Question 1

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

False

Question 2

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 relevant for a capital budgeting analysis as they directly result from the decision to undertake the project. Therefore, they should be included in the analysis to assess the feasibility and profitability of the project.

Question 3

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 4

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 difficult to predict the revenues that a project will generate, especially for large product development projects.

Question 5

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...

Question 6

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 affect the amount of cash that will be available to the company for investment in fixed assets.

Question 7

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 crucial step in the capital budgeting process. Factors such as inflation, changing economic conditions, and unforeseen events can all impact cash flow estimates. Additionally, forecasting techniques are not perfect and still require subjective assumptions and judgments.

Question 8

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 9

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 10

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. Accelerated depreciation can increase the present value of cash flows for profitable firms but can also lower reported profits in the current year. By using different depreciation methods for tax and stockholder reporting purposes, the reported profits issue can be resolved.

Question 11

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 do affect the cash flows and should be considered in capital budgeting analysis. For example, an increase in inventory would tie up cash, while a decrease would free up cash for other investments.

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 leads to larger depreciation expense in the early years of a project's life, which in turn increases the project's tax shield and therefore its cash flows. This results in higher NPV and IRR, making the project more attractive to the firm.

Question 13

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 interest rates, inflation rates, or regulations, can affect a firm's long-run cash flows and should be considered in cash flow estimation.

Question 14

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 depreciation expenses in earlier years, resulting in larger tax deductions and higher present value of tax savings compared to straight-line depreciation.

Question 15

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

This is true because the uncertainty and long-term nature of large projects make it difficult to accurately predict costs and revenues, so subjective judgment is often necessary. Discounted cash flow analysis is also used to estimate future cash flows and determine the project's net present value.

Question 16

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 17

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

Even if the externality cannot be precisely quantified, it should still be considered in the analysis and included in the decision-making process. Ignoring it could lead to inaccurate or incomplete assessments of the project's true costs and benefits.

Question 18

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 is the alternative use or potential income the land could generate if used for something else. As the firm already owns the land, it should be accounted for in the project's costs to accurately assess the profitability and feasibility of the investment.

Question 19

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 accurately is key to making informed decisions in capital budgeting. While methodology is important, it is secondary to obtaining reliable cash flow estimates.

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 is a common way to account for different levels of risk in a firm's project portfolio. This ensures that the expected return of each project is appropriately reflected in the firm's overall cost of capital, and allows for better decision-making about the allocation of resources among different projects.

Quiz 12: Cash Flow and Risk