A company plans to introduce a new product and are trying to decide what size of factory to build. If the product is successful, then they will want to build a big factory, but if the product is not a success, then they will wish they had built a smaller factory or none at all. There is a 50% chance of the product being a success. The cash flows associated with each outcome are given below. The WACC of a small factory is 7% and the WACC for a large factory is 8% due to the greater risk.

	Small Factory		Large Factory
	Not a success	Success Average	Not a success	Success Average
Today	-9000	-9000 -9000	-12000	-12000 -12000
Year 1	1600	2000 1800	1600	4000 2800
Year 2	1700	3000 2350	1800	5000 3400
Year 3	2000	4000 3000	2100	6500 4300
Year 4	2200	5000 3600	2300	9000 5150

1. What should the company do?

• Reject both Projects
• Build a small factory
• Build a large Factory

2. What is the expected NPV of building the small factory?

a. -115 b. -70 c. 84 d. 223

3. What kind of option does this project represent?

• Expansion
• Timing
• Flexibility
• Shutdown

4. Which of the following is an example of a flexibility option?

a. A company has the option to invest in a project today or to wait a year.

b. A company has the option to back out of a project that turns out to be unproductive.

c. A company pays a higher cost today in order to be able to reconfigure the projects inputs or outputs at a later date.

d. A company invests in a project today that may lead to enhanced technological improvements that allow it to expand into different markets at a later date.

5. Mulroney Corp. is considering two mutually exclusive projects. Both require an initial investment of $10,000 at t = 0. Project X has an expected life of 2 years with after-tax cash inflows of $6,000 and $8,000 at the end of Years 1 and 2, respectively. Project Y has an expected life of 4 years with after-tax cash inflows of $4,000 at the end of each of the next 4 years. Each project has a WACC of 8%. Use the replacement chain approach to determine the NPV of the most profitable project.

a. $3,248

b. $3,734

c. $4,484

d. $5,197

6. The firm has the following projects available to them:

Project IRR Cost

A 18% $5,000,000

B 16% $4,000,000

C 14% $3,000,000

D 12% $2,000,000

E 10% $1,000,000

It can raise the following amounts at different costs of capital.

WACC Amount Raised

9% $10,000,000

11% $12,000,000

13% $15,000,000

Which set of projects would maximize shareholder wealth?

a. A and B.

b. A, B, and C.

c. A, B, and D.

d. A, B, C, and D.

7. Kish Consolidated has two divisions of equal size: a computer division and a restaurant division. Its CFO believes that stand-alone restaurant companies typically have a WACC of 8%, while stand-alone computer companies typically have a 12% WACC. Consequently, Kish estimates that its average WACC is 10%. If Kish uses the 10% WACC for all projects in both divisions, then which of the following would occur?

a. Kish would accept too many projects in the computer division and not enough projects in its restaurant division resulting in lost value to shareholders.

b. Kish would accept too many projects in the restaurant division and not enough projects in its computer division resulting in lost value to shareholders.

c. Kish would be maximizing shareholder wealth by accepting only those projects which exceed their average WACC

d. None of the above

8. The relative risk of a proposed project is best accounted for by

a. Adjusting the discount rate upward if the project is judged to have above average risk.

b. Adjusting the discount rate downward if the project is judged to have above average risk.

c. Reducing the NPV by 10% for risky projects.

d. Picking a risk factor equal to the average discount rate.

9. Which of the following statements is CORRECT?

a. Using MACRS depreciation rather than straight line would normally have no effect on a projects total projected cash flows but would affect the timing of the cash flows and thus the NPV.

b. Under current laws and regulations, corporations must use straight line depreciation for all assets whose lives are 10 years or longer.

c. Corporations must use the same depreciation method (e.g., straight line or MACRS) for stockholder reporting and tax purposes.

d. Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.

10. Which of the following statements is CORRECT?

An externality is a situation where a project would have an adverse effect on some other part of the firms overall operations. If the project would have a favorable effect on other operations, then this is not an externality.

An example of an externality is a situation where a bank opens a new office, and that new office causes deposits of the banks other offices to decline.

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.

Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.

11. Merlin Labs has an overall (composite) WACC of 10%, which reflects the cost of capital for its average asset. Its assets vary widely in risk, and Merlin evaluates low-risk projects with a WACC of 8%, average projects at 10%, and high-risk projects at 12%. The company is considering the following projects:

Project Risk Expected Return

A High 15%

B Average 12

C High 11

D Low 9

E Low 6

Which set of projects would maximize shareholder wealth?

a. A and B.

b. A, B, and C.

c. A, C, and D.

d. A, B, and D.

12. Which of the following statements is CORRECT?

a. Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

b. One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.

c. Well-diversified stockholders do not need to consider market risk when determining required rates of return.

d. Simulation analysis is a computerized version of scenario analysis where input variables are selected based on their probability distributions.

13. Which of the following is NOT considered a relevant concern in determining incremental cash flows for a new product?

a. The use of high quality factory floor space that is currently unused but is available for production of other products.

b. Revenues from an existing product that would be lost as a result of customers switching to the new product.

c. Shipping and installation costs associated with preparing the machine to be used to produce the new product.

d. The cost of a marketing study completed last year related to the new product. This costs was expensed for tax purposes last year.

14. The firm has the following projects available to them, but they can only spend $10,000,000.

Project IRR Cost NPV at 9% WACC

A 18% $3,000,000 400,000

B 16% $6,000,000 600,000

C 14% $5,000,000 500,000

D 12% $1,000,000 100,000

E 10% $4,000,000 300,000

Which set of projects would maximize shareholder wealth?

a. A and B.

b. B, C, and D.

c. A, B, and D.

d. C, and E.