Question 1

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

When estimating the cash flows for a proposed project, it's important to consider any cannibalization effects the new project might have on existing products or services. Option E, which mentions that the new project is expected to reduce sales of one of the company's existing products by 5%, represents a cash flow impact directly attributable to the project. This is an example of an incremental cash flow, which is relevant for project analysis. Options A, B, C, and D describe sunk costs and financing costs, which are not directly relevant to the incremental cash flows of a project.

Question 2

A firm is considering a new project whose risk is greater than the risk of the firm's average project,based on all methods for assessing risk.In evaluating this project,it would be reasonable for management to do which of the following?
A)Increase the estimated NPV of the project to reflect its greater risk.
B)Reject the project, since its acceptance would increase the firm's risk.
C)Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
D)Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.
E)Increase the estimated IRR of the project to reflect its greater risk.

Accepted Answer

The best option for the management in this scenario is to increase the cost of capital used to evaluate the project to reflect its higher-than-average risk. This is because the cost of capital takes into account both the risk-free rate of return and market risk premium, and if the project has a higher risk than the firm's average project, it should be evaluated using a higher discount rate to reflect the higher risk. This would result in a lower NPV for the project, which would ensure that the project would only be accepted if it generates sufficient returns to compensate for the increased risk. Option A is incorrect because increasing the NPV of the project would not account for the higher risk. Option B is incorrect because outright rejecting the project without evaluating its potential returns would not be in the best interest of the firm. Option C is incorrect because the size of the project does not determine its risk, and the management should take into account the relative risk of the project compared to the firm's other projects. Option E is incorrect because increasing the IRR of the project would not account for the higher risk and would only provide misleading information about the project's potential returns.

Question 3

Which of the following statements is CORRECT?
A)Only incremental cash flows are relevant in project analysis, the proper incremental cash flows are the reported accounting profits, and thus reported accounting income should be used as the basis for investor and managerial decisions.
B)It is unrealistic to believe that any increases in net working capital required at the start of an expansion project can be recovered at the project's completion. Working capital like inventory is almost always used up in operations. Thus, cash flows associated with working capital should be included only at the start of a project's life.
C)If equipment is expected to be sold for more than its book value at the end of a project's life, this will result in a profit. In this case, despite taxes on the profit, the end-of-project cash flow will be greater than if the asset had been sold at book value, other things held constant.
D)Changes in net working capital refer to changes in current assets and current liabilities, not to changes in long-term assets and liabilities. Therefore, changes in net working capital should not be considered in a capital budgeting analysis.
E)If an asset is sold for less than its book value at the end of a project's life, it will generate a loss for the firm, hence its terminal cash flow will be negative.

Accepted Answer

If equipment is sold for more than its book value, the firm will receive cash inflows greater than the book value of the asset. Despite taxes on the profit, the cash flow will be greater than if the asset had been sold at book value. This is because the firm will receive more cash than it originally anticipated, which is a positive outcome for the project.

Question 4

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}{c}
\begin{array}{lll}
\
\text {Expected NPV}\
\text {Standard deviation (oNPV)}\
\text {Project beta (vs. market)}
\end{array}
\begin{array}{lll}
\text {Project $ X $ }\
\$ 500,000 \
\$ 200,000 \
1.4 
\end{array}
\begin{array}{lll}
\text {Project $ Y $ }\
\$ 500,000 \
\$ 250,000 \
0.8
\end{array}
\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. Which of the following statements is CORRECT?
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.

Accepted Answer

The answer of Tallant Technologies is considering two potential projects,X...

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)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 the study has already been incurred and expensed in the previous year, so it would not result in incremental cash flows for the new product. The other options all have a direct impact on the cash flows of the new project. A would result in lost revenues from the existing product, B involves costs associated with the new product's production process, D involves the potential sale of land that would impact the company's cash flow, and E involves the opportunity cost of using factory space for the new product instead of other potential products.

Question 6

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 an entity have effects on others that are not reflected in market prices. The example given in choice A, where a bank opening a new office leads to increased deposits in its other offices, is an example of a positive externality within the same organization.

Question 7

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 Company...

Question 8

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 on research that cannot be recovered, should not be considered in the estimation of new project cash flows.

