Deck 11: Cash Flows and Capital Budgeting

Question 1

The stand-alone principle says that we can treat a project as if it were a stand-alone company that has its own revenue, expenses, and investment requirements.

Answer 1

True

Question 2

Accounting earnings are a reliable measure of the costs and benefits of a project.

Answer 2

False

Question 3

Allocated costs such as corporate overhead should be included in cash flow calculations.

Answer 3

False

Question 4

Incremental cash flow from operations is the cash flow from a project that is expected to be generated after all operating expenses and taxes have been paid.

Question 5

Since our perspective when evaluating a project is that of all the shareholders only, then we should evaluate the after-tax cash flows produced by a project.

Question 6

If taken without accompanying changes in cash flow, changes in a company's accounting earnings do not impact the overall value of the company.

Question 7

If a company expects to increase its investment in inventory due to a prospective project, then this is an example of an incremental capital expenditure.

Question 8

If you start with incremental net operating profits after tax (NOPAT) and add depreciation and amortisation to it, then you will obtain incremental cash flow from operations.

Question 9

Opportunity costs should always be included in the cash flow calculations of a project.

Question 10

The impact of a project on another project's cash flows should be ignored.

Question 11

The purchase of a factory building for a prospective project is an example of an incremental addition to working capital.

Question 12

Nominal interest rates incorporate the expected rate of inflation.

Question 13

When evaluating a project on behalf of all of the investors in the company, creditors as well as shareholders, we should make our investment decision based on the pretax cash flows produced by a project.

Question 14

Free cash flow equals cash flow from operations minus required investments.

Question 15

Increases in working capital are considered cash flows associated with investments.

Question 16

BioGeological Pharmaceuticals invested $100 million on a heart drug that does not prevent heart disease. BioGeological has since found that the drug does prevent diabetes. When considering whether to market the drug as a diabetic panacea, the company should consider the $100 million spent while investigating the heart-related effects.

Question 17

When analysing a project, if the expected future cash flows are denominated in nominal dollars, then the discount rate should represent a nominal rate as well.

Question 18

The term incremental in the context of incremental after-tax free cash flows refers to the fact that the company's total after-tax free cash flows will change if the new project is adopted.

Question 19

Conceptually, free cash flows are what are left over for distribution to creditors and shareholders after the company has made the necessary investments in working capital and long-term assets.

Question 20

The research and development costs to date of a project should be considered when analysing the cash flows of a prospective project.

Question 21

In order to calculate free cash flow by starting with incremental cash flow from operations, we should

A) subtract the incremental capital expenditures and add the incremental additions to working capital.
B) add the incremental capital expenditures and the incremental additions to working capital.
C) subtract the incremental capital expenditures and the incremental additions to working capital.
D) None of the above.

Question 22

It is possible for a company to choose between a depreciation schedule based on either the straight-line or the reducing-balance for financial reporting purposes.

Question 23

You own a uranium mine, and the price of uranium is expected to increase at a rate of 3 percent per year. The cost of capital for your company is 15 percent, and you are evaluating whether or not to begin harvesting the element. The correct choice is to begin harvesting immediately if the current NPV of the project is positive.

Question 24

The NPV of a project is estimated by

A) discounting the expected cash flows of a project in the future.
B) discounting only the certain cash flows of a project in the future.
C) discounting the variance of the expected cash flows of a project in the future.
D) none of the above.

Question 25

The idea that we can evaluate the cash flows from a project independently of the cash flows for the company is known as

A) the stand-alone principle.
B) the dependent principle.
C) the independent principle.
D) none of the above.

Question 26

The written down value of an asset is the total cost of investment less accumulated depreciation.

Question 27

If the salvage value, at the time of an asset disposition, is less than the book value of the asset, then the company will effectively receive a positive cash flow from taxes on the sale.

Question 28

If the price of corn is $100 per bushel and the nominal rate of interest is 10 percent, then the real price of corn in the next period should also be $100.

