1. Chapter 11: Homework
1. Which of the following statements is CORRECT?
a. An externality is a situation where a project would have an adverse effect on some other part
of 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 new
office causes deposits in the bank’s other offices to decline.
c. The NPV method automatically deals correctly with externalities, even if the externalities
are not specifically identified, but the IRR method does not. This is another reason to favor
the NPV.
d. Both the NPV and IRR methods deal correctly with externalities, even if the externalities are
not 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 and
the stock market, and it also conducted thorough scenario and simulation analyses. This research
produced the following data:
Correlation of the project cash flows with cash flows from currently existing projects. Cash
flows are not correlated with the cash flows from existing projects. Cash flows are highly
correlated 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 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.
2. c. It is unrealistic to believe that any increases in net working capital required at the start of an
expansion project can be recovered at the project’s completion. Working capital like inventory is
almost always used up in operations. Thus, cash flows associated with 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 working capital refer to changes in current assets and current liabilities, not to
changes in long-term assets and liabilities. Therefore, changes in net working capital should not
be 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 that
would 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. $15,740
b. $16,569
c. $17,441
d. $18,359
e. $19,325
Answer: E is correct.
5. Florida Car Wash is considering a new project whose data are shown below. The equipment to
be 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 be
required. Revenues and other operating costs will be constant over the project’s life, and this is
just one of the firm’s many projects, so any losses on it can be used to offset profits in other
units. If the number of cars washed declined by 40% from the expected level, by how much
would the project’s NPV decline? (Hint: Note that cash flows are constant at the Year 1 level,
whatever that level is.)
