Question 1

Which of the following rules is CORRECT for capital budgeting analysis?
A) Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions.
B) Sunk costs are not included in the annual cash flows, but they must be deducted from the PV of the project's other costs when reaching the accept/reject decision.
C) A proposed project's estimated net income as determined by the firm's accountants, using generally accepted accounting principles (GAAP), is discounted at the WACC, and if the PV of this income stream exceeds the project's cost, the project should be accepted.
D) If a product is competitive with some of the firm's other products, this fact should be incorporated into the estimate of the relevant cash flows.However, if the new product is complementary to some of the firm's other products, this fact need not be reflected in the analysis.
E) The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.

Accepted Answer

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions. This means that any cash flows that would occur regardless of whether or not the project is accepted are not considered in the analysis. Only the additional or incremental cash flows that result from the project are relevant.

Question 2

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:
A) Previous expenditures associated with a market test to determine the feasibility of the project, provided those costs have been expensed for tax purposes.
B) The value of a building owned by the firm that will be used for this project.
C) A decline in the sales of an existing product, provided that decline is directly attributable to this project.
D) The salvage value of assets used for the project that will be recovered at the end of the project's life.
E) Changes in net working capital attributable to the project.

Accepted Answer

Previous expenditures, such as costs associated with a market test that have already been expensed for tax purposes, are considered sunk costs and should not be included in the projected cash flows of a new project.

Question 3

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 clear⎯there is no mortgage on it.Which of the following statements is CORRECT?
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.

Accepted Answer

The answer of While developing a new product line, Cook...

Question 4

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

Accepted Answer

The end-of-project recovery of any working capital required to operate the project should be included in the cash flows used to estimate a project's NPV. This is because working capital is typically invested to cover upfront costs and ongoing expenses, and at the end of a project, any remaining working capital should be returned to the company. Interest on funds borrowed, cannibalization effects, expenditures on research and development, and costs incurred prior to the analysis being conducted are all factors that may or may not be relevant to a project's cash flows, depending on the specific circumstances.

Question 5

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?
A) A new product will generate new sales, but some of those new sales will be from customers who switch from one of the firm's current products.
B) A firm must obtain new equipment for the project, and $1 million is required for shipping and installing the new machinery.
C) A firm has spent $2 million on R&D associated with a new product.These costs have been expensed for tax purposes, and they cannot be recovered regardless of whether the new project is accepted or rejected.
D) A firm can produce a new product, and the existence of that product will stimulate sales of some of the firm's other products.
E) A firm has a parcel of land that can be used for a new plant site or be sold, rented, or used for agricultural purposes.

Accepted Answer

The costs associated with R&D have already been expensed and cannot be recovered, therefore they are not incremental cash flows and should not be included in the capital budgeting analysis. The other options all involve cash flow changes that should be considered in the analysis.

Question 6

The CFO of Cicero Industries plans to calculate a new project's NPV by estimating the relevant cash flows for each year of the project's life (i.e., the initial investment cost, the annual operating cash flows, and the terminal cash flow), then discounting those cash flows at the company's overall WACC.Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
A) All sunk costs that have been incurred relating to the project.
B) All interest expenses on debt used to help finance the project.
C) The investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life.
D) Sunk costs that have been incurred relating to the project, but only if those costs were incurred prior to the current year.
E) Effects of the project on other divisions of the firm, but only if those effects lower the project's own direct cash flows.

Accepted Answer

The CFO should include the investment in working capital required to operate the project, even if that investment will be recovered at the end of the project's life. This is because the working capital investment is a cash outflow at the beginning of the project and a cash inflow at the end of the project, and therefore affects the project's overall cash flows. Sunk costs that have been incurred prior to the current year should not be included, as they are already incurred and are irrelevant to future cash flows. Interest expenses on debt used to finance the project should be included in the cost of capital used to discount cash flows, but not in the actual cash flows themselves. Effects of the project on other divisions of the firm should also not be included, unless they directly affect the project's own cash flows.

Question 7

Which of the following statements is CORRECT?
A) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to a downward bias in the NPV.
B) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
C) If one of the assets to be used by a potential project is already owned by the firm, and if that asset could be sold or leased to another firm if the new project were not undertaken, then the net after-tax proceeds that could be obtained should be charged as a cost to the project under consideration.
D) If one of the assets to be used by a potential project is already owned by the firm but is not being used, then any costs associated with that asset is a sunk cost and should be ignored.
E) In a capital budgeting analysis where part of the funds used to finance the project would be raised as debt, failure to include interest expense as a cost when determining the project's cash flows will lead to an upward bias in the NPV.

Accepted Answer

The opportunity cost of using an asset that could be sold or leased should be included in the project's cash flows, as it represents a foregone benefit.