Question 29

The unadjusted NPV of two projects with different useful lives can be compared to evaluate which project is the better of the two.

Question 30

Which of the following should not be included in a project's cash flow calculations?

A) cash expenses
B) cash revenues
C) allocated expenses
D) none of the above

Question 31

The cash flows used in capital budgeting calculations are based on.

A) historical estimates.
B) forecasts of future cash revenues, expenses, and investment outlays.
C) forecasts of profit.
D) forecasts of retained earnings available for financing projects.

Question 32

A progressive tax system means that a taxpayer will pay a higher tax rate for a given dollar of earnings for every successive year.

Question 33

Terminal-year free cash flows may differ from the cash flows provided in the typical year of a project for reasons such as the return/repayment of increases/reductions in additional working capital in the prior years.

Question 34

The expected cash flows for a project are fixed amounts that have zero variability in the projected values.

Question 35

Additions to tangible assets, intangible assets, and current assets can be described as

A) cash flows associated with investments.
B) operating cash flows.
C) free cash flows.
D) none of the above.

Question 36

Corporate overhead allocations should only be taken into account on project analysis if

A) the company is currently covering all of its overhead allocations.
B) the company is currently unable to cover all of its overhead allocations.
C) the overhead allocations involve cash expenditures.
D) none of the above.

Question 37

_________ refers to the cash flow that a project is expected to generate after all operating expenses and taxes have been paid.

A) Incremental cash flow from operations
B) Operating income
C) EBITDA
D) None of the above

Question 38

The company's ____________ is used to calculate NOPAT because the profits from a project are assumed to be incremental to the company.

A) fixed tax rate
B) company tax rate
C) marginal tax rate
D) none of the above

Question 39

The impact of a project on a company's overall value depends on

A) a company's accounting earnings.
B) a company's cash flow.
C) a project's cash flow.
D) none of the above.

Question 40

The term ___________ refers to the fact that these cash flows reflect the amount by which the company's total after-tax free cash flows will change if the project is adopted.

A) periodic
B) ending cash flows
C) incremental
D) none of the above

Question 41

A company is considering taking a project that will produce $12 million of revenue per year. Cash expenses will be $5 million, and depreciation expenses will be $1 million per year. If the company takes that project, then it will reduce the cash revenues of an existing project by $2 million. What is the free cash flow on the project, per year, if the company is in the 40 percent marginal tax rate?

A) $2.4 million
B) $3.4 million
C) $4.6 million
D) $5.0 million

Question 42

In order for a project to generate a positive net working capital cash flow at the conclusion of a project,

A) the project must have generated a cumulative negative cash flow during the life of the project.
B) the project must have generated a cumulative positive cash flow during the life of the project.
C) the project must have generated a cumulative negative cash flow at the conclusion of the project.
D) the project could not have generated a positive cash flow at the opening of the project.

Question 43

If a company has the option of leasing some factory space to another company or utilising it for another product line, then if the company chose the product line how should it handle the lost lease payments on the factory space?

A) Ignore it.
B) Include it as an opportunity cost.
C) Include half of it as additional revenue for the project.
D) None of the above.

Question 44

Stillwater Drinks is trying to determine when to harvest the water from the fountain of youth that it currently owns. If it harvests the water in year 1, the NPV of the project would increase over an immediate harvest by 18 percent. A year 2 harvest would create an NPV increase of 12 percent over that of year 1 and year 3 would create an NPV increase of 8 percent over that of year 2. If the cost of capital is 17 percent for Stillwater, then which harvest year would maximise the NPV for the company? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.
B) Harvest in year 1.
C) Harvest in year 2.
D) Harvest in year 3.

Question 45

For any Australian company all income is taxed at,

A) 30%.
B) 35%.
C) 40%.
D) none of the above.

Question 46

Company tax rates: Which of following business types has the lowest tax rate in Australia?

