Question 1

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.

Accepted Answer

A) True 
 B)False

Question 2

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.

Accepted Answer

A) True 
 B)False

Question 3

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.

Accepted Answer

A) True 
 B)False

Question 4

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?

Accepted Answer

A)  if the building could be sold, then the after-tax proceeds that would be generated by any such sale should be charged as a cost to any new project that would use it. 
B)  this is an example of an externality, because the very existence of the building affects the cash flows for any new project that rowell might consider. 
C)  since the building was built in the past, its cost is a sunk cost and thus need not be considered when new projects are being evaluated, even if it would be used by those new projects. 
D)  if there is a mortgage loan on the building, then the interest on that loan would have to be charged to any new project that used the building. 
E)  since the building has been paid for, it can be used by another project with no additional cost. therefore, it should not be reflected in the cash flows for any new project.

Question 5

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 6

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 investmentsσmanagers 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 7

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 8

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?
 $\begin{array}{lr}
\text { Project cost of capital ( } r \text { ) } & 10.0 \% \
\text { Net investment in fixed assets (depreciable basis) } & \$ 70,000 \
\text { Required new working capital } & \$ 10,000 \
\text { Straight-line deprec. rate } & 33.333 \% \
\text { Sales revenues, each year } & \$ 75,000 \
\text { Operating costs (excl. deprec.), each year } & \$ 30,000 \
\text { Expected pretax salvage value } & \$ 5,000 \
\text { Tax rate } & 350 \%
\end{array}$

Accepted Answer

A)  $20,762 
B)  $21,854 
C)  $23,005 
D)  $24,155 
E)  $25,363

Question 9

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.

Accepted Answer

A) True 
 B)False

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

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.

Accepted Answer

A) True 
 B)False

Question 12

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 decline. 
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 13

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.) 
$\begin{array}{lr}
\text { Project cost of capital (r) } & 10.0 \% \
\text { Net investment cost (depreciable basis) } & \$ 60,000 \
\text { Number of cars washed } & 2,800 \
\text { Average price per car } & \$ 25.00 \
\text { Fixed op. cost (excl. deprec.) } & \$ 10,000 \
\text { Variable op. cost/unit (i.e., VC per car washed) } & \$ 5.375 \
\text { Annual depreciation } & \$ 20,000 \
\text { Tax rate } & 35.0 \%
\end{array}$

Accepted Answer

A)  $28,939 
B)  $30,462 
C)  $32,066 
D)  $33,753 
E)  $35,530

Question 14

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: $\begin{array}{lrr}
& \text { Project X }& \text { Project Y } \
\text { Expected NPV } & \$ 500,000 & \$ 500,000 \
\text { Standard deviation (oNPV) }  & \$ 200,000 & \$ 250,000 \
\text { Project beta (vs. market) }& 1.4 & 0.8
\end{array}$
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?

Accepted Answer

A)  project x has more corporate (or within-firm) risk than project y. 
B)  project x has more market risk than project y. 
C)  project x has the same level of corporate risk as project y. 
D)  project x has less market risk than project y. 
E)  project x has more stand-alone risk than project y.

Question 15

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%.

Question 16

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 17

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.

Accepted Answer

A) True 
 B)False

Question 18

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

Accepted Answer

A)  interest on funds borrowed to help finance the project. 
B)  the end-of-project recovery of any working capital required to operate the project. 
C)  cannibalization effects, but only if those effects increase the project's projected cash flows. 
D)  expenditures to date on research and development related to the project, provided those costs have already been expensed for tax purposes. 
E)  all costs associated with the project that have been incurred prior to the time the analysis is being conducted.

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.

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.

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?

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

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