Question 1

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

This statement is true. While methodology is important in the capital budgeting process, accurately estimating project cash flows is crucial. The use of NPV or IRR can vary, but without reliable estimates of cash inflows and outflows, the methodology becomes less relevant.

Question 2

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 3

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 often associated with a high degree of uncertainty, which makes it difficult to estimate the revenues and costs accurately. As a result, subjective judgment is often used along with quantitative methods like discounted cash flow analysis to arrive at a more realistic estimate of the project's financial performance.

Question 4

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 a firm uses its own land for an investment project, it forgoes the opportunity to use or sell the land for other purposes. This means that there is an opportunity cost associated with using the land, and the project should be charged with that cost in order to accurately reflect the true cost of the investment.

Question 5

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

Using different depreciation methods for tax and stockholder reporting purposes can help solve the problem of lowered reported profits due to accelerated depreciation.

Question 6

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 expenses in the earlier years.

Question 7

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 can affect cash flows and should be taken into consideration in a capital budgeting analysis.

Question 8

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 environmental or social impacts, can have long-term effects on a firm's cash flows. Therefore, it is important to consider them in cash flow estimation.

Question 9

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 for capital budgeting projects.

Accepted Answer

The answer of Superior analytical techniques, such as NPV, used...

Question 10

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 revenue a project will generate, even for large product development projects.

Question 11

The two cardinal rules that financial analysts should follow to avoid 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 for capital budgeting projects.

Accepted Answer

The answer of The two cardinal rules that financial analysts...

Question 12

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

Incremental cash flows are relevant in capital budgeting analysis as they directly result from the decision to undertake the project. Therefore, they must be included in the analysis to accurately determine the project's net present value, internal rate of return, and other financial metrics.

Question 13

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 provides larger tax savings in the early years of a project's life, which increases the cash flows in those years and therefore increases the NPV and IRR.

Question 14

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

The answer of Typically, a project will have a higher...

Question 15

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 and uncertain process. It involves making assumptions about future revenue, expenses, and other factors that can be difficult to predict with certainty. Other steps in the capital budgeting process, such as evaluating the risk of the project and determining the appropriate discount rate, can also be challenging.

Question 16

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

This is true as using a risk-adjusted discount rate accounts for the differing risk levels of each project and adjusts the discount rate accordingly, providing a more accurate evaluation of the project's potential future cash flows.

Question 17

Changes in net operating 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 operating working capital should be reflected in a capital budgeting cash flow analysis because working capital is a necessary component to the operation of fixed assets.

Question 18

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 19

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

Even if the externality cannot be precisely quantified, it still has potential impacts on the project and should be considered in a qualitative manner. Ignoring it completely can lead to incomplete analysis and potential negative consequences.

Question 20

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

Accelerated depreciation provides larger tax savings in the earlier years of an asset's life, which in turn has a higher present value than the tax savings provided by straight-line depreciation.

Quiz 12: Cash Flow and Risk