Question 1

Which of the following statements is true regarding a replacement decision?
A) The benefits resulting from the new investment is treated as an inflow.
B) The net cash flow from the sale of an old equipment is treated as an outflow at t = 0 (initial investment outlay).
C) The depreciation expenses on the new equipment is treated as an outflow.
D) Any loss on the sale of the old equipment is multiplied by the tax rate and is treated as an outflow at t = 0 (initial investment outlay).
E) An increase in the net working capital is treated as an inflow when the project begins (initial investment outlay) and as an outflow when the project ends (terminal cash flow).

Accepted Answer

The benefits from the new investment are considered inflows as they represent the additional cash flows generated by the new equipment.

Question 2

Which of the following statements is true about relevant cash flows?
A) Day-to-day operating cash flows of a project are relevant cash flows.
B) Inflation during the project's lifetime is a relevant cash flow.
C) Depreciation expenses not relevant cash flows to be considered in the cash flow of a project.
D) Sunk costs of engineering study to determine the feasibility of a project are relevant cash flows.
E) Opportunity cost of land being used for the project that the firm already owns is a relevant cash flow.

Accepted Answer

A

Question 3

Quantification of risk is difficult, and there are different types of risks like stand-alone risk, market risk and political risk. Sensitivity analysis is a good technique to measure market risk.

Accepted Answer

Sensitivity analysis is primarily used to assess stand-alone risk by examining how changes in input variables affect a particular outcome, rather than specifically measuring market risk.

Question 4

A sunk cost is a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. These sunk costs are extremely important in capital budgeting decisions.

Accepted Answer

Sunk costs are not considered in capital budgeting decisions because they cannot be recovered and do not affect future cash flows or the decision-making process.

Question 5

Which of the following rules is essential for successful cash flow estimates, and ultimately, to successful capital budgeting?
A) The return on invested capital is the only relevant cash flow.
B) Only incremental cash flows are relevant to the accept/reject decision.
C) Total cash flows are relevant to capital budgeting analysis and the accept/reject decision.
D) Inflation is considered while estimating incremental cash flows.
E) Shipping and installation costs are included in cash flow estimation.

Accepted Answer

Only incremental cash flows are relevant to capital budgeting because the decision to accept or reject a project is based on the additional cash flows that will result from the investment, not on total cash flows. Therefore, all costs and benefits that result directly and exclusively from the investment should be included, while sunk costs and overheads should be excluded. The return on invested capital is important, but it should be calculated based on incremental cash flows. Inflation should be considered while estimating incremental cash flows, but shipping and installation costs may or may not be included, depending on the specific circumstances of the project.

Question 6

Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates.

Accepted Answer

Capital budgeting decisions should not solely rely on accounting income as it may not reflect the true cash flows and financial implications of the project. Instead, it should consider factors such as cash flows, risk, and the time value of money to make informed decisions that maximize shareholder wealth.

Question 7

According to the text, the financial staff's role in the forecasting process is to:
A) develop different assumptions for different departments.
B) make sure that no biases are inherent in the forecasts.
C) ensure that all the costs like sunk costs are included in the forecasting.
D) set the sales price and coordinating marketing schemes for use by other departments.
E) provide a rough estimate of cash flows as sophisticated techniques are available to check their accuracy.

Accepted Answer

The text states that the financial staff's role is to "scrutinize each forecast for possible biases and ensure that no biases are inherent in any forecast." Therefore, option B is the correct answer. The other options are either not mentioned in the text or do not accurately reflect the financial staff's role in the forecasting process.

Question 8

One problem with Monte Carlo simulation analysis is that while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.

Accepted Answer

Monte Carlo simulation analysis provides probabilistic outcomes and a range of possible results, which can aid in understanding the riskiness of a project. However, the analysis does not provide a definitive decision on whether to accept or reject a project, as the decision ultimately depends on various factors such as the company's risk tolerance, financial goals, and overall strategy.

Question 9

When evaluating a new project, a firm should consider _____, as an incremental cash flow occurs only at the start of a project's life.
A) initial investment outlay
B) feasibility study cost
C) sunk costs
D) opportunity costs
E) externalities

Accepted Answer

When evaluating a new project, one of the most important considerations is the initial investment outlay, which refers to the cash flow required to start the project. This includes costs such as equipment, materials, labor, and any other expenses associated with getting the project off the ground. Other factors such as feasibility study costs, sunk costs, opportunity costs, and externalities may also be important to consider, but they do not directly impact the cash flow of the project at its inception. Therefore, A is the best choice.

