Question 1

Which of the following statements is CORRECT?

Accepted Answer

A)  An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase. 
B)  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. 
C)  Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not. 
D)  Identifying an externality can never lead to an increase in the calculated NPV. 
E)  An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality. 
A)  An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to increase. 
B)  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. 
C)  Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not. 
D)  Identifying an externality can never lead to an increase in the calculated NPV. 
E)  An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality.

Question 2

Accelerated depreciation has an advantage for profitable firms in that it moves some cash flows forward, thus increasing their present value.On the other hand, using accelerated depreciation generally lowers the reported current year's profits because of the higher depreciation expenses.However, the reported profits problem can be solved by using different depreciation methods for tax and stockholder reporting purposes.

Accepted Answer

A) True 
 B)False

Question 3

If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.

Accepted Answer

A) True 
 B)False

Question 4

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

Accepted Answer

A)  Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. 
B)  The company has spent and expensed $1 million on R&D associated with the new project. 
C)  The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. 
D)  The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. 
E)  The new project is expected to reduce sales of one of the company's existing products by 5%. 
A)  Since the firm's director of capital budgeting spent some of her time last year to evaluate the new project, a portion of her salary for that year should be charged to the project's initial cost. 
B)  The company has spent and expensed $1 million on R&D associated with the new project. 
C)  The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project. 
D)  The firm would borrow all the money used to finance the new project, and the interest on this debt would be $1.5 million per year. 
E)  The new project is expected to reduce sales of one of the company's existing products by 5%.

Question 5

Your new employer, Freeman Software, is considering a new project whose data are shown below.The equipment that would be used has a 3-year tax life, and the allowed depreciation rates for such property are 33.33%, 44.45%, 14.81%, and 7.41% for Years 1 through 4.Revenues and other operating costs are expected to be constant over the project's 10-year expected life.What is the Year 1 cash flow? $\begin{array}{lr}
\text { Equipment cost (depreciable basis) } & \$ 65,000 \
\text { Sales revenues, each year } & \$ 60,000 \
\text { Operating costs (excl. deprec) } & \$ 25,000 \
\text { Tax rate } & 25.0 \%
\end{array}$

Accepted Answer

A)  $31,666 
B)  $31,849 
C)  $33,442 
D)  $35,114 
E)  $36,869 
A)  $31,666 
B)  $31,849 
C)  $33,442 
D)  $35,114 
E)  $36,869

Question 6

Which of the following statements is CORRECT?

Accepted Answer

A)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. 
B)  The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. 
C)  If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. 
D)  If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. 
E)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV. 
A)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV. 
B)  The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality. 
C)  If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration. 
D)  If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored. 
E)  In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.

Question 7

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.

Accepted Answer

A) True 
 B)False

Question 8

Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process.Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows.

Accepted Answer

A) True 
 B)False

Question 9

A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk.In evaluating this project, it would be reasonable for management to do which of the following?

Accepted Answer

A)  Increase the estimated NPV of the project to reflect its greater risk. 
B)  Reject the project, since its acceptance would increase the firm's risk. 
C)  Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. 
D)  Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. 
E)  Increase the estimated IRR of the project to reflect its greater risk. 
A)  Increase the estimated NPV of the project to reflect its greater risk. 
B)  Reject the project, since its acceptance would increase the firm's risk. 
C)  Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets. 
D)  Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. 
E)  Increase the estimated IRR of the project to reflect its greater risk.

Question 10

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

Accepted Answer

A) True 
 B)False

Question 11

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.

Accepted Answer

A) True 
 B)False

Question 12

Collins Inc.is investigating whether to develop a new product.In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

Accepted Answer

A)  The project will utilize some equipment the company currently owns but is not now using.A used equipment dealer has offered to buy the equipment. 
B)  The company has spent and expensed for tax purposes $3 million on research related to the new detergent.These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. 
C)  The new product will cut into sales of some of the firm's other products. 
D)  If the project is accepted, the company must invest $2 million in working capital.However, all of these funds will be recovered at the end of the project's life. 
E)  The company will produce the new product in a vacant building that was used to produce another product until last year.The building could be sold, leased to another company, or used in the future to produce another of the firm's products. 
A)  The project will utilize some equipment the company currently owns but is not now using.A used equipment dealer has offered to buy the equipment. 
B)  The company has spent and expensed for tax purposes $3 million on research related to the new detergent.These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future. 
C)  The new product will cut into sales of some of the firm's other products. 
D)  If the project is accepted, the company must invest $2 million in working capital.However, all of these funds will be recovered at the end of the project's life. 
E)  The company will produce the new product in a vacant building that was used to produce another product until last year.The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

Question 13

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?

Accepted Answer

A)  Revenues from an existing product would be lost as a result of customers switching to the new product. 
B)  Shipping and installation costs associated with a machine that would be used to produce the new product. 
C)  The cost of a study relating to the market for the new product that was completed last year.The results of this research were positive, and they led to the tentative decision to go ahead with the new product.The cost of the research was incurred and expensed for tax purposes last year. 
D)  It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm. 
E)  Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product.This space could be used for other products if it is not used for the project under consideration. 
A)  Revenues from an existing product would be lost as a result of customers switching to the new product. 
B)  Shipping and installation costs associated with a machine that would be used to produce the new product. 
C)  The cost of a study relating to the market for the new product that was completed last year.The results of this research were positive, and they led to the tentative decision to go ahead with the new product.The cost of the research was incurred and expensed for tax purposes last year. 
D)  It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm. 
E)  Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product.This space could be used for other products if it is not used for the project under consideration.