Question 8

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

With accelerated depreciation, larger depreciation expenses are taken in the earlier years which results in higher tax savings that have a higher present value when discounted back to the current time. This is because the tax savings are received earlier, allowing the business to reinvest them sooner.

Question 9

Collins Inc.is investigating whether to develop a new product.In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?
A) The project will utilize some equipment the company currently owns but is not now using.A used equipment dealer has offered to buy the equipment.
B) The company has spent and expensed for tax purposes $3 million on research related to the new detergent.These funds cannot be recovered, but the research may benefit other projects that might be proposed in the future.
C) The new product will cut into sales of some of the firm's other products.
D) If the project is accepted, the company must invest $2 million in working capital.However, all of these funds will be recovered at the end of the project's life.
E) The company will produce the new product in a vacant building that was used to produce another product until last year.The building could be sold, leased to another company, or used in the future to produce another of the firm's products.

Accepted Answer

Sunk costs, such as the $3 million already spent and expensed for tax purposes on research, should not be considered in the evaluation of future projects because these costs cannot be recovered and do not affect the future cash flows of the new project.

Question 10

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

Accepted Answer

Opportunity costs, such as the reduction in sales of existing products due to the new project, should be considered in cash flow estimation. Other options involve sunk costs or financing costs, which are not included in project cash flow analysis.

Question 11

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.

Accepted Answer

Accelerated depreciation causes net income to be lower in the early years of a project's life due to higher depreciation expenses, but it does not affect the total cash flows from operations, as depreciation is a non-cash expense. Over the life of the project, the total depreciation expense is the same for both methods, just allocated differently over time.

Question 12

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

Accelerated depreciation increases early cash flows due to tax savings, but it does not change the total cash flows over the project's life, only their timing.

Question 13

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

This statement is correct. Accelerated depreciation does have the advantage of increasing the present value of cash flows for profitable firms, but it also lowers reported profits in the current year due to higher depreciation expenses. However, the problem of lower reported profits can be addressed by using different depreciation methods for tax and stockholder reporting purposes.

Question 14

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 15

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, which increases the cash flows in those years and therefore increases the NPV and IRR of the project.

Question 16

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?
A) Revenues from an existing product would be lost as a result of customers switching to the new product.
B) Shipping and installation costs associated with a machine that would be used to produce the new product.
C) The cost of a study relating to the market for the new product that was completed last year.The results of this research were positive, and they led to the tentative decision to go ahead with the new product.The cost of the research was incurred and expensed for tax purposes last year.
D) It is learned that land the company owns and would use for the new project, if it is accepted, could be sold to another firm.
E) Using some of the firm's high-quality factory floor space that is currently unused to produce the proposed new product.This space could be used for other products if it is not used for the project under consideration.

Accepted Answer

The cost of a study that was completed last year and expensed for tax purposes cannot be considered incremental and should not be included in the capital budgeting analysis. It is a sunk cost and cannot be recovered. All other options (A, B, D, and E) involve cash flows that are incremental and should be included in the analysis.

Question 17

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 depending on the working capital needs of the project. While it is true that some new projects may require more working capital, others may require less. Additionally, replacement projects may also result in a positive or negative change in net working capital depending on the differences in working capital needs between the existing and replacement assets.

Question 18

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 represent cash flows related to the investment and operation of the fixed asset.

Question 19

Which of the following statements is CORRECT?
A) Under current laws and regulations, corporations must use straight-line depreciation for all assets whose lives are 5 years or longer.
B) Corporations must use the same depreciation method (e.g., straight line or accelerated) for stockholder reporting and tax purposes.
C) Since depreciation is not a cash expense, it has no effect on cash flows and thus no effect on capital budgeting decisions.
D) 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.
E) 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.

Accepted Answer

Accelerated depreciation affects the timing of cash flows by increasing depreciation expenses in the early years, which can lead to tax savings and thus affect the NPV, even though the total cash flows over the project's life remain the same.

Question 20

Which of the following statements is CORRECT?
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 increase.
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.

Accepted Answer

An externality refers to a situation where the actions of a firm or project have an impact on parties not directly involved in the transaction. The example given in choice A, where a bank's new office increases deposits in its other offices, is an example of a positive externality affecting the bank's other operations.

Quiz 11: Cash Flow Estimation and Risk Analysis

Which of the following rules is CORRECT for capital budgeting analysis?

When evaluating a new project, firms should include in the projected cash flows all of the following EXCEPT:

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

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 statements is CORRECT?

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.

Collins Inc.is investigating whether to develop a new product.In evaluating whether to go ahead with the project, which of the following items should NOT be explicitly considered when cash flows are estimated?

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

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.

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.

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.

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.

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?

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.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?