Question 10

Which of the following is an incremental cash flow?
A) Market research costs
B) Change in working capital
C) Sunk costs
D) Opportunity costs
E) Externalities

Accepted Answer

Incremental cash flows are the additional cash flows that a firm receives or pays as a result of a particular decision. Change in working capital is an incremental cash flow, as it represents the change in a firm's current assets and liabilities due to the decision being made. Market research costs, sunk costs, opportunity costs, and externalities are not incremental cash flows. Market research costs and sunk costs are considered irrelevant to decision making as they are already incurred and cannot be recovered. Opportunity costs represent the benefits forgone by choosing one alternative over another, and externalities are societal costs or benefits that are not captured by the firm.

Question 11

Hill Top Lumber Company is considering building a sawmill in the state of Washington because the company doesn't have such a facility to service its growing customer base that is located on the west coast. Hill Top's executives believe that future growth in west coast customers will make the sawmill project a good investment. When evaluating the acceptability of the project, which of the following would be considered a relevant cash flow that should be included when determining its initial investment outlay?
A) Hill Top spent $150,000 to prepare the feasibility report of the project.
B) The cost of the project, $2 million, if invested in existing projects could have provided a return of $3.5milion
C) The expected inflation during the project's life is 3%.
D) It will cost $3 million to clear the land on which Hill Top wants to build the sawmill.
E) It is estimated that $20 million of business from existing customers will move to the new sawmill.

Accepted Answer

The cost of clearing the land on which the sawmill will be built is a relevant cash flow because it is an initial investment outlay that is necessary for the project. Choices A, B, C, and E are not relevant cash flows for determining the project's initial investment outlay. Choice A is a sunk cost that has already been incurred and is not relevant to the decision. Choice B is an opportunity cost that is not relevant to the decision. Choice C is a future inflation rate that is not relevant to the initial investment outlay. Choice E is a future cash flow, but it is not relevant to the initial investment outlay.

Question 12

A key difference between a replacement project analysis and an expansion project analysis is that only the expansion project uses the net present value (NPV) method for project evaluation.

Accepted Answer

This statement is incorrect. Both replacement and expansion project analyses can use the net present value (NPV) method for project evaluation. The method used for project evaluation depends on the specific circumstances and goals of the project.

Question 13

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

Accepted Answer

Since the asset has a higher beta than the current beta of the firm, it is considered to be more risky. Therefore, the firm should use a higher discount rate than their average required rate of return to account for the increased risk.

Question 14

When evaluating the cash flows associated with a capital budgeting project, shipping and installation costs associated with the purchase of an asset, such as a lathe, are considered part of the:
A) initial investment outlay because these expenses are effectively part of the asset's purchase price.
B) incremental operating cash flows because shipping and installation costs represent expenses that have to be written off over the life of the asset.
C) terminal cash flows, because these expenses aren't paid until the end of the asset's life.
D) sunk costs because these expenses do not affect any current or future cash flows associated with investing in the asset.
E) opportunity cost of the project because these costs are increasing the potential of the project.

Accepted Answer

Shipping and installation costs are considered part of the initial investment outlay because these expenses are effectively part of the asset's purchase price. They are essential for acquiring the asset, and without them, the asset cannot be put into service. Therefore, they are considered part of the initial cost of the investment and will affect the project's cash flows.

Question 15

Which of the following items is considered when computing the terminal cash flow for an expansion project?
A) Change in net working capital.
B) Inflation during the project's life.
C) Book value of the asset.
D) Opportunity cost of the project.
E) Sunk cost of the project.

Accepted Answer

The terminal cash flow includes the recovery of net working capital, which is initially invested and then recovered at the end of the project.

Question 16

If an asset being considered for acquisition has a beta of zero, its expected return will be equal to the risk-free rate.

Accepted Answer

If an asset has a beta of zero, it means it has no systematic risk and is not affected by market movements. In this case, the expected return of the asset will be equal to the risk-free rate, which is the return that an investor can achieve by investing in a risk-free asset such as a Treasury bill. Therefore, the statement is true.

Question 17

When a particular project might have very uncertain cash flows, the Monte Carlo simulation technique can be used to measure the net present value (NPV) of the cash flows to understand the outcomes for worst case scenario and best case scenario.

Accepted Answer

The answer of When a particular project might have very...

