Question 1

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 costs are accounted for separately when calculating the project's net present value (NPV) through the discount rate.

Question 2

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 for the investment project is the potential income that could be earned if the land were leased or sold to another party. This cost should be included in the analysis of the project's profitability and feasibility.

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 deductions in the earlier years.

Question 4

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 may have positive externalities that could lead to increased sales or negative externalities that could impose additional costs.

Question 5

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

This statement is true. Accelerated depreciation allows for larger tax deductions in the earlier years of an asset's life, resulting in higher tax savings and higher present value of those savings. Straight-line depreciation spreads the tax deductions evenly over the asset's useful life, resulting in a lower present value of tax savings.

Question 6

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 decision-making, they cannot fully overcome the problem of poor cash flow estimation, as the accuracy of these methods heavily depends on the quality of the underlying cash flow projections.

Question 7

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

It is true that evaluating each project with the appropriate risk-adjusted discount rate is one way to handle the problem of projects differing in risk. The risk-adjusted discount rate takes into account the level of risk associated with a project and adjusts the discount rate accordingly, so that projects with higher levels of risk are discounted at a higher rate. This helps to ensure that the cash flows from high-risk projects are appropriately valued and compared with the cash flows from lower-risk projects.

Question 8

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 because they can affect cash flows. For example, an increase in inventory will tie up cash and reduce available funds for other investments or expenses.

Question 9

Any cash flows that can be classified as incremental to a particular project¾i.e., results directly from the decision to undertake the project¾should be reflected in the capital budgeting analysis.

Accepted Answer

It is important to include all cash flows that are directly attributed to a project in the capital budgeting analysis as these are considered incremental cash flows. This helps in determining the net present value (NPV) and internal rate of return (IRR) of the project accurately, which aid in making informed investment decisions.

Question 10

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 cash flows related to the operating activities of the project. Working capital is an important part of the cash flow analysis and can impact the overall profitability of the project.

Question 11

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 provide a present value benefit to profitable firms by moving cash flows forward, but it can also lower reported profits due to higher depreciation expenses. However, different depreciation methods can be used for tax and stockholder reporting purposes to address this issue.

Question 12

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

Accelerated depreciation increases early cash flows due to tax savings, but it does not change the total cash flows over the project's life; it only affects the timing.

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 regulations, competition, or market trends, can impact the future cash flows of a firm. Hence, those externalities should be considered while estimating cash flows.

Question 14

The coefficient of variation, calculated as the standard deviation of expected returns divided by the expected return, is a standardized measure of the risk per unit of expected return.

Accepted Answer

The coefficient of variation is indeed calculated as the standard deviation of expected returns divided by the expected return, and it is a standardized measure of the risk per unit of expected return.

Question 15

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 making sound capital budgeting decisions, and while different methodologies can be used (such as NPV or IRR), the accuracy of the estimated cash flows is more important.

Question 16

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 still difficult to make accurate revenue forecasts for projects, even for large product development projects.

Question 17

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

Improvements in forecasting techniques may make it easier to estimate cash flows, but it is still a complex and critically important step in the capital budgeting process. Factors such as changing market conditions or unexpected costs can impact cash flow estimates, making it important for companies to carefully consider and review their projections.

Question 18

Suppose a firm's CFO thinks that an externality is present in a project, but that it cannot be quantified with any precision¾estimates of its effect would really just be guesses.In this case, the externality should be ignored¾i.e., not considered at all¾because 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 19

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 decreases the taxable income of the firm in the earlier years of the project, resulting in a higher tax shield and a higher cash flow in those earlier years. This higher cash flow will positively affect both NPV and IRR, making the project more attractive and more likely to be accepted.

Question 20

The standard deviation is a better measure of risk than the coefficient of variation if the expected returns of the securities being compared differ significantly.

Accepted Answer

The coefficient of variation is a better measure of risk when comparing securities with significantly different expected returns because it standardizes the risk per unit of return, allowing for a more meaningful comparison across different scales of expected returns.

Quiz 11: Cash flow estimation and risk analysis