Exam 13: Capital Budgeting-Estimating Cash Flows and Analyzing Risk

Superior analytical techniques, such as NPV, used in combination with risk-adjusted cost of capital estimates, can overcome the problem of poor cash flow estimation and lead to generally correct accept/reject decisions.

Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.

Typically, a project will have a higher NPV if the firm uses accelerated rather than straight-line depreciation. This is because the total cash flows over the project's life will be higher if accelerated depreciation is used, other things held constant.

While developing a new product line, Cook Company spent $3 million two years ago to build a plant for a new product. It then decided not to go forward with the project, so the building is available for sale or for a new product. Cook owns the building free and clearσthere is no mortgage on it. Which of the following statements is CORRECT?

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.

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

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.

Sheridan Films is considering some new equipment whose data are shown below. The equipment has a 3-year tax life and would be fully depreciated by the straight-line method over 3 years, but it would have a positive pre-tax salvage value at the end of Year 3, when the project would be closed down. Also, some new working capital would be required, but it would be recovered at the end of the project's life. Revenues and other operating costs are expected to be constant over the project's 3-year life. What is the project's NPV? Project cost of capital ( r ) 10.0\% Net investment in fixed assets (depreciable basis) \ 70,000 Required new working capital \ 10,000 Straight-line deprec. rate 33.333\% Sales revenues, each year \ 75,000 Operating costs (excl. deprec.), each year \ 30,000 Expected pretax salvage value \ 5,000 Tax rate 350\%

Any cash flows that can be classified as incremental to a particular project-i.e., results directly from the decision to undertake the projectσshould be reflected in the capital budgeting analysis.

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.

The primary advantage to using accelerated rather than straight-line depreciation is that with accelerated depreciation the present value of the tax savings provided by depreciation will be higher, other things held constant.

Which of the following statements is CORRECT?

Spot-Free Car Wash is considering a new project whose data are shown below. The equipment to be used has a 3-year tax life, would be depreciated on a straight-line basis over the project's 3-year life, and would have a zero salvage value after Year 3. No new working capital would be required. Revenues and other operating costs will be constant over the project's life, and this is just one of the firm's many projects, so any losses on it can be used to offset profits in other units. If the number of cars washed declined by 40% from the expected level, by how much would the project's NPV decline? (Hint: Note that cash flows are constant at the Year 1 level, whatever that level is.) Project cost of capital (r) 10.0\% Net investment cost (depreciable basis) \ 60,000 Number of cars washed 2,800 Average price per car \ 25.00 Fixed op. cost (excl. deprec.) \ 10,000 Variable op. cost/unit (i.e., VC per car washed) \ 5.375 Annual depreciation \ 20,000 Tax rate 35.0\%

Tallant Technologies is considering two potential projects, X and Y. In assessing the projects' risks, the company estimated the beta of each project versus both the company's other assets and the stock market, and it also conducted thorough scenario and simulation analyses. This research produced the following data: Project X Project Y Expected NPV \ 500,000 \ 500,000 Standard deviation (oNPV) \ 200,000 \ 250,000 Project beta (vs. market) 1.4 0.8 Correlation of the project cash flows with cash flows from currently existing projects. Cash flows are not correlated with the cash flows from existing projects. Cash flows are highly correlated with the cash flows from existing projects.σσWhich of the following statements is CORRECT?

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

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.

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.

Which of the following factors should be included in the cash flows used to estimate a project's NPV?