Question 9

To increase productive capacity,a company is considering a proposed new plant.Which of the following statements is CORRECT?
A)Since depreciation is a non-cash expense, the firm does not need to deal with depreciation when calculating the operating cash flows.
B)When estimating the project's operating cash flows, it is important to include both opportunity costs and sunk costs, but the firm should ignore the cash flow effects of externalities since they are accounted for in the discounting process.
C)Capital budgeting decisions should be based on before-tax cash flows.
D)The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.
E)In calculating the project's operating cash flows, the firm should not deduct financing costs such as interest expense, because financing costs are accounted for by discounting at the WACC. If interest were deducted when estimating cash flows, this would, in effect, "double count" it.

Accepted Answer

Financing costs such as interest expense should not be deducted when calculating the project's operating cash flows because they are already accounted for in the discounting process using the weighted average cost of capital (WACC). Deducting financing costs would result in double counting, which could lead to inaccurate calculations.

Question 10

Laramie Labs uses a risk-adjustment when evaluating projects of different risk.Its overall (composite)WACC is 10%,which reflects the cost of capital for its average asset.Its assets vary widely in risk,and Laramie evaluates low-risk projects with a WACC of 8%,average-risk projects at 10%,and high-risk projects at 12%.The company is considering the following projects: $$\begin{array} { c c c } 
\underline{\text { Project }} &\underline{ \text { Risk }} &\underline{ \text { Expected Return }} \
\text { A } & \text { High } & 15 \% \
\text { B } & \text { Average } & 12 \% \
\text { C } & \text { High } & 11 \% \
\text { D } & \text { Low } & 9 \% \
\text { E } & \text { Low } & 6 \%
\end{array}$$ Which set of projects would maximize shareholder wealth?
A)A and B.
B)A, B, and C.
C)A, B, and D.
D)A, B, C, and D.
E)A, B, C, D, and E.

Accepted Answer

The goal is to maximize shareholder wealth. To do this, we must select projects that have a higher expected return than their corresponding WACCs. Project A has an expected return of 15%, which is greater than the WACC of 12%. Project B has an expected return of 12%, which matches the WACC of 10%. Project C has an expected return of 11%, which is greater than the WACC of 12%. Project D has an expected return of 9%, which is greater than the WACC of 8%. Project E has an expected return of 6%, which is less than the WACC of 8%. Therefore, the best choice(s) to maximize shareholder wealth are projects A, B, and D.

Question 11

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?
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 investments⎯managers 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.

Accepted Answer

The answer of Which of the following procedures does the...

Question 12

You have just landed an internship in the CFO's office of Hawkesworth Inc.Your first task is to estimate the Year 1 cash flow for a project with the following data.What is the Year 1 cash flow? $\begin{array}{c}
\begin{array}{lll}
\text {Sales revenues}\
\text {Depteciation}\
\text {Other operating costs}\
\text {Tax rate}
\end{array}
\begin{array}{r}
\$ 13,000 \
\$ 4,000 \
\$ 6,000 \
35.0 \%
\end{array}
\end{array}$

A)$5,950
B)$6,099
C)$6,251
D)$6,407
E)$6,568

Accepted Answer

Year 1 cash flow = Sales revenues - Depteciation - Other operating costs - Taxes= $13,000 - $4,000 - $6,000 - (35% * $13,000)= $13,000 - $4,000 - $6,000 - $4,550= $5,950

Question 13

Which of the following statements is CORRECT?
A)In comparing two projects using sensitivity analysis, the one with the steeper lines would be considered less risky, because a small error in estimating a variable such as unit sales would produce only a small error in the project's NPV.
B)The primary advantage of simulation analysis over scenario analysis is that scenario analysis requires a relatively powerful computer, coupled with an efficient financial planning software package, whereas simulation analysis can be done efficiently using a PC with a spreadsheet program or even with just a calculator.
C)Sensitivity analysis is a type of risk analysis that considers both the sensitivity of NPV to changes in key input variables and the probability of occurrence of these variables' values.
D)As computer technology advances, simulation analysis becomes increasingly obsolete and thus less likely to be used as compared to sensitivity analysis.
E)Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.

Accepted Answer

Sensitivity analysis examines how changes in one variable affect the outcome (e.g., NPV) without considering the likelihood of the occurrence of these variables, making it incomplete in terms of risk assessment.

Question 14

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. These costs have already occurred and cannot be recovered or changed by the decision to undertake or reject the project.

