Question 1

Which of the following statements is CORRECT?

Accepted Answer

C

Question 2

Suppose Walker Publishing Company is considering bringing out a new finance text whose projected revenues include some revenues that will be taken away from another of Walker's books. The lost sales on the older book are a sunk cost and as such should not be considered in the analysis for the new book.

Accepted Answer

The lost sales on the older book are considered an opportunity cost, not a sunk cost, and should be included in the analysis for the new book to accurately assess its financial impact.

Question 3

Which of the following statements is CORRECT?

Accepted Answer

Cannibalization refers to a situation where a new product eats into the sales of the firm's existing products. It is an internal issue and not illegal, as it affects the firm's own sales and profits.

Question 4

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 cash flows and should be considered in capital budgeting analysis, especially when estimating net working capital requirements.

Question 5

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 6

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

Accepted Answer

Sunk costs that have already been expensed for tax purposes are not relevant for capital budgeting decisions because they have already been paid and cannot be recovered. The other options (shipping and installation costs, cannibalization effects, opportunity costs, and changes in net working capital) are all relevant cash flows that must be considered in capital budgeting analysis.

Question 7

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

Since the land is currently owned by the firm, it could have been otherwise used for an alternative purpose. Hence, the opportunity cost of the land needs to be considered in the investment decision of the project.

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.

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.

Question 9

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 crucial in determining the profitability of the project and whether it should be pursued or not. Methodology, such as NPV and IRR, is important in analyzing the project, but accurate cash flow estimates are the foundation of the decision-making process.

Question 10

Which of the following statements is CORRECT?

Accepted Answer

A sunk cost is a cost that has already been incurred and cannot be recovered if the firm decides not to go forward with a project. It is irrelevant to the decision-making process and should not be considered when evaluating the potential profitability of a project. Option A is incorrect because sunk costs cannot be recovered, regardless of whether the project is accepted or rejected. Option C is incorrect because sunk costs should not be included in cash flow calculations. Option D is incorrect because it describes a cost that is not a sunk cost, but rather a consequence of opening a new store. Option E is incorrect because it describes a project cost that is not necessarily sunk, but rather a necessary cost to complete the project.

Question 11

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 can have an impact on a firm's cash flows in the long run, and therefore, must be considered during cash flow estimation. Failure to take externalities into account could lead to inaccurate cash flow projections and financial decisions. Examples of externalities that can affect a business's cash flow include changes in government regulations, shifts in customer preferences, and fluctuating market prices.

Question 12

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 process that involves uncertainties and biases. It requires careful analysis of market trends, sales forecasts, operating costs, tax implications, and other factors that can affect the profitability and risk of a project. Moreover, cash flow estimates should be adjusted for the time value of money, inflation, and other financial metrics to ensure that they reflect the economic reality of the investment. Therefore, while forecasting techniques can enhance the accuracy and reliability of cash flow estimates, they do not make the process easy or straightforward.

Question 13

Any cash flows that can be classified as incremental to a particular project-i.e., results directly from the decision to undertake the projectσshould be reflected in the capital budgeting analysis.

Accepted Answer

Incremental cash flows are relevant and should be considered in capital budgeting analysis because they are directly related to the decision to undertake the project. Any cash flows that would not occur if the project is not undertaken are incremental cash flows.

Question 14

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

Large, complex projects with a long development timeline can be subject to many uncertainties, making it difficult to accurately estimate revenues and costs. The use of subjective judgment and discounted cash flow analysis can help provide a more comprehensive understanding of the potential financial outcomes of the project.

Question 15

Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.

Accepted Answer

Opportunity costs refer to the potential benefits forgone by choosing one alternative over another. In the context of capital budgeting, opportunity costs include the cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated. Therefore, the statement is true.

Question 16

Which of the following statements is CORRECT?

Accepted Answer

The answer of Which of the following statements is CORRECT?
...

Question 17

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 18

The 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 because in the NPV (Net Present Value) equation, the numerator should use cash flows, not income calculated in accordance with generally accepted accounting principles (GAAP). The second rule is correct, as all incremental cash flows should indeed be considered in making accept/reject decisions.

Question 19

Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precisionσestimates of its effect would really just be guesses. In this case, the externality should be ignored-i.e., not considered at allσbecause if it were considered it would make the analysis appear more precise than it really is.

Accepted Answer

If the externality is potentially important, it should not be ignored, because then a large error might be made. At the very least, it should be discussed, and possibly the analysis should be done using several scenarios of the possible effects of the externality.

Question 20

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 usually be forecasted accurately, revenue projections for a project are often uncertain and can vary greatly.

Quiz 13: Capital Budgeting-Estimating Cash Flows and Analyzing Risk

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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.

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.

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?

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.

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.

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.

Which of the following statements is CORRECT?

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.

Because of improvements in forecasting techniques, estimating the cash flows associated with a project has become the easiest step in the capital budgeting process.

Any cash flows that can be classified as incremental to a particular project-i.e., results directly from the decision to undertake the projectσshould be reflected in the capital budgeting analysis.

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.

Opportunity costs include those cash inflows that could be generated from assets the firm already owns if those assets are not used for the project being evaluated.

Which of the following statements is CORRECT?

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.