Ch11 Test Questions & Answers How To Ensure That Projects

Principles of Corporate Finance, 13e (Brealey)

Chapter 11 How to Ensure that Projects Truly Have Positive NPVs

1) The best way to uncover forecasting errors contained within NPV estimates is by looking at

I) book values;

II) historical values;

III) market values

A) I only

B) II only

C) III only

D) I and II only

2) A new grocery store requires $50 million in initial investment. You estimate that the store will generate $5 million of after-tax cash flow each year for five years. At the end of five years, it can be sold for $60 million (ignore taxes). What is the NPV of the project at a discount rate of 10 percent?

A) $2.42 million

B) $10.82 million

C) $6.21 million

D) $2.82 million

3) A new grocery store requires $50 million in initial investment. You estimate that the store will generate $5 million of after-tax cash flow each year for five years. At the end of five years, it can be sold for $55 million (ignore taxes). What is the NPV of the project at a discount rate of 10 percent?

A) $2.4 million

B) $5.0 million

C) $3.1 million

D) $0.0 million

4) A rental property is providing an acceptable market rate of return of 13 percent. You expect next year's rent to be $1 million and that rent is expected to grow at 3 percent per year forever. What is the current value of the property?

A) $7.7 million

B) $10.0 million

C) $33.3 million

D) $50.0 million

5) A building is appraised at $1 million. This estimate is based on forecasted net rent of $100,000 per year discounted at a 10 percent cost of capital [PV = 100,000/ 0.1 = 1,000,000]. The rent is the net of repair and maintenance costs and taxes. Suppose the building is currently uninhabitable. It will take one year and $250,000 of work (spent at the end of the year) to bring it into rentable condition. How much would you be willing to pay for the building today?

A) $1,000,000

B) $681,818

C) $750,000

D) $909,090

6) USGOLD Company has an opportunity to invest in a gold mine. The initial investment is $250 million. Analysts estimate that the mine will produce 100,000 ounces of gold per year for the next 10 years. The extraction cost of gold is $150 per ounce and is expected to remain at that level. The current price of gold is $600 per ounce and is expected to increase 4 percent per year for the next 10 years. What is the NPV of the project at a discount rate of 10 percent? (Ignore taxes.)

A) −$3.8 million

B) $240.8 million

C) $257.8 million

D) $84.9 million

7) Suppose the current price of gold is $600 per ounce. The price of gold is expected to grow 4 percent per year for the foreseeable future. If the appropriate discount rate is 10 percent, then the current value of gold per ounce is

A) less than $600 per ounce.

B) $600 per ounce.

C) greater than $600 per ounce.

D) Not enough information is provided.

8) Suppose the current price of gold is $650 per ounce. The price of gold is expected to grow at 5 percent per year for the foreseeable future. If the appropriate discount rate is 8 percent, the present value of gold is

A) less than $650 per ounce.

B) greater than $650 per ounce.

C) $650 per ounce.

D) Not enough information is provided.

9) Suppose the current price of gold is $600 per ounce and the price of gold is expected to increase at a rate of 5 percent per year for the foreseeable future. What is the current value of 0.2 million ounces of gold to be produced each year for the next five years (the discount rate is 8 percent per year)?

A) $600.00 million

B) $521.64 million

C) $690.86 million

D) $3,000.00 million

10) Goldsmith Labs recovers gold from printed circuit boards. It has developed new equipment for this purpose. You have the following data.

(1) The equipment costs $250,000.

(2) It costs $200,000 per year to operate.

(3) It has an economic life of five years and is depreciated using the straight-line method.

(4) It will recover 300 ounces of gold per year.

(5) The current price of gold is $900 per ounce.

(6) The tax rate is 30 percent.

(7) The cost of capital is 8 percent.

What is the NPV of installing this equipment?

A) $430,400

B) $520,510

C) $470,400

D) $195,911

11) The formula P0 = Pt/((1 + r)t) applies to assets that

I) pay no dividends;

II) are traded in a competitive market;

III) cost nothing to hold

A) I only

B) I and II only

C) I, II, and III

D) II, and III only

12) Investing in gold is like investing in

I) a stock that pays quarterly dividends;

II) a stock that pays annual dividends;

III) Treasury bonds;

IV) a stock that pays no dividends

A) I only

B) II only

C) I, II, and III only

D) IV only

13) If you use futures prices to estimate the cash flows of a project, which discount rate should you use?

I) the cost of capital for the firm;

II) the cost of capital for the project;

III) the risk-free rate

A) I only

B) I and II only

C) III only

D) II only

14) If you use futures prices to estimate the cash flows from commodity production, the estimates are

I) present values of future cash flows

II) certainty equivalents;

III) same as the estimates using spot prices

A) I only

B) II only

C) III only

D) I and III only

15) One can determine the present value of risky cash flows by estimating

I) the expected cash flows and then discount these at a rate that is consistent with the risk of the cash flows;

II) the certainty-equivalent cash flows and then discount these at the risk-free rate;

III) the expected cash flows and then discount these at the risk-free rate

A) I only

B) II only

C) I and II only

D) III only

16) The use of certainty-equivalent cash flows can help in the following ways:

I) there is no need to estimate future prices;

II) there is no need to estimate the discount rate;

III) there is no need to estimate the quantity of commodity produced

A) I only

B) II only

C) I and II only

D) I, II, and III

17) Economic rents are returns that

A) exceed the opportunity cost of capital.

