Exam 12: Cash Flow and Risk

Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.

We can identify the cash costs and cash inflows to a company that will result from a project. These could be called "direct inflows and outflows," and the net difference is the direct net cash flow. If there are other costs and benefits that do not flow from or to the firm, but to other parties, these are called externalities, and they need not be considered as a part of the capital budgeting analysis.

In cash flow estimation, the existence of externalities should be taken into account if those externalities have any effects on the firm's long-run cash flows.

Which of the following is NOT a relevant cash flow and thus should NOT be reflected in the analysis of a capital budgeting project?

Wilson Co. 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 $8,500 at the end of Years 1 and 2, respectively. In addition, Project X can be repeated at the end of Year 2 with no changes in its cash flows. Project Y has an expected life of 4 years with after-tax cash inflows of $4,600 at the end of each of the next 4 years. Each project has a WACC of 11%. What is the equivalent annual annuity of the most profitable project?

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the equivalent annual annuity (EAA) approach.

Which of the following statements is CORRECT?

It is extremely difficult to estimate the revenues and costs associated with large, complex projects that take several years to develop. This is why subjective judgment is often used for such projects along with discounted cash flow analysis.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

A company is considering a new project. The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flows), then discounting those cash flows at the company's overall WACC. Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?

Which of the following statements is CORRECT?

Although it is extremely difficult to make accurate forecasts of the revenues that a project will generate, projects' initial outlays and subsequent costs can be forecasted with great accuracy. This is especially true for large product development projects.

Changes in net operating working capital should not be reflected in a capital budgeting cash flow analysis because capital budgeting relates to fixed assets, not working capital.

Since the focus of capital budgeting is on cash flows rather than on net income, changes in noncash balance sheet accounts such as inventory are not included in a capital budgeting analysis.

Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated beyond their initial lives.

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during every year of a project's life, other things held constant.

Which of the following statements is CORRECT?

A firm that bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses accelerated depreciation than if it uses straight-line depreciation, other things being equal.

Which one of the following would NOT result in incremental cash flows and thus should NOT be included in the capital budgeting analysis for a new product?