Question 1

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 often included in a capital budgeting analysis through adjustments made to cash flow calculations, such as changes in working capital.

Question 2

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 benefits that could have been gained from the next best alternative option foregone. In terms of evaluating a project, opportunity costs include the potential cash inflows that could have been generated if the firm's assets were used for an alternative project or investment opportunity. Therefore, the statement is true.

Question 3

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 to assess the project's operational viability. Financing costs are considered separately in the calculation of the project's net present value through the discount rate.

Question 4

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 improvements in forecasting techniques have certainly made cash flow estimation more accurate, it is still a complex and uncertain process that requires careful analysis and consideration of various factors. Other steps in the capital budgeting process, such as evaluating the riskiness of the project and determining the appropriate discount rate, can also be difficult and time-consuming.

Question 5

Which of the following is NOT a relevant cash flow and thus should not be reflected in the analysis of a capital budgeting project?
A) Shipping and installation costs.
B) Cannibalization effects.
C) Opportunity costs.
D) Sunk costs that have been expensed for tax purposes.
E) Changes in net working capital.

Accepted Answer

Sunk costs that have already been expensed for tax purposes are not relevant for capital budgeting decisions as they cannot be recovered regardless of the investment decision. All other options listed are relevant cash flows that should be considered in capital budgeting analysis.

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

Question 7

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 8

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 are difficult to estimate in terms of revenues and costs, and therefore subjective judgment and discounted cash flow analysis are used to make estimations.

Question 9

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 also difficult to accurately forecast the revenues that a project will generate, even for large product development projects.

Question 10

Which of the following statements is CORRECT?
A) Sunk costs must be considered if the IRR method is used but not if the firm relies on the NPV method.
B) A good example of a sunk cost is a situation where a bank opens a new office, and that new office leads to a decline in deposits of the bank's other offices.
C) A good example of a sunk cost is money that a banking corporation spent last year to investigate the site for a new office, then expensed that cost for tax purposes, and now is deciding whether to go forward with the project.
D) If sunk costs are considered and reflected in a project's cash flows, then the project's calculated NPV will be higher than it otherwise would be.
E) An example of a sunk cost is the cost associated with restoring the site of a strip mine once the ore has been depleted.

Accepted Answer

Sunk costs are past costs that have already been incurred and cannot be recovered. They should not influence the decision-making process for future investments. Choice C accurately describes a sunk cost: money spent on investigating a site for a potential project, which is now a past expense and irrelevant to the decision on whether to proceed with the project.

Question 11

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 12

Which of the following statements is CORRECT?
A) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its customers.Thus, cannibalization is dealt with by society through the antitrust laws.
B) If cannibalization exists, then the cash flows associated with the project must be increased to offset these effects.Otherwise, the calculated NPV will be biased downward.
C) If cannibalization is determined to exist, then this means that the calculated NPV if cannibalization is considered will be higher than the NPV if this effect is not recognized.
D) Cannibalization, as described in the text, is a type of externality that is not against the law, and any harm it causes is done to the firm itself.
E) If a firm is found guilty of cannibalization in a court of law, then it is judged to have taken unfair advantage of its competitors.Thus, cannibalization is dealt with by society through the antitrust laws.

Accepted Answer

Cannibalization refers to a situation where a company's new product eats into the sales of one of its existing products. This is not illegal or dealt with through antitrust laws; rather, it's a strategic and financial consideration for the company itself.

Question 13

Which of the following statements is CORRECT?
A) A sunk cost is any cost that was expended in the past but can be recovered if the firm decides not to go forward with the project.
B) A sunk cost is a cost that was incurred and expensed in the past and cannot be recovered if the firm decides not to go forward with the project.
C) Sunk costs were formerly hard to deal with but now that the NPV method is widely used, it is possible to simply include sunk costs in the cash flows and then calculate the PV of the project.
D) A good example of a sunk cost is a situation where Home Depot opens a new store, and that leads to a decline in sales of one of the firm's existing stores.
E) A sunk cost is any cost that must be expended in order to complete a project and bring it into operation.

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 the project. It is irrelevant to future decision making and should not be included in the decision making process.

Question 14

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 correct approach in the NPV (Net Present Value) equation is to use cash flows, not income calculated according to generally accepted accounting principles (GAAP). Incremental cash flows are indeed important, but the emphasis is on cash flows rather than accounting income for accurate capital budgeting decisions.

Question 15

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

Accepted Answer

Ignoring an externality simply because it cannot be precisely quantified can lead to a misinformed decision-making process. It's important to acknowledge and attempt to estimate its impact as best as possible, even if through qualitative measures, to ensure a more comprehensive analysis of the project's potential effects.

Question 16

Which of the following statements is CORRECT?
A) An example of an externality is a situation where a bank opens a new office, and that new office causes deposits in the bank's other offices to decline.
B) The NPV method automatically deals correctly with externalities, even if the externalities are not specifically identified, but the IRR method does not.This is another reason to favor the NPV.
C) Both the NPV and IRR methods deal correctly with externalities, even if the externalities are not specifically identified.However, the payback method does not.
D) Identifying an externality can never lead to an increase in the calculated NPV.
E) An externality is a situation where a project would have an adverse effect on some other part of the firm's overall operations.If the project would have a favorable effect on other operations, then this is not an externality.

Accepted Answer

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

Question 17

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

Accepted Answer

Cash flows that are directly related to a project should be considered in capital budgeting analysis to evaluate the profitability of the project.

Question 18

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

When an investment project would use land that the firm already owns, the project should still be charged with the opportunity cost of the land. This is because the land could have been used for alternative purposes or could have been sold or leased to generate income or returns. Hence, the land still has value which should be considered in the investment decision-making process.

Question 19

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 feasibility of a project and making investment decisions. While methodology is important in evaluating the expected returns and risks of a project, the accuracy of cash flow estimates is paramount. Without accurate cash flow estimates, any analysis based on NPV or IRR would be flawed.

Question 20

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 a significant impact on a firm's long-term cash flows and should therefore be factored into cash flow estimation. For example, negative externalities such as pollution can lead to legal and regulatory costs, while positive externalities such as improving infrastructure can lead to increased demand for a company's products or services.

Quiz 11: Cash Flow Estimation and Risk Analysis

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.

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.

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.

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

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

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.

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.

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.

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

Which of the following statements is CORRECT?

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

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.

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.

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.