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Exam 13: Risk and Capital Budgeting

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Question 41

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A "what if" simulation using a computer helps to:

A) reduce the risk associated with a particular investment.
B) determine the effects of changes in certain variables.
C) increase the accuracy of the inputs.
D) more than one of the above are true

E) A) and B)
F) All of the above

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Question 42

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Red River Corporation is considering the purchase of new equipment costing $500,000. The expected life of the equipment is 10 years. It is expected that the new equipment can generate an increase in net income of $60,000 per year for the next 10 years. The probabilities for the increase in net income depend on the state of the economy. $\begin{array}{lrrr}\text { Aftertax}&\text { Aftertax Probabilities}&\text { Net Income }\\\text { Recession } & .5 & (\$ 20,000) \\\text { Normal } & .3 & 40,000 \\\text { Boom } & .2 & 60,000\end{array}$ The equipment can be amortized using straight-line amortization for tax purposes. Red River's cost of capital is 14%. What is the expected NPV? Should they purchase the new equipment? Would your decision change if the cost of capital was 9%? Why or why not?

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Net present value is negative...

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Question 43

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Generally, because of the unpredictability of earnings, cyclical stocks are given higher price-earnings multiples than growth stocks.

Choosing projects with returns equal to the company norm but having a higher level of risk will most likely lower the company's share price.

The portfolio effect in capital budgeting refers to

In determining the appropriate discount rate for an individual project, the financial manager will be most influenced by the

Risk may be integrated into capital budgeting decisions by

Projects that are negatively correlated

The coefficient of variation (V) can be defined as the

Using the risk-adjusted discount rate approach, the cost of capital is applied to projects with

Simulation models allow the planner to

Projects with high positive correlation are sometimes valuable because they allow us to smooth out the overall performance of the firm during a business cycle.

As the time horizon becomes shorter, more uncertainty enters the forecast.

A basic assumption in financial theory is that most investors and managers are risk seekers.

A project has the following projected outcomes in dollars: $250, $350, and $500. The probabilities of their outcomes are 25%, 50%, and 25% respectively. What is the standard deviation of these outcomes?

Using the risk-adjusted discount rate approach, projects with high coefficients of variation will have ______ net present values than projects with low coefficients of variation.

A coefficient correlation of _____ provides no risk reduction.

Firm X is considering a project and its analysts have projected the following outcomes and their probabilities. $\begin{array}{lcc}\text { OUTCOME }&\text { PROBABILITY OF OUTCOME, }&\text { ASSUMPTIONS }\\\$ 5,250 & 25 \% & \text { pessimistic } \\\$ 7,800 & 45 \% & \text { moderately successful } \\\$ 13,500 & 30 \% & \text { optimistic }\end{array}$ What is the expected value of the outcomes?

In order to reduce risk in a firm, the firm would seek to enter a business that

The capital budgeting decisions of a firm will have no effect on the share price of the common stock.