Question 1

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.

Accepted Answer

The first rule is incorrect because in the NPV (Net Present Value) equation, the numerator should use cash flows, not income calculated in accordance with generally accepted accounting principles (GAAP). The second rule is correct, as all incremental cash flows should indeed be considered in making accept/reject decisions.

Question 2

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

Interest payments are not included in the cash flow analysis because cash flows are analyzed on a pre-financing basis. Financing effects are accounted for separately when calculating the net present value (NPV) or internal rate of return (IRR) by using the cost of capital, which reflects the cost of debt and equity.

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

False

Question 4

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

Accepted Answer

Even though the externality cannot be precisely quantified, it should not be completely ignored. Instead, the CFO should acknowledge its potential impact and consider it qualitatively in the analysis. Ignoring the externality could result in a flawed decision-making process.

Question 5

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

This is because accelerated depreciation results in higher tax savings in the earlier years of the project’s life, which increases the project’s NPV and IRR compared to the use of straight-line depreciation.

Question 6

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

The total amount of depreciation that can be taken over an asset's life is the same under both methods; the difference lies in the timing of the depreciation expense, with accelerated depreciation allowing for higher expenses in the earlier years.

Question 7

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

Accelerated depreciation allows for a larger portion of the asset's cost to be expensed in the earlier years, resulting in higher tax savings in those years. This higher tax savings results in a higher present value of those tax savings, providing an advantage over straight-line depreciation.

Question 8

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.

Accepted Answer

Externalities should be considered in the capital budgeting analysis because they can indirectly affect the project's cash flows and the overall value to the firm. For example, a project might have positive externalities that benefit other projects or the firm's reputation, leading to increased future cash flows.

Question 9

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

Accepted Answer

Changes in net working capital should be reflected in a capital budgeting cash flow analysis because they can affect the cash flows associated with a project. Net working capital is the difference between a company's current assets and current liabilities and changes in working capital are often required to support the project. Therefore, they should be included in the cash flow analysis.

Question 10

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

Accepted Answer

Any cash flows that are directly related to the decision to undertake a project should be included in the capital budgeting analysis. These cash flows are referred to as incremental cash flows and should be analyzed to determine the profitability and viability of the project.

Question 11

If an investment project would make use of land which the firm currently owns, the project should be charged with the opportunity cost of the land.

Accepted Answer

When a firm makes use of land that it already owns for an investment project, it is important to consider the opportunity cost of that land. This is because if the land had not been used for the investment project, it could have been used for an alternative purpose that could have generated a return or economic benefit. By taking the opportunity cost of the land into consideration, the firm can make a more informed decision about whether the investment project is worthwhile or not.

Question 12

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.

Accepted Answer

Changes in noncash balance sheet accounts such as inventory need to be considered in a capital budgeting analysis as they affect cash flows. For example, an increase in inventory would tie up cash and reduce the availability of funds for other uses, while a decrease in inventory would free up cash and increase the availability of funds for other uses.

Question 13

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.

Accepted Answer

While initial outlays and subsequent costs can be forecasted with great accuracy, it is also difficult to make accurate revenue forecasts for any project, including product development projects.

Question 14

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

Estimating project cash flows is indeed the most important step in the capital budgeting process, and it can be challenging to accurately predict them. While methodologies such as NPV and IRR are important for evaluating project viability, they depend heavily on the accuracy of the cash flow estimates.

Question 15

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

Accepted Answer

Although forecasting techniques have improved, estimating cash flows remains a complex and challenging step in the capital budgeting process. It requires considering factors such as timing, uncertainty, and relevant costs, among others.

Question 16

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

Externalities, which refer to the impact of a firm's activities on the wider economy or society, can affect a firm's long-term cash flows. For example, if a firm's operations lead to environmental damage or negative social consequences, the firm may face regulatory fines or reputational damage, which could reduce its future cash flows. Therefore, it is important to consider externalities in cash flow estimation to ensure that all relevant factors are taken into account.

Question 17

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

The statement accurately describes the advantages and trade-offs of using accelerated depreciation and also suggests a possible solution to the reported profits problem.

Question 18

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.

Accepted Answer

Evaluating each project with the appropriate risk-adjusted discount rate is a common method for accounting for differences in project risk. This approach considers the varying levels of risk associated with each project and adjusts the discount rate accordingly to reflect that risk.

Question 19

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.

Accepted Answer

Due to the long timeline and uncertainty, it is difficult to accurately estimate revenues and costs for large, complex projects. Therefore, subjective judgment is often used in conjunction with discounted cash flow analysis to make financial projections.

Question 20

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

While superior analytical techniques and risk-adjusted cost of capital estimates can improve the quality of investment decision-making, they cannot fully overcome the problem of poor cash flow estimation. The accuracy of accept/reject decisions is fundamentally dependent on the quality of the cash flow projections.

Quiz 11: Cash Flow Estimation and Risk Analysis