Question 1

Currently,Powell Products has a beta of 1.0,and its sales and profits are positively correlated with the overall economy.The company estimates that a 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 have more stand-alone risk than the firm's typical project.
B) The proposed new project would increase the firm's corporate risk.
C) The proposed new project would increase the firm's market risk.
D) The proposed new project would not affect the firm's risk at all.
E) The proposed new project would have less stand-alone risk than the firm's typical project.

Accepted Answer

Statement a 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 2

Which of the following statement completions is NOT CORRECT? For a profitable firm,when MACRS accelerated depreciation is compared to straight-line depreciation,MACRS accelerated allowances produce
A) Higher depreciation charges in the early years of an asset's life.
B) Larger cash flows in the earlier years of an asset's life.
C) Larger total undiscounted profits from the project over the project's life.
D) Smaller accounting profits in the early years,assuming the company uses the same depreciation method for tax and book purposes.
E) Lower tax payments in the earlier years of an asset's life.

Accepted Answer

MACRS accelerated depreciation results in higher depreciation charges in the early years of an asset's life (A), larger cash flows in the earlier years of an asset's life (B), smaller accounting profits in the early years assuming the company uses the same depreciation method for tax and book purposes (D), and lower tax payments in the earlier years of an asset's life (E). However, MACRS accelerated depreciation does not necessarily result in larger total undiscounted profits from the project over the project's life (C). This is because the choice of depreciation method only affects the timing of when depreciation charges are taken, not the total amount of depreciation over the asset's life.

Question 3

A company is considering a proposed new plant that would increase productive capacity.Which of the following statements is CORRECT?
A) 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.
B) Since depreciation is a non-cash expense,the firm does not need to deal with depreciation when calculating the operating cash flows.
C) 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.
D) Capital budgeting decisions should be based on before-tax cash flows because WACC is calculated on a before-tax basis.
E) The WACC used to discount cash flows in a capital budgeting analysis should be calculated on a before-tax basis.To do otherwise would bias the NPV upward.

Accepted Answer

A) Correct because in capital budgeting, interest expense is not deducted from operating cash flows since it's considered in the WACC, which is used for discounting those cash flows. Deducting interest would indeed result in double counting.

Question 4

Rowell 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.Rowell owns the building free and clear - there is no mortgage on it.Which of the following statements is CORRECT?
A) 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 of the capital budgeting analysis for any new project.
B) 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.
C) 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.
D) 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.
E) 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.

Accepted Answer

The correct answer is B because if the building could be sold, the opportunity cost of not selling it (i.e., the after-tax proceeds from a potential sale) should be considered as a cost for any new project that decides to use the building. This reflects the principle that the value of an asset to a project includes the foregone benefits from its best alternative use.

Question 5

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 IRR of the project to reflect its greater risk.
B) Increase the estimated NPV of the project to reflect its greater risk.
C) Reject the project,since its acceptance would increase the firm's risk.
D) Ignore the risk differential if the project would amount to only a small fraction of the firm's total assets.
E) Increase the cost of capital used to evaluate the project to reflect its higher-than-average risk.

Accepted Answer

When evaluating a project with higher-than-average risk, it is appropriate to adjust the cost of capital used to evaluate the project to reflect its higher risk. This is because the cost of capital represents the required return for the level of risk taken by the firm, and a higher risk project should have a higher required return. Option A and B are not appropriate as adjusting the estimated IRR or NPV would be manipulating the project's expected cash flows. Option C is too extreme and might result in missed opportunities for the firm. Option D is not appropriate as the size of the project is irrelevant when evaluating risk.

Question 6

Which of the following statements is CORRECT?
A) 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.
B) 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.
C) It is unrealistic to believe that any increases in net operating working capital required at the start of an expansion project can be recovered at the project's completion.Operating working capital like inventory is almost always used up in operations.Thus,cash flows associated with operating working capital should be included only at the start of a project's life.
D) 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.
E) Changes in net operating working capital refer to changes in current assets and current liabilities,not to changes in long-term assets and liabilities,hence they should not be considered in a capital budgeting analysis.

Accepted Answer

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. 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. This is because the firm would receive more cash than they had anticipated, resulting in a positive end-of-project cash flow.

Question 7

Dalrymple Inc.is considering production of 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 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.
B) 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.
C) The company has spent and expensed for tax purposes $3 million on research related to the new product.These funds cannot be recovered,but the research may benefit other projects that might be proposed in the future.
D) The new product will cut into sales of some of the firm's other products.
E) If the project is accepted,the company must invest an additional $2 million in net operating working capital.However,all of these funds will be recovered at the end of the project's life.

