Question 1

The relative risk of a proposed project is best accounted for by which of the following procedures?
A) Adjusting the discount rate upward if the project is judged to have above-average risk.
B) Adjusting the discount rate downward if the project is judged to have above-average risk.
C) Reducing the NPV by 10% for risky projects.
D) Picking a risk factor equal to the average discount rate.
E) Ignoring risk because project risk cannot be measured accurately.

Accepted Answer

The best way to account for the relative risk of a proposed project is to adjust the discount rate upward if the project is judged to have above-average risk. This is because a higher risk project would require a higher return to compensate for the additional risk. This approach is more appropriate than adjusting the discount rate downward, as this would decrease the required return and may not sufficiently account for the risk involved. Reducing the NPV by 10% or picking a risk factor equal to the average discount rate does not take into account the specific risk of the project. Ignoring risk is not recommended, as it can lead to inaccurate evaluations of the project's potential return.

Question 2

Which of the following statements is CORRECT?
A) Since depreciation is a cash expense, the faster an asset is depreciated, the lower the projected NPV from investing in the asset.
B) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
C) Corporations must use the same depreciation method for both stockholder reporting and tax purposes.
D) Using accelerated depreciation rather than straight line normally has the effect of speeding up cash flows and thus increasing a project's forecasted NPV.
E) Using accelerated depreciation rather than straight line normally has the effect of slowing down cash flows and thus reducing a project's forecasted NPV.

Accepted Answer

Using accelerated depreciation allows for larger deductions in the earlier years of an asset's life, which decreases taxable income and increases cash flows. This leads to a higher forecasted NPV for the project.

Question 3

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

Accepted Answer

The replacement chain approach is used in practice but with modifications and adjustments to the assumptions. While it may not be suitable for all projects, it can be a useful tool in project evaluation and selection when applied correctly.

Question 4

Which of the following statements is CORRECT?
A) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.
B) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
C) A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices.
D) A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
E) If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 5

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?
A) Project A, which has average risk and an IRR = 9%.
B) Project B, which has below-average risk and an IRR = 8.5%.
C) Project C, which has above-average risk and an IRR = 11%.
D) Without information about the projects' NPVs we cannot determine which one or ones should be accepted.
E) All of these projects should be accepted.

Accepted Answer

Since Tapley Inc. uses the NPV method when choosing projects, we cannot determine the best project without information about the projects' NPVs. However, we can determine which project satisfies the WACC requirement for its risk level. Project A has an IRR of 9%, which is lower than the WACC of 10% for average-risk projects, so it should not be accepted. Project C has an IRR of 11%, which is higher than the WACC of 12% for above-average risk projects, but we cannot determine if it is acceptable without the NPV. Project B has a below-average risk and an IRR of 8.5%, which is higher than the WACC of 8% for below-average risk projects, so it should be accepted. Therefore, the best choice is B.

Question 6

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

Opportunity costs refer to the potential cash inflows or benefits that could be generated if resources such as assets are not used for a particular project. Therefore, the statement is true.

Question 7

Which of the following statements is CORRECT?
A) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.
B) A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
C) A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
D) Sunk costs were formerly
E) A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.

Accepted Answer

A sunk cost is a cost that has already been incurred and cannot be recovered. It is an irretrievable cost that should not be considered when making future decisions. Option A is incorrect because completing a project and bringing it into operation is not the definition of sunk cost. Option B is also incorrect because sunk costs cannot be recovered. Option D is a misleading option as sunk costs are still relevant in decision making. Option E is not an example of sunk cost, but is an example of a potential consequence of a new project.

Question 8

Sensitivity analysis measures a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, say sales. Other things held constant, with the size of the independent variable graphed on the horizontal axis and the NPV on the vertical axis, the steeper the graph of the relationship line, the more risky the project, other things held constant.

Accepted Answer

Sensitivity analysis does measure a project's stand-alone risk by showing how much the project's NPV (or IRR) is affected by a small change in one of the input variables, and the steeper the graph of the relationship line, the more risky the project, other things held constant.

Question 9

Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives.

Accepted Answer

Extending the lives of projects to a common life is only valid if there is a high probability that the projects will be repeated beyond their initial lives. Otherwise, the comparison will not be accurate or meaningful.

