Chapter 11: Homework1. Which of the following statements is CORRECT?a. An externality is a situation where a project would have an adverse effect on some other partof the firm’s overall operations. If the project would have a favorable effect on other operations,then this is not an externality.b. An example of an externality is a situation where a bank opens a new office, and that newoffice causes deposits in the bank’s other offices to decline.c. The NPV method automatically deals correctly with externalities, even if the externalitiesare not specifically identified, but the IRR method does not. This is another reason to favorthe NPV.d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities arenot specifically identified. However, the payback method does not.e. Identifying an externality can never lead to an increase in the calculated NPV.Answer: C is correct.2. Taussig Technologies is considering two potential projects, X and Y. In assessing the projects’risks, the company estimated the beta of each project versus both the company’s other assets andthe stock market, and it also conducted thorough scenario and simulation analyses. This researchproduced the following data:Correlation of the project cash flows with cash flows from currently existing projects. Cashflows are not correlated with the cash flows from existing projects. Cash flows are highlycorrelated with the cash flows from existing projects.Which of the following statements is CORRECT?a. Project X has more stand-alone risk than Project Y.b. Project X has more corporate (or within-firm) risk than Project Y.c. Project X has more market risk than Project Y.d. Project X has the same level of corporate risk as Project Y.e. Project X has less market risk than Project Y.Answer: C is correct.3. 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 aloss 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 flowsare the reported accounting profits, and thus reported accounting income should be used as thebasis for investor and managerial decisions.
c. It is unrealistic to believe that any increases in net working capital required at the start of anexpansion project can be recovered at the project’s completion. Working capital like inventory isalmost always used up in operations. Thus, cash flows associated with working capital should beincluded 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’slife, this will result in a profit. In this case, despite taxes on the profit, the end-of-projectcash flow will be greater than if the asset had been sold at book value, other things heldconstant.e. Changes in net working capital refer to changes in current assets and current liabilities, not tochanges in long-term assets and liabilities. Therefore, changes in net working capital should notbe considered in a capital budgeting analysis.Answer: D is correct.4. Temple Corp. is considering a new project whose data are shown below. The equipment thatwould be used has a 3-year tax life, would be depreciated by the straight-line method over its 3-year life, and would have a zero salvage value. No new working capital would be required.Revenues and other operating costs are expected to be constant over the project’s 3-year life.What is the project’s NPV?a. $15,740b. $16,569c. $17,441d. $18,359e. $19,325Answer: E is correct.5. Florida Car Wash is considering a new project whose data are shown below. The equipment tobe used has a 3-year tax life, would be depreciated on a straight-line basis over the project’s 3-year life, and would have a zero salvage value after Year 3. No new working capital would berequired. Revenues and other operating costs will be constant over the project’s life, and this isjust one of the firm’s many projects, so any losses on it can be used to offset profits in otherunits. If the number of cars washed declined by 40% from the expected level, by how muchwould the project’s NPV decline? (Hint: Note that cash flows are constant at the Year 1 level,whatever that level is.)
a. $28,939b. $30,462c. $32,066d. $33,753e. $35,530Answer: E is correct.