Accepted Answer

The $3 million spent and expensed for tax purposes on research related to the new product is a sunk cost, which means it has already been incurred and cannot be recovered or changed by the decision to go ahead with the new project. Therefore, it should not be explicitly considered when estimating cash flows for the new project.

Question 8

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 an upward bias in the NPV.
B) 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.
C) The existence of any type of "externality" will reduce the calculated NPV versus the NPV that would exist without the externality.
D) 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 proceeds that could be obtained should be charged as a cost to the project under consideration.
E) 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.

Accepted Answer

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

Question 9

Which of the following rules is CORRECT for capital budgeting analysis?
A) The interest paid on funds borrowed to finance a project must be included in estimates of the project's cash flows.
B) Only incremental cash flows,which are the cash flows that would result if a project is accepted,are relevant when making accept/reject decisions for capital budgeting projects.
C) 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.
D) 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.
E) 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.

Accepted Answer

Only incremental cash flows, which are the cash flows that would result if a project is accepted, are relevant when making accept/reject decisions for capital budgeting projects. This means that only the cash flows that would change as a result of accepting the project should be considered in the analysis, and not any sunk costs or irrelevant cash flows.

Question 10

Other things held constant,which of the following would increase the NPV of a project being considered?
A) A shift from straight-line to MACRS depreciation.
B) Making the initial investment in the first year rather than spreading it over the first three years.
C) An increase in the discount rate associated with the project.
D) An increase in required net operating working capital.
E) The project would decrease sales of another product line.

Accepted Answer

The answer of Other things held constant,which of the following...

Question 11

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) 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.
B) Revenues from an existing product would be lost as a result of customers switching to the new product.
C) Shipping and installation costs associated with a machine that would be used to produce the new product.
D) 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.
E) 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.

Accepted Answer

The cost of the research in the past year is a sunk cost and cannot be recovered. Therefore, it cannot be considered as an incremental cash flow for the new project. Choices A, B, C, and E involve variables that will affect the cash flows of the project and can be considered in the capital budgeting analysis.

Question 12

As assistant to the CFO of Boulder Inc. ,you must estimate the Year 1 cash flow for a project with the following data.What is the Year 1 cash flow? Do not round the intermediate calculations and round the final answer to the nearest whole number. $$\begin{array} { l r } 
\text { Sales revenues } & \$ 13,100 \
\text { Depreciation } & \$ 4,000 \
\text { Other operating costs } & \$ 6,000 \
\text { Tax rate } & 35.0 \%
\end{array}$$
?
A) $6,015
B) $6,797
C) $6,436
D) $6,496
E) $5,414

Accepted Answer

The answer of As assistant to the CFO of Boulder...

Question 13

A company is considering a new project.The CFO plans to calculate the project's NPV by estimating the relevant cash flows for each year of the project's life (i.e. ,the initial investment cost,the annual operating cash flows,and the terminal cash flows),then discounting those cash flows at the company's overall WACC.Which one of the following factors should the CFO be sure to INCLUDE in the cash flows when estimating the relevant cash flows?
A) All sunk costs that have been incurred relating to the project.
B) All interest expenses on debt used to help finance the project.
C) The additional investment in net operating working capital required to operate the project,even if that investment will be recovered at the end of the project's life.
D) Sunk costs that have been incurred relating to the project,but only if those costs were incurred prior to the current year.
E) Effects of the project on other divisions of the firm,but only if those effects lower the project's own direct cash flows.

Accepted Answer

The CFO should include the additional investment in net operating working capital required to operate the project, even if that investment will be recovered at the end of the project's life. This is because the investment in working capital is a cash outflow that is necessary to operate the project, and it should be taken into account when calculating the project's cash flows. The other options are incorrect because: A) sunk costs are irrelevant and should not be included in the cash flows, B) interest expenses should already be included in the WACC used to discount the cash flows and should not be double-counted, D) sunk costs are irrelevant and should not be included in the cash flows, and E) effects on other divisions are not relevant to the project's own cash flows and should not be included in the cash flow estimation.

Question 14

Which of the following statements is CORRECT?
A) Sensitivity analysis as it is generally employed is incomplete in that it fails to consider the probability of occurrence of the key input variables.
B) 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.
C) 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.
D) 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.
E) As computer technology advances,simulation analysis becomes increasingly obsolete and thus less likely to be used than sensitivity analysis.

Accepted Answer

A) Sensitivity analysis, by its traditional definition, does not incorporate the probability of occurrence of the key input variables, making it a partial approach to risk assessment.

