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Exam 11: Capital Budgeting Cash Flows and Risk Refinements

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Question 1

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In capital budgeting,one of the most common scenario approaches is to estimate the NPVs associated with pessimistic (worst),most likely (expected),and optimistic (best)estimates of cash inflow.

A) True
B) False

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Question 2

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If an asset is sold for book value,the gain on the sale is composed of two parts: a capital gain and accumulated depreciation.

A) True
B) False

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Question 3

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Table 11.9 Johnson Farm Implement is faced with two mutually exclusive projects,P and Q.The following are the data about the two projects. -Which project do you recommend? (See Table 11.9)

If an asset is sold for more than its initial purchase price,the gain on the sale is composed of two parts: a capital gain and recaptured depreciation.

In capital budgeting,risk refers to ________.

Suppose the tax law changes to allow firms to immediately and fully deduct the cost of investments they make rather than depreciating them under the MACRS system.If all else remains the same,this change would tend to increase the NPV of an investment project.

The book value of an asset is equal to the ________.

Table 11.7 A firm is considering investment in a capital project which is described below.The firm's cost of capital is 18 percent and the risk-free rate is 6 percent.The project has a risk index of 1.5.The firm uses the following equation to determine the risk adjusted discount rate,RADR,for each project: RADR = Rf + Risk Index (Cost of capital - Rf) -The net present value of the project when adjusting for risk is ________.(See Table 11.7)

The risk-adjusted discount rate (RADR)is the risk-adjustment factor that represents the percent of estimated cash inflows that investors would be satisfied to receive for certain rather than the cash inflows that are possible for each year.

The three major cash flow components include the initial investment,nonoperating cash flows,and terminal cash flow.

An opportunity cost is a cash flow that could be realized from the best alternative use of an owned asset.

________ reflects the return that must be earned on the given project to compensate the firm's owners adequately.

A firm with limited funds for investment in capital assets must ration those funds by allocating them to projects that will maximize share value.

When unequal-lived projects are independent,the impact of differing lives must be considered because the projects do not provide service over comparable time periods.

Breakeven cash inflow refers to ________.

The tax treatment regarding the sale of existing assets that are sold for more than the original purchase price results in ________.

A firm is evaluating two mutually exclusive projects that have unequal lives.The firm must evaluate the projects using the annualized net present value approach and recommend which project they should select.The firm's cost of capital has been determined to be 18 percent,and the projects have the following initial investments and cash flows:

A(n) ________ allows management to avoid or minimize losses on projects that turn bad.

A mixer was purchased two years ago for $120,000 and can be sold for $125,000 today.The mixer has been depreciated using the MACRS 5-year recovery period and the firm pays 40 percent taxes on both ordinary income and capital gain. (a)Compute recaptured depreciation and capital gain (loss),if any. (b)Find the firm's tax liability.

Even though a business firm can be viewed as a portfolio of assets,firms are not rewarded for selecting a diversified portfolio of assets because investors can more efficiently diversify the risk on their own.