation, the profitability index may be used in place of NPV to choose among projects.

Monte Carlo simulation

Which of the following techniques provides the most information about a project's riskiness?

Sensitivity analysis

Scenario analysis

Monte Carlo simulation

Certainty equivalent method

Risk-adjusted discount rate method

Which of the following techniques provides the most information about a projects riskiness?

Which of the following statements about capital investment project scoring is most correct group of answer choices?

What is within firm risk?

Which of the following statements is true of the internal rate of return approach to assessing investments?