Question 1

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 such as changes in market demand or regulations can have a significant impact on a firm's long-term cash flows. Therefore, it is crucial to include them in cash flow estimation to ensure accurate forecasting and informed decision-making.

Question 2

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 accurately forecast the revenues that a project will generate. This is especially true for large product development projects, which may face many variables and uncertainties.

Question 3

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

This method, known as the "risk-adjusted discount rate approach," involves using a higher discount rate for higher-risk projects and a lower discount rate for lower-risk projects to account for the differences in the level of risk. By doing so, the net present value (NPV) of each project can be compared on an equal footing to determine which ones are the most viable.

Question 4

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 crucial in determining the viability of a project and should be the primary focus in capital budgeting. While methodology is important, it is of secondary importance to accurate cash flow estimates.

Question 5

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 6

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 true as accelerated depreciation does result in higher depreciation expenses which lower the reported current year's profits. However, firms can use different depreciation methods for tax and stockholder reporting purposes to solve this problem. Additionally, the advantage of moving cash flows forward by accelerating depreciation still remains.

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

This is because accelerated depreciation allows for larger deductions in the earlier years of an asset's life, resulting in greater tax savings in those years when the value of money is higher. This can increase the overall present value of tax savings.

Question 8

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

This statement is true. Incremental cash flows are the additional cash flows that a project generates and are directly associated with the decision to undertake the project. These cash flows should be considered in the capital budgeting analysis because they reflect the true costs and benefits of the project. Therefore, any cash flows that are not incremental should be excluded from the analysis.

Question 9

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

If the externality is potentially important,it should not be ignored,because then a large error might be made.At the very least,it should be discussed,and possibly the analysis should be done using several scenarios of the possible effects of the externality.

Question 10

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.

Question 11

The coefficient of variation,calculated as the standard deviation of expected returns divided by the expected return,is a standardized measure of the risk per unit of expected return.

Accepted Answer

The coefficient of variation is indeed calculated as the standard deviation of expected returns divided by the expected return, and it is commonly used as a standardized measure of risk per unit of expected return.

Question 12

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

When using either NPV or IRR for capital budgeting decisions, accelerated depreciation results in higher tax savings in the early years of a project, which leads to higher cash flows and therefore a higher NPV or IRR. As a result, a firm is more likely to accept a project with accelerated depreciation compared to straight-line depreciation, assuming all else is equal.

Question 13

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

The answer of Typically,a project will have a higher NPV...

Question 14

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 are included in a capital budgeting analysis as they can affect cash flows. For example, an increase in inventory may require additional cash outflows for storage and maintenance costs.

Question 15

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 16

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 (current assets minus current liabilities) should be reflected in a capital budgeting cash flow analysis because they affect the overall cash flows of the project. Changes in net working capital, such as increases in accounts receivable or inventory, represent cash outflows while decreases represent cash inflows. Therefore, it is important to include changes in net working capital in a capital budgeting analysis to accurately calculate the project's cash flows.

Question 17

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

The opportunity cost of using the land for the investment project is the potential value that could have been gained if the land were used for an alternative purpose, such as selling or leasing it. Therefore, the project should be charged with this opportunity cost to factor in the full cost of using the land.

Question 18

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 is still an uncertain and challenging step in capital budgeting due to the various factors that can affect cash flows, such as changing market conditions, unexpected events, and human errors.

Question 19

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

The coefficient of variation is a better measure of risk when comparing securities with significantly different expected returns because it standardizes the risk per unit of return, allowing for a more meaningful comparison across different scales of expected returns.

Question 20

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.

Quiz 11: Cash Flow Estimation and Risk Analysis