Exam 11: Cash flow estimation and risk analysis

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.)

Which of the following statements is CORRECT?

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?

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.

McPherson Company must purchase a new milling machine.The purchase price is $50, 000, including installation.The machine has a tax life of 5 years, and it can be depreciated according to the following rates.The firm expects to operate the machine for 4 years and then to sell it for $12, 500.If the marginal tax rate is 40%, what will the after-tax salvage value be when the machine is sold at the end of Year 4?

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.

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.

Garden-Grow Products is considering a new investment whose data are shown below.The equipment would be depreciated on a straight-line basis over the project's 3-year life, would have a zero salvage value, and would require some additional working capital that 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 life.What is the project's NPV? (Hint: Cash flows are constant in Years 1 to 3.)

VR Corporation has the opportunity to invest in a new project, the details of which are shown below.What is the Year 1 cash flow for the project?

Which of the following statements is CORRECT?

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.

Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision¾estimates of its effect would really just be guesses.In this case, the externality should be ignored¾i.e., not considered at all¾because if it were considered it would make the analysis appear more precise than it really is.

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?

Erickson Inc.is considering a capital budgeting project that has an expected return of 25% and a standard deviation of 30%.What is the project's coefficient of variation?

The two cardinal rules that financial analysts should follow to avoid capital budgeting errors are: (1)in the NPV equation, the numerator should use income calculated in accordance with generally accepted accounting principles, and (2)all incremental cash flows should be considered when making accept/reject decisions.

If a firm's projects differ in risk, then one way of handling this problem is to evaluate each project with the appropriate risk-adjusted discount rate.

Which of the following statements is CORRECT?

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.

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.