B) equal the opportunity cost of the capital.

C) are less than the opportunity cost of capital.

D) are not related to the opportunity cost of capital.

18) Long-lasting competitive advantages include

I) patents;

II) brand names;

III) economies of scale

A) I only

B) II only

C) I and II only

D) I, II, and III

19) Long-lasting competitive advantages include

I) proprietary technology;

II) protected markets with high barriers to entry for other firms;

III) strategic assets that competitors cannot easily duplicate

A) I only

B) II only

C) I and II only

D) I, II, and III

20) Which of the following is an example of a strategic asset?

A) Trucks

B) Diesel engines

C) Railroad containers

D) Railroad lines

21) Which of the following is not one of Michael Porter's five forces?

A) Average years of experience of CEO

B) Threat of substitutes

C) Rivalry among existing competitors

D) Bargaining power of both suppliers and customers

22) According to Warren Buffett, which of the following is the most important lesson on growth and profitability?

A) Investors should have invested in the car industry in the early twentieth century.

B) Investors should have invested in the aircraft manufacturing industry in the early twentieth century.

C) One should look to invest in economically important sectors of the economy that have room for many firms.

D) Understanding a firm's competitive advantage is more important than understanding the firm's growth rate or impact on society.

23) You are a manager considering a positive-NPV project. Which of the following announcements indicate that you may have underestimated its NPV?

A) Two critical industry suppliers announce that they will merge their firms.

B) A key competitor releases earnings results, and its stock price drops by 25 percent in response.

C) You just found out that the project's chief engineer has recently received multiple job offers from competing firms.

D) Your marketing staff alerts you that the new project may "cannibalize" sales (i.e., reduce sales) of existing product to a greater extent.

24) The NPV of a project can be thought of as the present value of its

A) economic rents.

B) profits.

C) revenues.

D) salvage value.

25) A positive NPV forecast for a new project is reliable only if it is based on

A) forecasts of cash flows.

B) Michael Porter's theories.

C) identifiable sources of economic rents.

D) results from Monte Carlo analysis.

26) You inherited a run-down house in Chicago. There is an active market in properties of this type, and similar properties currently sell for $100,000. If rented, the property can deliver cash returns of $12,000 per year forever. If the appropriate discount rate is 15 percent, how much is the house worth?

A) $80,000

B) $100,000

C) $150,000

D) $180,000

27) You inherited 100 acres of Iowa farmland. There is an active market in this type of land, and similar properties currently sell for $10,000 per acre. If the land is planted with corn, you expect that the land will deliver net cash flows of $800 per acre forever. If the discount rate is 10 percent, how much is the land worth per acre?

A) $10,000

B) $8,000

C) $18,000

D) $12,000

28) When markets become competitive, economic rents

A) increase.

B) decrease.

C) remain the same.

D) approach zero.

29) To best understand a proposed positive net present value project, managers should

A) recheck all calculations.

B) assume there are no forecast errors.

C) identify sources of economic rent.

D) evaluate other similar projects the company has undertaken in the past.

30) The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000-gallon capacity plant costs $500,000 to build and has an indefinite life, with no salvage value. The cost of capital is 20 percent (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.50. Assuming that the competition will never catch up and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

A) zero

B) +$500,000

C) +$250,000

D) +$50,000

31) The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000-gallon capacity plant costs $500,000 to build and has an indefinite life, with no salvage value. The cost of capital is 20 percent (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in three years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

A) +$500,000

B) +$210,648

C) +$250,000

D) −$150,000

32) The manufacture of herbal health tonic is a competitive industry. The manufacturing facilities have an annual output of 100,000 gallons. Operating costs are $2 per gallon. A 100,000-gallon capacity plant costs $500,000 to build and has an indefinite life, with no salvage value. The cost of capital is 20 percent (assume no taxes). Your company has discovered a new process that lowers the operating cost per gallon to $1.00. Assuming that the competition will catch up in five years and the market demand is sufficiently high, what is the net present value of building a new plant with new technology?

A) +$500,000

B) +$210,648

C) +$299,061

D) −$220,000

33) The annual demand (in millions) for baseballs is given by the equation: Demand = 10 × (4 − price). If the price of baseballs is $1.50, what is the annual demand for baseballs?

A) 10 million

B) 15 million

C) 20 million

D) 25 million

34) The annual demand (in millions) for golf balls is given by the equation: Demand = 6 × (5 − price). If the price of a golf ball is $3, what is the annual demand for golf balls?

