1) A large conglomerate with operating divisions in many industries uses risk-adjusted discount
rates in evaluating capital investment decisions. Consider the following statements concerning
the use of risk-adjusted discount rates.
I. The conglomerate may accept some investments with internal rates of return less than
the conglomerate’s overall average cost of capital.
II. Discount rates vary depending on the type of investment.
III. The conglomerate may reject some investments with internal rates of return greater
than the cost of capital.
IV. Discount rates may vary depending on the division.
Which of the above statements are correct?
A. I and III only.
B. II and IV only.
C. II, III, and IV only.
D. I, II, III, and IV.
2) A widely used approach that is used to recognize uncertainty about individual economic
variables while obtaining an immediate financial estimate of the consequences of possible
prediction errors is
A. Expected value analysis.
B. Learning curve analysis.
C. Sensitivity analysis.
D. Regression analysis.
3) Sensitivity analysis, if used with capital projects,
A. Is used extensively when cash flows are known with certainty.
B. Measures the change in the discounted cash flows when using the discounted payback method rather than the
net present value method.
C. Is a “what-if” technique that asks how a given outcome will change if the original estimates of the capital
budgeting model are changed.
D. Is a technique used to rank capital expenditure requests.
4) A manager wants to know the effect of a possible change in cash flows on the net present
value of a project. The technique used for this purpose is
A. Sensitivity analysis.
B. Risk analysis.
C. Cost behavior analysis.
D. Return on investment analysis.
5) Sensitivity analysis is used in capital budgeting to
A. Estimate a project’s internal rate of return.
B. Determine the amount that a variable can change without generating unacceptable results.
C. Simulate probabilistic customer reactions to a new product.
D. Identify the required market share to make a new product viable and produce acceptable results.
6) When evaluating a capital budgeting project, a company’s treasurer wants to know how
changes in operating income and the number of years in the project’s useful life will affect its
breakeven internal rate of return. The treasurer is most likely to use
A. Scenario analysis.
B. Sensitivity analysis.
C. Monte Carlo simulation.
D. Learning curve analysis.
7) A company received a legal settlement of $1 million. The company could apply this $1 million
toward its mortgage on the building it owns and save 4% in interest. The CFO suggested that
based on historical analysis of the market over time, it was likely the company could earn
around 8% over the term of the mortgage if it invested the money, which was a better return
than the 4%. The business owners elected to apply the money to the mortgage rather than
invest the money. Based on the decision described in this scenario, a reasonable conclusion
would be that the company has a
A. High risk tolerance and the certainty equivalent is greater than expected value.
B. Low risk tolerance and the certainty equivalent is less than expected value.
C. Low risk tolerance and the certainty equivalent is greater than expected value.
D. High risk tolerance and the risk tolerance equivalent is less than expected value.
8) An analyst plans to use a Monte Carlo experiment to simulate daily demand. The probability
distribution for the daily demand for heaters is as follows.
Daily demand for heaters Probability Random number intervals
0 .10 00-09
1 .15 10-24
2 .20 25-44
3 .20 45-64
4 .25
5 .10
The analyst is trying to assign random number intervals for each of the demand levels. She
has done so for the first four levels. If a total of 100 two-digit numbers are used in a simulation,
what random number intervals should the analyst assign to the 4 and 5 heater demand levels,
respectively?
A. 65-69; 70-88.
B. 65-84; 85-99.
C. 65-90; 91-100.
D. 65-89; 90-99.
9) Which one of the following is the best example of using sensitivity analysis in valuation?
A. Dividing the average annual income by net initial investment.
B. Measuring the time to recoup the initial investment.
C. Using discount rates that are higher in the later years.
D. Varying inputs to the net present value calculation.
10) A company wants to use discounted cash flow techniques when analyzing its capital investment projects.
The company is aware of the uncertainty involved in estimating future cash flows. A simple method some
companies employ to adjust for the uncertainty inherent in their estimates is to
A. Prepare a direct analysis of the probability of outcomes.
B. Use accelerated depreciation.
C. Adjust the minimum desired rate of return.
D. Increase the estimates of the cash flows.
11) When the risks of the individual components of a project’s cash flows are different, an
acceptable procedure to evaluate these cash flows is to
A. Divide each cash flow by the payback period.
B. Compute the net present value of each cash flow using the firm’s cost of capital.
C. Compare the internal rate of return from each cash flow to its risk.
D. Discount each cash flow using a discount rate that reflects the degree of risk.
12) A builder of custom homes recently invested $360,000 of material, labor, and overhead in a
residence for a customer. The customer, unfortunately, has just declared bankruptcy and must
back out of their contract. The builder’s management has identified the following two courses of
action:
1. Sell the unfinished residence “as is.” The company’s sales manager has assigned the
following selling prices and probabilities to this alternative:
Selling Price Probabilities
$280,000 0.1
320,000 0.6
350,000 0.3
2. Make several design changes at a cost of $70,000, complete the project, and sell the
home to another customer for $410,000.
On the basis of this information, the builder should
A. Select the sell “as is” option because of the chance of a $350,000 selling price.
B. Consider the $360,000 investment as a key decision factor in selecting among alternatives.
C. Redesign the residence for the new customer because, in comparison with the sell “as is” option, the firm is
$20,000 better off.
D. Redesign the residence for the new customer because, in comparison with the sell “as is” option, the firm is
$15,000 better off.
13) In preparing a multi-year revenue forecast, a financial analyst uses a technique that generates
a distribution of possible results based on repeated sampling. The analyst is most likely using
which one of the following?
A. Sensitivity analysis.
B. Monte Carlo simulation.
C. Scenario analysis.
D. Activity analysis.
14) The management of a utility company is considering making a series of investments over the
next 5 years to construct a new energy plant. Rather than commit to the full 5-year investment
schedule on day one, management wants to retain the flexibility in the timing and amount of
each investment in order to take into consideration future business conditions at each stage of
construction. Based on this information, which one of the following real options is
the most appropriate for this situation?
A. Abandon.
B. Delay.
C. Expand.
D. Scale back.
