Question 1

When calculating the cash flows for a project, you should include interest payments.

Accepted Answer

Interest payments are considered financing costs and are not included in the project's operating cash flows.

Question 2

Changes in net operating working capital do not need to be considered in capital budgeting cash flow analysis as long as the nominal (undiscounted) values of the changes are identical in each time period.

Accepted Answer

Changes in net operating working capital (NOWC) need to be considered in capital budgeting cash flow analysis, even if the nominal values of the changes are identical in each time period. This is because changes in NOWC can affect the company's cash flow and must be accounted for in the analysis.

Question 3

The lower the correlation of a project's cash flows with those of the rest of the firm, the greater will be the benefits of the project with regard to reducing within-firm risk.

Accepted Answer

If a project's cash flows have a low correlation with the rest of the firm's cash flows, it means the project is not affected by the same market factors as the rest of the firm, thus reducing the overall firm risk. In other words, the project's cash flows can act as a hedge against other risks within the firm, and therefore, the benefits of the project in terms of risk reduction will be greater.

Question 4

A project's market risk rises if the correlation of its cash flows with the economy decreases.

Accepted Answer

A project's market risk decreases if the correlation of its cash flows with the economy decreases, as it becomes less sensitive to economic fluctuations.

Question 5

If an asset being considered for acquisi¬tion has beta of zero, its purchase will have no effect on the firm's market risk.

Accepted Answer

The answer of If an asset being considered for acquisi¬tion...

Question 6

In cash flow estimation, the presence of externalities has no direct cash flow effects.

Accepted Answer

The presence of externalities can have indirect cash flow effects on a project, such as additional costs or benefits that may not be reflected in the initial cash flow estimate. Therefore, it is important to consider externalities when estimating cash flows.

Question 7

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 relevant in the analysis.

Accepted Answer

Changes in noncash balance sheet accounts such as inventory can have an impact on cash flows, therefore they are relevant in capital budgeting analysis. For example, an increase in inventory may require more cash to be tied up in working capital, and a decrease in inventory may free up cash for other investments.

Question 8

Although it is difficult to make accurate forecasts, the initial outlays and subsequent costs of large projects are forecast with great accuracy, but revenues are more uncertain and large errors are not uncommon.

Accepted Answer

Both costs and revenues of large projects are often subject to significant uncertainty and forecasting errors, not just revenues.

Question 9

Estimating project cash flows is considered the most important and the most difficult step in the capital budgeting process. Both the number of variables and the interdepartmental nature of the process contribute to the difficulty of estimating cash flows.

Accepted Answer

Estimating project cash flows is indeed considered one of the most important steps in the capital budgeting process and it is also one of the most difficult due to the number of variables involved and the interdepartmental nature of the process.

Question 10

Externalities present in projects being considered in capital budgeting are very difficult to quantify and as a result of this, they should be excluded from the financial analyses.

Accepted Answer

Externalities, although difficult to quantify, should not be excluded from financial analyses in capital budgeting. They can have significant impacts on the overall benefits and costs associated with a project, and therefore should be considered in the decision-making process.

Question 11

The primary advantage of accelerated depreciation over straight-line depreciation is that the total, undiscounted, depreciation tax savings over the life of the project are greater when an accelerated depreciation method is used.

Accepted Answer

The total, undiscounted depreciation tax savings over the life of the project are the same for both accelerated and straight-line depreciation methods; the advantage of accelerated depreciation is the timing of the tax savings, as it allows for greater tax deductions in the earlier years.

Question 12

With the current techniques available, estimating cash flows has become the easiest step in the analysis of a capital budgeting project.

Accepted Answer

While there are many techniques available to estimate cash flows, it can still be a complex process that requires careful consideration of various factors and assumptions. Other steps in capital budgeting analysis, such as determining appropriate discount rates and assessing project risks, can also be challenging.

Question 13

A firm which bases its capital budgeting decisions on either NPV or IRR will be more likely to accept a given project if it uses MACRS accelerated depreciation than if it uses the optional straight-line alternative, other things being equal.

Accepted Answer

This is because MACRS accelerated depreciation generates larger tax savings in earlier years, which increases the present value of the tax shield and therefore increases the net present value (NPV) and internal rate of return (IRR) of a project.

Question 14

Any cash flow that can be classified as incremental is relevant in a capital budgeting project analysis.

Accepted Answer

Incremental cash flows are those that occur as a result of undertaking the project being analyzed. They are relevant because they represent the additional cash inflows or outflows that would occur if the project is undertaken, and therefore impact the overall profitability of the project. Non-incremental cash flows, such as sunk costs or overhead expenses that do not change as a result of the project, are not relevant in capital budgeting analysis.

Question 15

Risky projects can be evaluated by discounting expected cash flows using a risk-adjusted discount rate.

Accepted Answer

Discounting expected cash flows using a risk-adjusted discount rate is a common method to evaluate risky projects. This takes into account the uncertainty and potential risks associated with the project, adjusting the discount rate accordingly to reflect the higher risk.

Question 16

When risk is explicitly accounted for in capital budgeting, a project will be acceptable to a firm if its IRR (or modified IRR) is greater than the firm's weighted average cost of capital.

Accepted Answer

The answer of When risk is explicitly accounted for in...

Question 17

Quantification of risk is the easiest part of incorporating risk into capital budgeting.

Accepted Answer

Quantifying risk involves assigning numerical values to potential risks, which can be difficult and time-consuming. Incorporating those quantified risks into a capital budgeting decision involves more complex analysis, including consideration of risk tolerance, probability distributions, and potential mitigation strategies, among other factors.

Question 18

A particular project might have very uncertain cash flows, hence a highly uncertain NPV and IRR, yet it may not have high market risk.

Accepted Answer

Market risk refers to the risk of the project's cash flows being affected by changes in overall market conditions such as interest rates, inflation, and economic events. Uncertainty in cash flows does not necessarily indicate high market risk as the project may be impacted by other factors such as industry-specific factors or company-specific factors. NPV and IRR measure the risk of the project's cash flows and are not directly related to market risk.

Question 19

Net incremental cash flow is calculated by adding back the change in depreciation to the change in net income.

Accepted Answer

Net incremental cash flow calculation involves adding back the change in depreciation (since it is a non-cash expense) to the change in net income to arrive at the increase in cash flow.

Question 20

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 revenue the land could have generated if it was used for an alternative purpose, such as selling or leasing it. Therefore, the project should be charged with this opportunity cost in order to accurately reflect the true cost of the investment.

Quiz 13: Capital Budgeting: Cash Flows and Risk