Question 1

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 statement is true. By using a risk-adjusted discount rate, a firm can account for the varying levels of risk associated with different projects and make a more accurate financial decision about whether or not to invest in them.

Question 2

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

It is true that estimating revenues and costs for large, complex projects that take several years to develop is difficult, and subjective judgment is often used along with discounted cash flow analysis to make estimates.

Question 3

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 make accurate forecasts of the revenues that a project will generate, even for large product development projects.

Question 4

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

Accepted Answer

The first rule is incorrect; the numerator in the NPV equation should use cash flows, not income calculated according to GAAP. The second rule is correct as all incremental cash flows should be considered.

Question 5

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 should be reflected in a capital budgeting cash flow analysis because they affect the cash flows related to the project. Net working capital includes current assets and current liabilities such as inventory, accounts receivable, and accounts payable, which can have a significant impact on the cash flows of a project. Therefore, changes in net working capital must be factored in when evaluating the cash flows of a capital budgeting project.

Question 6

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 significant impacts on a firm's cash flows, both positive and negative, and should be considered in cash flow estimation for long-term planning and decision making.

Question 7

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 capital budgeting as they can impact the overall value and feasibility of a project, affecting stakeholders beyond the company itself.

Question 8

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 step in the capital budgeting process that requires careful analysis and consideration of various factors such as inflation, taxes, and project risk.

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

Ignoring an external cost, no matter if it can be precisely quantified or not, can lead to incorrect decision-making and harm to society. When externalities are present, they should be acknowledged and efforts should be made to estimate their effects as accurately as possible. Failing to consider externalities can result in underinvestment in projects that yield positive externalities and overinvestment in projects that have negative externalities.

Question 10

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 through adjustments made to cash flows, such as accounting for changes in working capital.

Question 11

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 12

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 and challenging part of the capital budgeting process. While methodology is essential, it is secondary to obtaining a realistic estimate of cash flows.

Question 13

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 is true. Incremental cash flows are the cash flows that are directly related to a particular project and should be included in capital budgeting analysis.

Question 14

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 methods allow businesses to deduct a larger portion of an asset's cost in the early years of its useful life, resulting in higher tax savings in those first few years. This higher tax savings can increase the present value of the tax benefits of depreciation, making accelerated depreciation a more attractive option for businesses.

Question 15

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 project's cash flow analysis; they are considered in the cost of capital or discount rate used to evaluate the project's net present value.

Question 16

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 over the asset's life is the same regardless of the method; accelerated depreciation simply allows for more depreciation to be taken in the earlier years.

Question 17

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 true because accelerated depreciation methods such as MACRS can result in higher tax savings in the earlier years of the project, leading to higher cash flows and a higher NPV or IRR. Straight-line depreciation, on the other hand, spreads the tax savings evenly over the life of the asset, resulting in lower tax savings in the early years and potentially a lower NPV or IRR.

Question 18

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 benefit profitable firms by increasing the present value of cash flows, but it can also lower reported profits in the current year. However, companies can use different depreciation methods for tax and stockholder reporting to address this issue.

Question 19

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 value of the best alternative use of the land. Therefore, the project should be charged with the opportunity cost of the land to accurately reflect the cost of the investment decision.

Question 20

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.

Quiz 13: Cash Flows and Risk