Question 1

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 2

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 3

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

Large, complex projects with long development timelines are subject to numerous uncertainties and unforeseen events, making it difficult to estimate revenues and costs with accuracy. Therefore, subjective judgment is often used along with discounted cash flow analysis to assess the project's feasibility and profitability.

Question 4

Changes in net operating 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 operating working capital should be reflected in a capital budgeting cash flow analysis because they are necessary for the operation of the fixed assets and are therefore relevant to the cash flows associated with the project.

Question 5

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 actually included in a capital budgeting analysis through their effects on cash flows. For example, an increase in inventory would tie up cash that could be used for investment, so it would be subtracted from the expected cash inflows in the analysis.

Question 6

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

While forecasting techniques have improved, estimating cash flows is still a complex and challenging step in capital budgeting due to uncertainties, risks, and the need to consider various factors such as inflation, taxes, and competition.

Question 7

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 8

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 the land is the potential value that the land could generate if it was used for an alternative project or sold on the market. Therefore, if a firm uses its own land for a new investment project, the project should be charged with the opportunity cost of the land to reflect the potential income the land could generate if it was used for an alternative purpose.

Question 9

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 for capital budgeting projects.

Accepted Answer

The answer of Superior analytical techniques, such as NPV, used...

Question 10

The two cardinal rules that financial analysts should follow to avoid 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 for capital budgeting projects.

Accepted Answer

The answer of The two cardinal rules that financial analysts...

Question 11

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 larger deductions in earlier years, resulting in higher tax savings in those years. This leads to a higher present value of tax savings compared to straight-line depreciation, which spreads out the deductions evenly over time.

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

This is because accelerated depreciation generates greater tax shields in the earlier years of a project's life, resulting in higher expected cash flows in those periods. This, in turn, increases the value of the project's NPV and IRR, making it more attractive to the firm.

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

Accelerated depreciation does have the advantage of increasing present value for profitable firms, while also lowering reported profits for the current year due to higher depreciation expenses. However, companies can use different depreciation methods for tax and stockholder reporting purposes to solve this problem.

Question 14

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

While the externality may not be accurately quantifiable, it still has the potential to have a significant impact on the project's outcome. Ignoring it completely would not be a responsible approach to decision-making, and the firm should explore options for mitigating or addressing the potential impact of the externality.

Question 15

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 capital budgeting, and while methodology is important, it is secondary to accurate cash flow estimation.

Question 16

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

Incremental cash flows are important in capital budgeting analysis because they are directly related to the decision to undertake the project. These cash flows should be included in the analysis to provide a complete picture of the potential profitability and viability of the project.

Question 17

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 can have impacts on a firm's cash flows in the long run, such as changes in market demand or regulatory requirements. Therefore, they should be considered in cash flow estimation to provide a more accurate projection of the firm's future cash flows.

Question 18

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 19

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

Although initial outlays and subsequent costs can be forecasted with some degree of accuracy, it is also difficult to accurately predict them, especially for large and complex product development projects.

Question 20

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 takes into account the varying levels of risk associated with each project, providing a more accurate assessment of their potential profitability. This approach recognizes that projects with higher risk require a higher rate of return to compensate investors for the additional risk they are taking on.

Quiz 13: Cash Flow and Risk