Question 14

Fitzgerald Computers is considering a new project whose data are shown below.The required equipment has a 3-year tax life, after which it will be worthless, and it will be depreciated by the straight-line method over 3 years.Revenues and other operating costs are expected to be constant over the project's 3-year life.What is the project's Year 1 cash flow? $\begin{array}{lr}
\text { Equipment cost (depreciable basis) } & \$ 65,000 \
\text { Straight-line depreciation rate } & 33.333 \% \
\text { Sales revenues, each year } & \$ 60,000 \
\text { Operating costs (excl. deprec) } & \$ 25,000 \
\text { Tax rate } & 25.0 \%
\end{array}$

Accepted Answer

A)  $29,351 
B)  $30,103 
C)  $30,875 
D)  $31,667 
E)  $32,458 
A)  $29,351 
B)  $30,103 
C)  $30,875 
D)  $31,667 
E)  $32,458

Question 15

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

Accepted Answer

A)  Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify.It is better to not risk adjust at all. 
B)  Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. 
C)  Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV.Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables.This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure. 
D)  DCF techniques were originally developed to value passive investments (stocks and bonds).However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow stream.Opportunities for such actions are called real options.Real options are valuable, but this value is not captured by conventional NPV analysis.Therefore, a project's real options must be considered separately. 
E)  The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs.Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk. 
A)  Differential project risk cannot be accounted for by using "risk-adjusted discount rates" because it is highly subjective and difficult to justify.It is better to not risk adjust at all. 
B)  Other things held constant, if returns on a project are thought to be positively correlated with the returns on other firms in the economy, then the project's NPV will be found using a lower discount rate than would be appropriate if the project's returns were negatively correlated. 
C)  Monte Carlo simulation uses a computer to generate random sets of inputs, those inputs are then used to determine a trial NPV, and a number of trial NPVs are averaged to find the project's expected NPV.Sensitivity and scenario analyses, on the other hand, require much more information regarding the input variables, including probability distributions and correlations among those variables.This makes it easier to implement a simulation analysis than a scenario or a sensitivity analysis, hence simulation is the most frequently used procedure. 
D)  DCF techniques were originally developed to value passive investments (stocks and bonds).However, capital budgeting projects are not passive investments⎯managers can often take positive actions after the investment has been made that alter the cash flow stream.Opportunities for such actions are called real options.Real options are valuable, but this value is not captured by conventional NPV analysis.Therefore, a project's real options must be considered separately. 
E)  The firm's corporate, or overall, WACC is used to discount all project cash flows to find the projects' NPVs.Then, depending on how risky different projects are judged to be, the calculated NPVs are scaled up or down to adjust for differential risk.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

A)  In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV. 
B)  The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. 
C)  Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. 
D)  As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. 
E)  Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables. 
A)  In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV. 
B)  The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator. 
C)  Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values. 
D)  As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis. 
E)  Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

Question 17

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

Accepted Answer

A)  Shipping and installation costs. 
B)  Cannibalization effects. 
C)  Opportunity costs. 
D)  Sunk costs that have been expensed for tax purposes. 
E)  Changes in net working capital. 
A)  Shipping and installation costs. 
B)  Cannibalization effects. 
C)  Opportunity costs. 
D)  Sunk costs that have been expensed for tax purposes. 
E)  Changes in net working capital.

Question 18

Brandt Enterprises is considering a new project that has a cost of $1,000,000, and the CFO set up the following simple decision tree to show its three most likely scenarios.The firm could arrange with its work force and suppliers to cease operations at the end of Year 1 should it choose to do so, but to obtain this abandonment option, it would have to make a payment to those parties.How much is the option to abandon worth to the firm?

Accepted Answer

A)  $55.08 
B)  $57.98 
C)  $61.03 
D)  $64.08 
E)  $67.29 
A)  $55.08 
B)  $57.98 
C)  $61.03 
D)  $64.08 
E)  $67.29

Exam 11: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

If debt is to be used to finance a project, then when cash flows for a project are estimated, interest payments should be included in the analysis.

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?

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.

Estimating project cash flows is generally the most important, but also the most difficult, step in the capital budgeting process.Methodology, such as the use of NPV versus IRR, is important, but less so than obtaining a reasonably accurate estimate of projects' cash flows.

A firm is considering a new project whose risk is greater than the risk of the firm's average project, based on all methods for assessing risk.In evaluating this project, it would be reasonable for management to do which of the following?

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the total amount of depreciation that can be taken, assuming the asset is used for its full tax life, is greater.

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.

Collins Inc.is investigating whether to develop a new product.In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

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?

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

Which of the following statements is CORRECT?

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

An Overview of Financial Management and the Financial Environment

Financial Statements, Cash Flow, and Taxes

Analysis of Financial Statements

Time Value of Money

Bonds, Bond Valuation, and Interest Rates

Risk and Return

Corporate Valuation and Stock Valuation

Financial Options and Applications in Corporate Finance

The Cost of Capital

The Basics of Capital Budgeting: Evaluating Cash Flows

Corporate Valuation and Financial Planning

Corporate Governance

Distributions to Shareholders: Dividends and Repurchases

Capital Structure Decisions

Supply Chains and Working Capital Management

Multinational Financial Management

Public and Private Financing: Initial Offerings, Seasoned Offerings, and Investment Banks

Lease Financing

Hybrid Financing: Preferred Stock, Warrants, and Convertibles

Dynamic Capital Structures and Corporate Valuation

Mergers and Corporate Control

Enterprise Risk Management

Bankruptcy, Reorganization, and Liquidation

Portfolio Theory and Asset Pricing Models

Real Options

Providing and Obtaining Credit

Advanced Issues in Cash Management and Inventory Control

Pension Plan Management

Financial Management in Not-For-Profit Businesses

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