A) Corporate limited partnerships
B) Public trading trusts
C) Superannuation funds
D) Private companies

Question 47

If you are deciding whether to take one project or another, where the projects have different useful lives, then you could utilise

A) a repeated investment analysis to decide which project is better for the company.
B) an equivalent annual annuity analysis to decide which project is better for the company.
C) either of the above.
D) none of the above.

Question 48

If you are discounting a project's cash flows using the nominal cost of capital, then that means that you have taken the following into account:

A) the real rate of return
B) the expected rate of inflation
C) both of the above
D) none of the above

Question 49

When compared to the straight-line depreciation method, reducing-balance method has

A) a greater proportion of its depreciation early in the life of the asset.
B) a lesser proportion of its depreciation early in the life of the asset.
C) an equal proportion of its depreciation early in the life of the asset.
D) none of the above.

Question 50

_____________ represent dollars stated in terms of constant purchasing power.

A) Nominal dollars
B) Real dollars
C) Inflated dollars
D) None of the above

Question 51

The proper time to harvest an asset is when

A) the percentage NPV increase of harvesting a project at a future point in time is at the last date where the increase is greater than the cost of capital.
B) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is less than the cost of capital.
C) the percentage NPV increase of harvesting a project at a future point in time is at the first date where the increase is greater than the cost of capital.
D) none of the above.

Question 52

Company tax rates: Using the Australian company tax rate, calculate the total taxes payable for Lansing, Ltd., this year. Lansing's pretax income was $275,000.

A) $22,500
B) $68,250
C) $82,500
D) $107,250

Question 53

Windy Burgers is trying to determine when to harvest a herd of cows that it currently owns. If it harvests the herd in year 1, the NPV of the project would increase over an immediate harvest by 25 percent. A year 2 harvest would create an NPV increase of 15 percent over that of year 1 and year 3 would create an NPV increase of 7 percent over that of year 2. If the cost of capital is 12 percent for Windy, then which harvest year would maximise the NPV for the company? Assume that all NPVs are calculated from the perspective of today.

A) Harvest immediately.
B) Harvest in year 1.
C) Harvest in year 2.
D) Harvest in year 3.

Question 54

Brown Mack Ltd currently has two large manufacturing divisions that share a single plant. Brown Mack owns the plant but has calculated that $6 million of overhead expenses should be allocated to the two equal-sized divisions. If Brown Mack starts a third manufacturing division, of equal size to the other two divisions, then what overhead cost should the new division take into account on its capital budgeting cash flow analysis?

A) $0
B) $2 million
C) $3 million
D) $6 million

Question 55

A tax system in which taxpayers pay a progressively larger share of their income in taxes as their income rises is called

A) a flat tax system.
B) a progressive tax system.
C) a digressive tax system.
D) a political tax system.

Question 56

If inflation is anticipated to be 10 percent during the next year while a nominal rate of 20 percent will be earned on government bonds, then what is the accurate real rate of return on these securities?

A) 20.00%
B) 10.00%
C) 9.09%
D) None of the above

Question 57

Norman, Ltd is considering two mutually exclusive projects. Project A is a six-year project with a NPV of $3,000 and Project B is a four-year project with an NPV of $2,278. Project A has an EAC of $730 and Project B has an EAC of $750. Which project should the company select?

A) Choose Project A because it has the higher NPV.
B) Choose Project B because it has the lower NPV.
C) Choose Project B because it has the higher EAC.
D) Choose Project A because it has the lower EAC.

Question 58

Whenever a project has a negative impact on an existing project's cash flows, then that effect should

A) be ignored.
B) be ignored if the project is evaluated using the correct cost of capital.
C) be included as a negative revenue amount on the new project's cash flow analysis.
D) be included if the impact is limited to non-cash expenditures.

Question 59

If the real return on government bonds is 14 percent while the rate of expected inflation is anticipated to be 8 percent, then what should nominal rate of return be?

A) 14.00%
B) 33.00%
C) 23.12%
D) all of the above

Question 60

Which of the following is the best example of a sunk cost?

A) Future payments on a leased building.
B) Future research and development costs.
C) Historical research and development costs.
D) Historical non-cash expenses.