Question 18

Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because:
A) it represents a tax-deductible cash expense.
B) the firm has a cash outflow equal to the depreciation expense each year.
C) depreciation has an impact on the taxes paid by the firm, which is a cash flow.
D) depreciation is a sunk cost.
E) depreciation is a cash flow that doesn't change.

Accepted Answer

Depreciation has an impact on the taxes paid by the firm, which is a cash flow. Depreciation is a non-cash expense that reduces taxable income and therefore reduces taxes paid by the firm. This tax savings represents a cash flow that must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project. A is incorrect because depreciation is a non-cash expense, not a tax-deductible cash expense. B is incorrect because while the firm does have a cash outflow for the purchase of the asset, the depreciation expense is a non-cash expense. D is incorrect because depreciation is not a sunk cost - it is a non-cash expense that reduces the value of the asset over time. E is incorrect because depreciation is a non-cash expense that does change based on the method of depreciation and the useful life of the asset.

Question 19

Which of the following statements concerning cash flow evaluation in capital budgeting is correct?
A) When determining a project's terminal cash flows, it is generally assumed that the firm's operations do not return to the same level as they were before the project was purchased.
B) Any change in depreciation expense must be computed as it affects the cash flow of a project.
C) The relevant marginal cash flows associated with a project should always include depreciation, because depreciation is an annual operating expense that requires a cash payment.
D) If an asset is depreciated using the Modified Accelerated Cost Recovery System (MACRS), its depreciable basis is the amount that can be depreciated over the asset's useful life, which generally includes the purchase price minus any shipping and installation charges or other costs that are incurred in order to prepare the asset for use.
E) The sunk costs associated with an investment proposal are relevant cash flows for capital budgeting analysis, so they should not be included in the computation of the marginal cash flows.

Accepted Answer

Depreciation affects cash flow through tax savings, as it is a non-cash expense that reduces taxable income.

Question 20

Which of the following statements is true while considering an expansion project?
A) Depreciation expenses will be deducted from the net income to calculate supplemental operating cash flows.
B) The expansion project will be accepted if the net cash flows are negative.
C) Shipping and installation costs associated with preparing the machine to be used to produce the new product will be part of the initial outlay.
D) The cost of a product analysis completed in the previous tax year and specific to the new product will be included in the calculation of initial outlay.
E) Inflation rates during the new project's life will be incorporated in the cash flows.

Accepted Answer

Shipping and installation costs are part of the initial outlay as they are necessary to get the asset ready for use.

Quiz 10: Project Cash Flows and Risk

Which of the following statements is true regarding a replacement decision?

Which of the following statements is true about relevant cash flows?

Quantification of risk is difficult, and there are different types of risks like stand-alone risk, market risk and political risk. Sensitivity analysis is a good technique to measure market risk.

A sunk cost is a cash outlay that has already been incurred and that cannot be recovered regardless of whether the project is accepted or rejected. These sunk costs are extremely important in capital budgeting decisions.

Which of the following rules is essential for successful cash flow estimates, and ultimately, to successful capital budgeting?

Capital budgeting decisions must be based on the accounting income the project generates since stockholders are concerned with the reported net income the firm generates.

According to the text, the financial staff's role in the forecasting process is to:

One problem with Monte Carlo simulation analysis is that while the simulation may provide some insights into the riskiness of a project, the analysis does not lead to a clear-cut accept versus reject decision.

When evaluating a new project, a firm should consider _____, as an incremental cash flow occurs only at the start of a project's life.

Which of the following is an incremental cash flow?

A key difference between a replacement project analysis and an expansion project analysis is that only the expansion project uses the net present value (NPV) method for project evaluation.

If a firm is considering purchasing an asset whose beta is greater than the current beta of the firm, it should use a discount rate greater than the firm's average required rate of return to evaluate the possible investment.

When evaluating the cash flows associated with a capital budgeting project, shipping and installation costs associated with the purchase of an asset, such as a lathe, are considered part of the:

Which of the following items is considered when computing the terminal cash flow for an expansion project?

If an asset being considered for acquisition has a beta of zero, its expected return will be equal to the risk-free rate.

When a particular project might have very uncertain cash flows, the Monte Carlo simulation technique can be used to measure the net present value (NPV) of the cash flows to understand the outcomes for worst case scenario and best case scenario.

Depreciation must be considered when evaluating the incremental operating cash flows associated with a capital budgeting project because:

Which of the following statements concerning cash flow evaluation in capital budgeting is correct?

Which of the following statements is true while considering an expansion project?