Question 1

Which of the following statements is CORRECT?

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 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 is the forgone alternative use of the land, such as selling or leasing it. Therefore, the project should be charged with the opportunity cost of the land in order to properly account for all costs and make an informed investment decision.

Question 3

Which of the following statements is CORRECT?

Accepted Answer

A

Question 4

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 5

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, which are costs or benefits imposed onto third parties, can affect a firm's long-term cash flows. For example, a manufacturing firm that pollutes a nearby river may face increased regulatory costs or reputational damage that could affect its cash flows in the long run. Therefore, when estimating cash flows, it is important to consider externalities that may affect the firm's financial performance.

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 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 7

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 suboptimal decision-making. Even if an externality cannot be precisely quantified, it is important to acknowledge its presence and attempt to account for its potential impact in the analysis, using a range of estimates or qualitative assessments if necessary. This approach ensures a more comprehensive evaluation of the project's potential effects.

Question 8

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 9

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 that could be generated from the next best alternative when making a decision. In the context of capital budgeting, it means 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 10

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 11

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 irrelevant for capital budgeting decisions as they are not future cash flows that will be affected by the project. All other options listed are relevant cash flows that should be included in the analysis.

Question 12

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 13

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 should be considered in capital budgeting analysis as they are a direct result of the project decision.

Question 14

Which of the following statements is CORRECT?

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 correctly identifies a sunk cost as the money spent and expensed for tax purposes on investigating a site for a potential new office, which is now a past expense irrelevant to the decision on whether to proceed with the project.

Question 15

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 the project. This cost should not be considered in deciding whether to go forward with the project, as it no longer affects the cash flows of the project. Instead, only future costs and benefits should be considered when making the decision. Option A is incorrect because a sunk cost cannot be recovered. Option C is incorrect because sunk costs should not be included in cash flows. Option D is incorrect because a decline in sales of an existing store is not a sunk cost. Option E is incorrect because any cost that must be expended to complete a project is not necessarily a sunk cost.

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, predicting the revenues generated by a project is often difficult, as it depends on various factors such as market conditions and consumer behavior.

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

While forecasting techniques have certainly improved, estimating cash flows is still a complex and challenging step in the capital budgeting process as it involves predicting future revenue and expenses with a level of uncertainty.

Question 18

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

Due to the complexity and uncertainty involved in long-term projects, it can be difficult to make accurate financial projections. As a result, subjective judgment is often utilized along with discounted cash flow analysis to estimate revenues and costs.

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 for capital budgeting decisions and is often challenging. While methodology (such as NPV versus IRR) is important, it is secondary to the accuracy of the cash flow estimates.

Question 20

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, as they can affect the cash flows of a project. For example, an increase in inventory means a larger investment in working capital, which results in a cash outflow.

Quiz 11: Cash Flow Estimation and Risk Analysis

Which of the following statements is CORRECT?

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.

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.

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.

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

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.

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.

Which of the following statements is CORRECT?

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.

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

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.

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.

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.