A) 8 million

B) 12 million

C) 15 million

D) 18 million

35) Allen Technology Company is currently valued at $400 million. It is proposing a new plant with a net present value of $200 million. However, the new plant will reduce the value of one of its existing plants by $50 million. What is the value of the company if it invests in the new plant?

A) $600 million

B) $200 million

C) $550 million

D) $650 million

36) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$43,300; and year 3: +$58,300. (Assume no taxes.) If the discount rate is 20 percent, what is the value of the plant at the end of year 1?

A) +$76,569

B) -$23,400

C) $48,600

D) None of the options are correct.

37) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$43,300; and year 3: +$58,300. (Assume no taxes.) If the salvage value of the plant at the end of year 1 is $80,000, should you scrap the plant at the end of year 1?

A) Yes

B) No

C) More information is needed.

D) I don't know.

38) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$43,300; and year 3: +$58,300. (Assume there is no tax.) If the salvage value of the plant at the end of year is $66,700, would you scrap the plant at the end of year 1?

A) Yes

B) No

C) It depends on the net present value.

D) More information is needed.

39) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$$43,300; and year 3: +$58,300. (Assume no taxes.) If the discount rate is 20 percent, what is the value of the plant at the end of year 2? Round to the nearest $100.

A) $48,600

B) $38,520

C) -$51,600

D) Zero

40) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$43,300; and year 3: +$58,300. (Assume no taxes.) If the salvage value at the end of year 2 is $60,000, should you scrap the plant at the end of year 2?

A) Yes

B) No

C) I don't know.

D) More information is needed.

41) The manufacture of folic acid is a competitive business. A new plant costs $100,000 and lasts for three years. The cash flow from the plant is as follows: year 1: +$43,300; year 2: +$43,300; and year 3: +$58,300. (Assume no taxes.) If the salvage value at the end of year 2 is $40,000, would you scrap the plant at the end of year 2?

A) Yes

B) No

C) I don't know.

D) More information is needed.

42) A strategy of deliberately slowing down the rate of introduction of new products by well-established and technologically advanced firms is best described as

A) a good strategy that maximizes economic rents.

B) a dangerous strategy as it provides opportunities for other firms to introduce new products.

C) a good strategy because firms only have a limited number of good projects.

D) a zero-NPV strategy.

43) In a highly competitive market, how will a firm most likely produce positive economic rents?

A) Devising a new marketing plan that will gain market share from competitors

B) Renegotiating financing terms with the firm's funding sources

C) Introducing new technology that creates manufacturing efficiencies

D) Purchasing one of its competitor firms

44) What is the NPV of a project in a perfectly competitive environment?

A) Positive

B) Negative

C) Zero

D) The answer cannot be determined.

45) If an asset is worth more to others than it is to you, you should generally attempt to buy it from them.

46) Frequently, the financial manager can observe market values for real assets (e.g., real estate values, values of precious metals, etc.). However, they have no place in the capital budgeting analysis. For that purpose, discounted cash flow is the only proper tool.

47) Since gold is held as an investment but pays no cash dividends, today's price equals the present value of its forecasted future price.

48) The expected rise in the price of a mineral less extraction costs should equal the cost of capital.

49) For a stock that pays no dividends, today's price is the present value of next year's price.

50) The NPV of an investment is the discounted value of the economic rents that it is expected to produce.

51) In order to generate a positive NPV project, a firm must have an economic advantage over its competitors.

52) The cash forecasts for a positive NPV project is more reliable if the managers of the firm can identify the economic rents associated with the project.

53) According to Michael Porter, managers can secure a competitive advantage for their firms within their industry in three ways: They are by cost leadership, by product differentiation, and by focusing on a particular market niche.

54) While evaluating a project, an analyst should consider its effect upon the sales of the firm's existing products.

55) A firm that expects long-run economic rents from a particular project is likely ignoring the effects of competition.

56) Sometimes the gains from new technology are completely offset by the losses on existing plants.

57) The total NPV of a new plant is equal to the NPV of the new plant plus the change in the present value of existing plants due to the impact of the new plant.

58) In a competitive market, most firms can earn high economic rents.

59) Increasing market share is typically a successful strategy to create economic rents in a competitive market.

60) Price cutting in a competitive market will usually not lead to the creation of economic rents.

61) Briefly explain how investing in gold is like investing in a stock that pays no dividends.

62) Briefly explain the concept of economic rent.

63) Briefly explain the two general methods for forecasting the PVs of cash flows.

64) Why are economic rents important to a manager?

65) Briefly explain the main difference between the capital budgeting process and the strategic planning process.

66) Discuss how you would react if you were presented with a project that had a high positive NPV.

67) Briefly explain the effect of building new manufacturing plants on the firm's existing plants.

68) What is the total net present value (NPV) of an expansion plan?

69) Briefly explain the effect of competition on economic rents.

70) Briefly explain the advantage and the disadvantage of a high salvage value for a project.

71) Explain the economic concept that reduces firms' chances of earning economic rents.