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Q1. Which of the following is most likely to cause a problem when evaluating a capital budgeting project?
A) Including overhead costs in the total cost of a capital project.
B) Taking on the pet projects of management without going through the complete capital budgeting process.
C) Avoiding the use of IRR when evaluating mutually exclusive projects.
Correct answer is B)
Pet projects that influential managers want the company to invest in will ideally receive the same scrutiny received by other investments. Another potential concern with management’s pet projects is that overly optimistic projections will make the project appear more profitable than it really is. Note that using IRR for mutually exclusive projects will tend to steer management toward smaller, short term projects with high IRRs and may not lead management to the same decision as the more appropriate NPV method. Overhead costs are often difficult to estimate, but should be included in the cost of a capital project.
Q2. Sharon Kelley and Joyce Wening are discussing potential capital projects for the Flagstaff Corporation. Kelley is concerned about making errors in the capital budgeting decision making process and wants to take necessary steps to avoid such errors. In response to Kelley’s concerns, Wening makes the following statements:
Statement 1: We should avoid including factors such as management time and information technology support since these are sunk costs that should not be attributed to the project.
Statement 2: Once we have determined a set of profitable project options, we should stop considering other alternatives in order to focus our resources on making sure that we are not omitting relevant cash flows or double counting cash flows for our existing set of projects.
A) Both are correct.
B) Only one is correct.
C) Both are incorrect.
Correct answer is C)
Wening’s first statement is incorrect. Overhead costs are difficult quantify, but project costs should include any overhead costs that are attributable to a project. Wening’s second statement is also incorrect. Failure to consider investment alternatives is a major capital budgeting pitfall. Generating good investment ideas is the most important step in the capital budgeting process. Managers need to make sure they are not avoiding the consideration of “better” projects simply because the existing project under consideration is “good.”
Q3. Which of the following is least likely to cause a problem when analyzing a capital budgeting project?
A) Using the firm’s weighted average cost of capital for the discount rate on all projects.
B) Incorporating actions taken by competitors in the capital budgeting analysis.
C) Basing investment decisions on the impact on earnings per share.
Correct answer is B)
One of the common pitfalls when analyzing capital projects is not incorporating economic responses from competitors. Economic responses to an investment often affect profitability.
Note that managers who make decisions based on short-term EPS considerations may fail to consider projects that do not boost accounting numbers in the short-run, but are in the best long term interests of the business. The discount rate for a project should be adjusted for the project’s risk.
Q4. Rachel Moore, an analyst with Dawson Corporation, is discussing a potential capital project with her colleague, Phillip Cora. The project involves producing a new product that will be sold in discount retail stores. If sales for the new product are favorable, ffice:smarttags" />Dawson has the ability to purchase new equipment for the existing production facility that will expand production to double its current rate. However, Moore is concerned that other companies may easily replicate the product and that low barriers to entry will reduce Dawson’s profitability. If sales for the new product are disappointing after the first two years, Dawson has a potential buyer that will pay $2 million for the production facility. Moore explains these facts to Cora and asks him for help in computing an accurate net present value (NPV) for the project. Cora replies with the following statements:
Statement 1: You cannot compute a dollar value for the project that includes both the expansion option and the abandonment option, since only one of them can actually be exercised.
Statement 2: Since you do not have any control over what is going on at other companies, you should not factor in the creation of competing products from other companies into your analysis, and focus totally on the incremental cash flows generated from our production of the product.
How should Moore respond to Cora’s statements?
A) Agree with one only.
B) Agree with both
C) Agree with neither.
Correct answer is C)
Moore should disagree with both of Cora’s statements. Even though both the option to double production and the option to sell the production facility cannot be exercised simultaneously, they both add value to the project and should be both be considered in any analysis. Even if it is difficult to compute an exact dollar value for each option’s contribution to the project, Moore can compute the value for the project without the options, and if the project does not already have a positive NPV, she can estimate whether the option values are enough to make the NPV positive. Cora’s second statement is also incorrect. The reaction from competitors has a definite impact on the potential profitability of the project and must be considered in the analysis.
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发表于 2009-3-4 10:03
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