Question 15

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

Accepted Answer

Sensitivity analysis does not explicitly account for diversification effects, and it also does not take into account the probability of specific effects occurring, which makes options A and B incorrect. Well-diversified stockholders still need to consider market risk (systematic risk) when determining required rates of return, making C incorrect. Market risk directly affects stock prices through its impact on the cost of capital and required rates of return, making D incorrect. Simulation analysis is indeed a computerized version of scenario analysis that uses random selection of input variables based on their probability distributions, making E correct.

Question 16

Taussig 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: $\begin{array}{lll}&\text { Project } \mathrm{X}&\text { Project } \mathrm{Y}\
\text { Expected NPV } & \$ 350,000 & \$ 350,000 \
\text { Standard deviation (oNPV) } & \$ 100,000 & \$ 150,000 \
\text { Project beta (vs. market) } & 1.4 & 0.8\
\text { Correlation of the project cash flows }&\text { Cash flows are not correlated }&\text { Cash flows are highly correl ated }\
\text { with cash flows from currently }&\text { with the cash flows from }&\text { with the cash flows from }\
\text { existing projects. }&\text { existing projects. }&\text { existing projects. }\
\end{array}$
?
Which of the following statements is CORRECT?
A) Project X has more stand-alone risk than Project Y.
B) Project X has more corporate (or within-firm)risk than Project Y.
C) Project X has more market risk than Project Y.
D) Project X has the same level of corporate risk as Project Y.
E) Project X has the same market risk as Project Y since its cash flows are not correlated with the cash flows of existing projects.

Accepted Answer

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

Question 17

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 firm has a parcel of land that can be used for a new plant site or be sold,rented,or used for agricultural purposes.
B) 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.
C) A firm must obtain new equipment for the project,and $1 million is required for shipping and installing the new machinery.
D) A firm has spent $2 million on research and development 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.
E) A firm can produce a new product,and the existence of that product will stimulate sales of some of the firm's other products.

Accepted Answer

Research and development costs that have already been expensed cannot be recovered and therefore do not result in incremental cash flows. The other options all involve potential cash inflows or outflows that would result from the new product and should be considered in the capital budgeting analysis.

Question 18

When evaluating a new project,firms should include in the projected cash flows all of the following EXCEPT:
A) Changes in net operating working capital attributable to the project.
B) Previous expenditures associated with a market test to determine the feasibility of the project,provided those costs have been expensed for tax purposes.
C) The value of a building owned by the firm that will be used for this project.
D) A decline in the sales of an existing product,provided that decline is directly attributable to this project.
E) The salvage value of assets used for the project that will be recovered at the end of the project's life.

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 19

Which of the following should be considered when a company estimates the cash flows used to analyze a proposed project?
A) The new project is expected to reduce sales of one of the company's existing products by 5%.
B) 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.
C) The company has spent and expensed $1 million on research and development costs associated with the new project.
D) The company spent and expensed $10 million on a marketing study before its current analysis regarding whether to accept or reject the project.
E) 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.

Accepted Answer

The answer of Which of the following should be considered...

Question 20

Which of the following factors should be included in the cash flows used to estimate a project's NPV?
A) All costs associated with the project that have been incurred prior to the time the analysis is being conducted.
B) Interest on funds borrowed to help finance the project.
C) The end-of-project recovery of any additional net operating working capital required to operate the project.
D) Cannibalization effects,but only if those effects increase the project's projected cash flows.
E) Expenditures to date on research and development related to the project,provided those costs have already been expensed for tax purposes.

Accepted Answer

The cash flows used to estimate a project's NPV should include the end-of-project recovery of any additional net operating working capital required to operate the project. This is because working capital is tied up in the project and must be accounted for in the analysis. Options A, B, D, and E are not correct because sunk costs (Option A), interest (Option B), cannibalization effects (Option D), and expenditures to date on research and development (Option E) are not relevant for the project's future cash flows. Only costs and revenues that will occur in the future should be included in the cash flow analysis.

Quiz 12: Cash Flow Estimation and Risk Analysis

Which of the following statement completions is NOT CORRECT? For a profitable firm,when MACRS accelerated depreciation is compared to straight-line depreciation,MACRS accelerated allowances produce

A company is considering a proposed new plant that would increase productive capacity.Which of the following statements is CORRECT?

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?

Dalrymple Inc.is considering production of 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?

Which of the following statements is CORRECT?

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

Other things held constant,which of the following would increase the NPV of a project being considered?

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?

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?

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

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

Which of the following factors should be included in the cash flows used to estimate a project's NPV?