Exam 3 Solutions - Summer 2002 Final Exam 1. Which of the...

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Summer 2002 Final Exam 1. Which of the statements below is incorrect (least correct)? A. One of the problems with using the profitability index for mutually exclusive projects is that the relative superiority of one project over another can be influenced by the scale of the projects. * B. Net present value (NPV) analysis assumes that cash flows from a project can be reinvested at the current risk-free rate. C. Net present value (NPV) profiles can be influenced by the timing of a project’s cash flow. Projects with a “later” cash flow will be more sensitive to changes in the cost of capital and will have a steeper NPV profile. D. Using payback may lead to incorrect investment decisions, since it ignores all cash flows that occur after the payback period and, unless cash flows are discounted, it ignores the time value of money. E. For a single project with a normal cash flow stream (a single cash outflow at the beginning of the project), both NPV and IRR will lead to the same accept/reject decision. 2. Which of the following statements is most correct? A. For most projects, the modified internal rate of return (MIRR) will be superior to the internal rate of return (IRR), since MIRR assumes that cash flows can be reinvested at the project’s IRR, while IRR assumes that cash flows can be reinvested at the project’s cost of capital (WACC). B. If a project has net cash outflows during the life of the project (say reclamation expense at the end of the project’s life), and these cash outflows are riskier than the net cash inflows for the project, it would be most correct to discount these cash outflows at a higher cost of capital to adjust for this risk. C. Since a firm’s investment in net working capital for a specific project will be recaptured at the end of the project’s life, the net effect is zero and we can therefore ignore net working capital when performing a capital budgeting analysis for the project. * D. Inflation should always be considered when performing a capital budgeting analysis. Because of non-neutral inflation, there may be a difference in terms of net present value (NPV) when discounting real cash flows at real rates versus discounting nominal cash flows at nominal rates. E. If a project has multiple internal rates of return (IRR), the correct IRR to use for decision analysis is the lowest value. The lowest value is the best indicator of the true return on the project and will lead to correct accept/reject decisions when it is compared to the project’s cost of capital. 3. Assume that the equity beta for an all equity (unlevered) firm is 1.0. Assume now that the firm changes its capital structure to 50% debt and 50% equity, using 8% debt FIN 3403 - 2002 Summer Term – Final Exam Page 1 of 14
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financing, and a tax rate of 40%. You may also assume that the beta for debt is zero. Given these conditions, which of the following statements is most correct?
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This note was uploaded on 02/10/2011 for the course FIN 3403 taught by Professor Tapley during the Summer '06 term at University of Florida.

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Exam 3 Solutions - Summer 2002 Final Exam 1. Which of the...

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