Question 10

Which of the following statements is CORRECT?
A) Using accelerated depreciation rather than straight line would normally have no effect on a project's total projected cash flows but it would affect the timing of the cash flows and thus the NPV.
B) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
C) Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
D) Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
E) Under accelerated depreciation, higher depreciation charges occur in the early years, and this reduces the early cash flows and thus lowers a project's projected NPV.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 11

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

Accepted Answer

The answer of The two methods discussed in the text...

Question 12

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during eyear of a project's life, other things held constant.

Accepted Answer

The answer of The use of accelerated versus straight-line depreciation...

Question 13

The two methods discussed in the text for dealing with unequal project lives are approach.

Accepted Answer

The text discusses two methods for dealing with unequal project lives: the equivalent annual annuity method and the replacement chain method.

Question 14

Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.

Accepted Answer

The answer of Replacement chain or EAA analysis is required...

Question 15

The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.

Accepted Answer

The change in net working capital associated with new projects can be positive or negative. It depends on the specific project and its cash flow requirements. For example, if the new project requires a significant amount of inventory, accounts receivable, or prepaid expenses, then the change in net working capital for the project may be positive. However, if the project reduces inventory, accounts receivable, or prepaid expenses, then the change in net working capital may be negative. The same applies to replacement projects.

Question 16

Which of the following statements is CORRECT?
A) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors. Thus, cannibalization is dealt with by society through the antitrust laws.
B) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers. Thus, cannibalization is dealt with by society through the antitrust laws.
C) If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects. Otherwise, the calculated NPV will be biased downward.
D) If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.
E) Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 17

Which of the following statements is CORRECT?
A) Since depreciation is not a cash expense, and since cash flows and not accounting income are the relevant input, depreciation plays no role in capital budgeting.
B) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 3 years or longer.
C) If they use accelerated depreciation, firms will write off assets slower than they would under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
D) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally lower than they would be if straight-line depreciation were required for tax purposes.
E) If they use accelerated depreciation, firms can write off assets faster than they could under straight-line depreciation, and as a result projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Accepted Answer

Using accelerated depreciation allows firms to write off assets faster, which reduces taxable income and thus lowers the firm's tax liability. This results in increased after-tax cash flows, which can increase the project's forecasted NPV. Therefore, projects' forecasted NPVs are normally higher than they would be if straight-line depreciation were required for tax purposes.

Question 18

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

The lost sales on the older book are considered an opportunity cost, not a sunk cost, and should be included in the analysis for the new book to accurately assess its financial impact.

Question 19

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) 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.
D) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified. However, the payback method does not.
E) Identifying an externality can never lead to an increase in the calculated NPV.

Accepted Answer

The answer of Which of the following statements is CORRECT?
A)...

Question 20

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
A) Changes in net working capital.
B) Shipping and installation costs.
C) Cannibalization effects.
D) Opportunity costs.
E) Sunk costs that have been expensed for tax purposes.

Accepted Answer

The answer of Which of the following is NOT a...

Quiz 12: Cash Flow Estimation and Risk Analysis

The relative risk of a proposed project is best accounted for by which of the following procedures?

Which of the following statements is CORRECT?

Although the replacement chain approach is appealing for dealing with mutually exclusive projects that have different lives, it is not used in practice because no projects meet the assumptions the method requires.

Which of the following statements is CORRECT?

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?

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.

Which of the following statements is CORRECT?

Extending the lives of projects with different lives out to a common life for comparison purposes, while theoretically appealing, is valid only if there is a reasonably high probability that the projects will actually be repeated out beyond their initial lives.

Which of the following statements is CORRECT?

The two methods discussed in the text for dealing with unequal project lives are (1) the replacement chain approach and (2) the present value approach.

The use of accelerated versus straight-line depreciation causes net income reported to stockholders to be lower, and cash flows higher, during eyear of a project's life, other things held constant.

The two methods discussed in the text for dealing with unequal project lives are approach.

Replacement chain or EAA analysis is required when analyzing projects that have different lives. This is true regardless of whether the projects are mutually exclusive or independent of one another.

The change in net working capital associated with new projects is always positive, because new projects mean that more working capital will be required. This situation is especially true for replacement projects.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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?