Question 15

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

The correct rule for capital budgeting analysis is that only incremental cash flows (the cash flows that would result if a project is accepted) are relevant when making accept/reject decisions. Sunk costs (past expenses that cannot be recovered) should not be considered in the analysis, and the focus should be on the cash flows that will occur as a direct result of the project. While interest paid on funds borrowed to finance a project should be included in estimates of the project's cash flows, the estimated net income as determined by the firm's accountants using generally accepted accounting principles (GAAP) is not necessarily the relevant income figure for cash flow analysis. Finally, whether a proposed product is complementary or competitive with the firm's other products should be considered in the cash flow analysis since it can impact the project's future sales; there is no rule stating that it should or should not be reflected in the analysis.

Question 16

In your first job with TBL Inc.your task is to consider a new project whose data are shown below.What is the project's Year 1 cash flow? $\begin{array}{c}
\begin{array}{lll}
\text {Sales revenues}\
\text {Depteciation}\
\text {Other operating costs}\
\text {Tax rate}
\end{array}
\begin{array}{r}
\$ 22,000 \
\$ 8,000 \
\$12,000 \
35.0 \%
\end{array}
\end{array}$

A)$8,903
B)$9,179
C)$9,463
D)$9,746
E)$10,039

Accepted Answer

The Year 1 cash flow is calculated as: Sales revenues - Other operating costs - Taxes + Depreciation. Taxes are calculated on the operating income (Sales revenues - Other operating costs - Depreciation). So, Operating income = $22,000 - $12,000 - $8,000 = $2,000. Taxes = $2,000 * 35% = $700. Cash flow = $22,000 - $12,000 - $700 + $8,000 = $9,463.

Question 17

Which of the following statements is CORRECT?
A)One advantage of sensitivity analysis relative to scenario analysis is that it explicitly takes into account the probability of specific effects occurring, whereas scenario analysis cannot account for probabilities.
B)Well-diversified stockholders do not need to consider market risk when determining required rates of return.
C)Market risk is important, but it does not have a direct effect on stock prices because it only affects beta.
D)Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions.
E)Sensitivity analysis is a good way to measure market risk because it explicitly takes into account diversification effects.

Accepted Answer

Simulation analysis is a computerized version of scenario analysis where input variables are selected randomly on the basis of their probability distributions. The other statements are false. For instance, A is incorrect because sensitivity analysis only considers the impact of changes in a single variable, while scenario analysis looks at the impact of changes in multiple variables together.

Question 18

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 $2 million spent on R&D associated with the new product is a sunk cost and cannot be recovered regardless of whether the project is accepted or rejected. It does not result in incremental cash flows and should not be included in the capital budgeting analysis. The other options result in incremental cash flows and should be included in the analysis.

Question 19

Wansley Enterprises is considering a new project.The company has a beta of 1.0,and its sales and profits are positively correlated with the overall economy.The company estimates that the proposed new project would have a higher standard deviation and coefficient of variation than an average company project.Also,the new project's sales would be countercyclical in the sense that they would be high when the overall economy is down and low when the overall economy is strong.On the basis of this information,which of the following statements is CORRECT?
A)The proposed new project would increase the firm's corporate risk.
B)The proposed new project would increase the firm's market risk.
C)The proposed new project would not affect the firm's risk at all.
D)The proposed new project would have less stand-alone risk than the firm's typical project.
E)The proposed new project would have more stand-alone risk than the firm's typical project.

Accepted Answer

Statement e is true because the project has a relatively high standard deviation and thus more stand-alone risk than average. The project's revenues would be countercyclical to the rest of the firm's and to other firms' revenues, hence its within-firm and market risks would be relatively low.

Question 20

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

Regarding e and a, note that since interest should not be considered, exclusion will not lead to any type of bias, positive or negative.

Quiz 13: Cash Flow Estimation and Risk Analysis

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

A firm is considering a new project whose risk is greater than the risk of the firm's average project,based on all methods for assessing risk.In evaluating this project,it would be reasonable for management to do which of the following?

Which of the following statements is CORRECT?

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?

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?

To increase productive capacity,a company is considering a proposed new plant.Which of the following statements is CORRECT?

Which of the following procedures does the text say is used most frequently by businesses when they do capital budgeting analyses?

Which of the following statements is CORRECT?

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

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

Which of the following statements is CORRECT?

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?