Question 61

Projects with different lives: Your company is deciding whether to purchase a durable delivery vehicle or a short-term vehicle. The durable vehicle costs $25,000 and should last five years. The short-term vehicle costs $10,000 and should last two years. If the cost of capital for the company is 15 percent, then what is the equivalent annual cost for the best choice for the company? (Round to the nearest dollar.)

A) $5,000, either vehicle
B) $5,000, short-term vehicle
C) $6,151, short-term vehicle
D) $7,458, long-term vehicle

Question 62

Briefly explain the two methods of comparing projects with different useful lives.

Question 63

Computing the terminal-year FCF: Miles Cyprus Company purchased a truck that currently has a book value of $1,000. If the company sells the truck for $5,000 today, then what is the amount of cash that it will net after taxes if the company is subject to a 30 percent company tax rate?

A) $1,200
B) $3,800
C) $4,000
D) $5,000

Question 64

The cost of using an existing asset: Small Appliances Ltd is considering starting a new line of business with the excess capacity it currently has on its rivet machine. The current machine is expected to last four years at the current rate of production. However, if a new line of business is taken on, then the machine will have to be replaced in three years instead of four. A new machine that will last four years would cost $50,000. What is the cost of taking on the new line of business? Round to the nearest dollar and assume a 9 percent cost of capital.

A) $11,917
B) $12,500
C) $15,433
D) $50,000

Question 65

Why is depreciation and amortisation added back when calculating free cash flows generated by a project?

Question 66

When to replace an asset: Nemo Haulers is considering whether to purchase a new mini tractor for moving furniture within its warehouse. Nemo calculates that its current mini tractor generates $3,100 of cash flow per year. A new mini tractor would cost $3,000 and would provide cash flow of $4,000 per year for five years. What is the equivalent annual cash flow for the new mini tractor (round to the nearest dollar), and should Nemo purchase the new tractor? Assume the cost of capital for Nemo is 10 percent.

A) $3,000, do not purchase the new tractor
B) $3,209, purchase the new tractor
C) $4,000, purchase the new tractor
D) $12,163, purchase the new tractor

Question 67

When to replace an asset: Burt's Pizzas is considering whether to purchase an oven. Burt's calculates that its current oven generates $4,000 of cash flow per year. A new oven would cost $15,000 and would provide cash flow of $6,000 per year for six years. What is the equivalent annual cash flow for the new oven (round to the nearest dollar), and should Burt's purchase the new oven? Assume the cost of capital for Burt's is 12 percent.

A) $2,352, do not purchase the oven
B) $6,000, purchase the oven
C) $9,668, purchase the oven
D) $24,668, purchase the new tractor

Question 68

Projects with different lives: Your company is deciding whether to purchase a high-quality printer for your office or one of lesser quality. The high-quality printer costs $40,000 and should last four years. The lesser quality printer costs $30,000 and should last three years. If the cost of capital for the company is 13 percent, then what is the equivalent annual cost for the best choice for the company? Round to the nearest dollar.

A) $10,000, either vehicle
B) $10,000, short-term vehicle
C) $12,706, short-term vehicle
D) $13,448, long-term vehicle

Question 69

Expected cash flows: FireRock Wheel Corp is evaluating a project in which there is a 40 percent probability of revenues totalling $3 million and a 60 percent probability of revenues totalling $1 million per year. If cash expenses will be $1.0 million while depreciation expense will be $200,000, then what is the expected free cash flow from taking the project if the company tax rate for the company is 30 percent?

A) $200,000
B) $420,000
C) $600,000
D) $620,000

Question 70

Computing the terminal-year FCF: Babaloo Nightclubs purchased a disco mirror that currently has a book value of $10,000. If Babaloo sells the disco mirror for $500 today, then what is the amount of cash that it will net after taxes if the company is subject to a 39 percent company tax rate?

A) $500
B) $3,705
C) $4,205
D) $9,500

Question 71

Explain why in practice the cash flows associated with a project are not certain cash flows.